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Day 5 – Monday, July 26
III.
CORPORATE GOVERNANCE
Welcome back from your relaxing weekend and to our scintillating course on
comparative company law. This week we look at how power is allocated within the corporation.
As you remember, last week we looked at how corporations are regulated in the United States and
Europe – starting with the contract/institution debate, then looking at the basics of corporate law,
next focusing on the protections given non-shareholder creditors, and finally considering the
source of corporate/company law.
Now it’s time to look at the essence of corporate law – the ways in which power is
allocated between shareholders (capital) and management (labor). We first look at how business
profits are allocated in the US corporation and the Italian company – who makes the decision and
what judicial oversight is there of the internal process? We then turn to the question of the
purpose of the corporation/company and the responsibility of managers to non-shareholder
constituents – comparing the US approach and the European approach.
After this look at corporate governance, we turn our sights to shareholder protection. We
first consider the ways in which shareholders and stock markets are protected from those who
seek to exploit unfair informational advantages – looking at the similarities and differences in the
regulation of “insider trading” in the United States and Europe. We then wrap up this whirlwind
course looking at how financial fraud in US corporations has differed from fraud in European
companies – comparing the Enron scandal with the Parmalat scandal.
Then we will each get on an airplane, train or vaporetto, and return to our regular lives,
forever enriched by this comparative experience – especially with each other.
A.
Power Over Business Earnings
One of the main attributes of any business organization is how business profits are
allocated. Do they go entirely to the shareholders or do managers also share in them? This is an
age-old question. Remember in medieval Venice, profits in colleganze were divided between
capital contributors and labor contributors (with capital contributors getting the lion’s share,
reflecting that capital may be scarcer and thus more highly valued than labor). But then after a
few centuries, capital contributors kept all the profits and just paid labor a fixed salary.
In the modern corporation/company, shareholders have a right to profits – though there is
a question of timing. Must the profits be distributed when earned, or can they be accumulated
within the business to make even more profits and then distributed later? That is the question that
we first take up. Is the decision to retain profits one for the managers (the corporate board of
directors) or for the shareholders? And if shareholders are unhappy with how profits are
distributed, can they go to court and compel the board to act in a particular way? Interesting
questions – let’s find out.
1.
Locus of corporate power in the United States
We start in the United States by looking at the Delaware corporate statute, a typical one
in this regard. Who has power under Delaware law to decide the business affairs of the
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corporation, including the distribution of profits? Are there any protections for shareholders who
are unhappy with the allocation of power? We read a famous Delaware case that lays out the
nature of judicial review of corporate dividend policy in public corporations. We then read
another Delaware case that deals with the same issue in a closely-held corporations. What’s your
guess – different kinds of review for different kinds of businesses?
DELAWARE GENERAL CORPORATION LAW
Subchapter IV. Directors and Officers
§ 141. Board of Directors; Powers
(a) The business and affairs of every corporation organized under this chapter shall be
managed by of under the direction of the board of directors, . . . .
***
§ 170. Dividends; Payment
(a) The directors of every corporation, subject to any restrictions contained in its
certificate of incorporation, may declare and pay dividends upon the shares of its capital stock
…. either (1) out of its surplus, as defined in and computed in accordance with ‘’ 154 and 244 of
this title, or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in
which the dividend is declared and/or the preceding fiscal year.
___________________
Sinclair Oil Corp. v. Levien
Supreme Court of Delaware
280 A.2d 717 (1971)
This is an appeal by the defendant, Sinclair Oil Corporation (hereafter Sinclair), from an
order of the Court of Chancery in a derivative action [brought by minority shareholders of a
subsidiary corporation on behalf of the subsidiary] requiring Sinclair to account for damages
sustained by its subsidiary, Sinclair Venezuelan Oil Company (hereafter Sinven), organized by
Sinclair for the purpose of operating in Venezuela, as a result of dividends paid by Sinven, the
denial to Sinven of industrial development, and a breach of contract between Sinclair's
wholly-owned subsidiary, Sinclair International Oil Company, and Sinven.
THE FACTS
Sinclair, operating primarily as a holding company, is in the business of exploring for oil
and of producing and marketing crude oil and oil products. At all times relevant to this litigation,
it owned about 97% of Sinven's stock. The plaintiff owns about 3000 of 120,000 publicly held
shares of Sinven. Sinven, incorporated in 1922, has been engaged in petroleum operations
primarily in Venezuela and since 1959 has operated exclusively in Venezuela.
Sinclair nominates all members of Sinven's board of directors. The Chancellor found as a
fact that the directors were not independent of Sinclair. Almost without exception, they were
officers, directors, or employees of corporations in the Sinclair complex. By reason of Sinclair's
domination, it is clear that Sinclair owed Sinven a fiduciary duty. [cites omitted] Sinclair
concedes this.
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STANDARD OF REVIEW
The Chancellor held that because of Sinclair's fiduciary duty and its control over Sinven,
its relationship with Sinven must meet the test of intrinsic fairness. The standard of intrinsic
fairness involves both a high degree of fairness and a shift in the burden of proof. Under this
standard the burden is on Sinclair to prove, subject to careful judicial scrutiny, that its
transactions with Sinven were objectively fair.
Sinclair argues that the transactions between it and Sinven should be tested, not by the
test of intrinsic fairness with the accompanying shift of the burden of proof, but by the business
judgment rule under which a court will not interfere with the judgment of a board of directors
unless there is a showing of gross and palpable overreaching. A board of directors enjoys a
presumption of sound business judgment, and its decisions will not be disturbed if they can be
attributed to any rational business purpose. A court under such circumstances will not substitute
its own notions of what is or is not sound business judgment.
We think, however, that Sinclair's argument in this respect is misconceived. When the
situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing
the terms, the test of intrinsic fairness, with its resulting shifting of the burden of proof, is applied.
The basic situation for the application of the rule is the one in which the parent has received a
benefit to the exclusion and at the expense of the subsidiary.
A parent does indeed owe a fiduciary duty to its subsidiary when there are
parent-subsidiary dealings. However, this alone will not evoke the intrinsic fairness standard.
This standard will be applied only when the fiduciary duty is accompanied by self-dealing -- the
situation when a parent is on both sides of a transaction with its subsidiary. Self-dealing occurs
when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such
a way that the parent receives something from the subsidiary to the exclusion of, and detriment to,
the minority stockholders of the subsidiary.
CLAIM THAT SUBSIDIARY PAID EXCESSIVE DIVIDENDS
We turn now to the facts. The plaintiff argues that, from 1960 through 1966, Sinclair
caused Sinven to pay out such excessive dividends that the industrial development of Sinven was
effectively prevented, and it became in reality a corporation in dissolution.
From 1960 through 1966, Sinven paid out $108,000,000 in dividends ($38,000,000 in
excess of Sinven's earnings during the same period). The Chancellor held that Sinclair caused
these dividends to be paid during a period when it had a need for large amounts of cash.
Although the dividends paid exceeded earnings, the plaintiff concedes that the payments were
made in compliance with 8 Del.C. § 170, authorizing payment of dividends out of surplus or net
profits. However, the plaintiff attacks these dividends on the ground that they resulted from an
improper motive -- Sinclair's need for cash. The Chancellor, applying the intrinsic fairness
standard, held that Sinclair did not sustain its burden of proving that its transactions were
intrinsically fair to the minority stockholders of Sinven.
Since it is admitted that the dividends were paid in strict compliance with 8 Del.C. § 170
[distributions limited to payments from surplus and current earnings], the alleged excessiveness
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of the payments alone would not state a cause of action. Nevertheless, compliance with the
applicable statute may not, under all circumstances, justify all dividend payments. If a plaintiff
can meet his burden of proving that a dividend cannot be grounded on any reasonable business
objective, then the courts can and will interfere with the board's decision to pay the dividend.
We do not accept the argument that the intrinsic fairness test can never be applied to a
dividend declaration by a dominated board, although a dividend declaration by a dominated board
will not inevitably demand the application of the intrinsic fairness standard. If such a dividend is
in essence self-dealing by the parent, then the intrinsic fairness standard is the proper standard.
For example, suppose a parent dominates a subsidiary and its board of directors. The subsidiary
has outstanding two classes of stock, X and Y. Class X is owned by the parent and Class Y is
owned by minority stockholders of the subsidiary. If the subsidiary, at the direction of the parent,
declares a dividend on its Class X stock only, this might well be self-dealing by the parent. It
would be receiving something from the subsidiary to the exclusion of and detrimental to its
minority stockholders. This self-dealing, coupled with the parents' fiduciary duty, would make
intrinsic fairness the proper standard by which to evaluate the dividend payments.
Consequently it must be determined whether the dividend payments by Sinven were, in
essence, self-dealing by Sinclair. The dividends resulted in great sums of money being
transferred from Sinven to Sinclair. However, a proportionate share of this money was received
by the minority shareholders of Sinven. Sinclair received nothing from Sinven to the exclusion of
its minority stockholders. As such, these dividends were not self-dealing. We hold therefore that
the Chancellor erred in applying the intrinsic fairness test as to these dividend payments. The
business judgment standard should have been applied.
We conclude that the facts demonstrate that the dividend payments complied with the
business judgment standard and with 8 Del.C. § 170. The motives for causing the declaration of
dividends are immaterial unless the plaintiff can show that the dividend payments resulted from
improper motives and amounted to waste. The plaintiff contends only that the dividend payments
drained Sinven of cash to such an extent that it was prevented from expanding.
[The court then decided that the parent had not usurped corporate opportunities of the
subsidiary.]
Next, Sinclair argues that the Chancellor committed error when he held it liable to Sinven
for breach of contract. In 1961 Sinclair created Sinclair International Oil Company (hereafter
International), a wholly owned subsidiary used for the purpose of coordinating all of Sinclair’s
foreign operations. All crude purchases by Sinclair were made thereafter through International.
On September 28, 1961, Sinclair caused Sinven to contract with International whereby Sinven
agreed to sell all of its crude oil and refined products to International at specified prices. The
contract provided for minimum and maximum quantities and prices. The plaintiff contends that
Sinclair caused this contract to be breached in two respects. Although the contract called for
payment on receipt, International’s payments lagged as much as 30 days after receipt. Also, the
contract required International to purchase at least a fixed minimum amount of crude and refined
products from Sinven. International did not comply with this requirement.
Clearly, Sinclair’s act of contracting with its dominated subsidiary was self- dealing. Under
the contract Sinclair received the products produced by Sinven, and of course the minority
shareholders of Sinven were not able to share in the receipt of these products. If the contract was
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breached, then Sinclair received these products to the detriment of Sinven’s minority
shareholders. We agree with the Chancellor’s finding that the contract was breached by Sinclair,
both as to the time of payments and the amounts purchased.
Although a parent need not bind itself by a contract with its dominated subsidiary, Sinclair
chose to operate in this manner. As Sinclair has received the benefits of this contract, so must it
comply with the contractual duties. Under the intrinsic fairness standard, Sinclair must prove that
its causing Sinven not to enforce the contract was intrinsically fair to the minority shareholders of
Sinven. Sinclair has failed to meet this burden. Late payments were clearly breaches for which
Sinven should have sought and received adequate damages. As to the quantities purchased,
Sinclair argues that it purchased all the products produced by Sinven. This, however, does not
satisfy the standard of intrinsic fairness. Sinclair has failed to prove that Sinven could not
possibly have produced or someway have obtained the contract minimums. As such, Sinclair
must account on this claim.
Delaware Supreme Court (2005)
_______________________________________
NOTES
1.
The notion that the “affairs of the corporation are managed by, or under the direction of,
the board of directors” is not an American invention. Instead, the corporate board – a
discrete group of central decision-makers – arose out of European medieval political
ideas that favored collegial decision-making. See Franklin A. Gervurtz, The European
Origins and the Spread of the Corporate Board of Directors, 33 Stetson L. Rev. 925
(2004). While other trading companies, such as the merchant houses of imperial Japan,
gave authority to a single family member, trading companies in Europe developed a
system of centralized collegial management.
The boards of European trading companies (the forerunners of U.S. corporations)
originated in the structure of medieval guilds, where the guild charter established a board
to resolve inter-member disputes and regulate members’ conduct. Borne of the medieval
political practice (for example, in Florence) of representative assemblies, the boards of
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guilds and municipalities reflected a new preference for collegial decision-making. (It is
worth remembering that this was also the period when the 12-person jury arose in
northern Europe.)
The use of councils in Europe has even deeper roots in the Christian church,
whose councils famously decided such matters as the content of orthodox religious texts
and the resolution of church schisms. By contrast, the family-oriented hierarchical
structure of Japanese trading houses is consistent with Confucian values of obedience in
human relations. Of the five Confucian relationships among people (ruler-subject, fatherson, husband-wife, elder brother-younger brother, and friend-friend), four of the
relationships are vertical and demand unquestioning obedience.
2.
Notice that Sinclair Oil involved a derivative suit, in which a single shareholder sought to
enforce corporate rights. Should a single minority shareholder be able to challenge a
board’s dividend policy, applicable to all shareholders?
a.
What is a derivative suit? It is a representative suit in which a shareholder sues
on behalf of the corporation to vindicate corporate (generalized) rights, such the
right that corporate fiduciaries act with due care and utmost loyalty. In effect, the
shareholder seeks to become the voice for the corporation.
b.
Who may bring a derivative suit in Delaware? Any shareholder may sue,
regardless of the shareholder’s amount of ownership. Most corporate statutes,
including Delaware’s, require that the plaintiff-shareholder have been a
contemporaneous owner when the challenged wrong occurred.
c.
What must the plaintiff allege? The shareholder-plaintiff must allege some harm
to the corporation. Any recovery will be to the corporation, not to individual
shareholders.
3.
Consider the rule of U.S. corporate law that decisions about payments to shareholders is
made by the board of directors.
a.
Why should the shareholders who invested equity capital in the business not be
able to withdraw cash as they seem fit – after all, aren’t they the owners?
b.
What is the holding of the Delaware court in Sinclair Oil - when can a minority
shareholder challenge a dividend decision of the board? Why is dividend policy
a matter for the board to decide? Isn’t a return on investment an assumption of
any shareholder’s investment?
c.
One answer may be that shareholders can always change dividend policy by
electing a new board. But what if the dividend policy, as in Sinclair Oil, is made
by a board controlled by a majority shareholder. What protections do minority
shareholders have against abuse of management discretion – besides suing the
board in a lawsuit that will likely be futile?
4.
Notice that the court held Sinclair to be liable for self-dealing with its subsidiary. What
is self-dealing? Why is it wrong?
a.
Consider how the minority shareholders of the subsidiary must feel when they
discovered that Sinclair was taking profits from Sinven that it was not sharing
with Sinven shareholders. This is the essence of “tunneling.”
b.
What is the remedy for this self-dealing? Sinclair must return to Sinven any
amounts above the fair market value of the purchases it made, plus any purchases
it might have made if Sinven had been allowed to produce at full capacity.
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c.
One interesting final point: the court held that Sinclair could not “setoff” the
value to Sinven of being part of a corporate group – shared accounting, tax
breaks, etc. Instead, the assumption was that Sinclair had to deal with Sinven
like any other third party supplier! (We will soon see that Italian law is different
in this regard and permits a “setoff” – effectively negating challenges to intergroup dealings.)
_______________________________________
Litle v. Waters
Court of Chancery of Delaware, New Castle
1992 Del. Ch. LEXIS 25 (1992)
Plaintiff, Thomas J. Litle, instituted this lawsuit against defendants alleging that they had
committed, and continue to commit, various breaches of fiduciary duties.
As alleged in the complaint, in 1979 Litle and Waters formed Direct Order Sales
Corporation ("DOSCO"), a Delaware corporation which engaged in the catalog sales and
merchandise fulfillment business. At the beginning, DOSCO was unprofitable and Waters infused
it with capital by lending it money. In 1983, Litle and Waters formed Direct Marketing Guaranty
Trust Corporation ("old DMGT"), a New Hampshire corporation which engaged in the credit card
processing business for catalog sales transactions. Waters owned 2/3 of the stock of both
companies and Litle owned 1/3.
The two men agreed that Waters would provide the capital and Litle the management for
the two entities. Although the two elected to treat the corporations as S corporations, with flowthrough tax status, they never formally agreed that the corporations would actually pay dividends.
In September 1985, Waters fired Litle as president and CEO of both companies. Waters
then merged the two companies into DMGT Corp. ("new DMGT"). Waters became the new
corporation’s CEO and board chair, and then used the combined entities' profits to begin repaying
the debt that DOSCO had owed him.
Since the merger, new DMGT has done very well:
Year
1987
1988
1989
1990
Reported earnings
$ 739,000
$ 909,000
$ 3.8 million
$ 3.6 million
These earnings have resulted in a tax liability of $ 560,000 for Litle, who retained a 33% interest
in new DMGT, even though new DMGT has not distributed any dividends to its shareholders.
According to Litle, Waters is having new DMGT not pay dividends to make Litle's shares
worthless so that Waters can buy Litle out "on the cheap." In fact, Waters’s tried to have his
accountants justify this hoarding of cash, but the accountants could not state a need for not paying
dividends.
In the complaint, plaintiff alleges that "the Director Defendants breached their fiduciary
duties to the stockholders in that the course of action embarked upon was designed to and did
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favor one group of stockholders to the detriment of another." Defendants argue that "the
declaration and payment of a dividend rests in the discretion of the corporation's board of
directors in the exercise of its business judgment; that, before the courts will interfere with the
judgment of the board of directors in such matter, fraud or gross abuse of discretion must be
shown." Gabelli & Co., Inc. v. Liggett Group, Inc., Del. Supr., 479 A.2d 276, 280 (1984).
Further, defendants argue, the mere existence of funds from which the entity could pay dividends
does not prove fraud or abuse of discretion by a board in its determination not to declare
dividends. See Baron v. Allied Artists Pictures Corp., Del. Ch., 337 A.2d 653, 659 (1975), appeal
dismissed, Del. Supr., 365 A.2d 136 (1976). Defendants argue that the Board's decision to not to
declare dividends is protected, unless the plaintiff can show Aoppressive or fraudulent abuse of
discretion." Eshleman v. Keenan, Del. Ch., 22 Del. Ch. 82, 194 A. 40, 43 (1937).
In making their respective arguments, the parties overlook an important issue. That is,
what is the proper standard of judicial review or the Board's actions? Plaintiff merely states in a
footnote that an entire fairness standard applies. Defendants, by relying on Eshleman imply that
the business judgment standard applies.
An interested director is one that stands on both sides of a transaction or expects to
derive personal financial benefit from the transaction in the sense of self-dealing, as opposed to a
benefit which devolves upon the corporation or all stockholders generally. See Aronson v. Lewis,
Del. Supr., 473 A.2d 805, 812 (1984). The decision as to whether a director is disinterested
depends on whether the director . . . involved had [a] material financial or other interest in the
transaction different from the shareholders generally. "Material" in this setting refers to a
financial interest that in the circumstances created a reasonable probability that the independence
of the judgment of a reasonable person in such circumstances could be affected to the detriment
of the shareholders generally. Cinerama, Inc. v. Technicolor, Inc., Del. Ch., C.A. No. 8358, 1991
Del. Ch. LEXIS 105, *37 (Allen, C. June 24, 1991).
Waters served his own personal financial interests in making his decision to have DMGT
not declare dividends. By not making dividends, he was able to ensure that he would receive a
greater share of the cash available for corporate distributions via loan repayments. Further, the
decision enabled him to put pressure on Litle to sell his shares to him at a discount since the
shares are and were only a liability to Litle who receives no corporate distributions, yet owes
taxes on the company's income. Indeed, the loan repayments continue to enable Waters to keep
the pressure on Litle to sell the shares at a discount since the loan repayments provide cash that he
can use to pay his tax liability, while Litle has to find sources of cash to pay his tax liability.
Therefore, I must consider Waters to be an interested director with respect to the Board's decision
to not declare dividends.
Since plaintiff's complaint sufficiently alleges facts which justifies the applicability of the
entire fairness standard and defendant has not adequately rebutted its applicability by showing the
other new DMGT directors are independent, the burden shifts to defendants to demonstrate that
the decision to not declare dividends and to repay the company's debt to Waters was intrinsically
fair.
Counts I of plaintiff's complaint state claims for which I can grant relief. Defendants'
motion to dismiss Counts is DENIED.
_________________________________
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NOTES
1.
Consider when a derivative suit can be brought to challenge a majority-controlled board’s
dividend policy. Would the result in Litle v. Waters have been different if –
a.
the defendant had suggested a good business reason for not paying dividends -such as to expand DMGT’s credit card processing business to the Internet?
b.
the DMGT board had been composed of a majority of non-employee directors
who did not have any business or personal relationship with Waters?
c.
Waters had offered to pay Litle a fair price for his shares, but Litle had refused
hoping to get a better price later if the company went public?
2.
How is the approach in Sinclair Oil different from that of Litle v. Waters?
a.
Does it make any difference whether the minority shareholders are seeking to
have dividends paid rather to have them invalidated?
b.
Does it make any difference that the minority shareholder in Sinclair had
purchased publicly-traded shares in a holding company structure, while Litle
invested in a closely-held business?
_________________________________
2.
Locus of corporate power – Europe (and Italy)
Now that you’ve got a basic understanding of US corporate law on the question of how
profits are allocated within the firm or corporate group, let’s look at Europe. What happens if
company insiders (such as in a family-controlled business) decide to take out money from the
business for themselves and at the expense of minority shareholders? What are the protections
for minority shareholders in such cases?
It turns out that this question – sometimes called “tunneling” – is fundamental to how
corporate law systems are evaluated. Systems that protect minority investors get high marks;
those that do not are viewed as anti-capitalist pariahs. A 2006 research project involving a
collaboration of Lex Mundi (a worldwide association of independent law firms) and the World
Bank sought to investigate how well different countries protect corporate investors against selfdealing by corporate insiders. Doing Business: Protecting Investors, The World Bank (2006).
The project asked participating law firms to analyze a standard case in which a dominant
board member of a public company (who owns 60% of the company’s stock) proposes that the
company will purchase supplies from a private company in which he owns 90% -- at a price
higher than fair market value. The researchers sought information from each country on
questions such as who approves the transaction, what information must be disclosed, how easy is
it for shareholders to bring suit, and what do minority shareholders have to prove to stop the
transaction or receive compensation.
Using answers from 90 Lex Mundi law firms with a practice in 154 countries, the project
researchers constructed an index of “investor protection.” The project found that the countries
that have the best protection have several things in common: (1) they require immediate
disclosure of the transaction and the board members conflict of interest, (2) they require prior
approval of the transaction by other shareholders, (3) they enable shareholders to hold the
company’s directors liable and to have the transaction voided if its terms are unfair, and (4) they
permit shareholders who take the company directors to court to access all relevant documents.
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126
Where are investors protected—and where not?
Most protected
Least protected
New Zealand
Costa Rica
Singapore
Croatia
Canada
Albania
Hong Kong, China
Ethiopia
Malaysia
Iran
Israel
Ukraine
United States
Venezuela
South Africa
Vietnam
United Kingdom
Tanzania
Mauritius
Afghanistan
In assessing the difficulties in protecting investors, the corporate lawyers participating in
the survey identified the following major obstacles (the percentage of countries in which obstacle
was identified is shown in parenthesis):
•
•
•
•
•
Lack of information on related-party transactions (53%)
Investors must prove their case to the level of certainty in criminal cases (39%)
Directors keep profits from self-dealing even after being convicted of breach of duty
(37%)
Liability for directors only if they act fraudulently or in bad faith (13%)
No access to company’s or defendant’s documents (8%)
Several developing countries protect investors well, but in general poor countries regulate
self-dealing less often than rich countries. This is especially true in requiring disclosure, and
some poorer countries try to compensate for the lack of shareholder access to information and
courts by relying on government inspectors.
The study identified a correlation between investor protection and equity investment,
with lower protection being strongly associated with lower levels of investment. This is
consistent with other studies, including a recent study of private equity transactions that found
countries with a higher risk of expropriation experience half the investment (as a share of GDP)
compared with countries with good investor protections.
Consider the ratings of the following countries. (The first three entries indicate, in order,
the extent of disclosure, the extent of director liability, and the ease of shareholder suit – the last
entry, an average of the three, provides a composite “strength of investor protection.”)
Italy
France
Germany
Poland
Russia
United Kingdom
United States
Disclosure
7
10
5
7
7
10
7
D liability
2
1
5
4
3
7
9
Sh suit
5
5
6
8
5
7
9
Composite
4.7
5.3
5.3
6.3
5.0
8.0
8.3
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With respect to the United States, the study noted that the country protects investors
through broad court review of directors’ actions. During trial all relevant company documents are
open for inspection. In court, plaintiffs can directly question all witnesses, including the
defendant, without prior judicial review of the questions posed. Directors must show the
transaction was fair to the company—both in price and in dealing. This, the study concluded,
“makes the United States one of the easiest places to bring shareholder suits.”
_________________________
INTRODUCTORY NOTES
1.
Consider how a minority shareholder in an Italian company might challenge a board’s
refusal to recommend dividends.
a.
Can the shareholder convince the other shareholders to declare a dividend, even
though the board has failed to do so?
b.
Can the shareholder compel the company’s auditors to force the board to declare
a dividend or to initiate a judicial investigation of the board?
c.
Can the shareholder bring a court action to have a judge compel the declaration
of dividends. Does Italian company law contemplate derivative suits?
2.
Consider the related situation where a controlling shareholder causes the company to deal
with one of the shareholder’s companies, rather than with outside companies at market
rates. For example, suppose that Silvio Berlusconi had his company Telinvest, a countrywide network of TV stations, buy all of the TV cameras used by the stations through his
own company.
a.
If you were a minority shareholder in Telinvest, how would you feel about this?
How is your investment affected by the Berlusconi self-dealing?
b.
What rights would you have under Italian company law to claim that the
purchases of TV cameras were unfair to Telinvest?
3.
So control has its privileges! Would you rather be a controlling shareholder in Italy or the
United States? In a study by a Harvard economist of controlling shareholders in 661
firms in 18 countries, the value of control (which can be used to extract value at the
expense of other shareholders) was found to range from 0% (Denmark) to 50% (Mexico)
of the firm’s overall market value. That is, in Mexico the value of controlling a firm
worth $1,000 is $500 -- that is, a 50% shareholder with control would value his
ownership at $750, while the same shareholder without control would value his interest at
$250! What determines the value of control? The study measured the general strictness
of the legal environment (courts), the regulation of takeovers, power-concentrating
provisions in company charters, and the likelihood of control contests. It found that the
legal environment explains 75% of the cross-country variation in the value of control.
Tatiana Nenova, The Value of Corporate Costs and Control Benefits: A Cross-Country
Analysis, SSRN Paper 237809 (July 2000).
4.
Here’s a somewhat discouraged assessment by Professor Enriques of the current status of
Italian company law, even after the recent reforms:
US and Italian corporate laws couldn't be more different one from the other. In
the US, corporate law is enabling; in Italy mandatory terms in corporate law
provisions are still pervasive; in the US, corporate law concentrates on
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relationships between shareholders and managers and between minority and
majority shareholders; in Italy, many corporate law rules are in place also to
protect creditors. In the US, (Delaware) courts play a central role in policing
proper corporate behavior by enforcing open-ended standards (e.g. fairness);
Italian courts seldom are involved in corporate governance issues and tend to
defer to insiders' decisions.
Luca Enriques, US and Italian Corporate Law: Faraway, so Close (Diritto societario
statunitense e diritto societario italiano: In weiter Ferne, so nah). Giurisprudenza
Commerciale, Part I, pp. 274-287, SSRN paper 1014824 (2007).
5.
We next turn to a famous law review article by an Italian commercial law professor who
reviews how corporate governance works in listed companies in Italy. As you’ll notice,
Italian company law (like much of Continental Europe) proceeds on the assumption that
power in the company resides with the shareholders and happens during the shareholders’
meeting – or assembly. How does this compare with the United States?
You’ll also notice that the Italian company law system introduces another body
in the company governance system – namely, the board of auditors. Selected by
shareholders, the board of auditors is supposed to serve as a watchdog to protect
shareholders from wayward managers. In the United States, a similar function is
provided by outside accounting firms that audit the financial information of the
corporation. Although not formally part of the US corporate structure, these auditing
firms can be liable to shareholders if their audits fail to uncover internal corruption or
financial fraud.
_________________________________
Corporate Governance in Italy: Strong Owners, Faithful Managers:
An Assessment and a Proposal for Reform
6 IND. INT'L & COMP. L. REV. 91 (1995)
Lorenzo Stanghellini 1
E. The Protagonists of the Governance of the Societa per Azioni.
Power in the societa per azioni is allocated among three organs: the shareholders; the
board of directors; and the board of auditors. Broadly speaking, shareholders have the power to
decide who will manage the company, who will supervise the managers, and they have a voice in
1
Assistant Professor of Law, University of Florence, Italy. J.D., University of Florence (1987);
LL.M. Columbia University (1995).
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certain fundamental decisions. Directors manage the company, and auditors, who are part of the
corporate structure, supervise directors in the interests of shareholders and creditors.
1. The Shareholders.
Shareholders in the societa per azioni do not have direct power to manage the company.
Their fundamental powers consist in electing and removing directors and auditors, in determining
their compensation, in voting on amendments to the charter and by-laws (which include matters
such as the issuance of new stock and convertible bonds, mergers, dissolution of the company), in
voting on the issuance of bonds, C.c. art. 2364, 2365 (Italy), and ... the system is a special power
of shareholders over directors' and auditors' liability. 2 This feature will be specially examined
throughout this paper: directors and auditors may be held liable only if a majority of the voting
shareholders decide to institute action against them. C.c. art. 2393(1) (Italy). [This was the state
of affairs as of 1995, before the 2003 reforms permitted derivative suits.]
Shareholders act generally as a group, following a call for a meeting. Each shareholder,
however, or in certain cases shareholders representing a certain fraction of the capital, have some
special rights. These rights include authority to provoke inspections by the auditors and by the
court and to request and obtain a call of a shareholders' meeting. Each shareholder, moreover, has
the right to question in court the validity of any shareholders' resolution and to obtain its voidance
if it is proven to be against the law or the charter.
Shareholders normally are not allowed to give orders to the directors. Even so, the
amount of power shareholders of Italian companies have, when compared with their American
counterparts, can be considered very high. Shareholders have the final say on fundamental
matters like dividend policy and capital structure. They decide what part of the earnings must be
paid out to them and what part may be reinvested. * * *
2. The Board of Directors.
All members of the board of directors are elected by the shareholders; any contrary
provision is void. A partial exception to this principle is midstream vacancies owing to
resignation or other causes, which can be temporarily filled by the board itself. While a different
rule is permitted, the default rule is that all the members of the board are elected by the majority.
No representation on the board is thus granted to the minorities only by operation of the law, and
charters rarely provide otherwise.
The corporation is governed by a one-level board. [Again, this was the state of the law as
of 1995; after the 2003 reforms, Italian joint stock companies can choose among three structures:
a board/statutory auditor, a monistic board, and a dualistic board.] The board of directors has all
the powers necessary to manage the company, while the supervision of the management is
committed to the board of auditors that is independent from the board of directors and lacks any
managerial power. The Italian system is, therefore, "monistic," as opposed to "dualistic" systems
like Germany's, in which day-to-day operations, on the one hand, and major corporate policy
2
One of the most emphasized powers of shareholders is the power to approve the financial
statements of the company. The shareholders’ role with respect to this matter, however, is ambiguous at
best. Financial statements are obviously prepared by the board of directors (C.c. art. 2423(1) (Italy)),
which has the relevant information and can make the necessary evaluations. Whether shareholders can
only approve or reject financial statements or they can also modify them is a matter of debate.
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decisions and supervisory activity, on the other, are mandatorily apportioned at two different
levels of the same administrative structure.
The principal duty of directors is to manage the company in the interests of the
shareholders. Specific obligations to the creditors, imposed by the general civil law and by some
specific provisions, do not create a general duty to act in the creditors' interest. Moreover, even if
a certain amount of charitable contribution is commonly admitted, a general duty to act in the
interest of constituencies other than the shareholders or of the community at large does not exist.
3. The Board of Auditors.
The board of auditors, probably the most peculiar aspect of the Italian corporate
governance system, is composed of independent professionals entrusted by the shareholders with
the supervision of the directors. The manner in which auditors are elected is identical to that of
directors: the shareholders elect all the members of the board, and, unless the charter so provides,
no representation is granted to the minority.
The board of auditors is composed of either three or five members, plus two substitutes
for possible vacancies. A recent reform enacted in compliance with the Eighth European directive
on company law has tightened requirements for serving on the board, providing that all members
be chosen from the roll of the "revisori contabili" [auditors]. The roll is kept under public
supervision and lists persons with a significant curriculum of studies in law, business organization
and/or accounting, who have proven experience in practice, and who have passed a special
examination. Typically, auditors are practicing professionals who serve on the board of more than
one company.
The central idea behind the legal structure of the board of auditors is independence.
Relatives of the directors and persons who are employees or who are otherwise compensated on a
regular basis by the company or by its subsidiaries cannot be elected as auditors. Auditors serve
for a period of three years, and unlike directors, they can be removed exclusively for cause; the
shareholders' removal, moreover, takes effect only if approved by the court. Auditors have fixed
compensation and variable risks; their compensation is fixed for the entire period of service and
does not depend on the company's performance.
The auditors' duties are basically monitoring directors and acting in the place of the latter
if they refuse to follow the rules of corporate governance, or to accomplish specific and legally
mandated acts. It is not the auditors' responsibility to assess the appropriateness of business
decisions made by the board of directors. In other words, the auditors' task is to assure
compliance with the rules set forth in the law and the charter, not to review the conduct of the
board on its merits. 3
3
A recent case sent shockwaves through the corporate community. Judgment of May 7, 1993, No.
5263, Cass. Civ., 1994 FORO ITALIANO I, 130, found auditors liable for lack of intervention against a
series of negligent decisions causing the company to spend a substantial amount of money in partly
unauthorized real estate purchases, saying explicitly that it is the auditors' duty to review managerial
decisions. The case, however, concerned an easily detectable case of gross negligence, and it is arguable
that the duty to review managerial decisions constitutes only dictum.
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In particular, auditors must (a) meet as a board at least each quarter, and attend the
meetings of the shareholders and board of directors; (b) check regularly the company's books and
internal accounting system; and (c) prepare a report accompanying the annual financial
statements, which goes to the shareholders and then, together with the financial statements, is
made publicly available. (The auditors' report must take a position on the fairness of the financial
statements with respect to the accounting system and to the financial situation of the company.)
Moreover, auditors have a general power to make investigations and a duty to report to the
shareholders irregularities discovered in the management of the business. 4 They are not, however,
mere agents for the shareholders, as they may challenge in court the validity of shareholders'
resolutions.
Auditors are jointly and severally liable with the directors for the directors' acts or
omissions that cause losses to the company or its creditors, if they could have avoided the losses
through diligent behavior and monitoring. While the first kind of responsibility does not create
any particular difficulty, the second can be problematic because it involves a judgment on when
an omission has taken place. Therefore, deciding when auditors can be held responsible for
directors' conduct may not be simple.
Auditors can ask the court to void the board's resolutions approved with the vote of
interested directors. 5 The auditors can report acts of mismanagement to the shareholders, and they
can report criminal activities (embezzlement, frauds perpetrated on creditors, etc.) to criminal
prosecutors, who have the means to stop directors. If the directors do not, auditors must report the
company's losses to the shareholders and, in certain cases, can ask the court to appoint a
liquidator. In most cases, the auditors' normal monitoring activity and the threat of their
intervention will suffice to instill diligence in the directors.
In deciding on auditors' liability, the courts tend to follow a rule of reason. They normally
charge collusive or simply idle auditors with responsibility for directors' egregious violations that
easily could have been detected or for a delay in reporting to shareholders a financial crisis that
required their prompt intervention. In other words, courts charge auditors with having ignored
serious, and often multiple, "red flags." The fact that the majority of, or all of, the shareholders
were aware of the "red flags" is not deemed a valid defense.
There is a risk, however, that the auditors can become scapegoats for the losses of
insolvent companies. Most liability suits against directors and auditors are instituted by
bankruptcy trustees who want to enrich the estate by trying to involve auditors, often
professionals with deep pockets or insurance. It is up to the courts to discourage this type of
action. Courts seem to strike an appropriate balance when they dismiss charges against auditors
that diligently fulfilled their duties or were unable to detect skillfully concealed directors' acts of
mismanagement or misappropriation.
4
Auditors have the duty to make investigations when requested by shareholders holding at least
five percent of the capital. See C.c. art. 2408(2) (Italy).
5
It is my opinion that when requested by a shareholder, a court can issue an injunction under art.
700 Code of Civil Procedure (Italy) to prevent the board from implementing a transaction approved by
interested directors. (I argue this because of the criminal sanction imposed on directors acting in conflict of
interest, C.c. art. 2631 (Italy)). However, such a remedy would apply only ex ante, and could do nothing
once the transaction has been implemented.
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F. Summary
Based on the legal system, the following conclusions concerning the respective roles of
shareholders, board of directors and board of auditors can be inferred.
A. Shareholders.
A.1. Shareholders possess powerful tools of corporate governance. Essentially they
possess the right to vote on capital structure, on dividend policy and on fundamental changes such
as mergers. Normally, however, shareholders' powers consist of the right to veto the board's
actions rather than the right to impose such actions.
A.2. Shareholders' powers are primarily in the hands of the majority. In other words,
majority rule normally governs the way in which shareholders express their voice, while single
shareholders have very limited powers. The directors' liability rules, which we will examine next,
confirm this conclusion.
B. Board of directors.
B.1. The board of directors has all the powers not expressly reserved to the shareholders.
No formal separation between managerial and supervisory activity exists at the board level.
B.2. The board of directors, however, has a flexible structure that allows a delegation of
day-to-day operations and substantial decisional authority to a part of its members. Non-delegated
members still retain authority to intervene in every decision. A separation between directors in
charge of day-to-day operations and directors in charge of supervision exists in every
medium-large company.
C. Board of auditors.
C.1. The board of auditors is formally charged with supervision over the administration
of the company. Aside from the case of directors' conflict of interest, the board of auditors has no
direct intervention or veto power over directors' decisions. However, it has an effective, even if
indirect, means of preventing directors from committing unlawful acts. The board of auditors is
not charged with the duty to review directors' business decisions on their merits.
C.2. The board of auditors is normally elected by the majority of shareholders, i.e., by the
same group that elects directors. Yet auditors, once elected, are relatively independent of
shareholders and can challenge their resolutions, if invalid, in court. Whether the board of
auditors is an effective institution is an open question.
______________________________
NOTES
1.
The 2003 reform to Italian company law makes it easier for minority shareholders to
challenge actions of majority shareholders and company boards that interfere with their
rights. Below are the company law provisions on payment of dividends in joint stock
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companies (SpA) and shareholder challenges to actions taken at the shareholders’
meeting or by the board of directors.
a.
How are the current Italian company law provisions different from pre-reform
law? Are the new provisions more or less flexible in permitting the payment of
dividends? More or less protective of minority shareholder interests?
b.
Do you see any similarities in the new provisions to US law? For example, how
do the provisions of Article 2393-bis compare to US law?
2.
Under Italian company law, what is the procedure by which the board and shareholders
decide whether (or not) to declare dividends? As you will notice, the shareholders’
meeting is the locus of power in the Italian joint stock company – the shareholders
approve the financial accounts as presented by the board and then declare dividends.
a.
What are the rights of shareholders – to profits, to voting? Consider Article
2350, 2351.
b.
How do shareholders act? See Articles 2364, 2365. How often are shareholders’
meetings held? What are the rights of minority shareholders in calling a
shareholders’ meeting. See Article 2367.
c.
How are dividends determined? What must the directors do at the end of the
financial year? See Article 2423-2432. What happens at the annual shareholders’
meeting? See Article 2433.
d.
What is the effect of a shareholders’ resolution? See Article 2377. Can minority
shareholders challenge a shareholders’ resolution? See Articles 2378-2379.)
3.
How is this process for the distribution of profits different from the approach in the
United States?
a.
Can shareholders declare dividends on their own, or can they only approve or
disapprove of the board’s recommendation?
b.
What possibilities are there for a minority shareholder unhappy with the board’s
dividend policy? Can there be a challenge for board “bad faith”?
c.
Assume that the facts of Sinclair Oil v. Levien arose in Italy. Could a minority
shareholder challenge the decision to declare dividends at a level that allegedly
depleted the company’s growth potential? Outline an argument under the new
provisions added by the Italian company law reforms.
d.
Again assume the Sinclair Oil facts with respect to the self-dealing claim that the
parent had preferred a wholly-owned subsidiary over partially-owned Sinven.
Must the plaintiff show not only that Sinven was damages in its oil contracts with
wholly-owned International, but that this damages outweighed any benefit the
subsidiary enjoyed by being a member of the Sinclair group? According to Italian
Civil Code Article 2497, 1° paragraph, introduced by the 2003 reforms, a parent
corporation is not liable for damages to the shareholders of a partially-owned
subsidiary “when the damage are lacking according to the global result of the
activity of management and coordination or integrally eliminated as a result of
operations directed to this purpose.” Court and lawyers have read this to mean
that if the subsidiary is benefited by being a part of the group, the plaintiff must
show that any self-dealing harm exceeds group benefits – a nearly impossible
burden. See Jones Day, “Groups of Companies under the New Italian Law”
(March 2004). A similar result is provided for director liability under Article
2634, which exonerates directors in a corporate group if harm to the subsidiary
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e.
“is compensated by advantages achieved or reasonably expectable… from …
belonging to the group.”
Assume now that the facts of Litle v. Waters had arisen in Italy. Could Litle
challenge the actions of Waters in refusing to declare dividends? Outline an
argument under the new provisions added by the Italian company law reforms.
Italian Company Law
Civil Code, Book V (Arts. 2325-2548)
Joint Stock Companies
Section V The shares
Italian Company Law (pre-2003)
Civil Code, Book V (Arts. 2325-2548)
Joint Stock Companies
Section V The shares
Article 2350
Right to earnings and a share on
liquidation - Every share includes the right
to a proportional part of the net profits and
the net assets resulting from liquidation,
except for special rights established for
[workers’ shares].
The company may issue shares with
economic rights related to the results of the
activity in a specific sector. The by-laws
set forth the criteria [of such shares].
Article 2350
Right to earnings and a share on
liquidation - Every share includes the right
to a proportional part of the net profits and
the net assets resulting from liquidation,
except for special rights established for
[workers’ shares].
Article 2351
Right to vote - Every share includes the
right to vote.
[The] bylaws may provide for the creation
of shares without the voting right, with
voting right limited to specific matters, with
voting right subordinated to the happening of
certain conditions....
The value of such shares cannot be higher
in aggregate than one half of the capital.
Supervoting shares cannot be issued.
[Venture capital shares] may have voting
rights on specific matters and in particular
they may have the right to appoint ... an
independent member of the board of
directors or the supervisory board or of an
auditor.
Article 2351
Right to vote - Every share includes the
right to vote.
The articles of association can establish
that privileged shares ... have rights to vote
only under the conditions of Article 2365.
Shares with limited voting cannot exceed
half of the company’s capital.
Supervoting shares cannot be issued.
Section VI - Company bodies
Paragraph I - Shareholders
Article 2364
Regular meetings in companies without a
supervisory board - In a company without a
supervisory board, the regular meeting (1)
approves the financial statements, (2)
Section VI - Company bodies
Paragraph I - Shareholders
Article 2364
Regular shareholders’ meeting Shareholders at a regular meeting (1)
approve the financial statements, (2)
nominate the managers, the auditors and
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appoints and revokes the directors, appoints
the auditors and the chair of the board of
auditors .... (3) determine the compensation
of the managers and the auditors, unless set
out in the by-laws (4) resolves on the liability
of directors and auditors ....
The regular shareholders’ meeting shall be
convened at least once every year, within the
date fixed in the by-laws or in any case not
later than 120 days from the closing of the
fiscal year.
chair of the auditor board, (3) determine the
compensation of the managers and the
auditors, if not established in the articles of
association (4) resolve on the liability of
directors and auditors ...
The regular shareholder’s meeting shall be
convened at least once every year, within
four month after the closing of the fiscal
year.
Article 2367
Request by members for calling of
meeting - The directors or the management
board shall call a shareholders’ meeting
without delay, when a demand is made by
shareholders representing at least one-tenth
of the company’s capital or the lower
percentage provided in the by-laws and the
demand indicates the matters for the meeting.
...
Article 2367
Request by minority for calling of
meeting - The managers shall call a
shareholders’ meeting without delay, when a
demand is made by shareholders
representing at least one-fifth of the
company’s capital and the demand indicates
the matters for the meeting. ...
Article 2373
Conflict of interest - The resolution
approved with the determining vote of
members having a direct conflict of interest
or on behalf of third persons with that of the
company may be challenged in accordance
with Article 2377 if the company may be
prejudiced.
Article 2373
Conflict of interest - The right to vote shall
not be exercised by a shareholder in any
matter in which he has, himself or on
account of a third party, an interest
conflicting with that of the company. ... The
managers shall not vote in matters relating
to their liability. ...
Article 2377
Nullity of resolutions - The resolutions of
the shareholders' meeting passed in
compliance with the law and by-laws are
binding for all the members, even if not in
attendance or in disagreement.
The resolutions which are not passed in
compliance with the law or the by-laws may
be challenged by the members not present,
by the dissenting ones or those who did not
express a vote, by the directors, by the
supervisory board, or the board of statutory
auditors.
The challenge may be filed by the
members [when they own voting shares at
least 0.1% of listed company and 5% of the
others]; the by-laws may exclude such a
requirement.
Article 2377
Nullity of resolutions - The resolutions of
the shareholders' meeting passed in
compliance with the law and the deed of
incorporation are binding for all the
members even if not in attendance or in
disagreement.
The resolutions which are not passed in
compliance with the law and the deed of
incorporation may be challenged by the
directors, by the statutory auditors and by
the absent or dissenting members, and those
of the ordinary shareholders' meeting also by
the members with limited voting right,
within three months from the date of the
resolution or, if this is subject to registration
in the register of enterprises, within three
months from the registration. ...
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COMPARATIVE COMPANY LAW
The challenge ... must be filed within 90
das from the date of resolution or, if
registered in the registry of enterprises,
within 3 months from the date of registration
....
Article 2378.
Procedure for the challenge - The
challenge is submitted to the tribunal where
the company has its registered office.
The challenging member must show to be
the owner at the time of challenge [or the
shares provided in Article 2377]. [The
challenging party] may request suspension of
the execution of the resolution. ...
[The] judge may also rule at any time that
the members acting as plaintiffs offer
adequate guarantee for the restoration of
damages, if any. All the challenges related
to the same resolution must be dealt with at
the same time, and they are decided in only
one judgement. ....
Article 2378.
Procedure for the challenge - The
challenge is submitted to the tribunal where
the company has its registered office.
The challenging member must deposit at
least one share with the chancery.
The president of the tribunal may order
that the challenging member deposit a
proper guarantee for the possible
compensation of expenses. All the
challenges related to the same resolution
must be dealt with at the same time, and
they are decided in only one judgement. ....
Section VI-bis
Management and Control
Paragraph I.
General Provisions
Article 2380
Systems of management and control. If the
by-laws do not provide differently, the
management and the control of the company
are regulated by the following paragraphs 2,
3 4. .....
Section VI-bis
Management and Control
Paragraph II. The directors
Article 2380
Management of the Company -The
management of the company exclusively
belongs to the directors, who act as
necessary for the reaching of the corporate
object.
The management of the company may be
entrusted also to non members.
When the management is entrusted to
several persons, they constitute the board of
directors.
If the articles of association do not
establish the number of the directors, but
indicates only the maximum and minimum
number, the determination belongs to the
shareholders.
The board of directors elects among its
members' the chair, if not appointed by the
shareholders.
Paragraph II. The directors
Article 2380-bis
Management of the Company -The
management of the company exclusively
belongs to the directors, who act as necessary
for the reaching of the corporate object.
The management may also be entrusted
also to non members.
When the management is entrusted to
several persons, they constitute the board of
directors.
If the by-laws do not establish the number
of the directors, but indicates only the
maximum and minimum number, the
determination belongs to the shareholders.
The board of directors elects among its
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COMPARATIVE COMPANY LAW
members' the chair, if not appointed by the
shareholders.
Article 2392
Liability towards the company -The
directors must fulfil the duties imposed on
them by the law and by the by-laws with the
diligence required by the nature of their
appointment and by their specific
competences. They are liable jointly towards
the company for the damages arising from
the non-compliance with such duties, unless
it involves a matter delegated solely to the
executive committee or one or more
directors.
In any event the directors are jointly liable
... if, being aware of prejudicial acts, they do
not do what they could to stop the
performance or to eliminate or diminish the
damaging consequences of such acts.
The liability for acts and omissions of the
directors does not extend to the one among
them who, being without fault, had his
disagreement noted without delay in the
minutes and the resolutions of the board, by
giving immediate notice in writing to the
chair of statutory auditors.
Article 2393
Company’s action for liability - The
company’s action against the directors is
instituted following a resolution of the
shareholders’ meeting, even if the company
is in liquidation.
The resolution regarding the ability of the
directors can be passed on occasion of the
discussion on the balance sheet, even if it is
not indicated in the meeting agenda.
The action may be started with 5 years
from the termination of the director from his
appointment.
The resolution on the liability action entails
the revocation from office of the directors
against whom it is proposed, provided it is
passed with a favorable vote of at least one
fifth of the company's capital. ...
Article 2393-bis
Company action for liability by members.
Article 2392
Liability towards the company -The
directors must fulfil the duties imposed on
them by the law and by the articles of
association with the diligence of a trustee,
and they are jointly liable towards the
company for the damages arising from the
non-compliance with such duties, unless it
involves a matter delegated solely to the
executive committee or one or more
directors.
In any event the directors are jointly liable
if they have not supervised the general
workings of management or if, being aware
of prejudicial acts, they do not do what they
could to stop the performance or to
eliminate or diminish the damaging
consequences of such acts.
The liability for acts and omissions of the
directors does not extend to the one among
them who, being without fault, had his
disagreement noted without delay in the
minutes and the resolutions of the board, by
giving immediate notice in writing to the
chair of statutory auditors.
[same]
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The company action for liability may be
exercised by members representing at least
one fifth of the capital or such different
percentage indicated in the by-laws which in
any case cannot be greater than one third.
For [listed] companies the action may be
exercised by the members representing 1/20
of the company’s capital or such lower
amount contemplated in the by-laws.
The company must be convened in court
and the deed of summons may be served on
it also in the person of the chair of the board
of auditors.
The members who intend to promote the
action appoint, by majority of the capital
owned, one or more representatives for the
exercise of the action and for the fulfillment
of the related acts.
If the request is accepted, the company
pays the plaintiffs the judicial expenditures
and those incurred for the ascertainment of
the facts ....
The members who have initiated the action
may abandon it or settle; any compensation
for the waiver or settlement must be for the
benefit of the company. [Any settlement
must be approved at a shareholders’ meeting,
subject to a veto by 20% of shares, or 5% if a
listed company.]
Article 2394
Liability to the company's creditors - The
directors are answerable to the company's
creditors for non-observance of their duties
regarding the preservation of the company's
assets.
The action can be brought by the creditors
when the company's assets are insufficient
for the satisfaction of their credits.
The waiver of the action by the company
does not stop the exercise of the action by the
company's creditors. The settlement can be
challenged by the company's creditors only
through the action for revocation when there
are the causes of action.
[not in pre-reform law]
Article 2394
Liability to the company's creditors - The
directors are answerable to the company's
creditors for non-observance of their duties
regarding the preservation of the company's
assets.
The action can be brought by the creditors
when the company's assets are insufficient
for the satisfaction of their credits.
In the event of bankruptcy or of
administrative compulsory liquidation of the
company, the action may be brought by the
bankruptcy receiver or the commissionaire
liquidator.
The waiver of the action by the company
does not stop the exercise of the action by
the company's creditors. The settlement can
be challenged by the company's creditors
only through the action for revocation when
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there are the causes of action.
Article 2395
Individual action of the member and of
the third party - The provisions of the
preceding articles does not affect the right to
the compensation of damages pertaining to
the individual member or to third parties who
have been directly damaged by negligent or
fraudulent actions of the directors.
Section IX. The financial statements
Article 2423
Drafting preparation of the balance sheet The directors must prepare the financial
statements for the fiscal year, comprising the
balance sheet, a profit and loss statement and
explanatory notes.
The financial statements must be clearly
presented and they must represent truthfully
and correctly the assets and financial
situation of the company and the economic
results of the fiscal year. ....
Article 2430
Legal reserve - A sum corresponding to at
least one twentieth of the net annual profits
must be deducted from such profits to
establish a reserve, until this reaches onefifth of the company's capital. ....
Article 2431
Share premium - The sums received by the
company for the issue of shares at a price
higher than their nominal value cannot be
distributed until the legal reserve has reached
the limit established by article 2430.
Article 2432
Profit sharing - The sharing in profits by
promoters, founding members and directors
is computed on the basis of the net profits
resulting from the financial statements, after
the deduction for the legal reserve.
Article 2433
Distribution of profits to the members The decision on the distribution of profits is
approved by the members’ meeting which
approves the financial accounts ...
Dividends on the shares cannot be paid,
[same]
[same]
[same]
[same]
[same]
Article 2433
Distribution of profits to the members The shareholders meeting that approves the
financial statements shall resolve the
distribution of the profits to the
shareholders.
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except out of profits actually obtained and
resulting from the regularly approved
financial statements.
If a loss of the company’s capital occurs,
the distribution of profits cannot be made
until the capital is replenished or reduced in a
corresponding amount.
The dividends paid in violation of the
provisions of this article cannot be claimed
back, if the members collected them in good
faith on the basis of a regularly approved
financial statements, from which
corresponding net profits result.
Dividends on the shares cannot be paid,
except out of profits actually obtained and
resulting from the regularly approved
financial statements.
If a loss of the company’s capital occurs,
the distribution of profits cannot be made
until the capital is replenished or reduced in
a corresponding amount.
The dividends paid in violation of the
provisions of this article cannot be claimed
back, if the members collected them in good
faith on the basis of a regularly approved
financial statements, from which
corresponding net profits result.
2433-bis
Accounts on dividends. Payments on
account of dividends are permissible in
companies whose balance sheet is subject by
law to the certification by a [listed
accounting firm]. ....
The amount of payment on account of
dividends cannot exceed the amount of the
profits accrued since the close of the
previous fiscal year, reduced by the
proportions which shall be set aside as a
reserve pursuant to the law or the by-laws
and that of the available reserves, which is
lower.
Italian Parliament
__________________
[not in pre-reform law]
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NOTES
1.
Notice that when we studied US corporate law on power within the corporation, we
looked at two court decisions. Now, when we study Italian company law on the same
question, we look at a scholarly article and legislation (along with recent reforms). Do
you like finding law in cases or in legislation? Or does it depend on what you’ve become
used to?
2.
Looking at Italian law before the 2003 reforms, Professor Enriques described the
protections of minority shareholders as follows:
Although generally speaking there are few statutory rules protecting
minority shareholders, the holders of 10% of the capital can petition the local
court to get it to investigate the affairs of the company where irregularities are
suspected. A group of 20% of shareholders can call an emergency general
meeting. Until recently, no formal rules existed to provide for derivative actions.
The courts are, however, protective of minorities by using general concepts such
as good faith and fairness. Thus, the Court of Cassation has allowed
shareholders to bring actions to annul resolutions that violate their rights where
principles of good faith and fair play have not been observed.
Centre for Law & Business, Faculty of Law, University of Manchester, Company Law in
Europe: Recent Developments - Italy at 40-41 (Feb. 1999).
3.
How well does shareholder protection work in Italian courts? Looking at all of the
company law decisions by the Milan Tribunal during a recent 10-year period, Professor
Enriques analyzed those decisions dealing with questions of majority oppression, selfdealing transactions and non-payment of dividends. His findings were discouraging:
If corporate law matters to corporate governance and finance, then in
order to assess its quality in any given country, one must look at corporate law
"off the books," i.e., corporate law as applied by judges and other relevant public
officials. This paper provides an assessment of Italian corporate law off the
books based on analysis of a sample of 106 decisions by the Milan Tribunal,
Italy's most specialized court in corporate law. The judges' quality is evaluated by
looking at: (1) how deferential they are to corporate insiders; (2) how keen they
are to understand, and possibly take into account, the real rights and wrongs
underlying the case before them; (3) how antiformalistic their legal reasoning is;
(4) how concerned they are about the effects their decisions may have on the
generality of corporate actors.
The analysis casts a negative light on Milanese (and by extension,
Italian) corporate law judges. It highlights egregious cases of deference to
corporate insiders, especially with regard to parent-subsidiary relationships.
Furthermore, only recently, and in any case still sporadically, have at least a few
court's opinions been so drafted as to let the reader understand what the real
dispute was and which party had really acted opportunistically. In any case, it
appears to be rare for the court to take the substantive reasons for the dispute into
any account. Cases are described, in which the court has adduced very casuistic
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arguments. And finally, there is no sign that the judges care what signals they
send to corporate actors. Apparently, they are quite unconcerned about whether
their decisions provide the right incentives for directors and shareholders.
Luca Enriques (Universita' di Bologna; European Corporate Governance Institute), Off
the Books, but on the Record: Evidence from Italy on the Relevance of Judges to the
Quality of Corporate Law, Forthcoming in GLOBAL MARKETS, DOMESTIC INSTITUTIONS:
CORPORATE LAW AND GOVERNANCE IN A NEW ERA OF CROSS-BORDER DEALS (Curtis J.
Milhaupt ed., New York: Columbia University Press) SSRN Paper 300573 (October
2002).
4.
But these assessments of Italian company law came before the reforms of 2003 and 2005,
reflected in the legislative texts above. The Italian reforms are consistent with the winds
of change blowing across corporate Europe over the past decade. In 2002, the EU
Commission, foreseeing these changes, charged a group of so-called “wise men” to
recommend company law reforms. Their report represents a fundamental rethinking of
European company law. Here’s what they said on corporate governance:
_____________________________
Report of the High Level Group of Company Law Experts
on a Modern Regulatory Framework for Company Law in Europe
Brussels, 4 November 2002
CHAPTER III – “Corporate Governance”
The original mandate of the Group included a review of whether and, if so, how the EU
should actively co-ordinate and strengthen the efforts undertaken by and within Member States to
improve corporate governance in Europe. We stress that corporate governance is a system, having
its foundations partly in company law and partly in wider laws and practices and market
structures.
Being the residual claimholders, shareholders are ideally placed to act as a watchdog.
This is particularly important in listed companies, where minority’s apathy may have harmful
effects. Shareholders’ influence will highly depend on the costs and difficulties faced.
Shareholders’ influence was traditionally exercised through the general meeting, which is no
longer physically attended by many. Modern technology can be very helpful here, if it is
introduced in a balanced way.
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Pre-meeting communication is frequently a one-way process. The biggest difficulties and
costs arise with bearer shares, but registered shares also present some problems. Modern
technology may offer a solution to many problems. Putting meeting materials and proxy forms on
the company’s website is efficient for both the company and its shareholders. Many responses to
the consultation supported the enabling approach, but the Group believes that we should
anticipate future normal practice.
The rights to ask questions and table resolutions are often difficult to exercise, but
responses to the consultation did not call for mandatory provisions at EU level in this area. In
practice, the exercise of these important rights may be facilitated by modern technology, but
companies should be able to take measures to keep the whole process manageable. The necessary
flexibility for companies should be provided for at national level, but annual disclosure of how
these rights can be exercised should be required at EU level.
In view of the difficulties to attend meetings, shareholders should be able to vote in
absentia. The necessary facilities should be offered, but not imposed, to shareholders. Some
companies offer participation to general meeting via electronic means, which increase
shareholders’ influence in an efficient way. Use of electronic means in meetings should be
possible for companies, but not yet mandatory.
Institutional shareholders have large shareholdings with voting rights, and tend to use
them more frequently than before. Responses to the consultation were mixed about a possible
formalisation of the institutional investors’ role. The Group believes that good governance of
institutional investors requires disclosure to their beneficiaries of their investment and voting
policies, and a right of their beneficiaries to the voting records showing how voting rights have
been exercised in a particular case. Responses to the consultation did not support an obligation to
vote, and the Group agrees that there are no convincing reasons for imposing such an obligation.
In many cases, shareholders are inclined not to vote, due to a lack of influence and/or a
lack of information. The special investigation procedure offered in several Member States is an
important deterrent. A EU rule on special investigation right was supported by responses to the
consultation. It should be open to the general meeting or a significant minority, and any
authorisation by the court or administrative body should be based on serious suspicion of
improper behaviour.
Many difficulties prevent dispersed shareholders from directly monitoring management,
which calls for an active role of non-executive or supervisory directors. No particular form of
board structure (one-tier/two-tier) is intrinsically superior : each may be the most efficient in
particular circumstances.
The presence of (a group of) controlling shareholder(s) is likely to result in closer
monitoring of management, but non-executive or supervisory directors then have an important
role on behalf of the minority. Their general oversight role is of particular significance in three
areas, where conflicts of interests may arise: nomination of directors, remuneration of directors,
and audit of the accounting for the company’s performance. The need for more independent
monitoring is highlighted by the US regulatory response to recent scandals. The Group does not
express views on the composition of the full (supervisory) board, but intends to promote the role
of non-executive / supervisory directors. Nomination, remuneration and audit committees could
be set up, and composed of a majority of independent directors. To qualify as independent, a
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non-executive or supervisory director, apart from his directorship, must have no further
relationship, with the company, from which he derives material value. Certain other relationships
with the company, its executive directors or controlling shareholders may also impair
independence. Related parties and family relationships should also been taken into account. With
respect to the competence expected from non-executive or supervisory directors, existing rules
are generally abstract. Competence must be assessed together with the role a director has on the
board. Basic financial understanding is always required, but other skills may be of relevance.
Remuneration of directors is one of key area of conflict of interests. In order to align the
interests of executive directors with the interests of the shareholders, remuneration is often linked
to the share price, but this potentially has a series of negative effects. The Group considers that
there is no need for a prohibition of remuneration in shares and share options, but that appropriate
rules should be in place.
Recent corporate scandals and responses highlight the key importance of trust in financial
statements. At national level, the board traditionally has a collective responsibility for the probity
of financial statements, which avoids undue excessive individual influence. Collective
responsibility must cover all statements on the company’s financial position, except for ad hoc
disclosure (where proper delegation must be organised), and also all statements on key
non-financial data.
The introduction of a framework rule on wrongful trading was opposed by some
respondents who argued that this is a matter of insolvency law. The Group rejects this view: the
responsibility of directors when the company becomes insolvent has its most important effect
prior to insolvency and is a key element of an appropriate corporate governance system. Various
existing national rules make directors liable for not reacting when they ought to foresee the
company’s insolvency. The details of these national rules vary considerably, but they generally
apply to group companies and do not interfere with on-going business decisions. The majority of
responses to the consultation supported the introduction of a EU rule on wrongful trading.
Without overly restricting management’s decisions, such a rule would enhance creditors’
confidence and introduce an equivalent level of protection across the EU.
Misleading disclosure by directors should be properly sanctioned, and applicable
sanctions should be defined by Member States. Criminal and civil sanctions present some
weaknesses, and the disqualification of a person from serving as a director of companies across
the EU is an alternative sanction which may be easier to effectuate and has a powerful deterrent
and longer disabling effect.
A proper audit is fundamental to good corporate governance. Some initiatives have
already been taken by the Commission, among which the Recommendation on Auditor
Independence. A new Communication on Audit is expected soon. In the present Report, the
Group has focused on the internal aspects of auditing practices. As explained above, the Group
believes that there is a key role to play for non-executive or supervisory directors who are in the
majority independent. The main missions of the audit committee, which in practice is often set up
for these purposes, are summarised in the present Report with respect to both the relationship
between the executive managers and the external auditor, and the internal aspects of the audit
function.
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In the Consultative Document, the Group expressed reservations about the establishment
of a EU corporate governance code: the adoption of such a code would not achieve full
information for investors, and it would not contribute significantly to the improvement of
corporate governance in Europe. A clear majority of responses to the Consultative Document
rejected the creation of a European corporate governance code.
_________________________________
NOTES
1.
One of the members of the High Level Group commented:
Enron is not just an American balance sheet scandal, but should teach
Europe a lesson on how to act in a timely manner. One of the key concerns of
European company and capital market law reform should be improving European
corporate governance. For company law, the focus is clearly on the board.
Shareholder decision-making on the principles and limits of board, full disclosure
(also of the individual remuneration), and mandatory accounting of stock options
under revised international accounting standards might be useful European rules.
Disclosure is a powerful tool for improving corporate governance in Europe. It
interferes least with freedom and competition of enterprises in the market and
also avoids the well-known petrifying effect of European substantive law.
Non-disclosure and, even more, false disclosure must have consequences for the
directors that are felt.
Klaus J. Hopt (Professor, Max Planck Institute for Private Law), Abstract: Modern
Company and Capital Market Problems: Improving European Corporate Governance
after Enron, SSRN Paper 356102 (November 2002, revised December 2009).
2.
In response to the High Level Group Report the EU Commission urged reliance on
voluntary codes of corporate governance that companies must adopt (and comply with) or
explain their reasons for non-adoption. The focus is on private compliance rather than
judicial enforcement. In a communication that responded to the High Level Group
report, the EU Commission emphasized greater transparency, freedom of companies to
adopt what suits them best, and national (rather than pan-European) solutions.
3.
Voluntary codes of corporate governance, all of which apply on a “comply or explain”
basis, have proliferated in Europe. See Eddy Wymeersch, Enforcement of Corporate
Governance Codes, SSRN Paper 759364 (June 2005, revised February 2010) (providing
overview of European corporate governance codes, with focus on the codes of Germany
and the Netherlands, whose company law makes specific reference to such codes). The
widespread European view, contrary to the US approach taken in the Sarbanes-Oxley Act
of 2002, is that market-led enforcement and company-specific mechanisms constitute the
“best practice” for developing adaptive and effective corporate governance practices.
The ECGI (European Corporate Governance Institute) has placed all the various
European corporate governance codes online at http://www.ecgi.org/codes/index.php.
Italy’s Corporate Governance Code, available in both English and Italian, was published
in March 2006, and is completely voluntary. Here is the table of contents:
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Introduction
Article 1 – Role of the Board of Directors
Article 2 – Composition of the Board of Directors
Article 3 – Independent Directors
Article 4 – Treatment of corporate information
Article 5 – Internal committees of the Board of Directors
Article 6 – Appointment of Directors
Article 7 – Remuneration of Directors
Article 8 – Internal control system
Article 9 – Directors’ interests and transactions with related parties
Article 10 – Members of the Board of Auditors
Article 11 – Relations with the shareholders
Article 12 – Two tier and one-tier management and control systems
What standards apply to board conflicts of interest? The Italian governance code
contains only three references: (1) “The Board of Directors shall evaluate the
management of conflicts of interest” – 1.C.1.b; (2) “Non-executive directors shall pay
particular care to the areas where conflicts of interest may exist” – 2.P.2; and (3) “The
Board of Directors shall adopt measures aimed at ensuring where a director is bearer of
an interest … are performed in a transparent manner and meet criteria of procedural and
substantive fairness” – 9.P.1. What happens if a majority shareholder engages in unfair
self-dealing? The code creates no enforcement mechanisms. Shareholders have no rights
under the code to demand an inspection of company documents to uncover unfair selfdealing or other conflicts of interest. Nor is there any specification of the procedures
shareholders might use to prevent the transaction or obtain compensation.
By the way, what do you think is included in the Corporate Code of Conduct for
the United States? Check the index of corporate governance codes of countries around
the world. So why doesn’t the United States have one?
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147
Day 6 – Tuesday, July 27
B.
Corporate Purposes
One of the most fundamental questions in corporate law is “to whom does the board of
directors owe its duties?” If the answer is shareholders, then the board presumably should put the
interests of creditors, employees, and communities behind those of shareholders. If a business
decision will benefit shareholders, but harm other corporate constituents, then so be it.
Today’s readings begin with a classic case in US corporate law, which seems to say that
the purpose of the corporation is for the benefit of shareholders. (But when you scratch below the
surface, something different comes up.) We then turn to a current rethinking in US statutes and
among academics about the purpose of the corporation.
Next we look at this question in Italy and consider the liability of directors for putting
shareholder interests ahead of other company constituents. If a business fails, can directors be
held liable for not keeping it afloat? What if shareholders want directors to take business risks,
even if it means the possibility of bankruptcy? What happens if directors take such risks – will
they be held liable, and by whom?
1.
Shareholder wealth maximization -- United States
Dodge v. Ford Motor Co.
Supreme Court of Michigan
204 Mich. 459, 170 N.W. 668 (1919)
The Ford Motor Company is a corporation, organized and existing under Act No. 232 of
the Public Acts of 1903.
The parties in the first instance associating, who signed the articles, included Henry Ford,
whose subscription was for 255 shares, John F. Dodge, Horace E. Dodge, the plaintiffs, who each
subscribed for 50 shares, and several other persons. The company began business in the month of
June, 1903. In the year 1908, its articles were amended and the capital stock increased from
$150,000 to $2,000,000, the number of shares being increased to 20,000.
The business of the company continued to expand. The cars it manufactured met a public
demand, and were profitably marketed, so that, in addition to regular quarterly dividends equal to
5% monthly on the capital stock of $2,000,000, its board of directors declared and the company
paid [a total of $41,000,000 in special dividends]:
Fiscal Year
Cars sold
Profits
1910
18,664
$4,521,509
1911
34,466
$6,275,031
1912
68,544
$13,057,312
Surplus
Special dividends
$14,745,095
$3,000,000
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148
1913
168,304
$25,046,767
$28,124,173
$12,000,000
1914
248,307
$30,338,454
$48,827,032
$11,000,000
1915 (10 months)
264,351
$24,641,423
$59,135,770
$14,000,000
1916
472,350
$59,994,918
$111,960,907
$5,000,000
Originally, the car made by the Ford Motor Company sold for more than $900. From time to
time, the selling price was lowered and the car itself improved until in the year ending July 31,
1916, it sold for $440. For the year beginning August 1, 1916, the price of the car was reduced
$80 to $360.
The following is admitted to be a substantially correct statement of the financial affairs of
the company on July 31, 1916:
Assets
Working
Cash on hand and in bank
Michigan municipal bonds
Accounts Receivable
Merchandise and supplies
Investments--outside
Expense inventories
Plant
Land
Buildings and fixtures
Machinery and power plant
Factory Equipment
Tools
Patterns
Patents
Office Equipment
Total assets
$ 52,550,771
1,259,029
8,292,778
31,895,434
9,200
434,055
5,232,156
17,293,293
8,896,342
3,868,261
1,690,688
170,619
64,339
431,249
$132,088,219
Liabilities
Working
Accounts payable
Contract deposits
Accrued pay rolls
Accrued salaries
Accrued expenses
Contract rebates
Buyers’ P. S. rebate
Reserves
For fire insurance
For depreciation of plant
Total liabilities
Stockholders’ Equity
Surplus
Capital stock
Total
$ 7,680,866
1,519,296
847,953
338,268
1,175,070
2,199,988
48,099
57,493
4,260,275
$ 18,127,312
111,960,907
2,000,000
$132,088,219
The following statement gives details of the business of the Ford Motor Company for the
fiscal year July 31, 1915, to July 31, 1916:
Number of cars made in year
508,000
Total business done
$206,867,347
Profit for the year
$59,994,118
Cash in hand and in banks
$52,550,771
Materials on hand
$31,895,434
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Cars on hand (2 ½ weeks' output)
35,650
Cars sold during year
472,350
Employed at home plant
34,489
Employed at home offices
1,028
Employees in Detroit plant getting $5 a day or more
27,002
Employed at 84 branch plants
14,355
Total employees (all plants)
49,872
Total employees getting $5 a day or more
36,626
From a mere assembling plant, the plant of the Ford Motor Company came to be a
manufacturing plant, in which it made many of the parts of the car which in the beginning it had
purchased from others. At no time has it been able to meet the demand for its cars or in a large
way to enter upon the manufacture of motor trucks.
No special dividend having been paid after October, 1915 (a special dividend of
$2,000,000 was declared in November, 1916, before the filing of the answers), the plaintiffs, who
together own 2,000 shares, or one-tenth of the entire capital stock of the Ford Motor Company,
on the 2d of November, 1916, filed in the circuit court for the county of Wayne, in chancery, their
bill of complaint, in which bill they charge that since 1914 they have not been represented on the
board of directors of the Ford Motor Company, and that since that time the policy of the board of
directors has been dominated and controlled absolutely by Henry Ford, the president of the
company, who owns and for several years has owned 58% of the entire capital stock of the
company; it is charged that notwithstanding the earnings for the fiscal year ending July 31, 1916,
the Ford Motor Company has not since that date declared any special dividends:
"And the said Henry Ford, president of the company, has declared it to be the
settled policy of the company not to pay in the future any special dividends, but
to put back into the business for the future all of the earnings of the company,
other than the regular dividend of five per cent (5%) monthly upon the authorized
capital stock of the company--two million dollars ($2,000,000)."
This declaration of the future policy, it is charged in the bill, was published in the public
press in the city of Detroit and throughout the United States in substantially the following
language: "My ambition," declared Mr. Ford, "is to employ still more men; to spread the benefits
of this industrial system to the greatest possible number, to help them build up their lives and
their homes. To do this, we are putting the greatest share of our profits back into the business."
It is charged further that the said Henry Ford stated to plaintiffs personally, in substance,
that as all the stockholders had received back in dividends more than they had invested they were
not entitled to receive anything additional to the regular dividend of 5% a month, and that it was
not his policy to have larger dividends declared in the future, and that the profits and earnings of
the company would be put back into the business for the purpose of extending its operations and
increasing the number of its employees, and that, inasmuch as the profits were to be represented
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by investment in plants and capital investment, the stockholders would have no right to complain.
It is charged (paragraph 16) that—
"The said Henry Ford, dominating and controlling the policy of said company,
has declared it to be his purpose--and he has actually engaged in negotiations
looking to carrying such purposes into effect--to invest millions of dollars of the
company's money in the purchase of iron ore mines in the Northern Peninsula of
Michigan or state of Minnesota; to acquire by purchase or have built ships for the
purpose of transporting such ore to smelters to be erected on the River Rouge
adjacent to Detroit in the county of Wayne and state of Michigan; and to
construct and install steel manufacturing plants to produce steel products to be
used in the manufacture of cars at the factory of said company; and by this means
to deprive the stockholders of the company of the fair and reasonable returns
upon their investment by way of dividends to be declared upon their stockholding
interest in said company."
Plaintiffs ask for an injunction to restrain the carrying out of the alleged declared policy
of Mr. Ford and the company, for a decree requiring the distribution to stockholders of at least
75% of the accumulated cash surplus, and for the future that they be required to distribute all of
the earnings of the company except such as may be reasonably required for emergency purposes
in the conduct of the business.
The answer of the Ford Motor Company, denies that Henry Ford forced upon the board
of directors his policy of reducing the price of cars by $80, and says that the action of the board in
that behalf was unanimous and made after careful consideration. It admits that it has decided to
increase the output of the company and is engaged in practically duplicating its plan at Highland
Park; that it has been the policy of the company and its practice for eight or ten years to cut the
price of cars and increase the output, a plan which has been productive of great prosperity, and
that what was done the 1st of August, 1916, was strictly in accordance with this policy; that it was
not carried out by cutting the price of cars August 1, 1915, because after full discussion it was
determined that the proposed expansions of business were necessary to secure the continued
success of the company and that a considerable additional sum ought to be accumulated for the
purpose of extensions and making the improvements complained of. It is denied that the
proposed expansions jeopardize the interests of the plaintiffs and asserted that they are in
accordance with the best interests of the company and in pursuance of their past policy. It is
denied that the policy continued would destroy competition, and any idea of creating a monopoly
is denied.
The cause came on for hearing in open court [in the Circuit Court for Wayne County] on
the 21st of May, 1917. [The court ordered a dividend of one half of accumulated cash surplus and
enjoined the constructing of a smelting plant and furnaces.] Defendants have appealed.
OSTRANDER, C. J. (after stating the facts as above).
The rule which will govern courts in deciding these questions is not in dispute
"It is a well-recognized principle of law that the directors of a corporation, and
they alone, have the power to declare a dividend of the earnings of the
corporation, and to determine its amount. 5 Amer. & Eng. Enc. Law, 725.
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Courts of equity will not interfere in the management of the directors unless it is
clearly made to appear that they are guilty of fraud or misappropriation of the
corporate funds, or refuse to declare a dividend when the corporation has a
surplus of net profits which it can, without detriment to its business, divide
among its stockholders, and when a refusal to do so would amount to such an
abuse of discretion as would constitute a fraud, or breach of that good faith which
they are bound to exercise towards the stockholders." [from Hunter v. Roberts,
Throp & Co., 83 Mich. 63, 71.]
When plaintiffs made their complaint and demand for further dividends, the Ford Motor
Company had concluded its most prosperous year of business. The demand for its cars at the
price of the preceding year continued. It could make and could market in the year beginning
August 1, 1916, more than 500,000 cars.
It had declared no special dividend during the business year except the October, 1915,
dividend. It had been the practice, under similar circumstances, to declare larger dividends.
Considering only these facts, a refusal to declare and pay further dividends appears to be not an
exercise of discretion on the part of the directors, but an arbitrary refusal to do what the
circumstances required to be done.
These facts and others call upon the directors to justify their action, or failure or refusal to
act. In justification, the defendants have offered testimony tending to prove, and which does
prove, the following facts: It had been the policy of the corporation for a considerable time to
annually reduce the selling price of cars, while keeping up, or improving, their quality. As early
as in June, 1915, a general plan for the expansion of the productive capacity of the concern by a
practical duplication of its plant had been talked over by the executive officers and directors and
agreed upon; not all of the details having been settled, and no formal action of directors having
been taken. The erection of a smelter was considered, and engineering and other data in
connection therewith secured. In consequence, it was determined not to reduce the selling price
of cars for the year beginning August 1, 1915, but to maintain the price and to accumulate a large
surplus to pay for the proposed expansion of plant and equipment, and perhaps to build a plant for
smelting ore. It is hoped, by Mr. Ford, that eventually 1,000,000 cars will be annually produced.
The contemplated changes will permit the increased output.
The plan, as affecting the profits of the business for the year beginning August 1, 1916,
and thereafter, calls for a reduction in the selling price of the cars. It is true that this price might
be at any time increased, but the plan called for the reduction in price of $80 a car. The capacity
of the plant, without the additions thereto voted to be made (without a part of them at least),
would produce more than 600,000 cars annually. This number, and more, could have been sold
for $440 instead of $360, a difference in the return for capital, labor, and materials employed of at
least $48,000,000. In short, the plan does not call for and is not intended to produce immediately
a more profitable business, but a less profitable one; not only less profitable than formerly, but
less profitable than it is admitted it might be made. The apparent immediate effect will be to
diminish the value of shares and the returns to shareholders.
It is the contention of plaintiffs that the apparent effect of the plan is intended to be the
continued and continuing effect of it, and that it is deliberately proposed, not of record and not by
official corporate declaration, but nevertheless proposed, to continue the corporation henceforth
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as a semi-eleemosynary institution and not as a business institution. In support of this contention,
they point to the attitude and to the expressions of Mr. Henry Ford.
Mr. Henry Ford is the dominant force in the business of the Ford Motor Company. No
plan of operations could be adopted unless he consented, and no board of directors can be elected
whom he does not favor. One of the directors of the company has no stock. One share was
assigned to him to qualify him for the position, but it is not claimed that he owns it.
A business, one of the largest in the world, and one of the most profitable, has been built
up. It employs many men, at good pay. "My ambition," said Mr. Ford, "is to employ still more
men, to spread the benefits of this industrial system to the greatest possible number, to help them
build up their lives and their homes. To do this we are putting the greatest share of our profits
back in the business." "With regard to dividends, the company paid sixty per cent on its
capitalization of two million dollars, or $1,200,000, leaving $58,000,000 to reinvest for the
growth of the company. This is Mr. Ford's policy at present, and it is understood that the other
stockholders cheerfully accede to this plan."
The record, and especially the testimony of Mr. Ford, convinces that he has to some
extent the attitude towards shareholders of one who has dispensed and distributed to them large
gains and that they should be content to take what he chooses to give. His testimony creates the
impression, also, that he thinks the Ford Motor Company has made too much money, has had too
large profits, and that, although large profits might be still earned, a sharing of them with the
public, by reducing the price of the output of the company, ought to be undertaken. We have no
doubt that certain sentiments, philanthropic and altruistic, creditable to Mr. Ford, had large
influence in determining the policy to be pursued by the Ford Motor Company -- the policy which
has been herein referred to.
We do not draw in question, nor do counsel for the plaintiffs do so, the validity of the
general proposition stated by counsel nor the soundness of the opinions delivered in the cases
cited. The case presented here is not like any of them. The difference between an incidental
humanitarian expenditure of corporate funds for the benefit of the employees, like the building of
a hospital for their use and the employment of agencies for the betterment of their condition, and
a general purpose and plan to benefit mankind at the expense of others, is obvious. There should
be no confusion (of which there is evidence) of the duties which Mr. Ford conceives that he and
the stockholders owe to the general public and the duties which in law he and his codirectors owe
to protesting, minority stockholders. A business corporation is organized and carried on
primarily for the profit of the stockholders. The powers of the directors are to be employed for
that end. The discretion of directors is to be exercised in the choice of means to attain that end,
and does not extend to a change in the end itself, to the reduction of profits, or to the
nondistribution of profits among stockholders in order to devote them to other purposes.
There is committed to the discretion of directors, a discretion to be exercised in good
faith, the infinite details of business, including the wages which shall be paid to employees, the
number of hours they shall work, the conditions under which labor shall be carried on, and the
price for which products shall be offered to the public.
It is said by appellants that the motives of the board members are not material and will
not be inquired into by the court so long as their acts are within their lawful powers. As we have
pointed out, and the proposition does not require argument to sustain it, it is not within the lawful
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powers of a board of directors to shape and conduct the affairs of a corporation for the merely
incidental benefit of shareholders and for the primary purpose of benefiting others, and no one
will contend that, if the avowed purpose of the defendant directors was to sacrifice the interests of
shareholders, it would not be the duty of the courts to interfere.
We are not, however, persuaded that we should interfere with the proposed expansion of
the business of the Ford Motor Company. In view of the fact that the selling price of products
may be increased at any time, the ultimate results of the larger business cannot be certainly
estimated. The judges are not business experts. It is recognized that plans must often be made
for a long future, for expected competition, for a continuing as well as an immediately profitable
venture. The experience of the Ford Motor Company is evidence of capable management of its
affairs. It may be noticed, incidentally, that it took from the public the money required for the
execution of its plan, and that the very considerable salaries paid to Mr. Ford and to certain
executive officers and employees were not diminished. We are not satisfied that the alleged
motives of the directors, in so far as they are reflected in the conduct of the business, menace the
interests of shareholders. It is enough to say, perhaps, that the court of equity is at all times open
to complaining shareholders having a just grievance.
The decree of the court below fixing and determining the specific amount to be
distributed to stockholders is affirmed. In other respects, except as to the allowance of costs, the
said decree is reversed.
_____________________
NOTES
1.
In Dodge v. Ford Motor Co., the Michigan Supreme Court ordered Ford Motor to pay
special dividends to the company’s shareholders.
a.
What did the court articulate as the purpose of the American corporation?
b.
What had Henry Ford done that was contrary to that purpose?
2.
Dodge v. Ford Motor Co. is one of the leading cases of American corporate law. It states
the fundamental proposition that the business corporation is to be run for the benefit of
shareholders, not other constituents. According to the case, when the interests of
shareholders and other constituents (such as employees or customers) collide,
shareholders win – the “shareholder primacy” principle.
a.
If this is so, why did the court second-guess Henry Ford’s decision to stop the
special dividend to free money for marketing and expansion plans? Were these
plans inconsistent with the long-term advantage of the shareholders? Wouldn’t it
maximize shareholder wealth to put a Ford car in every U.S. driveway, owned by
employees who earned a munificent $5/day?
b.
Who stood to lose the most if Ford’s plans were ill-conceived – Henry Ford who
owned 57% of the company, or the Dodge brothers who owned only 10%? Do
you think Ford would purposefully spite himself?
c.
If the court believed that Ford’s plans were ill-conceived – that is, he was
foolishly lowering the price of cars and keeping too much money in reserve –
why did the court not enjoin Ford’s vertical expansion plans into mining,
smelting and steel production? Was the court pursuing its own social agenda?
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154
Perhaps the most famous quote from Dodge v. Ford Motor Co. is that “judges are not
business experts.” This has been cited in many cases that apply the business judgment
rule – a judicial philosophy of non-interference in business decisions. Is the business
judgment rule a good idea? Consider the following two business choices presented to the
board of a company:
Option A - safe course
Option B - risky course
Invest in a new machine to produce plastic
bottles, with the following potential:
Invest in a new machine to produce fiberoptics wires, with the following potential:
Strong economy
OK economy
Weak economy
$60
$50
$40
The company will make money no matter
how the economy turns out. Everybody
(management and employees) keeps their
jobs!
a.
b.
c.
Strong economy
OK economy
Weak economy
$300
$ 0
- $ 90
The company will not make money or will
lose money if the economy is OK or
weak. If so, some employees lose their
jobs!
Assuming that there is an equal chance of the economy being strong, OK or
weak, which investment option would you recommend the board choose?
Is your view different depending on whether you are a shareholder, an executive,
an hourly employee, a supplier, a community member?
Should shareholders be able to sue the board if it chooses Option B, and the
economy goes weak? After all, how could a board choose an option that in all
likelihood would not make money for the company?
3.
In the past few decades, many state legislatures have passed so-called “other
constituents” statutes, which seem to discredit the rhetoric of the Ford Motor case. The first such
statute arose in Pennsylvania and is modeled on a proposal by Ralph Nader, a progressive critic
of corporate power in America. Curiously, the statute was championed by corporate executives
in that state worried about hostile takeovers (that is, the purchase of a controlling interest by an
uninvited corporate raider). Can you explain that corporate executives seeking to preserve their
corporate power would want a statute that validates the power of the power to consider nonshareholder constituencies? Politics – in government and in the corporation – seems to make for
a lot of strange bedfellows.
After you read the statute, you will find a law review article written by a progressive
corporate law scholar – the antithesis of Easterbrook and Fischel. As you read the article by
Larry Mitchell, ask yourself whether it would be a good idea of employees and other nonshareholder constituents had the power to seek protection under corporate law to the same extent
as shareholders. Can a governance structure work where servants (the board) serve multiple
masters (shareholders, creditors, employees, suppliers, customers, communities, Mother Earth)?
But don’t these other constituents deserve protection -- how should corporate law view them?
The article following the one by Mitchell is by Jonathan Macey, who gives a
contractarian answer to our question. Shareholders bought a corporate contract and with it the
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rights and privileges of being a shareholder; other constituents could have chosen to be
shareholders, but mostly did not, so they get the protections of their contracts – and whatever else
they can obtain from the political process. Mother Earth must look elsewhere for protection;
corporate law does not consider her part of the contract.
Pennsylvania Business Corporation Law
§1715. Exercise of Powers Generally
(a) General rule. – In discharging the duties of their respective positions, the board of directors,
committees of the board and individual directors of a business corporation may, in considering
the best interests of the corporation, consider to the extent they deem appropriate:
(1) The effects of any action upon any or all groups affected by such action,
including shareholders, employees, suppliers, customers and creditors of the corporation,
and upon communities in which offices or other establishments of the corporation are
located.
(2) The short-term and long-term interests of the corporation, including benefits
that may accrue to the corporation from its long-term plans and the possibility that these
interests may be best served by the continued independence of the corporation.
(3) The resources, intent and conduct (past, stated and potential) of any person
seeking to acquire control of the corporation.
(b) Consideration of interests and factors. – The board of directors, committees of the board and
individual directors shall not be required, in considering the best interests of the corporation or
the effects of any action, to regard any corporate interest or the interests of any particular group
affected by such action as a dominant or controlling interest or factor. The consideration of
interests and factors in the manner described in this subsection and in subsection (a) shall not
constitute a violation of 1712 (relating to standard of care and justifiable reliance).
_________________________
A Theoretical and Practical Framework for Enforcing
Corporate Constituency Statutes
70 TEX. L. REV. 579 (Feb. 1992)
Lawrence E. Mitchell 6
In 1989, at the urging of Governor Mario Cuomo, the New York legislature joined 28
other states to enact a "constituency statute," which authorizes (but does not obligate) corporate
boards of directors to consider the interests of constituencies other than stockholders in making
corporate decisions. Commenting on the proposed New York legislation, then Commissioner
Joseph Grundfest of the U.S. SEC remarked:
The grant of authority without accountability raises the real and present danger
that boards will use [§ 717(b)] as a fig leaf. Specifically, [§ 717(b)] may allow
boards to rationalize decisions that they would not otherwise support in the name
6
Associate Professor of Law, George Washington University.
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of constituencies who are powerless to monitor or challenge the actions that are
purportedly taken in their interest.
Furthermore, in August 1990, despite the growing popularity of constituency statutes, the
Committee on Corporate Laws of the American Bar Association's Business Law Section declined
to include similar language in the Revised Model Business Corporation Act.
These reactions characterize the prevailing critical response to an increasing judicial and
legislative trend toward detaching the corporation's board of directors from its traditional, bipolar
relationship with the corporation's stockholders. The principal criticism of rejecting this
traditional relationship is that authorizing the board to consider constituencies that have no
monitoring or enforcement powers would leave the board accountable to nobody.
The critics are correct that, by acknowledging the interests of other corporate
constituents, constituency statutes diminish the board's accountability to stockholders. What the
critics often fail to appreciate, however, is that these statutes go further to question implicitly the
underlying precept that directors ought to be accountable exclusively to stockholders.
I. A Theoretical Approach to Constituency Statutes
There is probably no more frequently articulated principle of corporate law than that
directors are fiduciaries of the corporation and its stockholders. Rather, the basic approach has
been to equate the interests of the stockholders and the interests of the corporation, which have
been identified at the lowest common denominator as stockholder wealth maximization. The
justification for this identification of interest has been the traditional assertion that the
stockholders "own" the corporation and therefore are entitled to have it managed in their interest.
A. Constituency Statutes
The constituency statutes currently in force permit a corporation's board of directors to
consider the interests of an enumerated list of constituents as well as the interests of the
stockholders in deciding on proposed corporate action. * * * These statutes threaten to
revolutionize "generations of corporation law in the states where they have been enacted" by
changing the established principle that directors' fiduciary duties are owed primarily to (or at least
for the benefit of) stockholders.
. The specter is raised of a board of directors blindly groping to balance the conflicting
interests of a variety of constituent groups without any means of measuring the interests required
to be considered or of assessing the relative priorities of such interests. The ultimate consequence
of this directorial chaos would be the elimination of any check on managerial discretion.
B.
Vertical and Horizontal Conflicts of Interest and the Fiduciary Fallacy
Courts and scholars have traditionally focused their analyses of internal corporate
conflicts on disputes between stockholders and management over management's use of corporate
property or processes to gratify its own interest. These conflicts between virtually omnipotent
managers and relatively powerless constituents of the corporation (or the corporation itself) can
be described as "vertical conflicts of interest," since they exist between a powerful group and
relatively powerless groups within the hierarchical corporate structure.
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Vertical conflicts present the problem of restraining the board from acting in its own
self-interest to the detriment of these less powerful groups. An illustration of a vertical conflict of
interest is self-dealing by a director or officer.
The exception to this unitary approach is the conflicts among constituents, which has
been sharpened by the dislocations caused by the takeover phenomenon. I term these conflicts,
which exist among two or more relatively powerless groups that have interests in the corporation,
"horizontal conflicts." Examples of these conflicts are the expropriation of wealth from
bondholders by stockholders and the layoff of employees as a cost-cutting measure designed to
assure the repayment of debt assumed to finance a leveraged takeover.
Vertical conflicts arise from the position of the board as manager of property in which it
has no interest and from its charge to manage that property in the interests of others. On the other
hand, horizontal conflicts result from competing claims to property in which each group has a
legitimate interest.
Constituency statutes are a means of permitting the board to reallocate these costs
without exposing itself to additional risks of litigation over vertical conflicts.
C. The Fiduciary Fallacy Examined
1. The Purpose of Rules Restraining Vertical Conflicts
Fiduciary duties are designed to redress the imbalance of power between the person who
manages the economic or personal interests of another and the person who has delegated (or who
has had delegated for her) that power to the fiduciary. Seen in this light, a variety of economic
participants in the corporation might legitimately be owed a fiduciary duty by managers to refrain
from self-dealing. Stockholders surely fit within this category. But I argue that some corporate
constituent groups other than stockholders have sufficient interest in the corporation, and
insufficient self-protective capabilities, that they ought to be given some legal protection against
directorial self-dealing.
2.
The Confusion of Vertical Restraints with Corporate Purpose
Charitable contribution cases, relatively few in number, reflect the analytical confusion
between vertical and horizontal conflicts. Although originally grounded in the doctrine of ultra
vires, they too present the risk that directors will use corporate property to further their own
interests rather than those of the corporation. Because charitable contributions seem to go beyond
the business functions of the corporation, the issue of charitable contributions became related to
that of corporate purpose. But, as even a cursory examination of the cases demonstrates,
preclusion of directorial self-dealing is at the heart of the issue.
For example, the famous case of Dodge v. Ford Motor Co., established that the pursuit of
stockholder profit is the primary purpose of the corporation. And, to this day, Dodge v. Ford
remains the leading case on corporate purpose. But, although the opinion gives no hint of any
other question, the historical context of that case strongly suggests self-dealing overtones.
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The Dodge brothers, ten-percent stockholders of Ford Motor Company, sued in part to
compel payment by the corporation of larger dividends than they had been receiving, given the
corporation's enormous profits and retained earnings. Henry Ford, the defendant's controlling
stockholder, had recently articulated a policy of retaining all but a relatively small portion of
these profits to permit the company's expansion and to reduce the price of its cars.
Although the court accepted Ford's altruistic motives at face value it is of more than
passing interest that the Dodge brothers, whose own business was a significant parts supplier to
Ford, had started a competing automobile manufacturing company. Obviously, large dividends
from Ford would have been useful in financing their venture. It seems likely that Ford's motives
in withholding dividends may have gone beyond simple altruism.
3.
Rules Restraining Vertical Conflicts Intensify Horizontal Conflicts: The
Role of Constituency Statutes
All of the corporation's constituents benefit from legal restraints on vertical conflicts of
interest. To the extent that directorial self-dealing deprives the corporation of usurped corporate
assets, surely the interests of all who look to the corporation for wealth and security will be
served by prohibiting such conduct. However, the consequence of placing enforcement
mechanisms exclusively in the hands of stockholders, along with the right to vote for those
directors and effect wholesale changes in control by selling their stock, just as surely focuses
directors' attention solely on the stockholders and imposes costs on other constituents.
This, then, is the cost of rules restraining vertical conflicts. Seen in this light the role of
constituency statutes becomes clear: constituency statutes permit the board to reallocate the cost
of restraining managerial self-dealing among the corporation's various constituents, while
protecting the board from incurring additional risks of litigation by stockholders who are unhappy
with that reallocation. This is so because constituency statutes shield directors from stockholder
litigation when they consider the interests of other constituents, even though the result might be
that the stockholders obtain less wealth than they otherwise would.
The creation and allocation of these costs under the existing legal structure can be
illustrated by the paradigmatic horizontal conflict case: a leveraged takeover. [The author then
describes a takeover battle in which the board of Greenacres Corporation chooses between two
competing bids for the company: one at a lower price that would leave management intact and
protect existing noteholders and employees, and another bid at a higher price, but without any
protections for non-shareholder constituents.]
The board has no choice but to accept the higher offer under Revlon, Inc. v. MacAndrews
& Forbes Holdings, Inc. 7 which requires the board to act as auctioneers of the corporation to
obtain the highest price for the stockholders once the sale of the corporation has become
inevitable. Any other action would be a breach by the board of its fiduciary duty under the
Revlon rule.
If a constituency statute permitting the board to take account of the interests of creditors
and employees were in force in Greenacres's state of incorporation, the result might well have
been different. It would have been clear to the board that an extra $1 in value obtained for each
7
506 A.2d 173 (Del. 1986).
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stockholder would result in a $6 loss for each noteholder. Given the substantial premium the
stockholders would have received in any event, the board reasonably might have decided that the
interests of the corporation as a whole were better served by accepting the lower priced offer.
The diminished gain to the stockholders would represent a portion of the cost of rules restraining
the board from acting in its own interest, and would have been borne by the stockholders roughly
in proportion to the benefit they received from those rules.
As to the employees and their communities, the same $1 of foregone stock price might
have sufficiently limited the increase in the corporation's debt burden such that the acquiror
would not have had to close plants in order to pay debt service. The outgoing board might even
have been able to contract with the acquiror to provide some protection for employees against at
least immediate layoffs, and some assistance for employees who might have been laid off in the
near term for legitimate business reasons. The price of these protections would be the same
diminution in stockholder gain, but would reflect a fairer allocation of the cost of the self-dealing
rules that permitted the employee losses in the first place.
Under existing law, the Revlon rule prohibits the board from accepting the lower priced
offer to protect creditors, employees, communities, or other constituents. Meanwhile,
constituency statutes permit the board to internalize these costs and apportion them among those
groups benefitted by the general proscription of managerial self-dealing. ***
III. A Practical Model for Enforcing Constituency Statutes
It is obvious that the corporation is far more complex an undertaking, consisting of
intertwined human and economic relationships, than the traditional stockholder-owner model
permits. But the centerpiece of constituent recognition, the constituency statute, stops short of
fulfilling its ultimate goal. Most of the statutes are permissive, imposing no requirement that the
board consider constituent interests.
My suggested approach is relatively simple. The basic presumption underlying the test
would continue to be that directors are to act in the interests of maximizing stockholder wealth.
However, boards would further be required to take into account the extent to which such actions
harm a range of statutorily identified constituents. Members of each such constituent group
would have standing under the relevant constituency statute to challenge corporate actions that
they claim have injured them.
Plaintiffs would have the burden of proving that such actions were in fact injurious. The
injury must have been to a legitimate interest, and in this respect plaintiffs would need to resort to
express or implied contracts with the corporation, legitimate expectations, and the like. After the
plaintiff will have demonstrated injury, the burden would be placed on the board to prove that its
actions were undertaken in pursuit of a legitimate corporate purpose rather than in the interests of
the board itself. For example, the board would have to show that it was acting to promote the
interests of stockholders, of another statutorily identified constituent group, or of the corporation
as a whole. Finally, the plaintiffs would be permitted to prove that the board's stated purpose
could have been accomplished in a manner less injurious to their interests. If the plaintiffs were
to meet that burden, the appropriate remedy would be to enjoin the challenged transaction or, if
necessary and possible, to undo it.
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To see how this test might work, consider the hypothetical Greenacres takeover I
discussed earlier. If the directors permit the higher priced offer to succeed despite its concomitant
harm to noteholders, the noteholders can bring an action alleging a violation of the board's duty
not to harm. The board will then demonstrate, as it can, that the transaction is in pursuit of a
legitimate corporate objective, the maximization of the corporation's value. However, all of that
maximized value is going to benefit the stockholders to the damage of the noteholders in the
significant decrease in the market value of their notes. The noteholders may then demonstrate
that, had the board permitted the lower priced offer to succeed, the basic business goal would still
have been attained but with less harm to the noteholders and at only slight cost to the
stockholders.
The Greenacres employees have a similar cause of action, analyzed in a similar manner.
In considering the employees' rights, relevant evidence includes express or implicit promises of
job security, length of time that facilities had been operating, the average length of service of
employees of such facilities, compensation levels relative to those of comparable jobs (to help
evaluate, if possible, the trade-off between compensation and job security), severance benefits,
and other forms of vested, contingent compensation generally available to employees.
Ultimately, constituency statutes suggest a new role for the board [in which it] serves as
an independent mediator of a variety of legitimate economic and personal interests in the
corporation. This role acknowledges that the modern large corporation has become a pluralistic
entity. It also acknowledges the interdependence of corporate constituent groups and the
importance of each in attaining corporate success. Finally, it focuses on the board's responsibility
to resolve the tensions arising from conflicting interests within corporate groups in a manner most
beneficial to the entire enterprise.
_____________________________________
An Economic Analysis of the Various Rationales for Making
Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties
21 Stetson L. Rev. 23 (1991)
Jonathan R. Macey 8
I. INTRODUCTION
Under traditional state and corporate law doctrine, officers and directors of both public
and closely held firms owe fiduciary duties to shareholders and to shareholders alone. Directors
and officers are legally required to manage a corporation for the exclusive benefit of its
shareholders, and protection for other sorts of claimants exists only to the extent provided by
contract. This legal norm, however, has been subjected to considerable stress as a result of recent
legislative action in a majority of states that authorizes (or, in the case of one state, requires)
directors to take into account the interests of other "constituencies" such as employees, suppliers,
customers, and the local community in making business decisions.
II. THREE CRITICISMS OF NONSHAREHOLDER CONSTITUENCY STATUTES
A.
8
The Residual Claimant Argument
Professor, Cornell Law School, Ithaca, New York.
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The most well-known argument supporting the proposition that fiduciary duties should be
owed exclusively to shareholders is derived from the insight of modern financial theory that
shareholders retain the ultimate authority to control the corporation because they have the greatest
stake in the outcome of corporate decisionmaking. The idea here is that, despite the fact that
corporations are merely complex webs of contractual relations--and despite the fact that
shareholders do not "own" the modern, publicly held firm in any meaningful sense--the ultimate
right to guide the firm (or, more precisely, to have it guided on their behalf) is retained by the
shareholders because they are the group that values it most highly.
The implication is clear. Since shareholders value fiduciary duties most highly, they will
pay other corporate constituencies for the right to have these duties inure to their benefit. If, for
example, the shareholders place an aggregate value of $10 million on the legal protection
provided by a corporate governance system that allocates fiduciary duties exclusively to
shareholders, while other constituents value it at $2 million, then both parties will be better off if
the shareholders are permitted to compensate these other constituencies--in the form of higher
interest on bonds, higher wages to workers and managers, and better prices for suppliers and
customers-- for the right to have fiduciary duties flow exclusively to them.
Thus, all constituencies will be better off by allocating fiduciary duties within the firm
exclusively to shareholders if the latter place the highest value on such duties. But why would
shareholders, as residual claimants, place the highest value on fiduciary duties? After all, once we
accept the view that the firm is not an entity at all, but a set of contracts or series of bargains, the
organization decomposes into a group of identifiable participants--e.g., investors, managers,
creditors, employees, and suppliers--who negotiate an equilibrium position among themselves.
An implication of this perspective is to deny that any one class of participants (i.e., the
shareholders) have a natural right to view themselves as the owners of the firm. Rather,
shareholders are seen not as the firm's owners, but as suppliers of equity capital; they are the
"residual claimants," who bring to the firm their special ability at risk-bearing, which creditors,
managers, and employees tend to lack.
Of course, we view the shareholders as simply the residual claimants who have agreed to
accept a more uncertain future return because of their superior risk-bearing capacity, it is far from
self-evident that shareholders are necessarily entitled to control the firm," i.e., to have managers'
and directors' fiduciary duties flow exclusively to them. The rationale for why shareholders place
the highest value on such rights is said to be that:
Uniquely, the residual claimants ... are interested in the firm's overall
profitability, whereas creditors and managers presumably other constituents as
well] are essentially fixed claimants who wish only to see their claims repaid and
who will logically tend to resist risky activities. Having less interest in the overall
performance of the firm, creditors can bargain through contract and do not need
representation on the board to monitor all aspects of the firm's performance.
Thus, fiduciary duties exist because the decisions that face officers and directors of
corporations are sufficiently complex and difficult to predict that it would not be feasible to
specify in advance how to respond to a wide range of future contingencies. Fiduciary duties are
the mechanism invented by the legal system for filling in the unspecified terms of shareholders'
contingent contracts. These duties run solely to shareholders because, as residual claimants, gains
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and losses from abnormally good or bad performance are the lot of the shareholders, whose
claims stand last in line."
B. The "Too Many Masters" Argument
The second and perhaps the most common argument made against nonshareholder
constituency statutes is that such statutes, to the extent they effect any change whatsoever in
existing law, simply confuse the legal landscape by forcing directors to attempt an impossible
task--pleasing a multitude of masters with competing and conflicting interests. As the Committee
on Corporate Laws of the American Bar Association's Section on Business Law has argued in its
position paper on nonshareholder constituency statutes:
The confusion of directors in trying to comply with such statutes, if
interpreted to require directors to balance the interests of various constituencies
without according primacy to shareholder interests, would be profoundly
troubling. Even under existing law, particularly where directors must act quickly,
it is often difficult for directors acting in good faith to divine what is in the best
interests of shareholders and the corporation. If directors are required to consider
other interests as well, the decision- making process will become a balancing act
or search for compromise. When directors must not only decide what their duty
of loyalty mandates, but also to whom their duty of loyalty runs (and in what
proportions), poorer decisions can be expected.
Take, for example, the issue of whether a firm should relocate its headquarters from the
large metropolis that has served as its base for many years to a small town with better schools,
lower labor costs, and lower taxes. While shareholders might profit from this move, the
community in which the firm is presently located would clearly suffer. Some employees might
benefit, others might suffer. The firm could justify virtually any decision as serving the interests
of some constituency. Imagine now that the proposal to relocate the company comes not from
incumbent management, but from an outside bidder who is launching a hostile tender offer for the
company at a substantial premium over the current market price of the firm's shares. Here the
nonshareholder constituency statute can be used to justify resisting a lucrative offer that may be
in the best interests of the shareholders.
Thus, the problem with nonshareholder constituency statutes is not that they require
managers and directors to serve too many masters. The problem is that they have the potential to
permit managers and directors to serve no one but themselves.
C.
The Real Concern: Shareholders as the Group with the Most Acute Need for
Fiduciary Duties
The real drawback of nonshareholder constituency statutes is that they fail to recognize
that shareholders face more daunting contracting problems than other constituencies. These acute
contracting problems vindicate the traditional common law rule that managers and directors owe
their primary fiduciary responsibilities to shareholders. Nonshareholder constituencies can protect
themselves against virtually any kind of managerial opportunism by retaining negative control
over the firm's operations. Workers, bondholders, and even local communities can protect their
interests by contracting for the right to veto future proposed actions by management. By contrast,
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the shareholders must retain positive control over the actions of the firm in order to realize the
full potential value of their shares. * * *
Workers are perhaps the group with whom one sympathizes the most when thinking
about the possible benefits associated with nonshareholder constituency statutes. Unlike
shareholders, who are concerned with the overall profitability of the firm in which they have
invested, workers are concerned with wages, pensions, hours, and working conditions. From a
contracting perspective, wages and hours pose few, if any, contracting problems. Workers could
potentially protect their wage expectations with pension guarantees, golden parachutes, successor
clauses, stipulated cost of living adjustments, and other straightforward provisions. * * *
It might be argued that rank-and-file employees lack bargaining power, and that at-will
employment contracts are likely to reflect this lack of bargaining power. Consequently, it has
been argued that the gap-filling that is done in the context of at-will employment contracts is
likely to be unhelpful to employees.
This argument is flawed and without merit. If workers lack bargaining power in their
employment relationship, changing the law to add a fiduciary duty to this relationship will harm
workers, not help them. This is because extending the reach of fiduciary duties to rank-and-file
employees will not change any fundamental imbalance in the allocation of bargaining power
between workers and their employers that already exists. Any legal regime that "protects"
workers by making them the "beneficiaries" of fiduciary duties will, by definition, make those
same workers less valuable (in monetary terms) to their employers. The employers will, in turn,
utilize any bargaining power they possess to make the employees pay the full costs of these new
legal obligations.
_________________________________
NOTES
1.
The Pennsylvania “other constituency” statute gives the board of directors great leeway
in making corporate decisions.
a.
What do you imagine was the political genesis of this statute? Were these
statutes the brainchild of Ralph Nader (a consumer advocate) or corporate
executives?
b.
What situations did the Pennsylvania legislature have in mind that corporate
boards would use the statute’s assurances?
2.
Professor Macey asserts that nonshareholder constituents can protect their interests by
contract. This depends on how well these contract rights are protected. A recent study of
creditor protection in different legal systems shows that legal institutions that effectively
protect lenders (good accounting standards and judicial systems) are a good substitute for
collateral, making long-term debt available to firms even in volatile industries. In
countries where the law does not guarantee creditor rights, lenders prefer short-term debt
and the firms must liquidate projects when there are temporary difficulties. See
Mariassunta Giannetti, Do Better Institutions Mitigate Agency Problems? SSRN paper
203768 (2000).
3.
Compare the articles by Professors Mitchell and Macey.
a.
What is Mitchell’s thesis? What is Macey’s?
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COMPARATIVE COMPANY LAW
b.
c.
d.
In the world imagined by Mitchell, what rights should nonshareholders have if
they disagree with board action? Could employees sue if they thought layoffs
were unfair?
In the world imagined by Macey, what rights should nonshareholders have if
they disagree with board action? Could community leaders force a company not
to relocate a plant?
Who do you agree with? Why?
4.
Is “shareholder wealth maximization” really mandated by corporate law? What would
stop a corporation from pursuing a more balanced “socially conscious” business agenda?
If the answer is that corporate management merely responds to shareholder pressures
(reflected in market mechanisms), then what is to prevent investors from pressuring
management to adopt policies of greater social responsibility, exclusive of shareholder
profit maximization? Some have advocated that shareholders have greater ability to
make proposals urging corporate social responsibility and that corporate management be
required to disclose ethical analysis of corporate conduct. Ian Lee, Corporate Law, Profit
Maximization and the Responsible Shareholder, __ Stan. J. L. Bus & Fin __, SSRN Paper
692862 (Mar. 2005). Is “ethical investing” rational, simple-minded, or pernicious?
5,
Despite the rhetoric that directors of US corporations owe duties to maximize shareholder
wealth, the law actually imposes duties on directors to monitor the activities of the
corporation to ensure compliance with non-corporate legal norms B even when noncompliance (that is, violating the law) might maximize shareholder wealth. For example,
directors must establish and monitor the corporation’s compliance with government rules
on Medicare billing, environmental laws, and antitrust compliance. See In re Caremark
Int’l Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996) (approving settlement of
derivative litigation challenging directors’ failure to prevent corporate liability for
violating federal law applicable to health care providers).
The effect is that directors have become “watchdogs” for non-corporate regimes.
For example, the MBCA creates liability for directors whose “conduct consisted of . . . a
sustained failure ... to devote attention to ongoing oversight of the business and affairs of
the corporation, or a failure to devote timely attention when particular facts and
circumstances of significant concern materialize that would alert a reasonably attentive
director to the need therefor.” MBCA § 8.31(a)(2)(iv).
Whether directors face a real threat of personal liability in conducting their
“monitoring” duties has been the subject of recent attention, both in the United States and
abroad. Consider the liability of outside directors, under company law systems with
varying philosophies of shareholder primacy. According to a recent study comparing
four common law countries (Australia, Canada, Britain and the US) and three civil law
countries (France, Germany and Japan), the risk of “nominal liability” – that is, a court
finding of liability or settlement by directors B differs greatly from jurisdiction to
jurisdiction. But actual “out-of-pocket” liability – as that is, payments by directors
personally of damages or legal fees – is uniformly low. Even when directors are subject
to “nominal liability,” actual payment is made by the company or directors’ and officers’
(D&O) insurance. That is, despite differing philosophies and standards of director
accountability, actual results show a functional convergence across jurisdictions. Black,
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Cheffins & Klausner, Liability Risk for Outside Directors: A Cross-Border Analysis, 11
Euro. Fin. Mgmt. J. 153, SSRN paper 688647 (2005).
____________________________________
2.
Companies as social institutions -- Europe
INTRODUCTORY NOTES
1.
As we have seen, business companies in Europe are viewed as having broader social
roles and responsibilities than in the United States. The Anglo-American “shareholder
primacy” model is often contrasted with the European “social institution” model. But
perhaps these two models are converging – the Anglo-American model becoming more
European and the European model more Anglo-American. Consider the observations of
two US law professors on changes in Anglo-American corporate law, at least in Britain:
There is an active debate among corporate law professors about the
extent to which European companies are converging on the Anglo-American
shareholder-wealth-maximizing model of the corporation. In this model, the
paramount obligation of corporate officers and directors is to maximize the
near-term financial return to the company's shareholders. The American literature
has paid far less attention to the opposite phenomenon: factors that are causing
British and even American companies to converge on a European stakeholder
model of the corporation. The European view authorizes - or even requires management to take account of the interests of stakeholders, including such
constituencies as employees, residents of communities in which the company
operates, and advocates for more diffuse social and environmental interests.
We describe and evaluate recent legal developments, particularly in the
United Kingdom, that are not only causing greater attention to be paid to
stakeholders' interests, but that cast doubt on the intellectual construct,
Anglo-American corporate governance. We argue that on a number of corporate
governance measures, Britain has embarked upon a unique course to encourage
enlightened share value as the proper approach to corporate governance. This
approach explicitly adopts a long-term shareholder orientation, and assumes that
the long-term health of the company will depend in large part on its ability to
manage social, ethical and environmental risks. Accordingly, the U.K. has
recently moved to require the disclosure of such risks on an annual basis. In
addition, institutional investors in London are acting to bring social and
environmental issues, such as climate change and global labor standards, into the
ambit of mainstream concern in a way that is quite different from institutional
investor behavior in the United States. These developments, construed together,
suggest to us that a divergence is occurring between the United States and the
United Kingdom, such that our understanding of the Anglo-American corporate
governance model needs to be re-evaluated.
Cynthia A. Williams & John M. Conley, The Emerging Third Way?: The Erosion of the
Anglo-American Shareholder Value Construct, SSRN Paper 632347 (2004). Hasn’t the
United States also move in this direction?
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COMPARATIVE COMPANY LAW
Any legal system is defined by the rules it enforces. The following excerpts from the
Italian civil code identify the basis under which minority shareholders, creditors and
other corporate constituents may seek to vindicate their interests in the company. The
first column shows the current provisions, while the second column shows the provisions
before the 2003 company law reforms. As we have seen before, the 2003 reforms add the
possibility of a derivative claim by company members.
a.
Identify two ways in which the 2003 reforms change the liability rules for
directors of Italian companies, thus increasing the possibilities of shareholders to
claim the directors have improperly failed to maximize shareholder wealth.
b.
Consider the provision that creates “tort” liability for directors who cause unfair
harm to others, including shareholders and creditors and even employees. Italian
Civil Code Article 2043. Does this provision create liability based on
negligence, without showing of fault and even when the director was acting in
good faith?
c.
Consider the liability of directors to creditors and shareholders under the Italian
company law provisions. Do these provisions include a presumption that
directors have acted in the corporation’s best interest – that is, a business
judgment rule?
d.
Are directors in Italy, subject to greater or lesser risk of liability, in suits by
shareholders and creditors challenging their decisions?
Italian Civil Code
Obligations, Book IV / Section IX - Torts
Article 2043
Compensation for illicit acts - Whoever who has committed a harmful or culpable act that causes
unfair harm to another is obligated to compensate the other for the harm.
Italian Civil Code
Company Law, Book V (Arts. 2325-2348)
Section V The shares
Article 2393
Company’s action for liability - The
company’s action against the directors is
instituted following a resolution of the
shareholders’ meeting, even if the company is
in liquidation.
The resolution regarding the ability of the
directors can be passed on occasion of the
discussion on the balance sheet, even if it is
not indicated in the meeting agenda.
The action may be started with 5 years from
the termination of the director from his
appointment.
The resolution on the liability action entails
the revocation from office of the directors
against whom it is proposed, provided it is
passed with a favorable vote of at least one
fifth of the company's capital. ...
[same in pre-reform law]
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COMPARATIVE COMPANY LAW
Article 2393-bis
Company action for liability by members.
The company action for liability may be
exercised by members representing at least
one fifth of the capital or such different
percentage indicated in the by-laws which in
any case cannot be greater than one third.
For [listed] companies the action may be
exercised by the members representing 1/20
of the company’s capital or such lower
amount contemplated in the by-laws.
The company must be convened in court
and the deed of summons may be served on it
alos in the person of the chair of the board of
auditors.
The members who intend to promote the
action appoint, by majority of the capital
owned, one or more representatives for the
exercise of the action and for the fulfillment
of the related acts.
If the request is accepted, the company pays
the plaintiffs the judicial expenditures and
those incurred for the ascertainment of the
facts ....
The members who have initiated the action
may abandon it or settle; any compensation
for the waiver or settlement must be for the
benefit of the company. [Any settlement must
be approved at a shareholders’ meeting,
subject to a veto by 20% of shares, or 5% if a
listed company.]
Article 2394
Liability to the company's creditors - The
directors are answerable to the company's
creditors for non-observance of their duties
regarding the preservation of the company's
assets.
The action can be brought by the creditors
when the company's assets are insufficient for
the satisfaction of their credits.
The waiver of the action by the company
does not stop the exercise of the action by the
company's creditors. The settlement can be
challenged by the company's creditors only
through the action for revocation when there
are the causes of action.
[not in pre-reform law]
Article 2394
Liability to the company's creditors - The
directors are answerable to the company's
creditors for not with the obligations
regarding the preservation of the company's
assets. The action can be brought by the
creditors when the company's assets are
insufficient for the satisfaction of their credits.
In the event of bankruptcy or of
administrative compulsory liquidation of the
company, the action may be brought by the
bankruptcy receiver or the commissionaire
liquidator.
The waiver of the action by the company
does not stop the exercise of the action by the
company's creditors. The settlement can be
challenged by the company's creditors only
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COMPARATIVE COMPANY LAW
through the action for revocation when there
are the causes of action.
Article 2395
Individual action of the member and of the
third party - The provisions of the preceding
articles does not affect the right to the
compensation of damages pertaining to the
individual member or to third parties who
have been directly damaged by negligent or
fraudulent actions of the directors.
Article 2409
Court complaint - If there is legitimate
suspicion of grave irregularities in the
management by the directors in violation of
their duties, which may damage the company
...., the members representing one-tenth of the
company’s capital or, or in [listed public]
companies one-twentieth of the company’s
capital, can report the facts to the court with a
recourse to be served also on the company.
The court ... can order the inspection of the
company’s management at the request of
shareholders
The president of the court can bring a
liability action against the managers and
auditors.
[same in pre-reform law]
Article 2409
Court complaint - If there is legitimate
suspicion of grave irregularities in the
discharge of the duties of the managers or the
auditors, the shareholders who represent onetenth of the company’s capital can complain
of these facts to the court.
The court ... can order the inspection of the
company’s management at the request of
shareholders ...
The president of the court can bring a
liability action against the managers and
auditors.
Corporate Governance in Italy: Strong Owners, Faithful Managers:
An Assessment and a Proposal for Reform
6 IND. INT'L & COMP. L. REV. 91 (1995)
Lorenzo Stanghellini 9
III. THE SYSTEM OF CORPORATE DIRECTORS' LIABILITY: THE LAW
A.
The "Tortious Interference" Liability of Directors to Creditors.
The system of corporate directors' liability is entirely consistent with the assumption that
the key to Italian corporate governance structure lies in the tight relationship between directors
and majority shareholders.
Directors can be liable (a) to the company (Civil Code art. 2392, 2393 (Italy)), (b) to its
creditors (Civil Code art. 2394 (Italy)), and (c) to shareholders and third parties in general (Civil
Code art. 2043, 2395 (Italy)). These different kinds of liability rest on different grounds. While
the first is a consequence of directors' obligation to serve the company, the second and third
9
Assistant Professor of Law, University of Florence, Italy. J.D., University of Florence (1987);
LL.M. Columbia University (1995).
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derive from general principles of tort law. Putting aside directors' liability to the company for
later examination, let us now deal with the other two kinds of liability briefly.
Under Civil Code art. 2394 (Italy) directors are liable to creditors when the assets of the
company are insufficient to satisfy its obligations and directors have violated the "rules of
preservation of the company's assets" (e.g., they have distributed or wasted assets, or they have
paid out more dividends than they were allowed). This provision does not create a duty of the
board owed to creditors of the company, but only imposes upon it a duty to abstain from
prejudicing the relationship between the company and its creditors. The most convincing theory,
then, seems to be that which describes this provision as codifying a tort-of-interference liability.
Creditors can sue directors under the Civil Code art. 2394 (Italy) directly, except when
the company is in bankruptcy. In this case the trustee has standing to sue directors in the place of
the individual creditors, and the recovery flows into the estate.
B.
The General Tort Law Liability of Directors to Shareholders and Third
Parties.
Directors, according to general tort law principles, are also liable to shareholders or third
parties they directly prejudiced while exercising their office (Civil Code art. 2043 (Italy),
implicitly recalled by Civil Code art. 2395 (Italy)). Typical examples of such liability are the
violation of preemptive rights, or misstatements on the financial condition of the company in
connection with the purchase or sale of shares or with the extension of credit to the company.
The requirement that the prejudice be "directly" caused by the directors, expressly stated
by Civil Code art. 2395 (Italy), is commonly intended to preclude a direct suit for damages
against directors, brought by shareholders alleging the loss of value of the stock due to directors'
mismanagement or fraudulent practice; such injury is indeed the consequence of the injury to the
company, and therefore does not "directly" affect shareholders. Besides, shareholders cannot sue
directors derivatively, i.e., on behalf of the corporation, because no such provision exists.
The system of corporate governance, apparently neutral so far, begins to appear biased in
favor of directors. It can be argued that general tort law (Civil Code art. 2043 (Italy)) would allow
a shareholder to recover damages resulting from the loss of value of the stock; if that is so, art.
2395, far from allowing recovery for "direct" damages, precludes it for "indirect" ones. Moreover,
the absence of a shareholders' derivative remedy in the Italian legal system, which progressively
admits derivative suits as a general remedy for creditors, seems the product of a clear political
choice.
The barrier created by the law against shareholders' suits for directors' mismanagement or
fraud is in fact not a result arrived at by chance; to the contrary, legislative history demonstrates
that this was precisely what legislators wanted to achieve. 10 This introduces the central topic of
this paper: the liability of directors to the company.
10
The preclusion of shareholders' direct suits against directors goes back to the Second Code of
Commerce of 1882. An influential author of the time, approving such preclusion, described deplorable
maneuvers and settlements of "strike suits" in the years before the reform, having both the effect of
discouraging good directors and of allowing the recovery to flow directly into the pocket of shareholders. 2
CESARE VIVANTE, TRATTATO DI DIRITTO COMMERCIALE 471-72 (4th ed. 1912). It is the same
problem examined by Keenan v. Eshleman, 194 A. 40 (Del. Ch. 1937), aff'd 2 A.2d 904 (Del. 1938).
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COMPARATIVE COMPANY LAW
C.
The Liability of Directors to the Company.
1.
The Grounds.
Directors must manage a company with the diligence of a prudent person. 11 The law does
not explicitly impose a duty of diligence and a duty of good faith, but both are obviously
considered by the courts. Cases concerning directors' liability can be classified as follows:
(a)
Cases finding that directors violated specific duties, set by the law or the charter.
Here the courts often impose liability for the damages actually derived from the
violations, under a quasi-per se rule.
(b)
Cases finding that directors acted negligently. Such cases are not very common:
courts usually affirm their willingness not to interfere in business decisions, even
though they have not developed a complete and consciously applied "business
judgment rule." When the courts do find directors liable, it is often possible to
read some kind of interested directors' conduct between the lines, which the
plaintiff has been unable to establish with absolute certainty. 12
(c)
Cases finding that directors acted in conflict of interest with the company. In
these cases, the courts and, in some circumstances, the law itself impose strict
liability for the resulting damages, if any. Such cases are an overwhelming
majority of the total: some of them deal with borderline questions (e.g.,
parent-subsidiary relationship, corporate group policy), most of them with
outright fraud.
2.
The Procedure.
A suit against directors on behalf of the company can be instituted in three cases:
(a)
(b)
(c)
11
when shareholders, with a majority vote, have authorized it (Civil Code art.
2393(1) (Italy)); in this case the action is brought by the new directors or by an
especially appointed agent for the company;
when the court, requested by a quorum of shareholders or by the public
prosecutor, has ordered an investigation and, serious irregularities having been
found, has appointed a temporary administrator (Civil Code art. 2409 (Italy)); the
administrator has the power to bring a suit against directors;
when the company is bankrupt; in such case the action is brought by the trustee,
authorized by the bankruptcy judge (art. 146, Royal Decree of Mar. 16, 1942,
No. 267).
The Civil Code pays tribute to the Roman tradition in adopting the standard of the "good father
of a family" ("bonus paterfamilias"). Apart from sexist concerns, totally absent when the Civil Code was
enacted, courts have sometimes tried expressly to correct the standard, resorting to that of a normally
skilled entrepreneur, mindful of the complexity of business management (Judgment of June 26, 1989,
Tribunal of Milan, 1990 GIURISPRUDENZA COMMERCIALE II, 122).
12
According to the study by BONELLI (1991) from the enactment of the Civil Code to the end of
the 1980s, only in a handful of published cases have directors been held liable on pure negligence counts.
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COMPARATIVE COMPANY LAW
From a corporate governance standpoint, the difference among these three hypotheses is
apparent: while the second and third do not require the consensus of the majority of shareholders,
the first does.
This may have important consequences. An overwhelming majority of the actions against
directors is brought by bankruptcy trustees. Actions brought by companies in an ordinary
situation following a vote by the majority of shareholders are very rare and so are actions brought
under Civil Code art. 2409 (Italy) by administrators appointed by the court. Why is this so?
First, it is a common experience that bankruptcy trustees often look for expedients to
increase the value of the estate, and courts tend to be sympathetic to trustees. The higher number
of suits against directors of bankrupt companies can therefore be explained as the product of
abnormal judicial pressure against directors in such a setting.
Second, it is much more likely that previous mistakes or wrongdoings are found in the
pre-bankruptcy management of bankrupt companies because such actions tend to result in the
company's insolvency more than normal managerial action does. The higher number of suits
against directors of bankrupt companies can therefore be seen simply as a judicial reaction to
illegal actions that lead a company into bankruptcy.
The first explanation assumes an abnormal distribution of judicial reactions, the second
an abnormal distribution of starting points with which courts deal in a neutral way. Both
explanations are probably true, but not exhaustive; in may opinion, a third possibility exists.
To bring an action against directors, a majority vote by shareholders is necessary. No
conclusion can therefore be drawn from a simple analysis of the actions actually instituted
without at least taking into consideration the possible number of actions that the majority has
stopped. In other words, a correct statistic should include both liability suits which were actually
brought and those which were not. Unfortunately, published court reporters give accounts of the
former, but not of the latter.
An indirect method can be used to second-guess the system of directors' liability without
a majority vote requirement, however. We should look for cases that show an attempt to reach the
same goal: to put pressure on the majority and on directors for some kind of alleged wrongdoing.
Among these cases, we should try to spot those which, absent the majority vote requirement,
would most likely have concerned a minority suit against directors.
At that point, the corporate governance picture could be considered almost complete. If
cases showing a tension between the majority's and minority's dealing with management's choices
are found, it will be clear that the law shields not the directors as such, but the directors as agents
for the majority: given that the majority is allowed to bring a suit, directors are protected only
against the minority. As suits against auditors are subject to the same procedural requirements,
they too will fit into the picture as part of the game between the majority and minority.
D.
Summary
On a purely legal basis, the following conclusions on the liability of directors of societa
per azioni can be inferred.
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COMPARATIVE COMPANY LAW
A. Liability to creditors.
A.1. The law does not impose on the board the duty to act in the interests of creditors;
however, it imposes a duty not to prejudice their interests by means of illegal acts.
A.2. This duty is sanctioned by allowing creditors to sue directors personally, through an
action based on a "tort of interference" in their relationship with the company. When the company
is in bankruptcy, creditors lose standing to sue directors in favor of the trustee.
B. Liability to shareholders and third parties.
B.1. General tort law principles would arguably allow shareholders and third parties to
sue directors who have injured them. Civil Code art. 2395 (Italy) recalls such principles, but
limits standing to persons whom directors injured "directly." Such a limitation prevents individual
shareholders from suing directors simply for the loss of value of shares, which is considered an
indirect, "second-grade" injury.
B.2. The Italian private law system, unlike most others, admits derivative suits as a
general remedy for creditors; yet, Italian corporate law does not provide for derivative suits of
shareholders, who, like creditors, have a right whose satisfaction depends on someone else's
assets.
B.3. A provisional conclusion is that the system appears to be designed to shield directors
from shareholders' suits. But see summary infra C.5.
C. Liability to the company.
C.1. Cases finding directors liable to the company can be classified under three headings:
liability for violation of directors' specific duties, liability for negligence, and liability for conflict
of interest. Courts tend to be rather strict in cases belonging to the first and third categories, and
more or less consciously apply a sort of "business judgment rule" in cases belonging to the
second category (negligence claims).
C.2. Apart from an exception (provided for by Civil Code art. 2409 (Italy)), liability
suits against directors can be instituted by the company itself, following a majority vote of
shareholders, or when the company is in bankruptcy, by the bankruptcy trustee.
C.3. As a starting point to be supported by empirical evidence, we assumed that most
actions for liability against directors are instituted by bankruptcy trustees, and that only a
minority of such actions is instituted by non- bankrupt companies following a majority vote of
shareholders.
C.4. We offered some possible non-corporate governance explanations of such abnormal
distribution of plaintiffs in liability actions against directors. However, we advanced the
hypothesis that the majority vote requirement may constitute an effective barring, preventing
tensions between majority and minority shareholders over directors' mistakes or conflicts of
interest from being resolved by a judicial decision.
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COMPARATIVE COMPANY LAW
C.5. Should this hypothesis be proven true, the majority vote requirement for liability
suits against directors would assume a different significance: not a protection for directors, but a
tool in the hands of the majority shareholders. The legal corporate governance system would
reinforce the majority by protecting directors it elects against minority shareholders, and only
against them. This conclusion, however, does not necessarily entail a negative valuation if it is
not accompanied by the consideration of other factors concerning the balance of power between
the majority and minority.
_________________________________
NOTES
1.
Professor Stanghellini offers a complete analysis, as of 1995, of the liability of directors
of Italian companies to corporate constituents in various circumstances – particularly to
creditors.
a.
How is director liability in Italy different from that in the United States to
creditors? To shareholders?
b.
How would the Ford Motor case come out in Italy? Is the decision by a
corporate manager to prefer non-shareholder interests (employees and
consumers) grounds for a shareholder to sue? Would an Italian judge be
impressed with Ford’s reputation and business power?
c.
Would a 10% shareholder in Italy be able to claim irregularities by pointing to
management abuse?
d.
Article 2377 permits any shareholder to sue to invalidate a shareholder resolution
(such as one regarding dividends) if the resolution is contrary to law. Could the
Dodge Brothers have sued under this provision?
e.
What would you imagine are the effects of the Italian liability rules on the
behavior of directors?
f.
Would you prefer to be a shareholder in an Italian company or an American
company, all things being equal other than the director liability rules?
2.
Imagine an opposite set of facts from those presented in the Ford Motor case – that is,
that the Ford Motor Company board had chosen to pay a dividend to shareholders that
jeopardized the financial solvency of the company. As we have seen, the business
judgment rule in the United States accepts (even encourages) good faith risk-taking. The
Ford Motor directors would be liable only if they acted fraudulently, with a conflicting
interest, or with gross negligence.
What if director liability rules were different? In France, directors of companies
that have become insolvent are subject to a variety of sanctions. In fact, over 40
provisions of French insolvency law relate to sanctions against directors when a company
enters insolvency. In such cases, a commercial court can bring claims against corporate
managers on a showing of their “fault” – including failure to keep accounts, failure to
adequately supervise management, and failure to announce the company situation in due
time. The French Court of Cassation has defined “mismanagement” in a way different
from other legal faults, permitting French courts to inquire into acts for personal gain
(such as pay increases), falsifying accounting records, stopping the payment of debts, and
failing to supervise the company’s business. Bruce D. Fisher & Francois Lenglart,
Employee Reductions in Force: A Comparative Study of French and U.S. Legal
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Protections for Employees Downsized out of their Jobs: A Suggested Alternative to
Workforce Reductions , 26 Loy. L.A. Int’l & Comp. L. Rev. 181 (2003).
3.
Liability rules influence human behavior – particularly, when the rules are aimed at riskaverse company executives. Sometimes liability rules can have a stultifying effect,
creating more behavioral pressure than intended.
One alternative to liability rules is the use of voluntary codes of conduct, which
state aspirational goals without imposing legal consequences if they are not met. This
has become a favored technique among many multinational corporations, especially
regarding their conduct in developing countries, to promote balanced socially-responsible
conduct. These non-state codes address such issues as worker conditions, environmental
responsibility, global warming, and treatment of animals. Sorcha MacLeod, Corporate
Social Responsibility within the European Union Framework, 23 Wis. Int’l L.J. 541
(2005). Although Europe has traditionally embraced corporate social responsibility
(CSR) more than the United States, the EU has been slow to adopt mandatory measures
to enforce CSR. Instead, voluntary codes are prevalent. In 2001, the EU issued two
communications detailing its stance on CSR, choosing not to deal directly with corporate
misbehavior. In the end, EU business interests have wanted a soft-law approach, and
NGOs a mandatory playing field.
Many doubt whether the codes have any substance B they seem simply to be a
campaign of “corporate image.” Although some have proposed that the codes become
binding law, others suggest that government should be involved in the process of their
drafting or in reducing regulatory burdens for companies that adopt and comply with
appropriate codes. In the United States, for example, companies that have internal
compliance systems to detect, investigate and report criminal activity can significantly
reduce criminal fines. In Europe, many companies have adopted codes of ethics that
must be disclosed. See Sean D. Murphy, Taking Multinational Codes of Conduct to the
Next Level, 42 Colum. J. Trans. Law 389, SSRN paper 627608 (2005) (urging
governments to encourage codes by requiring disclosure and creating regulatory safe
harbors against criminal and civil liability for compliant companies).
_____________________________________
Labor Representation on Corporate Boards: Impacts and Problems
for Corporate Governance and Economic Integration in Europe
International Review of Law and Economics
June, 1994 (Geneva Vitznau Conference)
Klaus J. Hopt 13
I. Introduction
On April 5, 1993, the Council of Ministers held a major political debate on the fate of the
Societas Europaea. The Societas Europaea (S.E.), a genuine European stock corporation form,
has been advocated for decades but has never met with the unanimous approval of the Member
States of the European Community (EC). This failure is due primarily to labor representation on
13
Professor, Munich University Law School. Director of Institute of International Law, European
and International Business Law. Formerly Judge, Stuttgart Court of Appeals.
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corporate boards, which Germany does not want to jeopardize--and Great Britain and Ireland do
not want to accept--even in very mild versions.
Why is labor co-determination so controversial? Is it really just a "battle of creeds" as it
has been called? This article tries to demystify this question somewhat by looking for facts and
hypotheses and developing some answers and prospects. Co-determination is used as a synonym
for labor representation on corporate boards, i.e., participation of labor in the entrepreneurial
decision-making of the board (Unternehmensmitbestimmung), as distinguished from participation
by a works council, i.e., a special organ of labor at the plant level (betriebliche Mitbestimmung).
Labor participation on corporate boards exists in many European countries, albeit in very
different forms and degrees. This co-determination is nearly always mandatory, i.e., prescribed
by statute. … The two main problems of co-determination in Europe today are its impact on
corporate governance and on European integration.
II.
Legal and Economic Experience with the German ... Worker Co-determination
Model
1.
The Legal Regimes in Germany
In Germany there are at least four different systems of labor participation on corporate
boards: a one-third parity participation model, two full-parity models for coal and steel, and the
quasi-parity co-determination for corporations with more than 2,000 workers. Only the latter
model, which is based on the 1976 Co-determination Statute, can be considered here. In
corporations – stock corporations (AG) as well as limited liability companies (GmbH) – subject
to this statute, a supervisory board with the same number of representatives from the
shareholders' side and from labor has to be formed. In case of a deadlock the president of the
supervisory board, who is elected by the shareholders, has a double vote. This gives a slight
superiority to the shareholders.
The role of the supervisory board is not easy to describe. Its legal functions are primarily
the appointment, supervision, and, if necessary, the removal of the members of the management
board. The actual functions of the supervisory board vary considerably according to the
circumstances, in particular, the type of corporation. In corporations that are controlled by one or
more shareholders, for example, in corporations that belong to a group of companies, the
supervisory board is sometimes just an instrument in the hands of these shareholders. In
corporations with dispersed ownership (sometimes called public companies,
Publikumsgesellschaften) the supervisory board is quite often in a close consensus with the
management board.
2.
General Experience and Evaluation
In the 1970s co-determination on company boards was highly controversial. In Germany
it was even brought before the German Supreme Court (Bundesverfassungsgericht) to challenge
its constitutionality. At that time there were many conflicting predictions about the possible future
impact of such co-determination, both on the corporation, and more broadly, on the economy and
society. Today public controversy has died down almost completely. In general, labor
representation on corporate boards seems to be accepted in Germany.
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The fact of this acceptance must, of course, be taken with some caution. It does not
necessarily mean that German ... labor co-determination is a success. It may very well be that
companies and labor have just learned how to live under this institutional arrangement--which
they cannot change--and that they make the best of it. As to why more corporations do not seek to
escape the system, one has to see that changing the corporate seat is difficult legally, taxwise, and
economically.
As to the role of the members of a co-determined board, the conflict of interests problem
is considered to be serious. In theory shareholder representatives and labor representatives are
board members with the same rights and duties. In practice, however, the conflicts of interests
that arise, particularly for labor representatives, are unsolved. It is clear that the expectations of
the workers and the unions set into "their" representatives are irreconcilable with such a neutral
role. This is particularly acute for board secrecy. There are quite a number of cases in which
information on pending decisions with particular interest for labor, for example, in merger cases,
has leaked out. The trade unions maintain that passing such critical information to the workers
and the unions is fully legitimate.
3.
Functions of Co-determination within the Corporation (Intra-enterprise
Effects)
Apart from legal problems, labor representation on corporate boards has proved to have
certain functional effects within the corporation in a number of respects. One is the profile of
board members. This is obvious for the labor representatives in the supervisory board, who are
recruited from other strata of society and have a different outlook on the enterprise. The latter is
particularly true for those labor representatives who are not just union members (like nearly all
labor representatives), but who are deputized by the unions as such, as mandated by a very
controversial provision in German law.
The change in the profile of the members of the managing board is more interesting,
though not really surprising. Since the supervisory board makes the appointment, hardliners who
are not able or willing to get along with labor and its representatives on the supervisory board
have no chance. It is true that legally the shareholders' side could have its way by the double vote
of the chairman of the supervisory board. But this vote is hardly ever used, since the probable
moral and long-term costs usually far outweigh the victory in the concrete case.
Moreover, the decision-making process within the supervisory board is clearly affected.
Labor representation slows down the finding of a consensus considerably, and there is a built-In
polarization in the decision-making, even though legally no different benches are recognized.
This is shown, for example, by the standard practice of having separate pre-boardroom meetings
of the representatives of the two sides and is evidenced by the tendency of the labor
representatives to act and vote as a group.
Under the co-determination scheme it is obviously more difficult to make entrepreneurial
decisions that affect the workers of the individual company, such as, for example, reducing the
overall workforce or even dismissing workers. However, in cases of economic strain, even
dismissals have not been blocked by the labor side in the final outcome. It is hard to evaluate
whether labor influence has just contributed to a more peaceful handling of difficulties in the
company or whether, in the end result, it has had the costly effect of delaying necessary
adaptation to economic realities.
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COMPARATIVE COMPANY LAW
Labor co-determination may have resulted not only in more attention to the interests of
labor but, more generally, in an outlook that is more oriented towards the "enterprise" than
towards the corporation. However, this outlook is not new in Germany. Maximization of
shareholders' wealth has hardly ever been the objective of German stock corporations, certainly
not in companies with dispersed ownership and regarding payment of dividends.
4.
Functions of Co-Determination beyond the Corporation (Markets,
Economy, Society)
It is very difficult to assess other impacts of labor co-determination on the markets and
the economy. In general, one agrees that in Germany labor co-determination on corporate boards
has been one factor in helping to keep strikes down to an internationally very low level. This is,
of course, very important economically, but it is more to be attributed to the political and societal
functions of labor co-determination. Labor co-determination may also have improved the
information flow between management and labor. It may have positive effects on the motivation
of the workers.
There are still many who see mostly negative impacts. According to them labor
co-determination is very costly. It slows down the decision-making process in an unacceptable
way. It keeps companies from facing economic realities if labor interests are at stake. It may thus
contribute to slowing down the growth and development of the company. In this view,
boardroom co-determination is a major handicap for Germany in the competition to attract
foreign capital and companies: Labor co-determination may have been acceptable in times of
economic boom, but it becomes a burden in times of economic recession and in an environment
of much stiffer international competition.
It would be shortsighted to look at labor representation on corporate boards in a purely
economic perspective. Labor co-determination was not introduced by the legislature for economic
reasons, but much more for political and social reasons. It must be remembered that the
co-determination model was conceived by its earliest proponents as the fair participation of labor
as a productive factor and as a bridge towards a consensual cooperation between capital and
labor. Even today co-determination is looked at by many as an arrangement to make workers
co-citizens with equal rights. The German model, in particular, was introduced in 1920 and
1945/1949 as a result of the lost wars and in an effort to join forces for a collective new start.
In this perspective, labor co-determination is a highly important institutional factor for
keeping political and social unrest down and maintaining a climate in which capital and labor
cooperate despite all verbal attacks, controversies in collective bargaining and in the plants, and
fights in the courts and the parliament. It is an antagonism that is channeled institutionally in a
way that seems to work.
_________________________________
NOTES
1.
Besides liability standards or codes of conduct, Professor Hopt makes clear that structural
devices also affect director incentives in considering non-shareholder constituencies.
Perhaps the most famous structural device is the dual-board system of large German
companies, one which continues to attract a great deal of academic attention. See Bernd
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COMPARATIVE COMPANY LAW
Singhof & Oliver Seiler, Shareholder Participation in Corporate Decision-making under
German Law: A Comparative Analysis, 24 BROOKLYN J. INT’L L. 493-576 (1998).
a.
What is the dual-board system of Germany? Is it mandatory? Why is it called
co-determination? Where does real power reside in a German company? What
effects does it have on decision-making in German companies?
b.
What are the pros and cons of co-determination? Why is it seen as a shield
against hostile takeovers? Why is it seen as a deterrent to labor strikes? A study
confirms the intuition that when a country gives greater protection to workers it
gives less protection to investors -- that is, there is a political trade-off. See
Marco Pagano & Paolo Volpin, The Political Economy of Corporate
Governance, SSRN Paper 209314 (October 1999).
c.
German co-determination has been a stumbling block to European company law
harmonization, with Britain arguing that a monistic board is essential to British
corporate governance and Germany arguing that a dualistic board is are essential
to its system. Which view is winning? See also Klaus J. Hopt, The German
Two-Tier Board: Experience, Theories, Reforms, in COMPARATIVE CORPORATE
GOVERNANCE: THE STATE OF THE ART AND EMERGING RESEARCH SSRN PAPER
159555 (Oxford Press 1998) (predicting German boards may change swiftly
given economic and legal changes in Germany).
d.
Corporate governance in Germany has undergone much reform in the last
decade, with new legislation augmenting the traditional corporate control with
market-based corporate governance devices. That is, rather than corporate power
emanating from the board, the reforms to securities and accounting law place
greater emphasis on capital markets and ultimately shareholder power. Ulrich
Noack & Andreas Zetzche, Corporate Governance Reform in Germany: The
Second Decade, SSRN Paper 646761 (2005) (identifying the influence of
European, national and international reform agendas on German reforms).
2.
Besides co-determination at the board level, there are other means to introduce
employees into corporate decision-making. In the article excerpted above, Professor
Hopt mentions work councils, which function at the factory level. What is the effect of
work councils on company performance? A study found that work councils in
nonunionized British plants improved performance, while unionized plants had negative
results. Similarly, mandatory work councils improved performance of larger German
plants, but smaller German plants with works council under-performed their counterparts.
See Siebert, Wei, Addison & Wagner, Worker Participation and Firm Performance:
Evidence from German and Britain, 38 British J. of Indus. Rela. SSRN Paper 233033
(2000).
4.
Professor Mark Roe has observed that social democracies, like Italy and Germany,
pressure company managers to stabilize employment, to forego some profit-maximizing
business risks, and to make capital investments even when markets call for down-sizing.
This leads public firms in social democracies to stray from maximizing profits for
shareholders, as manager incentives often diverge from shareholder interests. This
explains why the ownership structure in Europe is more concentrated than the United
States, so that European shareholders can limit their managers’ discretion. It also
explains why the public firm owned by dispersed investors emerged in the United States,
where social democratic tendencies have historically not been as strong. Rather than
concentrated ownership, U.S. investors rely on incentive compensation of managers,
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COMPARATIVE COMPANY LAW
transparent accounting, hostile takeovers and strong shareholder-wealth maximization
norms. See Mark J. Roe, Political Preconditions to Separating Ownership from Control:
The Incompatibility of the American Public Firm with Social Democracy, SSRN Paper
165143 (1999, last revised 2008).
5.
Where do shareholders fit in the company? Over time and across legal cultures, the role
of shareholders has included (1) as owner/principal, (2) as beneficiary, (3) as bystander,
(4) as political participant, (5) as investor, (6) as guardian of the corporate fisc, and (7) as
managerial partner. See Jennifer Hill, Visions and Revisions of the Shareholder, 48 Am.
J. of Comparative L. 101, SSRN Paper 233137 (2000).
An interesting question: why is there so much debate about whose interests the
corporation should maximize? Even though different scholars and economic cultures
come to different conclusions, the actual differences in outcomes are small. Perhaps the
reason for the debate is that we seek “cognitive closure” – that is, that it’s important to
believe that our values (such as the purpose of modern business) have integrity and
coherence. See Amir N. Licht, The Maximands of Corporate Governance: A Theory of
Values and Cognitive Style, SSRN Paper 469801 (2003).
____________________________________
Corporate Law Different Across Legal Systems
Corporate Governance Around the World
THE WALL STREET JOURNAL
Oct. 27, 2003
Accounting scandals in the U.S. and Europe have led to a debate over the need to reform
the rules governing how companies are run and how the interests of shareholders, creditors and
employees can best be served.
The Organization for Economic Cooperation and Development established a set of
Corporate Governance guidelines, last updated in 2002, which have been adopted to a varying
extent by member countries.
Good corporate governance aims to ensure that corporations take into account the
interests of a wide range of constituencies, as well as the communities within which they operate,
and that their boards are accountable to the company and the shareholders. This helps to maintain
the confidence of investors -- both foreign and domestic -- and to attract more "patient",
long-term capital, according to the OECD.
But differences between the ways different stakeholders' interests are protected in various
countries persist, as does the debate about different approaches to balancing those interests.
Two models of corporate governance predominate: the American and the German. A
comparison between rules in five countries shows that shareholders have most guarantees under
the U.S. model, while creditors and employees in the U.S. are more likely to be required to trust
their interests will be safeguarded. Under the German model, the interests of creditors and
employees come first, and shareholders are required to exercise more trust.
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COMPARATIVE COMPANY LAW
180
Here is a comparison of some key corporate governance rules in the U.S., Germany,
Britain, France and Japan, collated from OECD and World Bank studies and data.
How Shareholders Are Protected
Germany scores lowest in measures designed to protect shareholders.
Shareholders have preemptive rights when new
shares are issued
Judicial mechanisms to contest decisions taken by
executives or at shareholder meetings
Mandatory dividends
One share - one vote principle
Compulsory separation between control and
decision, generally reflected as separate chairman
and CEO roles
Proxy shareholder voting by mail
Percentage of share capital to call an
extraordinary shareholders' meeting
US
Japan
France
Germany
UK
No
No
Yes
No
Yes
Yes
No
No
Yes
No
Yes
No
No
No
No
No
No
Yes
No
No
No
Yes
No
No
No
Yes
Yes
No
Yes
Yes
10%
3%
10%
5%
10%
How Employees Are Protected
Germany, France and other EU states generally protect employees more than the U.S. and the
United Kingdom.
Relative strictness of laws affecting individual
layoffs (OECD index with 12 indicators)
Relative strictness of laws affecting collective
layoffs (OECD index with four indicators)
Works Council or internal consultative groups
Participation plans for employees
Employees representation on board
US
Japan
France
Germany
UK
0.2
2.7
2.3
2.8
0.8
2.9
No
Yes
No
1.5
Yes
Yes
No
2.1
Yes
Yes
No
3.1
Yes
No
Yes
2.9
No
Yes
No
How Financial Creditors Are Protected
Britain and Germany offer the strongest measures to protect banks from the collapse of a business
that has borrowed money.
Reorganization restrictions linked to creditors'
agreement
Creditors' claims have priority in bankruptcy or
US
Japan
France
Germany
UK
No
No
No
No
No
No
Yes
Yes
Yes
Yes
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COMPARATIVE COMPANY LAW
reorganization law
Management cedes control during reorganization
Legal separation of decision and control
functions, generally reflected in separation of
CEO's and chairman's roles
Percentage of firms working with just one bank
(1999)
181
No
Yes
No
No
Yes
No
No
No
Yes
Yes
NA
NA
4%
15%
23%
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COMPARATIVE COMPANY LAW
Day 7 – Wednesday, July 28
IV.
SHAREHOLDER LIQUIDITY AND STOCK MARKETS
We now turn to one of the most high-profile topics of corporate governance – the duty of
those within the corporation who have confidential corporate information not to trade on that
inside information. The regulation of insider trading says a lot about the relationship between
corporate insiders and investors.
In the United States, the regulation of insider trading happens under the federal securities
laws and is mostly a matter of judge-made standards. We will see how three important US
Supreme Court decisions identified what constitutes insider trading – and when a person becomes
subject to a duty not to trade. (For those of you who work in a law firm or company where
confidential corporate information comes your way, take note!)
In Europe, the regulation of insider trading emanates from a directive of the EU Council.
The directive calls on member states to set up regulatory definitions and enforcement systems,
which the EU countries have done to varying degrees. We’ll look at the much clearer
“legislative” approach in Europe. And since the devil is in the details, and we’ll look at how
enforcement in Europe compares with that in the United States.
A.
Insider Trading Regulation
1.
Insider trading regulation -- United States
INTRODUCTORY NOTES
1.
What is insider trading? How can you make money if you know company secrets that,
when disclosed, will affect the company’s stock price?
2.
How is insider trading regulated, and what are the reasons for its regulation -a.
In the United States?
b.
In Europe?
3.
Consider the liability for the following persons in both the United States and Europe –
a.
Primary insiders. Does status as an insider (director, officer, major shareholder)
disqualify the person from trading in her company’s stock? When is an insider
prohibited from trading?
b.
Misappropriators. Does a person violate any rules if he has access to marketsensitive information about another company through his job or other position,
but who has no relationship with the company in whose stock he trades? When
is an outsider prohibited from trading?
c.
Tippees. Do non-insiders who receive a stock tip from an insider have any
duties? When a person receives a stock tip, what must that person do?
d.
Tipper. Do insiders have any duties not to reveal inside information? May a
tipper escape liability by claiming he was giving information to inform the
market?
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4.
COMPARATIVE COMPANY LAW
Compare the difference in attitudes toward insider trading in the United States and Italy:
[For an Italian it was fascinating to observe in 2002 how the US media
and politicians made a big fuss about Martha Stewart’s alleged trading on the
basis of a tip from her broker, while in Italy two prominent business people
watched as their reputations remained unaffected after being involved in insider
trading trials.
Carlo De Benedetti, once the controlling shareholder of Italy’s main
computer maker and still head of a conglomerate, plea-bargained an insider
trading charge – without apparent damage to his reputation. Emilio Gnutti, a
financier who played a central role in the takeover of Telecom Italia (the
country’s main telecommunications company), was convicted by a first degree
criminal court – with his financial reputation seemingly enhanced. Gnutti is now
partner with the Italian Prime Minister’s holding company and a member of the
coalition that controls Telecom Italia.]
Luca Enriques, Bad Apples, Bad Oranges: A Comment from the Old Continent on PostEnron Corporate Governance Reform, 38 Wake Forest L. Rev. 911 (2003)
5.
Does insider trading regulation make any difference? A recent study of insider trading
laws around the world finds a relationship between such laws and ownership
concentration -- the tougher the insider trading laws, the more diffuse the ownership of
publicly traded companies, the more accurate stock prices, and the more liquid (ready
marketability) of the stock markets. Countries with lax insider trading laws have small,
illiquid, and expensive equity markets. See Laura N Beny, Do Insider Trading Laws
Matter? Some Preliminary Comparative Evidence, 7 Am. Law & Econ. R. 144, SSRN
Paper 623481 (2005).
________________________________
UNITED STATES v. O'HAGAN
Supreme Court of the United States
521 U.S. 642 (1997)
JUSTICE GINSBURG delivered the opinion of the Court.
This case concerns the interpretation and enforcement of § 10(b) and § 14(e) of the
Securities Exchange Act of 1934, and rules made by the Securities and Exchange Commission
pursuant to these provisions, Rule 10b-5 and Rule 14e-3(a). Two prime questions are presented.
The first relates to the misappropriation of material, nonpublic information for securities trading;
the second concerns fraudulent practices in the tender offer setting. In particular, we address and
resolve these issues: (1) Is a person who trades in securities for personal profit, using confidential
information misappropriated in breach of a fiduciary duty to the source of the information, guilty
of violating § 10(b) and Rule 10b-5? (2) Did the Commission exceed its rulemaking authority by
adopting Rule 14e-3(a), which proscribes trading on undisclosed information in the tender offer
setting, even in the absence of a duty to disclose? Our answer to the first question is yes, and to
the second question, viewed in the context of this case, no.
I
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COMPARATIVE COMPANY LAW
Respondent James Herman O'Hagan was a partner in the law firm of Dorsey & Whitney
in Minneapolis, Minnesota. In July 1988, Grand Metropolitan PLC (Grand Met), a company
based in London, England, retained Dorsey & Whitney as local counsel to represent Grand Met
regarding a potential tender offer for the common stock of the Pillsbury Company, headquartered
in Minneapolis. Both Grand Met and Dorsey & Whitney took precautions to protect the
confidentiality of Grand Met's tender offer plans. O'Hagan did no work on the Grand Met
representation.... By the end of September, [O'Hagan had purchased] 2,500 unexpired Pillsbury
options, apparently more than any other individual investor. O'Hagan also purchased, in
September 1988, some 5,000 shares of Pillsbury common stock, at a price just under $39 per
share. When Grand Met announced its tender offer in October, the price of Pillsbury stock rose to
nearly $60 per share. O'Hagan then sold his Pillsbury call options and common stock, making a
profit of more than $4.3 million.
The Securities and Exchange Commission (SEC or Commission) initiated an
investigation into O'Hagan's transactions, culminating in a 57-count indictment [for mail fraud,
10b-5 securities fraud, violating Rule 14e-3 and money laundering statutes]. The indictment
alleged that O'Hagan defrauded his law firm and its client, Grand Met, by using for his own
trading purposes material, nonpublic information regarding Grand Met's planned tender offer.
According to the indictment, O'Hagan used the profits he gained through this trading to conceal
his previous embezzlement and conversion of unrelated client trust funds14. . . . A jury convicted
O'Hagan on all 57 counts, and he was sentenced to a 41-month term of imprisonment.
A divided panel of the Court of Appeals for the Eighth Circuit reversed all of O'Hagan's
convictions. 92 F. 3d 612 (1996).
II
We address first the Court of Appeals' reversal of O'Hagan's convictions under § 10(b)
and Rule 10b- 5. We hold, in accord with several other Courts of Appeals, that criminal liability
under § 10(b) may be predicated on the misappropriation theory.
A
In pertinent part, § 10(b) of the Exchange Act provides:
It shall be unlawful for any person, directly or indirectly, ... (b) To use or employ,
in connection with the purchase or sale of any security registered on a national
securities exchange or any security not so registered, any manipulative or
deceptive device or contrivance in contravention of such rules and regulations as
the [Securities and Exchange] Commission may prescribe as necessary or
appropriate in the public interest or for the protection of investors. 15 U.S.C. §
78j(b).
The statute thus proscribes (1) using any deceptive device (2) in connection with the purchase or
sale of securities, in contravention of rules prescribed by the Commission. The provision, as
14
O'Hagan was convicted of theft in state court, sentenced to 30 months imprisonment, and fined.
See State v. O'Hagan, 474 N.W.2d 613, 615,623 (Minn. App.1991). The Supreme Court of Minnesota
disbarred O'Hagan from the practice of law. See In re O'Hagan, 450 N.W.2d 571 (Minn. 1990).
184
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COMPARATIVE COMPANY LAW
written, does not confine its coverage to deception of a purchaser or seller of securities, see
United States v. Newman, 664 F. 2d 12, 17 (CA2 1981); rather, the statute reaches any deceptive
device used "in connection with the purchase or sale of any security."
Pursuant to its § 10(b) rulemaking authority, the Commission has adopted Rule 10b-5,
which, as relevant here, provides:
It shall be unlawful for any person, directly or indirectly, by the use of any means
or instrumentality of interstate commerce, or of the mails or of any facility of
any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud, [or] ...
(c) To engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
Liability under Rule 10b-5, our precedent indicates, does not extend beyond conduct
encompassed by § 10(b)'s prohibition. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 214 (1976)
(scope of Rule 10b-5 cannot exceed power Congress granted Commission under § 10(b).
Under the "traditional" or "classical theory" of insider trading liability, § 10(b) and Rule
10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis
of material nonpublic information. Trading on such information qualifies as a "deceptive device"
under § 10(b), we have affirmed, because "a relationship of trust and confidence [exists] between
the shareholders of a corporation and those insiders who have obtained confidential information
by reason of their position with that corporation." Chiarella v. United States, 445 U.S. 222, 228
(1980). That relationship, we recognized, "gives rise to a duty to disclose [or to abstain from
trading] because of the 'necessity of preventing a corporate insider from ... tak[ing] unfair
advantage of... uninformed ... stockholders." ' (citation omitted). The classical theory applies not
only to officers, directors, and other permanent insiders of a corporation, but also to attorneys,
accountants, consultants, and others who temporarily become fiduciaries of a corporation. See
Dirks v. SEC, 463 U.S. 646, 655, n. 14 (1983).
The "misappropriation theory" holds that a person commits fraud "in connection with" a
securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates
confidential information for securities trading purposes, in breach of a duty owed to the source of
the information. See Brief for United States 14. Under this theory, a fiduciary's undisclosed, selfserving use of a principal's information to purchase or sell securities, in breach of a duty of
loyalty and confidentiality, defrauds the principal of the exclusive use of that information. In lieu
of premising liability on a fiduciary relationship between company insider and purchaser or seller
of the company's stock, the misappropriation theory premises liability on a fiduciaryturned-trader's deception of those who entrusted him with access to confidential information.
The two theories are complementary, each addressing efforts to capitalize on nonpublic
information through the purchase or sale of securities. The classical theory targets a corporate
insider's breach of duty to shareholders with whom the insider transacts; the misappropriation
theory outlaws trading on the basis of nonpublic information by a corporate "outsider" in breach
of a duty owed not to a trading party, but to the source of the information. The misappropriation
theory is thus designed to "protec[t] the integrity of the securities markets against abuses by
'outsiders' to a corporation who have access to confidential information that will affect th[e]
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corporation's security price when revealed, but who owe no fiduciary or other duty to that
corporation's shareholders." Ibid.
In this case, the indictment alleged that O'Hagan, in breach of a duty of trust and
confidence he owed to his law firm,, Dorsey & Whitney, and to its client, Grand Met, traded on
the basis of nonpublic information regarding Grand Met's planned tender offer for Pillsbury
common stock. This conduct, the Government charged, constituted a fraudulent device in
connection with the purchase and sale of securities. 15
B
We agree with the Government that misappropriation, as just defined, satisfies § 10(b)'s
requirement that chargeable conduct involve a "deceptive device or contrivance" used "in
connection with" the purchase or sale of securities. We observe, first, that misappropriators, as
the Government describes them, deal in deception. A fiduciary who "[pretends] loyalty to the
principal while secretly converting the principal's information for personal gain," Brief for United
States 17, "dupes" or defrauds the principal. See Aldave, Misappropriation: A General Theory of
Liability for Trading on Nonpublic Information, 13 Hofstra L. Rev. 101, 119 (1984).
Deception through nondisclosure is central to the theory of liability for which the
Government seeks recognition. As counsel for the Government stated in explanation of the theory
at oral argument: "To satisfy the common law rule that a trustee may not use the property that
[has] been entrusted [to] him, there would have to be consent. To satisfy the requirement of the
Securities Act that there be no deception, there would only have to be disclosure." See generally
Restatement (Second) of Agency '' 390, 395 (1958) (agent's disclosure obligation regarding use
of confidential information). 16
We turn next to the § 10(b) requirement that the misappropriator's deceptive use of
information be "in connection with the purchase or sale of [a] security." This element is satisfied
because the fiduciary's fraud is consummated, not when the fiduciary gains the confidential
information, but when, without disclosure to his principal, he uses the information to purchase or
sell securities. The securities transaction and the breach of duty thus coincide. This is so even
though the person or entity defrauded is not the other party to the trade, but is, instead, the source
of the nonpublic information. See Aldave, 13 Hofstra L. Rev., at 120 ("a fraud or deceit can be
practiced on one person, with resultant harm to another person or group of persons"). A
misappropriator who trades on the basis of material, nonpublic information, in short, gains his
advantageous market position through deception; he deceives the source of the information and
simultaneously harms members of the investing public. See id., at 120-121, and n. 107.
The misappropriation theory targets information of a sort that misappropriators ordinarily
capitalize upon to gain no-risk profits through the purchase or sale of securities. Should a
15
The Government could not have prosecuted O'Hagan under the classical theory, for O'Hagan
was not an "insider" of Pillsbury, the corporation in whose stock he traded. Although an "outsider" with
respect to Pillsbury, O'Hagan had an intimate association with, and was found to have traded on
confidential information from, Dorsey & Whitney, counsel to tender offeror Grand Met. Under the
misappropriation theory, O'Hagan's securities trading does not escape Exchange Act sanction, as it would
under the dissent's reasoning, simply because he was associated with, and gained nonpublic information
from, the bidder, rather than the target.
16
Under the misappropriation theory urged in this case, the disclosure obligation runs to the
source of the information, here, Dorsey & Whitney and Grand Met.
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misappropriator put such information to other use, the statute's prohibition would not be
implicated. theory does not catch all conceivable forms of fraud involving confidential
information; rather, it catches fraudulent means of capitalizing on such information through
securities transactions.
The Government notes another limitation on the forms of fraud § 10(b) reaches: "The
misappropriation theory would not ... apply to a case in which a person defrauded a bank into
giving him a loan or embezzled cash from another, and then used the proceeds of the misdeed to
purchase securities." In such a case, the Government states, "the proceeds would have value to the
malefactor apart from their use in a securities transaction, and the fraud would be complete as
soon as the money was obtained." Ibid. In other words, money can buy, if not anything, then at
least many things; its misappropriation may thus be viewed as sufficiently detached from a
subsequent securities transaction that § 10(b)'s "in connection with" requirement would not be
met. Ibid.
The dissent's charge that the misappropriation theory is incoherent because information,
like funds, can be put to multiple uses, misses the point. The Exchange Act was enacted in part
"to insure the maintenance of fair and honest markets," 15 U.S.C. § 78b, and there is no question
that fraudulent uses of confidential information fall within § 10(b)'s prohibition if the fraud is "in
connection with" a securities transaction. It is hardly remarkable that a rule suitably applied to the
fraudulent uses of certain kinds of information would be stretched beyond reason were it applied
to the fraudulent use of money. . .
The misappropriation theory comports with § 10(b)'s language, which requires deception
"in connection with the purchase or sale of any security," not deception of an identifiable
purchaser or seller. The theory is also well-tuned to an animating purpose of the Exchange Act: to
insure honest securities markets and thereby promote investor confidence. See 45 Fed. Reg.
60412 (1980) (trading on misappropriated information "undermines the integrity of, and investor
confidence in, the securities markets"). Although informational disparity is inevitable in the
securities markets, investors likely would hesitate to venture their capital in a market where
trading based on misappropriated nonpublic information is unchecked by law. An investor's
informational disadvantage vis-a-vis a misappropriator with material, nonpublic information
stems from contrivance, not luck; it is a disadvantage that cannot be overcome with research or
skill. See Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal
Securities Laws, 93 Harv. L. Rev. 322, 356 (1979) ("If the market is thought to be systematically
populated with ... transactors [trading on the basis of misappropriated information] some
investors will refrain from dealing altogether, and others will incur costs to avoid dealing with
such transactors or corruptly to overcome their unerodable informational advantages."); Aldave,
13 Hofstra L. Rev., at 122-123.
In sum, considering the inhibiting impact on market participation of trading on
misappropriated information, and the congressional purposes underlying § 10(b), it makes scant
sense to hold a lawyer like O'Hagan a § 10(b) violator if he works for a law firm representing the
target of a tender offer, but not if he works for a law firm representing the bidder. The text of the
statute requires no such result.17 The misappropriation at issue here was properly made the
17
As noted earlier, however, the textual requirement of deception precludes ' 10(b) liability
when a person trading on the basis of nonpublic information has disclosed his trading plans to, or obtained
authorization from, the principal-even though such conduct may affect the securities markets in the same
manner as the conduct reached by the misappropriation theory. Contrary to the dissent's suggestion, the fact
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subject of a § 10(b) charge because it meets the statutory requirement that there be "deceptive"
conduct "in connection with" securities transactions.
[The Court next explains how the misappropriation theory is limited by the requirement
that the government, in a criminal case, prove the defendant acted “willfully” and that the
defendant can avoid imprisonment by proving he had no knowledge of the rule.]
III
. . . Did the Commission, as the Court of Appeals held, exceed its rulemaking authority
under § 14(e) when it adopted Rule 14e-3(a) without requiring a showing that the trading at issue
entailed a breach of fiduciary duty? We hold that the Commission, in this regard and to the extent
relevant to this case, did not exceed its authority.
[The Court looks at the language of the authorizing statute, § 14(e) of the Exchange Act,
and concludes that it permits the SEC to regulate market trading related to tender offers even if
there is no duty of “trust or confidence” held by those who trade on the basis of confidential
tender offer information.]
JUSTICE THOMAS, with whom THE CHIEF JUSTICE joins, concurring in the
judgment in part and dissenting in part.
Because the Commission's misappropriation theory fails to provide a coherent and
consistent interpretation of this essential requirement for liability under § 10(b), I dissent.
What the [majority's] embezzlement analogy does not do, however, is explain how the
relevant fraud is "use[d] or employ[d], in connection with" a securities transaction. And when the
majority seeks to distinguish the embezzlement of funds from the embezzlement of information,
it becomes clear that neither the Commission nor the majority has a coherent theory regarding §
10(b)'s "in connection with" requirement.
It seems obvious that the undisclosed misappropriation of confidential information is not
necessarily consummated by a securities transaction. In this case, for example, upon learning of
Grand Met's confidential takeover plans, O'Hagan could have done any number of things with the
information: He could have sold it to a newspaper for publication, he could have given or sold the
information to Pillsbury itself, or he could even have kept the information and used it solely for
his personal amusement, perhaps in a fantasy stock trading game.
Any of these activities would have deprived Grand Met of its right to "exclusive use," of
the information and, if undisclosed, would constitute "embezzlement" of Grand Met's
informational property. Under any theory of liability, however, these activities would not violate
§ 10(b) and, according to the Commission's monetary embezzlement analogy, these possibilities
are sufficient to preclude a violation under the misappropriation theory even where the
that ' 10(b) is only a partial antidote to the problems it was designed to alleviate does not call into question
its prohibition of conduct that falls within its textual proscription. Moreover, once a disloyal agent discloses
his imminent breach of duty, his principal may seek appropriate equitable relief under state law.
Furthermore, in the context of a tender offer, the principal who authorizes an agent's trading on confidential
information may, in the Commission's view, incur liability for an Exchange Act violation under Rule
14e-3(a).
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informational property was used for securities trading. That O'Hagan actually did use the
information to purchase securities is thus no more significant here than it is in the case of
embezzling money used to purchase securities. In both cases the embezzler could have done
something else with the property, and hence the Commission's necessary "connection" under the
securities laws would not be met. If the relevant test under the "in connection with" language is
whether the fraudulent act is necessarily tied to a securities transaction, then the misappropriation
of confidential information used to trade no more violates § 10(b) than does the misappropriation
of funds used to trade. As the Commission concedes that the latter is not covered under its theory,
I am at a loss to see how the same theory can coherently be applied to the former.
Justice Ruth Bader Ginsburg
______________________________
SECURITIES REGULATION: EXAMPLES AND EXPLANATIONS
(Aspen Law & Business 2002)
Alan R. Palmiter
CHAPTER 10
INSIDER TRADING
Insider trading has captivated the popular imagination. From press accounts, it would
seem the most contemptible of corporate behaviors. Remarkably, state corporate law mostly
accepts the principle of shareholder liquidity and regulates insider trading only narrowly. The
real law of insider trading is federal -- an offshoot of Rule 10b-5 under the Securities Exchange
Act of 1934.
§10.1
Introduction to Insider Trading
§10.1.1 Classic Insider Trading
The paradigm case of insider trading arises when a corporate insider trades (buys or sells)
shares of his company using material, nonpublic information obtained through the insider’s
corporate position. The insider exploits his informational advantage (a corporate asset) at the
expense of the company’s shareholders or others who deal in the company’s stock.
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The insider can exploit his advantage whether undisclosed information is good or bad. If
good news, the insider can profit by buying stock from shareholders before the price rises on the
favorable public disclosure. (An insider can garner an even greater profit on a smaller investment
by purchasing “call options” which give him a right to buy the shares at a fixed price in the
future.) If bad news, the insider can profit by selling to unknowing investors before the price falls
on unfavorable disclosure. (An insider who does not own shares can also profit by borrowing
shares and selling them for delivery in a few days when the price falls, known as “selling short,”
or by purchasing “put options” to sell the shares in the future.)
§10.1.2 Misappropriation of Information – Outsider Trading
An insider can also exploit an informational advantage by trading in other companies’
stock – “outsider trading.” If the insider learns that his company will do something that affects
the value of another company’s stock, trading on this material, nonpublic information can also be
profitable. The insider “misappropriates” this information at the expense of his firm. Although he
trades with shareholders of the other company, he violates a confidence of his firm.
Many cases reported in the media as “insider trading” are actually cases of outsider
trading on misappropriated information. Although classic insider trading and misappropriation
often are grouped together under the rubric of “insider trading,” it is useful to distinguish the two.
The justifications for regulating each differ.
§10.1.3 Theories for Regulation of Insider Trading
Consider some theories for regulating insider trading.
•
Insider trading is unfair to those who trade without access to the same information available
to insiders and others “in the know” -- a fairness rationale. The legislative history of the
Exchange Act, for example, is replete with congressional concern about “abuses” in trading
by insiders. This fairness notion, however, has not been generally accepted by state corporate
law which has steadfastly refused to infer a duty of candor by corporate insiders to
shareholders in anonymous trading markets. See Goodwin v. Agassiz, 186 N.E. 659 (Mass.
1933) (rejecting duty of insiders to shareholders except in face-to-face dealings). Moreover,
a fiduciary-fairness rationale cannot explain regulation of outsider trading based on
misappropriated information.
•
Insider trading undermines the integrity of stock trading markets, making investors leery of
putting their money into a market in which they can be exploited -- a market integrity
rationale. A fair and informed securities trading market, essential to raising capital, was the
purpose of the Exchange Act. Moreover, market intermediaries (such as stock exchange
specialists or over-the-counter makers) may increase the spread between their bid and ask
prices if they fear being victimized by insider traders. Greater spreads increase trading costs
and undermine market confidence. Yet a market integrity explanation may overstate the case
for insider trading regulation. Many professional participants in the securities markets
already trade on superior information; the efficient capital market hypothesis posits that stock
prices will reflect this better-informed trading. See §1.2.
•
Insider trading exploits confidential information of great value to its holder -- a business
property rationale. Those who trade on confidential information reap profits without paying
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for it and undermine incentives to engage in commercial activities that depend on
confidentiality. Although in the information age a property rationale makes sense, theories of
liability, enforcement and private damages have grown in the United States out of the rhetoric
of fiduciary fairness and market integrity.
Policing insider trading. Insider trading, cloaked as it is in secrecy, is difficult to track
down. The stock exchanges have elaborate, much-used surveillance systems to alert officials if
trading in a company’s stock moves outside of preset ranges. When unusual trading patterns show
up or trading occurs before major corporate announcements, exchange officials can ask brokerage
firms to turn over records of who traded at any given time. The exchanges conduct computer
cross-checks to spot “clusters” of trading -- such as from a particular city or brokerage firm. An
Automated Search and Match system, with data on thousands of companies and executives on
such things as social affiliations and even college ties, assists the exchanges. If the exchanges see
something suspicious, they turn the data over to the SEC for a formal investigation. The SEC can
subpoena phone records and take depositions, sometimes promising immunity to informants.
§10.2
Rule 10b-5 and Insider Trading
The development of 10b-5 insider trading duties is a fascinating story of judicial activism
and ingenuity in the face of a statutory lacuna. It also offers an interesting insight into the
operation of corporate federalism. Perceiving a failure by state corporate law to regulate insider
trading, federal courts have used Rule 10b-5 to develop a theory of disclosure-based regulation
that assumes the existence of corporate, fiduciary and confidentiality duties that state courts have
been unwilling to infer.
§10.2.1 Duty to “Abstain or Disclose”
Federal courts have understood Rule 10b-5 to prohibit securities fraud. See Chapter 9.
No person may misrepresent material facts that are likely to affect others’ trading decisions. This
general duty is meaningless to insider trading, which happens not through misrepresentations, but
rather silence. Over time, federal courts have developed a regime that prohibits insider trading
based on implied duties of confidentiality.
Parity of information. Early federal courts held that just as every securities trader is
dutibound not to lie about material facts, anyone “in possession of material inside information”
must either abstain from trading or disclose to the investing public -- a duty to abstain or disclose.
See SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968), cert. dismissed, 394 U.S. 976
(1969). But even the proponents of a “parity of information” (or “equal access”) approach
recognized that an absolute rule goes too far. Strategic silence is different from outright lying. To
impose an abstain-or-disclose duty on everyone with material, nonpublic information -- however
obtained -- would significantly dampen the enthusiasm for trading in the stock market. Capital
formation might dry up if investors in trading markets were prohibited from exploiting their hard
work, superior skill, acumen, or even their hunches. Investors would have little incentive to buy
securities if they could not resell them using perceived informational advantages.
Duty of confidentiality. In the early 1980s, the Supreme Court provided a framework
for the abstain-or-disclose duty. Chiarella v. United States, 445 U.S. 222 (1980); Dirks v. SEC,
463 U.S. 646 (1983). A decade later the Court brought “outsider trading” within this framework.
United States v. O’Hagan, 521 U.S. 642 (1997). Reading Rule 10b-5 as an antifraud rule, the
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Court has held that any person in the possession of material, nonpublic information has a duty to
disclose the information (or abstain from trading) if the person obtains the information in a
relation of trust or confidence -- normally a fiduciary relation. The Supreme Court thus has
anchored federal regulation of classic insider trading on a presumed duty of corporate insiders to
the company’s shareholders -- even though state corporate law has largely refused to infer such a
duty in impersonal trading markets. The Court has extended this duty-based regulation to trading
by outsiders who breach a duty of confidentiality to the source of the information -- even though
the source is unrelated to the company in whose securities they trade.
Chiarella v. United States. Chiarella was employed in the composing room of a financial
printer. Using his access to confidential takeover documents that his firm printed for
corporate raiders, he figured out the identity of certain takeover targets. Chiarella then
bought stock in the targets, contrary to explicit advisories by his employer. He later sold
at a profit when the raiders announced their bids. The Supreme Court reversed Chiarella’s
criminal conviction under Rule 10b-5 and held that Rule 10b-5 did not impose a “parity
of information” requirement. Merely trading on the basis of material, nonpublic
information, the Court held, could not trigger a duty to disclose or abstain. Chiarella had
no duty to the shareholders with whom he traded because he had no fiduciary relationship
to the target companies or their shareholders. (The Court decided that Chiarella could
not be convicted for trading on information misappropriated from his employer since the
theory was not presented to the jury.)
Dirks v. SEC. Dirks was a securities analyst whose job was to follow the insurance
industry. When he learned of an insurance company’s massive fraud and imminent
financial collapse from Secrist, a former company insider, Dirks passed on the
information to his firm’s clients. They dumped their holdings before the scandal became
public. On appeal from SEC disciplinary sanctions for Dirks’s tipping of confidential
information, the Supreme Court held that Dirks did not violate Rule 10b-5 because
Secrist’s reasons for revealing the scandal to Dirks were not to obtain an advantage for
himself. For Secrist to have tipped improperly, the Court held, there had to be a fiduciary
breach. The Court took the view that a breach occurs when the insider gains some direct
or indirect personal gain or a reputational benefit that can be cashed in later. In the case,
Secrist had exposed the fraud with no expectation of personal benefit, and Dirks could
not be liable for passing on the information to his firm’s clients.
United States v. O’Hagan. O’Hagan was a partner in a law firm retained by a third-party
bidder planning a tender offer. He purchased common stock and call options on the
target’s stock before the bid was announced. Both the bidder and law firm had taken
precautions to protect the bid’s secrecy. When the bid was announced, O’Hagan sold for
a profit of more than $4.3 million. After an SEC investigation, the Justice Department
brought an indictment against O’Hagan alleging securities fraud, mail fraud, and money
laundering. He was convicted on all counts and sentenced to prison. The Eight Circuit,
however, reversed his conviction on the ground misappropriation did not violate Rule
10b-5. (The Eight Circuit also held the SEC exceeded its authority in promulgating Rule
14e-3. See §10.2.3 below.) The Supreme Court reversed and validated the
misappropriation theory. The Court concluded that the unauthorized use of confidential
information is (1) the use of a “deceptive device” under '10(b) and (2) “in connection
with” securities trading. First, the misappropriator “deceives” the source that entrusted
him the material, nonpublic information by not disclosing his evil intentions. -- a
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193
violation of a duty of confidentiality. Second, the “fiduciary’s fraud is consummated, not
when the fiduciary gains the confidential information, but when ... he uses the
information to purchase or sell securities.” Citing to the legislative history of the
Exchange Act and to SEC releases, the Court concluded that misappropriation liability
would “insure the maintenance of fair and honest markets [and] thereby promote investor
confidence.” O’Hagan’s trading operated as a fraud on the source in connection with
securities trading -- a violation of Rule 10b-5.
Satisfying the disclosure duty. According to the logic of the 10b-5 “abstain or disclose”
construct, a fiducairy may trade on confidential information by first disclosing the information to
the person to whom she owes the fiduciary duty. See SEC v. Texas Gulf Sulphur Co., 401 F.2d
833 (2d Cir. 1968) (suggesting that insiders wait 24 to 48 hours after information is publicly
disclosed to give it time to be disseminated through wire services or publication in the financial
press). In a similar vein, some companies have internal policies that permit corporate insiders to
trade only during a one- or two-week period after company files quarterly and annual reports. As
a practical matter, the abstain-or-disclose duty is really a prohibition against trading, since any
disclosure must be effective to eliminate any informational advantage to the person who has
material, nonpublic information -- thus eliminating any incentive to trade.
§10.2.2 Insider Trading: Restatement of the Law
The linchpin of 10b-5 insider trading liability is the knowing misuse of material,
nonpublic information entrusted to a person with duties of confidentiality. Attempting to provide
a general definition, the SEC’s new Rule 10b5-1 offers a restatement of federal insider trading
law:
The “manipulative and deceptive devices” prohibited by Section 10(b) of
the Act and Rule 10b-5 thereunder include, among other things, the purchase or
sale of a security of any issuer, on the basis of material, nonpublic information
about that security or issuer, in breach of a duty of trust or confidence that is
owed directly, indirectly, or derivatively, to the issuer of that security or the
shareholders of that issuer, or to any other person who is the source of the
material, nonpublic information.
Although the Supreme Court has glossed over the provenance of these duties, its opinions
lead to some clear rules:
Insiders
Insiders who obtain material, nonpublic information because of
their corporate position -- directors, officers, employees, or
controlling shareholders -- have the clearest 10b-5 duty not to trade.
Chiarella.
Constructive (or
temporary) insiders
Constructive insiders who are retained temporarily by the company
in whose securities they trade C such as accountants, lawyers, and
investment bankers C are viewed as having the same 10b-5 duties
as corporate insiders. Dirks (dictum).
Outsiders (with duty to
source of information)
Outsiders with no relationship to the company in whose securities
they trade also have an abstain-or-disclose duty when aware of
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194
material, nonpublic information obtained in a relationship or trust
or confidence. O’Hagan. The outsider’s breach of confidence to
the information source is deemed a deception that occurs “in
connection with” his securities trading.
Tippers
Insiders and outsiders with a confidentiality duty who knowingly
make improper tips are liable as participants in illegal insider
trading. Dirks. The tip is improper if the tipper anticipates
reciprocal benefits -- such as when she sells the tip, gives it to
family or friends, or expects the tippee to return the favor. This
liability extends to sub-tippers who know (or should know) a tip is
confidential and came from someone who tipped improperly. The
tipper or sub-tipper can be held liable even though she does not
trade, so long as a tippee or sub-tippee down the line eventually
does.
Tippees
Those without a confidentiality duty inherit a 10b-5
abstain-or-disclose duty if they knowingly trade on improper tips.
Dirks. A tippee is liable for trading after obtaining material,
nonpublic information that he knows (or has reason to know) came
from a person who breached a confidentiality duty. In addition,
sub-tippees tipped by a tippee assume a duty not to trade, if they
know (or should know) the information came from a breach of
duty.
Traders in derivative
securities
The 10b-5 duty extends to trading with nonshareholders -- such as
options traders. O’Hagan (call options). The Insider Trading
Sanctions Act of 1984 makes it unlawful to trade in any derivative
instruments while in possession of material, nonpublic information
if trading in the underlying securities is illegal. Exchange Act
§20(d).
Strangers
A stranger with no relationship to the source of material, nonpublic
information C whether from an insider or outsider C has no 10b-5
duty to disclose or abstain. Chiarella. Strangers who overhear the
information or develop it on their own have no 10b-5 duties.
§10.2.3 Outsider trading -- misappropriation liability
Under the misappropriation theory, 10b-5 liability arises when a person trades on
confidential information in breach of a duty owed to the source of the information, even if the
source is a complete stranger to the traded securities. United States v. O’Hagan, 521 U.S. 642
(1997). This “fraud on the source” construct raises a number of issues: the basis for
misappropriation liability, the scope of the duty of confidentiality, and the validity of the SEC’s
rule creating misappropriation liability for tender offer information.
Misappropriation theory. The O’Hagan decision was an important victory for the SEC,
which ten years before had failed to convince the Supreme Court that Rule 10b-5 encompasses a
misappropriation theory. Carpenter v. United States, 484 U.S. 19 (1987) (split 4-4 decision). The
1987 case involved a Wall Street Journal reporter who wrote the widely read and influential
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column “Heard on the Street.” Although the column used public information to report on
particular companies, it invariably affected the companies’ stock prices. The newspaper had a
prepublication policy of keeping confidential the identity of subject companies to protect the
appearance of journalistic integrity. The reporter was convicted for misappropriating the advance
information and tipping it to both a friend and a broker, even though the Wall Street Journal had
no interest in the trading. The Court’s split 4-4 decision , though it upheld the reporter’s
conviction, had no precedential value and left a cloud of uncertainty hanging over 10b-5 insider
trading jurisprudence. See United States v. Bryan, 58 F.3d 933 (4th Cir. 1995) (rejecting
misappropriation theory when director of West Virginia lottery used confidential information to
buy securities of companies to which the lottery planned to award contracts).
Although the ruling in O’Hagan removed any uncertainty about whether Rule 10b-5
regulates securities trading using misappropriated information, it exposed doctrinal rifts in the
Court’s 10b-5 jurisprudence. First, O’Hagan suggests that there can be no 10b-5 insider trading
liability if there is no breach of trust or confidence. Thus, a person who gains access to material,
nonpublic information by other wrongful means C such as outright theft C would seemingly not
face 10b-5 sanctions. Moreover, a fiduciary who discloses his trading intentions or receives
permission to trade from the information source would escape 10b-5 liability since there would
arguably be no breach of his abstain-or-disclose duty. Second, O’Hagan leaves largely
unanswered the question of who has duties of trust or confidence and when a duty of
confidentiality attaches. For lawyer O’Hagan, it was easy to identify his duties to his law firm
and to the bidder, but the inquiry becomes more difficult when a person overhears a conversation
or has only a superficial relationship with the information source. See SEC v. Switzer, 590 F.
Supp. 756 (W.D. Okla. 1984) (holding that eavesdropper is not liable for trading after
overhearing CEO tell his wife the company might be liquidated).
Duty of confidentiality in misappropriation cases. The duty of trust or confidence in
misappropriation cases is clearest when confidential information is misappropriated in breach of
an established business relationship, such as investment banker-client or employer-employee.
The duty is less clear with respect to other business and personal relationships.
In an attempt to provide clarity, the SEC has adopted a rule that specifies the
circumstances in which a recipient of material, nonpublic information is deemed to owe a duty of
trust or confidence to the source for purposes of misappropriation liability. Rule 10b5-2(b).
•
The recipient agreed to maintain the information in confidence.
•
The persons involved in the communication have a history, pattern or practice of
sharing confidences (both business and non-business confidences) so the
recipient had reason to know the communicator expected the recipient to
maintain the information’s confidentiality.
•
The communicator of the information was a spouse, parent, child or sibling of the
recipient, unless the recipient could show (based on the facts and circumstances
of that family relationship) that there was no reasonable expectation of
confidentiality.
By their terms, the new rule’s first two categories clarify the duty of trust or confidence
in both non-business and business settings. Thus, a contractual relationship (though not
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necessarily creating a fiduciary relationship) could give rise to a duty not to use confidential
information, if that is what the parties had agreed or mutually understood. In addition, as the SEC
stated in its preliminary note to the rule, the list is not exclusive, and a relationship of trust or
confidence among family members or others can be established in other ways, as well.
§10.2.4 Remedies for Insider Trading
Insider traders are subject to an imposing host of sanctions and liabilities. As the
following makes clear, it is no wonder that law firms tell new lawyers not to trade on clients’
confidential information.
SEC injunctions and disgorgement. The SEC can seek a court order that enjoins the
inside trader or tippee from further insider trading (if likely to recur) and that compels the
disgorgement of any trading profits. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968)
(ordering establishment of fund from which shareholders and other contemporaneous traders
could recover from insider traders and tippers).
Civil liability to contemporaneous traders. In an impersonal trading market, it is
unclear who is hurt by insider trading and how much. Shareholders and investors who trade at the
same time as an insider presumably would have traded even had the insider fulfilled his duty and
abstained. If, however, the theory is that insider trading is unfair to contemporaneous traders,
recovery should be equal to the traders contemporaneous trading “losses”-- typically significantly
greater than the insiders gains. If the theory is that insider trading undermines the integrity of
trading markets, recovery should be disgorgement of the insider’s trading gains to the market as a
whole. If the theory is that insider traders pilfer valuable commercial information, recovery
should based on the losses to the owner of the confidential information.
Congress has addressed the issue and adopted a recovery scheme that borrows from both
the unfairness and disgorgement rationales. The Insider Trading and Securities Fraud
Enforcement Act of 1988 limits recovery to traders (shareholders or investors) whose trades were
contemporaneous with the insider’s. Recovery is based on the disgorgement of the insider’s
actual profits realized or losses avoided, reduced by any disgorgement obtained by the SEC under
its broad authority to seek injunctive relief (see above). Exchange Act §20A. Courts generally had
followed the same disgorgement theory. See Elkind v. Liggett & Meyers, Inc., 635 F.2d 156 (2d
Cir. 1980). If (as is usually the case) the amount of disgorgement exceeds plaintiffs’ “losses,” the
plaintiffs’ claims are prorated.
Civil recovery by “defrauded” source of confidential information. Owners of
confidential information who purchase or sell securities can bring a private action under Rule
10b-5 against insider traders and tippees who adversely affect their trading prices. See Blue Chip
Stamps v. Manor Drug Stores, 421 U.S. 723 (1975) (actual purchaser or seller standing
requirement). A “defrauded” company may recover if it suffered trading losses or was forced to
pay a higher price in a transaction because the insiders’ trading artificially raised the stock price.
FMC Corp. v. Boesky, 673 F.2d 272 (N.D. Ill. 1987), remanded, 852 F.2d 981 (7th Cir. 1988)
(holding tippee not liable for trading on misappropriated information concerning company’s
impending recapitalization plan because company lost nothing in the recapitalization). Although
some commentators have proposed corporate recovery on behalf of shareholders, courts have
insisted on a corporate (not shareholder) injury for there to be corporate recovery.
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Civil penalties. To buttress the SEC’s inherent enforcement powers, Congress passed
the Insider Trading Sanctions Act of 1984. The act authorizes the SEC to seek a judicially
imposed civil penalty against traders and tippees who violate Rule 10b-5 or Rule 14e-3 of up to
three times the profits realized (or losses avoided) in insider trading. Exchange Act §21A. The
penalty, which is paid into the federal treasury, is in addition to other remedies. Thus, it is
possible for an insider or tippee to disgorge her profits (in a private or SEC action) and pay the
treble-damage penalty.
“Watchdog” penalties. In the Insider Trading and Securities Fraud Enforcement Act of
1988, Congress added more deterrent bite be extending civil penalties to employers and other
who “control” insider traders and tippers. Exchange Act §21A. Controlling persons are subject to
additional penalties up to $1 million or three times the insider’s profits (whichever is greater) if
the controlling person knowingly or recklessly disregards the likelihood of insider trading by
persons under its control. Broker-dealers that fail to maintain procedures protecting against such
abuses may also be subject to these penalties if their laxity substantially contributed to the insider
trading.
“Bounty” rewards. To encourage informants the 1988 Act grants the SEC authority to
pay bounties to anyone who provides information leading to civil penalties. The bounty can be up
to 10 percent of the civil penalty collected. Exchange Act §21A(e).
Criminal sanctions. The Insider Trading and Securities Fraud Enforcement Act of 1988
also authorizes heavier criminal penalties for violators. Exchange Act §32(a). Congress increased
maximum criminal fines for violations of the Exchange Act from $100,000 to $1,000,000
($2,500,000 for non-individuals), and jail sentences from 5 years to 10 years.
___________________________________
NOTES
1.
Consider the practical effects of insider trading law. Geoffrey, chief executive of
Nile.com (a major Internet retailer), learns that his company will soon announce much
better than expected earnings. This will surely get the company’s stock out of the
doldrums.
a.
Can Geoffrey buy Nile.com stock?
b.
What if he had an existing stock purchase plan under which his broker would buy
500 shares of Nile.com stock every month? Can he buy pursuant to the plan?
c.
Suppose Geoffrey tells his daughter Jenna to buy Nile.com stock. Can she? Has
he violated a duty? Does Jenna, if she trades?
d.
Jenna tells her friend Michele to buy Nile.com. Has Jenna violated any duties?
Does Michele, if he trades?
2.
Consider the following. Geoffrey decides that Nile.com will acquire Down-theriver.com, a full-service travel site. He hires you to provide legal advice on the
acquisition.
a.
You acquire Down-the-river.com stock. Have you violated a duty?
b.
You tell your friend Michele to buy Down.the-river.com stock. Have you
violated the law? Has Michele, if he trades?
c.
Does it make any difference if Nile.com plans to acquire Down-the-river by
making a tender offer for its stock?
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_______________________________
2.
Insider trading regulation -- Europe
INTRODUCTORY NOTES
1.
Rather than the ad hoc insider trading regulation in the United States, arising from
common law adjudication and judicial law-making, the European Community has sought
to regulate insider trading through a comprehensive scheme of statutory regulation.
Bainbridge, An Overview of US Insider Trading Law: Lessons for the EU?, SSRN Paper
654703 (2005) (identifying doctrinal problems under US law – such as ability of
misappropriator to escape liability by disclosing plans to trade on confidential
information). Framed as a directive that requires implementation by each member
country, EU law seeks to specify particular conduct that is illegal. (The current insider
trading directive was promulgated in January 2003, and replaces an earlier directive
passed in 1989.) Some have applauded this effort, but as you will see, there has been a
discrepancy between what EU law regulates and what it actually enforces.
2.
Read the EC Directive below.
a.
How is EC law different from U.S. law on insider trading? What are the
purposes of EC insider trading law? Have they been fulfilled?
b.
Consider whether the activities and trading involving Nile.com described above
violate the EC directive – focusing specifically on Geoffrrey, Jenna, Michele, and
you as lawyer to Nile.com.
3.
If you were an investor, would you feel better about buying stock on the New York Stock
Exchange or the Milan Stock Exchange? Why?
4.
Insider trading regulation is spreading around the world. Before 1990, only 34 countries
had insider trading rules and only 9 had ever prosecuted violators. Today, of the 103
countries that have stock markets, 87 have insider trading rules. And 38 of these
countries have prosecuted insider trading cases. In a recent study on the effect of insider
trading laws, it was found that the cost of equity does not change when insider trading
rules are introduced, but decreases about 5% after the first prosecution. That is, investors
are willing to pay more for stock if they know insider trading will be punished. See Utpal
Bhattacharya & Hazem Daouk, The World Price of Insider Trading, SSRN Paper
200914, --- J. Fin. ---, SSRN Paper 249708 (2000).
______________________________
Directive 2003/6/EC of the European Parliament and of the Council
of 28 January 2003
on insider dealing and market manipulation (market abuse)
THE EUROPEAN PARLIAMENT AND THE COUNCIL OF THE EUROPEAN UNION,
Having regard to the Treaty establishing the European Community, and in particular
Article 95 thereof,
Having regard to the proposal from the Commission, Having regard to the opinion of the
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European Economic and Social Committee, Having regard to the opinion of the European
Central Bank, Acting in accordance with the procedure laid down in Article 251(4),
Whereas:
(1) A genuine Single Market for financial services is crucial for economic growth and job
creation in the Community.
(2) An integrated and efficient financial market requires market integrity. The smooth functioning
of securities markets and public confidence in markets are prerequisites for economic growth and
wealth. Market abuse harms the integrity of financial markets and public confidence in securities
and derivatives.
(4) At its meeting on 17 July 2000, the Council set up the Committee of Wise Men on the
Regulation of European Securities Markets. In its final report, the Committee of Wise Men
proposed the introduction of new legislative techniques based on a four-level approach, namely
framework principles, implementing measures, cooperation and enforcement. Level 1, the
Directive, should confine itself to broad general "framework" principles while Level 2 should
contain technical implementing measures to be adopted by the Commission with the assistance of
a committee.
(10) New financial and technical developments enhance the incentives, means and opportunities
for market abuse: through new products, new technologies, increasing cross-border activities and
the Internet.
(11) The existing Community legal framework to protect market integrity is incomplete. Legal
requirements vary from one Member State to another, leaving economic actors often uncertain
over concepts, definitions and enforcement.
(13) Given the changes in financial markets and in Community legislation since the adoption of
Council Directive 89/592/EEC of 13 November 1989 coordinating regulations on insider
dealing(6), that Directive should now be replaced, to ensure consistency with legislation against
market manipulation. A new Directive is also needed to avoid loopholes in Community
legislation which could be used for wrongful conduct and which would undermine public
confidence and therefore prejudice the smooth functioning of the markets.
(15) Insider dealing and market manipulation prevent full and proper market transparency, which
is a prerequisite for trading for all economic actors in integrated financial markets.
(17) As regards insider dealing, account should be taken of cases where inside information
originates not from a profession or function but from criminal activities, the preparation or
execution of which could have a significant effect on the prices of one or more financial
instruments or on price formation in the regulated market as such.
(18) Use of inside information can consist in the acquisition or disposal of financial instruments
by a person who knows, or ought to have known, that the information possessed is inside
information. In this respect, the competent authorities should consider what a normal and
reasonable person would know or should have known in the circumstances. Moreover, the mere
fact that market-makers, bodies authorised to act as counterparties, or persons authorised to
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execute orders on behalf of third parties with inside information confine themselves, in the first
two cases, to pursuing their legitimate business of buying or selling financial instruments or, in
the last case, to carrying out an order dutifully, should not in itself be deemed to constitute use of
such inside information.
(29) Having access to inside information relating to another company and using it in the context
of a public take-over bid for the purpose of gaining control of that company or proposing a
merger with that company should not in itself be deemed to constitute insider dealing.
(31) Research and estimates developed from publicly available data should not be regarded as
inside information and, therefore, any transaction carried out on the basis of such research or
estimates should not be deemed in itself to constitute insider dealing within the meaning of this
Directive.
HAVE ADOPTED THIS DIRECTIVE:
Article 1
For the purposes of this Directive:
1. "Inside information" shall mean information of a precise nature which has not been made
public, relating, directly or indirectly, to one or more issuers of financial instruments or to one or
more financial instruments and which, if it were made public, would be likely to have a
significant effect on the prices of those financial instruments or on the price of related derivative
financial instruments.
For persons charged with the execution of orders concerning financial instruments, "inside
information" shall also mean information conveyed by a client and related to the client's pending
orders, which is of a precise nature, which relates directly or indirectly to one or more issuers of
financial instruments or to one or more financial instruments, and which, if it were made public,
would be likely to have a significant effect on the prices of those financial instruments or on the
price of related derivative financial instruments.
2. "Market manipulation" shall mean: [not included here]
Article 2
1. Member States shall prohibit any person referred to in the second subparagraph who possesses
inside information from using that information by acquiring or disposing of, or by trying to
acquire or dispose of, for his own account or for the account of a third party, either directly or
indirectly, financial instruments to which that information relates.
The first subparagraph shall apply to any person who possesses that information:
(a) by virtue of his membership of the administrative, management or supervisory bodies
of the issuer; or
(b) by virtue of his holding in the capital of the issuer; or
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(c) by virtue of his having access to the information through the exercise of his
employment, profession or duties; or
(d) by virtue of his criminal activities.
2. Where the person referred to in paragraph 1 is a legal person, the prohibition laid down in that
paragraph shall also apply to the natural persons who take part in the decision to carry out the
transaction for the account of the legal person concerned.
3. This Article shall not apply to transactions conducted in the discharge of an obligation that has
become due to acquire or dispose of financial instruments where that obligation results from an
agreement concluded before the person concerned possessed inside information.
Article 3
Member States shall prohibit any person subject to the prohibition laid down in Article 2 from:
(a) disclosing inside information to any other person unless such disclosure is made in the
normal course of the exercise of his employment, profession or duties;
(b) recommending or inducing another person, on the basis of inside information, to
acquire or dispose of financial instruments to which that information relates.
Article 4
Member States shall ensure that Articles 2 and 3 also apply to any person, other than the persons
referred to in those Articles, who possesses inside information while that person knows, or ought
to have known, that it is inside information.
Articles 5 - 8
[These deal with market manipulation, member state enforcement, applicability to central bank
personnel, corporate buy-back programs]
Article 9
This Directive shall apply to any financial instrument admitted to trading on a regulated market in
at least one Member State, or for which a request for admission to trading on such a market has
been made, irrespective of whether or not the transaction itself actually takes place on that
market.
Article 10
Each Member State shall apply the prohibitions and requirements provided for in this Directive
to:
(a) actions carried out on its territory or abroad concerning financial instruments that are
admitted to trading on a regulated market situated or operating within its territory or for
which a request for admission to trading on such market has been made;
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(b) actions carried out on its territory concerning financial instruments that are admitted
to trading on a regulated market in a Member State or for which a request for admission
to trading on such market has been made.
Article 11
Without prejudice to the competences of the judicial authorities, each Member State shall
designate a single administrative authority competent to ensure that the provisions adopted
pursuant to this Directive are applied.
Member States shall establish effective consultative arrangements and procedures with market
participants concerning possible changes in national legislation. These arrangements may include
consultative committees within each competent authority, the membership of which should reflect
as far as possible the diversity of market participants, be they issuers, providers of financial
services or consumers.
Article 14
1. Without prejudice to the right of Member States to impose criminal sanctions, Member States
shall ensure, in conformity with their national law, that the appropriate administrative measures
can be taken or administrative sanctions be imposed against the persons responsible where the
provisions adopted in the implementation of this Directive have not been complied with. Member
States shall ensure that these measures are effective, proportionate and dissuasive. ***
Article 18
Member States shall bring into force the laws, regulations and administrative provisions
necessary to comply with this Directive not later than 12 October 2004. They shall forthwith
inform the Commission thereof.
Article 22
This Directive is addressed to the Member States.
Done at Brussels, 28 January 2003.
_______________________________________
Europe's Police Are Out of Luck on Insider Cases -Convictions Are Few Despite Signs Practice Has Become Pervasive
Wall Street Journal Aug 17, 2000
By WSJ staff reporters Anita Raghavan, Silvia Ascarelli, David Woodruff
When French investigators began digging into suspicious trades in Societe Generale SA
stock, it looked like they were onto a blockbuster insider-trading case that might shake the French
establishment. Among those probed: the former chairman of L'Oreal and a former top Finance
Ministry official who is now chairman of French retailer Rallye. It is now 12 years later, and the
case is celebrated -- for how long it has taken and how little it has reaped.
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No one has been charged, even after successive investigations by three magistrates. Only
now are prosecutors trying to decide if they have enough evidence to formally charge anyone. All
of those implicated in the case have repeatedly denied wrongdoing, but even if tried and found
guilty, so much time has passed that they would likely face light fines and no jail time.
Few prosecutions
Call it another brand of European unity: Despite signs that trading on not-yet-public information
is pervasive throughout Europe, convictions remain few and stiff punishment remains the
exception. In the past five years, prosecutors in the big stock markets of Britain, Germany,
France, Italy and Switzerland have won a total of just 19 criminal convictions for insider trading.
The tally in federal court in Manhattan alone? Forty-six.
The statistics tell an important story about regulation in Europe, where stockmarket
bloodhounds are kept on short leashes. "If you look at the recent history and it is not because of
lack of trying by [regulators] -- it is not a good story," says Phillip Thorpe, enforcement chief at
Britain's Financial Services Authority, which will assume responsibility for insider-trading
investigations next year. Mr. Thorpe says he can count the number of United Kingdom
insider-trading cases on the fingers of one hand, "and still have a few to play with."
Insider trading cheats honest investors and undermines public confidence in stock
markets at a time when more and more Europeans are dabbling in stocks for the first time. Left
unchecked, widespread insider trading could undermine the spread of a new stock culture that is
transforming European business. Says Frank Zarb, chairman of the U.S. National Association of
Securities Dealers, the parent of Nasdaq: "It is critical that retail investors feel the marketplace is
a good, solid, sound transparent one."
Weak enforcement
European regulators labor under unsophisticated computer systems, strained budgets and clumsy
coordination with the judicial system. They also face legal constraints that U.S. regulators don't.
Insider trading was made illegal in Germany only six years ago, and the American practice of
naming and shaming wrongdoers is forbidden by law there, unless the accused are public
officials.
Insider-trading probes often hit dead ends in Europe. In France, regulators have launched
21 full-fledged investigations since 1995; six led to administrative sanctions, none to criminal
convictions. Italy reports just eight indictments and two convictions for insider trading since
1991. The U.K., the biggest financial market in Europe, had three insider-trading convictions
between 1995 and 1999. Compare that to the U.S. record: Between 1995 and 1999, the Securities
and Exchange Commission won 162 civil cases against 270 defendants accused of insider trading,
and ordered the disgorgement of $40.4 million in illicit trading profits.
"There is no enforcement" in Europe, says Ignacio Pena, a finance professor at University
Carlos III in Madrid. One reason European authorities don't bring more insider-trading cases is
that in several countries -- Britain, Switzerland and Italy among them -- it is impossible to bring a
civil action as it is in the U.S., which carries a lower burden of proof.
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204
Regulators' budgets are tighter in Europe as well. The budgets of securities watchdogs in
Britain, Germany, France and Italy (which together have nearly as many people as the U.S.)
totaled $226.1 million in 1999. The SEC's was $342 million in the fiscal year ended Sept. 30,
1999. Lax regulation in Europe is a legacy of the past. But the long bull market, excitement about
the Internet and anxiety about public pension systems are changing that. The percentage of
Britons who own shares has risen to about 23% from 7% in the mid-1980s. In Germany, the
proportion has grown, though more slowly, to 7.8% from 5.3% in 1981. There have been some
signs of a shift. A British law that takes effect next year will, for the first time, allow authorities
to pursue civil cases.
Meanwhile, the SEC is intensifying its scrutiny of suspicious trading by European
investors and in European stocks. "The money here is big," says Richard Walker, the SEC
enforcement chief. "It puts them among the biggest insider-trading cases historically." Since
1994, the SEC has brought 10 cases that involved trading in U.S.-listed foreign securities, and
reached settlements or won default judgments in eight.
Many European countries simply lack the sophisticated computer equipment needed for
tracking suspicious trades. At the New York Stock Exchange, two senior surveillance analysts are
glued all day to electronic screens dotted with red, yellow and blue alerts.
Europe has fewer securities-market regulators than the U.S.
Country
Staff
members
Listed companies
(as of 1999)
Companies
per staff
member
Denmark
20
242
12
U.K.
200
2,399
12
Luxembourg
5
53
11
Ireland
10
78
8
Switzerland
30
232
8
Germany
130
741
6
Sweden
50
258
5
Netherlands
43
214
5
Finland
27
129
5
Greece
65
246
4
France
219
784
4
Austria
30
96
3
Spain
92
481
3
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COMPARATIVE COMPANY LAW
205
Belgium
80
156
2
Portugal
112
135
1
Italy
403
239
1
Europe
1,616
6,483
5**
United States
2,807
6,850
2*
*Excludes mutual funds
**Median
_________________________________
NOTES
1.
After the 2003 amendments to the EC Insider Trading Directive, many predicted that lax
enforcement would continue to plague European securities markets:
The EU's insider dealing directive will be too soft on offenders, its critics
argue. A weak law is an opportunity missed. A study by academics at Indiana
University in the US shows that the cost of capital in markets with a strong
insider-dealing regime can be 5% lower than in those without.
The EU directive on insider dealing, which is due to take effect this
month, is unlikely to improve this. The root of the problem is the directive's
requirement that companies disclose all inside information. The thinking goes: no
inside information, no insider dealing. This seems a good idea in principle. But
regulators have been forced to narrow the definition of what is and what isn't
inside information to ease the disclosure burden on issuers. It has fallen to the
Committee of European Securities Regulators (CESR) to set the details of the
single test on which the directive is based.
To begin with, CESR stuck to a broad test. But lobby groups, notably the
City of London Law Society, said the disclosure requirements for companies
would be unfair. Issuers would be forced to publicize events that would have no
material impact on their business but might lead investors to sell stocks, they
said. So the regulators narrowed the definition to include only information that a
reasonable investor would consider when buying or selling securities.
European regulators admit that the inside information test in the final
directive will be even weaker than some existing laws in individual EU countries.
"The UK market abuse regime outlaws dealing based on relevant information,"
says one regulator. "But sometimes what is deemed relevant might not come up
to the bar set by a price-sensitive test like CESR's." Professor Juan
Fernandez-Armesto, who chaired the working group of European regulators that
drafted the original directive for the Commission, says: "The reasonable investor
test is technically unfortunate. It looks like the result of last minute lobbying. It
does not improve the test, and creates additional confusion in the minds of the
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judges and regulators who apply the law. As such, it is an additional hurdle to
enforcement."
Rob Monnix, The flaw at the heart of Europe's insider dealing laws, International
Financial Law Review (May 02, 2003).
2.
But there are recent signs that the EU regulators may be becoming more aggressive:
US SEC chairman Christopher Cox recently observed that “financial
transactions are crossing national boundaries faster than ever before.” European
securities regulators are responding to this environment by bulking up their
enforcement muscle and bringing large enforcement cases that increasingly look
and feel like SEC cases in the US markets.
In the last few years, Europe has created new and far more potent
securities regulatory bodies that are beginning to make their presence felt. And
EU member states are implementing EU directives to achieve genuine crossborder convergence in securities regulation. As cross-border investigations
proliferate in Europe, the involvement of the traditionally aggressive SEC will
influence the continuing evolution of securities enforcement in Europe, and
recent developments suggest that the balance will be struck closer to the US
enforcement model.
European regulators are bringing headline- grabbing disciplinary and
enforcement actions that seek substantial financial penalties from large business
and financial services entities. In just over two years, Europeans have seen the
UK Financial Services Authority (FSA) fine Shell £17 million and Citigroup
£13.9 million, while the Dutch public prosecutor fined Ahold €8 million –
amounts previously unheard of in European securities enforcement. This trend
continued during 2006, with European regulators continuing to aggressively
pursue large targets and seek substantial fines across a variety of cases, often
with cooperation from, or parallel to, other European regulators and/or the SEC.
In December 2006, French police raided the Paris headquarters of
European Aeronautic Defence & Space (EADS), parent of Airbus, and the
offices of its French shareholder Lagardère, as part of an insider trading
investigation by two French investigating judges. The inquiry involves alleged
sales by EADS insiders in March before an April announcement that Lagardère
and Daimler Chrysler would each sell 7.5% interests in EADS.
The FSA fined Europe’s third-largest hedge fund manager, GLG
Partners, £750,000 in August 2006, and separately fined a former GLG
managing director £750,000 individually, for allegedly using confidential
information about a Japanese company’s upcoming offering of convertible
preferred shares to have a GLG fund short sell the issuer’s common shares. The
Japanese Securities and Exchange Surveillance Commission assisted the FSA’s
investigation.
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In an unrelated matter, in late December 2006, it was reported that the
French securities regulator, Autorité des Marchés Financiers (AMF), would fine
GLG Partners €1.2 million for alleged trading abuses in connection with an
Alcatel convertible bond offering, and would also fine Germany’s largest bank,
Deutsche Bank, €300,000 for alleged technical violations. Commentators noted
that this shows that regulators across Europe are talking to each other and taking
the issue of banks’ information flows seriously.
In December 2005, the FSA fined a finance director of Cambrian Mining
£25,000 for allegedly buying Cambrian shares on two occasions when he had
non-public information. Had he sold the shares after the information was
announced, which he did not, he would have had an imputed profits totalling
£6,400 – meaning that the fine was three times the amount of a hypothetical
profit, a particularly aggressive approach even by SEC standards.
Mayer Brown Rowe & Maw, A new age dawns: International enforcement is becoming
more cooperative and more similar to the SEC’s model in the US, Int’l Fin. L. Rev (Feb.
2007).
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Day 8 – Thursday, July 29
B.
Securities Fraud
1.
Securities (market) fraud -- United States
As we have seen, the US market economy is characterized by dispersed ownership in
deep and liquid equity-based capital markets. This is an exception to the worldwide pattern in
which concentrated ownership predominates. Why this divergence in ownership patterns? And
how do different ownership structures affect the behaviors that regulation should confront?
So we finish our topical comparison of US corporate law and European/Italian company
law by digging into the salacious details of two of the most well known business frauds of the
past decade – first, the Enron scandal (where one of the most successful and respected businesses
in the United States collapsed after major accounting manipulations were revealed) and the
Parmalat scandal (where one of the most successful Italian companies was bilked of billions of
euros by company insiders).
We first think about the origins of the different ownership patterns in the United States
and Europe – why are US companies owned by many different (now institutional) shareholders,
while Italian companies are owned primarily by family or inter-related company groups? Then
we take a quick look at some analysis about convergence – the approximation of different
regulatory regimes. Finally, we turn to a careful study of the Enron and Parmalat scandals and
the question: why were they different and how should that affect regulatory policy?
_________________________________
INTRODUCTORY NOTES
1.
Dispersed share ownership arose in the United States in the late 1800s and early 1900s at
a time of great money-making opportunities, but only negligible legal protection for
small investors. The famous “Robber Barons” of the era bribed judges and legislators,
and avoided the law by engaging in unregulated interstate business. But investors came
to be protected by self-regulatory institutions (like the New York Stock Exchange and its
listing requirements) and the bonding mechanism of investment banking firms that staked
their reputations on the companies whose securities they brought to market. A similar
story existed for Britain, though dispersed ownership arose at a slower pace there as the
London Stock Exchange slowly became an effective self-regulator.
In contrast, the Paris Bourse at the turn of the last century did not upgrade its
listing or disclosure standards. Why not? For one, it was a state-administered monopoly
whose stockbrokers were considered civil servants, with little incentive to bring new
companies to market. Likewise, in Germany, the state strongly supported the growth of
large private banks and imposed a punitive tax on securities transactions. The German
central bank lent money at favorable rates to private banks, which in turn satisfied the
capital needs of German industry without resort to equity markets. In short, concentrated
ownership was subsidized by the state.
2.
Will this divergence in ownership patterns change? Recent observers have argued that
civil law countries are unlikely to change because (1) their laws lack adequate protection
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for minority shareholders, (2) there are no markets in corporate control into which
dispersed shareholders can sell their shares, and (3) dispersed ownership is vulnerable to
left-leaning politics in “social democracies” that protect employment ahead of
investment. In short, some observers doubt that convergence can happen. See William
W. Bratton & Joseph A. McCahery, Comparative Corporate Governance and the Theory
of the Firm: The Case Against Global Cross Reference, 38 Col. J. Transnational L. ,
SSRN Paper 205455 (1999) (arguing that systems conducive to blockholding will
accommodate liquid trading markets).
Others see winds of change and anticipate greater convergence in corporate
governance. In fact, the principal question among many is whether that convergence will
be “formal” (an actual change in the law) or “functional” (the way that existing legal
institutions actually work). See John C. Coffee, The Rise of Dispersed Ownership: The
Role of Law in the Separation of Ownership and Control, SSRN Paper 254097 (2000).
3.
An interesting result of the differences in shareholder ownership B dispersed in the
United States and concentrated in Europe – is the incentives each creates. The dispersed
governance structure of the United States, in which managers are often paid with
company stock, encourages manipulation of reported earnings to artificially inflate stock
prices, as happened in Enron and WorldCom. While in Europe the concentrated
governance structure is prone to appropriation of private benefits, such as self-dealing or
outright theft by controlling persons, as in Parmalat. Thus, financial misconduct in each
structure arises from different motives and warrants different legal controls. For
example, the difficulty of achieving auditor independence in a concentrated governance
structure (where the controlling shareholder may be disinclined to choose a watchful
gatekeeper) suggests that public shareholders should choose the company’s auditor.
While in a dispersed system, auditor independence may be adequately assured by
oversight by an audit committee of outside directors, accompanied by heightened
standards of director and auditor liability.
The next readings give you an overview of Enron and Parmalat scandals. You’ll
want to ask yourself: who was asleep at the switch? We then conclude with an article
that compares the two high-profile corporate scandals and suggests different ownership
structures explains the differences in the two frauds and argues that different regulatory
regimes may be appropriate for different corporate landscapes. That is, convergence in
corporate/securities law may not be an appropriate path when convergence in business
firms and markets has not yet happened.
___________________________________
The (Quick) Story of Enron
Alan R. Palmiter (2010)
Corporate history
Enron traces its roots to the Northern Natural Gas Company, formed in 1932, in Omaha,
Nebraska. Over the years, the company went through various reorganizations and emerged in
1985 as InterNorth, a natural gas and electric transmission company with operations throughout
the United States. Under CEO Kenneth Lay, Enron's headquarters moved to Houston (even
though Lay had promised to keep them in Omaha – a little white lie). As part of the move, Lay
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changed the company’s name to "Enteron" until somebody pointed out that it sounded like the
Greek word for intestines. So it was quickly shortened to "Enron".
Enron soon began to expand beyond transmitting and distributing electricity and natural
gas, to building and operating power plants and pipelines worldwide – and then to the trading of
electricity and gas, along with all sorts of other things. Enron grew wealthy and its stock price
rose. Enron was named "America's Most Innovative Company" by "Fortune magazine" for six
consecutive years, from 1996 to 2001. It was on the Fortune's "100 Best Companies to Work for
in America" list in 2000, and its offices were stunning in their opulence.
Enron’s energy trading system was at the heart of the company’s success. Enron made it
possible for energy producers (such as powerplants) to sell their energy to customers (such as
local utilities) and buy transmission services from Enron or other transmitters – thus, making it
possible for energy buyers and sellers to connect across the United States, and later Europe. The
company expanded its energy trading platform to many other products, including pulp and wood
products, water storage and supply, and even derivatives (or financial bets) on weather,
commodities (like sugar, coffee, grains, hogs), and credit risks. In short, the company that began
as a gas producer and transmitter had become the world’s largest energy trader. See
http://en.wikipedia.org/wiki/Enron
But the company was not well. It had expanded too fast and many of its foreign
operations were financial flops – and management knew this. To cover this uncomfortable truth,
Enron management (assisted by its accounting firm Arthur Andersen and its law firm Vinson &
Elkins) recorded inflated assets and profits. Sick patient – doctor the books! Debts and losses
were put into entities formed "offshore" (special purpose vehicles, as they were known) that were
not included in the firm's financial statements, and other financial transactions between Enron and
related companies were used to take unprofitable entities off the company's books.
Accounting scandal of 2001
Soon the word began to leak out. As the stock and credit markets learned about Enron’s
irregular accounting procedures (perpetrated throughout the 1990s), access to capital from its
special-vehicle partners dried up and Enron eventually became in 2001 the largest bankruptcy in
history (though later Worldcom in 2002 and Lehman Brothers in 2008 would surpass it).
As the scandal unraveled, Enron shares dropped from over $90 to just pennies – and then
zero. Enron had been considered a blue chip stock (that is, super safe), so this was an
unprecedented and disastrous event in the financial world. When Enron filed for bankruptcy,
shareholders lost all their money – including all of the Enron employees who had put their
retirement nest eggs in company stock. And creditors lost most of their investments, though more
than $6 billion was recouped in class action lawsuits against some of the investment firms that
had participated in the special-purpose entities.
Not only did Enron disappear (its assets eventually bought up by bargain-hunters like
Warren Buffett), but the scandal led to the dissolution of Arthur Andersen, one of the world's top
accounting firms. The firm was found guilty of obstruction of justice in 2002 for destroying
documents related to its audit of Enron’s financial statements, making it impossible for the firm to
continue in the business of auditing public companies. Although the Supreme Court later threw
out the conviction in 2005, the damage had been done and Andersen was gone.
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Accounting practices
So what was Enron doing exactly? Enron had created special purpose offshore entities
into which investors would put cash and Enron would put its promises (backed by its stock).
Things were good as long as the entities were valued on the basis of future earnings, and the
entities generated paper profits that went straight to Enron’s books. As Enron became more
dependent on these “shaky” paper profits, company executives had to perform more and more
contorted financial deceptions to maintain the illusion of billions in profits -- while the company
was actually losing money mostly from its abysmal foreign operations. The good-looking paper
profits drove up the Enron stock price to new levels, at which point executives began to dump
their own Enron stock (smart move, but illegal insider trading).
There were rumblings that something at Enron was not right as early as >>> when a
group of Cornell business students prepared a study questioning Enron’s financial statements.
Later stock analysts would also raise questions – though Enron officials called them as
“assholes.” But finally it was an insider, a company accountant Sherron Watkins who blew the
whistle – at least, internally – and later testified before Congress about all the accounting
shenanigans at Enron. She would later be named a “Time Person of the Year” (along with two
other women, one at WorldCom and the other with the FBI, who helped uncover the widespread
corporate scandals of the 2000s).
The players
The principal players in the Enron scandal were CFO Andrew Fastow and CEO Jeffrey
Skilling. Fastow led the “innovative” move of creating the off-books companies and manipulated
the deals so he got a stake in the profits, thus providing himself with hundreds of millions of
dollars in guaranteed returns in the off-shore entities. Fastow would later plead guilty to
securities fraud, testify against Skilling, and be sentenced to prison for six years.
CEO Skilling, who took over the helm of the company from Lay in 2001, had the novel
idea to make Enron a company without "assets" – just a big trading company that owned the
“promise” of future earnings. The new Enron depended on mark to market accounting, in which
anticipated future profits from any deal were recorded on the company’s financials as if real
today. Thus, Enron recorded gains from deals that over time could (and did) turn out to be losses - Wall Street in the dot.com era loved it. Eventually, Skilling was sentenced to 24 years in prison,
which he appealed to the Supreme Court (a decision is expected any day).
What about former CEO Lay? When Skilling took over, he became chair of the Enron
board – a calming, avuncular figure. As investors began to question Enron’s stated profits, Lay
issued statements or made appearances to calm the markets and assure everyone that Enron was
headed in the right direction. Meanwhile, he was selling his own stock, over $70 million worth,
to repay his lines of credit. Lay eventually was convicted on securities fraud charges, but died
while awaiting (on vacation) to be sentenced, probably in the range of 20 to 30 years – thus the
conviction technically does not stand.
_______________________________
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NOTES
1.
What caused the Enron fraud? Every corporate scholar and his brother have an opinion.
Here’s an overview (written by the same law professor whose essay is next):
Between January 1997 and June 2002, approximately 10% of all listed
companies in the United States announced at least one financial statement
restatement. The stock prices of restating companies declined 10% on average on
the announcement of these restatements, with restating firms losing over $100
billion in market capitalization over a short three day trading window
surrounding these restatements.
Several different explanations are plausible, each focusing on a different actor:
1. The Gatekeeper Story looks to the professional "reputational
intermediaries" on whom investors rely for verification and certification i.e., auditors, analysts, debt rating agencies and attorneys - and views the
surge in financial restatements as the product of both (a) reduced legal
exposure for gatekeepers (as the result of legislation and judicial
decisions in the 1990's sheltering them from liability) and (b) the
increased potential for consulting income or other benefits from their
clients (resulting in gatekeeper acquiescence in accounting or financial
irregularities). This is essentially the story to which the Sarbanes-Oxley
Act responds.
2. The Misaligned Incentives Story instead focuses on managers and a
dramatic change in executive compensation during the 1990's, as firms
shifted from cash to equity-based compensation. Stock options (and legal
changes that enabled management to exercise the option and sell the
security without any delay) arguably gave management a strong
incentive to inflate reported earnings and create short-term price spikes
that were unsustainable, but which they alone could exploit. SarbanesOxley does not address this potential cause of irregularities – but the
2010 financial reform legislation does.
3. The Herding Story focuses on the incentives of investment fund
managers and argues that they are uniquely focused on their quarterly
performance vis-a-viz their rivals. As a result, they have an incentive to
"ride the bubble," even when they sense danger, because they fear more
the mistake of being prematurely prophetic. Again, Sarbanes-Oxley does
not address this cause of bubbles and price spikes – but the 2010
financial reforms take a stab at reversing human nature.
John Coffee, What Caused Enron?: A Capsule Social and Economic History of the
1990s, 89 Cornell L. Rev. 269, SSRN Paper 373581 (2004).
2.
Enron led to Congress enacting the Sarbanes-Oxley Act in 2002. The legislation, which
significantly federalize corporate governance, seeks to prevent corporate accounting
scandals. In some ways, the legislation is a study in the Enron scandal itself, with most
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of the provisions directly related to specific things that Congress identified had gone
wrong in the company.
Here’s a list of Enron wrongdoing and the corresponding part of Sarbanes-Oxley
meant to address it (some would say, the closing of the door after the horse had gotten out
of the barn).
Misconduct
Outside auditors failed to discover or
report accounting fraud. Some
attributed this failure to self-regulation
of the accounting profession, which
during the 1990s increasingly focused
on technical rules and client
satisfaction. In particular, the
accounting firm Arthur Andersen
(auditor for many scandal-ridden
companies) seemed indifferent toward
financial irregularities of many clients.
Regulatory response
•
•
•
•
Create a self-regulatory, five-person Public
Company Accounting Oversight Board to establish
auditing standards and regulate accounting
profession [SOA §101]
Require accounting firms that audit public
companies to register with PCAOB [SOA §102]
Authorize PCAOB to set standards for public
company audits and to enforce its audit rules [SOA
§§103, 104, 105]
Authorize SEC to sanction auditors for intentional,
reckless, and highly negligent conduct [SOA §602]
Outside auditors performed nonaudit
services that undermined their audit
independence. For example, Arthur
Andersen came to earn more from
Enron for its nonaudit services than for
its work as financial auditor.
•
Ban auditors from providing certain types of
nonaudit services and require preapproval by the
company’s audit committee of permissible
nonaudit services [SOA §§201, 202]
Outside auditors became too ‘cozy’
with executives of audit clients. For
example, many financial officers of
Enron were former principals of Arthur
Andersen, its auditor.
•
Require rotation of audit partner every five years
[SOA §203]
Close ‘revolving door’ for members of audit team
who within one year after engagement become
financial/accounting officers of audit client [SOA
§206]
Corporate boards (especially board
audit committees) failed to supervise
outside auditors and lacked expertise to
understand company’s finances. The
Enron board became a symbol of
directorial inattention.
•
Corporate executives failed to ascertain
the truthfulness of company filings and
to supervise subordinates, and
pressured auditors to give ‘clean’
reports.
•
•
•
•
Authorize SEC to have stock exchanges change
their listing requirements to require audit
committees composed only of independent
directors, with full authority over outside auditor
[SOA §301]
Require disclosure whether company has at least
one ‘financial expert’ on audit committee [SOA
§407]
Require SEC rules that CEO and CFO certify that
their company’s SEC filings are true, complete,
and fairly presented [SOA §302]
Require SEC rules on disclosure of internal
controls, and require top executives to certify them
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•
Companies failed to report (and the
•
SEC failed to notice) their true financial
condition, especially the potential effect
of risky off-balance sheet arrangements. •
•
Corporate cultures encouraged
irresponsible behavior, such as
unauthorized or excessive loans to
company executives.
•
•
•
Corporate executives sold company
stock while aware of accounting
misinformation and while employees in
company pension plan could not sell.
•
•
•
Outside securities lawyers, such as the
lawyers of Enron’s outside law firm
Vinson & Elkins, ‘papered’ illegal
transactions or failed to intercede.
•
•
[SOA §§302, 404]
Prohibit company officials from improperly
influencing outside auditors [SOA §303]
Require companies to make additional, real-time
disclosures in ‘plain English’ of current changes to
financial condition [SOA §409]
Mandate SEC rules requiring disclosure of all
material off-balance sheet arrangements [SOA
§401]
Require SEC to review filings by reporting
companies at least every three years [SOA §408]
Require disclosure whether the company has a
code of ethics applicable to senior financial
officers, or justify why not [SOA §406]
Authorize SEC to remove ‘unfit’ officers and
directors from their positions, and bar them from
similar offices in other public companies [SOA
§§305, 1105]
Ban ‘personal loans’ to company directors and
officers, except in regular course of company’s
lending business [SOA §402]
Require forfeiture of executive pay and trading
gains when company restates financials due to
misconduct [SOA §304]
Bar company executives from selling stock during
any trading blackout period imposed on employees
[SOA §306]
Require corporate insiders to disclose their trading
in company stock within two business days [SOA
§403]
Authorize SEC to create rules requiring lawyers
working for company to report securities violations
and fiduciary breaches up the internal corporate
ladder [SOA §307]
Authorize SEC to bring enforcement actions
against lawyers for malpractice [SOA §602]
Securities analysts prepared biased
research reports for companies with
which their securities firms did
business.
•
Mandate SEC to adopt rules on the independence
and objectivity of securities analysts, and protect
them from retaliation for negative reports or
ratings [SOA §501]
Many frauds only came to light because
of courageous ‘whistleblowers’ inside
•
Impose criminal liability on those who retaliate
against employees who provide evidence or assist
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the company.
•
•
•
Company officials and outside auditors
destroyed documents to cover up
wrongdoing. For example, Arthur
Andersen employees destroyed Enron
documents, hoping to hide the financial
scandal.
•
Company officials did not take their
oversight and disclosure responsibilities
seriously.
•
•
•
3.
in the investigation of business crimes [SOA
§1107]
Create a private action for whistleblowers who
experience retaliation to seek compensatory
damages, reinstatement, back pay, litigation costs
[SOA §806]
Require audit committees to create procedures for
handling (anonymous) complaints about
accounting improprieties [SOA §301]
Extend statute of limitations in cases of securities
fraud to two years from discovery, or five years
from violation [SOA §804]
Increase criminal sentences for destruction,
alteration, or falsification of records in federal
investigation, and for violating rules on document
retention [SOA §802]
Create a new crime for obstructing a proceeding,
including by tampering with documents [SOA
§1102]
Increase criminal sentences for corporate officials
who retaliate against whistleblowers, those who
commit mail and wire fraud, and those who falsely
certify financials [SOA §§806, 903, 906, 1107]
Create a new crime of ‘knowing securities fraud,’
with maximum prison term of 25 years [SOA
§807]
Notice the presence in the Enron story of Vinson & Elkins, the outside law firm of Enron.
These were the lawyers who put together the special-purpose entities that were at the
heart of the financial fraud. What should be their responsibility? What should the law do
in response to their shortcomings?
Maybe lawyers are just scribeners who write what their clients want – end of
matter. Other intermediaries have specific duties, imposed by law, but not lawyers. The
auditor has to certify financial statements, investment firms that sell securities must
perform a “due diligence” investigation, stock analysts have duties to their clients to
make honest and competent investment recommendations, and government regulators are
supposed to keep their eyes open for fraud.
Should the lawyer who suspects fraud refuse to do the necessary legal work, tell
higher-ups in the company and quit if they don’t act, or (even more dramatically) go
outside the company to regulators or prosecutors, and inform on the company – that is,
blow the whistle?
Can lawyers be both zealous advocates and gatekeepers? Well, Sarbanes-Oxley
says yes. It authorizes the SEC to require lawyers who gain information in the course of
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their representation that company officials are committing fraud (or other breaches of
fiduciary duty) to go “up the ladder” within the company and seek to have the company’s
general counsel, CEO or board directors stop the potential wrong-doing. See SEC Rule §
307. And the ABA model rules on professional conduct now allow, though don’t require,
that the lawyer blow the whistle – despite the attorney-client privilege that requires that
client confidences be kept secret.
So go back to Vinson & Elkins, the law firm that helped create the specialpurpose entities that had massive conflicts of interest and inadequate public disclosures,
and which the law firm should have known were fraudulent. Although the law firm did
not invest directly in the transactions, its legal opinions on the transactions were
necessary for the fraud to happen. Are they responsible doing nothing?
4.
Next is a journalistic account of what was happening at Parmalat, the Italian packaged
milk company, whose products you can still find on the grocer’s shelf.
Like Enron, Parmalat went through a big growth spurt in the late 1990s
expanding into foreign markets, particularly in the developing world. Most of the
expansion was financed with debt. By 2001, many of the new divisions were losing
money, and the company started to doctor its books to hide the extent of its losses and
debt. (For example, the company sold itself credit-linked notes, in effect placing on its
books financial bets on its own credit worthiness to conjure up assets out of thin air.)
In 2003 things unraveled. The company fired its CFO when he (unexpectedly)
announced the necessity of a new €500 million bond issue. Then the company failed to
raise money from Epicurum, a mutual fund linked to Parmalat, raising questions about its
ability to pay creditors. And finally the company went into bankruptcy when Parmalat's
bank, Bank of America, said that a €3.95 billion CD carried on Parmalat’s books was a
forgery. Hundreds of thousands of investors lost their money
The company’s CEO Calisto Tanzi, once a symbol of unlimited success, was
arrested and charged with financial fraud and money laundering. Tanzi admitted to
diverting Parmalat funds into companies he owned and was sentenced to 10 years in
prison, though seven other defendants (including executives and bankers) were acquitted.
In 2009, three lawsuits by Parmalat officials and companies against Bank of America and
auditors Grant Thornton were dismissed.
_______________________________
How Parmalat Spent and Spent
By Alessandra Galloni in Milan and David Reilly in London
Wall Street Journal, July 23, 2004
ONE QUESTION HAS bedeviled investors around the world since Italian dairy giant Parmalat
SpA collapsed last year in one of Europe's biggest-ever corporate frauds: Where did all the
money go?
In a report compiled for the Italian government, Enrico Bondi, the special administrator appointed
by the Italian government to run and restructure the now-insolvent milk company, has come up
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with a €14.2 billion answer (in U.S. terms, a $17.4 billion answer).
Parmalat used about 5€.4 billion to go on a global acquisition spree -- buying up companies in
Canada, the U.S., Latin America and Asia -- and to cover up losses around its far-flung empire,
according to the Bondi report.
The company also spent about €6.5 billion on interest payments related to its ever-increasing
debts, along with paying fees to banks and brokers helping to facilitate a 13-year borrowing spree
at the company, the report says.
The report alleges that a further €2.3 billion went to people or entities connected with Parmalat,
namely to companies affiliated with or controlled by its founder and former chairman, Calisto
Tanzi. Both Mr. Bondi and Italian prosecutors believe, for example, that nearly €500 million was
diverted to Parmatour SpA, a travel company run by the industrialist's daughter, Francesca. About
€59 million went to Sata SRL, a company in which Mr. Tanzi had a 60% interest, along with a
direct payment to him of €13 million, the report says.
But in other areas, Mr. Bondi's accountants have had less success in determining who ultimately
benefited from the alleged looting of Parmalat's coffers. Of the €2.3 billion, according to the
report, nearly half went to Wishaw Trading SA, a Parmalat subsidiary based in Uruguay. Wishaw
then passed much of the money on to companies or accounts whose owners haven't been
identified, the report says.
Mr. Bondi's report said that about half of the squandered money came from bond investors who
lent Parmalat €7.4 billion between 1990 and 2003. A further €4.1 billion came from Italian and
foreign banks, the report said. Altogether, the company raised €13.2 billion from outside sources
during this period and then spent an additional €1 billion from its internal cash flow.
This left Parmalat teetering under a €14.2 billion debt mountain when the fraud became apparent
late last year after a Parmalat bank account at Bank of America supposedly holding €3.9 billion
was found to be fictitious.
In addition, while Parmalat shares had a market value of more than €2 billion before the
company's collapse and it operated factories in 30 countries around the world, its actual assets
totaled less than €1 billion at the end of 2003, the report said.
Mr. Bondi's report -- the first in-depth statement by Parmalat's special commissioner -- also
suggests Italian and foreign banks played a role in enabling top company executives to sustain
their alleged fraud. Without naming names, the report charges that financial institutions used tax
havens to "issue bonds and lent money through structured finance, which helped Parmalat falsely
represent its economic and financial situation in its books."
Foreign banks were the main underwriters of Parmalat debt from 1990 through 2003, with J.P.
Morgan Chase leading the pack by arranging some €1.7 billion in debt. Among other Wall Street
firms, Morgan Stanley arranged €853 million, and Merrill Lynch & Co. €841 million, according
to the report.
While Mr. Bondi stops short of saying the banks knowingly colluded with Parmalat, he says that
the company's true financial condition was easily identifiable by comparing its published
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numbers with independent data available detailing the amount of bonds it had issued. "Parmalat's
disarray was knowable to financial operators," the report says.
Italian prosecutors have sought to indict the Bank of America, based in Charlotte, N.C.; the
Italian affiliate of auditor Deloitte Touche Tohmatsu; and Italaudit, the former Italian arm of
auditor Grant Thornton International, on securities-laws violations. Those indictment requests by
prosecutors in Milan, along with similar requests related to 29 people connected to Parmalat, are
still pending.
An investigation by prosecutors in Parma, near Parmalat's home in Collecchio, into the actual
fraud is continuing.
Parmalat is trying to emerge from bankruptcy protection, and the Italian government has
approved a restructuring plan that calls for debt holders to receive stock in a newly constituted
company that will in many cases be equal to 11.3% of their original investments. Investors who
owned stock in Parmalat will receive nothing.
In a report given to Italian prosecutors, Enrico Bondi, the special administrator appointed
to restructure Parmalat, details where he believes some of the money went. In billions of euros:
Acquisitions
Interest payments and fees related to bank debt
Interest payments and fees related to bonds
Siphoned off from the company
Losses at operating units
Taxes
Dividends
TOTAL
€3.8
€2.8
€2.5
€2.3
€1.6
€0.9
€0.3
€14.2 billion ($17.4 billion)
NOTES
1.
One interesting aspect of Parmalat was how the fraud was handled judicially. In Italy
prosecutors brought criminal charges against Tanzi and the other company insiders,
resulting (by Italian standards) in some extremely heavy jail sentences. But civil
litigation by shareholders and creditors seeking damages for their investment losses did
not occur in Italy, where there was (at the time) no clear procedure for class action
litigation – that is, litigation where multiple claims are joined together in a lawsuit
brought by a representative (and lawyer) of the class of injured parties, with full access to
company information and procedures for compensating the class lawyers.
2.
Instead, the civil suits were brought as class actions in the United States under the federal
securities laws by investors that claimed Parmalat’s contacts with the United States had
created jurisdiction in federal court. Since Parmalat was bankrupt, the US suits were
brought against the “gatekeepers” who allegedly failed in their duties – namely, the
outside auditor Grant Thornton and the underwriter on Parmalat’s ill-fated bond issues,
Bank of America. These suits eventually failed for lack of proof that the gatekeepers had
the requisite knowledge of Parmalat’s dire financial condition – that is, they failed
because the fraud had been successful! See Guido A. Ferrarini and Paolo Giudici,
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Financial Scandals and the Role of Private Enforcement: The Parmalat Case, SSRN
paper 730403 (2005).
_________________________________
A Theory of Corporate Scandals: Why the US and Europe Differ,
SSRN Paper 694581 (2005)
John C. Coffee, Jr. 18
Corporate scandals, particularly when they occur in concentrated outbursts, raise serious
issues that scholars have too long ignored. First, why do different types of scandals occur in
different economies? Second, why does a wave of scandals occur in one economy, but not in
another, even though both economies are closely interconnected in the global economy? This
brief essay answers both questions looking at the structure of share ownership.
Conventional wisdom explains a sudden concentration of corporate financial scandals as
the consequence of a stock market bubble. When the bubble burst, scandals follow, and,
eventually, new regulation. Historically, this has been true at least since the South Seas Bubble,
and this hypothesis works reasonably well to explain the turn-of-the-millennium experience in the
U.S. and Europe. Worldwide, a stock market bubble did burst in 2000, and in percentage terms
the decline was greater in many European countries than in the United States.19 But in Europe,
this sudden market decline was not associated with the same pervasive accounting and financial
irregularity that shook the U.S. economy and produced the Sarbanes-Oxley Act in 2002. Indeed,
financial statement restatements are rare in Europe.20
In contrast, the U.S. witnessed an accelerating crescendo of financial statement
restatements that began in the late 1990s. The United States General Accounting Office (“GAO”)
has found that over 10% of all listed companies in the United States announced at least one
financial statement restatement between 1997 and 2002. Later studies have placed the number
18
Adolf A. Berle Professor of Law at Columbia University Law School and Director, Center on Corporate
Governance, Columbia University Law School.
19
See Bengt Holmstrom and Steven Kaplan, The State of U.S. Corporate Governance: What’s Right and
What’s Wrong, 15 Accenture J. of App. Corp. Fin. 8, 9 (2003) (showing that from 2001 through December
31, 2002, the U.S. stock market returns were negative 32%, while France was negative 45% and Germany
negative 53%).
20
Although they have been rare in the past, FitchRatings, the credit ratings agency, predicts that they will
become common in Europe in 2005, as thousands of European companies switch from local accounting
standards to International Financial Reporting Standards, which are more demanding. See FitchRatings,
“Accounting and Financial Reporting Risk: 2005 Global Outlook,” March 14, 2005.
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even higher. Because a financial statement restatement is a serious event in the United States that,
depending on its magnitude, often results in a private class action, an SEC enforcement
proceeding, a major stock price drop, and/or a management shake-up, one suspects that these
announced restatements were but the tip of the proverbial iceberg, with many more companies
negotiating changes in their accounting practices with their outside auditors
that averted a formal restatement.
While Europe also had financial scandals over this same period (with the Parmalat
scandal being the most notorious), most were characteristically different than the U.S. style of
earnings manipulation scandal (of which Enron and WorldCom were the iconic examples).
What explains this difference and the difference in frequency? This short essay will
advance a simple, almost self-evident thesis: differences in the structure of share ownership
account for differences in corporate scandals, both in terms of the nature of the fraud, the identity
of the perpetrators, and the seeming disparity in the number of scandals at any given time. In
dispersed ownership systems, corporate managers tend to be the rogues of the story, while in
concentrated ownership systems, it is controlling shareholders who play the corresponding role.
Although this point may seem obvious, its corollary is less so: the modus operandi of
fraud is also characteristically different. Corporate managers tend to engage in earnings
manipulation, while controlling shareholders tend to exploit the private benefits of control.
Finally, and most importantly, given these differences, the role of gatekeepers in these two
systems must necessarily also be different. 21 While gatekeepers failed both at Enron and
Parmalat, they failed in characteristically different ways. In turn, different reforms may be
justified, and the panoply of reforms adopted in the United States, culminating in the SarbanesOxley Act of 2002, may not be the appropriate remedy in Europe.
Part I will review the recent American scandals to identify common denominators and the
underlying motivation that caused the sudden eruption of financial statement restatements. Part II
will turn to the evidence on private benefits of control in concentrated ownership systems.
Patterns also emerge here in terms of the maturity of the capital market. Part III will advance
some tentative conclusions about the differences in monitoring structures that are appropriate
under different ownership regimes.
Part I. Fraud in Dispersed Ownership Systems
While studies differ, all show a rapid acceleration in financial statement restatements in
the United States during the 1990s. The earliest of these studies finds that the number of earnings
restatements by publicly held U.S. corporations averaged roughly forty-nine per year from 1990
to 1997, then increased to ninety-one in 1998, and then soared to 150 and 156 in 1999 and 2000.
A later study by the United States General Accounting Office shows an even more dramatic
acceleration, as set forth in Figure I:
21
The term “gatekeeper” will not be elaborately defined for purposes of this short essay, but means a
reputational intermediary who pledges its considerable reputational capital to give credibility to its
statements or forecasts. Auditors, securities analysts, and credit ratings agencies are the most obvious
examples. See John Coffee, Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant
Reforms, 84 B.U.L. Rev. 301, 308-311 (2004).
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Nor were these restatements merely technical adjustments. Although some actually
increased earnings, the GAO study found that the typical restating firm lost an average 10% of its
market capitalization over a three day trading period surrounding the date of the announcement.
All told, the GAO estimated the total market losses (unadjusted for other market movements) at
$100 billion for restating firms in its incomplete sample for 1997-2002.
The intensity of the market’s negative reaction to an earnings restatement appears to be
greatest when the restatement involved revenue recognition issues. One study examining just the
period from 1997 to 1999 found that firms in which revenue recognition issues caused the
restatement experienced a market adjusted loss of -13.38% over a window period beginning three
days before the announcement and continuing until three days after the announcement. Yet,
despite the market’s fear of such practices, revenue recognition errors became the dominant cause
of restatements in the period from 1997 to 2002. The GAO Report found that revenue recognition
issues accounted for almost 38 percent of the restatements it identified over that period.
The prevalence of revenue recognition problems, even in the face of the market’s
sensitivity to them, shows a significant change in managerial behavior in the United States.
During earlier periods, U.S. managements famously employed “rainy day reserves” to hold back
the recognition of income that was in excess of the market’s expectation in order to defer its
recognition until some later quarter when there had been a shortfall in expected earnings – in
effect, income-smoothing. This traditional form of earnings management was intended to mask
the volatility of earnings and reassure investors who might have been alarmed by rapid
fluctuations in earnings. In contrast, managers in the late 1990s appear to have characteristically
“stolen” earnings from future periods in order to create an earnings spike that potentially could
not be sustained. Why? Although it had long been known that restating firms were typically
firms with high market expectations for future growth, the pressure on these firms to show a high
rate of earnings growth appears to have increased during the 1990s.
What, in turn, caused this increased pressure? To a considerable extent, it appears to
have been self-induced – that is, the product of increasingly optimistic predictions by
managements to financial analysts as to future earnings. But this answer just translates the prior
question into a different format: Why did managements become more optimistic about earnings
growth over this period? Here, one explanation does distinguish the U.S. from Europe, and it has
increasingly been viewed as the best explanation for the sudden spike in financial irregularity in
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the U.S. Put simply, executive compensation abruptly shifted in the United States during the
1990s, moving from a cash-based system to an equity-based system. More importantly, this shift
was not accompanied by any compensating change in corporate governance to control the
predictably perverse incentives that reliance on stock options can create.
One measure of the suddenness of this shift is the change over the decade in the median
compensation of a CEO of an S&P 500 Industrial company. As of 1990, the median such CEO
made $1.25 million with 92% of that amount paid in cash and 8% in equity. But during the 1990s,
both the scale and composition of executive compensation changed. By 2001, the median CEO
of an S&P industrial company was earning over $6 million, of which 66% was in equity. Figure
II shows the swiftness of this transition:
To illustrate the impact of this change, assume a CEO holds options on two million shares of his
company’s stock and that the company is trading at a price to earnings ratio of 30 to 1 (both
reasonable assumptions for this era). On this basis, if the CEO can cause the “premature”
recognition of revenues that result in an increase in annual earnings by simply $1 per share, the
CEO has caused a $30 price increase that should make him $60 million richer. Not a small
incentive!
Obviously, when one pays the CEO with stock options, one creates incentives for shortterm financial manipulation and accounting gamesmanship. Financial economists have found a
strong statistical correlation between higher levels of equity compensation and both earnings
management and financial restatements. One recent study by Efendi, Srivastava and Swanson
utilized a control group methodology and constructed two groups of companies, each composed
of 100 listed public companies.22 The first group’s members had restated their financial
statements in 2001 or 2002, while the control group was composed of otherwise similar firms that
had not restated.
22
Jap Efendi, Anup Srivastava, and Ed Swanson, Why Do Corporate Managers Misstate Financial
Statements: The Role of Option Compensation, Corporate Governance and Other Factors, (August 2004)
(http://ssrn.com/abstract=547920). For an earlier similar study, see Shane A. Johnson, Harley E. Ryan Jr.,
and Yisong S. Tian, Executive Compensation and Corporate Fraud, SSRN Paper 395960 (April 2003).
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What characteristic most distinguished the two groups? The leading factor that proved
most to influence the likelihood of a restatement was the presence of a substantial amount of “in
the money” stock options in the hands of the firm’s CEO. The CEOs of the firms in the restating
group held on average “in the money” options of $30.9 million, while CEOs in the nonrestating
control group averaged only $2.3 million – a nearly 14 to 1 difference. Further, if a CEO held
options equaling or exceeding 20 times his or her annual salary (and this was the 80th percentile
in their study – meaning that a substantial number of CEOs did exceed this level), the likelihood
of a restatement increased by 55%.
At this point, the contrast between managerial incentives in the U.S. and Europe comes
into clearer focus. These differences involve both the scale of compensation and its composition.
In 2004, CEO compensation as a multiple of average employee compensation was estimated to be
531:1 in the U.S., but only 16:1 in France, 11:1 in Germany, 10:1 in Japan, and 21:1 in nearby
Canada. Even Great Britain, with the most closely similar system of corporate governance to the
U.S., had only a 25:1 ratio. But even more important is the shift towards compensating the chief
executive primarily with stock options. While stock options have come to be widely used in
recent years in Europe, equity compensation constitutes a much lower percentage of total CEO
compensation (even in the U.K., it was only 24% in 2002). European CEOs not only make much
less, but their total compensation is also much less performance related.
What explains these differences? Compensation experts in the U.S. usually emphasize
the tax laws in the United States, which were amended in the early 1990s to restrict the corporate
deductibility of high cash compensation and thus induced corporations to use equity in preference
to cash. But this is only part of the fuller story. Much of the explanation is that institutional
investors in the U.S. pressured companies for a shift towards equity compensation. Why?
Institutional investors, who hold the majority of the stock in publicly held companies in the U.S.,
understand that, in a system of dispersed ownership, executive compensation is probably their
most important tool by which to align managerial incentives with shareholder incentives.
Throughout the 1960s and 1970s, they had seen senior managements of large corporations
manage their firms in a risk-averse and growth-maximizing fashion, retaining “free cash flow” to
the maximum extent possible. Such a style of management produced the bloated, and inefficient
conglomerates of that era (for example, Gulf & Western and IT&T). Put simply, a system of
exclusively cash compensation creates incentives to avoid risk and bankruptcy and to maximize
the size of the firm, regardless of profitability, because a larger firm size generally implies higher
cash compensation for its senior managers.
Once the U.S. tax laws and institutional pressure together produced a shift to equity
compensation in the 1990s, managers’ incentives changed, and managers sought to maximize
share value (as the institutions had wanted). But what the institutions failed to anticipate was that
there can be too much of a good thing. Aggressive use of these incentives in turn encouraged the
use of manipulative techniques to maximize stock price over the short-run. Although such spikes
may not be sustainable, corporate managers possess asymmetric information, and anticipating
their inability to maintain earnings growth, they can exercise their options and bail out.
One measure of this transition is the changing nature of financial irregularities. The
Sarbanes-Oxley Act required the SEC to study all its enforcement proceedings over the prior five
years (i.e., 1997-2002) to ascertain what kinds of financial and accounting irregularities were the
most common. Out of the 227 “enforcement matters” pursued by the SEC over this period, the
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SEC has reported that 126 (or 55%) alleged “improper revenue recognition.” Similarly, the earlier
noted GAO Study found that 38% of all restatements in its survey were for revenue recognition
timing errors. Either managers were recognizing the next period’s revenues prematurely – or
managers were simply inventing revenues that did not exist. Both forms of errors suggest that
managers were striving to manufacture an artificial (and possibly unsustainable) spike in
corporate income.
Part II. Fraud in Concentrated Ownership Regimes
The pattern in concentrated ownership systems is very different, but not necessarily
better. In the case of most European corporations, there is a controlling shareholder or
shareholder group. Why is this important? A controlling shareholder does not need to rely on
indirect mechanisms of control, such as equity compensation or stock options, in order to
incentivize management. Rather, it can rely on a “command and control” system because, unlike
the dispersed shareholders in the U.S., it can directly monitor and replace management. Hence,
corporate managers have both less discretion to engage in opportunistic earnings management
and less motivation to create an earnings spike (because it will not benefit a management not
compensated with stock options).
Equally important, the controlling shareholder also has much less interest in the day-today stock price of its company. Why? Because the controlling shareholder seldom, if ever, sells
its control block into the public market. Rather, if it sells at all, it will make a privately
negotiated sale at a substantial premium over the market price to an incoming, new controlling
shareholder. Such control premiums are characteristically much higher in Europe than in the
United States. As a result, controlling shareholders in Europe do not obsess over the day-to-day
market price and rationally do not engage in tactics to prematurely recognize revenues to spike
their stock price. These two explanations – lesser use of equity compensation and lesser interest
in the short-term stock price – explain at least in part why there were less accounting irregularities
in Europe than in the U.S. during the late 1990s.
Does this analysis imply that European managers are more ethical or that European
shareholders are better off than their American counterparts? By no means! Concentrated
ownership encourages a different type of financial overreaching: the extraction of private benefits
of control. Dyck and Zingales have shown that the private benefits of control vary significantly
across jurisdictions, ranging from -4% to +65%, depending in significant part on the legal
protections given minority shareholders. While there is evidence that the market cares about the
level of private benefits that controlling shareholders will extract, the market has a relatively
weak capacity to discern on a real time basis what benefits are in fact being expropriated.
In more developed economies, “operational” mechanisms can be used: for example,
controlling shareholders can compel the company to sell its output to, or buy its raw materials
from, a corporation that they independently own. In emerging markets, growing evidence
suggests that firms within corporate groups engage in more related party transactions that firms
that are not members of a controlled group.
Although it may be tempting to deem “tunneling” and related opportunistic practices as
characteristic only of emerging markets where legal protections are still evolving, considerable
evidence suggests that such practices are also prevalent in more “mature” European economies.
Indeed, some students of European corporate governance claim that the dominant form of
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concentrated ownership (i.e., absolute majority ownership) is simply inefficient because it permits
too much predatory misbehavior.
This provocative question need not here be resolved, but the nature of the scandals that
characterize concentrated ownership systems does merit our attention because they show a
distinct and different type of gatekeeper failure. Two recent scandals typify this pattern: Parmalat
and Hollinger. Parmalat is the paradigmatic fraud for Europe (just as Enron and WorldCom are
the representative frauds in the United States). Parmalat’s fraud essentially involved the balance
sheet, not the income statement. It failed when a €3.9 billion account with Bank of America
proved to be fictitious. At least, $17.4 billion in assets seemed to vanish from its balance sheet.
Efforts by its trustee to track down these missing funds appear to have found that at least €2.3
billion were paid to affiliated persons and shareholders. In short, private benefits appear to have
siphoned off to controlling shareholders through related party transactions. Unlike the short-term
stock manipulations that occur in the U.S., this was a scandal that had continued for many years,
probably for over a decade.
At the heart of the Parmalat fraud, there was also a failure by its gatekeepers. Parmalat’s
auditors for many years had been an American-based firm, Grant Thornton, whose personnel had
audited Parmalat and its subsidiaries since the 1980s. Although Italian law uniquely mandated the
rotation of audit firms, Grant, Thornton found an easy evasion. It gave up the role of being
auditor to the parent company in the Parmalat family, but continued to audit its subsidiaries.
Among these subsidiaries was the Caymans Islands based subsidiary, Boulat Financing
Corporation, whose books showed the fictitious Bank of America account whose discovery
triggered Parmalat’s insolvency.
What this contrast shows is that controlling shareholders may misappropriate assets, but
have much less reason to fabricate earnings. This does not mean that business ethics are better
(or worse) within a concentrated ownership regime, but only that the modus operandi for fraud is
different. The real conclusion is that different systems of ownership encourage characteristically
different styles of fraud.
Part III. Gatekeeper Failure Across Ownership Regimes
Both ownership regimes – dispersed and concentrated – show evidence of gatekeeper
failure. The U.S./U.K. system of dispersed ownership is vulnerable to gatekeepers not detecting
inflated earnings, and concentrated ownership systems fail to the extent that gatekeepers miss (or
at least fail to report) the expropriation of private benefits. A key difference, of course, is that in
dispersed ownership systems the villains are managers and the victims are shareholders, while, in
concentrated ownership systems,
the controlling shareholders overreach minority shareholders.
In turn, this raises the critical issue: can gatekeepers in concentrated ownership systems
monitor the controlling shareholder who hires (and potentially can fire) them? Although there
clearly have been numerous failures by gatekeepers in dispersed ownership systems, the answer
for these systems probably lies in principle in redesigning the governance circuitry within the
public corporation so that the gatekeeper does not report to those that it is expected to monitor.
Thus, the auditor or attorney can be required to report to an independent audit committee rather
than corporate managers. But this same answer does not work as well in a concentrated
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ownership system. In such a system, even an independent audit committee may serve at the
pleasure of a controlling shareholder.
Indeed, some forms of gatekeepers common in dispersed ownership systems seem
inherently less likely to be effective in a system of concentrated ownership. For example, the
securities analyst is inherently a gatekeeper for dispersed ownership regimes. In concentrated
ownership regimes, the volume of stock trading in its thinner capital markets is likely to be
insufficient to generate brokerage commissions sufficient to support a profession of analysts
covering all publicly held companies. But even if analyst coverage in concentrated ownership
regimes were equivalent to that in dispersed ownership systems, the analyst’s predictions of the
firm’s future earnings or value would still mean less to public shareholders if the controlling
shareholder remained in a position to squeeze-out the minority shareholders.
Even the role of the auditor differs in a concentrated ownership system. The existence of
a controlling shareholder necessarily affects auditor independence. In a dispersed ownership
system, corporate managers might sometimes “capture” the audit partner of their auditor (as
seemingly happened at Enron). But the policy answer was obvious (and Sarbanes-Oxley quickly
adopted it): rewire the internal circuitry so that the auditor reported to an independent audit
committee.
However, in a concentrated ownership system, this answer works less well because the
auditor is still reporting to a board that is, itself, potentially subservient to the controlling
shareholder. Thus, the auditor in this system is a monitor who cannot effectively escape the
control of the party that it is expected to monitor. Although diligent auditors could have
presumably detected the fraud at Parmalat (at least to the extent of detecting the fictitious bank
account at the Cayman Islands subsidiary), one suspects that they would have likely been
dismissed at the point at which they began to monitor earnestly.
There is an important historical dimension to this point. The independent auditor arose in
Britain in the middle 19th Century, just as industrialization and the growth of railroads was
compelling corporations to market their shares to a broader audience of investors. Amendments in
1844 and 1845 to the British Companies Act required an annual statutory audit with the auditor
being selected by the shareholders. This made sense, because the auditor was thus placed in a true
principal/agent relationship with the shareholders who relied on it. But this same relationship
does not exist when the auditor reports to shareholders in a system in which there is a controlling
shareholder. This may explain the slower development of auditing procedures and internal
controls in Europe.
Potentially, there is a further implication for the use of gatekeepers in concentrated
ownership economies. If the controlling shareholder can potentially dominate the selection of the
auditor or other gatekeepers, then it becomes at least arguable that if the auditor is to serve as an
effective reputational intermediary, it should be selected by the minority shareholders and report
to them.
Conclusion
Public policy should start (generally) from the recognition that dispersed ownership
creates managerial incentives to manipulate income, while concentrated ownership invites the
low-visibility extraction of private benefits. As a result, governance protections that work in one
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system may fail in the other. Even more importantly, different gatekeepers need to be designed
into different governance systems to monitor for different abuses.
Can you guess who is who?
Do any of these people look like crooks?
___________________________________
NOTES
1.
Most European companies have a controlling shareholder or shareholder group, whereas
most U.S. corporations are owned by dispersed groups of shareholders. What are the
advantages and disadvantages of each type of ownership? Which do you think is
preferable?
2.
Coffee notes that there was a shift in the 1990s to move U.S. executive compensation
from a cash-based system to an equity-based system. Do you think that this shift
contributed to the subsequent accounting scandals?
The differences between US and European executive pay are remarkable, and
perhaps at the root of the Enron scandal. But is the real reason for this reason that
corporate power in the US resides with management (the executives) while in Europe,
especially Italy, it often resides with the wealthy families that own the companies. See
Guido Ferrarini, Niamh Moloney & Cristina Vespro, Executive Remuneration in the EU:
Comparative Law and Practice, SSRN Paper 419120 (2003).
3.
What does Coffee mean by gatekeepers? (Does he have a copyright on this term?)
Coffee mentions lawyers and auditors as common examples of corporate gatekeepers. To
what extent should the lawyers and auditors be held responsible for not stopping (or even
noticing) the irregularities at Enron, Parmalat, and other companies? If you carried that
responsibility would that change how you carried out (or charged for) your professional
responsibilities?
4.
Coffee discusses some challenges with utilizing gatekeepers more effectively in the
European system of controlled ownership. Do you think the European system is
conducive to gatekeepers or is there another solution? If so, what would that look like?
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Perhaps Parmalat is not really a European fraud, as much as a unique Italian fraud. See
Andrea Melis, Corporate Governance Failures. To What Extent is Parmalat a Particularly
Italian Case?, SSRN Paper 563223 (2004).
The role of the ownership and control structure (with special regard to the
controlling shareholder's role) and of the board of statutory auditors have Italian
traits and might suggest that the Parmalat case is a particularly Italian scandal.
However, Italian corporate governance standards were not completely at fault in
the Parmalat case. Parmalat's corporate governance structure failed to comply
with some of the key existing Italian corporate governance standards of best
practice, such as the presence of independent directors and the composition of the
internal control committee. Besides, the role of the external auditor as well as the
internal control committee as non-effective monitors seem to put Parmalat into
the global argument case, not very different from other corporate scandals.
6.
Finally, you may have noticed that none of the pictures (and almost none of the cartoons)
in this book are of women. Would corporate law be different if there were more women
in the field? Would corporations be different if there were more women executives?
And would the world be a better place if it had been Lehman Sisters, not Lehman
Brothers?
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