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T H E A N ATO M Y O F C O R P O R AT E L AW
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The Anatomy
of Corporate Law
A Comparative and Functional Approach
Third Edition
REINIER KRAAKMAN
JOHN ARMOUR
PAU L D AV I E S
LU C A E N R I Q U E S
H E N RY H A N S M A N N
G E R A R D H E RT I G
K L AU S H O P T
HIDEKI KANDA
M A R I A N A PA RG E N D L E R
WO L F - ​G E O RG R I N G E
E DWA R D RO C K
With contributions from
SOFIE COOLS
and
GEN GOTO
1
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1
Great Clarendon Street, Oxford, OX2 6DP,
United Kingdom
Oxford University Press is a department of the University of Oxford.
It furthers the University’s objective of excellence in research, scholarship,
and education by publishing worldwide. Oxford is a registered trade mark of
Oxford University Press in the UK and in certain other countries
2017 © R. Kraakman, J. Armour, P. Davies, L. Enriques, H. Hansmann, G. Hertig, 2017
K. Hopt, H. Kanda, M. Pargendler, W.-​G. Ringe, and E. Rock 2017
The moral rights of the authors‌have been asserted
First edition published in 2004
Third edition published in 2017
Impression: 1
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v
Acknowledgments
The process of preparing the third edition was eased by the hospitality which we jointly
enjoyed from the University of Oxford and the University of Pennsylvania Law School.
As with prior editions, we have drawn shamelessly on our friends and colleagues for
comment on various parts of the book. We list them here and apologize in advance
to any whom we have omitted: Dan Awrey, Marcello Bianchi, Horst Eidenmüller,
Martin Gelter, Sergio Gilotta, Amir Licht, Alessio Pacces, Jenny Payne, Viviane Muller
Prado, Lorenzo Stanghellini, Tobias Tröger, Umakanth Varottil, Marco Ventoruzzo,
and Andrea Zorzi.
Once again, we should like to thank research centers and our home institutions
for providing financial support as we worked on this book. We thank the University
of Oxford for funding John Armour, Sofie Cools, Paul Davies, and Luca Enriques,
and Martin Bengtzen and Antonios Chatzivasileiadis for research assistance; the Yale
Law School for funding Henry Hansmann; the ETH for funding Gerard Hertig; the
Harvard Law School John M. Olin Center for Law, Economics, and Business for
funding Reinier Kraakman; the Fundação de Amparo à Pesquisa do Estado de São
Paulo (FAPESP) and FGV Law School in São Paulo (FGV Direito SP) for funding
Mariana Pargendler, and Rafael Bresciani for research assistance; Copenhagen Business
School for funding Wolf-Georg Ringe; and the Saul Fox Research Endowment at the
University of Pennsylvania Law School for funding Edward Rock who held the Saul
Fox Distinguished Professorship in Business Law from 2001 to 2016.
As ever, we thank our nearest and dearest, who may legitimately wonder why such a
short book always involves so much toing and froing.
The Authors
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Preface to the Third Edition
As the Preface to the Second Edition observed, the Anatomy is the product of a long-​
standing collaboration. The Third Edition carries this collaboration forward into a new
generation of scholars. Although the authors of the First Edition lent a hand, their role
was largely advisory. We called ourselves the “supervisory board.” Most of the credit
for the conceptual innovation and new research evident in this edition rightfully goes
to those co-​authors who joined the Anatomy prior to the Second Edition or before
the Third Edition was underway. This is as it should be. Corporate law like other
disciplines requires a steady infusion of new energy and fresh perspectives, if not to
remain relevant then at least to reach closure while it is fresh. This is not to say that the
Third Edition abandons the aspirations and conceptual framework of prior editions.
We remain committed to an approach to corporate law that is “international,” “functional,” “neutral,” and last but not least, “brief.” Indeed, the Third Edition is considerably improved on three of these dimensions and, against all odds, steadfastly holds the
line on its commitment to brevity.
The Anatomy has always been “international” and comparative, yet it has inevitably
been constrained in one sense, namely, the number of jurisdictions that it follows
through its functional chapters. Concrete references to the law of particular jurisdictions is key to making our analysis credible; too many jurisdictions would overreach
our collective expertise and invite the charge that we have cherry-​picked examples to
fit our conceptual framework. The Second Edition added Italy to our initial set of
five jurisdictions selected from a short list of developed economies: France, Germany,
Japan, the UK, and the U.S. Italy was chosen not only because it fit our jurisdictional
profile but also because a major scholar of Italian corporate law, Luca Enriques, joined
our collaboration. John Armour, who joined the Anatomy at the same time, broadened
our conception of corporate law to include aspects of bankruptcy and related fields
often located outside of our domain.
Our new co-​authors on this edition have similarly expanded our focus. Most visibly,
we now include Brazil among our core jurisdictions. This may seem surprising given
that prior editions relied exclusively on the legal regimes of developed economies. For
the authors of the Anatomy, however, it is a considered step forward. The inclusion of
a large emerging market economy—​the “B” in the so-​called BRICS—​broadens our
perspective and raises challenging new issues. We do not suggest that Brazil proxies
for the diverse range of emerging-​market jurisdictions, only that it is a reasonable
choice for expanding the Anatomy’s jurisdictional reach. And as suggested above, we
are pragmatic. The decisive factor in the choice of Brazil was that Mariana Pargendler,
a distinguished scholar of Brazilian corporate law, joined the Anatomy as a major contributor to the Third Edition. Although we are still constrained to referencing only a
handful of jurisdictions, Professor Pargendler’s integration of Brazilian law throughout
significantly adds to the international scope of the Third Edition. In yet another parallel with the Second Edition, our good fortune in enlisting Georg Ringe as an author
and contributor to this edition not only adds a distinguished scholar of German and
EU law to our bench but also contributes importantly to our analysis across all jurisdictions, particularly in the key areas of fundamental corporate transactions and corporate
control.
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Preface to the Third Edition
Readers of prior editions of the Anatomy can rest assured that the Third Edition
follows the functional analysis of its predecessors. We begin with an effort to define
“corporate law” by addressing the economic functions of the corporate form, identifying key classes of corporate stakeholders, and proposing a basic set of “agency problems”—​essentially contracting problems—​that corporate law addresses. We then set
out a typology of legal strategies that jurisdictions employ to mitigate these agency
problems. As before, we argue that corporate law must address basic agency problems
everywhere but the legal strategies deployed by particular jurisdictions vary with circumstances ranging from their politics and enforcement resources to their economic
development. Often legal regimes appear to have made functional adaptations to circumstances at hand; sometimes such adaptations appear to be missing. The Anatomy
reveals functional patterns across jurisdictions but has never purported to be a “theory
of everything” in our field, still less a theory of legal convergence that reaches beyond
the basic legal features of the corporate form that arose long ago (but are no less remarkable for that fact). Rather, it continues to be an analysis of basic agency problems and
recurrent legal strategies that are intended to mitigate them.
A striking extension of this analytical framework in the Third Edition, however,
is our recognition that the agency problems among the contractual participants in
the corporation resemble in important respects a different set of problems that arise
between parties affected by corporate activities but who lack any contractual leverage
over the firm. We term such parties—​who are not shareholders, managers, employees, or creditors—​the firm’s “external constituencies.” In many cases, corporate activities may harm these outside parties. For example, members of the general public are
harmed when large enterprises pollute the environment, fix prices, or violate human
rights. In other cases, corporations are in a unique position to advance the interests
of minorities or the social consensus of society at large by pursing policies that they
would not otherwise undertake; policies designed to prevent or redress minority and
gender discrimination are paradigmatic examples. Because the welfare of such external constituencies depends on corporate activity, their relationship to the corporation in some ways resembles that of a principal who is left to depend on her agent’s
actions. We note this parallel in the Third Edition as well as the complementary
point that many of the same legal strategies that mitigate agency problems among the
core corporate constituencies can be—​and are—​used to protect or benefit its external
constituencies.
The Third Edition introduces other conceptual innovations that are less visible to
readers but were no less energetically discussed by its authors. In particular, our chapters on creditor protection, fundamental corporate changes, and control transactions
have been extensively revised and restructured. Our new author Professor Georg Ringe
provided much of the energy as well as the research behind these changes, although
many veterans—​Paul Davies, Hideki Kanda, Klaus Hopt, and Ed Rock—​also contributed to these revisions. Professor Pargendler was the laboring oar on our many discussions of external constituencies.
Despite the strong conceptual framework of the Anatomy, the Third Edition remains
“neutral” in the sense that it does not take sides in important legal policy debates. Each
of the contributors to the Anatomy has strong views about questions such as economic
and social value of worker codetermination and the extent to which jurisdictions ought
to target the resources and organizational capabilities of large corporations to pursue
extra-​economic social ends. But the utility of the Anatomy’s analytical framework is that
it provides a context in which advocates of different positions on the major questions
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Preface to the Third Edition
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of the day can meet on common ground. We do not suggest that other approaches to
the analysis of corporate law are misguided. For example, accounts relying on political
economy rather than functionality shed a great deal of light on legal developments in
particular jurisdictions. They may be less useful, however, in sharpening policy discussions among competing advocates.
The last, and perhaps the key descriptor for a potential reader of the Anatomy is
“short.” We have remained scrupulously loyal to the promise of previous editions to
keep the Third Edition no longer than its predecessor despite the considerable discussion and new research that underlies it. While academic traditions vary, I can speak
personally to the temptation to lay aside even the most brilliant American law review
articles before I reach their half-​way points. Academic journals elsewhere may be
less taxing, but my co-​authors assure me that there is no equivalent to the Geneva
Conventions in the realm of legal treatises. Practitioners and those of our readers from
other academic disciplines may not understand our “sacrifices,” individually and collectively, in pruning our prose and eviscerating our footnotes. Nor are they likely to
appreciate the steely discipline of our general editors on this edition, John Armour and
Luca Enriques, in resisting our collective drive to qualify, elaborate, and support our
observations on almost every page of this volume. We leave our readers to judge if the
result has led us to overreach on some occasions and abandon nuance on others. But if
so, we ask for forbearance. Our collective judgment at many points was that the risk of
losing readership midway through this volume or of targeted consultation more than
offset the danger of thin description and premature closure.
A last point that deserves mention is the pervasive contribution of some authors to
the Third Edition that is not recognized in our attributions of authorship at the outset
of each chapter of the book. All of us shared our expertise in the law of the jurisdictions that we knew best, but five contributors to this edition merit separate recognition
for their work on behalf of the book as a whole. One is Mariana Pargendler who is
not only a leading co-​author of Chapter 4 in the Third Edition but also revised text
in many chapters and added support to every chapter to reflect the inclusion of Brazil
among our core jurisdictions. Elsewhere the law had evolved; with Brazil, we started
from scratch.
Our two Associate Authors, Sofie Cools and Gen Goto, have also made pervasive
contributions to this edition through their indefatigable research efforts, especially (but
not only) on recent French, EU, and Japanese developments. This is the first edition in
which the Anatomy has featured three generations of scholars. The additions and refinement of Sofie and Gen appear in every chapter of the new Anatomy. They have also
intervened actively in our internal discussions of big picture issues, including changes
to our conceptual and expositional framework. I speak for all the authors of this edition in applauding their contributions to every chapter in the Third Edition.
Finally, our two General Editors—​John Armour and Luca Enriques—​have literally
made the Third Edition possible after roughly the same number of years that separated the First and Second Editions. John and Luca have not only made major textual
contributions to multiple chapters in this edition and its predecessor, they have also
gracefully kept us on track for the past several years, counterbalanced the centripetal
forces inflating our page numbers, and performed the final edits that allow us to speak
in a distinctive voice across chapters and co-​authors. If coordinating academics is like
herding cats, as the old saw goes, then not only coordinating their efforts but pruning
and revising their prose is analogous to grooming cats while persuading them to march
in parade formation.
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Preface to the Third Edition
We are all immensely grateful. This edition of the Anatomy should be cited as John
Armour, Luca Enriques et al., The Anatomy of Corporate Law: A Comparative and
Functional Approach (3rd edn., Oxford University Press 2017).
Reinier Kraakman
Harvard Law School
September, 2016
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Contents
List of Authors
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1. What Is Corporate Law? John Armour, Henry Hansmann, Reinier Kraakman,
and Mariana Pargendler
1.1 Introduction
1.2 What Is a Corporation?
1.2.1
1.2.2
1.2.3
1.2.4
1.2.5
Legal personality
Limited liability
Transferable shares
Delegated management with a board structure
Investor ownership
1.3 Sources of Corporate Law
1.3.1 Special and partial corporate forms
1.3.2 Other bodies of law
1.4 Law versus Contract in Corporate Affairs
1.4.1 Mandatory laws versus default provisions
1.4.2 The benefits of legal rules
1.4.3 Choice of legal regime
1.5 What Is the Goal of Corporate Law?
1.6 What Forces Shape Corporate Law?
2. Agency Problems and Legal Strategies John Armour, Henry Hansmann, and Reinier Kraakman
2.1 Three Agency Problems
2.2 Legal Strategies for Reducing Agency Costs
2.2.1
2.2.2
2.2.3
2.2.4
2.2.5
2.2.6
Rules and standards
Setting the terms of entry and exit
Trusteeship and reward
Selection and removal
Initiation and ratification
Ex post and ex ante strategies
2.3 Disclosure
2.4 Compliance and Enforcement
2.4.1 Enforcement and intervention
2.4.2 Initiators of enforcement
2.4.3 Penalties
2.5 Legal Strategies in Corporate Context
2.6 Systematic Differences
3. The Basic Governance Structure: The Interests of Shareholders
as a Class John Armour, Luca Enriques, Henry Hansmann, and Reinier Kraakman
3.1 Delegated Management and Corporate Boards
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Contents
3.2 Appointment and Decision Rights
3.2.1
3.2.2
3.2.3
3.2.4
Appointing directors
Removing directors
Decision rights
Shareholder coordination
3.3 Agent Incentives
3.3.1 The trusteeship strategy: Independent directors
3.3.2 The reward strategy: Executive compensation
3.4 Legal Constraints and Affiliation Rights
3.4.1 The constraints strategy
3.4.2 Corporate governance-​related disclosure
3.5 Explaining Jurisdictional Variation
4. The Basic Governance Structure: Minority Shareholders
and Non-​Shareholder Constituencies Luca Enriques, Henry Hansmann, Reinier Kraakman,
and Mariana Pargendler
4.1 Protecting Minority Shareholders
4.1.1 Shareholder appointment rights and deviations
from one-​share–​one-​vote
4.1.2 Minority shareholder decision rights
4.1.3 The incentive strategy: Trusteeship and equal treatment
4.1.4 Constraints and affiliation rights
4.2 Protecting Employees
4.2.1 Appointment and decision rights strategies
4.2.2 The incentives and constraints strategies
4.3 Protecting External Constituencies
4.3.1 Affiliation strategies
4.3.2 Appointment and decision rights strategies
4.3.3 The incentives and constraints strategies
4.4 Explaining Jurisdictional Differences and Similarities
4.4.1 The law-​on-​the-​books
4.4.2 The law in practice
5. Transactions with Creditors John Armour, Gerard Hertig, and Hideki Kanda
5.1 Asset Partitioning and Agency Problems
5.1.1 Asset partitioning and corporate creditors
5.1.2 Shareholder–​creditor agency problems
5.1.3 Creditor–​creditor coordination and agency problems
5.2 Solvent Firms
5.2.1 The affiliation strategy—​mandatory disclosure
5.2.2 The rules strategy: Legal capital
5.3 Distressed Firms
5.3.1 The standards strategy
5.3.2 Governance strategies
5.4 Ownership Regimes and Creditor Protection
5.4.1 Regulatory or contractual controls for solvent firms?
5.4.2 The role of bankruptcy law
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Contents
6. Related-​Party Transactions Luca Enriques, Gerard Hertig, Hideki Kanda, and Mariana Pargendler
6.1 Why Are Related-​Party Transactions Permitted at All?
6.2 Legal Strategies for Related-​Party Transactions
6.2.1
6.2.2
6.2.3
6.2.4
6.2.5
The affiliation strategy
Agent incentives strategies
The decision rights strategy: Shareholder voting
The rules strategy: Prohibiting conflicted transactions
The standards strategy: The duty of loyalty and intra-​group
transactions review
6.3 Ownership Regimes and Related-​Party Transactions
7. Fundamental Changes Edward Rock, Paul Davies, Hideki Kanda, Reinier Kraakman,
and Wolf-​Georg Ringe
7.1 What are Fundamental Changes in the Relationship among
the Participants in the Firm?
7.2 Charter Amendments
7.2.1 The management–​shareholder conflict in charter amendments
7.2.2 The majority–​minority shareholder conflict in charter amendments
7.3 Share Issuance
7.3.1 The manager–​shareholder conflict
7.3.2 The majority–​minority conflict
7.4 Mergers and Divisions
7.4.1
7.4.2
7.4.3
7.4.4
The management–​shareholder conflict in mergers
The majority–​minority shareholder conflict in mergers
The protection of non-​shareholder constituencies in mergers
Corporate divisions
7.5 Reincorporation and Conversion
7.6 General Provisions on Significant Transactions
7.7 Explaining Differences in the Regulation of Fundamental Changes
8. Control Transactions Paul Davies, Klaus Hopt, and Wolf-​Georg Ringe
8.1 Regulatory Problems in Control Transactions
8.1.1 Control transactions
8.1.2 Agency and coordination issues
8.2 Agency Problems in Control Transactions
8.2.1 The decision rights choice: Shareholders only or shareholders
and board jointly
8.2.2 The “no frustration” rule
8.2.3 Joint decision-​making
8.2.4 Pre-​bid defensive measures
8.3 Coordination Problems among Target Shareholders
8.3.1
8.3.2
8.3.3
8.3.4
8.3.5
Disclosure
Trusteeship strategy
Reward (sharing) strategy
Exit rights: Mandatory bid rule and keeping the offer open
Acquisition of non-​accepting minorities
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Contents
8.4 Specific Issues upon Acquisition from a Controlling Shareholder
8.4.1 Exit rights and premium-​sharing
8.4.2 Facilitating bids for controlled companies
8.5 Explaining Differences in the Regulation of Control Transaction
8.5.1
8.5.2
8.5.3
8.5.4
Differences in form and differences in substance
Different regulatory environments
Political economy considerations
Regulatory uncertainty
9. Corporate Law and Securities Markets Luca Enriques, Gerard Hertig, Reinier Kraakman, and Edward Rock
9.1 Securities Regulation and Legal Strategies
9.1.1 Why securities regulation?
9.1.2 Affiliation terms strategies
9.1.3 Governance and regulatory strategies
9.2 Securities Law Enforcement
9.2.1 Public enforcement
9.2.2 Private enforcement
9.2.3 Gatekeeper control
9.3 Convergence and Persistence in Securities Regulation
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10. Beyond the Anatomy John Armour, Luca Enriques, Mariana Pargendler, and Wolf-​Georg Ringe
10.1 Beyond the Analysis
10.2 Beyond the Scope
10.3 Beyond the Present
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Index
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xv
List of Authors
John Armour is Hogan Lovells Professor of Law and Finance at Oxford and a Fellow of the
European Corporate Governance Institute. He was previously a member of the Faculty of Law
and the interdisciplinary Centre for Business Research at the University of Cambridge. He
has held visiting posts at various institutions including the University of Chicago, Columbia
Law School, the University of Frankfurt, the Max Planck Institute for Comparative Private
Law, Hamburg, and the University of Pennsylvania Law School. His main research interests lie in company law, corporate insolvency law and financial regulation, in which areas
he has published widely. He has been involved in policy projects commissioned by the UK’s
Department of Trade and Industry, Financial Services Authority and Insolvency Service, the
Commonwealth Secretariat and the World Bank. He currently serves as a member of the
European Commission’s Informal Company Law Expert Group.
Paul Davies is a Senior Research Fellow in the Centre for Commercial Law at Harris
Manchester College, University of Oxford. He was the Allen & Overy Professor of Corporate
Law, University of Oxford, between 2009 and 2014. Between 1998 and 2009 he was the
Cassel Professor of Commercial Law at the London School of Economics and Political Science.
He was a member of the Steering Group for the Company Law Review which preceded the
enactment of the Companies Act 2006, and has been involved recently in policy-​related work
for the UK Treasury. His most recent works include the 10th edition of Gower and Davies,
Principles of Modern Company Law (Sweet & Maxwell 2016, with Sarah Worthington);
and Introduction to Company Law (2nd edn., OUP 2010). He is a Fellow of the European
Corporate Governance Institute, a Fellow of the British Academy and an honorary Queen’s
Counsel.
Luca Enriques is the Allen & Overy Professor of Corporate Law in the Faculty of Law,
University of Oxford and an ECGI Research Fellow. He has been Professor of Business
Law at the University of Bologna and LUISS-​Rome. Between 2007 and 2012 he served as
a Commissioner at Consob, the Italian Securities and Exchange Commission. He has been
Visiting Professor at various institutions, including Harvard Law School, Instituto de Impresa
(Madrid), and IDC Herzliya. He has published several books and articles on topics relating to corporate law, corporate governance, and financial regulation. Recent publications
include Creeping Acquisitions in Europe: Enabling Companies to Be Better Safe than Sorry (with
Matteo Gatti), 15 Journal of Corporate Law Studies 55 (2015), and Disclosure and
Financial Market Regulation (with Sergio Gilotta), in The Oxford Handbook of Financial
Regulation (OUP 2015). He is a co-​author, together with John Armour, Paul Davies, and
others, of Principles of Financial Regulation (OUP 2016).
Henry Hansmann is the Oscar M. Ruebhausen Professor of Law at the Yale Law School. His
scholarship has focused principally on the law and economics of organizational ownership and
structure, and has dealt with all types of legal entities, both profit-​seeking and nonprofit, private and public. He has been Professor or Visiting Professor at Harvard University, New York
University, and the University of Pennsylvania Law Schools. Recent publications include Legal
Entities as Transferable Bundles of Contracts (with Kenneth Ayotte), 111 Michigan Law Review
715 (2013), and External and Internal Asset Partitioning: Corporations and Their Subsidiaries
(with Richard Squire), in Jeffrey Gordon and Georg Ringe (eds.), The Oxford Handbook
of Corporate Governance (OUP 2017). He is a Fellow of the American Academy of Arts
and Sciences and the European Corporate Governance Institute.
Gerard Hertig is Professor of Law at ETH Zurich and a ECGI research fellow. He was previously Professor of Administrative Law and Director of the Centre d’Etudes Juridiques
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List of Authors
Européennes at the University of Geneva Law School (1987–​95). He has been a Visiting
Professor at leading law schools in Asia, Europe, and the U.S. and practiced law as a member
of the Geneva bar. Recent publications include Decision-​Making During the Crisis: Why Did
the Treasury Let Commercial Banks Fail? (with Ettore Croci and Eric Nowak), Journal of
Empirical Finance (2016); Governance by Institutional Investors in a Stakeholder World, in The
Oxford Handbook of Corporate Law and Governance (OUP 2017); Shadow Resolutions
as a No-​No in a Sound Banking Union, with Luca Enriques, in Financial Regulation: A
Transatlantic Perspective (CUP, 2015).
Klaus Hopt was Director of the Max Planck Institute for Comparative and International
Private Law in Hamburg, Germany. His main areas of specialization include commercial law,
corporate law, banking, and securities regulation. He has been Professor of Law in Tübingen,
Florence, Bern, and Munich, Visiting Professor at numerous universities in Europe, Japan,
and the U.S. including University of Pennsylvania, University of Chicago, NYU, Harvard,
and Columbia, and Judge at the Court of Appeals, Stuttgart, Germany. He served as a member
of the High Level Group of Experts mandated by the European Commission to recommend
EU company and takeover law reforms. He is a Member of the German National Academy
(Leopoldina). Recent publications include Comparative Corporate Governance (CUP,
2013, with Andreas Fleckner (eds.)) and Corporate Boards in Law and Practice (OUP,
2013, with Paul Davies et al. (eds.)).
Hideki Kanda is Professor of Law at Gakushuin University Law School since 2016. His main
areas of specialization include commercial law, corporate law, banking regulation, and securities regulation. He was Professor of Law at the University of Tokyo until 2016. He also was
Visiting Professor of Law at the University of Chicago Law School (1989, 1991, and 1993)
and at Harvard Law School (1996). Recent publications include Corporate Law (18th edn.,
Kobundo, 2016, in Japanese), Comparative Corporate Governance (OUP, 1998, with
Klaus Hopt et al. (eds.)), and Economics of Corporate Law (University of Tokyo Press,
1998, with Yoshiro Miwa and Noriyuki Yanagawa (eds.), in Japanese).
Reinier Kraakman is the Ezra Ripley Thayer Professor of Law at Harvard Law School and a
Fellow of the European Corporate Governance Institute. He has written numerous articles on
corporate law and the economic analysis of corporate liability regimes. He teaches courses in
corporate law, corporate finances, and seminars on the theory of corporate law and comparative corporate governance. He is the author, with William T. Allen, of Commentaries and
Cases in the Law of Business Corporations, which is now in its fifth edition (Wolters
Kluwer, 2016). His more recent articles include Market Efficiency after the Financial Crisis:
It’s Still a Matter of Information Costs (with Ronald J. Gilson), 100 Virginia Law Review
313 (2014); Economic Policy and the Vicarious Liability of Firms, in Research Handbook
on the Economics of Torts (Edgar Elgar, 2013); Law and the Rise of the Firm (with Henry
Hansmann and Richard Squire), 119 Harvard Law Review 1333 (2006); and Property,
Contract, and Verification: The Numerus Clausus Problem and the Divisibility of Rights (with
Henry Hansmann), 31 Journal of Legal Studies S373 (2002).
Mariana Pargendler is Professor of Law at FGV Law School in São Paulo (FGV Direito SP),
where she directs the Center for Law, Economics, and Governance. She is also Global Associate
Professor of Law at New York University School of Law and has been a Visiting Professor of
Law at Stanford Law School. She is the author of numerous articles on corporate law and
comparative corporate governance. Her main recent publications include The Evolution of
Shareholder Voting Rights: Separation of Ownership and Consumption (with Henry Hansmann),
123 Yale Law Journal 948 (2014), Politics in the Origins: The Making of Corporate Law in
Nineteenth-​Century Brazil, 60 American Journal of Comparative Law 805 (2013), and
State Ownership and Corporate Governance, 80 Fordham Law Review 2917 (2012).
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List of Authors
xvii
Wolf-​Georg Ringe is Professor of Law at the University of Hamburg where he directs the
Institute of Law & Economics. He is also Visiting Professor at the University of Oxford,
Faculty of Law. Between 2012–17, he was Professor of International Commercial Law at
Copenhagen Business School. He has held visiting positions at various institutions in Europe
and North America, including Columbia Law School and Vanderbilt University. He is the
editor of the new Journal of Financial Regulation, which is published by the OUP since
2015. Professor Ringe has been involved in policy work with both the European Commission
and the European Parliament on issues of European Corporate Law. His current research
interests are in the general areas of law and finance, comparative corporate governance, capital
and financial markets, insolvency law, and conflict of laws. Recent publications include The
Deconstruction of Equity (OUP 2016) and The Oxford Handbook of Corporate
Law and Governance (OUP 2017, with Jeffrey Gordon (eds.)).
Edward Rock is Professor of Law at New York University Law School and director of NYU’s
Institute for Corporate Governance and Finance. He writes widely on corporate law, has been
Visiting Professor at the Universities of Frankfurt am Main, Jerusalem, and Columbia, and
has practiced law as a member of the Pennsylvania bar. Recent publications include Does
Majority Voting Improve Board Accountability? (with Stephen Choi, Jill Fisch, and Marcel
Kahan), 83 University of Chicago Law Review 1119 (2016), Institutional Investors in
Corporate Governance, in The Oxford Handbook of Corporate Law and Governance
(OUP 2017), and Symbolic Corporate Governance Politics (with Marcel Kahan), 94 Boston
University Law Review 1997 (2014).
xviii
1
1
What Is Corporate Law?
John Armour, Henry Hansmann, Reinier Kraakman,
and Mariana Pargendler
1.1 Introduction
What is the common structure of corporate (or company) law across different jurisdictions? Although this question is rarely asked by corporate law scholars, it is critically
important for the comparative investigation of the subject. Existing scholarship often
emphasizes the divergence among European, American, Japanese, and emerging market corporations in terms of corporate governance, share ownership, capital markets,
and business culture.1 But, despite the very real differences across jurisdictions along
these dimensions, the underlying uniformity of the corporate form is at least as impressive. Business corporations have a fundamentally similar set of legal characteristics—​
and face a fundamentally similar set of legal problems—​in all jurisdictions.
Consider, in this regard, the basic legal characteristics of the business corporation.
To anticipate our discussion below, there are five of these characteristics, most of which
will be easily recognizable to anyone familiar with business affairs. They are: legal personality, limited liability, transferable shares, delegated management under a board
structure, and investor ownership. These characteristics respond—​in ways we will
explore—​to the economic exigencies of the large modern business enterprise. Thus,
corporate law everywhere must, of necessity, provide for them. To be sure, there are
other forms of business enterprise that lack one or more of these characteristics. But
the remarkable fact—​and the fact that we wish to stress—​is that, in market economies,
almost all large-​scale business firms adopt a legal form that possesses all five of the basic
characteristics of the business corporation. Indeed, most small jointly owned firms
adopt this corporate form as well, although sometimes with deviations from one or
more of the five basic characteristics to fit their special needs.
It follows that a principal function of corporate law is to provide business enterprises
with a legal form that possesses these five core attributes. By making this form widely
available and user-​friendly, corporate law enables business participants to transact easily through the medium of the corporate entity, and thus lowers the costs of conducting business. Of course, the number of provisions that the typical corporation statute
devotes to defining the corporate form is likely to be only a small part of the statute as a
1 See e.g. Ronald J. Gilson and Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps Between
Corporation Governance and Industrial Organization, 102 Yale Law Journal 871 (1993); Bernard S.
Black and John C. Coffee, Hail Britannia? Institutional Investor Behavior Under Limited Regulation, 92
Michigan Law Review 1997 (1994); Varieties of Capitalism (Peter A. Hall and David Soskice eds.,
2001); Mark J. Roe, Political Determinants of Corporate Governance (2003); Corporate
Governance in Context: Corporations, States, and Markets in Europe, Japan, and the US
(Klaus J. Hopt et al. eds., 2005); Comparative Company Law: A Case-​Based Approach (Mathias
Siems and David Cabrelli eds., 2013).
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann,
Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 1 © John
Armour, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler, 2017. Published 2017 by Oxford University Press.
2
2
What Is Corporate Law?
whole.2 Nevertheless, these are the provisions that comprise the legal core of corporate
law that is shared by every jurisdiction. In this chapter, we briefly explore the contracting efficiencies that accompany these five features of the corporate form, and that, we
believe, have helped to propel the worldwide diffusion of the corporate form.
However, our principal focus in this book is not on the basic attributes that define
the corporate form. Rather, it is on a second, equally important function of corporate
law: namely, reducing the ongoing costs of organizing business through the corporate
form. Corporate law does this by facilitating coordination between participants in
corporate enterprise, and by reducing the scope for value-​reducing forms of opportunism among different constituencies. As we outline in Section 1.2, corporate laws
everywhere share core features which can be understood as serving to reduce the costs
for participants of organizing their activities in business firms.3
Most of corporate law can be understood as responding to three principal sources
of opportunism that are endemic to such organization: conflicts between managers
and shareholders, conflicts between controlling and non-​controlling shareholders, and
conflicts between shareholders and the corporation’s other contractual counterparties,
including particularly creditors and employees. All three of these generic conflicts may
usefully be characterized as what economists call “agency problems.” Chapter 2 examines these three agency problems, both in general and as they arise in the corporate
context, and surveys the range of legal strategies that can be employed to tackle those
problems.
The reader might object that these three types of coordination costs and agency conflicts are not uniquely “corporate.” After all, any form of jointly owned enterprise faces
coordination costs and engenders conflicts among its owners, managers, and third-​
party contractors. We agree; insofar as the corporation is only one of several legal forms
for the jointly owned firm, it faces the same generic functional challenges that confront
all jointly owned firms. Nevertheless, the particular characteristics of the corporate
form matter a great deal, since it is the form chosen by most large-​scale enterprises—​
and, as a practical matter, the only form that firms with widely dispersed ownership
can choose in many jurisdictions.4 In our view, this is because its particular characteristics make it uniquely effective at minimizing coordination costs. Moreover, these same
features determine the particular contours of its agency problems. To take an obvious
example, the fact that shareholders enjoy limited liability—​while, say, general partners
in a partnership do not—​has traditionally made creditor protection far more salient in
corporate law than it is in partnership law. Similarly, the fact that corporate investors
may trade their shares is the foundation of the anonymous trading stock market—​an
institution that has encouraged the separation of ownership from control, and so has
sharpened the management–​shareholder agency problem.
In this book, we explore the role of corporate law in minimizing coordination and
agency problems—​and thus, making the corporate form practicable—​in the most
2 We use the term “corporation statute” to refer to the general law that governs corporations, and
not to a corporation’s individual charter (or “articles of incorporation,” as that document is sometimes
also called).
3 These include the costs of searching for contracting partners and negotiating and drafting the
relevant agreements. Although such costs are often referred to as “transaction costs,” we eschew this
term because it is also used more broadly in other contexts, rendering it a fertile source of confusion.
4 This is because in most jurisdictions, only firms taking the corporate form may raise equity
finance from capital markets. However, there are exceptions to this general proposition. For example,
in the U.S., the equity securities of so-​called “master” limited partnerships and limited liability companies may be registered for public trading.
3
Introduction
3
important categories of corporate actions and decisions. More particularly, Chapters 3
to 9 address seven categories of transactions and decisions that involve the corpor­
ation, its owners, its managers, and the other parties with whom it deals. Most of
these categories of firm activity are, again, generic, rather than uniquely corporate. For
example, Chapters 3 and 4 address governance mechanisms that operate over the firm’s
ordinary business decisions, while Chapter 5 turns to the checks that operate on the
corporation’s transactions with creditors. As before, however, although similar agency
problems arise in similar contexts across all forms of jointly owned enterprise, the
response of corporate law turns in part on the unique legal features that characterize
the corporate form.
Taken together, the latter seven chapters of our book cover nearly all of the important
problems in corporate law. In each chapter, we describe how the basic coordination costs
and agency problems of the corporate form manifest themselves in a given category of
corporate activity, and then explore the range of alternative legal responses that are available. We illustrate these alternative approaches with examples from the corporate laws
of various prominent jurisdictions. We explore the patterns of homogeneity and heterogeneity that appear. Where there are significant differences across jurisdictions, we seek
to address both the sources and the consequences of those differences. Our examples are
drawn principally from a handful of major representative jurisdictions, which we label
our “core jurisdictions.” These are Brazil, France, Germany, Italy, Japan, the UK, and the
U.S., though we sometimes make incidental reference to the laws of other jurisdictions
to make particular points. We do not—​and cannot, in a short book—​attempt to be
comprehensive in our coverage of the substantive law; rather we make reference to the
laws of these jurisdictions as appropriate to illustrate and develop analytic propositions.
In focusing on the jurisdictions we know best, an element of subjectivity is of course
introduced. This reflects a heuristic endeavor on our part: the goal is not so much to
provide a definitive account of corporate laws anywhere (let alone everywhere), but a
common language for understanding them.
In emphasizing a strongly functional approach to the issues of comparative law,
this book differs from some of the more traditional comparative law scholarship, both
in the field of corporate law and elsewhere.5 We join an emerging tendency in comparative law scholarship by seeking to give a highly integrated view of the role and
structure of corporate law that provides a clear framework within which to organize an
understanding of individual systems, both alone and in comparison with each other.6
Moreover, while comparative law scholarship often has a tendency to emphasize differences between jurisdictions, our approach is to highlight similarities as well. Doing so
illuminates an underlying commonality of structure that transcends national boundaries. It also provides an important perspective on the basis for the international cross-​
fertilization of corporate law that has become more common in the wake of the growth
of global economic activity.
We realize that the term “functional,” which we have used here and in our title,
means different things to different people, and that some of the uses to which that term
has been put in the past—​particularly in the field of sociology—​have made it justifiably
5 Compare e.g. The Legal Basis of Corporate Governance in Publicly Held Corporations:
A Comparative Approach (Arthur R. Pinto and Gustavo Visentini eds., 1998); Gunther H. Roth
and Peter Kindler, The Spirit of Corporate Law (2013).
6 Other examples of this approach include John Armour et al., Principles of Financial
Regulation (2016); Gregor Bachmann et al., Regulating the Closed Corporation (2012);
Curtis Milhaupt and Katharina Pistor, Law and Capitalism (2008).
4
4
What Is Corporate Law?
suspect. It would perhaps be more accurate to call our approach “economic” rather
than “functional,” though the sometimes tendentious use of economic argumentation
in legal literature to support particular (generally laissez-​faire) policy positions, as well
as the tendency in economic analysis to neglect non-​pecuniary motivations or assume
an unrealistic degree of rationality in human action, have also caused many scholars—​
particularly outside the U.S.—​to be as wary of “economic analysis” as they are of “functional analysis.” For the purposes at hand, however, we need not commit ourselves on
fine points of social science methodology. We need simply note that the exigencies of
commercial activity and organization present practical problems that are roughly similar in market economies throughout the world. Our analysis is “functional” in the sense
that we organize discussion around the ways in which corporate laws respond to these
problems, and the various forces that have led different jurisdictions to choose roughly
similar—​though by no means always the same—​solutions to them.
That is not to say that our objective here is just to explore the commonality of
corporate law across jurisdictions. Of equal importance, we wish to offer a common
language and a general analytic framework with which to understand the purposes that
can potentially be served by corporate law, and with which to compare and evaluate
the efficacy of different legal regimes in serving those purposes.7 Indeed, it is our hope
that the analysis offered in this book will be of use not only to students of comparative
law, but also to those who simply wish to have a more solid framework within which
to view their own country’s corporation law.
Nor does emphasizing similarities in underlying structure mean ignoring differences
between countries’ corporate laws. Even if, as we think, corporate laws everywhere
respond to similar economic problems, there may be differences in the way they do
so, often reflecting local variety in the way other aspects of the system of economic
production are organized.8 The basis for such differences in corporate law rules is consequently illuminated by reference to the broader economic environment. Yet in other
cases, differences may result from the various concerns of domestic politics over distribution or from diverse interest group dynamics. Our unitary account cannot explain
the presence of such differences, but it does have implications for their persistence. To
the extent that such matters impede corporate law’s ability to respond to economic
exigencies, they will in time face economically motivated pressure for reform.
That said, we take no strong stand here in the enduring debate on the extent to
which corporate law is or should be “converging,” much less on to what it might converge.9 That is a subject on which reasonable minds (including, indeed, the authors
of this book) can reasonably disagree.10 Rather, we are seeking to set out a conceptual
7 In very general terms, our approach echoes that taken by Robert Clark in his important treatise,
Corporate Law (1986), and Frank Easterbrook and Daniel Fischel, in their discussion of U.S. law,
The Economic Structure of Corporate Law (1991). However, our analysis differs from—​and
goes beyond—​that offered by these and other commentators in several key respects. Most obviously,
we both present a comparative analysis that addresses the corporate law of multiple jurisdictions and
provide an integrated functional overview that stresses the agency problems at the core of corporate
law, rather than focusing on more particular legal institutions and solutions.
8 See Section 1.6.
9 See e.g. Convergence and Persistence in Corporate Governance (Jeffrey N. Gordon
and Mark J. Roe eds., 2004), Comparative Corporate Governance: A Functional and
International Analysis (Andreas M. Fleckner and Klaus J. Hopt eds., 2013).
10 The views of the authors of this chapter are briefly set out in Henry Hansmann and Reinier
Kraakman, The End of History for Corporate Law, 89 Georgetown Law Journal 439 (2001);
Henry Hansmann and Reinier Kraakman, Reflections on the End of History for Corporate Law, in
Convergence of Corporate Governance: Promise and Prospects (Abdul Rasheed and Toru
5
What Is a Corporation?
5
framework and a factual basis with which that and other important issues facing corporate law can be fruitfully explored.
1.2 What Is a Corporation?
As anticipated, the five core structural characteristics of the business corporation
are: (1) legal personality, (2) limited liability, (3) transferable shares, (4) centralized
management under a board structure, and (5) shared ownership by contributors of
equity capital. In virtually all economically important jurisdictions, there is a basic
statute that provides for the formation of firms with all of these characteristics. As
this pattern suggests, these characteristics have strongly complementary qualities for
many firms. Together, they make the corporation especially attractive for organizing
productive activity. But these characteristics also generate tensions and tradeoffs that
lend a distinctively corporate character to the agency problems that corporate law must
address.
1.2.1 Legal personality
In the economics literature, a firm is often characterized as a “nexus of contracts.”11 As
commonly used, this description is ambiguous. It is often invoked simply to emphasize
that most of the important relationships within a firm—​including, in particular, those
among the firm’s owners, managers, and employees—​are essentially contractual in character. This is an important insight, but it does not distinguish firms from other networks
of contractual relationships. It is perhaps more accurate to describe a firm as a “nexus
for contracts,” in the sense that a firm serves, fundamentally, as the common counterparty in numerous contracts with suppliers, employees, and customers, coordinating
the actions of these multiple persons through exercise of its contractual rights. The first
and most important contribution of corporate law, as of other forms of organizational
law, is to permit a firm to serve this coordinating role by operating as a single contracting party that is distinct from the various individuals who own or manage the firm. In
so doing, it enhances the ability of these individuals to engage together in joint projects.
The core element of the firm as a nexus for contracts is what civil lawyers refer to as
“separate patrimony.” This involves the demarcation of a pool of assets that are distinct
from other assets owned, singly or jointly, by the firm’s owners (the shareholders),12
and of which the firm itself, acting through its designated managers, is viewed in law as
being the owner. The firm’s entitlements of ownership over its designated assets include
Yoshikawa eds., 2012); John Armour, Simon Deakin, Priya Lele, and Mathias Siems, How Do Legal
Rules Evolve? Evidence from a Cross-​Country Comparison of Shareholder, Creditor, and Worker Protection,
57 American Journal of Comparative Law 579, 619–​29 (2009); and Mariana Pargendler, Corporate
Governance in Emerging Markets, in Oxford Handbook of Corporate Law and Governance
(Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017).
11 The characterization of a firm as a “nexus of contracts” originates with Michael Jensen and
William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3
Journal of Financial Economics 305 (1976), building on Armen Alchian and Harold Demsetz,
Production, Information Costs, and Economic Organization, 62 American Economic Review 777
(1972).
12 We use the term “owners” simply to refer to the group who have the entitlement to control the
firm’s assets. For an account of how this relates to the legal concept of “ownership” see John Armour
and Michael J. Whincop, The Proprietary Foundations of Corporate Law, 27 Oxford Journal of
Legal Studies 429, 436–​48 (2007).
6
6
What Is Corporate Law?
the rights to use the assets, to sell them, and—​of particular importance—​to make
them available for attachment by its creditors. Conversely, because these assets are
conceived as belonging to the firm, rather than the firm’s owners, they are unavailable
for attachment by the owners’ personal creditors. The core function of this separate
patrimony has been termed “entity shielding,” to emphasize that it involves shielding
the assets of the entity—​the corporation—​from the creditors of the entity’s owners.13
Entity shielding involves two relatively distinct rules of law. The first is a priority rule
that grants to creditors of the firm, as security for the firm’s debts, a claim on the firm’s
assets that is prior to the claims of the personal creditors of the firm’s owners. This rule
is shared by modern legal forms for enterprise organization, including partnerships.14
The consequence of this priority rule is that a firm’s assets are, as a default rule of law,15
automatically made available for the enforcement of contractual liabilities entered into
in the name of the firm.16 By thus bonding the firm’s contractual commitments, the
rule makes these commitments credible.
The second component of entity shielding—​a rule of “liquidation protection”—​
provides that the individual owners of the corporation (the shareholders) cannot withdraw their share of firm assets at will, nor can the personal creditors of an individual
owner foreclose on the owner’s share of firm assets.17 Such withdrawal or foreclosure
would force partial or complete liquidation of the firm. So the liquidation protection
rule serves to protect the going concern value of the firm against destruction by individual shareholders or their creditors.18 In contrast to the priority rule just discussed, it
is not found in some other standard legal forms for enterprise organization, such as the
partnership.19 Legal entities, such as the business corporation, that are characterized
by both these rules—​priority for business creditors and liquidation protection—​can
therefore be thought of as having “strong-form” entity shielding, as opposed to the
“weak-form” entity shielding found in partnerships, which are usually characterized
only by the priority rule and not by liquidation protection. By isolating the value of
the firm from the personal financial affairs of the firm’s owners, strong-form entity
shielding facilitates tradability of the firm’s shares, which is the third characteristic of
the corporate form. 20
13 The term “entity shielding” derives from Henry Hansmann, Reinier Kraakman, and Richard
Squire, Law and the Rise of the Firm, 119 Harvard Law Review 1333 (2006). The centrality of entity
shielding to organizational law is explored in Henry Hansmann and Reinier Kraakman, The Essential
Role of Organizational Law, 110 Yale Law Journal 387 (2000), where this same attribute was labelled
“affirmative asset partitioning.”
14 While even unregistered common law partnerships are subject to this priority rule, many civil
law jurisdictions recognize a class of unregistered “partnerships” that lack this rule of priority. In effect,
such partnerships are just special forms for the joint management of assets rather than distinct entities
for purposes of contracting.
15 On default rules, see Section 1.4.1.
16 The effect is the same as if the firm’s owners had themselves entered into a joint contract and
granted non-​recourse security over certain personal assets to the counterparty, as opposed to transferring those assets to the corporate entity, and then procuring the company to enter into the contract.
17 Hansmann and Kraakman, note 13, at 411–​13.
18 Edward B. Rock and Michael L. Wachter, Waiting for the Omelet to Set: Match-​Specific Assets and
Minority Oppression in Close Corporations, 24 Journal of Corporation Law 913, 918–​20 (1999);
Margaret M. Blair, Locking in Capital: What Corporate Law Achieved for Business Organizers in the
Nineteenth Century, 51 UCLA Law Review 387, 441–​9 (2003).
19 That said, it is possible in many jurisdictions to effect liquidation protection by agreement
amongst the owners of a partnership.
20 While strong-form entity shielding seems essential for free tradability of shares (see Hansmann
and Kraakman, note 13), limited liability does not: so long as shareholder liability for a firm’s debts
is pro rata rather than joint and several, free tradability of shares is feasible with unlimited personal
7
What Is a Corporation?
7
The benefits of these two rules—​creditor priority and liquidation protection—​
reinforce one another where the “assets” in question comprise contractual agreements.21 An increasingly important part of a firm’s value creation comes from the
interaction of the various contracts it has negotiated. These two rules assure counterparties that their performance will be delivered by reference to the value generated by
that bundle of contracts and the associated assets, amongst which there will typically
be complementarities. Not only does this make it easier to negotiate such contracts,
but it also facilitates liquidity on the part of shareholders. It is far easier for the owner
of a corporation to transfer her shares than it would be for a sole proprietor to transfer
her contracts.
For a firm to serve effectively as a contracting party, two other types of rules are also
needed. First, there must be rules specifying to third parties the individuals who have
authority to buy and sell assets in the name of the firm, and to enter into contracts that
are bonded by those assets.22 While participants in a firm are to a large extent free to
specify the delegation of authority by contract amongst themselves, background rules
are needed—​beyond such contractual agreement—​to deal with situations where agents
induce third parties to rely on the mere appearance of their authority. Such rules differ
according to organizational form. The particular rules of authority governing the corpor­
ation are treated below as a separate core characteristic, “delegated management.” They
provide that a subset of corporate managers (such as the board of directors or certain
officers), as opposed to individual owners, has power to bind the company in contract.23
Second, there must be rules specifying the procedures by which both the firm and
its counterparties can bring lawsuits on the contracts entered into in the name of the
firm. Corporations are subject to rules that make such suits easy to bring as a procedural matter. In particular, they eliminate any need to name, or serve notice on, the
firm’s individual owners—​procedures that plagued the Anglo-​American partnership
until the late nineteenth century.
The outcomes achieved by each of these three types of rules—​entity shielding,
authority, and procedure—​require dedicated legal doctrines to be effective in the sense
that, absent such doctrines, they could not be replicated simply by contracting among
a business’s owners and their suppliers and customers. That is, the law here serves
to reduce the costs of doing business. Entity shielding doctrine is needed to create
common expectations, among a firm and its various present and potential creditors,
concerning the effect that a contract between a firm and one of its creditors will have
on the security available to the firm’s other creditors.24 Rules governing the allocation
shareholder liability for corporate debts: see Henry Hansmann and Reinier Kraakman, Toward
Unlimited Shareholder Liability for Corporate Torts, 100 Yale Law Journal 1879 (1991); Charles R.
Hickson and John D. Turner, The Trading of Unlimited Liability Bank Shares in Nineteenth-​Century
Ireland: The Bagehot Hypothesis, 63 Journal of Economic History 931 (2003).
21 Kenneth Ayotte and Henry Hansmann, Legal Entities as Transferable Bundles of Contracts, 111
Michigan Law Review 715 (2013).
22 Armour and Whincop, note 12, at 441–​2.
23 Associated rules—​such as the doctrine of ultra vires—​may also prescribe limits as to the extent
to which managers may bind the company in contract.
24 To establish the priority of business creditors by contract, a firm’s owners would have to contract with its business creditors to include subordination provisions, with respect to business assets,
in all contracts between individual owners and individual creditors. Not only would such provisions
be cumbersome to draft and costly to monitor, but they would be subject to a high degree of moral
hazard—​an individual owner could breach her promise to subordinate the claims of her personal
creditors on the firm’s assets with impunity, since this promise would be unenforceable against personal creditors who were not party to the bargain. See Hansmann and Kraakman, note 13, at 407–​9.
8
8
What Is Corporate Law?
of authority are needed to establish common expectations as to who has authority to
transfer rights relating to corporate assets prior to entering into a contract for their
transfer.25 And procedures for lawsuits need to be specified by the state, whose third-​
party authority is invoked by those procedures. This need for special rules of law distinguishes these three types of rules from the other basic elements of the corporate
form discussed here, almost all of which could in theory be crafted by contract even if
the law did not provide for a standard form of enterprise organization that embodies
them.26
The concept of the “separate legal personality” of the corporation, as understood
in the legal literature, is in our terms a convenient heuristic formula for describing
organizational forms which enjoy the benefit of each of the three foregoing “foundational” rule types. Starting from the premise that the company is itself a person,
in the eyes of the law, it is straightforward to deduce that it should be capable of
entering into contracts and owning its own property; capable of delegating authority
to agents; and capable of suing and being sued in its own name. For expository convenience, we use the term “legal personality” to refer to organizational forms—​such as
the corporation—​that share these three attributes. However, we should make clear that
legal personality in the lawyer’s sense is not in itself an attribute that is a necessary precondition for the existence of any—​or indeed all—​of these rules,27 but merely a handy
label for a package that conveniently bundles them together. Although it is common in
the legal literature to extend syllogistic deduction from the premise of legal personality
to the existence of other characteristics of “personhood” beyond the three foundational
features we have described in this section, such as ethnicity,28 or the protected enjoyment of civil rights,29 we see no functional rationale that compels this.
1.2.2 Limited liability
The corporate form effectively provides a default term in contracts between a firm and
its creditors whereby the creditors are limited to making claims against assets that are
held in the name of (or “owned by”) the firm itself, and have no claim against assets
that the firm’s shareholders hold in their own names. While this rule of “limited liability” was not, historically, always associated with the corporate form,30 the association
25 To leave questions of authority to be determined simply by agreement between the owners of
the firm will make it costly for parties wishing to deal with the firm to discover whether authority has
in fact been granted in relation to any particular transaction. Authority rules must therefore trade off
contracting parties’ “due diligence” costs against preserving flexibility for owners to customize their
allocations of authority. See Armour and Whincop, note 12, at 442–​7.
26 See Hansmann and Kraakman, note 13, at 407–​9. The exception is limited shareholder liability
to corporate tort victims. See Section 1.2.2.
27 Thus, a common law partnership, which is commonly said by lawyers to lack legal personality,
can under English law enjoy each of the three foundational features described in this section: see §§
31, 33, 39 Partnership Act 1890 (UK); Armour and Whincop, note 12, at 460–​1; Burnes v. Pennell
(1849) 2 HL Cas 497, 521; 9 ER 1181, 1191; PD 7A, para. 5A Civil Procedure Rules (UK).
28 Richard R.W. Brooks, Incorporating Race, 106 Columbia Law Review 2023 (2006).
29 See Cnty. of Santa Clara v. S. Pac. R.R. Co., 118 United States Reports 394 (1886), and, more
recently, Burwell v. Hobby Lobby, 134 Supreme Court Reporter 2751 (2014).
30 For example, limited liability was not a standard feature of the English law of joint stock companies until the mid-​nineteenth century, and in California, shareholders bore unlimited personal liability for corporation obligations until 1931. See e.g. Paul L. Davies, Gower and Davies’ Principles
of Modern Company Law 40–​6 (6th edn., 1997); Phillip Blumberg, Limited Liability and Corporate
Groups, 11 Journal of Corporate Law 573 (1986).
9
What Is a Corporation?
9
has over time become nearly universal. This evolution indicates strongly the value of
limited liability as a contracting tool and financing device.
Limited liability shields the firm’s owners—​the shareholders—​from creditors’
claims. Importantly, this facilitates diversification.31 With unlimited liability, the
downside risk borne by shareholders depends on the way the business is carried on.
Shareholders will therefore generally prefer to be actively involved in the running
of the business, to keep this risk under control. This need to be “hands-​on” makes
investing in multiple businesses difficult. Limited liability, by contrast, imposes a
finite cap on downside losses, making it feasible for shareholders to diversify their
holdings.32 It lowers the aggregate risk of shareholders’ portfolios, reducing the risk
premium they will demand, and so lowers the firm’s cost of equity capital.
The “owner shielding” provided by limited liability is the converse of the “entity
shielding” described above as a component of legal personality.33 Entity shielding protects the assets of the firm from the creditors of the firm’s owners, while
limited liability protects the assets of the firm’s owners from the claims of the
firm’s creditors. Together, these forms of asset shielding (or “asset partitioning”)
ensure that business assets are pledged as security to business creditors, while
the personal assets of the business’s owners are reserved for the owners’ personal
creditors.34 As creditors of the firm commonly have a comparative advantage in
evaluating and monitoring the value of the firm’s assets, and an owner’s personal
creditors are likely to have a comparative advantage in evaluating and monitoring
the individual’s personal assets, such asset shielding can reduce the overall cost of
capital to the firm and its owners. It also permits firms to isolate different lines of
business—​and focus creditors’ monitoring efforts accordingly—​by incorporating
separate subsidiaries.35
We should emphasize that, when we refer to limited liability, we mean specifically limited liability in contract—​that is, limited liability to creditors who have contractual claims on the corporation. The compelling reasons for limited liability in
contract generally do not extend to limited liability to persons who are unable to
adjust the terms on which they extend credit to the corporation, such as third parties who have been injured as a consequence of the corporation’s negligent behavior.
Limited liability to such persons is arguably not a necessary feature of the corporate
form, and perhaps not even a socially valuable one, as we discuss more thoroughly
in Chapter 5.
31 Henry Manne, Our Two Corporation Systems: Law and Economics, 53 Virginia Law Review
259, 262 (1967).
32 “Unlimited liability” would ordinarily be joint and several amongst business owners. In terms of
the incentives discussed in the text, a form of liability that is imposed pro rata to the number of shares
held—​but without pre-​agreed limitation—​falls somewhere between this and the case of fully limited
liability. Shareholders with pro rata liability can reduce their downside exposure either by holding only
a small stake—​hence facilitating diversification—​or by exerting control over the way the business is
run: see Hansmann and Kraakman, note 20.
33 Hansmann, Kraakman, and Squire, note 13. Owner shielding established by a rule of limited
liability is less fundamental than entity shielding, in the sense that it can be achieved by contract,
without statutory fiat.
34 By “creditors” we mean here all persons who have a contractual claim on the firm, including
employees, suppliers, and customers.
35 Of course, asset shielding through group structures can also be used to reduce transparency as
to the location of assets. This concern underlies an important part of corporate law’s creditor-​oriented
rules: see Chapter 5.2.1.3.
10
10
What Is Corporate Law?
1.2.3 Transferable shares
Fully transferable shares in ownership are yet another basic characteristic of the business corporation that distinguishes the corporation from the partnership and various
other standard-​form legal entities. Transferability permits the firm to conduct business
uninterruptedly as the identity of its owners changes, thus avoiding the complications
of member withdrawal that are common among, for example, partnerships, cooperatives, and mutuals.36 This in turn enhances the liquidity of shareholders’ interests
and makes it easier for shareholders to construct and maintain diversified investment
portfolios.
Transferability of shares is the flipside of the liquidation protection that the corporation’s legal personality assures to its contractual counterparties. Precisely because counterparties can be confident that the “bundle of contracts” that constitutes the firm will
be kept together, there is no need for a rule requiring owners to continue to participate.
In the absence of a legal entity—​that is, if the owner contracts as sole proprietor—​then
counterparties would be concerned that assignment of their contracts would reduce
the value of their expected performance and hence wish to restrict it. It is precisely for
these reasons that all jurisdictions have a default rule prohibiting the assignment of
most contracts without the prior consent of the other contracting party. At the same
time, however, these consent requirements make it more difficult for the owner to sell
the business and liquidate her investment. Legal personality addresses these problems
by enabling the simultaneous transfer of all, but no less than all, of a firm’s contracts by
transferring the corporation’s shares. In other words, it permits the free transferability
of all of a firm’s contracts taken together (“bundle assignability”), while preserving the
general default rule that makes individual contracts non-​assignable without consent of
the contractual counterparty.37
Fully transferable shares do not necessarily mean freely tradable shares. Even if shares
are transferable, they may not be tradable without restriction in public markets, but
rather just transferable among limited groups of individuals or with the approval of the
current shareholders or of the corporation. Free tradability maximizes the liquidity of
shareholdings and the ability of shareholders to diversify their investments. It also gives
the firm maximal flexibility in raising capital. For these reasons, all jurisdictions provide for free tradability for at least one class of corporation. However, free tradability
can also make it difficult to maintain negotiated arrangements for sharing control and
participating in management. Consequently, all jurisdictions also provide mechanisms
for restricting transferability. Sometimes this is done by means of a separate statute,
while other jurisdictions simply provide for restraints on transferability as an option
under a general corporation statute.
As a matter of terminology, we will refer to corporations with freely tradable
shares as “open” or “public” corporations, and we will correspondingly use the terms
“closed” or “private” corporations to refer to corporations that have restrictions on
the tradability of their shares. In addition to this general division, two other distinctions are important. First, the shares of open corporations may be listed for trading
on a stock exchange, in which case we will refer to the firm as a “listed” or “publicly
traded” corporation, in contrast to an “unlisted” corporation. Second, a company’s
36 See Henry Hansmann, The Ownership of Enterprise 152–​5 (1996).
37 Ayotte and Hansmann, note 21. To be sure, the parties to individual contracts may—​and at
times do—​opt out of such a general rule of bundle assignability by requiring counterparty consent in
the event of a change of control of the firm.
11
What Is a Corporation?
11
shares may be held by a small number of individuals whose interpersonal relationships are important to the management of the firm, in which case we refer to it as
“closely held,” as opposed to “widely held.” It is common to speak, loosely, as if
all companies can be categorized as either “public” or “closed” corporations, bundling these distinctions together (and the widely used term “close corporation” itself
embodies this ambiguity, being used sometimes to mean “closed corporation,” sometimes to mean “closely held corporation,” and sometimes to mean both). But not
all companies with freely tradable shares in fact have widely held share ownership,
or are listed on stock exchanges. Conversely, it is common in some jurisdictions to
find corporations which, though their shares are not freely tradable, have hundreds
or thousands of shareholders, and consequently have little in common with a typical
closely held corporation that has only a handful of shareholders, some or all of whom
are from the same family.
Transferability of shares, as we have already suggested, is closely connected both with the
liquidation protection that is a feature of strong-form legal personality, and with limited
liability. Absent either of these features, the creditworthiness of the firm as a whole could
change, perhaps fundamentally, as the identity of its shareholders changed. Consequently,
the value of shares would be difficult for potential purchasers to judge.38 Ensuring a single
price for shares, independent of the wealth of the purchaser, permits securities markets
to aggregate information about the firm’s expected future performance through its stock
price.39 Moreover, a seller of shares could impose negative or positive externalities on his
fellow shareholders depending on the wealth of the person to whom he chose to sell. It is
therefore not surprising that strong-​form legal personality, limited liability, and transferable shares tend to go together, and are all features of the standard corporate form everywhere. This is in contrast to the conventional general partnership, which lacks all of these
features.
1.2.4 Delegated management with a board structure
Standard legal forms for enterprise organization differ in their allocation of control
rights, including the authority to bind the firm to contracts, the authority to exercise the powers granted to the firm by its contracts, and the authority to direct the
uses made of assets owned by the firm.40 For example, the default rules applicable
to general partnership forms usually grant power to a majority of partners to manage the firm in the ordinary course of business, while more fundamental decisions
require unanimity. Both aspects of this allocation are unworkable for business corpor­
ations with numerous and constantly changing owners, because of information and
38 Paul Halpern, Michael Trebilcock, and Stuart Turnbull, An Economic Analysis of Limited Liability
in Corporation Law, 30 University of Toronto Law Journal 117, 136–​8 (1980).
39 Ibid. See also Chapter 9.1.1.
40 We have already observed that an important precondition for a firm to serve as a nexus for contracts is a rule designating, for the benefit of third parties, the individuals who have authority to enter
into contracts that bind the firm and its assets (text accompanying notes 22–​3). Because there is often
overlap in practice between the scope of such external authority and the internal division of power to
control assets, the former, unlike the latter, cannot be based purely on agreement between participants
in the firm, but rather must be designated to some degree by rules of law. The underlying problem
being one of notice to third parties, the law governing closely held firms often leaves these matters to
be designated at will in the firm’s charter, while for widely held (and presumably large) firms, in which
it is advantageous to let multiple shareholders, creditors, and other third parties know the allocation of
authority without incurring the cost of reading the charter, the law is generally more rigid in designating the allocation of authority.
12
12
What Is Corporate Law?
coordination costs.41 Consequently, corporate law typically vests principal authority over corporate affairs in a board of directors or similar body that is periodically
elected, exclusively or primarily, by the firm’s shareholders. More specifically, business
corporations are distinguished by a governance structure in which all but the most
fundamental decisions are generally delegated to a board of directors that has four
basic features.
First, the board is, at least as a formal matter, separate from the operational managers
of the corporation.42 The legal distinction between them formally divides all corporate
decisions that do not require shareholder approval into those requiring approval by
the board of directors and those that can be made by the firm’s hired officers on their
own authority. This formal distinction between the board and hired officers facilitates
a separation between, on the one hand, initiation and execution of business decisions,
which is the province of hired officers, and on the other hand the monitoring and ratification of decisions, and the hiring of the officers themselves, which are the province
of the board. That separation serves as a useful check on the quality of decision-​making
by hired officers.43
Second, the board of a corporation is elected—​at least in substantial part—​by the
firm’s shareholders. The obvious utility of this approach is to help assure that the board
remains responsive to the interests of the firm’s owners, who bear the costs and benefits
of the firm’s decisions and whose interests, unlike those of other corporate constituencies, are not strongly protected by contract. This requirement of an elected board distinguishes the corporate form from other legal forms, such as nonprofit corporations or
business trusts, which permit or require a board structure, but do not require election
of the board by the firm’s (beneficial) owners.
Third, though largely or entirely chosen by the firm’s shareholders, the board is formally distinct from them. This separation economizes on the costs of decision-​making
by avoiding the need to inform the firm’s ultimate owners and obtain their consent for
all but the most fundamental decisions regarding the firm. It also permits the board to
serve as a mechanism for protecting the interests of minority shareholders and other
corporate constituencies, in ways we explore in Chapter 4.
Fourth, the board ordinarily has multiple members. This structure—​as opposed,
for example, to a structure concentrating authority in a single trustee, as in many private trusts—​facilitates mutual monitoring and checks idiosyncratic decision-​making.
However, there are exceptions. Many corporation statutes permit business planners
to dispense with a collective board in favor of a single general director or one-​person
board44—​the evident reason being that, for a very small corporation, most of the
41 See Clark, note 7, at 23–​4 and 801–​16; Sofie Cools, The Dividing Line Between Shareholder
Democracy and Board Autonomy, 11 European Company and Financial Law Review 258, 272–​3
(2014).
42 The nature of this separation varies according to whether the board has one or two tiers. In two-​
tier boards, top corporate officers occupy the board’s second (managing) tier, but are generally absent
from the first (supervisor) tier, which is at least nominally independent from the firm’s hired officers
(i.e. from the firm’s senior managerial employees, though employees may sit in the codetermined
supervisory boards). See Chapter 3.1.
43 See Eugene Fama and Michael Jensen, Agency Problems and Residual Claims, 26 Journal of Law
and Economics 327 (1983).
44 This is true not only of most statutes designed principally for private corporations, such as
France’s SARL (Art. L. 223-​18 Code de commerce) and SAS (Art. L. 227-​6 Code de commerce) and
Germany’s GmbH (§ 6 GmbH-​Gesetz), but also of the general corporate laws in the UK (§ 154(1)
Companies Act 2006), Italy (Art. 2380–​II Civil Code), and the U.S. state of Delaware, § 141(b)
Delaware General Corporation Law.
13
What Is a Corporation?
13
board’s legal functions, including its service as shareholder representative and focus of
liability, can be discharged effectively by a single elected director who also serves as the
firm’s principal manager.
1.2.5 Investor ownership
There are two key elements in the ownership of a firm, as we use the term “ownership”
here: the right to control the firm, and the right to receive the firm’s net earnings. The
law of business corporations is principally designed to facilitate the organization of
investor-​owned firms—​that is, firms in which both elements of ownership are tied to
investment of equity capital in the firm. More specifically, in an investor-​owned firm,
both the right to participate in control—​which generally involves voting in the election of directors and voting to approve major transactions—​and the right to receive the
firm’s residual earnings, or profits, are typically proportional to the amount of capital
contributed to the firm. Business corporation statutes generally provide for this allocation of control and earnings as the default rule.45
There are other forms of ownership that play an important role in contemporary
economies, and other bodies of organizational law—​including other bodies of corpor­
ate law—​that are specifically designed to facilitate the formation of those other types
of firms.46 For example, cooperative corporation statutes—​which provide for all of the
four features of the corporate form just described except for transferable shares, and
often permit the latter as an option as well—​allocate voting power and shares in profits
proportionally to acts of patronage, which may be the amount of inputs supplied to
the firm (in the case of a producer cooperative), or the amount of the firm’s products
purchased from the firm (in the case of a consumer cooperative).
The facilitation of investor ownership became a feature of the corporate form only
in the second half of the nineteenth century. Until then, both investor- and consumerowned firms worldwide had been routinely organized under a single corporate form.47
The subsequent specialization toward investor ownership followed from the dominant
role that investor-​owned firms have come to play in contemporary economies, and the
consequent advantages of having a form that is specialized to the particular needs of
such firms, and that signals clearly to all interested parties the particular character of
the firm with which they are dealing. The dominance of investor ownership among
large firms, in turn, reflects several conspicuous efficiency advantages of that form. One
is that, among the various participants in the firm, investors are often the most difficult
to protect simply by contractual means.48 Another is that investors of capital have (or,
through the design of their shares, can be induced to have) relatively homogeneous
interests among themselves, hence reducing—​though definitely not eliminating—​the
potential for costly conflict among those who share governance of the firm.49
45 For a recently enacted rule providing for a different default (double voting rights for longer term
shareholders in French listed corporations), see Chapter 4.1.1.
46 For a discussion of the varieties of forms of ownership found in contemporary economies, of
their respective economic roles, and of the relationship between these forms and the different bodies
of organizational law that govern them, see Hansmann, note 36.
47 Henry Hansmann and Mariana Pargendler, The Evolution of Shareholder Voting Rights: Separation
of Ownership and Consumption, 123 Yale Law Journal 948 (2014).
48 See e.g. Oliver Williamson, Corporate Governance, 93 Yale Law Journal 1197 (1984).
49 See Hansmann, note 36. For a discussion of the consequences of different risk preferences of
diversified and undiversified investors, see John Armour and Jeffrey N. Gordon, Systemic Harms and
Shareholder Value, 6 Journal of Legal Analysis 35, 50–​6 (2014).
14
14
What Is Corporate Law?
Specialization to investor ownership is yet another respect in which the law of business corporations differs from the law of partnership. The partnership form typically
does not presume that ownership is tied to contribution of capital, and though it is
often used in that fashion, it is also commonly employed to assign ownership of the
firm in whole or in part to contributors of labor or of other factors of production—​as
in partnerships of lawyers and other service professionals, or simply in the prototypical
two-​person partnership in which one partner supplies labor and the other capital. As a
consequence, the business corporation is less flexible than the partnership in terms of
assigning ownership. To be sure, with sufficient special contracting and manipulation
of the form, ownership of shares in a business corporation can be granted to contributors of labor or other factors of production, or in proportion to consumption of the
firm’s services. Moreover, as the corporate form has evolved, it has achieved greater flexibility in assigning ownership, either by permitting greater deviation from the default
rules in the basic corporate form (e.g. through restrictions on share ownership or transfer), or by developing a separate and more adaptable form for closed corporations.
Nevertheless, the default rules of corporate law continue to be generally designed for
investor ownership, and deviation from this pattern can be awkward. The complex
arrangements for sharing rights to earnings, assets, and control between entrepreneurs
and investors in high-​tech start-​up firms are a good example.50
There has been further specialization even amongst investor-​owned companies, with
the recent emergence of special forms of “public benefit” or “community interest”
corporations designed to accommodate the needs of hybrid firms that, while investor
owned, also commit to the pursuit of a specified social objective.51 In other instances,
state-​owned enterprises (SOEs) embrace the corporate form, hence permitting the
government to share ownership with private investors. Because the state is seldom, if
ever, a typical financial investor, state ownership entails a degree of heterogeneity in the
shareholder base that exceeds that of the typical investor-​owned firm, with potential
for unique conflicts of interest.52 Sometimes core corporate law itself deviates from the
assumption of investor ownership to permit persons other than investors of capital—​
for example, creditors or employees—​to participate in either control or profit-​sharing,
or both. Worker codetermination is a conspicuous example. The wisdom and means
of providing for such non-​investor participation in firms that are otherwise investor-​
owned remains one of the central controversies in corporate law, which we address
further in Chapter 4.
Most jurisdictions also have one or more statutory forms—​such as the U.S. nonprofit
corporation, the civil law foundation, and the UK company limited by guarantee—​
that provide for formation of nonprofit firms. These are firms in which no person may
participate simultaneously in both the right to control and the right to residual earnings (which is to say, the firms have no owners). While nonprofit organizations, like
cooperatives, are sometimes labelled “corporations,” however, they will not be within
the specific focus of our attention here—​even though a number of successful industrial
50 Stephen N. Kaplan and Per Strömberg, Financial Contracting Theory Meets the Real World: An
Empirical Analysis of Venture Capital Contracts, 70 Review of Economic Studies 281 (2003).
51 See e.g. Jesse Finfrock and Eric L. Talley, Social Entrepreneurship and Uncorporations, 2014
Illinois Law Review 1867; Regulator of Community Interest Companies (UK), Annual Report
2013/​2014 (2014).
52 See e.g. Mariana Pargendler, Aldo Musacchio, and Sergio G. Lazzarini, In Strange Company: The
Puzzle of Private Investment in State-​Controlled Firms, 46 Cornell International Law Journal 569
(2013).
15
Sources of Corporate Law
15
firms around the world are organized as nonprofits.53 Thus, when we use the term
“corporation” in this book, we refer only to the business corporation, and not to cooperative corporations, nonprofit corporations, municipal corporations, or other types of
incorporated entities. When there is potential for ambiguity, we will explicitly use the
term “business corporation” to make specific reference to the investor-​owned company
that is our principal focus.
1.3 Sources of Corporate Law
All jurisdictions with well-​developed market economies have a least one core statute
that establishes a basic corporate form with the five characteristics described above,
and that is designed particularly to permit the formation of public corporations.
Nevertheless, corporate law as we understand it here—​in functional terms—​generally
extends well beyond the bounds of this core statute.
1.3.1 Special and partial corporate forms
First, major jurisdictions commonly have at least one distinct statutory form specialized for the formation of closed corporations or limited liability companies. These
forms—​including the Brazilian Ltda, the French SARL, the German GmbH, the
Italian Srl, the Japanese godo kaisha, the American limited liability company, and the
UK private company54—​typically exhibit most of the canonical features of the corpor­
ate form. They differ from open, or “public,” companies chiefly because their shares,
though generally transferable at least in principle, are presumed—​and in some cases
required—​not to trade freely in a public market. Sometimes these forms also permit
departure from one of our five core characteristics—​delegated management—​by permitting elimination of the board in favor of direct management by shareholders.55 The
statutes creating these forms also commonly permit, and sometimes facilitate, special
allocations of control, earnings rights, and rights to employment among shareholders
that go beyond those permitted in the core public corporation statute.
Second, some jurisdictions have, in addition to these special closed corporation
forms, quasi-​corporate statutory forms that can be used to form business corporations
with all of our five core characteristics, though some of these characteristics must be
added by contract. One example is the limited liability partnership, which has recently
been added to the forms available in the law of the U.S., Japan, and some European
jurisdictions. This form simply grafts limited liability onto the traditional general partnership. U.S. and UK law now allow a limited partnership to have something close
to strong-form entity shielding (by limiting the rights of partners or their creditors
to force liquidation).56 Consequently, with appropriate governance provisions in the
partnership agreement, it is effectively possible to create a closed corporation as a limited liability partnership.
53 On the so-​called “industrial foundations,” see Steen Thomsen and Henry Hansmann, Managerial
Distance and Virtual Ownership: The Governance of Industrial Foundations, Working Paper (2013), at
ssrn.com.
54 In the case of the UK private company, the standard form is provided not by a separate statute,
but by a range of provisions in a single statute with differential application to public and private
companies.
55 See note 44.
56 See Hansmann, Kraakman and Squire, note 13, at 1391–​4.
16
16
What Is Corporate Law?
The U.S. statutory business trust offers another example. It provides for strong-​form
legal personality and limited liability, but leaves all elements of internal organization
to be specified in the organization’s governing instrument (charter), failing even to
provide statutory default rules for most such matters.57 With appropriate charter provisions, a statutory business trust can be made equivalent to a public corporation, with
the trust’s beneficiaries in the role of shareholders.
The analysis we offer in this book extends to all these special and quasi-​corporate
forms insofar as they display most or all of the core corporate characteristics. Although
we make occasional reference to some of these forms to underscore certain peculiarities, the description of our core jurisdictions’ corporate laws in Chapters 3 to 9 focuses
mainly on public corporations.
1.3.2 Other bodies of law
There are bodies of law that, at least in some jurisdictions, are contained in statutes or
case law that are separate from the core corporation statutes, and from the special and
quasi-​corporation statutes just described, but that are nonetheless instrumental to the
functioning of the five core characteristics of the corporate form or to addressing the
corporate agency problems we describe in Chapter 2. Hence, we view them functionally as part of corporate law.
To begin, the German law of groups, or Konzernrecht, qualifies limited liability
and limits the discretion of boards of directors in corporations that are closely related
through common ownership, seeking to protect the creditors and minority shareholders of corporations with controlling shareholders. Although the Konzernrecht—​
touched upon in more detail in Chapters 5 and 6—​is embodied in statutory law that
is formally distinct from the corporation statutes and case law, it is clearly an integral
part of German corporate law. Similarly, the statutory rules in many jurisdictions that
require employee representation on a corporation’s board of directors—​such as, conspicuously, the German law of codetermination—​qualify as elements of corporate law,
even though they occasionally originate outside the principal corporate law statutes,
because they impose a detailed structure of employee participation on the boards of
directors of large corporations.
Securities laws in many jurisdictions, including conspicuously the U.S., have strong
effects on corporate governance through rules mandating disclosure,58 and sometimes
regulating sale and resale of corporate securities, mergers and acquisitions, and corpor­
ate elections. Stock exchange rules, which can regulate numerous aspects of the internal affairs of exchange-​listed firms, can also serve as an additional source of corporate
law, as can other forms of self-​regulation, such as the UK’s City Code on Takeovers
and Mergers.59 These supplemental sources of law are necessarily part of the overall
structure of corporate law, and we shall be concerned here with all of them.
57 It differs from the common law private trust, from which it evolved, principally in providing
unambiguously for limited liability for the trust’s beneficiaries even if they exercise control.
58 A claim strongly put by Robert B. Thompson and Hillary A. Sale, Securities Fraud as Corporate
Governance: Reflections upon Federalism, 56 Vanderbilt Law Review 859 (2003).
59 We term such self-​regulation a source of “law” in part because it is commonly supported,
directly or indirectly, by law in the narrow sense. The self-​regulatory authority of the American stock
exchanges, for example, is both reinforced and constrained by the U.S. Securities Exchange Act and
the administrative rules promulgated by the Securities and Exchange Commission under that Act.
Similarly, the authority of the UK’s Takeover Panel was supported indirectly until 2006 by the recognition that if its rulings were not observed, formal regulation would follow. Since then, it has enjoyed
17
Law versus Contract in Corporate Affairs
17
There are many constraints imposed on companies by bodies of law designed to serve
objectives that are, in general, independent of the form taken by the organizations they
affect. While we will not explore these bodies in general, we will discuss those that have
important effects on corporate structure and conduct. Bankruptcy law—​or “insolvency law,” as it is termed in some jurisdictions—​is an example. Bankruptcy effects
a shift in the ownership of the firm from one group of investors to another—​from
shareholders to creditors. By providing creditors with an ultimate sanction against
defaulting firms, it casts a shadow over firms’ relations with their creditors, and affects
the extent to which creditors may need generalized protections in corporate law. We
thus consider the role of bankruptcy law in Chapter 5. Tax law also affects directly
the internal governance of corporations at various points; the U.S. denial of deductibility from corporate income, for tax purposes, of executive compensation in excess
of $1 million unless it is in the form of incentive pay, discussed in Chapter 3, is a clear
example.60 And, beyond providing for board representation of employees, labor law
in some countries—​as emphasized in Chapter 4—​involves employees or unions in the
corporate decision-​making process, as in requirements that works councils or other
workers’ organs be consulted prior to taking specified types of actions.
1.4 Law versus Contract in Corporate Affairs
The relationships among the participants in a corporation are, to an important degree,
contractual. The principal contract that binds them is the corporation’s charter (or
“articles of association” or “constitution,” as it is termed in some jurisdictions). The
charter sets out the basic terms of the relationship among the firm’s shareholders, and
between the shareholders and the firm’s directors and other managers.61 By explicit or
implicit reference, the charter can also become part of the contract between the firm
and its employees or creditors. One or more shareholders’ agreements may, in addition,
bind some or all of a corporation’s shareholders.
At the same time, corporations are the subject of a large body of statutory law. That
body of law is the principal focus of this book. Before examining the details of that law,
however, we must address a fundamental—​and surprisingly difficult—​question: What
role does this law play? As we have already seen, with few exceptions, the defining elements of the corporate form could in theory be established simply by contract. And the
same is true of most of the other rules of law that we examine throughout this book.
If those rules of law did not exist, the relationships they establish could still be created by means of contract, just by placing similar provisions in the organization’s charter. Indeed, this was the approach taken by the numerous unincorporated joint stock
companies formed in England during the eighteenth and early nineteenth centuries,
before incorporation became widely available in 1844. Those companies obtained their
legal personality from partnership and trust law, and created the rest of their corporate
structure—​including limited liability—​by means of contract.62 Why, then, do we today
formal statutory authority (Part 28 Companies Act 2006 (UK)), and so is no longer, strictly speaking,
“self-​regulatory.”
60 § 162(m) Internal Revenue Code (U.S.).
61 The charter may be supplemented by a separate set of bylaws, which commonly govern less
fundamental matters and are subject to different—​generally more flexible—​amendment rules than
is the charter.
62 Ron Harris, Industrializing English Law (2000); Hansmann, Kraakman, and Squire,
note 13.
18
18
What Is Corporate Law?
have, in every advanced economy, elaborate statutes providing numerous detailed rules
for the internal governance of corporations?
1.4.1 Mandatory laws versus default provisions
In addressing this question, it is important to distinguish between legal provisions that
are merely default rules, in the sense that they govern only if the parties do not expli­
citly provide for something different, and laws that are mandatory, leaving parties no
option but to conform to them.63
A significant part of corporate law—​more in some jurisdictions, less in others—​
consists of default provisions.64 To this extent, corporate law simply offers a standard
form contract that the parties can adopt, at their option, in whole or in part. A familiar
advantage of such a legally provided standard form is that it saves costs—​specifically,
it simplifies contracting among the parties involved by requiring that they specify only
those elements of their relationship that deviate from the standard terms. Corporate
law’s provision of such standard terms as default is thereby seen in economic terms as a
“public good.” Default provisions can serve this function best if they are “majoritarian”
in content—​that is, if they reflect the terms that the majority of well-​informed parties
would themselves most commonly choose.65
Default provisions can be supplied in a variety of ways, the choice of which affects
the ease and means of “contracting around” them.66 A common form of corporate law
default is a statutory provision that will govern unless the parties explicitly provide
an alternative. The common provision that each share carries one vote is an example.
A charter clause can deviate from that default by, for instance, providing for the issuance of a class of stock carrying no voting right.
Alternatively, corporate law itself sometimes specifies the rule that will govern if
the default provision is not chosen—​an “either-​or” provision. An example is offered
by French corporate law, which allows companies’ charters to opt for a two-​tier board
structure as an alternative to the default single-​tier one.67 In other words, the law in
this case gives the corporation a choice between two statutory provisions: one is the
default and the other is the “secondary” provision, with the latter applying only if the
firm opts out of the default (or, equivalently, “opts in” to the secondary provision).
The law may also impose special procedures for altering a default rule, such as by
requiring minority approval to alter default rules that protect their interests.68 An
extension of the binary two-​alternative-​provisions approach just described is to provide corporations with a choice among a “menu” of more than two specified rules.69
63 See generally the papers in the symposium edition entitled Contractual Freedom and Corporate
Law, in 89 Columbia Law Review 1395–​774 (1989).
64 They are “defaults” in the sense that they apply (as with computer settings) “in default” of the
parties stipulating something else.
65 Easterbrook and Fischel, note 7, at 34–​5.
66 The ease with which parties can “contract around” a default provision will affect the way it
operates. For a nuanced discussion of these and other issues, see Ian Ayres, Regulating Opt-​Out: An
Economic Theory of Altering Rules, 121 Yale Law Journal 2032 (2012). For an empirical perspective, see Yair Listokin, What do Corporate Default Rules and Menus Do? An Empirical Examination, 6
Journal of Empirical Legal Studies 279 (2009).
67 See Art. 225-​57 Code de commerce.
68 See Lucian A. Bebchuk and Assaf Hamdani, Optimal Defaults For Corporate Law Evolution, 96
Northwestern University Law Review 489 (2002).
69 Michael Klausner, Corporations, Corporate Law, and Networks of Contracts, 81 Virginia Law
Review 757, 839–​41 (1995).
19
Law versus Contract in Corporate Affairs
19
There are also important rules of corporate law that are mandatory.70 Large
German corporations, for example, have no alternative but to give half of their
supervisory board seats to representatives of their employees, and publicly traded
U.S. corporations have no alternative but to provide regular detailed financial disclosure in a closely prescribed format.71 The rationale for mandatory terms of these
types is usually based on some form of “contracting failure”: some parties might
otherwise be exploited because they are not well informed; the interests of third
parties might be affected; or collective action problems might otherwise lead to
contractual provisions that are inefficient or unfair.72 Mandatory terms may also
serve a useful standardizing function, in circumstances (such as with accounting
rules) where the benefits of compliance increase if everyone adheres to the same
provision.
Mandatory rules need not just serve a prescriptive function, however. When used in
conjunction with a choice of corporate forms, they can perform an enabling function
similar to that served by default rules. More particularly, mandatory rules can facilitate
freedom of contract by helping corporate actors to signal the terms they offer and to
bond themselves to those terms. The law accomplishes this by creating corporate forms
that are to some degree inflexible (i.e. are subject to mandatory rules), but then permitting choice among different corporate forms.73 There are two principal variants to this
approach.
First, a given jurisdiction can provide for a menu of different standard form legal
entities from which parties may choose in structuring an organization. In some
U.S. jurisdictions, for example, a firm with the five basic attributes of the business
corporation can be formed, alternatively, under a general business corporation statute,
a close corporation statute, a limited liability company statute, a limited liability partnership statute, or a business trust statute—​with each statute providing a somewhat
different set of mandatory and default rules. Second, even with respect to a particular
type of legal entity, such as the publicly traded business corporation, the organizers of a
firm may often choose among different jurisdictions’ laws. This leads us to the general
issue of choice of law and the related debate about “regulatory competition” in corpor­
ation law. Before addressing that topic, however, we need to say more about the role of
corporation law in general.
1.4.2 The benefits of legal rules
Default rules of corporate law do more than simply provide convenient standard
forms, encourage revelation of information, and facilitate choice of the most efficient
among several alternative rules. They also provide a means of accommodating, over
time, developments that cannot easily be foreseen at the outset.
A contract that, like a corporation’s charter, must govern complex relationships over
a long period of time, is necessarily incomplete. Situations will arise for which the
70 See Jeffrey N. Gordon, The Mandatory Structure of Corporate Law, 89 Columbia Law Review
1549 (1989).
71 See Chapter 4.2.1 (codetermination) and 6.2.1 and 9.1.1 (disclosure).
72 See generally Michael J. Trebilcock, The Limits of Freedom of Contract (1993).
73 Larry E. Ribstein, Statutory Forms for Closely Held Firms: Theories and Evidence From LLCs,
73 Washington University Law Quarterly 369 (1995); John Armour and Michael J. Whincop,
An Economic Analysis of Shared Property in Partnership and Close Corporations Law, 26 Journal of
Corporation Law 983 (2001).
20
20
What Is Corporate Law?
contract fails to provide clear guidance, either because the situation was not foreseeable at the time the contract was drafted or because the situation, though foreseeable,
seemed too unlikely to justify the costs of making clear provision for it in the contract.
Statutory amendments, administrative rulings, and judicial decisions can provide for
such situations as they arise, by either altering or interpreting existing rules. This is the
gap-​filling role of corporation law.
Courts play a key role in filling gaps, simply by interpreting privately drafted
contractual terms in a corporation’s charter. A firm will get the greatest advantage
from the courts’ interpretive activity if it adopts standard charter terms used by
many other firms, since those standard terms are likely to be subject to repeated
interpretation by the courts.74 And the most widely used standard charter terms
are often the default rules embodied in the corporation law. So, another advantage of sticking to the default provisions, rather than drafting specialized charter
terms, is to benefit from the constant gap-​filling activity stimulated by the body of
precedents developed as a result of other corporations that are also subject to those
rules.75 This is one example of a network effect that creates an incentive to choose a
common approach.76
The problem of contractual incompleteness goes beyond mere gap-​filling, however.
Given the long lifespan of many corporations, it is likely that some of a firm’s initial charter terms, no matter how carefully chosen, will become obsolete with the
passage of time owing to changes in the economic and legal environment. Default
rules of law have the feature that they are altered over time—​by statutory amendments and by judicial interpretation—​to adapt them to such changing circumstances.
Consequently, by adopting a statutory default rule, a firm has a degree of assurance
that the provision will not become anachronistic. If, in contrast, the firm puts in its
charter a specially drafted provision in place of the statutory default, only the firm
itself can amend the provision when, over time, a change is called for. This runs into
the problem that the firm’s own mechanisms for charter amendment may be vetoed
or hijacked by particular constituencies in order, respectively, to protect or further
their partial interests. Simply adopting the statutory default rules, and delegating to
the state the responsibility for altering those rules over time as circumstances change,
avoids these latter problems.77
It follows from much of the foregoing that, for many corporations, there may often
be little practical difference between mandatory and default rules. Firms end up, as
a practical matter, adopting default rules as well as the mandatory rules. The most
empirically significant dimensions of selection lie in the ability of participants to select
from a range of different business forms—​which we have discussed—​and of corporations to choose the jurisdiction by whose corporation law they will be governed, which
is the subject to which we turn next.
74 Ian Ayres, Making A Difference: The Contractual Contributions of Easterbrook and Fischel, 59
University of Chicago Law Review 1391, 1403–​8 (1992).
75 Klausner, note 69, at 826–​9.
76 A related network effect that may encourage firms to adopt standardized charter terms, and
in particular to accept default rules of law, is that those provisions are more familiar to analysts and
investors, thus reducing their costs of evaluating the firm as an investment. Similar network effects
may cause legal services to be less expensive for firms that adopt default rules of law. See Marcel Kahan
and Michael Klausner, Standardization and Innovation In Corporate Contracting (or “The Economics of
Boilerplate”), 83 Virginia Law Review 713 (1997).
77 See Henry Hansmann, Corporation and Contract, 8 American Law and Economics Review
1 (2006).
21
Law versus Contract in Corporate Affairs
21
1.4.3 Choice of legal regime
The various forms of flexibility in corporate law on which we have so far concentrated—​
the choice of specially drafted charter provisions versus default provisions, the choice of
one default rule in a given statute as opposed to another, and the choice of one statutory form versus another—​can all be provided within any given jurisdiction. As we
have noted, however, there can be yet another dimension of choice—​namely, choice of
the jurisdiction in which to incorporate.
In the U.S., for example, the prevailing choice of law rule for corporate law is the
“place of incorporation” rule, which permits a business corporation to be incorpor­
ated under—​and hence governed by—​the law of any of the fifty individual states
(or any foreign country), regardless of where the firm’s principal place of business, or
other assets and activities, are located. That form of choice, long available within the
U.S. and in a number of other countries as well, has now been largely extended to
entrepreneurs throughout the European Union as a consequence of European Court
of Justice decisions requiring the domestic recognition of corporations formed in other
member states adopting the place of incorporation rule.78 These denied the efficacy of
the “real seat” doctrine under which, in many European countries, firms were formerly
required to incorporate under the law of the state where the firm had its principal place
of business.79
The consequence of choice amongst jurisdictions is not simply to enlarge the range
of governance rules from which a given firm can choose. It also creates the opportunity
for a jurisdiction to induce firms to incorporate under its law—​and thereby bring
revenue to the state directly (through franchise fees) and indirectly (through increased
demand for local services)—​by making that jurisdiction’s corporate law attractive. This
permits the emergence of corporate law systems that are driven primarily by market
forces based on companies’ demand, and less influenced by other political forces that
typically shape democratic lawmaking.80 Whether such “regulatory competition” exists
at all—​and if it does, whether it is a good thing—​has long been the subject of vigorous debate.81 Pessimists argue that it creates a “race to the bottom” in which the state
that wins is that which goes furthest in stripping its law of protections for constituencies who do not control the (re)incorporation decision. Optimists argue that, on
the contrary, regulatory competition in corporate law creates a virtuous “race to the
78 Case C-​212/​97, Centros Ltd v. Erhvervs-​og Selskabssyrelsen [1999] European Court Reports
I-​1459; Case C-​208/​00, Überseering BV v. Nordic Construction Company Baumanagement GmbH
(NCC) [2002] European Court Reports I-​9919; Case C-​167/​01, Kamel van Koophandel en
Fabrieken voor Amsterdam v. Inspire Art Ltd [2003] European Court Reports I-​10155; Case C-​210/​
06, Cartesio Oktató és Szolgáltató bt [2008] European Court Reports I-​9641; Case C-​378/​10 VALE
Építési kft ECLI:EU:C:2012:440. See Marco Becht, Colin Mayer, and Hannes F. Wagner, Where
Do Firms Incorporate? Deregulation and the Cost of Entry, 14 Journal of Corporate Finance 241
(2008); John Armour and Wolf-​Georg Ringe, European Company Law 1999–​2010: Renaissance and
Crisis, 48 Common Market Law Review 125, 131–​43. The position as respects change of corporate
law for existing companies is more complex: see ibid., 158–​69.
79 However, insolvency law rules are more likely to be applied according to the place of business: see
Art. 3(1) and preamble para (30) Regulation (EU) 2015/​848, 2015 O.J. (L 141) 19; Case C-​341/​04
Eurofood IFSC ltd [2006] European Court Reports I-​3813; Case C-​306/​09 Re Interedil Srl [2011]
European Court Reports I-​9915; Case C-​594/​14 Kornhaas v Dithmar ECLI:EU:C:2015:806.
80 See Section 1.6; Ronald J. Gilson, Henry Hansmann, and Mariana Pargendler, Corporate
Chartering and Federalism: A New View, Working Paper (2015).
81 On the existential question, see e.g. Marcel Kahan and Ehud Kamar, The Myth of State
Competition in Corporate Law, 55 Stanford Law Review 679 (2002); Luca Enriques, EC Company
Law and the Fears of a European Delaware, 15 European Business Law Review 1259 (2004).
22
22
What Is Corporate Law?
top”: because the capital markets price, more or less accurately, the effects of corporate
law choice, the state that wins is that whose law maximizes shareholder welfare.82
Of course, there is dispute as to what constitutes an “optimal” body of corporate
law, even in theory—​a topic to which we will turn shortly. Yet an important bene­
fit associated with the existence of choice among multiple regulatory regimes is that
it creates opportunities for regulatory experimentation. That is, diverse legal regimes
serve as laboratories from which regulators and firms can learn more about the merits
and drawbacks of different modes of regulation.83 Moreover, there is unlikely to be a
single optimal body of corporate law applicable to all firms, since companies vary in
their needs for regulation. Choice among jurisdictions (or statutory menus) therefore
enables diverse legal regimes to cater to the needs of different types of firms.84 While
much of the literature on regulatory competition tends to assume corporate law is a
single uniform commodity, this is not always what we observe in practice.85
Finally, even if the optimal corporate law regime were uniform and known to parties, the existence of dual—​or even multiple—​regulatory regimes might be justified by
reference to politics. Reform of inefficient rules may be blocked by powerful interests—​
such as those of managers, controlling shareholders, or workers—​who benefit from the
status quo. In such instances, framing a reform as voluntary can disable opposition by
creating a more efficient parallel regime which, because it only applies to those who opt
into it, does not impinge on the entitlements of incumbents. Both the establishment of
the Novo Mercado premium listing segment in Brazil and certain EU measures such as
the creation of the European Company (Societas Europaea—​SE ) can be interpreted as
bypassing the political clout of interest groups in existing companies.86
1.5 What Is the Goal of Corporate Law?
What is the goal of corporate law, as distinct from its immediate functions of defining
a form of enterprise and containing the conflicts among the participants in this enterprise? As a normative matter, the overall objective of corporate law—​as of any branch
of law—​is presumably to serve the interests of society as a whole. More particularly,
the appropriate goal of corporate law is to advance the aggregate welfare of all who are
affected by a firm’s activities, including the firm’s shareholders, employees, suppliers,
and customers, as well as third parties such as local communities and beneficiaries of
82 The classical statements of the two polar views are William Cary, Federalism and Corporate
Law: Reflections upon Delaware, 83 Yale Law Journal 663 (1974), and Ralph Winter, State Law,
Shareholder Protection and the Theory of the Corporation, 6 Journal of Legal Studies 251 (1977).
For a recent review of this literature, see Roberta Romano, The Market for Corporate Law Redux, in
Oxford Handbook of Law and Economics (Francesco Parisi ed., 2015).
83 See Simon Deakin, Regulatory Competition Versus Harmonization in European Company Law in
Regulatory Competition and Economic Integration 190, 216–1​7 (Daniel Esty and Damien
Gerardin eds., 2001).
84 See John Armour, Who Should Make Corporate Law? EC Legislation versus Regulatory Competition,
58 Current Legal Problems 369 (2005).
85 See K.J. Martin Cremers and Simone M. Sepe, The Financial Value of Corporate Law: Evidence
from (Re)incorporations, Working Paper (2015), at ssrn.com; Jens Dammann and Matthias Schündeln,
The Incorporation Choices of Privately Held Corporations, 27 Journal of Law, Economics, and
Organization 79 (2011).
86 Ronald J. Gilson, Henry Hansmann, and Mariana Pargendler, Regulatory Dualism as a
Development Strategy: Corporate Reform in Brazil, the United States, and the European Union, 63
Stanford Law Review 475 (2011).
23
What Is the Goal of Corporate Law?
23
the natural environment.87 This is what economists would characterize as the pursuit
of overall social welfare.
At least in theory, however, the pursuit of overall social welfare may be compatible
with different immediate goals for corporate law. One view is that corporate law best
advances social welfare by reducing the costs of contracting among the corporation’s
contractual constituencies—​which include not only managers and shareholders but
also certain creditors and employees. The underlying assumption is that any externalities that the corporation generates are best addressed by regulatory constraints from
other areas of law. Indeed, legal strategies designed to maximize the value of firms
adopting the corporate structure constitute both the lion’s share of corporate law as it
is generally understood and the primary object of our analysis.
It is sometimes said that the goals of core corporate law should be even narrower.
In particular, it is sometimes said that the appropriate role of corporate law is simply to assure that the corporation serves the best interests of its shareholders or, more
specifically, to maximize financial returns to shareholders or, more specifically still, to
maximize the current market price of corporate shares. Such claims can be viewed in
two ways.
First, these claims can be taken at face value, in which case they neither describe corporate law as we observe it nor offer a normatively appealing aspiration for that body
of law. There would be little to recommend a body of law that, for example, permits
corporate shareholders to enrich themselves through transactions that make creditors
or employees worse off by $2 for every $1 that the shareholders gain.
Second, such claims can be understood as saying, more modestly, that focusing
principally on the maximization of shareholder returns is, in general, the best means
by which corporate law can serve the broader goal of advancing overall social welfare. In general, creditors, workers, and customers will consent to deal with a corpor­
ation only if they expect themselves to be better off as a result. Consequently, the
corporation—​and, in particular, its shareholders, as the firm’s residual claimants88 and
risk-​bearers—​have a direct pecuniary interest in making sure that corporate transactions are beneficial, not just to the shareholders, but to all parties who deal with the
firm. We believe that this second view is—​and surely ought to be—​the appropriate
interpretation of statements by legal scholars and economists asserting that shareholder
value is the proper object of corporate law.
We should keep in mind, as well, that to say that shareholder value is the principal objective toward which corporations should be managed is not to say that the
corporation should maximize pecuniary profits regardless of the means employed.
In particular, an unappealing implication of the unrestrained pursuit of profit is that
firms should not take the legal regime as pre-​determined, but instead become actively
involved in seeking to relax rules that constrain their imposition of externalities.89 Such
corporate influence in the rule-​making process is clearly problematic, and to the extent
87 We speak here of maximizing the “aggregate welfare” of society more as a loose metaphor than
a precise yardstick. There is no coherent way to put a number on society’s aggregate welfare, much
less to maximize that number—​and particularly so when many benefits are in appreciable part non-​
pecuniary. What we are suggesting here might be put more precisely in the language of welfare economics as pursuing Kaldor-​Hicks efficiency within acceptable patterns of distribution.
88 Shareholders are a corporation’s “residual claimants” in the sense that they are entitled to appropriate all (and only) the net assets and earnings of the corporation after all contractual claimants—​
such as employees, suppliers, and customers—​have been paid in full.
89 For firms in industries subject to regulation to control externalities, corporate political spending is universal: John C. Coates IV, Corporate Politics, Governance, and Value Before and After Citizens
United, 9 Journal of Empirical Legal Studies 657 (2012).
24
24
What Is Corporate Law?
that regulation is consequently compromised, it may be appropriate for corporate law
to seek to modify internal governance arrangements accordingly.90
How generally the pursuit of shareholder value is an effective means of advancing overall social welfare is an empirical question, on which reasonable minds can differ. While
each of the authors of this book has individual views on this claim, we do not take a
strong position on it in the chapters that follow. Rather, we undertake the broader task of
offering an analytic framework within which this question can be explored and debated.
Another view is that, given the prominent role of the business corporation in the
modern economy, corporate law can be harnessed to promote social welfare directly
through more tailored interventions, for example by imposing socially oriented disclosure obligations or molding the corporation’s internal governance arrangements to
address broader social problems. From this perspective, corporate law may be used
to promote economic or social objectives beyond maximizing the value of the firm,
such as reducing systemic risk, mitigating gender inequity, or protecting the environment.91 Although as old as corporate law itself,92 the deployment of corporate law to
protect the interests of parties external to the firm has found renewed favor among
law­makers in the wake of the recent financial crisis. We consider some examples of this
in Chapter 4, but otherwise concentrate on the role of corporate law in maximizing the
value of the firm by protecting the interests of its contractual constituencies.
1.6 What Forces Shape Corporate Law?
To say that the pursuit of aggregate social welfare is the appropriate goal of corporate
law is not to say, of course, that the law always pursues it in the same way. The particular contours of the problems to which corporate law responds may be, at least in part,
determined by other aspects of the corporate governance environment—​for example,
predominant industry type, institutions governing employee relations, and the structure of share ownership. These may consequently complement particular features of
corporate law.93 Similarly, other features of the environment—​for example, the quality
of legal institutions—​may make certain aspects of corporate law more or less effective
in performing these functions. In each case, these point to particular ways in which
corporate law can enhance social welfare—​the selection of which might be termed an
“efficiency” effect on corporate law.
90 Leo E. Strine, Jr. and Nicholas Walter, Conservative Collision Course: The Tension between
Conservative Law Theory and Citizens United, 100 Cornell Law Review 335 (2015).
91 By far the most popular means to protect interests external to the firm is through the imposition
of substantive rules or standards of different stripes (as those of antitrust law, environmental laws,
human rights laws, antidiscrimination laws, financial regulation, etc.). For our purposes, as in general
parlance, the use of legal rules for purposes other than increasing the value of the firm is the boundary
separating corporate from other areas of law. On the use of corporate governance to address a variety
of economic and social problems, see Mariana Pargendler, The Corporate Governance Obsession, 42
Journal of Corporation Law 101 (2016).
92 See e.g. Herbert Hovenkamp, Enterprise and American Law, 1836–​1937, 63–​4 (1991);
Hansmann and Pargendler, note 47, at 145.
93 For instance, an educational system that favors vocational and firm-​specific training will work
best under a labor law regime that protects employees against dismissal and under a system of corporate finance that is more relational and immune to short-​term oscillations in market conditions.
Germany traditionally embodied this institutional bundle. In the U.S., by contrast, a labor regime of
at-​will employment favors a more generalist style of education and facilitates vibrant capital markets
subject to dispersed ownership and hostile takeovers. See Hall and Soskice, note 1.
25
What Forces Shape Corporate Law?
25
Nor indeed does saying that the pursuit of social welfare is the appropriate goal of
corporate law imply that corporate law always does serve that goal. Understanding how
corporate law comes to pursue particular goals is a question of political economy—​that
is, the political and economic forces that shape lawmaking.94 The political economy
of corporate law generally reflects the interests of influential constituencies, such as
controlling shareholders, corporate managers, or organized workers. In the presence of
competitive markets, these interests often coalesce on welfare-​enhancing laws, produ­
cing the “efficiency” effect on corporate law. Yet in some circumstances, lawmakers pay
undue regard to the interests of particular constituencies, a fondness for which might
be termed a “political” effect on corporate law.
Another political effect is the phenomenon of populist reforms after a scandal or crisis.
In the period after a crisis, lawmakers feel strong pressure from the electorate to implement reforms, the content of which is determined by what appeals generally, which may
be quite different from what will actually solve the underlying economic problems.95
The extent to which there is a divergence is another political effect on corporate law.
Corporate law everywhere continues to bear the imprint of the historical path through
which it has evolved, reflecting both political and efficiency effects along the way.
Reforms triggered by the recent financial crisis illustrate both efficiency and political
concerns. In the immediate aftermath of the crisis, many asked whether it did not call
into question effectiveness of corporate law in promoting social welfare.96 As the dust
settled, it became tolerably clear—​at least to us—​that the implications of the crisis
were mostly confined to the governance regimes applicable to banks and other financial institutions,97 which have an unusual degree of interconnection and propensity
to contagion. Consequently, there are good functional reasons for introducing special
regimes for bank governance that differ from ordinary business firms. However, some
post-​crisis reforms have been more general in their scope—​which may be understood
as reflecting populist political concerns triggered by the crisis.98
We touch here briefly on perhaps the most conspicuous of the various forces that
help shape—​and, in turn, are shaped by—​corporate law: the pattern of corporate ownership. The nature and number of corporate shareholders differ markedly even among
the most developed market economies. In recent years, the extent of these differences
has lessened, but their historic and remaining contours surely leave a mark on the
structure of corporate law. Its relevance for our account is twofold: ownership structure
affects the functionality of different legal strategies, and also the interest group dynamics that govern changes in corporate law.
In the U.S. and the UK, there are large numbers of publicly traded corporations
that have dispersed share ownership, such that no single shareholder, or affiliated group
of shareholders, is capable of exercising control over the firm.99 Shareholdings among
94 See e.g. Mark J. Roe, Political Determinants of Corporate Governance (2003); Peter A.
Gourevitch and James Shinn, Political Power and Corporate Control (2005).
95 See Pepper D. Culpepper, Quiet Politics and Business Power (2011).
96 For a discussion of the goals of corporate law, see Section 1.5.
97 See Armour and Gordon, note 49; Armour et al., note 6, ch 17.
98 See e.g. Roberta Romano, Regulating in the Dark, 1 Journal of Financial Perspectives 23
(2013).
99 Rafael La Porta, Florencio Lopez-​de-​Silanes, and Andrei Shleifer, Corporate Ownership Around
the World, 54 Journal of Finance 471, 492–​3 (1999); Mara Faccio and Larry H.P. Lang, The
Ultimate Ownership of Western European Corporations, 65 Journal of Financial Economics 365,
379–​80 (2002). But see Clifford G. Holderness, The Myth of Diffuse Ownership in the United States,
22 Review of Financial Studies 1377 (2009).
26
26
What Is Corporate Law?
major Japanese firms are also often highly dispersed,100 though in the second half of
the twentieth century it was common for a substantial fraction of a firm’s stock to be
held by other firms in a loose group with substantial reciprocal cross-​shareholdings.101
In our other jurisdictions, in contrast, even firms with publicly trading shares have
traditionally had a controlling shareholder, in the form of another firm often at the top
of a closely coordinated group of other firms,102 individuals, families, or the state.103
The types of entities by or through which non-​controlling stakes are held also differ substantially from one country to another. The U.S. traditionally had high levels
of ownership by retail investors. In contrast, UK stock ownership in the late twentieth
century was dominated by institutional investors—​primarily domestic pension funds
and insurance companies.104 In Germany, large commercial banks traditionally held
substantial blocks of shares on their own account, and also served as custodians for
large amounts of stock owned by individuals, whose votes were often effectively exercised by the banks themselves.105
However, this pattern has changed in recent years. A secular growth in assets under
management by U.S. institutional investors—​principally mutual funds and employer-​
established pension funds106—​means their ownership of stock now dwarves that of
retail investors. This growth has also led U.S. institutions to invest in other stock markets around the world. Thus in the UK, domestic institutions have, since the turn of the
century, ceded ownership of the majority of stock to international investors, thought
to be mainly U.S. institutions.107 In Germany, many large companies also now have
a majority of foreign shareholders. And even elsewhere international investors hold a
substantial chunk of listed companies’ free float. While there is a certain degree of convergence in ownership structures across jurisdictions, there is arguably greater variance
in the shareholding patterns of different firms within any given jurisdiction.
The past two decades have also seen the rise of new types of institutional investor.
Conspicuous among these are hedge funds and private equity funds. Hedge funds are
100 By some accounts, share ownership in Japanese publicly held corporations is more dispersed
than in the U.S.: see Holderness, note 99; Julian Franks, Colin Mayer, and Hideaki Miyajima, The
Ownership of Japanese Corporations in the 20th Century, 27 Review of Financial Studies 2580
(2014).
101 See Tokyo Stock Exchange, 2013 Share Ownership Survey, 4 (2014); Franks et al.,
note 100, at 29–​40. For recent unwinding of cross-​shareholdings, see Gen Goto, Legally “Strong”
Shareholders of Japan, 3 Michigan Journal of Private Equity and Venture Capital 125, 144–​6
(2014).
102 However, there are indications that the traditional position in some jurisdictions, notably
Germany, is starting to change in favor of more dispersed stock ownership: see Steen Thomsen,
Convergence of Corporate Governance during the Stock Market Bubble: Towards Anglo-​American or
European Standards? in Corporate Governance and Firm Organization 297, 306–​12 (Anna
Grandori ed., 2004); Wolf-​Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate
Governance and the Erosion of Deutschland AG, 63 American Journal of Comparative Law 493
(2015).
103 See Alexander Aganin and Paolo Volpin, The History of Corporate Ownership in Italy, in A
History of Corporate Governance Around the World (Randall K. Morck ed., 2005); Mariana
Pargendler, State Ownership and Corporate Governance, 80 Fordham Law Review 2917 (2012); Aldo
Musacchio and Sergio Lazzarini, Reinventing State Capitalism: Leviathan in Business, Brazil
and Beyond (2014).
104 See Geof P. Stapledon, Institutional Shareholders and Corporate Governance (1996).
105 See e.g. Ralf Elsas and Jan P. Krahnen, Universal Banks and Relationships with Firms, in The
German Financial System 197 (Jan P. Krahnen and Reinhard H. Schmidt eds., 2006). See also
sources cited note 102.
106 Board of Governors of the Federal Reserve System, Flow of Funds Accounts in the United
States: Annual Flows and Outstandings, 2005–​13, 98 (Table L.213) (2014).
107 Office for National Statistics (UK), Ownership of UK Quoted Shares, 2013 (2014).
27
What Forces Shape Corporate Law?
27
relatively unregulated collective investment funds which, despite their name, often
adopt highly speculative strategies including purchasing substantial stakes in individual firms,108 and sometimes agitate for major changes in the firms’ structure, strategy,
or management. Private equity firms, in turn, are (typically) investment vehicles that
acquire, at least temporarily, control, and then complete ownership of formerly public
companies to effect major changes in the firms’ structure, strategy, or management.109
We have also seen the proliferation of state-​controlled institutional investors, such as
sovereign wealth funds.
Plausibly, differences in patterns of shareholding across countries correlate with differences in the structure of corporate law. An influential series of empirical studies
on “law and finance” reported that, at the end of the twentieth century, countries
with greater legal protection for shareholders (against opportunism by managers and
controlling shareholders) had less concentrated shareholdings,110 although subsequent
studies found the results to be sensitive to the way in which “protection” is measured.111
Such a pattern is consistent with both changes in the configuration of interest groups
who call for changes in corporate laws, and changes in the types of corporate law rules
that yield functional outcomes.
To some extent, therefore, the structure of corporate law in any given country is a
consequence of that country’s pattern of corporate ownership. This in turn is determined
at least in part by forces exogenous to corporate law.112 It has been argued, for example,
that the traditionally retail-​oriented pattern of U.S. shareholdings was a product of that
country’s history of populist politics, which generated a number of policies successfully designed to frustrate family and institutional control of industrial enterprise.113
Correspondingly, it is said that the traditionally more concentrated share ownership patterns in continental Europe and Japan complemented particular patterns of industrial
development.114 On this view, a controlling shareholder may, under certain circumstances, be better placed to make credible long-​term commitments to employees, which
in turn may facilitate labor relations—​and hence productivity—​where the goal is to
motivate workers to use existing technology, rather than to develop new technologies.115
108 Marcel Kahan and Edward B. Rock, Hedge Funds in Corporate Governance and Corporate
Control, 155 University of Pennsylvania Law Review 1021 (2007); Ronald J. Gilson and Jeffrey
N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance
Rights, 113 Columbia Law Review 863 (2013).
109 See Brian R. Cheffins and John Armour, The Eclipse of Private Equity, 33 Delaware Journal
of Corporate Law 1 (2008); Viral V. Acharya, Oliver F. Gottschalg, and Moritz Hahn, Corporate
Governance and Value Creation: Evidence from Private Equity, 26 Review of Financial Studies 368
(2013).
110 For a review, see Rafael La Porta, Florencio Lopez-​de-​Silanes, and Andrei Shleifer, The Economic
Consequences of Legal Origins, 46 Journal of Economic Literature 285 (2008).
111 See Sofie Cools, The Real Difference in Corporate Law Between the United States and Continental
Europe: Distribution of Powers, 30 Delaware Journal of Corporate Law 697 (2005); John Armour,
Simon Deakin, Prabirjit Sarkar, and Ajit Singh, Shareholder Protection and Stock Market Development:
An Empirical Test of the Legal Origins Hypothesis, 2 Journal of Empirical Legal Studies 343 (2009);
Holger Spamann, The “Antidirector Rights Index” Revisited, 23 Review of Financial Studies 467
(2010).
112 Brian R. Cheffins, Does Law Matter? The Separation of Ownership and Control in the United
Kingdom, 30 Journal of Legal Studies 459 (2001); John C. Coffee, Jr., The Rise of Dispersed
Ownership: The Roles of Law and the State in the Separation of Ownership and Control, 111 Yale Law
Journal 1 (2001).
113 Mark J. Roe, Strong Managers, Weak Owners (1994).
114 See Wendy Carlin and Colin Mayer, Finance, Investment and Growth, 69 Journal of Financial
Economics 191 (2003).
115 See Hall and Soskice, note 1; Barry Eichengreen, Europe’s Economy Since 1945 (2006);
Colin Mayer, Firm Commitment (2013). Compare also Chapter 4.4.1.
28
28
What Is Corporate Law?
This is principally a book about the structure and functions of corporate law, not
about its origins. Nonetheless, in the chapters that follow we will here and there
explore, briefly and somewhat speculatively, the influence of ownership structure—​
and of other forces as well—​in shaping the patterns of corporate law that we see
across jurisdictions.
29
2
Agency Problems and Legal Strategies
John Armour, Henry Hansmann, and Reinier Kraakman
2.1 Three Agency Problems
As we explained in Chapter 1,1 corporate law performs two general functions: first, it
establishes the structure of the corporate form as well as ancillary housekeeping rules
necessary to support this structure; second, it attempts to control conflicts of interest
among corporate constituencies, including those between corporate “insiders,” such as
controlling shareholders and top managers, and “outsiders,” such as minority shareholders or creditors. These conflicts all have the character of what economists refer to
as “agency problems” or “principal-​agent” problems. For readers unfamiliar with the
jargon of economists, an “agency problem”—​in the most general sense of the term—​
arises whenever one party, termed the “principal,” relies upon actions taken by another
party, termed the “agent,” which will affect the principal’s welfare. The problem lies in
motivating the agent to act in the principal’s interest rather than simply in the agent’s
own interest. Viewed in these broad terms, agency problems arise in a broad range of
contexts that go well beyond those that would formally be classified as agency relationships by lawyers.
In particular, almost any contractual relationship, in which one party (the
“agent”) promises performance to another (the “principal”), is potentially subject to
an agency problem. The core of the difficulty is that, because the agent commonly
has better information than does the principal about the relevant facts, the principal cannot easily assure himself that the agent’s performance is precisely what was
promised. As a consequence, the agent has an incentive to act opportunistically,2
skimping on the quality of his performance, or even diverting to himself some
of what was promised to the principal. This means, in turn, that the value of the
agent’s performance to the principal will be reduced, either directly or because, to
assure the quality of the agent’s performance, the principal must engage in costly
monitoring of the agent. The greater the complexity of the tasks undertaken by
the agent, and the greater the discretion the agent must be given, the larger these
“agency costs” are likely to be.3
As we noted in Chapter 1, three generic agency problems arise in business firms. The
first involves the conflict between the firm’s owners and its hired managers. Here the
owners are the principals and the managers are the agents. The problem lies in assuring
1 See Chapter 1.1.
2 We use the term “opportunism” here, following the usage of Oliver Williamson, to refer to self-​
interested behavior that involves some element of guile, deception, misrepresentation, or bad faith.
See Oliver Williamson, The Economic Institutions of Capitalism 47–​9 (1985).
3 See e.g. Steven Ross, The Economic Theory of Agency: The Principal’s Problem, 63 American
Economic Review 134 (1973); Principals and Agents: The Structure of Business (John W.
Pratt and Richard J. Zeckhauser eds., 1984).
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry
Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock.
Chapter 2 © John Armour, Henry Hansmann, and Reinier Kraakman, 2017. Published 2017 by Oxford University Press.
30
30
Agency Problems and Legal Strategies
that the managers are responsive to the owners’ interests rather than pursuing their
own personal interests.
The second agency problem involves the conflict between, on one hand, owners
who possess the majority or controlling interest in the firm and, on the other hand, the
minority or noncontrolling owners. Here the noncontrolling owners can be thought
of as the principals and the controlling owners as the agents, and the difficulty lies
in assuring that the former are not expropriated by the latter. While this problem is
most conspicuous in tensions between majority and minority shareholders,4 it appears
whenever some subset of a firm’s owners can control decisions affecting the class of
owners as a whole. Thus if minority shareholders enjoy veto rights in relation to particular decisions, it can give rise to a species of this second agency problem. Similar problems can arise between ordinary and preference shareholders, and between senior and
junior creditors in bankruptcy (when creditors are the effective owners of the firm).
The third agency problem involves the conflict between the firm itself—​including,
particularly, its owners—​and the other parties with whom the firm contracts, such as
creditors, employees, and customers. Here the difficulty lies in assuring that the firm, as
agent, does not behave opportunistically toward these various other principals—​such
as by expropriating creditors, exploiting workers, or misleading consumers. In addition
to these agency problems—​which we view as fundamentally voluntary in nature—​
there are also situations where a firm imposes costs on parties who do not contract
with it—​so-​called “externalities.” We treat these issues specifically in Chapters 4 and 5.
In each of the foregoing problems, the challenge of assuring agents’ responsiveness
is greater where there are multiple principals—​and especially so where they have diver­
ging interests, or “heterogeneous preferences” as economists say. Multiple principals
will face information and coordination costs, which will inhibit their ability to engage in
collective action.5 These in turn will interact with agency problems in two ways. First,
difficulties of coordinating between principals will lead them to delegate more of their
decision-​making to agents.6 Second, the more difficult it is for principals to coordinate
on a single set of goals for the agent, the harder it is to ensure that the agent does the
“right” thing.7 Coordination costs as between principals thereby exacerbate agency
problems.
Law can play an important role in reducing agency costs. Obvious examples are rules
and procedures that enhance disclosure by agents or facilitate enforcement actions
brought by principals against dishonest or negligent agents. Paradoxically, mechanisms
that impose constraints on agents’ ability to exploit their principals tend to benefit
agents as much as—​or even more than—​they benefit the principals. The reason is that
a principal will be willing to offer greater compensation to an agent when the principal
is assured of performance that is honest and of high quality. To take a conspicuous
example in the corporate context, rules of law that protect creditors from opportunistic
behavior on the part of corporations should reduce the interest rate that corporations
4 These problems become more severe the smaller the degree of ownership of the firm that is
enjoyed by the controlling shareholder. See Luca Enriques and Paolo Volpin, Corporate Governance
Reforms in Continental Europe, 21 Journal of Economic Perspectives 117, 122–​5 (2007).
5 Classic statements of this problem are found in James M. Buchanan and Gordon Tullock, The
Calculus of Consent 63–​116 (1962) and Mancur Olsen, The Logic of Collective Action
(1965).
6 Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law
66–​7 (1991).
7 See Hideki Kanda, Debtholders and Equityholders, 21 Journal of Legal Studies 431, 440–​1,
444–​5 (1992); Henry Hansmann, The Ownership of Enterprise 39–​44 (1996).
31
Legal Strategies for Reducing Agency Costs
31
must pay for credit, thus benefiting corporations as well as creditors. Likewise, legal
constraints on the ability of controlling shareholders to expropriate minority shareholders should increase the price at which shares can be sold to noncontrolling shareholders, hence reducing the cost of outside equity capital for corporations. And rules
of law that inhibit insider trading by corporate managers should increase the compensation that shareholders are willing to offer the managers. In general, reducing agency
costs is in the interests of all parties to a transaction, principals and agents alike.
It follows that the normative goal of advancing aggregate social welfare, as discussed
in Chapter 1,8 is generally equivalent to searching for optimal solutions to the corporation’s agency problems, in the sense of finding solutions that maximize the aggregate
welfare of the parties involved—​that is, of both principals and agents taken together.
2.2 Legal Strategies for Reducing Agency Costs
In addressing agency problems, the law turns repeatedly to a basic set of strategies. We
use the term “legal strategy” to mean a generic method of deploying law instrumentally
in a functional way—​the function in this context being to mitigate the vulnerability
of principals to the opportunism of their agents. A rule of law implementing a legal
strategy may be, as discussed in Chapter 1, either a mandatory or a default rule, or
one among a menu of alternative rules.9 Indeed, most such strategies do not necessarily require generally applicable legal norms for their implementation: a practice of
contracting may be an effective substitute, or contracts may complement a general rule
by tailoring it to particular circumstances. We observed in Chapter 1 that, of the five
defining characteristics of the corporate form, only one—​legal personality—​clearly
requires special rules of law.10 The other characteristics could, in principle, be adopted
by contract—​for example, through appropriate provisions in the articles of association
agreed to by the firm’s owners.11 The same is true of the various strategies we set out
in this section.12 It follows that the contribution of “the law” in implementing legal
strategies will vary depending on the strategy in question.
Legal strategies for controlling agency costs can be loosely categorized into two subsets, which we term, respectively, “regulatory strategies” and “governance strategies.”
Regulatory strategies are prescriptive: they dictate substantive terms that govern the
content of the principal-​agent relationship, tending to constrain the agent’s behavior
directly. By contrast, governance strategies seek to facilitate the principals’ control over
their agent’s behavior.13
The efficacy of governance strategies depends crucially on the ability of the principals to exercise their control rights. Coordination costs between principals will
make it more difficult for them either to monitor the agent so as to determine the
8 See Chapter 1.5.
9 See the discussion of the various forms that rules can take in Chapter 1.3–​1.4.
10 See Chapter 1.2.1.
11 Law can, however, provide useful assistance to parties in relation to these other characteristics
through the provision of “standard forms.” See Chapter 1.4.1.
12 For evidence on the role of contractual solutions to agency problems adopted by individual
firms, see Paul Gompers, Joy Ishii, and Andrew Metrick, Corporate Governance and Equity Prices, 118
Quarterly Journal of Economics 107 (2003); Lucian Bebchuk, Alma Cohen, and Allen Ferrell,
What Matters in Corporate Governance? 22 Review of Financial Studies 783 (2009).
13 An alternative labelling would therefore be a distinction between “agent-​constraining” and
“principal-​empowering” strategies.
32
32
Agency Problems and Legal Strategies
Table 2–​1 Legal Strategies for Protecting Principals
Ex Ante
Ex Post
Agent
Constraints
Affiliation
Terms
Incentive
Alignment
Appointment
Rights
Decision
Rights
Rules
Standards
Entry
Exit
Trusteeship
Reward
Selection
Removal
Initiation
Veto
appropriateness of her actions, or to decide whether, and how, to take action to sanction nonperformance. High coordination costs thus render governance strategies less
successful in controlling agents, and—​other things equal—​make regulatory strategies
more attractive.
Regulatory strategies have different preconditions for success. Most obviously,
they depend for efficacy on the ability of an external authority—​a court or regulatory body—​with sufficient expertise to determine whether or not the agent complied
with particular prescriptions. To be sure, governance strategies rely too on legal institutions to protect the principals’ decision-​making entitlements as respects corporate
assets—​that is, their “property rights.”14 But governance strategies themselves do not
specify appropriate courses of action. Specification of agents’ required behavior also
presupposes effective disclosure mechanisms to ensure that information about the
actions of agents can be “verified” by the relevant external body. In contrast, governance strategies—​where the principals are able to exercise them usefully—​require for
effective decisions only that the principals themselves are able to observe the actions
taken by the agent, for which purpose “softer” information may suffice.
Table 2–​1 sets out ten legal strategies which, taken together, span the law’s principal
methods of dealing with agency problems. These strategies are not limited to the corporate context; they can be deployed to protect nearly any vulnerable principal-​agent
relationship. Our focus here, however, is naturally on the ways that these strategies are
deployed in corporate law. At the outset, we should emphasize that the aim of this exercise is not to provide an authoritative taxonomy, but simply to offer a heuristic device
for thinking about the functional role of law in corporate affairs. As a result, the various strategies are not entirely discrete but sometimes overlap, and our categorization
of these strategies does not correlate perfectly with corporate law doctrine. Moreover,
their use in practice is not mutually exclusive: they may be applied, as appropriate, in
combination or individually.
2.2.1 Rules and standards
The most familiar pair of regulatory strategies constrains agents by commanding
them not to take courses of action that would harm the interests of their principals.
Lawmakers can frame such constraints as rules, which require or prohibit specific
behaviors, or as general standards, which leave the precise determination of compliance
to adjudicators after the fact.
Both rules and standards attempt to regulate the substance of agency relationships
directly. Rules, which prescribe specific behaviors ex ante,15 are commonly used in the
14 See Oliver D. Hart, Incomplete Contracts and the Theory of the Firm, 4 Journal of Law,
Economics, and Organization 119, at 123–​5 (1988).
15 For the canonical comparison of the merits of rules and standards as regulatory techniques,
see Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 Duke Law Journal 557 (1992).
33
Legal Strategies for Reducing Agency Costs
33
corporate context to protect a corporation’s creditors and public investors. Thus corporation statutes universally include creditor protection rules such as dividend restrictions, minimum capitalization requirements, or rules requiring action to be taken
following serious loss of capital.16 Similarly, capital market authorities frequently promulgate detailed rules to govern takeovers and proxy voting.17
By contrast, few jurisdictions rely solely on rules for regulating complex, intra-​
corporate relations, such as, for example, self-​dealing transactions initiated by controlling shareholders. Such matters are presumably too complex to regulate with just
a matrix of prohibitions and exemptions, which would threaten to codify loopholes
and create pointless rigidities. Rather than rule-​based regulation, then, intra-​corporate
topics such as insider self-​dealing tend to be governed by open standards that leave
discretion for adjudicators to determine ex post whether violations have occurred.18
Standards are also used to protect creditors and public investors, but the paradigmatic
examples of standards-​based regulation relate to the company’s internal affairs, as when
the law requires directors to act in “good faith” or mandates that self-​dealing transactions be “entirely fair.”19
The efficacy of both rules and standards depends in large measure on the vigor with
which they are enforced. In principle, rules can be mechanically enforced, but require
effort to be invested ex ante by rule-​making bodies to ensure they are appropriately
drafted. Standards, in contrast, require courts (or other adjudicators) to become more
deeply involved in evaluating and sometimes molding corporate decisions ex post.20
These decisions themselves then prescribe the standard to future parties, over time
building up to a body of guidance.
2.2.2 Setting the terms of entry and exit
A second set of regulatory strategies open to the law involve regulating the terms
on which principals affiliate with agents rather than—​as with rules and standards—​
regulating the actions of agents after the principal-​agent relationship is established.
The law can dictate terms of entry by, for example, requiring agents to disclose information about the likely quality of their performance before contracting with principals.21
Alternatively, the law can prescribe exit opportunities for principals, such as awarding
to a shareholder the right to sell her stock, or awarding to a creditor the right to call
for repayment of a loan. In publicly traded companies, the way in which these strategies are deployed affects directly the operation of capital markets and the market for
corporate control.
The entry strategy is particularly important in screening out opportunistic agents
in the public capital markets.22 Outside investors know little about public companies
unless they are told. Thus, it is widely accepted that public investors require some
16 See Chapter 5.2.2.
17 See e.g. Chapter 8.1.2.4 (takeovers) and Chapter 3.2.4 (proxy voting).
18 See Chapter 6.2.5. This is not to say that rules are wholly absent from such situations: some
jurisdictions regulate forms of self-​dealing judged to merit particular suspicion through rules in combination with a more general standards strategy.
19 See Chapter 6.2.5.
20 In this sense, standards lie between rules (which simply require a decision-​maker to determine
compliance) and another strategy that we will address below—​the trusteeship strategy, which requires
a neutral decision-​maker to exercise his or her own good faith best judgment in making a corporate
decision.
21 See Chapter 5.2.1 and Chapter 9.1.2.
22 See Chapter 9.1.2.
34
34
Agency Problems and Legal Strategies
form of systematic disclosure to obtain an adequate supply of information. Legal rules
mandating such disclosure provide an example of an entry strategy because stocks
cannot be sold unless the requisite information is supplied, generally by the corporation itself.23 A similar but more extreme form of the entry strategy is a requirement
that the purchasers of certain securities meet a threshold of net worth or financial
sophistication.24
The exit strategy, which is also pervasive in corporate law, allows principals to escape
opportunistic agents. Broadly speaking, there are two kinds of exit rights. The first is
the right to withdraw the value of one’s investment. The best example of such a right
in corporate law is the technique, employed in some jurisdictions, of awarding an
appraisal right to shareholders who dissent from certain major transactions such as
mergers.25 As we discuss in Chapter 7,26 appraisal permits shareholders who object to
a significant transaction to claim the value that their shares had prior to the disputed
transaction—​thus avoiding a prospective loss if, in their view, the firm has made a
value-​reducing decision.
The second type of exit right is the right of transfer—​the right to sell shares—​which is
of obvious importance to public shareholders. (Recall that transferability of shares is a
core characteristic of the corporate form.) Standing alone, a transfer right provides less
protection than a withdrawal right, since an informed transferee steps into the shoes of
the transferor, and will therefore offer a price that impounds the expected future loss
of value from insider mismanagement or opportunism. But the transfer right permits
the replacement of the current shareholder/​principal(s) by a new one that may be more
effective in controlling the firm’s management. Thus, unimpeded transfer rights allow
hostile takeovers in which the disaggregated shareholders of a mismanaged company
can sell their shares to a single active shareholder with a strong financial interest in
efficient management.27 Such a transfer of control rights, or even the threat of it, can
be a highly effective device for disciplining management.28 Moreover, transfer rights
are a prerequisite for stock markets, which also empower disaggregated shareholders by
providing a continuous assessment of managerial performance (among other things) in
23 The role of disclosure rules in facilitating entry is most intuitive in relation to prospectus disclosure for initial public offerings, and new issues of seasoned equity. Ongoing disclosure rules may
to some extent also facilitate entry, by new shareholders in the secondary market, while at the same
time facilitating exit by existing shareholders—​an example of a single set of rules implementing more
than one strategy. However, the function of ongoing disclosure rules is more general: see Section 2.3
and Chapter 9.1.2.
24 See Chapter 9.1.2.4.
25 The withdrawal right is a dominant governance device for the regulation of some non-​corporate
forms of enterprise such as the common law partnership at will, which can be dissolved at any time
by any partner. Business corporations sometimes grant similar withdrawal rights to their shareholders
through special charter provisions. The most conspicuous example is provided by open-​ended investment companies, such as mutual funds in the U.S., which are frequently formed as business corporations under the general corporation statutes. The universal default regime in corporate law, however,
provides for a much more limited set of withdrawal rights for shareholders, and in some jurisdictions
none at all. See John Morley and Quinn Curtis, Taking Exit Rights Seriously: Why Governance and Fee
Litigation Don’t Work in Mutual Funds, 120 Yale Law Journal 84 (2010).
26 See Chapter 7.2.2, 7.4.1.2.
27 Many firms introduce contractual provisions which serve to restrict transfer rights, such as “poison pills”: see Bebchuk et al., note 12. Some jurisdictions impose limits on the extent to which transfer
rights may be impeded. An example is the EU’s “breakthrough rule” for takeovers, implemented in a
few European countries. See Chapter 8.4.2.2.
28 Viewed this way, of course, legal rules that enhance transferability serve not just as an instance of
the exit strategy but, simultaneously, as an instance of the entry strategy and incentive strategy as well.
The same legal device can serve multiple protective functions.
35
Legal Strategies for Reducing Agency Costs
35
the form of share prices.29 Mandated disclosure also assists with this version of the exit
strategy, by increasing transparency for existing investors and potential bidders about
whether the company is underperforming under its current management team.30
2.2.3 Trusteeship and reward
Thus far we have described regulatory strategies that might be extended for the protection of vulnerable parties in any class of contractual relationships. We now move to
strategies that relate to the hierarchical elements of the principal-​agent relationship.
We consider first incentive alignment strategies, which straddle the boundary between
regulatory and governance strategies.
The first incentive alignment strategy—​the trusteeship strategy—​seeks to remove
conflicts of interest ex ante to ensure that an agent will not obtain personal gain
from disserving her principal. In many contexts—​including its origin in the role of a
“trustee” proper—​this involves a regulatory strategy, which does not define what the
agent can do, but rather what she can’t do.31 This strategy assumes that, in the absence
of strongly focused—​or “high-​powered”—​monetary incentives to behave opportunistically, agents will respond to the “low-​powered” incentives of conscience, pride, and
reputation,32 and are thus more likely to manage in the interests of their principals.
One well-​known example of the trusteeship strategy is the “independent director,”
now relied upon in many jurisdictions to monitor management. Such directors will
not personally profit from actions that disproportionately benefit the firm’s managers or controlling shareholders, and hence are expected to be guided more strongly
by conscience and reputation in making decisions.33 Similarly, reliance on auditors
to approve financial statements and certain corporate transactions is also an example
of trusteeship, provided the auditors are motivated principally by reputational concerns.34 In certain circumstances other agents external to the corporation may be called
29 See James Dow and Gary Gorton, Stock Market Efficiency and Economic Efficiency: Is There a
Connection? 52 Journal of Finance 1087 (1997). And see Chapter 9.1.1.
30 See John Armour and Brian Cheffins, Stock Market Prices and the Market for Corporate Control,
2016 University of Illinois Law Review 101 (2016).
31 See Matthew Conaglen, Fiduciary Loyalty: Protecting the Due Performance of Non-​
Fiduciary Duties (2010).
32 We use the terms “high-​powered incentives” and “low-​powered incentives” as they are conventionally used in the economics literature, to refer to the distinction between economic incentives on
the one hand and ethical or moral incentives on the other. These correspond to some degree with the
distinction drawn in the psychology literature between “extrinsic” (instrumental) and “intrinsic” (for an
activity’s own sake) motivation. Economic incentives are high-​powered in the sense that they are concrete and sharply focused. See e.g. Williamson, note 2, 137–​41; Bengt Hölmstrom and Paul Milgrom,
The Firm as an Incentive System, 84 American Economic Review 972 (1994). By referring to moral
norms as “low-​powered” incentives we do not mean to imply that they are generally less important in
governing human behavior than are monetary incentives. Surely, for most individuals in most circumstances, the opposite is true, and civilization would not have come very far if this were not the case.
33 On the reputational consequences for independent directors of poor performance, see David
Yermack, Remuneration, Retention, and Reputation Incentives for Outside Directors, 54 Journal of
Finance 2281 (2004); Eliezer M. Fich and Anil Shivdasani, Financial Fraud, Director Reputation,
and Shareholder Wealth, 86 Journal of Financial Economics 306 (2007); Ronald W. Masulis and
Shawn Mobbs, Independent Director Incentives: Where do Talented Directors Spend their Limited Time
and Energy? 111 Journal of Financial Economics 406 (2014).
34 While auditors face reputational sanctions for failure (see e.g. Jan Barton, Who Cares About
Auditor Reputation? 22 Contemporary Accounting Research 549 (2005)), their independence
and hence trustee status may be compromised by financial incentives in the form of consulting contracts: see John C. Coffee, What Caused Enron? A Capsule Social and Economic History of the 1990s, 89
Cornell Law Review 269, 291–​3 (2004).
36
36
Agency Problems and Legal Strategies
upon to serve as trustees, as when the law requires an investment banker, a state official,
or a court to approve corporate action.
The second incentive strategy is the reward strategy, which—​as the name implies—​
rewards agents for successfully advancing the interests of their principals. Broadly
speaking, there are two major reward mechanisms in corporate law. The more common
form of reward is a sharing rule that motivates loyalty by tying the agent’s monetary
returns directly to those of the principal. A conspicuous example is the protection that
minority shareholders enjoy from the equal treatment norm, which requires a strictly
pro rata distribution of dividends.35 As a consequence of this rule, controlling shareholders—​here the “agents”—​have an incentive to maximize the returns of the firm’s
minority shareholders—​here the “principals”—​at least to the extent that corporate
returns are paid out as dividends.
The reward mechanism less commonly the focus of corporate law is the pay-​for-​
performance regime, in which an agent, although not sharing in his principal’s returns,
is nonetheless paid for successfully advancing her interests. Even though no jurisdiction imposes such a scheme on shareholders, legal rules often either facilitate or discourage high-​powered incentives of this sort.36 American law, for example, has actively
encouraged incentive compensation devices such as stock option plans,37 while more
skeptical jurisdictions seek to restrict their use.38 Because of the peculiarly firm-​specific
(and even executive-​specific) nature of pay-​for-​performance packages, this reward
strategy is typically implemented by contract. The process of writing such contracts is
itself potentially susceptible to agency costs.39 In a development that illustrates how
multiple legal strategies may be deployed in combination, many jurisdictions have in
recent years prescribed decision rights regarding this process, typically granting shareholders a type of veto over compensation proposals, known as “say on pay.”40
There is potential for tension between trusteeship and reward. High-​caliber agents
will not adopt trusteeship roles without meaningful payment. Yet trustee compensation arrangements require careful thought, because they can generate high-​powered
incentives that weaken or even overpower low-​powered incentives.41 Heavy reliance
on stock options, for example, encourages risk-​taking, whereas the payment of a large
fixed stipend may discourage critical engagement. Neither approach would be desirable in a trustee. The key is therefore to ensure that trustees are paid enough to make
their role worth doing, but not so much as to sideline low-​powered incentives.42
35 See Chapter 4.1.3.2. On rules requiring pro rata sharing of takeover premia see Chapter 8.3.3
and 8.3.4.
36 See Chapter 3.3.2.
37 U.S. tax law has since 1993 limited the tax-​deductibility of executive compensation to a maximum of $1m per annum, except so far as payments are “performance based” (IRC §162(m)). This
greatly encouraged the use of incentive compensation: see Brian J. Hall and Kevin J. Murphy, The
Trouble with Stock Options, 17 Journal of Economic Perspectives 49 (2003).
38 See e.g. European Commission, Recommendation 2009/​
3177/​
EC on Strengthening the
Regime for the Remuneration of Directors of Listed Companies.
39 See Lucian Bebchuk and Jesse Fried, Pay Without Performance: The Unfulfilled Promise
of Executive Compensation (2004).
40 See Chapter 3.3.2 and Chapter 6.2.3.
41 See e.g. Bruno S. Frey and Felix Oberholzer-​Gee, The Cost of Price Incentives: An Empirical
Analysis of Motivation Crowding-​Out, 87 American Economic Review 746 (1997). The sorry saga
of the banking sector provides a salient illustration: see Alain Cohn, Ernst Fehr, and Michel André
Maréchal, Business Culture and Dishonesty in the Banking Industry, 516 Nature 86 (2014).
42 See e.g. Yermack, note 33, at 2286–​9 (outside directors of U.S. firms commonly receive stock
and option awards, but with a pay-​performance sensitivity much lower than for executives).
37
Legal Strategies for Reducing Agency Costs
37
2.2.4 Selection and removal
Given the central role of delegated management in the corporate form, it is no surprise that appointment rights—​the power to select or remove directors (or other man­
agers)—​are key strategies for controlling the enterprise. Indeed, these strategies are
at the very core of corporate governance. As we will discuss in Chapters 3 and 4,
moreover, the power to appoint directors is a core strategy not only for addressing the
agency problems of shareholders in relation to managers, but also, in some jurisdictions, for addressing agency problems of minority shareholders in relation to controlling shareholders, and of employees in relationship to the shareholder class as a whole.
2.2.5 Initiation and ratification
The final pair of legal strategies expands the power of principals to intervene in the
firm’s management. These are decision rights, which grant principals the power to initiate or ratify management decisions. Again, it is no surprise that this set of decision
rights strategies is much less prominent in corporate law than are appointment rights
strategies. This disparity is a logical consequence of the fact that the corporate form
is designed as a vehicle for the delegation of managerial power and authority to the
board of directors. Only the largest and most fundamental corporate decisions (such as
mergers and charter amendments) require the ratification of shareholders under existing corporation statutes, and no jurisdiction to our knowledge requires shareholders to
initiate managerial decisions.43
2.2.6 Ex post and ex ante strategies
The bottom rows in Table 2–​1 arrange our ten legal strategies into five pairs, each
with an “ex ante” and an “ex post” strategy. This presentation merely highlights the
fact that half of the strategies take full effect before an agent acts, while the other half
respond—​at least potentially—​to the quality of the agent’s action ex post. In the case
of agent constraints, for example, rules specify what the agent may or may not do ex
ante, while standards specify the general norm against which an agent’s actions will be
judged ex post. Thus, a rule might prohibit a class of self-​dealing transactions outright,
while a standard might mandate that these transactions will be judged against a norm
of fairness ex post.44 Similarly, in the case of setting the terms of entry and exit, an
entry strategy, such as mandatory disclosure, specifies what must be done before an
agent can deal with a principal, while an exit device such as appraisal rights permits
the principal to respond after the quality of the agent’s action is revealed.45 Turning to
incentive alignment, trusteeship is an ex ante strategy in the sense that it neutralizes an
agent’s adverse interests prior to her appointment by the principal, while most reward
strategies are ex post in the sense that their payouts are contingent on uncertain future
outcomes, and thus remain less than fully specified until after the agent acts.
The appointment and removal strategies also fall into ex ante and ex post pairs. If
principals can appoint their agents ex ante, they can screen for loyalty; if principals can
43 See Chapter 3.2.3. The utility, for reducing agency costs, of separating the initiation of decisions from their ratification was first emphasized by Eugene Fama and Michael Jensen, Separation of
Ownership and Control, 26 Journal of Law and Economics 301 (1983).
44 Compare Chapter 6.2.4 (ex ante prohibitions) and 6.2.5 (ex post standards).
45 Compare e.g. Chapters 5.2.1, 6.2.1.1, 9.1.2.5 (mandatory disclosure), and 7.2.2 (appraisal).
38
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Agency Problems and Legal Strategies
remove their agents ex post, they can punish disloyalty. Similarly, shareholders might
have the power to initiate a major corporate transaction such as a merger, or—​as is
ordinarily the case—​they might be restricted to ratifying a motion to merge offered by
the board of directors.46
We do not wish, however, to overemphasize the clarity or analytic power of this
categorization of legal strategies into ex ante and ex post types. One could well argue,
for example, that the reward strategy should not be considered an ex post strategy but
rather an ex ante strategy because, like the trusteeship strategy, it establishes in advance
the terms on which the agent will be compensated. Likewise, one could argue that
appointment rights cannot easily be broken into ex ante and ex post types, since an
election of directors might involve, simultaneously, the selection of new directors and
the removal of old ones. We offer the ex post/​ex ante distinction only as a classification
heuristic helpful for purposes of exposition.
Indeed, as we have already noted, it is in the same heuristic spirit that we offer our
categorization of legal strategies in general. The ten strategies arrayed in Table 2–​1
clearly overlap, and any given legal rule might well be classified as an instance of two
or more of those strategies. Again, our purpose here is simply to emphasize the various ways in which law can be used as an instrument, not to provide a new formalistic
schema that displaces rather than aids functional understanding.
2.3 Disclosure
Disclosure plays a fundamental role in controlling corporate agency costs. As we have
already noted,47 it is an important part of the affiliation terms strategies. Most obviously, prospectus disclosure forces agents to provide prospective principals with information that helps them to decide upon which terms, if any, they wish to enter the firm
as owners. To a lesser extent, periodic financial disclosure and ad hoc disclosure—​for
example, of information relevant to share prices, and of the terms of related party
transactions—​also permits principals to determine the extent to which they wish to
remain owners, or rather exit the firm. However, continuing disclosure also has more
general auxiliary effects in relation to each of the other strategies; hence we treat it
separately at this point in our discussion.
In relation to regulatory strategies that require enforcement, disclosure of related
party transactions helps to reveal the existence of transactions that may be subject to
challenge, and provides potential litigants with information to bring before a court.48 In
relation to governance strategies, disclosure can be used in several different, but complementary, ways. First, and most generally, mandating disclosure of the terms of the governance arrangements that are in place allows principals to assess appropriate intervention
tactics. Second, and specifically in relation to decision rights, mandatory disclosure of
the details of a proposed transaction for which the principals’ approval is sought can
improve the principals’ decision. Third, disclosure of those serving in trustee roles serves
to bond their reputations publicly to the effective monitoring of agents.
There is of course a need to ensure compliance with disclosure obligations themselves. This is a microcosm of the more general problem of securing agent compliance.
46 See Chapter 7.4.
47 See Section 2.2.2; see also Chapter 9.1.2.
48 See e.g. Simeon Djankov, Rafael La Porta, Florencio Lopes-​de-​Silanes, and Andrei Shleifer, The
Law and Economics of Self-​Dealing, 88 Journal of Financial Economics 430 (2008).
39
Compliance and Enforcement
39
For periodic disclosures, where the type of information is expected but the content
is not yet known (so-​called “known unknowns”), no additional compliance mechanism may be required beyond a public statement that the disclosure is expected. If the
principals are made aware that a particular piece of information (e.g. annual financial
statements, the structure and composition of the board, or executive compensation
arrangements) is expected to be disclosed in a particular format, then non-​disclosure
itself can send a negative signal to principals, stimulating them to act.49 The compliance issue with periodic disclosure is not so much whether it happens, but its quality,
and hence a trusteeship strategy—​in the form of auditors—​is typically used to assist
in assuring this. For ad hoc disclosure, the compliance issues are different, because by
definition, principals do not expect particular disclosures in advance. Here vigorous
legal enforcement seems to be needed to ensure compliance.50
2.4 Compliance and Enforcement
Legal strategies are relevant only to the extent that they help to induce agents to act
in the principal’s interest, which for brevity we term agent compliance. In this regard,
each strategy depends on the existence of other legal institutions—​such as courts, regulators, and procedural rules—​to secure enforcement of the legal norms. In this section,
we consider the relationship between enforcement and compliance. We then discuss
three modalities by which enforcement may be effected.
2.4.1 Enforcement and intervention
Enforcement is most directly relevant as regards regulatory strategies such as rules and
standards. These operate to constrain the agent’s behavior. They cannot do this credibly unless they are in fact enforced.51 This necessitates well-​functioning enforcement
institutions, such as courts and regulators, along with appropriately structured incentives to initiate cases.
In contrast, governance strategies rely largely upon intervention by principals to
generate agent compliance.52 Formal enforcement (of regulatory strategies) and intervention (by governance strategies) are therefore substitutes; both impose penalties on
agents in a bid to secure compliance. Whether this intervention takes the form of
appropriate selection of agents and structure of rewards, credible threats of removal,
or effective decision-​making on key issues, its success in securing agent compliance
depends primarily upon the ability of principals to coordinate and act at low cost.
To be sure, governance strategies rely upon background legal rules to support their
49 This mechanism is used to enforce disclosure of governance arrangements in the UK and elsewhere under so-​called “comply or explain” provisions.
50 See Utpal Bhattacharya and Hazem Daouk, The World Price of Insider Trading, 57 Journal
of Finance 75 (2002); John C. Coffee, Jr., Law and the Market: The Impact of Enforcement, 156
University of Pennsylvania Law Review 229, at 263–​66 (2007).
51 This point is not new. For early recognition, see Roscoe Pound, Law in Books and Law in Action,
44 American Law Review 12 (1910); Gary Becker, Crime and Punishment: An Economic Approach,
76 Journal of Political Economy 169 (1968).
52 It is possible to talk of such interventions as an informal form of “enforcement,” in the sense that
they make the impact of the governance strategies credible to the agent (see John Armour, Enforcement
Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment, in Rationality in
Company Law 71, at 73–​6 (John Armour and Jennifer Payne eds., 2009). However, to avoid confusion
with the more specific sense of enforcement understood by lawyers, we eschew here this wider sense.
40
40
Agency Problems and Legal Strategies
operation; in particular, they rely on rules defining the decision-​making authority of
the various corporate actors.53 They therefore also require legal enforcement institutions to make such delineations of authority effective. However, governance strategies
require less sophistication and information on the part of courts and regulators than
is required to enforce agent compliance more directly through regulatory strategies.54
Enforcement institutions, therefore, are of first-​order importance for regulatory strategies, but only of second-​order importance for governance strategies.
2.4.2 Initiators of enforcement
Turning now to the nature of these “enforcement institutions,” we distinguish three
modalities of enforcement, according to the character of the actors responsible for
taking the initiative: (1) public officials, (2) private parties acting in their own interests, and (3) strategically placed private parties (“gatekeepers”) conscripted to act in
the public interest. Modalities of enforcement might of course be classified across a
number of other dimensions. Our goal here is not to categorize for its own sake, but
to provoke thought about how the impact of substantive legal strategies is mediated
by different modalities of enforcement. We therefore simply sketch out a heuristic
classification based on one dimension—​the type of enforcers—​and encourage readers to think about how matters might be affected by other dimensions along which
enforcement may vary. The categorization we have chosen, we believe, has the advantage that it likely reflects the way in which agents involved in running a firm perceive
enforcement—​as affecting them through the actions of public officials, interested private parties, and gatekeepers.
2.4.2.1 Public enforcement
By “public enforcement,” we refer to all legal and regulatory actions brought by organs
of the state. This mode includes criminal and civil suits brought by public officials and
agencies, as well as various ex ante rights of approval exercised by public actors. For
example, in many jurisdictions, issuers making a public offer must submit the required
documents for review by securities regulators.
Public enforcement action can be initiated by a wide variety of state organs, ran­
ging from local prosecutors’ offices to national regulatory authorities that monitor corporate actions in real time—​such as the U.S. Securities and Exchange Commission
(SEC) monitoring corporate disclosures—​and have the power to intervene to prevent
breaches. We also describe some self-​regulatory and quasi-​regulatory authorities, such
as national stock exchanges and the UK’s Financial Reporting Council,55 as “public
enforcers.” Such bodies are enforcers to the extent that they are able in practice to
53 For example, decision rights strategies require courts to deny validity to a purported decision
made by a process that does not reflect the principals’ decision rights. In the absence of legal institutions
capable of protecting principals’ entitlements in relation to corporate assets, even purely governance-​
based strategies will be ineffective: see Bernard Black, Reinier Kraakman, and Anna Tarassova, Russian
Privatization and Corporate Governance: What Went Wrong? 52 Stanford Law Review 1731 (2000).
54 See Alan Schwartz, Relational Contracts in the Courts: An Analysis of Incomplete Agreements
and Judicial Strategies, 21 Journal of Legal Studies 271 (1992); Edward B. Rock and Michael L.
Wachter, Islands of Conscious Power: Law, Norms, and the Self-​Governing Corporation, 149 University
of Pennsylvania Law Review 1619 (2001).
55 The UK’s Financial Reporting Council, through its Conduct Committee, reviews the financial
statements of publicly traded companies for compliance with the law.
41
Compliance and Enforcement
41
compel compliance with their rules ex ante or to impose penalties for rule violations
ex post, whether these penalties are reputational, contractual, or civil. Moreover, they
are meaningfully described as public enforcers where their regulatory efficacy is spurred
by a credible threat of state intervention, and they can be seen as public franchisees.56
Where no such credible threat exists, then such organizations are better viewed as
purely private.
In theory, public enforcement suffers from the limitation—​as compared with private enforcement—​that the officials responsible for initiating suits have weaker incentives to do so than private plaintiffs, because they do not retain any financial payments
recovered.57 However, this distinction is increasingly eroded in cases where public
enforcers are permitted to retain some or all of penalties levied from corporate defendants, which may bias enforcement decisions according to ability to pay rather than
culpability.58 In practice, public enforcement is an important modality for securing
corporate agent compliance in almost all jurisdictions.59
2.4.2.2 Private enforcement
As with public enforcement, private enforcement embraces a wide range of institutions. At the formal end of the spectrum, these include class actions and derivative
suits, which require considerable legal and institutional infrastructure in the form of a
plaintiffs’ bar, cooperative judges, and favorable procedural law that facilitates actions
through matters as diverse as discovery rights, class actions, and legal fees.60 The U.S. is
an international outlier in the availability of these institutional complements to private
enforcement, with an “opt out” approach to class action certification and support for
contingency fees. As a result, rates of private enforcement in corporate law appear far
higher in the U.S. than any other of our core jurisdictions.61 Indeed, the probability
56 The concept of “coerced self-​regulation” is developed in Ian Ayres and John Braithwaite,
Responsive Regulation: Transcending the Deregulation Debate 101–​32 (1992).
57 Jonathan R. Hay and Andrei Shleifer, Private Enforcement of Public Laws: A Theory of Legal
Reform, 88 American Economic Review 398 (1998).
58 Margaret H. Lemos and Max Minzner, For-​Profit Public Enforcement, 127 Harvard Law
Review 853 (2014); Brandon L. Garrett, Too Big to Jail: How Prosecutors Compromise with
Corporations (2014).
59 See e.g. Armour, note 52, at 87–​102; John Armour and Caroline Schmidt, Building Enforcement
Capacity for Brazilian Corporate and Securities Law, in Public and Private Enforcement: China
and the World (Robin Huang and Nico Howson eds., forthcoming 2017); Coffee, Law and the
Market, note 50, at 258–​63; Howell E. Jackson and Mark J. Roe, Public and Private Enforcement of
Securities Laws: Resource-​Based Evidence, 93 Journal of Financial Economics 207 (2009); Rafael
La Porta, Florencio Lopes-​de-​Silanes, and Andrei Shleifer, What Works in Securities Laws? 61 Journal
of Finance 1 (2006).
60 For example, enhancements across several of these dimensions have been credited with triggering a significant increase in private enforcement in Japan: Tom Ginsburg and Glenn Hoetker, The
Unreluctant Litigant? An Empirical Analysis of Japan’s Turn to Litigation, 35 Journal of Legal Studies
31 (2006).
61 See e.g. John Armour, Bernard Black, Brian Cheffins, and Richard Nolan, Private Enforcement
of Corporate Law: An Empirical Comparison of the United Kingdom and the United States, 6 Journal
of Empirical Legal Studies 687 (2009) (absence of UK shareholder litigation); Guido Ferrarini
and Paolo Giudici, Financial Scandals and the Role of Private Enforcement: The Parmalat Case, in John
Armour and Joseph A. McCahery, After Enron: Improving Corporate Law and Modernising
Securities Regulation in Europe and the US 159 (2006) (lack of private enforcement in Italy);
Theodore Baums et al., Fortschritte bei Klagen Gegen Hauptversammlungsbeschlüsse?: Eine Empirische
Studie, ZIP 2007, 1629 (modest levels of shareholder litigation in Germany). While rates of shareholder litigation increased significantly in Japan during the 1990s (see Mark D. West, Why Shareholders
42
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Agency Problems and Legal Strategies
of lawsuits being launched alleging misfeasance by corporate directors in large merger
transactions was approaching 100 percent by 2012.62
Unlike public enforcement, the modality we term private enforcement depends
chiefly on the mechanism of deterrence—​namely, the imposition of penalties ex post
upon the discovery of misconduct. There are few direct analogs in private enforcement
to the ex ante regulatory approval we have included within the mode of public enforcement. One example of such enforcement may be the UK’s “scheme of arrangement”
procedure, whereby a company wishing to undertake a major restructuring transaction and having obtained requisite votes from shareholders (and creditors, if they are
parties) may seek court approval of the arrangement.63 The court will scrutinize the
procedural steps taken at this point, and if its sanction is given to the scheme, it cannot
be challenged ex post. However, if the focus is widened to include not only enforcement in the strict sense, but means of securing agent compliance more generally, there
is an important counterpart: private actors are of course very much involved in ex ante
governance interventions to secure compliance by agents. Indeed, while the discussion
in this section has focused on public and private actors as initiators of law enforcement,
the same conceptual distinction can also be made in relation to governance interventions. Public actors may also be involved in governance interventions, for instance
where the state is a significant stockholder. Although not observed in most of the jurisdictions we survey, in some countries—​for example, France, Italy, and Brazil—​state
ownership of controlling shares in publicly traded companies is common.64 Under
such circumstances, public actors—​
namely government agencies—​
take decisions
regarding governance intervention.
2.4.2.3 Gatekeeper control
Gatekeeper control involves the conscription of noncorporate actors, such as accountants and lawyers, in policing the conduct of corporate actors. This conscription generally involves exposing the gatekeepers to the threat of sanction for participation in
corporate misbehavior, or for failure to prevent or disclose misbehavior.65 The actors
so conscripted are “gatekeepers” in the sense that their participation is generally necessary, whether as a matter of practice or of law, to accomplish the corporate transactions
that are the ultimate focus of the enforcement efforts. We call the mode “gatekeeper
control ” to emphasize that it works by harnessing the control that gatekeepers have
over corporate transactions, and giving them a strong incentive to use that control to
prevent unwanted conduct.
Gatekeeper control is probably best viewed as a form of delegated intervention: principals do not themselves engage in scrutiny of the agent, but leave this to
the gatekeeper. Compliance is generally secured through the ex ante mechanism of
Sue: The Evidence from Japan, 30 Journal of Legal Studies 351 (2001)), they are still nothing like
the same level of frequency as in the U.S.
62 John Armour, Bernard Black, and Brian Cheffins, Is Delaware Losing its Cases? 9 Journal of
Empirical Legal Studies 605, at 623, 627 (2012). There is, however, no mechanism for public
enforcement by the state of Delaware.
63 Companies Act 2006 (UK), Part 26.
64 See Aldo Musacchio and Sérgio Lazzarini, Reinventing State Capitalism (2014).
65 See Reinier Kraakman, Gatekeepers: The Anatomy of a Third-​Party Enforcement Strategy, 2
Journal of Law Economics and Organization 53 (1986); John C. Coffee, Jr., Gatekeepers: The
Professions and Corporate Governance (2006).
43
Compliance and Enforcement
43
constraint (e.g. auditors refuse to issue an unqualified report) rather than through the
ex post mechanism of penalizing wrongdoers. Such delegation of course creates a new
agency problem between the gatekeeper and the principals. This is dealt with through
the application of the basic legal strategies to the gatekeepers themselves, with chief
reliance on the standards and trusteeship strategies.66
2.4.3 Penalties
Enforcement by the modalities described, or indeed governance interventions, secures
compliance either by introducing an ex ante requirement for approval, or imposing
an ex post penalty. We use the term “penalty” here as a broad functional category, to
encompass all consequences of enforcement that are likely to be costly for the defendant and thereby serve to deter misconduct. In many cases, the calibration of such
penalties is rather more subtle than at first might be imagined.
Perhaps the most obvious form of penalty is a payment of money.67 A preliminary
issue concerns who should bear the liability. For legal strategies seeking to control
manager–​shareholder and shareholder–​shareholder agency problems, the most obvious defendant is the agent in question. Whereas for the control of externalities, making the corporation pay the penalty encourages managers to take the expected costs of
penalties into account.
However, it is common practice in some jurisdictions—​such as the U.S., Germany,
and others—​for corporations to provide indemnities and insurance for managers
(“D&O insurance”), which has the effect of shifting the burden from the individual
to the firm. This generally reduces the effective size of financial obligations imposed by
civil liability on managers, so much so that even in jurisdictions where shareholder litigation is frequent, outside directors rarely, if ever, are required to make payments from
their personal assets following a shareholder lawsuit.68 The functional rationale for this
is that too-​zealous imposition of personal liability on managers might induce them to
behave in a risk-​averse fashion, contrary to the wishes of diversified shareholders.69
Conversely, it may be desirable in some cases to shift liability for failure to control
externalities from the firm to individual agents. Where corporate assets are insufficient
to cover expected losses, then limited shareholder liability means that there may be
insufficient incentive to internalize the costs of hazardous activities. Imposing penalties
on individuals associated with the firm can enhance the effectiveness of relevant legal
strategies.70
66 See e.g. Selangor United Rubber Estates v Cradock (No 3) [1968] 1 WLR 1555 (UK Ch D); RBC
Capital Markets LLC v Jervis 129 A.3d 816 (Del. 2015) (secondary liability for bankers who knowingly or dishonestly assist in boards’ breaches of duty).
67 In keeping with the broad use of the term “penalty,” we include here both compensatory and
punitive—​more narrowly defined—​payments.
68 Bernard Black, Brian Cheffins, and Michael Klausner, Liability Risk for Outside Directors: A Cross-​
Border Analysis, 11 European Financial Management 153 (2005); Tom Baker and Sean J. Griffith,
How the Merits Matter: Directors’ and Officers’ Insurance and Securities Settlements, 157 University of
Pennsylvania Law Review 755 (2009).
69 Reinier Kraakman, Corporate Liability Strategies and the Costs of Legal Controls, 93 Yale Law
Journal 957 (1984). See also Gutachten E zum 70. Deutschen Juristentag: Reform der
Organhaftung? Materielles Haftungsrecht und seine Durchsetzung in Privaten und
öffentlichen Unternehmen (Gregor Bachmann ed., 2014); cf. Regional Court (Landgericht)
München 10.12.2013 Zeitschrift für Wirtschaftsrecht (ZIP) 2014, 570 (the Siemens/​Neubürger case).
70 Kraakman, note 69; John Armour and Jeffrey N. Gordon, Systemic Harms and Shareholder Value,
6 Journal of Legal Analysis 35 (2014). See Chapter 4.3.
44
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Agency Problems and Legal Strategies
In many civil law countries, another important ex post consequence of violating
company law rules is annulment of corporate decisions.71 Such orders deny the legal
efficacy of corporate actions reached on the basis of a process that failed to conform
to applicable rules. This mechanism is useful for ensuring compliance with standards
and process rules regarding various governance strategies used to control the first two
varieties of agency cost on which we focus. The costs to a corporation of cancelling or
delaying its actions until the process has been regularized may be substantial, and for
this reason such annulments function as penalties in the sense we use the term here.
Where misconduct is deemed sufficiently serious to be classed as “criminal,”
then incarceration may also be available as a penalty for individual—​although not
corporate—​defendants.72 For corporate defendants in regulated industries, perhaps
the most severe penalty that may be inflicted is loss of a firm’s regulatory license, which
will effectively shut down its business. The threat of criminal sanctions and/​or loss of
regulatory licenses can, without careful calibration of expected sanctions, easily result
in over-​deterrence.73
Defendants may face a range of extra-​legal—​principally reputational—​consequences
flowing from enforcement actions. For individual agents, these may include loss of jobs
and greater difficulty finding other employment.74 For firms, reputational harm can be
understood as the downward revision by contracting partners of their expectations of
performance, with a consequently adverse impact on the firm’s terms of trade.75 This
can greatly exceed the size of financial penalties—​indeed, no financial penalty need
be imposed to trigger reputational loss, simply the credible dissemination of information about malfeasance.76 While the potential for reputational loss both makes the
total effective penalty larger, it also makes it less predictable.77 Moreover, corporate
misconduct that does not harm contracting counterparties, but rather imposes purely
external costs, does not necessarily imply any change in expectations about contractual
71 See Holger Fleischer, Fehlerhafte Aufsichtsratsbeschlüsse: Rechtsdogmatik—​Rechtsvergleichung—​
Rechtspolitik, Der Betrieb 2013, 160–​7 and 217–​24; Martin Gelter, Why do Shareholder Derivative
Suits Remain Rare in Continental Europe? 37 Brooklyn Journal of International Law 843–​92
(2012).
72 Whether criminal sanctions can be used at all against legal persons is controversial. While most
jurisdictions now permit this, some, such as Germany, refuse to do so. See generally Guy Stessens,
Corporate Criminal Liability: A Comparative Perspective, 43 International and Comparative Law
Quarterly 493 (1994).
73 See e.g. Jennifer Arlen, The Potentially Perverse Effects of Corporate Criminal Liability, 23 Journal
of Legal Studies 833 (1994); Daniel R. Fischel and Alan O. Sykes, Corporate Crime, 25 Journal
of Legal Studies 319 (1996). A particular concern in the EU context is competition law enforcement: see Case C-​172/​12 P, EI du Pont de Nemours v Commission [2013] European Court Reports
I-​0000, ECLI: EU: C:2013:605 (parent fined for breaches of competition law by subsidiary, with fine
amount calculated as a percentage of parent’s turnover).
74 See e.g. Fich and Shivdasani, note 33; Maria Correia and Michael Klausner, Are Securities Class
Actions “Supplemental” to SEC Enforcement? An Empirical Analysis, Working Paper, Stanford Law
School (2012).
75 See Jonathan Karpoff and John Lott, Jr., The Reputational Penalty Firms Face from Committing
Criminal Fraud, 36 Journal of Law and Economics 757 (1993); Cindy Alexander, On the Nature
of the Reputational Penalty for Corporate Crime: Evidence, 42 Journal of Law and Economics 489
(1999); Jonathan Karpoff, D. Scott Lee, and Gerald Martin, The Cost to Firms of Cooking the Books,
43 Journal of Financial and Quantitative Analysis 581 (2008).
76 See e.g. Benjamin L. Liebman and Curtis J. Milhaupt, Reputational Sanctions in China’s Securities
Market, 108 Columbia Law Review 929 (2008).
77 See John Armour, Colin Mayer, and Andrea Polo, Regulatory Sanctions and Reputational Damage
in Financial Markets, forthcoming, Journal of Financial and Quantitative Analysis (2017)
(finding no correlation between size of reputational loss and financial penalty).
45
Systematic Differences
45
performance, and does not appear to lead to reputational losses.78 This has implications for the selection of legal penalties in relation to the control of externalities.79
2.5 Legal Strategies in Corporate Context
The law does not apply legal strategies in the abstract but only in specific regulatory
contexts. For purposes of exposition and analysis, we have grouped those contexts into
six basic categories of corporate decisions and transactions. Each of the next seven
chapters focuses on one of those categories. Necessarily, the boundaries of these categories are to some degree arbitrary and overlapping. Nevertheless, each category has
a degree of functional unity, and the typical deployment of legal strategies in each is at
least moderately distinct.
Chapters 3 and 4 examine the legal strategies at play in the regulation of ordinary business transactions and decisions. Not surprisingly, governance strategies predominate in this context. Chapter 5 turns to corporate debt relationships and the
problem of creditor protection—​a context in which regulatory strategies are common,
except when the firm is insolvent, when the emphasis shifts to governance strategies.
Chapter 6 examines the legal regulation of related party (or self-​dealing) transactions;
Chapter 7 investigates the corporate law treatment of “significant” transactions, such as
mergers and major sales of assets, and Chapter 8 assesses the legal treatment of control
transactions such as sales of control blocks and hostile takeovers. As the discussion
below will show, jurisdictions adopt a fluid mix of regulatory and governance strategies
in all of the last three transactional contexts. Then, Chapter 9 turns to the regulation
of issuers on the public market, where regulatory strategies predominate.
While we do not claim that these transactional and decisional categories exhaust
all of corporate law, they cover most of what is conventionally understood to be corporate law, and nearly all of the interesting and controversial issues that the subject
presents today.
Within each of our seven substantive chapters, our analysis proceeds functionally. In
most chapters, our analytic discussion is organized by agency problems and legal strategies: for a given category of corporate decisions, we review the legal strategies that are
actively deployed by our core jurisdictions. In two chapters, however, the analytic discussion is organized somewhat differently—​by categories of transactions in Chapter 7
(significant transactions), and by agency problems in Chapter 8 (control transactions).
This variation in structure responds to the greater heterogeneity of the transactions
dealt with in those chapters. Finally, to the extent that there are significant differences
across jurisdictions in the legal strategies employed to regulate a given class of corporate
decisions, we attempt to assess the origins of these differences.
2.6 Systematic Differences
We might expect the use of the various legal strategies for controlling agency costs, and
of the associated modes of enforcement, to differ systematically across jurisdictions.
78 See Jonathan M. Karpoff, John R. Lott, Jr., and Eric W. Wehrly, The Reputational Penalties
for Environmental Violations: Empirical Evidence, 48 Journal of Law and Economics 653 (2005);
Armour et al., note 77.
79 See Chapter 4.3.
46
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Agency Problems and Legal Strategies
In particular, we would expect to see strong complementarities between the structure
of share ownership and the types of legal strategies relied upon most heavily to control agency costs. Since the efficacy of governance mechanisms is closely linked to the
extent to which principals are able to coordinate, it would be surprising if the structure
of share ownership did not affect the extent to which these strategies are employed to
control managers. In most jurisdictions around the world, the ownership of shares
in publicly traded firms is concentrated in the hands of relatively few shareholders—​
whether families or institutional investors. With such ownership patterns, owners face
relatively low coordination costs as between themselves, and are able to rely on governance strategies to control managers—​although of course the control of controlling shareholders themselves becomes more problematic. Where ownership of shares
is more diffuse, however, governance mechanisms are less effective in controlling man­
agers, and there is more need for regulatory mechanisms to take the fore.
Just as the choice of legal strategies for controlling agency problems is likely to complement the pattern of ownership, it will in turn be complemented by the nature and
sophistication of the enforcement institutions. In systems relying heavily on regulatory
strategies, enforcement institutions will likely have a greater role to play in securing
compliance by agents, as opposed to intervention by principals themselves.80 At a more
micro level, particular regulatory strategies complement and are supported by different enforcement institutions. Rules require a sophisticated and responsive regulator to
promulgate them, if they are not to end up imposing greater hindrance than benefit on
parties. Standards, on the other hand, require independent and sophisticated courts and
lawyers, if they are to be deployed effectively. Similarly, reliance on complex contracts
will likely place greater demands on enforcement institutions than simple legal rules.81
In addition, the appropriate scope of continuing disclosure obligations may vary
depending on the extent to which particular legal strategies are employed.82 Thus in the
U.S., where regulatory strategies are extensively used, continuing disclosure traditionally focused on self-​dealing transactions, so assisting in formal enforcement activities.
In the EU, by contrast, where greater reliance is placed on governance mechanisms,
disclosure obligations traditionally emphasized details of board structure. However,
these differences have narrowed in recent years—​in step with a more general convergence in ownership structure we discuss in Chapter 3—​with enhancements to disclosure of related-​party transactions in the EU and of board composition and functioning
in the U.S.83
The necessary extent of disclosure will also vary depending on the ownership structure. Where owners are highly coordinated, frequent disclosure may be less important
as a response to managerial agency costs:84 owners are better able to discover information for themselves, and governance strategies can be used to stimulate disclosure of
80 The existence of a demand for regulatory, as opposed to governance, strategies may be expected
to spur the development of regulatory expertise. Thus in jurisdictions with widely dispersed retail
shareholdings, such as the U.S., specialist courts tend to be more active because they are more in
demand. See Zohar Goshen, The Efficiency of Controlling Corporate Self-​Dealing: Theory Meets Reality,
91 California Law Review 393 (2003).
81 Edward Glaeser, Simon Johnson, and Andrei Shleifer, Coase Versus the Coasians, 116 Quarterly
Journal of Economics 853 (2001).
82 See e.g. para. 9 Recommendation 2005/​162/​EC on the role of non-​executive or supervisory
directors of listed companies and on committees of the (supervisory) board, 2005 O.J. (L 52) 51.
83 See Chapter 3.2.4, 3.4.2, and Chapter 6.2.1.1.
84 See John Armour and Jeffrey N. Gordon, The Berle-​Means Corporation in the 21st Century,
Working Paper (2008), at <http://​www.law.upenn.edu>.
47
Systematic Differences
47
greater information. This is not to say, however, that effective and adequately enforced
disclosure obligations do not matter in systems with coordinated owners. Rather, the
problem with coordinated owners is not the first of our three agency problems but the
second: conflicts between shareholders. Here disclosure ensures that information about
how powerful owners exercise their control rights—​including related party transactions—​is disseminated to minority shareholders, and that information management
transmits to controllers makes its way to all owners equally​, preventing so-​called “selective disclosure.”
Many such institutional differences may make little overall difference to the success
of firms’ control of their agency costs, as various combinations of strategies and associated institutions may be functionally equivalent. However, there are some institutions
whose presence or absence is likely to be important in any jurisdiction. In particular, given the fundamental role played by disclosure in supporting both the enforcement of regulatory strategies and the exercise of governance, institutions supporting
disclosure—​a strong and effective securities regulator and a sophisticated accounting
profession, for example—​are always likely to make an overall difference to the success
of firms in controlling agency costs.85
85 See Bernard Black, The Legal and Institutional Preconditions for Strong Securities Markets, 48
UCLA Law Review 781 (2001).
48
49
3
The Basic Governance Structure:
The Interests of Shareholders as a Class
John Armour, Luca Enriques, Henry Hansmann,
and Reinier Kraakman
As we saw in Chapter 2, corporate law must address three fundamental agency problems: the conflict between managers (executives and directors) and shareholders, the
conflict between controlling and minority shareholders, and the conflict between
shareholders and non-​shareholder constituencies. This chapter examines how the legal
strategies employed in corporate governance mitigate the manager–​shareholder conflict in our core jurisdictions; Chapter 4 then explores the role of governance in safeguarding minority shareholder and non-​shareholder interests.
Two of the core features of the corporate form underlie corporate governance. The
first is investor ownership, which, given the breadth of contemporary capital markets,
implies that ultimate control over the firm often lies in the hands of shareholders
who are far removed from the firm’s day-​to-​day operations and who face significant
information and coordination costs.1 The second is delegated management, which is
functional precisely because of shareholders’ information and coordination costs. Such
delegation in turn brings with it shareholder–​manager agency costs.
Corporate laws address the shareholder–​manager agency problem through both
governance and regulatory strategies. As this chapter outlines, however, their deployment and relative efficacy differ according to share ownership patterns. In countries
where controlling shareholders are common, appointment and decision rights are often
relatively strong, enabling such shareholders to exert influence directly over the management.2 At the opposite extreme, where share ownership is dispersed in the hands
of passive, uninformed investors, as was the case in the U.S. for much of the twentieth
century, appointment and decision rights are less effective, and more work is done by
agent incentives, in the form of appropriately calibrated rewards for managers and a
trusteeship role for non-​management directors in overseeing executives. Such strategies have been further supported by standards of conduct for directors and affiliation
rights, namely disclosure rules to ensure more informed share prices and greater liquidity, which in turn make exit rights, including by tendering shares in a hostile takeover
bid, more effective. Somewhere between these extremes—​and perhaps increasingly
1 Shareholder “coordination and information costs” can be understood as the costs of actually
making decisions among multiple shareholders (i.e. of getting informed and forging a majority preference), combined with the costs flowing from such decisions being suboptimal (because shareholders
are uninformed or conflicted). See Chapters 2.1 and 2.2. One of us has termed this combination
“ownership costs.” See Henry Hansmann, The Ownership of Enterprise 35 (1996).
2 These strategies similarly enable non-​controlling institutional shareholders in the few companies
in these countries that have no dominant shareholder.
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry
Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 3
© John Armour, Luca Enriques, Henry Hansmann, and Reinier Kraakman, 2017. Published 2017 by Oxford University Press.
50
50
The Interests of Shareholders as a Class
commonly—​lie ownership patterns where, although controlling shareholders are not
the norm, share ownership is concentrated in the portfolios of institutional investors,
with collective action being facilitated by both the sheer size of the largest shareholders’
holdings and specialized hedge funds’ activism.3
Before we describe the extent to which our core jurisdictions make use of the various legal strategies, a few general observations on boards of directors—​the key internal
governance institution in each of them—​will be useful.
3.1 Delegated Management and Corporate Boards
The governance law of public corporations has a similar basic structure in all of our core
jurisdictions. Reflecting investor ownership, it reserves certain fundamental decisions
to the general shareholders’ meeting, while delegated management implies assigning
much decision-​making power to boards of directors.
We have already seen that delegation of decision-​making power in relation to the
management of the company’s business makes sense as a way of economizing on the
information and coordination costs shareholders would face if they tried to make these
decisions themselves. So we might see the most basic task of boards as being to manage
the company’s business. However, many jurisdictions expect boards also to engage in
oversight of management, implying a second, trusteeship, role for directors.
Jurisdictions reflect different choices as respects formal board structures: in some
countries boards are “one-​tier,” whereas in others they are “two-​tier.”4 In jurisdictions
with one-​tier boards, such as the U.S., UK, and Japan, a unitary board has legal power
both to manage and supervise the management of a corporation, either directly or
through the board’s committees.5 By contrast, jurisdictions using two-​tier board structures prescribe a formal separation between the management and monitoring functions.
Monitoring powers are allocated to elected supervisory boards of non-​management
directors,6 which then appoint and supervise management boards that include the
principal executive officers in charge of designing and implementing business strategy.
Germany and Brazil mandate two-​tier boards for public corporations, while Italy and
France—​as well as the EU for the European Company—​offer a choice between one
and two-​tier boards.7 In theory, one-​tier boards concentrate decision-​making power
in the hands of directors, because they combine the managerial and supervisory roles
in one group. Thus in some jurisdictions, such as the U.S. and France, it is common
to combine the roles of board Chairman and Chief Executive Officer (“CEO”) in a
3 See Ronald J. Gilson and Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist
Investors and the Revaluation of Governance Rights, 113 Columbia Law Review 863 (2013).
4 There are also intermediate board structures in other jurisdictions, such as the “Nordic” board
of directors. See Per Lekvall, A Consolidated Nordic Governance Model, in The Nordic Corporate
Governance Model 52, 59–​63 (Per Lekvall ed., 2014).
5 Some jurisdictions—​such as Italy, Brazil, and East Asian jurisdictions influenced by German
law—​retain vestigial supervisory boards such as the “board of auditors” (Japan and Italy) or the “board
of supervisors” (Brazil and China). The powers of these secondary boards, which are functionally similar to those of audit committees on a unitary board, are generally limited, especially in Japan and Italy.
6 We use “non-​
management” in the sense of non-​
participation in management. Such non-​
participation in executive decision-​making is frequently mandated for supervisory boards in two-​tier
jurisdictions such as Germany. See §§ 105 and 111 IV Aktiengesetz.
7 §§ 76–​116 Aktiengesetz (Germany); Art. 138 Lei das Sociedades por Ações (Brazil); Art. L. 225–​
57 Code de commerce (France); Art. 2380 Civil Code (Italy); Art. 38 Council Regulation (EC) No
2157/​2001 of 8 October 2001 on the Statute for a European company (SE).
51
Appointment and Decision Rights
51
single-​tier board.8 By contrast, two-​tier jurisdictions such as Germany bar supervisory
boards from making managerial decisions.9
However, board practices can blur the distinction between the two structures.10
Informal leadership coalitions can short-​circuit the legal separation between management and supervisory boards. In companies with no controlling shareholder, the management board can often de facto select the supervisory board.11 At the same time,
hiving out “supervisory” functions to committees composed exclusively of independent directors gives single-​tier boards a quasi-​supervisory flavor.
Further, in jurisdictions with labor codetermination—​such as Germany, among our
core countries—​a two-​tier board performs an additional function. Here the supervisory board is not devoted exclusively to the interests of the shareholder class, but
rather serves the function of lowering the costs of coordination between two different constituencies, namely shareholders and employees. We address the governance
features of codetermination further in Chapter 4. At this point we merely note that
the two-​tier board structure facilitates strong labor participation in corporate governance as full access to sensitive information and business decision-​making can remain
with the management board, thereby mitigating potential conflicts of interest on the
supervisory board.
Codetermination imposes a minimum number of supervisory board members—​20
for its largest companies12—​which makes Germany something of an outlier when
it comes to board size. As we documented in the previous edition of this book,13
most jurisdictions have broadly converged on a similar size for boards, at around
9–​12 members. Smaller boards are thought to be more effective in performing their
monitoring role.14 With a view to adapting their board size to the international norm,
several major German companies such as Allianz, BASF, and Porsche have converted
into the EU-​wide Societas Europaea (SE), which allows for a minimum of only 12
directors.15
3.2 Appointment and Decision Rights
The most basic legal strategies implied by investor ownership are appointment rights: the
shareholders retain powers to appoint (and remove) members of the board of directors.
In addition, on matters where delegated management may lead to suboptimal outcomes due to badly aligned incentives, such as conflicted and end-​game transactions,
8 This is not universally the case. In the UK, Art. A.2.1 of the UK Corporate Governance Code
calls for a clear division of responsibility between a company’s chairman and chief executive officer,
which is by far the most common arrangement in UK listed companies.
9 See note 6.
10 See Paul Davies and Klaus J. Hopt, Corporate Boards in Europe—​Accountability and Convergence,
61 American Journal of Comparative Law 301 (2013).
11 See Klaus J. Hopt and Patrick C. Leyens, Board Models in Europe—​Recent Developments
of Internal Corporate Governance Structures in Germany, the United Kingdom, France and Italy, 1
European Company and Financial Law Review 135, 141 (2004).
12 See § 7 Mitbestimmungsgesetz (Codetermination Law) (at least 20 directors for supervisory
boards of firms with more than 20,000 employees).
13 At 69–​70.
14 See e.g. David Yermack, Higher Market Valuation of Companies with a Small Board of Directors,
40 Journal of Financial Economics 185 (1996); Jeffrey L. Coles, Naveen D. Daniel, and Lalitha
Naveen, Boards: Does One Size Fit All? 87 Journal of Financial Economics 329 (2008).
15 See Jochem Reichert, Experience with the SE in Germany, 4 Utrecht Law Review 22, 27–​8
(2008).
52
52
The Interests of Shareholders as a Class
corporate laws also grant shareholders decision rights. The efficacy of these mechanisms
in controlling agency costs are a function of shareholders’ information and coordination costs on the one hand, and the severity of managerial agency costs on the other.
The easier it is for shareholders to become informed, coordinate among themselves,
and make collective choices that maximize their collective welfare, the more efficiently
appointment and decision rights will control agency costs. But where shareholder
information and coordination costs are high, greater insulation for managers may be
in the joint interest of shareholders as well.
In other words, shareholder coordination has two faces: easier coordination can
decrease shareholder–​manager agency costs—​by permitting shareholders to control
managers more effectively—​while at the same time it might increase shareholder–​
shareholder agency costs—​by permitting a faction to gain control to the detriment of
the shareholders as a group. Shareholders as a group may suffer from control by a faction, either because that faction may divert corporate value to itself or because, owing
to asymmetric information or distorted incentives, it may wrongly displace a good
management team or force it to adopt inappropriate strategies.16
When shares are aggregated in the portfolios of institutional asset managers, as is
nowadays the case in many jurisdictions, in addition to the agency problem of delegated management at the firm level, a second tier of agency costs arises between the
institutional asset managers and their ultimate clients.17 Because such asset managers
are generally compensated on the basis of relative performance, they are unwilling to
invest resources in determining the appropriate exercise of governance rights in individual firms—​this would confer a gratuitous benefit on their competitors. However,
a lead is often set by “activist” funds, which compensate their managers on the basis
of absolute returns and earn a return by taking significant stakes in the companies
in which they invest.18 Whether such activist hedge funds are in a good position to
identify companies with weak strategies and/​or disloyal managers, or rather simply
target companies that stock markets fail to price adequately, forcing these companies
to engage in suboptimal, often “short-​term” business strategies, is one of the most
disputed issues in the current corporate governance debate.19 The empirical evidence
about the merits of this new corporate governance paradigm is as yet inconclusive,20
and the debate will continue on whether the new corporate governance paradigm
16 See Zohar Goshen and Richard Squire, Principal Costs: A New Theory for Corporate Law and
Governance, Working Paper (2015), available at ssrn.com.
17 Bernard S. Black, Agents Watching Agents: The Promise of Institutional Investor Voice, 39 UCLA
Law Review 811 (1991).
18 Marcel Kahan and Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control,
155 University of Pennsylvania Law Review 1021 (2007); Gilson and Gordon, note 3; Marco
Becht, Julian R. Franks, Jeremy Grant, and Hannes F. Wagner, The Returns to Hedge Fund Activism: An
International Study, 21 European Financial Management 106 (2015).
19 See e.g. Alon Brav, Wei Jiang, Frank Partnoy, and Randall Thomas, Hedge Fund Activism,
Corporate Governance, and Firm Performance, 63 Journal of Finance 1729 (2008); Gilson and
Gordon, note 3; April Klein and Emanuel Zur, Entrepreneurial Shareholder Activism: Hedge Funds
and Other Private Investors, 64 Journal of Finance 187 (2009); Lucian A. Bebchuk, Alon Brav, and
Wei Jiang, The Long-​Term Effects of Hedge Fund Activism, 115 Columbia Law Review 1085 (2015);
Yvan Allaire and Francois Dauphin, The Game of “Activist” Hedge Funds: Cui Bono? Working Paper
(2015), available at ssrn.com; Emiliano Catan and Marcel Kahan, The Law and Finance of Antitakeover
Statutes, 68 Stanford Law Review 629 (2016).
20 For a comprehensive review see John C. Coffee, Jr. and Darius Palia, The Wolf at the Door: The
Impact of Hedge Fund Activism on Corporate Governance, 1 Annals of Corporate Governance 1
(2016).
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Appointment and Decision Rights
53
based on activist hedge funds and institutional shareholders as arbiters of corporate
strategy brings net benefits to society.21
Before analyzing individual legal strategies across jurisdictions, we should bear in
mind that shareholder-​centric corporate laws are not a priori superior to board-​centric
ones. Solving the trade-​off between managerial agency costs and shareholder information and coordination costs turns out to be one of the hardest challenges for corpor­
ate policymakers. Even within a particular jurisdiction and a specific industry, the
dynamics between the two constituencies will play out differently due to a number of
factors: chief among them is the question of how easily management can convey information about its business strategy without destroying its value. Personalities, including
entrepreneurial genius, will also play a role. With this caveat in mind, we can begin
our tour of legal strategies used in this area, by considering appointment rights first.
3.2.1 Appointing directors
At the core of appointment rights lies shareholders’ power to vote on the selection of
directors. The impact of this power is much greater if shareholders also have the power
to nominate the candidates for election. The allocation of these entitlements reflects
the balance between shareholder information and coordination costs and managerial
agency costs. The latter are most tightly controlled by permitting shareholders to select
candidates for appointment. However, in the presence of high information and coordination costs, it may be preferable to let the board, possibly acting through its independent members, perform the search function that precedes nomination of candidates,
and have the shareholders simply vote on them.
This latter approach is common practice in most jurisdictions: the board usually
proposes a slate of nominees, which is rarely opposed at the annual shareholders’ meeting. The exceptions are Brazil and Italy, where concentrated ownership prevails and
formal director nominations by (controlling) shareholders are commonplace.22
As a check on agency costs, almost all jurisdictions permit a qualified minority
(usually a small percentage) of shareholders to contest the board’s slate by adding
additional nominees to the agenda of the shareholders’ meeting.23 Insurgent candidates nominated in this fashion face the same up-​or-​down majority vote as the
company’s own nominees other than in jurisdictions where shareholders usually vote
21 It is certainly plausible that the mechanisms employed to disclose information about publicly
traded companies might lead to stock price valuations which are less accurate for some types of business project—​“exploratory” innovation for example (see John Armour and Luca Enriques, Financing
Disruption, Working Paper (2016))—​but it is unclear whether such effects explain the pattern of
activist investing.
22 In Italy the law on listed companies itself drives this outcome, by treating shareholder-​proposed
slates as default. See Art. 147-​III Consolidated Act on Financial Supervision.
23 In the UK the default rule is that any shareholder can present her own board candidates for
appointment by ordinary resolution (Schedule 3, Model Articles for Public Companies, Companies
(Model Articles) Regulations 2008 No. 3229, Art. 20). In Japan a qualified minority (1 percent of
votes or 300 votes) may propose its own slate of candidates, which the company must include in its
mail voting/​proxy documents (Art. 303 and 305 Companies Act; see also Gen Goto, Legally “Strong”
Shareholders of Japan, 3 Michigan Journal of Private Equity and Venture Capital 125, 131–​6
(2014)). In Italy the quorum for the proposal of a slate of candidates varies from 0.5 percent for the
largest companies (by capitalization) to 4.5 percent for the smallest. Art. 144-​4 Consob Regulation on
Issuers. In Brazil, the relevant threshold for proxy access (or reimbursement of expenses) by insurgents
in public companies is 0.5 percent of the total capital. CVM Instruction No. 481 (2009) Arts. 31
and 32.
54
54
The Interests of Shareholders as a Class
on the slates as a package, as in Germany and Italy.24 Finally, special rules apply to
allow for minority shareholder representation on the boards of listed companies in
Brazil and Italy.25
Matters are more complex in the U.S., where board elections have always been a contentious issue attracting policymakers’ attention. First of all, the statutory default in Delaware
is a “plurality” voting rule, under which—​when an election is uncontested, that is, the
number of candidates equals the number of directors to be elected—​any number of votes
suffices to elect a nominee to a board seat.26 Following institutional investors’ dismay at
reappointment of candidates for whom large numbers of votes had been “withheld,” most
large companies have opted out of the default, switching to majority voting.27 Moreover,
Delaware law was amended to facilitate shareholder initiatives to switch to majority voting.28 And, while plurality remains relatively common in smaller companies, their boards
often yield to “withholding” campaign demands.29
Shareholders in U.S. companies have other tools to obtain representation on the
board. One such tool is proxy access—​that is, placing nominees on the company’s
proxy materials so all shareholders will have a choice between the board candidates
and the insurgents’ ones, without any need for the latter to circulate their own proxy
materials. The default in Delaware is against proxy access and federal rules regulating
proxies have traditionally refrained from mandating such access. After the Dodd-​Frank
Act of 2010 explicitly granted the SEC power to make rules facilitating inclusion of
shareholder nominations in the corporate proxy form,30 the SEC adopted a rule to this
effect, but the D.C. Circuit struck it down, ostensibly for failing to consider adequately
its economic effects.31 Currently, federal proxy rules allow shareholders to include proposals for proxy access in the company’s proxy materials and Delaware law has also
eased shareholders’ initiatives in favor of proxy access at individual companies.32 As
a consequence, shareholder proposals to adopt proxy access have become increasingly
common for U.S. listed companies, and many such companies now provide for it.33
Insurgents who wish to obtain control of the board, which is usually the case in connection with a hostile takeover bid,34 may launch a full-​blown proxy contest. In this
case, the insurgent bears all the costs of soliciting their own proxies and distributing
24 In German public companies any shareholder can add her own candidates up to two weeks
before the meeting (§ 127 AktG). Of course, that applies to German companies subject to codetermination for the subset of supervisory board members appointed by shareholders only.
25 See Chapter 4.1.1.
26 See e.g. § 216(3) Delaware General Corporation Law.
27 Stephen J. Choi, Jill E. Fisch, Marcel Kahan, and Edward B. Rock, Does Majority Voting Improve
Board Accountability? University of Chicago Law Review 1119 (2016).
28 See § 216(4) Delaware General Corporation Law (barring the board from revoking a stockholder bylaw requiring a majority vote for directors).
29 Marcel Kahan and Edward Rock, Symbolic Corporate Governance Politics, 94 Boston University
Law Review 1997, 2011 (2014).
30 § 971, Dodd-​Frank Act (2010).
31 Business Roundtable v. Securities and Exchange Commission, 647 Federal Reporter 3d 1144.
According to one study, the D.C. Circuit’s decision itself had a negative impact on the valuation
of potentially affected firms: see Bo Becker, Daniel Bergstresser, and Guhan Subramanian, Does
Shareholder Proxy Access Improve Firm Value? Evidence from the Business Roundtable’s Challenge, 56
Journal of Law & Economics 127 (2013).
32 § 112 Delaware General Corporation Law.
33 See e.g. Howard B. Dicker, 2016 Proxy Season: Engagement, Transparency, Proxy Access, Harvard
Law School Forum on Corporate Governance and Financial Regulation, 4 February 2016, available
at corpgov.law.harvard.edu.
34 See Chapter 8.2.3.
55
Appointment and Decision Rights
55
their own materials—​that is, ballots, registration statements (subject to SEC review),
and supporting materials.35
Finally, a popular tool among activists is what is known as a “short slate” proxy
solicitation.36 Since 1992, when the SEC amended its proxy rules to reduce obstacles
to shareholder activism, an insurgent in a proxy contest, typically a hedge fund, may
solicit proxies to vote in favor both of its nominees for a minority of directorships
and of a majority of the nominees in the company’s proxy materials.37 A “short slate”
makes it easier for a hedge fund activist to persuade institutional investors to support
its nominees and to push for a change in the company’s strategy from within the board.
3.2.2 Removing directors
The power to remove directors, if shareholders can exercise it effectively, is a very
potent mechanism for controlling agency costs, perhaps even more so than appointment rights. Many jurisdictions—​including the UK, France, Italy, Japan, and Brazil—​
accord shareholder majorities a non-​waivable right to remove directors at any time,
regardless of cause or the nominal duration of their term.38 Coupled with powers to
requisition a shareholders’ meeting—​for which the agenda will be circulated at the
company’s expense—​this creates a powerful check on agency costs. Boards recognize the credibility of this threat, and consequently will often accede to shareholder
demands for change in the boardroom without the need for a shareholders’ meeting
actually to be called.39
Our other jurisdictions provide weaker removal rights. German law encourages
accountability to shareholders of shareholder-​elected members of the supervisory
board by permitting their removal without cause, although only by a 75 percent majority.40 By contrast, shareholders may not remove the labor representatives, nor may the
supervisory board remove members of the management board without cause.41 This
latter rule reflects the idea that in the presence of representatives of very different constituencies, making managers (as opposed to supervisors) tightly accountable to their
constituency might be counter-​productive, undermining effective day-​to-​day decision-​
making. In the end, however, the possibility of direct shareholder influence mitigates
the limitation on managerial board member dismissal. Where a simple majority of the
general meeting approves a “no confidence” resolution against the management board,
this satisfies the “cause” requirement; in other words, the supervisory board is entitled
(and probably obliged) to remove the management board in such a situation.42
35 See e.g. Sofie Cools, The Real Difference in Corporate Law Between the United States and
Continental Europe: Distribution of Powers, 30 Delaware Journal of Corporate Law 697, 746
(2005).
36 See Coffee and Palia, note 20, at 24–​5.
37 See 17 C.F.R. §240.14a-​4(d)(4).
38 Sections 168 and 303 Companies Act 2006 (UK), Arts. L. 225-​18, 225-​75, and 225-​61 Code
de commerce (France); Arts. 2367 and 2383 Civil Code (Italy) (all providing for removal within
term and setting minimum thresholds to call special meetings in publicly traded companies). Art.
339(1) Companies Act (Japan) (simple majority required for removal without cause). Art. 140 Lei das
Sociedades por Ações (Brazil) (same).
39 See e.g. Marco Becht, Julian Franks, Colin Mayer, and Stefano Rossi, Returns to Shareholder
Activism: Evidence from a Clinical Study of the Hermes UK Focus Fund, 23 Review of Financial
Studies 3093 (2010).
40 § 103 AktG (Germany). Companies’ charters may provide for a higher or lower majority (ibid.),
which they rarely, if ever, do.
41 § 103 and 84(3) AktG (Germany).
42 § 84(3) AktG (Germany). In practice the management board member will not wait until the
supervisory board votes on the removal, but will step down “voluntarily.”
56
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The Interests of Shareholders as a Class
Many U.S. jurisdictions treat the right to remove directors without cause as a statutory default subject to reversal by a charter provision on point.43 In Delaware, however,
companies may only disallow removal without cause if they choose a staggered (or
“classified”) board, that is, a board where only a fraction of the members is elected each
year.44 Staggered boards used to be common until the mid-​2000s. In keeping with the
general trend towards greater shareholder appointment rights in the U.S., their use has
been in decline for several years,45 in parallel with a heated scholarly debate over their
corporate governance merits.46 Yet, Delaware indirectly cabins removal rights by denying shareholders the power to call a special shareholders’ meeting unless the company’s
charter expressly so provides.47
Especially where removal without cause is not permitted, the standard mode of director “removal” is dropping their names from the company’s slate or failing to re-elect
them. As a consequence, the length of directorial terms can be critical. Longer terms
provide insulation from proxy contests, temporary shareholder majorities, and even
powerful CEOs. Among our core jurisdictions, directorial terms are the shortest (one
year) in the U.S. (unless the company has a staggered board, in which case the term
is typically three years) and, as a matter of practice and corporate governance recommendations for the largest publicly traded companies, in the UK.48 Terms are short
(two years) in Japan as well, while in Italy and Brazil they are three years.49 At the
opposite end of the spectrum lie German and French corporations, which usually elect
(supervisory) directors for five-​or six-​year terms respectively, the maximum that their
corporation laws permit.50
Thus, removal rights generally track appointment rights: jurisdictions with
“shareholder-​centric” laws on the books—​the UK, France, Japan, Italy, and Brazil—​
provide shareholders with non-​waivable removal powers as well as robust nomination powers. Delaware—​the dominant U.S. jurisdiction—​weakens removal powers by
allowing staggered boards and discouraging special shareholders’ meetings, but has an
ever more commonly adopted default directorial term of one year which, together with
the recent introduction of more shareholder-​friendly rules on appointment,51 have
brought it broadly in line with other jurisdictions.
The correlation between appointment and removal powers does not hold for
German companies, whose shareholders have strong appointment rights for “their”
supervisory board members but can only oust them from lengthy terms by means of a
43 See § 8.08(a) Revised Model Business Corporation Act.
44 See § 141(k) Delaware General Corporation Law. Delaware General Corporation Law requires
that at least one-​third of the directors be elected annually (§141(d)) where there is a single class of
voting stock. Longer terms are possible, however, where corporate charters provide for multiple classes
of voting stock.
45 Marcel Kahan and Edward Rock, Embattled CEOs, 88 Texas Law Review 987, 1007–​9 (2009).
46 Compare e.g. Lucian A. Bebchuk, John C. Coates IV, and Guhan Subramanian, The Powerful
Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy, 54 Stanford Law Review
887 (2002) and Lucian A. Bebchuk, Alma Cohen, and Allen Ferrell, What Matters in Corporate
Governance?, 22 Review of Financial Studies 783 (2009), with Martijn Cremers, Lubomir P. Litov,
and Simone M. Sepe, Staggered Boards and Firm Value, Revisited, Working Paper (2014), available at
ssrn.com.
47 See §§ 211(b) and 211(d) Delaware General Corporation Law.
48 UK Corporate Governance Code (2014), B.7.1.
49 Art. 332(1) Companies Act (Japan); Art. 2383, Civil Code (Italy) (companies may opt for
shorter terms, but that is exceedingly rare); Art. 140, III Lei das Sociedades por Ações (Brazil).
50 § 102 I AktG (Germany); Art. L. 225-​18 Code de commerce (France).
51 See notes 28 and 32 and accompanying text.
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Appointment and Decision Rights
57
supermajority vote. German law favors stability on the management board as well, by
insulating its members from removal without cause to some degree.52
3.2.3 Decision rights
Since the corporate form seeks to facilitate delegated decision-​making, striking the
balance between shareholder decision rights and the powers reserved to managers is a
delicate exercise for corporate lawmakers. As we explain in later chapters, shareholders
obtain mandatory decision rights principally when directors (or their equivalents) have
conflicted interests or when decisions call for basic changes in governance structure
or fundamental transactions that potentially restructure the firm (Chapters 6 and 7).
Further attribution of decision rights closely tracks appointment rights—​it depends on
the nature of the shareholders and the coordination costs they face.
Almost all jurisdictions require shareholders to approve some corporate actions,
whether upon a board proposal or even a shareholder’s. Traditionally, U.S. law mandates shareholder ratification for a relatively narrow range of fundamental decisions
(in short: charter amendment and mergers), while our other core jurisdictions grant
shareholders a broader range of decision rights, including certain routine but important matters. For example, they require the general shareholders’ meeting to approve
dividend distributions.53 For UK listed companies, the premium Listing Rules require
shareholder approval of so-​called “Class 1” transactions, which exceed a threshold of significance (25 percent) measured by reference to a range of corporate valuation metrics.54
Equally important, all EU member states give shareholders the right to appoint and dismiss the auditors of listed and publicly traded companies,55 while shareholders also elect
the “statutory auditors” or “supervisors” of Japanese, Italian, and Brazilian companies.56
On one dimension—​shareholder voting on executive pay—​convergence is fast
approaching, on a rule that permits the shareholders’ meeting to cast a vote on man­
agers’ compensation packages. We deal with “say on pay” in Chapter 6.57
Jurisdictions also differ in the latitude of the initiation rights they grant shareholders. At one end of the spectrum, the UK and Brazil confer extensive powers on shareholders. The statutory default in the UK permits a 75 percent majority shareholder
vote to overrule the board on any matter, even if it is within the board’s competence.58
Brazil does not contain a similar rule, but permits a simple majority of shareholders to
make the lion’s share of business decisions beyond the very few matters that necessarily
require board action.59 In addition, duly filed shareholder agreements can even bind
52 See text following note 41.
53 §§ 58 and 174 AktG (Germany); Art. L. 232-​12 Code de commerce (France); Art. 2434 Civil
Code (Italy); Art. 454(1) Companies Act (Japan); Art. 132, II Lei das Sociedades por Ações. For
the UK, see Art. 70 Schedule 3, Model Articles for Public Companies, Companies (Model Articles)
Regulations 2008 No. 3229.
54 LR 10, UK Listing Rules.
55 Art. 37(1) EU Audit Directive (Directive 2006/​43/​EC on statutory audits of annual accounts
and consolidated accounts, 2006 O.J. (L 43) 1, as amended by Directive 2014/​56, 2014 O.J. (L
158) 196).
56 Ibid. See also Art. 329(1) Companies Act (Japan); Art. 2400 Civil Code (Italy); Art. 162 Lei das
Sociedades por Ações (Brazil).
57 See Chapter 6.2.3.
58 See Schedule 3, Art. 4 Model Articles for Public Companies, note 53. This power’s significance
is more symbolic than practical. A supermajority is hard to muster, yet a simple majority is enough to
remove the board (note 38) and consequently to induce it to do what the shareholders want.
59 Arts. 121 and 142 Lei das Sociedades por Ações.
58
58
The Interests of Shareholders as a Class
the vote of corporate directors, to the effect that votes contradicting the agreement are
not counted in shareholder and board meetings.60
Elsewhere, shareholders have less extensive rights. Routine business decisions generally fall within the (management) board’s exclusive authority to “manage” the corpor­
ation.61 Nevertheless, continental European jurisdictions and Japan allow qualified
percentages of shareholders to initiate and approve resolutions on a wide range of
matters including questions that may have fundamental importance to the company’s
management and strategic direction, such as amendments to the corporate charter.62
By contrast, U.S.—​or at least Delaware—​law is the least shareholder-​centric jurisdiction. As we discuss in Chapter 7, shareholders of Delaware corporations must ratify
fundamental corporate decisions such as mergers and charter amendments but lack the
power to initiate them.63
Even though shareholder decision rights in public companies diverge across jurisdictions, in closely held companies they converge on flexible and extensive shareholder
decision rights. A good example is the German limited liability company (GmbH),
which may become very large in capitalization and number of shareholders. The
GmbH not only mandates shareholder approval of financial statements and dividends,
but also authorizes the general shareholders’ meeting to instruct the company’s board
(or general director) on all aspects of company policy.64 The GmbH form, then, allows
shareholders complete authority to manage the business by direct voting—​unless the
company is subject to codetermination law by virtue of the size of its workforce.65 Our
other core jurisdictions are similarly flexible.
Finally, at the level of the individual shareholder, many jurisdictions permit derivative actions, which are not only an enforcement mechanism but also a right granted
to individual shareholders to manage a corporate cause of action. We discuss derivative suits further in Chapter 6 and the directors’ duties upon which they are based in
Section 3.4.1.
3.2.4 Shareholder coordination
Closely related to shareholders’ appointment and decision rights is the extent to which
the law seeks to assist dispersed shareholders in overcoming their collective action
problems. All of our target jurisdictions do this, up to a point.
Voting mechanisms are a conspicuous example. Small shareholders everywhere may
exercise their voice at shareholders’ meetings through attendance in person, which is obviously cumbersome, or through at least one of four mechanisms meant to make voting
less costly: voting by mail (or “distance voting”), proxy solicitation by corporate partisans,
60 Art. 118 Lei das Sociedades por Ações.
61 E.g. § 141(a) Delaware General Corporation Law; § 76 Aktiengesetz (Germany).
62 See Dirk Zetzsche, Shareholder Interaction Preceding Shareholder Meetings of Public Corporations—​
A Six Country Comparison, 2 European Company and Financial Law Review 107, 120–​8 (2005)
(France and Germany). For Italy see Art. 2367 Civil Code and Art. 126-​II Consolidated Act on
Financial Intermediation. For Japan, see Goto, note 23, at 129–​31, 135–​6.
63 See Chapters 7.2 and 7.4. However, shareholders in U.S. corporations do have initiation rights
with respect to amendments of corporate bylaws. While some action has taken place in this area, it
appears less than one might expect, given the relatively high stakes compared with other contentious
areas of corporate governance. See Kahan and Rock, note 29, at 2019.
64 §§ 37, 38, 46 GmbHG.
65 A GmbH subject to codetermination must have a two-​tier board and is subject to AG rules on
the division of functions between the boards, and between boards and shareholders. Karsten Schmidt,
Gesellschaftsrecht 482–​3 (4th edn., 2002).
59
Appointment and Decision Rights
59
proxy voting through custodial institutions or other intermediaries, and partici­pation in
an electronic meeting. For example, Japanese law allows firms with significant numbers
of shareholders to choose voting either by proxy or by mail.66 France, Germany, Italy,
and the UK allow corporations to opt for distance voting.67 As a consequence of the EU
Shareholder Rights Directive, all of these jurisdictions also now permit electronic meetings and voting.68 The U.S. traditionally relied on proxy voting,69 but has also made it
possible for companies to establish “electronic forums” for communication with, and
between, shareholders, and for proxy solicitation and appointment to be conducted via
the internet (so-​called “e-​proxies”).70 Finally, Brazilian law now enables distance voting
and permits companies to hold live electronic meetings and voting.71
When investors hold shares in individual companies, they usually do so via institutions such as banks (in most jurisdictions) or broker-​dealers (in the U.S.) acting as their
custodians. As such, these intermediaries have no financial interest in the shares deposited
with them. Yet they may face conflicts of interest owing to actual or prospective business
relationships with listed companies. For this reason, when they were empowered to vote
custodial shares, they generally favored the corporate nominees. This practice was once
common among U.S. broker-​dealers,72 and European custodians, such as banks, played
an even stronger, pro-​incumbent role in corporate governance. In Germany, for example,
where supervisory boards have traditionally not engaged in partisan proxy solicitation,73
banks serving as custodians for retail investors used to vote the shares in favor of corporate
nominees. This custodial exercise of voting rights was justified by reference to investors’
“implicit consent.”74 After market pressure and legal reform restricted this practice,75 voting outcomes in widely held German companies have occasionally become less predictably pro-​management.76
66 Japanese firms with 1000 or more shareholders must make this choice: Arts. 298(1)(iii) and
298(2) Companies Act. Voting by mail is also optional for smaller companies, and voting by electronic
means is optional for all Japanese companies: Art. 298(1)(iv) Companies Act. In practice most large
public Japanese firms adopt voting by mail rather than proxy voting.
67 Art. L. 225-​107 Code de commerce (France); Art. 2370(4) Civil Code and Art. 127 Consolidated
Act on Financial Intermediation (Italy). For Germany, see the 2001 law on registered shares and on
facilitating the exercise of the right to vote (NaStraG). In the UK, this can be done by inserting a
provision in the company’s articles: Companies Act (UK) 2006, s 284(4).
68 Art. 8 Directive 2007/​36/​EU, 2007 O.J. (L 184) 17.
69 The NYSE mandates proxy solicitation for “operating” listed U.S. firms except where solicitation
would be impossible (Rule 402.04(A) Listed Company Manual). See also Rules 4350(g) and 4360(g)
NASDAQ Marketplace Rules (same). No such law or listing requirement exists in Germany, France,
Italy, the UK, or Japan.
70 SEC Rules 14a-​16, 14a-​17.
71 CVM Instruction No. 481 (2009), as amended by CVM Instruction No. 561 (2015).
72 Since 2009 U.S. brokerage houses have been prohibited from voting shares held as nominees
(in “street name”) in directorial elections in the absence of direct instructions from beneficial owners: NYSE Rule 452. The Dodd-​Frank Act broadened the prohibition to voting on executive compensation, including say-​on-​pay (§ 957).
73 See Schmidt, note 65, at 854.
74 The shareholders could always instruct their banks as to how to vote their shares, but rarely gave
explicit instructions.
75 See Wolf-​Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance
and the Erosion of Deutschland AG, 63 American Journal of Comparative Law 493, 506–​7 (2015).
76 For example, the Chairs of Deutsche Börse’s supervisory and management boards agreed to
resign after activist investor pressure made it clear that they would face a vote of dismissal at the general meeting. See Norma Cohen and Patrick Jenkins, D Börse Chiefs Agree to Step Down, Financial
Times (Europe), 10 May 2005, at 1. For evidence of the decline in bank influence in Germany see
Ringe, note 75, 522–​4. For recent anecdotal evidence of increasingly successful hedge fund activism
in Germany, see Stada and Deliver, The Economist, 3 September 2016, at 58.
60
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The Interests of Shareholders as a Class
Such outcomes have also been furthered by the increasing internationalization and
institutionalization of share ownership in German companies.77 A similar ownership
pattern can be observed in other core jurisdictions: in each of them, shareholdings (or
minority shareholdings in companies with a controlling shareholder) are increasingly
in the hands of institutions, mostly asset managers acting for pension funds and insurance companies, with the largest among them often holding average stakes around
5 percent of the most liquid shares in many markets.78 Institutions that invest in the
market on behalf of multiple beneficiaries can aggregate control rights, thereby redu­
cing the collective action problems faced by disaggregated investors. Indeed, many
institutions with financial obligations to their beneficiaries or customers—​including
pension funds, mutual funds, and insurance companies—​have long been champions
of shareholder interests in the UK,79 and are increasingly so in the U.S., especially after
policymakers shifted from a legal framework that discouraged shareholder activism
and coordination to one which overall favors it.
U.S. federal proxy regulation was historically more concerned with the risk that
a faction of shareholders would gain control, to the detriment of the shareholders in general, than with managerial agency costs.80 That translated into rules that
not only discouraged insurgents seeking to gain control via proxy contests, but also
chilled coordination attempts among shareholders generally. Along with the advent
of ubiquitous institutional investor ownership, the proxy rules restrictions on inter-​
shareholder communication were greatly relaxed in 1992.81 And while barriers
to shareholder collective action still remain, including registration and disclosure
requirements for any 5 percent “group” of shareholders whose members agree to
coordinate their votes,82 hedge fund activists’ tactics have shown how favorable the
overall framework now is to shareholder engagement. Indeed, the U.S. rules prove
looser than those of our other jurisdictions when it comes to treating shareholders
as “acting in concert” with a view to engaging a target company’s management. They
are also more effective in nudging institutional investors into voting their portfolio
shares.
In the U.S., activist hedge funds may alert other hedge fund managers of their
intention to start a campaign without falling foul of insider trading laws.83 And if, as a
result, both the initial activist and other hedge funds buy shares in the target company,
they need not aggregate their holdings for disclosure purposes.84 On the contrary,
European insider trading rules would treat the intention to start a campaign as price
sensitive information, which would prevent those who learn about it from buying
additional shares.85 In addition, hazier definitions of “acting in concert” for mandatory
bid rule purposes, especially in countries such as Germany and France, which have not
77 Ringe, note 75 at 524–​6.
78 See e.g. Paul Davies, Shareholders in the United Kingdom, Research Handbook on
Shareholder Power 355, 357–​9 (Jennifer G. Hill and Randall S. Thomas eds., 2015) (UK); Edward
B. Rock, Institutional Investors in Corporate Governance, in Oxford Handbook of Corporate Law
and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017) (U.S.).
79 See Geof P. Stapledon, Institutional Shareholders and Corporate Governance (1996).
80 See e.g. John Pound, Proxy Voting and the SEC: Investor Protection Versus Market Efficiency, 29
Journal of Financial Economics 241 (1991).
81 See Regulation of Communication among Shareholders, Exchange Act Release No. 34-​31326
(1992). See SEC Rule 13d-​5 (17 C.F.R. § 240.13d-​5 (2008)).
82 See SEC Rule 13d-​5 (17 C.F.R. § 240.13d-​5 (2008)).
83 See Coffee and Palia, note 20, at 35.
84 See ibid. at 28–​42.
85 See Arts. 7–​9 Market Abuse Regulation, 2014 O.J. (L 173) 1).
61
Appointment and Decision Rights
61
tried to dissipate doubts via regulatory exemptions or guidance, mean that activists
have to beware the risk of jointly crossing the relevant thresholds.86
Moreover, since the 1980s, U.S. rules on institutional investors’ voting of portfolio
shares have proved hospitable to shareholder activism. A rule that first covered pension
funds, and was later extended to other asset managers, declared fiduciary duties applicable to decisions regarding the exercise of portfolio shares’ voting rights.87 In addition,
since 2003, mutual funds have had to disclose their proxy voting policies.88 These
regulations have helped to raise participation rates at both U.S. and foreign portfolio
companies and to standardize asset managers’ views on corporate governance issues,
usually in the direction of more pro-​shareholder corporate governance policies at the
portfolio company level. As importantly, such rules have hugely increased the demand
for proxy advisory services and therefore the influence on corporate governance of ISS
and Glass Lewis, the two dominant global proxy advisers.
In Europe policymakers have moved much less in the direction of mandating institutional investors’ involvement in corporate governance, although they have similarly
sought to ensure that, as responsible owners, institutions engage with their portfolio companies. The UK, followed by Japan, took the lead in this area by adopting a
‘Stewardship Code,” which aimed to increase asset managers’ accountability as regards
their exercise of ownership (mainly voting) rights.89 The Stewardship Code, however,
has no mandatory component: like for Corporate Governance Codes,90 the only obligation is for UK asset managers to declare whether they comply with it or otherwise
explain why they do not. Judging from both mandated statements by UK asset managers and voluntary ones by foreign institutions, the Stewardship Code’s principles,
perhaps because of their generality, seem broadly shared within the industry.91
Harder to tell is whether compliance with the Stewardship Code’s principles and,
in the U.S., with mandatory voting and voting policies disclosure requirements also
translates into improved governance and/​or management and financial performance at
portfolio companies.92 A cause for skepticism is that—​unlike Corporate Governance
86 See Chapter 8.3.4. The UK Takeovers Panel issued guidance on acting in concert by active
shareholders. See Takeover Panel, Practice Statement No. 26. Shareholder Activism (2009) (available
at www.thetakeoverpanel.org). Italy’s securities regulator (Consob) similarly clarified which coordinating actions, such as agreement to vote against a given board proposal, are not per se relevant for acting
in concert purposes: Art. 44-​IV Consob Regulation on Issuers.
87 See e.g. Robert B. Thompson, The Power of Shareholders in the United States, in Research
Handbook on Shareholder Power, note 78, 441, 451.
88 SEC, Proxy Voting by Investment Advisers, Release No. IA-​2106, 68 FR 6585 (7 Feb. 2003).
The European Commission is following suit in this area by championing a prescriptive approach along
the lines of the SEC rules. See Art. 3f Shareholders Rights Directive, as envisaged by the Proposed
Directive amending Directive 2007/​36/​EC as regards the encouragement of long-​term shareholder
engagement, Directive 2013/​34/​EU as regards certain elements of the corporate governance statement
and Directive 2004/​109/​EC, as approved by the European Parliament on 8 July 2015.
89 Financial Reporting Council (UK), The UK Stewardship Code (2012); Council of Experts
Concerning the Japanese Version of Stewardship Code, Principles for Responsible Institutional
Investors—​Japan’s Stewardship Code (2014).
90 See Chapter 3.3.1.
91 As the time of writing (June 2016), the Financial Reporting Council website lists 306 asset managers, owners, and service providers (such as proxy advisers), including Blackrock, Fidelity, Vanguard,
ISS, and Glass Lewis, who have stated their commitment to the Code. See www.frc.org.uk. The
Japanese Stewardship Code is a form of pure soft law, in that even Japanese institutional investors are
under no obligation to comply or explain. The Financial Services Agency’s website lists 207 institutional investors who have undertaken to comply or explain as of end of May 2016.
92 A review of the empirical evidence by one of this book’s authors gives few grounds for optimism.
See Rock, note 78.
62
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The Interests of Shareholders as a Class
Codes—​there are few obvious mechanisms through which the information disclosed
will be aggregated and acted upon by the asset managers’ ultimate principals, retail
investors in institutional investment vehicles.
3.3 Agent Incentives
Within the framework of the law, market forces play an important role in molding
corporate agents’ behavior. They have levered upon both the low-​powered incentives
of independent directors within boards tasked with a monitoring role (a trusteeship
strategy), and the high-​powered incentives created by seeking to align managers’ incentives with shareholders’ interests through equity-​linked compensation (a reward strategy). The law has intervened in these two areas, sometimes to support and reinforce
market practices, and sometimes to curb distortions in their use that might result from
the very agency problems such practices seek to ameliorate. Trusteeship and reward
strategies have also been used as complements, as where independent directors are
charged with the task of ensuring that executive compensation packages genuinely
align incentives rather than serving simply as ways for managers to transfer wealth to
themselves. While we discuss these two strategies separately below, it is therefore useful
to remember that board effectiveness is the outcome of the interaction, inter alia, of
both rewards and trusteeship: disentangling their separate contributions is one of the
many challenges that empirical studies must address in this area.93
3.3.1 The trusteeship strategy: Independent directors
Among our core jurisdictions, the principal trusteeship strategy for protecting the
interests of disaggregated shareholders is the inclusion of “independent” directors
amongst those comprising the board. Because their compensation packages tend to be
less sensitive than managers’ to share performance, they are free(r) from high-​powered
incentives. And because they are not themselves making day-​to-​day management decisions, they can be expected to identify less with management and to be more willing to be critical.94 The board—​whether one-​tier or two-​tier—​then comprises both
man­agers, whose incentives are shaped mainly by the rewards strategy,95 and non-​
executives, whose incentives are rather shaped by the trusteeship strategy.96
The increasingly common requirement that some or most members of a corporation’s board of directors not be executives of the firm reflects the trusteeship strategy
in that it removes one conspicuous high-​powered incentive for directors to favor the
interests of the firm’s management at the expense of other constituencies. Truly independent directors are board members who are not strongly tied by high-​powered financial incentives to any of the company’s constituencies and consequently are motivated
principally by ethical and reputational concerns. That is, of course, our definition of
a trustee.97
93 See also end of section 3.3.1.
94 Melvin A. Eisenberg, Legal Models of Management Structure in the Modern Corporation: Officers,
Directors, and Accountants, 63 California Law Review 375 (1975).
95 See Section 3.5.
96 See Ronald W. Masulis and Shawn Mobbs, Independent Director Incentives: Where Do Talented
Directors Spend Their Limited Time and Energy? 111 Journal of Financial Economics 406 (2014).
97 See Chapter 2.2.2.3.
63
Agent Incentives
63
All of our core jurisdictions now recognize a class of “independent” directors in this
sense, and most jurisdictions actively support at least some participation by these directors to key board committees (audit, nomination, and compensation). Complementing
its traditionally limited reliance on shareholder control rights, the U.S. is the originator of this form of trusteeship and still its most enthusiastic proponent. U.S. case law
generally encourages independent directors,98 while U.S. exchange rules now require
that company boards include a majority of independent directors and that key board
committees be composed by a majority, or entirely, of independent directors.99 In
addition, the Sarbanes-​Oxley Act of 2002 (“SOX”) mandated wholly independent
audit committees; eight years later, the Dodd-​Frank Act mandated wholly independent compensation committees.100 Similarly, the SOX-​inspired EU Audit Directive
requires publicly traded companies to have audit committees with a majority of independent directors, including an independent chair.101
Other than that, our EU jurisdictions promote independent directors mainly
through soft law, in the form of “corporate governance codes.” These are guidelines
for listed companies that address board composition, structure, and operation, and
are drafted by market participants under the aegis of an exchange or a public body.
Listed companies are not legally bound to follow these guidelines. Instead, they have
an obligation to report annually whether they comply with code provisions and, if they
do not comply, the reasons for their noncompliance—​a so-​called “comply or explain”
obligation.102 This device is intended to enlist reputation, shareholder voice, and market pressure to push companies toward best practices, while simultaneously avoiding
rigid rules in an area where one size clearly does not fit all.103
The UK’s code is most enthusiastic in its reliance on independence. It recommends
that at least half the board of listed companies (other than smaller ones) be composed of
independents,104 who should also fill the audit and remuneration committees as well as
a majority of the nomination committee.105 France, Germany, and Italy follow the same
direction, although they are less whole-​hearted in their embrace of independence. The
French code distinguishes between widely held companies (recommending independence
for half of the board) and companies with a controlling shareholder (recommending
98 In particular, Delaware courts have repeatedly emphasised the importance of independence as a
criterion for review of conflicted transactions or litigation decisions. See Chapter 6.2.2.1.
99 See Rules 303A.01 (listed companies must have a majority of independent directors) and
303A.04–​05 (nominating/​corporate governance and compensation committees composed entirely of
independent directors) NYSE Listed Company Manual; Rule 4350(c)(1) (majority of independent
directors required) and Rules 4350(c)(3)–​(4) (compensation and nominations committees comprised
solely of independent directors; one out of three members may lack independence provided that she is
not an officer or a family member of an officer) NASDAQ Marketplace Rules.
100 SOX, § 301; Dodd-​Frank Act of 2010, § 952.
101 Art. 39(1) Directive 2006/​43/​EC (note 55). However, Art. 39(5) Audit Directive allows
member states to opt out of the independence requirements where all members of the audit committee are also members of the supervisory board. Germany has made use of this opt-​out. See
Abschlussprüfungsreformgesetz of 10 May 2016, Art. 5 Nr. 1, 2.
102 See e.g. LR 9.8.6 UK Listing Rules; for Germany, § 161 AktG.
103 For example, it appears that compliance with code provisions is associated with increased
performance in UK firms with dispersed ownership, but has no measurable impact for firms with
a controlling shareholder: see Aridhar Arcot and Valentina Bruno, Corporate Governance and
Ownership: Evidence from a Non-​Mandatory Regulation, Working Paper (2014), available at ssrn.
com. See also Alain Pietrancosta, Enforcement of Corporate Governance Codes: A Legal Perspective, in
Festschrift für Klaus J. Hopt 1, 1109, 1130 (Stefan Grundmann et al. eds., 2010).
104 UK Corporate Governance Code (2014), Provisions B.1.2.
105 Ibid., Provisions B.2.1, C.3.1, and D.2.1.
64
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The Interests of Shareholders as a Class
independence for one-​third),106 while the German and Italian codes only recommend
an “adequate number” of independent directors/​members of the supervisory board, leaving broad discretion to individual companies.107 The case of independent directors in
Germany is particularly delicate, as shareholders may fear that directors who are “independent” of shareholders might side with labor representatives on a divided board. In
all three countries the codes recommend an independent audit committee,108 France
and Italy a remuneration committee, and Germany, with France, a nomination committee.109 Brazilian corporate law does not impose any director independence requirements,
but the premium listing segments of the São Paulo stock exchange (such as the Novo
Mercado and Level 2) mandate a minimum of 20 percent independent directors.110
As a response to criticisms of the traditional system of insider-​dominated boards
coupled with a nominally independent but weak board of statutory auditors,111 the
Japanese Companies Act permitted companies to adopt a U.S.-​style, tripartite committee structure in 2002. While a few firms with greater international exposure have
chosen this new structure,112 it has not proven particularly popular.113 However, the
reform of the Companies Act in 2014 push listed companies, on a comply or explain
basis, to appoint at least one outside director. This and a recommendation, in the
Corporate Governance Code of 2015,114 to appoint two independent directors, has
triggered a rapid increase in the number of listed companies appointing one or two
independent directors.115 Nevertheless, it remains infrequent for Japanese companies
to appoint any more independent directors.116
106 French Corporate Governance Code, Principle 9.2.
107 See Recommendation 5.4.2 German Corporate Governance Code; Principle 3.P.1, Italian
Corporate Governance Code (for the 40 most traded stocks, the recommendation is for one third of
independent directors: ibid., criterion 3.C.3).
108 On EU requirements for an audit committee see note 158.
109 See French Corporate Governance Code, Principle 15 and 17; Recommendation 5.3 German
Corporate Governance Code; Arts. 5–​7 Italian Corporate Governance Code. In Germany, a majority of the larger listed companies has set up remuneration committees as well. See Klaus J. Hopt and
Patrick C. Leyens, Board Models in Europe—​Recent Developments of Internal Corporate Governance
Structures in Germany, the United Kingdom, France, and Italy, 1 European Company and Financial
Law Review 135, 141 (2004).
110 Novo Mercado Regulations Art. 4.3; Level 2 Regulations Art. 5.3.
111 See note 5.
112 See Ronald J. Gilson and Curtis J. Milhaupt, Choice As Regulatory Reform: The Case of Japanese
Corporate Governance, 53 American Journal of Comparative Law 343, 349 (2005); Amon
Chizema and Yoshikatsu Shinozawa, The “Company with Committees”: Change or Continuity in
Japanese Corporate Governance?, 49 Journal of Management Studies 77 (2012).
113 As of July 2014, only 58 out of 3414 (or 1.7 percent of ) listed companies at the Tokyo Stock
Exchange took the form of a company with three committees. See Tokyo Stock Exchange, TSE-​
Listed Companies White Paper on Corporate Governance 2015, at 15 (available at http://​www.
jpx.co.jp/​english/​equities/​listing/​cg/​02.html).
114 The Council of Experts Concerning the Corporate Governance Code, Japan’s Corporate
Governance Code [Final Proposal] (2015).
115 For details and analysis of the recent reforms in Japan, see Gen Goto, Manabu Matsunaka, and
Souichirou Kozuka, Japan’s Gradual Reception of Independent Directors: An Empirical and Political-​
Economic Analysis, in Independent Directors in Asia (Harald Baum et al. eds.) (forthcoming).
The ratio of companies listed in the First Section of the Tokyo Stock Exchange (the top-​tier market
of Japan) appointing at least one outside director has increased from 30.2 percent in 2004 to 94.3
percent in 2015, and the ratio of the same companies appointing at least two independent directors
has increased from 12.9 percent in 2010 to 48.4 percent in 2015. See Tokyo Stock Exchange, Inc.,
Appointment of Outside Directors by TSE-​Listed Companies [Final Report] (29 July 2015), available
at http://​www.jpx.co.jp/​english/​listing/​stocks/​ind-​executive/​index.html.
116 Ibid. As of July 2015, the ratio of companies listed in the 1st Section of Tokyo Stock Exchange
having one third or more of independent directors was 12.2 percent, and the ratio of those having a
majority of independent directors majority was 2.7 percent.
65
Agent Incentives
65
Trustee-​like directors are thus increasingly considered to be a key element of
good governance in all of our core jurisdictions. In the U.S. and the UK, they
are most often seen as monitors of managers (although this task might be better
performed by directors who were dependent on shareholder interests).117 In EU
jurisdictions with concentrated ownership structures and Brazil, truly independent directors are more likely to be seen as champions of minority shareholders or non-​shareholder constituencies. Put differently, trustee-​like directors can
be seen as a wide-​spectrum prophylactic. They are potentially valuable for treating all agency problems (as well as externalities), but not exclusively dedicated
to treating any.118 Nevertheless, it is questionable whether nominally independent directors appointed by a controlling shareholder can properly function as
“trustees” who will protect the interests of minority shareholders, rather than as
agents for the controller.119 Moreover, independent directors come at a price, as
there is inevitably a tradeoff between a director’s independence and her knowledge
about the company.120 According to many, independent boards, with their limited
understanding of risk management and the technicalities of bank management,
contributed to the bank failures in 2008–​9.121 As a result, policymakers’ emphasis,
especially (but not exclusively) for financial institutions, is nowadays as much on
competence as independence.122
Unfortunately, the crucial empirical question whether independent directors have
a positive impact on firm performance is exceptionally difficult to answer.123 Because
board structure is primarily a matter for individual firms to decide, the proportion of
independent directors is likely as much a response to, as a cause of, variation in performance. Moreover, the aspects of board structure that affect performance vary by country
117 See e.g. Ronald J. Gilson and Reinier Kraakman, Reinventing the Outside Director: An Agenda
for Institutional Investors, 43 Stanford Law Review 863 (1991); Jonathan R. Macey, Corporate
Governance: Promises Kept, Promises Broken 90–​2 (2008).
118 On the use of independent directors to tackle a variety of agency and non-​agency problems
over time, see Mariana Pargendler, The Corporate Governance Obsession, 42 Journal of Corporation
Law 101 (2016).
119 See Wolf-​Georg Ringe, Independent Directors: After the Crisis, 14 European Business
Organization Law Review 401 (2013); Arcot and Bruno, note 103. See also Chapter 4.1.3.1 and
Chapter 6.2.2.1.
120 For discussion of trade​offs between independence and information on the board see Arnoud
W.A. Boot and Jonathan R. Macey, Monitoring Corporate Performance: The Role of Objectivity,
Proximity, and Adaptability in Corporate Governance, 89 Cornell Law Review 356 (2003). Cf. Jeffrey
N. Gordon, The Rise of Independent Directors in the United States, 1950–​2005: Of Shareholders Value
and Stock Market Prices, 59 Stanford Law Review 1465, at 1541–​63 (2007) (increasingly informed
share prices in the U.S. facilitate monitoring by independent directors); Enrichetta Ravina and Paola
Sapienza, What do Independent Directors Know? Evidence From Their Trading, 23 Review of Financial
Studies 962 (2008) (independent directors do almost as well as insiders in trading company stock,
suggesting no lack of information).
121 See e.g. Jacob de Haan and Razvan Vlahu, Corporate Governance of Banks: A Survey, 30 Journal
of Economic Surveys 228 (2016).
122 See e.g. Art. 91(1) Council Directive 2013/​36 of the European Parliament and of the Council
of 26 June 2013 on Access to the Activity of Credit Institutions and the Prudential Supervision of
Credit Institutions and Investment Firms, 2013 O.J. (L 176) 338: “Members of the management
body shall at all times be of sufficiently good repute and possess sufficient knowledge, skills and
experience to perform their duties. The overall composition of the management body shall reflect
an adequately broad range of experiences.” For non-​financial firms, see e.g. Principle B.1 Corporate
Governance Code (2014) (UK).
123 For a comprehensive review, see Renée B. Adams, Benjamin E. Hermalin, and Michael S.
Weisbach, The Role of Boards of Directors in Corporate Governance: A Conceptual Framework and Survey,
48 Journal of Economic Literature 58 (2010).
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The Interests of Shareholders as a Class
as much as by firm.124 Finally, no matter what definition the law or corporate governance
codes provide of independence, whether directors labeled as “independent” will act as
such depends on a congeries of factors, such as personal character and the actual remoteness of insiders from the appointment process, which are formidably difficult to measure.
3.3.2 The reward strategy: Executive compensation
The other technique used to modify agent incentives is the reward strategy. Like the
trusteeship of independent directors, this strategy is sometimes said to substitute for
direct shareholder monitoring and exercise of control rights when shareholders are
dispersed and face high coordination costs.125 The theory is that optimally structured
pay packages can align the interests of managers with those of shareholders as a class.
The reality is that managerial rewards can—​depending on their terms—​be as much
a strategy for controlling agency costs as a symptom of them. In addition, if alignment of managers’ and shareholders’ interests is achieved by taking the stock price as a
proxy for the latter, deviation from what is optimal even for shareholders may occur at
companies for which markets do an imperfect job in reflecting the “true” value of their
investment policies and business strategies, such as in sectors where innovation is more
relevant and harder to understand.126
Corporate law generally does not stipulate rewards directly, but regulates how companies can compensate their managers in order to advance the interests of the firm.
The most important reward for managers of publicly traded firms today is equity-​based
compensation, which comes in many forms—​namely, stock options, restricted stock,
and stock appreciation rights—​and now comprises large (albeit varying) portions of
total compensation for top managers in all of our core jurisdictions.
Consistently with the idea that the rewards strategy may substitute for shareholder
decision rights, the U.S.—​which has traditionally accorded shareholders the weakest
decision rights amongst our core jurisdictions—​has embraced high-​powered equity
incentives most comprehensively. Although Delaware courts initially regarded stock
options with suspicion,127 they soon made their peace, aided by the wide discretion
U.S. firms enjoy to issue rights and repurchase shares.128 Moreover, a 1994 change in
U.S. tax law129 gave options an enormous (if unintentional) boost by barring corporations from expensing executive compensation in excess of $1 million per year that was
not tied to firm performance.130
For the rewards strategy to operate effectively, compensation must be appropriately calibrated. The U.S. has long relied on disclosure to avoid excessive or incentive-​
distorting compensation. Nevertheless, objections of miscalibration have repeatedly
been voiced, with some cause.131 As hinted in previous sections, the Dodd-​Frank Act
124 Bernard S. Black, Antonio Gledson de Carvalho, and Érica Gorga, What Matters and for
Which Firms for Corporate Governance in Emerging Markets? Evidence from Brazil (and other BRIKC
Countries), 18 Journal of Corporate Finance 934 (2012).
125 Marcel Kahan and Edward Rock, How I Learned to Stop Worrying and Love the Pill: Adaptive
Responses to Takeover Law, 69 University of Chicago Law Review 871 (2002).
126 See text preceding note 21.
127 See e.g. Krebs v. California Eastern Airways, 90 Atlantic Reporter 2d 562 (Del. Ch. 1952).
128 E.g. § 157 Delaware General Corporation Law.
129 Internal Revenue Code § 162(m).
130 See John C. Coffee, A Theory of Corporate Scandals: Why the USA and Europe Differ, 21 Oxford
Review of Economic Policy 198, 202 (2005).
131 See Chapter 6 and especially 6.2.2.1.
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Agent Incentives
67
of 2010 sought to strengthen the efficacy of the trusteeship strategy’s control over
reward calibration, by requiring that compensation committees be composed entirely
of independent directors.132 At the same time, it mandated the introduction of shareholder decision rights in relation to executive compensation, by providing for an advisory “say on pay” vote.133
Our other core jurisdictions have relied less heavily on the rewards strategy. Thus,
there is less linkage between executive pay and corporate performance outside the U.S.,
even in jurisdictions where ownership is similarly dispersed such as Japan and the UK.
In the UK, shareholder decision rights have traditionally been stronger, meaning that
there has been less need for the reward strategy.134 In Japan, while recent policy discussions suggest increased favor for the reward strategy, the emphasis has traditionally
been on creating a sense of unity between management and employees, which clearly
makes the reward strategy an unlikely fit.135 And in other jurisdictions, the common
presence of a controlling shareholder is associated with significantly lower CEO compensation,136 presumably because the controlling shareholder can rely on his own decision rights both to ensure good performance from managers and to curb excessive pay.
These differences in the use of the rewards strategy also track differences in the legal
framework as regards the discretion of the board (as opposed to shareholders) to set pay.
This is nicely illustrated by comparing the roughly contemporaneous Delaware civil
litigation against Michael Eisner (Disney, Inc.’s former CEO) and other Disney directors over a termination payment that awarded $140 million to Disney’s President137
with the criminal prosecution of Josef Ackermann, at the time Deutsche Bank’s CEO
and a Mannesmann AG director, and two other members of Mannesmann supervisory
board, for paying Mannesmann’s CEO and members of his executive team “appreciation awards” (of approximately $20 million in the case of the CEO) for having
extracted an extraordinarily high premium from a hostile acquirer (Vodafone) after a
drawn-​out takeover battle.138
The two cases differed importantly on their facts. In Disney, the amount in issue
was contractually fixed ex ante, and the dispute turned on whether Disney’s directors
had been so grossly negligent as to have acted in bad faith, either in negotiating the
original contract or in not contesting a “no fault termination clause” that triggered the
$140 million payment to Disney’s ex-​President. In Mannesmann, the payments at issue
were gratuitous (ex post bonuses granted by Ackermann and one other member of the
132 Dodd-​Frank Act of 2010, § 952. The SOX had previously introduced modest controls on
executive compensation: see §§ 304 (mandating disgorgement of CEO/​CFO incentive compensation
received following a financial misstatement); 402 (banning corporate loans to senior executives to use
for exercising options).
133 Dodd-​Frank Act of 2010, § 951.
134 See Martin J. Conyon and Kevin J. Murphy, The Prince and the Pauper? CEO Pay in the United
States and United Kingdom, 110 Economic Journal 467 (2002). The greater performance-​sensitivity
in the U.S. means executives there bear more firm-​specific risk, which pushes upward the size of overall awards: Martin J. Conyon, John E. Core, and Wayne R. Guay, Are U.S. CEOs Paid More than U.K.
CEOs? Inferences from Risk-​Adjusted Pay, 24 Review of Financial Studies 402 (2011).
135 See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive
Compensation: Evidence from Japan, 2014 Columbia Business Law Journal 111.
136 See Martin J. Conyon et al., The Executive Compensation Controversy: A Transatlantic Analysis
55, Working Paper (2011); Marcos Barbosa Pinto and Ricardo Pereira Câmara Leal, Ownership
Concentration, Top Management and Board Compensation, 17 Revista de Administração
Contemporânea 304 (2013) (finding a negative correlation between the levels of ownership concentration and executive compensation in Brazil).
137 In re Walt Disney Co. Derivative Litigation, 906 Atlantic Reporter 2d 27 (Del. 2006).
138 See e.g. Curtis J. Milhaupt and Katharina Pistor, Law and Capitalism 69–​86 (2008).
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The Interests of Shareholders as a Class
compensation committee), but made with the full approval of Vodafone—​which, by
the time of the payout, held 98.66 percent of Mannesmann’s shares.
Despite these factual differences, the differing outcomes of the two cases are revealing. The Delaware court deployed the business judgment rule to exonerate Eisner and
the Disney board from civil liability despite evidence of negligence and an odor of conflict of interest (the discharged President had been a close personal friend of the CEO).
By contrast, the German Supreme Court (BGH), ruled that Ackermann might be
criminally liable for breach of trust in the form of dissipating corporate assets.139 From
the perspective of Delaware law, it is nearly inconceivable that a disinterested director
(Ackermann) would face civil liability for approving a gratuitous bonus ratified by a
98 percent disinterested shareholder, let alone a criminal penalty.140 Delaware has long
permitted disinterested boards to reward departing executives with compensation in
excess of their contractual entitlements.141 For the BGH, criminal liability followed
as a matter of course from the penal code, the fact that Mannesmann’s independent
existence was ending, and the absence of a pre-​negotiated golden parachute.142
While the U.S. has traditionally constrained managerial pay less than elsewhere,
signs of convergence are emerging. As we have noted, the U.S. has now introduced
limited shareholder ratification of executive compensation, in the form of “say on
pay.” At the same time, the mandatory disclosure of individual directors’ pay and
global competition for executives have driven overall compensation upwards even in
Germany, where the pattern of reliance on rewards has been even more pronounced
in the financial industry and in sectors most exposed to international competition.143
3.4 Legal Constraints and Affiliation Rights
Legal constraints and affiliation rights play an important role in the structure of corporate governance by protecting the interests of shareholders as a class. All managerial
and board decisions are constrained by general fiduciary norms, such as the duties
of loyalty and care. Moreover, affiliation rights in the form of mandatory disclosure
inform both shareholders and boards of directors by providing a metric for evaluating
managerial performance in the form of well-​informed share prices.144 And, of course,
139 BGH, Decision of 21 December 2005, 3 StR 470/​04. Unlike the lower court, the BGH relied
on criminal law alone (§ 266 Strafgesetzbuch (Criminal Code)), and did not pin its holding to § 87
AktG, which requires managerial compensation to be reasonable.
140 See Franklin A. Gevurtz, Disney in a Comparative Light, 55 American Journal of Comparative
Law 453, 484 (2007). Under Delaware law, shareholder ratification would also have protected the
second member of the Mannesmann executive committee, who, unlike Ackermann, stood to benefit
monetarily from the ex post bonuses as a former Mannesmann officer.
141 See Zupnick v. Goizueta, 698 Atlantic Reporter 2d 384 (Del. Ch. 1997) (upholding options
granted for past services at the end of tenure) and Blish v. Thompson Automatic Arms Corporation, Del.
Supr., 64 Atlantic Reporter 2d 581 (1948) (retroactive compensation is not made without consideration where an implied contract is shown to exist or where the amount awarded is not unreasonable
in view of the services rendered).
142 The Mannesmann decision is thought to be wrong by a clear majority of German commentators. The Mannesmann court remanded the case to the lower instance that was courageous enough to
drop the criminal case. The main consequence of the Mannesmann case was that many corporations
introduced a clause in the directors’ contracts allowing such rewards. See also Chapter 8.2.3.5.
143 Francesca Fabbri and Dalia Marin, What Explains the Rise in CEO Pay in Germany? A Panel
Data Analysis for 1977–​2009, IZA Discussion Paper No 6420 (2012). See also Alex Barker, Germany
Overtakes UK in Corporate Executive Pay Stakes, Financial Times, 5 January 2015. On the recent legal
reform of managerial compensation in Germany see Chapter 6.2.2.1.
144 See Gordon, note 120. See also Chapter 9.1.1.
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Legal Constraints and Affiliation Rights
69
the right to exit by freely selling shares underpins the market for corporate control,
an essential component of governance in dispersed ownership firms that we discuss
in Chapter 8. By contrast, exit rights by means of withdrawal of one’s investment in
the firm are made available less frequently in general corporate governance. Corporate
law makes use of them only in special circumstances, detailed in later chapters: for
example, as a remedy for minority shareholder abuse (Chapter 6) or as a check on
certain fundamental transactions such as mergers (Chapter 7).
3.4.1 The constraints strategy
Both hard-​edged rules and fiduciary standards would seem to be of little use, if not
counterproductive, to protect the interests of shareholders. After all, shareholders who
can appoint and remove managers should have no need to hobble managerial discretion with legal constraints—​except, perhaps, in the context of related party transactions, which we address in Chapter 6. Yet, all of our core jurisdictions impose a very
broad duty on corporate directors and officers to take reasonable care in the exercise
of their offices—​the duty of care. This duty is a non-​trivial component of the wider
corporate governance system: in some jurisdictions there is a real risk of being held
liable for its breach; in jurisdictions where this is not the case, compliance with other
sets of legal obligations, such as disclosure requirements, will implicitly force directors
to exercise due care in a number of situations, lest their disclosures prove wanting.145
It is tempting to view violations of the director’s or officer’s duty of care as a kind of
corporate “malpractice,” analogous to malpractice committed by other professionals
such as doctors. But the analogy is weak because defining “reasonable care” is far more
difficult for directors than for doctors: business decisions are even more idiosyncratic
than medical decisions.146 This is why courts in all jurisdictions display at least some
deference to corporate directors’ decision-​making.
At the very least, most of them will refrain from second-​guessing business decisions
on their merits.147 Yet, courts will usually review the process by which a given decision has been made, inquiring whether directors were sufficiently informed and took
reasonable steps, such as obtaining appropriate advice, to reach their decision. This is
the case in continental Europe, where some jurisdictions explicitly articulate a duty
to make well-​informed decisions.148 For example, under the German law on public
corporations, management board members shall not be deemed to have violated their
duty of care if they prove that, at the time of taking a business decision, they had
“good reason to assume that they were acting on the basis of adequate information
for the benefit of the company,” a provision that goes under the name of “business
145 See Robert B. Thompson and Hillary A. Sale, Securities Fraud as Corporate Governance: Reflections
upon Federalism, 56 Vanderbilt Law Review 859 (2003).
146 See e.g. Holger Spamann, Monetary Liability for Breach of the Duty of Care? 18–​19, Harvard
Law School John M. Olin Center Discussion Paper No. 835 (2015) (available at ssrn.com); see also
Re Barings plc (No 5) [2000]1 Butterworths Company Law Reports 523 at 536 (rejecting analogy
with medical malpractice and declining admissibility of expert evidence).
147 Even in Japan, where this is not the case, courts will only review decisions based on whether
they are “extremely unreasonable”: Supreme Court of Japan, 15 July 2010, 2091 HANREI JIHO 90.
For details of this case, see Dan W. Puchniak and Masafumi Nakahigashi, Comment, in Business Law
in Japan—​Cases and Comments (Moritz Bälz et al. eds., 2012).
148 Art. 2381 Civil Code (Italy); § 93 AktG (Germany). For a comparative discussion of the scope
and contours of the business judgment rule in Brazil, see Mariana Pargendler, Responsabilidade Civil
dos Administradores e Business Judgment Rule no Direito Brasileiro, 953 Revista dos Tribunais 51
(2015).
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The Interests of Shareholders as a Class
judgment rule” in that jurisdiction but the exculpatory reach of which the case law has
restricted.149 A post-​crisis surge in liability suits (and criminal prosecutions) against
directors, especially at banks, is testing the wisdom of granting courts such wide-​ranging discretion in reviewing business decisions.150
Unsurprisingly, the jurisdiction that is traditionally most open to private enforcement of corporate law via shareholder litigation, the U.S., is also the one that has gone
furthest in insulating managers from legal challenges of business decisions taken in
good faith (that is, in the honest belief that they would benefit the company’s business). Combined with ancillary institutions such as the (ubiquitously exercised) power
to introduce charter provisions waiving directors’ liability for good faith breaches of
duty151 and comprehensive D&O insurance, the U.S. business judgment rule significantly reduces the likelihood of a director ever having to make a payment in relation
to a duty of care suit.152
By contrast, other jurisdictions, including the UK, do proclaim an objective negligence standard for directors’ duty of care, without a business judgment rule or any
power to modify the duty by amendment of the company’s articles of association.153
However, these have been combined with procedural obstacles to enforcement such
that, outside bankruptcy, directors are rarely sued.154
The law’s deference to corporate decision-​making has two main justifications. The
first, already hinted at, is that judges are poorly equipped to evaluate highly contextual
business decisions. In particular, absent clear standards, hindsight bias can make even
the most reasonable managerial decision seem reckless ex post. The second is that, given
hazy standards and hindsight bias, the risk of legal error associated with aggressively
enforcing the duty of care might lead corporate decision-​makers to prefer safe pro­
jects with lower returns over risky projects with higher expected returns.155 Ultimately,
shareholders may stand to lose more from such “defensive management” than they
stand to gain from deterring occasional negligence.156
149 § 93 AktG (Germany). See Klaus J. Hopt and Markus Roth, Sorgfaltspflicht und Verantwortlichkeit
der Vorstandsmitglieder, in Aktiengesetz, Grosskommentar (Heribert Hirte et al. eds., 5th edn.,
2015), § 93 comments 61–​131; Klaus J. Hopt, Die Verantwortlichkeit von Vorstand und Aufsichtsrat,
Zeitschrift für Wirtschaftsrecht 2013, 1793.
150 Klaus J. Hopt, Responsibility of Banks and Their Directors, Including Liability and Enforcement,
in Functional or Dysfunctional—​The Law as a Cure? 159 (Lars Gorton, Jan Kleineman, and
Hans Wibom eds., 2014).
151 DGCL § 102(b)(7).
152 See Bernard Black, Brian Cheffins, and Michael Klausner, Outside Director Liability, 58
Stanford Law Review 1055 (2006).
153 UK Companies Act 2006 sections 174, 232; Art. 2381 and 2392, Civil Code (Italy). For
France, see Bruno Dondero, Chronique de jurisprudence de droit des sociétés, Gazette du Palais, 12
May 2015, No. 132, 19.
154 Practically no shareholder lawsuits are launched against directors of UK publicly traded companies (John Armour, Bernard Black, Brian Cheffins, and Richard Nolan, Private Enforcement of
Corporate Law: An Empirical Comparison of the United Kingdom and the United States, 6 Journal of
Empirical Legal Studies 687 (2009)). This likely reflects both procedural obstacles to litigation and
the usefulness of shareholders’ governance rights. In any event, UK courts have discretion to grant
relief for breach of duty where directors acted “honestly and reasonably” (UK Companies Act 2006
section 1157). The UK reformed its law relating to derivative actions in 2008, making it easier for
shareholders to challenge duty of care violations. If this ever results in high levels of litigation, it is to
be expected that there will be pressure to dilute the standard of care.
155 See e.g. Gagliardi v. Trifoods International, Inc. 683 Atlantic Reporter 2d 1049 at 1052–​3
(Del. Ch. 1996).
156 In the U.S., the rare cases in which courts hold directors personally liable for gross negligence in
decision-​making tend to involve unusual circumstances, such as a merger or sale of the entire company
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Legal Constraints and Affiliation Rights
71
The general duty of care applies—​as far as it goes—​to all functions of the board. As
the monitoring role of the board has grown, a natural step has been to develop the duty
of care as regards oversight, which plays into corporate governance and serves in part
to protect shareholder interests. For example, case law in Delaware and the UK holds
that the duty of care extends to creating “information and reporting systems” that can
allow the board to assess corporate compliance with applicable laws.157 Similarly, in
the EU and Japan the law tasks supervisory boards, audit committees, and statutory
auditors with ensuring that publicly traded companies have adequate auditing checks
and risk management controls in place.158 And SOX Section 404, a milder version of
which was adopted in the EU, requires CEOs and CFOs of U.S. firms to report on
the effectiveness of their firms’ internal financial control.159 Such provisions are mainly
enforced by outside auditor attestation.160
3.4.2 Corporate governance-​related disclosure
While mandatory disclosure is not itself one of the legal strategies that we articulated
in Chapter 2, it plays a critical supporting role in the functioning of all legal strategies,
and in all aspects of corporate law—​at least for publicly traded companies. The structure of the corporate governance system is no exception.
All our core jurisdictions mandate extensive public disclosure as a condition for
allowing companies into the public markets. That is the focus of Chapter 9. There is
considerable convergence in disclosure obligations, including on aspects of continuing
or the onset of insolvency. See Chapter 5.3.1.1. Moreover, even in these cases, the courts often hint at
something more than negligence—​bad faith or a conflict of interest that is difficult to prove—​as the
real basis for liability. The famous Delaware example is Smith v. Van Gorkom, 488 Atlantic Reporter
2d 858 (Del. 1985), in which the Delaware Supreme Court clearly believed that a retiring CEO had a
strong personal interest in selling his company, which added an element of disloyalty to the arguably
negligent process followed by the board in consummating the sale.
157 See In re Caremark Int’l Inc. Derivative Litigation, 698 Atlantic Reporter 2d. 959 (Del. Ch.
1996), reaffirmed by the Del. Supreme Court in In re Citigroup Inc. S’holder Derivative Litig., 964
Atlantic Reporter 2d 106 (Del. Ch. 2009). Breach of this duty entails that the corporation had
in place no information and reporting system whatsoever or that directors knew of its inadequacy.
German law is less deferential. See LG München, decision of 10 December 2013 (5 HKO 1387/​10—​
Neubürger), ZIP 2014, 570 (management board member held liable for having failed to implement
a comprehensive compliance system to detect unlawful activities). The UK adopts a straightforward
negligence standard: see Re Barings plc (No.5), note 146, especially at 486–​9, and Companies Act
2006 s 174.
158 See FSA Disclosure Rules and Transparency Rules DTR 7.1 (UK); § 91(2) AktG (Germany);
Art. L. 225–​235 Code de Commerce (France); Art. 149 Consolidated Act on Financial intermediation (Italy). For Japan, see Arts. 362(4)(iv), 390(2), 399-​2(3), 399-​13(1), 404(2), and 416(1) of the
Companies Act, and Arts. 24-​4-​4(1) and 193-​2(2) of the Financial Instruments and Exchange Act.
The EU directive on statutory audits (Directive 2006/​43/​EC, note 55) requires companies to have
an audit committee (comprised of directors or established as a separate body under national law) that
shall, inter alia, “monitor the effectiveness of the [company’s] internal quality control and risk management systems and, where applicable, its internal audit, regarding the financial reporting of the audited
entity.” Art. 39(6)(c).
159 SOX § 404. See Art. 24-​4-​4 Financial Instruments and Exchange Act (Japan). In the EU, the
directive on company reporting (Art. 20(1)(c) Directive 2013/​34/​EU, 2013 O.J. (L 182) 19) requires
listed companies to include in their annual corporate governance statement “a description of the
main features of the [their] internal control and risk management systems in relation to the financial
reporting process.”
160 SOX § 404(b). Art. 193-​2(2) Financial Instruments and Exchange Act (Japan). In the EU the
external auditor has to report to the audit committee “on any significant deficiencies in the audited
entity’s … internal financial control system, and/​or in the accounting system.” Art. 11(2)(j) Regulation
(EU) 537/​2014, 2014 O.J. (L 158) 77.
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The Interests of Shareholders as a Class
disclosure that are governance-​related. For example, all of our core jurisdictions require
firms to disclose their ownership structure (significant shareholdings and voting
agreements), executive compensation, and the details of board composition and
functioning.161
It is quite plausible that such extensive disclosure obligations make both a direct
contribution to the quality of corporate governance, by informing shareholders, and
an indirect contribution, by enlisting market prices in evaluating the performance of
corporate insiders.162 In particular, by making stock prices more informative, mandatory disclosure makes hostile takeovers less risky. Arguably, the comprehensive nature
of U.S. proxy statements, and the large potential liability that attaches to misrepresentations, builds on this assumption.
Even continental European jurisdictions, which have no such strong tradition of
mandatory disclosures, attach serious consequences to a company’s withholding of
material information bearing on a shareholder vote. Shareholder litigation aimed at
voiding shareholder resolutions taken on the basis of incomplete or misleading disclosure is particularly common in Germany, where courts take such matters very seriously,
both in publicly traded and privately held companies.163
3.5 Explaining Jurisdictional Variation
A review of major jurisdictions reveals that they often use the same strategies to shape
corporate governance in fundamentally similar ways. For example, all our sample jurisdictions mandate that shareholders elect directors (or a voting majority of them) and
all require a shareholder majority to approve fundamental changes, such as mergers
and charter amendments. As highlighted in Section 3.3.1, each of our jurisdictions
has adopted the trusteeship strategy as part of the now-​global norms of good corporate
governance. Alongside universal reliance on independent directors, all major jurisdictions also rely on mandatory disclosure to enlist the market as a monitor of the performance of public companies and aid disaggregated shareholders in exercising their
appointment, decision, and exit rights.
Despite these global similarities, however, there are differences in how and to what
extent the governance laws of our target jurisdictions are structured to protect shareholder interests against managerial opportunism. Moreover, the law-​on-​the-​books,
whether hard or soft, only imperfectly reflects each jurisdiction’s distinctive balance of
power among shareholders, managers, labor, and the state.
If we were to array our seven core jurisdictions on a spectrum from the most to the
least empowering for shareholders vis-​à-​vis managers in publicly traded companies, we
161 For ownership and compensation disclosure requirements, see Chapter 6.2.1.1. U.S. Regulation
S-​K, 17 C.F.R. Part 229 Item 601(b)(3)(i)–​(ii), requires filing the corporate charter and bylaws in
financial reports. In addition, any voting trust agreement and corporate code of ethics must be filed
in Form 10Q. See Item 601(b) Exhibit Table. Disclosure of voting agreements is also required by
the EC Takeover Bids Directive (Art. 10 Directive 2004/​25/​EC, 2004 O.J. (L 142) 12). For board
structure, see European Commission, Recommendation 2014/​208/​EU on the Quality of Corporate
Governance Reporting, 2014 O.J. (L 109) 43.
162 See generally John Armour, Enforcement Strategies in UK Corporate Governance: A Roadmap
and Empirical Assessment, in Rationality in Company Law 71, at 102–​4 (John Armour and Jennifer
Payne eds., 2009); Gordon, note 120.
163 See e.g. Ulrick Noack and Dirk Zetzsche, Corporate Governance Reform in Germany: The Second
Decade, 15 European Business Law Review 1033, 1044 (2005).
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Explaining Jurisdictional Variation
73
would most likely put Brazil and the UK at one extreme. However, while both these
countries lean heavily toward shareholder power, the similarities end there.
In the UK, the corporate governance environment fully accords with the shareholder-​
friendly legal framework: despite the fact that shareholdings are diffuse, UK governance is heavily influenced by institutional shareholders, who are well equipped to
represent the interests of shareholders as a class.164
Brazil has much more in common with continental European countries such as
Italy and France than with the UK. As in those countries, dominant shareholders, or
stable coalitions of blockholders, are prevalent in Brazilian companies.165 This ownership structure largely neutralizes the management–​shareholder agency conflict. Large
blockholders, like traditional business principals, hire and fire as they wish; they do
not need, and probably do not want, anything more than appointment, removal, and
decision rights to protect their interests. It seems natural, then, that jurisdictions dominated by large-​block shareholders should have company laws that empower shareholders as a class. This is exactly what the law does in France, Italy, and especially Brazil.
Each accords shareholders significant rights, such as the non-​waivable minority rights
to initiate a shareholders’ meeting, to initiate a resolution to amend the corporate
charter, to place board nominees on the agenda of shareholders’ meeting, and the
right to remove directors without cause by majority vote. Each of these powers, which
correspondingly constrain managerial discretion, require a shareholders’ meeting resolution, the outcome of which dominant shareholders will be able to determine. As a
byproduct, governance at the few listed companies in those countries with no dominant shareholder will also be heavily tilted in the direction of shareholder power. That,
in turn, helps make such companies a rarity, because strong shareholder power makes
dispersed ownership companies more prone to hostile takeovers.
The second way in which the governance landscape shifts in continental Europe
and in Brazil is that, to a greater degree than in the U.S. or UK, corporate governance is a three-​party game that revolves around more than the interests of shareholders and managers. In Italy, France, and Brazil, the third party is the state, which
is simultaneously an intrusive regulator, a major shareholder,166 and a defender of
“national champions,” in which it may or may not hold an equity stake.167 In France
there is a well-​travelled career track between elite state bureaucracies and the corporate
164 See text accompanying note 79.
165 See e.g. Julian Franks, Colin Mayer, Paolo Volpin, and Hannes F. Wagner, The Life Cycle of
Family Ownership: International Evidence, 25 Review of Financial Studies 1675 (2012) (controlled
ownership structures appear stable over time in our core jurisdictions).
166 See Mariana Pargendler, State Ownership and Corporate Governance, 80 Fordham Law Review
2917 (2012). For instance, as of May 2016, the Italian Government controlled Italian companies representing almost 30 per cent of the total capitalization of the blue chips index (S&P Mib)
(source: authors’ elaboration, based on Consob data).
167 A good example is the French state’s failed attempt to prevent General Electric from taking
over Alstom’s electricity generation business. In 2014, the French government opposed such proposed
acquisition, mainly out of concern for its effects on Alstom’s rail transport activities and on employment. For that purpose, it issued a decree granting itself a veto over takeovers of companies in the
energy supply, water, transport, telecommunications, and public health sectors (Decree No. 2014-​479
of 14 May 2014). The French government also encouraged Siemens to make a rival bid. In the end,
however, GE secured the deal after making a number of commitments with the French government
regarding the exercise of voting rights and director positions. See David Jolly and Jack Ewing, G.E.’s
Bid for Alstom Is Blessed by France, New York Times, 21 June 2014, at B1). In Brazil, the development
bank has made generous debt and minority equity investments to support the creation of national
champions.
74
74
The Interests of Shareholders as a Class
headquarters of France’s largest companies.168 In Brazil, not only is the state the controlling shareholder in numerous listed firms, but the main institutional investors
in the country—​the pension funds of state-​owned enterprises and the development
bank—​are themselves under government control.169
The role of the state in corporate governance reinforces both shareholder-​friendly
governance law and concentrated ownership in these jurisdictions—​though strengthening the power of the state as a controlling shareholder does not necessarily serve
the interests of minority shareholders.170 On the one hand, the politicians and civil
servants who control the state shareholdings in these jurisdictions have a natural incentive to favor strong shareholder rights, both because they represent the state as a shareholder and because they can discreetly act through other large-​block shareholders to
ensure that corporate policies reflect the state’s priorities. On the other hand, well-​
connected blockholders can be an economic asset for firms in a politicized environment, to the extent that these “owners” have more legitimacy and resources to protect
their companies from political intervention than mere managers backed by dispersed
shareholders could muster.171 Thus, an interventionist state, concentrated ownership,
and shareholder-​friendly law may be mutually reinforcing, especially when the state
holds large blocks of stock in its own right.172
Germany’s corporate law is similar to that of other continental European states in
terms of shareholder powers, but with two important qualifications. First, board members’ insulation from shareholder pressures is greater, thanks to lengthier terms of office
and less shareholder-​friendly removal rules. Second, the codetermination statute mandates labor directors on the board with interests that tend to be opposed to those of
the shareholder class. As an outcome, German law for companies without a dominant
shareholder appears to be more manager-​oriented than in other countries with a prevalence of concentrated ownership.173
In contrast to Italy, France, and Brazil, the third actor in German corporate governance is not the state but labor. As discussed further in Chapter 4, German law provides
for quasi-​parity codetermination, in which employees and union representatives fill half
of the seats on the supervisory boards of large firms.174 Of course, labor directors, like
shareholder directors, have a fiduciary obligation to further the interests of “the company” rather than those of their own constituency. Nevertheless, labor’s interests have
significantly less in common with those of large-​block German shareholders than the
state’s interests might have with those of blockholders in France and Italy, especially at a
time when their governments are experiencing public budgets constraints, which make
168 See e.g. William Lazonick, Corporate Governance, Innovative Enterprise and Economic
Development, 49–​56 (2006) (describing the elite education and civil service experience of typical
French CEOs).
169 See e.g. Mariana Pargendler, Governing State Capitalism: The Case of Brazil, in Regulating
the Visible Hand? The Institutional Implications of Chinese State Capitalism 377, 385–​8
(Benjamin Liebman and Curtis J. Milhaupt eds., 2015).
170 See Pargendler, note 166.
171 This observation tracks Mark Roe’s similar point that strong labor favors strong capital, in the
form of controlling shareholders. See Mark J. Roe, Legal Origin, Politics, and the Modern Stock Market,
120 Harvard Law Review 460 (2006).
172 See generally, Pargendler, note 169; Ben Ross Schneider, Hierarchical Capitalism in Latin
America (2013); Aldo Musacchio and Sergio G. Lazzarini, Leviathan in Business: Varieties of
State Capitalism and Their Implications for Economic Performance (2014).
173 Perhaps relatedly, the ownership structure of the largest German companies is now much more
similar to that in the U.S. and the UK than has for long been the case. See Ringe, note 75, 507–​9.
174 See Chapter 4.2.1.
75
Explaining Jurisdictional Variation
75
their financial interest qua shareholders more salient. In addition, state intervention in
corporate governance is likely to be sporadic, while labor directors continuously monitor German firms. We suspect (and we are not the first to do so175) that the net effect of
Germany’s closely divided supervisory board is to enhance the power of top managers—​
that is, of the management board—​relative to that of shareholders (or even labor). Put
differently, the average large German company is likely to be more managerialist than a
similar firm in a large blockholder jurisdiction such as Italy or France.176
U.S. corporate law is harder to encapsulate. While Delaware law has traditionally
been viewed as board-​centric, the shift toward shareholder empowerment that has
taken place in the last couple of decades177 has occurred with very little change in state
law and only in part due to federal law reforms. In other words, changes in the relative
power of shareholders and managers following the reconcentration of shares in institutional investors’ hands led to changes in corporate governance practices that flexible
existing laws could accommodate and corporate law reforms have mainly followed. As
an outcome, the U.S. is nowadays much less of a poster child for managerialist corpor­
ate law than in the past.
Finally, Japanese corporate law also has a plausible claim to shareholder-​friendly
law on the basis of its short director terms and easy removal rights. But in Japan the
gap in spirit between a shareholder-​friendly corporate law and the reality of Japanese
corporate governance appears to be larger than in any other core jurisdiction. Japan
is a dispersed-​shareholder jurisdiction, like the U.S. and UK,178 but its shareholders
are weak, and its managers are strong, even compared to the U.S. Moreover, although
there are hints of change in response to recent reforms, Japanese boards remain overwhelmingly dominated by inside directors. So, how can Japanese governance practice
entrench managers while its corporate law empowers shareholders? A number of factors help explain this puzzle, including the dispersion of Japanese shareholdings since
World War II, a statutory law derived from early—​and shareholder-​friendly—​German
law, the role of the state in mobilizing Japanese recovery after the war, a strong reliance
on debt rather than equity financing, and the continuous increase in Japanese share
prices for four decades after the war.179
But there is another partial answer that seems especially salient today. Japan has a
tradition of stable friendly shareholdings among operating firms (kabushiki mochiai
or cross-​shareholdings) that cement business relationships and insulate top managers
from challenge. These business-​to-​business holdings are numerous but generally not
175 See Katharina Pistor, Codetermination: A Sociopolitical Model with Governance Externalities in
Employees and Corporate Governance 171 (Margaret M. Blair and Mark J. Roe eds., 1999).
176 It can hardly be otherwise if Germany’s two-​tier board structure functions in part to insulate
companies’ business decisions from dissension on their supervisory boards by assigning these decisions to their management boards. A revealing indication of the power of the management board is
that often in widely held companies the management board itself, rather than the supervisory board,
informally nominates the company’s shareholder nominees to the supervisory board. See note 11.
177 See e.g. Edward B. Rock, Adapting to the New Shareholder-​Centric Reality, 161 University of
Pennsylvania Law Review 1907, 1917–​26 (2013).
178 One recent study finds that listed companies in the UK and Japan have the most dispersed ownership structures in the world, while the U.S. trails some distance behind. See Clifford G. Holderness,
The Myth of Diffuse Ownership in the United States, 22 Review of Financial Studies 1377 (2009).
179 See Masahiko Aoki, Toward an Economic Model of the Japanese Firm, 28 Journal of Economic
Literature 1 (1990); Ronald J. Gilson and Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps
Between Corporate Governance and Industrial Organization, 102 Yale Law Journal 871 (1993);
Steven Kaplan, Top Executive Rewards and Firm Performance: A Comparison of Japan and the U.S., 102
Journal of Political Economy 510 (1994).
76
76
The Interests of Shareholders as a Class
large, and they are frequently not even reciprocal. But the important point is that they
are stable and management-​friendly.180 In prior decades these “captive” shareholders
accounted for a much higher percentage of the outstanding shares of Japanese listed
companies than they do today, when they represent around one-​third of outstanding shares—​only slightly more than the share percentage held by foreign investors in
Japanese firms.181 While U.S.-​style hedge fund activism against Japanese companies in
the 2000s has been largely unsuccessful, mostly because of cross-​shareholdings,182 this
change in shareholder identity, as well as the stagnant economy since the 1990s, has
made large listed companies and the Japanese government more sensitive to investors’
demands.183 At the same time, once cross-​shareholdings are unwound, the legislator
may deem existing Japanese corporate law too shareholder-​friendly and make it less so.
A final puzzle that we have encountered in this chapter is why a single model of
best practices (independent directors and a tripartite committee structure) increasingly
dominates governance reform in all core jurisdictions when the agency problem that
gave rise to this model—​managerial opportunism vis-​à-​vis the shareholder class—​is
paramount only in diffuse shareholding jurisdictions such as the U.S. and UK.
The obvious question with respect to best practices is: why should one size fit all,
given the dramatic differences in ownership structure across our target jurisdictions?
One plausible explanation is the wide-​spectrum prophylactic hypothesis:184 the same
global good governance recipe of independent directors and independent committees
somehow responds effectively to the various agency problems: not only the problem of
managerial opportunism, but also the conflict between majority shareholders on one
hand, and minority shareholders or non-​shareholder constituencies on the other. We
explore this issue in Chapter 4. In essence, this must imply that the formula means
different things in different contexts. For example, adding independent directors may
empower Japanese shareholders and reinforce shareholder dominance in the UK, while
it traditionally served to justify allocating power to the board rather than shareholders in the U.S. The question, then, is whether convergence on the substance of best
governance practices is true functional convergence or mere stylistic convergence that
hides persistent differences in the actual structure of corporate governance across
jurisdictions.185
180 See Julian Franks, Colin Mayer, and Hideaki Miyajima, The Ownership of Japanese Corporations
in the 20th Century, 27 Review of Financial Studies 2580 (2014). We take no position on the continuing debate about the importance of the Keiretsu, or networks of companies bound by cross shareholding and relations with a “main bank.” Compare Curtis Milhaupt and Mark D. West, Economic
Organizations and Corporate Governance in Japan: The Impact of Formal and Informal
Rules (2004) with J. Mark Ramseyer and Yoshiro Miwa, The Fable of the Keiretsu, Urban
Legends of the Japanese Economy, ch. 2 (2006).
181 As of 1986, manager-​friendly business companies, banks, and insurance companies together
held more than 60 percent of market capitalization. This ratio fell to slightly more than 30 percent in
2012. On the other hand, holdings by foreign investors rose from 5 percent in 1986 to 28 percent in
2012. Note, however, that this unwinding of cross-​shareholding relationships is taking place mostly in
large public companies and less in small and medium-​sized listed ones. See Goto, note 23, at 144–​6.
182 See Goto, note 23, at 140–​4. Whether U.S.-​style hedge fund activists will come back to Japan
making the most of its shareholder-​friendly law remains to be seen.
183 An example of such attitude by the government is the adoption of the Stewardship Code and
the Corporate Governance Code. See notes 89 and 114.
184 See Section 3.3.1.
185 Formal convergence that obscures substantive divergence in corporate law is the natural converse of formal divergence that obscures functional convergence. See Ronald J. Gilson, Globalizing
Corporate Governance: Convergence of Form or Function, 49 American Journal of Comparative Law
329 (2001).
77
Explaining Jurisdictional Variation
77
However, a second plausible explanation is that international best practices are
largely ornamental in blockholder jurisdictions, since dominant shareholder coalitions retain the power to hire and fire the entire board, including its nominally independent directors. On this account, controlling blockholders may not lose much in
terms of real power, while their controlled corporations will display all the features that
institutional investors expect. More puzzling perhaps is why investors should accord
any significance to such compliance. Here we simply note that the coordination costs
investors face in the domestic environment are multiplied many times over when they
invest overseas. Even activist investors, whom we saw earlier to be the most willing
to invest in gathering firm-​specific governance information, do significantly worse in
their cross-​border interventions than in their domestic engagements.186
186 Becht et al., note 18.
78
79
4
The Basic Governance Structure:
Minority Shareholders
and Non-​Shareholder Constituencies
Luca Enriques, Henry Hansmann, Reinier Kraakman,
and Mariana Pargendler
The corporate governance system principally supports the interests of shareholders
as a class. Nevertheless, corporate law can—​and to some degree must—​also address
the agency conflicts jeopardizing the interests of minority shareholder and non-​
shareholder contractual constituencies. And herein lies the rub. To mitigate either
the minority shareholder or the non-​shareholder agency problems, a governance
regime must necessarily constrain the power of the shareholder majority and thereby
aggravate the managerial agency problem. Conversely, governance arrangements that
reduce managerial agency costs by empowering the shareholder majority are likely to
exacerbate the agency problems faced by minority shareholders and non-​shareholders
at the hands of controlling shareholders.
In this chapter, we first address the protection of minority shareholders, and then
turn to governance arrangements that protect the firm’s employees—​the principal non-​
shareholder constituency to enjoy such protections as a matter of right in some jurisdictions. In Chapter 5, we address the protections granted to corporate creditors.
While corporate law mostly deals with the relationship between the corporation
and its contractual counterparties, it is sometimes called upon to protect the interests
of constituencies external to the corporate form as well.1 The final part of this chapter
explores how the legal strategies of corporate law can also be directed to serve the interests of non-​contractual stakeholders.
4.1 Protecting Minority Shareholders
It is well-​documented by empirical research that dominant shareholders enjoy “private
benefits of control”—​that is, disproportionate returns—​often at the expense of minority shareholders.2 These benefits are impounded in the control premia charged for
controlling blocks and in the price differentials that obtain between publicly traded
1 See Chapter 1.5.
2 See Tatiana Nenova, The Value of Corporate Voting Rights and Control: A Cross-​Country Analysis, 68
Journal of Financial Economics 325, 336 (2003) (employing share price differentials for dual class
firms to calculate private benefits); Alexander Dyck and Luigi Zingales, Private Benefits of Control: An
International Comparison, 59 Journal of Finance 537, 551 (2004) (employing control premia in
sales of control blocks to calculate private benefits).
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann,
Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 4 © Luca
Enriques, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler, 2017. Published 2017 by Oxford University Press.
80
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Minority Shareholders and Non-Shareholder Constituencies
high-​and low-​vote shares in the same companies. Both measures are often assumed to
be rough indicators of the extent of minority shareholder expropriation.3 The varying
degrees of protection accorded to minority shareholders by differing corporate governance systems explain at least some of the variation in these indicators.
4.1.1 Shareholder appointment rights and deviations
from one-​share–​one-​vote
One way to protect minority shareholders is by granting them the right to appoint one
or more directors. Specifically, company law can enhance minority appointment rights
by reserving board seats for minority shareholders or over-​weighting minority votes in
the election of directors. Even if they only select a fraction of the board, a minority can
still benefit from access to information and, in some cases, the opportunity to form coalitions with independent directors. Of course, shareholder agreements or charters can—​and
sometimes do—​require the appointment of minority directors for individual firms. The
law can achieve a similar result on a broader scale by mandating cumulative or proportional voting, which allow relatively large blocks of minority shares to elect one or more
directors. Moreover, lawmakers can further increase the power of minority directors by
assigning them key committee roles or by permitting them to exercise veto powers over
certain classes of board decisions.4
Significantly, however, general corporate law rules granting minority board representation are relatively uncommon among our core jurisdictions. Italy mandates board
representation for minority shareholders in listed companies.5 Brazil grants minority
shareholders who hold more than a 10 or 15 percent stake (of preferred or common
stock, respectively) the right to appoint a board member, as well as cumulative voting at
the request of shareholders representing at least 10 percent of voting capital.6 However,
the high coordination costs associated with these thresholds mean that generally only
blockholders, rather than dispersed minority shareholders, benefit from the associated
rights. Cumulative voting is the statutory default in Japan,7 but it is routinely avoided
by charter provisions. In France, the UK, and the U.S. firms may adopt a cumulative
voting rule, but publicly traded firms rarely do so;8 and in Germany, commentators
dispute whether cumulative voting is permissible at all in public corporations.9 In the
3 See note 136 and accompanying text.
4 For example, Art. 78 Russian Joint-​Stock Companies Law requires that major transactions,
including those that implicate the interests of controlling shareholders, be unanimously approved
by directors. Consequently, “disinterested” minority directors can block major transactions between
the company and its controlling shareholders or managers. In Brazil, directors elected by minority
shareholders have veto rights over the appointment and removal of independent auditors: Art. 142,
§ 2º Lei das Sociedades por Ações.
5 Art. 147-​3 Consolidated Act on Financial Intermediation (requiring that at least one director be
elected by minority shareholders).
6 Art. 141 Lei das Sociedades por Ações. If neither group satisfies the relevant threshold, they may
pool votes to make a joint board appointment. See also Art. 239 (granting minority shareholders the
right to elect one board member in government-​controlled firms).
7 Art. 342 Companies Act.
8 At the turn of the twentieth century, cumulative voting was common in the U.S. See e.g. Jeffrey
N. Gordon, Institutions as Relational Investors: A New Look at Cumulative Voting, 94 Columbia Law
Review 124 (1994); cf. §§ 708(a) and 301.5(a) California Corporation Code (respectively mandating
cumulative voting and authorizing opt-​out from cumulative voting for listed companies).
9 See Mathias Siems, Convergence in Shareholder Law 172 (2008). Even though the majority
agrees that proportional voting is permissible, no important German corporation has included such
a charter provision. See also Paul L. Davies and Klaus J. Hopt, Boards in Europe—​Accountability and
81
Protecting Minority Shareholders
81
UK, the new premium listing rules for companies with controlling shareholders grant
minority investors what may be called an “expressive” veto on the appointment of
independent directors. Their appointment is initially subject to separate approval by
all shareholders and minority shareholders. If such approval is not obtained, then the
shareholder majority can determine the election after a “cooling-​off” period, between
90 and 120 days later.10
While the use of appointment rights directly to protect minorities is rare, all jurisdictions regulate the apportionment of voting rights in relation to share ownership—​a
central mechanism that affects both the appointment and decision rights of shareholders. Corporate laws generally embrace a default rule that each share carries one
vote. Awarding voting rights in direct proportion to share ownership has the benefit
of aligning economic exposure and control within the firm, but may leave minority shareholders vulnerable to opportunistic behavior by controlling shareholders. At
the same time, where the value of incumbents’ control is high—​whether because the
law fails to restrict dominant shareholders’ opportunism or because, in the absence
of a dominant shareholder, managerial agency costs would be high—​proportionality
between cash-​flow and voting rights may impair a company’s ability to raise further
equity finance and secure profitable investment opportunities.11 Consequently, our
jurisdictions often contemplate adjustments to shareholder appointment and decision
rights in both directions, that is, both by limiting the power of dominant shareholders
and by allowing them to enhance it in various ways.
All jurisdictions permit at least some deviations from the one-​share–​one-​vote norm
to let dominant shareholders enhance their control over the corporation. These mechanisms include dual-​class equity structures with disparate voting rights, circular shareholdings, and pyramidal ownership structures. While our core jurisdictions universally
restrict circular shareholding schemes12 and vote-​buying by parties antagonistic to the
interests of shareholders as a class,13 they diverge with respect to the availability and
use of other similar devices.
Germany and Brazil go furthest in limiting deviations from one-​share–​one-​vote that
increase the power of controlling shareholders: both countries ban shares with multiple
Convergence, 61 American Journal of Comparative Law 301 (2013) (noting that cumulative voting has failed to gain much traction in Europe).
10 UK Listing Rules, 9.2.2E and 9.2.2F.
11 See e.g. Kristian Rydkvist, Dual-​class Shares: A Review, 8 Oxford Review of Economic Policy
45 (1992).
12 Most jurisdictions forbid subsidiaries from voting the shares of their parent companies: Art.
L. 233–​31 Code de commerce (France); Art. 2359–​II Civil Code (Italy); Art. 308(1) Companies Act
(Japan); § 160(c) Delaware General Corporation Law; § 135 Companies Act 2006 (UK). German,
Brazilian, and Japanese laws bar subsidiaries from owning shares of their parents except in special circumstances (§71d AktG; Art. 244 Lei das Sociedades por Ações; Art. 135 Companies Act). A number
of countries, such as Italy, France, and Germany, also ban voting in the case of cross-​shareholdings
by companies that are in no parent-​
subsidiary relationship. See Shearman & Sterling, LLP,
Proportionality Between Ownership and Control in EU Listed Companies: Comparative
Legal Study 17 (2007) at http://​www.ecgi.de/​osov/​final_​report.php.
13 A less traditional example of separating control rights from cash-​flow rights is so-​called “empty
voting,” in which investors use stock lending, equity swaps, or other derivatives to acquire “naked”
votes in corporations in which they may even hold a negative economic interest (i.e. gain if the stock
price goes down rather than up). See Henry T.C. Hu and Bernard Black, The New Vote Buying: Empty
Voting and Hidden (Morphable) Ownership, 79 Southern California Law Review 811 (2006).
Empty voting, like vote buying, can be used to undermine shareholder welfare. Despite efforts at
increasing transparency over economic interests, as opposed to formal ownership rights, no jurisdiction provides for ownership disclosure rules that are geared for disclosure of empty voting per se. See
Wolf-Georg Ringe, The Deconstruction of Equity 162–​99 (2016).
82
82
Minority Shareholders and Non-Shareholder Constituencies
votes and cap the issuance of non-​voting or limited-​voting preference shares to 50 percent of outstanding shares.14 In Brazil, where dual-​class firms were historically common, non-​voting shares are prohibited outright in the Novo Mercado, the premium
corporate governance segment of the São Paulo Stock Exchange.15 Even these jurisdictions, however, do not regulate pyramidal ownership structures (where company
A owns a majority of the voting shares of company B, which in turn owns a majority of
the voting shares of company C, and so on),16 which have identical effects to dual-​class
shares in separating cash flow and voting rights.17 The U.S., by contrast, goes furthest
in banning or discouraging the use of pyramidal structures through holding company
regulations and the taxation of inter-​corporate distributions.18
Similarly, some European jurisdictions permit the issuance of so-​called fidelity shares,
which condition the award of additional voting rights on a minimum holding period as
a shareholder. For instance, Italian law recently enabled corporations to award double
voting rights to shareholders who have held onto their shares for at least two years.19
This mechanism had long been available in France on an opt-​in basis, but in 2014, as
part of an openly protectionist law on takeovers, it became the default rule for listed
companies. Unless such companies opt out, their shares spawn double voting rights
after two years in the same hands.20 Although such “tenure voting” systems are usually
justified as protecting the interests of long-​term over short-​term shareholders,21 they
tend also to embed the power of controlling shareholders relative to outside investors.
The U.S. and UK permit different classes of shares to carry any combination of cash
flow and voting rights, but U.S. and Japanese exchange listing rules bar recapitalizations that dilute the voting rights of outstanding shares.22 While the New York Stock
14 See §§ 12 II and 139 II Aktiengesetz AktG (Germany); and Arts. 15, § 2o, and 110, § 2o, Lei
das Sociedades por Ações (Brazil). In Brazil, however, companies have recently circumvented the ban
on multi-​voting stock by adopting a functionally equivalent dual-​class structure where the public float
carries economic rights that are a multiple of those granted to insiders. Brazil’s Securities Commission
(CVM) blessed this structure in the Azul case in 2013. France caps the issue of non-​voting shares by
listed companies at 25 percent of all outstanding shares. Arts. L. 228–​11 to L. 228–​20 Code de commerce. In 2014, Italy partially repealed the ban on multiple voting shares: it now allows non-​listed
companies to issue shares with up to three votes. Such companies may later go public, but cannot
subsequently increase the proportion of multiple voting shares. The 50 percent cap on non-​voting and
limited voting shares has, instead, been maintained. See Art. 2351 Civil Code, as amended (Italy).
Similarly to Germany and Brazil, Japan imposes a 50 percent cap on non-​voting and limited voting
shares: Arts. 108(1)(iii) and 115 Companies Act.
15 For a discussion, see Ronald J. Gilson, Henry Hansmann, and Mariana Pargendler, Regulatory
Dualism as a Development Strategy: Corporate Reform in Brazil, the United States, and the European
Union, 63 Stanford Law Review 475, 489–​90 (2011).
16 As a result, pyramidal firms have emerged in Brazil’s Novo Mercado, as elsewhere.
17 See e.g. Lucian A. Bebchuk, Reinier Kraakman, and George Triantis, Pyramids, Cross-​Ownership,
and Dual Class Equity: The Mechanisms and Agency Costs of Separating Control from Cash-​Flow Rights,
in Concentrated Corporate Ownership 445 (Randall K. Morck ed., 2000).
18 See Steven A. Bank and Brian R. Cheffins, The Corporate Pyramid Fable, 84 Business History
Review 435 (2010); Eugene Kandel, Konstantin Kosenko, Randall Morck, and Yishay Yafeh,
The Great Pyramids of America: A Revised History of US Business Groups, Corporate Ownership and
Regulation, 1930–​1950, NBER Working Paper No w19691 (2015).
19 Art. 129-​V Consolidated Act on Financial Intermediation, as amended in 2014. This mechanism may actually serve to enhance the power of the state as shareholder.
20 Art. L. 225-​123 Code de commerce, as amended by Loi. No. 2014-​384 of 29 March 2014
(known as the “Loi Florange”). See also Chapter 8.2.3.
21 See Chapter 3.2.
22 See Rule 313 NYSE Listed Company Manual and Rule 4351 NASDAQ Marketplace Rules
(voting rights of existing shareholders of publicly traded common stock cannot be disparately reduced
or restricted through any corporate action or issuance). See also Tokyo Stock Exchange, Securities
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Protecting Minority Shareholders
83
Exchange (NYSE) listing rules banned deviations from proportional voting for most
of the twentieth century, dual-​class shares have recently enjoyed something of a renaissance in media and hi-​tech corporations.23 The U.S. has even attracted high profile
dual-​class companies from abroad: for instance, Chinese e-​commerce giant Alibaba
opted to go public on the NYSE after being unable to list on the Hong Kong Stock
Exchange, which still adheres to a strict one-​share–​one-​vote rule. In the UK, where
institutional investors had successfully discouraged dual-class shares altogether,24 the
Premium market segment is now exclusively for companies listing classes of shares with
proportionate voting rights.25 Thus, although legal support for a one-​share–​one-​vote
norm is limited, all our core jurisdictions restrict some ways of leveraging voting rights
that are regarded as particularly harmful.
Much rarer than devices that empower a certain group of shareholders are legal
devices that simply dilute the voting power of large shareholders, to benefit small
shareholders. Perhaps the best known technique of this sort is “vote capping,” that is,
imposing a ceiling on the control rights of large shareholders and correlatively inflating
the voting power of small shareholders. For example, a stipulation that no shareholder
may cast more than 5 percent of the votes reallocates 75 percent of the control rights
that a 20 percent shareholder would otherwise exercise to shareholders with stakes of
less than 5 percent.
Except for Germany and Japan,26 all our core jurisdictions permit publicly traded
corporations to opt into voting caps by charter provision. Today, however, the real
motivation for voting caps is more likely to be the deterrence of takeovers than the
protection of minority investors. They are more commonly adopted where no controlling block exists, to dissuade the building of one, rather than to constrain the voting
power of an existing block-​holder. Voting caps survive today chiefly in France and, to
a lesser extent, in Italy and Brazil.27
Listing Regulations, Rule 601(1)(xvii) and Enforcement Rules for Securities Listing Regulations, Rule
601(4)(xiv) (prohibiting unreasonable ex post restrictions on shareholder voting rights).
23 Prominent examples include News Corporation, Google (now Alphabet), Facebook, and
LinkedIn, where the use of “super-​voting” shares has allowed the founding shareholders, who arguably
have a strategic role in the value of the company, to keep control of the corporation without holding
the majority of the share capital.
24 See Julian Franks, Colin Mayer, and Stefano Rossi, Spending Less Time with the Family: The
Decline of Family Ownership in the United Kingdom, in A History of Corporate Governance
Around the World 581, 604 (Randall K. Morck ed., 2005).
25 UK Listing Rule 7.2.1A, Premium Listing Principle 4.
26 Voting caps were banned for German publicly traded (listed) companies in 1998. See § 134 I
Aktiengesetz (AktG) (as amended by KonTraG). Still, there was one important exception: Volkswagen
AG, which is regulated by a special law, was subject to a 20 percent voting cap. The European Court
of Justice ruled that the voting cap (together with other provisions of the VW Act) impeded the
free movement of capital which was guaranteed by Art. 56(1) EC Treaty (now Art. 63 TFEU); see
Case C-​112/​05, Commission v. Germany, Judgment of 23 October 2007, European Court Reports
[2007] I‐8995. Japan adopts the rule of one-​share, one-vote and does not allow voting caps. See Art.
308(1) Companies Act. Italy banned voting caps from 2003 to 2014 (other than for privatized companies). See Art. 2351 Civil Code, as amended (Italy).
27 For France see Art. L. 225-​125 Code de commerce; Art. 231-​54 Règlement Général de l’AMF
(declaring, however, voting caps ineffective at the first general meeting after a bidder has acquired
two thirds or more of the voting shares). For Brazil, see Art. 110, § 1º Lei das Sociedades por Ações,
(permitting voting caps); Novo Mercado Regulations, Art. 3.1.1 (prohibiting voting caps below 5
percent, except as required by privatization laws or industry regulations). Although extremely rare in
the UK and the U.S. today, voting caps were common in the nineteenth century in the U.S., Europe,
and Brazil. See Mariana Pargendler and Henry Hansmann, A New View of Shareholder Voting in the
Nineteenth Century, 55 Business History 585 (2013).
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Minority Shareholders and Non-Shareholder Constituencies
4.1.2 Minority shareholder decision rights
As in the case of appointment rights, the law sometimes protects minority shareholders by enhancing their direct decision rights. Minority decision rights are strongest
when the law entrusts individual shareholders (or a small minority of them) with the
power to make a corporate decision. Such is the case for instance when the law allows
individual shareholders, or a small shareholder minority, to bring suit in the corporation’s name against directors or other parties against whom the corporation may have
a cause of action.28 Granting decision rights to a majority of minority shareholders is
also an effective governance strategy. For this reason, corporate laws sometimes impose
a majority-​of-​the-​minority approval requirement on transactions between controlling
shareholders and their corporations.29
In addition, all our core jurisdictions fortify minority decision rights over fundamental corporate decisions by imposing special majority or supermajority approval
requirements. As we discuss in Chapter 7, the range of significant decisions subject
to shareholder voting varies, as does the particular voting threshold required for
approval.30 As a practical matter, however, the relevant threshold is almost always
higher than the simple majority of the votes cast at a general shareholders’ meeting.
Arguably, then, most jurisdictions use decision rights to protect large blocks of minority shares against expropriation effected via major transactions such as mergers.
Several European jurisdictions pursue this end explicitly by awarding the holders of
a sufficient percentage of minority shares (25 percent or more of voting shares) a statutory blocking right—​to prevent a “bare” majority from trumping the will of a “near”
majority.31 Most U.S. states and Brazil require a majority of the outstanding shares to
approve fundamental transactions such as mergers, which implies a supermajority of
the votes that are actually cast.32 The size of the supermajority in this case depends on
the percentage of shares represented at the meeting, which, in turn, reflects the salience
of the transaction for minority shareholders. Nevertheless, requirement of approval
by a majority of the outstanding shares is no protection for minority investors if the
controlling shareholder enjoys such a majority.33
4.1.3 The incentive strategy: Trusteeship and equal treatment
The incentive strategy for protecting minority shareholders takes two forms. One is
the familiar device of populating boards and key board committees with independent directors. As noted in Chapter 3, lawmakers seem to view independent directors as a kind of broad-​spectrum prophylactic, suitable for treating both the agency
problems of minority shareholders and those of shareholders as a class. The second
mode of protecting minority shareholders is strong enforcement of the equal treatment norm, particularly with respect to distribution and voting rights. This norm
applies to both closely held and publicly traded firms, and blurs into an aspect of
the constraints strategy: a fiduciary duty of loyalty to the corporation that implicitly
extends towards minority shareholders and perhaps other corporate constituencies
as well.
28 See Chapter 3.2.3 and Chapter 6.2.5.4.
29 See Chapter 6.2.3 and Chapter 7.4.2.3.
30 See Chapter 7.7.
31 See Chapter 7.2 and 7.4.
32 See e.g. § 251 Delaware General Corporation Law (merger); § 242 (charter amendment);
Art. 136 Lei das Sociedades por Ações.
33 Such levels of control are common in Brazil, for example.
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Protecting Minority Shareholders
85
4.1.3.1 The trusteeship strategy and independent directors
The addition of independent directors to the board is a popular device, not only as a
solution to shareholder–​manager agency problems,34 but also for protecting minority shareholders and non-​shareholder constituencies. Lawmakers implicitly assume
that independent directors—​motivated by “low-​powered incentives”—​namely, morality, professionalism, and personal reputation—​will stand up to controlling shareholders in the interest of the enterprise as a whole,35 including its minority shareholders
and, to varying degrees, its non-​shareholder constituencies. Strong forms of trusteeship
reduce the possibility of controlling the board by shareholders (or by anyone else). In
the extreme case, no constituency, including shareholders, can directly appoint representatives to the company’s board. This was the core principle of the Netherlands’ old
“structure regime,”36 under which the boards of some large companies became self-​
appointing organs, much like the boards of many nonprofit corporations or foundations. Alternatively, investors themselves may contract to give one or more mutually
selected independent directors the decisive voice on the board as a governance solution
to intra-​shareholder opportunism. This pattern is common in venture capital-​backed
firms.37
In our core jurisdictions, however, most “independent” directors are neither self-​
appointing nor rigorously screened for independence by savvy investors. Instead, director “independence” typically means at most financial and familial independence from
controlling shareholders (as well as from the company and its top corporate officers).38
A director qualifies as independent under such a definition even if she is vetted and
approved by the company’s controlling shareholder—​and even if she has social ties to
the controller—​as long as she has no close family or financial ties, such as an employment position or a consulting relationship, with the controller. A conventional example is that an officer of an unrelated, third-​party company qualifies as an independent
director of the corporation, but an officer of a holding company with a controlling
block of stock in the corporation does not. Moreover, the fact that in many jurisdictions shareholders have the right to remove directors (including independent directors)
at any time further exacerbates concerns about the lack of actual independence in
controlled firms.
Finally, the most modest and basic form of a director-​based trusteeship strategy
abandons all pretense to independence and simply requires board approval for important company decisions. For example, the authority to initiate proposals to merge the
company can be vested exclusively in the board of directors under U.S. and Italian
law.39 Alternatively, shareholders may be barred from directly making any decisions
34 See Chapter 3.3.1.
35 For a critical assessment, see Wolf-​Georg Ringe, Independent Directors: After the Crisis, 14
European Business Organization Law Review 401 (2013).
36 See e.g. Edo Groenewald, Corporate Governance in the Netherlands: From the Verdam Report of
1964 to the Tabaksblat Code of 2003, 6 European Business Organization Law Review 291 (2005).
37 See Jesse M. Fried and Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81
New York University Law Review 967, 988 (2006).
38 And, according to the listing rules of U.S. stock exchanges, not even that: they only require
independence from the company and top management. Jurisdictions with concentrated ownership structures, however, usually impose some form of independence from controlling shareholders. For a comprehensive survey, see Dan W. Puchniak and Luh Luh Lan, Independent Directors in
Singapore: Puzzling Compliance Requiring Explanation, American Journal of Comparative Law
(forthcoming).
39 See § 251 (b) Delaware General Corporation Law; Chapter 3.4; Art. 2367 Civil Code (Italy).
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Minority Shareholders and Non-Shareholder Constituencies
about the company’s business without the board’s invitation, as under German law.40
These measures constrain the controlling shareholder to pursue her policies through
directors who, although appointed by her, nevertheless face different responsibilities,
incentives, and potential liabilities from controlling shareholders.
Of course, how well the director-​based trusteeship strategy works, even when some
or most directors are financially independent of controlling shareholders, remains an
open question. We have already expressed our skepticism about the efficacy of these
directors as trustees for minority shareholders.41 Nevertheless, U.S. case law provides
anecdotal evidence that independent boards or committees can make a difference in
cash-​out mergers,42 or when controlling shareholders egregiously overreach.43
4.1.3.2 The equal treatment norm
The equal treatment of shares (and shareholders) of the same class is a fundamental
norm of corporate law. Although this norm can be viewed as a rule-​based constraint
on corporate controllers, it can also be seen as a species of the incentive strategy. To
the extent that it effectively binds the controlling shareholder, it motivates her to act in
the interests of shareholders as a class, which includes the interests of minority shareholders. As with all abstract norms, however, its functioning is subject to at least two
important qualifications. The first concerns the range of corporate decisions or shareholder actions that trigger this norm. The second qualification concerns the meaning
of the norm itself. For example, are two shareholders treated equally when a corporate
decision has the same formal implications for each, even though it favors the distribution or the risk preferences of the controlling shareholder over those of the minority shareholder? Insofar as shareholder preferences are heterogeneous and controlling
shareholders have legitimate power to shape corporate policy, some level of unequal
treatment seems endemic to the corporate form.44
Our core jurisdictions differ with respect to these qualifications of the equal treatment norm. In general, civil law jurisdictions—​and particularly those that have been
40 § 119 II AktG (shareholders may only vote on management issues if asked by the management
board). But see Chapter 7.6 for the case law on implicit shareholders’ meeting prerogatives (the so-​
called Holzmüller doctrine).
41 See Chapter 3.3.1. See also Ringe, note 35. For a broad discussion of the value of independent directors in U.S. family controlled listed companies see Deborah A. DeMott, Guests at the
Table: Independent Directors in Family-​Influenced Public Companies, 33 Journal of Corporation
Law 819 (2008).
42 See Chapter 7.4.2.
43 An example is the Hollinger case, in which the Delaware Chancery Court backed a majority
of independent directors who ousted the dominant shareholder from the board, and prevented him
from disposing of his controlling stake in the company as he wished. See Hollinger Int’l, Inc. v. Black,
844 Atlantic Reporter 2d 1022 (Del. Ch. 2004). The independent directors in Hollinger acted,
however, only after the controlling shareholder’s misdeeds were already under investigation by the
Securities and Exchange Commission (SEC), and the controller had openly violated a contract with
the board as a whole to promote the sale of the company in a fashion that would benefit all shareholders rather than the controller alone. See also Chapter 8.4.
44 For an instructive U.S. example on the point, compare Donahue v. Rodd Electrotype Co., 328
North Eastern Reporter 2d 505 (Mass. 1975), in which the court mandates that closely held
corporations must purchase shares pro rata from minority and controlling shareholders, with Wilkes
v. Springside Nursing Home, Inc., 353 North Eastern Reporter 2d 637 (Mass. 1976), in which the
same court recognizes that controlling shareholders may pursue their right of “selfish ownership” at a
cost to minority shareholders as long as they have a legitimate business purpose.
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Protecting Minority Shareholders
87
heavily influenced by German law—​tend to view equal treatment as a broad principle
(or source of law) that suffuses all aspects of corporate law. Germany and Japan also
frame the principle of equal treatment as a general statutory provision.45 By contrast,
the common law jurisdictions—​the U.S. and UK—​specify equal treatment by case
law or statute in particular contexts, but are less inclined to embrace a general legal
standard of equal treatment as distinct from constraint-​like standards such as the controlling shareholder’s duty to act fairly vis-​à-​vis minority shareholders.46
These jurisdictional differences in the deference accorded to equal treatment
have important consequences in a number of corporate law areas. As we discuss in
Chapter 8, respect for equal treatment makes American-​style poison pills more difficult
to implement in jurisdictions that discourage companies from distinguishing among
shareholders in awarding benefits, including stock purchase rights.47 Indeed, it is arguable that the law in the U.S.—​or at least Delaware—​accords the widest latitude for
unequal treatment of identical shares among all of our core jurisdictions, though there
are some isolated areas in which it enforces the equal treatment norm with exceptional
vigor. Although most jurisdictions enforce the equal treatment norm most strongly in
the area of corporate distributions (that is, dividends and share repurchases) and share
issues, U.S. law in practice limits categorical enforcement only to the payment of dividends. In general, targeted share repurchases, even at prices above market, are permissible in the U.S., and companies may issue shares to third parties without providing
preemption rights to incumbent shareholders.
Another area in which deference to the equal treatment norm has important implications is the law of corporate groups (i.e. groups of companies under the common
control of another company, often managed as a single, integrated business). As we
discuss in Chapters 5 and 6, some jurisdictions—​such as Germany, France, Italy, and
Brazil—​provide for special regulation in this area, permitting judicial evaluation of
intra-​group transactions in aggregate.48 Equal treatment is thus interpreted as applying
not to individual transactions, but to aggregates of transactions.
To conclude, the reach of the equality norm varies greatly, both within and between
jurisdictions. However, all our jurisdictions rely on this device, in at least some circumstances, to align the incentives of controlling and minority shareholders.
45 § 53a Aktiengesetz (Germany) and Art. 109(1) Companies Act (Japan). There is also a gray area
in German law when it comes to the preferential provision of information to blockholders vis-​à-​vis
other shareholders. A number of EU directives provisions more or less broadly impose the equal treatment principle upon EU publicly traded companies as well. See Art. 46 Directive 2012/​30/​EU, 2012
O.J. (L 315) 74; Art. 3(1)(a) Directive 2004/​25/​EC, 2004 O.J. (L 345) 64; Art. 17(1) Directive 2004/​
109/​EC, 2004 O.J. (L 390) 38; Art. 4 Directive 2007/​36/​EC, 2007 O.J. (L 184) 17.
46 Under Delaware law, equal treatment of minority shareholders determines whether a given
transaction is conceived as self-​dealing and scrutinized as such. Insofar as minority shareholders have
received formally equal treatment (i.e. controlling shareholders have not benefited at the minority’s
expense), the business judgment rule applies. Sinclair Oil Corp. v. Levien, 280 Atlantic Reporter
2d 717 (Del 1971). On the treatment of related-​party transactions by controlling shareholders, see
Chapter 6.2.2 and 6.2.5.
47 Given Japan’s strong statutory provision enshrining the equal treatment norm, the evolving
Japanese case law on warrant-​based takeover defenses is particularly interesting in this regard. See
Bull-​dog Sauce v. Steel Partners, Minshu 61–​5-​2215 (Japan. S. Ct. 2007) (permitting a discriminatory
distribution of warrants where the warrant plan, overwhelmingly approved by an informed shareholder vote, provided compensation for discriminatory treatment to the defeated tender offeror). See
Chapter 8.2.3.
48 See Chapter 5.2.1.3 and 5.3.1.2, and Chapter 6.2.5.3.
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Minority Shareholders and Non-Shareholder Constituencies
4.1.4 Constraints and affiliation rights
We group together the remaining strategies for protecting minority shareholders
because there is less to say about them in a chapter devoted to the governance system.
Legal constraints—​principally in the form of standards such as the duty of loyalty,
the oppression standard, and abuse of majority voting—​are widely used to protect
the interests of minority shareholders. In fact, these standards are often specific applications of the equal treatment norm, as when courts allow only “fair” transactions
between companies and their controllers—​meaning, in effect, that controlling shareholders cannot accept unauthorized distributions from the corporate treasury at the
expense of the firm’s minority shareholders. We examine these standards more closely
in Chapters 6 and 7, although we must stress here that they may help minority shareholders in settings involving neither a related-​party transaction nor a fundamental
change.49
Finally, the affiliation strategy, in the guise of mandatory disclosure, is at least
as important for protecting minority shareholders as it is for protecting shareholders as a class. To the extent that disclosure, as a condition for entering and
trading in the public markets, reveals controlling shareholder structures and conflicted transactions, market prices may bring home to controllers the costs of their
opportunism.50 Moreover, mandatory disclosure provides the information necessary to protect minority shareholders through other mechanisms, such as voting or
litigation.51
By contrast, the exit strategy goes only so far in protecting minority shareholders.
On the one hand, free transferability of shares, one of the five key elements of the business corporation, is helpful but incomplete as a minority protection tool. It permits
dissatisfied minority shareholders to sell their shares on the market, but only if there is
a market for the company’s shares, and even then, usually at a price that already reflects
the controlling shareholder’s abuses.52 On the other hand, minority shareholders are
generally unable to exit the firm by taking with them their proportional share of the
corporation’s assets. After all, permanency of investment is a hallmark of the corporate
form. As we address in Chapters 6, 7, and 8, corporate law sometimes does provide
stronger exit rights, in particular for closely held companies, but usually only upon
egregious abuse of power by a controlling shareholder or in conjunction with a major
transformation of the enterprise. Examples include the availability of appraisal rights
(essentially, a put option) upon the occurrence of a fundamental transaction in many
jurisdictions;53 or the mandatory bid rule triggered by a sale of control and sell-​out
rights in Europe and Brazil.54
49 For instance, in some jurisdictions a minority shareholder in a closely held firm may challenge
as oppressive or abusive a controlling shareholder’s decision to discharge the minority shareholder as
an employee or to remove her from the board when all of the company’s distributions to shareholders
take the form of employee or director compensation.
50 See Chapter 6.2.1.1.
51 See Chapter 9.1.2.3.
52 Informed blockholders can also use the threat of exit, and its impact on stock price, to discipline managers, thereby improving firm governance ex ante—​although this mechanism is likely to be
more effective in firms lacking a controlling shareholder. See Alex Edmans, Blockholders and Corporate
Governance, 6 Annual Review of Financial Economics 23 (2014) (reviewing the use of exit by
blockholders as a governance device).
53 See Chapter 7.2.2 and 7.4.1.2.
54 See Chapter 8.3.4.
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89
4.2 Protecting Employees
In addition to protecting minority shareholders, the corporate governance system
extends important protections to non-​shareholder constituencies in a contractual relationship with the corporation. Corporate law in all jurisdictions provides specialized
protections to corporate creditors, which we consider separately in Chapter 5. Here we
focus principally on the governance protections accorded to employees.
As contractual counterparties to the corporation, employees may deserve the protection of corporate law insofar as they are particularly susceptible to exploitation by the
firm—​and labor law regulations are held to be insufficient to protect workers or costlier
to implement. From an economic perspective, this vulnerability emerges from the specific nature of the human capital investments that workers may make in their employer’s
business, such as by learning to use the firm’s technology or relocating to a remote region
where a particular facility is located.55 When these investments are firm-​specific (in
the sense that they are useful only in the context of this employment), a profit-​seeking
corporation may subsequently exploit an employee’s lack of outside options to “hold
up” the employee.56 This could be done by renegotiating the employment contract
to transfer surplus from the worker to the firm, for example by decreasing wages and
benefits, or worsening working conditions. To the extent that employees are able to
foresee the prospect of such opportunistic behavior by the firm, they will be less willing
to undertake firm-​specific investments to begin with, thus ultimately harming profits.57
Our core jurisdictions differ profoundly in the extent to which they rely on corpor­
ate law for the protection of employees. Where they do, appointment rights, decision
rights, and incentives are the principal strategies of choice. Of course, employees may
also benefit indirectly from strategies designed to protect shareholders and creditors.
For instance, mandated financial disclosures can assist employees, as well as investors,
in their affiliation decisions. Disclosure rules have recently been harnessed to protect
employees in a different way: labor unions in the U.S. have pushed for a rule requiring
companies to disclose the “pay ratio” between the CEO and the median worker, a figure that might arguably help their bargaining position in wage negotiations.58 Finally,
a recent legal change in the UK also purports to rely on corporate law as a substitute
for the labor law protections by permitting the elimination of various labor rights for
“employee shareholders” having received a grant of at least £2,000 in company stock.59
55 Moreover, employees may also have firm-​specific financial investments in the form of unfunded
defined-​benefit pension obligations, which are more common in Germany and Japan. See Martin
Gelter, The Pension System and the Rise of Shareholder Primacy, 43 Seton Hall Law Review 909, 966
(2013).
56 See generally Margaret M. Blair, Ownership and Control: Rethinking Corporate
Governance for the Twenty-​first Century (1995); Paul L. Davies, Efficiency Arguments for the
Collective Representation of Workers: A Sketch, in The Autonomy of Labour Law 367 (Alan Bogg
et al. eds., 2015).
57 For a thorough articulation of the view that corporate law should protect parties making
specific investments in the firm, see Margaret Blair and Lynn Stout, A Team Production Theory of
Corporate Law, 85 Virginia Law Review 247 (1999); Martin Gelter, The Dark Side of Shareholder
Influence: Managerial Autonomy and Stakeholder Orientation in Comparative Corporate Governance, 50
Harvard International Law Journal 129 (2009).
58 On the “pay ratio” rule, see Section 4.3.1.
59 See s. 205A, Employment Rights Act 1996, as introduced by the Growth and Infrastructure
Act 2013 (s. 31).
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Minority Shareholders and Non-Shareholder Constituencies
A minority shareholding in the employer is, however, an implausible substitute: an
undiversified position only compounds workers’ vulnerability to firm-​specific risks and
opportunism.
4.2.1 Appointment and decision rights strategies
The widespread introduction of employee-​appointed directors to the boards of large
European corporations is one of the most remarkable experiments in corporate governance of the twentieth century. Many European countries now mandate employee-​
appointed directors in at least some large companies,60 although our core jurisdictions
are not fully representative in this respect. The U.S., UK, Italy, and Japan do not mandate employee board participation. Even French requirements are tame by the standards of most other countries imposing worker participation, which typically require
that employee representatives constitute one-​third of the board.61 France requires some
employee board representation for listed companies in which employees own more
than 3 percent of the shares.62 Since 2013, large companies must also stipulate in their
articles of association that one or two directors will be appointed as employee representatives.63 However, in the majority of French companies (with over 50 employees)
employees may only select two (sometimes four) non-​voting representatives to attend
board meetings.64 Employee participation requirements are also mild in Brazil: they
apply solely to firms controlled by the federal government and mandate the appointment of only one employee representative, who is not permitted to vote on labor-​
related matters.65
By contrast, German law establishes “quasi-​
parity codetermination,” in which
employee directors comprise half the members of supervisory boards in German
companies with over 2,000 (German-​based) employees.66 Just as importantly, some
of these labor directors must be union nominees, who generally come from outside
the enterprise.67 Moreover, only German-​based employees and German trade unions
have a right to appoint labor directors—​though such differential treatment of foreign
employees has recently become questionable under EU law.68
Although shareholders and workers appoint equal numbers of directors to the supervisory boards of large German companies (as the term “quasi-​parity” denotes), this does not
mean that they share power equally as a formal legal matter, since the supervisory board’s
60 The only EU countries that have not introduced any significant form of worker board representation are Belgium, Bulgaria, Cyprus, Estonia, Italy, Latvia, Lithuania, Malta, Romania, and the UK.
Many countries, however, provide for employee board representation only in state-​owned companies.
See www.worker-​participation.eu/​.
61 This is the case for instance in Austria, Denmark, Luxembourg, and Hungary. See Aline
Conchon, Board-​level Employee Representation Rights in Europe: Facts and Trends, European Trade
Union Institute Report No. 121 (2011), www.etui.org.
62 Arts. L. 225-​23 and L. 225-​71 Code de commerce (for a one-​tier board and a supervisory board
respectively).
63 Arts. L. 225-​27-​1 and L. 225-​79-​2 Code de commerce (for one-​tier boards and supervisory
boards respectively), introduced by Loi No. 2013-​504 of 14 June 2013.
64 Art. L. 432-​6 Code du travail.
65 Lei 12.353, de 28 de dezembro de 2010 (Braz.).
66 §§ 1 and 7 Mitbestimmungsgesetz. German companies with between 500 and 2,000 employees
must grant one-​third of their board seats to employees. §§ 1 and 4 Drittelbeteiligungsgesetz.
67 In the largest companies seven members are elected by employees and three are appointed by
trade unions. § 7 II Mitbestimmungsgesetz.
68 See Kammergericht, decision of 16 October 2015, 14 W 89/​
15, Zeitschrift für
Wirtschaftsrecht 2172 (2015) (requesting a preliminary ruling by the Court of Justice of the
European Union on the issue. As of our writing, the case is still pending).
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Protecting Employees
91
chairman, who is elected from among the shareholder representatives, has the statutory
right to cast a tie-​breaking vote in a second round of balloting in case of deadlock.69
Nevertheless, employee representatives retain considerable power, formally through a
statutory right to veto nominees to the management board,70 and informally, because
they are in a position to disrupt the proceedings of the supervisory board. In addition,
the German codetermination statute allocates one seat on the management board to a
“human resources director,” who often has close ties with unions and employees.71 Thus,
German codetermination gives labor significant leverage over corporate policy by according it influence over the composition of the management board, access to information,
and the power to withhold consent from contentious company decisions. This latter
point is especially critical, because the usual practice of supervisory boards is to take decisions by consensus and because the shareholder bench of the supervisory board may not
act monolithically, owing to the presence of independent board members.72
With the exception of Germany, whose laws permit works councils to co-​decide
(with management) on a number of employee-​sensitive matters,73 corporate laws never
confer direct decision-​making rights on workers. EU directives on works councils do
provide employee information and consultation (but not decision) rights on matters
of particular employee concern, such as the prospective trend of employment, any
substantial change in a firm’s organization, collective redundancies or sales of undertakings.74 Such rights give labor lead time to organize resistance, make its case, or
otherwise protect employees’ interests. Even if works councils cannot influence major
corporate decisions, the information flow that they provide, from top management to
the shop floor and vice versa, arguably creates as much trust between companies and
their employees as mandatory employee representation on the board, especially since
labor representatives on works councils are typically the firm’s own employees rather
than outside union appointees.75
4.2.2 The incentives and constraints strategies
Incentive devices are less important in protecting employees than they are in protecting minority shareholders. Consider the trusteeship strategy first. Of course independent directors appointed by shareholders may function as weak trustees on behalf of
employees, just as they do for minority shareholders, if law and local business culture
motivate them to do so. And to some extent the law does facilitate such weak trusteeship even in the U.S., where many states other than Delaware permit—​but do not
69 § 29 II Mitbestimmungsgesetz.
70 Election to the management board is by a two-​thirds majority vote of the supervisory board
(§ 31 II Mitbestimmungsgesetz). If there is no two-​thirds majority for a candidate, lengthy proceedings are instituted which finally award the tie-​breaking vote in a simple majority vote to the chairman
of the supervisory board.
71 § 33 Mitbestimmungsgesetz. (Germany).
72 See Chapter 3.3.1.
73 §§ 87 et seq. Betriebsverfassungsgesetz (Germany).
74 See European Works Council Directive (Recast Directive 2009/​38/​EC, 2009 O.J. (L 122) 28);
Art. 4 General Framework Directive (Directive 2002/​14/​EC, 2002 O.J. (L 80) 29); Art. 2 Collective
Redundancies Directive (Council Directive 98/​59/​
EC, 1998 O.J. (L 224) 16); Art. 7 Sale of
Undertakings Directive (Council Directive 2001/​23/​EC, 2001 O.J. (L 82) 16).
75 Works councils can provide a better framework for information-​sharing than the supervisory
board also because, unlike trade unions, they are usually not involved in negotiations of employment
terms: see Annette Van Den Berg, The Contribution of Work Representation to Solving the Governance
Structure Problem, 8 Journal of Management and Governance 129 (2004). See also Davies,
note 56.
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Minority Shareholders and Non-Shareholder Constituencies
require—​directors to consider the interests of employees and other non-​shareholder
constituencies in making important decisions, especially in the context of a hostile
takeover.76
Unlike minority shareholders, non-​shareholder contractual constituencies do not—​
and usually cannot—​enjoy the protection of the equal sharing norm. Employees, lenders, and suppliers generally receive the bulk of their compensation as fixed payments
rather than volatile claims on the net income of the firm as a whole. Where employees
invest in developing firm-​specific human capital, such fixed payments may be the firm’s
dominant risk-​sharing arrangement, as the stockholders are generally able to diversify
their financial investments across firms.
Employee stock ownership might seem to be a weak variant of the equal sharing
device. Some jurisdictions encourage firms to share equity ownership with employees,
on the theory that this will improve corporate governance and diminish tensions within
the firm.77 Yet share ownership entails different, and less satisfactory, consequences for
employees than for outside investors with diversified portfolios. For employees, ownership of their firm’s shares increases the already large—​and largely undiversified—​firm-​
specific risk that they bear. Moreover, it is unclear whether employee share ownership
serves to protect the interests of employees as a class, as employee-​shareholders generally remain a minority, without significant governance rights. Nevertheless, the grant of
stock options to lower-​level employees is surprisingly frequent in practice, especially in
high-​tech industries: stock options can help alleviate financing and capital constraints
facing the firm, as well as promote retention and the sorting of optimistic employees.78
Finally, the constraints strategy for protecting employees is largely embodied in dedicated regulatory structures, such as labor law, which, for reasons of space, we exclude
from the purview of this book except in the context of fundamental corporate decisions, addressed in Chapter 7 below.79 Otherwise, the laws that permit or mandate corporate directors to have regard to non-​shareholder constituencies typically encompass
the interests of employees as well.80 Nevertheless, these other corporate law constraints
for protecting non-​shareholder constituencies are usually toothless or narrowly targeted, as discussed further below.
4.3 Protecting External Constituencies
Corporate laws everywhere focus primarily on the relationships between the corpor­
ation and its contractual constituencies—​notably, managers and shareholders, but also
creditors and employees. Yet there is no doubt that the corporation’s economic relevance and impact go well beyond its relationships with contractual counterparties.
76 See Chapter 8.1.2.3. For a trustee-​like analysis of the U.S. board, see Blair and Stout, note 57.
77 There are also instances of the reward strategy in the form of legally sanctioned sharing regimes.
For example, the U.S. has tax-​favored employee stock ownership plans: see Henry Hansmann, The
Ownership of Enterprise 87 (1996). France mandates both extensive information and limited
employee profit-​sharing rights in all firms with more than 50 workers. See Arts. L. 2322-​1, 2323-​6 to
2323-​23-​60, 3322-​2, 3324-​1 and 3324-​10 Code du travail.
78 See e.g. John E. Core and Wayne R. Guay, Stock Option Plans for Non-​executive Employees, 61
Journal of Financial Economics 253 (2001) (finding an association between the use of stock
options and financing and capital constraints); Paul Oyer and Scott Schaefer, Why Do Some Firms
Give Stock Options to All Employees? An Empirical Examination of Alternative Theories, 76 Journal
of Financial Economics 99 (2005) (attributing the widespread use of stock options to sorting and
retention goals, rather than incentives).
79 See Chapter 7.4.3.2.
80 See Section 4.3.3.
93
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93
Left unchecked, corporations may engage in socially harmful behavior, such as environmental degradation, violations of human rights, anticompetitive behavior, or practices that pose systemic risk to the economy. The recent scandal involving German
car manufacturer Volkswagen—​which designed its cars’ software to cheat emissions
tests—​illustrates this concern. The company’s relentless pursuit of growth, which initially benefited both shareholders and workers, encouraged managerial choices that
clearly conflicted with the wider interests of society.
Of course, corporations have no monopoly on socially harmful activities: individuals and other organizational forms engage in them as well. Yet because the corporate
form is particularly conducive to large-​scale enterprise, the social harms it engenders
are correspondingly large-​scale. Moreover, limited liability—​an essential feature of the
corporate form—​serves to compound the problem, by permitting shareholders to bear
only a fraction of the costs their companies’ activities cause for third parties.81 And
precisely because they cannot protect themselves through contract, the corporation’s
non-​contractual stakeholders have a greater need for legal protection than do its contractual constituencies.
The crucial question is not whether the corporation’s non-​contractual stakeholders
deserve legal protection of some sort—​they clearly do—​but whether corporate law is
the proper channel through which to deliver this. A simple answer is that protection of
interests extraneous to the firm should come from other areas of law, such as environmental law, human rights law, antitrust law, or financial regulation. Indeed, the use of
legal rules and standards—​the constraints strategy—​to promote interests extraneous
to the corporate form is, almost by definition, not corporate law, but the application to
corporations—​as legal persons—​of norms from other fields of law.
On occasion, however, regulators from our core jurisdictions resort to the same governance strategies and incentive strategies outlined in Chapter 2, not (only) to mitigate
agency problems within the firm, but (also) to achieve broader societal objectives. Such
an approach may be necessitated when—​owing to regulators’ information gaps or to
successful industry lobbying—​more direct regulatory responses to externalities and
other social problems are not feasible.82 On the other hand, corporate law may become
an easy target of populist or misguided reform efforts that can easily decrease the efficiency of its regime without generating any meaningful gains for other constituencies.
The use of corporate law to protect external constituencies is by no means new.
Historically, the very availability of incorporation was conditioned on the showing of
a specific public benefit resulting from the enterprise. Other features of early corporate
laws were specifically devised to mitigate monopoly problems or otherwise protect the
interests of consumers.83 In fact, the historical and contemporary uses of corporate
law to protect non-​contractual stakeholders are too numerous to describe in full.84 It
is worth noting, however, that in recent years—​and in particular, in the wake of the
recent financial crisis—​there has been a visible resurgence in the use of legal strategies
that shape the internal governance of business corporations, in particular in the financial sector, to tackle broader social and economic problems.
81 See Chapter 1.2.2 and Chapter 5.1.2.3.
82 See Mariana Pargendler, The Corporate Governance Obsession, 42 Journal of Corporation
Law 101 (2016).
83 Henry Hansmann and Mariana Pargendler, The Evolution of Shareholder Voting Rights: Separation
of Ownership and Consumption, 123 Yale Law Journal 948 (2014).
84 This is particularly conspicuous with respect to takeover regulation, which is often shaped by the
interests of labor, local communities, and the national economy. For examples, see Chapter 8.
94
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Minority Shareholders and Non-Shareholder Constituencies
Before proceeding, one caveat is necessary. Most attempts to protect external
interests—​from gender equality in the boardroom to the reduction of systemic risk
and the protection of human rights—​can be, and have been, rationalized in terms of
promoting long-​term shareholder value. Nevertheless, while the long-​term interests of
shareholders may at times coincide with those of society at large, perfect alignment in
all circumstances is implausible. In the following discussion, we consider instances in
which the legal strategies of corporate law are deployed with the interests of external
constituencies in mind, without taking a firm stance on the extent to which they also
benefit investors.
4.3.1 Affiliation strategies
The vast majority of the disclosure requirements imposed on publicly traded companies concern factual matters that assist investors in evaluating the corporation’s
financial condition and, to a lesser extent, in exercising their governance rights.85 By
increasing the quality and quantity of information available to the public, mandating
such disclosures enhances the efficiency of stock prices and supports financially motivated affiliation (and, to a lesser extent, voting) decisions by shareholders as a class.
In recent years, however, there has been a rise in the use of “non-​financial” or “social”
disclosure requirements.86 These new obligations relate to information that, while
arguably valuable from a social standpoint, may not always be relevant for shareholder
affiliation decisions motivated solely by financial considerations. Rather, their goal
is to facilitate entry and exit decisions by shareholders (and consumers) on socially
minded criteria and, where such decisions are taken on a sufficiently large scale, to
shape substantive corporate conduct. For instance, the U.S. Dodd-​Frank Act of 2010
requires publicly traded companies to disclose their use of conflict minerals from the
Democratic Republic of the Congo—​a rule intended ultimately to discourage the use
of such minerals and thereby alleviate the humanitarian crisis in the region.87 Similarly,
a new SEC requirement that U.S. public companies must disclose the extent to which
they consider diversity in director nominations is at least partly motivated by fairness
concerns towards women and minorities.
The Dodd-​Frank Act also includes a provision mandating disclosure of the ratio
of CEO compensation to that of their company’s median employee. This rule is best
understood as a response to growing apprehension about inequality, rather than as a
metric for evaluating corporate financial performance. In Japan, too, new executive
compensation disclosure obligations in part reflect growing unease about pay gaps
between CEOs and their average employees.88 For the first time, Japan now requires
individualized reporting of executive compensation packages, but only for those executives whose annual pay exceeds ¥100 million (approximately US$1 million)—​a high
threshold that is not met in most Japanese companies.89
85 See Chapter 3.4.2 and Chapter 9.
86 See e.g. Donald C. Langevoort and Robert B. Thompson, “Publicness” in Contemporary Securities
Regulation after the JOBS Act, 101 Georgetown Law Journal 337 (2013).
87 The D.C. Circuit has found that the portion of such a rule requiring a company to report that
its products have not been found to be “DRC conflict free” violates freedom of speech under the U.S.
Constitution: Nat’l Ass’n of Mfrs. v. SEC, 2014 Westlaw 1408274 (D.C. Cir., Apr. 14, 2014).
88 See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive
Compensation: Evidence from Japan, 2014 Columbia Business Law Review 111, 129.
89 Cabinet Office Ordinance on Disclosure of Corporate Affairs, Form 2 (Precautions for
Recording (57)d) and Form 3 (Precautions for Recording (37)).
95
Protecting External Constituencies
95
Non-​
financial disclosure has also gained particular traction in the EU. The
Accounting Directive now requires companies that operate in extractive industries to
publish details on payments they make to local governments in the countries in which
they operate.90 Moreover, a 2014 directive mandates disclosure of non-​financial information in management reports, including the company’s policy and performance with
respect to “environmental, social and employee matters, respect for human rights, anti-​
corruption and bribery matters.”91 These new reporting requirements have a broad
footprint: they apply to all large “public interest entities,” a category which includes
not only listed companies, but also large closely held banks and insurance firms with
more than 500 employees. The goal is presumably to focus pressure from shareholders,
consumers, and civil society at large so as to steer corporations towards socially desirable outcomes. In Japan, there is relatively little mandatory disclosure of non-​financial
information to protect external constituencies, although the Tokyo Stock Exchange
requires companies to describe how they respect the interests of various stakeholders in
their governance reports.
Whether disclosure is an appropriate means to accomplish these ambitious goals
remains an open question, which we consider further below.
4.3.2 Appointment and decision rights strategies
The interests of external constituencies could in theory also be advanced through the allocation of appointment and decision rights. Although reformers have argued for “constituency directors” at various points in time (especially in the 1970s),92 none of our core
jurisdictions confers general appointment rights on non-​shareholder constituencies other
than employees. The only exception is the appointment rights conferred by certain “golden
shares”—​such as France’s action spécifique—​which permit governments to appoint board
representatives in privatized firms.93
Yet most jurisdictions have director qualification requirements that constrain shareholders’ choice of appointees in view of broader economic or social purposes. A classical
example is the prohibition, in countries such as the U.S., Germany, and Italy, of interlocking directorates across financial institutions, which aims to preserve competition by
preventing directors from simultaneously serving on the boards of rival firms.94
More recently, Germany, Italy, and France and other countries have instituted mandatory minimum quotas on corporate boards,95 and Japan has concurrently introduced
voluntary targets. Gender quotas are best viewed as a constraint on the exercise of
90 See Arts. 41–​8 Directive 2013/​34/​EU, 2013 O.J. (L 182) 19. “Extractive industries” encompass
the exploration and extraction of minerals, oil, natural gas deposits, or other materials. The disclosure
provisions also apply to firms engaged in logging activity in primary forests (Art. 41).
91 Directive 2014/​95/​EU, 2014 O.J. (L 330) 4, which inserted Art. 19A to Directive 2013/​34/​EU.
92 See e.g. Ralph Nader, Mark Green, and Joel Seligman, Taming the Giant Corporation 125
(1976) (advocating the presence of an informed representative on the board for each public concern,
such as environmental matters, consumer interests, compliance, among others).
93 Art. 31-​1 Ordonnance No. 2014-​948 of 20 August 2014, inserted by Loi No. 2015-​990 of 6
August 2015.
94 Section 8 of the Clayton Act (U.S.); § 100 section 2 No. 3 AktG (Germany); Art. 36, Decree-​
Law 6 December 2011, No. 201 (Italy).
95 Aktiengesetz § 96(2) (30 percent of supervisory board seats for the largest companies with
employee board representation); Arts. 225-​18-​1 and 225-​69-​1 Code de commerce (in force, respectively, as of 1 January 2017 and 2020); Art. 147-​III Consolidated Act on Financial Intermediation
(Italy) (one-​third of board seats). The Italian law on gender quota only applies to three board elections
following its entry into force in 2012.
96
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Minority Shareholders and Non-Shareholder Constituencies
appointment rights that seeks to further more than simply the interests of shareholders.
The empirical literature does not evidence any clear link between board diversity and
corporate performance.96 While a similar absence of evidence has not stopped independent directors being promoted as a means of securing shareholders’ interests,97 a
likely alternative motivation for these new quota requirements is the political desire to
promote gender fairness. Perhaps also, they may seek to further the interests of non-​
shareholder constituencies, as some studies suggest that female directors exhibit different preferences from male directors with respect to risk-​taking and the protection of
stakeholders.98
Decision rights are also occasionally used to protect the interests of non-​
shareholder constituencies. This is not done directly, at least in our core jurisdictions, but indirectly, by conferring decision rights on the state. An example is the
retention by governments of “golden shares” in privatized firms. These first emerged
in the UK during privatizations in the 1980s, and then spread to Brazil, France,
Germany, and Italy.99 Golden shares grant the state veto rights over certain fundamental corporate decisions (such as mergers, dissolutions, and sales of assets)
disproportionately to, or sometimes irrespective of, any ownership interest in the
firm. Governments with golden shares can be “shareholders” in name only—​they
are not necessarily investors in, or beneficial owners of, the firm.100 The rationale
for awarding such outsize decision rights to governments is presumably to protect
the public interest at large.101
Golden shares are not the only instrument by which governments can exercise direct
corporate power to promote social objectives. Another is direct state ownership of
enterprise, either via majority stakes or significant blockholdings.102 Despite waves of
96 See e.g. Deborah H. Rhode and Amanda Packel, Diversity on Boards: How Much Difference Does
Difference Make? 39 Delaware Journal of Corporate Law 363 (2014) (reviewing the empirical literature on female participation on boards and concluding that “the relationship between diversity and
financial performance has not been convincingly established”); Renee B. Adams, Women on Boards:
The Superheroes of Tomorrow?, ECGI Finance WP No 466/​2016 (2016) (similar).
97 See Chapter 3.2.
98 See e.g. George R. Franke, Deborah F. Crown, and Deborah F. Spake, Gender Differences in
Ethical Perceptions of Business Practices, 82 Journal of Applied Psychology 920 (1997) (women
more likely than men to perceive certain business practices unethical); Renée B. Adams and Daniel
Ferreira, Women in the Boardroom and Their Impact on Governance and Performance, 94 Journal
of Financial Economics 291 (2009) (diverse boards devote more effort to monitoring); David
A. Matsa and Amalia R. Miller, A Female Style in Corporate Leadership? Evidence from Quotas, 5
American Economic Journal: Applied Economics 136 (2013) (boards subject to gender quotas
increased relative labor costs and made fewer workforce reductions). But see Renée B. Adams and
Vanitha Ragunathan, Lehman Sisters, Working Paper (2015), at ssrn.com (banks with more women
directors no less prone to risk-​taking).
99 However, golden shares have been successfully challenged in the EU as an impediment to the
free movement of capital. See e.g. Wolf-​Georg Ringe, Company Law and Free Movement of Capital, 69
Cambridge Law Journal 378 (2010).
100 Whether golden shares entitle governments to cash-​flow rights varies by jurisdiction. Even
where they do, the associated decision rights are disproportionately powerful.
101 However, corporate income taxation makes the government a residual claimant of sorts in all firms
in a way that serves to align the interests of the government with those of shareholders. Indeed, a high
rate of tax compliance is associated with lower private benefits of control. See Dyck and Zingales, note 2.
102 Bernardo Bortolotti and Mara Faccio, Government Control of Privatized Firms, 22 Review of
Financial Studies 2907, 2924 (2009) (common law governments resort to golden shares more frequently; civil law governments relying more on continued equity ownership in privatized firms); Aldo
Musacchio and Sergio G. Lazzarini, Leviathan in Business, Brazil and Beyond (2014) (examining
different varieties of state capitalism).
97
Protecting External Constituencies
97
privatizations, significant state ownership persists in several of our core jurisdictions—​
most conspicuously in France, Germany, Italy, and Brazil.103 By exercising appointment
and voting rights through its role as shareholder, the state may steer the firm to achieve
political objectives, even at the expense of financial returns. State-​owned enterprises
(SOEs) are usually subject to the same corporate law regime applicable to private firms,
which generally affords the state as controlling shareholder wide discretion to pursue
public goals.104 For example, Brazil’s corporations statute applies to the state the same
fiduciary duties applicable to private controlling shareholders, but otherwise specifically
authorizes it to pursue the public interest that justified an SOE’s creation.105
Finally, scholars and policymakers have at times expressed hope that shareholders
themselves might exercise decision rights in ways that promote the interests of society
at large. The basic premise is that the rise in institutional investors pursuing indexing strategies entailing economy-​wide exposure, together with the broader spread of
equity ownership across various segments of society in some jurisdictions (especially
the U.S.), created a natural alignment between the interests of these “universal owners” and the public interest.106 The expansion of shareholder rights following the 2008
financial crisis—​as exemplified by the rise of “say on pay” around the globe—​is at least
partly premised on this assumption.107
4.3.3 The incentives and constraints strategies
As discussed above, the widespread use of the constraints strategy to protect the interests of external constituencies is usually thought to happen beyond the perimeter of
“corporate law.” There are, however, limited exceptions to this. First, other areas of law
can harness the mechanisms and enforcement tools of corporate law to pursue their
goals, which can make disciplinary boundaries more porous. For example, the U.S.
Foreign Corrupt Practices Act of 1977 (FCPA) on accounting and internal control
rules, on the one hand, and on SEC enforcement against public issuers, on the other,
in the pursuit of corruption.
Another exception is the imposition on directors of duties to consider the interests
of constituencies other than shareholders—​an expression of the standards strategy. The
corporate laws of many jurisdictions provide that directors owe their duty of loyalty to
the company rather than to any of its constituencies.108 Such a duty is most naturally
understood as an exhortation to maximize the net aggregate returns (pecuniary and
non-​pecuniary) of all corporate constituencies.
103 See Mariana Pargendler, State Ownership and Corporate Governance, 80 Fordham Law Review
2917 (2012).
104 Marcel Kahan and Edward Rock, When the Government is the Controlling Shareholder, 89 Texas
Law Review 1293 (2011); Mariana Pargendler, Governing State Capitalism: The Case of Brazil, in
Chinese State Capitalism and Institutional Change: Domestic and Global Implications
385 (Curtis J. Milhaupt and Benjamin Liebman eds., 2015).
105 Art. 4º § 1º Lei 10.303, de 30 de junho de 2016 (Braz.).
106 See e.g. Robert A. G. Monks and Nell Minow, Watching the Watchers 121 (1996); James
P. Hawley and Andrew T. Williams, The Rise of Fiduciary Capitalism (2000); Gelter, The Pension
System, note 55.
107 The same idea has inspired recent proposals to employ the constraints strategy to impose more
stringent liability standards on managers of systemically important firms. See John Armour and Jeffrey
N. Gordon, Systemic Harms and Shareholder Value, 6 Journal of Legal Analysis 35 (2014) (suggesting diversified shareholders would act “as a proxy for society” in enforcing such liability).
108 E.g. Germany: §§ 76 I and 93 I 2 AktG; Japan: Art. 355 Companies Act.
98
98
Minority Shareholders and Non-Shareholder Constituencies
In theory, implementing this obligation might (or might not) require division of
company surplus between shareholders and non-​shareholder constituencies such as
employees, in order to maximize the aggregate private welfare of all corporate constituencies.109 In practice, however, courts are not well-​placed to determine which policies
maximize aggregate private welfare. This explains why, even where it is spelt out, a duty
to pursue the corporation’s interest (in this broad sense) is unenforceable. Even fair-​
minded directors are unlikely to know how best to distribute surplus among multiple
corporate constituencies. Thus, the exhortation to boards to pursue their corporations’
interests is less an equal sharing norm than, at best, a vague counsel of virtue, and, at
worst, a smokescreen for board pursuit of their own interests. For instance, the UK
Companies Act 2006 requires directors to seek to promote “the benefit of [the company’s] members as a whole, and in doing so [to] have regard (amongst other matters) to …
the interests of the company’s employees, … [and] the impact of the company’s operations on the community and the environment.”110 However, the obligation is framed
subjectively, extending only to “act[ing] in the way he considers, in good faith” would
bring about that result, which encourages judicial deference to directors. Moreover,
third parties have no standing to enforce the duty. Similarly, Brazil’s corporations statute provides that directors should act in the best interests of the company, “subject to
the exigencies of public good and the social function of enterprise”; controlling shareholders, in turn, have duties and responsibilities towards “the remaining shareholders,
workers, and the community in which [the company] operates.”111 Yet this type of
language appears to have no constraining force, much like similar language in the typical American constituency statute.112
None of our core jurisdictions deploy duties to advance the interests of non-​
shareholder constituencies with quite such ambition as the new regime introduced by
India’s Companies Act of 2013. This requires companies to create a corporate social
responsibility committee and spend at least 2 percent of average net profits on promoting their “corporate social responsibility policy”—​preferably in local areas—​or to
explain their reasons for noncompliance. The Indian statute’s definition of “corporate
social responsibility” is particularly broad, encompassing not only social objectives
closely related to the firms’ primary activities, but also general humanitarian goals
such as the eradication of extreme hunger and poverty, reducing child mortality, and
combating various diseases.113 Unsurprisingly, given its ambition, the effectiveness of
this regime remains very much open to question.
Yet while our core jurisdictions do not compel spending on social causes, they do
not prohibit it, either. A number of them explicitly sanction corporations’ ability to
make reasonable charitable contributions.114 Legal systems may also encourage corpor­
ate charitable contributions through various tax deductions. And even in the United
States, where fiduciary duties to shareholders are formally perhaps the strongest,115
109 Note that maximizing the private welfare of all of the firm’s current constituencies is not equivalent to maximizing overall social welfare, which would include, for example, the welfare of potential
employees who are never hired because the high wages of current employees limit firm expansion.
110 § 172 Companies Act 2006 (UK).
111 Arts. 164 and 116 Lei das Sociedades por Ações.
112 See Chapter 8.5.
113 Companies Act 2013 (India), Art. 135 and Schedule VII.
114 See e.g. § 122(9) Delaware General Corporation Law; Art. 154, § 4º Lei das Sociedades
por Ações.
115 The most famous articulation of the shareholder primacy ideal comes from the case of Dodge
v. Ford Motor Company, 170 NW 668 (Mich. 1919) (“it is not within the lawful powers of a board
of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of
99
Protecting External Constituencies
99
in practice directors enjoy wide latitude to further the interests of non-​shareholder
constituencies so long as the decision is framed in terms of promoting long-​term shareholder value.116
Corporate law may also indirectly protect non-​shareholder constituencies through the
imposition of oversight liability on directors for failures to implement and monitor internal systems of compliance against illegal activity. By making it likelier that illegal activities
will be detected and their effects contained, such oversight obligations, which we touched
upon briefly in Section 3.4.1, can also protect external constituencies.117 Some jurisdictions also impose liability for damages caused to third parties by the directors’ negligence
(or gross negligence) in breaching a duty to the corporation.118 In practice, however, this
duty is principally read to protect the creditors of closely held corporations.119
Finally, another (blunt) use of the constraints strategy to protect the interests of
external constituencies is through the imposition of personal liability on directors and
officers—​or even shareholders—​for violations of law.120 All of our core jurisdictions
occasionally deviate from the general rule that only the corporation—​as a distinct legal
person—​is liable for its actions to accommodate the deterrence and compensation
goals of other branches of law, such as product liability, social securities law, tax law,
patent law, environmental law, labor law, antitrust law, and financial regulation.121
These include both direct sanctions for intentional or reckless violations of law and
secondary liability to pay damages to third parties if the firm becomes insolvent.
Irrespective of the scope and content of corporate fiduciary duties, the trusteeship
strategy in the form of independent directors—​as the “broad-​spectrum prophylactic” previously mentioned—​is also used to protect both contractual constituencies
and stakeholders external to the firm.122 For instance, the New York Stock Exchange
first required the inclusion of independent directors in audit committees in the late
1970s as a response to the corruption scandals of that era, even though corporate
corruption can easily serve the financial interests of investors (if to the detriment of
society at large). Indeed, one may argue that such ambiguity with respect to the function served by independent directors—​the protection of shareholders as a class, of
minority shareholders, of non-​shareholder contractual constituencies, or of external
shareholders and for the primary purpose of benefiting others”). See, more recently, eBay Domestic
Holdings, Inc. v. Newmark, 16 Atlantic Reporter 3d 1, 33 (Del. Ch. 2010) (“Promoting, protecting, or pursuing non-​stockholder considerations must lead at some point to value for stockholders”).
116 Einer Elhauge, Sacrificing Corporate Profits in the Public Interest, 80 New York University
Law Review 733 (2005) (business judgment rule deference entails significant managerial discretion
to sacrifice profits in the public interest).
117 Claire Hill and Brett McDonnell, Reconsidering Board Oversight Duties after the Financial Crisis,
University of Illinois Law Review 859, 866–​7 (2013).
118 Art. 429(1) Companies Act (Japan); Art. 2395 Civil Code (Italy); Art. L. 225-​251 Code de
commerce (France). However, French courts virtually never impose liability on directors on behalf of
third parties as long as the company is solvent. See Maurice Cozian et al., Droit des sociétés 179
(28th edn., 2015).
119 See Chapter 5.3.1.1.
120 See Reinier H. Kraakman, Corporate Liability Strategies and the Costs of Legal Controls, 93 Yale
Law Journal 857 (1984).
121 See e.g. Klaus J. Hopt and Markus Roth, Sorgfaltspflicht und Verantwortlichkeit der
Vorstandsmitglieder, in Aktiengesetz: Grosskommentar (Heribert Hirte et al. eds., 5th edn., 2015),
§ 93 comments 656 et seq (discussing controversial imposition of personal liability on corporate directors in Germany for product liability cases).
122 See e.g. Victor Brudney, The Independent Director—​Heavenly City or Potemkin Village? 95
Harvard Law Review 597, 597 (1981–​2) (“Numerous observers have argued that the addition of
independent directors to corporate boards would solve the problem of corporate social responsibility
without incurring the costs of external regulation”).
100
100
Minority Shareholders and Non-Shareholder Constituencies
stakeholders—​has in fact facilitated political consensus and contributed to the spread
of this mechanism in our core jurisdictions over time.123 The reward strategy has also
been increasingly deployed to protect the interests of non-​shareholder constituencies.
Rather than attempting to tie executive remuneration to benefits conferred by the
corporation on society as a whole—​which would clearly be impractical—​the reward
strategy has rather been used to discourage certain practices considered to be especially
harmful from a social standpoint.
In the wake of the financial crisis, there has been considerable concern that, by tying
executive remuneration to short-​term returns, compensation packages in financial
institutions contributed to the system’s collapse by encouraging managers to take risks
that were excessive from a social standpoint.124 In systemically important financial
institutions, the interests of undiversified shareholders conflict with those of society as
a whole—​both because financial crises have disastrous macroeconomic consequences
and because taxpayers are left to pick up the bill to bail out failing banks.
Yet, given the countervailing advantages of equity-​based compensation, none of our
core jurisdictions has completely banned its use in financial institutions, though the EU
has capped the variable component at twice fixed pay.125 Nor has there been any permanent imposition of ceilings on the level of compensation, notwithstanding populist
demands and growing concern about inequality. Except for the EU’s cap on variable pay,
most reforms in this area took the form of decision strategies, as in the global spread of
the “say on pay” rule,126 of trusteeship strategies, as in the most stringent independence
requirements for members of compensation committees imposed in the U.S,127 and of
affiliation strategies, as in the greater disclosure requirements in the U.S. and Japan.128
4.4 Explaining Jurisdictional Differences and Similarities
As with our discussion of the primary manager–​
shareholder agency problem in
Chapter 3, we first assess our core jurisdictions according to the protection that substantive law offers to minority shareholders, employees, and external stakeholders,
respectively, and then according to the protection that these constituencies enjoy in
practice, considering not only corporate law but also societal and legal institutions
more generally.
4.4.1 The law-​on-​the-​books
The substantive law-​on-​the-​books gives little guidance as to which jurisdictions place
more emphasis on protecting minority shareholders and external constituencies. It
does, however, provide an indication of which countries go furthest to protect employees through corporate law.
123 Pargendler, note 82.
124 See e.g. Lucian A. Bebchuk and Holger Spamann, Regulating Bankers’ Pay, 98 Georgetown
Law Journal 247 (2010).
125 Art. 94(1)(g) Capital Requirements Directive IV, 2013 O.J. (L 176) 338. The basic cap is set
at 100 percent of fixed pay, which may be increased to 200 percent with shareholder approval. See
generally John Armour et al., Principles of Financial Regulation 380–​8 (2016). Moreover, the
supervisory board members of most large German firms no longer receive stock options, though their
fixed salary has increased considerably.
126 See Section 4.3.2 and Chapter 6.2.3.
127 See Chapter 3.3.1.
128 See Section 4.3.1.
101
Explaining Jurisdictional Differences and Similarities
101
Consider minority shareholders first. Our analysis has shown that only Brazil and
Italy among our core jurisdictions rely on appointment rights, in the form of minority-​
elected board members, to protect minority shareholders. Elsewhere the long-​term
trend is in the opposite direction—​
namely, away from minority empowerment
through devices such as cumulative voting and strong supermajority voting rules.129
Why do so few jurisdictions mandate minority-​friendly appointment rights for
listed companies? One answer is that “partisan” representation of minority shareholders in controlled companies can be costly, by introducing conflict in board
meetings, discouraging candid business discussions, and, at its worst, providing
competitors with access to sensitive information.130 Another answer is that minority shareholders in publicly traded corporations are a heterogeneous group. On the
one hand, retail investors are the most vulnerable minority but, as a consequence
of collective action problems, are also the group least able to pursue their interests
effectively through appointment and decision rights. This is especially so under
the high ownership percentage thresholds required for the exercise of such rights
in Brazil and Italy. On the other hand, the minority shareholders best able to use
appointment rights are large-​block investors, who are also best able to contract for
governance protections (e.g. in a shareholder agreement) even without the addition
of mandatory terms in the law.
Board representation for minority shareholders might make more sense if, as is
relatively often the case in Brazil and Italy for the largest companies,131 institutional
investors, as opposed to other blockholders, nominate minority directors. At least in
the U.S., however, stringent laws on insider trading and onerous ownership disclosure
rules that prevent coordination among shareholders132 historically discouraged most
institutional investors from exercising appointment rights, making this strategy less
appealing. For activist investors such as hedge funds, however, board representation
for minority investors has proved to be a potent tool, even in the U.S.—​especially in
light of the growing collaboration between hedge funds and traditional institutional
investors.133
What, then, of other legal strategies for protecting minority investors? Among our
core jurisdictions the U.S., followed by the UK, appears to rely most extensively on
independent directors (in publicly traded companies), even more so after the Sarbanes-​
Oxley and Dodd-​Frank Acts enhanced their role. But since independent directors may
be appointed by controlling shareholders, even in the U.S. and the UK, their allegiance
is always suspect unless their interest in maintaining a good reputation among outside
shareholders at large is greater than their desire to be re-​elected in a particular firm
(or in other firms with controlling shareholders). The U.S., however, complements
the trusteeship strategy with the strongest mandatory disclosure system of all our core
jurisdictions.134
129 See Chapter 3.2.1 and Chapter 4.1.1.
130 See e.g. Gordon, note 8, at 167 (discussing traditional critiques of cumulative voting).
131 Institutional investors nominate around one-​third of the minority-​appointed directors in
companies voluntarily providing such information. See Assonime, Corporate Governance in
Italy: Compliance with the CG Code and Directors’ remuneration (Year 2012) 62–​70
(2013), at http://​www.assonime.it.
132 See Mark J. Roe, Strong Managers, Weak Owners: The Political Roots of American
Corporate Finance 273 (1994).
133 See Kobi Kastiel, Against All Odds: Shareholder Activism in Controlled Companies, 2016
Columbia Business Law Review 60.
134 See Chapter 6.2.1.1 and Chapter 9.
102
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Minority Shareholders and Non-Shareholder Constituencies
Alternatively, consider the equal treatment norm as a minority safeguard. Here,
Japan—​followed by continental European jurisdictions and Brazil—​is the country with
the most stringent standards, at least on-​the-​books. The UK also gives substance to the
equal treatment norm in the form of preemption rights and minority-​protective takeover
rules, while Delaware appears to rely on it the least. Put differently, all we know from
reviewing the law-​on-​the-​books is that jurisdictions pursue different strategies to protect
minority interests. How well these strategies work in practice is a totally different story.
When it comes to governance strategies that protect labor’s interest, Germany’s system of quasi-​parity codetermination, coupled with works council co-​decision rights,
clearly stands out.135 France follows, a considerable distance behind Germany, by mandating a far more attenuated labor presence on company boards and, for companies
with more than fifty employees, a works council with mere information and consultation rights.136 But France, like Japan, Germany, Italy, and Brazil, has strong labor
law rules governing basic employee interests, ranging from pension rights to terms of
dismissal.137 The U.S., followed by the UK, is the least protective of our core jurisdictions, both in direct regulation of employee rights and in structuring the corporate
governance system to reflect employee interests. Overall, the observed pattern seems
consistent with the view that the presence of powerful shareholders increases the risk
of exploitation of workers.138
Conversely, different jurisdictions embrace a variety of strategies with respect to the
protection of external constituencies, making it difficult to establish a clear pecking
order. The use of the affiliation strategy through mandatory disclosure of non-​financial
information is currently most extensive in EU countries, and least so in Brazil. Whether
explicitly or implicitly, all jurisdictions require or at least permit the board to take into
account the interests of non-​shareholder constituencies.139
State influence through ownership or golden shares is strongest in Brazil, France,
and Italy, and again weakest in the U.S., with other jurisdictions falling somewhere
in between. On the other hand, the decision rights of shareholders are weakest in the
U.S., thus arguably insulating boards from shareholder pressure and enabling them, if
only de facto, to promote a broader set of interests.140
4.4.2 The law in practice
As we argue above, the law-​on-​the-​books provides an imperfect measure of the protection accorded to corporate constituencies. This is particularly the case for minority
shareholders.
135 For reviews of the empirical literature on these mechanisms, see John T. Addison and Claus
Schnabel, Worker Directors: A German Product that Did Not Export, 50 Industrial Relations 354,
354 (2011); Davies, note 56.
136 See Rebecca Gumbrell-​McCormick and Richard Hyman, Embedded Collectivism? Workplace
Representation in France and Germany, 37 Industrial Relations Journal 473, 482 (2006).
137 See e.g. Juan C. Botero, Simeon Djankov, Rafael La Porta, Florencio Lopez-​de-​Silanes, and
Andrei Shleifer, The Regulation of Labor, 119 Quarterly Journal of Economics 1339 (2004)
(France’s labor law is most restrictive among our jurisdictions).
138 Gelter, The Dark Side, note 57. But see Mark J. Roe, Political Preconditions to Separating
Ownership from Control, 53 Stanford Law Review 539 (2000) (for the different view that social
democracies induce concentrated ownership in order to counterbalance the influence of labor in firm
management).
139 See notes 111–​12 and accompanying text.
140 See Chapter 3.4. See also Christopher M. Bruner, Corporate Governance in the Common
Law World 105 (2013).
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Explaining Jurisdictional Differences and Similarities
103
4.4.2.1 Minority shareholders
Two prominent empirical papers, applying different methodologies to data from the
1990s, suggest that controlling shareholders obtained private benefits that ranged from
small to negligible in the UK, U.S., and Japan respectively, through moderately larger
in Germany (approximately 10 percent), very large in Italy (30 percent or more) and
France (28 percent), to extraordinarily large (65 percent) in Brazil.141 Thus, to the
extent that private benefits of control measure the severity of the majority–​minority
shareholder agency problem, our core jurisdictions differed dramatically in the extent
of protection that they offered to minority shareholders, even if these differences were
not evident a priori from the law-​on-​the-​books.142
Moreover, these variations followed a clear pattern. The three jurisdictions in which
large corporations ordinarily have dispersed ownership also had low private benefits
of control, while the three countries in which concentrated ownership dominates had
moderate to large private benefits.
This association between dispersed ownership and low private benefits of control
is not accidental. In fact, widely held firms can only thrive in contexts where private
bene­fits of control are relatively small. Whenever private benefits of control are sufficiently large, dispersed ownership becomes inherently unstable, since a potential raider
would have much to gain from acquiring a controlling block and expropriating the
remaining minority.143
Nevertheless, the numerous corporate reforms implemented in our core jurisdictions since the 1990s, combined with the modest rise in ownership dispersion in some
contexts (Brazil)144 and the reduction of the wedge between ownership and control in
others (Italy),145 cast doubt on the continued accuracy of these earlier measurements
of private benefits of control. Strikingly, there are no cross-​country studies that update
the earlier estimates of private benefits of control—​which would be a critical element
in assessing whether and how the recent wave of corporate law reforms mattered.
In any case, the data from the 1990s suggest that the award of appointment rights
to minority shareholders in Italy and Brazil was a response—​albeit not necessarily a
solution—​to the mistreatment of minority shareholders. Moreover, it indicates that
the strong equal treatment norms found in civil law jurisdictions did not necessarily protect minority shareholders, nor did a relatively low percentage of independent
directors (as in Japan) necessarily inflate private benefits of control. Even domination
by a controlling shareholder is not a reliable predictor, since Scandinavian jurisdictions
141 The two papers are Nenova, note 2, at 336 (employing share price differentials for dual-class
firms to calculate private benefits) and Dyck and Zingales, note 2 (employing control premia in sales
of control blocks to calculate private benefits). Although these two papers present similar results across
all other jurisdictions, they differ sharply for France (2 percent vs. 28 percent). Here Nenova’s finding
of 28 percent is more plausible because it is based on nine observations of French firms, while Dyck
and Zingales have only four observations of French control transactions.
142 But see Sofie Cools, The Real Difference in Corporate Law Between the United States and
Continental Europe: Distribution of Powers, 30 Delaware Journal of Corporate Law 697, 760–​1
(2005) (the sizeable difference in scope of shareholder voting rights across jurisdictions may lead to
different values of control, even without private benefits).
143 See e.g. Lucian Bebchuk and Mark Roe, A Theory of Path Dependence in Corporate Ownership
and Governance, 52 Stanford Law Review 127 (1999).
144 Érica Gorga, Changing the Paradigm of Stock Ownership from Concentrated Towards Dispersed
Ownership? Evidence from Brazil and Consequences for Emerging Countries, 29 Northwestern
Journal of International Law and Business 439 (2009).
145 Massimo Belcredi and Luca Enriques, in Research Handbook on Shareholder Power 383,
385 (Jennifer G. Hill and Randall S. Thomas eds., 2015).
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Minority Shareholders and Non-Shareholder Constituencies
generally manifested low levels of private benefits despite concentrated ownership
structures.146
What, then, predicts the efficacy of minority shareholder protections and, by implication, the extent of private benefits of control? The literature suggests that many disparate factors matter, including legal rules, the general business culture, and even the
competitiveness of the product markets.147
In line with the analysis of Chapter 3, we suggest that ownership structures, on
the one hand, and legal protection of minority shareholders, on the other, are mutually reinforcing.148 In jurisdictions where concentrated ownership prevails, controlling
shareholders tend to block the enactment of laws that could curb their private benefits.
By contrast, in jurisdictions where ownership is dispersed, institutions and the investing public are likely to have greater political clout in pushing for reforms that reduce
minority expropriation. Our core jurisdictions seem to confirm this pattern.
In the UK, the interests of institutional shareholders dominate the institutions of
lawmaking and enforcement, such as the Financial Conduct Authority (as UK Listing
Authority), the Financial Reporting Council and the Takeover Panel. Large institutional investors are normally hands-​off shareholders with every reason to oppose any
form of suspected favoritism toward corporate controllers.
In the U.S., political influence is more evenly balanced between institutional investors and professional managers. But again, neither managers and institutional investors
nor state courts and the SEC have reason to treat controlling shareholders with kid
gloves. Stringent U.S. disclosure requirements, holding company regulations,149 and
taxation of intra-​corporate distributions150 are all indications of the comparative weakness of controlling shareholders under U.S. law. Delaware courts also take a tougher
stance toward self-​dealing by controlling shareholders than by officers and directors.151
Finally, shareholder class actions and enforcement by the SEC are, respectively, very
common and increasingly severe.
The case of Japan would seem to be similar in one respect. As we argue in Chapter 3,
while a large percentage of shares of listed companies still lies in the hands of stable
corporate shareholders, the amount held by each is usually small. As there is no controlling shareholder in these companies, the equal treatment norm is accepted without
much opposition.152
By contrast, in jurisdictions such as France, Italy, and Brazil, where large shareholders
control most listed companies, one assumes that controlling shareholders are a potent
political influence. The fact that the state is a major shareholder in many companies
in these countries—​and is often a member of the controlling coalition in the companies in which it holds a non-​controlling stake—​further compounds the influence of
146 See Ronald J. Gilson, Controlling Shareholders and Corporate Governance: Complicating the
Comparative Taxonomy, 119 Harvard Law Review 1641 (2006).
147 See Dyck and Zingales, note 2.
148 See also Bebchuk and Roe, note 143.
149 Roe, Strong Managers, Weak Owners, note 132, at 98.
150 Randall Morck and Bernard Yeung, Dividend Taxation and Corporate Governance, 19 Journal
of Economic Perspectives 163 (2005).
151 See Chapter 6.2.5.
152 Note, however, that managers who dominate listed companies do have an interest in providing
benefits to friendly shareholders in order to maintain their support. For example, a company may
financially assist employees’ purchases of the company’s shares. Provided there is a reasonable motivation (such as promotion of employees’ welfare), this is not prevented by the equal treatment norm.
Also, once hostile acquirers become a significant threat despite friendly shareholder support, managers
gain an interest in discriminating among shareholders in order to facilitate warrant or rights-​based
takeover defenses. See Chapter 8.2.3.2.
105
Explaining Jurisdictional Differences and Similarities
105
controlling shareholders, as we noted in Chapter 3. Anecdotal evidence concords with
the existing (albeit dated) empirical evidence to suggest that the minority–​majority
agency problem remains severe in these jurisdictions, despite legal efforts to mitigate it
through increased mandatory disclosure, appointment rights for minority shareholders
in Italy and Brazil, and pressure to add independent directors arising from listing standards or codes of best practice.153
4.4.2.2 Employee protection
In contrast to the weak correlation between formal law and minority shareholder protection, the correlation between law and employee protection is strong. German company
law does, in fact, reallocate corporate power to unions and works councils through quasi-​
parity codetermination and co-​decision rights.
The question then becomes: how effective is co​determination as an employee protection tool? In other words, what exactly can labor directors accomplish apart from the narrow goal of enhancing labor’s bargaining power? In Germany they can influence business
policies.154 There is also evidence that codetermination may provide valuable insurance
to skilled workers, protecting them against layoffs due to external shocks in exchange for
lower wages.155 But in addition to this, labor directors may also play an important informational role, at least in theory. Mutually wasteful bargaining behavior such as strikes and
lock-​outs result in part from distrust between firms and employees.156 By credibly informing employees, labor directors might limit such costly bargaining behavior. Likewise, by
revealing the firm’s intentions, labor directors can alert workers about possible future plant
closings and related layoffs. Whether employee representation at the board level actually
improves industrial relations based on trust between labor and shareholders is impossible
to say in the absence of econometric studies on the issue.
An alternative theory, with some empirical support in the literature, argues that
codetermination can provide German supervisory boards with “valuable first-​hand
operational knowledge” that improves board decision-​making and increases firm value
in the subset of firms in which the need for intra-​firm coordination is greatest.157 Yet
there is also evidence that quasi-​parity codetermination in larger German firms reduces
firm value158—​and still other, non-​comparable, studies finding that codetermination
increases employee productivity or firm profitability.159
153 See Chapter 3.3.1, and Sections 4.1.1 and 4.1.3.1.
154 See Chapter 3.5.
155 E. Han Kim, Ernst Maug, and Christoph Schneider, Labor Representation in Governance as
an Insurance Mechanism, Working Paper (2016), at ssrn.com (skilled workers in German firms with
quasi-​parity codetermination receive wages that are 3.5 percent lower in exchange for protection
against layoffs).
156 See R.B. Freeman and E.P. Lazear, An Economic Analysis of Works Councils, in Works
Councils: Consultation, Representation and Cooperation in Industrial Relations 27
(J. Roger and W. Streek eds., 1995). See generally John Kennan and Robert Wilson, Bargaining with
Incomplete Information, 31 Journal of Economic Literature 45 (1993).
157 Larry Fauver and Michael E. Fuerst, Does Good Corporate Governance Include Employee
Representation? Evidence from German Corporate Boards, 82 Journal of Financial Economics 673,
679 (2006).
158 See ibid. at 698–​701; Gary Gorton and Frank A. Schmid, Capital, Labor, and the Firm: A Study
of German Codetermination, 2 Journal of the European Economic Association 863 (2004).
159 For a useful if partisan review, see Simon Renaud, Dynamic Efficiency of Supervisory Board
Codetermination in Germany, 21 Labour 689 (2007). Renaud’s strongly positive findings about the
effects of quasi-​parity codetermination on profitability and productivity are suspect because they rely
on balance sheet data and fail to include the range of control variables found in the finance-​oriented
literature such as Fauver and Fuerst, note 157.
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Minority Shareholders and Non-Shareholder Constituencies
Moreover, the question remains: if large efficiencies result from codetermination,
why do the parties fail to contract for labor directors voluntarily and divide the surplus?
Why do we seldom see labor directors where they are not mandated by law? And if
mandatory law is needed to overcome collective action problems associated with the
introduction of voluntary codetermination, why is mandatory regulation necessary to
sustain codetermination once it has been introduced? Although commentators have
offered speculative economic answers to these questions,160 the empirical literature
again remains sparse.
There may also be ideological or cultural explanations for the dearth of employee
directors outside of continental Europe. But a competing explanation is that the costs
of labor representation exceed its benefits, or at least are feared to do so. One source
of concern is the difficulty of bridging the sharply divergent interests of the board’s
constituent groups of employees and shareholders, or even among employees themselves, in framing policy or supervising management. Voting is a highly imperfect way
of making decisions in the presence of such conflicts. Majority decision-​making by
a divided board risks opportunistic outcomes that diminish the value of the firm as
a whole,161 and is also likely to make for a costly and cumbersome decision-​making
process.162
In addition, strong labor representation on the board may exacerbate the agency
conflict between managers and shareholders as a class. Managerial discretion plausibly increases if shareholder and labor directors split over corporate policy, or if large
and divided supervisory boards lack the institutional capacity to monitor managers
closely.163 Indeed, managers may withhold information from boards with the acquiescence of shareholders to limit leaks to employees and competitors.164 Strong labor may
benefit managers, just as strong managers have proven to be loyal protectors of labor’s
interests in large Japanese companies, even without a regime of codetermination.165
160 See e.g. Fauver and Fuerst, note 157, at 679 (proposing that firms may be deterred from adopting codetermination voluntarily by adverse selection in recruiting employees and managers, even if
codetermination would increase firm value).
161 Perhaps for this reason, the double voting right of the chairman of the supervisory board of
co​determined corporations in Germany is very rarely used (its use is thought to undermine labor
relations).
162 It is nearly always the case that, in any given firm (whether investor-​, employee-​, customer-​, or
supplier-​owned), the group of persons sharing ownership is remarkable for its homogeneity of interest. Even within investor-​owned firms, for example, it is highly unusual for both preferred and common shareholders to share significant voting rights. Likewise, within entirely employee-​owned firms it
is rare for both managerial and line employees to share control (and voting rights are often given to the
line employees, who tend to be more homogeneous). See Hansmann, note 75, at 62–​4 and 91–​2. This
suggests that the appointment strategy is not easily adapted to resolve significant conflicts of interest.
163 But see Fauver and Fuerst, note 157 (in some instances employee board representation may
increase supervisory boards’ monitoring capacity and thereby reduce agency costs).
164 See Katharina Pistor, Co-​Determination in Germany: A Socio Political Model with Governance
Externalities, in Employees and Corporate Governance 163, 188–​91 (Margaret M. Blair and
Mark J. Roe eds., 1999). Pistor also provides an illuminating account of the practice of codetermination in German firms as forcing segmentation of the supervisory board into employee and management “benches,” which meet separately prior to board meetings (a practice that the German Corporate
Governance Code, in the one and only provision addressing codetermination, endorses) and always
present a common front in formal meetings of the supervisory board. The common practice of for­
cing supervisory boards to review the auditor’s report at the board meeting, but not permitting board
members to receive a copy for close review, is emblematic of the informational restrictions placed by
the management board on the supervisory board (ibid, 191).
165 See Masahiko Aoki, Toward an Economic Model of the Japanese Firm, 28 Journal of Economic
Literature 1 (1990).
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Explaining Jurisdictional Differences and Similarities
107
Most directors in Japanese firms are managers who were promoted from within the
ranks of the companies, and they tend to take the interests of core employees to heart.
So which side of the ledger dominates, the costs or the benefits of codetermination? At least in the case of German-​style codetermination, the empirical literature is,
as hinted, surprisingly mixed. Certainly large German firms survive and even flourish under the quasi-​parity regime of employee representation, and it seems intuitively
likely that codetermination has contributed to the heavy orientation of the German
economy toward manufacturing exports. Nevertheless, it is difficult to tease out
the opportunity costs suffered by the German economy as a result of strong-​form
codetermination.
4.4.2.3 External constituencies
Evaluating the correlation between formal law and the actual protection of non-​contractual constituencies is exceedingly difficult. The interests of different stakeholders
might conflict with one another, and measuring the impact of various strategies on
overall social welfare is simply impossible. Moreover, the desirability of using corporate
law to protect non-​contractual constituencies hinges not only on its ability to protect
stakeholders, but also on how it fares compared with regulation by other fields of law.
As a result, any normative assessment of existing approaches to corporate law in different jurisdictions will be tentative at best.
There is good reason to be cautious about the use of corporate law to tackle broad
social problems. Sometimes such attempts simply lack teeth. When fiduciary duties
are enlarged to encompass non-​contractual constituencies, they are usually unenforceable by those constituencies. Not only are there procedural constraints to enforceability (non-​shareholders usually lack standing to sue), but even determining what
general social welfare requires at any point in time is an insurmountable task even for
directors—​let alone for courts.
By contrast, state influence in corporate governance (by means of state ownership
and, to a lesser extent, golden shares) is far more consequential. SOEs often pursue
social (usually political) objectives that conflict with shareholder wealth maximization.
Yet the effects of state ownership on overall social welfare are dubious, especially when
regulatory alternatives are taken into account.166
More recently, policymakers have hoped that institutional investors, as “universal
owners” exposed to the entire market, will act as stewards of the public good.167 The
new non-​financial disclosure requirements, as well as recent reforms leading to greater
shareholder empowerment in executive compensation decisions and otherwise, are at
least partly premised (or at least gained further political traction based) on this assumption. However, diversified institutional shareholders usually lack both the knowledge
and the incentives necessary for such interventions. And the undiversified shareholders
166 See e.g. World Bank, Bureaucrats in Business: The Economics and Politics of
Government Ownership (1995) (finding that state-​owned factories pollute more than private factories); Andrei Shleifer, State Versus Private Ownership, 34 Journal of Economic Perspectives 133
(1998) (arguing that social goals are usually best addressed by government contracting and regulation).
167 See e.g. European Commission, Green Paper: The EU Corporate Governance Framework
(2011); http://​ec.europa.eu; John Kay, The Kay Review of UK Equity Markets and Long-​Term
Decision Making: Final Report 74 (2012) (“institutional investors acting in the best interest of
their clients should consider the environmental and social impact of companies’ activities and associated risks among a range of factors which might impact on the performance of a company, or the
wider interests of savers, in the long-​term”).
108
108
Minority Shareholders and Non-Shareholder Constituencies
who are more likely to be influential, such as hedge funds, are usually uninterested in
promoting goals other than financial returns.168 In fact, a study on the reputational
consequences for firms found liable of financial regulation violations in the UK found
that breaches of rules designed to protect third parties actually resulted in a positive
stock market reaction for the companies, suggesting the shareholders like firms to push
the boundaries.169
Nevertheless, there seems to be a clear recent trend toward employing the legal
strategies of corporate law to tackle broad social problems. Whether this is a functional
response to government failures in addressing externalities, or merely window-​dressing
to deflect more fundamental regulatory reforms, remains an open question.170 There is,
however, reason to be skeptical about the ability of corporate law to significantly tackle
concerns which reach far beyond the agency problems that form its core competency.
168 Edward B. Rock, Institutional Investors in Corporate Governance, in Oxford Handbook of
Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2016).
169 John Armour, Colin Mayer, and Andrea Polo, Regulatory Sanctions and Reputational Damage in
Financial Markets, Working Paper (2015), at ssrn.com.
170 Pargendler, note 82.
109
5
Transactions with Creditors
John Armour, Gerard Hertig, and Hideki Kanda
In Chapter 1, we saw that two of the core structural characteristics of the business corporation—​legal personality and limited liability—​involve partitioning pools of assets,
both to and from creditors’ claims. As we explained, these facilitate contracting and
investment by making certain which assets will—​and will not—​be available to support
particular claims. However, these features also bring with them potential for agency
costs. Although both shareholders and creditors are interested in the corporate assets,
these assets ordinarily under the shareholders’ control.
Indeed, a firm’s creditors have a dual role in relation to the other participants in the
enterprise. Under ordinary circumstances, most creditors are no more than contractual counterparties. However, if the firm defaults on payment obligations, its creditors become entitled to seize and sell its assets.1 At this point, the creditors change
roles: they become, in a meaningful sense, the owners of the firm’s assets.2 This dual
role means that creditors may experience different agency problems at different points
in time. As contractual counterparties, they face the possibility of opportunistic behavior by the firm acting in the interests of its shareholders. Yet if the firm defaults, the
problem can morph into assuring that one group of owners is not expropriated by
another: that is, a creditor–​creditor conflict of interest. Moreover, the creditors’ contingent ownership will cast a shadow over how relations among participants in the firm
are conducted, even while it is financially healthy.
Consequently, every corporate law includes some provisions protecting corporate
creditors. By serving to reduce agency costs, these measures help lower the cost of
raising debt finance,3 and of using the corporate form as a vehicle for contracting. Of
course, the general law of debtor-​creditor relations will apply to such transactions. We
focus here on legal strategies specifically directed at creditors of corporate debtors, commonly justified as responding to particular problems stemming from the partitioning
of corporate assets. This chapter considers the way in which the features of the corpor­
ate form give rise to such agency problems, and the legal strategies employed by our
major jurisdictions to address them.
1 See Section 5.1.2.
2 See Jean Tirole, The Theory of Corporate Finance 389–​
95 (2006); Patrick Bolton,
Corporate Finance, Incomplete Contracts, and Corporate Control, 30 Journal of Law, Economics &
Organization 164 (2014); On “ownership” for these purposes, see Chapter 1.2.5.
3 Stronger creditors’ rights are associated with increased credit availability: see e.g. Rainer
Haselmann, Katharina Pistor, and Vikrant Vig, How Law Affects Lending, 23 Review of Financial
Studies 549 (2010). This is especially so given effective debt enforcement: Simeon Djankov, Oliver
Hart, Caralee McLiesh, and Andrei Shleifer, Debt Enforcement Around the World, 116 Journal
of Political Economy 1105 (2008). For a review, see John Armour, Antonia Menezes, Mahesh
Uttamchandani, and Kristin van Zwieten, How Do Creditor Rights Matter for Debt Finance? A Review
of Empirical Evidence, in Secured Transactions Law, Economic Impact and Reform 1 (Frederique
Dahan ed., 2015).
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry
Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock.
Chapter 5 © John Armour, Gerard Hertig, and Hideki Kanda, 2017. Published 2017 by Oxford University Press.
110
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Transactions with Creditors
One of the general themes of this chapter will be that the mix of legal strategies
deployed to protect creditors depends on how easy it is for different suppliers of capital
to coordinate. There has been a major shift, over the past decade or so, in the way in
which large firms in many of our countries raise debt finance. They now raise more
through markets, and less from banks.4 This has increased coordination costs for creditors, and the mix of legal strategies that functions best to ameliorate agency costs has
consequently changed.
5.1 Asset Partitioning and Agency Problems
5.1.1 Asset partitioning and corporate creditors
We saw in Chapter 1 that the asset partitioning function of corporate law has two
aspects. First, entity shielding—​a consequence of legal personality—​which ensures that
the claims of corporate creditors have priority over shareholders (and their creditors) to
the company’s asset pool. This makes credible the firm’s pledge to make its assets available for its creditors. Secondly, limited liability (or “owner shielding”) shields the assets
of the firm’s owners (the shareholders) from the claims of the firm’s creditors, which
amongst other things facilitates diversification by shareholders.
Asset partitioning also has a subtle impact on the firm’s creditors. As creditors’
recourse is limited to corporate assets, lenders need only evaluate and monitor these
assets, lowering their overall costs. The limitation also facilitates specialization by creditors, because those with expertise in evaluating and monitoring assets of the type
owned by the firm will—​all other things equal—​be able to offer cheaper credit. The
cost savings from matching creditors’ monitoring capabilities with the assets to which
they have recourse also provides a rationale for corporate group structures. That is, asset
partitioning permits firms to isolate different lines of business, or types of asset, for
the purpose of obtaining credit. By separately incorporating—​as subsidiaries—​distinct
ventures or lines of business, the assets associated with each venture can conveniently
be made available just to the creditors who deal with that venture.5 This in turn allows
creditors to specialize in monitoring the asset types they understand best, even if they
have little ability to monitor the assets of the group’s other ventures.
For this matching of creditors to assets to work best, the creditors’ claims must be
backed only by the assets of the entity to which they have lent. If the creditors can
also look elsewhere for recourse, this not only increases the cost of their information-​
gathering, but also undermines their incentives to monitor the assets of the entity in
question.6 This is illustrated by the travails of securitization. In a securitization, assets
are partitioned from an originating firm by transfer to a separate entity, which raises
credit by issuing securities backed by these assets only. In theory, this could capture the
benefits of creditor specialization in monitoring, if the securities are issued to creditors who are knowledgeable about the assets. However, this benefit is diluted if—​as
was common in many securitization deals prior to the financial crisis—​such creditors
are offered additional rights of recourse (known as a “credit enhancement”) from the
originating company and/​or a third party.
4 An exception is the U.S., for which market-​based debt finance has long been more significant.
5 Creditors of the parent company are said to be “structurally subordinated” because their only
claim to the subsidiary’s assets is via the parent company’s shareholding.
6 See Richard Squire, The Case for Symmetry in Creditors’ Rights, 118 Yale Law Journal 806 (2009).
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Asset Partitioning and Agency Problems
111
5.1.2 Shareholder–​creditor agency problems
Corporate law’s asset partitioning functions bring with them potential to exacerbate
agency problems that arise between debtors and creditors. Ex ante, the entity shielding
performed by corporate personality can assist shareholders in misrepresenting the value
of corporate assets by falsely claiming that the firm holds title to assets that actually
belong to the shareholders in their personal capacity, or to other entities. Ex post, the
fact that shareholders benefit from the firm’s successes, while owner shielding protects their personal assets from the consequences of its failure, gives them incentives to
engage in actions that benefit themselves at the expense of creditors.
Such actions may take a variety of forms.7 Most basically, the shareholders may
siphon assets out of the corporate pool in favor of themselves. This kind of action,
which is sometimes referred to as “asset dilution” (or asset diversion), increases shareholders’ personal wealth, but harms creditors by reducing the assets available to satisfy
their claims.
Second, creditors’ interests may be harmed by an increase in the riskiness—​that is,
the volatility—​of the firm’s business, in particular through “asset substitution.”8 Here
shareholders do not take the firm’s assets for themselves, but rather sell assets used in
low-​risk business activities to pay for the acquisition of assets used in high-​risk business
activities.9 Shareholders can benefit from an increase in the riskiness of the firm’s cash
flows, because if things go well, all the extra goes to them, whereas if things go badly,
they lose no more than they already had at stake. Creditors, however, will be harmed
by this change. It will increase the probability that the firm will not generate sufficient
cash to repay them, with no countervailing benefit if things go well, given that creditors’ claims against the firm are fixed.10 To make things worse, such a substitution may
be attractive to shareholders even if it reduces the overall value of the firm’s assets: that
is, the shareholders may prefer a larger slice of a smaller overall pie.11
A third way in which shareholders may benefit at creditors’ expense is by increasing
the firm’s overall borrowing. If the “new” creditors end up sharing the firm’s assets with
the “old” creditors in the event of failure, this reduces the expected recoveries of the
old creditors should the firm default. This benefits the shareholders by enabling them,
in effect, to have the benefit of finance from the old creditors on terms which, in light
7 For a classic account, see Robert C. Clark, The Duties of the Corporate Debtor to its Creditors, 90
Harvard Law Review 505, 506–​17 (1977).
8 See Michael C. Jensen and William H. Meckling, Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure, 3 Journal of Financial Economics 305, 334–​7 (1976); Dan
Galai and Ronald W. Masulis, The Option Pricing Model and the Risk Factor of Stock, 3 Journal of
Financial Economics 53 (1976).
9 However, empirical evidence regarding the significance of asset substitution (or risk-​shifting)
is mixed: see Gregor Andrade and Steven Kaplan, How Costly is Financial (not Economic) Distress?
Evidence from Highly Leveraged Transactions that Became Distressed, 53 Journal of Finance 1443
(1998); Assaf Eisdorfer, Empirical Evidence of Risk Shifting in Financially Distressed Firms, 63 Journal
of Finance 609 (2008); Pablo Hernández, Paul Povel, and Giogo Sertsios, Does Risk Shifting Really
Happen? Results from an Experiment, Working Paper (2014).
10 The firm need not actually default on its debts for its creditors to be harmed: the value of their
claims in the secondary market will be reduced immediately by the shareholders’ action.
11 The phenomenon of firms investing in business projects that a rational investor would reject as
yielding too low a rate of return is sometimes referred to as “overinvestment.” The inverse problem—​
referred to as “underinvestment”—​may also arise in situations where the firm has liabilities exceeding
its assets. Such a firm may have growth opportunities that require further investments of capital, but
shareholders will be unwilling to make such an investment as the resulting payoffs will accrue to, or at
least be shared with, creditors: Stewart C. Myers, Determinants of Corporate Borrowing, 5 Journal of
Financial Economics 147 (1977).
112
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Transactions with Creditors
of the addition of the new creditors, now look too favorable. This effect is sometimes
referred to as “debt dilution.”12 The ultimate impact on the old creditors will of course
depend on what the firm does with the new funds. But because the new borrowing is
subsidized (by the old lenders), the new lenders may be persuaded to fund projects that
are value-​decreasing, and which, without such a subsidy, they would decline to fund.13
The intensity of the shareholder–​creditor agency problem will be influenced by
managerial risk aversion and shareholder control over firm decision-​making. Managers
of widely held firms who do not have significant equity stakes of their own will share
little of the “upside” payoffs received by shareholders, and may be more averse to
increasing the risk of default because of harm to their reputations if the firm becomes
financially distressed.14 As a result, they are less likely to be tempted to take actions that
benefit shareholders at the expense of creditors than are managers who are accountable
to a controlling shareholder, or who have a significant personal stake in enhancing the
firm’s share price, as for example through stock options. In general, the more successful
the various strategies described in Chapter 3 are in aligning managers’ interests with
shareholders’, the stronger will be managers’ incentives to act in a way that may benefit
shareholders at creditors’ expense.
Control transactions can affect creditors adversely along several of these dimensions at once—​a phenomenon known as “event risk.” A leveraged management buyout, for example, may jointly increase the firm’s debt load, change the direction of its
business and tightly tie managers to shareholder returns through significant personal
stockholdings.15
Shareholder–​creditor conflicts have the potential to reduce the overall value of the
firm’s assets.16 Thus both creditors and shareholders can benefit from appropriate
restrictions on the ability to divert or substitute assets, because such restrictions are
likely to reduce a firm’s cost of debt finance.17 Indeed, creditors and corporate borrowers frequently agree to a range of debt covenants in addition to their basic obligations
to repay principal and interest. Often these include restrictions on the firm’s ability to
engage in activities that might conflict with creditors’ interests—​such as payments of
dividends to shareholders, significant asset transactions, or increases in borrowing.18
Creditors may also take security interests in corporate assets, which restrict the scope
12 See e.g. Alan Schwartz, A Theory of Loan Priorities, 18 Journal of Legal Studies 209 (1989).
13 A version of this conflict involves granting contingent debt obligations—​such as personal
guarantees—​for which liability is correlated with the firm’s insolvency risk. These reduce the assets
available for other creditors precisely at the time they would be needed most. See Richard Squire,
Shareholder Opportunism in a World of Risky Debt, 123 Harvard Law Review 1151 (2010).
14 E.g. managers of U.S. firms undergoing debt restructurings frequently lose their jobs: Edith
Hotchkiss, Post-​Bankruptcy Performance and Management Turnover, 50 Journal of Finance 21
(1995); Kenneth M. Ayotte and Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1
Journal of Legal Analysis 511 (2009).
15 See Paul Asquith and Thierry A. Wizman, Event Risk, Covenants, and Bondholder Returns in
Leveraged Buyouts, 27 Journal of Financial Economics 195 (1990); Sudheer Chava, Dmitry
Livdan, and Amiyatosh Purnanandam, Do Shareholder Rights Affect the Cost of Bank Loans? 22 Review
of Financial Studies 2973 (2009) (takeover defenses, reducing event risk, associated with lower
costs of credit).
16 See e.g. Jensen and Meckling, note 8.
17 Clifford W. Smith, Jr. and Jerold B. Warner, On Financial Contracting: An Analysis of Bond
Covenants, 7 Journal of Financial Economics 117 (1979); Michael H. Bradley and Michael R.
Roberts, The Structure and Pricing of Corporate Debt Covenants, 5 Quarterly Journal of Finance
1 (2015).
18 See Smith and Warner, note 17; William W. Bratton, Bond Covenants and Creditor
Protection: Economics and Law, Theory and Practice, Substance and Process, 7 European Business
Organization Law Review 39 (2006). In addition to these non-​financial covenants, debtors
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Asset Partitioning and Agency Problems
113
for asset substitution by requiring the firm to obtain the consent of the creditor before
the asset can be alienated free from the creditor’s interest,19 and prevent the creditor
from being diluted.20 More effective protection still can be achieved by using entity
shielding: putting assets supporting a loan into a subsidiary, thus “structurally subordinating” all the borrower’s other creditors.21 Each of these mechanisms gives the
creditors a certain amount of control over the debtor’s activities.22
As creditors and firms frequently expend resources in writing covenants or agreeing
upon security interests, one might ask whether corporate law could reduce these transaction costs. However, as we shall see, corporate law largely abjures from regulating
transactions with creditors as such.
This general reliance on contract, rather than legal provisions, calls for explanation.
We believe three factors are particularly salient. First, there is a risk of overkill: having
too many restrictions on the firm’s behavior can be as harmful as too few. Just as shareholders have incentives to steer the firm to take too much risk, creditors have incentives
to encourage it to take too little.23 The appropriate balance is likely to vary depending
on the firm’s business model,24 and so leaving its determination to contract, rather
than the general law, allows it to be set with greater sensitivity. Consistently with this
analysis, empirical studies report that contractual protection granted by firms to their
creditors can be just as effective as creditor protection conferred generally by the law.25
Second, creditors’ interests in the firm—​their time and risk horizons—​are likely to
be much more heterogeneous than those of shareholders.26 As a result, the provision
commonly agree to a range of so-​called financial covenants: promises to maintain a certain level
of financial health. These serve as “tripwires,” the violation of which gives creditors greater control
through the renegotiation of debt terms: See Greg Nini, David C. Smith, and Amir Sufi, Creditor
Control Rights, Corporate Governance, and Firm Value, 25 Review of Financial Studies 1713 (2012).
19 Clifford W. Smith, Jr. and Jerold B. Warner, Bankruptcy, Secured Debt, and Optimal Capital
Structure: Comment, 34 Journal of Finance 247 (1979). For overviews of the literature on secured
credit, see Barry E. Adler, Secured Credit Contracts, in The New Palgrave Dictionary of Economics
and the Law, Vol. 3, 405 (Peter Newman ed., 1998); Jean Tirole, note 2, 164–​70, 251–​4; Efraim
Benmelech and Nittai K. Bergman, Collateral Pricing, 91 Journal of Financial Economics 339
(2009).
20 Dilution can also be restricted in the lending agreement (with a “negative pledge”), but a security
interest is self-​enforcing in its protection of the creditor’s priority: Alan Schwartz, Priority Contracts
and Priority in Bankruptcy, 82 Cornell Law Review 1396 (1996).
21 See Kenneth Ayotte and Stav Gaon, Asset-​Backed Securities: Costs and Benefits of “Bankruptcy
Remoteness”, 24 Review of Financial Studies 1299 (2011); Douglas G. Baird and Anthony Casey,
No Exit? Withdrawal Rights and the Law of Corporate Reorganizations, 113 Columbia Law Review 1
(2013).
22 See Ronald J. Daniels and George G. Triantis, The Role of Debt in Interactive Corporate
Governance, 83 California Law Review 1073 (1995); Douglas G. Baird and Robert K. Rasmussen,
Private Debt and the Missing Lever of Corporate Governance, 154 University of Pennsylvania Law
Review 1209 (2006).
23 Viral V. Acharya and Krishnamurthy V. Subramanian, Bankruptcy Codes and Innovation, 22
Review of Financial Studies 4949 (2009); Greg Nini, David C. Smith, and Amir Sufi, Creditor
Control Rights and Firm Investment Policy, 92 Journal of Financial Economics 400 (2009); Viral V.
Acharya, Yakov Amihud, and Lubimor Litov, Creditor Rights and Corporate Risk-​Taking, 102 Journal
of Financial Economics 150 (2011).
24 See e.g. Efraim Benmelech and Nittai K. Bergman, Vintage Capital and Creditor Protection, 99
Journal of Financial Economics 308 (2011).
25 See Paul Brockman and Emre Unlu, Dividend Policy, Creditor Rights, and the Agency Costs of
Debt, 92 Journal of Financial Economics 276 (2009); Darius P. Miller and Natalia Reisel, Do
Country-​Level Investor Protections Affect Security-​Level Contract Design? Evidence from Foreign Bond
Covenants, 25 Review of Financial Studies 408 (2012).
26 Hideki Kanda, Debtholders and Equityholders, 21 Journal of Legal Studies 431, 440–​1, 444–​5
(1992); Marcel Kahan, The Qualified Case Against Mandatory Terms in Bonds, 89 Northwestern
University Law Review 565, 609–​10 (1995).
114
114
Transactions with Creditors
of standard-​form “terms” to protect creditors may be at once over-​protective of
some creditors and under-​protective of others. And third, the appropriate content of
creditor-​protective restrictions may change over time, making it necessary to renegotiate them. The ease of renegotiation (and hence the appropriate initial tightness of
the restrictions) will depend on creditors’ coordination and information costs—​largely
tracking the number and identity of the creditors. It is harder for many bondholders, for example, to renegotiate, than for a few bank lenders.27 Restrictions seeking
to govern relations with all of a firm’s creditors would create significant renegotiation
problems unless they are set at a very lax level at the outset—​so much so, that in most
cases it would not be worth doing at all.28
However, in three particular instances—​which we now consider—​it appears that
these general conditions do not hold, and consequently the benefits of corporate law
responding to shareholder–​
creditor agency problems relations plausibly outweigh
their costs.
5.1.2.1 The vicinity of insolvency
All our jurisdictions specifically deal with shareholder–​creditor agency problems in
relation to corporations that are financially distressed—​that is, “in the vicinity of
insolvency.” The incentives for shareholders or managers to engage in value-​decreasing
transactions, such as asset substitution, become particularly intense when a firm’s
solvency is in doubt. Correspondingly, legal restrictions targeting corporations in
financial distress are likely to have benefits. Moreover, lawmakers may view the costs
as modest, because such provisions directly affect only a small subset of the firms in
the economy.29
A common theme in these restrictions is for the law to seek to encourage managers
of distressed corporations—​who are, by and large, well-​placed to assess the firm’s financial situation—​to act in the interests of creditors, rather than shareholders, and to initiate, if appropriate, a transition to informal debt restructuring or formal bankruptcy
proceedings.30 In many jurisdictions, this approach is also extended to controlling
shareholders, through a variety of mechanisms such as liability as de facto or shadow
directors, equitable subordination of shareholder loans in bankruptcy, and “piercing
the corporate veil.” Moreover, third parties may be recruited as monitors through the
operation of fraudulent conveyance laws and their equivalents. At the same time, the
laws in all our jurisdictions give creditors the right to trigger bankruptcy proceedings
against firms that are insolvent.
27 Thus bond agreements commonly have fewer (and weaker) covenants than bank lending agreements: compare Bradley and Roberts, note 17 with Robert C. Nash, Jeffry M. Netter, and Annette
B. Poulsen, Determinants of Contractual Relations Between Shareholders and Bondholders: Investment
Opportunities and Restrictive Covenants, 9 Journal of Corporate Finance 201 (2003).
28 John Armour, Legal Capital: An Outdated Concept?, 7 European Business Organization Law
Review 5, 21–​2 (2006).
29 However, this may be a little simplistic, as the effects of such provisions will be taken into
account in ex ante decision-​making. Excessive sanctions in financial distress may dull risk-​taking in
solvent firms: see Michelle J. White, The Costs of Corporate Bankruptcy: A U.S.-​European Comparison,
in Corporate Bankruptcy: Legal and Economic Perspectives, 467 (Jagdeep S. Bhandari and
Lawrence A. Weiss eds., 1996); Acharya and Subramanian, note 23.
30 See e.g. UNCITRAL, Legislative Guide on Insolvency Law, Part Four: Directors’
Obligations in the Period Approaching Insolvency (2013).
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Asset Partitioning and Agency Problems
115
5.1.2.2 Groups
Corporate groups are multi-​company structures under a common controller, be it the
shareholders of a dominant company, coalitions of shareholders controlling it, or even
its managers. Group structures make extensive use of corporate law’s asset partitioning
functions within a single economic firm. As we have seen, this can be used to facilitate the
allocation of credit risk to creditors best placed to evaluate and monitor particular assets.
However, groups also give rise to particularly intense agency problems. Subsidiary
corporations are by definition subject to a controlling shareholder, which as we have
seen increases the potential for shareholder–​creditor agency costs. And groups present
opportunities—​increasing with the complexity of their structure—​for opaque transfers of assets and creation of intra-​group liabilities that have the potential to undermine
creditors’ positions.31 Such injury could occur by design, or simply as fallout from
transactions undertaken in the interests of the controlling shareholder.32 For example,
the entire group might gain a production, distribution, or tax advantage by shifting
assets from one member to another, even though this shift makes the transferor’s debt
riskier and thus injures its creditors.
These problems are compounded by the fact that identifying corporate groups itself
is sometimes difficult. “Control” over group members—​a necessary prerequisite of
groups—​is hard to define;33 voting agreements that create control blocks often go undisclosed; and simple rules based on a putative controller’s voting rights can be misleading.34
5.1.2.3 Externalities
So-​called “non-​adjusting” creditors—​those parties who for whatever reason are owed
money by a corporate entity, but are unable to adjust the terms of their exposure to
reflect the risk that they bear—​pose a particular challenge.35 Most obviously, this group
includes victims of corporate torts and the state in right of regulatory claims.36 In
31 See Simon Johnson, Rafael La Porta, Florencio Lopez-​De-​Silanes, and Andrei Shleifer, Tunneling,
90 American Economic Review, Papers and Proceedings 22 (2000); Vladimir Atanasov,
Bernard Black, and Conrad Ciccotello, Unbundling and Measuring Tunneling, 2014 University of
Illinois Law Review 1697 (2014). The issue of minority shareholder protection is addressed in
Chapters 6 and 7.
32 See Jaap Winter et al., Report of the High Level Expert Group of Company Law Experts
on A Modern Regulatory Framework for Company Law in Europe (2002), 94–​9; Richard
Squire, Strategic Liability in the Corporate Group, 78 University of Chicago Law Review 605
(2011).
33 See e.g. Art. 22 Directive 2013/​34/​EU, 2013 O.J. (L 182) 19 (articulating seven different tests
for “control” for the purposes of parent/​subsidiary status); Art. 2(13)–​(14) Regulation (EU) 2015/​
848, 2015 O.J. (L 141) 19.
34 E.g. control of a closely held company might require 51 percent of its voting rights, while control of a publicly held company might only require 10–​20 percent of its voting rights.
35 For a taxonomy of such claimants, see Lucian A. Bebchuk and Jesse M. Fried, The Uneasy Case
for the Priority of Secured Claims in Bankruptcy, 105 Yale Law Journal 857 (1996). Even contractual
creditors such as workers, consumers, and trade creditors can be incompletely adjusting due to the
small size of their claims relative to the cost of adjusting. However, while trade creditors frequently
do not adjust the terms on which they lend, they nevertheless adjust the amount of credit extended
according to the riskiness of the borrower: see Mitchell A. Petersen and Raghuram J. Rajan, Trade
Credit: Theories and Evidence, 10 Review of Financial Studies 661, 678–​9 (1997).
36 Although the state is able to adjust the intensity of enforcement: see e.g. Katharina Pistor, Who
Tolls the Bells for Firms? Tales from Transition Economies, 46 Columbia Journal of Transnational
Law 612 (2007).
116
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Transactions with Creditors
economic terms, rights to compensation force injurers to bear the social costs of their
actions, and consequently encourage them to take appropriate precautions. However,
when limited liability shields the assets of those controlling, and profiting from, the
company’s activities, tort law’s economic function is undermined.37 This is especially
the case when shareholders undercapitalize, or shift assets out of, risky operating companies precisely in order to minimize their potential tort liability.38
Victims of corporate torts consequently need greater protections than do other
creditors of distressed companies, and many measures have been proposed to that end.
For example, non-​adjusting creditors might be given priority over other creditors in
insolvency proceedings.39 Alternatively, shareholders might be held liable for excess
tort liability, either on a pro rata basis in every case of tort liability, or to the full extent
of damages in cases in which shareholders control risky activities directly.40 Yet effective protection to non-​adjusting creditors is rare in our core jurisdictions, although
Brazil perhaps goes furthest in this regard: unlimited shareholder liability through veil-​
piercing is the norm whenever corporate assets are insufficient to compensate the damages caused to workers, consumers, and the environment.41
One regulatory strategy that is adopted in a number of jurisdictions—​although
not strictly speaking part of corporate law—​is to require firms pursuing hazardous
activities to carry a certain minimum level of insurance. For example, many European
countries, Brazil, and Japan have such requirements in relation to automobile and
workplace accidents or the processing of toxic waste. These requirements are often
supplemented by legislation providing that, on the insolvency of the tortfeasor, entitlement to payment by the liability insurer is automatically transferred to the victim.
However, while these requirements make it less attractive for entrepreneurs to opt for
the corporate form for the purpose of opportunistically externalizing costs, they are
typically not corporation-​specific.
5.1.3 Creditor–​creditor coordination and agency problems
The entity shielding function of organizational law gives priority to the claims of a legal
entity’s creditors against its assets, ahead of the claims of its owners—​in the case of a
company, its shareholders—​and their creditors. To be effective, this requires the law to
block owners (and their creditors) from having recourse to an entity’s assets at a time
when its creditors would wish to do so. The dividing line is insolvency: if the entity
cannot pay its creditors in full from its assets, then the law must ensure shareholders
receive no further payment.
The way in which this is done is, in essence, to give creditors the power to substitute themselves as owners, ousting the shareholders. Creditors have a real option to
37 See Steven Shavell, Foundations of the Economic Analysis of Law, 230–​2 (2004).
38 Empirical studies of firms operating in hazardous industries suggest that this occurs: see Al
H. Ringleb and Steven N. Wiggins, Liability and Large-​Scale, Long-​Term Hazards, 98 Journal of
Political Economy 574 (1990).
39 David W. Leebron, Limited Liability, Torts Victims, and Creditors, 91 Columbia Law Review
1565 (1991).
40 For a pro rata approach, see Henry Hansmann and Reinier Kraakman, Toward Unlimited
Shareholder Liability for Corporate Torts, 100 Yale Law Journal 1879 (1991); for a control approach,
see Nina A. Mendelson, A Control-​Based Approach to Shareholder Liability, 102 Columbia Law
Review 1203 (2002).
41 Art. 28 Consumer Protection Code (consumers); Lei 9.605 of 1998 (environment). Courts
apply unlimited shareholder liability in favor of workers by analogy to consumer protection legislation. See Bruno Salama, O Fim da Responsabilidade Limitada no Brasil (2014).
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Asset Partitioning and Agency Problems
117
become the owners of the firm’s assets, insofar as is necessary to repay their claims,
which becomes exercisable if the firm defaults on its obligations to them.42 An unpaid
creditor may seek a court order enforcing its claim against the debtor’s assets, and ordinarily it is the threat of such enforcement that gives the debtor an incentive to repay.
It follows that where the firm has defaulted generally on its credit obligations, then its
creditors have the option, between them, to become owners of all its assets.43
However, the creditors will then face a coordination problem. If each acts individually to enforce, this will very quickly result in the break-​up of the firm’s business. When
the firm’s assets are worth more kept together than broken up, this is an inefficient
outcome and creditors would collectively be better off by agreeing not to enforce, and
instead to restructure the firm’s debts. Each creditor nevertheless has an incentive to
enforce individually: those who do so first will get full payment, rather than a less-​
than-​complete payout in a restructuring. Resolving these problems is bankruptcy law’s
core function.44
As indicated, all our jurisdictions give creditors the right to trigger bankruptcy
proceedings against firms that are insolvent.45 This transforms creditors’ individual
entitlements to seize or attach particular assets into entitlements to participate in a collective process. Bankruptcy law introduces a new structure for the firm that typically
retains the five basic features of the corporate form described in Chapter 1, with the
difference that the creditors, rather than the shareholders, are now the owners.46 First,
the staying of creditors’ individual claims means that the firm’s assets are subject to
strong-​form entity shielding: personal creditors of the firm’s creditors can no longer
seize the corporate assets to which the firm’s creditors lay claim, so that the specific
value of the assets may be retained.47 Second, creditors have limited liability for the
firm’s post-​bankruptcy debts, which facilitates continuation of the firm’s business if
appropriate.48 Third, creditors’ claims are usually freely transferable in bankruptcy, as
are those of shareholders in the solvent firm.49 Fourth, the bankruptcy procedure will
typically specify a form of delegated management, distinct from individual creditors
and with associated authority rules, usually taking the form of a “crisis manager” of
some description. Fifth, this “crisis manager” is generally accountable to creditors.
Reflecting the importance of the decision to continue or close down the business, jurisdictions often provide a choice of more than one bankruptcy procedure,
42 See George G. Triantis, The Interplay Between Liquidation and Reorganization in Bankruptcy: The
Role of Screens, Gatekeepers, and Guillotines, 16 International Review of Law and Economics
101 (1996); Douglas G. Baird and Robert K. Rasmussen, Control Rights, Property Rights and the
Conceptual Foundations of Corporate Reorganizations, 87 Virginia Law Review 921 (2001); Robert
K. Rasmussen, Secured Debts, Control Rights and Options, 25 Cardozo Law Review 1935 (2004).
43 We assume, as can normally be observed in practice, that equity is wiped out in firms that default
generally on their obligations.
44 Thomas H. Jackson, The Logic and Limits of Bankruptcy Law 7–​19 (1986).
45 There are a variety of definitions of insolvency, but two criteria predominate: a debtor is insolvent when its liabilities exceed its assets (“balance-​sheet test,” or “overindebtedness”); or when it is
durably unable to pay its debts as they fall due (“cash-​flow test” or “commercial” insolvency).
46 Here we use the term “owners” in the functional sense articulated in Chapter 1, namely the
group entitled to control the firm’s assets (see Chapter 1.2.5). The extent to which bankruptcy transfers such control from shareholders to creditors varies across jurisdictions (see Section 5.3.2).
47 This is an important functional difference from bankruptcy laws applicable to individuals,
which often do not provide for such effective entity shielding, at least against secured creditors.
48 The creditors’ liability is generally limited to the value of their pro rata share of the debtor’s
assets: that is, they cannot lose more than what is left of the debtor’s assets.
49 See Victoria Ivashina, Benjamin Iverson, and David C. Smith, The Ownership and Trading of
Debt Claims in Chapter 11 Restructurings, 119 Journal of Financial Economics 316 (2016); Wei
Jiang, Kai Li, and Wei Wang, Hedge Funds and Chapter 11, 67 Journal of Finance 513 (2012).
118
118
Transactions with Creditors
with different associated authority and control structures. Liquidation procedures
are geared towards a sale of the firm’s assets by auction, whereas reorganization, or
“rescue,” procedures seek to facilitate a renegotiation of the firm’s obligations to its
creditors.50 Of course, creditors often would rather not have a distressed firm actually go into “formal” bankruptcy proceedings. This is because a firm’s bankruptcy
calls its future into question, with the consequence that its suppliers and customers
downgrade their expectations about its commitment to performance—​which, in turn
reduces the value that can be obtained by selling the firm’s assets. Hence it is common for firms to seek, and creditors to agree to, a course of action that avoids formal
bankruptcy, but yields similar outcomes. This might take the form of a “workout”—​a
reorganization in the shadow of bankruptcy proceedings—if creditors are supportive
of the firm’s management and business model. Alternatively, it might take the form of
a sale—​liquidation—​of the firm’s business, “pre-​packaged” before the start of formal
proceedings. Inter-​creditor coordination and agency costs mean that the chances of
achieving a workout or “pre-​pack” reduce with the number, and heterogeneity, of
creditors involved in renegotiation,51 making bankruptcy law’s role correspondingly
more important.52
While creditors have significant influence over the selection between bankruptcy
procedures (for example, by agreeing to “pre-​packaged” restructuring plans), few, if
any, jurisdictions permit firms to contract with their creditors to use a particular procedure,53 and none permits firms to design their own.54 This approach can be supported
on similar grounds to the availability of a number of different organizational forms
for legal entities, each with mandatory features.55 A limited menu of such bankruptcy
procedures can generate a body of judicial precedent regarding their interpretation.
This in turn renders them more valuable to future parties, because there is greater certainty as to the court’s approach. Consequently, at a step before that, it influences how
much creditors will be willing to lend in the first place.56 In other words, standardization through bankruptcy law is likely to make it easier for parties to determine the
background against which they are negotiating. Moreover, mandatory rules prevent
50 See e.g. UNCITRAL, Legislative Guide on Insolvency Law 26–​31 (2004).
51 See e.g. Stuart C. Gilson, Kose John, and Larry L.P. Lang, Troubled Debt Restructurings: An
Empirical Study of Private Reorganization of Firms in Default, 27 Journal of Financial Economics
315, 354 (1990); Paul Asquith, Robert Gertner, and David Scharfstein, Anatomy of Financial
Distress: An Examination of Junk-​Bond Issuers, 109 Quarterly Journal of Economics 625, 655
(1994); Antje Brunner and Jan Pieter Krahnan, Multiple Lenders and Corporate Distress: Evidence on
Debt Restructuring, 75 Review of Economic Studies 415 (2008).
52 Claims trading by activist investors can also help to concentrate debt structure and lower coordination costs: see Ivashina et al., note 49.
53 The UK formerly permitted firms to grant a secured creditor the right to enforce against the
entirety of their assets, through a procedure known as “receivership.” This was, however, abolished for
most firms by the Enterprise Act 2002. See John Armour and Sandra Frisby, Rethinking Receivership,
21 Oxford Journal of Legal Studies 73 (2001).
54 For “bankruptcy contracting” to work, a firm must be able to make a choice which binds all
its creditors, otherwise the coordination problem is not solved: see Alan Schwartz, A Contract Theory
Approach to Bankruptcy, 107 Yale Law Journal 1807 (1998); Stanley D. Longhofer and Stephen
R. Peters, Protection for Whom? Creditor Conflict and Bankruptcy, 6 American Law and Economics
Review 249 (2004). However, parties remain free to partition assets across subsidiaries, which permits
them to tailor the scope of the pool of assets which will be subject to bankruptcy: see Baird and Casey,
note 21.
55 See Chapter 1.3.1 and 1.4.1.
56 See Oliver Hart, Firms, Contracts, and Financial Structure (1995); Alan Schwartz, A
Normative Theory of Business Bankruptcy, 91 Virginia Law Review 1199 (2005).
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Solvent Firms
119
parties from agreeing on bankruptcy procedures that benefit them at the expense of
non-​adjusting creditors.57
We now turn to the legal strategies deployed by our jurisdictions to respond to these
problems. We look first at the (modest) control of shareholder–​creditor agency problems in firms that are solvent, and second, the (intensive) control of such problems,
and also creditor–​creditor coordination and agency problems, in insolvent firms.
5.2 Solvent Firms
To the extent that corporate law seeks to control shareholder–​creditor agency problems
in solvent firms, it does so through ex ante strategies: affiliation and rules.58 The affiliation strategy, as we shall see, is primarily geared towards credit raised from markets,
whereas the rules strategy is more appropriate for bank-​based debt finance.
5.2.1 The affiliation strategy—​mandatory disclosure
Creditors generally do not contract without obtaining information from the borrower
about its financial performance, unless they can rely on reputation and other publicly
available information. In addition, larger creditors often create exit opportunities for
themselves in the form of acceleration clauses (whereby the debt becomes due and
payable upon violation of contractual covenants) and/​or security interests (whereby
payment is expedited through enforcement against particular assets).59
Corporate law facilitates these transactions by requiring companies to disclose certain basic information. Most obviously, all jurisdictions require that the names of corporate entities reflect their status through a suffix, such as “Inc.,” “Ltd.,” “GmbH,”
“SA,” or the like.60 Companies are also required to file their charters in public registers, which makes available information about company name, legal capital, classes of
shares, and so forth.61 Beyond this common core of obligations, there are differences
regarding mandatory disclosure to creditors—​which increasingly depend on the type
of company, rather than the jurisdiction of incorporation.
Mandatory disclosure obligations are likely to be more beneficial for creditors supplying finance by way of markets than for bank lenders.62 Banks generally make relatively large investments in borrower companies, and so have incentives to engage in
screening and monitoring of debtors. To this end, banks typically develop sophisticated
capabilities for assessing credit risk and monitoring debtor behavior. It is worthwhile
for banks to invest in gathering and analyzing private information because once they
have it, they can offer better priced terms than less-​informed competitors. This is the
57 See generally Lucian Ayre Bebchuk, and Jesse M. Fried, The Uneasy Case for the Priority of
Secured Claims in Bankruptcy, 105 Yale Law Journal 857, 882–​91 (1996).
58 This is because the very event that triggers the operation of ex post strategies in this context is
the firm’s lack of solvency.
59 See e.g. Robert E. Scott, The Truth about Secured Financing, 82 Cornell Law Review 1436
(1997).
60 See Jonathan R. Macey, The Limited Liability Company: Lessons for Corporate Law, 73
Washington University Law Quarterly 433, 439–​40 (1995).
61 See e.g. Arts. 2–​3 Directive 2009/​101/​EC, 2009 O.J. (L 258) 11 (EU); Revised Model Business
Corporation Act § 2.02(a) (U.S.); Art. 32, II, a Lei 8.934 of 1984 (Brazil); Art. 911(3) Companies
Act (Japan).
62 The question of whether disclosure needs to be mandatory, as opposed to voluntary, is discussed
in Chapter 9.1.2.
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model of “relationship lending,” under which it will be more expensive for a borrower
to switch to a different lender who does not understand the risks and rewards of their
business as well as the current lender. Of course, financial information about debtors is
useful for banks, but if its disclosure is not mandated, the bank has the incentives and
the power simply to demand the information from the debtor on an ongoing basis as
part of the terms of the loan.
Matters are different for investors in public markets, for two important reasons.
First, such investors typically each supply a much smaller proportion of the borrower’s
debt finance than would a bank. Consequently, they face higher coordination costs
in gathering and analyzing information about the debtor. Second, gathering new
private information might impede their ability to sell their investment in the marketplace, because of restrictions on insider trading. As a result, the affiliation strategy—​
channeled through mandatory disclosure—​likely complements public debt more than
bank loan markets.
5.2.1.1 Closely held corporations
Banks are the principal supplier of outside finance to small companies.63 Hence disclosure seems less obviously functional than for larger companies. While closely held
corporations in all our jurisdictions are required to keep financial accounts, those in
the U.S. are subject to no duty to disclose these to persons other than their shareholders.64 In contrast, our other jurisdictions in principle require close companies to
prepare financial statements (in accordance with applicable accounting standards) and
make these available for public inspection.65 However, the rules in these jurisdictions
are often softened for smaller firms, on the basis that the fixed costs of compliance fall
disproportionately upon them.66
5.2.1.2 Publicly traded corporations
Disclosure by publicly traded companies is extensively regulated in all our jurisdictions.67 Under U.S. securities law, a company issuing publicly traded securities—​
including bonds—​must disclose all material information bearing on the value of
the issue and the issuer’s financial condition in a registration statement filed with
the SEC.68 EU initial disclosure requirements have become increasingly similar to
U.S. requirements.69
There has also been considerable convergence as regards financial statements.
U.S. publicly traded firms must periodically file financial statements that are prepared
63 See Alicia M. Robb and David T. Robinson, The Capital Structure Decisions of New Firms, 27
Review of Financial Studies 153 (2014).
64 See William J. Carney, The Production of Corporate Law, 71 Southern California Law Review
715, 761 (1998).
65 See Art. 2(1)(f ) Directive 2009/​101/​EC (“First Company Law Directive (Recast)”), 2009 O.J.
(L 258) 11 and Accounting Directive 2013/​14/​EU, 2013 O.J. (L 182) 19 (EU); Arts. 176 and 289
Lei das Sociedades por Ações (Brazil); Art. 440 Companies Act (Japan).
66 See e.g. Art. 14 Accounting Directive (EU: applying a graduated scale such that the very smallest
firms have the greatest permitted exemptions); Art. 440 Companies Act (Japan: obligation to disclose
profit and loss accounts applicable only to large companies).
67 See also Chapter 9.1.2.5.
68 Securities Act 1933 §§ 5–​7.
69 See Prospectus Directive 2003/​71/​EC, 2003 O.J. (L 345) 64; Transparency Directive 2004/​
109/​EC, 2004 O.J. (L 390) 38, both as amended by Directive 2010/​73/​EU.
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121
in accordance with U.S. GAAP.70 Where EU member states once imposed a congeries
of different domestic accounting standards, publicly traded firms listed on EU markets have since 2005 been required to apply the International Financial Reporting
Standards (“IFRS”)—​which are closer to the Anglo-​American tradition of financial
reporting—​to their consolidated financial statements.71 Publicly traded firms in Brazil
must also follow IFRS.72 Japan too has undertaken disclosure and accounting reforms,
which have rendered Japanese GAAP closer to IFRS, and has increasingly encouraged
the voluntary adoption of IFRS by Japanese firms.73 On the other hand, as we shall
see in Chapter 9, there remain real differences in the intensity of enforcement of these
disclosure obligations.74
5.2.1.3 Groups
Disclosure has particular significance in the context of corporate groups, as creditors
of group companies are especially vulnerable to shareholder opportunism.75 Perhaps
because of its significance, group accounting is an area in which convergence is highly
visible. Hence, as discussed, listed groups in all of our core jurisdictions are required to
prepare consolidated accounts in conformity with “equivalent” GAAP and IFRS standards. However, regulatory efforts to get all listed groups to use IFRS standards still
face hurdles, especially in the U.S.76 In addition, real differences remain when it comes
to non-​listed groups. In particular, only Brazil (with respect to formal groups) and the
EU (with respect to larger groups) extend the consolidation requirement to closely held
groups.77 Moreover, while most jurisdictions require public companies to disclose intra-​
group transactions, German law curiously provides creditors with less protection than
one might expect given the traditional conservativeness of its accounting. In particular,
apart from the limited number of companies belonging to so-​called “formal” contractual
groups,78 the German Konzernrecht merely obligates controlled firms to provide creditors with an audited summary of the extensive report—​termed the Abhängigkeitsbericht
or “dependence” report—​that these companies must deliver to their supervisory board.79
70 See e.g. Securities Exchange Act 1934, § 13; Sarbanes-​Oxley Act, §§ 401, 409; Regulation S-​X.
See also Chapter 9.1.2.6.
71 Regulation 1606/​2002 on the Application of International Accounting Standards (The “IAS
Regulation”), 2002 O.J. (L 243) 1. See Chapter 9.1.2.6.
72 CVM Instruction No. 457 of 2010, Art. 1º.
73 See Accounting Standards Board of Japan and IASB, Agreement on Initiatives to Accelerate the
Convergence of Accounting Standards (8 August 2007); IFRS, IFRS Application Around the World—​
Jurisdictional Profile: Japan (2014).
74 See Chapter 9.2.
75 See Section 5.1.2.2.
76 See e.g. SEC (U.S.), Work Plan for the Consolidation of Incorporating IFRS into the Financial
Reporting System for U.S. Issuers, Final Staff Report (2012); SEC (U.S.), Strategic Plan: Fiscal Years
2014–​18, 8 (2014); European Commission, State of Play on Convergence Between IFRS and Third
Country GAAP, Staff Working Paper SEC(2011) 991 final.
77 Arts. 22–​3 Accounting Directive (EU); Art. 275 Lei das Sociedades por Ações (Brazil; such
formal groups are however rare in Brazilian corporate practice).
78 So-​called formal groups are those listed as such in the trade register as having entered into a
“control agreement”: see §§ 291, 294 Aktiengesetz. Although the exact numbers are uncertain, only a
minority of German corporate groups are thought to have opted for this formal structure: see Volker
Emmerich and Mathias Habersack, Konzernrecht 198 (10th edn., 2013). See also Section 5.3.1.2.
Compare Art. 2497–​II Civil Code (Italy), under which a controlled company must disclose the effect
of the controlling entity’s dominance on its management and results.
79 See § 312 Aktiengesetz; Uwe Hüffer and Jens Koch, Aktiengesetz (12th edn., 2016), § 312
para 38. See also Chapter 6.2.1.1 (disclosure requirements for related-​party transactions).
122
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5.2.1.4 The role of gatekeepers
The quality of mandated disclosures can be enhanced through verification by trusted
third parties, or “gatekeepers.”80 Indeed, auditors are universally employed to verify
accounting disclosures, and credit bureaus have become increasingly important in
aggregating and disseminating information about borrowers’ credit histories.81 For
larger borrowers, credit rating agencies (“CRAs”) have emerged as key gatekeepers,
to which many of creditors’ traditional investigation functions have been delegated,
especially where debt is widely dispersed through the use of bonds or securitization of
bank loans.82
All major jurisdictions require publicly traded companies to use outside auditors to
verify their financial statements. Moreover, many of our jurisdictions require professional audits for larger closely held companies.83
In screening debtor financial statements and assessing bond issuers’ default risk
respectively, auditors and CRAs can in theory reduce borrowers’ cost of capital, by
pledging their reputational capital. This aspect of gatekeeping is reinforced in all our
jurisdictions by licensing requirements, the setting of operational standards and ex post
liability for auditors and CRAs, which together provide a framework for dealing with
gatekeeper “failure.”84
Auditors must ensure that a company’s financial statements reflect the applicable
laws and accounting standards. Shareholders and creditors increasingly also rely on
them to monitor for breaches of managers’ fiduciary duties.85 Although auditors disclaim any duties beyond verifying financial statements, they are increasingly pressed to
accept a broader scope of responsibility.86 The 1990s saw a number of legislative moves
to rein in auditor liability,87 only to be rolled back during the outcry following Enron,
Parmalat, and other accounting scandals in the early 2000s.88 Then again the implosion of Arthur Andersen after its Enron-​related criminal investigation highlighted the
dangers of tampering with auditor reputation and provided further impetus for limiting auditor liability.89
80 See Chapter 2.4.2.3.
81 See Simeon Djankov, Caralee McLiesh, and Andrei Shleifer, Private Credit in 129 Countries, 84
Journal of Financial Economics 299 (2007).
82 See Arnoud W.A. Boot, Todd T. Milbourn, and Anjolein Schmeits, Credit Ratings as Coordination
Mechanisms, 19 Review of Financial Studies 80 (2006).
83 See Art. 34 Accounting Directive (EU); Art. 328 Companies Act (Japan); Art. 3º Lei 11.638
of 2007 (Brazil).
84 See John Armour et al., Principles of Financial Regulation ch. 6 (2016).
85 See Chapter 6.2.1.1.
86 See John C. Coffee, Jr., Gatekeepers: The Professions and Corporate Governance, at
168 (2006); Paul L. Davies and Sarah Worthington, Gower and Davies’ Principles of Modern
Company Law 847–​53 (9th edn., 2012).
87 See, for the U.S., John C. Coffee, What Caused Enron? A Capsule Social and Economic History
of the 1990s, 89 Cornell Law Review 269 (2004); for Japan, Arts. 34-​2-​2 et seq. Certified Public
Accountant Act (revised, 2007); for France, Art. L. 822-​18 Code de commerce (three-​year limitation period); for Italy, Art. 164 Testo Unico della Finanza; for the UK, Limited Liability Partnership
Act 2000.
88 See §§ 101–​9 Sarbanes-​Oxley Act 2001 (U.S.); Commission Communication COM(2003)
286, Reinforcing the Statutory Audit in the EU, 2003 O.J. (C 236) 2; Directive 2006/​43/​EC on statutory audits of annual accounts and consolidated accounts, 2006 O.J. (L 157) 87.
89 See e.g. Commission Recommendation concerning the limitation of the civil liability of statutory auditors and audit firms, 2008 O.J. (L 162) 39 (EU); Walter Doralt, Alexander Hellgardt, Klaus
123
Solvent Firms
123
Following the Enron scandal, both the U.S. and the EU introduced requirements
to safeguard the independence of auditors of publicly traded firms, including a prohibition on the provision of other, non-​audit services by audit firms, and mandatory
rotation of audit partners.90 The EU has recently gone further by mandating rotation of publicly traded companies’ audit firms every ten years.91 While there is some
evidence that mandatory partner rotation helps reduce the incidence of accounting
restatements,92 audit firm rotation is difficult to implement in a concentrated market
for auditors, given the prohibitions on non-​audit services, and the evidence for its
efficacy is rather more questionable.93
Similarly, the failure of CRAs to rate mortgage-​based financial products effectively
in the run-​up to the financial crisis has triggered increased regulatory scrutiny for these
agencies. While CRAs make positive contributions to the mitigation of information
asymmetry,94 they are also subject to conflicts of interest, because their ratings are generally paid for by the issuer.95 Hence, regulation introducing measures such as licensing
requirements, liability for gross negligence, transparency in rating methodology, and/​or
seeking to foster competition in the sector, has been introduced in all our jurisdictions.96
A particular problem for the efficacy of CRAs as gatekeepers has been the use, in
prudential regulation applicable to institutional investors, of minimum rating requirements as a precondition for investment in an asset class. To the extent that investors
use ratings simply to satisfy regulatory conditions, as opposed to relying on their information content, demand for CRAs’ services need not be reduced by poor quality.97
To counter this problem, lawmakers around the world have sought to reduce such
mandated reliance on credit ratings by institutional investors.98
J. Hopt, Patrick C. Leyens, Markus Roth, and Reinhard Zimmermann, Auditors’ Liability and its
Impact on the European Financial Markets, 67 Cambridge Law Journal 62 (2008).
90 Sarbanes-​Oxley Act of 2002, §§ 201, 202 (U.S.: rotation after 5 years); Arts. 22 and 42 Directive
2006/​43/​EC on statutory audits, 2006 O.J. (L 157) 87, as amended by Directive 2014/​56/​EU, 2014
O.J. (L 158) 196 (EU: rotation after 7 years).
91 Art. 17 Regulation (EU) No 537/​2014 on specific requirements regarding statutory audit of
public-​interest entities, 2014 O.J. (L 158) 77.
92 Henry Laurion, Alastair Lawrence, and James Ryans, U.S. Audit Partner Rotations, Working
Paper, Berkeley Haas School of Business (2015).
93 See e.g. Mara Cameran, Giulia Negri, and Angela K. Pettinicchio, The Audit Mandatory Rotation
Rule: The State of the Art, 3(2) Journal of Financial Perspectives (2015). Brazil also has a 5-​year
audit firm rotation requirement, although no partner rotation rule: ibid.
94 See Amir Sufi, The Real Effect of Debt Certification: Evidence from the Introduction of Bank Loan
Ratings, 22 Review of Financial Studies 1659 (2009).
95 See Lawrence J. White, Markets: The Credit Rating Agencies, 24 Journal of Economic
Perspectives 211 (2010); John M. Griffin and Dragon Y. Tang, Did Credit Rating Agencies Make
Unbiased Assumptions on CDOs?, 101 American Economic Review: Papers & Proceedings 125
(2011).
96 See Regulation (EC) No 1060/​2009 on Credit Rating Agencies, 2009 O.J. (L 302) 1, as
amended by Regulation (EC) No 462/​2013, 2013 O.J. (L 146) 1 (EU); Dodd-​Frank Act of 2010,
§§931–​939H (U.S.); CVM Instruction No. 521 of 2012 (Brazil); Art. 38(iii), Arts. 66-​27–​Art. 66-​49
Financial Instruments and Exchange Act (Japan) (the Japanese regulation does not impose liability
on CRAs).
97 See Christian C. Opp, Marcus M. Opp, and Milton Harris, Rating Agencies in the Face of
Regulation, 108 Journal of Financial Economics 46 (2013).
98 See e.g. SEC (U.S.), Report on Review of Reliance on Credit Rating Agencies, Staff Report (2011);
European Commission, EU Response to the Financial Stability Board (FSB): EU Action Plan to Reduce
Reliance on Credit Rating Agency (CRA) Ratings, Directorate General Internal Market and Services Staff
Working Paper (2014).
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Transactions with Creditors
5.2.2╇The rules strategy:€Legal capital
If mandatory disclosure helps creditors to protect themselves, then the rules strategy
seeks to provide protection for them in a standardized form. The most important rules
traditionally relate to “legal capital.”99 These can apply to at least three separate aspects
of corporate finance, which we consider in turn: (1) prescribing a minimum initial
investment of equity capital; (2) restrictions on payments out to shareholders; and (3)
triggering actions that must be taken following serious depletion of capital.
As discussed,100 the law’s provision of such standardized terms is most functional
when creditors are (relatively) homogeneous, and can coordinate (relatively) easily: in
other words, when banks are the primary lenders. This helps to explain why this strategy has traditionally been used less in the U.S. than elsewhere, and now appears to be
falling into desuetude more generally.
5.2.2.1╇Minimum capital
Amongst our jurisdictions, only those in Europe impose minimum equity investment thresholds for access to the corporate form (i.e. “minimum capital” rules). EU
law requires public corporations to have initial legal capital of no less than €25,000,
although member states may set higher thresholds if they wish.101 Although this number is large by the standards of our other jurisdictions, which require nothing at all,102
it appears small compared to the actual capital needs of businesses organized as public
firms. As a consequence, the EU’s minimum capital requirement does not appear to
impose a significant barrier to entry to public corporation status.103 Moreover, all of
our core jurisdictions now permit incorporation of a private company without any
minimum capital requirement.104
It seems unlikely that minimum capital requirements on formation provide any real
protection to creditors, as a firm’s initial capital will be long gone if it ever files for bankruptcy. In addition, the reduction or abolition of minimum capital rules throughout
99╇ In “par value” jurisdictions, legal capital is at least the aggregate nominal (“par”) value of issued
shares (typically lower than the issue price), and may be extended to the entire issue price (so-╉called
“share premium”). In jurisdictions permitting “no par” shares, legal capital is initially set by a company’s organizers at any amount up to the issue price of a company’s shares.
100╇Section 5.1.2.
101╇ See Art. 6 Directive 2012/╉30/EU (“Second Company Law Directive (Recast)”), 2012 O.J.
(L 315) 74 (applicable to AG, SA, SpA, plc, etc).
102╇ On the U.S., see Bayless Manning and James J. Hanks, Legal Capital (4th edn., 2013). Japan
abolished minimum capital requirements in its Companies Act of 2005. Similarly, Brazil imposes no
minimum capital requirement.
103╇KPMG, Feasibility Study on an Alternative to the Capital Maintenance Regime Established by the
Second Company Law Directive 77/╉91/╉EEC of 13 December 1976 and an Examination of the Impact on
Profit Distribution of the New EU-╉Accounting Regime: Main Report (2008). In theory, capital regulation could go further and require companies to maintain a specific debt-╉equity ratio. Yet given that
different businesses carry different risks, it is hard to see how any such general ratio could be useful.
104╇See Reiner Braun, Horst Eidenmüller, Andreas Engert, and Lars Hornuf, Does Charter
Competition Foster Entrepreneurship? A Difference-╉in-╉Difference Approach to European Company Law
Reforms, 51 Journal of Common Market Studies 399 (2013). Italy was the last of our core jurisdictions to permit incorporation without minimum initial capital, making the change in 2013: see
Art. 2463-╉II Civil Code (Italy). Proposals for a European single-╉member company form will, if
implemented, make incorporation without minimum capital available across the EU: see European
Commission, Proposal for a Directive on Single-╉Member Private Limited Liability Companies, 2014/╉
0120 (COD).
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Solvent Firms
125
Europe has been associated with an increase in entrepreneurship.105 Nevertheless, most
entrepreneurs appear to invest some capital in newly formed firms, even in the absence
of minimum capital rules.106 This finding is hard to interpret: it may indicate that the
presence of capital is a rough-​and-​ready proxy for the “seriousness” of entrepreneurs,
by showing that they commit a non-​trivial amount of money to their project;107 or it
may simply reflect a desire to avoid potential liability for trading while insolvent.108
5.2.2.2 Distribution restrictions
Company laws generally restrict distributions to shareholders—​including dividends
and share repurchases—​in order to prevent asset dilution.109 Although these distribution restrictions vary across jurisdictions, the most common is on the payment of
dividends which impair the company’s legal capital—​that is, distributions that exceed
the difference between the book value of the company’s assets and the amount of its
legal capital, as shown in the balance sheet.110
Rules restricting distributions can be viewed as an “opt-​in” set of standard terms.
On this view, any firm that has legal capital in excess of minimum requirements does
so by choice, not because of a mandatory requirement.111 In such a situation, distribution constraints simply reinforce the credibility of the shareholders’ promise to
retain their capital investment in the firm. From a debtor perspective, such an “opt-​in”
has the advantage that when there are multiple creditors, transaction costs are low
compared to the repeated negotiation of a (possibly diverse) set of contractual covenants.112 From a creditor perspective, however, legal capital may not be sufficient
protection. Heterogeneity among creditors will result in some of them demanding
covenant protections as well as “one size fits all” legal capital, thus reducing transaction
cost savings.113
105 See John Armour and Douglas J. Cumming, Bankruptcy Law and Entrepreneurship, 10
American Law and Economics Review 303 (2008); Braun et al., note 104.
106 See Marco Becht, Colin Mayer, and Hannes F. Wagner, Where Do Firms Incorporate? Deregulation
and the Cost of Entry, 14 Journal of Corporate Finance 241 (2008) (after France removed minimum capital requirements for SaRL form in 2003, 86.8 percent of new firms set their initial capital
below the previous minimum of €7,500, but only 4.9 percent had a minimum capital as low as €1).
107 See John Hudson, The Limited Liability Company: Success, Failure and Future, 161 Royal
Bank of Scotland Review 26 (1989); Horst Eidenmüller, Barbara Grunewald, and Ulrich Noack,
Minimum Capital and the System of Legal Capital, in Legal Capital in Europe, 1, 25–​7 (Marcus
Lutter ed., 2006).
108 See Section 5.3.1.
109 See text to note 7.
110 For an overview of a variety of dividend restriction rules, see Brian R. Cheffins, Company
Law: Theory, Structure and Operation 534–​5 (1997); Holger Fleischer, Disguised Distributions
and Capital Maintenance in European Company Law, in Lutter, note 107, 94.
111 Wolfgang Schön, The Future of Legal Capital, 5 European Business Organization Law
Review 429, 438–​9 (2004). However, firms have no real choice in jurisdictions where the entire share
issue price is treated as capital, as in the UK, and so equity finance cannot be raised without application of distribution restrictions: see Eilís Ferran, The Place for Creditor Protection on the Agenda for
Modernisation of Company Law in the European Union, 3 European Company and Financial Law
Review 178, 196 (2006).
112 See Yaxuan Xi and John Wald, State Laws and Debt Covenants, 51 Journal of Law &
Economics 179 (2008) (firms in U.S. states with “tighter” dividend restrictions in company law
have less debt covenants in their borrowing agreements). But see also Edward B. Rock, Adapting to
the New Shareholder-​Centric Reality, 161 University of Pennsylvania Law Review 1907, 1984–​6
(2012) (questioning these results by pointing out that there are no meaningful differences in dividend
restrictions between states).
113 See Kanda, note 26, 440; Kahan, note 26, 609–​10.
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Transactions with Creditors
The extent to which distribution restrictions block payments to shareholders is affected
by the scope of the transactions they cover. In many jurisdictions, such as Germany, the
U.S., and the UK, the restriction on distributions is applied not only to transactions formally structured as dividend payments or share repurchases, but also to undervalued transactions between a company and its shareholders, which the courts may recharacterize as
“disguised distributions.”114
In the U.S., the efficacy of even the basic distribution restriction is undermined in
many states by giving the shareholders, or in some cases the board of directors, power to
reduce a company’s legal capital—​and hence the level at which the distribution restriction
is set—​without creditor consent.115 By contrast, our other jurisdictions require any reduction in legal capital to be preceded by adequate protection—​for example, a third party
guarantee or veto rights—​for existing creditors.116
The efficacy of distribution restrictions also depends upon accounting methodology.
While conservative accounting provides less information about the ongoing value of the
firms, it is more protective of creditors’ interests than “true and fair view” accounting when
it comes to reducing the discretion to pay dividends or otherwise transfer assets to shareholders from the pool that bonds the company’s debts.117 Hence, the increasing reliance
on “marking-​to-​market” in U.S. GAAP may be one of the reasons for the declining use of
profit distribution covenants by U.S. publicly traded corporations.118 This, in turn, calls
into question the continued utility of legal capital restrictions following the move to IFRS
accounting by many listed European firms.119
5.2.2.3 Loss of capital
In some jurisdictions—​particularly in Europe, but not in the U.S.—​there are rules
governing actions that must be taken following a serious loss of capital. EU law
requires public companies to call a shareholders’ meeting to consider dissolution or
other appropriate measures after a “serious loss of capital,” defined as net assets falling
below half the company’s legal capital.120 Several European jurisdictions have adopted
114 On the UK, see Progress Property Co Ltd v Moorgarth Group Ltd [2010] UKSC 55; on Germany,
see Fleischer, note 110; on the U.S., see e.g. Rock, note 112, at 1953–​6 (Delaware). For Brazil, see Art.
177, § 1º, VI Criminal Code (distribution of “fictional” dividends is a crime). There is no such extension in France and Italy: see Pierre-​Henri Conac, Luca Enriques, and Martin Gelter, Constraining
Dominant Shareholders’ Self-​Dealing: The Legal Framework in France, Germany, and Italy, 4 European
Company and Financial Law Review 491 (2007).
115 However, there is a residual constraint that dividends of such magnitude that they “diminish
the company’s ability to pay its debts” will be held unlawful: in re Int’l Radiator Co., 92 Atlantic
Reporter 255, 255 (Del. Cl., 1914). Moreover, fraudulent conveyance law restricts dividend payments by insolvent companies: see Section 5.3.1.3.
116 See Art. 36 Second Company Law Directive (Recast) (EU); Arts. 447 and 449 Japanese
Companies Act (Japan); Art. 174 Lei das Sociedades por Ações (Brazil). These rules are sometimes
called “capital maintenance” rules in the EU and “capital unchangeability” rules in Japan.
117 See Bernhard Pellens and Thorsten Sellhorn, Creditor Protection through IFRS Reporting and
Solvency Tests, in Lutter, note 107, 365; see also Schön, note 111.
118 See Joy Begley and R. Freedman, The Changing Role of Accounting Numbers in Public Lending
Agreements, 18 Accounting Horizons 81 (2004); Christoph Kuhner, The Future of Creditor
Protection through Capital Maintenance Rules in European Company Law—​An Economic Perspective,
in Lutter, note 107, 341.
119 Ferran, note 111, 200–​15. See also Section 5.2.1.2.
120 See Art. 19 Second Company Law Directive (Recast). EU law also protects creditors against
capital reduction through charter amendments or share repurchases (but not against capital reduction to reflect permanent losses, shareholder opportunism then being less of an issue): ibid., Arts.
20–​21, 36–​37.
127
Distressed Firms
127
yet stronger rules, mandating those running the firm either to obtain fresh equity
finance or stop trading when a certain level of depletion of net assets has occurred.121
In France and Italy, the company must be put into liquidation should its net assets fall
below half its legal capital (France) or, jointly, below two-​thirds of its legal capital and
the statutory minimum capital (Italy), and the shareholders fail to remedy the problem.122 In Germany, the company must file for insolvency when the value of its net
assets falls below zero.123
In theory, such rules could reinforce the credibility of legal capital as a financial
cushion for creditors by acting as capital adequacy provisions similar to those governing financial institutions. Yet given low minimum capital thresholds, even the most
stringent loss of capital requirements are concerned more with promoting early filing
for bankruptcy than with capital adequacy.124 To be sure, encouraging earlier liquidation or insolvency proceedings will serve to shorten the “twilight period” during
which shareholder opportunism can harm creditors. Yet the costs of initiating bankruptcy proceedings too soon may be even higher. While such costs can be avoided by
a re­negotiation, the more heterogeneous the firm’s creditors, the less likely this will be
to succeed.125
5.3 Distressed Firms
If a debtor becomes financially distressed, its assets are probably insufficient to pay
all its creditors and permit them a collective exit. Under these circumstances, governance strategies move to the fore: in bankruptcy, the creditors may have appointment rights as respects the firm’s “crisis manager” and generally have decision rights
as respects its plan. These are complemented by other strategies, principally standards and trusteeship. Their application covers two phases: first, the period of transition into bankruptcy, and second the bankruptcy procedure itself.126 The relevant
strategies deal largely—​but not exclusively—​with shareholder–​creditor conflicts in
the first phase and creditor–​creditor conflicts in the second. The understanding that
these strategies will be employed ex post necessarily influences private contracting
121 This is a balance-​sheet test, not a cash-​flow test. See note 45.
122 See Art. L. 224-​2 Code de commerce (France); Arts. 2447 and 2482–​3 Civil Code (Italy).
However, Art. 182-​
VI Legge Fallimentare disapplies the obligation if the company files for
reorganization.
123 §§ 15a and 19 Insolvenzordnung (Germany). However, there is an exclusion for companies
which have negative net assets (“overindebtedness”), but for which the probability of continued operation is otherwise “highly likely” (§ 19(2) Insolvenzordnung).
124 See Lorenzo Stanghellini, Directors’ Duties and the Optimal Timing of Insolvency: A Reassessment of
the “Recapitalize or Liquidate” Rule, in Il Diritto delle Società Oggi. Innovazioni e Persistenze
731 (Paolo Benazzo, Mario Cera, and Sergio Patriarca eds., 2011).
125 Moreover, a “guillotine” rule may simply result in (some) creditors being forced to accept less of
the restructuring surplus in any renegotiation. In the out-​of-​court restructuring of Ferruzzi Finanziaria
in 1993, those in control of the firm (the largest creditors) were able, by virtue of the imminent need
to file for bankruptcy, to make a “take it or leave it” restructuring offer that appropriated most of
the restructuring surplus at the expense of other creditors: see Alessandro Penati and Luigi Zingales,
Efficiency and Distribution in Financial Restructuring: The Case of the Ferruzzi Group, Working Paper
(1997), at http://​faculty.chicagobooth.edu.
126 Before it begins and once it is over, the bankruptcy process might also be viewed as a form
of affiliation strategy, as it permits a collective exit by creditors. Yet, as it unfolds, it is unmistakably
concerned with governance.
128
128
Transactions with Creditors
with creditors, both at the ex ante stage of determining debt structure, and later in
any renegotiation.
5.3.1 The standards strategy
Standards are used widely to protect corporate creditors. While the implementing provisions have various labels (examples include faute de gestion, wrongful trading, and
fraudulent conveyances), each imposes a species of ex post liability according to an
open-​textured standard on persons associated with a distressed company. The ex post
nature of the standards strategy means that it tends only to be employed if something
has gone wrong in a lending relationship—​that is, where the debtor company is in
financial distress. More particularly, these duties divide into three categories according to whom they target: (1) directors; (2) controlling shareholders; and (3) “favored”
creditors. Precisely because they are not relevant unless the firm has failed, the application of standards is less sensitive to the coordination costs of creditors than the rules
strategy. Instead, they are, as with all instances of the standards strategy, highly sensitive
to the efficacy of the judicial institutions called on to apply them.
5.3.1.1 Directors
In each of our jurisdictions, directors, including de facto or shadow directors, may be
held personally liable for net increases in losses to creditors resulting from the board’s
negligence or fraud to creditors when the company is, or is nearly, insolvent.127 Such
duties can be framed and enforced with differing levels of intensity, influencing the
extent to which they affect directors’ incentives. First, for the substantive content of
the duty, a less onerous standard (“fraud” or “scienter”) is triggered only by actions so
harmful to creditors as to call into question directors’ subjective good faith. A more
intensive standard (“negligence”) imposes liability for negligently worsening the financial position of the insolvent company. Second, the intensity can be varied through the
trigger for the duty’s imposition: the greater the degree of financial distress in which
the company must be before the duty kicks in, the more targeted will be its effect on
incentives. A third dimension over which intensity varies is enforcement. Enforcement
is likely to be facilitated if the duties are owed directly to individual creditors, and
reduced for duties owed only to the company, which will be unlikely to be enforced
unless the company enters bankruptcy proceedings.128
The appropriate intensity of such director liability depends on the ownership structure and/​or governance of the debtor firm.129 Shareholder–​creditor agency problems
are likely to be most pronounced in firms where managers’ and shareholders’ interests
are closely aligned, that is, where ownership is concentrated or incentive compensation
schemes and governance arrangements effectively prompt managers to pursue shareholder interests. For larger firms with dispersed shareholders and no such mechanisms,
managers have fewer incentives to pursue measures that benefit shareholders at creditors’ expense. Under the latter circumstances directorial liability based on creditors’
127 See also Chapter 3.4.1.
128 However, some jurisdictions (e.g. Delaware) permit creditors of an insolvent company to launch
a derivative action: see Quadrant Structured Products Co. Ltd. v. Vertin, 115 Atlantic Reporter 3d
535 (Del. Ch., 2015).
129 See text to note 14.
129
Distressed Firms
129
interests may over-​deter directors, resulting in less risk-​taking than would be optimal.130 Directorial liability may therefore be expected to be most useful where shareholders’ and managers’ interests are aligned.
Among our jurisdictions, the lowest-​intensity standard for directorial liability to
creditors is employed in the U.S. That is consistent with its long history of both dispersed ownership and managerial autonomy.131 Most U.S. states employ the technique
of a shift in the content of directors’ duty of loyalty in relation to insolvent firms and
the duty is owed to the corporation, rather than individual creditors.132 There was
flirtation in some states with a direct tortious claim against directors for “deepening
insolvency”—​that is, marginal losses incurred by creditors as a result of directors’ failure to shut down an insolvent firm,133 but this was explicitly ruled out in Delaware.134
In addition, if a transaction amounts to a direct or indirect breach of the residual
distribution restrictions discussed in Section 5.2.2.2, this can trigger negligence-​based
liability for directors who approved or oversaw it.135
In the UK, like in the U.S., there is a shift in the content of the duties of directors of
insolvent firms, these being owed only to the company.136 This includes directors’ duty
of care.137 The UK also imposes additional negligence-​based liability on directors for
“wrongful trading,” if they fail to take reasonable care in protecting creditors’ interests
once insolvency proceedings have become inevitable.138
Continental European jurisdictions deploy more intensive standards against directors, consistent with the generally more concentrated ownership structure of their large
firms. In these countries, not only do directors of financially distressed firms face liability for negligence, generally based on duties mediated through the company,139 but in
some jurisdictions—​such as France and Italy—​directors can potentially be held liable
simply for failing to take action following serious loss of capital.140
In Japan, duties to creditors are triggered even earlier, as creditors have standing to
bring a direct action against directors for damage they suffer as a result of the directors’
gross negligence in the performance of their duties to the company, even if the company
130 See also Cheffins, note 110, 537–​48; Henry T.C. Hu and Jay Lawrence Westbrook, Abolition of
the Corporate Duty to Creditors, 107 Columbia Law Review 1321 (2007).
131 See e.g. Mark J. Roe, Strong Managers, Weak Owners: The Political Roots of American
Corporate Finance (1994).
132 North American Catholic Education Programming Foundation v. Gheewalla, 930 Atlantic
Reporter 2d 92, 98–​102 (Del., 2007); Quadrant Structured Products, note 128.
133 See e.g. Official Committee of Unsecured Creditors v. R.F. Laffertey & Co, 267 Federal Reporter
3d 340 (3d. Circuit, 2001) (Pennsylvania).
134 Trenwick America Litigation Trust v. Ernst & Young LLP, 906 Atlantic Reporter 2d 168,
204–​7 (Delaware Chancery, 2006).
135 Delaware General Corporation Law §174. Significantly, this negligence-​based liability is not
excluded by a waiver of directors’ general duty of care under §102(b)(7).
136 West Mercia Safetywear Ltd v. Dodd [1989] 4 Butterworths Company Law Cases 30, 33;
§ 172(3) Companies Act 2006 (UK); Kuwait Asia Bank EC v. National Mutual Life Nominees Ltd
[1991] 1 Appeal Cases 187, 217–​19.
137 Roberts v Frohlich [2011] EWHC 257 (Ch), [2011] 2 Butterworths Company Law
Cases 625.
138 Insolvency Act 1986 §§ 214, 246ZA (UK). There is also negligence-​based liability for directors
who permit the company to pay an unlawful distribution: Bairstow v Queens Moat House plc [2001]
EWCA Civ 712.
139 See for France, L. 225–​251 Code de commerce, as well as the much feared Art. L. 651-​2 Code
de commerce (insuffisance d’actifs)—​see also text to note 155; for Germany, § 43 GmbH-​Gesetz, §§
93 and 116 Aktiengesetz; for Italy, Art. 2394 and 2394-​II Civil Code.
140 On loss of capital, see Section 5.2.2.3. On liability, see note 151 (Germany and Italy); Art.
L. 651–​2 Code de commerce (France).
130
130
Transactions with Creditors
is solvent.141 Although this liability is rarely imposed on directors of publicly traded
firms, it is frequently litigated in the case of closely held companies.142 The Japanese
Supreme Court has also developed an oversight liability doctrine, under which non-​
executive directors are liable to creditors if they grossly fail to monitor misbehaving
managers. Finally, while increased shareholder litigation during the 1990s prompted
statutory limitation on director liability,143 creditor rights were left unaffected.
Brazil seems to be a special case insofar as the scope of managers’ fiduciary duties—​
which are always owed to the company—​do not formally change in the vicinity of
insolvency.144 This, of course, does not rule out the imposition of liability if managers
harm the company (and, consequently, its creditors) through an unlawful act or breach
of fiduciary duty.
Another important difference between our jurisdictions lies in the risk of public enforcement. Most have directors’ disqualification schemes that permit the state
to sanction failure by directors to meet relevant standards of pro-​creditor conduct
(including breaches of accounting rules or fiduciary duties) by banning them from
being involved in the management of a company.145 This is a further way to increase
the intensity of deterrence, especially when civil liability has limited deterrence value
due to directors’ wealth constraints.146 In the UK, for example, any possible misconduct must be investigated in corporate bankruptcy, with a view to initiating possible
disqualification proceedings.147 As a consequence, disqualification is approximately
100 times more common in the UK than is a judgment in a private suit against directors of an insolvent company.148 Disqualification plays a more limited role in other
jurisdictions, especially in the U.S., where it is only available for directors of publicly
traded companies, and is not employed as a creditor protection measure.
Criminal liability is also imposed on directors whose breaches of statutory duties
worsen the financial position of their company. In the U.S., as we shall see in Chapter 9,
the focus is on antifraud provisions that generally protect investors against losses
resulting from negligent misrepresentation in issuer disclosures. The scope of criminal provisions is much more specific in continental Europe and Brazil.149 In France,
directors who act opportunistically in the vicinity of insolvency face up to five years
141 Art. 429 Companies Act. Although most suits under this provision are filed when the company
is insolvent, plaintiffs benefit from not needing to prove that the company was insolvent at the relevant time. Italy also has a similar rule (Art. 2394 Civil Code), but such suits are rare.
142 Over a hundred cases have been published in the second half of the twentieth century, with
more than 90 percent brought by creditors. Of course, sometimes directors are not held liable. See e.g.
Kochi District Court, 10 September 2014, 1452 Kinyu Shoji Hanrei 42. For the most comprehensive
survey, see Kazushi Yoshihara, Commentaries to Art. 429, in Commentaries of the Companies Act,
Vol.9, at 337–​419 (Shinsaku Iwahara ed., 2014) (in Japanese).
143 See Arts. 425–​7 Companies Act (Japan).
144 Arts. 153 et seq. Lei das Sociedades por Ações (Brazil).
145 See Art. L. 653-​8 Code de commerce (France); Arts. 216–​17 and 223–​24 Legge Fallimentare
(Italy) (as an outcome of a finding of criminal liability, but with criminal liability extending to grossly
negligent behavior); Art. 331(1)(iii) Companies Act (Japan); Company Directors Disqualification Act
1986 (UK); Securities Enforcement Remedies and Penny Stock Reform Act of 1990, 15 U.S. Code §§
77t(e), 78u(d)(2) (U.S.); Art. 147, § 1º Lei das Sociedades por Ações (Brazil).
146 Text to note 129.
147 Company Directors Disqualification Act 1986, § 7. Since 2015, these proceedings can also
impose compensation orders: ibid., §§ 15A–​15C.
148 See Insolvency Service, Enforcement Outcomes April to June 2015, Table 1; John Armour,
Enforcement Strategies in UK Company Law: A Roadmap and Empirical Assessment, in Rationality in
Company Law 71 (John Armour and Jennifer Payne eds., 2009).
149 See Arts. 168 et seq. Lei 11.101 of 2005.
131
Distressed Firms
131
imprisonment.150 Germany and Italy adopt an even more inclusive approach, with
directors facing criminal sanctions if they violate their duty to call a general meeting
when legal capital is lost (Germany) or when they fail, if only negligently, to avoid the
worsening of the financial position of the company (Italy).151
5.3.1.2 Shareholders
All jurisdictions offer doctrinal tools for holding shareholders liable for the debts of insolvent corporations, although the use of these tools is generally restricted to controlling or
managing shareholders who “abuse” the corporate form.152 The three principal tools are
the doctrine of de facto or shadow directors, equitable subordination, and “piercing the
corporate veil.”153 In addition, some jurisdictions apply enhanced standards to corporate
groups.
The doctrine of de facto or shadow directors154 involves extending the liabilities of directors to a person who acts as a member of, or exercises control over, the board, without
formally having been appointed as such. For example, under French law, a controlling
shareholder who directs a company’s management to violate their fiduciary duties may be
required to indemnify the company for its losses (insuffisance d’actifs).155 Versions of this
doctrine are also applied in our other jurisdictions, apart from the U.S. and Brazil.156 The
UK distinguishes between the case of solvent and insolvent subsidiaries: a parent company
will expressly not be treated as a shadow director of a solvent subsidiary simply because it
exercises control over the subsidiary’s board, but this proviso is inapplicable in respect of
liabilities associated with the insolvency of the subsidiary.157
A second form of shareholder liability involves the subordination of debt claims
brought by controlling shareholders against the estates of their bankrupt companies.158
150 Arts. L. 654-​1 to L. 654-​3 Code de commerce.
151 For Germany, see § 401 Aktiengesetz and § 84 GmbH, as well as Heribert Hirte,
Kapitalgesellschaftsrecht 135–​6 (5th edn., 2006) (providing an overview of leading German
cases). For Italy see Corte di Cassazione, Sez. V penale, 9 October 2014, No. 8863 (criminal liability if
failure to take action leads to, or worsens, the company’s financial distress). France recently abolished
criminal provisions of a similar content (former Arts. L. 241-​6, 1° and. L. 242-​29, 1° Code de commerce, as repealed by Loi No. 2012-​387 of 22 March 2012).
152 In Brazil, however, where veil-​piercing is broadly applied, minority shareholders are routinely
held liable for labor obligations.
153 Actions might also be brought against shareholders in many jurisdictions to challenge distributions by virtue of the breach of distribution rules discussed in Section 5.2.2.2 or using fraudulent
conveyance or actio pauliana powers: see Section 5.3.1.3. To the extent that the liability is negligence-​
based, it takes on the quality of a standard, although it depends for efficacy on the underlying rules
restricting distributions.
154 In some jurisdictions, such as the UK, shadow directors are said to influence directors secretly,
as distinguished from de facto directors who act openly as directors but are not (see e.g. Re Hydrodan
(Corby) Ltd [1994] Butterworths Company Law Cases 161). We use the terms interchangeably.
155 Art. L. 651-​2 Code de commerce. See André Jacquemont, Droit des Entreprises en
Difficulté, 605–​9 (8th edn., 2013).
156 See, for Germany, Bundesgerichtshof Zivilsachen 104, 44; for Italy, Corte di Cassazione,
14 September 1999, No. 9795, 27 Giurisprudenza Commerciale II 167 (2000); for Japan, Art.
429 Companies Act; for the UK, §§ 250–​1 Companies Act 2006; Secretary of State for Trade and
Industry v. Deverell [2001] Chancery Division 340, 354–​5.
157 Compare Companies Act 2006 (UK) §251(3); Insolvency Act 1986 (UK) §251.
158 See generally Martin Gelter and Juerg Roth, Subordination of Shareholder Loans from a Legal
and Economic Perspective, 5 Journal for Institutional Comparisons 40 (2007). Technically, subordination is a recharacterization of the shareholder’s claim from debt to equity, but the result is
functionally similar to liability.
132
132
Transactions with Creditors
In some jurisdictions (Germany and Brazil), major shareholders’ loans are automatically subordinated,159 whereas in other jurisdictions (Italy and the U.S.) this depends
on the circumstances or conduct of the shareholder.160 The rationale is to deter over­
investment in distressed firms, but such doctrines must walk a tightrope between
deterring this and permitting controlling shareholders to make legitimate efforts to
rescue failing firms through the injection of new debt capital.161 Perhaps reflecting
these difficulties, this doctrine is not applied in France or the UK.162
Finally, all our jurisdictions permit courts to “pierce the corporate veil” in
extreme circumstances; that is, to hold controlling shareholders or the controllers
of corporate groups personally liable for the company’s debts. In general, courts
do not set aside the corporate form easily.163 The exception to this is Brazil, where
veil-​piercing is common. In no jurisdiction has veil-​piercing been directed against
publicly traded companies or—​apart from in Brazil—​passive (non-​controlling)
shareholders, and most successful cases involve fraud: that is, blatant misrepresentation or ex post opportunism by shareholders.164 Thus, U.S. jurisdictions permit
veil-​piercing when (1) controlling shareholders disregard the integrity of their companies by failing to observe formalities, intermingling personal and company assets,
or failing to capitalize the company adequately—​and (2) there is an element of
fraud or “injustice,” as when shareholders have clearly behaved opportunistically.
Japan and most EU jurisdictions apply the veil-​piercing doctrine similarly, as does
Brazil for adjusting creditors.165 In France, for example, insolvency procedures can
be extended to shareholders that disregard the integrity of their companies (action
en confusion de patrimoine).166 Brazil is unique among our jurisdictions in permitting veil-​piercing in the absence of fraud or abuse, for the benefit of certain non-​
adjusting creditors—​notably workers, consumers, and victims of environmental
harm.167
159 See, for Germany, §§ 39 (subordination of loans by shareholder with >10 percent equity capital) and 135 (avoidance of repayments of such loans within one year of insolvency) Insolvenzordnung;
Dirk A. Verse, Shareholder Loans in Corporate Insolvency—​A New Approach to an Old Problem, 9
German Law Journal 1109 (2008); for Brazil, Art. 83, VIII Lei 11.101 of 2005 (automatic subordination of shareholder loans).
160 Taylor v. Standard Gas and Electronic Corporation, 306 United States Reports 307 (1939);
Pepper v. Litton, 308 United States Reports 295 (1939) (U.S.: where shareholder has “behaved
inequitably”); For Italy, Art. 2467 (close companies) and Art. 2497-​II (within groups) Civil Code
(where firm’s financial condition would have required an equity contribution rather than a loan).
161 See Martin Gelter, The Subordination of Shareholder Loans in Bankruptcy, 26 International
Review of Law & Economics 478 (2006).
162 See, for France, Maurice Cozian et al., Droit des Sociétés 152 (28th edn., 2015); for the UK,
Salomon v. A. Salomon & Co Ltd [1897] Appeal Cases 22.
163 See e.g. Prest v Petrodel Resources Ltd [2013] UKSC 34 (UK); Stephen M. Bainbridge, Abolishing
Veil Piercing, 26 Journal of Corporation Law 479 (2001) (U.S.).
164 See for the U.S.: Peter B. Oh, Veil-​Piercing, 89 Texas Law Review 81 (2010); John H.
Matheson, Why Courts Pierce: An Empirical Study of Piercing the Corporate Veil, 7 Berkeley Business
Law Journal 1 (2010); for Germany: Uwe Hüffer and Jens Koch, Aktiengesetz (12th edn., 2016),
§ 1 paras 15–​33: Durchgriffslehre; for the UK: Davies and Worthington, note 86, 217–​22; for Brazil:
Meyerhof Salama, note 41. In Japan, veil-​piercing is a frequently litigated issue since its first application by Supreme Court Judgment 27 February 1969, 23 Minshu 511.
165 Although German courts discuss policy considerations in veil-​piercing analyses, this has few
practical implications: see Friedrich Kübler and Heinz-​Dieter Assmann, Gesellschaftrecht § 23
I 2 (6th edn., 2006). For Brazil, see Art. 50 Civil Code; for Japan, see Marco Ventoruzzo et al.,
Comparative Corporate Law 175–​8 (2015).
166 Arts. L. 621–​2 (sauvegarde), L. 631–​7 (redressement judiciaire) and L. 641–​1 (liquidation judiciaire) Code de commerce (France).
167 See note 41 and text thereto.
133
Distressed Firms
133
Piercing the corporate veil can be seen as performing a broadly similar function to
imposing liability on a shareholder as a de facto or shadow director or subordinating a
shareholder’s loans. However, for the courts of some jurisdictions, “disregarding” the
company’s legal personality with regard to one party means that it must be disregarded
for all—​with the result that veil-​piercing acts as a much blunter instrument for controlling opportunism than do the other two doctrines, which by their nature may be
targeted more precisely.
Veil-​piercing doctrines are also occasionally used to protect the creditors of corpor­
ate groups. In the U.S., the doctrine of “substantive consolidation” gives bankruptcy
courts the power to put assets and liabilities of two related corporations into a single
pool.168 Brazilian courts also have—​and very liberally employ—​this power.169 Like
the French “action en confusion de patrimoine,” this is a means to respond to debtor
opportunism taking the form of concealing assets in different corporate boxes, or of
shunting assets around within a group. However, the doctrine makes the creditors of
one corporate entity better off at the expense of those of the other and, therefore, is
most appropriate where all creditors have been deceived as to the location of assets, or
where the creditors that are made worse off acted collusively with the debtor.170
Veil-​piercing is, if anything, less common within groups of companies than it is
between companies and controlling shareholders who are individuals.171 That said, a
special set of creditor protection standards covers groups of companies in some jurisdictions. The German Konzernrecht provides the most elaborate example of such a law,
attempting to balance the interests of groups as a whole with those of the creditors and
minority shareholders of their individual members.172 In groups in which the parties
enter into a “control agreement,” the parent must indemnify its subsidiaries for any
losses that stem from acting in the group’s interests.173 Should this fail to happen,
creditors of the subsidiary may challenge its indemnification claim or sue the parent’s directors for damages.174 If a controlling company has not entered into a control
agreement (i.e. in a de facto group), it must compensate any subsidiaries that it causes
to act contrary to those subsidiaries’ own interests.175 Should the parent fail to do so,
creditors of the subsidiary may sue the parent for damages.176
168 See e.g. In Re Augie/​Restivio Baking Co, 860 Federal Reporter 2d 506 (2d Cir. 1988). See
also Irit Mevorach, The Appropriate Treatment of Corporate Groups in Insolvency, 8 European Business
Organization Law Review 179 (2007).
169 See e.g. In re Rede Energia S.A., Case No. 14-​10078 (SCC) (Bankr S.D.N.Y., 2014) (unsuccessfully arguing that Brazil’s liberal use of substantive consolidation violates U.S. public policy).
170 See Douglas G. Baird, The Elements of Bankruptcy 158–​66 (5th edn., 2010).
171 In the U.S., Oh, note 164, at 130–​2, and Matheson, note 164, at 58, both report that courts
pierce the veil at higher rates to reach the assets of individual shareholders than those of corporate
shareholders. In Brazil, labor laws formally impose joint and several liability for labor obligations on
companies belonging to the same group (Art. 2º Consolidação das Leis do Trabalho), though judicial
decisions have extended a similar treatment to individual controlling shareholders.
172 See Emmerich and Habersack, note 78; for a comparative perspective, see Klaus J. Hopt,
Groups of Companies: A Comparative Study of the Economics, Law, and Regulation of Corporate Groups,
in The Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​
Georg Ringe eds., 2017).
173 See § 302 Aktiengesetz. For the distinction between contractual and de facto groups, see § 18
Aktiengesetz.
174 See §§ 302 and 309 Aktiengesetz (subsidiary is an AG); Emmerich and Habersack, note 78,
566–​7 (subsidiary is a GmbH).
175 See § 311 Aktiengesetz (subsidiary is an AG). Emmerich and Habersack, note 78, 535 (subsidiary is a GmbH). The same approach has been adopted in Italy: see Art. 2497 Civil Code.
176 See § 317 Aktiengesetz; Bundesgerichtshof Zivilsachen 149, 10 (Bremer Vulkan) and
Bundesgerichtshof Zivilsachen 173, 246 (Trihotel ).
134
134
Transactions with Creditors
German law’s focus on protecting the interests of the individual entity contrasts with
the cooperation-​oriented French approach to the same issues. Under French case law,
a group’s controller is not liable for instructing a subsidiary to act in the interests of
the group rather than its own interests as long as the group is (1) stable, (2) pursuing a
coherent business policy, and (3) distributing the group’s costs and revenues equitably
among its members.177 The French focus on the “enterprise” has been perceived as
having the advantage of reflecting a more functional approach,178 while the indemnification requirements of Konzernrecht seem more protective of a given subsidiary’s
creditors. However, French courts take serious consideration of creditor interests when
applying the equitable cooperation doctrine,179 whereas German courts have recently
adopted a more balanced doctrine of “solvency threatening” parent intervention
(Existenzvernichtungshaftung) for closely held firms.180 Similarly, in the UK, the greater
likelihood of characterizing a parent company as a “shadow director” of an insolvent
company operates to balance the interests of shareholders of solvent groups against
those of creditors.181
5.3.1.3 Creditors and other third parties
The standards strategy is also employed in a variety of guises as regards creditors and
other third parties. In these applications, the focus is sometimes on recruiting third
parties as gatekeepers, in others on preventing one creditor from getting a better position vis-​à-​vis the others, and in many cases, both.
The first approach targets third parties who enter into transactions with a debtor in
the vicinity of insolvency that are manifestly disadvantageous to the debtor. Such third
parties may find that the transaction is set aside ex post in the debtor’s bankruptcy, and
that they are required to return the benefits they received. These results are brought about
under doctrines deriving from the actio pauliana in continental Europe and Brazil, fraudulent conveyance in the U.S. and Japan, and “undervalue transactions” in the UK.182 The
standards strategy recruits third parties as gatekeepers by making them wary of desperate
transactions entered into by a distressed debtor, whose shareholders may be engaging in
asset substitution.183 The gatekeeper will only be able to rely on the transaction if they
177 This is the holding of the well-​known Rozenblum case (Cour de Cassation (Ch. Crim.) 4
February 1985, 1985 Revue des Sociétés 648), a criminal “abus de biens sociaux” case. For a comparative law discussion see European Commission Informal Company Law Expert Group, Report on
the Recognition of the Interest of the Group, section 2.2 (2016).
178 See e.g. Report of the Reflection Group on the Future of EU Company Law
(2011), 59–​65.
179 See Marie-​Emma Boursier, Le Fait Justificatif de Groupe dans l’Abus de Biens Sociaux: Entre
Efficacité et Clandestinité, 125 Revue des Sociétés 273 (2005); Report of the Reflection Group,
note 178, at 63.
180 See note 176; Mathias Habersack, Trihotel—​Das Ende der Debatte?, 37 Zeitschrift für
Unternehmens-​und Gesellschaftsrecht 533 (2008); Hüffer and Koch, note 164, § 1 paras.
21–​33.
181 See note 154 and text thereto.
182 See Arts. 130, 168, and 172, Lei 11.101 of 2005 (Brazil); Arts. L. 632-​1 and L. 632-​2 Code
de commerce (France); § 129 Insolvenzordnung (Germany); Art. 64-​7 Legge Fallimentare (Italy);
Uniform Fraudulent Conveyance Act and the Bankruptcy Code (11 U.S. Code) § 548 (U.S.); Art.
424 Civil Code and Art. 160 Bankruptcy Act (Japan); §§ 238, 241, 423–​5 Insolvency Act 1986 (UK).
183 See Douglas G. Baird and Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper
Domain, 38 Vanderbilt Law Review 829 (1985); John Armour, Transactions at an Undervalue, in
Vulnerable Transactions in Corporate Insolvency 46–​7 (John Armour and Howard N. Bennett
eds., 2003).
135
Distressed Firms
135
can show they were in “good faith,”184 or more specifically, that there were reasonable
grounds for believing, at the time, that it would benefit the debtor’s business.185
The second type of application targets “insider” creditors who influence distressed
debtors in a way harmful to other creditors. One version focuses on involvement in
management decisions, whereby influential creditors such as banks may be made liable
as de facto directors or, if an animus societatis can be established, as partners of the
insolvent firm. In some jurisdictions, such as the UK, liability attaches to any person knowingly carrying on a company’s business with the intent to defraud creditors,
whereas in others, like Italy or the U.S., there is no shortage of doctrines that impose
liability upon lenders who deal with insolvent firms.186 There is a real risk, however, of
over-​deterrence: banks may be shy of entering into workout arrangements with failing
companies for fear of such liability, even though courts rarely impose liability when
banks merely attempt to protect their loans.187
Another application of the standards strategy against “insider” creditors concerns
so-​called “preferential” transactions—​resulting in a particular creditor being placed in
a better position than the others in the debtor’s bankruptcy. In continental European
jurisdictions and Brazil, the actio pauliana may also be used to challenge such transactions,188 the principal requirement being that the creditor benefiting from it has acted
in bad faith, which is presumed in some instances.189 Similarly, in Japan, the benefiting
creditor must have been aware of the debtor’s insolvency.190 In the U.S. and UK, by
contrast, there is no need to demonstrate any knowledge or bad faith on the part of
the creditor, although the UK requires that the debtor have had some desire to favor
the creditor, and the U.S. only permits transactions to be set aside up to 90 days before
bankruptcy.191 The rationale for reversing preferential transactions has, however, been
questioned: to the extent such liability simply redistributes losses amongst creditors,
and is costly to enforce, it may tend to reduce aggregate welfare.192
5.3.2 Governance strategies
5.3.2.1 Appointment rights
All our jurisdictions give creditors power to initiate a change in the control of the assets
of a financially distressed company by triggering bankruptcy proceedings. A single
184 See § 8(a) Uniform Fraudulent Transfer Act (U.S.) (but primary transferees have no good faith
defense under Bankruptcy Code, 11 U.S. Code § 548); Art. 67 Legge Fallimentare (Italy).
185 See § 238(5) Insolvency Act 1986 (UK).
186 See, for the UK, § 213 Insolvency Act 1986; Morris v Bank of India [2005] 2 Butterworths
Company Law Cases 328; for Italy, see Corte di Cassazione, 28 March 2006, No. 7029, Diritto
Fallimentare II/​630 (2006) (de facto director); for the U.S., Lynn M. LoPucki and Christopher R.
Mirick, Strategies for Creditors in Bankruptcy Proceedings (6th edn., 2014).
187 See for France, Cozian et al., note 162, at 161; for Germany, § 826 BGB
(“Insolvenzverschleppung”); for Italy, Corte di Cassazione SU, 28 March 2006, No. 7028, 2007
Diritto della Banca e del Mercato Finanziario 149; for the UK, see Davies and Worthington,
note 86, 232–​3; for the U.S. Baird and Rasmussen, note 22.
188 See sources cited in note 182.
189 See e.g. Arts. 66 and 67(1) Legge Fallimentare (Italy). See also § 135 Insolvenzordnung
(Germany), discussed in note 159 (automatic avoidance of shareholder loans repaid within one year
of insolvency).
190 Art. 162 Bankruptcy Act (Japan).
191 § 239 Insolvency Act 1986 (UK); Bankruptcy Code, 11 U.S. Code § 547 (U.S. The “look-​
back” period extends to one year for insiders).
192 Alan Schwartz, A Normative Theory of Business Bankruptcy, 91 Virginia Law Review 1199,
1224–​31 (2005).
136
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Transactions with Creditors
creditor can generally exercise this power by demonstrating that the debtor is insolvent
in the “cash-​flow” sense—​that is, unable to pay debts as they fall due.193 The U.S.,
however, requires that three creditors bring a petition together.194 While most jurisdictions permit managers to commence proceedings prophylactically before their firm has
actually become insolvent, the U.S. uniquely does so without imposing any requirement that the debtor be close to insolvency.195
In most of our jurisdictions, a consequence of transition to bankruptcy is removal of
the board from effective control of corporate assets, and its replacement with, or supervision by, an “administrator” or “crisis manager” to whom operational managers are
accountable.196 In general, creditors, rather than shareholders, have rights to appoint
this person. However, the creditors’ appointment rights are often exercised subject to
oversight by the court,197 which plays a trusteeship role within our schema. In some
jurisdictions this trusteeship role takes precedence, such that the court has exclusive
power to select a crisis manager.198
An alternative to appointing a crisis manager is to permit the incumbent managers
to remain in situ.199 This economizes on costs associated with getting an outsider up to
speed with running the business, and capitalizes on any firm-​specific human capital the
managers may possess. In this case, the trusteeship strategy—​in the form of court oversight—​is relied upon even more heavily to control shareholder–​creditor agency costs.
“Reorganization” or “rescue” proceedings on this pattern have become more common
in our core jurisdictions. For example, in reorganization proceedings under Chapter
11 of the U.S. Bankruptcy Code, board members continue in office and maintain their
powers to control the company’s assets, albeit with their fiduciary duties now owed
to the creditors.200 Creditors may apply to the court to appoint a trustee to take over
control, or to switch the proceedings into Chapter 7—​where a trustee in bankruptcy
is appointed by creditors as crisis manager.201
Japan, France, Germany, and Brazil have adopted more modest versions of the
U.S. approach. In Germany, courts must allow boards to remain in control of corpor­
ate assets—​under the surveillance of a custodian—​unless there is evidence that this
193 See Arts. L. 631-​1 Code de commerce (redressement judiciaire) and L. 640-​1 and 640-​5 (liquidation judiciare) (France); § 14(1) Insolvenzordnung (Germany); Arts. 5 et seq. Legge Fallimentare
(Italy); § 123(1)(e) Insolvency Act 1986 (UK); Arts. 15 and 16 Bankruptcy Act (Japan); Art. 94, I and
97, IV Lei 11.101 of 2005 (Brazil).
194 Bankruptcy Code, 11 U.S. Code §§ 303(b)(1).
195 See § 18 Insolvenzordnung (Germany); Art. L. 620–​1 Code de commerce (France: procédure
de sauvegarde); Art. 160 Legge Fallimentare (Italy: concordato preventivo); Insolvency Act 1986 Sch B1
¶¶ 22, 27(2)(a) (UK); Art. 97, IV Lei 11.101 of 2005 (Brazil); Art. 21 Civil Rehabilitation Act and
Art. 17 Corporate Reorganization Act (Japan); compare Bankruptcy Code, 11 U.S. Code § 301(a)
(U.S.: voluntary petition—​no requirement that debtor be financially distressed).
196 See Arts. L. 622-​1 (procédure de sauvegarde), L. 631-​9 (redressement judiciaire) and L. 641-​1
(liquidation judiciaire) Code de commerce (France); § 56 Insolvenzordnung (Germany); Art. 21 Legge
Fallimentare (Italy); Insolvency Act 1986 Schedule B1 ¶¶ 59, 61, 64 (UK); Bankruptcy Code, 11 U.S.
Code § 323 (U.S.); Art. 22 Lei 11.101 of 2005 (Brazil).
197 See § 56 Insolvenzordnung (Germany); Insolvency Act 1986 § 139 and Schedule B1 ¶ 14
(UK); Bankruptcy Code, 11 U.S. Code § 702 (U.S.).
198 See Arts. L. 621-​4 (procédure de sauvegarde), L. 631-​9 (redressement judiciaire) and L. 641-​
1 (liquidation judiciaire) Code de commerce (France); Art. 27 Legge Fallimentare (Italy); Art. 74
Bankruptcy Act (Japan); Art. 99, IX Lei 11.101 of 2005 (Brazil).
199 See European Commission, Recommendation of 12 March 2004 on a new approach to business failure and insolvency, C(2014) 1500 final (the “Restructuring Recommendation”), ¶ 6.
200 Bankruptcy Code, 11 U.S. Code § 1107 (U.S.). See note 132 and text thereto.
201 Ibid., §§ 1104, 1112.
137
Distressed Firms
137
will disadvantage creditors.202 In Japan, courts may forgo the appointment of a crisis
manager if petitioned to that effect by a creditor or another interested party, whereas
French courts may do so for smaller corporations.203 Managers also retain their posts
in reorganization proceedings in Brazil, unless they engage in proscribed conduct
or the reorganization plan provides otherwise.204 And in the UK, an administrator
may elect to keep the incumbent management in post, subject to his oversight.205
Italian law has moved closest to the U.S. model: when a reorganization proceeding is
opened, management is not displaced unless the plan is declared not feasible or creditors reject it.206
Practitioners have developed a technique whereby restructuring outcomes can be
achieved with the debtor’s management in post regardless of the formal position in
bankruptcy. This involves agreeing a prospective restructuring or sale, which is then
executed through a “pre-​packaged” insolvency process. The crisis manager’s formal
appointment lasts long enough only for her to execute the agreed sale on behalf of the
company. This saves both on the destruction of goodwill that occurs during formal
proceedings and on the appointment costs of crisis managers.207 Such “pre-​packaged”
bankruptcies have long been common in the U.S. and UK,208 and following recent
reforms to facilitate their use, are growing in popularity in other jurisdictions as
well.209
5.3.2.2 Decision rights
In most jurisdictions, a proposal for “exit” from bankruptcy proceedings—​whether by
a sale or closure of the business or a restructuring of its balance sheet—​is initiated by
the crisis manager, subject to veto rights from creditors.
202 § 270 Insolvenzordnung (Germany). If this has the unanimous support of the initial creditors’
committee, then it is deemed to be beneficial to the creditors: ibid., § 270(3).
203 See Arts. 38 and 64 et seq. Civil Rehabilitation Act 1999 (simple general reorganization proceedings) and Art. 67 Corporate Reorganization Act 1952 (more formal proceedings for joint-​stock
companies, amended in 2002 to introduce debtor-​in-​possession schemes) (Japan); Arts. L. 621-​4
(sauvegarde) and L. 631-​9 (redressement judiciaire) Code de commerce (France) (firms with less than
20 employees or turnover below €3,000,000: Art. R. 621-​11 Code de commerce).
204 Arts. 50 IV-​V and 64 Lei 11.101 of 2005.
205 Insolvency Act 1986 (UK) Sch B1, ¶¶ 59-​61.
206 Arts. 167 (concordato preventivo) and 27 (fallimento), Legge Fallimentare.
207 See John Armour, The Rise of the “Pre-​Pack”: Corporate Restructuring in the UK and Proposals for
Reform, in Restructuring in Troubled Times: Director and Creditor Perspectives (Robert P.
Austin and Fady J.G. Aoun eds., 2012), 43, 58–​60.
208 See e.g. Elizabeth Tashjian, Ronald C. Lease, and John J. McConnell, An Empirical Analysis of
Prepackaged Bankruptcies, 40 Journal of Financial Economics 135 (1996) (U.S.); Sandra Frisby, A
Preliminary Analysis of Pre-​Packaged Administrations (2007); Andrea Polo, Secured Creditor Control in
Bankruptcy: Costs and Conflict (2012), at ssrn.com (UK).
209 See e.g. § 270b Insolvenzordnung (Germany, from 2012); Art. L. 611-​7 Code de commerce,
as amended by Decree No. 2014-​326 (France). Italy allows out-​of-​court pre-​packs which are binding only to consenting creditors; a majority rule applies, however, to financial creditors: Art. 182-​II
and 182-​VII Legge Fallimentare (Italy) (however, pre-​packs using “Chapter-​11”-​style reorganizations, a broad equivalent of which had been introduced in 2005, are no longer available: Art. 163-​II
Legge Fallimentare, as amended in 2015). These developments were encouraged at EU level by the
Restructuring Recommendation (note 199), ¶ 7. See generally Horst Eidenmüller and Kristin van
Zwieten, Restructuring the European Business Enterprise: The EU Commission Recommendation on a
New Approach to Business Failure and Insolvency, 16 European Business Organization Law Review
625 (2015).
138
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Transactions with Creditors
However, exceptions include France, Italy, and the U.S., where for debtors entering “reorganization” proceedings, the restructuring plan in the first instance is
proposed by the debtor.210 The leverage this grants to debtors has, however, been
reduced. In France, creditors now have initiation rights concurrent with debtors
or crisis managers in relation to plans for large corporations.211 Similarly, in Italy,
significant creditors now also enjoy concurrent initiation rights.212 In the U.S.,
although the debtor enjoys the exclusive right to initiate a plan for the first 120 days
after entry into bankruptcy,213 creditors now use the debtor’s need for financing in
bankruptcy as a lever to exert control over the development of the restructuring
plan.214 The resulting plans have consequently become more favorable to creditors
over time.215
Deciding upon a plan for exiting bankruptcy also runs into problems of inter-​
creditor conflicts.216 Creditors who are in a junior class that is “out of the money” will,
analogously to shareholders in a financially distressed firm, tend to prefer more risky
outcomes. Creditors who are in a senior class that is “oversecured”—​that is, the assets
are more than enough to pay them off—​will prefer a less risky plan. Giving either
group a say in the outcome will at best add to transaction costs and at worst lead to
an inappropriate decision about the firm’s future. Jurisdictions that give veto rights to
creditors over the confirmation of a restructuring plan try to reduce this problem by
seeking to give only those creditors who are “residual claimants” a say in the process.
Hence, most jurisdictions do not allow voting by either creditors who will recover in
full or, in some jurisdictions, by junior creditors who are “out of the money” under
the plan.217
Where the bankruptcy proceedings are “pre-​packaged”—​as we have seen, an increasingly common phenomenon218—​any necessary agreements to secure approval are
obtained in advance—​including, where appropriate, a creditor vote. The agreements
reached must be congruent with the decision rights available in formal proceedings,
otherwise parties will have an incentive to trigger formal proceedings instead.
210 In France and Italy, this occurs in sauvegarde proceedings (Art. L. 626-​2 Code de commerce)
and in concordato preventivo (Art. 161 Legge Fallimentare), respectively. In the U.S., this occurs in
Chapter 11 proceedings: Bankruptcy Code, 11 U.S. Code § 1121.
211 Any member of a creditors’ committee may submit an alternative plan to the debtor’s; to be
implemented a plan must be approved by a two-​thirds majority of each committee of creditors: Arts.
L. 626-​30-​2 and 626-​31 (sauvegarde) and L. 631-​19 (redressement judiciaire) Code de commerce, as
amended in 2014. However, for corporations with less than 150 employees and turnover of less than
€20m, the court retains discretion regarding the outcome of proceedings: Arts. L. 626-​9, L. 626-​34-​1,
L. 631-​19, and R. 626-​52 Code de commerce.
212 Creditors holding at least 10 percent of the debtor’s debt may also propose a plan in concordato
preventivo (Art. 163, as amended in 2015).
213 Bankruptcy Code, 11 U.S. Code § 1121. This may be extended by the court to 180 days.
214 David A. Skeel, Jr., Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152
University of Pennsylvania Law Review 917 (2003).
215 See Ayotte and Morrison, note 14; Barry E. Adler, Vedran Capkun, and Lawrence A. Weiss,
Value Destruction in the New Era of Chapter 11, 29 Journal of Law, Economics and Organization
461 (2013).
216 See Philippe Aghion, Oliver Hart, and John Moore, The Economics of Bankruptcy Reform, 8
Journal of Law, Economics, and Organization 523 (1992).
217 See §§ 237 Insolvenzordnung (Germany); Arts. 127 and 177 Legge Fallimentare (Italy);
Schedule B1 ¶ 52 Insolvency Act 1986 (UK); Bankruptcy Code, 11 U.S. Code §§ 1126(f )–​(g) (U.S.).
Compare Arts. L. 626-​30-​2 and L. 626-​32 Code de commerce (France) (vote of all creditors not being
paid in full, but subject to court decision); Art. 45, § 3º Lei 11.101 of 2005 (Brazil).
218 See Section 5.3.2.1.
139
Distressed Firms
139
5.3.2.3 Incentive strategies
The trusteeship strategy arguably plays a more important role in our jurisdictions for
creditor than for shareholder protection purposes, whereas the converse is true for the
rewards strategy. There seem to be two reasons for this. The first reflects basic differences in the payoffs to creditors and shareholders. The rewards strategy, which incentivizes agents to act in principals’ interests by sharing the payoffs, cannot function so
effectively in relation to agents acting for creditors, for the creditors’ maximum payoffs
are fixed by their contracts.219 Instead, creditors are more concerned about the possibility of losses—​hence a reward strategy, which relies upon offering participation in
upsides, does not seem an obvious fit.220 The second reason stems from the problems
of inter-​creditor agency costs that arise once a firm moves under the control of its creditors. Because the value of a firm’s assets is uncertain and creditors are often grouped in
differing classes of priority, it is unlikely to be clear to which group any reward should
be offered and how it should be calibrated.
There are two principal types of trusteeship in relation to bankrupt firms. The first is
the “crisis manager” who runs or oversees a bankrupt firm. Indeed, in many procedures
this person is known as a “trustee in bankruptcy” to capture the idea that they have
custody of the corporate assets not for their own financial gain, but for the benefit of
the various claimants interested therein.221
The second significant trusteeship role in the governance of bankrupt firms is the oversight role of courts. Courts’ role is principally to act as arbiters between the many different classes of claimant in an insolvency proceeding. The more fundamental the potential
conflict, the greater the role for court oversight qua trustee. France still relies perhaps most
heavily on courts, entrusting them with the ultimate decision regarding the future deployment of the firm’s assets, although their power has been reduced considerably in recent
years, especially for large firms.222 Courts in our other jurisdictions—​and in France for
large firms—​are not primarily responsible for making the decision how to exit formal proceedings.223 Rather, they confirm significant decisions and resolve questions and disputes
arising between different classes of claimant. They also oversee decisions to sell assets.224
219 Compensation structures may, however, mitigate the asset substitution problem. See James
Brander and Michel Poitevin, Managerial Compensation and the Agency Problem, 13 Managerial and
Decision Economics 55 (1992); Kose John and Teresa John, Top-​Management Compensation and
Capital Structure, 48 Journal of Finance 949 (1993).
220 However, to the extent that rewards take the form of claims against their firms for pension
entitlements, the rewards strategy aligns managers’ interests with creditors: see Alex Edmans and Qi
Liu, Inside Debt, 15 Review of Finance 75 (2011); Chenyang Wei and David Yermack, Investor
Reactions to CEOs’ Inside Debt Incentives, 24 Review of Financial Studies 3813 (2011).
221 On the analogy of a “trust,” see Ayerst v C&K Construction Ltd [1976] Appeal Cases 167, 176–​80.
222 See note 211 and text thereto.
223 See e.g. for Germany, § 248 Insolvenzordnung (confirmation of plan); for Japan, Patrick Shea
and Kaori Miyake, Insolvency-​Related Reorganization Procedures in Japan: The Four Cornerstones, 14
University of California at Los Angeles Pacific Basin Law Review 243 (1996) (applicable to
Chapter 11-​type procedures only); for the UK, Insolvency Act 1986 Schedule B1 ¶¶ 63, 68 (administrator may apply to court for directions), 70–​3 (court to authorize sale of assets subject to security),
76–​9 (extension or termination of administration proceedings); for Italy, Art. 180 Legge Fallimentare
(confirmation of plan); for the U.S. Bankruptcy Code, 11 U.S. Code §§ 1129 (confirmation of plan)
and 1104 (appointment of trustee or examiner where requested); for Brazil, Art. 58 Lei 11.101 of
2005 (judicial confirmation of plan despite the lack of approval by all class of creditors).
224 See e.g. Bankruptcy Code, 11 U.S. Code § 363(b) (U.S.) (court approval for sale of assets other
than in the ordinary course of business); Insolvency Act 1986 Sch B1, ¶ 60A (UK: power to require
court approval for sale of assets to connected party).
140
140
Transactions with Creditors
While courts lack the high-​powered financial incentives of market participants, which may
make their valuation analyses less incisive, their lack of financial interest also means that
their actions are less likely to be motivated by strategic considerations. Consistently with
this, there is some evidence that bankruptcy procedures controlled by courts achieve no
worse returns for creditors, on average, than do decisions made by market participants.225
5.4 Ownership Regimes and Creditor Protection
Corporate law in every jurisdiction supplements debtor-​creditor law in facilitating
transactions between corporations and their creditors. All our jurisdictions, moreover,
have adopted the same set of broad legal strategies: regulatory strategies in relation to
firms not in default (mandatory disclosure, with some rule-​based controls, and a range
of standards applied to firms that are in financial difficulties), coupled with governance
strategies for firms that are in default.
However, this similarity at the framework level masks variation at a more micro
level. One way of characterizing these variations is to describe countries’ legal regimes
as being “debtor-​friendly” or “creditor-​friendly,” according to the extent to which they
facilitate or restrict creditor enforcement against a financially distressed debtor.226
Thus, the U.S., and to a lesser extent, Japanese, approaches are said to be debtor-​
friendly; the UK and, to a lesser extent, German approaches are said to be creditor-​
friendly. However, the existence of different classes of creditors suggests that a binary
division into pro-​creditor pro-​debtor may be too simplistic. For example, is the presence of an automatic stay of secured creditors’ claims in bankruptcy proceedings
“creditor friendly”? The answer likely depends on whether the “creditor” is secured
or unsecured. While some have sought to attribute differences in creditor protection
to the civil law or common law origins of a jurisdiction,227 this account is called into
question not only by the framework similarities across jurisdictions that we document
in this chapter, but also the considerable micro-​level variation in creditor rights within
the civil and common law families.228
As indicated in Chapter 1, legal strategies appear to be significantly related to ownership structures, although perhaps less directly in relation to creditor rights than
when it comes to the basic governance structure. Some systems’ concentration of debt
finance in the hands of banks has both efficiency and distributional consequences for
creditor rights, which mirror those we have seen vis-​à-​vis share ownership structure
in Chapters 3 and 4. Concentrated debt claims lower creditors’ coordination costs,
225 See Edward R. Morrison, Bankruptcy Decision Making: An Empirical Study of Continuation
Bias in Small-​Business Bankruptcies, 50 Journal of Law and Economics 381 (2007); Régis Blazy,
Bertrand Chopard, Agnès Fimayer, and Jean-​Daniel Guigou, Employment Preservation vs. Creditors’
Repayment Under Bankruptcy Law: The French Dilemma? 31 International Review of Law &
Economics 126 (2011).
226 See e.g. Julian R. Franks, Kjell G. Nyborg, and Walter N. Torous, A Comparison of U.S., UK,
and German Insolvency Codes, 25 Financial Management 86 (1996); Sefa Franken, Creditor-​ and
Debtor-​Oriented Corporate Bankruptcy Regimes Revisited, 5 European Business Organization Law
Review 645 (2004).
227 See Djankov et al., Private Credit, note 81.
228 See Erik Berglöf, Howard Rosenthal, and Ernst-​Ludwig von Thadden, The Formation of Legal
Institutions for Bankruptcy: A Comparative Study of Legislative History, Working Paper (2001), at vwl.
uni-​mannheim.de; John Armour, Simon Deakin, Priya Lele, and Mathias Siems, How Do Legal Rules
Evolve? Evidence from a Cross-​Country Comparison of Shareholder, Creditor and Worker Protection, 57
American Journal of Comparative Law 579, 612–​5 (2009).
141
Ownership Regimes and Creditor Protection
141
permitting more effective use of control rights as a means of controlling shareholder–​
creditor agency costs. At the same time, the aggregate financial interest of banks allows
them to influence politics as much as any other constituencies, including shareholders
or managers in borrower firms.229 Banks’ interest group activism, however, is likely
to vary with the nature of the financial system as well as with the structure of share
ownership.
5.4.1 Regulatory or contractual controls for solvent firms?
As regards solvent firms, Germany and Italy have traditionally gone furthest amongst
our jurisdictions in providing standard terms to facilitate contracting with creditors—​
in the form of creditor-​oriented accounting principles and legal capital rules. The
U.S. has taken the opposite approach, having adopted market-​oriented disclosure
requirements and abstained from imposing capital constraints. Our other jurisdictions
lie somewhere in between, with France being closer to Germany and the UK closer to
the U.S.
The traditional approach of German—​and to a lesser extent, Italian—​law complements a typical capital structure in which firms’ debt finance is largely raised from
banks. If debt is “concentrated”—​both at the firm and country level—​in the hands of
these institutions, this makes creditor co​ordination relatively straightforward. In turn,
this facilitates both monitoring and—​where necessary—​renegotiation. Under these
circumstances, the drawbacks of standard terms are minimized,230 but their potential benefits remain. More generally, because concentrated debt facilitates creditors’
response to shareholder–​creditor agency costs, it complements concentrated share
ownership, which otherwise tends to increase these costs.231
In the U.S., by contrast, banking concentration was restricted and share ownership
was traditionally widely dispersed.232 In such a regime, corporate debt tended to be
more dispersed, increasing creditor heterogeneity and co​ordination costs, and reducing
the advantages of one-​size-​fits-​all standard terms. Consequently, creditors derived few
benefits from firms’ adherence to such provisions, but debtors still bore their costs. This
complemented a relative absence of such mandatory standard terms.
France and Brazil, like Germany, have concentrated share ownership, although the
importance of the state as both equity and debt holder (through state-​owned banks)
allows for a more relaxed approach to the mandating of standard terms. While the
UK and Japan, like the U.S., have relatively dispersed share ownership, their banking
sectors have traditionally been far more concentrated.233 Associated with this, lending
for UK and Japanese firms has tended, until recently, to be more bank-​oriented. This
has been associated with a greater use of mandatory standard terms than in the U.S.
229 See Luca Enriques and Jonathan R. Macey, Creditors Versus Capital Formation: The Case Against
the European Legal Capital Rules, 86 Cornell Law Review 1165, 1202–​3 (2001); see also Bruce G.
Carruthers and Terence C. Halliday, Rescuing Business: The Making of Corporate Bankruptcy
Law in England and the United States (1998).
230 Discussed in text to notes 23–​8.
231 See John Armour, Brian R. Cheffins, and David A. Skeel, Corporate Ownership Structure and
the Evolution of Bankruptcy Law: Lessons from the United Kingdom, 55 Vanderbilt Law Review 1699
(2002); Jan Mahrt-​Smith, The Interaction of Capital Structure and Ownership Structure, 78 Journal
of Business 787 (2005).
232 Roe, note 131, at 54–​9.
233 See e.g. Brian R. Cheffins, Corporate Ownership and Control: British Business
Transformed (2008).
142
142
Transactions with Creditors
However, as we saw in Chapters 1 and 3, patterns of share ownership are shifting in many jurisdictions. The gradual fragmentation of share ownership in large
German companies—​because it increases shareholders’ coordination costs—​will tend
to reduce concerns about shareholder–​creditor agency costs. By the same token, however, the concentration of U.S. stock ownership in the hands of increasingly activist institutional investors clearly has the propensity to increase shareholder–​creditor
agency costs.234
Yet on the analysis above, the implications of changes in share ownership for corporate law’s protection of creditors depends on the structure of debt finance. In much
of Europe, there has been a growth in secondary markets for debt finance, which has
fragmented the ultimate holders of debt finance for public companies, even if many
of the loans are still originated by banks.235 Indeed, the change in debt finance has
been at least as significant as the changes in share ownership.236 This shift appears to
have been accelerated by the aftermath of the financial crisis, which saw tightening of
capital controls—​and consequent reduction in credit supply—​at many banks.237 As a
response to this reduction, the European Commission is launching a battery of policy
proposals, known as the “Capital Markets Union,” designed to deepen capital market
finance for both debt and equity.238
Increased creditor heterogeneity and coordination costs make the standard “creditor
terms” less useful, and more likely to cause hindrance. Thus, it seems broadly functional
that strongly pro-​creditor European measures such as minimum capital, historic cost
accounting, and vigorous pro-​creditor duties for directors should have been slightly
relaxed in recent years. However, the inverse development—​that is, growth of bank
financing at the expense of debt markets—​has not occurred in the U.S. As a consequence, while more concentrated shareholders may increase shareholder–​creditor agency
costs, the ability of creditors to coordinate so as to make effective use of “creditor terms”
still remains low. This makes it less obviously functional for U.S. law to increase the
supply of creditor terms in response to the greater potential shareholder opportunism.
5.4.2 The role of bankruptcy law
If firms have few creditors, then corporate bankruptcy law need only perform the role
of liquidating failed firms: firms that have businesses worth saving can be restructured
by a private “workout.”239 However, as the dispersion of creditors increases, so does the
difficulty of achieving a private solution, and it becomes increasingly valuable to have
234 Rock, note 112.
235 See e.g. Deutsche Bank, Corporate Bond Issuance in Europe: Where Do We Stand and Where Are
We Heading? 31 January 2013.
236 The majority of large European firms are still not widely held: see Julian Franks, Colin Mayer,
Paolo Volpin, and Hannes Wagner, The Life Cycle of Family Ownership: International Evidence, 25
Review of Financial Studies 1675, 1689 (2012) (37 percent of largest 1,000 firms in each of
France, Germany, and Italy widely held; 74 percent in the UK).
237 See e.g. Fiorella De Fiore and Harald Uhlig, Corporate Debt Structure and the Financial Crisis,
ECB Working Paper No 1759 (2015).
238 European Commission, Action Plan on Building a Capital Market Union, COM(2015) 468
final (2015).
239 In such a milieu, the absence of any governance strategies in bankruptcy law geared towards
the continuation—​as opposed to the closure—​of a distressed firm can actually serve to increase the
chances of a successful workout. The knowledge that the consequences of failing to agree will be highly
destructive can focus creditors’ minds.
143
Ownership Regimes and Creditor Protection
143
the option of a bankruptcy procedure that uses governance strategies to help creditors
take ownership of a firm that continues to operate.240
As we have seen, Chapter 11 of the U.S. Bankruptcy Code gives managers of
distressed companies discretion to orchestrate a court-​supervised turnaround while
remaining at the helm. At the same time, large U.S. firms traditionally raised debt
finance from a wider number of creditors—​relying more on bonds and less on bank
debt—​than was the case in other jurisdictions.241 This corresponded with an environment in which banks were fragmented, and consequently posed no real opposition to
the passage of the “manager-​friendly” bankruptcy code in 1978.242
The UK is at the opposite pole. It has traditionally been very favorable to the
enforcement of individual creditors’ security with almost no judicial involvement, so
much so that until recently a bank holding a security interest covering the entirety
of the debtor’s assets was permitted to control privately the realization of the assets
of the distressed firm.243 This has corresponded to a strong, concentrated, banking
sector, with relatively low use of bonds, as opposed to bank, finance.244 As a consequence, private workouts play a significant role even for large public firms, with the
threat of “tough” bankruptcy proceedings acting as a powerful mechanism for securing compliance from recalcitrant debtors ex ante and creditors unwilling to negotiate
ex post. Bankruptcy has, in this environment, tended to be reserved for more severe
failures—​an outcome reflecting the interests of both the debtor’s institutional owners
and its banks.245 Germany, Italy, and Japan also follow a similar pattern. In France,
bankruptcy proceedings have tended to be used more frequently, corresponding not
with greater bank power, but with greater state involvement.
However, these cross-​country differences in debt structure appear less significant
today in light of the growth in secondary markets for debt finance, which has facilitated disintermediation in European jurisdictions, and concentration—​typically led
by hedge funds—​in the debt of distressed U.S. firms. As a result, differences in the
structure of bankruptcy laws may increasingly come to be explicable by reference to
differences in the functioning of judicial institutions, which limit the extent to which
court oversight can effectively implement the trusteeship strategy to control creditor–​
creditor agency costs in bankruptcy.246
240 See Viral V. Acharya, Rangarajan K. Sundaram, and Kose John, Cross-​Country Variations in
Capital Structures: The Role of Bankruptcy Codes, 20 Journal of Financial Intermediation 25 (2011).
241 See e.g. Jenny Corbett and Tim Jenkinson, How is Investment Financed? A Study of Germany,
Japan, the United Kingdom and the United States, 65 (Suppl.) Manchester School 69, 74–​5,
80–​1, 85 (1997); William R. Emmons and Frank A. Schmid, Corporate Governance and Corporate
Performance, in Corporate Governance and Globalization 59, 78 (Stephen S. Cohen and Gavin
Boyd eds., 1998) (“Simply put, firms in the United States and Canada issue significant amounts of
bonds but nowhere else in the G7 countries is this true”).
242 See Roe, note 131; on banks’ weak opposition to the 1978 Act, see Carruthers and Halliday,
note 229, at 166–​94; David A. Skeel, Jr., Debt’s Dominion 180–​3 (2001).
243 See Armour and Frisby, note 53.
244 See Peter Brierley and Gertjan Vleighe, Corporate Workouts, the London Approach and Financial
Stability, 7 Financial Stability Review 168, 175 (1999).
245 See Stijn Claessens and Leora F. Klapper, Bankruptcy Around the World: Explanations of Its
Relative Use, 7 American Law and Economics Review 253, 262 (2005) (U.S. bankruptcy
rate—​proportion of firms filing for bankruptcy proceedings—​was higher than all our other jurisdictions: U.S. 3.65 percent, France 2.62 percent, UK 1.65 percent, Germany 1.03 percent, Italy
0.54 percent, and Japan 0.22 percent).
246 See e.g. Mehnaz Safavian and Siddharth Sharma, When Do Creditor Rights Work?, 35 Journal
of Comparative Economics 484, 500–​2, 506–​7 (2007); Kenneth Ayotte and Hayong Yun, Matching
Bankruptcy Laws to Legal Environments, 25 Journal of Law, Economics & Organization 2 (2009);
Mark J. Roe and Federico Cenzi Venezze, A Capital Market, Corporate Law Approach to Creditor
Conduct, 112 Michigan Law Review 59 (2013).
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6
Related-​Party Transactions
Luca Enriques, Gerard Hertig, Hideki Kanda,
and Mariana Pargendler
In Chapters 3 and 4, we reviewed the response of company law to agency problems
in the context of the ordinary management of the corporation. Chapter 5 has shown
that all jurisdictions have adopted legal strategies targeting transactions that siphon
off assets to the detriment of creditors. Value diversion is, of course, also a core issue
in the relationship between managers and shareholders and between controlling and
non-​controlling shareholders.
This chapter centers upon a straightforward technique for value diversion: related-​
party transactions. As we use the term, these include both transactions in which related
parties such as directors and controlling shareholders deal with the corporation—​
traditional self-​dealing and managerial compensation—​and transactions in which
related parties may appropriate value belonging to the corporation—​the taking of corporate opportunities and trading in the company’s shares.1
In traditional self-​dealing, the law’s concern is that an influential manager or a controlling shareholder will transact with the company on terms less favorable for the company than could be obtained in an arm’s length negotiation. Self-​dealing typically refers
to purchases or sales of assets, goods, or services by related parties, as when a controlling
shareholder supplies components to the controlled company. But it also refers to other
transactions, such as company guarantees in favor of its parent and transactions with
close relatives of managers or with companies owned by their families. In such cases,
the conflicts of interest are acute. Compensation agreements, while technically a form
of self-​dealing, are unavoidable for companies and thus less suspect. Nevertheless, as
hinted at in Chapter 3, there is an obvious risk of collusion among senior managers and
the board in setting compensation levels. For example, directors might approve excessive compensation because they are richly compensated themselves, or because they fear
losing their seats on the board if they refuse.2 Controlling shareholders, in turn, might
favor overly generous pay packages to themselves (if they occupy managerial positions)
or to professional managers who acquiesce to minority abuse.3
In corporate opportunity cases, related parties take business opportunities that
should have been offered to their companies instead.4 Similarly, when trading in the
1 See Robert C. Clark, Corporate Law 141–​5 (1986). In this chapter, unless otherwise indicated,
we refer to corporate law provisions on “public” or “open” corporations, whether or not listed on an
organized securities exchange.
2 See Lucian Bebchuk and Jesse Fried, Pay Without Performance 25–​7 (2004).
3 See e.g. Jacob Kastiel, Executive Compensation in Controlled Companies, 90 Indiana Law Journal
1131 (2015).
4 A famous example is the personal acquisition of Pepsi-​Cola by the executive of another beverage
company. See Guth v. Loft, Inc., 5 Atlantic Reporter 2d 503 (Delaware Supreme Court 1939).
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry
Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 6
© Luca Enriques, Gerard Hertig, Hideki Kanda, and Mariana Pargendler , 2017. Published 2017 by Oxford University Press.
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Related-Party Transactions
company’s shares on the basis of yet undisclosed price-​sensitive corporate information
(so-​called insider trading), officers, directors, and controlling shareholders appropriate
part of the value of company information by selling or buying before it is reflected in
stock prices.
Related-​party transactions fall under the broader category of “tunneling,”5 which
covers all forms of misappropriation of value (assets, cash flows, or the company’s
equity itself ) by corporate insiders.6 We deal with other, more specialized forms of
tunneling in later chapters, including tunneling associated with significant corporate
actions, such as parent-​subsidiary mergers and freeze-​outs of minority shareholders
(Chapter 7), the extraction of private benefits in connection with control transactions
(Chapter 8), and misappropriation arising from securities fraud other than insider
trading (Chapter 9).
6.1 Why Are Related-​Party Transactions
Permitted at All?
As a threshold matter, we must ask why related-​party transactions are permitted at all,
given their vulnerability to abuse by corporate insiders.
Consider first traditional self-​dealing transactions and the taking of business opportunities. Directors, officers, and controlling shareholders are often the only parties
with whom smaller companies can transact: outsiders may be unable to evaluate their
prospects without facing disproportionate transaction costs or benefiting from the revelation of trade secrets or confidential plans that companies would better keep for
themselves. Similarly, a self-​dealing transaction may be entered into and a corporate
opportunity transferred to an insider on more favorable terms, because the insider may
know the company—​or the profitability of the corporate opportunity—​better than an
unrelated but distrustful party.
Even more intuitively, prohibiting managerial compensation and trading in the
company’s shares would simply be absurd. Just as no one would agree to work for the
corporation for free, managers cannot reasonably be prevented from investing in their
companies, or controlling shareholders from selling their company’s shares.
Equally important, per se prohibitions of related-​party transactions may not accomplish much. They are unlikely to reduce the incentives to engage in one-​shot expropriations of firm assets (“steal-​and-​run transactions”), these being in any event unlawful
under general private or criminal law. They are arguably unnecessary for more modest forms of abusive self-​dealing that may be deterred by civil liability or a credible
threat to the wrongdoer’s continuing employment. Further, unless the legal system
and its enforcement agents can tackle tunneling in all its forms, the prohibition on
related-​party transactions would just push insiders into using other tunneling techniques. Admittedly, the law-on-the-books and in action may be sophisticated enough
to effectively deal with tunneling in all its forms. But then there should be no reason
for using such a raw technique as a prohibition on related-​party transactions to prevent
5 See Simon Johnson, Rafael La Porta, Florencio Lopez-​de-​Silanes, and Andrei Shleifer, Tunneling,
90(2) American Economic Review 22 (2000): the term was “coined originally to characterize the
expropriation of minority shareholders in the Czech Republic (as in removing assets through an
underground tunnel).”
6 See Vladimir Atanasov, Bernard Black, and Conrad S. Ciccotello, Law and Tunneling, 37
Journal of Corporation Law 1 (2011).
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147
corporate theft.7 This explains why jurisdictions permit related-​party transactions even
when conflicts of interests are especially acute because of the dispersion of shareholder
ownership or the use of control-​enhancing mechanisms, such as pyramids and dual
class shares.8
6.2 Legal Strategies for Related-​Party Transactions
All jurisdictions, however, subject related-​party transactions to legal constraints.9 Corporate
laws resort to a wide range of legal strategies to constrain related-​party transactions, and
more precisely to four of the five sets of legal strategies described in Chapter 2: affiliation
terms (mandatory disclosure and dissolution rights), agent incentives (trusteeship in particular), decision rights (shareholder approval), as well as agent constraints (rules and standards). Appointment rights are not used directly to tackle such transactions, but they can
constrain them indirectly: shareholders are less likely to reappoint (and, where possible, also
more likely to remove) directors who have approved abusive related-​party transactions.10
6.2.1 The affiliation strategy
6.2.1.1 Mandatory disclosure
Mandatory disclosure that alerts shareholders and the market to related-​party transactions is
an intuitively effective control against expropriation by managers or controlling shareholders. The strategy enlists capital and labor markets as well as financial analysts and the media in
deterring suspect transactions with the threat of lower share prices, dismissal, and the risk of
reputational harm. It also supports internal decision-​makers’ independence, as they will act
more assertively if they know the related-​party transaction they may approve will be subject
to public scrutiny. Further, it facilitates private and public enforcement against the extraction of private benefits: compliance with the disclosure requirement conveys information
about suspect transactions to enforcement actors, while failure to disclose is easier to punish
than actual abuse, given that no proof of harm has to be given.11 Finally, mandatory disclosure imposes no substantive or procedural constraint on legitimate self-​dealing, compensation contracts, or trading in shares, although one can think of situations in which beneficial
related-​party transactions would only be entered into if they could be kept confidential.
At the same time, mandatory disclosure may lead to over-​enforcement: enforcement actors will be more likely to challenge even legitimate related-​party transactions,
either because they believe in good faith that they are harmful to the corporation or to
obtain a lucrative settlement, relying on the fact that courts may well err in judging a
transaction’s legality.12
7 See Luca Enriques, Related Party Transactions: Policy Options and Real-​World Challenges (with a
Critique of the European Commission Proposal), 16 European Business Organization Law Review
1, 14 (2015).
8 See Chapter 4.1.1.
9 See Zohar Goshen, The Efficiency of Controlling Corporate Self-​Dealing: Theory Meets Reality, 91
California Law Review 393 (2003).
10 For instance, shareholders dissatisfied with executive compensation decisions often withhold
support from members of compensation committees.
11 See e.g. Bernard S. Black, The Core Fiduciary Duties of Outside Directors, 2001 Asia Business
Law Review 3, 10.
12 Mandatory disclosure can also prove costly for other reasons, for example if it makes competitors aware of strategic changes or forces firms to set up information collection systems that are
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While all of our jurisdictions require public disclosure of self-​dealing transactions,
managerial compensation, and trading in the company’s shares, the regulatory intensity varies.
Let us start with self-​dealing. U.S. securities law imposes disclosure duties to all
companies, U.S. and (to some extent) foreign, that trade in the public market.13 These
companies must report annually all transactions that exceed U.S. $120,000 in value
and in which directors, executive officers, or a large shareholder have a “material interest.”14 U.S. Generally Accepted Accounting Principles (“‘U.S.-​GAAP”) complement
this requirement by imposing annual disclosure of all “material” transactions between
the company and its officers, directors, or controlling shareholders.15
EU requirements, as distinct from the law of member states, used to be much less
demanding. In the last fifteen years, however, the EU has made significant steps in
the direction of greater disclosure of related-​party transactions. Under International
Financial Reporting Standards (IFRS),16 EU listed companies have to disclose annually any transaction with directors, senior executives, and controlling shareholders.17
Similarly to the U.S., however, non-​“material” transactions can be omitted.18 In addition, similar transactions can be disclosed in aggregate form.19 Other EU accounting
law provisions complement these disclosure mandates by requiring that member states,
at a minimum, require companies (other than smaller ones) to reveal all material related-​
party transactions that have not been concluded under “normal” market conditions.20
Some member states impose further disclosure requirements. Single firm
accounting standards are converging towards IFRS in many of them.21 In addition,
UK listed companies must circulate a form (circular) prior to entering into material
related-​party transactions.22 Italy, like Brazil,23 requires listed firms to disclose large
related-​party transactions within seven days.24
disproportionate to their size. All jurisdictions tackle the issue by limiting the addressees and scope of
disclosure requirements. For a general discussion, see Chapter 9.1.2.4.
13 See Chapter 9.1.2.4.
14 SEC Regulation S-​K, Item 404 (applying more precisely to any shareholder with more than
5 percent of any class of the voting securities).
15 See Statement of Financial Accounting Standards (SFAS) 57, Related Party Disclosure.
16 Regulation 1606/​2002 on the Application of International Accounting Standards, 2002 O.J.
(L 243) 1.
17 See International Accounting Standard (IAS) 24 (part of the International Financial Reporting
Standards). Art. 5(4) Transparency Directive (Directive 2004/​109/​EC, 2004 O.J. (L 390) 38) provides for half-​yearly disclosure of “major related parties transactions.”
18 See IAS 1, para. 31 (“An entity need not provide a specific disclosure required by an IFRS if the
information is not material”).
19 IAS 24, para. 24.
20 Arts. 17(1)(r) and 28 Directive 2013/​34/​EU, 2013 O.J. (L 182) 19. It is up to member states to
decide whether disclosure can be limited to transactions that have not been concluded under “normal”
market conditions. The materiality principle is spelled out generally in Art. 6(1)(j). Smaller companies
are those that do not satisfy at least two of the following criteria: (1) balance-​sheet total: €4 million,
(2) annual net turnover: €8 million, or (3) 50 employees on average during the financial year. See Art.
3 Directive 2013/​34/​EU.
21 See European Commission, Report on the Operation of IAS Regulation 1606/​2002
COM (2008) 215 Final (2008), at www.ec.europa.eu.
22 See Listing Rules, section 11.1.7 (non-​routine transactions, other than smaller ones, by listed
firms); §§ 188–​226 Companies Act 2006 (various property, credit, and compensation transactions).
23 CVM Instruction No. 480 (2009) (Brazil). Brazilian listed companies must also comply
with IFRS and, like Italian ones, disclose their policies and practices to ensure the fairness of such
transactions.
24 See Art. 5 Commissione Nazionale per le Società e la Borsa (Consob) Regulation on Related
Party Transactions (large transactions, by listed firms) (Italy). In the version approved by the European
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149
By contrast, Germany has remained lenient towards controlling shareholders. While
the Corporate Governance Code recommends that listed companies inform the annual
meeting about any conflict of interests that arose within the supervisory board,25
statutory corporate law goes little further than the EU requires even in the context
of corpor­ate groups: while parent companies must disclose the share of their profits
and losses that is attributable to their subsidiaries taken as a whole,26 Konzernrecht
limits the information rights of minority shareholders in these subsidiaries to an
audited summary of the legally required annual report on intra-​group transactions
(Abhängigkeitsbericht).27 In Japan, all companies are required to disclose details of their
transactions with directors, officers, or third parties acting on their behest.28 Japanese
accounting regulations complement these disclosure mandates by requiring companies
to list material transactions with controlling shareholders.29
Jurisdictions have also broadly converged in requiring disclosure of individual managers’ compensation. In the U.S., companies traded on a public market must disclose
all compensation paid to the CEO, the CFO, and the three other most highly compensated executives.30
European Union rules are more lenient, because IFRS impose annual disclosure of
aggregate compensation to directors and key managers of listed companies.31 Individual
member states, however, go beyond EU requirements. In accord with European
Commission recommendations, all major member states mandate that listed companies
disclose individual directors’ compensation,32 and even in continental European jurisdictions remuneration disclosure practices are closing the gap with traditionally more
detailed U.S. and UK ones.33 Japan has recently reformed its laws to impose individualized reporting of executive compensation for the first time, though the requirement is
Parliament on 8 July 2015, proposed Art. 9c of the Shareholders Rights Directive, as envisaged by
the Proposed Directive amending Directive 2007/​36/​EC as regards the encouragement of long-​term
shareholder engagement, Directive 2013/​34/​EU as regards certain elements of the corporate governance statement and Directive 2004/​109/​EC (hereinafter, the Proposed Directive), would similarly
impose ad hoc disclosure of larger related-​party transactions.
25 See section 5.5.3 Corporate Governance Code. Likewise, the management board has to inform
the supervisory board about its own conflicts of interest. See section 4.3.4, ibid.
26 § 307(2) Handelsgesetzbuch (HGB).
27 § 312(1) and (3) Aktiengesetz (AktG). The annual report mentioned in the text, itself not available to shareholders or the public, has to comprise all of the intra-​group transactions and is subject to
the company auditor’s control. See also Chapter 5.2.1.3.
28 Art. 118(v) Ministerial Ordinance for the Enforcement of the Companies Act, Arts. 98(1)(xv)
and 112 Ministerial Ordinance for the Accounting of Companies.
29 Accounting Standards Board of Japan (ASBJ), Disclosure of Related Party Transactions (17
October 2006) (applicable to reporting companies under the Financial Instruments and Exchange
Act.) Regarding voluntary compliance with U.S. GAAP by closely held corporations, see Chapter
5.2.1.1.
30 SEC Regulation S-​K, Item 402. Recent reforms have also extended the scope of mandatory
disclosure to encompass the role of compensation consultants and their potential conflicts of interest.
SEC Regulation S-​K, Item 407.
31 See IAS 24.
32 See Commission Recommendation fostering an appropriate regime for the remuneration of
directors of listed companies, 2004 O.J. (L 385) 55, and Commission Recommendation complementing Recommendations 2004/​913/​EC and 2005/​162/​EC as regards the regime for the remuneration of directors of listed companies, 2009 O.J. (L 120) 28 (EU); Art. L. 225-​102-​1 Code de
commerce (France); § 285 No. 9 Handelsgesetzbuch (HGB) (Germany) (aggregate disclosure for all
public companies, and individual disclosure for listed companies); Annex 3A, Schedule 7-​2 Consob
Regulation on Issuers (Italy); sections 420–​1 Companies Act 2006 (UK).
33 See Roberto Barontini et al., Directors Remunerations Before and After the Crisis: Measuring the
Impact of reforms in Europe, in Board and Shareholders in European Listed Companies 251,
276–​9 (Massimo Belcredi and Guido Ferrarini eds., 2013).
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limited to executives earning ¥100 million or more a year.34 This figure is sufficiently
low as to be unlikely to work as an indirect cap, but it is of course likely to induce some
clustering of compensation packages just below the disclosure threshold.35 Brazilian law,
by contrast, is less rigorous: it requires disclosure of aggregate compensation and more
recently also the minimum, maximum, and average compensation amounts paid in
each governance body, though some executives have challenged the latter mandate as an
unconstitutional violation of their fundamental right to privacy and personal security.36
Individualized compensation disclosure may actually have unintended consequences.
Because prospective CEOs insist on being paid “above average” and boards find it difficult
to justify the appointment of a “below average” CEO, such disclosure may lead to an
increase of executive pay across the board.37
Finally, some convergence can also be observed in the area of disclosure of trading in
the company’s shares, especially by managers and directors, a measure which may curb
insider trading. The U.S., Italy, and Japan require officers, directors, and large shareholders
(typically above 10 percent) of a listed company to disclose transactions in the company’s
shares.38 Similarly, under EU and Brazilian law, listed companies’ directors and senior
executives are required to disclose their transactions in company shares, but shareholders
must disclose such transactions only when they cross thresholds typically ranging from
5 percent to 75 percent of voting rights, which makes this a blunt tool to curb insider
trading.39 There has thus been substantial convergence in the treatment of related-​party
transactions in listed companies and that trend is likely to continue in coming years. Many
jurisdictions are subjecting their major firms to IFRS and regulators everywhere are tightening their supervision of the reporting of insider trades. Even more importantly, auditors
around the world are tightening their scrutiny of transactions that may reflect asset diversion or profit manipulation.
To begin with, the International Standards on Auditing, a set of non-​binding principles on how to conduct audits issued by the International Federation of Accountants,
require auditors to pay special attention to related-​party transactions.40 In addition, many jurisdictions have adopted statutory provisions that strengthen precisely
this mandate.41 And the growing use of firm-​wide auditing standards by Big Four
34 Cabinet Office Ordinance on Disclosure of Corporate Affairs, Form 2 (Precautions for
Recording (57)d) and Form 3 (Precautions for Recording (37)).
35 See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive
Compensation: Evidence from Japan, Columbia Business Law Review 111, 156 (2014).
36 Most companies have however complied with these regulations. See Mariana Pargendler,
Corporate Governance in Emerging Markets, in Oxford Handbook of Corporate Law and
Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017).
37 For a theoretical model, see Rachel M. Hayes and Scott Schaefer, CEO Pay and the Lake Wobegon
Effect, 94 Journal of Financial Economics 280 (2009).
38 § 16(a) 1934 Securities Exchange Act (U.S.); Art. 114(7) Consolidated Act on Financial
Intermediation (Italy); Art. 163 Financial Instruments and Exchange Act (Japan).
39 In the EU, see, for managers, Art. 19 Market Abuse Regulation 596/​2014, 2014 O.J. (L 173) 1;
for shareholders, Art. 9 Transparency Directive 2004/​109/​EC (the acquisition and disposal of voting
rights must be disclosed at the 5 percent, 10 percent, 20 percent, 25 percent, 30 percent or 1/​3, 50 percent and 2/​3, or 75 percent thresholds); Arts. 116-​A, 157, § 6º, and Art. 165-​A Lei das Sociedades
por Ações; Arts. 11 and 12 CVM Instruction No. 358 (2002) (Brazil) (requiring disclosure of trades
by shareholders only when they cross thresholds of 5 percent, 10 percent, 15 percent, etc. of any given
class of shares).
40 See International Standard on Auditing 550.
41 Art. 149-​50 Consolidated Act on Financial Intermediation; Art. 2391-​II Civil Code (Italy);
§ 313 AktG (Germany; and see also Section 5.2.1.3); Art. L. 225-​40 Code de commerce (France);
Art. 193-​2(1) Financial Instruments and Exchange Act (Japan); Section 10A Securities Exchange Act.
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151
accounting firms magnifies the significance of this increased focus across jurisdictions.
However, the effective impact of these developments remains an open question in
jurisdictions where audit fees or auditor liability risks are comparatively low and in
firms that have controlling shareholders.42
When it comes to ex post enforcement, the machinery is still much more effective in
the U.S. than elsewhere. A failure to disclose related-​party transactions, if detected, can
give rise to SEC enforcement actions, criminal prosecution, and, occasionally, a private
securities fraud class action on behalf of shareholders.
Outside the U.S., the use of securities fraud provisions to attack related-​party transactions has thus far been much less common. Listed companies can opt into the more
severe U.S. disclosure system by cross-​listing their shares in a U.S. stock market, thus
bonding to more stringent securities laws.43 Nevertheless, the limited extraterritor­
ial effects of U.S. securities laws mean that investors who acquire shares of cross-​
listed firms outside of the U.S. may be left without a remedy in case of disclosure
violations.44
The law on the books and in action is less comparable for non-​listed companies.
While U.S. law does not impose mandatory disclosure requirements on non-​public
companies, they tend to reveal related-​party transactions through voluntary compliance with U.S. GAAP.45 In Europe, Brazil, and Japan, on the other hand, it is difficult
to tell whether larger non-​listed firms disclose material self-​dealing transactions and
unclear whether smaller firms voluntarily reveal such information, especially in countries with a single set of accounts for corporate and tax law purposes.46
As an aid to private enforcement against abusive related-​party transactions, targeted
disclosure is sometimes available to shareholders suspicious of a given transaction.
European jurisdictions allow minority shareholders to file a request for the designation of a business expert or special auditor to investigate specific transactions, often
self-​dealing ones.47 These court-​appointed experts are a means for shareholders to
obtain information needed to challenge unfair self-​dealing. This can prove especially
important in the absence of U.S.-​style discovery mechanisms, which makes it harder
for plaintiffs to obtain evidence on insiders’ wrongdoings. But while this information-​
gathering mechanism is of increasing importance in France and Germany, it seems less
effective elsewhere.48 On the other hand, U.S. law not only is favorable to plaintiffs
42 See Yasuyuki Fuchita, Financial Gatekeepers in Japan, in Financial Gatekeepers, Can they
Protect Investors? 13, 23–​9 (Yasuyuki Fuchita and Robert E. Litan eds., 2006); John C. Coffee Jr.,
Gatekeepers: The Professions and Corporate Governance 89–​93 (2006).
43 For a review of the literature on dual listing and the “bonding hypothesis,” see Olga Dodd, Why
Do Firms Cross-​list Their Shares on Foreign Exchanges? A Review of Cross-​Listing Theories and Empirical
Evidence, 5 Review of Behavioral Finance 77 (2013).
44 See Érica Gorga, The Impact of the Financial Crisis on Nonfinancial Firms: The Case of
Brazilian Corporations and the “Double Circularity” Problem in Transnational Securities Litigation, 16
Theoretical Inquiries in Law 131 (2015). After the U.S. Supreme Court decision in Morrison
v. National Australia Bank, 561 United States Reports 247 (2010), which denies extraterritorial
effects to U.S. securities regulations, only investors purchasing securities in the U.S. are able to recover
from such violations, thus leading to unequal treatment vis-​à-​vis domestic investors.
45 See American Institute of Certified Public Accountants, Private Company Financial Reporting
Task Force Report 8 (2005) (many private companies prepare their financial statements in accordance
with U.S. GAAP).
46 See Chapter 5.2.1.1.
47 See e.g. § 142 AktG (Germany).
48 See, for France, Maurice Cozian et al., Droit des sociétés 249 (28th edn., 2015) (high number of petitions to designate an expert de gestion); for Germany, Gerald Spindler, in Aktiengesetz
Kommentar (Karsten Schmidt and Marcus Lutter eds., 3rd edn., 2015) § 142 para 7 (same).
Compare, for the UK, Paul L. Davies and Sarah Worthington, Gower and Davies Principles of
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with its discovery rules, but also grants shareholders the right to inspect a company’s
books and records, provided they prove “a proper purpose.”49 Japanese law grants
both of these rights (designation of special auditor and inspection of company’s books
and records) to shareholders holding 3 percent or more of shares or voting rights.50
Brazilian law is similar (though more restrictive): shareholders holding 5 percent of
total capital may sue to request access to the company’s books and records but only by
pointing to wrongdoing or “justified suspicion of serious violations.”51
6.2.1.2 Dissolution and exit rights
Voting power and influence over management make it possible for those in control
to appropriate corporate profits, for example, in the form of salaries for the members
of the controlling family. When such practices take the form of egregious abuse and
occur systematically, most of our major jurisdictions give the minority a right to force
a corporate dissolution.52 This exit strategy, however, is limited to closely held companies and, even in that context, actual dissolution is rare: courts tend to protect the
going-​concern value of companies by encouraging or requiring their controllers to buy
out minority shareholders.53 Brazil has relied on the exit strategy the most, as courts
have recently permitted minority shareholders in closely held corporations to compel
a partial dissolution (effectively forcing the company to buy out their shares) without
the need to prove the existence of abuse—​possibly as a response to the procedural and
evidentiary hurdles generally plaguing plaintiffs.54
In practice, then, minority shareholders in closely held corporations typically get a
kind of put option, conditional upon serious oppression: they can exercise a contractual or equitable right to sell their shares to the controller or the company. Exercise
of this right normally involves litigation to determine the share price for the buy-​out.
Because litigation involving valuation issues is costly, the dissolution right is mainly
a negotiating tool in situations of minority “oppression,” thus discouraging extreme
forms of abuse ex ante.
Modern Corporate Law 673 (9th edn., 2012); for Italy, Luca Enriques, Scelte Pubbliche e Interessi
Particolari nella Riforma del Diritto Societario, 2005 Mercato Concorrenza Regole 145, 170 (the
2003 corporate law reform emasculated a similar protection tool). For a comparative law discussion,
see Forum Europaeum Corporate Group Law, Corporate Group Law for Europe, 1 European Business
Organization Law Review 165, 207–​17 (2000).
49 Delaware GCL § 220; for more details, see William T. Allen, Reinier Kraakman, and Guhan
Subramanian, Commentaries and Cases on the Law of Business Organization 167–​8 (4th edn.,
2012).
50 Arts. 358 and 433 Companies Act (Japan).
51 Art. 105 Lei das Sociedades por Ações.
52 Art. 1844-​7 Code Civil (France); § 61 GmbH-​Gesetz (shareholders with 10 percent of the
shares can seek dissolution) (Germany); Art. 833 Companies Act (10 percent shareholder can seek dissolution before the court) (Japan); section 122(1)(g) Insolvency Act 1986 (UK); § 14.30(2) RMBCA;
§ 40 Model Statutory Close Corporation Supplement (U.S.). No such right exists under Italian law.
53 See, for France, Cozian et al., note 48, at 274–​5 (courts do not grant dissolution lightly);
for Germany, Detlef Kleindiek, § 61 No. 8, in GmbH-​Gesetz Kommentar (Walter Bayer, Peter
Hommelhoff, Detlef Kleindiek, and Marcus Lutter eds., 19th edn. 2016) (dissolution will only be
granted in exceptional circumstances); for the UK, Davies and Worthington, note 48, at 744–​6 (the
unfair prejudice remedy has crowded out winding-​up petitions).
54 The mere allegation of a breach of affectio societatis (the will to be part of a common organization) seems to suffice. See e.g. STJ, ERESP 419.174-​SP (2008). Brazil’s new Code of Civil Procedure
now specifically provides that 5 percent shareholders may request the partial dissolution of a close
corporation by demonstrating that the company cannot fulfill its purpose. Art. 599 § 2º Lei 13.105
of 2015.
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6.2.2 Agent incentives strategies
Asset diversion is constrained everywhere through reward strategies. Minority shareholders are generally protected against discriminatory cash dividends through the pro
rata rule, as we have seen in Chapter 4.55 In some European countries, minority shareholders are also protected by creditor-​oriented provisions on concealed distributions.
In Germany and the UK, “undervalue transactions” between the corporation and its
controlling shareholder can be characterized by courts as “disguised” or “hidden” and,
therefore, unlawful distributions,56 but rarely are such cases litigated outside bankruptcy. Most jurisdictions, however, enlist the board to review at least some conflicted
transactions, which we can categorize as a trusteeship strategy at least wherever boards
are independent or the law disqualifies non-​independent directors from deciding on
the transaction.
6.2.2.1 Letting the board decide
One way to screen related-​party transactions is to require internal decision-​makers
with no interest in the matter, or even better, independent from the related party, to
approve the transaction. Most commonly, this means requiring the board to resolve on
the transaction without the vote of the interested party. A variation on this theme is to
reserve the matter to a subset of disinterested directors, the independent ones.
Requiring or encouraging disinterested (or independent) director approval of conflicted transactions has several virtues: first, compliance is (relatively) cheap; second,
fair, value-​increasing transactions will likely be approved and thereby, in some jurisdictions, insulated from outside attack;57 third, disinterested directors may well raise
questions at least about suspect related-​party transactions.
The major costs of a board approval requirement are just the inverse of its virtues.
Disinterested and even independent directors may not be the loyal trustees that the law
contemplates. For the most part, they are selected with the (interested) consent of top
executive officers, controlling shareholders, or both. If they are unlikely to block fair
transactions, they may also be unlikely or unable to object to unfair ones, especially at
the margin.
The involvement of boards in the approval of related-​party transactions can come
in many shapes. In increasing order of prophylactic potential, jurisdictions may, first
of all, require that the board to be informed about related-​party transactions58—​
which amounts to implicitly subjecting them to a weak form of board authorization or ratification. Second, they may require or strongly encourage explicit board
approval of at least some related-​party transactions. Third, they may require board
approval and require the related party, its affiliates or more generally interested directors to abstain from voting. Finally, it may grant a veto power or exclusive decision-​
making power to independent directors or a committee exclusively only comprised
of them.
55 See Chapter 4.1.3.2.
56 See Holger Fleischer, Disguised Distributions and Capital Maintenance in European Company
Law, in Legal Capital in Europe 94 (Marcus Lutter ed., 2006).
57 See Robert B. Thompson and Randall S. Thomas, The Public and Private Faces of Derivative Law
Suits, 57 Vanderbilt Law Review 1747, 1787 (2004).
58 See Corporate Governance Code § 4.3.4 (Germany); Art. 2391 Civil Code (Italy); section 177
Companies Act 2006 (UK).
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Whether explicitly or implicitly, all jurisdictions impose, or strongly encourage,
some form of board approval of at least some self-​dealing transactions.59 For instance,
under UK law, listed companies’ boards de facto approve all related-​party transactions
that have to be submitted to a shareholder vote,60 but for non-​listed companies such
approval is limited to a subset of them, namely substantial property transactions and
credit transactions with directors.61 By contrast, French and Japanese laws mandate
disinterested board authorization for all non-​routine transactions between a company
and its directors, general managers or, in the case of France, major shareholders.62
In Italy, in turn, additional rules applying to listed companies heavily rely on independent directors. They require that a committee of independent directors provides its own
advice on the related-​party transaction, which the board then has to vote on: the advice
is non-​binding for smaller transactions and binding for larger ones, unless the required
company’s own internal code on such transactions provides that approval by disinterested
shareholders is sufficient in the event of independent directors’ negative advice.63
Finally, in the absence of company law requirements, the Brazilian Securities
Commission has promoted the use of the trusteeship strategy by suggesting that the
approval by an independent special committee will serve as evidence of discharge of
managers’ fiduciary duties in the context of a parent-​subsidiary merger.64 Similarly,
the best practice of obtaining approval by an independent special committee is also
gaining ground in Japan in the context of freeze-​out and M&A transactions involving
controlling shareholders.65
Although U.S. jurisdictions stop short of mandating board approval of managerial
self-​dealing, they strongly encourage it. State law creates incentives for interested managers to seek board approval by according transactions that are authorized (or ratified)
by the board business judgment rule protection.66 Board approval also plays a crucial
59 Italian law mandates board approval merely for self-​dealing transactions in which directors otherwise having the authority to decide on them are self-​interested. Art. 2391 Civil Code. German
requirements mainly apply to lending to, and significant services provided by, supervisory board
members—​and German courts have been very strict in policing remunerated legal and management
services and advice to the company by supervisory board members. See §§ 89, 114–​15 AktG; BGH,
decision of 10 July 2012—​II ZR 48/​11 (Fresenius), NJW 2012, 3235. German law also imposes company representation by a member of the supervisory board for company transactions with members
of the management board (§ 112 AktG). Finally, Germany’s Corporate Governance Code (§ 4.3.3)
recommends supervisory board approval for transactions with members of the management board and
for “important” transactions with persons they are close to. Brazilian law only requires board approval
(as an alternative to shareholder approval) for corporate loans to directors and officers, and for the use
of company assets or services. Art. 154, § 2°, b Lei das Sociedades por Ações.
60 See Chapter 6.2.3.
61 See sections 188–​226 Companies Act 2006 (also covering payments for loss of office and longterm service contracts).
62 For France, see Arts. L. 225-​38 (one-​tier board) and L. 225-​86 (two-​tier board) Code de commerce (also applicable to third parties acting for directors or general managers) and Arts. L. 225-​39
and L. 225-​86 Code de commerce (exempting routine transactions). However, as a matter of practice, transactions between companies of the same group are often deemed to be routine ones. See
Dominique Schmidt, Les conflits d’intérêts dans la société anonyme 120 (2nd edn., 2004). For
Japan, see Arts. 356(1)(ii)(iii) and 365(1) Companies Act (all transactions with directors personally;
no statutory exemption for routine ones). Japanese courts also require board approval for transactions
between companies with interlocking directors. See e.g. Supreme Court of Japan, 23 December 1971,
656 Hanrei Jiho 85.
63 Arts. 7–​8 Consob Regulation on Related Party Transactions.
64 CVM Advisory Opinion No. 35 (2008).
65 See Chapter 7.4.1.2.
66 See § 8.31 Model Business Corporation Act; Flieger v. Lawrence, 361 Atlantic Reporter
2d 218 (Delaware Supreme Court 1976); Kahn v. Lynch Communications Systems, Incorporated, 638
Atlantic Reporter 2d 1110 (Delaware Supreme Court 1994).
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155
role for transactions with controlling shareholders, which are usually subject to the
stringent “entire fairness” standard. As an incentive for independent director approval,
Delaware law shifts the burden of proof to the party challenging a transaction with a
controlling shareholder when the board vests the task of negotiating the transaction
in a committee of substantively independent directors and gives them the necessary
resources (like access to independent legal and financial advice) to accomplish their
task.67 But while this may be de facto necessary to pass the “entire fairness” test applied
by Delaware courts,68 it may not be sufficient, as Delaware courts tend to look at a wider
range of facts.69 In the context of going-​private mergers with controlling shareholders,
recent case law appears to have strengthened Delaware law’s reliance on a combination
of the trusteeship and decision rights strategies, by affording business judgment rule
protection to transactions that are approved both by an independent and well-​functioning special committee of the board and by a majority of minority shareholders.70
It is, however, too early to tell whether companies will often take advantage of this safe
harbor, given the risks of obtaining majority of the minority approval in the presence
of activist hedge funds that may well coalesce to veto the transaction.
Most major jurisdictions nowadays require boards of listed companies to approve
the compensation of top executive officers.71 As the level of executive compensation
has soared, regulatory reforms and investor pressure have prompted listed companies
to adopt implementation measures, such as assigning compensation decisions to specialized committees on the board staffed entirely by independent directors—​a trend
that has been reinforced by post-​Enron and post-​financial crisis reforms.72 In the U.S.,
compensation committees of listed companies now must be fully independent and
have the authority to retain their own consultants, counsel, and other advisers.73 At the
same time, judges tend to defer to boards’ decision-​making on compensation matters
even more than for other related-​party transactions. Board approval of executive compensation is unlikely to be successfully questioned in the U.S., which otherwise strictly
67 See Allen et al., note 49, at 323; Kahn v. Lynch Communications Systems, note 66; Weinberger
v. UOP, Inc., 457 Atlantic Reporter 2d 701 (Delaware Supreme Court 1983).
68 See Chapter 6.2.5.2.
69 On the intricacies of Delaware case law on procedural fairness in parent-​subsidiary transactions,
see William J. Carney and George B. Shepherd, The Mystery of Delaware Law’s Continuing Success,
2009 University of Illinois Law Review 1.
70 Kahn v. M & F Worldwide Corp., 88 Atlantic Reporter 3d 635 (Delaware Supreme Court 2014).
71 See § 8.11 Model Business Corporation Act (U.S.); § 87 AktG (Germany); Art. 2389(3)
Civil Code (Italy); Art. 361(1) Companies Act (in Japanese companies with statutory auditors,
approval of the shareholders’ meeting is required for aggregate amount payable to all directors, and
the board is allowed to decide compensation for each director within that limit) and Art. 404(3)
Companies Act (in “committee” companies, the compensation committee decides the individual
amount of compensation for each director and officer) (Japan). In the UK, board approval is a
default rule (see § 84 Table A, Companies Regulations 1985, as amended), but it is unusual for
firms to opt out of it, both for historical reasons (the alternative used to be shareholder approval)
and, for listed firms, because the Combined Code recommends approval by a remuneration committee on a comply or explain basis (B.2.2). In France, shareholders determine the global amount
of director remuneration, which the board then divides among the directors. Arts. L. 225-​45, L.
225-​46, L. 225-​63, L. 225-​83, and L. 225-​84 Code de commerce (France). Brazil is again distinctive in this regard, as its shareholder-​centric model of corporate governance has long attributed the
determination of aggregate executive compensation to shareholders. Art. 152 Lei das Sociedades
por Ações.
72 For an overview of recent developments and proposed regulations in this area, see Guido
Ferrarini and Maria Cristina Ungureanu, Executive Remuneration: A Comparative Overview, in
Oxford Handbook of Corporate Law and Governance, note 36.
73 See Chapter 3.3.
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polices related-​party transactions.74 And even in Germany, where there is evidence of a
more aggressive judicial approach towards compensation, courts are unlikely to question board approval unless there is gross inadequacy between compensation levels and
job characteristics.75 Things may change following a recent reform imposing liability
on supervisory board members for setting “unreasonable” compensation, that is, that
exceeds “usual compensation” without special reasons or does not promote a listed
company’s “sustainable development.”76
Finally, jurisdictions increasingly encourage their managers to obtain board approval
prior to the exploitation of information that could be of use to their corporation. In
the U.S., the UK, and Japan directors who exploit a “corporate opportunity” to their
personal advantage are deemed to have acted fairly only if they properly disclosed the
business prospect to disinterested directors and took it with their approval.77 Virtually
the same doctrine has also gained acceptance in Germany (under the rubric of the
Geschäftschancen doctrine), Italy, Brazil, and even (as a possible abus de biens/​pouvoirs
sociaux or violation of the duty of loyalty) in France.78
6.2.3 The decision rights strategy: Shareholder voting
As an alternative or complement to disinterested board approval of related-​party transactions, jurisdictions may require or encourage shareholder approval. Shareholders,
after all, are the parties who lose from managerial or controlling shareholder opportunism. Outside directors are (at best) disinterested, while shareholders are affirmatively
interested in preserving corporate value. It might therefore appear that the shareholders’
meeting should screen conflicted transactions. But, of course, this reasoning runs counter to the logic of delegated management which characterizes the corporate form.79
No jurisdiction mandates across-​the-​board shareholder approval for related-​party
transactions, not even with controlling shareholders. This is because doing so might
be excessively cumbersome, especially for companies that are integrated into groups,
where such transactions can be very frequent. Further, either the self-​interested shareholder (the controlling one, when one exists) is allowed to vote or a majority of the
minority shareholders is needed to pass the resolution. In the former case, the outcome
is a foregone conclusion and the requirement serves mainly an informative function. In
the latter case, as policymakers in some jurisdictions fear, the decision will be made by
a minority that may well lack information or hold out opportunistically.
74 However, Delaware courts may apply the more onerous “entire fairness” test when directors
approve their own compensation, unless shareholders have properly ratified the decision. Calma v.
Templeton, 114 Atlantic Reporter 3d 563 (Del. Ch. 2015). See also Chapter 3.3.2 for an account
of the deployment of the business judgment rule in the Disney case.
75 § 87 AktG (supervisory board approval for compensation of executives that are members of the
Vorstand). See also Chapter 3.3.2 for an account of the (quite unusual) Mannesmann case.
76 § 87 AktG. See also Klaus. J. Hopt, Conflict of Interest Secrecy and Insider Information of
Directors—​A Comparative Analysis, 10 European Company and Financial Law Review 167, 181
(2013) (noting that the reform is plagued by “many doctrinal and practical difficulties”).
77 See e.g. Allen et al., note 49, at 315. See also section 175 Companies Act 2006 (UK) and Arts.
356(1)(i) and 365(1) Companies Act (Japan).
78 See, for Germany, Thomas E. Abeltshauser, Leitungshaftung im Kapitalgesellschaftsrecht
373 (1998); Art. 2391(5) Civil Code (Italy); Art. 155 Lei das Sociedades por Ações (Brazil); for
France, see Cozian et al., note 48, at 164, 186, and 373 (causing the loss of a profit opportunity is
potentially abusive).
79 See Chapter 1.2.4.
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157
“Majority of the minority” shareholder approval is a well-​established institution in the
U.S. and UK,80 two jurisdictions in which large companies typically lack a controlling shareholder, but is much less developed in continental Europe, where controlling shareholders
have significant voting (and lobbying) power. It is, however, gaining ground in Japan with
respect to freeze-​out and M&A transactions with controlling shareholders, as a result of
Delaware influence.81 In Brazil, the question of whether a conflicted controlling shareholder
can vote to approve a related-​party transaction is controversial and remains unsettled.82
Convergence among our jurisdictions in the use of decision rights is greater when it
comes to executive compensation. All of our jurisdictions require listed firms to submit
some forms of executive compensation to shareholder approval.83 All jurisdictions also grant
shareholders a binding (in the UK, Japan, and Brazil) or advisory vote on executive compensation packages (a regime known as “say on pay”).84 Moreover, U.S. stock exchanges
require a shareholder vote on all equity compensation plans whereas some states mandate
shareholder approval of stock option plans.85 In the EU, most member states have adopted
rules on prior shareholder approval of share-​based incentive schemes (Germany, Italy, and
the UK being the most demanding by mandating such a vote without limitations).86
Beyond the realm of executive compensation, the UK, followed by France, appears
to be most inclined to give shareholders a say on related-​party transactions. The UK
mandates ex ante shareholder approval for large non-​routine transactions with directors and large shareholders of listed companies.87 If controlled companies that have a
premium listing fail to comply with the terms of the required “relationship agreement”
with its controlling shareholders, ex ante approval by minority shareholders will be
required for any transaction with the controlling shareholder.88 For other companies,
the Companies Act requires shareholder approval of some transactions with directors, in particular substantial property transactions and credit transactions.89 French
80 On Delaware law see e.g. Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and
Some of the New Challenges We (and Europe) Face, 30 Delaware Journal of Corporate Law 673,
678 (2005).
81 See Mori, Hamada, and Matsumoto, M&A-​ho Taikei [Comprehensive Analysis of M&A
Laws of Japan] 761–​6 (2015) (in Japanese).
82 The controversy centers on the interpretation of Art. 115 Lei das Sociedades por Ações. It is
however uncontroversial that controlling shareholders can vote to approve parent-​subsidiary mergers.
Art. 264 Lei das Sociedades por Ações.
83 See §§ 113 and 120(4) AktG (Germany); Arts. L 225-​45, L. 225-​53, L. 225-​63, and L. 225-​
83 Code de commerce (France); Arts. 2389 Civil Code and 114–​II Consolidated Act on Financial
Intermediation (Italy); Art. 361(1) Companies Act (Japan).
84 In Japan and Brazil, however, shareholders must only approve aggregate (rather than individual) executive compensation packages. The proposed revisions to the Shareholder Rights Directive
would introduce binding “say on pay” for listed companies across the EU (proposed Arts. 9a and 9b
Shareholders Rights Directive, as envisaged by the Proposed Directive, note 24).
85 See § 303A.08 New York Stock Exchange Listing Rules; Jeffrey N. Gordon, Executive
Compensation: If There’s a Problem, What’s the Remedy? The Case for “Compensation Discussion and
Analysis”, 30 Journal of Corporation Law 675, 699 (2005). Moreover, Section 162(m) of the
Internal Revenue Code conditions the tax deductibility of performance-​based compensation on shareholder approval of the material terms of the compensation plan.
86 See Commission Staff Working Document, Report on the application of the Commission
Recommendation on directors’ remuneration (2007) 1022.
87 See Davies and Worthington, note 48, 580–​1.
88 See Listing Rules, section 11.1.1. The relationship agreement with the controlling shareholder
must contain certain “independence provisions,” including the requirement that related-​party transactions be conducted at arm’s length and on normal commercial terms and the controlling shareholder
do not circumvent the listing rules. Listing Rules, section 6.1.4D R.
89 See note 61.
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statutory law requires shareholder ratification of all non-​routine self-​dealing transactions entered into during the prior financial year.90
While the French approach seems stringent and encompassing, in practice it may
not prove as effective as UK law. As in the UK for listed companies, it leaves corporate
decision-​makers with wide discretion in deciding whether a transaction is non-​routine
and, thus, needs to be approved by shareholders.91 But the timing of shareholder
approval makes it much less meaningful as a tool to prevent misappropriation: unlike
in the UK, shareholders cannot block abusive related-​party transactions before they
become effective, but only express their (precatory) dissatisfaction ex post.92
Other jurisdictions are less insistent on shareholder approval. Italy, for instance, only
requires shareholder approval when a director of a publicly traded corporation wants to
sit on the board of a competing corporation.93
6.2.4 The rules strategy: Prohibiting conflicted transactions
Sweeping prohibitions of related-​party transactions were once common in company
law. Today, for the reasons outlined in Section 6.1, they apply only to a handful of
transactions, namely credit transactions, third party employment contracts, and some
forms of trading by insiders.94
Only France and the U.S. currently prohibit loans between a company and one of its
directors. The French prohibition has a long tradition.95 By contrast, the U.S. prohibition is relatively new. In the 1990s and early 2000s, company loans were used by some
managers to leverage their ownership of company shares, thus increasing their incentives to engage in questionable practices aimed at bolstering the share price. Further,
they were often used as “stealth compensation,” as managers often failed to repay
the loans and companies forgave them.96 As a response to Enron and other scandals,
Congress prohibited public companies from making personal loans to executives.97
While the U.S. reaction is understandable, it remains unclear why loans to managers
should be more suspect than other conflicted contracts (e.g. consulting contracts). At
best, the logic must be that these loans are especially unlikely to generate efficiencies
significant enough to offset their risks.
Apart from bans on loans, prohibitions tend to focus on transactions between managers and third parties that are thought to divert the value of information property
rights on which the law assigns to the company (or its shareholders). One example is
Germany’s non-​compete rule for top executives in closely held companies.98 Of course,
90 Arts. L. 225-​40 (one-​tier board) and 225-​88 (two-​tier board) Code de commerce (France).
Conflicted shareholders or managers are forbidden from voting their shares to approve their own
transactions—​the outcome being nullified if they are found to have voted.
91 See Schmidt, note 62, at 117–​21 (criticizing the French regime because it grants insiders too
much discretion).
92 The practical effect of a shareholder vote rejecting a properly board-​approved transaction is virtually nil. See Luca Enriques, The Law on Company Directors’ Self-​Dealing: A Comparative Analysis, 2
International and Comparative Corporate Law Journal 297, 327–​8 (2000).
93 Art. 2390 Civil Code (Italy). See also text preceding note 63.
94 Of course, specific rules on conflicted transactions, usually not banning them outright, exist for
certain industries, such as banking.
95 See Arts. L. 225-​43 and L. 225-​91 Code de commerce (France).
96 See Bebchuk and Fried, note 2, at 112–​17.
97 § 402 Sarbanes-​Oxley Act.
98 See Peter Hommelhoff and Detlef Kleindiek No. 20 Anhang § 6 in Bayer et al., note 53. By
contrast, the supervisory boards of German public companies may allow top managers to compete.
See § 88 AktG.
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barring executives from competing with their companies often makes sense, as executives who serve two competing firms will inevitably favor one over the other in allocating time and sensitive information. Nevertheless, there may be circumstances in which
companies will reasonably prefer to allow their managers to compete. For example,
smaller companies may need to permit competition to attract competent executives,
and larger firms may benefit from the know-​how gathered by their executives as directors of competitors in the same industry. For this reason, most jurisdictions deal with
competition issues through other legal strategies.
“Insider trading” is a third—​and much more important—​class of transactions that
jurisdictions typically subject to restrictions. To be sure, insider trading is not strictly
speaking a related-​party transaction like the others examined in this chapter, for at least
two reasons. First, the counterparty to the typical insider trading transaction is not the
corporation itself, but an unrelated third party. Second, insider trading bans no longer
apply exclusively to “insiders” but also encompass certain outsiders who are under a duty
of confidentiality and, in jurisdictions with wider-​reaching insider trading laws, anyone
who otherwise knows that they are in possession of material non-​public information:99
when that is the case, as we further discuss in Chapter 9, the rationale is more broadly
to ensure securities markets’ liquidity and efficiency than to prevent self-​dealing. That
said, we address insider trading also in this chapter in view of one of the rationales of the
prohibition: namely, the idea that insiders trading on non-​public information are misappropriating information that belongs to the corporation for their own benefit.
There are two sorts of rules against trading by insiders: prophylactic restrictions on
short-​term trading and direct bans on trading on material inside information. The
most important prophylactic rules are restrictions on “short swing” (within less than
six months) purchase-​and-​sale or sale-​and-​purchase transactions by “statutory insiders”
of U.S. and Japanese registered companies, including directors, officers, and holders of
10 percent or more of a company’s equity.100 These rules effectively prohibit short-​term
trading by allocating the resulting profits (or losses avoided) to the corporate treasury, on
the theory that these gains are likely to derive from non-​public corporate information.
The UK adopts similar restrictions in their listing requirements for the same purpose.101
Still more significantly, all major jurisdictions now impose some kind of ban on
insiders’ trading on the basis of non-​public price-​sensitive information. European jurisdictions and Brazil bar anyone in possession of material, undisclosed inside information
from trading in the relevant company’s publicly traded securities based on that information.102 The scope of insider trading prohibitions is however narrower in Japan and
the U.S. Japan only prohibits managers, employees, shareholders holding more than
3 percent of the shares, as well as direct tippees thereof, from trading on non-​public
information.103 The U.S., by contrast, bars trading by insiders who possess non-​public
99 See notes 102–​4 and accompanying text.
100 See § 16(b) 1934 Securities Exchange Act (U.S.); Art. 164 Financial Instruments and Exchange
Act (Japan).
101 See the minimum requirements set by the UK Listing Authority’s Model Code (Listing Rules
9, Annex 1): a director may only deal in securities of the listed company after clearance by the board
chairman, but clearance must not be given on considerations of a short-​term nature (§ 8(b)).
102 For the EU, see Art. 8 Market Abuse Regulation 596/​2014. For an interpretation of the meaning of “use” of inside information in the EU context, see ECJ, Case C-​45/​08 Spector Photo Group NV
(ruling that the act of trading while in possession of inside information gives rise to a rebuttable presumption that he or she has used such information). In Brazil, however, criminal penalties only apply
to persons who are under a legal duty to keep the information confidential. Art. 27-​D Lei 6.385, de 7
de dezembro de 1976 (Brazil), and Art. 13 CVM Instruction No. 358 (2002).
103 Art. 166 Financial Instruments and Exchange Act (Japan).
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information, by outsiders who misappropriate inside information in breach of a duty to
the source of the information, and by direct and indirect tippees thereof who knew that
the information was obtained through the tipper’s breach of duty.104
Although all jurisdictions mandate stiff civil, administrative, and/​or criminal sanctions for illegal insider trading (e.g. disgorgement of profits, treble damages, other
civil penalties, and prison sentences),105 the U.S. has traditionally mounted a much
larger enforcement effort than other jurisdictions.106 Lower enforcement levels in
other contexts probably reflect the higher burden of proof faced by prosecutors due
to a statutory preference for criminal over civil sanctions in Europe and Japan, as
well as more limited public enforcement resources.107 The divergence in enforcement
approaches might well increase in the future. While prosecutions of insider trading in
the U.S. have intensified in recent years, the European Court of Human Rights has
held that the structure of Italian (and, by implication, European) regulation of insider
trading might run afoul of fundamental rights, such as procedural protections and the
prohibition of double jeopardy.108
Why are (selective) bans the strategy of choice for insider trading? The reason
must be that potential benefits are much less visible, and therefore less plausible,
than those resulting from self-​dealing transactions. Mutually advantageous transactions between directors and (small) corporations are easy to imagine: for example,
the director with superior information may be the only party willing to transact
with the firm. To date, lawmakers remain unpersuaded that trading based on undisclosed information might sometimes have similar benefits. Some academics have
argued that lawmakers underestimate the advantages it has as an efficient form of
incentive compensation or as a superior channel of non-​public information into
share prices.109 Other scholars, however, have questioned the informational benefits
104 However, the specific contours of insider trading liability in the U.S. remain fuzzy. For a discussion see John C. Coffee Jr., Introduction: Mapping the Future of Insider Trading Law, 2013 Columbia
Business Law Review 281.
105 For the U.S., see Louis Loss, Joel Seligman, and Troy Paredes, Fundamentals of Securities
Regulation 1412–​19 (6th edn., 2011) (also discussing special sanctions such as disgorgement, civil
penalties, and bounty provisions); for France, see Daniel Ohl, Droit des sociétés cotées 351 (3rd
edn., 2008) (criminal sanctions and administrative fines); for Germany, Rolf Sethe, Insiderrecht No.
13-​17, in Heinz-​Dieter Assmann and Rolf A. Schütze, Handbuch des Kapitalanlagerechts (4th
edn., 2015) (criminal sanctions and disgorgement of profits); for the UK, see Davies and Worthington,
note 48, 1167–​71 (criminal sanctions, administrative fines, disgorgement of profits).
106 The U.S. has historically had a very high number of public and private enforcement actions
against insider trading compared to other jurisdictions, though the latter jurisdictions’ record seems
to have improved in recent years. For a recent study on the level of enforcement against market abuse
in the EU, see Douglas Cumming, Alexander Peter Groh, and Sofia Johan, Same Rules, Different
Enforcement: Market Abuse in Europe, Working Paper (2014), at ssrn.com (finding that Germany and
France had the highest number of detected offences for market abuse between 2008 and 2010). In
Japan, between 2000 and March 2015 the Securities and Exchange Surveillance Commission (SESC)
has reported 64 cases of insider trading to prosecutors. Also, civil penalties against insider trading have
been enforced vigorously since their introduction in 2005. See SESC’s Annual Reports, fsa.go.jp/​sesc/​
english/​reports/​reports.htm. In Brazil, the Securities Commission (CVM) opened 40 administrative
proceedings related to insider trading between 2002 and 2014. Of a total of 187 defendants, 51 were
convicted by the Commission. Viviane Muller Prado and Renato Vilela, Insider Trading X-​Ray in the
Brazilian Securities Commission (CVM) 2002–​2014, Working Paper (2015), ssrn.com.
107 See Chapter 9.2.1.
108 Grande Stevens et autres c. Italie (App No. 18640/​10, 18647/​10, 18663/​10, 18668/​10) (2014)
ECHR 4 March 2014.
109 See e.g. Henry G. Manne, Insider Trading and the Stock Market (1966); Dennis W.
Carlton and Daniel R. Fischel, The Regulation of Insider Trading, 35 Stanford Law Review 857
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of trading based upon non-​public information and provided evidence that it may
have a negative impact on market liquidity by increasing bid-​ask spreads.110 A recent
review of the literature on the effects of insider trading laws has described the existing evidence as inconclusive.111
6.2.5 The standards strategy: The duty of loyalty and intra-​group
transactions review
If nowadays rules are rarely used to regulate conflicted transactions, standards are pervasive. All jurisdictions impose standards—​which we group under the umbrella phrase
“duty of loyalty”—​to control related-​party conflicts and limit the risk of asset or information diversion. In essence, the duty of loyalty is a fairness standard which requires judges
to determine ex post whether shareholders—​as a class or as a minority—​are worse off as an
outcome of the related-​party transaction.
Duty-​of-​loyalty doctrines encompass a variety of labels across jurisdictions, such
as the duty of entire fairness, the prohibition against “wrongful profiting from position,” or the crimes of “abuse of corporate assets” (in France), and breach of trust
(in Germany).112 Whatever the labels and the details, these doctrines have a similar
thrust: unfair related-​party transactions are unlawful and it is for the courts to determine unfairness after the fact. The strictness of enforcement, not to mention courts’
ability to understand and evaluate business transactions, varies.113 Some courts, like
Delaware’s, tend to be strict, and only consider fair those transactions in which the
company either obtains deal terms comparable to those it would have obtained in a
transaction with a non-​related party or negotiates with the related party following procedural steps that mimic those that are typical of an arm’s length transaction. For other
courts, like Italy’s, it is enough that the transaction is not harmful to the company (i.e.
the sale price is no lower than the company’s reservation price). Finally, some courts,
like the UK’s, focus on the existence of a conflict of interest as defined by law and
observance of the procedure for handling it, the fairness of the transaction only being
relevant to the measure of damages.114
(1983). See also the empirical study by Nihat Aktas, Eric de Bodt, and Hervé Van Oppens, Legal
Insider Trading and Market Efficiency, 32 Journal of Banking and Finance 1379 (2008).
110 Reinier Kraakman, The Legal Theory of Insider Trading Regulation in the United States,
in European Insider Dealing 39 (Klaus J. Hopt and Eddy Wymeersch eds., 1991); Zohar
Goshen and Gideon Parchomovsky, On Insider Trading, Markets, and “Negative” Property Rights
in Information, 87 Virginia Law Review 1229 (2001); Raymond P.H. Fishe and Michel A. Robe,
The Impact of Illegal Insider Trading in Dealer and Specialist Markets, 71 Journal of Financial
Economics 461 (2004).
111 Utpal Bhattacharya, Insider Trading Controversies: A Literature Review, 6 Annual Review of
Financial Economics 385 (2014).
112 See note 78 for France; for Germany see § 266 I StGB (Criminal Code).
113 How sophisticated courts are will be a function of their specialization in corporate law. From
this perspective, a fundamental difference exists between countries, such as Germany and France,
where standards are expressed in criminal provisions and enforced by (non-​specialized) criminal
courts, and countries where civil law courts dealing mainly with corporate law cases, like Delaware’s,
hear breach of fiduciary duty cases.
114 See Davies and Worthington, note 48, at 561: if there is a conflict of interest of the type covered
by self-​dealing law, British courts will find a breach of duty on the part of the director, even if the
transaction is fair. But if, as it is usually the case, specific rules apply on related-​party transactions and
there has been no violation thereof, judges will not look into the fairness of the transaction. See ibid.,
at 569. As an outcome, it is rare for British courts to engage in standard-​based review of related-​party
transactions.
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In addition, rules allocating the burden of proof are relevant to how effective the
fairness standard will be in protecting shareholder interests. In Delaware, defendants
have the burden of proving the transaction’s fairness, unless procedural steps have been
taken to mimic the dynamics of an arms’ length negotiation (such as entrusting a
committee of independent directors with the exclusive power to negotiate with the
controlling shareholder).115 Other jurisdictions usually allocate the burden of proving
unfairness of related-​party transactions upon plaintiffs.
6.2.5.1 Directors and officers
As we described in Section 6.2.2, most of our jurisdictions assign responsibility for
ensuring compliance with the duty of loyalty to disinterested directors, through the
widely required—​or encouraged—​screening of related-​party transactions. Thus, the
standards strategy frequently operates in conjunction with the trusteeship strategy.
Jurisdictions differ, however, in the extent to which the standards strategy functions
independently of other strategies.
The duty of loyalty plays the largest autonomous role in the U.S., where courts
generally review the fairness of transactions with directors that have not been preapproved by disinterested directors. Delaware courts, in particular, are well-​known
for their careful scrutiny of procedural fairness issues and for aggressively articulating norms of fair corporate behavior including admonishing managers when
the transaction’s terms are not in line with those of an arms’ length transaction.116
European, Japanese, and Brazilian courts, by contrast, seldom question the “fairness” of conflicted transactions and even self-​interested managers are unlikely to be
sued, let alone held liable, for breaches of the duty of loyalty. We will revert to this
in Section 6.2.5.4.
6.2.5.2 Controlling shareholders
In all jurisdictions, controlling shareholders may be held accountable for having
engaged in “unfair” self-​dealing. The liability risk is highest in U.S. jurisdictions. Courts
apply tough standards—​the “entire fairness” test (in Delaware) and the “utmost good
faith and loyalty” test (in some other states)—​to self-​dealing by controlling shareholders, even when such transactions have been preapproved by independent directors—​
although Delaware has recently applied business judgment review when the trusteeship
strategy is combined with a decision rights strategy in the form of a “majority of the
minority” vote.117 European jurisdictions, Brazil, and Japan are not as strict.
The European approach reflects a general reluctance to hold controlling shareholders liable so long as they are not directly involved in the company’s management. But
when controlling shareholders assume actual control, European jurisdictions become
more demanding. Controlling shareholders who actively intervene in corporate affairs
115 See e.g. Allen et al., note 49, at 289–​92, 308–​9.
116 See Edward B. Rock, Saints and Sinners: How Does Delaware Corporate Law Work? 44
UCLA Law Review 1009 (1997). While such procedures can be costly for directors in terms of
time and reputation, personal liability of independent directors is extremely rare. See Bernard Black
and Brian R. Cheffins, Outside Director Liability across Countries, 84 Texas Law Review 1385
(2006). Indemnification provisions and insurance protection make the liability risk even lower. See
Chapter 3.4.1.
117 See note 70 and accompanying text.
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163
may become de facto or “shadow” directors and face civil liability and even criminal
sanctions as directors, for example, under the French abus de biens sociaux provisions.118
6.2.5.3 Groups
Upon the premise that companies belonging to a group enter into transactions with
each other as a matter of routine and that the efficiency of the group structure depends
on such transactions, Germany, France, Italy, and Brazil allow courts to evaluate
whether the overall operations of an individual subsidiary, and especially its interactions with the parent and other affiliates, are fair as a whole.119 This implies that a
successful challenge of an individual transaction harming a subsidiary will become
more difficult, because the defendants will win, if they persuade the judge that that the
damage from the individual transaction is offset once the overall management of the
group is taken into account.
The German law of corporate groups (Konzernrecht) is the most elaborate, but ultimately relies on a simple fairness standard. Corporate parents in contractual groups have
the power to instruct their subsidiaries to follow group interests rather than their own individual ones.120 But, as a quid pro quo, they must indemnify their subsidiaries for any losses
that stem from acting in the group’s interests.121 In de facto groups, the parent company
similarly cannot force its subsidiaries to act contrary to their interests without providing
compensation.122 Should a parent fail to do so, any minority shareholder would have the
right to gather evidence via a special auditor appointed by the court and to sue directors
and the parent company for damages on behalf of the subsidiary.123 In practice, it is often
difficult to establish whether the subsidiary has been harmed or not.124
Whether the German regime strikes the right balance between the need for flexibility in the management of connected firms and minority shareholder protection
remains disputed.125 In the past, parent companies frequently ignored the indemnification or compensation requirements—​unless the subsidiary was insolvent, in which
case not much was left for minority shareholders anyway.126 Nowadays, improvements
118 Art. L. 246-​2 Code de commerce. In Germany, AG shareholders using their influence on the
company to instruct supervisory or management board members to act to the detriment of the firm or
its shareholders may be liable for damages. § 117(1) AktG. See also section 251 Companies Act (UK).
119 For the argument that focusing on each single transaction to prevent controlling shareholders’
abuse, as most jurisdictions (and especially Delaware) do, may lead to inefficient allocation of control rights by systematically disfavoring control by business partners, see Jens Dammann, Corporate
Ostracism: Freezing-​Out Controlling Shareholders, 33 Journal of Corporation Law 681 (2008).
120 On the difference between contractual and de facto groups under German law, see Chapter
5.2.1.3 and 5.3.1.2.
121 See § 302 AktG. Similarly, in Brazil, parent companies can sacrifice the interests of subsidiaries
only in formally registered corporate groups (which are very rare in practice) and subject to the compensation mechanisms described in the group’s convention. Art. 245 Lei das Sociedades por Ações.
122 § 311 AktG. In Brazil, where de facto corporate groups are common, all related-​party transactions between affiliates must, at least in theory, be “strictly fair” or subject to the payment of adequate
compensation. Art. 276 Lei das Sociedades por Ações.
123 §§ 142 II, 315 and 317 AktG. See also Chapter 6.2.1.1.
124 The main tests are whether parent-​subsidiary transactions are at arm’s length and whether the
subsidiary’s directors have otherwise exceeded their business discretion. Uwe Hüffer and Jens Koch,
Aktiengesetz, § 311 AktG No. 31-​36 (11th edn., 2014).
125 See Jochen Vetter, in Schmidt and Lutter, note 48, § 311 paras. 8–​9 (for AGs); Tobias H.
Troeger, Corporate Groups, Working Paper (2014), at ssrn.com.
126 See Forum Europaeum Corporate Group Law, Corporate Group Law for Europe, 1 European
Business Organization Law Review 165, 202–​4 (2000).
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in business practices and an increase in litigation risks seem to have resulted in a more
adequate treatment of minority shareholders.127
Italy’s approach to corporate groups is less articulate than Germany’s, but still recognizes the specificities of this organizational form. It allows parent companies to manage
their subsidiaries as a mere business unit and provides for ex post review of the overall
fairness of a subsidiary’s management. Minority shareholders of subsidiary corporations can sue the parent company and its directors for pro rata damages if their powers
over the subsidiary’s business are abused. However, the parent cannot be held liable if
it proves that there is no damage “in light of the overall results of the parent’s management and co-​ordination activity.”128
French case law allows for even more flexibility:129 parent companies may
instruct their subsidiaries to sacrifice their own interests for those of the corpor­
ate group without incurring criminal liability for abuse of corporate assets.130 The
Rozenblum doctrine holds that a French corporate parent may legitimately divert
value from one of its subsidiaries if three conditions are met: the structure of the
group is stable, the parent is implementing a coherent group policy, and there is
an overall equitable intra-​group distribution of costs and revenues. As a practical
matter, judges tend to accept this defense and hold the distribution of costs and
revenues overall equitable so long as intra-​group transactions do not pose a threat
to the company’s solvency.131
6.2.5.4 Enforcement
In its core content (fairness), the duty of loyalty is similar in common and civil law
jurisdictions, but its bite crucially depends on how often and how stringently courts
enforce it. From this perspective, managers and dominant shareholders face greater
risks in the U.S. than in most other jurisdictions, with Japan and France falling somewhere in between.132
U.S. (and especially Delaware) courts are much more willing than courts elsewhere
to review conflicted transactions for fairness even when it requires second-​guessing the
merits of business choices that are tainted by self-​interest.133 Further, U.S. law greatly
facilitates shareholder lawsuits. Not only are the procedural hurdles for shareholder
suits comparatively low in the U.S., but a unique combination of contingent fees, discovery mechanisms, pleading rules, generous attorney’s fee awards, and the absence of
the “loser pays” rule have concurred to support a specialized and highly active plaintiff’s
127 See Vetter, note 125, para. 8.
128 Art. 2497 Civil Code. See Corte di Cassazione, 24 August 2004, No. 16707, Giurisprudenza
commerciale 2005/​II, 40.
129 See Klaus J. Hopt, Groups of Companies, in Oxford Handbook of Corporate Law and
Governance, note 36.
130 (1985) Revue des Sociétés 648 (Cour de Cassation); see also Cozian et al., note 48, at 792.
131 See Marie-​Emma Boursier, Le Fait Justificatif de Groupe dans l’Abus de Biens Sociaux: Entre
Efficacité et Clandestinité, 2005 Revue des Sociétés 273.
132 See also Klaus J. Hopt, Common Principles of Corporate Governance in Europe, in The Coming
Together of the Common Law and the Civil Law 105, 109 (Basil S. Markesinis ed., 2000).
133 Cf. Luca Enriques, Do Corporate Law Judges Matter? Some Evidence from Milan, 3 European
Business Organization Law Review 765, 795–​801 (2002) (contrasting Delaware judges’ judicial
style with Italian courts’ reluctance to second-​guess solvent companies’ business decisions, even when
tainted by conflicts of interest).
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165
bar.134 In addition to that, federal securities regulation complements state-​level private
enforcement of director and dominant shareholder duties, ensuring that the critical
facts are available to plaintiffs.135
In other jurisdictions, private litigation of duty of loyalty issues is much less common. Limitations to standing to sue, such as minimum ownership thresholds and other
procedural hurdles, make it hard for minority shareholders to challenge self-​dealing by
both managers and controlling shareholders, especially in Germany, Italy, and Brazil. As
a result, in Germany, private litigation is mostly limited to transactions which have to be
approved by the shareholders’ meeting (e.g. mergers and recapitalizations) and takes the
form of challenges to the validity of the meeting resolution (usually for incomplete disclosure) or the price for the appraisal remedy.136 In the UK, litigation concerning closed
companies is relatively common, both as fiduciary duty claims and as unfair prejudice
petitions. In Japan, a modest procedural reform sparked an explosion in derivative suits
against managers in the early 1990s.137 In the absence of discovery mechanisms similar
to U.S. ones, most Japanese suits concentrate on misbehavior identified by public prosecutors, and rely on the evidence unearthed in criminal proceedings.138
A peculiar case is France, where certain forms of self-​dealing amounting to a vaguely
defined “abuse of corporate assets” (abus de biens sociaux) face a non-​trivial risk of criminal
sanctions. Prosecutions for abus de biens sociaux, most often upon minority shareholders’
petitions, are common, making it the most prosecuted corporate crime in France.139 So,
enforcement there is privately initiated, but then is exclusively in public hands.
In Brazil, it is the Securities Commission that plays an active role: it has the power to
impose fines and other sanctions (such as suspension from office or board position) for
violations of the fiduciary duty of loyalty and does exercise it from time to time.140 Yet
such administrative action is not an adequate substitute for court enforcement. Fines,
unlike damages, provide no compensation to the company or its shareholders, and
their low value in Brazil compromises deterrence. Similarly, in the last ten years or so
the Italian Securities Commission has prioritized supervision on related-​party transactions and has been particularly active in ensuring compliance with its regulation, both
ex ante, via formal and informal interventions to ensure more comprehensive disclosure, and ex post, sanctioning members of the board of auditors for failure to monitor
compliance with the regulation.141
134 See e.g. Martin Gelter, Why Do Shareholder Derivative Suits Remain Rare in Continental Europe?
37 Brooklyn Journal of International Law 843 (2012).
135 See Sections 6.2.1.1 and 6.2.4.
136 See Pierre-​Henri Conac, Luca Enriques, and Martin Gelter, Constraining Dominant Shareholders’
Self-​Dealing: The Legal Framework in France, Germany, and Italy, 4 European Company & Financial
Law Review 491, 513–​14 and 526 (2007). See also Chapter 7.4.1.
137 See Dan W. Puchniak and Masafumi Nakahigashi, Japan’s Love for Derivative Actions: Irrational
Behavior and Non-​Economic Motives as Rational Explanations for Shareholder Litigation, 45 Vanderbilt
Journal of Transnational Law 1 (2012).
138 See Mark D. West, Why Shareholders Sue: The Evidence from Japan, 30 Journal of Legal
Studies 351, 378 (2001).
139 See Art. L. 242-​6 Code de commerce (jail up to 5 years, fine up to €375,000). Paul Le Cannu
and Bruno Dondero, Droit des sociétés 536 (6th edn., 2015).
140 Art. 11 Lei 6.385, de 7 de dezembro de 1976 (Brazil) (authorizing the Commission to impose
various sanctions, including fines, for violations of the Corporations Law as well as of securities
regulations).
141 See Consob, Relazione per l’anno 2014 26, 194–​7, and 262 (2015); Consob, Relazione
per l’anno 2013 274–​5 (2015) (both available at www.consob.it).
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6.3 Ownership Regimes and Related-​Party Transactions
In broad outline, our major jurisdictions resemble each other in their reliance on the
same legal strategies to address related-​party transactions. In all jurisdictions, periodic disclosure, especially for listed companies, features as an important mechanism
to prevent tunneling, while the opposite is true for exit rights in listed companies.
Prohibitions are rare, and are mainly used for insider trading. With the notable exception of Germany and Brazil, trusteeship (in the form of disinterested or independent
director approval) and, to a lesser degree, decision rights (in the form of shareholders’
meeting approval, with or without counting related-parties’ votes) are commonly used.
Yet, a closer look at substantive rules and the consideration of differences in the intensity in enforcement reveal that similarities are less striking than they look.
In general, continental European and Brazilian laws tend not to impose stringent
constraints on related-​party transactions, especially as regards transactions with the
dominant shareholder. Continental European jurisdictions leave considerable discretion to a company’s board and management, which face no serious risk of liability
unless the firm becomes insolvent—​in which case shareholders are unlikely to benefit
from any enforcement action. In Germany, Italy, and Brazil, where families have long
controlled many public firms, corporate law defers most to directors’ and managers’
judgment. Following scandals in the early 2000s, however, Italian rules for listed companies have improved: tighter disclosure requirements have gone hand in hand with
a greater role for independent directors in screening related-​party transactions. The
question is of course how well-​grounded reliance on independent directors can be in
a country where, with the exception of one minority-​elected director,142 the controlling shareholder selects the board members. No corresponding hard law reforms have
taken place in Germany, where neither statutory law nor the Corporate Governance
Code place any reliance on the trusteeship strategy in the form of independent director approval, unlike in Italy, or on shareholder decision rights, unlike in the UK and
France; infrequent enforcement of standards outside bankruptcy make them of little
relevance in practice, especially compared to the U.S.143 The likelihood of Germany’s
converging to stricter standards appears to be low, as illustrated by Germany’s strong
opposition to the European Commission’s proposal for a European regime on related-​
party transactions,144 which led to a Council and European Parliament proposal allowing member states to retain the status quo.145
In France, corporate law grants disinterested (as opposed to independent) board
members a screening role and also mandates a shareholder vote on all non-​routine
transactions. The vote, however, takes place once a year and ultimately may not affect
142 See Chapter 4.1.1.
143 German scholars frequently point out that the equivalent minority protection in Germany
would be achieved in three ways: (1) the supervisory board represents the company for direct transactions with the management board; (2) corporate group law polices transactions with controlling shareholders; and (3) elaborate case law on hidden distributions, equality of shareholders, and shareholders’
fiduciary duties addresses specific suspicious transactions with shareholders generally. See Holger
Fleischer, Related Party Transactions bei börsennotierten Gesellschaften: Deutsches Aktien(konzern)recht
und Europäische Reformvorschläge, Betriebs-​Berater 2691 (2014). Nevertheless, even the cumulative
impact of these measures does not appear to catch all situations that may present problems of minority protection.
144 See e.g. Jochen Vetter, Regelungsbedarf für Related Party Transactions? 179 Zeitschrift für das
gesamte Handelsrecht und Wirtschaftsrecht 273 (2015).
145 See note 147.
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Ownership Regimes and Related-Party Transactions
167
a transaction’s validity or directors’ liability other than to insulate the transaction from
judicial review in case of a favorable vote. Further, in all three countries special, more
lenient rules or doctrines on intra-​group transactions apply. Brazilian law is probably
even more lax in policing related-​party transactions involving either controlling shareholders or managers: trusteeship and decisions strategies are used only sparingly, while
enforcement problems hamper the efficacy of disclosure mandates and duty of loyalty
standards. This, perhaps, can help explain why Brazil has had uniquely high levels of
private benefits of control,146 and, more speculatively, why its courts have been so
liberal in granting requests for partial dissolution by minority shareholders in closely
held corporations.
The situation is quite different in the other countries. The UK has long relied on
disclosure and decision rights (in the hands of shareholders other than the related parties and their affiliates) as the main strategy to address large related-​party transactions
in listed companies.147
In the U.S., courts do not shy away from imposing liability on managers for self-​
dealing transactions, but, contrary to continental European jurisdictions, tend to be
even stricter when it comes to transactions between dominant shareholders and their
controlled companies. While appropriate board approval typically leads courts to
review transactions with directors under the business judgment rule, approval by both
a special committee of independent directors and a “majority of the minority” of shareholders is required to obtain the same degree of deference for significant transactions
with controlling shareholders.
At the same time, U.S. courts do shy away from second-​guessing executive compensation decisions. Curbs on excessive managerial pay thus depend on independent
directors as trustees and on disclosure. It is doubtful whether these strategies work
well to constrain compensation practices. Independent directors are often themselves
executives at other companies or former executives. Disclosure, which is otherwise an
effective curb on tunneling and is quite intensive in the U.S. when it comes to related-​
party transactions (including executive compensation arrangements), can have unintended consequences on compensation levels: it may in fact result in higher pay across
companies, given that each board will feel pressured to pay their CEOs higher than the
industry average, lest it signals the hiring of a subpar CEO.
Similarly, little convergence can be observed with respect to the enforcement mechanisms employed to police related-​party transactions. Shareholder derivative suits are
significant only in the U.S. and, to a lesser degree, Japan (where they are not available against controlling shareholders). Consequently, as discussed, board approval of
transactions with managers or controlling shareholders is more likely to be subject
to judicial review in the U.S. than elsewhere. Similarly, the use of securities fraud
provisions for failure to disclose transactions with related parties is also more common in the U.S., reflecting its unique institutions of private enforcement (such as
class actions and a plaintiffs bar). In Germany, shareholder suits are used, in practice,
only to challenge shareholders’ meeting resolutions (which may approve related-​party
transactions like parent-​subsidiary mergers) or to obtain judicial review of the appraisal
146 See Chapter 4.4.2.1.
147 A model the European Commission had tried to extend to all EU countries. However, as
approved in the plenary session of the European Parliament on 8 July 2015, proposed Art. 9c(2),
as envisaged by the Proposed Directive would leave member states free to decide whether to require
majority of the minority approval of material transactions or board approval (with safeguards to prevent the related party from influencing the outcome of the board vote).
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price. Disgruntled shareholders in a French company having engaged in a related-​party
transaction will have to file a complaint with the criminal court for abuse of corpor­
ate assets, which implies a higher threshold for a successful challenge. In Brazil and
Italy, shareholder litigation is rare, albeit not unheard of, and the bulk of enforcement
efforts is borne by securities regulators via both formal and informal actions. Finally, in
the UK, enforcement is more informal and governance-​based than elsewhere as far as
publicly traded companies are concerned, chiefly relying upon institutional investors’
pressure.148 This model, however, has recently been tested at East Asian companies
listed in the UK.149 Indeed, the recognition that institutional investor pressure could
do little against controllers willing to extract significant private benefits prompted a
change in the listing rules granting a greater say to independent directors and minority
shareholders.
The differences we have highlighted so far reflect the by now well-​known distinction
between concentrated and diffused ownership systems. Shareholdings in listed companies are more concentrated in continental Europe and Brazil than in Japan, the UK,
or the U.S.150 In theory, given that opportunistic managerial behavior is more likely in
the U.S. (historically lower ownership concentration going hand in hand with reduced
shareholder monitoring), it would be reasonable for courts or lawmakers to address the
issue by imposing tougher constraints on managers than those prevailing in continental Europe. Conversely, given the higher risk of minority shareholder expropriation by
controlling shareholders, one would expect courts or lawmakers in continental Europe
to subject controlling shareholders to more stringent constraints than their U.S. counterparts. But interest group dynamics have led to a partially different outcome: it would
appear that managers (in the U.S. and Japan) and large shareholders (in Europe and
Brazil) have made effective use of their political clout to oppose stronger curbs on their
opportunism.151
In the case of the UK, the rigor of the related-​party regime for listed companies
reflects the political influence of strong institutional investors. In France, in turn, the
emphasis on ex post shareholder approval may also reflect the historically strong role of
the state as a shareholder: unlike a controlling family’s member, to keep a close eye on
directors and top managers, the state cannot sit on the board in any meaningful way,
but it can have a different bureaucracy exercise its voting rights (and therefore monitor
board members’ self-​dealing, so to speak, “from a distance,” i.e. reducing the risk of
collusion between directors and top managers). That may also help explain why French
requirements for shareholder ratification are perfunctory: they provide a focal point for
shareholders’ attention and allow, as the case may be, for the exercise of more effective
powers, including removal, vis-​à-​vis unfaithful directors and managers. The relevant
role of the state as a controlling shareholder may also explain the controller-​friendly
regime applicable to related-​party transactions in Brazil.152
148 With respect to closed companies see Chapter 6.2.5.4.
149 See Roger Barker and Iris H.Y. Chiu, Protecting Minority Shareholders in Blockholder-​Controlled
Companies: Evaluating the UK’s Enhanced Listing Regime in Comparison with Investor Protection Regimes
in New York and Hong Kong, 10 Capital Markets Law Journal 98, 104–​5 (2014).
150 See Chapter 1.6.
151 This does not necessarily translate into high, let alone uniform, level of tunneling across jurisdictions. We have in fact seen that the level of private benefits of control has differed across countries.
See Chapter 4.4.2.1. Other factors, whether economic or cultural, may be at work to compensate for
weaker legal constraints in some jurisdictions.
152 See Mariana Pargendler, State Ownership and Corporate Governance, 80 Fordham Law Review
2917 (2012).
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Ownership Regimes and Related-Party Transactions
169
Differences in enforcement intensity again correlate with ownership structures.
Here, however, ownership patterns also interact with the dynamics of enforcement
institutions. In fact, the relevant interest groups here are not just managers and dominant shareholders, on the one hand, and investors on the other. Those involved in
the functioning of the enforcement system (such as the bar, securities regulators, and
judges themselves) may be well-​organized and politically connected enough, whether
alone or coalescing with investor organizations, to achieve the goal of having corporate
law rules in place that increase enforcement activity. The plaintiff bar and the securities
regulator have traditionally been much stronger in the U.S. than in any other of our
core jurisdictions.
In addition, the U.S. experience seems to indicate that high levels of private litigation can prompt public enforcers to be more active themselves: prosecutors and the
SEC risk public criticism if they cannot show that they are doing as much as the private
bar. Increased public enforcement, in turn, spurs private litigation that piggybacks on
the evidence unearthed.153 In sum, competition between private and public enforcers
seems to lead to an overall higher level of enforcement. Outside the U.S., then, the
absence of a specialized plaintiffs’ bar has a negative impact on public enforcement as
well; and public enforcement, where relevant, is insufficient to spur private enforcement in the presence of procedural hurdles.
Finally, it goes without saying that ownership structures are not static—​and neither
is the law. In a number of jurisdictions where ownership is concentrated, namely Italy
and Brazil, recent increases in institutional investor ownership, on the one hand, and
expansion and family succession considerations, on the other, have led to the tightening, at least on the books, of regulations on related-​party transactions.
What is puzzling is that, despite an even stronger trend toward dispersed and institutional ownership,154 no similar reform efforts have gained momentum in Germany.
An optimistic answer would be that the smaller size of private benefits in that country
compared to Brazil and Italy155 is evidence that related-​party transactions and tunneling more generally are not a serious concern for shareholders of German listed companies, possibly because other tools of minority protection are doing the job.156 But once
again, path dependence and interest group dynamics may provide an equally plausible
explanation. The law of corporate groups, by accommodating the frequent use of intra-​
group transactions, reinforces group-​based organizational structures. Their operation
would be more burdensome under the set of rules prevailing elsewhere, which raise the
costs of individual related-​party transactions.157 In addition, and relatedly, powerful
interest groups, public notaries, and lawyers, including many legal scholars, strongly
support traditional group law as the most effective mechanism to address transactions
with dominant shareholders.
153 See James D. Cox, Randall S. Thomas, and Dana Kiku, SEC Enforcement Heuristics: An
Empirical Enquiry, 53 Duke Law Journal 737, 761 (2003).
154 Wolf-​Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance
and the Erosion of Deutschland AG, 63 American Journal of Comparative Law 493 (2015).
155 See Chapter 4.4.2.1. 156 See note 143. 157 See Dammann, note 119.
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7
Fundamental Changes
Edward Rock, Paul Davies, Hideki Kanda,
Reinier Kraakman, and Wolf-​Georg Ringe
In Chapters 3 and 4, we discussed the basic governance structure of the corporation.
In this chapter, we discuss fundamental or structural changes in the relationship among
the participants in the firm, and how corporate law mitigates the opportunism that can
accompany these changes. Examples for such fundamental changes include mergers, share
issuances or other structural changes; however, it is difficult to find a generalizable notion
of what makes changes “fundamental.”
The key rationale for regulating fundamental changes by law is to protect certain constituencies such as minority shareholders against the threat of opportunistic midstream
changes in the life of a corporation. In the absence of legal rules, those in control of the
corporation could successfully adopt changes that would unilaterally benefit them at the
expense of other constituencies. Collective action problems, asymmetric information, and
contractual incompleteness in long-​lived corporations make midstream changes in the
fundamental relationships among the firm’s participants ripe for abuse.
Whilst there is some disagreement about the need to protect corporate constituencies at the formation stage by mandatory legal rules,1 most commentators agree that
there is a stronger case for legislative interference in midstream situations.2 As initial
investors reasonably anticipate later opportunistic changes, they would discount for
this risk at the stage of their investment decision. To overcome this problem, firms
need a credible commitment signal to convince investors that no opportunistic amendments will occur in the future. Mandatory legal protection devices arguably provide
a solution to this problem.3 This assessment is consistent with the limited extent of
private ordering: several studies suggest that contractual freedom is rarely exercised in
corporate law and that default arrangements and mandatory rules matter.4
1 A rich academic debate focuses on the question of whether IPO markets price charter terms
correctly. See Lucian A. Bebchuk, Why Firms Adopt Antitakeover Arrangements, 152 University of
Pennsylvania Law Review 713, 740 (2003); Bernard S. Black, Is Corporate Law Trivial? A Political
and Economic Analysis, 84 Northwestern University Law Review 542, 571–​2 (1990). See also
Jeffrey N. Gordon, The Mandatory Structure of Corporate Law, 89 Columbia Law Review 1549, 1563
(1989).
2 On the distinction between formation stage and midstream changes see e.g. Gordon, note 1, at
1593; Lucian A. Bebchuk, The Debate on Contractual Freedom in Corporate Law, 89 Columbia Law
Review 1395, 1401 (1989).
3 Gordon, note 1, at 1593.
4 Yair Listokin, What Do Corporate Default Rules and Menus Do? An Empirical Examination, 6
Journal of Empirical Legal Studies 279 (2009); Henry Hansmann, Corporation and Contract, 8
American Law and Economics Review 1 (2006). For the specific case of IPOs see John C. Coates IV,
Explaining Variation in Takeover Defenses: Blame the Lawyers, 89 California Law Review 1301, 1357
(2001); Robert Daines and Michael Klausner, Do IPO Charters Maximize Firm Value? Antitakeover
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann,
Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 7 © Edward
Rock, Paul Davies, Hideki Kanda, Reinier Kraakman, and Wolf-Georg Ringe, 2017. Published 2017 by Oxford University Press.
172
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Fundamental Changes
Jurisdictions differ in their assessment of this problem along two dimensions. First,
there is disagreement on which situations require a statutory protection mechanism:
put differently, which changes are so “fundamental” that they should trigger legal interference? Secondly, the legal strategies that are used to address the problem vary significantly across jurisdictions. Depending on the jurisdiction, these strategies include: a
judicial review of the fairness of the change, double-​majority or supermajority requirements for the effectiveness of the change, majority-​of-​the-minority requirements, exit
rights, or a combination of these. Many of the legal devices utilized in this context can
be classified along the categories that we develop in Chapter 2.
The functionality of a particular jurisdiction’s approach might depend—​again—​on
the prevailing agency conflict that it seeks to address. As we shall see, some of the
fundamental changes that we discuss in this chapter will be more salient in a certain
ownership environment than in another. The same holds true for the effectiveness of a
remedy. For example, a shareholder approval requirement by simple majority would be
of little use in countries where controlling shareholders are the norm.5 These jurisdictions are more likely to require a supermajority or a majority-​of-​the-​minority consent.
To complicate matters further, fundamental changes do not only concern shareholder or minority shareholder expropriation. To the extent that other stakeholders
might be affected, the law might also come to the help of creditors or employees, for
example. Fundamental changes affecting a company’s financial structure or delisting
decisions, for instance, might have negative consequences for creditors; mergers may
have repercussions on the employment of the combined firms. To the extent that these
constituencies are held to be unable to protect themselves, some of our core jurisdictions also provide protective measures for them.
7.1 What are Fundamental Changes in the Relationship
among the Participants in the Firm?
Corporate law worldwide provides for special regulation of many fundamental changes.
Centralized management exercises most decision-​making power in the corporate form,
but this rule does not extend to decisions that have the potential of fundamentally
rea­llocating power among the firm’s participants.6 No jurisdiction, for example, authorizes the board of directors to amend the company’s charter in a material way or to
effect unilaterally a merger that alters the company’s risk and return profile. The board’s
power over such basic decisions is always circumscribed, usually by shareholder decision rights and sometimes by other forms of legal intervention as well. Even a traditionally board-​centered jurisdiction such as Delaware must grapple with the problem
of protecting settled expectations against attempts by managers to grab power allocated
to shareholders, by majority shareholders to take advantage of minority shareholders,
and by shareholders to benefit at the expense of creditors or employees. Indeed, in
Chapter 6, we have already reviewed the limits on board authority to approve transactions involving high-​powered conflicts of interest between the company and its directors or controlling shareholders.7
Provisions in IPOs, 17 Journal of Law, Economics & Organization 83, 95 (2001). For an overall assessment, see Michael Klausner, Fact and Fiction in Corporate Governance, 65 Stanford Law
Review 1325, 1346 et seq. (2013).
5 See Chapter 6.2.3.
6 See Chapter 3.4.
7 See Chapter 6.2.2 and 6.2.3.
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Fundamental Changes in the Relationship among Firm Participants
173
In this chapter, we address how corporate law limits board authority to change the
fundamental allocation of power. Although there is no single set of characteristics that
marks the limits of the board’s power to decide unilaterally, either across jurisdictions
or within them, there are some general tendencies. Corporate law seldom limits board
discretion unless corporate actions or decisions share at least one of the following characteristics: (1) they are large relative to the participants’ stake in the company; (2) they
create a possible conflict of interests for directors, even if this conflict does not qualify as
a related-​party transaction; or (3) they involve general, non-​firm specific, investment-​
like judgments that shareholders are arguably equipped to make for themselves.
Although these three characteristics largely describe the limitations on board discretion,
jurisdictions inevitably diverge to some extent in how they select and regulate “fundamental changes.” That is because they weigh the interests of shareholders, minority shareholders, and stakeholders differently, and because the dominant agency problem differs
depending on the prevailing pattern of share ownership. With this caveat in mind, let us
turn to the three key characteristics associated with significant corporate transformations.
Consider first the size of a corporate action. At first glance, it is not obvious why
size should matter to board discretion. One might suppose that if the board’s expertise
is critical in ordinary business decisions, it is even more so for decisions that involve
very large stakes for participants or for the company. The response to this point, however, is that the relative size of a corporate action also increases the value of any legal
intervention that affects the company’s decision-​making. To take the classic example,
given that shareholders’ meetings to authorize corporate transactions are costly, they
are more likely to be efficient (if they are efficient at all) for large transactions than for
small ones. In other words, the higher transaction costs associated with a shareholders’ meeting (as compared to a board meeting) are justified when agency costs are
potentially high.8 In addition, shareholders’ meetings are more likely to be effective if
the stakes are large enough to overcome shareholders’ information and coordination
problems.9 On the other hand, it seems that the size of a decision alone does not trigger
heightened regulation; corporate law generally delegates even the largest investment
and borrowing decisions to the board alone.
The second key characteristic of corporate actions that is often associated with constraints on board discretion is a risk of self-​interested decision-​making by the board.
Low-​powered conflicts of interest frequently dog major transactions, even without
signs of flagrant self-​dealing. For example, directors and officers who negotiate to sell
their companies enter a “final period” or “end game,” in which their incentives turn
less on the interests of their current shareholders than on side deals with, or future
employment by, their acquiring companies.10 Unlike the case of related-party transactions, these conflicts of interests do not depend on who is the counterparty or on other
factual circumstances, but inherently ensue from the subject matter of the corporate
action itself.11 Even such low-​powered conflicts of interest can seriously harm shareholders, and are thus a focus of regulation.
8 Sofie Cools, The Dividing Line Between Shareholder Democracy and Board Autonomy: Inherent
Conflicts of Interest as Normative Criterion, 11 European Company and Financial Law Review 258,
273–​5 (2014).
9 Edward B. Rock, Institutional Investors in Corporate Governance, in Oxford Handbook of
Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017).
10 See Ronald J. Gilson and Reinier Kraakman, What Triggers Revlon?, 25 Wake Forest Law
Review 37 (1990).
11 Cools, note 8, at 275–​8.
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Fundamental Changes
Finally, a third characteristic often associated with transformative corporate actions
that are subject to special rules is that they are such as not to require a firm-​specific
judgment, but rather one that resembles a decision on how to allocate portfolio money.
Hence, shareholders’ comparative disadvantage in decision-​making vis-​à-​vis the company’s management will be lower, despite the inevitable information asymmetries,
than for typical business decisions. For instance, shareholders in company A may find
it more congenial to decide on whether A should merge with company B than on
whether A should make R&D investments to market a product that may compete
with company B’s. In the former case, the point is whether an aggregate AB company
resulting from a merger at a given exchange ratio is a better investment than one in
A as a stand-​alone company. In the latter case, specific knowledge, among many other
things, about whether the R&D department has the right mix of human resources to
successfully develop a product like B’s will be necessary and shareholders are unlikely
to ever have access to the relevant information.
In the following, we consider several corporate transformations that trigger special
scrutiny, including charter amendments, share issuances, mergers, corporate divisions
and asset sales, re​incorporations, and conversions. As we shall see, many of these corporate-​level restructurings can be used to freeze out minority shareholders. In addition,
in some jurisdictions controllers can employ a compulsory share exchange to freeze out
minority shareholders even without a corporate-​level restructuring. Given this, and the
fact that the legal strategies used to protect minority shareholders in corporate-​level
freeze-​outs often track those used in shareholder-​level restructurings, we extend our
discussion to cover freeze-​out (or squeeze-​out) transactions more generally.12
Interestingly, despite the vulnerability of minority shareholders in freeze-​out transactions, none of our core jurisdictions prohibits controllers from taking public corpor­
ations private, or parent companies from forcing the sale of minority shares in their
subsidiaries. The reason may be that such transactions can generate efficiency gains
despite the deep conflicts that they entail. First, they eliminate the chronic conflicts of
interest between parent companies and partly owned subsidiaries that arise from intra-​
group self-​dealing transactions and allocations of business opportunities.13 Secondly,
by allowing for a collective solution, they may motivate controllers to allow minority
shareholders to cash out of otherwise illiquid investments. Third, controlling shareholders may be less inclined to invest additional capital in positive net present-​value
projects if they are forced to share their returns with minorities.14 Finally, in many
jurisdictions going-​private transactions eliminate the costs of being a public company,
such as preparing disclosure documents and the opportunity costs of disclosing information of value to the firm’s competitors.
7.2 Charter Amendments
Although many of the relationships among participants in the firm are structured by
contract, including contracts with creditors and shareholder agreements, corporate law
12 However, we postpone full discussion of post-​public offer squeeze-​outs until Chapter 8.
13 See Chapter 4.1.3.2.
14 This rationale for freeze-​outs requires additional assumptions to be plausible. Imagine, for
example, a risk-​averse controlling shareholder with private information about a prospect of lucrative
but risky returns from expanding the company’s operations. Such a controller might not be able to
raise outside capital without jeopardizing his control, and might not be willing to provide additional
capital himself.
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Charter Amendments
175
contains a special sort of contractual device that allows for flexibility, constitutional
commitments, and publicity: the corporate charter.15 Like other constitutions, corpor­
ate charters establish a basic governance structure and allow the entrenchment of terms,
typically through a special amendment process. Unlike ordinary contracts, corporate
charters can be amended with less than unanimous approval by the parties to the charter, must be filed in a public register and are generally available to anyone who asks. In
addition, charters bind all the shareholders, including new ones, without the need to
obtain their contractual consent. Each of these features serves important functions.
All the jurisdictions considered here treat a charter amendment as a fundamental
change.16 The most pervasive regulatory strategy employed is that of an ex post decision
right: shareholders are called to ratify the charter amendment. As we saw in Chapter 2,
this is a typical strategy for regulating fundamental changes: the regular distribution
of powers in the corporation, that is, the delegation of authority to the management,
is reversed in extreme situations which are deemed important for the principals.17
However, such decision rights come in different variations across jurisdictions: under
Delaware law, for example, a charter amendment must be proposed by the board and
ratified by a majority of the outstanding stock.18 By contrast, in European jurisdictions
and in Japan, the charter can normally be amended by a supermajority shareholder
vote, and without board initiative.19 The U.S. rule creates a bilateral veto; that is, neither the board nor the shareholders can amend the charter alone. By contrast, requiring
only supermajority shareholder approval allows large minority shareholders to veto
proposed charter amendments, but gives management no formal say in the matter.
Both sets of amendment rules permit corporate planners to entrench governance
provisions in the charter—​an option that is particularly valuable since our core jurisdictions allow any charter provision not in conflict with the law. By means of charter
provisions, shareholders can make credible pre-​commitments. For example, under the
Delaware approach, dispersed shareholders who approve an antitakeover provision in
the charter—​such as a classified board—​strengthen the bargaining role of the board
in an attempted takeover by reducing the likelihood that they would accept, or that
an acquirer would make, a takeover offer without the approval of the board.20 Under
the supermajority shareholder approval mechanism, shareholders bond themselves to
consider (large) minority interests.
The extent to which charter provisions entrench governance rules depends on the
structure of share ownership. As described above, where shareholdings are dispersed,
the Delaware approach creates a bilateral veto between managers and shareholders,
15 Marcel Kahan and Edward Rock, Corporate Constitutionalism: Antitakeover Charter Provisions as
Precommitment, 152 University of Pennsylvania Law Review 473 (2003). Note that what we term
the “charter” often has another name according to jurisdiction, such as the “certificate of incorporation,” the “articles of association,” the “statutes,” or the “constitution.” However, when we refer to the
charter we do not include what in the U.S. are known as the “bylaws,” a separate document specifying
the internal structure and rules of the organization. See note 32 and accompanying text.
16 Although jurisdictions disagree on the mandatory scope of corporate charters, see text accompanying notes 28–33.
17 See Chapter 2.2.2.2.
18 Delaware General Corporation Law (hereafter DGCL) § 242.
19 UK Companies Act 2006, section 21; France: Art. L. 225-​96 Code de commerce; Germany:
AktG § 119(1) no 5; Italy: Art. 2365 Civil Code; Japan: Art. 466 Companies Act. These systems may
permit changes to be effected in exceptional cases by the board alone, but generally only where the
change is regarded as minor or there are strong public policy reasons for board-​alone decision-​making.
Of course, in practice most proposals for charter amendments originate from the board.
20 See Kahan and Rock, note 15.
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Fundamental Changes
which allows current shareholders to guard against uninformed decision-​making by
future shareholders (through charter provisions such as the staggered board), at the
risk of facilitating management entrenchment.21 While Delaware’s board-​centered
corporate law system views the bilateral veto as an attractive feature of corporate law,
shareholder-​centered systems, such as the UK, are more concerned with management
entrenchment, and the charter amendment regime is thus one which formally excludes
management from the decision on whether to amend the charter.
In a system with concentrated holdings, by contrast, a bilateral board-​shareholder
veto is likely to be empty, since controlling shareholders can generally choose boards
that will do their bidding. In these systems, however, a supermajority voting requirement gives (large) minority shareholders a veto, thus creating a bilateral veto among
shareholders. In this way the majority may be able to make credible pre-​commitments
to the minority through appropriate provisions in the charter, providing that minority shareholders can ensure that their holdings are not diluted below the veto threshold. Perhaps to obviate this risk, some corporate law systems permit the shareholders
to increase the supermajority requirement for certain provisions, even to the level of
unanimity.22
Brazil is exceptional among our core jurisdictions in generally allowing for charter
amendments without board initiative and by a simple majority of shareholders, though
certain changes (such as alterations to the rights of preferred shares, reduction of the
mandatory dividend or modification of the corporate purpose) require the affirmative
vote of a majority of the common shares outstanding and entitle dissenting shareholders to appraisal rights.23 In lieu of stronger decision rights, Brazilian law relies
on a standards strategy that imposes liability on controlling shareholders for charter
amendments that are “not in the interest of the company” and that “seek to harm”
minority shareholders, workers, and bondholders—​a standard that is arguably overly
demanding to be effective in constraining abuse.24 Combined with a prohibition on
supermajority approval requirements in publicly traded corporations’ charters,25 this
regime in practice reduces the ability of controlling shareholders to make credible pre-​
commitments in the corporate charter.
Of course, in Brazil as well as elsewhere, shareholder agreements existing separately
from the charter can be used to entrench governance provisions as well. One disadvantage of a shareholder agreement is that, like other contracts, it would ordinarily
require unanimous consent to amend, but it is usually possible to structure a shareholder agreement so that amendments are binding on all upon approval by a majority.
Ultimately, the great advantage of entrenchment in the charter is that it operates more
smoothly, by automatically binding new shareholders, than an extra-​charter agreement. However, because many jurisdictions do not require the disclosure of shareholder agreements, at least if the company is not listed, that may be perceived as a
countervailing advantage.26 Of course, a shareholder agreement to which only some
21 Of course management entrenchment can be constrained in other ways. See Chapter 8.2.3.1.
22 See e.g. Companies Act 2006, section 22 (UK). The commitment must be present on formation
or be introduced later with the unanimous consent of the shareholders.
23 Arts. 122, 129, 136, and 137 Lei das Sociedades por Ações.
24 Art. 117, § 1º, c ibid.
25 Art. 136 ibid.
26 Italy is an example of a jurisdiction mandating disclosure of shareholder agreements. See e.g.
Vincenzo V. Chionna, La pubblicità dei patti parasociali (2008). Another example is Brazil,
where shareholder agreements must be publicly filed in order to bind the company: Art. 118 Lei das
Sociedades por Ações.
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Charter Amendments
177
shareholders are party may also operate as a mechanism for entrenching control rather
than for protecting the minority.
In recognition of the governance and publicity functions of charters, jurisdictions typically mandate the inclusion of specific governance arrangements in them. For example,
“dual-​class” capital structures in which some shares have more votes than others, where
permitted,27 may be required to appear in the charter; similarly, where permitted, limitations on directorial liability.28 The more prescriptive a jurisdiction is about the mandatory contents of corporate charters, the more important is the amendment procedure.
Whilst some jurisdictions specify only a few rudimentary issues that charters need to
address, and leave the remainder to the company’s discretion, the German concept of
Satzungsstrenge (“strictness of the charter”) means that the charter may only include provisions (or deviate from the default regime) in the fields where it is expressly permitted to
do so.29 Against this backdrop, it appears that lawmakers can influence the effectiveness
of the corporate charter not only by specifying the procedure for its modification, but
also by regulating the substantial scope of the charter. This has indirect consequences for
what subject matters would qualify as fundamental changes in any given jurisdiction.
For example, all jurisdictions require corporate charters to deal with the company’s
share capital in a significant way, inter alia by stating the number of authorized shares,
the number of share classes, and the powers, rights, qualifications, and restrictions on
these shares. The extent to which such terms constrain the board in the issuance of
shares depends, however, on a larger set of rules. Thus, in Delaware, while the charter
must state the number of authorized shares, the board has authority to issue stock
below the number of shares fixed in the charter. By contrast, European jurisdictions
contain at least statutory default rules requiring shareholder authorization of share
issues or pre​emption rights.30
Another example of divergence is the structure of the board of directors. In several
European jurisdictions, matters of board structure, such as the number of board seats
(but not the number or function of board committees) must be memorialized in the
charter, and may thus be changed only by a supermajority shareholder vote.31 By contrast, in the U.S., such provisions are typically included in the “bylaws”—​the rules for
the day-​to-​day running of the corporation, typically adopted by the board—​although
they can be placed in the charter, if desired.32 UK law has also traditionally regarded
27 See Chapter 4.1.1.
28 DGCL § 102(b)(7); Arts. 426 and 427 Companies Act (Japan). Even in jurisdictions which
do not insist that such requirements appear in the charter, the charter provides a convenient way of
making them public or giving them binding force. See e.g. Art. 3 Second EU Directive (2012/​30/​
EU), requiring certain information about shareholder rights to appear “in either the statutes or the
instrument of incorporation or a separate document published in accordance with the procedure laid
down in the laws of each Member State … ” Restrictions on the transfer of shares, in Delaware, may
be in the charter, the bylaws, or a shareholder agreement: DGCL § 202(b). The UK does not insist on
the rights of classes of shareholders being set out in the charter (as opposed to the terms of issue of the
shares), though they often are dealt with in the articles of association.
29 AktG § 23(5).
30 Share issuance rules are discussed in Section 7.3.
31 The charter must specify the number of supervisory board seats for German AGs if it is to
comprise more than the mandatory minimum (§ 95 AktG). For the French SA, the charter only sets
a maximum number of seats within the range (3–​18) allowed by law (Art. L. 225-​17 Code de commerce). By contrast, the law allows German GmbHs great freedom regarding the number of board
seats: the charter may e.g. specify a number, set a range, or leave the decision to another body.
32 Bylaws, under Delaware law, have a curious status. Formally, if the certificate of incorporation is thought of as the corporate constitution, the bylaws can be understood to be the corporate
statutes: they govern the day-​to-​day operation of the firm but when the certificate of incorporation
and the bylaws conflict, the certificate of incorporation governs: DGCL § 109. An odd provision of
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Fundamental Changes
board structure (including committees) and composition to be quintessentially matters
of “internal management,” that may either be enshrined in the charter or left to rules
made by the board itself. These differences in mandatory content are of decreasing
importance, however, because of the trend in all major jurisdictions to mandate, by law
or rules of best practice, that key board committees in listed companies, especially the
audit committee, be independent and follow specific procedures.33
7.2.1 The management–​shareholder conflict
in charter amendments
Charter provisions can be used to entrench management vis-​à-​vis shareholders. For
example, a charter provision establishing a classified (or staggered) board gives the
directors a temporary veto over efforts by shareholders to oust them in response to
a bid for control (unless directors are mandatorily subject to removal by an ordinary
majority of the shareholders, irrespective of what the charter says).34 The decision rights
strategy is used to control management–​shareholder agency costs: any midstream charter change must be approved by shareholder vote.
7.2.2 The majority–​minority shareholder conflict
in charter amendments
Although the supermajority vote may provide a degree of protection for minorities,
most jurisdictions go further. In many systems, charter amendments that adversely
affect a separate class of shareholders must be approved by a majority of that class
voting together.35 Such a “reinforced” decision right strategy is particularly important
for preferred shareholders, who often lack voting rights and who rely in consequence
on the charter, and the rules governing its amendment, to protect their interests. Such
protection, however, must be carefully drafted to actually fulfil its purpose.36 For
example, Delaware case law provides that unless the preferred stock clearly states that
class approval is required for changes to the terms, whether by charter amendment or
by merger, the protection offered is illusory.37 Equally, British and Italian courts have
drawn a sharp distinction between variations of the formal rights of a class of shareholders (requiring separate approval) and changes in the charter reducing the value
of those rights but not changing them formally (not requiring class approval). Thus,
in the UK, increasing the voting rights of another class of shares or even eliminating preference shares entirely through a reduction of capital (provided the preference
the Delaware law has made bylaws a focus of shareholder activism. While the power to adopt bylaws
may be, and typically is, delegated to the board of directors, that delegation does not divest shareholders of the power to adopt, amend or repeal bylaws: DGCL § 109. This has sparked a variety of
conflicts over the permissible scope of bylaws and left unanswered some fundamental questions such
as what happens if the board, pursuant to its delegated power, repeals a shareholder-​adopted bylaw.
See Chapter 3.2.1 and 3.2.3.
33 See Chapter 3.3.2.
34 See Chapter 3.1.3.
35 See e.g. DGCL § 242; Art. 2376 Civil Code (Italy); Art. L. 225-​99 Code de commerce (France);
Companies Act 2006, Part 17, ch. 9 (UK); AktG § 179(3) (Germany); Art. 322 Companies Act
(Japan); Art. 136, § 1º Lei das Sociedades por Ações (Brazil).
36 William Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control, 100
Michigan Law Review 891, 922–​39 (2002); William Bratton and Michael L. Wachter, A Theory of
Preferred Stock, 161 University of Pennsylvania Law Review 1815, 1831 ff. (2013).
37 Bratton, note 36.
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Charter Amendments
179
shareholders are treated in accordance with the rights they would have on a liquidation
of the company) have been held to fall outside the class protection.38
Most jurisdictions also use regulatory strategies alongside this. For example, they
may have a fallback standard allowing courts to review the most egregious examples of
self-​interested charter changes, whether involving class rights or not, but these standards are rarely invoked successfully.39 However, a more common protection is the
exit right strategy, mostly in the form of an appraisal right.40 Italy, Japan, Brazil, most
U.S. states (though not Delaware), and France provide appraisal rights for charter
amendments that materially affect the rights of dissenting shareholders (e.g. altering
preferential rights or limiting voting rights).41
Charter provisions can also be used to solidify control by a controlling shareholder.
A dual-​class capital structure (either high voting and low voting, or voting and non-​
voting, stock), which must be in the charter to be valid, will allow shareholders with a
minority of the cash-​flow rights to retain control.42 As such, it is a powerful entrenchment device. Having been banned by the New York Stock Exchange (NYSE) listing
rules for the most part of the twentieth century, it has seen somewhat of a renaissance
in both media and IT corporations lately.43 Midstream introductions of dual-​class
structures are frequently understood as efforts by would-​be controlling shareholders
(often current managers) to exploit non-​controlling shareholders’ collective action
problems to induce them to approve value-​reducing amendments. In response, former
SEC rule 19c-​4 required stock exchanges to refuse to list firms that had engaged in
midstream dual-​class recapitalizations.44 Although the SEC rule was ultimately held
to be beyond its regulatory authority,45 the exchanges, which had already adopted
conforming rules, left them in place. Japan is similar in that stock exchanges generally
do not permit midstream dual-​class recapitalizations that would exploit existing non-​
controlling shareholders.46
38 See Paul Davies and Sarah Worthington, Gower And Davies’ Principles Of Modern
Company Law (9th edn., 2012), paras. 19-​32 to 19-​37.
39 E.g. abus de majorité in France (see Maurice Cozian, Alain Viandier, and Florence Deboissy,
Droit des Sociétés 239–​41 (28th edn., 2015)); provisions prohibiting “unfair prejudice” in the UK
(see Davies and Worthington, note 38, ch. 20). AktG § 243(2) permits a challenge by an individual
shareholder to any decision of the general meeting on the grounds that another voting shareholder
has acquired through the resolution “special benefits for himself or another person to the detriment
of the company or other shareholders.” See Art. 831(1)(iii) Companies Act (Japan) (similar rule).
Potentially more important, the UK has also developed a review standard in the specific context of
charter changes i.e. the requirement that the change be effected “bona fide in the interests of the company.” This rather opaque formula tends to require simply that the majority act in good faith, except
in cases of expropriation of shares where it has a larger impact. See Re Charterhouse Capital Limited
[2014] EWHC 1410 (Ch) [230]–​[237].
40 See Chapter 2.2.1.2.
41 Art. 2437 Civil Code (Italy) (appraisal right granted for charter amendments regarding e.g.
voting rights or significant changes in the scope of business); § 13.02 Revised Model Business
Corporation Act (hereafter “RMBA”) (U.S.). For Brazil see note 23 and accompanying text. In
France, when a controlling shareholder proposes to alter the charter of a listed company in a significant way, it must inform the market regulator (Autorité des Marchés Financiers, AMF) in advance,
which may require the controllers to make a buy-​out offer, on terms agreed with the AMF, for the
minority shares. Art. L. 433-​4 Code Monétaire et Financier; Art. 236-​6 Règlement Général de l’AMF.
42 See also Chapter 4.1.1.
43 Recent examples are the New York Times, News Corporation, and Comcast, as well as Google,
Facebook, and LinkedIn, where the use of “super-​voting” stocks has allowed the founding shareholders to keep control of the corporation without holding the majority of the share capital.
44 Voting Rights Listing Standards, Release No. 34-​25891, 53 Fed. Reg. 26376 (1988).
45 Business Roundtable v. SEC, 905 Federal Reporter 2d 406 (D.C. Cir. 1990).
46 See Tokyo Stock Exchange, Listing System Improvement FY2008, 27 May 2008.
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Fundamental Changes
In Europe, dual-​class recapitalizations are controversial although generally permitted;47 and they are regulated differently than in the U.S. Even if the charter confers on
the board the discretion to issue classes of shares with differing cash-​flow or governance
rights attached, mandatory rules of corporate law, derived from the Second Directive,
require shareholder consent to any particular exercise of the power and also require pre-​
emptive rights to be given to the existing shareholders in the case of the issue of equity
shares for cash.48 Consequently, dual-​class recapitalizations have been handled not
through specific rules implementing the proportionality principle but rather through
the general rules on charter amendments.49
7.3 Share Issuance
Transactions involving the company’s share capital can realign interests: issuance of
new shares can dilute the ownership of existing shareholders; their repurchase and
capital reductions can entrench managers, create a controlling shareholder, provide an
exit to an advantaged shareholder, and injure creditors.50 Most jurisdictions again use
predominantly a decision-​rights approach to address these issues.
7.3.1 The manager–​shareholder conflict
Shareholders as a class have an interest in maintaining direct control over major decisions that can jeopardize their interests, most importantly by diluting their cash flow
or voting rights.51 Above all, this concerns the corporate decision to issue new shares.
In such transactions, managers’ incentives may be problematic: share issuances can be
used to build empires, entrench managers, and dilute shareholder influence. Not surprisingly, then, we find the familiar requirements of board and shareholder approval.
In the U.S. and Japan the distinction between the number of shares authorized by
the charter and the number of shares that are actually issued and outstanding is, in
practice, highly relevant. An increase in the amount of authorized capital is an organic
change that must be approved by a qualified vote of the shareholders. By contrast, a
new issue of shares that leaves the number of issued shares below the authorization
limit lies within the discretion of the board. Since most companies have actually issued
only a fraction of their authorized shares at any particular point, the decision to issue
shares is effectively a board decision that does not require shareholder approval.52 But
there are exceptions: U.S. listing requirements require a shareholder vote when a new
47 See Arman Khachaturyan, Trapped in Delusions: Democracy, Fairness and the One-​Share-​One-​Vote
Rule in the European Union, 8 European Business Organization Law Review 335 (2007); Mike
Burkart and Samuel Lee, One Share-​One Vote: The Theory, 12 Review of Finance 1 (2008); Renée
Adams and Daniel Ferreira, One Share-​One Vote: The Empirical Evidence, 12 Review of Finance
51 (2008); Wolf-​
Georg Ringe, Deviations from Ownership-​
Control Proportionality—​
Economic
Protectionism Revisited, in Company Law and Economic Protectionism 209 (Ulf Bernitz and Wolf-​
Georg Ringe eds., 2010).
48 See Section 7.3.
49 The European Commission rejected proposals to make the proportionality principle mandatory
at the EU level. See European Commission, Impact Assessment on the Proportionality between Capital
and Control in Listed Companies, SEC (2007) 1705, December 2007.
50 Note, too, that some of these adjustments to capital are also organic changes, since they require
material amendments to company charters.
51 See Section 7.1.
52 Grimes v. Alteon, 804 Atlantic Reporter 2d 256 (Del. 2002). Frequently, the charter’s limitation on authorized shares will be illusory. When a charter contains an authorized but unissued series
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181
issue of shares is large enough to shift voting control over a listed company, unless the
new issue takes the form of an offering to dispersed public shareholders.53 In Japan,
since 2014, the law requires shareholder approval when the subscriber of newly issued
shares comes to own the majority of shares and 10 percent or more of shareholders
oppose the issuance.54
By contrast, EU jurisdictions have a stronger tradition of putting new share issues
to the vote of shareholders, although the company’s charter or the shareholders in general meeting may delegate that decision to the board, for periods of up to five years.55
This position may not appear as much different from that in the U.S., but European
corporate practices give the shareholders more control over shareholder rights plans.56
Concerns about share dilution also arise whenever companies repurchase outstanding stock or reduce the company’s equity capital. EU law responds to these concerns
in part by mandating that any reduction in subscribed legal capital in publicly held
companies must be ratified by a qualified majority of shareholders.57 By contrast, most
U.S. jurisdictions allow companies relatively broad flexibility with their legal capital
without seeking shareholder approval58—​an approach that reflects the U.S. view of
legal capital as a vestigial concept rather than a meaningful trigger for shareholder
decision rights.59 Japan falls somewhere in the middle. While the minimum capital
requirement was abolished under the Companies Act of 2005, the notion of legal capital is maintained for the regulation of distributions, and the reduction of legal capital
requires supermajority shareholder decision.60
7.3.2 The majority–​minority conflict
Although all shareholders risk dilution from new equity and corporate distributions,
minority shareholders face the largest risk because they are often not protected by
of preferred stock (“blank check preferred”), the board’s power under DGCL § 152 to fix the terms
of the preferred stock upon issue gives the board the effective power to issue ownership and voting
interests that may even allow the board to transfer control. This occurred in the bailout of AIG. Steven
M. Davidoff and David T. Zaring, Regulation by Deal: The Government’s Response to the Financial
Crisis, 61 Administrative Law Review 463 (2009). The power conferred on the board by authorized
but unissued preferred stock also provides the foundation for the board’s power to issue “poison pill”
shareholder rights plans without shareholder approval. See Chapter 8.2.3.
53 See § 312.03(c) NYSE Listed Company Manual and §§ 712, 713 American Stock
Exchange Company Guide. The qualifications of these requirements in the U.S. make clear that
they are directed at control transfers rather than at dilution.
54 Art. 206-​2 Companies Act. The new requirement may not be enough to prevent managerial
entrenchment. In such a case, shareholders can seek for a court’s injunction of the issuance of stock
asserting that it is “significantly unfair,” a remedy that courts have granted when the primary purpose
of the issuance is to preserve the control of management. Art. 210(ii) Companies Act.
55 Art. 29 Second Directive (now 2012/​30/​EU). On this point see Vanessa Edwards, EC Company
Law 77–​8 (1999). Member states may determine the majority required for such shareholder author­
ization and also add further limitations on the authority that may be delegated to the board, e.g. no
more than half the par value of the existing capital in Germany: AktG § 202(3). UK institutional
shareholder guidance indicates that such shareholders will vote in favor of giving boards authorization
to issue more than one-​third of the existing share capital (and in any event no more than two-​thirds)
only on the basis that the whole board should stand for re-​election at the following general meeting.
In addition, the actual use of this authorization should comply with the preemption requirements,
discussed below. See Association of British Insures, Directors’ Powers to Allot Share Capital and Disapply
Shareholders’ Pre-​emption Rights, December 2008.
56 See Chapter 8.2.3.
57 See Art. 34 Second Directive.
58 § 244 DGCL (the reduction of the legal capital can be made by a decision of the board of
directors).
59 On the very limited role of legal capital in the U.S., see Chapter 5.2.2.
60 Arts. 309(2)(ix) and 447(1) Companies Act.
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Fundamental Changes
shareholder decision rights. Instead, minority shareholders must depend on other legal
strategies for protection, such as sharing norms, rules, and standards.
Preemptive rights are a paradigmatic example of the sharing strategy. By allowing existing shareholders to purchase new shares pro rata before any shares are offered to outsiders,
preemptive rights permit minority shareholders to safeguard their proportionate investment stakes and discourage controlling shareholders from acquiring additional shares
from the firm at low prices.
Jurisdictions differ in their approaches to preemptive rights. The U.S. and Japan only
enforce preemptive rights that are enshrined in company charters (opt-​in).61 Brazil grants them
as the statutory default, as do all European jurisdictions, due to requirements in the Second
Directive.62 European shareholders may opt out of this default for individual cases with qualified majority; and they may also delegate the power to issue the shares to the board, subject to
some limitations.63 Consequently, the strength of the preemption rule depends in part on the
willingness of the shareholders to waive it. In the UK, institutional shareholders strongly support it and have developed Preemption Guidelines narrowly identifying the situations in which
they will routinely vote in favor of disapplication resolutions put forward by listed companies.64
In France the default rule is strengthened through regulation: the market regulator will in effect
require that for listed companies a “priority subscription” period for existing shareholders is
made available, even if preemption rights proper are removed.65 On the face of it, German
law seems to take the strictest stance as waiving preemptive rights requires a material reason
(sachlicher Grund ), which is subject to judicial review.66 Despite this hurdle, corporate practice
has found its ways to comply with the requirement, and time-​limited delegation to the board
plus the waiver of preemptive rights appear common practice today.67 In Brazil, companies
adopting the system of authorized capital may eliminate preemptive rights by charter provision
under a limited set of circumstances, such as when the shares issued are to be sold in the public
market; otherwise, preemptive rights will necessarily apply.68
Like other devices for protecting minority shareholders, preemptive rights have a
cost. Above all, by forcing companies to solicit their own shareholders before turning to the market, they delay, and therefore increase execution risk of, new issues of
shares.69 This became visibly apparent during the 2008/​9 financial crisis, where speedy
61 See § 6.30 RMBCA. Japan does recognize them for closely held firms, see Art.199(2) and 309(2)
(v) Companies Act (two-​thirds majority necessary for excluding pre​emptive rights).
62 For Europe, see Art. 33 Second Directive (shareholders must be offered shares on a preemptive
basis when capital is increased by consideration in cash, a right that cannot be restricted once and for
all by the corporate charter, but only by general meeting resolution).
63 Second Directive, Arts. 29(2) and 33(4) and (5).
64 Preemption Group, Disapplying Pre-​Emption Rights: A Statement of Principles (March 2015): no
more than 5 percent of the issued common shares in any year or more than 7.5 percent over a rolling
period of three years.
65 Cozian et al., note 39, at 475–​7.
66 This is true for either the shareholder resolution waiving the rights or the board decision, where
authorized. See Bundesgerichtshof (BGH), March 13, 1978 –​II ZR 142/​76, BGHZ 71, 40, 46 [Kali
+ Salz]; BGH, June 23, 1997 –​II ZR 132/​93, BGHZ 136, 133, 139 [Siemens/​Nold]. The insistence
on preemptive rights appears to have been a major driver for the Holzmüller case, requiring shareholder approval for the transfer of major assets to a subsidiary. See Section 7.6. The standard is relaxed
if the share issuance does not exceed 10 percent of the current registered share capital and the issue
price is not substantially below the current market price. See AktG § 186(3).
67 Rüdiger Veil, Commentary on § 202, para 2, in Aktiengesetz Kommentar (Karsten Schmidt
and Marcus Lutter eds., 3rd edn., 2015).
68 Art. 172 Lei das Sociedades por Ações.
69 In particular, the shares of the company making the rights issue may come under pressure from
short-​sellers, even when the shares are issued at a substantial discount to the market price, at least
where the issuer is seen to be in a weak financial position.
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Mergers and Divisions
183
execution of decisions to raise fresh capital proved to be paramount.70 They also limit
management’s ability to issue blocks of shares with significant voting power. These
problems may explain why both Japan and U.S. states have abandoned preemptive
rights as the statutory default, and why Japanese and U.S. shareholders almost never
attempt to override this default by writing preemptive rights into their corporate
charters.71
In lieu of preemptive rights, U.S. jurisdictions rely on a standards strategy, the duty
of loyalty, to thwart opportunistic issues of shares. Enforcing the duty of loyalty is
costly and litigation-​intensive, but, where private enforcement institutions work reasonably well, it may protect minority shareholders no less effectively than preemptive
rights do. Even in the UK, in small companies where minority shareholders may not be
able to block the disapplication of preemptive rights, they may file a petition al­leging
“unfair prejudice” and seeking a right to be bought out at a fair price.72 Japan and
Brazil combine the standards and the decision-​rights strategy here. In Japan, shareholders in non-​public companies enjoy preemptive rights, and all companies, including public ones, must receive supermajority shareholder approval to issue new shares
to third parties at “particularly” favorable prices.73 Brazilian law, in turn, requires the
price in new share issuances to be fixed “without unjustified dilution of existing shareholders,” irrespective of the availability of preemptive rights.74
The European preemption rules apply only to share issues for cash. In non-​cash
issues the minority is also at risk if shares are issued to the majority or persons connected with them at an undervaluation. Again, the approach of EU law is to address
the problem through rules, notably by requiring independent valuation of the non-​
cash consideration in public companies.75
7.4 Mergers and Divisions
A merger can revolutionize the relationships among the participants in the firm.
Mergers and consolidations pool the assets and liabilities of two or more corporations
into a single corporation, which is either one of the combining entities (the “surviving
company”), or an entirely new company (the “emerging company”).76 In the process,
a shareholder’s ownership stake can be diluted, transformed, or, in some jurisdictions,
cashed out.77 A preferred stockholder’s accrued dividends can be wiped out. A shareholder in a widely dispersed firm can find itself a shareholder in a controlled firm.
A shareholder in a firm with no antitakeover protections can wake up a shareholder in
70 See e.g. Kate Burgess, Pre-​emption: Knowing Your Rights is a Serious Issue, Financial Times,
3 February 2010 (reporting on the difficulties HBOS met with its rights issue). Nevertheless the
Government proposed to maintain the preemption principle whilst seeking to reduce the timetable for such issues. See Office of Public Sector Information, Report of the Rights Issue Review
Group, November 2008.
71 See Robert C. Clark, Corporate Law 719 (1986) (U.S. public corporations very rarely recognize preemptive rights). By contrast, preemptive rights are more often granted in U.S. closely held
corporations (Robert W. Hamilton, The Law of Corporations 196 (5th edn., 2000)) and especially
at companies raising funds from venture capitalists (see e.g. George G. Triantis, Financial Contract
Design in the World of Venture Capital, 68 University of Chicago Law Review 305, 312 (2001)).
72 On unfair prejudice see note 39.
73 Arts. 199(2), 201(1), 309(2)(v) Companies Act (Japan).
74 Art. 170 § 1º Lei das Sociedades por Ações.
75 Art. 10 Second Directive, somewhat relaxed by Art. 11, introduced in 2006.
76 Therein lies the difference to the takeover; see Chapter 8.1.
77 In a so-​called cash-​out merger, shareholders in one of the two merged companies have no choice
but to accept cash in exchange for their shares.
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Fundamental Changes
a company that is effectively takeover-​proof. A shareholder in a privately held company
can end up a shareholder of a publicly held company or vice versa. The overwhelming problems, however, are related to price, that is, typically the exchange ratio in this
context: a shareholder can be forced to exchange his shares for shares in the surviving
or emerging company that are worth less.
Because mergers can so fundamentally realign the relationships among the firm participants, every jurisdiction accords special treatment to mergers and other modes of
consolidation. Although some mergers result in no realignment of interests (and are
typically exempted from the shareholder approval requirement), many mergers exhibit
the functional characteristics of fundamental changes: they are large; they often give
rise to agency problems;78 and they involve investment-​like decisions.
These problems are predominantly addressed by a decision rights strategy. Thus,
most jurisdictions require supermajority shareholder authorization for a merger or
consolidation. In the EU, the Third Company Law Directive sets a minimum approval
requirement of at least two-​thirds of the votes at the shareholders’ meeting (or, as
an alternative, one half of outstanding shares).79 Some member states impose even
higher voting thresholds. For example, Germany and the UK80 require 75 percent of
voting shareholders to approve a merger, while France and Japan require at least a two-​
thirds majority of voting shares with a minimum quorum of one fourth and one-​third
of the outstanding shares, respectively.81 By contrast, Brazil and most U.S. jurisdictions require a majority of all outstanding shares to approve a merger or other organic
change, although this might easily translate into 70 percent or more of shares that are
actually voted.82
These shareholder ratification requirements ordinarily apply to both (or all) participants in a merger or consolidation.83 The fact that shareholders of acquiring companies
78 The jobs of the weaker merging firm’s managers are often as much at risk as those of managers in
the targets of hostile takeovers (see Chapter 8.1.2.1), even if the merger is officially called a “merger of
equals.” Regarding the similarity between hostile and friendly transactions, see G. William Schwert,
Hostility in Takeovers: In the Eyes of the Beholder? 55 Journal of Finance 2599 (2000).
79 Art. 7 Third Company Law Directive 2011/​35/​EU, 2011 O.J. (L 110) 1, applicable to domestic mergers of public companies. This article also requires the consent of each class of shareholders
whose rights are affected, voting separately, not just of the shareholders’ meeting. On “class rights”
see Section 7.2.2.
80 The UK is peculiar in not having a free-​standing statutory merger procedure. Instead, the
“scheme of arrangement” (Companies Act 2006, Part 26) can be used to this end. A “scheme” may
be used more generally to adjust the mutual rights of shareholders and/​or creditors and the company, whether or not another company is involved in the scheme. It was originally designed (in the
nineteenth century) for the adjustment of creditors’ rights in insolvency. If the scheme is used to
effect a merger or division, it may attract the additional regulation of Part 27, implementing the
Third and Sixth EU Directives, though some mergers and divisions fall outside Part 27. Although
the scheme is increasingly often used to effect a control shift (see Chapter 8.1.1), scheme mergers are
relatively uncommon in the UK. See generally Jennifer Payne, Schemes of Arrangement: Theory,
Structure and Operation (2014).
81 § 65 Umwandlungsgesetz (unless the charter sets a higher threshold) (Germany); ss. 899 and
907 of Companies Act 2006 (UK); Arts. L. 236-​2 and L. 225-​96 Code de commerce (France). For
Japan, see Arts. 783, 795, 804, 309(2)(xii) Companies Act. Similarly, Italy requires a two-​thirds
majority of shares representing at least one-​fifth of the outstanding capital for listed companies (SPA)
(in non-​listed public companies, a simple majority of the voting shares may, however, approve the
merger) (Arts. 2368-​2369 Civil Code).
82 Art. 136 Lei das Sociedades por Ações (Brazil); § 251(c) DGCL; § 11.04(e) RMBCA. If only
70 percent of shareholders vote, more than 71 percent of voting shareholders must approve a transaction to provide a majority of outstanding shares.
83 Jurisdictions allowing for cash-​out mergers, like Delaware and Japan, differ on whether they
require approval of acquiring companies’ shareholders as well. Delaware law does not (§ 251(f )(3)
DGCL), whereas Japanese law does (Arts.795(1), 796 Companies Act).
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Mergers and Divisions
185
must often authorize mergers (even if there is no alteration of their charters) suggests that
corporate law is less concerned with formal legal identity than with the sheer size of these
transactions, and the possibility that they can radically alter the power and composition
of the acquiring corporation’s management. Consistent with this focus on transactions
that fundamentally re-​order relations is the fact that some jurisdictions do not require
the acquirer’s shareholder authorization when it is much larger than the company it
targets, as long as the merger does not alter the surviving corporation’s charter.84 Here
the implication is that a shareholder vote is unnecessary because the boards of acquiring
companies are merely making modest purchases that, for tax reasons or otherwise, are
conveniently structured as a merger rather than as asset purchases or share acquisitions.
7.4.1 The management–​shareholder conflict in mergers
The two principal management–​shareholder agency conflicts that potentially arise in
mergers are: (a) management’s self-​interested refusal to agree to a merger that shareholders support; and (b) self-​interested attempts by management to build empires or
to negotiate their future job status or compensation with an acquiring company at the
expense of their shareholders.85 Because these agency problems primarily arise in dispersed ownership structures, we focus here mostly on the U.S., the UK, and Japan.86
7.4.1.1 Managerial “entrenchment”
What is to be done when managers resist a merger proposal which shareholders would
like to accept? How can a system distinguish between resistance that is driven by a
sincere, well-​founded belief that a merger is not in the interests of shareholders from
resistance that is driven by self-​interest? In a board-​centered system such as the U.S.,
managerial entrenchment is addressed through a combination of a trusteeship strategy
(boards dominated by independent directors) combined with a rewards strategy (high-​
powered incentive compensation for managers triggered by a change in control) and an
appointment rights strategy (although boards may veto a merger proposal, shareholders can vote in a new slate of directors).
The UK deals with such issues broadly similarly but differs from the U.S. in two
important respects: first, there is no board veto on merger proposals and, second, as
seen in Chapter 3, it is easier for shareholders to remove directors.87 Yet, there are
practical difficulties in convening the shareholders’ meeting without the cooperation
of the board.88 Hence, like in the U.S., an acquirer can shift the form of the transaction to a straight share acquisition: as we shall see in Chapter 8, by doing so, unlike in
the U.S., the acquirer can then invoke the Takeover Code’s ban on frustrating action
to neutralize any negative action the target management might take against the tender
offer without shareholder approval.89
84 See § 251(f ) DGCL (Delaware) (voting not required if surviving corporation issues less than
20 percent additional shares); Art. 796(3) Companies Act (Japan) (voting not required if surviving
corporation pays consideration of 20 percent or less of its net worth, with some exceptions).
85 A third conflict arises in management buyouts when managers, with a financial sponsor, seek
to acquire the company from the public shareholders. It is discussed in Section 7.4.2, in the context
of freeze-​outs.
86 For majority–minority shareholder conflict see Section 7.4.2.
87 See Chapter 3.2.2.
88 For the difficulties an acquirer has in using the UK-​style merger against a hostile target see Re
Savoy Hotel Ltd [1981] Ch 351, discussed in Davies and Worthington, note 38, para. 29-​5.
89 These issues are discussed more fully in Chapter 8 in the context of control shifts. See Chapter 8.2.
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Fundamental Changes
7.4.1.2 Managerial nest-​feathering
A second manager–​shareholder agency problem arises where managers, in negotiating
a merger agreement, put their own interests—​in building an empire through acquisitions or in securing employment with the surviving firm—​ahead of shareholders’.
Here, interestingly, the strategies adopted by different jurisdictions are rather similar. First, the shareholder approval requirement90 gives shareholders a means of challenging a merger driven by managerialism. Large-​block shareholders or coalitions of
blockholders, including hedge funds and institutional investors, will sometimes have
the voting power to block corporate actions, especially when there is a clearly better
alternative transaction proposed.91
Secondly, with the purpose of improving the quality of shareholder decision-​
making, many jurisdictions require approval by gatekeepers of the terms of mergers,
consolidations, and other organic changes (a trusteeship strategy). For example, EU
law requires merging public companies to commission independent experts’ reports
on the substantive terms of mergers prior to their shareholders’ meetings.92 In Japan,
when the proposed merger is one with the company’s controlling shareholder, the stock
exchanges require a third party to analyze whether it is fair to the shareholders.93 And
in the U.S., public companies pursuing a merger customarily seek to protect themselves from shareholder suits by soliciting fairness opinions from investment bankers,94
which shareholders can peruse before they vote.
Third, the U.S. and Japan also protect shareholders through an exit strategy—​the
appraisal remedy—​that allows dissatisfied shareholders to escape the financial effects of
organic changes approved by shareholder majorities by selling their shares back to the
corporation at a “reasonable” price in certain circumstances.95 Brazil and Italy provide
for a similar remedy, which however applies more selectively.96 Although EU law does
not require appraisal in the event of a merger as such, French, German, as well as Italian
corporate law provisions granting appraisal rights in case of significant changes in the
charter of public companies will catch some mergers.97 Appraisal may be made available
expressly where the merger involves a change in legal form or some other unusual restriction on shareholders’ rights.98 As a side benefit, the appraisal remedy also protects shareholders as a class by making unpopular decisions more expensive for the company to
pursue.99 The cost of these protections is that this same remedy may harm shareholders if
90 note 81.
91 For examples, see Marcel Kahan and Edward Rock, Hedge Funds in Corporate Governance and
Corporate Control, 155 University of Pennsylvania Law Review 1021 (2007).
92 Art. 10 Third Directive (requiring third-​party reports on the fairness of merger terms, though
the holders of voting securities in the company can waive this requirement on the basis of unanimity).
93 Tokyo Stock Exchange, Securities Listing Rules, Art. 441-​2.
94 See e.g. Smith v. Van Gorkom, 488 Atlantic Reporter 2d 858 (Delaware Supreme Court
1985) (sale of a company without valuation report and with little deliberation is grossly negligent
despite premium price).
95 On the appraisal remedy under Japanese law, see Alan K. Koh, Appraising Japan’s Appraisal
Remedy, 62 American Journal of Comparative Law 417 (2014).
96 Dissenting shareholders in Brazil may seek appraisal only if their shares do not have sufficient liquidity after the merger: Arts. 136, IV, and 137, II Lei das Sociedades por Ações. In Italy, appraisal rights are
granted in favor of shareholders of closed companies and of those of a listed company merging into a non-​
listed one: Civil Code, Arts. 2505-​IV (closed companies) and 2437-​V (listed into non-​listed company).
97 See text attached to note 41 and Alain Viandier, OPA, OPE et Autres Offres Publiques
460–​1 (5th edn., 2014).
98 See Art. 236-​5 Règlement Général de l’AMF (France; transformation of an SA into a société en
commandite par actions); § 29 Unwandlungsgesetz (Germany); Article 2437 Civil Code (Italy).
99 See Hideki Kanda and Saul Levmore, The Appraisal Remedy and the Goals of Corporate Law, 32
UCLA Law Review 429 (1985).
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Mergers and Divisions
187
the need for cash to satisfy appraisal demands scuttles transactions that would otherwise
increase the company’s value.100
The scope of the appraisal remedy varies widely among U.S. states and the non-​
U.S. jurisdictions that offer this exit right. In practice, however, cumbersome
procedures, delay, and uncertainty often discourage small shareholders from seeking appraisal in the jurisdictions that offer it. For example, shareholders seeking
to perfect their appraisal rights in Delaware must first file a written dissent to
the objectionable transaction before the shareholders’ meeting in which it will
be considered; they must refrain from voting for the transaction at the meeting;
and they may be forced to pursue their valuation claims in court for two years
or more before obtaining a judgment. In addition, many U.S. states, including
Delaware and RMBCA jurisdictions, further limit appraisal rights by introducing
a so-​called “stock market exception” to their availability in corporate mergers.101
Under this “exception,” shareholders do not receive appraisal rights if the merger
consideration consists of stock in a widely traded company rather than cash, debt,
or closely held equity—​apparently on the theory either that appraisal rights ought
to protect the liquidity rather than the value of minority shares, or that the valuation provided by the market, while imperfect, is unlikely to be systematically less
accurate than that provided by a court.102 As a result, appraisal rights are of little
use to shareholders who wish to challenge the price they receive in stock mergers
between public corporations.103
These difficulties may explain why most European jurisdictions have never turned
to the exit strategy—​appraisal rights—​as a general remedy to protect minority shareholders in mergers. Instead, as we have seen, EU law relies on a decision rights strategy
(shareholder approval) and on the trusteeship strategy as well, to the extent that EU
law requires valuation by independent experts who are liable to shareholders for their
misconduct.104
Note, however, that some individual member states go beyond the minimum
required by EU law and provide individual shareholders with a right to challenge the
fairness of merger prices, a right that resembles the appraisal remedy in spirit if not
in form. This is the case in both Germany and Italy where shareholders of merged
companies may sue the surviving companies for the difference between the value of
the shares they previously owned and the value of those they received in exchange.105
100 See Bayless Manning, The Shareholder’s Appraisal Remedy: An Essay for Frank Coker, 72 Yale
Law Journal 223 (1962).
101 § 13.02 RMBCA; § 262 DGCL.
102 Of course this theory does not explain why appraisal rights are available when shareholders
receive cash, the most liquid merger consideration possible.
103 See Paul G. Mahoney and Mark Weinstein, The Appraisal Remedy and Merger Premiums, 1
American Law and Economics Review 239 (1999) (analyzing 1,350 mergers involving publicly held firms from 1975–​91); Joel Seligman, Reappraising the Appraisal Remedy, 52 George
Washington Law Review 829 (1984) (only about 20 mergers from 1972–​81 resulted in appraisal
proceedings).
104 Art. 20 Third Directive (liability of managers vis-​à-​vis their shareholders) and Art. 21 (liability
of independent experts vis-​à-​vis shareholders); Art. 18 Sixth Directive (liability of managers and independent experts vis-​à-​vis shareholders). See also Matthias Habersack and Dirk Verse, Europäisches
Gesellschaftsrecht (4th edn., 2011) para. 16-​20.
105 § 15 Umwandlungsgesetz; Art. 2504-​
IV Civil Code; see also Karsten Schmidt,
Gesellschaftsrecht 390 (4th edn., 2002); Pierre-​Henri Conac, Luca Enriques, and Martin Gelter,
Constraining Dominant Shareholders’ Self-​Dealing: The Legal Framework in France, Germany, and Italy,
4 European Company and Financial Law Review 491, 525 (2007). The particular difficulty with
the German system is that it may result in an adjustment of the terms after the merger has been carried into effect.
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Fundamental Changes
Indeed, the ability of individual shareholders to request the differential payment has
proved so effective in Germany that it has acted as a considerable deterrent to mergers
in that country.106
7.4.2 The majority–​minority shareholder conflict in mergers
In the presence of a controlling shareholder, mergers with unconnected companies
involve risks for minority shareholders that are similar to those we have seen in previous sections. Hence, many of the mechanisms that limit manager–​shareholder conflicts, for example independent assessment of the merger terms or appraisal rights,
operate to protect minority shareholders against majority shareholders as well.107 That
is, they provide protection for non-​controlling shareholders against company controllers, whether those controllers are management or majority shareholders (or, of
course, both). However, some of the techniques, notably shareholder approval (even
on a supermajority basis) will be less effective in such a situation. But in the event of
a merger with an affiliate of the controlling shareholders, such as a parent-​subsidiary
merger, the conflicts of interest at the level of the subsidiary are more intense, and actually very similar to the agency problem we have focused on in Chapter 6: such mergers
are, in fact, related party transactions. Majority–​minority conflicts are even more acute
in freeze-​out mergers, where a controlling shareholder, using the merger structure,
eliminates the non-​controlling shareholders either for cash or stock.108 Management
buyouts, in which managers team up with a financial sponsor to acquire the company,
present many of the same problems.
All of our major jurisdictions strengthen the protection of minority shareholders
when controlling shareholders stand on both sides of a merger. In particular, standards
play a more important role in regulating conflicted transactions.109 European jurisdictions offer minority shareholders the right to sue under a variety of protective standards. In France, for example, controlled mergers can be invalidated under the abus de
majorité doctrine,110 while, in the UK the “unfair prejudice” remedy is at least potentially available to provide an exit right for the minority at a fair price.111 Although in
the U.S. standards play a relatively small role in the regulation of most arm’s-​length
organic changes (except when the company is being sold for cash or broken up112 or
a merger or other transaction promises to create a new controlling shareholder where
there had been none before),113 they become prominent in controlling shareholder
transactions.114
106 See Section 7.4.2.3.1.
107 The exception are decision rights in the form of shareholder approval, which will be ineffective
unless the requirement is for majority-​of-​the-​minority approval.
108 For a comparative perspective, see Marco Ventoruzzo, Freeze-​Outs: Transcontinental Analysis
and Reform Proposals, 50 Virginia Journal of International Law 841 (2010).
109 See Chapter 6.2.5.
110 Cozian et al., note 39, at 740, n. 11.
111 On the “unfair prejudice” remedy see Davies and Worthington, note 38, ch. 20.
112 Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. 506 Atlantic Reporter 2d 173
(Delaware 1986).
113 See e.g. Paramount Communications, Inc. v. QVC Network, Inc., 637 Atlantic Reporter 2d
34 (Delaware Supreme Court 1994).
114 See Mahoney and Weinstein, note 103, 272–​4; compare Weinberger v. UOP, Inc., 457 Atlantic
Reporter 2d. 701 (Delaware Supreme Court 1983); Kahn v. Lynch Communications Systems, Inc., 638
Atlantic Reporter 2d 1111 (Delaware 1994). Robert B. Thompson, Squeeze-​out Mergers and the
“New” Appraisal Remedy, 62 Washington University Law Quarterly 415 (1984). See also Chapter
6.2.2.1.
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189
7.4.2.1 When the parent has more than 90 percent
In an attempt to balance the interests of minority and controlling shareholders, jurisdictions generally facilitate minority buyouts when a controlling shareholder owns
more than 90 percent of a company’s shares. For example, EU law allows member
states to substitute the equivalent of appraisal rights for expert assessment of the
merger plans and to dispense with the need for a vote by the shareholders of the
acquiring company when an acquiring corporation owns more than 90 percent of a
target company—​an option inspired by Germany’s Konzernrecht.115 More dramatically, a parent company holding more than 90 percent of a subsidiary can unilaterally merge the subsidiary into itself without a shareholders meeting of the controlled
company (a so-​called “short-​form” merger) in most U.S. jurisdictions—​with minority
shareholders entitled to appraisal rights in lieu of a shareholder vote.116 Japanese law
is similar.117
7.4.2.2 When the parent has less than 90 percent
U.S. law also permits cash-​out mergers, or, as they are often referred to, freeze-​outs, in
situations in which the controlling shareholders own less than 90 percent of a subsidiary’s shares, but at the price of providing additional minority shareholder protection
beyond what would be available in an uncontrolled merger. Japanese law is, again,
similar.118 U.S. securities regulation requires public corporations that go private (as
a result of the freeze-​out merger) to make disclosures relating to the fairness of the
transaction and to any discussions with third parties who may be interested in acquiring the company,119 while in France the market regulator may require the appraisal
remedy to be made available in the case of the merger of a listed subsidiary into a
controlling company where it deems it necessary to protect the minority’s interests.120
In addition, the Delaware courts generally review parent-​subsidiary mergers under
the rigorous “entire fairness” standard, with the burden on the controlling shareholder
to prove fair price and fair process.121 However, the burden of proof is shifted to the
plaintiff where the transaction was either (i) negotiated by a special committee comprised of independent directors or (ii) supplemented by approval by a majority of the
minority shareholders.122 When both of these steps are taken, the transaction will generally be reviewed under the more deferential business judgment rule.123 In establishing this framework, the case law morphs from an ex post review standard to a de facto
trusteeship strategy, as the use of independent committees is rewarded.
The law in EU jurisdictions is less clear-​cut with respect to controlled mergers and
freeze-​outs involving companies in which the controlling shareholder holds less than
115 See Arts. 27–​
9 Third Directive. See also Volker Emmerich and Mathias Habersack,
Konzernrecht 141–​6 (10th edn., 2013).
116 See e.g. § 253 DGCL.
117 Art. 784(1) Companies Act (Japan).
118 In cash-​out mergers (or more generally mergers in which the consideration is other than the
stock of the surviving company), disclosure of additional information is required. See Arts. 182 and
184 Ordinance for Enforcement of the Companies Act.
119 Rule 13e-​3 1934 Securities Exchange Act.
120 Art. 236-​6 Règlement Général de l’AMF.
121 See Chapter 6.2.2.1.
122 Kahn v. Lynch, note 114.
123 Kahn v. M & F Worldwide Corp., 88 Atlantic Reporter 3d 635; see also In re Cox
Communications, Inc. 879 Atlantic Reporter 2d 604. See Chapter 6.2.2.1. For Japan, see Wataru
Tanaka, Going Private and the Role of Courts: A Comparison of Delaware and Japan, 3 University of
Tokyo Soft Law Review 12 (2011).
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Fundamental Changes
90 percent.124 The minimum requirements established by EU Directives apply to such
transactions, but beyond this, EU member states have generally adopted a “neutral”
approach in their national laws that, in contrast to U.S. jurisdictions, does not actively
facilitate freeze-​outs.125 In France, a company’s charter may provide that its minority
shareholders can be cashed out in well-​defined circumstances, although the terms of
such a buy-​out would be subject to a Delaware-​like fairness review by the courts.126
Without an authorizing provision in the charter, however, it does not seem that a controlling shareholder may freeze out even abusive minority shareholders.127 By contrast,
German law does recognize the right of a controlling shareholder to freeze out an
abusive minority shareholder, but neither the German statutes nor the German courts
acknowledge a general right of controlling shareholders with under 95 percent of an
issuer’s shares to freeze out its minority shareholders.128 In Italy, absent an absolute
right to cash out minorities, a freeze-​out may only take place with regard to shareholders with a number of shares lower than is needed to receive one share in the resulting
company.129
7.4.2.3 Freeze-​outs through non-​merger techniques
7.4.2.3.1 Compulsory share sales
Many jurisdictions also provide freeze-​out (or, as they are also known, squeeze-​out)
techniques which are not based formally on a merger transaction. As we shall see in
­chapter 8,130 under EU law an acquirer which ends up with 90 to 95 percent of a target’s
shares after a public offer is able to squeeze out the non-​accepting shareholders on the
terms of the public offer (or something near it)—​and the minority has a similar right
to be bought out. In some jurisdictions the same facility is made available, whether
or not the 90 or 95 percent threshold is reached via a public offer. In this case, fixing
the price is a more sensitive matter. In France, a shareholder group holding 95 percent
or more of voting rights in a listed company may eliminate the minority by making a
public offer to acquire their shares, followed by a compulsory acquisition of the shares
of the non-​accepting shareholders.131 The price in the compulsory acquisition has to
be approved ex ante by the market regulator, which operates on the basis of a proposal
prepared by the acquirer’s investment bank, the report of an expert commissioned by
the target and its own judgment.132 Germany also provides a squeeze-​out procedure at
124 For a recent comparison, see Christian A. Krebs, Freeze-​Out Transactions in Germany and the
U.S.: A Comparative Analysis, 13 German Law Journal 941 (2012).
125 Regarding the German approach, see Bundesverfassungsgericht, Aug. 7, 1962—​1 BvL 16/​60,
Bundesverfassungsgericht (BVerfGE) 14, 263 [Feldmühle]: Schmidt, note 105, at 348.
126 Cozian et al., note 39, at 216–​18.
127 See Cour de Cassation Commerciale, 1996 Revue des Sociétés 554 (freeze-​out is prohibited
unless permitted by statute or the corporation’s charter).
128 BGH, March 20, 1995–​II ZR 205/​94, BGHZ 129, 136 [Girmes].
129 See Luigi A. Bianchi, La Congruità del Rapporto di Cambio nella Fusione 101 (2002).
130 See Chapter 8.3.5. If, however, an existing 90 percent majority mounts a bid for the company
simply in order to squeeze out the minority, UK scrutinizes the reason for the squeeze-​out by reference
to a standard akin to that applied to charter amendments to that end. See Re Bugle Press Ltd [1961]
Ch 270.
131 Art. L. 433-​4 Code Monétaire et Financier; Arts. 236-​3, 236-​4, and 237-​1 Règlement Général
de l’AMF. The minority has a parallel right to be bought out (Art. L. 433-​4 Code Monétaire et
Financier; Arts. 236-​1 and 236-​2 Règlement Général de l’AMF).
132 Arts. 237-​2, 261-​1(II), and 262-​1 Règlement Général de l’AMF. See generally Viandier, note
97, at 495–​8.
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191
the 95 percent level for all public companies, which tracks merger rules (including the
need for a report from the 95 percent shareholder and a report from a court-​appointed
expert on the adequacy of the compensation).133 Unlike in the French procedure, the
price is not approved ex ante but is subject to ex post challenge by any individual minority shareholder before a court, whose decision will apply to all minority shareholders
(Spruchverfahren). Although the challenge does not normally prevent the squeeze-​out
from being effected immediately, the post squeeze-​out procedure can be protracted
(even up to ten years), which generates a strong incentive for the 95 percent shareholder
to settle the minority’s claim and an equally strong incentive for arbitrageurs to acquire
the minority’s shares in order to take advantage of the court challenge.134
In Japan, a complex procedure using a special type of class of shares, which requires
two-​thirds majority vote at the shareholders’ meeting, has been used in practice to
squeeze out minorities, motivated mostly by tax reasons. Japan also introduced a new
procedure in 2014 that allows a shareholder holding 90 percent or more of the company’s shares to squeeze out the minority shareholders without a shareholders’ meeting.135
In jurisdictions (such as the UK) which lack explicit procedures for squeezing out
minorities (other than post-​bid), a variety of substitute corporate procedures may be
available. The issue is whether these more general procedures provide adequate safeguards against majority opportunism when used to effect a squeeze-​out. The simplest
form of these non-​specific squeeze-​out mechanisms is a charter amendment requiring the
minority to transfer their shares to the majority or to the company. Because the standard
supermajority requirement for charter changes may seem inadequate minority protection in the squeeze-​out situation, UK courts, under their general power to review charter
amendments,136 have developed a requirement for a good corporate reason for even a
fair-​price squeeze-​out, in contrast with the simple requirement for good faith in respect of
other changes to the charter. In Australia, from a similar doctrinal starting-​point, the High
Court has barred such compulsory acquisitions except in very limited circumstances.137
7.4.2.3.2 Other squeeze-​out techniques
A charter amendment is not, however, the only, or even the typical, way of eliminating
a small minority in the absence of an explicit procedure for so doing. A reverse stock
split, a sale of all the assets of the company followed by its dissolution138 or, in those
133 §§ 327a-​
f AktG. See Thomas Stohlmeier, German Public Takeover Law (2nd edn.,
2007) 139.
134 Stohlmeier, note 133, at 145. The post-​bid squeeze-​out procedure does not suffer from this
defect, because of the strong presumption that the bid price is the appropriate price. See § 39a(3)
WpÜG and Chapter 8.3.5.
135 Art. 179 Companies Act (Japan). For details, see Marco Ventoruzzo et al., Comparative
Corporate Law 497 (2015).
136 UK courts may rely on the “unfair prejudice” remedy, but the case law has also developed a
general review standard for charter changes: i.e. the requirement that the change be effected “bona fide
in the interests of the company.” See note 39. This rather opaque formula tends to require simply that
the majority act in good faith, except in cases of expropriation of shares where it has a larger impact.
See Gamlestaden Fastigheter AB v. Baltic Partners Ltd [2008] 1 BCLC 468.
137 Gambotto v. WCP Ltd (1995) 127 Australian Law Reports 417 (High Court of Australia),
which seems to accept compulsory acquisition if the purpose is to protect the company from harm but
not if it is to confer a benefit on it.
138 A procedure explicitly provided for in § 179a AktG (Germany), on a 75 percent vote of the
shareholders, but in fact not taken up often in practice for a number of reasons, including the ability
of the minority to delay the transaction for long periods by challenging the price for the transfer of the
assets. Consequently, the more recently introduced general squeeze-​out procedure (Section 7.4.2.3.1)
is typically employed. See Stohlmeier, note 133, at 150.
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Fundamental Changes
jurisdictions still attaching importance to legal capital, a reduction of capital, may all
be used to this end. Again, since these procedures are not designed for squeeze-​outs,
the protection against opportunism lies mainly in the deployment of standards strategies governing the majority’s decision.139
The delisting of a traded company may also operate as a squeeze-​out. Delisting and
deregistration deprive shareholders and creditors of the benefits of extended mandatory disclosure, in addition to vastly reducing the shares’ liquidity. In light of this, exit
from either regulatory structure is a fundamental change in the firm.140 As we discuss
in Chapter 9, securities regulation and stock exchange rules provide a wide variety of
protections for shareholders against both managers and controlling shareholders seeking to delist or to downgrade an issuer.141
7.4.3 The protection of non-​shareholder constituencies in mergers
Several of our core jurisdictions seek to protect non-​shareholder constituencies (creditors and/​or employees) in mergers and other organic changes in addition to addressing
the agency problems between managers and shareholders and between controlling and
minority shareholders.
7.4.3.1 The protection of creditors
As we noted in Chapter 5, the European jurisdictions, Japan, and Brazil are generally
more creditor-​friendly than the U.S.142 In keeping with this tradition, these jurisdictions offer special protection to creditors when firms undergo mergers and similar
organic changes. Brazilian law goes as far as to grant creditors that are harmed by the
merger the formal right to seek its annulment within sixty days.143 Although creditors lack the power to stop mergers in the EU or Japan, they are entitled to demand
adequate safeguards when a merger puts their claims at risk.144 These safeguards often
extend to a requirement that their claims be secured by the surviving or emerging
company or that their claims be discharged before the merger, which may act as a
significant disincentive to the merger.145
7.4.3.2 The protection of employees
There are two main issues here. First, to what extent do employees have a “voice”
(whether through collective bargaining or legal rules providing for workforce-​based
works councils or board-​level representation) in the merger decision and to what
139 See Rock Nominees Ltd v. RCO (Holdings) plc [2004] 2 BCLC 439 (CA—​UK): bidder, which
had fallen just short of the 90 percent threshold for a post-​bid squeeze-​out, proposed to sell the business of the new subsidiary to another group company, liquidate the vendor and distribute its assets to
the shareholders. The Court of Appeal refused to regard this proposal as infringing the “unfair prejudice” standard for reviewing controllers’ decisions (see note 39) where the price obtained in the sale
was “the best price reasonably obtainable.” It was also clear that the minority opposed the deal because
it hoped to obtain a “ransom price” through a voluntary sale of its shareholding to the new parent.
140 See Jonathan Macey, Maureen O’Hara, and David Pompilio, Down and Out in the Stock Market:
The Law and Economics of the Delisting Process, 51 Journal of Law & Economics 683 (2008).
141 Chapter 9.1.2.7.
142 See Chapter 5.4.
143 Lei das Sociedades por Ações Art. 232.
144 See Art. 13 Third Directive.
145 § 22 Umwandlungsgesetz (Germany) (§ 321 AktG to similar effect); Arts. 789, 799, and 810
Companies Act (Japan).
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193
extent will those voice arrangements be carried over to the resulting company? This
refers to the likely impact of the merger, either immediately or in the future, on the
development of terms and conditions of employment and the availability of job and
promotion opportunities. The second issue is whether employees have the option to
transfer their existing terms and conditions of employment (which, depending on
the situation, may be located in a collective agreement or in an individual contract
of employment), including any voice arrangements, to the corporation which results
from the merger.
Voice may be provided through general governance provisions relating, for example, to board-​level representation of employees, as discussed in Chapter 4. Or voice
may be injected through a mechanism independent of the board and applying only
to certain categories of corporate decision. Here, EU law adopts a strong stance. On
a transfer of a business (of which the merger is a prototypical example) the Acquired
Rights Directive146 mandates consultation on the part of both transferor and transferee
employers with the representatives of the employees (unionized or non-​unionized)
prior to the transfer of the business. The focus of the consultation is on the implications of the merger for the employees.147 Given the stately and public procedure of the
merger (production of a merger plan, its public filing, the experts’ report, the shareholders’ meeting), it is not normally too demanding to fit consultation with employee
representatives into this timetable.148
U.S. law is more cautious. There is no general consultation duty on transferor or
transferee companies. If both merging companies are unionized, then the effects of the
merger are a mandatory topic of bargaining. If one company is unionized and the other
is not, the only way to implement the merger is to put the companies into separate
subsidiaries because the union component has bargaining rights that can prevent any
sensible integration of the operation.
The quality of the voice mechanisms after the merger will normally depend on the
rules applying to the surviving or emerging company. This has proved to be a particular problem in cross-​border mergers in the European Union, since voice requirements,
especially in terms of board-​level representation, vary significantly from member state to
member state. We discuss this issue further in Section 7.5. For purely domestic mergers,
the Acquired Rights Directive has a limited provision preserving the voice arrangements
existing within the transferor after the transfer.149 However, since in most member states
the provision of employee voice at enterprise or establishment level is a matter of legal
requirement, the rules applicable to the surviving or emerging company will lead to the
transferred business being covered by equivalent voice arrangements.
U.S. law, again, preserves voice arrangements only with respect to unionized companies. When operations are transferred by merger or stock sale, both the collective
bargaining agreement and the statutory duty to bargain carry forward automatically.
146 Directive 2001/​23/​EC, Chapter III.
147 Ibid., Art. 7 (“the legal, economic and social implications of the transfer for the employees” and
“any measures envisaged in relation to the employees”; yet, the employer must also state “the reasons
for the transfer”). In some member states, for example, France, the employee representatives have
more extensive rights to review the business reasons for the transfer (Art. L. 2323-​19 Code du travail).
148 However, for analysis of a case where the transfer of a business (not a merger) to one of two
competing acquirers was significantly influenced by the consultation obligation (BMW’s disposal of a
large part of its UK assets in 2000) see John Armour and Simon Deakin, The Rover Case—​Bargaining
in the Shadow of TUPE (2000) 29 Industrial Law Journal 395.
149 Art. 6. This operates only if (a) the undertaking transferred “preserves its autonomy” and (b) “the
conditions necessary for the reappointment of the representatives” after the transfer are not met.
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Fundamental Changes
By contrast, when operations are transferred by a sale of assets and the rehiring of
employees, the collective bargaining agreement only carries forward when the asset
purchaser explicitly or constructively adopts it, while the presumption of continued
majority support and related statutory duty to bargain carry over when more than
50 percent of the asset purchaser’s employees (in the relevant bargaining unit) worked
for the seller.150
As to the second point—​protection of acquired rights—​the “universal transmission” mechanism of the statutory merger procedure may operate so as to transfer the
individual entitlements of the employees to the surviving or emerging entity.151 In any
event the EU Directive requires that on a transfer of a business the contracts of employment of workers employed in the transferor company are automatically transferred in
an unaltered form to the surviving or emerging entity.152 It also makes the fact of the
transfer an unacceptable ground for dismissal. These two rules put the burden of any
subsequent lay-​off compensation on the transferee employer, but this can normally be
allowed for in the price paid for the transferor’s business. The more problematic rule
from an economic perspective is that transferred employees who remain on the job also
retain the pre-​existing terms and conditions of their employment. This makes it difficult for the transferee to integrate the transferred employees into a common structure
of terms and conditions of employment for its enlarged workforce, since even changes
subsequently negotiated by the transferee with the representatives of the employees are
at risk of legal challenge.
By contrast, the U.S. adheres to the common law doctrine of the personal nature of
the contract of service153 and does not provide for automatic transfer of the contract of
employment in the non-​unionized area. Even in the unionized area the same approach
has influenced judicial interpretation of the U.S. National Labor Relations Act. The
extent to which collectively agreed terms and conditions will be carried over to the
transferee employer depends on the form of the transaction, as described above.154
7.4.4 Corporate divisions
A corporate division is the transactional inverse of a merger: it divides the assets and
liabilities of a single corporation into two or more surviving corporations, one of which
may be the dividing corporation itself.155
Despite logical similarities between mergers and divisions, however, jurisdictions
differ on whether they are as closely regulated as mergers. The U.S. only regulates divisions on an ad hoc basis when opportunism appears or when the corporation sells all
or substantially all of its assets, and Japan regulates divisions only perfunctorily.156 At
150 Edward B. Rock and Michael L. Wachter, Labor Law Successorship: A Corporate Law Approach,
92 Michigan Law Review 203, 212–​32 (1993).
151 Though in the UK the courts found automatic statutory transfer of employment contracts to
be inconsistent with the personal nature of the relationship embodied in them: see Nokes v. Doncaster
Amalgamated Collieries Ltd [1940] AC 1014, HL.
152 Directive 2001/​23/​EC, Chapter II, replacing an earlier directive of 1977.
153 See text accompanying note 151.
154 Rock and Wachter, note 150; Howard Johnson Co. v. Detroit Local Joint Executive Bd 417
United States Reports 249 (1974).
155 A corporate division is not to be confused with the creation of a subsidiary: while in the latter
it is also the case that a corporation divides into two entities, in the former case, the divided entity
does not end up holding the shares in the newly formed company or issued by another company in
exchange for the company’s assets.
156 See Arts. 783, 784, 795, 796, 804, and 805 Companies Act (Japan).
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Mergers and Divisions
195
first glance, the EU is different. The provisions of the Sixth Company Law Directive157
regulating divisions are a virtual mirror-​image of the Third Directive dealing with mer­
gers, including its provisions on minority and creditor protection. In practice, however,
member states do not scrutinize divisions as closely as mergers, and the reach of the
detailed requirements can be avoided.158
Even where the division rules apply, European shareholders are accorded less protection than in the inverse situation of a merger. We suspect the reason lies in the
functional characteristics that make corporate actions “significant” in the first instance.
To begin with, a division is a “smaller” transaction than most mergers, insofar as it
merely restructures the existing assets and liabilities of a company instead of adding
to the company’s existing assets and liabilities. In addition, and most significantly,
the risk of conflict of interests in a corporate division—​or at least conflict between
the shareholders and managers—​is lower than the parallel risk of conflict in mergers.
Further, empire dismantling is less prone to create management–​shareholder conflicts
than empire building. And the final period problem is less severe in a division: the
managers and directors from the dividing firm usually stay on to manage at least one
of the continuing firms.
Apart from shareholders, the protection of creditors and employees appears particularly necessary in the case of corporate divisions. The risk is that creditors’ claims will
be impaired because the division of assets and liabilities (which is determined in the
division contract) is not pro rata as between the receiving companies. Thus, EU law
makes companies receiving assets through a division jointly and severally responsible to
pre-​division creditors, though the liability of the receiving companies other than the one
to which the debt was transferred may be limited to the value of the assets transferred.159
Employees can also be affected by corporate divisions. For example, the assets may
be transferred to an entity that seeks to avoid obligations under a collective bargaining
agreement. As discussed above, under U.S. labor law, the rights of employees depend on
the mode by which operations are transferred.160 By contrast, the employee protection
provided by EU law, as discussed in Section 7.4.3.2, turns on whether there has been a
“transfer of a business” from one employer to another, a phrase which is apt to cover divisions as much as mergers and indeed sales of assets, unless they are “bare” sales of assets,
so that the legal form of the transaction is less central to the application of the rules.161
In Japan, the general rule is that divisions transfer debts without consent of individual creditors (though they can object and get payment or collateral162), but employees are given special rights to voice and generally, unless they agree, their employment
contracts are not transferred.163
157 Sixth Company Law Directive 82/​891/​EEC, 1982 O.J. (L 378) 47.
158 E.g. an individual transfer of assets and debts falls outside the regime of divisions.
159 Art. 12 Sixth Directive. The joint and several liability of the transferee companies may be
dispensed with entirely if, as is the case in the UK, the division requires the approval of a court (as a
“scheme of arrangement”) and is dependent upon the consent of 75 percent of each class of creditor.
160 See note 150.
161 Crucially, however, the Directive does not cover a control shift effected by a transfer of shares, as
discussed in the next chapter, because there is no change in the identity of the employer. In such a case
individual and collective contractual obligations of the employer are not formally affected, whilst the
consultation obligations which the directive would otherwise impose are now applied under the provisions requiring employers to consult generally on matters likely to have a significant impact on their
employees. See Directive 2002/​14/​EC establishing a general framework for informing and consulting
employees in the European Community, 2002 O.J. (L 80) 29.
162 Arts. 759(2)-​(4) and 764(2)-​(4) Companies Act.
163 See Act for the Succession of Employment Contracts in Corporate Divisions (2000) (Japan).
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Fundamental Changes
7.5 Reincorporation and Conversion
The migration of a corporation between jurisdictions can also fundamentally transform the relationship among the participants. If the new home’s corporate law is more
pro-​management or pro-​controlling shareholder, such a migration can aggravate the
management–​shareholder or controlling-​minority shareholder agency problems. If
the new home’s corporate law is less protective of non-​shareholder interests, such a
migration can be a means by which shareholders and managers transfer value from
non-​shareholder constituencies to themselves. These problems are controlled using
different tools.
Consider the mechanics of corporate migration. The easiest process is to allow companies, by declaration, to change their jurisdiction of incorporation. In Canada, for
example, a corporation can move its jurisdiction while preserving legal personality (i.e.
all its legal rights and obligations) between provinces, upon a two-​thirds vote of shareholders, so long as the corporate body will, inter alia, remain liable to creditors in the
new jurisdiction.164 When a corporation fulfills these straightforward requirements, it
ceases to be, for example, an Ontario corporation and starts to be an Alberta or federal
corporation. This simple, direct approach is highly unusual.165
A more common mechanism allows a corporation to migrate by merger. In the
U.S., for example, the mechanism commonly used to transform, say, a California corporation into a Delaware corporation is for the California corporation to merge with
a newly established, wholly owned Delaware subsidiary, with the Delaware subsidiary
continuing as the surviving corporation.166 Shareholders of the California corporation typically receive the same percentage of ownership in the Delaware corporation as they previously had in the California corporation. Elsewhere, a scheme of
arrangement—​which requires a shareholder vote and court approval—​has been used
to effect a migration.167 In addition, there are more complex mechanisms involving
asset or stock sales that can reach the same outcome, although sometimes with different tax consequences.168 In the common migration-​by-​merger structure, minority
shareholders and other constituencies are usually no more and no less protected than in
any other merger.169
EU law has been heavily promoting cross-​border corporate mobility within Europe.
There seem to be three avenues in place now to effect a cross-​border relocation. The first,
and most uncertain way is to reincorporate to another EU jurisdiction by converting into
164 Douglas J. Cumming and Jeffrey G. MacIntosh, The Rationales Underlying Reincorporation and
Implications for Canadian Corporations, 22 International Review of Law & Economics 277, 279
(2002).
165 A similar procedure is available to the European Company (see below) to move between EU
jurisdictions. The Company Law Review (UK) proposed a similar procedure for British companies to
move both between the UK jurisdictions and to jurisdictions outside the UK, but the proposal was
not taken up in the 2006 reforms, evidently because of Treasury fears of loss of tax revenues. See CLR,
Final Report (2001), ch. 13 (URN 01/​942).
166 See e.g. Ronald J. Gilson, Globalizing Corporate Governance: Convergence of Form or Function,
49 American Journal of Comparative Law 329, 355 n. 90 (2001).
167 For an account of News Corp’s migration from Australia to Delaware by a scheme of arrangement, see Jennifer G. Hill, Subverting Shareholder Rights: Lessons from News Corp.’s Migration to
Delaware, 63 Vanderbilt Law Review 1 (2010).
168 For an analysis of the intersection of charter competition and tax considerations, see Mitchell
Kane and Edward Rock, Corporate Taxation and International Charter Competition, 106 Michigan
Law Review 1229 (2008).
169 Section 7.4. Yet, this is not the case in the EU. See text accompanying notes 180–​1.
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Reincorporation and Conversion
197
the equivalent legal form of the destination state, relying on the case-​law of the European
Court of Justice. Whereas the early CJEU cases concerning cross-​border mobility had
mostly focused on the formation stage of companies,170 more recent jurisprudence deals
with the possibility to effect midstream changes. Taken together, the two recent decisions in Cartesio171 and Vale172 suggest that a destination state is under an obligation
to offer a conversion procedure for accommodating foreign companies, analogous to its
local laws, and that the state of origin is under a corresponding obligation to allow the
company to leave.173 However, this territory is still relatively uncertain and awaits real-​life
exploration.174
The second strategy is to use the legal form of a Societas Europaea,175 a type of pan-​
European corporate entity, which expressly allows for cross-​border relocation with retention of legal personality.176 Art. 8 SE Regulation provides for an elaborate system of
protection rights to the benefit of minority shareholders, creditors, and employees.177
There is now a non-​negligible number of SEs, and a substantial proportion of them have
already carried out a seat transfer.178
The third and final route for corporate migration is to employ the European Cross-​
Border Merger Directive.179 Similar to the migration-​by-​merger strategy used in the
U.S., the migrating company may be merged onto an existing or newly formed shell
company or subsidiary in the destination state.180 But unlike in the U.S., and following
170 See on this Wolf-​Georg Ringe, Corporate Mobility in the European Union—​a Flash in the Pan?
An Empirical Study on the Success of Lawmaking and Regulatory Competition, 10 European Company
& Financial Law Review 230 (2013).
171 Case C-​210/​06 Cartesio Oktató és Szolgáltató bt, [2008] ECR I-​9641.
172 Case C-​378/​10 VALE Építési kft, ECLI:EU:C:2012:440.
173 In a first decision, the OLG (Court of Appeal) of Nuremberg accepted these European parameters and allowed a Portuguese company to convert to a German equivalent: OLG Nürnberg, June
19, 2013 –​12 W 520/​13, Neue Zeitschrift für Gesellschaftsrecht (NZG) 2014, 349. See also
Kammergericht Berlin, March 21, 2016 –​22 W 64/​15, NZG 2016, 834.
174 This uncertainty has led to reinforced calls for a specific EU instrument, dealing with cross-​
border shifts of the registered office.
175 The SE was established by two instruments in 2001: Council Regulation (EC) No 2157/​2001
on the Statute for a European Company (“SE Regulation”), and the accompanying Council Directive
2001/​86/​EC of 8 October 2001 supplementing the Statute for a European company with regard to
the involvement of employees (“SE Directive”). It can only be created by either merger, the creation of
a holding company, creation of a joint subsidiary, or conversion of an existing company set up under
the laws of a member state.
176 SE Regulation, Arts. 7, 8, and 69. The only downside is that a reincorporation also requires a
simultaneous shift in the location of its head office. For the argument that the requirement for the
head office to be located in the state of incorporation is in conflict with the right to freedom of establishment created by the European Treaties see Wolf-​Georg Ringe, The European Company Statute in the
Context of Freedom of Establishment, 7 Journal of Corporate Law Studies 185 (2007).
177 See, in particular, SE Regulation Art. 8(2), (3), (5), and (7).
178 By 2014, over 2,100 SEs were registered across the EU, the large majority of which were based
in the Czech Republic and Germany (and many of which were, in fact, shell companies). So far, we
know of 79 successfully completed seat transfers under Art. 8 SE Regulation, which is only 4 percent
of all SEs, but 27 percent of those SEs with more than 5 employees (289). This is based on data from
the European Trade Union Institute (http://​ecdb.worker-​participation.eu/​).
179 Directive 2005/​56/​EC of 26 October 2005 on cross-​border mergers of limited liability companies, 2005 O.J. (L 310) 1 (hereinafter Cross-​Border Merger [CBM] Directive). To some extent
the CJEU jumped the gun by holding in the SEVIC case that Germany violated (what is now) Arts.
49 and 56 TFEU (freedoms of establishment and capital) by permitting the registration of domestic mergers without also permitting equivalent registration of cross-​border mergers (Case C-​411/​03,
SEVIC Systems AG [2005] ECR I-​10805, paras. 16–​19).
180 Unlike with the SE, transfer of the head office seems not to be required, unless it is a requirement of the national law of the new state. See John Armour and Wolf-​Georg Ringe, European Company
198
198
Fundamental Changes
upon the steps of the SE framework, this Directive features a number of protection
devices for shareholders, creditors, and especially employees in addition to those provided for domestic mergers.
Since member states vary substantially in their national law requirements for boardlevel representation of employees, a major concern for employees is that reincorporation
will be to a member state with no or less extensive requirements of this type. Both the SE
framework and the CBM Directive adopt the principle that the pre-​reincorporation rules
will continue to apply post-​reincorporation. When one or more of the companies that are
merging or forming an SE are subject to employee board-​level influence requirements,
those requirements will be carried over to the surviving or resulting company, even if the
laws of the new state of incorporation would not otherwise require board-level influence.181
To be sure, the safety standards for the creation of an SE and for cross-​border mer­
gers under the Directive are default rules, but strong default rules, since they can be
modified only if management and employee representatives negotiate a different solution in advance of the reincorporation.182 This approach is intended to prevent cross-​
border mergers from undermining existing board-​level voice requirements but not
to extend such requirements to companies not previously subject to them (e.g. in a
cross-​border merger of companies, none of which was previously subject to mandatory
board-​level employee voice). Despite this policy, however, German companies have
been over-​represented in the number of SEs formed to date and seem to have been
able to obtain what they regard as attractive modifications of their national employee
representation systems, even if they have been unable (or, perhaps, unwilling) to avoid
codetermination altogether.183
Beyond cross-​jurisdictional reincorporations, firms may also choose to change the
type of corporate form or abandon the corporate form altogether in favor of partial
corporate forms or other organizational structures, a strategy known as conversion. As
discussed in Chapter 1, the ability to select among different organizational forms is
Law 1999–​2010: Renaissance and Crisis, 48 Common Market Law Review 125, 161 ff. (2011);
Bech Bruun & Lexidale, Study on the Application of the Cross-​Border Mergers Directive,
September 2013, Main Findings 23.
181 Wolf-​Georg Ringe, Mitbestimmungsrechtliche Folgen einer SE-​Sitzverlegung, Neue Zeitschrift
für Gesellschaftsrecht 931 (2006). Voice provided otherwise than via board-level influence (principally via mandatory consultation of employee representatives) is subject to the rules of the jurisdiction of the resulting or emerging entity in the case of a cross-​border merger and to rules modeled on
the European Works Councils Directive (Directive 94/​45/​EC) in the case of an SE.
182 This summarizes a very complicated set of provisions (see Paul Davies, Workers on the Board
of the European Company?, 32 Industrial Law Journal 75 (2003)); and the provisions themselves
vary slightly according to whether the reincorporation is effected by formation of an SE or under
the CBM Directive. The requirement for pre-​merger settlement of the board influence issue through
negotiations with the employee representatives is likely significantly to slow down the formation of
SEs. In a merger effected under the Directive the merging companies can opt for the “fall-​back” rules
on board-level representation without entering into any negotiations with the employee representatives. See on the bargaining process and content Horst Eidenmüller, Lars Hornuf, and Markus Reps,
Contracting Employee Involvement: An Analysis of Bargaining over Employee Involvement Rules for a
Societas Europaea, 12 Journal of Corporate Law Studies 201 (2012).
183 For example, a reduction in the size of the board (Chapter 3.1), a more international composition of the board or a “freezing” of the domestic level of representation (e.g. a German company about
to cross the employee threshold which would trigger the move from one-​third to parity representation
can form an SE, which will then remain subject to one-​third also after crossing the employee threshold). See Berndt Keller and Frank Werner, The Establishment of the European Company: The First Cases
from an Industrial Relations Perspective, 14 European Journal of Industrial Relations 153 (2008).
199
General Provisions on Significant Transactions
199
an essential component of the flexibility that entrepreneurs enjoy to tailor the legal
regime to the concrete needs of any given enterprise. However, a midstream change
in the entity type is potentially more drastic than charter amendments, which typically alter discrete features of the organizational contract, and possibly as consequential
as reincorporations: both after conversion and following migration, the outcome is a
wholesale alteration in the default and mandatory rules provided by law.
While most jurisdictions permit corporations to convert into other business forms
without the need for prior dissolution, such decisions typically invite close scrutiny. For
instance, both Delaware and Brazil in principle employ an exceptionally strong decision strategy to police conversions, which are the only corporate decisions requiring
unanimous shareholder approval.184 Yet there are ways around such rigors. Delaware
permits companies to effect a change in organizational form through mergers—​which
are policed through the comparatively more flexible mechanisms applicable to mer­
gers, as discussed in Section 7.4. Brazilian law permits companies to opt out of the
stringent default rule through charter provision. Other jurisdictions treat changes in
business form similarly to charter amendments, relying on a combination of decision
strategies in the form of supermajority voting requirements and on judicial enforcement of fiduciary duties.185 However, the precise quorum required to approve a conversion may also depend on the new entity type being selected—​and on the nature of
its differences vis-​à-​vis the business corporation. Delaware law requires the approval of
a majority of the outstanding shares for a merger leading to a conversion into a limited liability company, but of two-​thirds of the outstanding shares for a conversion or
merger into a public benefit corporation—​an organizational form which, as the name
suggests, requires the pursuit of a “public benefit” beyond profit.186
7.6 General Provisions on Significant Transactions
Given the uncertainty about what corporate decisions are “fundamental,” it is understandable that legal systems seek to remove particular types of transaction from unilateral board control, rather than laying down general tests to identify significant
transactions. The downside of the transaction-​by-​transaction approach is that it can
often be side-​stepped by adopting a non-​regulated transaction that achieves the same
functional goal. To be sure, in some jurisdictions, strongly enforced directors’ duties
operate as powerful general standards across transactional types. This is particularly the
case in Delaware. However, where a decision rights strategy is thought to be appropriate, the problem of identifying the fundamental corporate decisions and transactions
is particularly acute.
Both Germany and the UK have developed general criteria for the identification of
situations in which shareholder consent for a transaction is required, though in neither case as a result of legislative action.187 In Germany the doctrine was developed
184 DGCL § 266; Lei das Sociedades por Ações Art. 221 (requiring unanimous approval as a
default rule that can be altered in the charter).
185 E.g. Umwandlungsgesetz §§ 226, 240 (Germany), and CA 2006, section 90 (UK) both specify,
inter alia, a 75 percent majority requirement for conversions from private to public company.
186 DGCL § 363. See also Chapter 1.2.5.
187 The only exception in German law is AktG § 179a which requires shareholder approval where
the company transfers all of its assets: see note 138. In Italy, some decisions entailing a substantial
change of the company’s business require shareholder approval: see Art. 2361 Civil Code (acquisition
200
200
Fundamental Changes
by the highest civil court (the Bundesgerichtshof [BGH]), despite the provision in the
open company law restricting the powers of the shareholders to a list of matters and
otherwise providing that “the shareholders’ meeting may decide on matters concerning the management of the company only if required by the management board.”188
In its famous Holzmüller189 decision, later restricted and somewhat clarified in its
Gelatine I and II decisions,190 the BGH turned this provision on its head in the case
of a spin-​off of a major part of the company’s operations into a separate subsidiary.
In principle, it required shareholder approval for such a restructuring on the grounds
that the rights which the shareholders of the parent previously had in relation to
these assets would be exercisable in future in relation to the new subsidiary by the
management board of the parent alone, as the representative of the new subsidiary’s
only shareholder.191 The decision caused enormous uncertainty as to when the management had to seek the approval of the shareholders in corporate restructurings.
Although the Gelatine cases somewhat restrict the scope of the doctrine, by confining it to decisions affecting a major part of the company’s assets and having a highly
significant impact on the practical value of the shareholders’ rights, uncertainty still
exists in relation to the scope of the doctrine.192 A more recent decision by the
Frankfurt Court of Appeal confirmed that the Holzmüller principle does not apply
to acquisitions of major assets.193
In the UK, the Financial Conduct Authority’s “significant transactions” rules,194
which apply to companies with a premium listing on the main market in London, aim
at a similar objective, but do so in a more mechanical way.195 In principle, any transaction (by the company or its subsidiary undertakings) of certain size, relative to the
listed company proposing it, requires ex ante shareholder approval, unless it is within
the ordinary course of the company’s business or is a financing transaction not involving the acquisition or disposal of fixed assets of the company.196 The requisite size is
25 percent or more of any one of the listed company’s assets, profits or gross capital
of shareholdings by public companies to be approved whenever it results in a substantial change of a
company’s business); Art. 2479 Civil Code (in private companies, transactions causing a substantial
change in the company’s business require shareholder approval; Art. 2473 grants dissenting shareholders appraisal rights as well).
188 AktG § 119(2).
189 BGH, Feb. 25, 1982 –​II ZR 174/​80, BGHZ 83,122.
190 BGH, Apr. 26, 2004 –​II ZR 155/​02, BGHZ 159, 30 (Gelatine I ) and BGH, Apr. 26,
2004 –​II ZR 154/​02, ZIP 2004, 1001 (Gelatine II ). See generally Marc Löbbe, Corporate
Groups: Competences of the Shareholders’ Meeting and Minority Protection, 5 German Law Journal
1057 (2004).
191 The threat to parent shareholders’ preemptive rights also played a role: see Section 7.3.2.
192 As a result of the Gelatine cases it is now clear that, where shareholder approval is required,
three-​quarters of those voting must consent, by analogy with what is needed to change the constitution of the company: see Section 7.2. Under Delaware law, dropping assets into a subsidiary does
not require a shareholder vote, even if they amount to all or substantially all of the assets: DGCL
§ 271(c).
193 At least where the articles of association of the company allow the management to pursue such
an acquisition. See OLG Frankfurt, Dec. 7, 2010 –​5 U 29/​10, NZG 2011, 62.
194 Listing Rules, c­ hapter 10.
195 “This chapter is intended to cover transactions that are outside the ordinary course of the listed
company’s business and may change a security holder’s economic interest in the company’s assets or
liabilities” (LR 10.1.4).
196 LR 10.1.3. On the impact of such rules on share prices, see Marco Becht, Andrea Polo, and
Stefano Rossi, Does Mandatory Shareholder Voting Prevent Bad Acquisitions?, 29 Review of Financial
Studies 3035 (2016).
201
Explaining Differences in the Regulation of Fundamental Changes
201
or where the consideration for the transaction is 25 percent or more of value of the
ordinary shares of the listed company.197
France does not make use of the decision rights strategy in general, although the
market regulator may accord an exit right to minority shareholders under the provisions discussed above,198 that is, when a listed company’s controllers propose to
transfer or contribute all or substantially all of its assets or to “reorient the company’s
business.”199 This, as we have seen, is part of a set of provisions empowering the regulator to protect minority interests through the buy-​out requirement where the majority propose significant legal or financial changes to the business by way of significant
amendments to the company’s charter, merger of the company into its controller,
disposal of all or most of its assets or a prolonged suspension of dividend payments,
as well as reorientation of the business.200 As such, the French approach, besides its
different remedy, seems to fall in between the German one of trying to identify a
general principle and the British one of using financial thresholds for triggering the
minority protections, by laying down a list of circumstances in which a buy-​out may
be required.
7.7 Explaining Differences in the Regulation
of Fundamental Changes
The most striking conclusion to emerge from our review of fundamental corporate
changes is how overall uniform major jurisdictions are in their distinctions between
the bulk of corporate actions that are fully delegated to the board, and the handful
of corporate changes in which the board’s authority is limited, by a shareholder vote
requirement or direct regulation. A “decision rights” strategy seems to be the method
most widely used to constrain the problems involved with fundamental changes, and
complementary strategies are more rarely in operation. In all jurisdictions, mergers,
charter amendments, reincorporations, and dissolutions fall outside the scope of (complete) delegation to the board of directors, and require shareholder approval, usually
with a special quorum.201
Despite widespread consensus about which corporate changes ought to be regulated
and which ought to be left to the board, jurisdictions nonetheless differ in certain
familiar respects. In general, these differences do not track the common law/​civil law
divide.202 Although continental European jurisdictions rely less on judicially enforced
standards to regulate mergers than do the Anglo-​American jurisdictions, merger transactions are atypical of the broader class of significant corporate actions. Over the entire
class, France and Germany rely as heavily on standards as the U.S. or the UK.
197 LR 10.2.2, 10.5, and 10 Annex 1. A reverse takeover (LR 10.2.3) and an indemnity (LR
10.2.4) are included in the covered transactions in certain circumstances, but the rules can be waived
in restricted circumstances if the listed company is in financial difficulty (LR 10.8).
198 Section 7.2.2.
199 Art. 236-​6 Règlement Général de l’AMF. See Viandier, note 97, at 461–​4.
200 See Sections 7.2.2, 7.4.1.2, 7.4.2.2, and 7.4.2.3.1.
201 By contrast, in no jurisdiction does the investment of capital in firm projects or the incurring
of debt require shareholder approval, no matter how large these transactions are.
202 Differences mostly concern the question of how much the board is in charge in initiating or
co-​deciding on the proposed fundamental change; another difference appears to be the threshold of
shareholder approval (mostly simple versus super majority).
202
202
Fundamental Changes
Rather than following the common law/​civil law divide, differences in the regulation of significant corporate actions among our jurisdictions appear to reflect a
broader pattern of divergences in governance structures. EU law and, to some extent
Japanese law, accord more attention to management–​shareholder conflict in regulating corporate decisions than does the law of U.S. jurisdictions. In Europe, shareholder approval tends to be for a limited period of time (e.g. for authorized capital
or the repurchase of shares) and is required for a wider range of decisions (e.g. reductions in legal capital) than in the U.S. In Japan, shareholders must approve large
acquisitions, even when acquiring companies engage in cash-​out mergers. European
shareholders (except, as noted above, in Italy) may also initiate organic changes,
including mergers and major restructurings, by extraordinary resolution, whereas in
U.S. jurisdictions shareholders can only veto them, after such organic changes have
been proposed by the board. Brazilian law stands out by permitting a mere majority
of shareholders to initiate fundamental changes, while relying on a standards strategy
to impose liability on controlling shareholders for abusive action—​though enforcement remains an issue.
The greater power of the general shareholders’ meeting to make significant corporate
decisions in Europe and Brazil reflects the stronger legal position of shareholders and
their lobbying power in these jurisdictions, which in turn mirrors—​as we noted in
Chapter 3—​the well-​known differences in ownership structures.203 In the U.S., where
shares tend to be widely held and management is dominant, only the board can initiate
fundamental changes. In Europe, where controlling shareholders are dominant or, as
in the UK, institutional investors push the regulatory agenda, shareholders have greater
power to initiate major changes.
But if the U.S. provides less protection to shareholders as a class, it offers more
protection to minority shareholders. As noted above, boards must approve important decisions in the U.S., which modestly limits the power of controlling shareholders. In addition, both the U.S. and Japan provide an exit strategy, in the form of
appraisal rights, for minority shareholders who vote against mergers or (in Japan and
most U.S. states) other organic transactions. U.S. jurisdictions also provide a standard
of entire fairness, backed by the threat of a class action lawsuit, for significant transactions between entities controlled by a dominant shareholder. By contrast, European
boards generally do not limit the power of controlling shareholders, appraisal rights are
uncommon in the EU, and shareholders suing for violations of standards face significant enforcement obstacles.204 In general, European jurisdictions focus their efforts on
protecting minority shareholders from changes in legal capital. For example, unlike the
U.S. or Japan, all major European jurisdictions grant at least default preemptive rights
in case of new issues of shares.
The differences among jurisdictions also seem roughly to map the extent of transactional flexibility within jurisdictions: in the U.S. and the UK, where a variety of
alternative transactional forms can be used to achieve the same goal, the systems are
forced to adopt ex post standards strategies. By contrast, where transactional flexibility is more limited, more regulation can be ex ante. While France, Germany, Italy,
and Japan have legislated detailed merger procedures to safeguard shareholder decision rights, the UK and U.S. rely heavily on the judiciary to screen mergers under
203 See Chapter 3.1.1.5, 3.1.2.5, and 3.2.5.
204 See Chapter 5.1.5 and 5.2.3.3.
203
Explaining Differences in the Regulation of Fundamental Changes
203
the aegis of a basic fairness standard, with the UK also addressing mergers in the
Takeover Code.205
Finally, the protection of non-​shareholder constituencies in significant corporate
actions resembles that offered by corporate governance more generally. As compared
with U.S. law, all our other core jurisdictions are more protective of creditors, both
in general (through capital maintenance rules) and when firms embark on mergers
and other organic changes. Moreover, not surprisingly, EU law provides workers with
substantially more protection in mergers and other restructurings than U.S. law does.
205 See Chapter 8 for discussion of the Takeover Code.
204
205
8
Control Transactions
Paul Davies, Klaus Hopt, and Wolf-​Georg Ringe
8.1 Regulatory Problems in Control Transactions
In this chapter we consider the legal strategies for addressing the problems which arise
when a person (the acquirer) attempts, through offers to the company’s shareholders,
to acquire sufficient voting shares in a company to give it control of that company.
8.1.1 Control transactions
The core “control transaction” in this chapter is one between a third party (the acquirer)1
and the company’s shareholders. Of course, control may also shift as a result of a transaction between the company and its shareholders or the investing public (as when a
company issues or re-​purchases shares or engages in a statutory merger). However, the
latter type of transactions can be analyzed in the same manner as other corporate decisions, a task we have undertaken in Chapter 7. The absence of a corporate decision and
the presence of a new actor, in the shape of the acquirer, give the agency problems of
control transactions a special character which warrants separate treatment.2
Admittedly, in terms of end result, there may not be much difference between a
statutory merger3 and a takeover bid where the successful bidder squeezes out the non-​
accepting minority. Yet, in terms of the legal techniques used to effect the control shift,
there is a chasm between the two mechanisms. A merger involves corporate decisions,
usually by both shareholders and the board,4 and often by all companies involved.
Control transactions, by contrast, are effected by private contract between the acquirer
and the shareholders individually. Nevertheless, at least in friendly acquisitions, the
acquirer often has a free choice whether to structure its bid as a contractual offer or as
a merger proposal. This creates the regulatory question of whether control transactions
should be regulated so as to mimic the results of statutory merger regulation or instead
be treated as presenting distinct regulatory issues.5
1 Of course, the acquirer may, and typically will, already be a shareholder of the target company,
but it need not be and the relevant rules (other than shareholding disclosure rules) do not turn on
whether it is or not. The bidder may also be or contain the existing management of the target company
(as in a management buy-​out (MBO)). This situation generates significant agency problems for the
shareholders of the target company which we address below.
2 The special character of control transactions is also reflected in the increasing number of jurisdictions which have adopted sets of rules, separate from their general company laws, to regulate them.
3 See Chapter 7.4.
4 Where the merger is adapted to function as a post-​bid squeeze-​out technique, the shareholder
vote may be dispensed with. See Section 8.3.5.
5 If the choice is to regulate control transactions differently, the converse question then arises.
Should control transaction regulation be added to merger regulation in order to prevent transactional arbitrage? In the UK and countries which have followed its lead, control transaction rules are
extended, in so far as is appropriate, to supplement regulation of mergers. (The Panel on Takeovers
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry
Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock.
Chapter 8 © Paul Davies, Klaus Hopt, and Wolf-Georg Ringe, 2017. Published 2017 by Oxford University Press.
206
206
Control Transactions
Control transactions may be structured in a variety of ways: private contracts with
a single or a small number of important shareholders (“sale of control”); purchases of
shares on the market; or a general and public offer to all the shareholders of the target
company.6 The public offer may be either “friendly” (i.e. supported by the management of the target company) or “hostile” (i.e. made over the heads of target management to the shareholders of the target).7
Of the three acquisition methods, the second and third are clearly facilitated if the
target’s shares are traded on a public market. For this reason, companies with publicly
traded shares are at the center of attention in this chapter. In fact, legislation specific to
control transactions is usually (though not always) confined to companies whose securities are traded on public markets (or some sub-​set of these, such as the top-​tier markets).8 Not only are hostile bids difficult to organize other than in relation to publicly
traded companies, but also the shareholders’ agency and coordination problems are less
pronounced in companies with small numbers of shareholders. Nevertheless, control
transactions are not logically confined to public companies and we will also make some
reference to non-​traded companies. In jurisdictions which rely on general corporate
standards, such as fiduciary duties, rather than rules specific to control transactions,
to regulate the behavior of target management or the target’s controlling shareholders,
the application of these standards to the managements and shareholders of non-​traded
companies raises no difficult boundary questions.9
The global takeover market has steadily grown over the past decades, with the
only exceptions being after the 2001 Dotcom bubble burst and during the 2008/​9
financial crisis.10 The takeover market now appears to have recovered from its most
recent crisis.11 Traditionally, the U.S. and the UK have the most active takeover
markets, while takeovers are rarer in continental Europe, emerging markets, and
in Japan. Empirical studies show that takeovers are usually profitable for the target
shareholders,12 whilst the share price of the bidder is frequently unaffected by the
and Mergers, The Takeover Code (11th edn., 2013) § A3(b) and Appendix 7—​hereafter “Takeover
Code”). But in most jurisdictions the regulation of takeovers is confined to control shifts. Thus, Art.
2(1)(a) Directive of the European Parliament and of the Council on Takeover Bids, 2004/​25/​EC,
2004 O.J. (L 142) 12 (hereafter “Takeover Directive”) excludes statutory mergers.
6 Whether these three acquisition strategies give rise to the same regulatory problems is subject of
considerable debate. See e.g. note 144.
7 Of course, the board’s decision whether to recommend an offer, either at the outset or during the
course of an initially hostile offer, will often be influenced by its estimate of the bidder’s chances of succeeding with a hostile offer. And while it may be difficult to characterize a particular bid as “friendly”
or “hostile,” the question of whether a particular system of rules facilitates hostile bids is of enormous
importance. See Section 8.2.1.
8 Thus the Takeover Directive applies only to companies whose securities are traded on a “regulated market” (Art. 1(1)). In contrast, however, the UK Takeover Code applies to all companies which
may offer their shares to the public and even to closely held companies where there has been something analogous to a public market in the private company’s shares (Takeover Code, § A3(a)).
9 See Section 8.4.1 for a discussion of U.S. rules on sales of shares by controlling shareholders to
looters.
10 For recent analyses, see Marina Martynova and Luc Renneboog, The Performance of the European
Market for Corporate Control: Evidence from the Fifth Takeover Wave, 17 European Financial
Management 208 (2011); Marccus Partners, External Study on the application of the
Directive on takeover bids, section IV (2012).
11 Arash Massoudi and Ed Hammond, Hostile Bids Reach 14-​Year High, Financial Times, 9 June
2014, at 3.
12 Roberta Romano, A Guide to Takeovers: Theory, Evidence, and Regulation, 9 Yale Journal
on Regulation 119, 122 (1992); Marina Martynova and Luc Renneboog, A Century of Corporate
Takeovers: What Have We Learned and Where Do We Stand?, 32 Journal of Banking & Finance
2148, 2153 (2008); Klaus J. Hopt, Takeover Defenses in Europe: A Comparative, Theoretical and Policy
Analysis, 20 Columbia Journal of European Law 249, 252 (2014).
207
Regulatory Problems in Control Transactions
207
bid or may even suffer.13 Overall, however, takeovers appear to create value for both
groups taken together.14 Nevertheless, judged solely from the bidder’s perspective,
many takeovers turn out to have been an economic misjudgment in retrospect. This
raises the question of why takeovers happen in the first place.15 That is not an issue
which control transaction rules tend to address, at least not directly.16 With due
exceptions, bidder management and shareholder relations are usually left to general corporate governance rules.17 Nevertheless, skepticism about or enthusiasm for
takeover bids is reflected in takeover rules, and especially in the extent to which they
facilitate hostile bids.
8.1.2 Agency and coordination issues
Takeover regulation worldwide seeks to address two main issues: agency problems,
predominantly within the target company, and coordination problems among the target shareholders. The specific shape of these problems largely depends on whether the
target company is controlled by a blockholder or widely held; and takeover regulation
usually seeks to reflect these differences by responding to the typical or prevailing standard of ownership concentration in the jurisdiction—​knowing, of course, that firms of
all different shades of concentration exist in each of our jurisdictions.
8.1.2.1 Agency conflicts
Consider agency conflicts first. Where there are no controlling shareholders in the target company, the main focus is on the first agency relationship, that is, the relationship
between the board and the shareholders as a class. Prior to the offer de facto control
of the company was probably in the hands of the target board, so that, following a
takeover, control shifts from the board of the target to the acquirer. Therefore, there
is a disjunction between the parties to the dealings which bring about the transfer of
control (acquirer and target shareholders) and the parties to the control shift itself
(acquirer and target board).
It is precisely this disjunction which generates the agency issues which need to be
addressed. The control transaction may be wealth-​enhancing from the target shareholders’ point of view but threaten the jobs and perquisites of the existing senior management. The incumbent management of the target may thus have an incentive to
block such transfers by adopting a range of different “defensive measures.” They may
seek to make the target less attractive to a potential bidder or to prevent the offer being
13 Jarrad Harford, Mark Humphery-​Jenner, and Ronan Powell, The Sources of Value Destruction in
Acquisitions by Entrenched Managers, 106 Journal of Financial Economics 247 (2012). See, with
further references, Klaus J. Hopt, European Takeover Reform of 2012/​2013—​Time to Re-​examine the
Mandatory Bid, 15 European Business Organization Law Review 143, 150 (2014).
14 B. Espen Eckbo, Corporate Takeovers and Economic Efficiency, 6 Annual Review of Financial
Economics 51, 67 (2014). See also Martynova and Renneboog, note 12, at 2164.
15 A number of explanations are usually put forward: first, managers may be over-​optimistic,
underestimating the overall costs, the likelihood of success, and the concessions that need to be
made during the bidding process; secondly, the bidder management may deliberately enter into an
unprofitable takeover for opportunistic reasons (“empire building”); and thirdly, the transaction
may be beneficial for the entire group instead of the single bidder company. See also Hopt, note
13, at 150.
16 Recent research suggests that a requirement of shareholder consent at the bidding company
may help mitigate these problems. See Marco Becht, Andrea Polo, and Stefano Rossi, Does Mandatory
Shareholder Voting Prevent Bad Acquisitions?, 29 Review of Financial Studies 3035 (2016).
17 See Chapter 7.6.
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put to the shareholders. These steps may take a myriad of forms but the main categories
are: i) placing a block of the target’s shares in the hands of persons not likely to accept
a hostile bid; ii) structuring the rights of the shareholders and creditors, for example,
through poison pills; and iii) placing strategic assets outside the reach of a successful
bidder.
Alternatively, the transaction may not be wealth-​enhancing from the shareholders’
point of view but the incumbent management may have an incentive to promote it to
the shareholders, because the management stands to gain from the proposed control
shift, either by reaping significant compensation for loss of office or by being part of
the bidding consortium. Incumbent management may use their influence with the
shareholders and their knowledge of the company to “sell” the offer to its addressees or,
in the case of competing bids, to favor one bidder over another.
Target firms with a controlling shareholder are not exposed to this managerial
agency cost. Regulation needs to address, however, the agency relationship between
the controller and the other shareholders of the target. The controlling shareholder
may seek to obtain more than its proportionate share of the current value of the
company or even impound into the sale price the value of the new controller’s future
opportunistic treatment of the non-​controlling shareholders. This is particularly so
where the target, upon acquisition, will become a member of a group of companies
where business opportunities, which the target has been able to exploit in the past,
may be allocated to other group members. The law can address this problem by focusing on the existing controlling shareholder’s decision to sell, on the terms upon which
the acquirer obtains the controlling block, or upon the subsequent conduct of the
affairs of the target by the new controller. In the last case, reliance will be placed on
the general legal strategies for constraining controlling shareholders, including group
law.18 The first and second cases point towards legal strategies specifically addressing
the control transaction, though these may take a wide variety of forms, up to and
including an exit right for the minority upon a change of control, via a mandatory
bid requirement.19
By contrast, takeover rules do not often address the agency problems which arise as
between the shareholders of the acquiring company and their board in relation to the
decision to acquire the target; and we shall follow that lead in this chapter. This issue
is but an example of the general agency problems existing between shareholders (and
creditors) and boards in relation to setting the corporate strategy, which have been
fully analyzed in earlier chapters.20 However, it is central to this chapter to consider the
extent to which regulation purportedly designed to address the agency and coordination costs of target shareholders impacts upon the incentives for potential bidders to
put forward an offer.
8.1.2.2 Coordination problems
The rules governing control transactions need also to deal with the coordination problems of the target shareholders. In particular, the acquirer may seek to induce dispersed
shareholders of the target to accept an offer which is less than optimal. There are a
number of ways in which this can be done,21 but in essence they rely on information asymmetry, undue pressure to accept the bid, or unequal treatment of the target’s
18 See Chapter 6.2.5.3.
19 See Section 8.3.4.
20 See Chapters 3, 5, and 7 (and especially Section 7.6).
21 See Section 8.3.
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Regulatory Problems in Control Transactions
209
shareholders. Where the target company is controlled by a blockholder, the same problem arises for the remaining shareholders, possibly as against acquirer and controlling
shareholder combined.
8.1.2.3 Agency problems of non-​shareholders
Whatever the structure of the target company’s shareholding, agency issues will also
arise between the acquirer and non-​shareholders, especially employees. Indeed, some have
argued that a substantial proportion of the gains to acquirers from takeovers are the result
of wealth transfers from non-​shareholder groups, especially the employees of the target.22
The responses of takeover regulation to this issue can be put, broadly, into one
of three classes. First, those systems which allocate to the shareholders of the target the exclusive power to approve the offer find it difficult to fit into that structure a significant mechanism for the protection of non-​shareholder interests, other
than via disclosure of information.23 This strategy is heavily adopted by the Takeover
Directive, but the disclosure obligation sits in a vacuum, dependent for its effectiveness upon rules and institutions existing outside corporate law. In some jurisdictions
such structures—​usually some form of works council—​do exist and may be built
into the takeover process by national legislation. The recent takeover law reform in
France has strengthened information rights for target employees to the extent that
the procedure may severely complicate the mechanics of the bid altogether.24 Recent
changes to the UK Code improved the disclosure, monitoring, and enforcement by
the Panel of takeover promises (so-​called “post-​offer undertakings”) that the bidder
(or, exceptionally, the target) makes in the course of a bid and which are directed at
non-​shareholder concerns.25
Where, however, the board is given a significant role in the takeover process, a second pattern can be discerned, which is to regard the survival of target management
as a proxy for the furtherance of the interests of non-​shareholder groups. Thus, in
the U.S., one popular form of state anti​takeover statute (the so-​called “constituency
statute”) expands the range of interests beyond the shareholders’ which management is
entitled (but not bound) to take into account when responding to a takeover bid.26 It is
doubtful, however, whether, by itself, relieving directors of liability to the shareholders
if they act to promote non-​shareholder interests encourages anything more than self-​
interested behavior on the part of the target board. The greater the range of interests
which directors are entitled to take into account when exercising their discretion, the
more difficult it will be to demonstrate in any particular case that the standard has been
breached. If this is a correct analysis, non-​shareholder constituencies will benefit from
22 Margaret M. Blair, Ownership and Control (1995); Andrei Shleifer and Lawrence H.
Summers, Breach of Trust in Hostile Takeovers, in Corporate Takeovers: Causes and Consequences
33 (Alan J. Auerbach ed., 1988).
23 Of course, non-​shareholder interests may be protected through mechanisms existing outside
company law which deal with some of the possible consequences of a control shift, e.g. mandatory
consultation over lay-​offs. See Chapter 7.4.3.2.
24 The Loi “Florange” No. 2014-​384 of 29 March 2014 requires consultation over the bid itself
between the CEO of the target and the works council (Code du travail, Arts. L. 2323-​21 to L. 2323-​
24). The board of directors cannot issue a recommendation before the works council does, which may
significantly slow down the process and even discourage takeover bids.
25 New Rules 19.7 and 19.8. The background is non-​compliance with such promises in the past.
26 See e.g. § 717(b) New York Business Corporation Law. To the extent it applies, section 172
Companies Act 2006 (UK) is another good example.
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Control Transactions
such rules only to the extent that their interests are aligned with those of the target
board.27
The third pattern involves giving non-​shareholders decision rights, though in practice jurisdictions only deploy this strategy in relation to employee interests. In those
jurisdictions (notably Germany) in which company law is used in a significant way to
regulate the process of contracting for labor,28 the presence of employee representatives
on the supervisory board and the relative insulation of the board from the direct influence of the shareholders may enable those representatives to have a significant input
into takeover-​related decisions, up to the point where control shifts are hard to achieve
without the consent of the employee representatives.29
Creditors, as well as employees, may stand to lose out as a result of changes in the
company’s risk profile post-​bid, perhaps arising from the leveraged nature of the bid.
Those most at risk, the long-​term lenders, are well placed to protect themselves by
contractual provisions, such as “event risk” covenants in loans.30 Such protections may
not always be fully protective of the creditors, but adopting sub-​optimal contractual
protection is normally part of the commercial bargain. Consequently, the agency costs
of creditors are not usually addressed in control-​shift rules.31
8.1.2.4 The sources of rules governing control transactions
In principle, regulation of control transactions can be addressed through rules specific
to control shifts or by the application of the established principles of corporate and
securities law, albeit in a new context. In practice, this question is largely conterminous
with the question of whether these rules are made by legislators or courts. All our jurisdictions utilize to some degree both types of approach, but the balance between them
can vary considerably. Towards one end of the spectrum stands Delaware. Here the
courts have played a major role by adapting the general fiduciary standards applying
to boards and controlling shareholders to the control shift context.32 Takeover-​specific
law, whether in the form of federal (Williams Act)33 or state legislation (rules governing access to the short-​form, squeeze-​out merger),34 plays a subordinate role.
27 See also Mark J. Roe, Political Determinants of Corporate Governance 45 (2002)
(employee influence is indirect and weak, constituency statutes being made by and for managers).
28 See Chapter 4.2.1.
29 German law de facto opts out from the Takeover Directive’s board neutrality rule by allowing
defensive measures if these have been approved by the supervisory board which is codetermined in
the large corporations.
30 William W. Bratton, Bond Covenants and Creditor Protection, 7 European Business
Orga­nization Law Review 39, especially at 58–​62 (2006).
31 It is sometimes difficult to distinguish covenants whose aim is to protect the lender and those
which aim to protect target management (“poison debt”); in fact, both groups may have an interest in
inserting provisions which make debt repayable upon a change of control. However, this point relates
to the agency costs of the shareholders, not the creditors.
32 It has been argued that the litigation focus of U.S. takeover regulation made it easier for a pro-​
management approach to emerge because, on the one hand, case law precedents are relatively free
from interest-​group influence and, on the other, the courts can decide only the cases which come
before them and management (and their lawyers) are in a good position to control the flow of litigation and appear as repeat players before the courts. See John Armour and David Skeel, Who Writes the
Rules for Hostile Takeovers, and Why?—​The Peculiar Divergences of U.S. and U.K. Takeover Regulation,
95 Georgetown Law Journal 1727, 1793 (2007).
33 1968, 82 Stat. 454, codified at 15 U.S.C. §§ 78m(d)–​(e) and 78n(d)–​(f ), adding new §§ 13(d),
13(e), and 14(d)–​(f ) to the Securities Exchange Act of 1934.
34 Section 8.3.5.
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Agency Problems in Control Transactions
211
By contrast, in the EU rules specific to control shifts are more important (though not to
the complete exclusion of general rules of corporate and securities law). Thus, the Takeover
Directive lays down an extensive set of rules which are confined to control shifts. Similarly,
the regulation of control transfers under Brazilian law is also primarily based on specific
rules.35 Japan sits somewhat between these two models.36 It has legislation specific to
control shifts,37 but, on the central issue of the allocation of decision rights over the offer,
court-​developed general standards applying to directors’ decisions are still central.38
Where regulation of control shifts is predominantly through takeover-​specific rules,
the rule-​maker is likely to create a specialized agency to apply the rules, as mandated
by the Takeover Directive.39 This will generally be the financial markets regulator but
may be a specific regulator for takeovers.40
8.2 Agency Problems in Control Transactions
Agency problems may arise in both widely held and controlled target corporations: the
incumbent controller is the target board in the former case and the blockholder in the
latter. In both cases, takeover regulation addresses the tensions between the “controller”
and the (minority) shareholders. In the following, we will first predominantly look at
the case of a widely held target, and subsequently address the specific differences in a
target company that is controlled by a blockholder (Section 8.4).
8.2.1 The decision rights choice: Shareholders only
or shareholders and board jointly
The central issue is whether the bidder is free to make and maintain an offer to the
target shareholders without the consent of the incumbent management. The available
solutions range from allocating the decision on the control transaction exclusively to
the shareholders by depriving the management of any role in the interactions between
acquirer and target shareholders, to designing the control shift decision as a joint one
for incumbent management and shareholders. In the former case, the shareholders’
agency problems as against the management are resolved by terminating the agency
relationship for this class of decision: the principal is protected by becoming the
decision-​maker41 and free transferability of shares becomes paramount. In the latter
case, both management and target shareholders must consent if the control shift is to
35 See e.g. Arts. 254-​A and 257 Lei das Sociedades por Ações.
36 On the emerging framework in Japan, see John Armour, Jack B. Jacobs, and Curtis J. Milhaupt,
The Evolution of Hostile Takeover Regimes in Developed and Emerging Markets: An Analytical Framework,
52 Harvard International Law Journal 291, 248 ff. (2011); Hideki Kanda, Takeover Defences and
the Role of Law: A Japanese Perspective, in Perspectives in Company Law and Financial Regulation
413 (Michel Tison et al. eds., 2009); Masaru Hayakawa, Die Zulässigkeit von Abwehrmaßnahmen im
sich entwickelnden japanischen Übernahmerecht, in Festschrift für Klaus J. Hopt 3081 (Stefan
Grundmann et al. eds., 2010).
37 See Art. 27-​2 of the Financial Instruments and Exchange Act and Section 8.3.4.
38 Section 8.2.2—​coupled in this case with non-​binding guidelines issued by the government.
39 Art. 4(1).
40 The former is by far the more common choice within Europe but the UK and countries which
follow its model usually give the supervision of takeovers to a body separate from the general financial
market regulator.
41 Typically, the shareholders determine the fate of the offer by deciding individually whether to
accept the offer or not, but in some cases the shareholders’ decision may be a collective one, as where
the shareholders decide in a meeting whether to approve the taking of defensive measures by the
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Control Transactions
occur. The acquirer is forced to negotiate with both groups. The potential gains from
the control shift may now have to be split three ways (acquirer, target shareholders,
target management) and, to the extent that the benefits to management of their continuing control of the target company exceed any share of the gain from the control
shift which the acquirer is able or willing to allocate to them, fewer control shifts
will occur.
8.2.2 The “no frustration” rule
The UK Takeover Code embodies the former choice in a strong form. Since its inception in 1968 it has contained a “no frustration” principle addressed to the board of
the target company. This provides that “during the course of an offer, or even before
the date of the offer if the board of the offeree company has reason to believe that a
bona fide offer might be imminent, the board must not, without the approval of the
shareholders in general meeting, take any action which may result in any offer or bona
fide possible offer being frustrated or in shareholders being denied the opportunity to
decide on its merits … ”42 This will affect, e.g. the issuance of new shares, the acquisition or disposal of significant assets, leveraging the capital structure or entering into
substantial contracts other than in the ordinary course of business.43 The board will,
however, typically remain entitled, in fact required, to give its assessment of the bid and
may search for an alternative bidder (the “white knight”).44
The no frustration or, in EU jargon, “board neutrality” rule45 is an effects-​based
rule, not one dependent on the intentions or motives of the board. Action on the part
of the incumbent management which might obstruct an offer is legitimate under this
rule only if the shareholders themselves have approved it, that is, have in effect rejected
the offer. The no frustration rule recognizes that effective implementation of exclusive
shareholder decision-​making requires rules which ensure not only that shareholders are
free to accept offers which are put to them, but also that offerors are free to put offers
to the shareholders. In other words, the law must provide entry rules for acquirers as
well as exit rules for shareholders.
The no frustration rule is not, however, imposed by the Takeover Directive; rather
the choice is left to the member states. All the major continental jurisdictions make
it possible for companies to avoid the “no frustration” rule (with varying degrees of
flexibility).46 Where the “no frustration” rule is not applied, the general principles of
national corporate law determine the target board’s freedom of action.
incumbent management or where the shareholders vote to remove a board that will not redeem a
poison pill: Sections 8.2.2 and 8.2.3.
42 Rule 21.1.
43 See Takeover Code, Rule 21.1(b). Note that the items listed there are examples only.
44 See e.g. Art. 9(2) and (5) Takeover Directive. Jurisdictions are generally relaxed about white
knights because the decision of whether to accept an offer and, if so, which one, is still ultimately left
to the shareholders.
45 The EU-​level discussion normally uses the term “board neutrality” but we prefer the term “no
frustration” as more accurately indicating the scope of the rule. See Section 8.2.2.1.
46 After the Directive was implemented across the EU, takeover laws across member states were
surprisingly overall less favorable to board neutrality than they had been previously. See Paul Davies,
Edmund-​Philipp Schuster, and Emilie van de Walle de Ghelcke, The Takeover Directive as a Protectionist
Tool? in Company Law and Economic Protectionism 105, 138 ff. (Ulf Bernitz and Wolf-​Georg
Ringe eds., 2010). Even a jurisdiction like France, which originally adopted the neutrality rule, has
gone back on that choice (see Section 8.2.3.).
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Agency Problems in Control Transactions
213
It is clear in both the Takeover Code and the Directive that shareholder approval
means approval given during the offer period for the specific measures proposed and not
a general authorization given in advance of any particular offer. A weaker form of the
shareholder approval rule is to permit shareholder authorization of defensive measures
in advance of a specific offer. This is a weaker form of the rule because the choice which
the shareholders are making is presented to them less sharply than under a post-​bid
approval rule.47 On the other hand, rendering pre-​bid approval of post-​bid defensive
measures ineffective makes it more difficult for shareholders to commit themselves to
handling future offers through board negotiation with the bidder.48 Pre-​bid shareholder
approval is one way of legitimizing defensive action in Germany49 and also in Japan.
In the latter, the governmental guidelines favor pre-​bid approval of defensive action “to
allow the shareholders to make appropriate investment decisions.”50 However, court
decisions are unclear on whether pre-​bid approval will always legitimize defensive measures.51 Given the scarcity of hostile takeovers in Brazil, the law on the legitimacy of
defensive measures remains underdeveloped and, therefore, uncertain. Nevertheless,
Brazil’s newly created Takeover Panel, whose membership is voluntary and still small,
imposes a version of the no frustration rule during a pending offer.52
8.2.2.1 No frustration, neutrality, passivity, and competing bids
The “no frustration” rule does not require boards to be “neutral,” let alone “passive.”
There will remain a number of situations where the target board, consistently with
the rule, may take action which may significantly influence the outcome of the offer.
First, incumbent management remains free to persuade shareholders to exercise their
right of choice in a particular way and, indeed, in most jurisdictions the target board is
required to provide the shareholders with an opinion on the offer. This recognizes the
role of the incumbent management in addressing the information asymmetry problems of the target shareholders.
47 This point is well captured in the French terminology which refers to advance authorization as
approval given “à froid” and authorization given after the offer as given “à chaud.”
48 On pre-​commitment see Chapter 7.2. For the possible use of pre-​bid defensive measures to this
end see Section 8.2.3.
49 Wertpapiererwerbs-​und Übernahmegesetz (“WpÜG”), § 33(2). Such permission may be
given for periods of up to eighteen months by resolutions requiring the approval of three-​quarters
of the shareholders, though the constitution of a particular company may set more demanding rules.
However, approval may also be given post-​bid by the supervisory board without shareholder approval
(WpÜG § 33(1)), and so pre-​bid approval by shareholders seems unimportant in practice. See Klaus
J. Hopt, Obstacles to Corporate Restructuring: Observations from a European and German Perspective,
in Perspectives in Company Law and Financial Regulation 373, at 373–​95 (Michel Tison et al.
eds., 2009).
50 Ministry of Economy, Trade and Industry (METI) and Ministry of Justice, Guidelines
Regarding Takeover Defense for the Purposes of Protection and Enhancement of
Corporate Value and Shareholders’ Common Interests, 27 May 2005, p. 2. These guidelines
are not legally binding but seek to capture court decisions and best practice. See also Corporate Value
Study Group, Takeover Defense Measures in Light of Recent Environmental Changes, 30
June 2008.
51 As of the time of writing, there has been no court decision concerning a defensive measure based
on the Guidelines accompanied by pre-​bid approval. However, the Supreme Court in the Bulldog
Sauce case upheld the issuance of warrants as a defensive measure that had been approved by the
shareholders after the bid had been launched and acquirer was treated fairly in respect of its pre-​bid
holdings (if not in the same manner as the other shareholders of the target): Supreme Court of Japan,
7 August 2007, 61 Minshu 2215. See also Sadakazu Osaki, The Bulldog Sauce Takeover Defense, 10(3)
Nomura Capital Markets Review 1 (2007).
52 Código de Autorregulação de Aquisições e Fusões Art. 156, IX.
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Control Transactions
Second, the management may appeal to the competition authorities to block the
bid, presumably the rationale being that this is an efficient way of keeping the public
authorities informed about potential competition concerns, whilst the public interest
in competitive markets must trump the private interest of shareholders in accepting
the offer made to them.
Third, the rule is usually understood as a negative one, not requiring incumbent
management to take positive steps to facilitate an offer to the shareholders (except in
some cases where a facility has already been extended to a rival bidder). Thus, the no
frustration rule does not normally require the target management to give a potential
bidder access to the target’s books in order to formulate its offer.53 The first and third
possibilities often give the management of the target significant negotiating power with
the bidder as to the terms of the offer. This may explain why takeover premia are not
significantly different in the UK from the U.S., despite the no frustration rule in the
UK Code.54
8.2.2.2 White knights and competing bids
The no frustration rule does not prevent an incumbent management from seeking to
enlarge the shareholders’ choice, for example, by seeking a “white knight.” Whether
or not sought by the incumbent management, a competing bidder may emerge. The
wealth-​enhancing impact of competing bids as far as target shareholders are concerned
is well established in the empirical literature. However, the cost associated with rules
which facilitate competing bids is that they reduce the incentives for first offers to be
made. First bidders often lose out if a competitor emerges, and in that situation the
search and other costs incurred by the first bidder will be thrown away. This will discourage first bidders generally and so reduce the number of offers.55
More broadly, “any regulation that delays the consummation of a hostile [or even a
friendly] bid … increases the likelihood of an auction by providing time for another
bidder to enter the fray, upon the target’s solicitation or otherwise.”56 Thus, takeover
rules ostensibly aimed at other problems may have a significant impact on the chances
that an alternative offer will be forthcoming. An example is rules which require the bid
to remain open for a certain minimum period of time (in order that shareholders shall
not be pressurized into accepting the offer before they have had a chance to evaluate
it). Another is rules requiring disclosure to the market of the beneficial ownership of
shareholdings above a certain size, which may give a potential competitor advance
warning that an offer for a particular target company is likely to be forthcoming.57 If
a competitor does emerge, whether through the actions of the target management or
not, its task is facilitated in those systems which permit acceptors to withdraw their
acceptance of the first offer, unless it has been declared unconditional, either for any
53 Certainty about the target’s income generating potential may be very important for a leveraged
offeror.
54 John C. Coates IV, M&A Break Fees: U.S. Litigation vs. UK Regulation, in Regulation versus
Litigation: Perspectives From Economics and Law 239, 255 (Daniel P. Kessler ed., 2011).
55 Frank H. Easterbrook and Daniel R. Fischel, The Proper Role of a Target’s Management in
Responding to a Tender Offer, 94 Harvard Law Review 1161 (1981). This trend is reinforced by some
jurisdictions’ requirement of information parity. For instance, in the UK, if the target board shares
information during due diligence to a preferred bidder, it must be willing to share similar information
to another bidder (although not preferred) in response to specific questions (Takeover Code, Rule 22).
56 Romano, note 12, at 156.
57 See Section 8.2.4.
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Agency Problems in Control Transactions
215
reason or if a competing offer emerges.58 To the same effect are rules giving competing
bidders equal treatment with the first bidder as far as information is concerned.59
There are a number of techniques which can be used to mitigate the downside to
the first bidder of rules which facilitate competing bids.60 Where the directors of the
potential target judge that it is in the shareholders’ interests that a bid be made for
their company and that an offer will not be forthcoming without some protection
against the emergence of a competitor, the directors of the target may contract not to
seek a white knight or not to cooperate with one if it emerges. However, contracting
not to recommend a better competing offer is normally ruled out on fiduciary duty
grounds.61 More effective from the first offeror’s point of view would be a financial
commitment from the target company in the form of an “inducement fee” or “break
fee,” designed to compensate the first offeror for the costs incurred if it is defeated by a
rival. Such fees are common in the U.S., but have recently been severely constrained in
the UK due to their potential impact upon free shareholder decision-​making.62 They
could be used to give a substantial advantage to the bidder preferred by the incumbent
management. Finally, the first offeror could be left free to protect itself in the market
by buying shares inexpensively in advance of the publication of the offer, which shares
it can sell at a profit into the competitor’s winning offer if its own offer is not accepted.
Although pre-​bid purchases of shares in the target (by the offeror) do not normally
fall foul of insider dealing prohibitions,63 rules requiring the public disclosure of share
stakes and of economic interest in shares limit the opportunity to make cheap pre-​bid
purchases of the target’s shares.64
Overall, in those jurisdictions which do not permit substantial inducement fees,
the ability of the first bidder to protect itself against the financial consequences of a
competitor’s success are limited.
8.2.3 Joint decision-​making
Where management is permitted unilaterally to take effective defensive measures in
relation to an offer, the process of decision-​making becomes in effect a joint one involving both shareholders and management on the target company’s side. Unless the target
board decides not to take defensive measures or to remove those already implemented,
the offer is in practice incapable of acceptance by the shareholders. Perhaps the best
58 This is the predominant rule in takeover regulations, including in the U.S. (see § 14(d)5
Securities Exchange Act and Rule 14d-​7)—​though not in the UK (Takeover Code, Rule 34, allowing
withdrawals only more narrowly). The bidder may seek to avoid this rule by obtaining irrevocable
acceptances outside the offer (and usually before it is made)—​though the acceptor may choose to
make the acceptance conditional upon no competing bidder emerging.
59 See note 55 and Section 8.3.1.
60 For further analysis see Athanasios Kouloridas, The Law and Economics of Takeovers: an
Acquirer’s Perspective (2008) chs. 6 and 7.
61 Dawson International plc v. Coats Patons plc [1990] Butterworths Company Law Cases 560
(Court of Session).
62 They are usually in the 2–​5 percent range in the U.S. Significantly, the UK Code (rule 21.2
notes) still allows break fees (up to 1 percent) in favor of a competing bidder, where the original offer
was not recommended by the target board. It also allows a 1 percent fee in favor of the first bidder,
if that offer is the outcome of a formal sale process initiated by the target board. They are allowed in
Germany: see Hopt, note 12, at 276.
63 See e.g. Recital 30 to EU Market Abuse Regulation 596/​2014, 2014 O.J. (L 173) 1.
64 See, in the context of the shareholder activism debate, John C. Coffee, Jr., and Darius Palia,
The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance, 1 Annals of
Corporate Governance 1 (2016).
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Control Transactions
known of such measures is the “poison pill” or shareholders’ rights plan, as developed
in the U.S.65 Here, the company’s charter provides that the crossing by an acquirer of
a relatively low threshold of ownership (typically, 10 or 20 percent) triggers rights for
target shareholders to acquire shares in either the target or the acquirer on favorable
terms, from which the acquirer itself is excluded.66 The dilutive effect of the plan on
the acquirer renders the acquisition of further shares in the target fruitless or impossibly expensive. The ease with which a plan can be adopted by management of potential
target companies means that even companies with no apparent defense in place can
adopt one in short order, so that the distinction between pre-​and post-​bid defensive
measures becomes meaningless. It has also been considered to be a powerful legal technique, apparently putting the incumbent management in a position where they can
“just say no” to a potential acquirer.67 Where the bid is acceptable, in the board’s view,
it may “redeem” the pill and thus allow the takeover to go ahead. Defensive measures in
the U.S. rely so heavily on poison pills that separate “anti​takeover” statutes adopted by
a number of states have become largely irrelevant.68 As we will see below, the standard
mode of “hostile” takeover bids shifts to the proxy contest, where the bidder seeks to
replace the board with one which will redeem the pill.69
In France the legislature in 2006 designed a shareholder rights plan (so-​called “bons
Breton” or, tellingly, “bons patriotes”)70 and slotted it into the overall statutory regulation of control transactions. However, as is generally the case in Europe, the issuance of
new shares requires shareholder approval. Initially, French law required that approval
to be given post-​bid (with a reciprocity-​based exception), in compliance with the no
frustration rule. However, in 2014 (under the so-​called “Loi Florange”)71 the French
no​frustration rule was repealed and pre-​bid approval of plans made available (though
requiring periodic renewal). Now, the scheme operates as a way for shareholders to
commit to the incumbent management. French shareholders appear to have made
little use of the possibility, arguably distrusting the management before they even know
the terms of an offer.72
65 Poison pills were first designed as a response to the 1980s hostile takeover wave. In many
respects, they function today as a shield against contemporary activist hedge funds. Put differently,
activist hedge funds may be considered, in some degree, as a market response to the dramatically
increased effectiveness of defensive tactics against hostile bids resulting from poison pills.
66 See e.g. Lucian A. Bebchuk and Allen Ferrell, Federalism and Corporate Law: The Race to Protect
Managers from Takeovers, 99 Columbia Law Review 1168 (1999). See also, by the same authors, On
Takeover Law and Regulatory Competition, 57 Business Lawyer 1047 (2002).
67 “The passage of time has dulled many to the incredibly powerful and novel device that a so-​
called poison pill is. That device has no other purpose than to give the board issuing the rights the
leverage to prevent transactions it does not favor by diluting the buying proponent’s interests (even
in its own corporation if the rights ‘flip-​over’)”: Strine V-​C in Hollinger Int’l v. Black, 844 Atlantic
Reporter 2d 1022, 1064–​5 (2004, Del. Ch.).
68 Emiliano Catan and Marcel Kahan, The Law and Finance of Antitakeover Statutes, 68 Stanford
Law Review 629 (2016).
69 See Section 8.2.3.2.
70 See Loi No 2006-​387 of 31 March 2006. Given the presence of a mandatory bid rule in France,
the warrants are triggered only by a general offer and, for that reason, it was unnecessary to exclude
the offeror from the rights.
71 See Arts L. 233-​32 and L. 233-​33 Code de commerce, as amended by the Loi “Florange” No.
2014-​384 of 29 March 2014. On this reform, see Quentin Durand, Loi visant à reconquérir l’économie
réelle: présentation des aspects relatifs aux offres publiques, Bulletin Joly Bourse 274 (2014); Eva
Mouial-​Bassilana and Irina Parachkévoya, Les apports de la loi Florange au droit des sociétés, Bulletin
Joly Sociétés 314 (2014); Alain Viandier, OPA, OPE, et Autres Offres Publiques, nos 2045 ff.
(5th edn., 2014).
72 Durand, note 71, at 281, n. 53.
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217
This recent reform has brought France somewhat closer to the U.S. system, as it
is now possible for the shareholders to issue warrants before a bid is launched or to
authorize the board to issue them even when a bid has been launched, without further
shareholder involvement. The authorized board can thus negotiate with a potential
bidder and equally has discretion to trigger the warrants. Nevertheless, a number of
important differences persist. First, unlike U.S. poison pills, the French warrants can
only be adopted or authorized by shareholder resolution and not by the board alone.
Secondly, the warrants must be issued to all the shareholders, including the acquirer’s
likely pre-​bid shares.73 Thirdly, the bons Breton can only be triggered when a genuine
“takeover bid” has been launched. They will not work against creeping acquisitions.
And finally, the French warrants are bid-​specific. When the bid is not successful, they
automatically become void.74
With the removal of the no​frustration rule, incumbent management may be able to
take other defensive steps, either with pre-​bid shareholder approval or without shareholder approval. In France as in other jurisdictions in this position the possibilities
for unilateral defensive measures will depend upon the extent to which shareholder
approval is required under general corporate law or the company’s articles.75 As we
have seen in previous chapters,76 the powers of centralized management are extensive
in relation to the handling of the company’s assets, but in many jurisdictions they
are more constrained where issues of shares or securities convertible into shares are
concerned, because of their dilution potential for the existing shareholders. However,
defensive measures which focus on the company’s capital rather than its business assets
would be more attractive to incumbent management, because they are less disruptive
of the underlying business and a more powerful deterrent of the acquirer.
Equally, the development of share warrants as a defensive measure in Japan was
premised upon changes in general corporate law (not aimed specifically at control
transactions) which expanded the board’s unilateral share-​issuing powers.77 Whether it
is legitimate for the board to use its powers to defeat a takeover is, of course, a separ­
ate question, but without the power, the question does not even arise. Alternatively,
acquirers may be discouraged through a customized version of the mandatory bid rule.
The Brazilian version of the “poison pill” originally consisted in “immutable” charter
provisions imposing on acquirers of a certain percentage of the company’s stock the
obligation to launch a mandatory bid to all shareholders—​often at a large premium
over the market price specified ex ante. Conceived as entrenchment devices for existing blockholders holding less than a majority of the voting capital, these provisions
soon became controversial and their legality was questioned.78 Subsequent revisions to
the Novo Mercado, Brazil’s premium corporate governance listing segment, outlawed
immutable provisions, so that a majority of shareholders can amend the charter to
eliminate the mandatory bid requirement at any time.79
73 Though the shares which the bidder has agreed to acquire through the bid do not count for
entitlement to the warrants. See also note 70.
74 Art. L.233-​32, II, fourth alinéa Code de Commerce.
75 See Matteo Gatti, The Power to Decide on Takeovers: Directors or Shareholders, What Difference
Does It Make?, 20 Fordham Journal of Corporate & Financial Law 73 (2014).
76 See especially Chapter 3.2.3 and Chapter 7.
77 For the use of share warrants as defensive measures in Japan, see notes 50 and 51 and their
accompanying text.
78 Parecer de Orientação CVM No. 36 (2009).
79 Novo Mercado Regulations Art. 3.1.2.
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8.2.3.1 Strategies for controlling the board’s powers to take defensive measures
Although the no frustration rule is not a fully fledged passivity rule, it nevertheless
operates so as to put the shareholders in the driving seat as far as decision-​making on
the offer is concerned. The coordination problems of target shareholders as against the
acquirer then become a significant concern where the no frustration principle applies.
By contrast, joint decision-​making strategies permit the incumbent management to
negotiate on behalf of the shareholders and to take other steps in their interests, such
as rejecting bids which undervalue the company. If incumbent management’s decision-​
making power is used in the shareholders’ interests, rather than to promote the self-​
interest of the management, it can be argued that the outcome is superior to that
achieved by lodging the decision right wholly with the shareholders.80 However, to
achieve this result, a joint decision-​rights strategy needs to be accompanied by one
or more other strategies which constrain incumbent management discretion. There
is a range of available strategies: standards, trusteeship, removal rights, and reward
strategies.
8.2.3.2 Standards
Ex post scrutiny by the courts of the exercise of the veto power by management is
available in principle, under the general law relating to directors’ duties. The rigor of
this scrutiny can vary by jurisdiction and over time. It has been argued81 that in the
1980s the Delaware courts applied fiduciary duties to directors in such a way as to
sustain refusals to redeem poison pills only where the bid was formulated abusively as
against the target shareholders. Later on, court review became more accommodating
of managerial interests. The starting point was adoption of the view that decisions on
the fate of a bid are in principle as much a part of the management of the company,
and thus within the province of the directors, as any other part of corporate strategy.82
The shareholders’ interests became paramount only if the incumbent management
had reached a decision to sell control of the company or to dispose of its assets.83
Otherwise, the decision to maintain the existing business strategy of the company by
resisting a takeover was one that the board was in principle free to take, whether or not
the offer would maximize shareholder wealth in the short term.84
In Japan as well, in the absence of shareholder approval, the governmental guidelines and court decisions anticipate that defensive action by target management will
be lawful only where it enhances “corporate value” and promotes the shareholders’
80 The attractiveness of this argument depends, of course, on (a) how easily the shareholders’ coordination problems can be addressed if management is sidelined (Section 8.3) and (b) how much scope
for negotiation is left to the incumbent board under the no​frustration rule (Section 8.2.2.1).
81 Lucian Bebchuk, The Case Against Board Veto in Corporate Takeovers, 69 University of Chicago
Law Review 973 at 1184–​8 (2002). See also R. Gilson, UNOCAL Fifteen Years Later (and What We
Can Do About It), 26 Delaware Journal of Corporate Law 491 (2001).
82 Paramount Communications Inc. v. Time Inc., 571 Atlantic Reporter 2d 1140 (1989); Unocal
Corp. v. Mesa Petroleum Co., 493 Atlantic Reporter 2d 946 (1985); Unitrin Inc. v. American General
Corporation, 651 Atlantic Reporter 2d 1361 (1995).
83 Revlon Inc. v. MacAndrews & Forbes Holdings Inc., 506 Atlantic Reporter 2d 173 (1986);
Paramount Communications v. QVC Network, 637 Atlantic Reporter 2d 34 (1994).
84 In many U.S. states the managerialist approach was adopted legislatively through “constituency statutes” which, while appearing to advance the interests of stakeholders, in particular labor and
regional interests, in practice operated—​and were probably intended to operate—​to shield management from shareholder challenge. Romano, note 12, at 171, and Section 8.1.2.3.
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Agency Problems in Control Transactions
219
interests.85 Consequently, defensive measures not approved by the shareholders will
stand a greater chance of meeting this standard if the bid is coercive, animated by
greenmail, or based on information asymmetry as between acquirer and target shareholders.86 Overall, there is little evidence in any jurisdiction that the courts are willing
to scrutinize rigorously the discretion vested in management under the dual decision-​
making model.87
8.2.3.3 Removal rights
In the U.S., strong defensive measures available to target boards induced the response
from acquirers, who were unwilling or unable to appease the incumbents, of relying on
removal rights, that is, launching a proxy fight to seek removal of the target directors.
Where the proxy fight is successful, the bidder can replace the directors with his own
appointees, who will then redeem the pill. Whilst this strategy has been obstructed
for a long time due to the presence of staggered boards88 in many U.S. corporations,
the more recent years have shown a trend towards “destaggering,”89 which renders this
strategy more attractive. Nevertheless, the need to remove the incumbents constrains
the acquirer’s freedom in relation to the timing of the offer because, in Delaware,
removal is practicable only at the annual general meeting.90
8.2.3.4 Trusteeship
An additional strategy to constrain incumbent management discretion on takeover-​
related decisions is to require approval from independent directors. In Germany
defensive measures proposed by the managing board need approval by the super­
visory board.91 This strategy heavily depends for its effectiveness on the ability of the
supervisory board to play a genuinely independent role. This may be questionable in
the case where the board is codetermined, since the employee representatives on the
85 Defensive measures against a non-​coercive bid were struck down in the Livedoor case: Tokyo
High Court Decision on 23 March 2005, 1899 Hanrei Jiho 56.
86 METI and MoJ Guidelines, note 50, at 4–​5. For a discussion of Livedoor and other cases see
Sôichirô Kozuka, Recent Developments in Takeover Law: Changes in Business Practices Meet Decade-​Old
Rule, 21 Zeitschrift für Japanisches Recht 5, 12–​16 (2005).
87 Thus, in Germany the managing board’s power to take defensive action with the consent of the
shareholders and/​or the supervisory board will not relieve it of its duty to act in the best interests of
the company. Whilst there is much academic discussion of what this limitation means, it is doubtful
whether it prevents management entrenchment except in egregious cases. However, there is some
evidence that the Delaware courts have done a better job with the standards strategy when it has been
deployed to control managerial promotion of (rather than resistance to) control shifts. See Robert B.
Thompson and Randall S. Thomas, The New Look of Shareholder Litigation: Acquisition-​Oriented Class
Actions, 57 Vanderbilt Law Review 113 (2004).
88 A board is called “staggered” where a proportion only—​normally one-​third—​of the board is up
for re-​election at each annual meeting. See Chapter 3.2.2.
89 More than 60 percent of S&P 500 companies had a staggered board in 2002; by 2013,
this number had declined to 12 percent. See Weili Ge, Lloyd Tanlu, and Jenny Li Zhang, Board
Destaggering: Corporate Governance Out of Focus? Working Paper (2014), at ssrn.com.
90 On the advantages of the bid over a proxy fight see Louis Loss, Joel Seligman, and Troy Paredes,
Fundamentals of Securities Regulation 562 (6th edn., 2011).
91 The managing board may seek the advance approval of the shareholders for defensive measures
but then any exercise of the power must be approved by the supervisory board (WpÜG § 33(2)) or it
may take defensive measures simply with the approval of the supervisory board (WpÜG § 33(1), last
sentence). Only the last-​minute amendments to § 33 in the legislative process explain this oddity. In
practice, there seems little value to the management in obtaining prior approval of the shareholders.
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Control Transactions
supervisory board will typically favor the management’s rather than the shareholders’
standpoint.92 Equally, board decisions in the U.S. to redeem or not a poison pill are
typically taken by the independent members of the board. Here there are no complications arising from codetermination but the independence of the non-​executives is still
an open issue.
The U.S. alternative to negotiating with the incumbents is, in reality, often a combination of removal and trusteeship strategies, since overwhelmingly the boards of
U.S. public companies are composed of independent directors. That these combined
strategies may not work out as the acquirer intended is shown by the Airgas case. Airgas
was subject to a hostile bid by competitor Air Products, but the former’s board, relying on its poison pill, rejected the bid as too low.93 Air Products thus initiated a proxy
fight and successfully installed three new independent directors in Airgas’ board. These
newly elected directors, after taking independent advice, surprised the market by sharing the other directors’ view that the bid indeed undervalued Airgas, and became the
most vociferous opponents of Air Products’ offer. This ultimately credible result seems
to have emerged from the combination of two strategies discussed here: the removal
strategy—​
replacing incumbent directors—​
and the trusteeship strategy—​
installing
genuinely independent directors, not just representatives of the bidder, plus the use of
outside advice.94
Another variant of, or addition to, the trusteeship strategy is the obligation on the
board to seek “independent advice” or a “fairness opinion” from outside the company—​something which was also a factor in the Airgas case.95 This is required in
the UK and France.96 In the U.S., fairness opinions are routinely obtained by the
target board, as a consequence of the Delaware case-​law, most importantly Smith v.
Van Gorkom.97 More recently, both the Delaware courts and the SEC have developed
detailed guidelines on what counts as an “independent” fairness opinion.98
8.2.3.5 Reward strategy
Under this strategy the self-​
interest of the incumbent management in retaining
their jobs is replaced by self-​interest in obtaining a financial reward which is dependent upon surrendering control of the company to the acquirer.99 This may arise
because: (i) rewards under general incentive remuneration schemes for managers
are triggered upon a transfer of control;100 (ii) payments can be claimed under the
92 See Hopt, note 49, at III.A.b.
93 For a fuller description, see Air Products and Chemicals, Inc. v. Airgas, Inc., 16 Atlantic
Reporter 3d 48 (Del. Ch. 2011).
94 See Edward B. Rock, Institutional Investors in Corporate Governance, in Oxford Handbook
of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017), available at <http://​www.oxfordhandbooks.com/​view/​10.1093/​oxfordhb/​9780198743682.001.0001/​
oxfordhb-​9780198743682>.
95 Ibid.
96 UK Takeover Code, r 3; Règlement Général de l’AMF, Book II, Title VI, chapters I and II.
97 488 Atlantic Reporter 2d 858 (Del. 1985).
98 For detailed references, see David Friedman, The Regulator in Robes: Examining the SEC and the
Delaware Court of Chancery’s Parallel Disclosure Regimes, 113 Columbia Law Review 1543 (2013).
99 Marcel Kahan and Edward B. Rock, How I Learned to Stop Worrying and Love the Pill: Adaptive
Responses to Takeover Law, 69 University of Chicago Law Review 871 (2002); Jeffrey N. Gordon,
An American Perspective on Anti-​takeover Laws in the EU: The German Example, in Reforming
Company and Takeover Law in Europe 541 (Guido Ferrarini et al. eds., 2004).
100 E.g. because of accelerated stock options.
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Agency Problems in Control Transactions
221
management’s contracts of service;101 or (iii) less often, ad hoc payments are made to
the incumbent management, either by the acquirer or the target company, in connection with a successful control shift. Where such payments are available, it is argued
that the reward strategy succeeds in generating powerful incentives not to invoke the
poison pill or other defensive measures.102 However, as explained below, in many legal
systems it is unacceptable or unlawful to make payments of a sufficient size to amount
to a significant counter-​incentive for the managers, at least without the consent of the
shareholders.
Thus, as we saw in Chapter 3, in the Mannesmann case, a payment to the CEO of a
German target company after a successful takeover led to criminal charges against him
for corporate waste (embezzlement). The test developed by the top criminal court for
corporate waste was a tough and objective one,103 and it has received strong criticism
in the academic literature.104 This liability can be avoided by contracting in advance
for the payment of compensation for loss of office, and corporate practice has quickly
adjusted, but the decision appears to have chilled the levels of contractual compensation as well. In the UK gratuitous payments as well as some contractual entitlements
in connection with loss of office after a takeover require shareholder approval, in the
absence of which the payments are regarded as held on trust for the shareholders who
accepted the offer.105 This remedy nicely underlines the fact that strengthening the role
of incumbent management in control shifts is likely to lead to the diversion to them
of part of the control premium.106 However, the UK rules operate in the presence of
the no frustration rule. Hence, the need to incentivize directors to avoid defensive
measures is arguably less important.
Overall, the initial decision-​rights choice is likely to be highly significant. Whilst in
some jurisdictions, notably the U.S., the deployment of additional strategies, especially
the reward strategy, may produce a result in which the outcomes of the joint decision-​making process are not significantly different (in terms of deterring value-​enhancing bids) from those arrived at under the no​frustration rule, this conclusion is highly
dependent upon those additional strategies being available and effective. In the absence
of pro-​shareholder courts with effective review powers, easy removal of incumbent
management or the ability to offer significant financial incentives to management to
view the bid neutrally, rejection of the no​frustration rule is likely to reduce the number
of control shifts.107
101 E.g. contractual golden parachutes.
102 Lucian Bebchuk and Jesse Fried, Pay Without Performance (2004) 89–​91; Alessio M.
Pacces, Rethinking Corporate Governance: The Law and Economics of Control Powers
(2012) ch. 3.3 (welcoming such a result on theoretical grounds as enabling a manager/​entrepreneur
to be compensated for idiosyncratic private benefits of control on a control shift, at a lower level
of ownership of the company than she would aim for if such side-​payments were not available);
Bengt Holmstrom and Steven N. Kaplan, Corporate Governance and Merger Activity in the United
States: Making Sense of the 1980s and 1990s, 15 Journal of Economic Perspectives 121 (2001).
103 BGH 21 December 2005, Neue Juristische Wochenschrift 2006, 522. See also
Chapter 3.3.2.
104 Gerald Spindler, Vorstandsvergütungen und Abfindungen auf dem aktien-​und strafrechtlichen
Prüfstand—​
Das Mannesmann-​
Urteil des BGH, ZIP-​Zeitschrift für Wirtschaftsrecht 349
(2006).
105 Companies Act 2006, sections 219, 222(3), and 226C.
106 Cf. Gordon, note 99, at 555 (“One way to understand [golden parachutes and accelerated stock
options] is as a buyback by shareholders of the takeover–​resistance endowment that managers were
able to obtain from the legislatures and the courts during the 1980s”).
107 See ibid. (making these points in relation to Germany, where neither easy removal of the board
nor high-​powered incentives to accept offers are available).
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8.2.4 Pre-​bid defensive measures
It has often been pointed out that a major limitation of the no​frustration rule is that
the requirement for shareholder approval of defensive tactics applies only once a bid
is in contemplation.108 This formulation of the no​frustration rule generates powerful incentives for managements at risk of a bid to act effectively against potential
offers before they materialize. Moreover, developments elsewhere in company and
securities law may enhance these possibilities. For example, mandatory and rapid
disclosure of the beneficial ownership of voting shares helps incumbent management
by increasing the time available to them to prepare defensive steps. Most jurisdictions now have rules requiring the beneficial holders of shares in listed companies,
whether acting alone or in concert, to disclose that fact to the company and the
market when certain minimum levels are exceeded,109 and increasingly economic
interests in shares are brought within the disclosure obligation.110 The beneficial
owner may be required to disclose not just the fact of the ownership, but also its
intentions in relation to control of the company.111 Some jurisdictions go further
and give companies’ charters the power to trigger disclosure at lower levels than the
lowest statutory threshold.112
Following the EU’s High Level Group, we can identify six categories of pre-​bid
defensive measures:113 (a) barriers to the acquisition of shares in the company (for
example, ownership caps or poison pills114); (b) obstacles to gaining control in the
general meeting (voting caps; multiple voting shares); (c) limits on the ability to control the board of directors (codetermination, staggered boards, special appointment
rights for some shareholders); (d) arrangements preventing control of the company’s assets (lock-​ups); (e) the creation of financial or management problems for the
acquirer as a result of the acquisition (poison debt); and (f ) actions raising regulatory
issues (such as engaging in defensive acquisitions creating antitrust problems if the
108 See Paul Davies, The Regulation of Defensive Tactics in the United Kingdom and the United States,
in European Takeovers: Law and Practice 195 (Klaus J. Hopt and Eddy Wymeersch eds., 1992).
If a defense put in place pre-​bid requires action on the part of the board post-​bid to be effective, it will
be caught by the no​frustration rule (e.g. post-​bid, shareholder approval is needed to issue shares which
the board had previously been authorized to issue).
109 Most national laws require regular disclosure at the 5 percent or 3 percent mark. See e.g.
Transparency Directive 2004/​109, Art. 9(1): initial disclosure at 5 percent, but member states can
introduce a lower threshold. See Chapter 6.2.1.1.
110 See new Art. 13(1)(b) of Transparency Directive 2004/​109/​EC, as revised in 2013. For the
U.S., see CSX Corp v. The Children’s Investment Fund (UK) LLP 562 Federal Supplement 2d 511
(2008), bringing equity swaps within Securities Exchange Act 1934 § 13(d). On the policy discussion
around such requirements, see Maiju Kettunen and Wolf-​Georg Ringe, Disclosure Regulation of Cash-​
Settled Equity Derivatives—​An Intentions-​Based Approach, Lloyd’s Maritime & Commercial Law
Quarterly 227 (2012). On creeping acquisitions, see Section 8.3.4.
111 § 13(d) Securities Exchange Act 1934 (U.S.); Art. L.233-​7, VII Code de commerce (France),
where this additional information is required at the 10 percent, 15 percent, 20 percent, and 25
percent levels; Wertpapierhandelsgesetz (WpHG) § 27a, only at the 10 percent level (Germany);
Art. 27-​23 et seq. of the Financial Instruments and Exchange Act 2006 (Japan).
112 See Art. L. 233-​7, III Code de commerce (France) and Part 22 of the Companies Act 2006
(UK). The European Commission proposed in 2014 to give all EU companies on top-​tier markets the
right to obtain disclosure of beneficial ownership at the 0.5 percent level in its suggested amendments
to the (in this context, inaptly named) Shareholder Rights Directive.
113 Report of the High Level Group of Company Law Experts Issues Related to Takeover Bids, Brussels,
January 2002, Annex 4. Some of these defensive steps could be taken, of course, post-​bid as well.
114 A poison pill may be adopted pre-​or post-​bid, normally the former. However, there is still a
post-​bid issue, namely, whether the directors redeem the pill (i.e. remove the shareholder rights plan),
their unilateral power to do this being a central part of the scheme.
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Agency Problems in Control Transactions
223
hostile bid is successful).115 Another effective pre-​bid defense could be change-​of-​
control clauses in executive contracts, such as the ones recently upheld by the French
Supreme Court.116
It would be too great an interference with the operation of centralized management
to apply the no frustration rule when no bid is on the table, at least on the basis of an
“effects” test.117 Any commercial decision which might have the effect of deterring a
future bidder for the company would then have to be approved by the shareholders.
Nevertheless, one might think that the no​frustration rule would be ineffective unless
accompanied by some type of pre-​bid controls. A number of legal strategies are available. The most general of these are the standards applied by company law to all board
decision-​making (duties of care and loyalty). These standards are necessarily less constraining than the no frustration rule, for the reasons just given. Typically, some form
of a “primary purpose” rule is used to distinguish legitimate from illegitimate decisions
taken pre-​bid which have defensive qualities as well as commercial rationales.118 Such
rules necessarily give management considerable freedom to take action for which there
is a plausible commercial rationale, even if that action has defensive qualities of which
the directors are aware and welcome, for example, an acquisition of assets which will
create competition problems for a future bidder or which will put a block of shares
into friendly hands.119
Rules dealing with specific decisions may be more constraining, but are necessarily
also of less general import. Rules on significant transactions may require shareholder
approval of certain types of pre-​bid corporate action with defensive qualities.120 We saw
above that rules on shareholder consent to capital issues have placed obstacles in the
way of the straightforward adoption of “poison pills” in Europe.121 Here, pre-​bid, the
joint decision-​making process is the more pro-​shareholder choice, since the available
alternative is not unilateral decision-​making by shareholders but unilateral decision-​
making by the board. However, these veto rights for shareholders are generally driven
by more general corporate law concerns than the control of pre-​bid defensive measures
and, hence, have a somewhat adventitious impact on control shifts.
Overall, management is necessarily given greater freedom to entrench itself pre-​bid
than post, and the legal strategies used to control managerial opportunism pre-​bid are
simply the general strategies used to protect the shareholders as principals and against
the management as agents which are discussed elsewhere in this book.122 Nevertheless,
115 See also European Commission, Report on the Application of Directive 2004/​25/​EC on Takeover
Bids, 28 June 2012, COM(2012) 347, para. 14.
116 Cour de cassation, decision of 26 January 2011 (no 09-​71271), Havas.
117 Of course, the precise point at which the line between pre-​and post-​periods is drawn can be
the subject of some debate. The Takeover Code draws it once the board “has reason to believe that
a bona fide offer might be imminent” (Rule 21.1: see Section 8.2.2), whilst the Takeover Directive’s
(default) no frustration rule applies only when the board is informed by the bidder of its decision to
make an offer (Arts. 9(2) and 6(1)).
118 On the UK “proper purpose” rule, see recently Eclairs Group Ltd v JKX Oil & Gas Plc [2015]
UKSC 71.
119 Even post-​bid the courts may have difficulty applying the primary purpose rule so as to restrain
effectively self-​interested defensive action. See the discussion of the Miyairi Valve litigation in Japan by
Kozuka, note 86, at 10–​11. See also Harlowe’s Nominees Pty Ltd v Woodside (Lake Entrance) Oil Co. 42
Australian Law Journal Reports 123 (High Court of Australia) (1968).
120 See Chapter 7 for a discussion of the extent to which significant decisions require shareholder
approval.
121 See Section 8.2.3.
122 See Chapters 3 and 7. The “break​through rule” is an exception to this statement. See Section
8.4.2.2.
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Control Transactions
in the hands of sophisticated shareholders who are able to coordinate their actions,
pre-​bid approval requirements can be effective.123
8.3 Coordination Problems among Target Shareholders
When an offer is put to the shareholders of the target company, they face, potentially,
significant coordination problems. This is because the decision to accept or reject the
bid is normally made by the shareholders individually, rather than by way of a collective decision which binds everyone, and so there is considerable scope for a bidder to
seek to divide the shareholder body. This problem arises in both controlled and widely
held firms: naturally, collective action problems will be larger in a dispersed ownership
scenario; but minority shareholders of a controlled target company will be subject to
similar coordination obstacles, in particular in agreed (friendly) bids.
In both ownership environments, the coordination issues of (minority) shareholders may be mitigated to some degree through the target board’s negotiations with the
potential acquirer.124 Under the joint decision-​making model, the board is in a strong
position to negotiate in this way (though it may prefer to negotiate in its own interests),125 whilst even under the nofrustration rule, the board retains non-​trivial powers
to protect the shareholders’ interests, as we have seen.126 However, if there is effective
specific regulation of the shareholders’ coordination problems, there is less need for
incumbent directors to perform this role, and the risks of board entrenchment are
reduced.
We now turn to examine the legal techniques which can be deployed to reduce
target shareholders’ coordination costs. To some extent, these strategies also address
the agency costs, as described above.127 We need to note that all these techniques have
costs, in particular by reducing potential bidders’ incentives to make offers. The main
strategies deployed are a mix of ex ante rules (mandatory disclosures) and the trusteeship strategy; and, ex post, a combination of the reward strategy (sharing requirement)
and an exit right.
8.3.1 Disclosure
Provision of up-​to-​date, accurate, and relevant information can help target shareholders with both their coordination and agency problems. In particular, disclosure of
information by target management reduces the force of one of the arguments in favor
of the joint decision-​making model, that is, that managers have information about
the target’s value which the market lacks.128 Even without regulation, information
will be disclosed voluntarily in the bid process, but regulation may force disclosure of
123 For the argument that this explains the absence of widespread non-​voting and weighted-​voting shares in the UK, despite its strong no​frustration rule, see Paul Davies, Shareholders in the United
Kingdom, in Research Handbook on Shareholder Power 355 (Randall Thomas and Jennifer Hill
eds., 2015).
124 Note that in a controlled target company, the blockholder may have direct negotiations with
the bidder; alternatively, the board may be controlled by the blockholder so that the real bargaining
partner would also be the blockholder.
125 See Section 8.2.3.1.
126 See Section 8.2.2.1.
127 See Section 8.2.
128 Ronald J. Gilson and Reinier Kraakman, The Mechanisms of Market Efficiency Twenty Years
Later: The Hindsight Bias, in After Enron 57 (John Armour and Joseph A. McCahery eds., 2006), noting, however, that target management may find it difficult to make the disclosed information credible.
225
Coordination Problems among Target Shareholders
225
information which bidder or target would rather hide and discourage unsubstantiated
and unverifiable claims.
Company law, of course, contains information disclosure provisions which operate
independently of control transactions. However, annual financial statements are often
out of date and, despite the continuing reporting obligations applied to listed companies in most jurisdictions,129 it is likely that both the target board and the acquirer
will be better informed about their respective companies than the target shareholders. Thus, it is not surprising that all jurisdictions have an elaborate set of provisions
mandating disclosure by both the target board and the acquirer for the benefit of the
target shareholders. It is routine to find rules requiring the disclosure of information
on the nature of the offer, the financial position of the offeror and target companies,
and the impact of a successful offer on the wealth of the senior management of both
bidder and target.
It is common to accompany the disclosure requirements with an obligation to obtain
and make available an independent opinion on merits of the offer. The independent
opinion is facilitated by the disclosure requirements, as are assessments by third parties,
such as securities analysts. Independent advice is particularly important in a management buy-​out. Here incumbent management appears in a dual role: as fiduciaries for
the shareholders and as buyers of their shares. Equally, where a competing bid emerges,
whether in an MBO context or not, rules requiring equal treatment of the bidders in
terms of information provided to them by the target make it less easy for target management to further the cause of their preferred bidder.130
In addition, takeover regulation requires offers to be open for a certain minimum
time (practice seems to coalesce around the 20-​day mark) and revised offers to be
kept open for somewhat shorter periods,131 in order that target shareholders and analysts can absorb the information. The main counterargument against very generous
absorption periods is the need to minimize the period during which the target’s future
is uncertain and, in particular, during which the normal functioning of the centralized management of the target is disrupted.132 In addition, mandatory minimum offer
periods increase the opportunities for defensive measures by the target board or the
emergence of a white knight, imposing a cost on acquirers and, possibly, upon shareholders of potential targets through the chilling effect upon potential bidders.133 In
129 See Chapter 9.1.2.5.
130 In jurisdictions without takeover-​specific regulation on the matter, it may be possible to
leave the issue to general corporate law, notably the rules on self-​dealing transactions. See Werner F.
Ebke, The Regulation of Management Buyouts in American Law: A European Perspective, in European
Takeovers: Law and Practice, note 108, 304–​6—​though it should be noted that the transaction
here is technically one between the director (or associated person) and the shareholders, not the company. In the case of MBOs of close companies common law jurisdictions may deal with the grosser
information disparities by imposing a duty on the directors to disclose information to the shareholders as an element of their fiduciary duties (see e.g. Coleman v. Myers [1977] 2 New Zealand Law
Reports 225, NZCA). See also note 55.
131 The Williams Act (note 33) in the U.S. was motivated in particular by the desire to control
“Saturday night specials” i.e. offers to which the shareholders had an unreasonably short time to
respond, the term being apparently used originally to refer to inexpensive hand-​guns popular for use
on Saturday nights.
132 Designed to reduce the period the company is “in play,” recent changes to the UK Takeover
Code limit the freedom of acquirers to let it be known that they might make a bid but without manifesting a firm intention to do so: Rule 2.6, inserted 2011 (the “put up or shut up” rule). This provision seeks to remove uncertainty around market rumors or potential bid announcements and thus to
improve the situation of target shareholders as against “virtual bids.”
133 See Section 8.2.2.2 for a discussion of competing bids and the passivity rule.
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Control Transactions
efficient securities markets, moreover, new information is rapidly impounded into the
share price, and so it is likely that the main practical effect of the minimum periods is
to allow new information to be generated and to facilitate competing bids rather than
to promote understanding of the information disclosed.
8.3.2 Trusteeship strategy
Target shareholders face the risk that the incumbent management will exaggerate the
unattractive features of a hostile bid and do the opposite with a friendly one. As we
have seen immediately above, an ex ante common response is to require the incumbent
management to obtain “competent independent advice” on the merits of the offer
(usually from an investment bank) and to make it known to the shareholders. This is
partly a disclosure of information strategy and partly a trusteeship strategy: the investment bank does not take the decision but it provides an assessment of the offer, the
accuracy of which has reputational consequences for the bank. Particularly sensitive
items of information, such as profit forecasts, may be subject to third-​party assessment.
Where there is an MBO, the directors involved in the bidding team may be excluded
from those responsible for giving the target’s view of the offer, thus allocating that
responsibility to the non-​conflicted directors of the target.134 Ex post liability rules may
add something to the ex ante incentives to be accurate.
8.3.3 Reward (sharing) strategy
A notable feature of laws aimed at solving target shareholders’ coordination problems is
their adoption of the equal treatment rule—​though this principle can be implemented
with varying degrees of rigor. The principle stands in the way of acquirers that wish to
put pressure on target shareholders to accept the offer, by promising some (normally
those who accept early) better terms than others.135 In general, systems which place
decision-​making on the bid in the hands of the shareholders alone have developed
the equality principle more fully than those which have adopted the model of joint
decision-​making.
All systems recognize the equal treatment principle to some degree. It can be applied,
first, within the offer (i.e. that the offer addressees receive the same terms136); second,
as between those who accept the offer and those who sell their shares to the offeror outside the offer, whether before or after a formal offer is launched; and, third, as between
those who sell their shares to an acquirer as part of a control-​building acquisition and
those who are left as shareholders in the company. In this third case, implementation
of the equality principle goes beyond a sharing strategy and involves providing an exit
right for the target shareholders.
The first level of equality is recognized in all our jurisdictions. Thus, “front-​end
loaded” offers are ruled out; and prior acceptors receive the higher price if the offer is
later increased. However, instead of formulating differential general offers, the acquirer
may seek to offer some target shareholders (in particular, a blockholder) preferential
terms by obtaining their shares outside the offer. One solution is to prohibit purchases
outside the offer, though this rule can be sensibly applied only to purchases during
134 UK Takeover Code, Rule 25.2 (notes 4 and 5).
135 Paul Davies, The Notion of Equality in European Takeover Regulation, in Takeovers in English
and German Law 9 (Jennifer Payne ed., 2002).
136 Or equivalent terms, where the offer covers more than one class of share.
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Coordination Problems among Target Shareholders
227
or close to the offer period.137 An alternative strategy is to require the offer consideration to be raised to the level of the out-​of-​bid purchases.138 Where such purchases are
permitted during the offer period, the imposition of a sharing rule seems universal.
Some jurisdictions go further and impose a sharing rule triggered by recent pre-​bid
purchases.139 A pre-​bid sharing rule gains considerable importance where the target
company is controlled by a blockholder, since the consequence is that the takeover premium paid to the blockholder effectively has be shared with all other minority shareholders, if the acquirer launches a general offer soon after the acquisition of the block.
Many jurisdictions in fact mandate such an offer, as we shall see in the next section.
8.3.4 Exit rights: Mandatory bid rule and keeping the offer open
The strongest, and most controversial, expression of the sharing principle is the requirement that the acquirer of shares make a general offer to the other shareholders once it
has acquired sufficient shares (whether on or off market) to obtain control of the target.
Control is usually defined as holding 30 percent (or one-​third) of the voting shares in
the company.140 This is the mandatory bid rule.141 It is a particularly demanding rule
if, as is common, it requires that the offer be at the highest price paid for the controlling shares142 and that shareholders be given the option of taking cash.143 Here the law,
in imposing a duty on the acquirer to make a general offer, provides the shareholders
with a right to exit the company and at an attractive price. The mandatory bid rule
does not simply structure an offer the acquirer wishes in principle to make, but requires
a bid in a situation where the acquirer might prefer not to make one at all.
Such a requirement might be defended on two grounds. First, the absence of a
mandatory bid rule would permit the acquirer to put pressure on those to whom offers
are made during the control acquisition process to accept those offers, for fear that
any later offer will be at a lower level or not materialize at all. Where the offer is value-​
decreasing or its impact on the target is just unclear, use of the mandatory bid rule to
137 See e.g. in France Art. 231-​41 Règlement Général de l’AMF, which prohibits market purchases
of the target shares during the offer period in share exchange offers because of the risk of market
manipulation, with an exception for share repurchase programs (Viandier, note 71, at 367). In cash
bids, the bidder is not allowed to acquire securities of the target during the “pre-​offer” period, i.e. the
period between publication of the terms of the offer and the formal offer, if the terms had to be published earlier due to rumors in the market (Art. 231-​38, II Règlement Général de l’AMF).
138 Again, French law provides an example: where the bidder acquires securities of the target during
the offer period at a higher price, the offer price will be revised accordingly (Art. 231-​39 Règlement
Général de l’AMF).
139 Rules 6 and 11 UK Takeover Code (but requiring cash only where the pre-​bid purchases for
cash reach 10 percent of the class in question over the previous 12 months); WpÜG § 31 and WpÜG-​
Angebotsverordnung § 4 (Germany) (requiring cash at the 5 percent level but only where that percentage was acquired for cash in the six months prior to the bid). The Takeover Directive does not
require sharing in this situation.
140 That is most common within the EU. See Commission’s Report on the Implementation of the
Directive on Takeover Bids (SEC(2007) 268, February 2007), annex 2. For alternative approaches
worldwide, see Umakanth Varottil, Comparative Takeover Regulation and the Concept of ‘Control’,
Singapore Journal of Legal Studies 208 (2015).
141 The additional issues arising when a mandatory bid rule is imposed upon an acquirer who
obtains the control block from an existing controlling shareholder are discussed Section 8.4 and 8.4.2.
142 The Takeover Directive, Art. 5(4), imposes a highest price rule, subject to the power of the
supervisory body to allow dispensations from this requirement in defined cases. But see the system in
Brazil, Section 8.4.2.1.
143 The Takeover Directive permits the mandatory bid to consist of “liquid securities” but some
member states (e.g. UK Takeover Code rule 9.5) require the offer to be in cash or accompanied by a
cash alternative.
228
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Control Transactions
remove pressure to tender thus addresses a significant coordination issue of the shareholders as against the acquirer. Where the bid is value-​increasing for target company
shareholders, it can be argued that providing the non-​accepting shareholders with an
exit right is not necessary. However, it may be difficult for the rule-​maker to identify ex
ante which category the offer falls into, so that the choice is between applying or not
applying the mandatory bid rule across the board.
Moreover, though the offer may be value-​increasing for the target company’s shareholders as a whole, the non-​controlling shareholders may not obtain in the future their
pro ​rata share of that value, for example because of the extraction of private benefits of
control by the acquirer. That leads to the second rationale for the mandatory bid rule.
Permitting the acquisition of control over the whole of the company’s assets by purchasing
only a proportion of the company’s shares encourages transfers of control to those likely
to exploit the private benefits of corporate control. On this view, the mandatory bid rule
constitutes a preemptive strike against majority oppression of minority shareholders by
providing minority shareholders with an exit right at the point of acquisition of control.144
It assumes that general corporate law is not fully adequate to police the behavior of controllers.145 On this rationale, the mandatory bid rule should be accompanied by a prohibition on partial general offers, even where, through a pro rata acceptance rule, all target
shareholders are treated equally. By extension, one would expect to find a rule requiring
comparable offers to be made for all classes of equity shares in the target, whether those
classes carry voting rights or not.146
Mandatory bid rules are now quite widespread. The Takeover Directive requires EU member states to impose a mandatory bid rule (whilst leaving a number of crucial features of the
rule, including the triggering percentage, to be determined at national level).147 However,
the mandatory bid rule is not part of U.S. federal law nor the law of Delaware, where shareholders’ coordination problems are dealt with by empowering target management.148
While popular among lawmakers and investors, the mandatory bid rule runs the
risk of reducing the number of control transactions which occur. First, the implicit
prohibition on partial bids makes control transactions more expensive for potential
bidders: either the bidder offers for the whole of the voting share capital and, often, at
a high price149 or it does not offer for control at all.150 Secondly, the mandatory bid
144 The balance between this effect and its discouragement of efficient transfers of control is disputed. See Lucian Bebchuk, Efficient and Inefficient Sales of Corporate Control, 109 Quarterly Journal
of Economics 854 (1994); Marcel Kahan, Sales of Corporate Control, 9 Journal of Law, Economics
and Organization 368 (1993). More recently Edmund-​Philipp Schuster, The Mandatory Bid Rule:
Efficient, After All?, 76 Modern Law Review 529 (2013).
145 It constitutes, in the concept developed by German law, an example of Konzerneingangskontrolle
(regulation of group entry). See Alessio M. Pacces, note 102, at ch. 7.4.5, arguing for reliance on
fiduciary duties to control future diversionary private benefits of control rather than a mandatory bid
rule. But cf. Caroline Bolle, A Comparative Overview of the Mandatory Bid Rule in Belgium,
France, Germany and the United Kingdom 279–​80 (2008), suggesting that the mandatory bid
is more effective.
146 The UK Takeover Code contains both such rules: see rules 14 (offers where more than one class
of equity share) and 36 (partial offers).
147 Art. 5 Takeover Directive. See note 140 and accompanying text.
148 In any event partial bids are in fact rare in the U.S., due to the pervasiveness of poison pills.
149 See note 142. The UK and France also require that a takeover bid be conditional upon reaching
at least 50 percent of the shares, which also discourages low-​ball offers. See Luca Enriques and Matteo
Gatti, Creeping Acquisitions in Europe: Enabling Companies to be Better Safe than Sorry, 15 Journal of
Corporate Law Studies 55, 78 (2015).
150 See e.g. Clas Bergström, Peter Högfeldt, and Johan Molin, The Optimality of the Mandatory
Bid, 13 Journal of Law, Economics & Organization 433 (1997); Stefano Rossi and Paolo Volpin,
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Coordination Problems among Target Shareholders
229
rule may also require the bidder to offer a cash alternative when otherwise it would
have been free to make a wholly paper offer. Thirdly, the rules fixing the price at which
the acquirer must offer for the outstanding shares may expose the acquirer to adverse
movements in the market between the acquisition of de facto control and the making of
a full offer. The chilling effect of the rule is particularly intense where there is a controlling shareholder, but it occurs also where the acquirer builds up a controlling stake by
acquisitions from non-​controlling shareholders.151
Some, but by no means all, takeover regimes have responded to these concerns.
A somewhat common technique is not to extend the rationale underlying the mandatory bid rule to a complete prohibition of partial general offers.152
Switzerland goes further and permits shareholders of potential target companies to
choose between the protection of the mandatory bid rule in its full form or modifying
it to encourage changes of control. The Swiss regulation permits the shareholders to
raise the triggering percentage from one-​third (the default setting) to up to 49 percent
or to disapply the rule entirely.153
Mandatory bid rules tend to be complex, partly because of the need to close obvious loopholes. Thus, the rule will usually apply to those “acting in concert” to acquire
shares,154 not just to single acquirers, but the notion of a “concert party” is not self-​
evident.155 It may also be possible to circumvent the rule by using derivatives that provide on their face only an economic interest in shares, or through a “creeping takeover,”
i.e. small acquisitions of shares spread out over a period of time, frequently exploiting
loopholes in public disclosure or takeover laws.156
Additional complexity is generated where it is thought necessary to subordinate
the policy behind the mandatory bid rule to more highly valued objectives, for example, where the threshold is exceeded in the course of rescuing a failing company. The
Cross-​Country Determinants of Mergers and Acquisitions, 74 Journal of Financial Economics 277
(2004), showing that takeover premia are higher in countries with strong shareholder protection,
especially those with mandatory bid rules.
151 On the other hand, the mandatory bid rule discourages acquisitions driven by the prospect
of private benefits of control, in the form of diversion of corporate assets and opportunities to the
controller, because it creates a risk to the acquirer that it will end up with all or nearly all of the shares
and no one to expropriate.
152 Italy permits partial bids for at least 60 percent of the shares, provided that a majority of
shareholders other than the offeror and connected persons approves the offer and the offeror has not
acquired more than 1 percent of the shares over the preceding 12 months. (Legislative Decree No. 58
of 24 February 1998 (as amended) Art. 107). Japan, by contrast, permits general offers to acquire up
to two-​thirds of the shares via a tender offer to all shareholders or market purchases (Arts. 27-​2(1),
27-​2(5) and 27-​13(4) of the Financial Instruments and Exchange Act; Arts. 8(5)(iii) and 14-​2-​2 of
the Order for Enforcement of the Financial Instruments and Exchange Act). See Tomotaka Fujita,
The Takeover Regulation in Japan: Peculiar Developments in the Mandatory Offer Rule, 3 UT Soft Law
Review 24 (2011).
153 Börsengesetz (Switzerland), Arts. 22(2) and 32(1). These provisions must be contained in the
company’s charter. Total disapplication can be decided upon only before listing.
154 Takeover Directive, Art. 5. There is a considerable danger that the acting in concert extension
will chill shareholder activism, a development which policy​makers may or may not welcome. Contrast
the Risk Limitation Act 2008 in Germany (discussed by Hopt, note 49, at III.B) with the Takeover
Code, note 2 to Rule 9.1.
155 Leading to proposals for greater harmonization with the EU: see European Securities Markets
Expert Group, Preliminary Views on the Definition of Acting in Concert between the Transparency
Directive and the Takeover Bids Directive, November 2008. See more specifically Chapter 3.2.4.
156 Enriques and Gatti, note 149. The UK Takeover Code is unusual in applying the mandatory
bid rule to any acquisition of voting shares by a shareholder holding between 30 and 50 percent of the
voting shares. After the Loi Florange (note 71), French law comes close to this: Art. L. 433-​3, I Code
Monétaire et Financier.
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Takeover Directive allows national authorities to identify specific situations in which
the rule may be set aside. Member States have made ample use of this flexibility. The
European Commission perceives these various derogations as a risk to the European
level playing field,157 but they may have the advantage of allowing for value-​enhancing
control shifts where they otherwise would not be made.
In addition to the mandatory bid rule, a minor form of the exit right can be found
in the obligation imposed in some jurisdictions on an offeror to keep the offer open for
acceptance, even after the acquirer has obtained the level of acceptances it sought.158
This enables a shareholder, whose first preference is to reject the offer but who thinks
the share price will suffer if the acquirer obtains control, to maintain the position of
non-​acceptance until it is clear that the acquirer has obtained control and to exit at that
point under the offer terms.159 This problem may be acute in a controlled company,
where minority shareholders may not know whether the blockholder will accept the
offer. This option is more effective than the often provided right to “sell out” to an
acquirer who obtains a high proportion of the shares,160 because it operates at whatever
level the acquirer declares the offer “unconditional as to acceptances.”
8.3.5 Acquisition of non-​accepting minorities
The absence of a binding corporate decision in a control transaction may confer hold-​
up powers on the shareholders who do not accept the offer, despite the fact that the
majority of the shareholder base has chosen to do so, in an attempt to extract better
terms from the offeror. Failure to accept may also result from simple apathy or from
an assessment that the new controller will run the company well so that staying in the
company is the attractive option. Most jurisdictions provide, in one way or another,
for the squeeze-​out of minorities on the terms accepted by the majority, usually, however, only where a very high proportion of the shareholders have accepted the offer.
The right to squeeze-​out minorities facilitates the initial fixing of the level of the offer
at less than acquirer’s expected gains from the acquisition by taking off the table the
options of remaining in the company or exiting at a price higher than the offer price.
It thus encourages bids.161
In most jurisdictions, minority hold-​ups or incentives not to tender are directly
addressed by takeover-​specific rules162 which give the acquirer compulsory purchase
157 See Commission Report, note 115, para. 17; European Company Law Experts, The Application
of the Takeover Bids Directive—​Response to the European Commission’s Report (November 2013),
section 3.
158 See e.g. UK Takeover Code, rule 31.4 (but qualified by Rule 33.2); WpÜG, § 16(2) (Germany),
both adopting a two-​week period. In Italy, a similar rule applies, but limited to tender offers launched
by someone already holding a stake higher than 30 percent, or by management. Art. 40-​II, Consob
Regulation on Issuers.
159 Lucian A. Bebchuk, Pressure to Tender: An Analysis and a Proposed Remedy, 12 Delaware
Journal of Corporate Law 911 (1987). See however Guhan Subramanian, A New Takeover Defense
Mechanism: Using an Equal Treatment Agreement as an Alternative to the Poison Pill, 23 Delaware
Journal of Corporate Law 375, 387 (1998).
160 Art. 16 Takeover Directive. See Section 8.3.5.
161 Mike Burkart and Fausto Panunzi, Mandatory Bids, Squeeze-​Outs and Similar Transactions, in
Reforming Company and Takeover Law in Europe, note 99, at 753–​6.
162 Some jurisdictions have both types of rule. In Germany the introduction of the squeeze-​out
power specific to control shifts was important precisely because of its presumption that the bid price
is fair (WpÜG § 39a(3)), in contrast to endless opportunities to challenge the price under the general
merger procedure (AktG § 327b). Under both specific and general squeeze-​out mechanisms the courts
are likely to be worried if the threshold is (to be) reached as a result of a bid by an already controlling
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Specific Issues upon Acquisition from a Controlling Shareholder
231
powers over the non-​accepting minority.163 The Delaware version is the “two-​step
merger,” that is, a tender offer for the shares followed by a short-​form merger of the
new subsidiary with the acquirer (i.e. without a shareholder vote), taking advantage
of the fact that Delaware law has a general provision allowing squeeze-​out mergers at
the 90 percent level.164 The importance of the short-​form squeeze-​out to acquirers is
reflected in its extension in 2013 to acquirers with less than 90 percent after the first
step but nevertheless enough votes to obtain shareholder approval for merger (normally a majority of the issued shares).165 Unlike the earlier procedure, the 2013 reform
is takeover-​specific, ie. the first-​step general offer is now a mandatory element of the
procedure.166
In many countries the right of the offeror at above the 90 percent level to acquire
minority shares compulsorily is “balanced” by the right of minorities to be bought out
at that level (“sell out”), a right which, again, may or may not be tied to a preceding
takeover offer.167 Functionally, the two are very different. A squeeze-​out right promotes offers whilst a right to be bought out reduces the pressure on target shareholders
to tender, though that objective is in fact better achieved by rules requiring the bid to
be kept open for a period after it has become unconditional.168
8.4 Specific Issues upon Acquisition
from a Controlling Shareholder
Where there is a controlling shareholder or shareholding group the allocation of the
decision on the offer as between the shareholders alone and shareholders and target
board jointly loses much of its significance, for, on either basis, the controlling shareholder is likely to determine whether the control shift occurs.169 However, the shareholder–​board agency issues are here replaced by minority–​majority agency problems.
shareholder. See Re Bugle Press [1961] Ch 279, CA (UK) and Re Pure Resources Inc., 808 Atlantic
Reporter 2d 421 (Del. Ch. 2002)—​both in effect requiring the acquirer to show the offer to be fair.
163 Art. 15 Takeover Directive requires Member States to provide such a mechanism, provided that
the offeror reaches at least 90 percent of the shares as an outcome of the bid.
164 DGCL § 253. And see Chapter 7.4.2.
165 Although the acquirer would win the shareholder vote, a vote is expensive for the newly
acquired target because of the need to comply with proxy solicitation rules.
166 DGCL §251(h). Other conditions reinforce this orientation. The first step must be a tender
offer for all the shares with voting rights in a merger, the merger must follow as soon as possible after
the conclusion of the tender offer, the offer consideration must be that contained in the merger proposal, the procedure is open only to third-​party acquirers (i.e. not existing controllers) and the target
management must consent (i.e. “friendly” takeovers only).
167 Both types of rule are discussed in greater detail in Forum Europaeum Corporate Group Law,
Corporate Group Law for Europe, 1 European Business Organization Law Review 165, 226 ff.
(2000). The Takeover Directive requires both a squeeze-​out and a sell-​out right.
168 See Section 8.3.4. An offeror may be satisfied with a controlling stake short of the 90 percent
level and thus not be subject to the sell-​out right, whereas the “keep it open” requirement applies at
whatever level the acquirer declares the bid to be unconditional.
169 This depends, of course, on the board being immediately responsive to the wishes of the majority. If it is not, even a majority holder may not be able to assert its will. For a striking example see
Hollinger Int’l v. Black, 844 Atlantic Reporter 2d 1022 (2004, Del. Ch.), where the Delaware
Court of Chancery upheld the power of the board of a subsidiary to adopt a poison pill in order to
block a transfer by the controller of the parent of his shareholding in the parent to a third party. This
case involved egregious facts. In particular, the controller of the parent was in breach of contractual
and fiduciary duties (as a director of the subsidiary) in engaging in the transfer, and the transferee was
aware of the facts giving rise to the breaches of duty. See also Chapter 4.1.3.1.
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Since minority–​majority conflicts are not unique to control transactions, it is possible to leave their resolution to the standard company law techniques analyzed in
previous chapters. However, laws dealing with control shifts have tended to generate
more demanding obligations for controlling shareholders which arise only in this context. There are two central issues. First, are the selling controlling shareholder and the
acquirer free to agree the terms of sale of the controlling block without offering the
non-​controlling shareholders either a part of the control premium or an opportunity
to exit the company? Second, may the controlling shareholder, by refusing to dispose
of its shares, prevent the control shift from occurring?
8.4.1 Exit rights and premium-​sharing
In dealing with sales of control blocks, the central question is whether the law imposes
a sharing rule. This question may be approached either from the side of the selling controlling shareholder (i.e., by imposing a duty on the seller to share the control premium
with the non-​selling minority: sharing of the consideration), or, from the side of the
acquirer (i.e., by imposing a duty upon the purchaser of the controlling block to offer
to buy the non-​controlling shares at the same price as that obtained by the controlling
shareholder: sharing of both the consideration and the exit opportunity).
Looking first at obligations attached to the selling controlling shareholder, some jurisdictions in the U.S. have used fiduciary standards to impose a sharing rule.170 However,
despite some academic argument to the contrary,171 U.S. courts have not adopted a
general equality principle which might have led them to generate an unqualified right for
non-​controlling shareholders to share in the control premium. The law is probably best
stated from the opposite starting point: “a controlling shareholder has the same right to
dispose of voting equity securities as any other shareholder, including … for a price that
is not made proportionally available to other shareholders,” but subject to a requirement
for fair dealing.172 Provided self-​dealing is effectively controlled, permitting sales at a
premium price would give both seller and acquirer an appropriate reward for their extra
monitoring costs.173 Despite this, purchases of control from blockholders disjunct from
the buy-​out of minorities are rare in the U.S., possibly because private benefits of control
are low and finance to acquire 100 percent of the shares is generally available.
As far as duties on the acquirer are concerned, many of the sharing rules discussed
in Section 8.3 will operate in favor of minority shareholders against a shareholder
purchasing a controlling block, for example, the rules determining the level of the consideration.174 Consequently, an acquirer that wishes to obtain an equity stake in the
target beyond that which the purchase of the controlling block will provide may find it
170 As in looting cases: see Gerdes v. Reynolds, 28 New York Supplement Reporter 2nd Series
622 (1941); or where the sale can be identified as involving the alienation of something belonging to
all shareholders: Perlman v. Feldman, 219 Federal Reporter 2d Series 173 (1955); Brown v. Halbert,
76 California Reporter 781 (1969).
171 William Andrews, The Stockholder’s Right to Equal Opportunity in the Sale of Shares, 78 Harvard
Law Review 505 (1965). For an incisive general discussion of this area see Robert Clark, Corporate
Law 478–​98 (1986).
172 American Law Institute, Principles of Corporate Governance § 5.16.
173 For the argument that in general the controlling shareholder should be free to transfer control,
whether directly or indirectly, for the reason given in the text, see Ronald J. Gilson and Jeffrey N.
Gordon, Controlling Controlling Shareholders, 152 University of Pennsylvania Law Review 785,
793–​6, 811–1​6 (2003).
174 Section 8.3.3. In most cases these rules can be avoided if the acquirer is prepared to wait long
enough before launching an offer for full control.
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Specific Issues upon Acquisition from a Controlling Shareholder
233
difficult to offer a sufficiently high price to the controlling shareholder to secure those
shares if the rules require the subsequent public offer to reflect the price paid outside
or prior to the bid. The greatest controversy, however, revolves around the question of
whether the mandatory bid rule should be applied to a transfer of a controlling position, so as to require the acquirer to make a public offer, where it would otherwise not
wish to do so, and on the same terms as those accepted by the controlling seller.
It can be argued that there is a vital difference between purchasing control from a
blockholder and acquiring it from the market in a widely held company, because in the
former case the minority is no worse off after the control shift than it was previously.
However, such a view ignores the risks which the control shift generates for the minority. The acquirer, even if it does not intend to loot the company, may embark upon a
different and less successful strategy; may be less respectful of the minority’s interests
and rights; or may just simply use the acquired control to implement a group strategy
at the expense of the new group member company and its minority shareholders.175 As
noted above in relation to acquisitions of control, it is very difficult to establish ex ante
whether the minority shareholders will be disadvantaged by the sale of the controlling
block, so that the regulatory choice is between reliance on general corporate law to
protect the minority against unfairness in the future and giving the minority an exit
right at the time of the control shift.
Nevertheless, the costs of the mandatory exit right are potentially much greater in a
situation of a control block sale than for acquisitions of control from dispersed shareholders. The acquirer no longer has the option of sticking with the control block it has
purchased at a price acceptable to the seller. Under the mandatory bid rule it must now
offer that price to the non-​controlling shareholders as well. It may well face the situation that it cannot pay the existing controller the price it wants to consent to the deal
(reflecting private benefits of control) without overpaying for the company as a whole.
If private benefits of control are high, the disincentive effect of a mandatory sharing of bid premiums will be significant.176 Fewer control shifts will occur, even where
the acquirer intends to increase the operational efficiencies of the target. In countries
where controlling shareholders are common, this may be seen as a strong objection to
the mandatory bid rule.177 The adverse impact of the mandatory bid rule is further
enhanced if it applies to indirect acquisitions of control.178 On the other hand, the
175 These are, of course, the arguments in favor of the mandatory bid rule, even where the seller is
not a controlling shareholder. See Section 8.3.4.
176 John C. Coffee, Regulating the Market for Corporate Control, 84 Columbia Law Review 1145,
1282–​9 (1984); Bebchuk, note 144.
177 See Luca Enriques, The Mandatory Bid Rule in the Proposed EC Takeover Directive: Harmonization
as Rent-​Seeking? in Reforming Company and Takeover Law in Europe, note 99, at 785. See further
Pacces, note 102, at 335–​7, arguing for the abandonment of the mandatory bid rule and for permitting the acquirer of the controlling block to make a post-​acquisition bid at the higher of the pre-​and
post-​acquisition market price of the target’s shares. A further consequence of our analysis is that a
harmonized mandatory bid rule across the EU will in fact produce very different impacts depending
on the level of private benefits of control.
178 Sometimes referred to as the “chain principle,” i.e., a person acquiring control of company
A, which itself holds a controlling block in company B; or a company using its own subsidiary A to
acquire control in company B. Must the acquirer make a general offer to the outside shareholders of
company B? Perhaps reflecting the British penchant for wholly owned subsidiaries, the Takeover Code
starts from the presumption that an offer is not required (Rule 9.1, Note 8); German law, as befits its
commitment to group law, starts from the opposite presumption but allows the supervisory authority
to dispense with the obligation if the assets of the subsidiary are less than 20 percent of the assets of
the parent (WpÜG §§ 35, 37 and WpÜG-​Angebotsverordnung § 9(2) no. 3). See also similarly, for
Italy, Art. 45 Consob Regulation on Issuers, as amended.
234
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Control Transactions
mandatory bid rule will discourage transfers to acquirers who intend simply to extract
higher benefits of control than the existing controller: the exit right at a premium
ensures that there will be no minority for the new controller to exploit.
8.4.2 Facilitating bids for controlled companies
The existence of controlling blocks of shareholders in public companies clearly constitutes a structural barrier to control shifts, if the controllers are unwilling to relinquish
their position. However, there is not much company law can do about such barriers: “[c]‌oncentrated patterns of ownership represent … simply the existing condition
of the economic environment.”179 Nevertheless, there are two avenues through which
lawmakers can facilitate bids in a controlled shareholder environment. First, they may
create exemptions from or impose a weaker version of the mandatory bid rule, so that
its adverse impact on control shifts is diluted. Secondly, they may neutralize “technical”
barriers to control shifts such as control-​reinforcing mechanisms.
8.4.2.1 Weakening the mandatory bid rule
We have seen that the mandatory bid rule has a chilling effect on control shifts, irrespective of whether the target has dispersed or concentrated ownership. Given that the
existence of a controlling shareholder in the target serves as a deterring factor itself,
lawmakers may be tempted to consider the two elements together as excessive and thus
attempt to weaken the impact of the mandatory bid rule. Seen in this light, the various
exceptions, exemptions, and limitations of the mandatory bid rule thus may be there
for a perfectly rational reason: a weak version of the mandatory bid rule may be more
functional for a system of concentrated ownership.
An example of weaker versions of the mandatory bid rule are the so-​called “partial”
sharing rules that are in force in China and India.180 Thus, in China, a mandatory
bid needs only be for a minimum of 5 percent of the outstanding shares, which naturally dilutes its effect.181 Similarly, the Indian version of the rule requires any acquirer
exceeding 25 percent of the voting rights in the target company to make a mandatory
tender offer for at least 26 percent of the shares of the target company.182 Another version is the Brazilian requirement that a mandatory bid be made to all common shareholders, but only at 80 percent of the price paid to the controlling shareholder183—​an
implicit recognition of the exceptionally high private benefits that controlling shareholders enjoy in that country.184 Moreover, the fact that the mandatory bid rule by law
only applies to voting shares significantly reduces its scope given the high incidence of
179 Ronald J. Gilson, The Political Ecology of Takeovers in European Takeovers: Law and Practice,
note 108, at 67, discussing the difference between “structural” and “technical” barriers to takeovers.
180 Armour, Jacobs, and Milhaupt, note 36, at 274 ff.
181 Measures for the Administration of the Takeover of Listed Companies (China Securities Regulatory
Commission, 27 August 2008, revised), art. 25, available at www.lawinfochina.com/​display.
aspx?lib=law&id=7043&CGid=. See Chao Xi, The Political Economy of Takeover Regulation: What
Does the Mandatory Bid Rule in China Tell us?, Journal of Business Law 142 (2015).
182 Securities Exchange Board of India (Substantial Acquisition of Shares and Takeovers)
Regulations 2011. See Umakanth Varottil, The Nature of the Market for Corporate Control in India,
Working Paper (2015), at ssrn.com.
183 Art. 254-​A Lei das Sociedades por Ações. However, the Novo Mercado, Brazil’s premium corporate governance listing segment, requires a mandatory bid rule at the same price paid to controlling
shareholders. Art. 8.1 Novo Mercado Regulations.
184 See Chapter 4.4.2.1.
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Specific Issues upon Acquisition from a Controlling Shareholder
235
non-​voting preferred shares in Brazil’s capital market.185 All three jurisdictions provide
examples of a cautious legal transplant: accepting the mandatory bid rule as worldwide
best practice, but adjusting it to the specific regulatory environment in place. All three
regimes thus avoid the costly effect of a full sharing rule.186
A different strategy would be an “optional” mandatory bid rule.187 As we saw above,
Swiss law serves as an example by permitting shareholders to modify or remove the rule
in their charters.188 Potential target shareholders can thus deliberately facilitate control
changes in their company.
Other jurisdictions achieve a similar outcome in a much less transparent way. Even
though EU member states all provide for a fully fledged mandatory bid rule as required
by the Directive, the laws’ lacunae and lax enforcement in some of them189 may also be
understood as functional to the purpose of mitigating the mandatory bid rule’s chilling
effects. For instance, German law—​intentionally or not—​allows for circumventions of
the mandatory bid rule where the bidder acquires economic rather than legal interests
in shares, or where a “creeping takeover” is combined with a voluntary bid at a deliberately low price.190
In light of these considerations, some commentators have even argued that takeover
regulation should rather be “unbiased” instead of prescriptive, and let decision-​makers
on the individual company level decide on their level of control contestability.191
Others caution against too far-​reaching flexibility, citing potential real-​life problems
in controlled companies and asking whether the market will adequately price in the
choices made by individual companies.192
8.4.2.2 Addressing technical elements: The breakthrough rule
Technical barriers to takeovers may be susceptible to regulation through corporate law.
The breakthrough rule (BTR), which EU member states may impose or at least make
available to companies on an opt-​in basis,193 constitutes an example of a legislative
attempt to address technical barriers to control shifts.
The BTR aims to prevent boards and controlling shareholders from structuring the
rights of shareholders pre-​bid in such a way as to deter bids. Subject to the payment of
compensation, it removes some restrictions on shareholders’ transfer and voting rights
once a bid is made, whether the restrictions are found in the company’s charter or in
contracts among shareholders (to which contracts the company may or may not be
party).194 Such restrictions are not permitted to operate during the offer period. More
importantly, they are ineffective, and multiple voting shares will be reduced to one
185 Art. 254-​A Lei das Sociedades por Ações. The regulations of the Level 2 listing segment of the
São Paulo Stock Exchange however impose a mandatory bid rule with respect to both voting and
non-​voting preferred shareholders at the same price paid to the controlling shareholder. Art. 8.1 Level
2 Regulations.
186 Armour, Jacobs, and Milhaupt, note 36, at 274 ff.
187 See Luca Enriques, Ronald J. Gilson, and Alessio M. Pacces, The Case for an Unbiased Takeover
Law (with an Application to the European Union), 4 Harvard Business Law Review 85 (2014).
188 See Section 8.3.4.
189 See Enriques and Gatti, note 149, at 76–​9.
190 Theodor Baums, Low Balling, Creeping in und deutsches Übernahmerecht, ZIP –​Zeitschrift
Für Wirtschaftsrecht 2374 (2010).
191 Enriques, Gilson, and Pacces, note 187.
192 See Hopt, note 13, at 156–​7; Johannes W. Fedderke and Marco Ventoruzzo, The Biases of an
“Unbiased” Optional Takeovers Regime: The Mandatory Bid Threshold as a Reverse Drawbridge, available
at ssrn.com.
193 Arts. 11 and 12 Takeover Directive.
194 Art. 11.
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Control Transactions
vote per share, at any shareholder meeting called to approve defensive measures under
the no frustration rule195 and at the first general meeting called by a bidder who has
obtained 75 percent of the voting shares. At this meeting any “extraordinary right” of
shareholders in relation to the appointment and removal of directors shall not apply
either.196 The overall aim of the BTR is to render contestable the control of companies
where control has been created through (some) forms of departure from the notion of
“one share one vote” or by shareholder agreements.
The break-​through of voting restrictions during the offer period might be thought
to be necessary to make the no frustration rule work effectively. The post-​acquisition
break-​through is potentially more significant and gives the successful bidder an opportunity to translate its higher-​than-​75-​percent stake into control of the company by
placing its nominees on the board and by amending the company’s constitution so that
its voting power reflects its economic interest in the company.
The optional BTR has been an unsuccessful experiment, since only a few, small member states have chosen to make it mandatory. Further, the BTR is nowhere the default
rule and no company in member states where it is optional appears to have opted into
it.197 A combination of two elements explains why so few member states opted for a
mandatory BTR. On the one hand, the BTR does not catch simple controlling positions where the one-​share, one-​vote rule is observed, so that the majority of controlling
positions within European companies were not affected by it; on the other, the BTR
does not catch some departures from the one-​share one-​vote principle, such as pyramids:198 these two circumstances together were enough to generate aggressive—​and
successful—​lobbying by those that a mandatory BTR would have caught. The reason
why no companies have opted into the BTR is even simpler: an opt-​in at company level
requires a supermajority vote of the shareholders in most cases, and controlling shareholders, still possessing their technical advantages, have weak incentives to vote in favor.
8.5 Explaining Differences in the Regulation
of Control Transaction
We have analyzed control shift regulation along three dimensions, focusing mainly on
two: the location of decision-​making on the offer and the protection of target shareholders (especially non-​controlling shareholders) against opportunism on the part of
the acquirer (or acquirer plus controlling shareholder). The minor dimension was the
responsiveness of the regulation to non-​shareholder constituencies.
Two immediate conclusions can be drawn from our analysis. The first and negative conclusion is that none of the systems puts the goal of maximizing the number
195 Section 8.2.2.
196 Thus rights of codetermination (see Section 8.1.2.3) are not affected because these are normally
not shareholder rights of appointment and will be contained in legislation rather than the company’s
articles.
197 See Commission’s Report on the Implementation of the Directive on Takeover Bids, note 140,
at 7–​8.
198 See John C. Coates IV, The Proposed ‘Break-​Through’ Rule-Ownership, Takeovers and EU Law:
How Contestable Should EU Corporations Be?, in Reforming Company and Takeover Law in
Europe, note 99, 677, 683–​4 (summarizing data suggesting that only a maximum of 4 percent of
public firms in the EU would be affected, and arguing that the controlling shareholders in some
of those might be able to avoid the impact of the BTR by increasing their holdings of cash-​flow
rights or moving to equivalent structures not caught by the BTR, such as pyramid structures and/​or
cross-​holdings).
237
Explaining Differences in the Regulation of Control Transaction
237
of control shifts at the center of their regulatory structures. The maximum number of
takeovers is likely to be generated by a system which enjoins upon target management
a rule of passivity in relation to actual or threatened takeovers (the first dimension)
and which gives the acquirer the maximum freedom to structure its bid (the second
dimension), whilst (non-​)shareholder interests are ignored. None of our jurisdictions
conforms to this pattern: the regulation of agency and coordination issues in takeovers
is a better, if more complex, explanation of the goals and effects of national regulatory
systems than the maximization of the number of bids.
Second, the overall characterization of a system requires that attention be paid to
both the major dimensions of regulation.199 A system which rigorously controls defensive tactics on the part of management may nevertheless still chill takeovers by, say,
strict insistence upon equality of treatment of the target shareholders by the acquirer
or the prohibition of partial bids. Indeed, it is probably no accident that those systems
which, historically, most clearly favor shareholder decision-​making in bid contexts (UK
and France—​the latter now only doubtfully in this category) also have the most developed rules against acquirer opportunism, addressing intra-​shareholder coordination
problems. Deprived of the protection of centralized management, the target shareholders need explicit regulatory intervention as against acquirers, but that intervention—​
notably the mandatory bid rule—​may also protect indirectly incumbent management.
A system configured in this way may both make it difficult for incumbent management
to entrench themselves against tender offers which do emerge and reduce the incidence
of such offers. Which effect is predominant in practice is an empirical question.200
8.5.1 Differences in form and differences in substance
The most sensitive question in relation to control transactions is whether they can be
implemented over the opposition of the incumbent board. So, the crucial dividing line
appears to lie between those systems which place the decision on the control transaction wholly in the hands of the target shareholders and those which give both target
shareholders and the board a veto right.
However, there are reasons for thinking that this division may be an over-​
simplification. First, a jurisdiction following the joint decision model may develop
adaptive mechanisms which, to a greater or lesser extent, reproduce the effects of an
allocation wholly to the shareholders of the target company. The U.S. demonstrates the
possibilities for a development of this kind.201 Thus, Armour and Skeel have observed
that, whilst the proportion of hostile bids in the U.S. is smaller than in the UK,202
which allocates the decision entirely to the shareholders, the overall level of control
shifts is not much different.203 In other words, a combination of legal strategies and
199 See also Sanford J. Grossman and Oliver Hart, An Analysis of the Principal-​Agent Problem, 51
Econometrica 7 (1983).
200 Martynova and Renneboog, note 12, table 2, show that in the 1990s European merger wave
58 percent of all hostile takeovers within Europe involved UK or Irish targets, as did 68 percent of
all tender offers (hostile or friendly), whilst the premium paid for UK targets exceeded that paid for
continental targets (at 235).
201 See Section 8.2.3.1.
202 Armour and Skeel, note 32, table 1; see also Coates, note 54, 253 (7 percent hostile bids in the
UK versus 3 percent in the U.S.).
203 Armour and Skeel, note 32, at 1741. Whether the two systems are functionally absolutely
equivalent is not clear (see ibid. at 1742–​3, arguing that the U.S. system has costs which the straightforward adoption of a no frustration rule avoids).
238
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Control Transactions
institutional facts may permit the shareholders to reap the benefits of joint decision-​
making over control shifts (shareholders overcome their coordination problems by
using management to negotiate with the bidder on their behalf ) without incurring
the costs of this arrangement (notably management entrenchment). Where those legal
strategies are not available or the institutional facts do not obtain, however, the initial
allocation of the decision right will indeed be crucial.
8.5.2 Different regulatory environments
Ownership structure, industry structure, and complementarities already in place matter for the design of functional legal rules. Strategic choices will certainly also play a
role.204
Thus, we might expect countries with concentrated ownership structures to be
less reliant on takeovers as a corporate governance device, since managerial monitoring is arguably performed by corporate blockholders. These countries—​actually the
overwhelming majority of all jurisdictions worldwide205—​might be less in “need” to
deploy pro-​bidders takeovers laws.206 This could be an explanation for the reluctance
of some continental European countries to support a mandatory board neutrality rule
in the Takeover Directive.207 Japan with its closely knit network of cross-​shareholdings
is also an example of a system where tools of external corporate governance other than
hostile takeovers have prevailed historically—​though cross-​shareholdings have weakened in recent years.208
Likewise, we could hypothesize that different designs of a takeover framework may
be more appropriate for different types of industry. A growing literature discusses the
“varieties of capitalism” and how they impact on legal rules.209 Thus, it could be argued
that industries with certain types of productive technology need to make long-​term
commitments to employees as a quid pro quo for the employees’ investment in firm-​
specific human capital or acceptance of flexible working. In such a scenario, takeovers
might be perceived as disruptive to such long-​term commitment and likely to produce
a “breach of trust” by the acquirer towards the existing employees.210
Finally, the design of appropriate rules seems to be naturally influenced by the pre-​
existing body of laws and tools. In other words, complementarities and path dependencies are important factors for the design of laws. For example, they may explain
a lot of the peculiar UK/​U.S. divide described above. The UK system of company
law has always been strongly shareholder-​centered—​the board’s powers derive from
the company’s charter, not the legislation, and the charter is, formally, wholly under
204 Guido Ferrarini and Geoffrey Miller, A Simple Theory of Takeover Regulation in the United States
and Europe, 42 Cornell International Law Journal 301 (2009). See also Hopt, note 12, at 259.
205 Marco Becht and Colin Mayer, Introduction, in The Control of Corporate Europe (Fabrizio
Barca and Marco Becht eds., 2001).
206 It could be argued that these countries should better focus on rules that address intra-​shareholder
agency costs directly, such as related party transactions. See Chapter 6.
207 See Section 8.2.2.
208 Joseph Lee, Critical Exposition of Japanese Takeover Law in an International Context, Working
Paper (2016), at ssrn.com.
209 See Varieties of Capitalism: The Institutional Foundations of Comparative Advantage
(Peter A. Hall and David Soskice, eds., 2001); Wendy Carlin and Colin Mayer, How Do Financial
Systems Affect Economic Performance?, in Corporate Governance: Theoretical and Empirical
Perspectives 137 (Xavier Vives ed., 2000).
210 Shleifer and Summers, note 22; Paul Davies, Efficiency Arguments for the Collective Representation
of Workers, in The Autonomy of Labour Law (Alan Bogg et al. eds., 2015).
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Explaining Differences in the Regulation of Control Transaction
239
the control of the shareholders;211 directors can be removed at any time by ordinary
shareholder vote. U.S. law has traditionally been more protective of the prerogatives of
centralized management, whilst preserving the ultimate control of the shareholders.212
Hence, allocating decision-​making on control shifts wholly to the shareholders fitted
well with established patterns of UK corporate governance, whilst in the U.S. board
influence over control shifts was established in a more convoluted and, perhaps, less
stable way, but one doctrinally consistent with its managerial orientation.213
In a similar vein, jurisdictions might choose to promote alternative elements of corporate governance as substitutes for an active takeover market.214 It should be noted,
however, that such alternative improvements will rarely be sufficient: the threat of a
hostile bid usually remains “the most effective corporate governance mechanism.”215
Another important complementarity to consider is the regulatory framework addressing shareholder engagement. Over recent years, various policy initiatives have sought
to promote active shareholder participation in corporate affairs. It has been pointed
out that some elements of takeover regulation—​most importantly, the mandatory bid
rule in conjunction with the concept of “acting in concert”—​may run against the
policy goal of promoting shareholder engagement.216
8.5.3 Political economy considerations
Divergences in takeover regulation may also be explained by different political choices
and perceptions in different jurisdictions. Chief amongst the driving factors here
is a potential backlash against a perceived sale of strategic firms into foreign hands.
Takeovers can make newspaper headlines—​and broad-​scale takeovers of companies by,
in particular, foreign acquirers have the potential of being used for protectionist counteractions. This is even more likely during times of economic crisis, as the recent global
financial crisis has demonstrated.217 For example, Italy—​briefly during the financial
crisis—​and more recently France opted out of the board neutrality rule contained
in the EU Takeover Directive.218 Even the traditionally takeover-​friendly UK saw a
fierce political debate after the 2009 takeover of iconic chocolate maker Cadbury by
American food giant Kraft.219
211 See Chapter 7.2.
212 See Chapter 3.5.
213 Armour and Skeel, note 32, at 1767–​8, point out that the traditional doctrinal pro-​shareholder
orientation of British corporate law was reinforced by the rise of institutional shareholding during
the precise period that modern takeover regulation was being developed in the UK, i.e. in the 1960s,
whereas this coincidence did not occur in the U.S. Equally, one might speculate that, if managerial
stock option plans were to become a less significant part of compensation in the U.S., then U.S. institutional investors might begin to agitate for shareholder-​friendly control-​shift regulation.
214 Paul Davies and Klaus J. Hopt, Corporate Boards in Europe—​Accountability and Convergence, 61
American Journal of Comparative Law 301 (2013).
215 Jonathan Macey, Corporate Governance: Promises Kept, Promises Broken 10, 118 ff.
(2008). On the market of corporate control and the pros and cons of the no​frustration rule see Hopt,
note 12, at 261–​8.
216 See ESMA, Information on Shareholder Cooperation and Acting in Concert under the Takeover
Bids Directive, ESMA/​2013/​1642 (12 November 2013); Martin Winner, Active Shareholders and
European Takeover Regulation, 12 European Company and Financial Law Review 364 (2014). See
also Chapter 3.2.4.
217 See a number of contributions in Company Law and Economic Protectionism (Ulf Bernitz
and Wolf-​Georg Ringe eds., 2010).
218 See Sections 8.2.2 and 8.2.3.2.
219 Some even called for the adoption of a specific “Cadbury’s Law” to better protect British firms
from foreign takeovers. See Wolf-​Georg Ringe, Deviations from Ownership-​Control Proportionality—​
Economic Protectionism Revisited, in Company Law and Economic Protectionism, note 217, at 235.
240
240
Control Transactions
In many emerging markets, takeovers are generally very rare, mostly because of
severe ownership concentration in the hands of families and the state, but also due to
regulatory hurdles in those (rare) countries where ownership is a little more dispersed,
such as India.220 But even in developed Western economies, politicians may fall prey
to the perceived need to “protect” the local economy from foreign bidders. A case in
point is France, where policymakers of all parties regularly act or intervene to create or
protect “national champions.” Law and politics may frequently blend into each other.
Consider the example of the 2014 acquisition of French industry champion Alstom by
U.S. conglomerate General Electric (GE). Despite the fact that the French government
was not a shareholder in Alstom, and despite there being no legal requirement to do
so, it was clear as a matter of fact that GE had to (and did) negotiate directly with the
Elysée Palace before it was eventually “allowed” to proceed with the bid. In the course
of this takeover, the French government additionally adopted a legislative decree, protecting local key industries by an official government veto on control shifts.221 In all
jurisdictions such policies are common for sensitive industries, for example to shield
the local defense industry from foreign influence.222
Apart from the perceived need to protect strategic industries, the reasons for public
uproar are frequently the impact that takeovers have on the workforce. It is true that
takeovers frequently lead to redundancies—​though restructurings are not unique to
takeovers. And it is no wonder that trade unions are amongst the most vociferous
groups protesting against takeovers. Public attitudes are severely tested where—​as for
example in the above-mentioned Cadbury/​Kraft transaction—​previous promises to
keep employment are broken after completion of the takeover.
Ultimately, then, this relates back to the many agency conflicts that control transactions generate, in particular for non-​shareholder groups.223 In those countries where
company law is used to address company–​employee agency issues as a matter of general practice via employee or union representation on the board (namely, Germany),
a control shift effected simply by means of a transaction between the acquirer and the
target shareholders, thus by-​passing the corporate organ which embodies the principle
of employee representation, is likely to be regarded with suspicion. Conversely, the
freedom of management to take defensive measures may be seen as a proxy for the
protection of the interests of employees and, possibly, other stakeholders.
8.5.4 Regulatory uncertainty
There is an important qualification to all the arguments made above. None of the
various factors that may shed light on particular regulatory choices can explain them
220 Armour, Jacobs, and Milhaupt, note 36, at 273 ff.; Érica Gorga, Changing the Paradigm of Stock
Ownership from Concentrated Towards Dispersed Ownership? Evidence from Brazil and Consequences
for Emerging Countries, 29 Northwestern Journal of International Law & Business 439, 445
(2009); Mariana Pargendler, Corporate Governance in Emerging Markets, in Oxford Handbook of
Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017).
221 Hugh Carnegy, Michael Stothard, and Elizabeth Rigby, French “Nuclear Weapon” against
Takeovers Sparks Blast from Cable, Financial Times, 16 May 2014, p. 1.
222 Germany revised its Foreign Trade Act (Außenwirtschaftsgesetz) in 2008, establishing a review
process for investments from outside the EEA if a company takes a stake in a German company of
more than 25 percent. See Hopt, note 49, at 384 ff. Similarly, the U.S. review process for foreign
investments—​undertaken by the Committee on Foreign Investments in the United States (CFIUS)—​
was amended in 2007/​8 to accommodate concerns that the process in its previous form had been
ineffective and too lenient.
223 See Section 8.1.2.3.
241
Explaining Differences in the Regulation of Control Transaction
241
in their entirety, and most importantly, lawmakers face severe uncertainty as to the
prevailing regulatory problem that they need to solve. For example, in relation to ownership structure, we know that the average size of the largest block varies from jurisdiction to jurisdiction,224 so that in jurisdictions with medium-​sized average blocks,
hostile takeovers may be difficult, but not ruled out entirely. Further, consider the
impact of changes over time: for example, there is evidence, in important jurisdictions,
of a weakening of the grip of blockholders over the years.225 Finally, even in jurisdictions dominated by large blockholders, shareholdings in particular companies atypically may be dispersed. Thus, there are very few jurisdictions in which hostile takeovers
are fully ruled out on shareholder structure grounds. More importantly, over the last
few decades the hostile bid has become a significant event in a number of jurisdictions
where previously it was virtually unknown.226
Lastly, the desire of rule-​makers to fit takeover rules into the existing parameters of
corporate law will explain much of the responses in these situations. All those uncertainties and conflicting interests will become even more acute in heterogeneous, federal
systems (such as the EU), where a common pattern is not observable.
Thus, it is fair to say that regulators are somewhat “agnostic” when it comes to
choosing an appropriate takeover regime for their specific needs: even if we optimistically imagine that lawmakers seriously seek to optimize their takeover framework
in the public interest by designing functional rules that fit to the assumed real-​life
business realities, they can never be sure that these assumptions hold true (i) for all
business entities that they seek to regulate, (ii) across different industries, and (iii)
over time. This agnosticism has two consequences. First, lawmakers will try to encapsulate the “typical” situation relevant for their jurisdiction by, for example, assuming
that companies controlled by a blockholder are the “typical” (as distinguished from
ubiquitous) situation they need to address. Secondly, regulators faced with continued
uncertainty and conflicting pieces of real-​life evidence will plainly be unsure on how
to determine the optimal regime and so respond to other policy arguments. This is the
point where political considerations, lobbying efforts, and regulatory capture fall onto
fertile grounds. A good illustration is the adoption of the EU Takeover Directive, with
the European Commission pushing for a pro-​takeover response as an important tool
for promoting an integrated “single market” within the Union,227 whilst some member
states (and the European Parliament) responded to current popular fears of globalization and its impact.228 With the abandonment of the no frustration rule and the BTR
224 Becht and Mayer, note 205, table 1.1, reporting that in the late 1990s the median size of the
largest voting block in listed companies varied from 57 percent in Germany to 20 percent in France.
225 For Germany, see Wolf-​Georg Ringe, Changing Law and Ownership Patterns in Germany:
Corporate Governance and the Erosion of Deutschland AG, 63 American Journal of Comparative
Law 493 (2015). For Japan, see Japan Exchange Group, 2015 ShareOwnership Survey (2016), at
<http://​www.jpx.co.jp/​english/​markets/​statistics-​equities/​examination/​01.html>.
226 Julian Franks et al., The Life Cycle of Family Ownership: International Evidence, 25 Review of
Financial Studies 1675 (2012), report in appendix A1 that the average number of listed companies
which were the target of an unsolicited bid expressed as a percentage of all listed companies between
2001–​6 was 0.9 percent in Germany; 1.1 percent in Italy; and 0.7 percent in France. The UK figure
was 3.3 percent. The same general trend can be found in Japan, as the litigation it has generated
attests: see note 51.
227 For which policy there was considerable empirical support. See, for example, Marina Martynova
and Luc Renneboog, Mergers and Acquisitions in Europe, in Advances in Corporate Finance and
Asset Pricing 13, 20 (Luc Renneboog ed., 2006), stating that the European merger boom of the
1990s “boiled down to business expansion in order to address the challenges of the European market.”
228 See Klaus J. Hopt, Observations on European Politics, Protectionism, and the Financial Crisis,
in Company Law and Economic Protectionism 13, 20–​1 (Ulf Bernitz and Wolf-​Georg Ringe
eds., 2010).
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Control Transactions
as mandatory rules at EU level,229 protectionists may be said to have had the better
of the argument with pro-​integration forces. This trend was repeated in the process of
transposing the Directive, where, overall, there was a more protectionist approach on
the part of the member states than had obtained previously.230
The sobering bottom line is that takeover regulation is a mixture of political interests, strategic consequences, lobbying efforts, and the external pressure of capital markets. At best, regulators will attempt to capture the “most typical” agency conflicts
and coordination problems they need to address and ensure that they update their
approach as and when real-​life changes occur. As strict one-​size-​fits-​all regulation rarely
truly reflects business realities, takeover rules that allow for exceptions and/​or discretionary decisions would seem to be welfare-​improving, but there is no guarantee that
the choices so provided are exercised in a way consistent with social welfare.231
229 Section 8.2.2 and 8.4.2.2. 230 Davies et al., note 46. 231 Section 8.4.2.
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Corporate Law and Securities Markets
Luca Enriques, Gerard Hertig, Reinier Kraakman, and Edward Rock
Corporations are formidable tools for raising finance from the public. The core features of corporate law set out in Chapter 1, especially limited liability and transferability of shares, make corporations highly effective for this purpose. Yet, as we have
seen throughout this book, raising external capital exacerbates the agency problems
described in Chapter 2. A broad shareholder (or debtholder) base entails higher information and coordination costs and more pervasive information asymmetries, which
agents (managers, dominant shareholders, shareholders as a class) can exploit to pursue
their own interests to the detriment of principals (shareholders, minority shareholders,
and holders of debt instruments).
Historically, the idea that providers of external capital—​that is, (individual) investors—​needed protection from the risk of fraudulent or opportunistic behavior on the
part of issuers and their agents was at the root of special rules dealing with (a) the
process of selling securities (shares, bonds, debentures) to the public, (b) the status of
companies with securities traded in “public” or “securities” markets,1 and (c) the process of exiting from such a status.2
From a more functional perspective, this body of rules, commonly referred to as
“securities law” or “securities regulation,” supports corporations in their efforts to raise
external capital in the face of the familiar agency problems.3 The broad thrust of securities law is concerned with affiliation strategies—​the entry and exit of investors to and
from the body of shareholders—​primarily by increasing the quantity, quality, and reliability of corporate disclosures. Securities laws also provide enforcement mechanisms
capable of bypassing the collective action problems faced by dispersed investors. To the
extent that these measures increase investors’ expected returns, firms that issue securities to the public (“issuers”) should enjoy a lower cost of capital.
This chapter provides a necessarily brief and partial overview of the regulatory
framework for securities markets in our core jurisdictions. Our treatment is partial
for two reasons. First, securities law regulates not only issuers, but also public markets
as a form of infrastructure providing liquidity services to investors and traders. Such
1 By “public,” or “securities,” markets we refer to organized capital markets that trade standardized
financial instruments (securities) and are generally accessible to investors. Although EU law parlance
refers instead to “financial instruments,” and there are some technical differences in scope between
these and the U.S. conception of “securities,” the terms broadly overlap. Cf. Louis Loss, Joel Seligman,
and Troy Paredes, Fundamentals of Securities Regulation 353–​457 (6th edn., 2011) (U.S.);
Niamh Moloney, EU Securities and Financial Markets Regulation 84–​5 (3rd edn., 2014) (EU).
We generically refer to securities throughout the text.
2 See Joel Seligman, The Historical Need for a Mandatory Corporate Disclosure System, 9 Journal of
Corporation Law 1 (1983).
3 As highlighted in Chapters 1 and 4, securities laws are sometimes used for social purposes which
are hard to square with the idea of reducing the cost of capital for issuers or even of protecting investors. See Chapters 1.5 and 4.3.1.
The Anatomy of Corporate Law. Third Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry
Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 9
© Luca Enriques, Gerard Hertig, Reinier Kraakman, and Edward Rock, 2017. Published 2017 by Oxford University Press.
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public market regulation includes rules about margin requirements for investors, the
registration and conduct of broker-​dealers, and the structure and operations of stock
exchanges and other market infrastructure institutions. Given the book’s focus on corporations, we do not address market regulations of this sort here,4 but rather focus on
the legal strategies directly addressing issuers and their agents. The second reason for
limited coverage of securities regulation at this point is that Chapters 3 to 8 have, in the
course of the treatment of their various topics, already analyzed a number of provisions
that are formally classed as securities regulation.5
9.1 Securities Regulation and Legal Strategies
The legal strategies used to enhance securities markets are based on affiliation terms.
More precisely, compliance with securities laws is a condition for entering, remaining
in, and exiting the public markets, even if entry or exit may not be entirely voluntary.
That said, it is convenient to group the legal strategies employed in the service of public
traded markets into four categories. The first is the paradigmatic exemplar of the entry
strategy: mandatory disclosure in all of its dimensions, including the prescription of
accounting methods. The second category is an exit strategy: here, it takes the form
of rules and regulations that a company has to comply with in order to cease to be
treated as an issuer and therefore subject to securities regulation. The third and fourth
categories include governance and regulatory strategies contingent on participating in
the public markets.
But before we describe how our core jurisdictions deploy these legal strategies, let us
briefly illustrate the functions of securities regulation.
9.1.1 Why securities regulation?
The most immediate goal of the securities law provisions we focus on in this chapter is
to provide market participants with a better disclosure environment. When supported
by an active market where traders compete to realize gains from new information, a
well-​functioning disclosure system increases the “informativeness” of market prices,
often referred to as the market’s “informational efficiency.”6 Furthermore, effective
sanctions for misleading statements increase the veracity of disclosures, meaning investors can rely on them more safely.
In tandem with a prohibition on insider trading,7 more informative prices mean
that potential buyers and sellers have less to fear that, by trading, they will lose money
to counterparties who know more about the issuer’s prospects than is already reflected
in the market price. Therefore, participation in securities markets will be broader, with
a positive effect on market liquidity—​that is, the ability of investors to sell their securities easily and rapidly with little or no impact on price.8
4 For an introduction to this area of regulation see John Armour, Daniel Awrey, Paul Davies, Luca
Enriques, Jeffrey Gordon, Colin Mayer, and Jennifer Payne, Principles of Financial Regulation,
143–​59 (2016).
5 See e.g. Chapter 6.2.1.1.
6 See Ronald J. Gilson and Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 Virginia
Law Review 549 (1984); see also Armour et al., note 4, ch. 5.
7 See Section 9.1.3.2.
8 In the absence of a prohibition on insider trading, new information can become impounded in
stock prices without disclosure, through outsiders drawing inferences from the trading behavior of
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245
Market liquidity is important for a number of reasons. First of all, the prospect of
a liquid market is relevant to primary markets—​that is, where issuers first offer their
securities to the public. If potential buyers can expect to be investing in liquid shares,
they will be willing to pay a higher price (reflecting a lower liquidity discount, if any).
Ultimately, issuers’ cost of capital will be lower. Second, as discussed in Chapters 2,
3, and 8, liquid securities markets affect corporate governance in various ways: liquid
shares facilitate the use of equity-​based compensation for managers and serve as an
alternative currency for takeovers.9
Almost all thus agree that a system which allows information to be speedily incorporated into prices is desirable. Although some argue that less liquidity would reduce
the incentives for trading with a very short time horizon and would therefore push
investors to take a longer view, reducing the amount of available information would
be an indirect, seemingly costly, and possibly ineffective, way of attaining that goal.10
A different question altogether is whether mandatory disclosure, via informationally
efficient securities prices, can also be relied on to enhance allocative efficiency—​that
is, to ensure that scarce capital is channeled toward the most promising investment
projects. The link between informational and allocative efficiency would be as follows: informationally efficient prices also incorporate the estimates about issuers’ profitability that skilled analysts and traders elaborate from publicly available information.
The greater the available information, the more accurate such estimates. Within the
firm, independent directors focused on shareholder wealth and managers with equity-​
based compensation packages may thus use stock price reactions as guidance for corpor­
ate strategy.11 Provided outsiders’ estimates of a company’s expected profitability are
more precise than a biased insider’s, the efficiency of corporate asset allocation will be
improved.12 Whether this is really the case is highly debatable and the correct answer
may well vary market by market, industry by industry, and company by company. For
instance, it may be harder for outsiders to come up with better estimates than insiders
in highly innovative industries where uncertainty is extreme and the trajectory of entire
new markets is impossible to understand, let alone “objectively” predict.13
9.1.2 Affiliation terms strategies
All of our core jurisdictions make compliance with extensive mandatory disclosure
regimes a condition of issuers’ access to public trading markets. In addition, they
insiders: Henry G Manne, Insider Trading and the Stock Market (1966). However, this not only
reduces liquidity for the reasons discussed in the text, but also makes it more difficult for outsiders
to determine why the price has moved, meaning that although the price may react quickly to new
events, the level at which it settles would be less grounded on analysis: Zohar Goshen and Gideon
Parchomovsky, The Essential Role of Securities Regulation, 55 Duke Law Journal 711 (2006). The history of U.S. stock markets, which shifted from an insider-​driven to a disclosure-​driven system during
the twentieth century, provides some support for this view: see John Armour and Brian Cheffins, Stock
Market Prices and the Market for Corporate Control, 2016 University of Illinois Law Review 101.
9 See Chapters 2.2.1.2, 3.5, and 8.1.1.
10 See e.g. Robert C. Pozen and Mark J. Roe, Those Short-​Sighted Attacks on Quarterly Earnings
(2015), corpgov.law.harvard.edu.
11 James Dow and Gary Gorton, Stock Market Efficiency and Economic Efficiency: Is There
a Connection? 52 Journal of Finance 1087 (1997); Jeffrey N. Gordon, The Rise of Independent
Directors in the United States, 1950–​2005: Of Shareholder Value and Stock Market Prices, 59 Stanford
Law Review 1465 (2007).
12 Cf. Luca Enriques, Ronald J. Gilson, and Alessio M. Pacces, The Case for an Unbiased Takeover
Law (with an Application to the European Union), 4 Harvard Business Law Review 85, 93–​5 (2014).
13 See John Armour and Luca Enriques, Financing Disruption, Working Paper (2016).
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restrict firms’ freedom to exit such markets, thereby strengthening their commitment
to high disclosure standards and to a liquid market for their securities.14 But why must
policymakers impose such requirements? Why can we not expect issuers to provide
market participants with all the information they need to make accurate assessments
about the value of securities?
9.1.2.1 The underproduction of information
The case for mandatory disclosure assumes that firms will not disclose sufficient, or sufficiently comparable, information unless they are required to do so. Several theoretical
arguments support this view.15
First, there are the familiar agency problems within corporations. Corporate insiders
often prefer to suppress bad news: managers may do so to obtain higher compensation or
to retain their jobs; shareholders may gain from silence by selling their shares at a higher
price, or by having their companies raise additional capital more cheaply. Biased disclosure
raises the cost of capital across the board and distorts its allocation when real-​world market
conditions prevent companies from signaling their true value. Tying mandatory disclosure
to legal liability helps assure the market about the absence of bias in a company’s disclosures and the credibility of its commitments to continue honest disclosure in the future.16
A second justification for mandatory disclosure is that, even apart from internal
agency problems, the private benefits of disclosure to issuers may be less than its social
benefits to market participants. Sensitive disclosures might damage any given firm in
the market, while having the same disclosures delivered by all firms might generate a
net benefit for shareholders holding a diversified portfolio. Put differently, diversified
investors care less about individual firms than about the informational effects on the
market as a whole. Arguably, disclosure is justified provided it leads to increased aggregate returns and lower price volatility across the market.17
Finally, a third justification for mandatory disclosure is the value of standardization
of substance, format, and quality. At bottom, this solves a coordination problem among
firms. Standardization through mandatory disclosure improves comparability, and thus
increases the value of information to its users. Although firms have surmounted this
collective action problem in the past—​for example, through accounting and stock
exchange rules—​mandatory disclosure may accelerate the standardization process.
9.1.2.2 The empirical evidence
Despite the foregoing arguments, legal scholars have long debated how far issuers should be given discretion over disclosure to public markets.18 Recent empirical
14 See Edward B. Rock, Securities Regulation as Lobster Trap: A Credible Commitment Theory of
Mandatory Disclosure, 23 Cardozo Law Review 675 (2002).
15 For a more comprehensive review see Luca Enriques and Sergio Gilotta, Disclosure and Financial
Market Regulation, in The Oxford Handbook of Financial Regulation 511 (Niamh Moloney,
Eilis Ferran, and Jennifer Payne eds., 2015).
16 John C. Coffee, The Future as History: The Prospects for Global Convergence in Corporate
Governance and its Implications, 93 Northwestern University Law Review 641 (1999).
17 See e.g. Frank H. Easterbrook and Daniel R. Fischel, Mandatory Disclosure and the Protection of
Investors, 70 Virginia Law Review 669 (1984).
18 See e.g. Roberta Romano, The Advantage of Competitive Federalism for Securities
Regulation (2002); Merritt B. Fox, Retaining Mandatory Securities Disclosure: Why Issuer Choice Is
Not Investor Empowerment, 85 Virginia Law Review 1335 (1999).
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Securities Regulation and Legal Strategies
247
literature supports the conventional view that publicly traded firms under-​report
information—​and especially negative information—​if disclosure is not mandated.
While early studies of the U.S. mandatory disclosure regime suggested otherwise,
at least for exchange-​traded companies, they suffered from serious methodological
weaknesses.19 More recent studies provide stronger evidence of benefits. One reports
that large U.S. firms trading on over-​the-​counter markets realized highly significant
positive abnormal returns when they were first made subject to continuous mandatory
disclosure requirements in 1964.20 Another study finds that mandatory disclosure is
associated with a dramatic reduction in the volatility of stock returns.21 Moreover,
non-​U.S. studies point in the same direction, with several cross-​jurisdictional comparisons identifying benefits of mandating disclosure.22 For example, one study concluded
that more extensive disclosure requirements, coupled with stricter enforcement mechanisms, significantly lowered the cost of equity capital.23 Another found that stricter
securities laws within the EU, coupled with effective enforcement, were associated with
improved liquidity.24
Note, however, that empirical studies providing evidence of benefits (in terms of
higher liquidity and lower cost of capital) do not measure mandatory disclosure’s direct
and indirect costs, some of which are impossible to quantify.25 Notwithstanding that,
there is widespread support for the proposition that mandatory disclosure improves
social welfare. Today, the debate is not so much on whether mandatory disclosure is
justified as on how broad its scope should be (both in terms of addressees and contents)
and how effective enforcement can be ensured in different institutional contexts.26
9.1.2.3 The benefits of information
Mandatory disclosure serves the principal, though not exclusive, purpose of enhan­
cing price informativeness. The familiar yet remarkable fact is that in modern markets
the disparate traders—​savvy stock pickers, arbitrageurs, algo-​traders, short sellers,
and others—​impound new information into price extremely rapidly. As hinted, this
not only enhances liquidity by attracting uninformed traders, but also allows companies to use market prices as benchmarks of performance, to guide investment
decisions, acquire other companies, and better compensate managers.27 Similarly,
19 See Christian Leuz and Peter D. Wysocki, The Economics of Disclosure and Financial Reporting
Regulation: Evidence and Suggestions for Future Research, 54 Journal of Accounting Research 525
(2016) (providing a rich survey of the theoretical and empirical literature).
20 See Michael Greenstone, Paul Oyer, and Annette Vissing-​Jorgensen, Mandated Disclosure,
Stock Returns and the 1964 Securities Acts Amendments, 121 Quarterly Journal of Economics 399
(2006).
21 See Allen Ferrell, Mandated Disclosure and Stock Returns: Evidence from the Over-​the-​Counter
Market, 36 Journal of Legal Studies 213 (2007).
22 See Allen Ferrell, The Case for Mandatory Disclosure in Securities Regulation Around the World, 2
Brooklyn Journal of Business Law 81, 88–​99 (2007) for a review.
23 Luzi Hail and Christian Leuz, International Differences in the Cost of Equity Capital: Do Legal
Institutions and Securities Regulation Matter? 44 Journal of Accounting Research 485 (2006).
24 Hans B. Christensen, Luzi Hail, and Christian Leuz, Capital-​
Market Effects of Securities
Regulation: Prior Conditions, Implementation, and Enforcement, 29 Review of Financial Studies
2885 (2016).
25 See e.g. ibid., at 2916.
26 See Benjamin E. Hermalin and Michael S. Weisbach, Information Disclosure and Corporate
Governance, 67 Journal of Finance 195 (2012); Leuz and Wysocki, note 19.
27 See Anat R. Admati and Paul Pfleiderer, Forcing Firms to Talk: Financial Disclosure Regulation
and Externalities, 13 Review of Financial Studies 479 (2000); Ronald A. Dye, Mandatory versus
Voluntary Disclosure: The Cases of Real and Financial Externalities, 65 Accounting Review 1 (1990).
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lenders and other financial intermediaries make use of corporate disclosure to reduce
monitoring costs and engage in profitable signaling.28 In short, issuers, sophisticated
traders, and public investors alike rely on well-​informed public market prices.
But mandatory disclosure supports public securities markets in ways that extend
beyond its positive impact on pricing. Disclosure also greases the wheels for the other
legal strategies of corporate law.29 On the governance side, informed shareholders can
better exercise their decision and appointment rights. Thus, the requirement in most
of our jurisdictions that public issuers disclose the individual rather than the aggregate
compensation of senior managers is almost certainly intended to counter a perceived
agency problem rather than to enhance informational efficiency.30 On the regulatory
side, information crucially affects the enforcement of rules and standards. To take an
obvious example, shareholders might never detect dubious related-​party transactions
if companies were not required to disclose them. The enforcement role of mandatory
disclosure is particularly clear in the U.S. As noted before,31 issuers must report transactions with insiders involving sums as low as $120,000—​an amount that is seldom
material to most issuers’ share prices but might well help identify any inclination by
insiders to breach their duty of loyalty.
9.1.2.4 The scope of disclosure requirements
All jurisdictions impose disclosure duties on companies with securities traded on
domestic public trading markets and, notwithstanding academic policy proposals,32
none of them allows issuers unfettered discretion in the choice of their own disclosure
regimes.33 Jurisdictions differ, however, in the quantity and content of information
that they require companies to disclose. More precisely, disclosure regimes can be distinguished along two dimensions: (1) the range of transactions and issuers that trigger
disclosure obligations, and (2) the breadth of information requirements.
Consider first the mandatory disclosure threshold for securities offerings. All of our
core jurisdictions adjust the level of required disclosure—​from minimal to extensive—​
according to the number and presumed sophistication of the investors to whom the
securities are sold and the amount of the offering, in an effort to balance the costs and
benefits of disclosure.
While details vary across jurisdictions, all distinguish between private and public
offerings of securities on the one hand, and sophisticated and unsophisticated investors
on the other. Few, if any, rules apply to private (or smaller) offers and to offers made to
sophisticated investors, the definition of private (and smaller) offers and of sophisticated
investors being broadly similar across jurisdictions, especially after the U.S. relaxed its
28 See Anjan V. Thakor, An Exploration of Competitive Signaling Equilibria with “Third Party”
Information Production, 37 Journal of Finance 717 (1982); Tim S. Campbell and William A.
Kracaw, Information Production, Market Signaling, and the Theory of Financial Intermediation, 35
Journal of Finance 863 (1980).
29 See Chapter 2.4.
30 See generally Paul G. Mahoney, Mandatory Disclosure as a Solution to Agency Problems, 62
University of Chicago Law Review 1047, 1080 (1995).
31 See Chapter 6.2.1.1.
32 See, e.g. Stephen J. Choi and Andrew T. Guzman, Portable Reciprocity: Rethinking the
International Reach of Securities Regulation, 71 Southern California Law Review 903 (1998);
Romano, The Advantage, note 18.
33 Cf. Luca Enriques and Tobias H. Tröger, Issuer Choice in Europe, 67 Cambridge Law Journal
521, 529–​33 (2008) (highlighting the limited scope of regulatory arbitrage for issuers of shares as
opposed to debt issuers within the European Union).
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Securities Regulation and Legal Strategies
249
rules for primary offers with the JOBS Act of 2012. However, EU jurisdictions have
traditionally been much less concerned than the U.S. or Japan with avoiding resales to
the public of securities issued on the basis of a prospectus exemption.34
In contrast to the regulation of new issues of securities, the scope of continuing disclosure requirements for public issuers varies more among our core jurisdictions. The
EU requirements are narrow in scope: they have traditionally extended only to firms
traded on regulated markets.35 Some of them, however, are now broader, reflecting the
new trading environment in which exchanges compete with more lightly regulated
providers of liquidity services: on-​going mandatory disclosure of material information36 has been extended to issuers having approved (or requested admission to) trading of their securities on a multilateral trading facility.37 By contrast, as a matter of EU
law, even a share offering successfully targeting many investors by a large firm does
not trigger continuing disclosure obligations.38 Brazil also limits continuing disclosure
obligations to firms that trade on regulated markets, but defines regulated markets
broadly to encompass both formal exchanges and over-​the-​counter markets.39
Disclosure requirements in other non-​EU jurisdictions are broader. In Japan, public
companies subject to continuing disclosure duties include not only issuers of exchange-​
listed securities, but also issuers of securities registered with over-​the-​counter markets,
issuers that have previously filed disclosure documents for issuance of securities with
the regulator under the relevant statute, and companies that have had 1000 or more
shareholders on the last day of any of the last five business years.40 The U.S. requirements are similar to Japan’s.41
9.1.2.5 The contents of disclosure
The content of mandatory disclosure, like its scope, is broadly similar across jurisdictions. The registration statement or prospectus that accompanies new public issues of
securities must describe them and the issuer in detail, as well as the intended use of
the proceeds from their issuance. It must also include a comprehensive set of financial
34 See Moloney, note 1, at 95–​6. Japanese law tries to restrict resale of the securities issued by private
placement to the general public by not extending the private placement exemption to securities that
are likely to be resold: Art. 2(3)(ii)(a), (b)(2), and (c) Financial Instruments and Exchange Act; Arts.
1-​4, 1-​5-​2, and 1-​7 Cabinet Order for Implementation of Financial Instruments and Exchange Act.
35 That is still currently the case with periodic and ownership disclosures: see Art. 1 Transparency
Directive. Art. 4(1)(21) Markets in Financial Instruments Directive, 2014 O.J. (L 173) 349, defines a
“regulated market” as a multilateral system, which brings together or facilitates the bringing together
of multiple third-​party buying and selling interests in financial instruments according to its rules and/​
or systems, and which is authorized as such and functions regularly in accordance with the applicable
rules set out in the Directive itself.
36 See Chapter 9.1.2.5.
37 Art. 17 Market Abuse Regulation, 2014 O.J. (L 173) 1. A “multilateral trading facility” is a multilateral system, which brings together multiple third-​party buying and selling interests in financial
instruments, in accordance with non-​discretionary rules and in accordance with the applicable rules
set out in the Markets in Financial Instruments Directive (Art. 4(1)(22)).
38 Italy is the only main EU jurisdiction where some of the “ad hoc” and periodic disclosure
requirements also apply to such an issuer. See Art. 116 Consolidated Act on Financial Intermediation,
in connection with Art. 2-​2 Consob Regulation on Issuers.
39 Art. 22 Lei 6.385, de 7 de dezembro de 1976 (Brazil); Arts. 1º and 13 CVM Instruction No.
480 (2009); Art. 1º CVM Instruction No. 461 (2007).
40 Art. 24(1) Financial Instruments and Exchange Act; Arts. 3 and 3-​6(4) Cabinet Order for the
Enforcement of the Financial Instruments and Exchange Act.
41 §§ 12(g) and 15(d) 1934 Securities Exchange Act and Rule 12g-​1.
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statements prepared in accordance with applicable accounting standards, and extensively describe the nature and performance of an issuer’s business and the identity of its
management and large shareholders.
Notwithstanding these commonalities, however, our core jurisdictions differ in their
commitment to disclosure as a tool to support securities markets. To see why, consider
that information subject to disclosure falls into one of four categories. The first is a
basic description of the company, ranging from an inventory of its assets to an accur­
ate statement of its current financial position and past cash flows. This is the hard,
“benchmark” data that would allow an investor to value the firm as a going concern if
the future were exactly like the past.
All jurisdictions require substantial disclosure of such hard data. However, jurisdictions still differ with respect to the detail they require, as accounting methods have yet
to be fully harmonized or implemented in uniform ways.42 In addition, the U.S. and
the EU now differ with respect to quarterly reporting. While U.S. securities regulation
mandates quarterly reports, which are a key feature of the U.S. disclosure system, they
are no longer mandatory in the EU,43 on the basis that they are costly for small and
medium size firms to produce and that they are said to “encourage short-​term performance and discourage long-​term investment.”44
A second category of disclosure mandated in some jurisdictions encompasses “soft,”
“projective,” or “forward-​looking” information. This includes management’s predictions about likely price changes in each of the multiple markets in which the firm
operates (such as product, supply, capital, and labor markets), as well as management’s
best estimates of likely changes in demand for the firm’s products, including any new
products or cost-​saving technologies that the firm plans to introduce. Investors may
use this “scenario” information better to estimate future changes in a firm’s cash flows.
Such information is thus critical for valuing firms with conventional financial methodologies such as discounted cash-​flow analysis. Despite the importance of projective
data, forward-​looking information accounts for only a tiny fraction of mandated disclosure in our core jurisdictions.45
The U.S. pioneered the reporting of forward-​looking information by requiring that
reports contain a “Management Discussion and Analysis of Financial Condition and
Results of Operations” (“MD&A”),46 and encouraging (but not requiring) companies
to disclose forward-​looking financial projections by shielding such projections from
securities litigation.47 Japan followed suit by introducing MD&A reporting in 2003.48
The EU also mandates the disclosure of soft and projective information, but in a very
42 See Section 9.1.2.6.
43 See Art. 1(5) Directive 2013/​50/​EU, 2013 O.J. (L 294) 13). Member states may still impose
quarterly reports so long as, in short, they deem it necessary: ibid., Art. 1(2)(b).
44 Ibid., preamble (4).
45 See e.g. Vivien Beattie, Bill McInnes, and Stella Fearnley, A Methodology for Analysing and
Evaluating Narratives in Annual Reports: A Comprehensive Descriptive Profile and Metrics for Disclosure
Quality Attributes, 28 Accounting Forum 205, 213 (2004).
46 Regulation S-​K, Item 303. Since 1980, the MD&A report has to include an extensive discussion of “known trends or uncertainties” that might have a favorable or unfavorable impact on future
financial performance.
47 1933 Securities Act, Rule 175 (adopted in 1979).
48 Cabinet Office Ordinance on Disclosure of Corporate Affairs, Form 2 (Precautions for
Recording (36)) and Form 3-​2 (Precautions for Recording (16)) (as amended in 2014). Brazil introduced MD&A-​style reporting in 2009, but the scope of required forward-​looking information is
comparatively circumscribed. The disclosure of estimates and projections remains optional. Art. 22
and items 10 and 11 of Annex 24 CVM Instruction No. 480 (2009).
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251
generic (and therefore not particularly prescriptive) way.49 As a matter of practice,
larger issuers have since long voluntarily offered more forward-​looking information
than was strictly required.50
The U.S., then, has been the leader in requiring disclosure of soft and future-​oriented
information, the volume of which has in fact increased in recent years.51 Despite a lack
of similarly strong requirements, an increase in volume can also be observed in other core
jurisdictions as well.52
A third category of mandatory disclosure relates directly to governance issues and
agency problems. As we have seen in previous chapters, this category includes information
about top management compensation, as well as information about the corporate value
that finds its way to insiders and controlling shareholders.53 It also includes information
that is ancillary to informed voting by shareholders, an area which is highly litigation-​
intensive in Germany, where courts take voting-​related disclosures very seriously,54 and
well-​developed, thanks to federal regulation of proxy voting and best practices, respectively in the U.S. and the UK.55
Finally, a fourth category of mandatory disclosure is “event-​related” disclosure—​
that is, new “material” or “price sensitive” information about the issuer that is likely to
have an impact on the market price of securities. Here, the U.S., on the one hand, and
European and Brazilian regulations, on the other, follow two very different approaches.
In the U.S., there is no obligation to disclose new information per se,56 unless it falls
within one of the many pre-​identified mandated disclosure items,57 or unless the company has in the past made a public statement that the new event now makes misleading, in which case, according to some courts, a duty to update exists.58 With a view
to curbing insider trading and fostering equal access to information for all market
participants, EU and Brazilian laws instead require the immediate disclosure of any
new price sensitive information.59
49 Arts. 4(2)(c) and 5(4) Transparency Directive merely require that firms traded on a regulated
market report “principal risks and uncertainties that they face” on a yearly and half-​yearly basis.
50 See Gary K. Meek, Clare B. Roberts, and Sidney J. Gray, Factors Influencing Voluntary Annual
Report Disclosures by U.S., U.K. and Continental European Multinational Corporations, 26 Journal of
International Business Studies 555, 558 (1995).
51 See Marilyn F. Johnson, Ron Kasznik, and Karen K. Nelson, The Impact of Securities Litigation
Reform on the Disclosure of Forward-​Looking Information by High Technology Firms, 39 Journal of
Accounting Research 297 (2001) (finding a significant increase in both the frequency of firms issuing forecasts and the mean number of forecasts issued following the adoption of the safe h
​ arbor rule).
52 See e.g. for the UK, Paul L. Davies and Sarah Worthington, Gower & Davies Principles of
Modern Company Law 774–​5 (9th edn., 2012). In Japan, it has been customary for listed corporations to disclose their earnings forecast for the next term. See http://​www.jpx.co.jp/​equities/​listed-​co/​
format/​forecast/​index.html (in Japanese).
53 See Chapter 6.2.1.1.
54 See e.g. Ulrick Noack and Dirk Zetzsche, Corporate Governance Reform in Germany: The Second
Decade, 15 European Business Law Review 1033, 1044 (2005).
55 See Loss et al., note 1, 700–​811; Davies and Worthington, note 52, 406–​9.
56 See e.g. Marc I. Steinberg, Insider Trading, Selective Disclosure, and Prompt Disclosure: A Comparative
Analysis, 22 University of Pennsylvania Journal of International Economic Law 635, 657–​8
(2001).
57 See Form 8-​K (17 CFR 249.308).
58 See Donald C. Langevoort and G. Mitu Gulati, The Muddled Duty to Disclose under Rule 10b-​5,
57 Vanderbilt Law Review 1639, 1664–​71 (2004).
59 See Art. 17 Market Abuse Regulation; Art. 157, § 4º Lei das Sociedades por Ações; Art. 22,
§ 1º, VI Lei 6.385, de 7 de dezembro de 1976; Art. 2o CVM Instruction 358 (2002) (Brazil). To
be sure, U.S. stock exchanges impose a similar obligation, but they seldom enforce it. See Steinberg,
note 56, at 657. Japanese law lies somewhere in-​between, as it itemizes information to be disclosed,
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However, the difference in practical outcomes of the two regimes may not be as great as it
looks. On the one hand, the granular and ever-​expanding itemized disclosure requirements
in the U.S. combine with pro-​disclosure practices (both to avoid the risks of liability under
the “duty to update” doctrine and to avoid the wrath of analysts) to ensure that U.S. issuers
make public plenty of “ad hoc” information without waiting for the next periodic disclosure.60 On the other hand, a standard—​as in the EU and Brazil—​that relies on information
having the character of “price-​sensitivity” leaves scope for discretion in deciding when a
piece of information is ripe for disclosure (it must be “of a precise nature” in the EU61) and
material (what does it mean that it “may have a meaningful impact on share prices” under
Brazilian law?). In addition, in both the EU and in Brazil, disclosure may be delayed if it
would prejudice a “legitimate interest” of the company.62 That said, the European Court
of Justice has so far interpreted the concept of “inside information” broadly, and lawmakers
followed the Court’s lead in reforming the market abuse relevant disclosure rules in 2014.63
Even an “intermediate step in a protracted process,” such as the commencement of merger
negotiations, is to be disclosed if it is itself of a precise nature and price sensitive.64
9.1.2.6 Accounting methods
Financial reporting regimes—​the provision of information about a firm’s past and
current financial position—​have evolved from two very different models.65 One,
the “continental European” model, originated in seventeenth century France with
the goals of protecting creditors and facilitating the taxation of firms. The other, the
“Anglo-​American” model, developed in the UK during the nineteenth century with
the goal of enhancing the ability of equity holders to monitor their investments. Put
differently, the interests of creditors, insiders, and the state strongly influenced a continental European model of accounting, while the interests of equity holders informed
the Anglo-​American accounting model.66
These disparate interests point toward different valuation methods. Traditionally,
valuation has looked either to historical cost, which captures the conservative thrust of
continental accounting, or to “fair market value,” which tracks the interests of equity
holders. With due exceptions and qualifications, both accounting methods report
like U.S. law, but also requires disclosure of any event with an impact higher than pre-​set quantitative
thresholds (Art. 24-​5 Financial Instruments and Exchange Act and Art. 19 Cabinet Office Ordinance
on Disclosure of Corporate Affairs).
60 See James D. Cox, Robert W. Hillman, and Donald C. Langevoort, Securities Regulation:
Cases and Materials 728 (7th edn., 2013); Steinberg, note 56, at 659.
61 Although the Court of Justice of the European Union interpreted the term “precise” broadly,
holding that information can be precise even if it is impossible to tell whether it will impact prices
upwards or downwards. See Case C-628/13, Lafonta v. AMF ECLI:EU:C:2015:162.
62 Art. 157, § 5º Lei das Sociedades por Ações and Art. 6o CVM Instruction 358 (2002); Art.
17(4)(a) Market Abuse Regulation (to be sure, Art. 17(4)(b) makes this exemption’s scope narrower
by adding that delay is not permitted if it is likely to mislead the public).
63 See Case C-​19/​11 Geltl v Daimler ECLI:EU:C:2012:397; recitals (16) and (17) and Art. 7
Market Abuse Regulation.
64 Art. 7(3) Market Abuse Regulation.
65 See Bruce Mackenzie et al., Interpretation and Application of International Financial
Reporting Standards 3–​4 (2014).
66 Indeed, even today the U.S. and UK distinguish between financial and tax accounting, while
most European jurisdictions employ the same accounting method for both tax and financial reporting
purposes. See e.g. Martin Gelter and Zehra G. Kavame Eroglu, Whose Trojan Horse? The Dynamics
of Resistance against IFRS, 36 University of Pennsylvania Journal of International Law 89,
144–​5 (2014).
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assets on the balance sheet at the lower of historical cost or market value.67 However,
traditional continental accounting makes much broader use of historical cost, which
yields easily verifiable data but also allows firms to defer profit recognition over time
(which in turn may help conceal worsened performance), and, in inflationary periods,
undervalues non-​financial assets.68
By contrast, the fair value approach relies on current market prices as its metric
(especially for financial assets), and is therefore more likely to correlate with the stock
market valuation of firms.69 However, if financial assets lack an active market, fair
value accounting requires that they be marked to a model of what their market value
“should” be70—​a highly discretionary exercise which may well lead to inconsistent,
if not misleading, results. Moreover, fair value accounting increases the volatility
of financial reporting and may not reflect the going-​concern value of firm-​specific
assets.71 Indeed, the financial crisis has dramatically highlighted the pro-​cyclical effects
of marking assets to market when market prices are purportedly “distressed,” and therefore below the normal-​times hold-​to-​maturity value of complex financial assets.72
Nevertheless the divergence between the Continental and Anglo-​
American
approaches toward accounting should not be exaggerated. As indicated above, both
models have always used historical cost to value non-​financial assets.73 In addition,
accountants are conservative by profession, which should discourage them from overvaluing financial assets under fair value accounting.74 Finally, EU harmonization,
coupled with the growing importance of global capital markets, has prompted continental European jurisdictions to accept a wider role for fair value, especially with the
EU’s endorsement of International Financial Reporting Standards, which draw heavily
from the U.S./​UK approach.75 Even Germany, which had traditionally favored a “precautionary approach” (Vorsichtsprinzip) to the valuation of balance-​sheet items, edged
toward accepting the fair value model before the financial crisis erupted.76 As a result,
financial reporting methodologies converged throughout the 1990s and the 2000s.
67 See Joanne M. Flood, Interpretation and Application of Generally Accepted Accounting
Principles 978–​81 (2014).
68 See Alexander Bleck and Xuewen Liu, Market Transparency and the Accounting Regime, 45
Journal of Accounting Research 229 (2007) (historical costs give management a veil under which
they can potentially mask a firm’s true economic performance).
69 ”Fair value” is defined as the price for which an asset or a liability can be exchanged between
willing and knowledgeable parties in an arm’s length transaction. Note that empirical evidence on the
share price relevance of fair value accounting is mixed. See e.g. Jochen Zimmermann and Jörg-​Richard
Werner, Fair Value Accounting under IAS/​IFRS: Concepts, Reasons, Criticisms, in International
Accounting 127 (Greg N. Gregoriou and Mahamed Gaber eds., 2006).
70 See FAS 157: for the Financial Accounting Standards Board, a fair value measurement is based
on market data reporting (observable inputs) and, to the extent market data is unavailable, on the best
information available (unobservable inputs).
71 See Guillaume Plantin, Haresh Sapra, and Hyun Song Shin, Marking-​to-​Market: Panacea or
Pandora’s Box, 46 Journal of Accounting Research 435 (2008) (marking to market is especially
problematic when assets are long-​lived, illiquid, and senior).
72 See Franklin Allen and Elena Carletti, Mark-​to-​Market Accounting and Liquidity Pricing, 45
Journal of Accounting and Economics 358 (2008); Plantin et al., note 71. See also International
Monetary Fund, Global Financial Stability Report 58–​66 (2008).
73 See e.g. Janice Loftus, A Fair Go to Fair Value, in Gregoriou and Gaber, note 69, at 41.
74 See e.g. Sugata Roychowdhuroy and Ross L. Watts, Asymmetric Timeliness of Earnings, Market-​
to-​Book and Conservatism in Financial Earnings, 44 Journal of Accounting and Economics 2
(2007).
75 See Gelter and Kavame Eroglu, note 66, 148.
76 See Werner F. Ebke, Rechnungslegung und Publizität in europarechtlicher und rechtsvergleichender Sicht, in Internationale Rechnungslegungsstandards für börsenunabhängige
Unternehmen? 67 (Werner F. Ebke, Claus Luttermann, and Stanley Siegel eds., 2007).
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Since the crisis, however, criticism of fair value accounting has increased77 and
Germany has backtracked from the idea of imposing it, leaving companies a free
choice on the matter.78 At the same time, U.S. securities regulators have also backtracked from the idea of allowing U.S. companies to use International Financial
Reporting Standards (IFRS), which would have greatly enhanced international
convergence.79
All in all, the extent to which accounts drawn up according to IFRS are comparable
to U.S. Generally Accepted Accounting Principles (GAAP) accounts is still limited
and varies with a number of factors, including industry, legal origins, and enforcement
intensity.80 And even similar accounting methods do not necessarily imply uniform
accounting practices. Institutional differences in ownership regimes and regulatory
structures will remain a source of divergence.81 For example, U.S. GAAP are said
to rely on detailed rules to reduce the risk of shareholder litigation alleging faulty
accounting—​a concern that is much less salient elsewhere.82 Conversely, jurisdictions
with low litigation risk, such as European ones, have embraced the principle-​oriented
IFRS, which leave more room for managerial discretion. Ironically, flexibility may help
explain the global popularity of IFRS, even though flexibility reduces the comparability of financial statements between and within IFRS jurisdictions.83 But comparability across or within jurisdictions can also be difficult under rule-​oriented accounting
systems, insofar as rules cannot anticipate all cases and must be supplemented by standards anyway.84
9.1.2.7 Protecting exit rights: making commitments credible
The impact of securities regulation on market behavior would be negligible if issuers could engage in transactions allowing them to escape the regime while retaining
a broad shareholder base. In other words, easy exit would encourage firms to bait
and switch—​to attract investors with the implicit promise of full disclosure and high
liquidity, and then “go dark” by abandoning their status as public companies. But buyers would discount that possibility and refuse to pay the “premium” otherwise associated with securities regulation. That is the reason why all jurisdictions have rules in
place that make it harder for issuers to free themselves of such a regime: in other words,
restrictive exit rules are a key component of securities regulation.85 This is, however, an
area of considerable divergence across jurisdictions.
Some of them establish objective criteria for allowing companies to cease complying with public reporting obligations. Sometimes, these criteria are quantitative. For
example, U.S., Italian, and Japanese securities laws cease to require disclosures when
77 See Gelter and Kavame Eroglu, note 66, 159–​63.
78 See Bilanzrechtsmodernisierungsgesetz (BilMoG) (2009).
79 See Gelter and Kavame Eroglu, note 66, 103–​4.
80 See Mary E. Barth et al., Are IFRS-​Based and US GAAP-​Based Accounting Amounts Comparable?
54 Journal of Accounting and Economics 68 (2012).
81 Yuan Ding, Ole-​Christian Hope, Thomas Jeanjean, and Hervé Stolowy, Differences Between
Domestic Accounting Standards and IAS: Measurement, Determinants and Implications, 26 Journal of
Accounting and Public Policy 26 (2007).
82 See e.g. Gelter and Kavame Eroglu, note 66, 124.
83 See Christopher Nobes and Robert Parker, Comparative International Accounting ch. 7
(12th edn., 2012).
84 See William W. Bratton, Enron, Sarbanes-​Oxley and Accounting: Rules Versus Principles Versus
Rents, 48 Villanova Law Review 1023 (2003).
85 See Rock, note 14.
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the number of a company’s shareholders drops below given thresholds.86 By contrast,
in other European jurisdictions and Brazil, disclosure requirements cease to apply as
soon as an issuer’s securities are no longer admitted to trading on a regulated market
(or trading facility).87
Public companies that are exchange-​listed must also comply with the rules governing voluntary delisting.88 In many jurisdictions, the law specifically empowers supervisory authorities to oppose delisting applications when it is in the interests of investors
to do so or laws are violated.89 This public law approach reinforces the effectiveness of
delisting-​related company law requirements, which some jurisdictions deploy. So, for
instance, the NYSE requires a board resolution and notice,90 while the Main Market
of the London Stock Exchange requires supermajority shareholder approval.91 After
lengthy debate, Germany now places the delisting decision in the hands of corpor­ate
management,92 but imposes an exit right for (minority) shareholders at a fair price.93
Brazil displays the strictest regime: public companies wishing to go private must
launch a mandatory bid at a “fair price” to the remaining public shareholders, as well
as obtain either the acceptance of the bid or the express consent to deregistration from
shareholders comprising two-​thirds of the company’s free float.94
86 While the exact rules are more complex, that is the case when the number of a U.S. issuer’s
shareholders falls below 300 (or, in the case of banks, 1200) or, in Japan, an issuer’s legal capital drops
below 500 million yen. See §§ 12(g)(4) and 15(d) 1934 Securities Exchange Act (U.S.) and Art. 24(1)
Financial Instruments and Exchange Act and Art. 3–​6(1) Cabinet Order for the Enforcement of the
Financial Instruments and Exchange Act (Japan). In Italy, crossing the relevant thresholds downwards
allows companies to go dark, i.e. to stop complying with “ad hoc” and periodic reporting obligations;
other disclosure obligations cease to apply when securities are no longer traded on a regulated market
or trading facility, as in the rest of Europe.
87 See e.g. Moloney, note 1, at 133–​4.
88 Delisting may also be involuntary, for failure to meet listing standards or rule violations. See
Shinhua Liu, The Impact of Involuntary Foreign Delistings: An Empirical Analysis, 10 Journal of
Emerging Markets 22 (2005) (identifying 103 foreign firm delistings from U.S. markets between
1990 and 2003, 100 being threshold-​related and three due to failure to meet other non-​numerical
standards).
89 See Art. 64 Consolidated Law on Financial Intermediation (Italy); Börsengesetz § 39(2)
(Germany). Japanese law is unclear: although Art. 127 of FIEA grants the JFSA the power to order
re-​listing when the stock exchange delists shares of a corporation “in violation of the exchange rules,”
there is no provision in the Tokyo Stock Exchange listing rules spelling out the conditions for voluntary delisting. The practice of the Tokyo Stock Exchange, however, is said to be restrictive: corporations that have been permitted to delist voluntarily were those that were also cross-​listed on other
exchange(s).
90 NYSE Listed Company Manual § 806.00. It should be noted that previously it was far more
difficult to delist, with the longstanding rule requiring a vote of two-​thirds of the shareholders in favor
and not more than 10 percent against. Rock, note 14, at 683. The change to a rule permitting easier
exit was in response to pressure from foreign private issuers who wished to leave the NYSE in the wake
of Sarbanes-​Oxley.
91 FCA Listing Rule 5.2.5.
92 The Frosta decision (BGH, Oct. 8, 2013—​II ZB 26/​12, NJW 2014, 146) thus reversed the
earlier Macrotron decision (BGH, Nov. 25, 2002—​II ZR 133/​01, BGHZ 153, 47), which required
shareholder approval.
93 This exit right was reinstalled in late 2015 in response to commonly perceived gaps in minority protection following Frosta (note 93). Revised § 39 Börsengesetz now requires an exit right
at the weighted average market price of the previous six months. For details, see Walter Bayer,
Delisting: Korrektur der Frosta-​
Rechtsprechung durch den Gesetzgeber, Neue Zeitschrift für
Gesellschaftsrecht 1169 (2015).
94 Art. 4º, § 4º Lei das Sociedades por Ações; Art. 16 CVM Instruction No. 361 (2002). If the
controlling shareholder or the company succeeds in acquiring more than two-​thirds of any given class
of shares, CVM regulations require the offer to remain open to the remaining shareholders for three
months at the same price—​a mechanism that effectively reduces the pressure to tender. Art. 10, § 2o
CVM Instruction No. 361 (2002).
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9.1.3 Governance and regulatory strategies
In addition to mandating disclosure, lawmakers and stock exchanges also impose
“quality” restrictions on companies’ access to securities markets and restrictions on
market participants’ trading. Both are meant to curb behavior, such as misleading
statements or price manipulation, which may alienate investors from securities markets
and thereby hinder market liquidity.
9.1.3.1 Quality controls
In general terms, the rationale for quality controls relies on two premises. First, that
fraud perpetrated at a publicly traded firm, unlike at a closely held one, may have a
market-​wide impact: that is, it may raise the cost of capital for all companies in the
market. The second premise is that better governance reduces the risk of fraud. Quality
controls can take the form of minimum corporate governance requirements, trusteeship intervention and entry restrictions based on proxies for the prospective issuer’s
quality. Such controls can be public (when they are the product of laws, regulations, or
public agents’ decisions) or semi-​private:95 the latter is the case with stock exchange-​
devised listing or admission to trading requirements.96
9.1.3.1.1 Governance strategies
In prior chapters, we have provided examples of corporate governance quality standards, such as board independence, the three-​committee structure, supermajority
requirements, and so on, that policymakers (and stock exchanges) impose on publicly
traded companies.97 Here, we briefly focus on a variation of the trusteeship strategy,
the screening by regulators or stock exchanges of companies eligible for public trading.
When the screening is performed by a public authority, this is known as “merit
regulation.” Many U.S. states permit state regulators to refuse approval of an issue of
securities that fails to conform to certain guidelines or appears—​to the officials—​to be
particularly risky without offsetting economic merit. In practice, most securities offerings are now exempt from state regulators’ review.98
EU law also allows listing authorities (which may be securities regulators as well as
stock exchanges) to screen applications for exchange listings in the interest of protecting
the investing public.99 Thus, the UK’s Financial Services and Markets Act 2000 authorizes
the UK Listing Authority to refuse a listing application that it considers detrimental to the
95 Of course, quality controls also exist that are purely private, such as when the intermediary
setting up a non-​regulated market (e.g. a multilateral trading facility that does not require regulators’ approval of its admission to trading rules) provides for specific quality requirements: think of
Italy’s Alternative Investment Market or Euronext’s Alternext, both specializing in small and medium
enterprises, but still providing for some minimal initial liquidity thresholds. See Borsa Italiana, AIM
Italia/​Mercato Alternativo del Capitale: Rules for Companies 33 (2016) (available at <www.
borsaitaliana.it>); for Alternext, see <www.euronext.com/​en/​listings/​select-​your-​market>.
96 These are only semi-​private because they are subject to securities regulators’ approval: regulators
can both informally make their approval of listing rules conditional upon the inclusion of further
requirements and reject attempts at getting rid of existing quality controls. It is therefore hard to tell
to what extent listing rules are really a form of self-​regulation or rather public regulations in disguise.
97 See Chapters 3.1, 3.2., 3.3, 3.4, 6.2.3, and 7.3.1.
98 Section 18, Securities Act 1933, as amended (15 U.S. Code § 77r).
99 See Art. 11 Consolidated Admission and Reporting Directive, 2001 O.J. (L 184) 1, applicable
to “official” listed segments.
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interests of investors.100 Similarly, the Italian authority may oppose exchange listings that,
based on its own information, would be against its supervisory goal of ensuring “market
transparency, the orderly conduct of trading and investor protection.”101 However, quality-​
control provisions have fallen from favor among European policymakers as well: the powers we have described are seldom, if ever, used.102
9.1.3.1.2 Quality checks upon entering public markets
In addition to investor protections based on mandatory disclosure for securities offerings and merit regulation, our core jurisdictions provide for minimum quality rules,
whether self-​regulatory or public, to screen issuers entering the public market.
“Official” or “first-​tier” markets typically mandate a minimum size for corporate
issuers (whether in terms of assets or market capitalization), a minimum float and a
minimum number of securities holders in order to ensure quality mainly in terms of
sufficient liquidity. Some of them also screen prospective listed companies based on
past profitability, which is, intuitively, quite a rough indicator of quality. For example,
for its so-​called first section, the Tokyo Stock Exchange requires at least 20,000 unit
shares, 4 billion yen in market capitalization, 2,200 shareholders, and a high minimum
pre-​tax profit calculated over a two-​year period.103 Other exchanges impose similar,
although mostly less rigorous, requirements.104
9.1.3.2 Market manipulation (securities fraud)
and insider trading restrictions
Finally, our jurisdictions use regulatory strategies (rules and standards) to curb abusive
practices on securities markets. In particular, all of them ban the dissemination of false
or misleading statements about an issuer, whether by the issuer itself or by third parties105 (known as market manipulation in Europe, and securities fraud in the U.S.),106
and provide for some restrictions on trades by those who are in possession of inside
information about an issuer (insider trading).
100 Financial Services and Markets Act 2000 (UK) section 75(5).
101 Art. 64 Consolidated Law on Financial Intermediation (Italy).
102 See also Moloney, note 1, 171–​2. In Brazil, quality controls are similarly exceptional; they only
apply when a company is constituted by public subscription, a practice that is effectively unheard of
in modern business practice: Art. 82, § 2º Lei das Sociedades por Ações.
103 Tokyo Stock Exchange, Securities Listing Regulations, Rule 308.
104 For NYSE’s requirements, which are based on pre-​tax corporate income ($10 million in the
aggregate for the previous three years) or, failing that, on a “Valuation/​Revenue Test” or an “Assets and
Equity Test,” see New York Stock Exchange Listed Company Manual Section 102.01. For a company
listing in connection with an IPO, the NYSE also requires a minimum of 400 shareholders with 100
shares each and a float of at least 1.1 million publicly held shares with a value of $40 million. European
listing rules require a minimum float of usually 25 percent of the subscribed capital (e.g. for France,
Rule 6702/​1 Euronext Rulebook, Harmonised Rules), a minimum (and usually waivable) foreseeable
market capitalization (e.g. €40 million in Italy, Art. 2.2.2 Listing Rules for the markets set up and
managed by Borsa Italiana SpA) and a minimum of three years of prior business (e.g. for Germany and
the UK, see § 3 Börsenzulassungsverordnung; § 6.1.7 Listing Rules). The São Paulo Stock Exchange
requires a minimum free float of 25 percent in its premium corporate governance listing segments,
but otherwise imposes no limitations in terms of firm size, number of shareholders, or profitability.
105 Similarly, trading techniques that are aimed to move market prices so as to profit from the
artificial change in price thus obtained are prohibited (so-​called trade-​based manipulation).
106 See Art. 1 Market Abuse Regulation, 2014 O.J. (L 173) 1 (EU); 17 C.F.R. § 240.10b-​5 (U.S.);
CVM Instruction No. 8 (1979) (Brazil); Arts. 158–​9 Financial Instruments and Exchange Act (Japan).
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The rationale for bans on market manipulation is intuitive: securities markets would
be more akin to casinos if issuers were free to lie about themselves or third parties
could spread lies about issuers with impunity. In fact, such bans adapt the inveterate
common or private law on fraud to the specific features of securities markets, with the
main purpose of easing enforcement and deterring such forms of misbehavior. In so
doing, the bans reinforce the credibility of individual issuers’ disclosures and thereby
contribute to lowering their cost of capital.
Only slightly less intuitive is why jurisdictions should prevent those in possession
of insider information from trading on it. We have already seen in Chapter 6 that one
rationale is to protect corporations from expropriation by their insiders: a manager
who trades on inside information pertaining to the company is effectively misappropriating a valuable asset of the firm.107
However, most of our jurisdictions have moved away from the idea that insider trading presupposes the misappropriation of a corporate asset (or, similarly, the violation
of a fiduciary duty). Rather, the explicit underlying rationale has more to do with the
concept of market egalitarianism—​that is, the idea that those who trade in securities on
a public market should be able to rely on the fact that they are informationally on an
equal footing with all other traders, because those with inside information are barred
from trading. This rationale has made its way into European legislation and case law
and is reflected in a broad-​sweeping ban on trading by any person possessing insider
information, irrespective of that person’s relationship with the company and how the
information was acquired.108 It has traditionally also been advocated by the U.S. SEC,
yet so far without success.109
An economically better grounded justification for a broad-​scope insider trading ban
is that it is beneficial to market liquidity: in markets where liquidity is ensured by market makers, the perception that they may systemically trade with insiders with super­
ior information would lead them to increase bid-​ask spreads.110 Similarly, in markets
where participants trade with each other via brokers, the ban will reassure informed
traders that their investments in acquiring, processing, and acting upon new information about issuers may be rewarded: like market makers, if informed traders had to
compete with insiders in the trading of securities, they would systematically lose. 111
9.2 Securities Law Enforcement
As hinted in the introduction to this chapter, a key component of an effective securities law regime is an enforcement apparatus making up for the serious collective action
problems affecting investors in public markets. Our core jurisdictions rely on all of the
enforcement modalities outlined in Chapter 2—​namely, public and private enforcement and gatekeeper control—​for this purpose.112 Yet jurisdictions differ dramatically
107 See Chapter 6.2.4.
108 See Art. 8 and Preamble 24, Market Abuse Regulation. See also ECJ, Case C-​45/​08 Spector
Photo Group [2009] E.C.R. I-​12073. For the scope of insider trading prohibitions in the U.S., Brazil,
and Japan see Chapter 6.2.4.
109 See Dirks v SEC, 103 Supreme Court Reporter 3255 (1983); U.S. v. Newman, 733 Federal
Reporter 3d 438 (2d Cir. 2014).
110 See Chapter 6.2.4.
111 See Zohar Goshen and Gideon Parchomovsky, On Insider Trading, Markets and “Negative”
Property Rights in Information 87 Virginia Law Review 1230 (2001).
112 See Chapter 2.3.2.
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259
in the mix of enforcement modes they employ, as well as in the severity and intensity
of enforcement.
9.2.1 Public enforcement
Public enforcement is initiated by government actors (usually, in this context, securities regulators and public prosecutors) or private institutions with quasi-​governmental
powers such as self-​regulatory bodies and stock exchanges.113 All of our major jurisdictions devote significant resources to public enforcement of securities laws.
Two resource-​
based measures provide a rough indication of the intensity of
enforcement by market regulatory authorities in our major jurisdictions. Looking at
public enforcement staff relative to population, the UK and the U.S. stand out: these
two jurisdictions devote at least three times the staff to public securities enforcement (adjusted for population) as any one of our remaining five jurisdictions.114
Enforcement budgets adjusted for GDP yield much the same result, with the budgets
of the UK and U.S. exceeding those of Brazil, France, Germany, and Japan by ratios
of three or four.115
Despite the similarity in inputs, the balance between formal and informal public enforcement outputs in the U.S. and the UK differs significantly. Historically,
U.S. administrative and criminal authorities bring many more formal enforcement
actions than their UK counterparts. UK authorities have traditionally appeared to
accomplish much informally, by raising their eyebrow or by engaging with issuers
without pursuing cases against them.116 In the wake of the crisis, however, even the
UK has been putting considerably more weight on formal public enforcement.117
These results do not include many aspects of public enforcement, such as criminal
prosecutions and enforcement undertaken by exchanges. But here, too, the U.S. public
enforcement machinery seems to have more firepower, having imposed “real” prison
sentences on top executives or dominant shareholders in high profile cases such as
Enron, WorldCom, and Tyco International and, more recently, on a number of investment managers and corporate directors for insider trading.118 European jurisdictions
113 For a more elaborated definition of public enforcement, see Chapter 2.3.2.1. Of course, one
could equally qualify self-​regulatory bodies and stock exchanges as private enforcers, due to their
hybrid nature.
114 Howell E. Jackson and Mark J. Roe, Public and Private Enforcement of Securities Regulation:
Resource-​Based Evidence, 93 Journal of Financial Economics 207, Table 2 (2009), also showing
that, by comparison, France, Italy, Germany, and Japan have roughly the same population-​adjusted
enforcement staff; data are from the mid-​2000s. Brazil has the lowest population-​adjusted enforcement staff of our core jurisdictions. Note that the evidence consolidates issuer behavior and market
trading enforcement.
115 Ibid. (note that the data is not adjusted for per capita market capitalization). The exception is
Italy, where the enforcement budget is closer to U.S.–UK levels, but staffing remains far below them.
116 See Jackson and Roe, note 114, 235; John Armour, Enforcement Strategies in UK Corporate
Governance: A Roadmap and Empirical Assessment, in Rationality in Company Law: Essays in
Honour of Dan D. Prentice 71, 87–​92 (John Armour and Jennifer Payne eds., 2009).
117 See Eilís Ferran and Look Chan Ho, Principles of Corporate Finance Law 413 (2nd edn.,
2014). See also Brooke Masters, Don’t Hold Your Breath Waiting for a Tesco Fraud Case, The Financial
Times, 1–​2 November 2014 (London), at 16 (reporting a handful of cases of public enforcement
against issuers’ fraudulent disclosures, their mixed judicial outcome and one important reason why
they are harder to win than in the U.S., i.e. the difficulty of “cut[ting] co-​operation deals with lower
level conspirators”).
118 See e.g. Tebsy Paul, Friends with Benefits: Analyzing the Implications of United States v. Newman
for the Future of Insider Trading, 5 American University Business Law Review 109, 124 (2015).
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and Brazil are more lenient when it comes to punishing securities fraud,119 while in
Japan, public enforcement relies mainly (and increasingly) on administrative fines.
Moreover, as discussed in Chapter 6, higher levels of U.S. private enforcement go
hand-​in-​hand with higher levels of public enforcement.120 Vibrant private litigation
prompts public enforcers to be more active themselves while, conversely, private litigation feeds on evidence gathered by public enforcers.121
9.2.2 Private enforcement
The chief private enforcement mechanism for investor protection consists of investor
lawsuits for damages, brought chiefly against issuing companies. Less frequently, the
defendants are audit firms and other public “speakers,” such as financial analysts and
their employers, whose credibility can materially influence market prices. The law in
all of our major jurisdictions imposes negligence-​based liability when it mandates the
disclosure of specific information in prospectuses.122 In the U.S. and the UK, however, the law employs the more lenient standard for liability of “knowing misconduct”
(knowing or reckless misconduct in the UK) in the case of violations of on-​going and
periodic disclosure requirements.123
Despite the more lenient standards of liability, reliance on private enforcement (i.e.
securities litigation) is much greater in the U.S.:124 the securities class action based on
the “fraud on the market” theory is one of the most important mechanisms for enfor­
cing mandatory disclosure requirements, notwithstanding past U.S. Congress efforts
to cabin it.125 The fraud on the market theory facilitates securities fraud class actions
by relieving plaintiffs from the burden of proving that they relied on the false or misleading information when they made their investment decisions: there is a presumption that the market share price at which they traded reflected all available material
information, including the false statement, and was therefore distorted by it. In other
words, plaintiffs may rely on the integrity of the price formation process on (presumptively well-​functioning) securities markets.126
119 See e.g. for France, Nicolas Rontchevsky, L’harmonisation des sanctions pénales, Bulletin Joly
Bourse 139, 1 March 2012, n° 3.
120 See Chapter 6.2.5.4.
121 See James D. Cox, Randall S. Thomas, and Lynn Bai, There Are Plaintiffs and … There Are
Plaintiffs: An Empirical Analysis of Securities Class Action Settlements, 61 Vanderbilt Law Review 355
(2008) (finding that private suits with parallel SEC actions settle for significantly more than private
suits without such proceedings).
122 For the U.S., see e.g. §§ 11 and 12(a)(2) Securities Act 1933; for the UK, § 90
Financial Services and Market Act 2000; for France, Germany, and Italy, see Prospekt-​ und
Kapitalmarktinformationshaftung 9, 125–​7 (Klaus J. Hopt and Hans-​Christoph Voigt eds.,
2005). On Japan see text accompanying notes 128–​9.
123 See Hopt and Voigt, note 122, 9, 125–​6 (contrasting this approach with that adopted in
European jurisdictions, with Germany lying in between, in that it requires knowledge or gross negligence).