COMPARATIVE COMPANY LAW AND CORPORATE GOVERNANCE

Lectures on Company Law

Prof. Jukka Mähönen

October 2012

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Lectures on company law

Jukka Mähönen: Comparative Company Law and Corporate Governance• Wed 10.10.2012 16–20 P722• Thu  11.10.2012 16–19 P673• Fri    12.10.2012 16–19 P673

Seppo Villa: Corporate Finance• Tue  16.10.2012 10–13 P674• Wed 17.10.2012 10–13 P722• Thu  18.10.2012 10–14 (12.15 – 14:00 exam) AUD XII

(Main building)• Re-exam day: public exam day 20.11.2012 Place: PI

Time: 09:00

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Comparative company law and corporate governance

Aims• Theoretical basis of modern company law and

corporate governance: contract and agency theory, governance models

• History of company law and corporate governance and company law families

• General structure of EU company law

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Comparative company law and corporate governance

• Main features of corporate form (legal personality, limited liability, residual rights, separation of control and ownership, free transfer of shares)

Literature• Reinier Kraakman et al.: The anatomy of

corporate law : a comparative and functional approach, 2nd ed., Oxford University Press: New York 2009

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Corporate Finance

Aims• The structure of corporate finance• The distinction between equity and loans• Mezzanine finance: subordinated loans,

preferred shares• The annual accounts

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Corporate finance

• The doctrine of capital maintenance• Distribution of funds• Creditor protection: solvency and balance sheet tests

Literature• Kraakman et al (2009) • Seppo Villa: Creditor Protection and the Application of

the Solvency and Balance Sheet Tests under the Company Laws of Finland and New Zealand

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Theoretical basis

Mainstream corporate law paradigm• Kraakman et al. (2009)

End of history of corporate law• Henry Hansmann & Reinier Kraakman: The

end of history for corporate law. Georgetown Law Journal, 439–468 (2001)

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Theoretical basis

Critique against mainstream paradigm• Adolf Berle & Gardiner Means: The Modern

Corporation and Private Property (1932)• Luh Luh Lan & Loizos Heracleous: Rethinking

agency theory: The view from law. Academy of Management Review, 294–314 (2010)

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Mainstream paradigm

Emphasis on contracting and self-regulation

Basis on microeconomics: theory of the firm• Nexus of contracts theory• Principal agent theory

Shareholder primacy

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Critique

Managerialism• Expert management the corporate strategic centre in a

bureaucratic hierarchyStakeholder primacy

• Duty of managers and directors to take into consideration the interests of non-shareholder constituencies having stakes in the company as important as those of shareholders

Director primacy• The board of directors a central, independent decision-maker

mediating competing stakeholder interests and allocating the firm surplus among them

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Important to remember

Long history of corporate law• Roman law: familia, peculium, societas, societas

publicanorum• Medieval law: societas, compagnia, commenda,

guilds• Early modern time: great companies

• Dutch East Indian Company (VOC)• English East Indian Company (EIC)

• Modern regulation• ca 1850-

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Historical theories on company law

Fiction theory

Organic theory

Aggregate theory

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Fiction theory

Company a state-created legal fiction only, without substantial reality or own free will• Public good

Basis: state concession

German variant: Friedrich von Savigny, Karl Puchta

U.S. variant: Darthmouth College v. Woodward (1819); David Millon: Frontiers of legal thought I: Theories of the corporation. Duke Law Journal, 201–262 (1990)

Influence: Stakeholder primacy

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Organic theory

Company a real entity having a separate existence from its shareholders

Company a naturally occurring beingGerman variant: Georg Beseler, Otto von GierkeU.S. variant: Ernst Freund: The legal nature of

corporations (1897)Influence

• Managerialism: Berle & Means (1932)

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Aggregate theory

Company formed by voluntary private contracting• Basis: contract theory

German variant: Rudolf von Ihering (interest theory)U.S. variant: Victor Morawetz: Private corporations (1886),

Charles Beach: The Law of Private Corporations (1891)

Aggregate theory

Influence• Shareholder primacy: Michael J. Jensen & William H.

Meckling: Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics, 305–360 (1976); Hansmann & Kraakman (2001)

• Director primacy: Margaret Blair & Lynn Stout: A team production theory of corporate law. Virginia Law Review, 247–328 (1999)

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Company law regulation

contract law• corporate agreement, by-laws, articles of association etc.

specific company legislation• legal personality• limitations of stakeholder responsibilities

joint and self-regulation• corporate governance codes

public supervision• general: eg Companies House, Finnish Board of Patents

and Registration• securities markets: eg. SEC, FSA

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Comparative approach

Three legal families• Anglo-American• Continental European (French-Germanic)• Scandinavian

Harmonization of EU company law

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Comparative approach

Different views on the scope of company lawRelation to other branches of law

• contract law• securities law• labour law• environmental law• tax law• administrative law• basic and human rights• four freedoms in the EC Treaty

Different kinds of corporate forms

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Comparative approach

Typical corporate forms• partnerships• limited partnerships• company limited by shares

• private (ltd, GmbH, SARL, SAS, ApS)• public (plc, AG, SA, AS)

• cooperatives• non-profit organizations

• civil law “foundations”• cf. trust and its European counterparts• charitable companies

• “associations”

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European harmonization

Changes in British company law• Convergence to Continental company law

”Americanization” of EU company law during the last decade

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French-German system

Civil law• Emphasis on the legislator and jurisprudence• Inefficient role of courts as rule makers

Debt finance

Emphasis on creditor protection

Weak shareholder rights against directors

Strong dividend rights (substitution hypothesis: weak shareholder protection is compensated by dividends)

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French-German system

Example: German Aktiengesellschaft (AG)• Two-tier system

• Vorstand (”board”)• Aufsichtsrat (”supervisory board”)

• Strong creditor protection• Hausbank system

• Growing importance of securities markets• Kodex

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Scandinavian system

French-German basisLegal realismCourts as law-makersStronger role of equity financing than in French-German

system but weaker than in Anglo-American worldModern legislation

• Norway 1997• Sweden 2005• Finland 2006• Denmark 2009

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Scandinavian system

Points to be remember• Multiple voting rights

• Cf. Germany

• Equal treatment of shareholders• Cf. Anglo-American law

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Anglo-American system

Statutory law like in Continental and Scandinavian countries

Common law: courts as law-makers

Codification of case law in statutory law

Equity financing

Strong role for securities markets

Strong investor protection• Strong shareholder rights against directors

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Anglo-American system

UK: 2006 Companies Act• SME approach• Enlightened value maximization

US• State legislation• Fiduciary duties and business judgment rule• Corporate law competition: Delaware

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”Americanization” of European law

Recent trends in EU company law

National law: the new 2006 Finnish Companies Act• ”Revlon duties”: directors’ duties in takeovers• Business judgment rule in duty of care

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EU company law

4 Regulations• European Economic Interest Groupings (EEIG,

1985)• European Companies (SE, 2001)• IAS/IFRS Standards (IAS Regulation, 2002)• European Cooperative Societies (SCE 2003)

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EU company law

13 Directives“Old” directives

• Disclosure (1st Dir., 1968)• Capital (2nd Dir., 1977)• Merger (3rd Dir., 1977)• Annual Accounts (4th Dir., 1978)• Division (6th Dir., 1982)• Consolidated Accounts (7th Dir., 1983)• Auditors (8th Dir., 1984)• Branches (11th Dir., 1989)• Single-Member Companies (12th. Dir., 1989)

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EU company law

“New” directives US impact• Takeovers (13th Dir., 2003)• Transparency (2004)• Cross-border mergers (10th Dir. 2005)• Auditing (new 8th Dir, 2007)• Shareholders’ rights (2007)

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European corporate forms

European economic interest grouping (EEIG)• primarily a cross-border• partnership or ‘joint venture’• depending on the applicable law – eg. Finnish law: rules of a

partnershipEuropean public company (SE)

• cross-border public company limited by shares• Finnish law: rules of a plc

European cooperative society (SCE)• cross-border cooperative society• Eg Finnish law: rules of a cooperative society

European private company (SPE)

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General features of limited liability law

a limited liability company a very young phenomenonclassical company laws 1855-1900

• Britain 1855• France 1867• Germany 1871-91• Sweden and Finland 1895• U.S. States (New York, New Jersey, Delaware) end of the

19th Centurya recognizable company form in all industrialized countries

by 1900

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Main features

full legal personality

limited liability

recidual rights

separation of control and ownership

free transfer of shares

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Legal personality

Enables • separation of corporate assets and corporate creditors

from shareholders’ assets and liabilities (asset partitioning)

• Protection of corporate assets from shareholders’ creditors (entity shielding)

See Henry Hansmann & Reinier Kraakman & Richard Squire: Law and the Rise of the Firm, Harvard Law Review), 1333-1403 (2006)

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Legal personality

Three elements• Protection of creditors from shareholders• Protection of company from shareholders’ creditors• Protection of corporate creditors from shareholders’

creditors

Weak forms• Partnership

Strong forms • Limited liability company

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Legal personality

State intervention necessary to achieve protection of corporate assets from shareholders’ creditors

Transaction costs!• Negotiations between every shareholders and

every creditor• Moral hazard!• Free transfer of shares

• Asymmetric information

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Pros

Reduction of potential creditor information costsreduction of creditor monitoring costsreduction of management agency costsreduction of administrative costs of bankruptcyReduction of amount of inefficient bankruptcies

• Protection of going concern value

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Pros

Enables capital accumulation and investment diversification

Increases transfer of shares• Cf partnership• Shareholder’s creditor

• Right to corporate assets• Right to share

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Cons

Debtor opportunism and moral hazard• Risk premium• Shareholders’ creditors!

Enforcement costsA sophisticated bankruptcy system

• Weak legal personality

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Cons

Illiquid investments• Dispersed ownership• Free transfer of shares!

Exploitation by controlling persons• Opportunistic behaviour of controlling

shareholders and directors• Problem of private benefits

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Private benefits

Pecuniary private benefits v non-pecuniary private benefits• See Ronald J. Gilson: Controlling Shareholders and

Corporate Governance: Complicating the Comparative Taxonomy, Harvard Law Review, 1641-1679 (2006)

Pecuniary benefits: ”stealing” (eg tunnelling)Non-pecuniary benefits: do not reduce corporate value

• Political influence• Societal status

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Legal tools

Fiduciary duties: directors and controlling shareholders

Equal treatment

Derivative suits

Market for corporate control

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Limited liability

Owner shielding• Shareholders protected from corporate

creditors• Not very important• Cf. partnership• Not necessary for free transfer of shares

Directors’ competence: agency

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Limited liability

Not problematic for creditors• Contractual protection – eg control covenants• Risk premium

Weak creditors and non-contractual creditors• Free-riding

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Other

Recídual rights• Against opportunistic partial liquidation before

total liquidation

Separation ownership and control• Agency problem

Free transfer of shares• Legal personality

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Main features – exceptions

recidual rights belong to the shareholders v. charitable companies

full legal personality v lifting the corporate veil• moral hazard

free transfer – exceptions for private companies

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Main features – exceptions

Separation of control and ownership: lots of variations• shareholders meeting v board of directors• board of directors v general manager• board of directors v supervisory board

one tier – two tier – one and a half tier – two and a half tier systems

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Historical developments

Four basic models• manager-oriented• labour-oriented• state-oriented• shareholder-oriented

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Manager-oriented model

United States ca 1930-1970power vested with independent professional managementbest possibilities to govern the company for the benefit of

the society• cf. corporate social responsibility

if no control – danger of opportunistic behavior• principal agency problem

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Labour-oriented model

the most important stakeholder: the employees (=trade unions)

Germany after WWII• Mitwirkungsrecht• in AG supervisory boards (Aufsichtsrat)

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Labour-oriented model

EU• proposal for the 5th directive 1983• British resistance• see however directives attached to the SE and

SCE Regulations and cross-border directives on employee participation

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State-oriented model

direct government intervention on firms’ governance

control vested with the state bureaucracy instead of owners or management

France and Japan after WWII

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State-oriented model

Tools• direct state ownership• regulation of foreign investments• licence systems and other restrictions for

competition• criminal and adminstrative law sanctions (cf.

private law sanctions)

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Shareholder oriented model

In the United States, from the 1960s

Other parts of the world, from the 1980s and 1990s

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Why dominant?

US dominance in the global marketsweakening of German and Japanese economicscritique against state ownershipfinancial reporting by quarters instead of fiscal yearscritique against public regulation from the 1980s

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Shareholder primacy

Main idea shareholder primacy: the shareholders have a special role among the corporate stakeholders

emphasis on contracting and self-regulation

theoretical basis: principal agent theory

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Theoretical basis

Theory of the firm (Akerlof, Fama, Jensen, Meckling)

Agency theory

• Principal-agent theory: problem of asymmetric information

• Incomplete contracting theory: problem of transaction costs

Origins in large profit-making firms

• How to govern the relationships between management and shareholders?

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Principal agency theory

Main features• Agency• Asymmetric information• Incomplete contracting• Moral hazard (”opportunism”)

Legal tools• Fiduciary duties• Transparency

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Principal agent theory in a company

A firm is nexus of contractual input and output relations between the firm’s stakeholders

From this point of view, a firm does not have ”owners” in the traditional sense

Shareholders input only one among other contractual parties, eg creditors

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Special role of shareholders

Shareholders carry the residual risk on the firmThe most vulnerable stakeholder group for

management opportunismThe most vulnerable of all: the minority

shareholders• Management opportunism• Controlling shareholder opportunism

How to prevent opportunism?

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Principal agent relationship

The board of directors: agents of shareholders monitoring the management

The board must be seen as the agent for all shareholders and shareholders only

Directors’s duties to and only to shareholders• Fiduciary duties: duty of care and duty of

loyalty

Company interest = Shareholder interest

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Division of control rights

In a company with no controlling shareholders: the directors ”own” the company by controlling it without hearing the investors• “director primacy”

New interest conflict between the directors and the shareholders: the directors have the control but not a residual risk no incentives to maximize the residual

Other two interest conflict relationships• Controlling sharreholders v the minority shareholders• Shareholders v creditors

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Corporate governance

How to solve the interest conflicts between shareholders v directors and controlling shareholders v minority shareholders

How the shareholders ensure that the directors serve shareholders’ without opportunism?

How the minority can trust the controlling shareholders?

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Corporate governance

Problems to be solved• Information asymmetry: Efficient monitoring?• Transparency

Tools• Legal rules• Self-regulation• Shareholders’ decisions• Information duties

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Main question: How to monitor?

The essential role of intermediaries• Auditors• Analysts• Rating agencies

Duty to verify agent information on behalf of principals

Moral hazard• Enron• Financial crisis

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Importance of information

Transparency rules

Balances information asymmetry between principals and agents

Enables efficient markets for corporate governance

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Creditor protection

Primarily an insolvency law not company law problem

Continental and Nordic company law: main focus in company law – efficient?

Change of focus in company law reforms:• Creditor protection shareholder protection

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Capital maintenance rules

Distribution rules• Balance sheet tests• Solvency tests

Minimum capital rules

Maintenance of going concern value• Prevents partial liquidations nad so moral hazard

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Protection of other stakeholders

Distribution rules

Lifting the corporate veil

Labour law

Environmental law

Insolvency law

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Example: Finland

1978 Companies Act: State-oriented model

State-controlled firms

Licencing systems

Restrictions to foreign ownership

Employee representation: labour law

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Example: Finland

2006 Companies Act: Shareholder primacy

Investor protection

Freedom of contract

Creditor protection

Ex post protection of shareholders

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Critique towards shareholder primacy

Director primacy

Stakeholder primacy

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Director primacy

The company is a a nexus of firm-specific investments• complex productive activity involving many parties

where the resulting output is generally neither separable nor individually attributable to original contributors = “team production”

Purpose of the company• maximize total corporate returns• satisfy group-specific stakeholder returns so that

commitment to team production is sustained

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Director primacy

The board mediates the competing interests of different team members• The company itself the principal• Duty of the board to maximize the sum of all risk-

adjusted returns enjoyed by the team members• Directors’ fiduciary duties towards all risk-bearing

stakeholders: business judgment rule

Problems?

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Stakeholder primacy

The board and the management balance the needs of all corporate constituents = stakeholder community

“Communitarianism”

Stakeholders’ representation rights

Problems?

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Corporate social responsibility

Sustainable development• Economic responsibilities• Environmental responsibilities• Social responsibilities

Test of theories• Shareholder primacy• Director primacy

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Corporate social responsibility

Shareholder primacy• ”Enlightened” value maximization: Long-term interest of the

shareholders• Specific corporate law duties towards stakeholders,

communities, environment?Director primacy

• The board mediating the conflicting interests of team members

Communitarianism• Public interest

Example: Human right risks

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Human right risks

Examples• Legal risk from human right violations• Risks from tarnishing brands and reputation• Operational risk from weakening competitiveness

Can shareholder primacy solve these problems?

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Example of European company law: Finland

General aspects of Finnish corporate law• National commercial corporate forms

• Partnership• Limited partnership• Co-operative society• Private company• Public company

• European corporate forms• European economic interest grouping (EEIG)• European company (SE)• European co-operative society (SCE)• Not very popular in Finland, you may say …

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Background

General aspects• No limited liability parnership

(”Kommanditaktiengesellschaft”) – problem for private equity/venture capital

• Basically same rules for both private and public companies• No ”GmbH”/”SARL”/”SAS” corporation forms• All companies governed by the Finnish Companies Act of

2006 (FCA)

• Tax rules create incentives to use private company for all kinds of business

• Problems for medical, law and accounting firms

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Background

History of Finnish corporate law• Partnerships and limited partnerships based on

medieval Continental practices• Partnership law codified in the Commercial Code of 1734• Limited partnership law codified in the Limited

Partnerships Decree of 1864• Now both codified in the Partnerships Act of 1988 (FPA)

• Co-operative law based on Swedish models• Especially Co-operatives Act of 1954• New Co-operatives Act of 2001 influenced by Companies

Act of 1978

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Background

History• First Companies Decree of 1864 based on French Code de

commerce of 1807• Concession principle

• Companies Act of 1895 based on Swedish, German and French law• Registration principle

• Companies Act of 1978 heavily based on Swedish Companies Act of 1975

• Based on Swedish Companies Act of 1944

• Implementation of EC Company Directives in 1997• Different solutions in Sweden and Finland: end of copying Swedish law

• Why?

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Finnish Company Law Theory

Based traditionally on German and Swedish doctrine• Fiction theory• Organic theory

Change in the paradigm in mid-1990s• Law and economics approach

• Theory of the firm

• Principal agency theory

• Shareholder value maximization

”Americanization” of Finnish corporate law academia

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Change in the markets

Great depression in the early 1990sBank crisis

• Diminishing influence of banks in Finnish listed companiesFinnish securities markets opened

• European Economic Area• Barriers to hinder foreign investments broken down• Reform of Finnish Securities Markets Act

From Hausbank system to Berle & Means companies• Dispersed international ownership in many major listed

companies

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Change in the Legal Structure

Member of the EEA in 1994

Member of the EU in 1995

Implementation of EC company law

Need for total evaluation of Finnish company law

Result: Companies Act of 2006

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Goals of the FCA

Adaptation in changes in int’l cross-border financial markets

Changes in the economic environment of Finnish firms: towards competitive markets

How to reach these goals? Totally new and competitive Companies Act: Race to the top

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Goals of the FCA

More possibilities for Finnish firms both domestically and internationally

Effective protection to minority shareholders and creditors

Suitable for SMEs

• Decrease of minimum share capital from 8,000 euros to 2,500 euros

Answers to challenges created by changes in legal environment

• Especially the IFRS

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How to reach the goals?

Less and lighter formalities

Principle-based approach

More emphasis on freedom of contract

On the other hand: idea of the Companies Act as a standard form contract• Comprehensive collection of non-mandatory default

rules• Theoretical background: firm as nexus of contracts

(Jensen & Meckling)

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How to reach the goals?

Change in the ideology of minority and creditor protection• From ex ante approach to ex post approach• From invalidity to damages

Modernization of legal language

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Changes in practice

However, not a revolution but more fine-tuningRevising bad written law

• Division rulesCodifying best practices

• Fast and easy incorporationNew possibilities, e.g., for M&As

• Triangular mergers• Change of corporate form

• Company partnership• Company limited partnership• Company co-operative

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Principle-based approach

Difficult principal agency problems solved used by principles• Discretion of shareholders (FCA 1:9): freedom

of contract• Purpose of the company (FCA 1:5):

shareholder value• Equal treatment of shareholders (FCA 1:7)• Fiduciary duties (FCA 1:5)

Interpretation: Towards U.S. law

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Discretion of shareholders

Right to deviate the default rules by using articles of association• Not the mandatory creditor protection rules

Unanimous shareholders can• deviate non-mandatory law and articles of

association• act in writing instead of holding general

meetings

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Shareholder value

Idea of ”enlightened” shareholder value maximization• Michael Jensen• Cf. The UK Companies Act of 2006

Exception when the company is on sale: Revlon duties

Problem: How to implement corporate social responsibility?

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Fiduciary duties

Duty of care

Duty of loyalty

Business judgment rule

Clearest sign of direct U.S. influence in the FCA

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Minority protection

Equal treatment of all shareholders

Right for derivative suit for all shareholder when the principle is grossly violated

In other cases: 10 % minority

No right for indirect loss (no incentive for opportunism)

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Minority protection

On the other hand: possibility to restrict the right of the company to damages from directors, the CEO, shareholders and auditors by a provision in the articles of association (FCA 22:9)

Strict limitations for the provision• Adaptation of the provision requires shareholders’

unanimity• Does not cover violations of mandatory rules of the FCA

(creditor protection rules)• Does not cover losses caused deliberately or through

gross negligence

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Changes in finance and distributions

Default rule: shares without par value (FCA 3:5)• Par value can be introduced by articles of

association: freedom of contract

Solvency test in distributions (FCA 13:2)• Balance sheet test (FCA 13:5) required by the

Capital Directive

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Corporate governance

One tier system as a general rule• Negative attitudes towards supervisory boards• Too negative? Alternative for board committees

American way in nominating board member candidates for the general meeting• Nomination committee of the board

However, important exceptions use the Swedish model• Nominated by the controlling shareholders• E.g., the State-controlled listed companies

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Is the new law a success?

Who knows – but yearly incorporations have been increased by 60 % after the new law was introduced

83 % of the new companies without par value

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Challenges

Still need for more flexibility for SMES• Problems from one law fits for all ideology still exists

How to interpret • the duty of loyalty?• the business judgment rule?• the solvency test?

Special problems in takeovers• What kinds of poison pills are applicable?• Interpretation of fiduciary duties of the directors of the

target company• Helsinki Takeover Code

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Challenges

No clear doctrine on• piercing the corporate veil• fiduciary duties of the controlling shareholders

No case law yet

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Challenges

But the most important one• No clear picture of the future of EU company

law• Reform of capital maintenance rules?• One share one vote principle?• New European corporation forms?• Total right for transfer of seat?

• Cartesio pending in the ECJ

• Race to the top or race to the bottom?

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Corporate governance in Finnish law: Comparison

Partnerships

Limited partnerships

Limited liability companies

Cooperatives

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Partnerships and limited partnerships

no statutory organization models in FPA

• the partners have a right to agree on the organization

each partner with unlimited liability, in that capacity, has a right and a duty to act

partners with unlimited liability have a veto-right

actions affecting the basis of collaboration

• unanimity (limited partners included)

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Limited liability companies

Separation of powers• General meeting• Management

• Board of directors• Managing directors (optional)• Supervisory board (optional)

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Limited liability companies

Board of directors• Mandatory• All corporate matters other than those vested

in the hands of the shareholders at a generalmeeting

• Fiduciary duties• Business judgment rule

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Limited liability companies

General meeting• Only matters specifically mentioned in the CA• Transfer of powers of the directors

• Articles of Association• Unanimous shareholders in casu

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Limited liability companies

Optional organs• Supervisory board

• if so stipulated in the Articles

• Managing director

Two- or three-tier management affects the division of powers between the organs responsible for the management

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Limited liability companies

Finnish corporate governance code 2008• Listed companies• Board committees

• Audit committee• Nomination committee• Remuneration committee

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Cooperatives

Approximately similar to a companyMeeting of the MembersThe by-laws may transfer the powers to a body

called the RepresentativesDefault rule: one member-one voteBoard of directorsManaging director (optional)Supervisory board (optional)