International Corporate Governance - · PDF fileInternational Corporate Governance 2009 |...

International Corporate Governance2 0 0 9 | D I G I T A L G U I D E

E X E C U T I V E V I E W M E D I A L I M I T E D

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A B O U T T H I S D I G I T A L G U I D E

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International Corporate Governance

2 0 0 9 | D I G I T A L G U I D E

Editor | Oliver HargreavesPublished in the United Kingdomby Executive View Media Limited

29th Floor, 1 Canada Square, Canary Wharf London, E14 5DY, United Kingdom

Tel: +44 (0) 207 712 1779

© 2009 Executive View Media LimitedISBN: 978-1-907420-01-6

© Contributors to this Digital Guide retain copyright of their works, herein published under licence.

The information provided in this publication represents the opinions of the authors and not necessarily their firms. Information should not be considered as legal or financial advice, which should always be sought

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C O N T R I B U T I N G F I R M S

A&L Goodbody

Allen & Gledhill LLP

Allen & Overy LLP

Amarchand & Mangaldas & Suresh A. Shroff & Co.

Baker & McKenzie LLP

Blank Rome LLP

Bowman Gilfillan

Broich Bezzengerger

Cameira Law

Castrén & Snellman Attorneys Ltd.

Cremades & Calvo-Sotelo

Deneys Reitz

DLA Phillips Fox

DLA Piper

Freehills

Goodmans

Hammarskiöld & Co.

Kubas Kos Gaertner

Montgomery McCracken Walker & Rhoads

Nixon Peabody LLP

Norton Rose

Oppenhoff & Partner

Orrick

Patton Boggs LLP

Vieira de Almeida

Contents | www.executiveview.com

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1 | A M E R I C A S

United States ___________________________________________________________________________ 6

Modifying Executive Compensation: the Tax Woes of Bonus Clawbacks __________________________6

Voluntarily Disclosing Corruption Problems in the United States: Unclear Consequences Signal Caution __ 8

Integrating Corporate Governance with Company Risk Management – a Practical Approach __________ 11

Responsibilities of Directors and Officers When a Corporation Becomes Insolvent _________________ 14

New Era of Mandatory Disclosures Will Significantly Impact Those Who Do Business with the Federal

Government _______________________________________________________________ 16

US Corporate Governance Tug-of-War: Guidance for Directors Designated by Private Equity and Venture

Capital Funds ______________________________________________________________20

Canada _______________________________________________________________________________ 24

Beyond the Boy Scout Image: New Rules for Investing in Canada _____________________________24

Acquiror-Side Shareholder Approval Arrives in Canada ___________________________________ 27

Raising Capital in Canada and the Role of the Toronto Stock Exchange _________________________30

2 | E U R O P E

United Kingdom _______________________________________________________________________ 35

Audit Committee Risks and Responsibilities ___________________________________________ 35

Bribery Reform in the UK: Where to Now? ____________________________________________38

Italy __________________________________________________________________________________ 41

Independent Directors of a Listed Company in Italy ______________________________________ 41

Spain ________________________________________________________________________________ 44

Minority Shareholders’ Rights in Spanish Listed Companies and in the Conthe Code ________________44

Sweden ______________________________________________________________________________ 47

Golden Parachute Entitles Managing Director to 24 Monthly Payments _________________________ 47

Time to Ban Competitors Within the Executive Board _____________________________________49

Management Demanded £71m From the Banks to Stay With Insolvent Portfolio Company ____________50


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Ireland _______________________________________________________________________________ 53

New Rights for Shareholders in EU Listed Companies – the Shareholders’ Rights (Directive 2007/36/EC)

Regulations 2009 ___________________________________________________________ 53

The Nominee Director – his Duties to the Company and to his Appointor and Whether They can be

Modified by Agreement _______________________________________________________ 57

The Office of the Director of Corporate Enforcement in Ireland – an Overview ____________________ 61

Finland _______________________________________________________________________________ 65

Liabilities and Challenges of a Company’s Management in the Financial Crisis ____________________65

Opinion on the Regime of Management Remuneration Policies in Finland _______________________68

New Code on Corporate Governance for Listed Companies _________________________________ 71

Germany _____________________________________________________________________________ 75

The New German Voting Rights Disclosure Rules ________________________________________ 75

Corporate Governance of a German Stock Corporation ____________________________________ 77

Corporate Governance of a German GmbH ____________________________________________80

Organising Groups of Companies in Germany __________________________________________84

New Rules for the Remuneration of Board Members in Germany _____________________________88

Portugal ______________________________________________________________________________ 92

Corporate Governance in Portuguese Companies During M&A _______________________________92

Current Trends in Portuguese Corporate Governance _____________________________________94

Corporate Governance in Portugal: What Lies Ahead? _____________________________________ 97

Poland ______________________________________________________________________________ 100

The Latest Changes in Polish Company Law __________________________________________ 100

3 | A S I A P A C I F I C

Australia _____________________________________________________________________________ 103

Role of the Audit Committee _____________________________________________________ 103

Creating a Governance Framework Across Multiple Jurisdictions ____________________________ 108

Corporate Governance in M&A ___________________________________________________ 112

International Corporate Governance – Major Decision on Non-Executive Directors in Australia and

Their Duties of Care ________________________________________________________ 114


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New Zealand _________________________________________________________________________ 118

Corporate Governance in New Zealand ______________________________________________ 118

India ________________________________________________________________________________ 121

Companies Bill 2009: Future of Corporate Governance in India _____________________________ 121

Insider Trading and Corporate Governance ___________________________________________ 125

Re-thinking the Audit Process Post-Satyam: From Rhetoric to Practice ________________________ 130

International Dimensions of Corporate Governance _____________________________________ 133

Singapore ___________________________________________________________________________ 137

Audit Committees in Singapore ___________________________________________________ 137

Rights and Remedies of Minority Shareholders in Singapore _______________________________ 140

The Role of Directors of a Target Company in a Public Take-over in Singapore ___________________ 144

Securities Regulatory Reform: Directors and Substantial Shareholders Disclosure Obligations of a

Listed Corporation _________________________________________________________ 148

4 | A F R I C A

South Africa __________________________________________________________________________ 153

South Africa’s New Companies Act _________________________________________________ 153

An Act Fit for the King? ________________________________________________________ 157


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1A M E R I C A S

United States | www.executiveview.com

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Modifying Executive Compensation: the Tax Woes of Bonus Clawbacks

BY HENRY MORGENBESSER | ALLEN & OVERY LLP

Media coverage of Ponzi schemes, excessive or improper bonuses, bankruptcies, TARP bailouts, and a

multitude of illegal, imprudent or unreasonable actions taken by organisations and individuals within the

financial services industry has dominated recent international business news. It is no wonder that a middle

income American, struggling to stay employed and financially afloat, is outraged by the compensation paid

to those wizards of Wall Street viewed by the public as responsible for the global economic downturn that

is directly affecting their day-to-day existence. The public’s anger over compensation that cannot readily

be justified based upon performance metrics has been mirrored in the US Congress, where bills related to

executive compensation have been introduced at lightning speed. The current spate of legislative initiatives

go far beyond ‘say on pay’, limiting the types, amount and timing of payment of compensation payable by

the bailed out institutions. Given that the US now has a vested shareholder interest in the very financial

institutions it is attempting to regulate, it is no wonder that Congress intends to micromanage how its

bailout money is spent on employee remuneration.

Unfortunately, bad facts tend to make bad law, and there have been more bad facts in the past 6-9

months than one would rationally envision to occur for such a short period. No company has arguably

faced more outrage, including from its newly appointed CEO, Ed Liddy, than American International Group

(AIG), where bonuses allegedly in the amount of $165 million were paid, with more bonus money slated to

be paid in 2009, in spite of the fact that its financial products division incurred huge losses which, but for

the Federal bailout, might well have resulted in a bankruptcy filing. Nevertheless, Mr. Liddy testified that

such payments had to be made by AIG because they were contractually mandated. Congress responded by

hastily introducing a bill in the US House of Representatives that would tax these payments at a whopping

90 percent income tax rate, in addition to any applicable state or local income tax. That bill was passed

by more than a 3-1 vote. The constitutionality of this punitive and retroactive tax, if enacted, has been

questioned by the legal community, where many believe that it would amount to an impermissible ‘bill of

attainder’ under Article I, § 9 of the US Constitution or an unlawful taking of property under the Takings

Clause of the Fifth Amendment thereof. This House-initiated bill appears to have stalled in the US Senate,

where its passage remains uncertain.

Putting aside issues as to the reasonableness of existing compensation practices that have evolved in the

past 20-25 years and the constitutionality of the so-called ‘AIG tax’, there are several tax technical reasons

why employees who have been asked, encouraged or told that their bonuses or other compensation already

paid or due to be paid in 2009 or later years will be clawed back or deferred should not voluntarily cede to

U N I T E D S T A T E S

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public pressure, without further assurance from the government that the tax consequences of doing so will

be neutral. The two principal issues discussed below are: (i) concerns that an already made bonus or other

compensation payment cannot be undone from an income tax perspective; and (ii) the application of Section

409A of the US Internal Revenue Code (‘Code’), a nightmarish section added to Code in 2004 which requires

‘deferred compensation’ to comply with Section 409A and with several hundred pages of confusing regulatory

guidance.

Executives who have already received bonuses in early 2009 are already in actual receipt of their bonus

amounts and have had unfettered use of the funds received. Absent a mistake of fact where it can be demonstrated

that the individual had no legal right to the payment, there is no readily apparent basis in the Code to avoid

taxation in 2009 on any such amounts already paid. It has been reported that some AIG executives have

returned their bonuses, while others have committed to donating their after-tax bonus payments to charity

(which, if the 90 percent tax were to be enacted, may be miniscule). Anyone who has ‘voluntarily’ returned

their bonus runs the risk of being taxed on the bonus amount already received without the ability to pay the tax

because the funds were returned to their employer. While the employer could then elect to repay the bonus to

any affected individual to cover their respective tax obligations, there is no certainty in the current economic

and political climate that a bailed out financial institution will have the financial wherewithal or government

permission to do so. Thus, in the absence of a backstop to cover one’s potential taxes, it would be economically

foolish, perhaps suicidal, for an affected individual to go out on a limb and risk the adverse tax result. In fact,

it is even possible that an employer’s repayment of the bonus to pay the tax bill on the original bonus payment

could itself be viewed as a separate income taxable payment event, thus triggering a new set of income taxes

on top of the taxes owed when the bonus payment was originally made.

A related concern is the interplay of Section 409A with TARP and similar statutory bailout initiatives in

the UK and other foreign jurisdictions. Section 409A has elaborate rules on how compensation earned in one

year and paid in a later year (including certain bonuses, equity awards, retirement pay and even severance

payments) is be taxed, including when initial deferral elections must be made, enumerated events when

payments may be accelerated and prescribed methods by which subsequent deferrals may be elected. Failure

to adhere to Section 409A will result in a 20 percent penalty tax on the employee based upon the amount

involved plus interest, in addition to accelerated recognition of income taxation and possible state penalty

tax (e.g., California has a similar 20 percent tax). Under the TARP-related legislation and similar foreign

law, otherwise contractually-mandated compensation scheduled for payment in 2009 are being deferred or

restructured. Section 409A and its regulations offer no clear exception for these particular circumstances.

A failure to make a compensation payment in 2009 pursuant to its original scheduled payment date could

subject the employee to the Section 409A penalty tax and income recognition notwithstanding the deferred

payment to a later year.

Regardless of the reason inspiring employees to repay or accept a deferral of their compensation, some

employees are being advised by their tax / executive compensation lawyers to withhold their consent to any

change in their contractually obligated compensation without advance assurance either from the Federal

government that no adverse tax consequences will flow from the modification of the payment or from their

employer that they will indemnify them to the fullest extent permitted by law for any resulting adverse tax

consequences. Congress can streamline the process for those directly affected by the ever-evolving political


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agenda by quickly legislating away any unintended adverse tax consequences, but it will need to act with a

broad view of how its well-intentioned policy in one area can inadvertently impact individuals and companies

who agree, by choice or necessity, to play by the new rules.

Henry Morgenbesser is a Partner at Allen & Overy LLP.

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Voluntarily Disclosing Corruption Problems in the United States: Unclear Consequences Signal Caution

BY RICHARD DEAN | BAKER & MCKENZIE LLP

When a company which operates in the United States, or is otherwise connected to the United States because

its shares are traded on a US stock exchange, learns that one of its employees has paid or authorised bribes

to government officials somewhere in the world in order to secure business for the company, it is faced with

an extremely difficult and complex decision regarding how it will orient itself towards the US authorities, in

particular the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC). The DOJ is

responsible for enforcing the criminal anti-bribery part of the Foreign Corrupt Practices Act (FCPA) and the

SEC’s jurisdiction extends to the accounting provisions of the FCPA. The latter require that companies whose

shares are traded on US stock exchanges maintain accurate and complete books and records and proper internal

controls to ensure, in essence, that the use of company assets is properly monitored and that accurate financial

reporting can be accomplished.

In the circumstances described above, both the DOJ and the SEC would encourage the company to make

voluntary disclosure to them of the potentially improper conduct. The incentives for the company to make such

disclosure include the prospect of more lenient treatment and the opportunity to conduct its own investigation,

albeit under the oversight of the US government, without suffering an intrusive, time-consuming, costly and

often aggressive investigation pursued directly by the DOJ and the SEC.

Corporate laws generally require that a company, which becomes aware of potential wrongdoing by its

employees or agents, promptly and effectively investigate the facts to determine the nature and extent of any

misconduct. Once such investigation is complete, proper steps should be taken to remediate the misconduct.

Such steps may include disciplinary action against employees, improved internal controls, enhanced compliance

measures and FCPA training.

However, whether to make voluntary disclosure to the DOJ and the SEC and thereby subject the company

to an investigation at best overseen, or at worst conducted, by the US government involves a complex set of

factors.

Of course, there may be reasons why disclosure is required under US securities laws applicable to companies,

both US and non-US, whose shares are traded on US stock exchanges. Whether disclosure is required depends

on whether the potential misconduct, the business affected by or related to it, and the other circumstances of the

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misconduct rise to the level of “materiality”, which has both objective and subjective components. For example,

misconduct that affects a substantial portion of a company’s business or may result in millions of dollars of fines

and penalties may qualify as material under objective standards because of its potential impact on the company’s

financial statements.

On the subjective side, bribes involving less business and less potential liability may still qualify as material

events if they were approved by a member of senior management or if such conduct is pervasive throughout

the company’s operations in other emerging markets. These factors affect the materiality judgment subjectively

because they are relevant to investor confidence in management’s integrity and its effective oversight of the global

business.

It is also possible that the company may have contracts with the US government that require disclosure of

potential misconduct or that the company has ongoing obligations to the DOJ or the SEC related to previous

misconduct, which could separately trigger disclosure obligations.

In addition, requirements under the US Sarbanes-Oxley Act, pursuant to which senior executives must certify

the accuracy of financial statements and the quality of a company’s financial disclosure controls have led to a large

number of disclosures of conduct constituting potential FCPA violations as exceptions to those certifications.

In a certain sense these are voluntary disclosures, but since such exceptions are publicly reported to the SEC,

exceptions which relate to possible FCPA violations should simultaneously be disclosed to the DOJ and to the

Enforcement Division of the SEC.

Judgments about Sarbanes-Oxley issues often involve both legal counsel and the company’s auditors, and

the latter are particularly influential in determining whether exceptions may be required to Sarbanes-Oxley

certifications.

In this category of quasi-voluntary disclosures also fall disclosures made because the company believes that the

DOJ or the SEC will likely find out about the potential violation so it is best to make disclosure. Such circumstances

include imminent media reports; the likelihood of a whistleblower; or a court proceeding or regulatory inquiry in

another country, to name a few.

With this background, we turn to the question of the pros and cons of voluntary disclosure. Even if one

concludes that the background provided above suggests that there really are few truly “voluntary” disclosures, the

factors now discussed will be relevant to the “close” cases where debate exists over whether disclosure is required

or appropriate.

The SEC has for some time, and the DOJ more recently, demonstrated leniency for companies that make

voluntary disclosure and cooperate fully by reporting to the government the process and results of their

investigations into potential FCPA violations. Such leniency may include not charging the company or, if charges

are levied, seeking lower fines and penalties. It is clearly US government policy to encourage such disclosures

because they provide substantial assistance to regulators in enforcing the FCPA.

However, it is important to keep in mind that, unless required to disclose in the circumstances described

above, companies which identify potential FCPA violations have no obligation to make disclosure. It may be

perfectly appropriate for a company to investigate the matter thoroughly and then implement effective remedial

measures without ever facing the DOJ or the SEC. Indeed, enthusiasm for voluntary disclosure, as stoked by the

US government, should be tempered by careful consideration of the disadvantages, which can be summarised

as follows:


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First, the company will endure a lengthy process to reach final resolution of the case, the timing of which will

be dictated mostly by the US government. This process can take years.

Second, government involvement may broaden the scope of the investigation to address other areas of the

company’s business or to reach back further in time to examine additional conduct. At a minimum, the government

will require the production of substantial amounts of documents and other evidence. The result will be substantial

additional cost.

Three, the company’s compliance program will be reviewed from the policy level to its practical, day-to-day

implementation. This scrutiny will at a minimum be time consuming and costly and may become the basis for

additional charges depending on the government’s evaluation of the company’s “compliance culture”.

Fourth, there is a possibility that the US government may not accept the results of the company’s investigation

and conduct its own investigation, particularly since the DOJ now has the support of a dedicated FBI staff and is

beginning to use more traditional law enforcement techniques in FCPA cases.

Fifth, even companies that make voluntary disclosure and fully cooperate may face aggressive law enforcement

techniques if the US government decides to conduct its own investigation, particularly if the government has

access to evidence that the company cannot obtain.

Sixth, the DOJ and the SEC conduct parallel investigations. Although they cooperate, it is not unusual for a

company to be faced with overlapping, uncoordinated document requests and competing deadlines.

Finally, once the case becomes public either through the company’s periodic public filings or if the government

charges the company, the company may face additional scrutiny by law enforcement agencies in other countries

(typically the jurisdictions in which the improper payments were made) and private lawsuits by shareholders or

competitors claiming damages arising from the improper payments.

At a minimum, if at all possible, a company uncovering a potential FCPA violation should evaluate the facts

and circumstances carefully in an attempt to understand the nature and scope of the potential wrongdoing before

deciding that voluntary disclosure is the best way to handle the problem. Unfortunately, despite encouragement

from the US government, there are significant disadvantages which should be carefully reviewed in light of the

facts and circumstances of the potential FCPA violation, the likelihood of detection, the state of the company’s

compliance culture and the company’s orientation toward the US authorities.

This article first appeared in the June 2009 issue of Financier Worldwide Magazine www.financierworldwide.com

Richard Dean is a Partner at Baker & McKenzie LLP.


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Integrating Corporate Governance with Company Risk Management – a Practical Approach

BY JANE STORERO AND YELENA BARYCHEV | BLANK ROME LLP

The subprime crisis and economic downturn experienced during 2008, which led to unprecedented federal

legislation and a government bailout of key players in the financial services industry, focused the public’s attention

on the relationship between risk taking and commonly utilised compensation practices. Once this line between

“risk” and “reward” was drawn, the importance of integrating the company’s risk management function with the

board’s traditional corporate governance practices became critical to effectively addressing and monitoring risk.

The necessity of integrating corporate governance practices with the company’s risk management function

is highlighted by the recent rule changes (See SEC Release No. 33-9052, Proxy Disclosure and Solicitation

Enhancements (July 10, 2009)) proposed by the US Securities and Exchange Commission (SEC) which created

a direct link between a public company’s corporate governance practices and its approach to risk management.

Amendments to rules proposed by the SEC on July 10, 2009 focus on the relationship between the public company’s

compensation practices and the level of risk-taking, as well as the relationship between director qualifications and

risk management skills. The proposed SEC rules also require disclosures related to the board of directors’ role in

the company’s risk management. It is anticipated that compliance with the final rules to be adopted by the SEC

will be required commencing with the 2010 proxy season. In light of these proposed rule changes, the board of a

public company will want to consider defining not only its role but the role of the various board committees with

respect to the company’s risk management.

Although in the process of preparing the final rules, the SEC may tweak some of the proposed rules, it is

anticipated that risk management concepts will remain the cornerstone of such rules. The SEC believes that

recent market downturn reinforced the need for additional disclosure to shed light on a public company’s risk

management profile. Through disclosure proposals discussed in this article, the SEC continues to attempt to dictate

the corporate governance practices of public companies. The SEC essentially suggests that the compensation and

nominating committees of the board of directors should play a more prominent role in shaping risk management

policies related to the company’s compensation and leadership structure.

The SEC proposed to add a new section to the Compensation Discussion and Analysis (CD&A), which large

public companies have to include in their disclosure documents, discussing how the company compensates and

incentivises its employees who may create risk. Generally, the purpose of the CD&A is to provide investors with

material information related to the company’s compensation policies and decisions regarding top management.

Although the proposed SEC disclosure has the usual materiality qualifier, and the new disclosure is required only

if the risks arising from the company’s compensation policies and practices may have a material effect on the

company, the scope of the proposed CD&A rules is much broader than the current one. Under the existing rules,

CD&A disclosure covers only named executive officers, which include the company’s chief executive officer, chief

financial officer and three most highly compensated executive officers other than the CEO and CFO. Proposed

CD&A disclosure focuses on the company’s overall compensation program as it relates to risk management for all

employees, including non-executive employees.

To provide some guidance to public companies on the application of the proposed rules, the SEC listed in


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its proposing release the following examples of compensation policies and practices that may require such

disclosure:

• policies at a business unit of the company that carries a significant portion of the company’s risk profile;

• policies at a business unit with compensation structured significantly differently than other units within the

company;

• policies at business units that are significantly more profitable than other units within the company;

• policies at business units where the compensation expense is a significant percentage of the unit’s revenues;

and

• policies that vary significantly from the overall risk and reward structure of the company (for example,

when bonuses are awarded upon accomplishment of a task, while income and risk to the company from the

task extend over a significantly longer period of time).

In addition, the SEC proposing release provided examples of the issues that the company may need to address

in the CD&A regarding the compensation policies or practices of business units or employees, which include the

following:

• the general design philosophy of the company’s compensation policies for employees whose behaviour

would be most affected by the incentives established by the policies, as such policies relate to or affect risk

taking by those employees on behalf of the company, and the manner of its implementation;

• the company’s risk assessment or incentive considerations, if any, in structuring its compensation policies

or in awarding and paying compensation;

• how the company’s compensation policies relate to the realisation of risks resulting from the actions of

employees in both the short term and the long term, such as through policies requiring claw backs or

imposing holding periods;

• the company’s policies regarding adjustments to its compensation policies to address changes in its risk

profile;

• material adjustments the company has made to its compensation policies or practices as a result of changes

in its risk profile; and

• the extent to which the company monitors its compensation policies to determine whether its risk

management objectives are being met with respect to incentivising its employees.

The new CD&A disclosure is intended to identify whether the company has established a compensation system

leading to excessive risk taking by its employees, in particular, senior management. Under the proposed SEC

rules, a public company will have to assess its risk management structure and the level of risk that employees

might be encouraged to take to meet their incentive compensation elements. The SEC also emphasised that, to

the extent that such risk considerations constitute a material aspect of the company’s compensation policies or

practices for named executive officers, the company must discuss such considerations as part of its CD&A under

the current SEC rules.

CD&A is generally prepared by the company’s management and not the compensation committee of the board

of directors. However, the compensation committee has to disclose in its report that the committee reviewed and

discussed the CD&A and, based on such review and discussions, recommended to the board of directors that the


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company include the CD&A in its annual report on Form 10-K, proxy statement or information statement filed with

the SEC. Such recommendation presupposes the compensation committee’s approval of the CD&A. Therefore, in

light of the proposed rules related to the company’s risk management policies and corresponding compensation

practices, the compensation committee should be familiar with the company’s overall risk management structure.

In addition, the compensation committee’s decision-making process related to particular awards of equity or non-

equity compensation should involve an analysis of whether such awards would incentivise the level of risk taking

that is inconsistent with the company’s overall risk management policies. Depending on the company’s size and

type of business, it may have hired a risk management officer and/or established a risk management committee

to identify and monitor risks facing the company. In the course of reviewing the CD&A or making specific

compensation decisions, the compensation committee should consider inviting the company’s risk management

officer or a representative of the risk management committee to the compensation committee meeting where the

relationship between compensation and risk management is discussed in order to get a perspective and overall

understanding of the company’s current risk management policies and practices. By gaining a better understanding

of the company’s risk profile, and policies and practices in place to limit risk, the compensation committee will

be better equipped to design or redesign the company’s compensation policies to avoid rewarding excessive risk

taking by senior management.

In addition, the SEC proposed to expand the disclosure regarding the qualifications of directors and nominees

for director which, if adopted, will align the nominating committee’s procedures and policies with the company’s

risk management strategies. For example, the proposed amendments would require a discussion of the specific

experience, qualifications, attributes or skills that qualify a person to serve as the company’s director and

committee member or other information explaining why the person’s service would benefit the company. The

types of information that may be disclosed include information about a director’s or nominee’s risk assessment

skills, particular areas of expertise or other relevant qualifications. Under current SEC rules, disclosure is required

regarding the nominating committee’s process for identifying and evaluating director nominees as well as specific

qualities or skills that the nominating committee believes the company’s directors should possess. In light of the

SEC’s proposed rules, the nominating committee should review and revise such process, as necessary, as well as

the qualifications for directors to include the consideration of the director’s risk assessment skills. The SEC has

emphasised that the capacity to assess risk and respond to various challenges that a public company may face

becomes an important qualification for public company directors.

Under the proposed SEC rules, a public company would be required to disclose the extent of the board’s role

in the company’s risk management process and the effect that this board involvement has on the company’s

leadership structure in order to provide investors with information about the board’s perception and management

of the company’s risks. The SEC suggested that such disclosure should address:

• whether the board implements its risk management function through the board, as a whole, or through a

committee (for example, an audit committee);

• whether the people who oversee risk management report directly to the board, as a whole, or to a board

committee; and

• how the board, or a board committee, monitors risk.

Risk management is likely to be a recurring topic on the agenda of the meetings of board committees, as well as


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the board, of public companies. The effective integration of the risk management function into the company’s

corporate governance practices will require preplanning and the education of committee members now charged

with addressing the various facets of the public company’s risk profile. In this regard, many companies will elect to

utilise the audit committee to monitor risk. In light of the proposed SEC rules described above, the compensation

and nominating committees will also need to be versed in the company’s risk management policies and how they

impact the oversight functions these committees are tasked with.

The risk management discussion at the compensation or nominating committee level outlined above should

lead to a board level discussion devoted to this topic and should include reports to the board from the appropriate

committees on this issue. Although the proposed SEC rules do not include changes that affect audit committee

procedures, the audit committee should also focus on the risk management strategies of the company and provide

its recommendations to the board with respect to the company’s risk management and the committee’s efforts

to monitor management’s attempts to limit risk. This role will likely require coordination between the audit

committee on the one hand, and nominating and compensation committees on the other hand. After reviewing

the committees’ recommendations, the board should discuss whether any policy or procedure changes should be

introduced into the company’s risk management, compensation or leadership structure.

Committees and board recommendations and decisions related to risk management should be reflected

in the minutes of each committee meeting and the board of directors meeting devoted to this topic. Careful

documentation of board and committee decisions regarding risk and related issues will be important given the

enhanced disclosure requirements proposed by the SEC.

Jane K. Storero is a Partner and Yelena Barychev is an Associate at Blank Rome LLP. The authors

acknowledge the valuable assistance of Katharine E. Berg, an associate at Blank Rome LLP, in

connection with this article.


Responsibilities of Directors and Officers When a Corporation Becomes Insolvent

BY NATALIE RAMSEY | MONTGOMERY MCCRACKEN WALKER & RHOADS

The duties and responsibilities of officers and directors are established by, and vary with, state law. This article

will discuss Delaware law, which often is cited as a leading jurisdiction in this area.

Under Delaware law, directors and officers of a solvent company owe fiduciary duties of care and loyalty to the

company’s owners.

The duty of care requires officers and directors to affirmatively protect the interests of the corporation, and to

refrain from engaging in conduct that would cause harm to the corporation. The duty of loyalty requires that the

best interests of the corporation and its shareholders take precedence over the personal interests of the officers

or directors. Put another way, directors and officers must act in a disinterested manner. Together, these duties





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require, among other things, that managers act prudently in making business decisions, implement appropriate

oversight mechanisms, and share all material information with the company’s owners when seeking approval of

a transaction.

With certain specified exceptions, Delaware law permits a corporation’s charter to explicitly provide that the

personal liability of a director for monetary damages for breach of the duty of care may be limited or eliminated

entirely. See 8 Del. C. § 102(b)(7). The corporate charter may not, however, abrogate liability for breaches of the

duty of loyalty.

Courts applying Delaware law utilise the business judgement rule to evaluate the performance of these fiduciary

duties. That is, generally courts will defer to the judgement of a company’s managers, and will not interfere with

those decisions – even if they appear to be unwise or cause loss to the company – so long as the decision was

made in good faith (among other things, not with subjective bad faith or an intentional dereliction of duty), with

reasonable awareness of all available material information, and after careful consideration of the alternatives.

However, if an officer or director acts in an interested manner, (e.g., if an officer or director has a personal

financial stake in a business transaction), the interested director may be required to prove the “entire fairness” of

the challenged transaction to the corporation. Under this standard, Delaware law requires that a court examine

both the procedural and the substantive aspects of the decision-making process, including the fairness of the

outcome and the adequacy of the disclosures. Burdens of proof under the entire fairness test may shift in certain

scenarios.

As long as a corporation is financially healthy, the rules and the application of the rules are well established. A

solvent company’s directors and officers owe no fiduciary duties to the company’s creditors. Rather, creditors are

protected by bargained for contractual rights (including lien rights) and other sources of creditors’ rights as may

be available under the statutory or common law (for example, a right to recover fraudulent conveyances).

The law regarding the duties of directors and officers when a corporation is insolvent (under either the balance

sheet test or the equity test), or in the “zone of insolvency”, had been uncertain, but recently has become more

clear.

In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (2007),

the Delaware Supreme Court ruled that when a corporation is operating in the zone of insolvency, or bordering

on insolvency, directors acting on behalf of a corporation must continue to discharge their fiduciary duties to the

corporation and its shareholders by exercising their business judgement in the best interests of the corporation for

the benefit of its shareholder owners. That is, the fiduciary duties do not shift and become owed to the corporation’s

creditors.

Notwithstanding this rule of law, because the creditors become the residual beneficiaries of the value of an

insolvent corporation, in replacement of the shareholders, the execution or implementation of management’s

duties in the zone of insolvency, as well as when the corporation has become insolvent in fact, may nevertheless

change. As “trustees” of corporate assets, the directors and officers must act to protect and preserve the value

of the enterprise. Thus, approval of a substantial dividend to the shareholders of an insolvent corporation may

subject the directors who approved that dividend to a challenge by creditors acting on behalf of the corporation

that the directors breached their fiduciary duties by so doing. While Delaware law does not recognise a direct

cause of action by creditors against a corporation, it does recognise a right by the creditors to sue derivatively on

behalf of the corporation for breaches of any fiduciary duties that diminish the value of the corporation.


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Accordingly, while there are no new or direct duties imposed on directors or officers of an entity that is insolvent

or bordering on insolvency under Delaware law, it is clear that once a corporation nears insolvency, management

must proceed with the objective of preserving and enhancing the entire corporate enterprise rather than acting for

the benefit of any single group. When faced with this situation, officers and directors should proceed with caution

to ensure that they fully understand the nuances of, and how best to comply with, their duties in this evolving area

of law.

Natalie Ramsey is a Partner at Montgomery McCracken Walker & Rhoads.


New Era of Mandatory Disclosures Will Significantly Impact Those Who Do Business with the Federal Government

BY COLIN O’SULLIVAN AND D. GRAYSON YEARGIN | NIXON PEABODY LLP

The global financial meltdown has led to a wave of federal government spending, resulting in billions of dollars

worth of new government contracts. At the same time, however, the government has made it clear that it is greatly

increasing its efforts to prevent and detect fraud involving its money. Now, the government is requiring those who

contract with it to shoulder part of this burden. As part of this federal vigilance, government contractors must

comply with new, complicated, and controversial mandatory disclosure and internal controls requirements. It is

critical that all companies doing business with the government determine how the new regulations affect them

and assess the effectiveness of their compliance programs.

I. Why Did The Government Change Existing Practice?

The new requirements are a departure from long-standing federal policies that simply encourage voluntary

disclosures. Voluntary disclosure programs exist in a variety of forms, including those incorporated into the

laws regulating antitrust, environmental issues, and the defense and healthcare industries. Companies that

disclose are generally rewarded with the possibility of lesser sanctions and the potential avoidance of criminal

prosecution.

The government recognized that the move to a mandatory disclosure program for government contractors

reflects a “sea change.” It insists, however, that such a “major departure” is warranted because the voluntary

programs simply do not work.

II. The Key Contours of the New Regulations

The regulations, effective December 12, 2008, can be found in amendments to existing Federal Acquisition

Regulations (FAR). The new requirements implement two key changes. First, they mandate disclosure by

government contractors of “credible evidence” of criminal violations, False Claims Act violations, and significant

overpayments. Second, they obligate certain contractors to adopt an enhanced internal control system.




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A. Mandatory Disclosure

The 2008 amendments require disclosure of improper activities related to government contracts. These new

disclosure requirements have three distinct sources: (1) in a clause now required to be inserted into specified

government contracts and subcontracts; (2) as part of the new requirements of internal control systems

mandated for certain contractors; and (3) in the expanded grounds for contractor suspension and debarment.

These are discussed in detail below.

1. Disclosure Under the Clause in FAR 52.203-13

The narrowest of the three grounds for mandatory disclosure is found in the amended clause required by FAR

52.203-13 (Contractor Code of Business Ethics and Conduct). This clause must be inserted in all government

contracts executed after the December 12, 2008 effective date if the value of the contract is expected to exceed $5

million and the performance period of the contract is at least 120 days. FAR 3.1004(a). It creates an obligation

to make a timely, written disclosure to the relevant agency’s office of the inspector general (OIG),4 with a

copy to the contracting officer, of certain improper activities in connection with the award, performance, or

closeout of the contract containing the clause or “any subcontract thereunder.” The contractor must disclose

“credible evidence” of a violation of federal criminal law involving fraud, conflict of interest, bribery, or gratuity

violations found in Title 18 of the United States Code, or a violation of the civil False Claims Act.

Although the regulations do not define “credible evidence” or “timely” disclosure, the amendments’

procedural history offers some insight. The original proposal required disclosure when a contractor had

“reasonable grounds to believe” a violation had occurred. 73 Fed. Reg. at 67073. This standard, however,

generated concern that contractors would substantially over-report out of an abundance of caution and

significantly increase company costs, because it would require investigation of baseless claims and incidents.

Id.

The “credible evidence” standard replaced the “reasonable grounds to believe” standard partly in response

to these concerns. The “credible evidence” standard “indicates a higher standard, implying that the contractor

will have the opportunity to take some time for preliminary examination of the evidence to determine its

credibility before deciding to disclose to the [g]overnment.” Id. at 67073-74. This suggests that reasonable

reporting delays to assess the credibility of a potential violation are permissible, but does not provide guidance

as to what might be a reasonable period of time for investigation.

The procedural history also sheds some light on the meaning of “timely.” There is no pre-determined

acceptable time period. The government rejected a set time period as “arbitrary,” suggesting that it “would

cause more problems than it would resolve.” Instead, the “timely” requirement must be read in the context

of the “credible evidence” standard: a contractor has time to determine whether evidence is credible before

it is obligated to disclose the evidence. Id. at 67074. A contractor is not required to “carry out a complex

investigation”; rather, it should “take reasonable steps … sufficient to determine that the evidence is credible.”

Id.

The mandatory disclosure triggered by the FAR 52.203-13 clause is not retroactive. “[T]he reportable

violations [mandated by FAR 52.203-13] are limited to the contract containing the clause” - violations that

“would necessarily be after the effective date of the rule and after incorporation of the clause.” Id. at 67073.

Disclosure is required until three years after the last payment on the contract containing the clause.


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2. Disclosure Required in Internal Control Systems

The new internal controls requirements are the second source of mandatory disclosure. The FAR 52.203-13

clause also requires contractors (and subcontractors), other than small businesses and contractors that hold only

commercial-item contracts, to incorporate mandatory disclosure into their system of internal controls within 90

days of the award of a contract containing the clause.

This required mandatory disclosure mechanism is similar to the one spelled out in the clause itself (discussed

above). FAR 52.203-13(c)(2). There are two main differences. First, a contractor must disclose a violation relating

to any government contract it holds (or a subcontract thereunder), regardless of whether it contains the clause

mentioned above. 73 Fed. Reg. at 67075. Therefore, a contractor must disclose for any contract it holds “until at

least 3 years after final payment on the contract.” FAR 52.203.13(c)(2)(ii)(F)(3).

Second, the requirement is retroactive. Contractors are expected to make disclosures related to contracts

entered into before December 12, 2008, to comply with their new internal controls systems. Contractors must

disclose conduct relating to contracts that are active or for which there has been final payment within the last three

years. The procedural history provides:

[We] do not agree with the respondents who think that disclosure under the internal control system or as

a potential cause for suspension/debarment should only apply to conduct occurring after the date the rule is

effective or the clause is included in the contract, or the internal control system is established. The laws against

these violations were already in place before the rule became effective or any of these other occurrences. This rule

is not establishing a new rule against theft or embezzlement and making it retroactive. The only thing that was not

in place was the requirement to disclose. Id. at 67074.

3. Disclosure Required Due to Expansion of Suspension/Debarment Provisions

By far the broadest of the new bases for mandatory disclosure is the expansion of the grounds for suspension

or debarment of government contractors. FAR 9.406-2(b)(1) (debarment); FAR 9.407- 2(a)(8) (suspension). A

contractor may face suspension or debarment for the knowing failure by a “principal” to “timely disclose” credible

evidence in connection with its contracts (or subcontracts thereunder) of a violation of federal criminal law

involving fraud, conflict of interest, bribery, or gratuity violations found in Title 18 of the United States Code; a

violation of the civil False Claims Act; or a significant overpayment on a contract. Id. Unlike the requirements in

FAR 52.203-13, the suspension and debarment provisions require disclosure to the “[g]overnment” generally.

This new basis for suspension and debarment applies to all contractors. Further, unlike the 52.203-13 clause,

this provision requires the disclosure of overpayments if they are “significant.” The regulations do not define

“significant.” The suspension and debarment disclosure requirements are retroactive; contractors are required

to disclose violations or overpayments on contracts that are still open or for which there has been final payment

within the last three years.

A failure to disclose is only a ground for suspension or debarment if it is by a “principal” of the contractor.

A “principal” is defined as “an officer, director, owner, partner, or person having primary management or

supervisory responsibilities within a business entity.” FAR 2.101(b)(2); FAR 52.203-13(a). The term “should be

interpreted broadly, and could include compliance officers or directors of internal audit.” 73 Fed. Reg. at 67079.

This limitation was inserted to ensure that a failure to disclose not be a basis for suspension or debarment if

lower-level employees, who are not managers or supervisors, commit a crime and conceal the crime from the


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contractor’s supervisory-level personnel. Principals are only required to disclose their actual knowledge. After

receiving public comment on this issue, the government rejected the “should have known” standard, noting that

the knowledge requirement protects government interests in preventing and punishing fraud, while also guarding

contractors from overly burdensome disclosure requirements.

B. The Expansion of Ethics Awareness and Compliance Programs and Internal Control Systems

The second major feature of the FAR amendments is the expansion of existing regulations to strengthen compliance

programs. These additional requirements are triggered when a contractor, other than a small business or a

commercial-item contractor, receives a contract worth more than $5 million with a period of performance over

120 days. Once such a contract is awarded, the contractor has 90 days to implement the new internal controls.

Among other items, these new controls require “full cooperation” with any government agencies responsible

for audits; “reasonable efforts” not to hire or promote as a principal any person who due diligence would have

exposed as having engaged in conduct that conflicts with the contractor’s code of business ethics and conduct;

“reasonable efforts” not to do business with subcontractors with poor records of business integrity and ethics; and

management of the compliance and control programs by a contractor employee at a “sufficiently high level” in the

company to ensure the program’s effectiveness.

The amendments provide a broad definition of “full cooperation.” The FAR defines “full cooperation” as:

disclosure to the [g]overnment of the information sufficient for law enforcement to identify the nature and extent

of the offense and the individuals responsible for the conduct. It includes providing timely and complete response

to [g]overnment auditors’ and investigators’ request for documents and access to employees with information ….

FAR 52.203-13(a).

“Full cooperation” does not require a waiver of attorney-client privilege or any Fifth Amendment right,

and does not restrict a contractor from conducting an internal investigation or defending any actions brought

against it.

III. Initiatives of the New Administration

The amendments to the FAR are part of the government’s broader efforts to reform government contracting and

punish procurement fraud. These increased efforts at prevention, detection, and enforcement underscore the

need for contractors to remain in compliance with the complex laws and regulations governing contracts with the

United States.

According to its December 2008 report, the National Procurement Fraud Task Force, a multi-agency initiative

established by the Department of Justice, has pursued “more than 400 procurement fraud cases that have resulted

in criminal charges, convictions, civil actions, or settlements since the creation of the Task Force” in October

2006. More than 300 of these cases have resulted in criminal convictions.

In sync with other government efforts, the Obama administration has also indicated that it intends to reform

the government contracting system. Eliminating fraud in procurement was a centerpiece of President Obama’s

2008 election campaign, and, on March 4, 2009, President Obama signed a memorandum intended to save the

federal government billions of dollars a year by starting the overhaul of what President Obama describes as a

broken system of government contracting. The Defense, National Aeronautics and Space Administration, General

Services Administration, Office of Personnel Management, and other federal agencies to develop guidance on


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strengthening contract oversight, ending unnecessary no-bid and cost-plus deals, and maximizing competition in

procurement.

Further, on May 20, 2009, President Obama signed the Fraud Enforcement and Recovery Act (FERA) into law.

This law introduced sweeping changes to the False Claims Act (FCA), which is the government’s main weapon in

combating fraud involving federal money. FERA also provided hundreds of millions of dollars for the enforcement

of the FCA and similar laws.

IV. Best Practices: Ensuring Compliance

The new mandatory disclosure and internal controls provisions of the FAR complicate what was already a

complex area of regulation. Contractors must reassess the effectiveness of their compliance programs and take

immediate steps to ensure compliance. In addition, contractors that are faced with issues that may require

disclosure need to closely examine the new requirements to avoid potentially devastating consequences.

Companies are well-advised to consider hiring counsel with expertise to assist in the process of ensuring

compliance. In this era of close scrutiny, companies doing business with the government cannot be too careful.

Colin O’Sullivan is an Associate and D. Grayson Yeargin is an Associate at Nixon Peabody LLP.


US Corporate Governance Tug-of-War: Guidance for Directors Designated by Private Equity and Venture Capital Funds

BY ROBERT M. BEARMAN AND SHAWN M. TURNER | PATTON BOGGS LLP

The US Sarbanes-Oxley Act of 2002 and current global economic troubles have increased the risk of litigation

against directors of US corporations. Directors face increased scrutiny and pressure from stockholders, regulators

and creditors, as well as other stakeholders, such as community leaders and politicians. Persons designated by

private equity or venture capital funds to serve on boards of directors of companies doing business in the US face

even greater scrutiny and should be aware of recent US corporate governance developments.

Frequently, when private equity or venture capital funds invest in US companies, the funds will require the

right to designate one or more representatives to serve on the company’s board. The fund may choose to designate

fund principals or employees, or persons not affiliated with the fund but in whom the fund has confidence. These

fund designees often are added to boards at the fund’s insistence not only to monitor and protect the fund’s

interest in the company, but also to add expertise and to provide the benefit of their experience in serving on other

boards of companies in which the fund has made investments.

Designated directors are subject not only to the increased pressure facing directors generally, but are increasingly

being subjected to enhanced scrutiny because of their special position. A designated director owes a duty to the

designating fund that may conflict with the duties he owes to the company and its common stockholders or

other equity holders. The risk of conflict increases when funds pressure companies, often through the designated





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director, to take actions that will allow the funds to exit all or a significant portion of their investment position.

The designated director, in turn, may find himself caught between the proverbial rock and a hard place: the fund,

which typically employs the director, and in which the director may have a direct or indirect ownership interest,

on the one hand, and the company and its common stockholders or other equity holders on the other hand.

Fiduciary Duties, Generally

Directors of US corporations generally owe fiduciary duties to their corporations and their stockholders. Director

fiduciary duties are governed by state and federal statutes and regulations, common law and the corporation’s

governance documents, including certificates of incorporation, preferred stock certificates of designation, bylaws,

board committee charters and specific governance policies. Both state statutes and common law generally mandate

that directors stand in a fiduciary relation to the corporation and its stockholders and are required to perform

their duties as directors (including duties as board committee members) in good faith (the duty of good faith),

with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use

under similar circumstances (the duty of care), and in a manner they reasonably believe to be in the best interests

of the corporation and its stockholders (the duty of loyalty).

The duty of loyalty often is the lynchpin of designated directors. To satisfy the duty of loyalty, a director who

is an employee of the designating fund, or who has a direct or indirect ownership interest in the designating fund,

should not act in a manner that uniquely benefits the fund. The designated director may not be beholden to a fund,

or so under a fund’s influence that the director’s discretion would be sterilised.

Business Judgment Rule

If directors act in good faith and free from a conflict of interest, the business judgment rule should insulate them

from personal liability for actions taken by the board. Essentially, the business judgment rule is a presumption

that, in making a business decision, a corporation’s directors acted on an informed basis, in good faith and in

the honest belief that the action taken was in the best interests of the corporation and its stockholders. A party

challenging the directors’ decision bears the burden of rebutting the presumption. If the presumption is not

rebutted, the reviewing court should not second guess board business decisions. If the presumption is rebutted,

the burden of proving the entire fairness of the scrutinised action could shift to the director-defendant.

In re Trados Incorporated Shareholder Litigation

A recent case decided in the early stages of litigation in Delaware highlights the increased risk for designated

directors, and the interplay between director fiduciary duties and the business judgment rule. In In re Trados

Incorporated Shareholder Litigation, No. 1512-CC (Del. Ch. July 24, 2009), venture capitalists invested in Trados

and received 51% of the corporation’s preferred stock with a liquidation preference of $57.9 million. They also

had a right to appoint a majority of the corporation’s directors; however, they did not have a contractual right

to force a sale of Trados. The seven person Trados board consisted of four persons designated by the preferred

stockholders, each of whom was either an employee of a preferred stockholder or held an equity interest in the

preferred stockholder, two Trados executives, and one independent director.

In April 2004, the board began discussing potential sale transactions due, in part, to Trados’s poor performance

and poor prospects. In August 2004, the Trados board rejected a $40 million merger offer. During the fourth quarter


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of 2004, Trados’s financial condition improved, and in April 2005, the Trados board unanimously approved a $60

merger offer. Trados’s preferred stockholders received $52 million of their $57.9 million liquidation preference,

and management (including the two executive directors) received the remaining $8 million. Importantly, the

common stockholders did not receive any funds from the merger.

The plaintiff-common stockholder in Trados asserted that the merger was undertaken at the behest of certain

preferred stockholders that desired a transaction that would trigger their large liquidation preference and allow

them to exit their investment. The common stockholder argued there was no need to sell because Trados was

well-financed and its performance was improving dramatically, and that the Trados board favoured the preferred

stockholders’ interests either at the expense of the common stockholders, or without properly considering the

effect of the merger on the common stockholders.

The court determined that the plaintiff stockholder had alleged sufficient facts, if true, to rebut the presumption

of the business judgment rule and survive the motion to dismiss. Presumably, there will be further proceedings in

the litigation, and there is a risk that the defendant-directors may need to demonstrate that the transaction and

the sale process were fair. This is a much higher standard than what the directors would have needed to show had

their actions been protected by the business judgment rule.

Limiting Director Liability and Preserving Indemnification

Generally, so long as designated directors satisfy their fiduciary obligations, their personal liability for board

actions should be limited and indemnified. In fact, most states permit companies to eliminate or limit director

personal liability to the corporation or its stockholders for breaches of fiduciary duties, subject to certain

limitations. Many states also have statutes addressing director indemnification, which frequently is mandatory if

the director is successful in the proceedings, and may not be available if the director is liable to the corporation. A

fund may attempt to avail its designated director of the statutorily-permitted protections and even expand them

by negotiating specific exculpatory and indemnification provisions in their investment documents. In addition, if a

fund is investing in a Delaware limited liability company rather than a corporation, there are statutory provisions

that permit investors to contractually eliminate liability for breaches of fiduciary duties so long as the contract

does not eliminate liability for a bad faith violation of the implied covenant of good faith and fair dealing.

If an investor is not successful in negotiating exculpatory language in the investment documents protecting the

designated director, the director’s risk of personal liability may be increased if he fails to satisfy his fiduciary duties,

including by allowing an actual or potential conflict between his personal interests and the best interests of the

corporation and its stockholders to obscure his ability to make decisions objectively. Indemnification provisions,

limitations on liability and director and officer insurance coverage may not insulate the director from personal

liability in these circumstances.

Managing the Risk of Designated Director Personal Liability

Designated directors are well-advised to pay close attention to their potentially conflicting duties when considering

strategies to enhance or liquidate the designating fund’s interests in the corporation, either through a sale of all

or substantially all of the corporation’s assets, a merger, or an equity restructuring. These transactions generally

are more closely scrutinized by stockholders, particularly the common stockholders that may end up receiving no

consideration from the transaction. A designated director advocating a fundamental transaction similar to those


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described above runs the risk of increasing his visibility and becoming a lightening rod for breach of fiduciary duty

claims.

There are preventive steps funds with designated directors and boards can take to decrease the risk that

directors will be deemed to have breached their fiduciary duties within the context of a fundamental corporate

transaction, especially where the transaction may trigger a liquidation preference or large payout for the fund:

• If there is a conflict of interest between common stockholders and preferred stockholders, the designated

directors must remember that their fiduciary duty to common stockholders is paramount.

• Private equity and venture capital funds should consider designating directors with no employment

relationship with, or ownership interest in, the fund.

• Boards should consider having more than one disinterested, independent director and creating a committee

of independent disinterested directors to consider the transaction, thus maximising the benefit of the

business judgment rule.

• Boards should make certain they can show, through meeting minutes or otherwise, that they considered the

impact of the sale on all classes of equity owners.

• Boards should consider authorising valuations and fairness analyses and opinions when considering

whether to engage in a fundamental transaction.

• Directors should consider providing common stockholders with some return on their investment.

• The fund receiving preferred stock for its investment must realise that its rights, privileges and preferences

are contractual in nature. As such, if there are rights the fund considers important, such as forced sale rights

or designated director exculpation, the fund should expressly provide for those rights in the investment

documentation.

Robert M. Bearman is a Partner and Shawn M. Turner is an Associate at Patton Boggs LLP.





Canada | www.executiveview.com

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Beyond the Boy Scout Image: New Rules for Investing in Canada

BY CHAT ORTVED | GOODMANS

Changes to the Investment Canada Act (the “Act”) in March of 2009, along with noticeable changes in the way

the act is being applied by federal regulators, have begun to alter the landscape of foreign investment in Canada.

While clearly Canada remains “open for business”, in the words of former PM Brian Mulroney, executives should

understand the ways in which their potential investments can be scrutinised, both before and after they occur.

Introduction

When Canadian mining icon Inco was acquired by Brazil’s Companhia Vale do Rio Doce in 2006, its CEO told the

press, “Canada is a Boy Scout playing among countries who play hardball”. Back in the mid 1980s, Prime Minister

Brian Mulroney declared Canada “open for business”, and at least for Inco, whose attempt to build a made-in-

Canada global mining giant was foiled by foreign bidders, the door had swung a little too wide.

Regardless of one’s perspective, be it leaning towards protectionism, an absolute “open for business” policy

or anything in between, it is clear that the broad language of the Act has traditionally allowed significant foreign

investment in Canada. Whether or not that makes us Boy Scouts, this country has developed a reputation for being

welcoming to foreign investors.

On March 12, 2009, proposed amendments to the Act became law, carrying important implications for current

business practices and corporate transactions. The amendments do not necessarily make foreign investment in

Canada more onerous; indeed, because of raised thresholds fewer transactions will be subject to review. However,

the amendments do provide regulators with a new, broad power, allowing the government to veto any investment

by a non-Canadian if that investment could threaten “national security” (similar to a veto that exists under the

United States’ foreign investment regime).

Along with the changes to the regulatory regime, there appears to have been a change recently, as well, in

the approach federal regulators are taking with respect to scrutinising foreign investments. Perhaps sensitive to

concerns raised by the provinces and in the press, regulators have been more willing to not only attempt to extract

concrete undertakings from foreign acquirors, but to seek to enforce those undertakings once given. There have

thus been two types of changes to Canada’s foreign investment regime: the written amendments that affect what

investments the government will review and the practical changes that affect those investments once they have

already been made.

Application of the Act

An acquisition of direct or indirect control of a Canadian business by a non-Canadian or an investment by a non-

C A N A D A


www.executiveview.com | Canada

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Canadian that establishes a new Canadian business may trigger the requirements of the Act. The first question,

therefore, is whether the acquiror is “Canadian.” For the purposes of the Act, a “Canadian” is, in the case of an

individual, either a citizen or permanent resident or, in the case of a non-individual, an entity that is controlled

by a Canadian. The second question is whether there has been an acquisition of control. Where the person or

entity acquiring control of a target is a non-Canadian, the acquisition is subject to various deeming provisions

and presumptions. For instance, where a non-Canadian acquires a majority of the voting interests of the target,

the Act deems an acquisition of control. Conversely, where a non-Canadian acquires less than one third of the

voting interests, the Act deems there to have been no acquisition of control. Where a non-Canadian acquires less

than a majority but more than one third of the voting interests of a target, the Act presumes control to have been

acquired, but the acquiror can rebut that presumption if it can establish that the entity is not, in fact, controlled

by the acquiror.

Notification and Review

The Act establishes two categories of investment by non-Canadians: those subject to notification and those subject

to review. Generally, all acquisitions of control or establishments of new Canadian businesses by non-Canadians

that are not subject to review are subject to notification. The non-Canadian has 30 days after the implementation

of the investment to file a notice with Industry Canada.

Where an investment by a non-Canadian meets certain thresholds, the investor cannot complete the investment

without filing an application for review and, after completing the review process, receiving the approval of the

Minister. For instance, in general, direct acquisition of control of a business with gross assets of $5 million or

more is generally subject to review, as is an indirect acquisition of control (through the acquisition of shares in

a non-Canadian entity) where the assets of the Canadian business amount to $50 million or more. However, the

amendments to the Act have increased some of these thresholds significantly for some investors. For a direct

acquisition of a Canadian business by WTO investors, or non-Canadians from WTO member states, the threshold

has risen from $312 million (book value) to $600 million (enterprise value, which has been defined to be the

market capitalisation of the entity plus its total liabilities minus its cash and cash equivalents), increasing to $800

million for 2011 and 2012 and to $1 billion thereafter. Indirect acquisitions by WTO investors are not reviewable.

Acquisitions or establishments of businesses relating to Canada’s cultural heritage or national identity, on the

other hand, remain subject to possible review regardless of size.

Net Benefit and National Security

Once a transaction meets the relevant review threshold, the relevant Minister (either the Industry Minister or the

Canadian Heritage Minister, depending on the proposed investment) must determine that the investment is likely

to be of “net benefit” to Canada. If the investment is of net benefit to Canada, it can pass the review process. This

“net benefit” test, as evidenced, for example, by the acquisition of Inco, has historically not been difficult to satisfy.

However, as discussed further below, in cases where regulators foresee some detriment to Canada they have the

power to demand undertakings from foreign investors, such as maintaining certain jobs or plants, that tip the

balance of “net benefit” in favour of the investment.

The increased thresholds for review should decrease the number of reviewable acquisitions of Canadian

businesses by non-Canadians. However, the amended Act also creates a broad, new power of review, not subject



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to any threshold, allowing regulators to review any investment that could be “injurious to Canadian national

security.” The Act does not define the concept of “national security”, but it is conceivable that the government

could exercise its power broadly to either block investments or extract undertakings from the investor. In fact, on

August 19, 2009, George Forrest International Afrique S.P.R.L. (“GFI”), which had entered an arrangement with

Canadian company Forsys Metals Corp. (“Forsys”), a uranium producer whose deposits are located in Namibia,

Africa, announced that it had received a letter from Industry Canada advising that it was prohibited from effecting

the transaction until further notice. Forsys announced on August 25, 2009 that it was terminating the transaction

due to GFI’s failure to transfer funds in accordance with the arrangement.

GFI’s arrangement to acquire Forsys fell below the review thresholds set out in the Act. While the basis for the

letter from Industry Canada was unclear, it stands to reason that since this intervention was not an element of a

“net benefit” review, it may have been grounded in the new “national security” review provisions of the Act. If so,

the government appears quite willing to use its new powers.

Post-Investment Scrutiny: Undertakings

Though less explicitly than through the creation of a new power for the government in the amended Act, regulators

also appear to have begun to scrutinise foreign investments more closely, even once approval has been given.

Regulators have appeared more willing, recently, perhaps due to concern from the provinces in which the target is

located and increased attention in the press, to demand undertakings from potential investors in order to satisfy

the “net benefit” threshold. Undertakings can include commitments to continue research and development in

Canada for certain periods, not to substantially reduce the number or types of employees, to maintain a substantial

regional or corporate office and to maintain a level of Canadian representation at the senior executive and board

level. For example, when United States Steel Corp. (“U.S. Steel”) acquired Stelco Inc. (“Stelco”) in 2007, it gave

certain undertakings aimed at the protection of Canadian jobs and investment in Stelco’s operations in Hamilton,

including a pledge to maintain employment levels and to increase steel production in Canada by at least 10%.

Further, regulators have also been quite public recently in their insistence on those undertakings being fulfilled.

In the past, undertakings given during the review process have often been either waived or negotiated when they

were not fulfilled. While that remains possible, the government’s attitude on the negotiability of undertakings

may be hardening. In May of 2009, Industry Minister Tony Clement sent a demand letter to U.S. Steel insisting

that it fulfil the undertakings given in the Stelco acquisition. The government has subsequently initiated court

proceedings against U.S. Steel, the first time the government has formally commenced enforcement proceedings

for non-compliance by a foreign owner. This more aggressive attitude may have more to do with establishing

a bargaining position than actually forcing U.S. Steel to fulfil its undertakings. Nonetheless, the government’s

position appears less like a Boy Scout’s.

Conclusion

Canada’s foreign investment regime has changed in 2009. In some ways it has softened, particularly in relation

to increased thresholds for review, but it has gained breadth in the form of the national security review. While it

remains to be seen how liberally the government will apply its new review powers, the Forsys case indicates that

they may not sit idle. And the enforcement proceedings concerning U.S. Steel, as well, show a willingness on the

government’s behalf to hold foreign investors to the commitments that tilted the “net benefit” test in their favour.



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Executives considering investing, directly or indirectly, in Canadian businesses should be aware of these changes,

both in the process of review prior to the investment and the level of accountability following its implementation.

Canada is still open for business; but the regulators have placed a hand on the door and their eyes on the shop.

Chat Ortved is an Associate at Goodmans.


Acquiror-Side Shareholder Approval Arrives in Canada

BY NEILL MAY AND CHAT ORTVED | GOODMANS

Introduction: The Long Road to Here

The announcement by the Toronto Stock Exchange (TSX) that a listed issuer will require the approval of its

shareholders in order to acquire other publicly-held issuers in certain circumstances is the latest, and possibly

last, chapter in a long debate on the topic in Canada.

Most international exchanges require acquirer-side shareholder approval in public M&A transactions. For

example, the New York Stock Exchange requires shareholder approval for transactions that involve the acquiror

issuing more than 20% of its shares; the London Stock Exchange’s threshold is 25% dilution, including where the

target is publicly traded. The TSX, in contrast, had for many years waived shareholder approval requirements

for issuers proposing to acquire public targets and, in 2005, formally incorporated the exemption into its rules

(though the exchange retained discretion to impose shareholder approval).

Historically, the argument in favour of exemption was that public M&A transactions were subject to a significant

degree of scrutiny and discipline, including (i) that disclosure documents, with prospectus-level disclosure, must

be produced, and (ii) that for publicly-traded targets a market price is readily available. It had also been argued

that because Canadian companies often have less access to capital and credit than companies in larger markets,

the ability to undertake acquisitions without shareholder approval was an important compensating advantage.

At its core, the debate is simple. Canadian shareholders have argued, with increasing intensity recently, that they

should have approval rights for materially dilutive transactions. On the other side, issuers and others have argued

that requiring shareholder approval increases the conditionality and cost of proposed transactions (neither securities

nor corporate law in Canada requires security holder approval by the issuer for arm’s length dilutive transactions).

On September 25, 2009 the TSX, having earlier this year proposed the imposition of a shareholder approval

requirement for transactions that would result in greater than 50% dilution, announced that shareholder approval

would be required for public M&A transactions where the acquiror issues 25% or more of its securities. The rule

comes into force on November 24, 2009.

The TSX retains discretion, in extraordinary circumstances, to exempt public issuers from the new rule.

However, executives of companies trading on the TSX should be aware that, like their counterparts in the United

States and the United Kingdom, they will be required to look to their shareholders when engaging in a dilutive

acquisition at 25% or beyond.





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How Did We Get Here: HudBay Minerals and the OSC

The impetus for the TSX’s change of heart was apparently a decision of the Ontario Securities Commission (OSC)

relating to the then proposed acquisition of Lundin Mining Corporation (“Lundin”) by HudBay Minerals Inc.

(“HudBay”).

In November of 2008, HudBay had announced a deal to purchase all of the outstanding shares of Lundin.

Under the transaction, each Lundin shareholder would have received 0.3913 HudBay shares, such that the

HudBay shareholders and the Lundin shareholders would each, as a group, have held approximately 50% of the

post-closing shares of HudBay. The TSX approved HudBay’s application to list the shares that it proposed to issue

to Lundin shareholders; in other words, the TSX did not require HudBay to seek shareholder approval.

On January 23, 2009, the OSC set aside the TSX’s approval. The OSC determined that, because of the impact

that the transaction might have on HudBay and its shareholders, the “quality of the marketplace…would be

significantly undermined” if the transaction were to proceed without HudBay shareholder approval.

The OSC considered several factors when assessing the effect of HudBay’s acquisition of Lundin on the “quality

of the marketplace.” The OSC noted that the level of dilution that the HudBay shareholders would experience

would be “at the very outer end of the range of dilutions permitted by the TSX in other transactions without

shareholder approval,” also describing the dilution as “extreme.” Further, the economic impact of the transaction

on HudBay’s shareholders was significant, evidenced by a 40% drop in the price of HudBay’s shares immediately

following its public announcement of the deal.

The OSC also considered that HudBay’s board of directors would be fundamentally altered, noting that in its

view while “not every change in a board’s composition requires shareholder approval”, a change as fundamental

as the one contemplated in HudBay’s circumstances should be approved by the shareholders.

Other factors the OSC considered were the timing of transaction, which had been accelerated in such a way

(with what the OSC called “uncommon haste”) as to occur prior to the time fixed for HudBay’s requisitioned

shareholders’ meeting, and the transformational impact of the transaction on HudBay and its shareholders,

including a change in capital structure and exposure to Lundin’s assets that would lead to a significantly higher

risk profile.

Taken together, in the OSC’s opinion, these factors undermined the quality of the marketplace enough to

warrant overturning the TSX’s listing approval and requiring HudBay to seek shareholder approval in order to

proceed with its acquisition. The transaction did not proceed.

Shortly after the HudBay decision, the TSX published a proposal to change its rules to require shareholder

approval in public transactions at 50% or greater dilution. Ultimately, as noted above, the new rule will require

approval of the acquiror’s shareholders where the acquiror proposes to issue 25% or more of its stock.

HudBay’s Obiter: What Else is New?

The story of HudBay and the OSC does not quite end with the TSX changing its rules. The OSC did not limit itself

in its reasons to the context of shareholder approval in dilutive transactions. In comments that, though inspired

by HudBay’s circumstances, were neither raised in the application nor addressed in either party’s submissions,

the OSC discussed the role of the financial advisors and of a pre-transaction private placement.

While not required by law in Canada, it has been common practice for boards to seek fairness opinions from

financial advisors when proceeding with an acquisition. In connection with its proposed acquisition of Lundin, the



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special committee of HudBay’s board of directors had obtained a fairness opinion from its financial advisor stating

that the transaction was fair, from a financial point of view, to the shareholders of HudBay. The financial advisor

was to receive a success fee payable upon completion of the acquisition.

The OSC stated that, in its view, where a financial advisor is entitled to a success fee, “such fees create a

financial incentive for an advisor to facilitate the successful completion of a transaction when the principal focus

should be on the financial evaluation of the transaction from the perspective of shareholders.” In other words,

such fees create a conflict of interest for financial advisors, rendering their fairness opinions, in the OSC’s view,

unreliable. While the OSC’s comments with respect to fairness opinions were clearly obiter, they may motivate

boards to seek fairness opinions from firms other than the principal financial advisor.

The OSC’s second theme of obiter comments relates to a private placement through which Hudbay acquired

19.9% of the outstanding common shares of Lundin prior to the proposed acquisition. Of course, Hudbay intended

to vote these shares in favour of the acquisition. The OSC, however, noted that had the transaction proceeded it

would not have permitted HudBay to vote those shares. It stated that “an acquirer should not generally be entitled,

through a subscription for shares carried out in anticipation of a merger transaction, to significantly influence or

affect the outcome of the vote on that transaction.” Like the OSC’s comments on fairness opinions, its comments

on private placements are not law. It thus remains unclear what their effect will be and how companies proposing

to undertake mergers will proceed in light of the OSC’s comments.

Conclusions

It will be difficult to quantify the effects of the requirement for acquiror shareholder approval. If issuer concerns

about increased costs are realized it will be a challenge to determine how TSX listed issuers may have been

disadvantaged in competitive auctions for targets. At a minimum, though, the new rule has eliminated uncertainty

for acquirors. Before the rule change they had found themselves in the increasingly uncomfortable position of

balancing corporate objectives on the one hand and shareholder insistence on approval rights on the other.

Acquirors now know what threshold will trigger those approval rights.

The effects of the obiter comments made by the OSC in its HudBay decision with respect to fairness opinions

and private placements in anticipation of an acquisition should be more easily discernible, though they have yet

to play out.

Neill May and Chat Ortved are lawyers at Goodmans.







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Raising Capital in Canada and the Role of the Toronto Stock Exchange

BY NEILL MAY AND BRAD ROSS | GOODMANS LLP

As global capital markets continue their ascent from the lows experienced in late 2008 and early 2009, many

corporate executives may find themselves, for the first time in many months, once again turning their minds to

financing opportunities. This article is intended to provide a general overview of the regulatory framework that

governs the raising of capital in Canada. It also examines some recent developments regarding the role played by

the Toronto Stock Exchange (TSX) in regulating private placements and public offerings conducted by TSX-listed

issuers.

Regulatory Framework

Securities regulation in Canada falls under provincial jurisdiction. As a result, an issuer seeking to raise capital

in Canada is currently required to comply with the laws, rules and policies implemented by each of Canada’s 13

provinces and territories in which capital is proposed to be raised. In many areas, however, the various provincial

regulators have adopted harmonised rules and procedures, which has the practical effect of streamlining the

regulatory regime and process in multi-jurisdictional transactions.

Securities commissions are only one of many organisations that create and enforce rules to ensure the integrity

of capital markets. Stock exchanges, such as the TSX, are separate self-regulated organisations that function

distinctly from the securities commissions. As such, notwithstanding compliance with applicable securities laws,

an issuer wishing to offer securities to be listed and traded on the TSX must comply with the rules of, and obtain

approval from, the TSX. Securities commissions, however, remain responsible for the supervision of the TSX and

may hear appeals of TSX decisions or rulings.

Private Placements

Overview

The general rule in Canada is that a company may not issue securities unless it prepares and delivers to potential

investors a “prospectus”, which is a document describing in detail the business and affairs of the issuer and the

type of security being issued. In certain circumstances, however, Canadian securities laws permit securities to be

sold on a “prospectus exempt” or “private placement” basis, which may result in substantial time and costs savings

for the issuer.

Private Placement Exemptions

The principal private placement exemptions have been harmonised across the country, with the most commonly

used exemptions (by non-private issuers) relating to sales of securities to “accredited investors” (such as

institutional investors and high net worth individuals) and sales where the cash purchase price for the securities

is at least C$150,000. Certain provinces have more flexible exemptions to facilitate capital-raising activities for

junior issuers.



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Restrictions on Resale

Securities distributed under the various private placement exemptions are subject to restrictions on their resale,

meaning that purchasers of securities under a private placement are not altogether free to sell the securities

they have purchased. The applicable resale restriction will depend on the parties to the trade and the particular

exemption that was relied upon to distribute the securities. Typically, securities issued pursuant to a private

placement exemption may not be traded before the date that is four months and a day after the later of (i) the

date the securities are initially distributed, and (ii) the date the issuer became a “reporting issuer” (in other words,

subject to public disclosure obligations) in any province or territory.

Role of the TSX in Regulating Private Placements

Private placements by TSX-listed issuers require approval of the TSX. The TSX has broad discretion with respect

to its review of private placements and the conditions which it may impose, in particular concerning shareholder

approval. As set out in the TSX Company Manual, the TSX will generally require shareholder approval of a

private placement where (i) the aggregate number of securities to be issued exceeds 25% of the issuer’s issued and

outstanding securities and the offering price is less than the market price, (ii) the offering is priced below certain

allowable discounts to the current market price of the issuer’s securities (regardless of the level of dilution), (iii)

insiders are subscribing for in excess of 10% of an issuer’s capital, or (iv) the transaction will “materially affect

control of the issuer”.

The role of the TSX in regulating private placements was recently examined by the Ontario Securities

Commission (OSC) when it dismissed an application by a significant unitholder of InterRent Real Estate Investment

Trust (“InterRent”) to reverse a decision of the TSX to accept a private placement by InterRent without requiring

unitholder approval.

InterRent had previously applied to the TSX for approval of a private placement of over nine million trust

units, which represented approximately 49% of InterRent’s issued and outstanding trust units. The TSX

allowed InterRent to proceed with the private placement without seeking unitholder approval on the basis that,

among other things, (i) the private placement was not being effected at a discount to market price, and (ii) the

subscribers to the private placement would not be acting together to affect control of the issuer.

A significant unitholder of InterRent challenged the decision of the TSX, arguing that the private placement,

together with other transactions being proposed by InterRent, would materially affect control of InterRent.

The unitholder asked the OSC to overturn the decision of the TSX and require InterRent to seek unitholder

approval of the private placement. The OSC dismissed the application. While full reasons had not been released

as of the date of this article, in announcing its decision, the OSC noted that the TSX had followed a fair process

and had reached a decision that was reasonable in the circumstances (while carefully articulating its reasons

for doing so).

The InterRent decision serves as an endorsement of the broad discretion held by the TSX in regulating

private placements by TSX-listed issuers. It also reflects that the OSC will be reluctant to intervene in a

decision of the TSX unless an applicant can meet the “heavy burden of proving that intervention is justified”,

such as where (i) the TSX had proceeded on an incorrect principle, (ii) the TSX erred in law, (iii) the TSX

overlooked material evidence, or (iv) new and compelling evidence may be available that was not initially

presented to the TSX.



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Public Offerings

Overview

If an issuer wishes to raise capital from a large number of investors, or if the private placement exemptions

discussed above are not available, it may wish to conduct a public offering of securities. A public offering (which is

typically completed in connection with the listing of the securities on a stock exchange such as the TSX) requires

that the prospective issuer prepare and publicly file a prospectus with the relevant securities regulator(s).

Purpose of a Prospectus

As in other jurisdictions, the primary purpose of a Canadian prospectus is to enable potential investors to make

an informed investment decision. A prospectus must contain detailed disclosure about the issuer’s business,

directors and officers, capital structure, and other material information, together with detailed financial statement

disclosure and a description of the risk factors relating to an investment in the securities.

Under applicable securities laws, a prospectus must provide full, true and plain disclosure of all material

facts about the securities that the issuer proposes to issue. A “material fact” is any fact that would reasonably

be expected to have a significant effect on the market price or value of the offered securities. If a prospectus

contains a “misrepresentation” (defined generally as an untrue statement of a material fact or an omission to

state a material fact that is required to be stated in the prospectus or that is necessary to make a statement in

the prospectus not misleading in the light of the circumstances in which it was made), securities laws provide a

purchaser of securities with a right of action for damages against the issuer and each of its directors, as well as

each officer and each underwriter who signed the prospectus and all experts (such as lawyers and accountants)

named in the prospectus. Securities legislation also provides a purchaser of securities under a prospectus with a

right of rescission.

Role of the TSX in Regulating Prospectus Offerings

The TSX has approval rights in respect of prospectus offerings by listed issuers, but until recently this had not

been a meaningful consideration. To the contrary, because of the TSX’s detailed restrictions on private placements

(discussed above), many issuers historically viewed prospectus offerings as a path to completion of a financing

that could not practicably meet the requirements for a private placement transaction.

The TSX had recently signalled that it would more actively consider using its approval rights in the context of

prospectus offerings, and its recent denial of a proposed prospectus offering by OPTI Canada Inc. (“OPTI”) is an

indication that the ground has shifted.

The TSX’s Company Manual provides that the TSX has discretion to apply the rules applicable to private

placements, including the rules as to the maximum discount to market price that will be permitted without prior

shareholder approval, to a prospectus distribution. In exercising that discretion “the TSX will consider factors

such as (i) the method of the distribution, (ii) the participation of insiders, (iii) the number of places, (iv) the

offering price, and (v) the economic dilution.”

In June 2009, OPTI announced that it had reached an agreement with a syndicate of underwriters for a

prospectus offering. The public offering price was at a discount that exceeded the maximum permissible under

the private placement rules (absent shareholder approval). After the proposed offering was announced, the TSX



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informed OPTI that it would not accept notice of the financing without shareholder approval, which OPTI stated

could not be obtained in a practicable timeframe. There was no indication from the TSX or OPTI as to whether any

factors other than the discount in the offering price influenced the TSX’s decision.

OPTI eventually reached a new agreement on its proposed prospectus offering, at a price that was accepted by

the TSX without any requirement for shareholder approval, in part because the offering price was 5¢ higher than

the initial price, but largely because OPTI’s share price had fallen approximately 30% in reaction to the TSX’s

initial refusal to approve the prospectus offering.

The OPTI decision should serve as a reminder of the TSX’s broad discretion to actively scrutinise prospectus

offerings, and to apply elements of its private placement rules to prospectus financings.

Neill May and Brad Ross are lawyers at Goodmans.






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2E U R O P E

www.executiveview.com | United Kingdom

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Audit Committee Risks and Responsibilities

BY DUNCAN WIGGETTS | DLA PIPER

The Effect of the Recession

One of the inevitable consequences of the credit crunch and current global recession has been the attempt to

apportion blame. There have been many articles and reports written about not only those who have been directly

responsible for actions damaging the wealth or standing of companies, but also about those who have been charged

with safeguarding shareholders interests in the companies most adversely affected by recent events. Attention has

fallen on the role of non-executive directors on boards and, in particular, on the role and performance of non-

executive directors sitting on audit committees.

The role of a non-executive director can be extremely difficult. Crucial decisions often need to be made by

audit committees and boards, and there are consequences for getting those decisions wrong. Audit committees

have an unenviable task in terms of their ability to get close enough to the business whilst still retaining the

vestige of independence, and the recent and current prevailing regulatory response of increasing potential risks

and liabilities could ultimately lead to further damage to levels of good corporate governance.

Responsibilities

The role and ambit of an audit committee in any company is for the board to decide. Its usual role is to monitor the

financial reporting process within a company. This ensures that the financial information regarding the company’s

performance during a period is reported as accurately as possible to enable existing and potential investors to

make informed choices on whether to invest or to continue to hold their investments in the company. An audit

committee should report back to the full board with its conclusions on the robustness of the company’s processes

and the reliability of the company’s proposed financial disclosures so that board approval is obtained prior to

publication.

As part of this overall objective, an audit committee has the responsibility, either explicitly through specific

guidelines developed by a company or implicitly, to:

• review regularly the effectiveness of the company’s internal financial controls;

• to provide direction to, and monitor the performance of, internal audit; and

• to select and monitor the independence and performance of external auditors.

The task of evaluating the effectiveness of a company’s internal financial controls will vary considerably from

company to company. The starting point for any such evaluation has to be how much a company has done to

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identify key internal controls and document others. Most UK companies with a listing on a US exchange will have

had to go through this process as a result of the internal control regime brought in by s.404 of the Sarbanes-Oxley

Act and audit committees of these companies may well have more understanding of the location and operation

of essential controls. Some companies with no US listing have gone through a similar process at the behest of

executive management or the board but a significant proportion of other audit committees may be operating

without a complete route map or understanding. And, even if there is an abundance of paperwork and a mapping

of controls, the key responsibility for an audit committee must be to ensure regular testing of the operational

effectiveness of the control by internal or external auditors rather than rely on assurances neatly described on

paper.

An audit committee’s responsibility in relation to the work of internal audit is to ensure firstly that the company’s

internal audit function has the right skill set, that it is sufficiently resourced given the size and complexity of

the company’s operations and that it can operate and investigate issues which may involve members of senior

management without fear of internal retribution. There is a risk if internal audit is poorly directed that work is not

specifically directed to provide assurance on key identified risks and / or that internal audit believes its primary

objective to be process enhancement rather than investigative.

In relation to external auditors, audit committees’ first responsibility is to make a responsible and considered

choice of external auditors. This is not an easy task for audit committees of major international companies

given the practical problems of seeking auditors outside of the Big 4, the conflicts arising through firms auditing

competitors and the auditor independence rules. The latter rules mean that a change in auditor to another of the

Big 4 might necessitate knock on disruption to the business by the new audit firm having to hand over extensive

tax or advisory assignments. Where independence rules allow other non-audit work to be performed, the audit

committee must be extremely vigilant to ensure that independence of the external auditors is not compromised

by the prospect of jeopardising lucrative additional fees. Once selected, the audit committee must make sufficient

time available to formulate an adequate audit plan which focuses on the clearly identified risk issues and on the

risk locations where the company does business. There is also a risk, if executive management drives the audit fee

too low, that corners may be cut in order to keep the audit engagement profitable. Therefore, the audit committee

should ensure that there is an appropriate fee, appropriate seniority of staff and appropriate levels of assurance

on pre-agreed risk areas.

It is important also that an audit committee should forge a strong relationship with external auditors where

the auditors feel comfortable in expressing concerns or misgivings about accounting treatments or even integrity

concerns in relation to members of management. It is important that the external auditor does not think that he

or she is potentially threatening the client relationship by putting an issue on the table. This will be the case, of

course, where the auditors consider that the audit committee does not appear or act sufficiently independent of

executive management.

Some audit committees have, either explicitly by their terms of reference or implicitly, taken on the role

of monitoring the performance of risk management systems. Indeed, this is envisaged as the role of an audit

committee by recent European legislation. However, there are strong arguments that either the responsibility

for monitoring risk should rest with the board or that it should be dealt with by a separate risk committee. The

recent Walker Report into the UK banking industry, and the Financial Reporting Council report into all UK listed

companies, recommend the establishment of stand alone risk committees for all plcs. It is unclear, however,



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whether it is being proposed that risk committees report through the audit committees to the board or have a

separate reporting line and, if the latter, how significant overlap will be avoided.

Risks

It is almost certain that an audit committee will be seen to have failed in its duty if there is discovered to be a

material mis-statement in the published financial statements. This could result out of a failure in the effectiveness

of the company’s financial controls or, given their ability to override many important controls, misconduct by

senior management either misappropriating assets from the company or in manipulating the accounts to present

a much healthier financial performance.

One major risk, often unappreciated, is the failure to investigate thoroughly any question mark over the integrity

of a member of senior management when allegations or suspicions surface even where there is no immediate

question of a material effect on the figures. These allegations must be taken seriously and investigated thoroughly.

Any number of controls could also have been subverted by a dishonest member of senior management who was

motivated to manipulate figures. If a restatement is required, there is, of course, a significant risk of an immediate

sell-off of stock by investors and consequent decrease in share price. This may have serious consequential effects

such as the breach of loan covenants tied to share price or the vulnerability of the company to takeover.

But what of the personal risks for the non-executive directors who sit on audit committees? Aside from

reputational damage, the main personal risk of an audit committee member is from litigation instigated by

shareholders as a result of an actual or perceived breach of duty or negligence.

UK company law does not distinguish between executive and non-executive directors and therefore both have

the same responsibilities, and owe the same duties, to shareholders. Non-executive directors sitting on audit

committee are therefore affected by the recent codification of directors’ duties into statute by the Companies Act

2006 and also by the widening of the types of claims which can be brought by shareholders against directors in

the name of the company, commonly called derivative actions.

Whilst there is debate as to whether the codification process has widened directors’ duties rather than just

increased the number of factors to be taken into account in decision making, it is the widening of the potential

litigation threat which has concerned audit committee members the most in my experience and discussions with

them. Although there are still in place effective checks and balances on the successful prosecution of such an

action by a shareholder or a group of shareholders (the consent of the Court is required and the financial benefit of

the action only accrues to the company), a director sitting on an audit committee can now be sued as much as any

of the executive directors for breach of duty or even negligence, whereas before the 2006 Act recourse was limited

to where there was a fraud on the minority.

One factor which might make audit committee directors possibly even more vulnerable than most is the largely

unheralded change made to the FSA Listing Rules last year as a result of the changes which had to be made to UK

law arising from the EU 8th Company Law Directive passed by the EU Parliament in June 2006. New corporate

governance rules for UK plcs have been introduced into the Disclosure and Transparency Rules in the form of

two new chapters; DTR 1B and DTR 7. These rules not only make it compulsory for the first time for a UK listed

company to have an audit committee with at least one independent member and one financial expert, but also

make the audit committee responsible for monitoring certain aspects, including the financial reporting process

and the effectiveness of the internal control, internal audit and risk management systems. Notably, the mandatory



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duty does not limit the responsibility (and risk) to the monitoring of controls relating to financial reporting.

Given the greater focus on, and the increasing risks for, directors sitting on audit committees, a further risk

is failing to have in place sufficient insurance cover to protect them in case of litigation. Directors should not

underestimate the amount of cover which could be burnt through by the legal fees in advising and defending

executive management who are almost always investigated, sued or prosecuted first by the authorities or

shareholders. Little may be left in the pot for the directors once litigation begins, so it is becoming increasingly

important for directors to check the level of cover available.

As the credit crunch bites, more and more companies are facing increasing regulatory and shareholder scrutiny.

Management at all levels are under pressure to meet targets and expectations. Compliance has also become

more complex with rules, regulations and legal requirements bringing additional demands and costs to bear on

companies. In this uncertain and changing environment, it is now more important than ever that audit committee

members understand the extent of their responsibilities and put risk management at the top of the agenda.

Duncan Wiggetts is a Partner at DLA Piper.


Bribery Reform in the UK: Where to Now?

CHRIS CAMPBELL-HOLT AND SAM EASTWOOD | NORTON ROSE

The need for companies in the UK to adopt and implement anti-corruption measures in their day to day business

dealings is more real than ever before.

In its November 2008 report, the Law Commission recommended a complete overhaul of the UK’s criminal

law of bribery. Building upon the proposals of the Law Commission, the UK Ministry of Justice published on

25 March 2009 the Bribery Bill. It is designed to provide a new, modern and comprehensive scheme of bribery

offences to enable courts and prosecutors to respond effectively to bribery in the UK and abroad. A new offence

of bribing a foreign public official is proposed in the Bill as well as the extension of current offences to include

foreign nationals who live and work in the UK. Significantly, the Bill introduces a new corporate offence for failing

to prevent corruption such that companies in addition to individuals are now vulnerable to bribery prosecutions.

The proposed corporate offence would make corporations liable to criminal prosecution and at risk of heavy

fines for failing to do all they can to stop bribery in their business dealings. Corporations can defend prosecutions by

showing they had adequate procedures in place to prevent employees or agents committing bribery. The meaning

of the phrase “adequate procedures” is not defined but is commonly understood to mean appropriate ethical and

compliance systems to stop employees and agents committing bribery and to deal with them appropriately if and

when they do. The Serious Fraud Office issued guidance on this aspect in July 2009.

It is widely expected that the Bribery Bill will be enacted in early 2010.

To date, enforcement of bribery and corruption laws in the UK has been very difficult, despite notable attempts

by the Financial Services Authority in January 2009 when it fined Aon Limited £5.25 million for inadequate





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internal control systems, and by the Serious Fraud Office in October 2008 when it accepted a £2.25 million

settlement plus costs from Balfour Beatty plc following an investigation into payment irregularities in which it

deployed for the first time civil recovery powers made available to it as from April 2008. The overall lack of

enforcement success has been so severe that the OECD’s Working Group on Bribery, comprising experts from 37

member countries, has reported that it is “disappointed and seriously concerned” about the UK’s failure to bring

prosecutions and hold to account those who commit bribery offences. Since then, Mabey & Johnson Ltd became

in September 2009 the first major British company to be convicted of foreign bribery following a guilty plea, with

a total of £6.61 million to pay in financial penalties, costs and compensation to affected countries. Most recently,

the Serious Fraud Office obtained a civil recovery order of approximately £5 million against AMEC plc. Against

the backdrop of this increased enforcement activity, the Serious Fraud Office formally indicated in July 2009 its

intention to further intensify its efforts to prosecute corruption and provided guidance to corporates on its policies

on self-reporting overseas bribery.

In light of this changing environment, the companies need to address their current approach to risk management.

Bribery related allegations and litigation risk serious reputational and financial damage for companies, in the light

of which companies should address with comprehensive policies and procedures. It is not satisfactory to simply

create a code of ethics. There must be specific policies and procedures in place to facilitate implementation of the

core values inherent in any code of ethics. Second, there must be a requirement to ensure policies and procedures

provide value above the goal of compliance. This is not simply a matter of legal compliance, but of implementing

policies to the extent that they embed a culture of high ethical behaviour in everyday business operations. Finally,

they must monitor progress and react appropriately when any adverse information arises.

Companies committed to rising to these challenges should consider guidance issued in July 2009 by the Serious

Fraud Office and Lord Woolf’s recommendations in his report on BAE Systems in May 2008. It was Lord Woolf’s

report that influenced the Law Commission’s proposal for a new corporate offence, and his report is likely to be

used as a reference point in any forthcoming legislative reform. The report contains guidance on key risk areas

that could usefully assist any company that has to defend itself against corruption allegations.

Lord Woolf recommended that BAE should set up, monitor and enforce an ethics code; appoint a board level

executive with responsibility for the ethics policy; use the corporate responsibility committee to oversee and

report on the management of ethical risk; establish procedures for checking the ethical risk of all business, and

refer decisions to the board when such risks are identified; and apply all ethics codes and procedures to dealings

with agents and business partners.

Companies must conduct due diligence procedures on all people they deal with, be it employees, agents,

contractors, suppliers or new business partners. Who are they, what are their backgrounds and experience? Are

they competent to do what they are tasked to do? What and how are they paid? Are their fees proportionate

to what they do? How were they introduced to you? How are you managing their activities? For joint venture

partners, who are the ultimate beneficial owners? How did your joint venture partner acquire the right to do what

it does or how will it acquire such a right?

Some companies have gone further than this. The defence and aerospace industries are particularly high-risk

sectors and a number of companies in these areas have developed internal policies that require interviews of

agents and suppliers by the corporation’s in-house lawyers, completion of questionnaires and high-level external

due diligence.



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Training is also key. Some corporates think they can embed a culture of high ethical behaviour by simply

investing in an e-learning package without doing anything else. This is unlikely to help by itself. Companies should

invest in training at all levels of their corporation, from board to shop-floor, and through a range of measures,

including e-learning where appropriate but crucially also face-to-face training, tests, annual refreshers, annual

self-certification, and periodic review of all training to ensure they do all that can be expected to embed a high

ethical culture within the day to day practices of their corporations.

But embedding this high ethical culture is only the beginning. Regularly monitoring of systems for compliance is

also necessary with hotlines, annual certifications, contract reviews, contract and payments sign-off authorisations,

and audit procurement, all useful monitoring mechanisms. Finance departments also have a significant compliance

role and should be mindful of any suspicious payments or inappropriate expense claims. Legislative reform in

the UK in the form of the Bribery Bill will lead to increased prosecutions of corporations and heavy financial

penalties by way of fines and confiscation of profits by the UK enforcement agencies. Companies convicted of

bribery and corruption also face losing works and supply contracts under the Public Contracts Regulations 2006,

which implement the EU Consolidated Directive on Public Procurement 2004.

In the current economic climate it is more important than ever for companies to get their anti-corruption

strategies in place and add value to their businesses by proactively managing the risk of unnecessary and costly

litigation and related reputational fallout.

Chris Campbell-Holt is a Researcher and Sam Eastwood is a Partner at Norton Rose.






www.executiveview.com | Italy

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Independent Directors of a Listed Company in Italy

BY ALESSANDRO DE NICOLA | ORRICK

The European Union in its Recommendation 2005/162/EC (adopted to promote standards ensuring that the

boards of listed companies offer sufficient guarantees of independence) outlined the following as key points for

the role of non-executive or supervisory directors of listed companies:

• Separation of the role of Chief Executive Director and supervisory Board: the company’s bodies should

be composed by an appropriate mix of executive and non-executive/supervisory directors in order to avoid

any individual or group of individuals coming to lead the decision-making process;

• Sufficient number of Independent Directors: a sufficient number of independent non-executive or

supervisory directors should be elected to the supervisory board of companies to ensure that any material

conflict of interests involving directors will be properly dealt with;

• Creation of Board Committees to solve conflict of interests: three types of committees should be created

within the supervisory boards – nomination, remuneration and audit – whenever these duties are not

the direct responsibility of shareholders. The presence of independent non-executive directors in such

committees is strongly emphasised;

• Transparency concerning Independent Board Members: the disclosure of individual directors’ competences

and of adequate information on the board’s determination of the directors’ independence is strongly

advised; and

• High standards for the qualifications and commitment of supervisory Board Members: an efficient

supervisory board should have the required diversity of knowledge, judgment, and experience to complete

its tasks properly.

All these key points are present in the Italian legal system. In fact, they are mentioned in the Italian Corporate

Governance Code, in the Italian Civil Code and in the Legislative Decree No. 58 of February 25, 1998.

The Italian Corporate Governance Code, the Italian Civil Code and the Legislative Decree No. 58 of

February 25, 1998

Italian Corporate Governance Code

The Corporate Governance Code, first edited in 1999 and then revised in 2006, is an ensemble of best practices

and corporate governance principles developed by a specific Committee created by Borsa Italiana S.p.a.

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Although adoption and compliance with the Code is not mandatory, a recent research conducted by Assonime

in 2008 revealed that the 95% of Italian listed companies adopted it.

The main principle set out by the Code on the theme of independent directors is that the qualification of a non-

executive director as independent does not express a judgment of value, but rather indicates an actually existing

situation: the absence of any relation with the issuer, or with subjects linked to the issuer, such as to actually

affect, due to their importance, to be evaluated in relation to the individual subject, the independence of judgment

and the unbiased assessment of the management activity.

The evaluation of the independence of non-executive directors is up to the board of directors that have to

decide with regard more to the substance than to the form.

Italian Civil Code

The Italian Civil Code, after the reform of the 2003, requires for those company (listed and not listed) which opted

for the one-tier system (similar to the Anglo-Saxon model: a board of directors with an audit committee and no

supervisory bodies) the compulsory presence of independent directors in the “Comitato per il controllo sulla

gestione” (Audit Committee) which is constituted inside the board of directors: art. 2409-septiesdecies prescribes

that at least one-third of the members of the board must have the same independence requirements required for

the board of statutory auditors and that the Audit Committee must be composed all by independent directors.

Those not listed companies who opted for the traditional system or the double-tier system are not obliged to

have independent directors.

Legislative Decree No. 58 of February 25, 1998

To enforce the provisions of both the Corporate Governance Code and the Civil Code, a recent reform modified also

the Art. 147-ter of the Legislative Decree No. 58 of 25.2.1998, which now statues that “at least one of the members

of the Board of Directors, or two if the Board of Directors is composed of more than seven members, should satisfy

the independence requirements established for members of the board of statutory auditors in Article 148.3 and, if

provided for in the bylaws, the additional requirements established in codes of conduct drawn up by management

companies of regulated markets or by trade associations. This paragraph shall not apply to the boards of directors

of companies organized under the one-tier system, which shall continue to be subject to the second paragraph of

Article 2409-septiesdecies of the Civil Code. The independent director who, following his or her nomination, loses

those requisites of independence should immediately inform the Board of Directors about this and, in any case

falls from his/her office”.

This means that all listed companies now should have al least one independent director regardless of their

administration system.

A Definition of Independence

But from who do the non-executive directors have to be independent?

The independent directors have to prevent abuses of the management team, so for this reason they need to be

independent from the executive directors and from the controlling shareholders, or shareholders which are able

to exercise a considerable influence.


www.executiveview.com | Italy

43

So, looking for a definition of independence, the best one should be: independence of judgment. Independence

means freedom from any business, family, or other relationship with the company, its controlling shareholder, or

the management.

For these reasons, the Corporate Governance Code in 2006 tried to indicate some criteria symptomatic of

the absence of independence, but these criteria are just a proposal and the board of directors is free to adopt

additional or different criteria by giving “adequate information” about the effectiveness of any different evaluation

in terms of independence.

As the Corporate Governance Code is not compulsory, in defining the meaning of independence, a significant

role is played by Consob’s Comunication of February 26, 2009 on the nomination of the members of the board of

directors and of statutory auditors.

The elements detected by Consob as an index of dependence are:

• relations of kinship;

• membership in the recent past in a shareholders’ agreement provided for by art. 122 TUF involving shares

of the issuer;

• ownership, directly or indirectly, of shares, even of companies of the group;

• being an employee or a member of the social bodies of the company in the recent past;

• being candidate in the previous election of the boards of directors or statutory auditors in the list presented

by shareholders who hold, also jointly, a controlling interest or relative majority of the company.

Conclusion

Independent directors play a key role in the corporate governance system.

The basic idea is that corporate governance should ensure that boards exercise appropriate scrutiny over

management and dominant shareholders, for two main reasons:

• the independent directors are not directly involved in the administration of the company and they are not

the expression of just one part of the ownership, so they can balance the conflict of interests ingenerated by

the separation of ownership and control;

• the presence of independent directors in the Board reduces the agency costs and limits the problems related

to asymmetric information (i.e., moral hazard and adverse selection).

Alessandro De Nicola is managing partner of Orrick’s Italy offices and head of the European

Corporate Group.





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Minority Shareholders’ Rights in Spanish Listed Companies and in the Conthe Code

BY ALFONSO MORCILLO AND EDUARDO SEBASTIÁN DE ERICE | CREMADES & CALVO-SOTELO

The Spanish Joint Stock Companies Law (Ley de Sociedades Anónimas, or “LSA”), as the basic law governing

listed and non listed joint stock companies, not only deals with preventing but also with potential solutions to

conflicts arising between shareholders and the management of a company, between shareholders and creditors,

and between shareholders and other shareholders.

Spanish joint stock companies are designed with a corporate structure characterised by separation, openness

and a majority based decision making process, bringing about both their success and their failure.

On one hand, shareholders are comforted by the certainty that they will not be held personally liable for any

debts of the company, whatever its economic performance. Additionally, the fact that the company is managed

by specialised professionals adds to its appeal. On the other hand, because management’s relationship with the

actual owners of the capital is impersonal, it can lead to reckless behaviour promoted by the moral alibi that

misconduct does not directly harm any specific individual.

Listed companies’ need for financial support, along with the relatively significant growth of Spanish families’

saving capacity before the current financial decline, have favoured the progressive participation of small investors

in the equity structure of listed issuers. Indeed, few European markets surpass the Madrid Stock Exchange in

family held stock.

Although a company’s general meeting does not directly decide on the every day conduct of the corporate

business, directors appointed by majority shareholders actually impose the guidelines that the company must

follow. Despite the recommended standards, Spanish listed companies have not yet achieved the expected level of

independent directors within their governing bodies.

The LSA contains several provisions to protect shareholders in general, and minority shareholders in particular.

Some of the more important provisions are the following:

• Shareholders representing at least 5 % of the capital stock may request from the directors the calling of

a shareholders meeting with an agenda specified in the request, which the directors must call to be held

within 30 days from the request. Failure to do so by the directors entitles the requesting shareholders to

apply to a judge for the meeting to be called.

• Seven days before any shareholders meeting, any shareholder may request from the directors written

information on items in the agenda for the meeting, which can only be denied by the directors if they believe

that the publicity of the information may be harmful to the company. The directors, however, may not

refuse to give that information if the request has been made by shareholders representing at least a quarter

S P A I N


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of the capital stock of the company.

• Shareholders representing a proportional fraction of the capital stock may join to appoint a number of

directors of the board proportional to the fraction they represent.

• Shareholders who represent one-fifth of the share capital may request government intervention in the

company, in order to ensure its viability as a going concern.

• Any shareholder may request from the Mercantile Register the appointment of an auditor, when the

company is under the legal obligation of have its accounts audited and fails to do so.

• Any shareholder may challenge in court any resolution of the shareholder meeting which is contrary to the

law or to the bylaws or which favours other shareholders to the detriment of the company.

• Shareholders representing at least 5% of the capital stock of the company may request from the Mercantile

Register the appointment of an auditor, when the company is under no legal obligation of have its accounts

audited, in order to review the companies accounts for any given fiscal year, within 3 months from the end

of said fiscal year.

• Shareholders representing at least 5% of the capital stock of the company may also challenge resolutions

of the directors which are contrary to the law within 30 days from the date on which they became aware of

them.

• Minority shareholders representing at least 1% of the share capital can request, up to five days before the

holding of a shareholders meeting, the presence of a public notary to draw up the minutes of the meeting.

The Unified Code of Corporate Governance, also known as the Conthe Code, was approved by the Spanish Securities

market Commission in 2007 in order to unify prior corporate governance rules of listed companies contained in

the so called Olivencia and Aldama Codes, approved in 1998 and 2003. The Conthe Code recommendations are

not compulsory, but listed companies must explain the reasons for any non compliance in their annual corporate

governance report.

The Code contains 58 recommendations. As examples, it is recommended that: the shareholder meeting should

approve any restructuring of the company; matters which are substantially different should be voted separately;

financial institutions that represent a plurality of shareholders should split their vote in accordance with the

instructions of the shareholders they represent; the board should be made up of not less than 5 and no more

than 15 members, of which the external directors (i.e., the non executive directors) should represent an ample

majority; the number of independent directors should be at least one-third of all the members of the board; the

nature of each member should be explained and justified to the shareholders meeting which elects or ratifies

them; and, where the number of women on the board is nil or scarce, the reasons for this and initiatives to correct

the situation should be explained.

As a code dealing with corporate governance, the Conthe Code focuses on the board of directors, and has only

indirect references to the rights of minority shareholders. Thus, it recommends that when a member of the board

has been appointed at the proposal of a shareholder with less than a 5% share in the capital stock, the proper

explanations should be given. Those explanations should also be given when proposals made by shareholders

to be represented on the board have been rejected, whilst proposals made by other shareholders with similar

shareholdings in the company have been approved.

The Conthe Code has been criticised by both listed companies and scholars. The former chairman of the


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Spanish Securities Market Commission, Blas Calzada , asserted in his book “ The Governance of Spain: A Critical

Analysis” that the Conthe Code is not useful at all, being too long, too complicated and too confusing to achieve

its purpose.

Usually, minority shareholders are not connected to the main activity of the company; they do not get what

they deserve in return for their efforts to get involved in the company. This situation turns them into apathetic

shareholders. The Conthe Code offers insufficient protection for minority shareholders. On one hand, the Code

tries to clarify the corporation’s activity, including relevant issues like the compensation of directors or the planning

of board meetings aimed at providing better information to investors and promoting investment activity. But on

the other hand, the Code does not protect the shareholder in specific situations, such as fostering the presence

of minority shareholders at the general meeting. Furthermore, references to independent members of the board

of directors and the obligation to have as many independent board members as existing free floating capital are

weak and insubstantial. The same weakness is observed in the supposedly beneficial measure of the involvement

of shareholder’s associations in the board of directors.

To sum it up, we have to assert that the necessary impulse to change the subordinate and apathetic position

of the minority shareholder in listed companies rests on the legislative effort, not just on good governance

recommendations.

Alfonso Morcillo is an Associate and Eduardo Sebastián de Erice is a Partner at Cremades &

Calvo-Sotelo.






www.executiveview.com | Sweden

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Golden Parachute Entitles Managing Director to 24 Monthly Payments

BY CARL-JOHAN DEUSCHL AND ERIK NORDIN | HAMMARSKIÖLD & CO.

The managing director of the Swedish home textile chain Hemtex, Göran Ydstrand, had a golden parachute in his

employment contract that entitled him to 24 monthly payments due to material change of ownership in Hemtex.

Ydstrand was appointed as managing director of Hemtex as late as March 2009. Approximately six months

after Ydstrand was appointed, he left his position at his own request. Despite the fact that he left his position at

his own request after only six months and that Hemtex has made substantial losses the last quarters, Ydstrand

was rewarded with £752,000 which corresponds to 24 monthly payments. The reason for the payments was a

public bid from the retail investor firm Hakon Invest, which led to an acquisition of a majority stake of the shares

in Hemtex. The acquisition triggered Ydstrand’s golden parachute, which gave Ydstrand the opportunity to leave

the company with a substantial reward, after only six months in office.

Golden parachutes are typically used as anti-takeover measures for public companies to avoid hostile takeovers.

Golden parachutes are special compensation arrangements provided from the company to the management or

key employees to have an anti-takeover effect. Management and key employees are rewarded with considerable

amounts in case of a takeover which decreases the value of the target company. Such golden parachutes harm

the target company financially as well as the bidder, who might lose management and the key employees after

the acquisition of the target company. The golden parachutes may be used in advance of a bid to make the target

company less desirable but they may also, especially in the US, be implemented in the midst of a takeover battle.

Most golden parachutes involve relatively limited amounts in comparison with the purchase price of the shares,

and the anti-takeover effects may therefore be relatively insignificant. However, the fact that management and key

employees might leave the target company after payment of such golden parachutes is probably more worrying for

the bidder than the amount payable for the target company.

Anti-takeover measures are frequently used in the US. Especially during the 1980s, most Fortune 500

companies had some type of defence mechanism in force. Anti-takeover measures are implemented in order to

increase the likelihood of negative result for a bidder that attempts to take over a listed company. The measures

shall make the target company less attractive and more expensive to take over for the bidder.

Anti-takeover measures not only include golden parachutes but also a large number of other steps and measures,

such as amendments of the articles of association and change of control provisions in material agreements.

A relevant question in this context is why anti-takeover measures and defence mechanisms are implemented

in listed companies. The basic idea with publicly traded shares is that the shares shall be freely traded, and public

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bids and takeovers are natural occurrences in a free market. Obviously, such defence mechanisms are not in the

shareholders’ interest, as the defence mechanisms both harm the company and counteract the public bid in itself.

Shareholders do not normally want the board of directors of the target company to decrease the possibility of a

bid as, after all, it is the shareholders who own the company and have made the investment and not the board of

directors. Such anti-takeover measures are almost always harmful for the shareholders of the target company, as

the measures directly harm both the company and the shareholders of the company. The natural question is: in

whose interest are the anti-takeover measures implemented? The answer is that the measures are in the interest

of the board of directors and the management of the company.

In case of takeover of the whole target company, the bidder might delist the shares and take the company from

public to private in order to achieve benefits within the bidder’s group, such as economies of scale, improving

the mix in its company portfolio, or because the bidder is of the opinion that the company is better suited to

being delisted rather than listed. Further, if the target company is acquired by a private equity firm, the company

might be restructured, split up in to several companies and eventually sold. Further, the target company might be

incorporated in an existing group and the board of directors and the management of the target company might be

replaced by management and directors chosen by the bidder. Even if the management and the board of directors

can stay, the company is now only a subsidiary and not a prestigious independent listed company. In addition to

the loss of prestige, the benefits and the salaries of management and board of directors might also be affected by

such changes.

Even if the bidder has no intention of delisting the target company, and only acquires a minority stake of the

company, a new owner might have higher or different goals and be more demanding than the current owners.

Further, as discussed above, the bidder might also have its own preferences in respect of management team and

board of directors. No matter whether the bidder intends to take the company private or keep it public, a change

of ownership is risky for the board of directors and the management. In addition to the risks that management and

the board of directors may fear in case of a takeover, the management, in case of golden parachute arrangement, of

course also sees a possibility of being richly awarded in case of a takeover. That reason might be equally important

as the fear of losing their positions, prestige and benefits.

The conclusion is that the anti-takeover measures are introduced to protect and reward the management and

the board of directors, rather than the target company and its shareholders.

So how is it possible to implement mechanisms that are to the advantage of the prominent figures of the

company but to the disadvantage to the company and the shareholders? The answer is weak shareholder

structures. Such mechanisms are probably more common in companies with a weak shareholder structure where

the management team and the board of directors, more or less independently, run the company and dictate their

own salaries, benefits and other terms and conditions. A listed company with one or several strong owners is less

likely to implement such mechanisms. It is, anyhow, remarkable that the prominent figures of listed companies

can implement such mechanisms that obviously are in favour of themselves only, without any public debate

and negative publicity. What happened to the fundamental object of corporations: maximising the profit of the

shareholders?

In Sweden, hostile takeovers have not been common and, subsequently, anti-takeover measures are not

widespread. More common are stay-on bonuses, which are designed to keep management and certain key employees

in the company in case of a material change of ownership. The stay-on bonus will reward the management and



49

key employees if they stay in their respective positions for a certain time after the takeover. Such bonuses are, if

kept at reasonable levels, beneficial for the individuals involved, as well as the bidder and the shareholders as they

ensure consistency in the important integration period following a takeover. Ydstrand’s golden parachute might

not have been a takeover defence, but rather a generous emolument. The golden parachute might, in other words,

have been designed to give Ydstrand a one sided possibility to escape in case of a change of ownership, rather

than provide a shelter against takeovers. It is possible that Ydstrand, before he accepted the job, was aware of

the fact that a takeover may occur, and demanded such golden parachute to protect himself if such takeover was

effected.

It could, of course, not be ruled out that the US phenomenon with anti-takeover measures now, more than 25

years later, has come to Sweden. The real reason behind the golden parachute will probably never be disclosed to

the public. Perhaps this, after all, was the first sign of newly-established practice in Swedish listed companies?

Carl-Johan Deuschl is a Partner and Erik Nordin is an Associate at Hammarskiöld & Co.


Time to Ban Competitors Within the Executive Board

BY CARL-JOHAN DEUSCHL AND JOAKIM SUNDBOM | HAMMARSKIÖLD & CO.

Recent, well-chronicled events within certain Swedish listed companies’ executive boards have once again highlighted

the problem of board members acting simultaneously as board members of rival companies.

In the US, a clear ban on board representation by competing companies has existed since 1914. However, in Sweden

this development is heading, strangely enough, in the opposite direction. The regulations aimed at counteracting

simultaneous board representation have been relaxed. It is time to introduce legislation that prohibits concurrent

board directors of rival companies.

In Sweden, it is not unusual for a person to have a board commission within two or more competing companies. It

would seem that these people should posses an inner compass allowing them to see the unsuitability of this situation,

and decline the position. Why? The saying “No man can serve two masters” is an easily comprehensible and fitting

reason. In Sweden, however, the whole question has been leavened by something of a ”jack-of-all-trades” mentality

which seems to assume that a person can disregard that which he or she knows about a commission as a member

of one board, while acting as a member of another company’s board, even if it is a rival company. It seems to be

completely legitimate to contend that one can surmount problems that would otherwise result as a consequence of

divided loyalty.

Apart from questions of loyalty there is also a competition reason for prohibiting simultaneous board representation

within rival companies. Within the executive board, questions of significance to marketing strategy are discussed.

It is uncontroversial, within the field of competition law, that the exchange of such information between rivals is

typically seen as limiting competition. If the exchange of information contains such information that would normally

be kept secret and can affect the company’s conduct on the market, this is normally viewed as a serious violation of






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competition legislation.

However, it has proved to be difficult to apply competition rules in a situation where the business’ collaboration

is limited to the sharing of board members. Nor does Swedish company law address the problem as neither the

disqualification rules of the Swedish Companies Act nor does the fundamental duty of loyalty and professional

secrecy, according to basic corporate principles, put a decisive end to representatives from rival companies serving on

executive boards.

In the US, this was already recognised as a competition law problem before the First World War, and in 1914 a clear

ban on board members who simultaneously served as board members of rival companies was introduced. An example

of the application of these regulations is that the Federal Trade Commission recently launched an investigation into

simultaneous representation on the boards of Google and Apple.

In Sweden, on the other hand, recent developments have actually proceeded in the opposite direction. As an

example, up until 2008 the Swedish code for corporate governance contained, among other things, a footnote which

prescribed that directors of rival companies should not form part of a company’s nominating committee. However, in

the latest revision of the code, a decision was taken to remove this restriction.

To the best of our knowledge, the question of regulating company directors who simultaneously serve as board

members of rival companies has not been the object of formal consideration within Government Office. However,

approximately 10 years ago, the Swedish Competition Authority made a survey of active board directors simultaneously

serving on the executive boards of rival companies. The survey revealed that this was occurring on a significant scale.

The Competition Authority’s survey showed that it was not at all unusual to find concurrent board directors even in

situations where there was no owner relationship between the rival companies in question. However, the Competition

Authority did not suggest stronger legislation; instead it advocated continued investigation initiatives and analyses.

We have difficulty seeing the disadvantages of prohibiting rivalry within executive boards and think that it is high

time that Sweden introduces such a ban, which on the other side of the Atlantic has long been considered an accepted

method of counteracting unhealthy competition.

Carl-Johan Deuschl and Joakim Sundbom are Partners at Hammarskiöld & Co.


Management Demanded £71m From the Banks to Stay With Insolvent Portfolio Company

BY PEDER HAMMARSKIÖLD AND ERIK NORDIN | HAMMARSKIÖLD & CO

The management team of the insolvent, private equity controlled portfolio company Dometic demanded bonuses

and shares worth approximately £71 million in order to continue working for the company. The demands from

the management have put tremendous pressure on the company as well as on the lending banks. In Sweden, we

have not seen this kind of “blackmailing behaviour” from the management of insolvent companies before – will

this behaviour become established practice in the future?






51

In 2005, private equity firm BC Partners acquired Dometic, the Swedish caravans fittings maker, through a

secondary buyout from EQT for approximately £885 million. Dometic, a former division of the Swedish appliance

giant Electrolux, has been controlled by private equity firms for the last 9 years and suffers financially from its

overleveraged position.

During 2008 and 2009, Dometic dismissed hundreds of employees, made a substantial financial loss and

almost became insolvent. Dometic was unable to pay its due debts and BC Partners was not willing to invest the

additional capital required, which was approximately £531 million according to the lending banks. This led to a

situation where the only way out for the lending banks was to take over the ownership of Dometic. In this serious

situation, the management of Dometic made a claim for additional bonuses and shares in order to continue

working for the company after a takeover by the lending banks. The lending banks concluded that they could not

prevent a bankruptcy of Dometic without management onboard, therefore, the lending banks had to accept the

demanded incentives prior to the takeover of Dometic.

The incentives for the management team amounts to £71 million and consists of bonuses and shares in Dometic.

The bonuses include both direct payments to the management team, without any specific services in return except

for staying in their respective positions, and additional payments if the company reaches certain profit goals. The

profit goals are not stretch goals – the lower profit goal has been reached, by a wide margin, for the last seven years

and the second profit goal was last reached in 2007. The incentive scheme also provides the management team

with 25 percent of the shares in Dometic. Furthermore, the management is entitled to additional compensation

when the lending banks are selling their shares in Dometic. The incentive scheme can, depending on Dometic’s

financial development, in total be worth considerably more than £71 million. Provided that Dometic’s enterprise

value reaches £1.1 billion, the incentive scheme could be worth up to £110 million.

There are two main reasons why such demands will probably arise more often (and be successful) in private

equity owned portfolio companies rather than in companies owned by industrial investors.

The first reason is the debt structure in the portfolio companies owned by private equity firms. The portfolio

companies are always under a high debt pressure. In order to not breach the covenants in the financial arrangements,

the portfolio companies must not only keep their current profit and cash flow level, they must often increase them

on a yearly basis. Industrial companies do not have these kinds of debt levels. As a consequence, insolvent portfolio

companies owned by private equity firms can have solid operational businesses with substantial yearly operational

profits but the profits are wiped out by the interest rates and amortisation. In case of insolvency, the lending banks

will try to save portfolio companies where the business generates operational profits. In order to save such portfolio

companies, management is essential – and management can, therefore, demand generous incentive schemes.

Industrial companies facing an insolvency situation have, more often than not, a poor operational business that is

insolvent even though it does not carry a high level of debt. No lending banks will compensate the management of

a company with poor operational business to continue to carry out loss making business. The lending banks will

probably, in such cases, prefer to apply for bankruptcy.

The second reason is the fact that management is co-investor in the private equity owned companies, while

management in industrial companies is normally not co-investing. As the management team is co-investing in

portfolio companies, the members of management risk making an, often substantial, loss when the company is

on the border of bankruptcy. The members of management have often taken personal bank loans and perhaps

pledged their homes in order to be able to co-invest in the company. In case of an insolvency situation, the



52

management team can see an opportunity to cover its losses and get compensation from the lending banks in

case of a takeover. In the same second as the lending banks acquire the company, the management, as well as the

private equity investors, lose their entire investment. Furthermore, these kinds of demands from management,

might also restrain the lending banks from taking over the portfolio company, and work as an instrument for

management (and the private equity investors) to keep their shares.

An interesting question is whether management could use its strong position to demand corresponding

incentive schemes from the private equity investor (instead of the lending bank). The answer is no. As long as

the private equity investor and management control the company, a detailed shareholders’ agreement normally

regulates their behaviour and actions. In most shareholders’ agreement between the private equity investor and

management, the management members would be considered “bad leavers” if they chose to leave the company, and

in such a case management would have a contractual obligation to offer their shares to the private equity investor

for a nominal value. Further, as long as management and the private equity investor are in control of the shares

they have a mutual interest to cooperate, and also a duty of loyalty under the shareholders’ agreement. When the

lending banks take over the company, no shareholders’ agreement is in force any longer, and management can act

in a more unrestricted way. Furthermore, it might be understandable that management, which probably sees the

lending banks as the “enemy” who chase their shares in the company (as well perhaps, as their pledged homes),

prefer to squeeze out the lending banks rather than the private equity investor.

Our conclusion is that lavish management incentives in an insolvent situation will not become established

practice in all types of insolvency situations in Sweden, even though management of industrial companies might

be “inspired” by the Dometic case. However, it is likely that the management of companies owned by private

equity firms will be opportunistic and try to demand more or less unreasonable incentive schemes from the

lending banks in order to cover their own losses. Compensation as high as £71 million will, however, not become

established practice in Sweden.

Peder Hammarskiöld is a Partner and Erik Nordin is an Associate at Hammarskiöld & Co.






www.executiveview.com | Ireland

53

New Rights for Shareholders in EU Listed Companies – the Shareholders’ Rights (Directive 2007/36/EC) Regulations 2009

BY KEVIN ALLEN AND MIRIAM KELLY | A&L GOODBODY

New regulations, containing a number of significant provisions on the rights of shareholders in listed companies,

were transposed into law in Ireland on 6 August 2009. The Shareholders’ Rights (Directive 2007/36/EC)

Regulations 2009 (the “Regulations”) implement the provisions of the 2007 EU directive on shareholders’ rights

which was due for implementation in August 2009 by member states across the EU.

The Regulations should be of interest to shareholders of listed companies in Ireland and also to the companies

themselves who, as a result of the Regulations, may want to take action in a number of areas.

This article deals in brief with the scope of the Regulations, some of the key provisions of the Regulations,

when the Regulations take effect for listed companies and the steps companies may wish to take as a result of the

Regulations.

The practical implications of these new provisions are currently being examined by companies and their

advisers, and accordingly further issues may arise which will need to be addressed from time to time as the

Regulations are further stress-tested.

Scope of the Regulations

The Regulations apply to companies listed on the Main Market of the Irish Stock Exchange and to companies

listed on a regulated market elsewhere in the EU but having their registered office in Ireland. The Regulations do

not apply to companies whose shares are traded on AIM or IEX, to UCITs and non-UCITs or to companies without

a listing.

In general, the rights granted under the Regulations apply only to the registered members of affected

companies.

Power of Members to Requisition an EGM

One of the key changes introduced by the Regulations concerns the ability of members to call an EGM. Previously,

a member or members representing not less than 10% of the paid up voting share capital of the company could

requisition an EGM under the Irish Companies Acts. The Regulations amend this provision so that, in respect of

listed companies only, a member or members representing not less than 5% of the paid up voting share capital of

the company can now requisition an EGM. A similar amendment has been included on this issue in the equivalent

regulations introduced in the UK.

I R E L A N D


Ireland | www.executiveview.com

54

Notice Period for EGMs

Another significant provision of the Regulations concerns the notice period for EGMs. Previously under Irish law,

AGMs were required to be held on 21 days’ notice, but EGMs (other than meetings for the passing of a special

resolution) could be held on 14 days’ notice. The Regulations now provide that EGMs of listed companies (other

than meetings for the passing of a special resolution) may be held on 14 days’ notice, only where:

a) the company offers all members the facility to vote by electronic means at general meetings; and

b) the company has passed a special resolution, approving the holding of EGMs on 14 days’ notice, at its

immediately preceding AGM or at a general meeting held since that meeting.

It is anticipated that many companies will want to retain the right to hold EGMs on 14 days notice and, therefore,

implement conditions (a) and (b) mentioned above to facilitate this. Accordingly, we recommend that companies’

articles of association be reviewed to ensure that members are permitted to vote by electronic means for the

purposes of condition (a) and that companies pass the special resolution at their next general meeting for the

purposes of condition (b).

It is noteworthy that a number of issues arise around the interpretation of these provisions. In particular:

• The meaning of the term “to vote by electronic means” is unfortunately not defined in the Regulations.

(A&L Goodbody had asked the DETE to do so in order to put the matter beyond doubt.) However the DETE

have confirmed, both verbally and in the guidance notes issued by the DETE on 23 September 2009 on the

Regulations (the “Guidance”), that “to vote by electronic means” for this purpose can mean to vote by proxy

appointed electronically. (This accords with the UK position on the issue.)

• It is not entirely clear whether it is sufficient to have passed the special resolution required to satisfy

condition (b) at a meeting held prior to the date of coming into force of the Regulations. The language of the

Regulations (unlike the equivalent UK regulations) does not clarify this point and the Guidance, likewise,

is unfortunately somewhat misleading on the issue. However, helpfully, the DETE have confirmed to us

verbally that any such resolution passed prior to the date of the Regulations will be effective. (This is in line

with the provisions of the equivalent UK regulations and the position adopted by a number of companies

both in the UK and Ireland).

• There is also a potential concern around the wording of the resolution. The Regulations state that a special

resolution “reducing the period of notice to 14 days” should be passed. However, the terminology of

“reducing the period”, although it is drawn from the underlying EU directive, is arguably inappropriate,

because Irish law, as amended by the Regulations, provides for a notice period of 14 days for EGMs on

certain conditions, rather than a longer notice period which can then be “reduced” to 14 days. Neither the

Regulations nor the Guidance state that there is any particular required language which must be included

in the resolution. (The Guidance simply states that “members’ consent must be sought by way of special

resolution”.) Accordingly, our view is that there is no particular requirement to include words to the effect

that the notice period is reduced to 14 days in the wording of the resolution.

Members’ Right to Ask Questions at Meetings

Members will have the right to ask questions related to items on the agenda of a general meeting and to receive

answers, subject to certain qualifications (such as where the answer has already been given on the company’s



55

internet site or where the chairperson considers that answering the question is undesirable in the interests of the

good order of the meeting). Prior to this, a member’s right to be heard was somewhat more limited and had no

statutory basis. Changes such as this are likely to be of interest to chairpersons of listed companies.

Members’ Right to Put Items on the Agenda of AGMs and to Table Resolutions at AGMs and EGMs

The Regulations provide that a member or members holding 3% of the issued share capital of the company,

representing at least 3% of its total voting rights, will have the right to put items on the agenda and to table draft

resolutions to be adopted at AGMs. The request must be received by the company at least 42 days before the

relevant meeting. Where an agenda has been circulated to members prior to the exercise by a member of this right,

the company must re-circulate a revised agenda.

The Regulations also provide that a member or members holding 3% of the issued share capital of the company,

representing at least 3% of its total voting rights, will have the right to “table a draft resolution for an item on the

agenda” of an EGM. What this means in practice is unclear. In particular:

• Does it mean that a member with the requisite majority can table resolutions only in respect of items

that could be reasonably considered to be connected with the agenda of the meeting and, if so, what does

“connected” in this context mean?

• If a member tables a resolution which deals with the same subject matter as a resolution already contained

in the notice, which resolution takes precedence?

• If a number of resolutions are received from members which deal with similar subject matter but which

may contain slightly different language, do all resolutions require to be put to the members?

Some of these questions could also arise in relation to the right of members, mentioned above, to put items

on the agenda and table resolutions at AGMs.

In addition, unlike with AGMs, the Regulations do not set out any time limit by which such draft

resolutions are to be submitted in respect of EGMs. The Guidance states that it was decided to leave the

setting of a deadline for companies themselves to determine. But the Guidance then proceeds to give an

example of how such a deadline might be implemented, which example unfortunately obfuscates the issue

somewhat.

It remains to be seen how companies will address these issues, but a “common sense” approach to the

area, which balances the rights and interests of shareholders with the efficient management of company

meetings, should be the starting point for any company dealing with these issues.

Publication of the Date of the Next AGM

The Regulations provide that in order to facilitate a member availing of the right to put items on the agenda

of AGMs and to table resolutions (mentioned above), the company shall ensure that the date of its next

AGM is placed on its internet site by: (i) the end of the previous financial year; or (ii) not later than 70 days

prior to the date of the AGM; whichever is earlier.

This is a new requirement for listed companies which could perhaps in some cases be somewhat onerous.

Companies will need to bear this requirement in mind well in advance of the planning of AGMs going

forward.



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Content and Publication of Notices of General Meetings

The Regulations contain a number of provisions regarding notices of general meetings of listed companies,

including the following:

• Notices of general meetings must contain certain minimum information.

• The company must publish on its internet site a specified minimum list of items prior to a general meeting,

such as the notice, share information and documents to be submitted to the general meeting.

• A notice of a general meeting must be free of charge and issued in a manner ensuring fast access to it on a

non-discriminatory basis (presumably to ensure that resident and non-resident shareholders receive notice

at the same time).

Electronic Participation and Voting in Advance

Listed companies will now be allowed to offer members participation in and voting at general meetings by

electronic means (although there is likely to be debate about exactly what this means). Listed companies will also

be allowed to offer the possibility of voting by correspondence in advance of a general meeting. However neither

of these provisions is mandatory and companies are merely permitted to provide these facilities. Having said that,

it is possible that in the future companies may come under pressure from members to provide such facilities.

Proxies

The Regulations also contain a number of provisions around the appointment of proxies and professional nominees

in listed companies, including the following:

• Proxy holders will now be under a statutory duty to act in accordance with shareholder instructions.

• Proxies may be appointed (and the appointment may be revoked) by either written notification to the

company or by electronic means.

• More than one proxy may be appointed by a member in certain circumstances. Previously under the Irish

Companies Acts, members could only appoint more than one proxy to attend on the same occasion where

the articles of the company provided for it. Now, a member of a listed company can appoint more than one

proxy in respect of shares held in different securities accounts. In addition, a member of a listed company

acting as an intermediary on behalf of a client shall not be prohibited from appointing more than one proxy

to act on behalf of the intermediary’s various clients.

Establishment and Publication of Voting Results

The Regulations also provide that, where a member requests a full account of a vote before or on the declaration

of the result of the vote at a general meeting, the company must establish for each resolution the number of shares

for which votes have been validly cast, the total votes validly cast, the proportion of the share capital represented

by those votes, the number of votes cast in favour and against and the number of abstentions.

In addition, voting results must be published on the company’s internet site not later than 15 days after the meeting.

When the Regulations Take Effect for Companies

The Regulations come into force on 6 August 2009, but apply in relation to meetings of listed companies of which

notice is given on or after that date.



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Next Steps for Listed Companies

There are a number of issues, from a legal perspective, arising out of the Regulations in relation to which listed

companies may decide to take action. In particular, it is advisable for companies to propose a resolution to deal

with the issue of EGM notice, mentioned above, as soon as possible at their next general meeting. In addition,

companies should consider having their articles of association reviewed in light of the provisions of the Regulations

to identify any amendments which may be required to be made, for example in the areas of the appointment of

proxies by electronic means, the appointment of multiple proxies in certain cases and the contents of notices of

general meetings.

Kevin Allen is a Partner and Miriam Kelly is a Corporate Professional Support Lawyer at A&L

Goodbody.


The Nominee Director – his Duties to the Company and to his Appointor and Whether They can be Modified by Agreement

BY KEVIN ALLEN AND MIRIAM KELLY | A&L GOODBODY

The Issue

The position of the nominee director is an interesting one. The role does not have any solid statutory reference

point in Ireland and yet the practice of appointing nominee directors to the boards of joint ventures and other

companies has existed for quite some time. One critical issue which arises around nominee directors is the extent

to which the director can have regard to the interests of his appointor. In answering this question, it is necessary to

examine to whom the director owes his fiduciary duties, whether his duty to the company is in any way impacted

upon by his relationship with his appointor, and whether it is possible to modify his duties by contract. This article

looks at these questions, particularly in light of recent developments including new UK case law on the topic, and

sets out some conclusions and suggestions for nominee directors and their appointors to bear in mind.

What is a Nominee Director?

A nominee director is a director who is appointed to the board of a company like any other director but, crucially,

whose appointment is at the request or on the nomination of a third party and whose job is to “look after” such

party’s interests. The right to appoint a nominee director is often enshrined in the articles of association of the

company or the agreement between the shareholders of the company. In a joint venture, there is often more than

one nominee director on the board, appointed by each joint venture party.

To Whom Does a Nominee Director Owe Duties?

Under Irish law, no distinction is drawn between the duties of a nominee director and any other director, and so

nominee directors owe the same duties as other directors to the company, its creditors and employees. However






58

the nominee director also finds himself contemporaneously under an expectation, or perhaps even an obligation,

to his appointor to act in the appointor’s best interests. The legal position on the extent to which the nominee can

have regard to the interests of his appointor has, however, undergone a change over the years.

With one exception, the Irish Companies Acts make no reference to the concept of a nominee director. That

exception is contained in Section 150 of the Companies Act 1990. Section 150 obliges the court, in the context of

the winding up of a company, to make a restriction order in respect of any director of the company, unless it is

satisfied, among other things, that the person concerned was a director of the company solely by reason of his

nomination as such by a financial institution or by a venture capital company. However, the statutory provision

setting out the venture capital exemption has effectively never come into force, and from a practical perspective,

it is very rare for a financial institution to appoint anyone as a nominee director in connection with the giving

of credit facilities. Accordingly, these provisions have been of limited relevance in the context of restriction

proceedings. Nevertheless they do represent, to some extent at least, recognition of sorts by the legislature that,

in certain circumstances, it is appropriate to draw a distinction between a nominee director and a director who is

not the nominee of any person. (It is of interest that the heads of the proposed new Companies Consolidation and

Reform Bill, which is due to replace the existing Irish Companies Acts in the next year or two, in addition to giving

a statutory basis to the fiduciary duties of directors, also include a provision stating that a nominee director is

entitled to have regard to the interests of his appointor (Head 9, Part A5 of the Bill). What this provision will mean

in practice is hard to anticipate, but it certainly acknowledges the twin responsibilities of the nominee director at

a statutory level.)

As the legislature has not grappled with the matter, it has fallen to the courts to decide where the duties of the

nominee director lie. In general, courts in the past have been unwilling to acknowledge the commercial reality,

adopting instead the position that it was reprehensible for a director to have regard to anyone’s interests but those

of the company. More recently however, the courts, including the Irish courts in the case of Irish Press v Ingersoll

Irish Publications Limited (15 December 1993, unreported, High Court), have taken a more commercial view and

have acknowledged that there is nothing wrong with a director’s appointor having a view as to where the interests

of the company lie and requesting its director to follow that direction, so long as in following such direction the

director is not doing harm to the company or any other shareholder’s interests in the company. This would now

seem to be the position under Irish law. The judge in this Irish case stated that:

“The position of nominee directors can be a difficult one if they disagree with the views of the person or body

appointing them. Their duty is to act in the interests of the company. They have also got a duty to act on the

instructions of their nominating party. But acting in the interests of the company is no more that acting in the

interests of all its shareholders. If what they are asked to do involves seeking to damage the interests of one section

of the shareholders in favour of another then as a director they have a duty not to do that. However, if what they

are required to do is merely something that they themselves personally think is not the way to approach the matter

then they must give way. There is nothing wrong with the appointing body or party having a view as to where the

interests of the company lie and ensuring that its nominees follow that direction provided that in so doing they are

not seeking to damage anybody’s else’s interest in the company.”

A number of very recent UK cases have again considered the issue of the nominee director’s duties. Hawkes v

Cuddy (Court of Appeal [2009] EWCA Civ 291) involved the Welsh rugby team, the Ospreys, which was established

out of two rival teams, Neath and Swansea. When the Ospreys became successful, disputes arose and a key question



59

in the ensuing litigation was the extent to which the nominee director appointed by Neath to the board of Ospreys

was entitled or obliged to have regard to the wishes of his appointor. This case reiterated what, in our view, is the

current legal position in Ireland, which is that the nominee is entitled to have regard to the appointor’s interests

but only to the extent that they are not incompatible with his duty to act in the interests of the company itself.

Interestingly, the Court of Appeal in this case also confirmed that, whereas the nominee director may owe duties

to his appointor by reason of the terms of his appointment or because he is an employee or officer of his appointor,

the fact that a director has been nominated to that office by the appointor does not, of itself, impose any duty on

the director owed to his appointor. This is, in our view, a helpful clarification of this particular aspect of the duties

owed by nominee directors and is not inconsistent with the views expressed in the Irish Press case.

Can the Nominee’s Duties be Modified by Contract?

A key question which arises in the context of nominee directors is the extent to which the duties they owe to

the company can be modified by provisions inserted in the company’s articles of association or in the governing

shareholders agreement. This question has arisen in a number of the recent UK cases in this area, perhaps one of

the most noteworthy of these being Cobden Investments Limited v RWM Langport Ltd, Southern Counties Fresh

Foods Limited, Romford Wholesale Meats Limited (High Court [2008] EWHC 2810 (Ch)). In general terms, the

conclusion seems to be that it is possible, to a certain extent, to modify the duties owed by nominee directors by

agreement of all the shareholders. The High Court in the Southern Counties Fresh Foods case considered the

point in detail, examining the case law including recent cases such as Hawkes v Cuddy, and set out a very useful

summary of the law in the UK in the area, as follows:

“[T]he position of a nominee director is, I conclude, as follows.

a. First, he owes the same duties to the company as any other director.

b. Secondly, he owes his duties as a director to the company alone.

c. Thirdly, the company is entitled to expect from the director his best independent judgment.

d. However, fourthly, these duties can be qualified in the case of a nominee director just as they can be

qualified in the case of any other director. In particular, such duties (except perhaps for certain core

duties) can be qualified by the unanimous assent of the shareholders.

e. But, fifthly, it is doubtful whether, as a matter of English law, it is possible to release a director from his

general duty to act in the best interests of the company.

f. Sixthly, even if it is possible to do so, it would require strong evidence to demonstrate that that had

been done, ideally an express written agreement signed by all of the shareholders. The onus must lie

on those saying that the general rule has been attenuated or, to use another word, relaxed, as a result of

unanimous shareholder approval to demonstrate that such approval has been given. And, I must add,

they must show the extent to which the general rule has been relaxed.

g. Seventhly, however, I see no reason in principle why in relation to specific areas of interest, a director

should not be released from his fiduciary duty to give his best independent judgment to the company.

In particular, if a director is charged with negotiating on behalf of his appointor an agreement with

the company where the interests of his appointor and the company are opposed, the shareholders

can unanimously agree that he may conduct such negotiation without regard to the interests of the

company…..



60

But whatever can be said as a matter of generality, I consider that the extent of the duties of a director in such a situation

are very much fact-specific. The general duty is clear; the difficult question is the extent to which the duty is qualified.

That qualification will depend critically on the context of the relationship and the particular action which is said to

constitute a breach of duty.”

Whereas the issue of whether a nominee director’s duties can be modified by agreement does not seem to have

been considered by the Irish courts yet, the decision in the Southern Counties Fresh Foods case will be persuasive here

should the issue ever come before the courts. Accordingly, in considering the role of nominee directors in the future, the

possibility of shareholders agreeing provisions to deal with potential conflicts of interest should be borne in mind.

Of course the duties of the nominee director to the company cannot be completely overridden and it will be a

question of the extent to which such modification will be upheld. As the court in the Southern Counties Fresh Foods

case stated, it is doubtful whether, as a matter of law, it is possible to entirely release a director from his general duty

to act in the best interests of the company. In addition, of course, it is worth remembering that all directors including

nominee directors are subject to the obligations contained in the Irish Companies Acts, and elsewhere in respect of

listed and regulated entities, to disclose conflicts of interest. But nonetheless the possibility of modifying a nominee

director’s duties, if only to a certain extent or in relation to certain matters, is a real one, a fact which should be of

interest to joint venture parties, nominees and their appointors into the future.

Conclusion and Suggested Steps

Nominee directors owe the same duties to the company as any other director. The extent to which they are required

to take their appointors’ interests into account is likely to depend on the terms of appointment of the director or

his position as employee or officer with the appointor. Where the nominee does owe some duty to his appointor,

he is entitled to have regard to the appointor’s interests but only to the extent that they are not incompatible with

his duty to act in the interests of the company itself. Whereas the issue of whether a nominee director’s duties can

be modified by agreement does not seem to have been considered by the Irish courts yet, it is likely that recent UK

case law will be persuasive here. This means that it may be possible (although only to a certain extent or in relation

to certain matters) to modify the duties owed by nominee directors to the company by agreement. Accordingly,

nominee directors and their appointors should consider the possibility of including provisions in the company’s

articles or in the governing shareholders agreement to deal with how the nominee director should act in the event

of a conflict of interest. Lastly, nominee directors should bear in mind that they, like all directors, are subject to

the obligations contained in the Irish Companies Acts, and elsewhere in respect of listed and regulated entities,

with regard to directors and disclosure of conflicts of interest.

Kevin Allen is a Partner and Miriam Kelly is a Corporate Professional Support Lawyer at A&L

Goodbody.







61

The Office of the Director of Corporate Enforcement in Ireland – an Overview

BY KEVIN ALLEN AND SINEAD KELLY | A&L GOODBODY

The Office of the Director of Corporate Enforcement (ODCE) was created by the Company Law Enforcement Act

2001.

The primary mandate of the Director of Corporate Enforcement (the “Director”) is to encourage compliance

with and adherence to the requirements of the Companies Acts 1963 – 2009 and to bring to account those who

disregard the law. The Director has a number of statutory functions, and powers to achieve those functions,

including supervision, investigation through the appointment of inspectors, criminal investigation, prosecution,

civil enforcement and sanction. Importantly, the Director is independent as an office holder, but is politically

accountable to the Minister for Enterprise, Trade and Employment.

Investigations and search and seizure powers

The ODCE may initiate fact-finding company investigations where there is a reasonable belief that a serious or

“indictable” offence has been committed. To facilitate this, information relating to offences under the Companies

Acts which has been gathered by the Competition Authority, the Garda Siochana (the Irish police force) and the

Revenue Commissioners may be disclosed to the ODCE. Investigations may be undertaken at the request of the

Director, or by an inspector appointed by the High Court to conduct an inquiry into a company’s affairs. In a

recent case in 2008, the ODCE moved to have an inspector appointed by the High Court to a public company and

two of its subsidiaries, following a high profile Supreme Court insider dealing case.

In the recent past, the ODCE have also relied on inspectors’ reports to underpin disqualification applications in

respect of directors of certain financial institutions, where wrongdoing was established by the inspectors.

The Companies (Amendment) Act, 2009 which became operative earlier this year considerably enhances the

investigative powers enjoyed by the Director of Corporate Enforcement under the Companies Act 1990. In order

to understand the impact of the changes it might be useful to briefly look at the powers set out in Part II of the

1990 Act.

Companies Act, 1990

Under this Act, the Director may apply to the High Court to have an inspector appointed to investigate a company

where the circumstances suggest that the affairs of the company are being conducted with:

• the intention to defraud, or in an unlawful manner; or

• where there is a concern, the company officers are guilty of fraud, misfeasance or other misconduct, or the

company members are not being given adequate information.

The inspector appointed may be an officer of the ODCE. Company officers and agents must produce all books and

documents and give all reasonable assistance to the inspector who also has authority to examine such officers

and require them to produce written responses. A refusal to cooperate may result in a direction from the High

Court compelling production of documents, etc. The inspector must make a report to the Court and a copy of this



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must be sent to the Director. Where the public interest considerations support this, the Director may apply for a

winding up order in respect of the company.

Secondly, the Director may also appoint an inspector to investigate the membership of any company to

determine the true persons who are financially interested in the success or failure of the company, or who are in a

position to materially control and influence it.

Thirdly, the Director may also conduct his own enquiry into the ownership of any shares in or debentures of a

company where he considers that a formal investigation is not necessary.

In each of the above cases, there must be reasonable grounds that this is necessary for:

• the effective administration of the law relating to companies;

• the effective discharge of his functions;

• the public interest.

The Director has ancillary powers to freeze all rights in respect of shares or debentures in connection with

such an enquiry or investigation. This may be lifted where the information is disclosed or the shares are

to be sold. Finally, the Director may also give directions to companies falling within its charge where he

believes that this is necessary to examine the books and documents of the company to determine whether an

inspector should be appointed and where the affairs of the company are being conducted to defraud creditors

or members or for a fraudulent purpose. The Director also has the power to apply to court for a search

warrant to enter premises.

The Companies (Amendment) Act 2009 amends these powers of seizure with the effect that search

warrants which are usually up to one month duration from the date of issue can be further extended by the

District Court upon the application of the ODCE. There is thus the potential for protracted periods during

which a search warrant can run. The new Act gives considerable discretion to officers of the ODCE conducting

a search so that they may order the production of documents which relate to the company’s records from

third parties where these relate to a company under investigation; they must specify which documents are

required and the time and place at which they are to be produced; 21 days notice is required unless there is a

risk of damage to the records; past and present officers of the company and such third parties must give all

reasonable assistance.

Where not immediately clear whether certain material or information, including computers, is relevant to

the investigation, the officer has power to remove it for off-site examination. Factors that are relevant to this

are whether this would cause damage to the property, the number of persons required and costs. Arrangements

must also be made to store and safeguard this material, for owner access and for confidentiality. Material

taken off-site may be held by the ODCE for determination for a period of three months. Material which is not

relevant must be returned within seven days of that determination being made.

The Companies Act 1990 had a carve-out for information protected by legal professional privilege. The

new Act allows an officer of the ODCE to seize privileged information “on a sealed and confidential basis”

pending adjudication by the Court as to whether or not it is privileged. The Court may appoint an independent

person to determine this.

These changes potentially place the Director of Corporate Enforcement in a stronger position than other regulators

in the context of his investigative powers.



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Criminal Investigation and Prosecutions

The ODCE prosecute minor or “summary” company law offences and they refer indictable offences for prosecution

by the Director of Public Prosecutions. Although summary prosecutions take place in the District Court, full details

of prosecutions secured by the ODCE, including the company name, directors’ names and the sanction imposed,

are published regularly on its website. The Director has also been granted statutory power to impose on the spot

fines. However, this provision has never been commenced in law and there appears to be little political will to do

so in the immediate future.

Civil Enforcement and Sanction

Directors who face criminal sanctions can also face certain civil sanctions for company law breaches. In

recent years in has become clear that the ODCE welcome voluntary rectification of minor breaches where

inadvertent and honest mistakes have been made by company directors. To avail of voluntary rectification,

the directors in question would have to illustrate to the ODCE that systems had been put in place to prevent

further similar breaches occurring.

In terms of directors’ conduct, two additional remedies are available to the ODCE, namely, restriction

or disqualification of directors. Restriction of directors applies only to directors of insolvent companies

and is designed to ensure that a person who has previously acted as a director of a company which has

been wound up leaving unpaid debts cannot subsequently act as a company director, unless certain criteria

are met. Liquidators are required to apply to the High Court for restriction orders unless they have been

relieved of this obligation by the ODCE. Restrictions are for a five year period.

Disqualification occurs automatically when a director is convicted of an indictable offence in relation

to a company’s affairs. This includes indictable offences under health and safety, competition and other

legislation. The ODCE can also petition the High Court to disqualify a director where they have shown

themselves not to be a suitable person to be involved in the management or promotion of a company. The

ODCE will routinely seek disqualification for two or more breaches of the requirement to keep proper

books of account, persistent convictions of company law breaches and for directors of struck-off companies

where there are outstanding company filings. Disqualification periods are discretionary and tend to be of

not less than five years and not more than 12 years duration.

Insolvency – Supervision of Liquidators and Receivers

The Director’s functions also include the supervision of liquidators and receivers. The Director may petition

to the Court for the winding up of a company, where the affairs of the company have been investigated by an

inspector and the Director forms the opinion that the company should be wound up in the public interest.

In addition, the Director may require a liquidator or receiver to produce his books for examination and

be questioned on the contents of the books. Liquidators are required to report periodically to the ODCE

during the course of a winding up and specifically, liquidators must report on the conduct of the company’s

directors within six months of his appointment. The ODCE also may seek an order freezing the assets of

companies, directors or company officers where there are grounds for believing that those assets may be

removed or disposed of.



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The ODCE Today

In recent years, the ODCE has been focusing its attention on pursuing the objective of protecting company

stakeholders and shareholders. To this end, it has targeted excessive loans to directors by companies, companies

who fail to keep proper books of account and the auditing of company accounts. From a general corporate

governance perspective, the ODCE’s vision for the future appears to be one of openness and transparency in the

way Irish companies operate.

To date in 2009, the ODCE has been involved in carrying out an investigation into the affairs of the only

nationalised bank in Ireland. In addition, the Director, Paul Appleby, requested and was granted extra powers in

the form of the Companies (Amendment) Act 2009 (discussed above).

In the seven years since the creation of the ODCE, Ireland’s economy has swung from a point of prosperity and

growth, to a recession and contraction. The ODCE has been a significant feature in corporate Ireland during that

time and will undoubtedly remain so in the future.

Kevin Allen is a Partner and Sinead Kelly is a Corporate Professional Support Lawyer at A&L

Goodbody.






www.executiveview.com | Finland

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Liabilities and Challenges of a Company’s Management in the Financial Crisis

BY PAULIINA TENHUNEN AND ANNA-KAISA NENONEN | CASTRÉN & SNELLMAN ATTORNEYS LTD.

The financial crisis has enhanced the discussions regarding challenges that the management in limited liability

companies have. The liability of the management has emphasised when increasingly more companies have faced

financial troubles.

This article discusses the duties and liabilities of the company’s management in Finland. Management’s liability

in this article is discussed from the financial crisis viewpoint as financial difficulties are more common nowadays

and questions regarding management liability naturally arise.

The Finnish Companies Act (624/2006) regulates the duties and the liabilities of the members of the board

of directors, but there are also certain situations when the board members can become liable under the Finnish

Penal Code (39/1889).

Generally, in Finland, company’s management is understood to cover the board of directors and the managing

director. The shareholders’ meeting elects the board of directors. In private companies, the term of the board

members is indefinite, but in most of the public companies, the term ends with the conclusion of the annual

general meeting following the appointment of the member. However, also in private companies it is common to

elect the board of directors yearly. The managing director is appointed by the board of directors.

Especially in public limited liability companies, the board members are non-executive directors, i.e., they are

not working for the company. Many of them can be board members in several listed companies, in other words,

they are “board professionals”. However, in private and smaller companies the board members are usually, for

example, owners or managers of that company.

Duties of the Management

The members of the board of directors have a general duty to act with due care in the best interest of the company.

The decisions of the board should be based on sufficient background information, different alternatives should

be assessed carefully, the decisions should be logical and the decision makers should not have any conflicting

interests with the interests of the company.

The general duties of the board are (i) to supervise the management, (ii) to organise the operations of the

company properly and (iii) to organise the supervision of the bookkeeping and financial administration.

The managing director shall see to the executive management of the company in accordance with the instructions

and orders given by the board of directors. The managing director shall also see that the accounts of the company

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are in compliance with the law and that its financial affairs have been arranged in a reliable manner.

The board of directors has a duty to monitor the amount of the company’s equity. If it appears to the board of

directors that the company has a negative equity, the board shall without delay submit a notice concerning the loss

of the company’s share capital to the Trade Register. The registration concerning the loss of share capital can be

removed from the register only if the company files an audited balance sheet to the Trade Register that indicates

that the equity of the company is at least half of the share capital.

The Companies Act does not set any obligation for the board of directors to file for bankruptcy of the company

even in situations where the company is excessively indebted or insolvent. The company may continue its business

operations, but the board of directors must act diligently in order to avoid criminal liability and/or liability for

damages.

Liability of Members of the Board of Directors

General

The liability of board members and the managing director is very similar and governed by the same provisions.

In principle, a board member, a managing director or a shareholder is not liable for the acts or omissions of a

limited liability company, for example, they are not liable for the company’s debt. Such responsibility can only be

created by a specific provision or through a separate agreement.

The liability of the members of the board of directors and the managing director of a limited liability company

can be considered two-dimensional: firstly, there exists liability for damages, and secondly, criminal liability for

unlawful actions.

Liability for Damages

Under the Companies Act a member of the board of directors and the managing director shall be liable towards

the company for the loss he or she has in office, in violation of the duty of care, wilfully or negligently caused to

the company.

Furthermore, a member of the board of directors and the managing director shall be liable towards the company,

a shareholder or a third party for the loss he or she has, in case of breach of the Companies Act or the articles of

association of the company, in office deliberately or negligently caused. A loss caused by such violation is deemed

to have been caused negligently if the person liable does not prove that he or she has acted with due care. The

same applies to a loss that has been caused by an act to the benefit of a related party. In the latter situation, the

actualisation of liability does not provide evidence of intent to gain benefit to a related party, but only that the

measure in question has occurred for the benefit of a related party.

As regards the board members, although the board of directors act collectively, the liability for damages is

considered separately for each individual member. Acts of board members and the managing director are

considered both objectively, i.e., how a careful person would have acted in the same situation, and subjectively,

i.e., with respect to his and her experience, education and expertise.

According to the “business judgement rule” a board member or the managing director of the company are

not considered to have breached their duty of care if, considering the circumstances, the decisions in question

have been based on proper preparation and analysis enabling a logical and well justified decision and the board’s



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measures aim for the company’s benefit. Furthermore it is required that the decision is not affected by the board

members’ personal conflicting interests and that the company’s risk management mechanisms are appropriate.

Thus, attention must be paid to the proper documentation of the decision making, as in practice the minutes of the

board meetings provide evidence that the criteria of the business judgement rule have been fulfilled.

Liability for Unlawful Actions

Under the Companies Act, transactions which reduce the assets of the company or increase its liabilities without

a sound business reason shall constitute unlawful distribution of assets. Unlawful distribution of assets must be

taken into consideration especially with regard to insolvency situations.

Assets received from the company as unlawful distribution of assets must be refunded to the company, if the

receiver of the assets knew or should have known that the distribution was in violation of the Companies Act or

the Articles of Association of the company. The amount to be refunded shall bear annual interest at the current

reference rate.

Moreover, if the unlawful distribution of funds is considered to be intentional and it endangers the interests of

the company’s shareholders or creditors, this may be considered as a “company law offence”, which is subject to

public prosecution. The company law offence may result in a penalty of a maximum one year of imprisonment.

Liability under the Penal Code

Firstly, tax offences are regulated under the Penal Code. Criminal liability may arise in case incorrect information

is given to the tax authorities in order to avoid taxes or get tax benefits or certain fees of a tax nature have not been

accounted to the tax authorities (withholding tax, value added tax, employer’s social security contribution).

Furthermore, company’s management may commit an accounting offence. According to the Penal Code an

entity/person with a legal duty to keep accounts, his representative, a person exercising actual decision-making

authority in a corporation with a legal duty to keep books, or the person entrusted with the keeping of accounts,

who in violation of the requirements of legislation on accounting neglects the recording of business transactions or

the balancing of the accounts, enters false or misleading data into the accounts, or destroys, conceals or damages

account documentation, and in this way impedes the obtaining of a true and sufficient picture of the financial

result or financial standing of the entity/person with the legal obligation to keep accounts, may be sentenced for an

“accounting offence”. Accounting offence may also be aggravated or negligent.

Offences by a debtor are also regulated under the Penal Code and management of the company may become liable

for these offences. For example, dishonesty by a debtor occurs e.g., when a debtor destroys property or transfers

property abroad in order to place it beyond the reach of creditors. Furthermore, fraud by debtor occurs if a debtor

who, in order to obtain unlawful financial benefit e.g., in bankruptcy or restructuring proceedings, conceals property

or gives false or misleading information on a circumstance that is significant from the point of view of the creditors.

Pauliina Tenhunen is a Partner and Anna-Kaisa Nenonen is an Associate at Castrén & Snellman

Attorneys Ltd.







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Opinion on the Regime of Management Remuneration Policies in Finland

BY PAULIINA TENHUNEN AND MIRA VÄISÄNEN | CASTRÉN & SNELLMAN

Due to the ongoing global financial crisis and economic recession which commenced in 2008, the defects of

management remuneration policies have become a headline topic in Europe and the United States. First, there

was critical debate on the remuneration policies in the financial services sector but quite rapidly this criticism

expanded to concern management remuneration policies of other privately and publicly owned companies as

well. As a result of the debate, the current management remuneration schemes and policies have been deemed

excessive in terms of the amount of monetary compensation to the management of companies. The outstandingly

significant amounts of management remuneration have been considered to be in vast contradiction with the

personnel redundancies and temporary dismissals justified by financial reasons carried out in these companies.

Furthermore, the management remuneration policies have been considered to unjustifiably favour overly risk-

taking in the hope of personal gain to managers.

As a result of the critical public debate, the European Commission has on 29 April 2009 issued a Recommendation

on the remuneration of the management of listed companies. On the same date the European Commission has

also issued a Recommendation on the remuneration policies in the financial services sector. The latter is not

discussed in this article.

The Recommendation on the remuneration of the management of listed companies of April 2009 complements

the European Commission’s previous recommendations, Recommendation 2004/913/EC fostering an appropriate

regime for the remuneration of directors of listed companies, and Recommendation 2005/162/EC on the role of

non-executive or supervisory directors of listed companies and on the committees of the board. The main objectives

of these Recommendations are to ensure transparency of remuneration practices, to abolish risk-favouring

remuneration policies, to support the long term sustainability of the company and to ensure that remuneration is

based on performance. Furthermore, their objective is to increase shareholder control of remuneration policies

and individual remuneration in companies.

The main objective of the Recommendation on the remuneration of the management of listed companies issued

on 29 April is to provide further guidelines for performance based management remuneration by introducing best

practices which should be complied with in designing and implementing management remuneration policies.

The Recommendation 2004/913/EC has been implemented in Finland by means of self-regulation in the Finnish

Corporate Governance Code. The Corporate Governance system of Finnish listed companies is based on Finnish

legislation, and the statutory procedures are complemented by the Finnish Corporate Governance Code which

came into force on 1 January 2009 and which was preceded by the first Corporate Governance Recommendation

in Finland issued in 1997 and the Corporate Governance Recommendation for Listed Companies issued in 2003.

The Finnish Corporate Governance Code is a part of the Helsinki stock exchange self-regulation and is aimed at

companies listed on the Helsinki exchange.

The objective of the Code is that Finnish listed companies apply corporate governance practices that are of

a high international standard. The Code follows the so-called Comply or Explain principle which means that a

company is considered to comply with the Code even if it departs from an individual recommendation, provided



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that the company accounts for and explains the departure.

The Finnish Corporate Governance Code harmonises the practices of listed companies as well as the information

given to shareholders and other investors. One of the main objectives of the Code is to improve the transparency

of management remuneration and the management remuneration policies in Finland by introducing guidelines

for publicising the management remuneration policies and other financial benefits of the directors for a financial

period.

Under the Finnish Companies Act (624/2006) the decision on the remuneration of members of the board

of directors is made by the general meeting of shareholders of the company. Decisions on the remuneration of

the managing director and other operative management and other executives, on the other hand, are made by

the board of directors. Decisions on any management (whether members of the board or members of executive

or non-executive management) share based incentive schemes (share issues or option rights) are made by the

general meeting. The board may also be authorised by the general meeting to decide on share based incentive

schemes. In practice, it is often the board of directors who decide on the division of the share based incentives

within the management of the company.

In order to promote the transparency and systematic functioning of the company’s remuneration policy

as well as to improve the efficient preparation of matters pertaining to the appointment and remuneration of

the managing director and other operative management of the company as well as the remuneration policy of

other personnel, the board of directors of a company may, according to the Finnish Corporate Governance Code,

establish a remuneration committee. The duties of the remuneration committee may include, e.g., preparation

of matters pertaining to remuneration and other financial benefits along with the appointment of the company’s

managing director, possible deputy managing director and other management and executives. Due to the nature

of the matters which the remuneration committee deals with, the majority of the members of the remuneration

committee shall be independent of the company, and neither the managing director nor executive directors may

be members of the committee.

According to the Finnish Corporate Governance Code, a listed company must amongst other report publicly

and in detail the grounds for the management remuneration policies of the company as well as the decision-

making process, in which the management remuneration is determined. According to the Code, the remuneration

policies of listed companies must cover basic salary e.g., performance-related remuneration schemes, pension

schemes, and share and share-related remuneration schemes. Companies must describe the remuneration and all

financial benefits of each of its directors for board and committee and other possible duties for a financial period.

If the chairman of the board or a director has an employment relationship or service contract with the company

(e.g., executive chairman; executive director) or acts as an adviser to the company, the company shall describe

the salaries and fees as well as other financial benefits paid for this duty during the financial period. Furthermore,

payments by all companies belonging to the same group shall be included in the salaries, fees and other financial

benefits.

According to the Code, remuneration for board and committee work or part of the remuneration may be

paid in the form of company shares. Shareholdings of the directors in the company are considered to promote

good corporate governance. According to the Code a good way of increasing the directors’ shareholdings is to

pay the remuneration or part of the remuneration for their board and committee work in the form of shares.

However, according to the Code it is not recommended that a non-executive director participate in a share-related



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remuneration scheme. The use of share-related remuneration schemes to remunerate non-executive directors is, as

a rule, not considered justified from the perspective of the interests of shareholders. This is because the participation

of the board in the same share-related remuneration scheme as the other executives or personnel may deteriorate the

implementation of the board’s supervision duty and lead to conflicts of interest.

If the company decides to remunerate its directors by share based incentive schemes, it shall according to the Code

describe the number of shares granted to each of the directors as remuneration for board and committee work in the

same manner as the other remuneration and financial benefits. If directors participate in share-related remuneration

schemes, the fees based on such schemes shall also be described.

The Finnish Corporate Governance Code and its latest predecessor, the Corporate Governance Recommendation

for listed companies (2003) have been seen to work well and to meet high standards internationally. However, new

regulation and international developments have created a need to re-evaluate the level of the Code’s recommendations.

As a result of this, and the Commission’s Recommendation of 29 April 2009 on the remuneration of the management

of listed companies according to which management remuneration should be based on performance, the Finnish

Securities Market Association founded a working group at the end of June 2009 for the purpose of preparing the self-

regulation of the remuneration schemes of listed companies in Finland.

The assignment of the working group of the Securities Market Association is to determine by the end of February

2010 whether there are needs to amend the Finnish Corporate Governance Code. Furthermore, the assignment of the

working group is to make proposals for the possibly necessary amendments to the Code and to determine whether

the implementation of the Shareholders’ Rights Directive, adopted by the EU on 11 July 2007 and which facilitates

the exercise of basic shareholders’ rights and solve problems in the cross-border exercise of such rights, particularly

voting rights, will cause adjustments to the Code.

At the moment it appears that the EU-level definition of policies will not greatly affect the Finnish Corporate

Governance Code’s recommendations as the Code is generally considered to correspond with the international

practices and policies concerning transparency of the management remuneration. The initial estimate is that the

Finnish Corporate Governance Code meets the standards set in the Recommendation issued on 29 April 2009 on

management remuneration.

Furthermore, it is worth mentioning that in Finland, cases where overly excessive management remuneration has

been an issue have not been reported. On the contrary, the policies of the Finnish listed companies for the most part

comply with the Commission’s Recommendations. For example, severance payments exceeding a managing director’s

two-year salary are hardly ever applied in Finland in practice.

However, since the offshore ownership in the Helsinki stock exchange is over 50%, Finland will need a high standard

Corporate Governance system responding to the needs of international institutional investors. Thus, it is important

that the international development is monitored in order to think over the fine-tuning of the Finnish system.

Pauliina Tenhunen is a Partner and Mira Väisänen is an Associate at Castrén & Snellman

Attorneys Ltd.







71

New Code on Corporate Governance for Listed Companies

BY PAULIINA TENHUNEN AND SAIJA VITTANIEMI | CASTRÉN & SNELLMAN

The Board of the Finnish Securities Market Association approved a new Corporate Governance Code (Code) for

listed companies in October 2008. The Code replaced the Corporate Governance Recommendation for Listed

Companies issued by the Helsinki Stock Exchange (HSE) in December 2003.

The Corporate Governance Recommendation for Listed Companies issued in 2003 has been seen to work well

and to meet high standards internationally. However, new regulation and international developments created a

need to update the recommendation.

The corporate governance system for Finnish listed companies is based on Finnish legislation, and the Code

complements statutory procedures.

KPMG Finland provides an annual corporate governance survey on the application of the Code. The surveys

are mainly based on annual reports and financial statements of Finnish listed companies. According to KPMG

Finland’s previous surveys, the most challenging aspect of corporate governance for companies has been reporting

their board structure, remuneration systems, internal control, risk management and internal audits. Thus, in its

2008 survey (published 2009) KPMG concentrated on the progress made by listed companies in this area. The

KPMG survey used 2007 as the year of comparison.

This article goes through and introduces the main amendments and changes between the new Code and HSE

recommendation.

New Code

Aims

The Code is intended to harmonise the practices of listed companies as well as the information given to shareholders

and other investors. It is also intended to improve the transparency of administrative bodies, management

remuneration and remuneration systems. The Code also provides an overall picture of the central principles of

the corporate governance system of Finnish listed companies.

The Code has been prepared in accordance with the so-called Comply or Explain principle. This means that

listed companies must comply with all the recommendations of the Code or provide an explanation for not doing

so. Thus, if a company departs from an individual recommendation it is required to account for and explain the

deviation.

Based on the summary of the KPMG survey, 81% of listed companies follow the recommendations of the

Code, and the remaining listed companies refer to the HSE recommendation. The differences between the HSE

recommendation and the new Code principally concern general shareholders’ meetings, boards of directors, the

composition of committees, remuneration systems and risk management.

Shareholders’ Meetings

The Code requires that notices convening general meetings and the information relating to the proposals and

the agenda of the meeting must be made available on the company website at least 21 days before the general



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meeting. The recommendation is based on the directive which was implemented August 3, 2009. Thus, the Code

requires a stricter schedule for general meetings than was required under the HSE recommendation. This advance

information is intended to enable the shareholders to evaluate whether they wish to attend the general meeting,

present questions at the meeting and decide how they intend to vote.

Additionally, the Code requires that the auditor shall be present at the annual general meeting, whereas the

HSE recommendation did not include any provisions requiring the presence of the auditor. The presence of the

auditor at the annual general meeting allows the shareholders to ask the auditor for more detailed information on

matters that may have an impact on the evaluation of the financial statements or some other issue on the agenda

of the meeting.

Board of Directors

Unlike the HSE recommendation, the Code does not require any minimum number of board members to be

elected. However, the Code does require that the number of directors and the composition of the board must be

adequate to enable the board to discharge its duties in an efficient manner. In addition, the Code requires that

both men and women must be represented on the board. This requirement becomes applicable from the first

annual general meeting held after 1 January 2010. The aim is to improve the proportion of women represented

on the board.

In addition, the Code requires that the board must evaluate the independence of the directors and report which

directors it determines to be independent of the company and which directors it determines to be independent of

significant shareholders. Thus, the board must evaluate and describe the independence of the directors in a more

precise manner under the Code than under the HSE recommendation.

All listed companies have reported their number of boar members. Both genders are represented on the boards

of listed companies, though the nine out of ten board members are men while only one out of ten are women.

In addition, 48% of listed companies do not have both genders represented in the board. Given that the Code’s

recommendation that both men and women be represented on the board comes into force as of the first annual

general meeting held after 1 January 2010, gender issues are likely to become even more prominent in general

meetings this coming spring (summary of KPMG survey 2008).

Committees

The proper functioning of the corporate governance of a company requires that the work of the board be organised

as efficiently as possible. The establishment of board committees may enhance the efficient preparation of matters

within the competence of the board. The recommendations on board committees are applicable only if the company

establishes a committee.

According to the Code, the committees shall generally have at least three members. However, a committee may

exceptionally consist of two members in companies with a small board.

The members of audit committee must be qualified to perform the responsibilities of the committee, and at

least one member must specifically have expertise in accounting, bookkeeping or auditing. Thus, the Code requires

more specific expertise of the members of the audit committee than the HSE recommendation as regards matters

pertaining to the financial reporting and control of the company.

The Code represents a stricter approach to the independence of committee members than the HSE



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recommendation. As regards audit committees, the Code requires that all the members of the audit committee

must be independent of the company and, in addition, at least one member must be independent of significant

shareholders. Furthermore, the majority of the members of nomination committees and remuneration committees

must be independent of the company.

In comparison to the HSE recommendation, the reporting requirement has been tightened in the Code by

requiring that the company report the number of committee meetings held during the financial period and the

attendance of committee members at the meetings. The purpose of this stipulation is to permit shareholders to

evaluate how active the committee has been and subsequently also the efficiency of the board’s work.

Remuneration Systems

According to the Code, listed companies must describe the principles and decision-making process concerning

their remuneration policies covering the managing director and other executives. This means information on

the division of salaries and fees into fixed and variable parts, as well as the main information on how the variable

parts of the salaries and fees are defined as well as information on share and share-related remuneration schemes

and additional pension schemes. The board must decide on the remuneration of the managing director, and the

company must specify the body that determines the remuneration of other executives.

Thus, the Code takes a somewhat more detailed approach to remuneration policies and the principles and

decision-making process regarding remuneration than the HSE recommendation did.

Reporting of board member remuneration is noticed to be on an excellent level in listed companies. In addition,

most listed companies also report payments made in shares and share-based incentive schemes.

According to the Code, it is not recommended that a non-executive director participates in a share-related

remuneration scheme. Compliance with this Code’s recommendation has improved overall in comparison to the

year 2007.

Reporting of remuneration policies for managing directors and other management of listed companies has

improved overall. Listed companies have most often neglected to describe the division of salaries and fees into

fixed and variable parts, as well as the main information on how the variable parts of the salaries and fees are

defined.

Thus, reporting of the remuneration and other final benefits has improved overall (summary of KPMG survey

2008).

Internal Control

There is no difference between the HSE recommendation and the Code as regards internal control. However,

internal control has been identified as one of the challenging issues for listed companies to report.

According to the summary of KPMG survey, the description by listed companies of their internal operation

principles has improved compared to the year 2007, however, a great deal of room for improvement remains.

It is worth noting that listed companies have left the description of internal control in the background in their

financial reports. According to the Code, the purpose of internal control and risk management is to ensure the

effective and profitable operations of the company, reliable information on and compliance with the relevant

regulations and operating principles. Thus, it is recommended that listed companies would in their financial

reports structure their internal control regimes, for example, in the form of corporate values and codes of conduct,



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reporting and control system descriptions, internal manuals, plans and forecasts, personnel queries and acceptance

procedures, etc. In their financial reports companies should describe internal control in a separate section and not

as a mere cursory reference (summary of KPMG survey 2008).

Risk Management

According to the Code, listed company must describe the major risks and uncertainties that the board is aware of

and the principles on which risk management is organised. The purpose of this stipulation is to ensure that the

risks related to the business operations of the company are identified, evaluated and monitored. The Code thus

takes a more detailed approach to risk management in this area than the HSE recommendation did.

Listed companies have, on the whole, slightly improved the descriptions of their risk management. However,

some companies need to put further effort into reporting their company-specific risks instead of only describing

their risks on a general level (summary of KPMG survey 2008).

Internal Audit

There is no difference between the HSE recommendation and the Code as regards internal audit. However, internal

audit has been identified as one of the challenging issues for listed companies to report.

Dedicated internal audit units are common only in large listed companies. However, an increasing number of

mid-sized companies have developed their own internal audit units, and overall, it has become more common for

listed companies to have their own internal units. However, outsourcing of internal audit functions has become

more common especially in small listed companies (summary of KPMG survey 2008).

Pauliina Tenhunen is a Partner and Saija Vittaniemi is a Senior Associate at Castrén & Snellman

Attorneys Ltd.






www.executiveview.com | Germany

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The New German Voting Rights Disclosure Rules

BY ANDREAS FUECHSEL | BROICH BEZZENBERGER

As a reaction to the increasing activities of activist investors in Germany, German lawmakers have considerably

extended the notification duties for shareholdings in Germany under the German Securities Trading Act (WpHG)

during the last two years. While the German parliament has attempted to provide rules against creeping stake

building in German public companies, the new rules fall short of addressing current issues with stake building via

cash-settled swaps or options. This article provides an overview of the current regime.

Notification Requirements

Reaching or crossing one of the following voting right thresholds in a public company listed in the regular market

triggers notification requirements in Germany: 3%, 5%, 10%, 15%, 20%, 25%, 30%, 50 and 75%. The notification is

triggered by direct or indirect control over voting rights, not over share capital. Non-voting preferred stock, therefore,

does not trigger notification obligations. The notification would generally only comprise the fact of the level of voting

rights held at close of business of the day of notification.

As from 31 May 2009, however, Schedule 13D-type disclosure statements must be published for investors crossing

the 10% or a higher threshold. Each of those “material” investors must inform the issuer within 20 trading days about

the purpose of the purchases and the source of funds used in making the purchases. Moreover, each investor shall

disclose whether: (i) the investment serves strategic purposes or the realisation of trading profits; (ii) he intends to

acquire further voting rights within the next 12 months; (iii) he strives for exercising influence on the composition of

the management / supervisory boards of the issuer; and (iv) he strives for materially changing the capital structure of

the company (in particular in relation to the debt/ equity ratio or the dividend policy). The company must publish the

statement at its own cost. Based on experience with Schedule 13D disclosures in the United States, activist investors

may therefore utilise these notifications as a medium to promote their investment objectives.

All direct or indirect corporate or contractual control over voting rights may trigger the notification requirements

if all such voting rights, counted together, exceed a notification threshold. Likewise, the notification requirement for a

position may be triggered for various entities and persons, and for various attribution grounds at the same time (e.g.,

lawful ownership, economic ownership, control over voting rights held in a subsidiary, etc.). In corporate groups,

the notification may have to be separately made for each entity holding voting rights directly, and, separately, for

each direct or indirect parent company having direct or indirect control over such entity. In typical fund structures,

separate notifications may be required for the fund entities, the asset management companies, and each of their

direct or indirect controlling shareholders. Frictions between Continental European and Anglo-American custody

structures (in particular in connection with prime brokerage arrangements) may result in various questions that,

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given the severe consequences of inaccurate notifications, should be addressed early on.

Attribution of Financial Instruments

Disclosure obligations for derivatives giving contractual rights to request transfer of voting shares do not apply

before the 5% threshold is crossed. However, voting shares and derivatives must be aggregated for counting

towards the disclosure threshold for derivatives, i.e., the 5% derivatives notification thresholds is triggered if the

investor, in addition to 2.99% of voting stock, acquired derivatives giving the right to acquire additional 2.01%

of voting shares. If, however, the voting stock had already been separately disclosed upon individually crossing

a threshold, an additional disclosure due to the aggregation of voting stock and derivatives would only become

necessary where, due to the aggregation, an additional disclosure threshold was crossed. Derivatives which are

structured as a “right in rem” (i.e., title to the shares automatically passes upon exercise of the option without the

need for an additional transfer agreement) are regarded as voting rights but not as derivatives.

Acting in Concert

The voting rights of parties acting in concert will be attributed entirely to either party. Under the revised WpHG,

acting in concert requires an agreement between the concert parties relating to either (i) the exercise of voting

rights or (ii) the permanent and significant influence over the business strategy of the issuer by other means.

Thus, acting in concert can, in addition to coordinated voting, comprise all kinds of arrangements or coordinated

actions provided the colluding shareholders intend to permanently and significantly influence the business

strategy of the target company, e.g., to fundamentally change the business model or to push a company into

some corporate action such as selling or breaking up itself. Therefore, even the coordinated acquisition of shares,

standstill arrangements or concerted letters to the management could qualify as acting in concert if pursued

with the relevant common understanding. However, the law expressly provides for a general exception from the

application of acting in concert in single instances. Thus, neither the coordination of votes regarding agenda

items of an individual general meeting nor the repeated vote on the same subject should, per se, constitute acting

in concert. Given that shareholders acting in concert that hold more than 30% of the votes may be subject to the

obligation to launch a mandatory tender offer, legal advice should be sought in any case of doubt.

Timeframe and Consequences in Case of Disclosure Violations

Once a relevant threshold is reached or crossed, the WpHG requires the investor to disclose its holdings within

no more than four days on which stock exchanges in Germany are open for trading. To safeguard compliance,

the revised WpHG tightens the legal consequences of a violation of the disclosure requirements of material

shareholdings. Any intentional or grossly negligent violation of the disclosure requirements regarding the number

of voting rights does not only entail a loss of all rights stemming from the shares for the relevant default period but

also for a period of six months following correction of the failure.

Andreas Fuechsel is a Partner at Broich Bezzenberger.






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Corporate Governance of a German Stock Corporation

BY DR. GÜNTER SEULEN | OPPENHOFF & PARTNER

While the limited liability company (GmbH) is the most common corporate form in Germany, the stock corporation

(Aktiengesellschaft, AG) is the corporate form of choice in order to access capital markets. For German legislation,

the model shareholder in a stock corporation is therefore a financial investor with minority shareholding, who is

mainly interested in dividends but not in running the company. Nevertheless, major and even more so majority

shareholders are able to become involved in the management of the company.

Legal Framework

The regulatory framework for the corporate governance of a German stock corporation comprises in particular

the German Stock Corporation Act (Aktiengesetz), the company’s articles of association (Satzung) and its by-laws

(Geschäftsordnungen).

For listed companies, these rules are complemented by the German Corporate Governance Code (Deutscher

Corporate Governance Kodex, DCGK) and various capital markets rules. The DCGK seeks to summarise the

statutory corporate governance rules of a stock corporation as well as to set out internationally and nationally

recognised standards for good and responsible governance. The DCGK is soft law which is enforced by a “comply

or explain” system: listed companies must confirm annually whether they do, or to which extent and why they do

not, comply with the DCGK. The DCGK also requests listed companies to publish an annual corporate governance

report. Non-listed companies are recommended to respect the DCGK, too.

One of the main features of the corporate governance organisation of a German stock corporation is its

mandatory two-tier board, comprising the management board (Vorstand) and the supervisory board (Aufsichtsrat).

Together with the general shareholders’ meeting (Hauptversammlung), they form the three statutory bodies of

the company.

The Management Board

The management board is solely responsible for the management of the company and its representation vis-à-

vis third parties. It is not bound by instructions of the supervisory board or the general shareholders’ meeting.

However, the articles or the supervisory board must specify certain transactions of fundamental importance

which require the supervisory board’s prior approval. The management board can have by-laws on its internal

organisation and the departmental responsibilities of its members. The power of representation of the board

members, however, is neither limited by approval requirements nor by the by-laws.

The management board has one or several members. If the share capital exceeds €3 million (about US$4.5

million), the minimum is two members unless the articles provide otherwise. Only natural persons can be members.

Persons who have committed certain white-collar crimes are disqualified. The board members are appointed and

dismissed by the supervisory board. The maximum term of appointment is five years, even though the DCGK

recommends a shorter term for first time appointments. A reappointment is possible. For listed companies, the

DCGK also requests an age limit.

During their term, the members of the management board can only be dismissed for important cause, such



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as gross violation of duties or inability to manage the company properly. An important cause is also assumed if

the general shareholders’ meeting has resolved that it no longer trusts a board member, except if this is clearly

arbitrary.

In a stock corporation with more than 2,000 employees, the supervisory board must also appoint a so-called

labour director (Arbeitsdirektor), who has the same rights and duties as the other members of the management

board and is responsible for all management matters relating to employment and social issues.

The appointment of the board members as such must be distinguished from the conclusion of a service agreement

between them and the company which stipulates the terms of engagement, in particular the remuneration. New

rules have recently been adopted with regard to the remuneration of management board members, which are

summarised in a separate article in this feature. In concluding the service agreement the company is represented

by the supervisory board. The total amount of the remuneration of the management board must be disclosed in

the annual accounts. A listed company must also disclose the individual remuneration of the board members,

divided into non-performance-related, performance-related and long-term incentive components, unless the

general shareholders’ meeting abolishes this requirement with three-quarters majority.

Duties and Liabilities of the Management Board Members

In general, the members of the management board must apply the care of a diligent and conscientious manager.

Their duties include: to act in the company’s best interest, to ensure compliance with applicable laws, to disclose

conflicts of interest, to comply with their comprehensive non-competition obligation, not to disclose confidential

information, to duly prepare the annual accounts, not to distribute the company’s assets – other than the balance

sheet profit – to the shareholders and to file for insolvency when necessary. The management board must report

to the supervisory board on a regular basis and consult with it on the strategy, business development and risk

management of the company as well as other issues of importance. It must also implement an appropriate risk

management and controlling.

In case of a breach of duties, the board members are jointly and severally liable to the company. However,

a breach of duty is not given if the board members could reasonably assume that they made their management

decision based on adequate information and in the best interest of the company, even if such decision proves to be

detrimental in the end (business judgement rule). A D&O insurance is permissible and common, but must include

a deductible of 10% of the loss up to not less than 150% of the fixed annual remuneration.

The Supervisory Board

The supervisory board controls and supervises the management board and advises it as to the management of the

company. It also appoints and dismisses the members of the management board and represents the company in

its dealings with them. It must further decide on certain important transactions which, according to the articles

or the supervisory board itself, require its approval. However, the supervisory board does not exercise any actual

management powers. Being a member of the supervisory board of a German stock corporation is not considered

to be a full-time job. The supervisory board can form committees for the preparation of its resolutions or even to

take resolutions in its place, excluding on certain important matters which must be decided by the full board.

The members of the supervisory board can be shareholders or non-shareholders, but must be natural persons.

Members of the management board cannot at the same time be members of the supervisory board. According to a



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recent change of the law, they must also not be elected to the supervisory board within two years after termination

of their management board membership, except upon motion of shareholders holding an aggregate of more than

25% of the votes. Legal representatives of a subsidiary of the stock corporation or of a company whose supervisory

board comprises a member of the stock corporation’s management board may also not serve on the supervisory

board (so that there are no members who supervise their own supervisors). Since May 2009, the supervisory

board of stock corporations which are listed or have issued listed securities must have at least one independent

member with accounting or auditing experience.

If no co-determination applies, the number of supervisory board members must be a multiple of three, whereas

the maximum number depends on the share capital of the company. Co-determination rules, if applicable, provide

for a higher minimum number.

In principle, the members of the supervisory board are appointed by the general shareholders’ meeting. However,

co-determination rules provide that employees are also represented in the Supervisory Board of companies with

more than 500 or 2,000 employees in Germany. The board is then composed of employee representatives to one-

third or one-half, respectively. For enterprises with more than 2,000 employees, the chairman of the supervisory

board, who is usually a representative of the shareholders, has the casting vote in the case of split resolutions. The

shareholders’ and the employees representatives are equally obliged to act in the company’s best interest.

Members of the supervisory board which have been appointed by the general shareholders’ meeting can also be

dismissed by shareholders’ resolution. Unless the articles provide otherwise, a majority of at least three-quarters of

the votes cast is required. Board members who have been delegated may be dismissed by the entitled shareholder

at any time.

The compensation of the supervisory board members is determined by resolution of the general shareholders’

meeting. In case of a breach of duties, including their confidentiality obligation, supervisory board members are

also liable to the company for damages. The aforementioned business judgment rule and the restrictions on D&O

insurance apply to the supervisory board members, too.

The General Shareholders’ Meeting

The general shareholders’ meeting of a stock corporation has only rather restricted powers, as there is only a

limited number of issues the shareholders can vote on. One of the most important matters is the appointment

(and dismissal) of the supervisory board members, as already described above. Furthermore, the shareholders’

meeting decides on the allocation of profits, the annual discharge of the members of the management and

supervisory board (which, however, does not release such members from liability), the assertion of damage claims

against management or supervisory board members, the appointment of auditors, amendments of the Articles of

Incorporation as well as further organisational matters.

(Minority) shareholders who hold at least an aggregate of 5% of the share capital can request that a general

meeting is called or that certain items are put on the agenda. The latter can also be requested by shareholders with

an aggregate share in the company’s capital of not less than €500,000 (about US$747,000), irrespective of the

percentage of their shareholding.

At the general meeting, each shareholder can take the floor and can submit questions. The management must

answer questions which are relevant with regard to the agenda, except under certain exceptional circumstances,

e.g., to the extent this could cause a material disadvantage to the company.



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Each shareholder can challenge the validity of a shareholders’ resolution in court. Minority shareholders of listed

companies often use this to put pressure on the company with the aim of benefitting from a settlement agreement.

However, the German legislator has tried to diminish the possibility and impact of such abusive actions in recent

years.

Accounts and Audit

The annual accounts of the stock corporation are prepared by the management board and then reviewed by the

auditor and the supervisory board. The supervisory board (i.e., not the general shareholders’ meeting) is also

responsible for finally adopting the accounts – unless the boards jointly decide to defer this decision to the general

shareholders’ meeting.

The annual accounts must be audited by an independent qualified auditor or auditing firm unless the company

is small-sized (but always in case of a listed company). The auditor is nominated by the supervisory board and

elected by the general shareholders’ meeting on an annual basis.

The European Stock Corporation (SE)

The “classical” German stock corporation must be distinguished from the European Stock Corporation (Societas

Europaea, SE). An SE with its seat in Germany is, in the essence, a German stock corporation, but has a “trans-

national” image. It has become more common in recent years, in particular for internationally operating companies

like Allianz, BASF and Porsche. However, an SE also provides more flexibility to create tailor-made corporate

governance structures. For example, unlike a German stock corporation an SE can also have a one-tier board. It

can also be used to prevent that a company becomes subject to a higher level of co-determination, which makes

the SE quite attractive for mid-sized enterprises, too. The shares in an SE can be listed on a stock exchange.

Dr. Günter Seulen is a Partner at Oppenhoff & Partner.


Corporate Governance of a German GmbH

BY DR. FALK OSTERLOH | OPPENHOFF & PARTNER

Introduction

With almost one million registered companies, the limited liability company (Gesellschaft mit beschränkter

Haftung, GmbH) is the most common legal form for corporations in Germany. Its simple structure, which gives

it the highest degree of flexibility of all corporations under German law, suites small and large businesses alike,

provided that the number of shareholders will be small and the shares in the GmbH will not be publicly traded. Its

corporate governance structure also makes it very useful as the corporate form for enterprises which are wholly-

owned by other (foreign) legal entities.

The regulatory framework for the corporate governance of a GmbH is formed by the Limited Liability Companies





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Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung, GmbHG), the articles of association

(Gesellschaftsvertrag) and the GmbH’s by-laws (Geschäftsordnungen). In November 2008 a major reform of

German company law, the Law for the Modernisation of the German Limited Liability Company Law and the

Prevention of Misuse (Gesetz zur Modernisierung des GmbH-Rechts und zur Bekämpfung von Missbräuchen,

MoMiG), came into force, which among others introduced a special type of limited liability company with a

reduced minimum share capital, the so-called limited liability entrepreneurial company (Unternehmergesellschaft

(haftungsbeschränkt), UG). It constitutes an alternative private limited company form of particular interest for

founders of new businesses who only have and need a limited amount of nominal capital – e.g., in the service

sector. However, the UG and the GmbH share the same basic rules of corporate governance.

Corporate Bodies

Managing Directors

The managing directors (Geschäftsführer) are a statutory body of a GmbH. The GmbH must have one or more

managing directors. Both shareholders and non-shareholders may be appointed and neither a prescribed

maximum number nor an age restriction apply. Only natural persons may be appointed. The MoMiG has recently

extended the reasons for disqualification to ensure that persons who violated core provisions of business criminal

law cannot be appointed as managing directors of a GmbH. The managing directors do not need to be of German

nationality, but according to case law, they must at least be entitled to enter Germany anytime without restriction.

In a GmbH with more than 2,000 employees a so-called labour director (Arbeitsdirektor) must be appointed, who

has the same rights and duties as a managing director and the responsibility for all management matters relating

to employment and social issues.

If the articles do not provide otherwise, the managing directors are appointed and their appointment is revoked

– this is possible at any time with or without cause – by the shareholders’ meeting with a simple majority of the

votes cast. There is no statutory restriction upon their term.

Managing directors perform their services on the basis of service agreements, which are governed by contract

rather than labour law. These agreements are concluded by the shareholders’ meeting, representing the company.

The shareholders’ meeting determines the remuneration of the managing directors, who may but are not required

to hold shares in the GmbH.

The directors manage the GmbH and represent it vis-à-vis third parties. Their identity and signing powers

must be entered into the commercial register. They can have joint or sole power of representation. In addition,

it is possible to release the managing directors from the restriction under German law to represent the GmbH in

transactions with themselves or with a third party represented by themselves. The power to represent the GmbH

cannot be restricted externally. However, the internal powers of the managing directors may be limited either

through the articles or, more flexibly, through by-laws. Additionally, managing directors are (internally) obliged

to comply with instruction resolutions of the shareholders’ meeting or another corporate body to which this power

has been delegated.

Shareholders’ Meeting

The second statutory body of the GmbH is the shareholders’ meeting (Gesellschafterversammlung), with which



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generally all corporate powers rest. This power is exercised by way of shareholders’ resolutions. If agreed among

the shareholders, resolutions may be passed in writing without actually holding a shareholders’ meeting. Ordinary

shareholders’ meetings must be held at least annually.

The GmbH may have one or more shareholders, who can be individuals or legal entities. There is no restriction

on the residence or nationality of the shareholders.

Unless provided otherwise in the articles, the shareholders’ meeting resolves on most matters with simple

majority of the votes cast. The shareholders’ meeting is also solely competent to resolve specific matters of

fundamental importance for the GmbH, such as a change of articles including capital increase or mergers. In

these events, mandatory requirements such as a higher quorum or notarisation of the shareholders’ meeting may

apply. Apart from that, the shareholders are free to regulate shareholders’ meeting and resolutions in the articles

at their discretion.

The voting powers of shareholders are usually linked to the nominal value of their shares (Geschäftsanteile).

While in general shares with equal nominal value convey equal rights to all shareholders, the articles may

assign less or more voting, dividend or other rights to certain shares or even exclude such rights, thus creating

different classes of shares. Voting rights in the shareholders’ meeting may be restricted in certain matters where

shareholders pursue or are deemed to pursue their own interests. Contractual voting restrictions in the articles

are permissible.

Supervisory Board and Additional Bodies

A two-tier structure consisting of an additional supervisory board (Aufsichtsrat) with two-thirds shareholders’

representatives and one-third employee representatives is only mandatory if the GmbH has more than 500

employees in Germany (Drittelbeteiligungsgesetz). For a GmbH with more than 2,000 employees such board

must consist of one-half of shareholders and one-half of employee representatives and a chairman appointed by

the shareholders’ representatives, who has a casting vote (Mitbestimmungsgesetz). The mandatory supervisory

board’s function is to control and supervise the management. This function cannot be taken away or delegated.

In order to ensure an effective supervision, certain restrictions apply to the appointment of its members, e.g., a

member can neither be a managing director of the GmbH nor a member of the supervisory board of more than

nine other companies with a mandatory supervisory board.

In a GmbH without a mandatory supervisory board, such board or further bodies may be stipulated in

the articles. The shareholders’ meeting may transfer a broad scope of its powers to these bodies, but certain

fundamental rights must remain with the shareholders’ meeting. However, if the articles create a body which is

comparable in function to a supervisory board, this body must be endowed with certain rights in order to enable

it to perform its supervisory functions.

Shareholders’ Rights

Each shareholder has specific individual rights, such as the right to attend the shareholders’ meetings and to

exercise voting rights. Profits are distributed and shareholders have a subscription right with regard to new shares

in proportion to the shares held, unless stipulated otherwise in the articles.

Furthermore, each shareholder has a mandatory right of information with respect to all matters of the

GmbH, which may only be restricted as an exception. Also, shareholders are entitled to challenge the validity of



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shareholders’ resolutions in court on the basis that the resolution was defective or bring an action in court against

other shareholders on behalf of the GmbH itself, even tough certain restrictions apply.

Minority rights are protected by statutory provisions. For example, shareholders who combine at least 10% of

the share capital have the right to demand the calling of a shareholders’ meeting or that any items be put on the

agenda. The statutory rights are supplemented by the corporate duty of loyalty (Treuepflicht) and the principle of

equal treatment (Gleichbehandlung). The duty of loyalty applies to all shareholders equally. It calls for a reasonable

recognition of the interests of the GmbH and those of co-shareholders and may lead to a restriction in the exercise

of shareholders’ rights while its breach can result in damage claims. The principle of equal treatment states that

shareholders cannot be subjected to unequal treatment by the GmbH or other shareholders without their consent,

unless the articles provide otherwise with respect to specific situations.

Duties and Liabilities

Managing Directors and Members of Supervisory Board

While managing the GmbH’s daily business, managing directors owe a duty of loyalty towards it which includes

avoiding conflicts of interest between themselves and the GmbH. Furthermore, managing directors are subject to

specific statutory duties, such as arranging for necessary fillings with the commercial register or convening the annual

shareholders’ meeting.

The managing directors must perform their duties with the diligence of a prudent businessman. In the event

of a breach of duty, they are jointly and severally liable to the GmbH, while liability to third parties only exists in

rare cases such as fraud. Disadvantageous business decisions do not constitute a breach of duty if the respective

managing director reasonably believes that he was acting in the GmbH’s best interest and based this decision on

appropriate information. Managing directors are also liable for any repayment of share capital in breach of the capital

maintenance rules, for acquisitions by the GmbH of its own shares beyond the statutory regulations or any payments

made if the GmbH is unable to pay its debts or is over-indebted from a balance sheet perspective. In the latter case,

they must also apply for insolvency proceedings within three weeks of becoming aware of the situation. The MoMiG

recently extended the liability of managing directors who act as accessories to shareholders making asset withdrawals

from their GmbH, thus bringing about its insolvency.

If the shareholders’ meeting grants a discharge, the managing directors are released from all claims of the GmbH

against them that were apparent to the shareholders at the time of the meeting. However, such discharge is void

where it would impede rights of third parties. D&O insurance is common and the payment of related premiums by

the GmbH is permitted.

According to case law, a person who has not been formally appointed can be held liable as managing director if he

is acting as such towards third parties, is held out as a director by the GmbH, or claims and purports to be a director.

Members of the supervisory board must provide independent advice and supervise the managing directors. They

also owe a duty of loyalty and secrecy to the GmbH. If they breach these duties, they are liable towards the GmbH,

whereas certain provisions regarding the liability of managing directors apply analogously.

Shareholders

German law protects the principle of a limited liability. However, a shareholder has to repay any payment made



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to him in breach of the mandatory provisions relating to the protection of the GmbH’s share capital. Besides this,

piercing the corporate veil has been allowed by the courts only in rather extreme cases where serious considerations

require – for equity reasons – that the separate legal form of the GmbH is disregarded.

Due to recent changes brought by the MoMiG, responsibility for filing for insolvency now falls to the shareholders

if the GmbH no longer has a managing director: This means that the duty to file an insolvency petition can no

longer be evaded by the “disappearance” of the managing directors. Furthermore, shareholders who permit a

person, who is disqualified to be a managing director, to manage the GmbH’s business may incur liability for any

damage or loss caused to the GmbH by that person.

Disclosure

A GmbH must draw up its annual accounts within three month after the end of the business year in accordance

with German GAAP. If the GmbH is a mid-sized or large company or orientated towards the capital markets,

additional requirements apply. The auditor must be a qualified auditor (Wirtschaftsprüfer) or with respect to

small or mid-sized GmbHs a qualified accountant (vereidigter Buchprüfer). He must be independent and free of

any conflicts of interest.

Every GmbH, except a small-sized GmbH, must disclose the overall remuneration per body of its managing

directors, members of the supervisory board or other bodies in the annual accounts. However, remuneration of

individual managing directors does not need to be disclosed.

Dr. Falk Osterloh is an Associate at Oppenhoff & Partner.


Organising Groups of Companies in Germany

BY DR. GÜNTER SEULEN AND DR. GUNNAR KNORR | OPPENHOFF & PARTNER

Companies in a group are often managed like business units of the group’s parent company, even though they are

legally separate entities. This gives rise to conflicts of interest between the parent company on the one hand and

minority shareholders (if any) and creditors of the individual entities on the other. Likewise, the taxation of the

individual group companies contradicts the unity of their business. Unlike many other jurisdictions, Germany

has a very sophisticated set of statutory and case law rules in corporate and tax law, which seek to balance these

conflicts and contradictions.

German company law distinguishes between the control of a parent over a subsidiary “only” on the basis of

majority shareholding or other factual circumstances, and such, which is based on a contractual relationship

between the parent and the subsidiary. In either case, the legal approach is determined by the strong emphasis

which German law puts on the protection of the registered share capital of stock corporations and limited liability

companies (GmbHs), on which this summary will focus. Distributions to the shareholders of a limited liability

company must only be made from its “free” equity, i.e., the equity in excess of the share capital, and, for a stock





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corporation only from the balance sheet profit.

Hence, German company law tries to protect the subsidiary, its creditors and minority shareholders against

losses inflicted by the parent’s influence on the management of the subsidiary. However, the relevant rules also

allow groups of companies to customise their tax and control structure to their specific needs.

Domination on a Contractual Basis (Vertragskonzern)

In order to have a reliable basis for the exercise of control, the parent and the subsidiary can enter into an

inter-company agreement. The most common types of such agreements are the domination agreement

(Beherrschungsvertrag) and the profit and loss pooling agreement (Gewinnabführungsvertrag), which can be

– and very often are – combined. The relevant statutory rules are to be found in the German Stock Corporation

Act (Aktiengesetz), but also apply, mutatis mutandis, to a GmbH.

It should be mentioned that German law also allows an even further reaching integration of the subsidiary

into the parent’s business (Eingliederung) and certain other types of contractual control arrangements which are,

however, less common and will not be discussed in this brief overview.

Domination Agreement (Beherrschungsvertrag)

A domination agreement entitles the parent company to give binding instructions to the management of the

subsidiary. A domination agreement thus effectively integrates the business activities of the subsidiary into the

operations and management structure of the parent, while at the same time maintaining the legal independence

of the two entities. It is therefore sometimes described as a “virtual merger”.

While the management of the subsidiary stays responsible for the running of the business of the dominated

company, it is bound to follow the parent’s instructions. This applies even if the instruction is detrimental to the

interests of the subsidiary, as long as it serves the interest of the parent and/or the group as a whole. In addition,

measures requested by the parent must neither be unlawful nor endanger the existence of the subsidiary.

The conclusion and subsequent practice of a domination agreement can lead to tax unity for VAT and real estate

transfer tax purposes if the dominating entity directly or indirectly owns the majority of the dominated entity. In

such structure, dominated and dominating entities are for VAT purposes regarded as one entity. Therefore, any

transactions carried out between these entities are not subject to VAT. However, unlike a profit and loss pooling

agreement (see below), the conclusion of a domination agreement does not have an impact on the income tax

treatment of its parties.

Profit and Loss Pooling Agreement (Gewinnabführungsvertrag)

Under a profit and loss pooling agreement (Gewinnabführungsvertrag), the annual profit or loss of the subsidiary

is transferred to the parent. The latter is then able to pool the profit or loss of the subsidiary with its own profits

and losses. Unlike a domination agreement, the profit and loss pooling agreement does not give the parent the

right to give instructions to the management of the subsidiary – hence, the two kinds of agreements are often

combined.

The profit transfer is limited to the amount of the annual profit minus any loss carry forward and minus (in

case of a stock corporation) any amounts to be allocated to the statutory reserve. Profit reserves can only be

transferred if they were generated during the term of the profit and loss pooling agreement. However, “old” profit



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reserves can still be distributed as dividends. Hence, the financial situation of the subsidiary is “frozen” at the state

it was in when the agreement became effective.

In practice, one of the most important reasons for concluding a profit and loss pooling agreement is the

possibility to achieve group taxation, i.e., to be taxed only on the consolidated group income. This way, losses

in one entity can be immediately offset with profits in another, reducing the effective group tax rate. In order

to obtain group taxation, a profit and loss pooling agreement needs to be concluded for a minimum term of five

years, during which it needs to be duly executed.

Protection of Creditors and Third-Party Shareholders

In order to balance the economic impact of the domination and/or the profit transfer and to protect the economic

interests of the subsidiary, its other shareholders, if any, and its creditors, the parent must reimburse the

subsidiary for any annual loss which is generated during the term of the domination and/or profit and loss pooling

agreement.

If the subsidiary is a stock corporation, any further shareholders in the subsidiary which are not affiliated to the

parent (third-party shareholders) are also entitled to exit the company at adequate consideration in cash and/or

shares in the parent. As an alternative, they can keep their shares and receive an annual compensation payment

which is calculated on the basis of the projected profits of either the subsidiary or the parent. Such consideration

and annual payments have to be set out in the agreement itself, which must be audited, and are reviewed by the

court upon request of any entitled shareholder. However, if the subsidiary has no third-party shareholders, the

offer of an exit consideration and an annual payment are not required.

The offer of an exit compensation and an annual payment are also not necessary if the subsidiary is a GmbH.

This is because a domination or profit and loss pooling agreement with a subsidiary GmbH requires a unanimous

approval resolution of its shareholders. As each shareholder can prevent the agreement to become effective, there

is no need for additional statutory protection.

Conclusion of the Agreement

Domination or profit and loss pooling agreements are negotiated and concluded by the management of the parent

and the subsidiary, but need approval by the shareholders of both entities. Shareholder approval must be granted

with a majority of at least three quarters of the votes cast in case of a stock corporation and – as mentioned –

unanimously in case of a subsidiary GmbH. Subject to a unanimous waiver by the shareholders, the management

must provide a written report on the agreement, in particular on the adequacy of the exit compensation and

the annual payment. The agreement must also be reviewed by a court-appointed auditor – again unless the

shareholders unanimously waive this requirement. In order to become effective, the agreement finally needs to be

registered in the commercial register of the subsidiary.

The agreement can be concluded for a fixed or an indefinite term. Where group taxation is intended, the

minimum term required for the agreement is five full years. A profit and loss pooling (but not a domination

agreement) agreement can even be concluded with retroactive effect as of the beginning of the business year in

which it is registered, provided that the subsidiary was majority owned by its dominating shareholder for the

entire fiscal year.



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Termination of the Agreement

Domination and profit and loss pooling agreements can be terminated by mutual agreement or unilaterally by

either party for cause or on special grounds stipulated in the agreement. A termination cannot have retroactive

effect and, hence, does not affect rights and obligations which are already in existence, e.g., the obligation of the

parent to cover losses of past business years. If the agreement terminates within the business year (rather than at

its end), an interim balance sheet must be prepared to determine the amount of loss compensation, if any, which

is due for the running business year. The termination of the agreement must also be filed with and registered in

the commercial register of the subsidiary.

Termination after more than five years has no tax effects on previous years. Where a profit and loss pooling

agreement has not been executed for five consecutive years, it will only be accepted for tax purposes, if it is

terminated for cause. Acceptable reasons for premature termination are inter alia change of control and mergers.

If no valid cause for the early termination exists, group taxation will lapse with retroactive effect. Otherwise, group

taxation will only lapse with effect of the business year, in which the agreement was terminated.

Factual Domination (Faktischer Konzern)

While domination and profit and loss pooling agreements are an effective tool to optimise the tax and control

structure within a group, German law also provides rules for less formalised forms of control over a subsidiary.

The most common case is certainly the exercise of factual control only on the basis of a majority shareholding

(Faktischer Konzern).

Elaborate rules on factual control are set out in the German Stock Corporation Act (Aktiengesetz) and apply

to stock corporations only. The controlling shareholder is allowed to induce the management of a controlled

stock corporation to take measures which are detrimental to the stock corporation, but must grant, or agree on,

a compensation by the end of the business year. Without such compensation, and unless a careful manager of an

independent entity would also have taken the relevant measure, the controlling shareholder as well as its board

members will be personably liable for damages. In order to monitor the relationship between the controlling

shareholder and the subsidiary stock corporation, the management of the latter must prepare an annual dependency

report to the supervisory board which is also audited.

The aforementioned rules do not apply to a factually controlled GmbH. However, minority shareholders in a

controlled GmbH are protected by duties of loyalty and equal treatment which restrict the controlling shareholder

in exercising its influence to the GmbH’s and the minority shareholders’ detriment. Creditors are protected by

statutory rules on capital maintenance. In addition, the controlling shareholder and its management may become

liable for damages if an abuse of the control position causes an insolvency of the GmbH.

Just as the conclusion of a domination agreement, factual domination can lead to tax unity for VAT and real

estate transfer tax purposes, thus avoiding VAT on all intra-group transactions in the factual group of companies,

but has no consequences with regard to income taxation.

Dr. Günter Seulen and Dr. Gunnar Knorr are partners at Oppenhoff & Partner.







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New Rules for the Remuneration of Board Members in Germany

BY DR. AXEL WENZEL | OPPENHOFF & PARTNER

According to the German government’s view, false performance incentives within the remunerations systems

have been one of the driving factors behind the financial market crisis. To achieve long-term performance

incentives, the German legislator has enacted the Appropriateness of Managing Board Remuneration Act (Gesetz

zur Angemessenheit der Vorstandsvergütung – VorstAG), which came into force on 5 August 2009. The VorstAG

has amended quite a number of provisions of the German Stock Corporation Act (Aktiengesetz – AktG) and

the German Commercial Code (Handelsgesetzbuch – HGB) dealing with management remuneration. These

provisions apply to stock corporations and large (more than 2,000 employees) limited liability companies (GmbH).

In particular, the general principles stipulated in Section 87 AktG have been extended and tightened. These and

other amendments induced by the VorstAG shall be briefly addressed in this article.

Appropriateness of Remuneration

Whilst up till now the aggregate remuneration (salary, profit participation, allowance for special expenditures,

insurance rates, provisions and all types of fringe benefits) had only to be in due proportion to the duties and

responsibilities of the member of the managing board and the situation of the company, they now also have to be

in due proportion to the performance of the member and must not exceed the “customary” remuneration, unless

there are particular, vindicatory reasons (Section 87 para. 1 sentence 1 AktG).

The implementation of such performance related criteria did not materially change the legal situation. Ever

since, case law has considered the performance of managing board members when determining the appropriateness

of their remuneration. In this respect, there has only been an expressed codification. The only new requirement is

the necessity of a customary remuneration.

According to the legislative materials, one would have to look at the branch, size, and country of the company

(horizontal comparability) and at the salary matrix within the company (vertical comparability) in order to

determine whether a remuneration is customary.

Vindicatory reasons which may justify an unusual remuneration could be particular demands which are placed

on the managing board member (e.g., because of difficult reorganisation tasks) or a particular qualification of the

candidate.

Existing remuneration agreements need not to be adjusted, but the new law applies to certain contract

amendments.

The supervisory board – which represents the company against the managing board (Section 112 AktG) – is

liable for damages in the event of an inappropriate remuneration. Again, this was also the case under case law so

far, but has now been expressly codified.

The aforementioned rules also apply to pensions, payments to surviving dependents and related benefits.

Sustainability

The remuneration structure of listed stock corporations has to be aligned with the sustainable development of the

corporation (Section 87 para. 1 sentence 2 AktG).



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While the term “sustainable development” is often used for an ecological realignment of the corporate

management, this is not meant here. The new provision seeks to prevent career concerns and a preferred focus

on the present (“short termism”) from causing an entrepreneurial flash in the pan and the taking of irresponsible

risks to inflate variable payments. In lieu thereof, the managing board shall be induced to focus more strongly on

the long-term success of the company, for example by investing in R&D or employee training. As to the question of

how to achieve this legislative aim, the legislator offers little assistance. The only indication provided is that variable

components of remuneration are to be assessed on a perennial basis. However, performance-rating over the full

time-span of office, bonus malus systems with effective malus components (e.g., in case of high indebtedness) or

share-ownership-guidelines (commitment of managing board members to acquire and permanently hold shares

of the company) may be feasible solutions.

The requirement of an alignment with a sustainable development implies neither that short-term or non-

recurring remuneration components (for example for planned acquisitions or sales of shares in the company) are

excluded, nor that an abdication of variable components of remuneration is necessary. They are admissible as

long as they do not run contrary to a sustainable development of the company. Thus, remuneration systems with

short-term components have to implement mechanisms to correct unexpected developments (e.g., extraordinary

profits through disinvestments or other windfall profits) or they have to be justified by special interests of the

company.

Bonuses for entering, leaving, or staying with the company are – as the case may be – also admissible.

Facilitated Reduction of Remuneration by the Supervisory Board

Already under the old law, the supervisory board had the competence to reduce the remuneration in the case of

a deterioration of the business situation of the company. This competence has been extended by the VorstAG.

Formerly, a reduction was only possible, if – in the case of an “essential” deterioration – the further granting

would have meant a “serious” inequity. The law was very restrictive and a reduction only came into consideration

in extreme cases in which the very existence of the company was threatened. At present, such conditions would

still always fulfil these qualifications, but they are no longer required to reduce the remuneration.

The revised law only focuses on the features “deterioration of the company’s situation” and “inequity”.

Neither does the deterioration of the company’s situation have to be essential, nor does the inequity of further

granting in such situation have to be serious. According to the government’s statement, a reduction comes into

consideration if the company makes redundancies, if it is not able to distribute profits, and if the further granting

of remuneration would be inequitable for the company. In particular – according to the legislative materials

– further granting of salary is inequitable if the deterioration of the situation of the company is imputable to

the respective member of the managing board. This also applies to retired members, but a reduction is only

admissible within the first three years after retirement. Moreover, it is now not only possible for the supervisory

board to reduce the remuneration as a last resort, but it is required to do so and may only abstain from a

reduction under particular circumstances. This means a permanent duty of the supervisory board to monitor

and check carefully in order to avoid liability.

As a further intensification, the remuneration “shall be reduced to the appropriate amount” compared to an

“appropriate reduction” which was possible prior to the VorstAG. The latter merely meant a cautious reduction

without avoidable severity.



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Competence for Decisions on Remuneration

Under the previous legal situation, the configuration of managing board members’ terms of contracts – and thus

in particular the determination of their remuneration – could be delegated to the personnel committee of the

supervisory board. This possibility has frequently been exercised in practice and the personnel committees have

worked out the contracts with and determined the remuneration of the managing board. Now, the legislator seeks

to achieve more transparency and a strengthening of the supervisory board’s responsibility. Since the new law

came into force, a delegation of the decision on remuneration to a committee is no longer possible. Decisions on

the remuneration coercively have to be made by the plenum of the supervisory board. A personnel committee may

only have a preparatory function.

Stock Options

According to the new law, stock options may only be executed four years (formerly: two years) after the options

have been granted. Important for the practice is that the blocking period does not only apply to real stock options

but arguably also to phantom stocks, stock appreciation rights and similar instruments.

Disclosure

Already under the old law, payments to members of the board of directors that were promised in the event of

premature or regular termination of the employment (e.g., pay-offs, pensions, payments to surviving dependents)

had to be disclosed. This duty has now been extended with respect to the details which have to be disclosed in

the notes on the accounts. According to the new law – which applies to annual accounts/consolidated accounts

for business years beginning after 31 December 2009 – the promises have to be disclosed at their capital value

together with the accruals for these promises in the current business year.

D&O Insurances

Directors’ and officers’ liability insurances now coercively require a personal retention by the managing board member

of at least 10% of the damage up to a limit of at least 150% of the annual base salary. According to the legislative

materials, the retention applies to each individual damage event and the limit for all damage events in the year.

Existing directors’ and officers’ liability insurances must include a retention by 1 July 2010. This does not apply,

however, in the event that the company is bound by an agreement to afford insurance without retention if that agreement

was concluded before the VorstAG came into force. In this case, the company may fulfil such an agreement.

Thereby, the legislator seeks to implement behaviour control through a not completely insurable personal liability.

Private insurances of the managing board member which cover the retention of the D&O insurance are, however,

admissible.

These restrictions do not apply to D&O insurances of supervisory board members. With respect to listed companies,

the German Corporate Governance Code (Deutscher Corporate Governance Kodex, DCGK) recommends, however,

to arrange for according agreements with members of the supervisory board, too.

Vote of the General Assembly

General assemblies of listed companies may now vote on the remuneration system. This vote is not binding;

the general assembly may merely pronounce its approbation or disapprobation. According to the legislator’s



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intentions, this innovation should urge the responsible persons to act with particular diligence while determining

the remuneration of the members of the board of directors. There may be consequences due to factual impacts

in the public and the risks of public relations disasters. This provision is based on the very similar provision of

Section 439 of the UK Companies Act 2006, “Say on Pay”.

Cooling Off Period

Former members of the board of managing directors must not become members of the supervisory board of the

company within a biennial cooling-off period, unless the election takes place on a proposal by shareholders who,

together, hold more than 25% of the shares in the company. The resolution itself, of course, still needs to be passed

with simple majority.

This provision does not apply to retired managing board members who became members of the supervisory

board of the company before the VorstAG came into force.

Summary

The VorstAG leads to some significant changes in the context of managing board remuneration. Just to highlight

some of the changes: The principle of “Pay for Performance” has been further developed to a principle of “Pay

for Long-Term-Performance”, the co-determination of the shareholders has been strengthened, insurance for

personal liability of managing board members is more complicated and the competence for deciding on the

remuneration has been moved from the personnel committee to the plenum of the supervisory board. A number of

these changes will be adapted easily in practice; some changes will be painful for the companies. Many questions

are still unanswered and reliable case law will still be a long time coming.

Dr. Axel Wenzel is an Associate at Oppenhoff & Partner.





Portugal | www.executiveview.com

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Corporate Governance in Portuguese Companies During M&A

BY TRACY HAARHOFF | CAMEIRA LAW

Corporate governance, by consisting of the system through which companies are directed and controlled, aims to

protect shareholders rights, enhance disclosure and transparency, facilitate effective functioning of the board and

provide an efficient legal and regulatory framework.

The Portuguese legal and regulatory framework on corporate governance includes not only regulations and

recommendations from CMVM (Comissâo de Mercado de Valores Mobiliários – Stock Market Supervisory

Authority), but also specific legal provisions from the Portuguese Companies Code and Portuguese Securities

Code. CMVM recommendations (as opposed to mandatory regulations) gained binding force in light of the

amendments to Regulation 7/2001, enshrining provisions requiring all companies to disclose, in an annual

corporate governance report, those recommendations which they have not followed, and to explain every non-

compliance (the so called “comply or explain” principle).

The Portuguese Companies Code sets out a general duty for directors to act with “the diligence of a prudent

businessman” in the interests of the company and its shareholders.

The degree of diligence required is not clear-cut and is determined on a case by case basis taking into account

the circumstances under which the director acted as well as the nature of the act, its appropriateness and its

purpose.

Corporate Governance in the Context of M&A: Public and Private Transactions and Hostile Takeover Bids

Corporate governance is meaningful in the context of M&A transactions, basically covering the rights and duties

of both the offeror and target during the transaction and dealing with the investigation of corporate governance

compliance by the target.

Well run companies which have adopted good governance strategies will essentially enjoy a considerably

stronger level of protection in the context of increasing pressure from a burgeoning M&A market.

Public transactions. Corporate governance matters arising during preliminary talks in a public takeover

transaction, prior to publication of the preliminary announcement to launch a takeover bid, fundamentally

concern the duty of confidentiality on the terms of the deal. At this stage corporate governance will also comprise

of rules specially conceived to prevent insider dealing and market manipulation conduct (such as disclosure

of price sensitive information). Corporate governance matters raised during negotiations concern duties of

negotiating on a bona fide basis, the contents of the preliminary announcement to launch a takeover bid or the

offer documents, duties of the board of the target company referring to disclosure of information and duties not

to frustrate the bid.

P O R T U G A L


www.executiveview.com | Portugal

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During the due diligence phase, corporate governance compliance by the target company will include analysis

of governance models, information referring to corporate records, shareholder information, securities issuance,

corporate finance, financial and tax records, details on employment and management contracts and all related

information. The Portuguese Securities Code imposes on the board of the target company, after publication of the

preliminary announcement, an obligation to present a detailed report regarding the opportunity and conditions of

the offer which must be sent to the Supervisory Market Authority and to the offeror, containing details of financial

information and feasibility study reports carried out by a CMVM-registered auditor. The Portuguese Securities

Code also expressly prohibits the board of the target company from practising acts that may materially affect the

net asset situation of the company, thus frustrating the objectives announced by the offeror, except in very special

circumstances. Furthermore, the offeror is also bound by special duties of liability for any damage incurred as a

result of the decision to launch a takeover with the main objective of placing the target company in a day-to-day

management situation.

Private transactions. Relevant corporate governance provisions on preliminary talks refers to general duties

of care in terms of the interests of the company and its shareholders, which are also applied to all stages of the

transaction. Corporate governance matters are dealt with in the establishment of warranties and indemnities to

provide for corporate governance compliance by the target.

Contrary to what happens in a public takeover bid, in private acquisitions there are no specific duties imposed

on directors in relation to the disclosure of information to the potential purchaser. The general duties remain the

same throughout the several stages of the transaction until final completion.

In a private acquisition, the due diligence process will mainly focus on the review of documentation provided

by the vendor relating to corporate government compliance as well as information that may be publicly available

at the Companies Registry. Review of corporate records as well as tax and financial information will be carried

out. The purchaser will ensure that required notifications under the provisions of the Companies Code referring

to corporate governance matters have been complied with, namely the consent of the company to the transaction

and in certain cases also the procedures referring to pre-emptive rights of the existing shareholders.

In the acquisition of a private company there are no specific corporate governance rules on either the offeror’s

or the target’s disclosure duties. Corporate governance issues may be raised directly in relation with drafting

of documentation, especially when warranties and indemnities are agreed to cover occasional deficiencies in

corporate governance by the target.

Hostile takeover bids. In a hostile takeover bid, during the standstill period, directors of the target company

may not take any action aimed exclusively at frustrating the bid, or which may materially affect the company’s

net asset situation. By contrast, they are bound by the principle of bona fides and have a general duty to act in

the best interests of the target company, or have a fiduciary duty towards the company, until such time as the bid

assessment has been successfully completed. (An exception is made for acts authorised by resolution of a majority

of three-quarters of the voting rights, at a general meeting called specifically for that purpose, during the offer

period).

Conclusion

Frequently, corporate governance matters in public and private transactions will include amendments to the

statutes which may involve restructuring of the board, redefinition of the board, redefinition of the decision



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making process within the company and amendment of the required majorities to pass a resolution. They may

ultimately concern protective devices enshrined in the statutes.

Corporate governance matters associated with a merger project of either private or public companies will

concern experts’ and boards’ reports on the motives, conditions and objectives of the merger, as well as audit

reports on the criteria established by the board for the exchange of shareholdings in the merging companies.

This article first appeared in Financier Worldwide Magazine www.financierworldwide.com

Tracy Haarhoff is an Associate at Cameira Law.


Current Trends in Portuguese Corporate Governance

BY PAULO OLAVO CUNHA AND SOFIA BOBONE | VIEIRA DE ALMEIDA

Since 2006, Portugal has experienced significant developments in corporate governance.

Corporate governance is the system through which commercial companies are ruled and administrated. In a

nutshell, corporate governance is the combination of rules and principles that the management body of a commercial

company should observe while exercising its duties and that shall always take into consideration the rules that aim to

achieve transparency on management decisions, define the undertakings of each corporate bodies and ensure that

the management bodies reflect the shareholders’ guidelines and general principles of business.

The first rules ever published in Portugal concerning corporate governance date back to 2001 with Portuguese

Securities Market Supervisory Authority’s (“CMVM”) regulation 7/2001.

Portuguese commercial companies are governed by the Commercial Companies Code approved and in force since

1986 (“PCC”). This Code has been subject to a significant reform in 2006 (approved by Decree-Law nº 76-A/2006,

March 29) through which several amendments have been introduced to the two existing governance models and

simultaneously a new model was introduced (the so called Anglo-Saxon model). Corporate governance combines

self-regulation aspects (characteristic of Soft Law) with mandatory rules which will be applied even if everyone

agrees on a different solution for the company’s governance.

Currently, the main corporate governance sources are the PCC, the Portuguese Securities Code (“PSC”, approved

by Decree-Law nº 486/99, Nov. 13, as amended), the CMVM Regulation 01/2007 (Sept. 21) in force since January 1,

2009 and the CMVM Recommendation under the form of the Corporate Governance Code (“CGC”).

PCC regulates the incorporation and operation of companies established in Portugal setting three different models

of management and auditing bodies (Latin or Classic Model, German or Dualist Model and Anglo-Saxon Model)

and the principles for corporate governance structure in general such as disclosure duties applicable to all kinds

of commercial corporate entities, management and supervisory boards’ duties, rights and liabilities, shareholders’

rights and obligations.

With regards to corporate governance, the PSC regulates securities and information regarding securities issuer


http://www.financierworldwide.com




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companies listed on a regulated market situated or operating in Portugal (“Listed Companies”). Most importantly

it sets out important corporate governance rules such as obligation to disclose an Annual Governance Report which

will then be implemented according to the legislation referred to below.

Regulation 1/2007 (which was amended by CMVM’s Regulation 5/2008) has been in force since January 1, 2009

and establishes the model for the Annual Governance Report to be followed by Listed Companies.

CGC was published in 2007 as a recommendation of the rules of conduct on corporate governance and a list of

best practices. These recommendations only apply to Listed Companies although the law refers that it may also be

adopted by other types of companies if so desired. The implementation of this code is not mandatory and is based on

a “comply or explain” model that shall be disclosed through the Annual Governance Report.

While the basic rules of corporate governance, its models and structure (set out in PCC) apply to all commercial

corporate entities, no specific best practices provisions are directed to all corporate entities. The main developments

Portugal has achieved in that area are directed only to Listed Companies. To such companies CMVM, in its capacity

as supervisory authority, has committed a lot of effort in suggesting best practices to be adopted and that should

ensure the transparency of the market, or at least the markets’ judgement in this regard.

Additionally we would like to point out that a resolution of the Portuguese Council of Ministers (Resolution

49/2007, March 27) sets out the corporate governance rules for State-owned enterprises.

The most important achievement was the duty imposed on Listed Companies to publish the previously mentioned

Annual Governance Report. Such report is regulated by Regulation 1/2007 and should contain 4 chapters.

The first chapter (referred to as Chapter 0) must make reference to the corporate governance codes adopted by

the Listed Companies and explicitly mention which rules of such code have been adopted and which have not. As

a result, Listed Companies must adopt the CGC but may also adopt more than one code. For the rules that each

company decides not to follow, it is mandatory to contain an explanation for such decision. The grounds for such

decision are not provided by the law and unfortunately in most cases the decision not to comply has been based in

the argument that it was deemed irrelevant or not favourable.

CGC has recommended some important practices of corporate governance. The most important concern: (i) the

limitation of the shares blockage period imposed for the participation in Shareholders’ Meetings; (ii) the obligation to

attribute one voting right per share; (iii) the disclosure obligation on corporate information regarding Shareholders’

Meetings and resolutions; (iv) the avoidance of measures to prevent successful takeover bids (such as the limitation

of the number of votes that each shareholder may hold or use); (v) the creation of internal control systems; (vi)

the adoption and observation of a remuneration policy; and (vii) the information that should be available on the

company’s website.

Moreover, some practices recommended regarding the General Meeting of Shareholders such as: (i) the

chairman of the GM should have the adequate human and logistic backup resources facing the company’s needs

and its economical situation, and his remuneration should be included in the company’s annual report; (ii) the

articles of association should not establish a quorum (constitution or deliberation quorum) higher to the foreseen

by law; (iii) the correspondence vote should not have any restrictions and the deadline to receive it should be no

more than three days prior to the Meeting. In what concerns the Board of Directors there are also recommendations

of which we highlight: (i) the duty to comprise a sufficient number of non-executive members, in order to ensure

the effective supervision, oversight and evaluation of its executive members; (ii) the need to have a certain number

of independent non-executive board members, depending on the size and shareholding structure of the company,



96

equal to no less than a quarter of the total number of directors.

The Annual Governance Report contains also second, third and fourth chapters (Chapter I, II and III). The second

chapter refers to disclosure duties regarding General Meetings of Shareholders. The third chapter refers to disclosure

duties regarding administration and supervisory boards. The fourth and last chapter concerns general duties of

disclosure.

The information to be disclosed in the Annual Governance Report refers mostly to governance policies related issues.

The Portuguese Listing Market (Euronext Lisbon) is a relatively small market comprising less than 60 Listed

Companies. Although Listed Companies have been complying with their duty to publish the Annual Governance

Report, some items have been controversial. The most relevant case concerns the remuneration of corporate bodies.

Listed Companies have been reluctant to disclose the individual remuneration of the members of the Board of

Directors and several interpretations of such obligation have been discussed.

Although the CGC represents great progress in imposing rules of conduct for listed companies and setting the

tone for what is considered best practices in that area, it has faced problems of effectiveness.

As previously mentioned, the CGC is a recommendation and its compliance is optional. The only consequence for

the non-compliance is the obligation to provide an explanation for such. Possibly, the market could evaluate the lack

of compliance in a negative way. However, the fact is that the market did not give much attention to the compliance

of such rules until recently. Therefore, the sought out consequence of a market evaluation has lacked effectiveness

and the absence of other consequences did not bring much success to that area.

Fortunately (and looking at the bright side of things) the global economic crisis has triggered the market’s attention

to disclosure and transparency issues and to corporate governance’s best practices. One of the issues that gathered

much attention is the remuneration of corporate bodies. As previously mentioned, Listed Companies insisted on not

publishing the individual remuneration of corporate bodies and disclosing solely the remuneration policies. Most

recently and as a result, on June 19, 2009 a new law (Law nr. 28/2009) was published pursuant to which Listed

Companies are obliged to disclose, amongst other things, the remuneration policy and the annual remuneration

of the members of the Board of Directors and the Supervisory Council. This time, this duty is not only subject to a

“comply or explain” model but its failure to comply will trigger a misdemeanour offence punished with a fine.

Given the impact of the failure of market supervision structure and methods on the global economic crisis, a

profound discussion on such methods and disclosure procedures was brought to investors’ and governments’

attention.

Therefore, in Portugal, like in other countries, we are now in the process of analysing what has been done and

what could be done in this respect to ensure the necessary transparency in the markets. The best practices must in

some cases be more than a simple recommendation and are now being seen as a need in order to ensure the markets’

continuance.

In light of the above, CMVM intends to revoke Regulation 1/2007 and the CGC and publish new legislation on

this matter that shall be more demanding, strict and rigid.

Paulo Olavo Cunha is Of Counsel and Sofia Bobone is a Junior Associate at Vieira de Almeida.







97

Corporate Governance in Portugal: What Lies Ahead?

BY PAULO OLAVO CUNHA | VIEIRA DE ALMEIDA

Corporate governance’s legal framework is currently in transition in Portugal, in line with other countries, as

a reaction to the behaviour of managing directors that led to the global economic crisis. Although Portugal did

not suffer as a great an impact as other counties from such malpractices, there were some cases that forced legal

authorities to come up with new solutions and review our current legal regime.

The Portuguese Securities Market Supervisory Authority (“CMVM”) has recently launched a public consultation

paper on a proposed revision to the Corporate Governance Code (“CGC”) and on Regulation 1/2007 which is the

most important legislation in what concerns corporate governance and its best practices.

Regulation 1/2007 provides a model for an Annual Governance Report that all securities issuer companies

listed on a regulated market situated or operating in Portugal (“Listed Companies”) must publish.

CGC was published in 2007 as a recommendation of the rules of conduct on corporate governance and a list

of best practices. Compliance with such code must be specifically referred to in the Annual Governance Report,

explaining which provisions have been followed, which have not, and in that case why.

The global economic crisis has brought to everyone’s attention a series of issues that had so far been silent.

Investors and governments are suddenly claiming for regulation and supervision of markets that had self-

regulation as one of the key principles of success.

While a vast number of disclosure obligations on governance issues had been in force, many companies were

struggling to find arguments that could justify their lack of compliance with such obligations.

In this respect, several new laws have been published in an attempt to ensure the markets transparency, such as

Law 28/2009, of June 19 (which was a result of EC Commission Recommendation of 30 April 2009 – 2009/384/

EC and 2009/385/EC) pursuant to which Listed Companies and others deemed to be of public interest are obliged

to disclose, amongst other things, the remuneration policy and the annual remuneration of the members of the

Board of Directors and the Supervisory Council. Another important issue was address with an amendment to the

Portuguese Commercial Companies Code (through Decree-Law 185/2009, of August 12) according to which all

commercial companies must publish a report on their governance structure and practices adopted. We are yet to

see if all companies will follow this provision and what kind of information will be disclosed in such report.

Furthermore, CMVM has published a proposal of new regulation of corporate governance principles (revoking

regulation 1/2007 mentioned above) and a new corporate governance code (replacing the existing CGC).

The new Regulation under discussion introduces a new principle which allows Listed Companies to adopt a

different corporate governance code as an alternative to the one published by CMVM. Such choice must be well-

founded and previously communicated to CMVM. The alternative code to be adopted must cover at least the

same issues covered by CMVM’s corporate governance code and must be drawn up by an independent institution

formed by experts in corporate governance. In any case a “comply or explain” method is maintained in this

proposed regulation and Listed Companies are still forced to refer which provisions of the corporate governance

code are complied with and which are not, and if not why. So far, only one alternative code is being discussed. This

alternative has been presented for discussion by the Portuguese Institute of Corporate Governance and the final

draft is not yet ready.



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This new proposed regulation reinforces the obligation to disclose remuneration of corporate bodies that is

in force as a result of Law 28/2009, of March 19 while it also establishes that beyond those obligations Listed

Companies must also in the Annual Governance Report disclose (i) the aggregate and individual annual fixed

and variable remuneration of corporate bodies, (ii) the fixed and variable amounts of the remuneration making

reference to what has already been paid and what was deferred, (iii) the remuneration received by the same

corporate bodies from other companies within the same group or from companies held by shareholders with

qualifying holdings and (iv) any pension rights attributed.

Let us now focus on the new corporate governance code proposed by CMVM and that is currently under

discussion.

First of all we would like to emphasise the importance of the topics that are addressed in this code because,

as previously mentioned, even if Listed Companies chose to adopt an alternative code, such code must always

address, at least, the same matters that are addressed in CMVM’s code.

This proposed corporate governance code includes five main alterations that will constitute a substantial

change to the existing rules. Those five great changes focus on (i) proportionality between voting rights and share

holdings, (ii) risk management, (iii) incompatibilities and independence requirements, (iv) remuneration, and (v)

rotation of corporate bodies.

Addressing each of these items in particular, the new Corporate Governance Code foresees the obligation to

observe proportionality between voting rights and shareholdings preferably through attributing one vote to each

share. It is also established that proportionality is not being observed when companies issue shares without voting

rights and when companies establish voting rights held by one shareholder or related shareholders will not count

over a certain threshold. This new principle has been criticised as it may lead to misinterpretations that represent

a rule more demanding than the existing and because it ignores a very common and acceptable category of shares

which are non-voting preferred shares.

As per the internal risk control systems, the current CGC provides that companies must create internal control

systems for the effective detection of risks connected with its activity in order to safeguard its assets and to the

benefit of transparency of governance. This proposed code maintains the same provision but added a list of the

components that form the risk control internal systems.

The proposed code also reinforces the requirements regarding independence and incompatibilities of the

members of the board of directors.

The independence concept is reinforced by stating that if they should not be deemed independent, any member

would not be deemed as such if the appointment referred to another corporate body. This rule will result in the

application to the board of directors of the independence criteria provided for the supervisory board members.

Another rule regarding independence specifically refers that the auditors should not provide any other services to

the company.

Also, not only has it reinforced the requirement for the companies to have non-executive members of the board,

it now states that executive members should not affect the choice of non executive members. This proposed change

is not seen as causing much impact as the directors legally do not have powers to interfere on the appointment of

board members.

CMVM’s proposed corporate governance code is stricter in what concerns remuneration of corporate bodies.

This topic has been one of the most controversial. This proposed version details a series of rules regarding



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remuneration of a board of directors. It is now provided as general guidelines that the remuneration of the

members of the board of directors: (i) must be in line with the long term interests of the company; (ii) a variable

part of the remuneration must be based in a performance evaluation; (iii) it should not incentivise the excessive

assumption of risks; (iv) the calculation of the variable stake of the remuneration must obey to pre-determined

criteria that should be easily measurable and (v) there should be caps to the maximum amount to be paid as fixed

and variable remuneration.

In more detailed aspects that have been more controversial, it is proposed that a significant part of the variable

remuneration should be deferred for a period of no less than three years and its payment shall be subject to

the continuance of the company’s positive performance throughout such period. This provision has been highly

criticised as it may result in the decrease of the directors’ remuneration subject to external factors such as

macroeconomic developments that are beyond the directors’ control. Also, many are claiming that the directors

could be in a position to suffer from a new board of directors’ negative performance during the three years

subsequent to the termination of their term in office.

Another controversial provision set forth that compensation for the termination without cause of the term in

office of a director should be contractually limited to a previously established amount that should not exceed two

years of the fixed remuneration. This rule establish a limitation to the general rule provided in the Portuguese

Commercial Companies Code that states that such amount should either be contractually agreed or calculated in

accordance with legal general terms never exceeding the amount that the director should be entitled up the end of

his term in office. This general rule is perhaps fairer because in a scenario where a director is appointed for a four

year term and then dismissed without cause after six months, it could lead to an unfair limitation of his rights.

As to the rotation of corporate bodies, it is now demanded that companies should adopt a rotation of branch

attributed to members of the board of directors. This provision is being widely criticised as directors should not

be in a position to assume branches that they are not best suited for just because rotation may be seen as healthy

and more transparent. In alternative, a limitation of the number of terms in office of the Chief Financial Officer

could be accepted. In line with this, the proposed corporate governance code provided a mandatory rotation of the

external auditor every seven years.

This proposed regulation and code are still under discussion; we are all yet to find out whether CMVM will alter

the current versions as a result of the public consultation. In any case, in the near future we can expect a new code

and regulation that will reinforce transparency and hopefully contribute to a fairer market. We will be looking

forward to see what the final draft of the new regulation and corporate governance code will maintain, and what

will change.

Paulo Olavo Cunha is Of Counsel at Vieira de Almeida.





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The Latest Changes in Polish Company Law

BY RAFAL KOS | KUBAS KOS GAERTNER

An important amendment of the Polish Commercial Companies Code was introduced on 1st August 2009

regarding the rights of stockholders of public companies.

Particularly important for foreign stockholders of Polish public companies is the new possibility of

participating in annual general meetings through electronic communication means and possession of the

right to vote through a proxy.

Firstly, stockholders have been given the possibility to vote at the annual general meeting through

correspondence, as long as this is foreseen by the internal rules of the general meeting, whereby the duty

has also been foreseen for the company to prepare and make available forms serving the purpose of such

manner of voting. Another, just as important amendment especially for foreign stockholders situated far

away from the seat of the Polish company, is the regulation of new ways of conducting general meetings with

the aid of electronic means, and in particular the allowance of the transmission of the meeting or a two-way

communication between stockholders in real time during general meetings. Stockholders may also currently

submit demands in real time for the inclusion of certain matters on the agenda of the next general meeting.

Moreover, of equal importance for foreign stockholders is the introduction of a duty for public companies to

possess internet websites on which given information is to be obligatorily placed, in particular concerning

general meetings, their calls, the content of resolution drafts, etc.

It is also worthwhile noting the following changes in relation to the issue of expansion of proxies’ rights.

Firstly, the possibility of representation of more than one stockholder by a single proxy has been clearly

foreseen and furthermore, the proxy of several stockholders is explicitly entitled to vote differently on each

stock of the represented stockholders. Secondly, stockholders presently have the possibility of appointing

various proxies to vote on the basis of public company stocks if they are entered on various security accounts.

Moreover, stockholders may now grant powers of attorney for voting on the basis of public company stocks

in an electronic form, without the necessity of signing such powers of attorney with a secure electronic

signature.

The final major change for public companies that should be highlighted is the introduction of a so-called

record date, namely a rule pursuant to which the right to participate in the general meeting of a public

company is held by persons who are the company’s stockholders 16 days prior to the date of the general

meeting (the record date of participation in the general meeting).

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Undoubtedly, by increasing the rights of public company stockholders, these changes will significantly

contribute to improving corporate governance in Polish joint stock companies, thus bringing them closer to

EU standards in this scope.

Rafal Kos is a Partner at Kubas Kos Gaertner.





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A S I A P A C I F I C

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Role of the Audit Committee

BY ALASTAIR MACPHEE AND SAMANTHA O’BRIEN | DLA PHILLIPS FOX

Boards are now under increasing pressure from shareholders, regulators and governments to assume the ultimate

responsibility for risk management and to have a formal statement of risk appetite. The increased focus on

governance, compliance and risk has been accompanied by a review of the role of board sub-committees and, in

particular, the role of the audit committee. This article reviews the role of the audit committee within the context

of Australian governance practices.

Relationship Between Governance, Risk And Compliance

Broadly speaking, “corporate governance” is concerned with the manner in which corporations are directed and

controlled and, in particular, the accountability and control mechanisms to which they are subjected. These

mechanisms aim to ensure that, in their direction and coordination of corporate activities, the board is accountable

to the applicable stakeholders and management is accountable to the board.

In addition to the Corporations Act and general law principles, guidance regarding good corporate governance

is provided by the ASX Corporate Governance Principles and Recommendations and, in the case of entities

regulated by APRA, various prudential standards.

Risk management and compliance are both important aspects of corporate governance. The board will

typically be responsible for oversight of the company, including oversight of the company’s internal controls, risk

management systems and compliance systems. The board may not design all such controls and systems, but will

usually have ultimate responsibility for:

• reviewing and ratifying them;

• ensuring that staff and contractors understand and comply with them; and

• ensuring that they are reviewed on a regular basis and amended as necessary.

Various board committees may be established to advise the board on these matters.

The duties imposed on directors under statute and general law reinforce the board’s role in this regard. ASX

Principle 7 is also relevant for listed entities, as are various prudential standards for entities regulated by APRA.

Good governance practices will assist in identifying, assessing and managing risk, and ensuring compliance

with all applicable laws, codes and the like. However, the concept of “good governance” goes beyond oversight

and the implementation and maintenance of effective risk management and compliance systems and practices.

Good governance is often viewed as involving a balance between “performance” and “conformance” objectives,

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including the board’s role in providing strategic leadership for the corporation and developing and implementing

the corporation’s strategic direction in compliance with all legal obligations and in response to the prevailing risk

analysis.

Board Charters and Delegations

General Overview

Board delegations and board charters play an important role in good corporate governance.

A corporation’s constituent documents (if it has them) will typically reserve almost all corporate decisions and

powers to the board, save for those decisions reserved to members by law. However, the board will rarely manage

all of the corporation’s day-to-day activities – this is usually the role of senior management, subject to board

oversight.

Generally, the authority for non-directors to bind the corporation will derive from a board delegation. This may

be a formal instrument of delegation, or alternatively the delegation may be set out in the relevant employment

contract or in a board resolution. The delegation may be directed to a single named individual or office, or

alternatively may set out various levels of authority within the management structure, often accompanied by

relevant monetary thresholds and authorisation protocols.

That said, certain office-bearers within a corporation will have the “usual authority” to bind the company

simply by appointment to that office (e.g., CEO, Managing Director, secretary), as determined by the usual scope

of that office and the nature of the corporation’s business, among other factors.

Many boards adopt a “board charter” or similar document, often in conjunction with a “code of conduct”

and a range of governance policies. The board charter will typically provide the overarching framework for the

governance of the corporation by outlining the respective roles of the board and management, key principles

regarding board composition and board committees, the manner in which corporate strategy and corporate

policy will be developed, approved and reviewed, and how the corporation’s management and operations will be

monitored, among other matters. This is reinforced by ASX Recommendation 1.1.

If the board adopts a separate “code of conduct” or similar policy applicable to the company’s directors, officers

and employees, this would typically outline the ethical standards expected of the corporation’s personnel, and

may extend to matters such as trading in the corporation’s securities by directors and officers. These matters are

reinforced by ASX Principle 3.

Audit Committee

Broadly speaking, the essential function of the audit committee is to assist the board in protecting the interests

of shareholders with respect to financial reporting and internal controls by having independent oversight of

management and assessing the performance of both internal and external auditors.

The ASX Listing Rules oblige the top 500 listed companies to have an audit committee, and life and general

insurers and authorised deposit taking institutions regulated by APRA are also required to do the same. In each

case, guidance is provided as to the composition and functions of the audit committee. Many other corporations

also adopt this approach on the basis that it represents corporate governance “best practice”, and for this reason

all listed entities are encouraged to have an audit committee.



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The powers and responsibilities of the audit committee will typically be set out in a charter (as is encouraged

in ASX Recommendation 4.3). The charter will also usually address how the committee will be composed, how

frequently it will meet and its specific reporting obligations.

Composition of Committee

Both the ASX Principles and APRA prudential standards specify how the audit committee should be composed.

ASX Recommendation 4.2 states that the audit committee should:

• consist only of non-executive directors, with a majority being “independent” directors (as defined in

Recommendation 2.1);

• be chaired by an independent chair who is not chair of the board; and

• have at least three members.

The ASX commentary on Principle 4 further notes that the audit committee should “be of sufficient size,

independence and technical expertise to discharge its mandate effectively”.

APRA’s prudential standards on governance set out its requirements for the “Board Audit Committee”, which

are substantially similar to the ASX Principles.

It is generally accepted that the audit committee (as a whole) should possess appropriate financial, business

and governance expertise, including knowledge of the business and the industry, with at least one member being

a qualified accountant or finance professional with appropriate experience. All members of the committee should

be financially literate and be capable of asking “hard questions” and appropriately challenging management.

Relationship Between Management and Auditors

The external auditor’s primary function is to audit the corporation’s financial report and provide an external,

independent check on the manner in which the financial statements have been prepared and presented. In many

respects, the auditor is a “professional gatekeeper” with ultimate responsibility to the corporation’s shareholders

(and other stakeholders who may rely on those financial statements).

In contrast, an internal audit function is primarily concerned with analysing the effectiveness of the corporation’s

internal compliance and control systems, including risk management systems, and whether they have been

implemented appropriately. This may extend to assessing the corporation’s governance practices, including the

ethics and behaviour of its directors and other officers and staff. This function is largely for the benefit of the board

(and the corporation itself), and is of increasing relevance following the global economic crisis and the growing

focus on “enterprise risk management”.

However, in both cases good governance requires that those performing the audit:

• are provided with adequate and accurate information in a timely manner;

• have appropriate access to both management and the board (often via the audit committee); and

• are not inappropriately influenced by management.

Auditor “independence” is now the critical issue from an external audit perspective (both in terms of perception

and of reality). To be engaged as a corporation’s auditor, a person must be registered under the Corporations Act,

be independent and have no conflicts of interest. The Corporations Act identifies a range of relationships that



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will impact on the auditor’s independence and may prevent their engagement.

Auditors must also provide independence declarations and confirm that they have not contravened any

applicable code of conduct. The auditing standards issued by the Auditing and Assurance Standards Board

impose additional restrictions and have legal force in respect of Corporations Act audits.

The Corporations Act also obliges listed companies to identify the non-audit services provided by the auditor,

and related fees. The board must declare that those services have not impacted on the auditor’s independence

and the board’s basis for so concluding.

For entities regulated by APRA, prudential standards require that an appointed external auditor meet

certain requirements for independence, fitness and propriety and set out the scope of the external auditor’s

role and responsibilities.

Role of Internal Audit in Achieving Effective Governance

The internal audit function began as an invoice verification mechanism but now plays an important role in

achieving both the “conformance” and “performance” aspects of good corporate governance. For example,

a strong internal audit function will assist not only with compliance, risk assessment and management and

financial controls, but also with strategy implementation, cost management and achieving greater internal

efficiency.

This is a balancing exercise and the mandate and functions of internal audit should be reviewed

regularly to ensure their alignment with corporate strategy, as well as the prevailing business and regulatory

environments.

The existence of an audit committee and an internal audit function can also be seen as contributing to good

corporate governance by:

• utilising the specialist skills of particular directors while freeing up the board to focus on higher level

issues;

• facilitating improved communications between management and the board, and with external

auditors;

• providing the board and management with greater comfort that internal controls remain effective

(although neither the board nor management should solely rely on the internal audit function in this

respect); and

• providing the board with a source of information independent of management.

Larger companies will generally have an internal audit function. Listed entities are encouraged to consider

having such a function under ASX Principle 7, while entities regulated by APRA must have an independent

and adequately resourced internal audit function, and the internal auditor must report, and have unfettered

access to, the board audit committee.

Although the board should periodically consider the scope and effectiveness of internal risk monitoring

systems, and the performance of both internal and external audit service providers, the audit committee will

typically have primary oversight of internal (and external) audit and risk management functions, and will

report to the board accordingly with its recommendations. However, this does not derogate from the duties of

the other directors regarding the matters considered by the audit committee.



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Accordingly, a core function of the audit committee is to review the corporation’s internal controls

and risk management systems on a regular basis and to ensure that any necessary changes are promptly

implemented at all appropriate levels. In assessing the effectiveness of a corporation’s internal audit function,

key considerations include the level of skills, experience and resourcing of those performing this function,

alignment of focus with issues of concern to the board and the audit committee and benchmarking against

industry best practice.

The adoption or amendment of the internal audit mandate will typically require sign-off from the audit

committee, as will a proposal to outsource any aspect of the internal audit function. As with the audit committee,

the internal audit function requires sufficient independence of management, and sufficient authority and

funding, in order to perform effectively. For this reason, the head of internal audit may also report directly to

the chair of the audit committee.

Finally, there is a growing governance practice and regulatory focus on the importance of a robust

“whistleblowing” mechanism in achieving good governance, managing risk and preventing fraud, and this

may overlap with the internal audit function. The audit committee charter will often seek to entrench such

arrangements, which would then be formally notified to all staff.

Role of External Audit in Management of Risk

The OECD has recently highlighted the failure to manage risk as one of the key governance considerations

flowing from the global financial crisis. A rigorous and impartial external audit process is often regarded as a

key component in risk management.

Auditor independence requirements aim in part to assist with risk management by reinforcing the auditor’s

role as an appropriately sceptical gatekeeper. Although the focus of external audit is primarily financial, the

audit process may identify other risk-related issues (like licensing and authorisation compliance) that should

be brought to the attention of the audit committee, the board and/or other parties such as regulators.

As the external auditor and audit process are intended to provide an additional safeguard for shareholders

and other stakeholders, the audit committee will typically have primary responsibility for assessing the external

auditor’s performance and making recommendations to the board regarding appointment and removal of the

auditor. In the case of entities regulated by APRA, the audit committee must invite the external auditor to

meetings of that committee.

Alastair Macphee is Special Counsel and Samantha O’Brien is a Partner at DLA Phillips Fox.







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Creating a Governance Framework Across Multiple Jurisdictions

BY MARIANNE ROBINSON AND DAVID MORRIS | DLA PHILLIPS FOX

“Whether in the UK, US, Australia or New Zealand the elements of good corporate governance are obvious to all.

They rest initially on elements of integrity, understanding roles and responsibilities, honesty and fairness, and

transparency. All these issues are essential for fundamental trust and confidence in commercial dealing.” (Jane

Diplock AO Chairman Executive Committee, IOSCO New Zealand Securities Commission 2008).

The global financial crisis (GFC) has caused politicians and investors to call for increased investor protection

through regulation. Many countries have adopted more prescription without considering the impact of such

reforms on international capital flows and the global nature of modern business. There appears to have been

little questioning of whether prescription of itself creates effective governance or builds consumer confidence and

trust.

Australia has a principles based approach which allows companies to tailor governance frameworks to their

specific needs. In encouraging this approach, Australian regulators have enabled companies to “own” their

governance agendas and allowed sufficient flexibility for companies to operate across the globe. The Australian

approach to governance and compliance is attracting international attention after the robust performance of

the Australian financial system despite the GFC. Australia in 2009 has been confirmed in the World Economic

Forum’s recent report as ranked second in the world ahead of the United States, Singapore and Hong Kong in

terms of financial systems and capital markets.

Prior to the GFC, regulatory risk had already emerged as one of the major challenges facing businesses

operating in multiple legal regimes and under the supervision of multiple regulators. Executives cited regulatory

issues as a major deterrent for investment in new markets and worried that failure to meet the requirements of

different regulators and the different approaches taken by those regulators could damage the company’s share

price and reputation. Since the GFC the different responses from law makers and regulators have exacerbated

the concerns and increased the importance of finding governance frameworks that can be effective across several

legal jurisdictions.

Australia’s Approach to Integrating Governance and Compliance with Risk

The growth of mega corporations operating across multiple legal jurisdictions under the many different regulatory

regimes and philosophies has accentuated the inefficiencies caused by the lack of a uniform approach to GRC

(governance, risk and compliance) and the costs associated with the need to comply or face serious personal and

financial penalties. These issues are not confined to regulatory issues but extend to matters of governance as well

as accounting.

One of the key issues associated with the governance debate and how to globalise the application of governance

standards is the lack of a clear definition of what is meant by governance. The debate was rekindled with the

collapse of several high profile companies in the 1980s and has gained momentum with the GFC.

Australia has been strongly influenced by the corporate governance principles developed in 1999 by the

Organisation for Economic Cooperation and Development (OECD) to ensure the stability of global capital markets

and increase investor confidence. The principles were revised in 2004 to increase the emphasis on the regulatory



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framework, the function of shareholders and the rights and roles of other stakeholders, such as creditors. Many of

the concepts on which the OECD principles are based were incorporated in Australian legislation and in particular

the Corporations Act 2001 (Cth). The principles have also been used as the basis for the Corporate Governance

Principles and Recommendations issued by the Australian Securities Exchange (ASX Principles). The ASX

Principles have been used as the benchmark for the governance standards applied by the Australian Prudential

Regulatory Authority (APRA) which prudentially regulates Australian banks, building societies, superannuation

entities and insurance companies (life and general) and the Australian Securities & Investments Commission

(ASIC) which regulates markets, companies and financial products and services.

Within the Australian regulatory environment there is a strong emphasis on the independence of the board

chairperson as well as the requirement for independence of the external auditor and, where relevant, the external

actuary. Each of these has separate reporting obligations to the regulators when matters of solvency or non

compliance are detected. Governance is seen as an effective mechanism in managing risks associated with fraud,

misrepresentation and lack of transparency.

In addition to Australian corporations legislation, there are now a plethora of guidelines, policy statements and

rules imposed by regulators as best practice guidelines that must also be accommodated.

Australian regulators have benchmarked policies to the ASX Principles, the Australian and New Zealand

Standards AS/NZ 3806–Compliance and AS/NZ 42360–Risk Management. Increasingly, small businesses and

the public sector are benchmarking governance practices to AS8000–Corporate Governance.

Governance Benchmarks

One of the challenges experienced by those Australian companies operating outside Australia or with a parent or

associated companies overseas has been the significant differences between the Australian principles based and

“if not, why not” approach to governance and the prescriptive “one approach fits all” requirements in legislation

such as the US Sarbanes-Oxley Act 2000 (SOX Act). While the cost of compliance with the SOX Act has been

extremely high, companies have been unable to modify or adapt the provisions to reflect the needs and risks of

individual companies especially those operating across multiple jurisdictions. Australian companies now face the

dilemma of how to function under a rules based prescriptive set of requirements to comply with the SOX Act while

operating within a flexible principles based approach applying within Australia.

When there are several legal jurisdictions which must be accommodated within one corporation or corporate

group, then corporate culture, codes of conduct and processes of accountability assume greater importance as

they provide a framework on which the company can base its decision making and guide it through the regulatory

environment in which it operates.

When a company operates in multiple legal jurisdictions it is essential that its corporate governance and

compliance frameworks are effective. The Australian principles based approach to regulation is mirrored in the

standards used for governance, compliance and risk. These are principles based and allow companies, government

entities and not for profit entities to develop their own effective frameworks. Unlike the prescriptive SOX Act, the

Australian approach provides a pathway based on the development of an effective corporate culture into which is

built compliance and risk management monitoring processes that are specific to the company’s needs.

Once implemented, the governance processes should create a system of checks and balances to protect the

company and its various stakeholders from risks that cause tension between the various stakeholders.



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When operating in multiple jurisdictions there are certain aspects of an effective governance framework that can

be used to establish common ground. These are:

• The role played by the board in establishing effective controls;

• A well understood and monitored code of conduct and ethics;

• Role of internal and external audit;

• Importance of auditor independence;

• Clear delegations of authority;

• Transparency in decision making;

• Clearly delineated role of professional gatekeepers;

• Precise allocation of responsibility from the board to relevant committees and individuals;

• Process for accountability for actions taken by those using the delegated power.

Legislation is not required to build these concepts into the company’s culture.

Importance of Communication

The management of a company has no power or authority other than that delegated to it by the board. For this

reason, board and board sub-committee charters establishing clear guidelines in relation to this delegation

are essential in ensuring that responsibility for specific areas of compliance are achieved. Apart from aiding

transparency, clear lines of responsibility and accountability highlight to individuals the precise areas for which

they are responsible and in respect of which they will be judged.

Relationship with Regulators

“A wise person once said that the test of a truly moral person, is whether he does the right thing when no one is

looking. Certainly, the test for all firms is whether they maintain and each day reinforce a culture of compliance

– which includes a culture of doing not only what is within the strict parameters of the law but also what is right

– whether or not a regulator or anyone else is looking.” (Richards, US Sec, April 2003).

Australian governance principles operate on the basis that unethical people will commit unethical acts

irrespective of how prescriptive the law is. For this reason peer pressure combined with the role of professional

gatekeepers such as auditors, debt rating agencies and securities analysts all play a role in creating effective

corporate governance.

Professional bodies and regulators throughout the world are reviewing their approach to cross border

regulation. In March 2009 the International Federation of Accountants, which has members in 122 countries and

jurisdictions, called for G20 countries to adopt international standards for auditing so as to strengthen transparency

and accountability in the context of the audit of financial information. This combined with the adoption of global

standards such as the Basel accords and the work being carried out by the International Organisation of Securities

Commission (IOSCO) was seen as a means of complementing the OECD principles of corporate governance and

would in combination provide an improved climate for investor confidence.

Australia and NZ regulators are well represented in the international regulator fraternity. The head of the

IOSCO Executive Committee is Jane Diplock who heads up the NZ Securities Commission and who also sits

on the IOSCO Financial Stability and the Financial Crisis Advisory Boards. In October 2009, the Chairman of



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the Australian corporate regulator ASIC, Tony D’Alosio, was appointed Chairman of the World Economic Joint

Forum which works closely with the G20 Financial Stability Board and is to play a prominent role in international

regulatory responses to the GFC.

A common theme being heard from regulators in the region is the need for clear and unambiguous standards

combined with consistent enforcement by regulators, especially finance and banking regulators. In the international

sphere regulators now meet frequently to discuss common approaches to enforcement and to share information.

The Australian principles based approach to regulation provides a sound base for different types of products

and services by focusing on best practice in the development of internal processes and their review by independent

external auditors. For this reason it is possible to comply with Australian regulation while remaining in compliance

with principles underpinning another country’s culture and values. An example of this is seen in the Australian

approach to Shariah law and Islamic finance.

In 2009 APRA met with members of the Dubai Export Development Corporation to explain how Australian

principles based regulation is compatible with the need of Shariah compliant finance – an area identified as one

in which enormous growth is predicated for the Asia-Pacific region. The delegation was encouraged to learn that

the Australian Financial Markets Association (AFMA) has formed the Islamic Finance Committee to have regular

dialogue with the Treasury regarding taxation matters which are important to Islamic finance.

The Role of Senior Management

Senior management have a crucial role to play in the implementation of effective cross border governance

frameworks, especially from the perspective of ensuring the seamless integration of compliance and governance

into everyday work practices.

Since 2001 Australian regulators have implemented several initiatives to establish basic thresholds of

competencies for senior officers of corporate entities, particularly in the financial services sector. Prudentially

regulated entities are required to assess whether directors, senior managers and consultants in key roles are “fit

and proper” for their designated responsible person position. To complete this task, entities must develop sets of

competencies and assess the individual against the relevant requirements. Collectively, boards and management

need to show that there is the right mix and balance of experience and expertise for the needs of the company.

Continuing professional development and accountability are key aspects of the required annual assessments.

Conflicts of interest must also be declared. Prudential Standards in relation to executive remuneration are expected

by the end of 2009 and are likely to extend to contractors and intermediaries of APRA regulated financial entities

such as banks, insurance companies and superannuation entities.

The Importance of Governance in Periods of Crisis

There has been a rapid globalisation in recent years which has produced flows between countries of people,

capital, services, ideas, information and also criminal activity. The Australian principles approach to governance

provides a base for cross border market expansion by providing a strong transparent philosophical basis for

the codes of conduct and values on which a company is founded. The compliance needs and management of

risks specific to a region or many regions can be built on this sound base especially if there is a well articulated

corporate culture supported by well defined protocols and concepts that are sufficiently flexible to recognise

cultural differences and varying legal regimes. The GFC has demonstrated that the Australian approach to



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governance has been effective although there have been no signs of complacency from either the government or

regulators, especially in the area of executive remuneration and transparency in decision making.

Marianne Robinson is the Manager Compliance Solutions and David Morris is the Corporate

Practice Group Leader at DLA Phillips Fox.


Corporate Governance in M&A

BY LAWRIE WARD AND ADRIAN SMITH | DLA PHILLIPS FOX

While a takeover (or prospect of a takeover) will not change the general duties of a director, it does raise a number

of issues from a corporate governance perspective that require special consideration by directors of both bidders

and targets. The Australian legal position is considered below.

General Duty

All actions by directors must be taken without conflict, for a proper purpose and for the benefit of the “company

as a whole”. The term “company as a whole” has been judicially considered to mean both: all the shareholders of

the company and the company as a commercial entity. Accordingly, directors should ensure that their actions are

appropriate for the interests of both.

Directors of bidders and targets must continue to perform their general duties during a takeover bid or proposed

takeover bid and must also consider special duties arising from the particular circumstances.

Directors of Bidders

In Australia the announcement of takeover bids is regulated to minimise uncertainty and possible market

manipulation. Directors of a bidder must ensure that the bidder does not publicly propose a takeover bid unless

the directors have satisfied themselves that the bid will be made and that the bidder is able to meet its obligations

under that bid.

Directors of a bidder must ensure that the bidder’s takeover documents include the required statutory

information, do not include statements which are misleading or deceptive and do not omit material which has the

effect of making the takeover documents misleading or deceptive.

Directors of Targets

As a general rule, directors of a target must not procure the company to take any action outside the usual course

of its business that will defeat or “frustrate” a proposed takeover, for example by taking action that will prevent

satisfaction of a condition of the bid.

If directors properly form the opinion that the takeover is not in the best interests of a company as a whole,

or that another proposal may obtain a better result for shareholders, they may take defensive steps against the






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bid. One such step is to seek shareholder approval for what would otherwise be a “frustrating action”. Other

potential courses of action include critical analysis of the conditions or value of the bid, the share of combined

value and synergies accruing to the target’s shareholders, approaching the takeovers panel if the bidder’s conduct

is “unacceptable” or its takeover documents are defective, and seeking a rival bidder.

Common Directors

Persons who are directors of both the bidder and the target must take particular care to avoid any conflict of

interest (or perceived conflict) during the takeover process.

The most common method is for the director to declare their interest to the board and excuse themselves from

board communications by both companies regarding the takeover, and any board meetings at which the takeover

will be discussed.

Despite taking such steps, criticism from the shareholders of the bidder and target may be such that the director

may consider resigning from one or both positions.

Continuous Disclosure

Directors of listed companies need to be acutely aware of their company’s ongoing disclosure requirements to the

market and a strong governance structure is essential in this respect. ASX and ASIC both continue to reiterate the

importance of companies’ compliance with their obligations of continuous disclosure under Listing Rule 3.1 and

section 674 of the Corporations Act respectively, which require immediate disclosure of price sensitive information

to the market generally unless limited and specific exceptions apply (e.g., under Listing Rule 3.1A, disclosure may

be withheld or delayed for matters which remain confidential, uncertain and subject to negotiation and that a

reasonable person would not consider that matter should be disclosed).

In respect of the disclosure of significant M&A transactions by disclosing entities, directors and other company

officers need to carefully consider and balance the company’s disclosure obligations under the Listing Rules and

the Corporations Act against the need to maintain confidentiality for incomplete arrangements and negotiations.

This aspect of the disclosure regime has faced increased scrutiny by ASX recently, particularly as a number

of large listed entities seek to dispose of non-core assets as part of their restructuring in the current economic

environment.

The continuous disclosure landscape has changed significantly over the past 12 to 18 months as a result of the

economic crisis. Given that the test for disclosure requirements under the Corporations Act and the Listing Rules

utilises a “reasonable person” test (i.e., what would a reasonable investor expect to receive by way of disclosure

from a company), it is clear that the expectations of that hypothetical reasonable investor today are far different

from what they were three to five years ago. This change in the disclosure landscape arose from the recent market

volatility and losses incurred by investors in listed companies during the height of the economic crisis. As a

result, investor awareness and sensitivity has dramatically increased, resulting in a corresponding requirement

for greater scrutiny of the obligations to promptly disclose material information and the need for a strong and

effective governance structure.

Directors of listed entities need to adapt to the new disclosure landscape or otherwise run the risk of falling foul

of the regulators. As directors should be aware, any failure by their company to adequately and properly disclose

information in accordance with the Listing Rules and the Corporations Act could see them exposed as individuals



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to the possibility of regulatory action and, in extreme cases, potential shareholder claims. For this purpose, it is

important for directors to be aware that any breach of the continuous disclosure requirements of the Listing Rules

is a breach of the Corporations Act disclosure requirements and is actionable by ASIC.

Some key continuous disclosure factors that directors of listed entities should consider in the M&A sphere include:

• Considering whether the potential transacting parties should make an initial general disclosure to the

market regarding an approach or potential transaction so as to restrict the potential for market rumourtrage

or leaks to impact the market in the company’s securities.

• Closely monitoring whether any “leaks” or potential confidentiality breaches have occurred (including

monitoring of any spikes in the company’s share price and volume) and assessing whether the company

can continue to rely on the exception from disclosure under Listing Rule 3.1A.

• Involving legal and other advisers in initial discussions regarding disclosure of potential M&A transactions,

so that directors are in a position to satisfy their duties to the listed entity and its shareholders.

To reduce the risk of directors breaching their duties in the M&A context in the areas noted above, it is essential

that the company has a clear corporate governance structure against which key decisions are tested and one which

has a strong education and compliance component to it.

Lawrie Ward and Adrian Smith are Partners at DLA Phillips Fox.


International Corporate Governance – Major Decision on Non-Executive Directors in Australia and Their Duties of Care

BY BOB BAXT | FREEHILLS

Ongoing financing concerns that are facing economies all over the world, including the Australian economy,

although it is “shaping up” more promisingly than others (at least on the surface), have continued to pose

challenges for company directors, especially non-executive company directors. The role that non-executive

directors play in the management of high profile Australian companies, and the duties imposed upon them, have

been highlighted in a stark fashion by two recent decisions in which the Australian Securities and Investments

Commission (ASIC) (which is the main regulator in the Australian corporate law field) has civilly prosecuted

executive and non-executive directors, and certain officers of the James Hardie group of companies for various

breaches of the law. In these two cases, Australian Securities and Investments Commission v McDonald (no 11)

[2009] NSWSC 387 (“McDonald No. 11”), and Australian Securities and Investments Commission v McDonald

(no 12) [2009] NSWSC 714 (“McDonald No. 12”), critical questions have been raised about the responsibilities of

non-executive directors and their ability to rely on management in carrying out their duties.

The two judgments handed down by Gzell J have “shaken up” the professional community (and to a certain

extent their advisors). Non-executive directors will find it difficult, as a result of these decisions to continue to






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take what some would say has been a more casual approach to the information and advice provided to them by

management. Despite changes to the Corporations Act (“the Act”) which were introduced in the early part of this

century and which made it clear that directors could rely on management and delegate their powers as long as care

was taken, this decision suggests that non-executive directors will be very much at risk if they do not undertake a

considerably greater amount of due diligence in reviewing information and recommendations provided to them

by management.

To appreciate the importance of these judgments, a brief factual background is provided.

Factual Context

The James Hardie Group of Companies were heavily involved in the production of products which contained a

significant amount of asbestos material and related material. James Hardie Industrial Limited (JHIL), the holding

company of the group, wished to form a medical research and compensation foundation (“the Foundation”) to

meet compensation claims brought by asbestos sufferers as well as to fund related medical research.

A Draft Australian Securities Exchange (ASX) Announcement prepared by management was apparently

“approved” by the board of directors of JHIL for release to the financial market and to the public. The announcement

stated that the Foundation would commence operations with AUS$284 million sufficient “to meet all legitimate

compensation claims” which turned out to be unfounded. This contention was based on a cashflow model and

estimate reports conducted by experts PricewaterhouseCoopers, Access Economics Pty Ltd and Trowbridge

Deloitte Ltd. As a result of various difficulties sustained by the Foundation, ASIC brought proceedings against all

ten directors alleging that they had approved the announcement in circumstances where there was insufficient

evidence to support the contention, or in one way or another failed to enquire into matters sufficiently. ASIC

argued that the Draft ASX Announcement was false or misleading, and that this publication and relevant events

established its claim that the directors had breached their duty of care and diligence prescribed by s 180(1) of the

Act.

There were a number of other allegations brought by ASIC against selected directors and officers of the

company. Both JHIL and the new holding company, James Hardie Industries NV (JHINV), were also joined in

the proceedings as defendants. These claims were based on similar inaccuracies in press releases and presentation

slides prepared by the Chief Executive Officer, Mr Macdonald, concerning the funds available to the Foundation, as

well as the execution of a deed of covenant and indemnity. ASIC also alleged that a further announcement relating

to a scheme of arrangement to shift the Foundation into a new holding company was false or misleading.

This article deals only with the allegations that the directors were not acting with the appropriate care and

diligence required under s180(1) of the Act. In particular ASIC was concerned that the non-executive directors had

not paid sufficient attention to the preparation and release of the ASX announcement.

At a board meeting of JHIL held on 15 February 2001 the Draft ASX Announcement was to be discussed,

together with certain information and reports. It was argued by certain of the non-executive directors in the

relevant proceedings that the draft ASX announcement had not in fact been placed before the board, nor had it

been approved by the board, Gzell J drew a different conclusion from the evidence. His conclusions were based on

the following factors (amongst others):

• Each director had received notice that the resolution was to be considered at the meeting for the approval

of the Draft ASX announcement; therefore each director should have accessed the relevant information to



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carry out their obligations and in relation to this decision. In his view the directors knew or ought to have

known that if there was an inaccurate ASX announcement this would attract potential legal liability and

criticism.

• There was no evidence produced by the directors of sufficient weight to show that they had objected to the

formulation of the draft ASX announcement.

• The practice at the board meetings of JHIL was that the senior vice president of corporate affairs would

read out the relevant draft announcements and that there was no evidence to suggest that this was not the

case here.

Gzell J was very critical of the evidence provided by various directors in relation to their consideration of the draft

announcement. He noted that it was “extraordinary that none of the non-executive directors who gave evidence

recalled seeing the document that announced a most significant event in the life of the James Hardie Group, an

event that they were at pains to ensure was well received by the market” (McDonald No. 11 at para 1161).

In his view the directors knew that the Draft ASX Announcement contained false or misleading statements

because the relevant directors had stated that they would not have approved the document had they addressed it

at the board meeting.

Whilst the Judge was critical of the role played by the company secretary, who was also general counsel, and

the role of the chief executive officer of the company, whose responsibility was to ascertain whether the directors

were satisfied with the Draft ASX Announcement, as noted earlier most interest in the case centres on the hard line

approach taken by Gzell J towards the non-executive directors. They claimed that even if some of the allegations

by ASIC were correct, that they were nevertheless entitled to rely on their colleagues and the experts that the

company had retained in satisfying their relevant obligations (relying on s189 of the Act). This argument was

rejected.

Gzell J was caustic in his dismissal of their arguments. In his view they should not be able to rely on the

fact that other directors and advisors may have been involved in reviewing the documents. In this case he was

reviewing what was in effect a plain English document. He added: “This was not a matter in which a director was

entitled to rely upon those of his co-directors more concerned with communications strategy to consider the Draft

ASX Announcement. This was a key statement in relation to a highly significant restructure of the James Hardie

Group Management having brought the matter to the board, none of them was entitled to abdicate responsibility

by delegating his or her duty to a fellow director” (McDonald No. 11 at para 260).

In his view the directors had not given the Draft ASX Announcement the attention that it deserved. He stated

that they “must have realised that unqualified statements if there were sufficient funds in the Foundation to cover

all legitimate asbestos claims could not be made” (at McDonald No. 11 at para 303).

Having held that the non-executive directors were liable, the court next had to deal with what penalties might

be appropriate. A separate hearing was held in relation to the penalties as well as the relief the directors sought

pursuant to discretions vested in the court under ss1317S(2) and 1318 of the Act. These two sections of the Act in

effect provide the court with the ability to forgive directors (or excuse them) in whole or in part for breaches of the

law, if the court is satisfied that the directors had acted honestly and, having taken into account all of the matters

and the relevant circumstances the court felt that it should exercise a discretion in favour of the directors.

In McDonald No 12 Gzell J was more stringent in his criticism than perhaps they had been at the trial. Whilst



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ASIC did not argue that the relevant directors did not act honestly, Gzell J went out of his way to show that the

directors seeking relief had not acted honestly. Whilst he conceded the directors may have believed that they

were acting in the best interests of the James Hardie Group of companies, the fact that they did not deal with the

accuracy for the relevant announcement, and the evidence provided at the time, led him to the view that they were

not acting honestly. In reaching his conclusions, Gzell J reviewed a significant number of cases in which these

statutory provisions had been the subject of careful consideration by other courts. The arguments put forward

by non-executive directors that in their view management had taken the necessary steps to ensure the accuracy

of the relevant ASX announcement had not been justified by the evidence. Even though the approval of the ASX

announcement may have been an isolated event, it was a matter that demanded their utmost attention.

He added these important comments: “Non-executive directors are required to exercise a degree of care and

diligence and a reasonable person in their position would exercise, whether this matter calling for their attention

is an isolated incident or not’ (McDonald No. 12 at para 88).”

The Judge felt that in all of the circumstances of the case he could not forgive the directors. He concluded his

review of the important issue with these comments: “The fact that the [board meeting on 15 February 2001] was

a busy board meeting does not excuse the non-executive directors’ breach of duty nor was this a case for reliance

upon management, a co-director or an expert advisor. Management had sought the board’s approval and the task

of approving the Draft ASX Announcement involved no more than an understanding of the English language used

in the document. The fact that neither management nor the advisors raised any doubt about proving the Draft

ASX announcement does not advance the case of the non-executive directors in the unusual circumstances of this

case. The document was brought to the board for its approval and approval was granted. It was incumbent upon

the non-executive directors to ensure that the statements about full funding of the Foundation were adequate.

They failed in their duty by approving statements that they ought to have known were misleading” (McDonald

No. 12 at para 77 and 78).

In his view, the breach of duty by the directors was a serious one because the market relied on the company

making accurate statements.

He disqualified each of the non-executive directors for five years (he also imposed monetary fines but these

were lower than the fines sought by ASIC). The disqualifications have been regarded by many as harsh in light of

a softer approach taken by a strong NSW Court of Appeal a couple of years earlier in the Vines litigation (Vines v

ASIC (2007) [NSWCA 126: 63 ACSR 505]).

The decision as indicated earlier sent shockwaves through the business community. Nearly all the directors

have appealed these decisions. A finding against the company for breaching the law in relation to misleading or

deceptive conduct is also being appealed. It will be some 6-12 months before the appeals are heard and decided.

In the meantime the decisions are being taken very seriously by the community as a clear signal that a higher level

of care and diligence would be required from and by non-executive directors in carrying out their obligations.

Bob Baxt is a Partner at Freehills.





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Corporate Governance in New Zealand

BY RACHEL TAYLOR | DLA PHILLIPS FOX

Global market conditions have highlighted the need for companies to focus on good governance. They have also

emphasised the need for corporate governance practices to be agile in changing circumstances.

In New Zealand, the collapse of many finance companies from 2007 has also focused investor (and regulator)

attention on the governance standards of that sector, previously subject to light governance regulation.

As with most overseas jurisdictions, regulators in New Zealand have moved to strengthen corporate governance

standards, and encourage boards and management to adopt and monitor them.

The Securities Commission is the primary regulator of public issuers in New Zealand. It issues a handbook

on corporate governance which sets out nine key governance principles, and guidelines for achieving them.

This handbook is a commonly used base for governance programmes in New Zealand and is used by a range of

companies (public issuers and others), trusts and public sector entities.

The nine corporate governance principles set out in the handbook are:

• Directors should observe and foster high ethical standards;

• There should be a balance of independence, skills, knowledge, experience, and perspectives among directors

so that the board works effectively;

• The board should use committees where this would enhance its effectiveness in key areas while retaining

board responsibility;

• The board should demand integrity, both in financial reporting and in the timeliness and balance of

disclosures on entity affairs;

• The remuneration of directors and executives should be transparent, fair and reasonable;

• The board should regularly verify that the entity has appropriate processes that identify and manage

potential and relevant risks;

• The board should ensure the quality and independence of the external audit process;

• The board should foster constructive relationships with shareholders that encourage them to engage with

the entity; and

• The board should respect the interests of stakeholders within the context of the entity’s ownership type and

its fundamental purpose.

Listed issuers are also required to report compliance against the NZX Corporate Governance Best Practice Code.

This requires companies to adopt a code of ethics, separate the Chief Executive and the Chair roles, ensure provision

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of quality information to boards on a timely basis, formulate separate committees and establish a communication

framework with both internal and external audit.

The institute of directors in New Zealand continues to provide guidance and promote excellence in corporate

governance and training for directors.

Governance standards for non-bank deposit takers like finance companies have recently been increased to

require adherence to risk management programmes and independent board representation – and the sector is

now regulated by the Reserve Bank, New Zealand’s central bank.

Key Governance Issues in New Zealand

Board Composition

Emphasis has been placed on having a board that has a balance of skills, competence and independence from

management. Increasingly boards will undertake ongoing training and assessment of their performance (including

peer assessment).

In the finance company sector, management led boards will now have the checks of independent members.

More generally, there is an emphasis on diversity of skills to ensure the board operates as a balanced team.

Inadequate disclosure in prospectuses and investment statements has been identified as a factor in the collapse of

a number of finance companies in New Zealand. New Zealand’s disclosure regime, like that of other jurisdictions,

requires that offer documents are not misleading or deceptive, and that they adequately set out the risks associated

with the particular investment offered. Governance processes that ensure that directors discharge their disclosure

obligations (that offer documents are legally compliant, complete and truthful) better protect investors and enable

informed investment choice. They will also help protect directors from the personal consequences of failing to

comply with securities laws.

Transparent and Fair Remuneration Policies

While New Zealand has not seen the level of remuneration with significant bonus components (and attendant

investor backlash) experienced in the United States and elsewhere, it has the same need for transparency around

remuneration packages and performance incentives of company executives. There have been cases where investors

and the media have heavily criticised directors and management for taking what has been seen as excessive

remuneration in the face of poor company performance. Equally, incentive payments have also been criticised as

encouraging risk-taking to achieve personal results. Ultimately, it is a matter of balance for the board to determine

fair remuneration policies.

Shareholder Communication and Participation

In New Zealand, directors are required under general company law to act in the best interests of the company,

rather than shareholders.

While this may at times be a semantic distinction, as the interests of the company and its shareholders will

usually be aligned, it may not have encouraged the same level of shareholder communication as may be seen in other

jurisdictions, where the obligations of the board are owed to shareholders. This in turn was a likely contributor to a

lack of engagement by shareholders, including institutions, in the affairs of companies in which they invested.


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Publicly owned companies are encouraged by the Securities Commission Corporate Governance Principles

and Guidelines to maintain up to date websites containing dedicated governance and strategy information, and

to facilitate shareholder dialogue.

The New Zealand Shareholders’ Association has, since its inception in 2001, sought to change the way boards

of listed companies act in relation to their shareholders and enhance the quality of board decision making and

communication – encouraging shareholder engagement.

A Governance and Compliance Focused Culture

The focus of New Zealand law is not on “box ticking” governance but on fostering corporate cultures with a

commitment at board and management level to a governance ethic that is tailored to the particular activities of the

entity. Recent economic conditions have highlighted the need for governance to be adaptable to rapidly changing

conditions.

The Role of Risk and Compliance Officers

The role of risk and compliance as part of a corporate governance programme under regulation (and practice)

in New Zealand at present does not require a dedicated officer. Typically, the role is one that reports to the Chief

Financial Officer, although increasingly it will report directly to the board, or to the board’s risk and assurance

committee.

It is considered that formal structures, involving a dedicated risk and compliance manager responsible for

governance procedures and formal board sub committees (currently seen in listed entities) will be used more

widely by unlisted entities seeking to improve their corporate governance.

In addition, corporate governance is increasingly seen as more than, and separate from, risk identification and

legal compliance.

Rachel Taylor is a partner at DLA Phillips Fox.





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Companies Bill 2009: Future of Corporate Governance in India

BY SHARDUL S. SHROFF, INDER MOHAN SINGH AND ALOK GOEL | AMARCHAND & MANGALDAS & SURESH A.

SHROFF & CO.

The Companies Bill, 2009 (“the Bill”) was introduced by the Government in the Lok Sabha on August 03, 2009 to

replace the existing Companies Act, 1956 (“the Act”). The Bill is the result of the recommendations of the Expert

Committee on Company Law under the Chairmanship of Dr. J.J. Irani and detailed consultations with various

Ministries, Departments and government regulators. The Bill is being re-introduced as the earlier version had

lapsed because of dissolution of the previous Lok Sabha. It is divided into 28 chapters with 426 clauses.

The Minister for Corporate Affairs stated that the main objectives of the Bill were to: (i) to revise and modify

company law in consonance with changes in the national and international economy; (ii) to bring about compactness

by deleting redundant provisions and regrouping scattered provisions; (iii) to rewrite various provisions of the

Act to enable easy interpretation; and (iv) to delink procedural aspects from substantive law and provide greater

flexibility in rule making to enable adaptation to the changing economic and technical environment.

The Bill makes significant new and amended provisions with an emphasis on enhancing corporate governance

standards. Certain major issues of enhancing corporate governance could be summarised as follows.

Shareholder Democracy

The Bill intends for less government intervention in the private sector and propagates letting shareholders decide

what they want to do, as this will reinforce shareholder democracy. The Bill does not prescribe any limit on overall

maximum managerial remuneration, in contrast to the ceiling of 11% on total managerial remuneration under

existing company law; it also dispenses with the requirement of Central Government approval in certain cases.

Further, companies having paid-up capital as may be prescribed, or transactions of prescribed limits, can enter

into related party transactions if approved by shareholders by way of special resolution, unless the transaction is

in the ordinary course of business and at arm’s length. This is a departure from the existing Act, which requires

approval from the Central Government.

The Bill recognises voting by shareholders at a general meeting through electronic means in such a manner

as may be prescribed. This will ensure wider participation in the affairs of the company and will lead to greater

shareholder democracy. It also permits investors to claim unpaid dividends and interest from the Investor

Education and Protection Fund, which is not permitted under the provisions of existing company law after seven

years.

Listed companies for the first time would be required to submit a report to the Registrar of Companies on each

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annual general meeting in the manner as may be prescribed and to confirm that the meeting was convened, held

and conducted as per the legal requirements.

Independent Director

The Act remained silent on the provision of independent directors, which so far remains the exclusive domain of

the Securities Exchange Board of India. The Bill has at last taken the long waited step of making provisions for

appointment of independent directors. Every listed public company is required to have at least one-third of its

directors as independent directors. The Bill empowers the Central Government to prescribe the share capital of listed

company and to prescribe the minimum number of independent directors in other categories of public companies

and subsidiaries of public company.

The board has been given the responsibility of ensuring, while appointing an independent director, that such

independent director is a person of integrity, possesses relevant expertise and experience, and is not disqualified to

act as an independent director. The board needs to submits a report in the general meeting that, in its opinion, an

independent director proposed for appointment fulfils the conditions specified in the Bill for such an appointment.

The proposed company law attempts to lay down the duties of a director. A director is required to act: (i) in

accordance with the articles of association, (ii) in good faith to promote the objectives of the company for the benefit

of members; and (iii) in the best interest of the company. A director also has to exercise his duties with due and

reasonable care, skill and diligence and is prohibited from achieving or attempting to achieve any undue advantage

either to himself or to his relatives, partners or associates.

Key Managerial Person (“KMP”)

The Bill categories the managing director, chief executive officer, manager and, in the absence of a managing

director, chief executive officer or manager, the full-time directors and directors, along with the company

secretary and the chief financial officer, as KMP and authorises the Central Government to prescribe the class

or description of companies which shall appoint KMP. In case of any vacancy in the office of a KMP, the same is

required to be filled by the board at its meeting within a period of six months from the date of such vacancy. KMP

are considered at par with directors with regard to accountability in number of provisions, including treating

KMP as officer in default; requirements to submit information and remuneration details to the registrar in annual

returns; requirements to submit details of their interest, if any, in explanatory statement for special businesses;

requirements to disclose interest in contracts; and prohibition of forward dealings, etc.

Additional Board Matters

The Bill also proposes to expand matters that shall be decided only by way of resolutions passed at board meetings.

Such additional matters are; approval of financial statements, director’s report, any scheme of arrangement /

reconstructions / takeover of a company, diversifications of the business of the company, and acquisitions of a

controlling stake in another company.

Additional Disclosures

The Bill provides for additional disclosures under the directors’ report, such as shareholding pattern, number

of board meetings held, disclosure relating to managerial remuneration, particulars of inter-corporate loans /



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investments beyond permitted ceilings, and particulars of related party contracts along with the justification for

entering into such contract or arrangement. Some of these disclosures are part of the listing agreement applicable

to listed company only. Further, additional disclosures needs to be made in the annual return, such as particulars

of holding / subsidiary / associate companies, details of promoters and changes thereto, meetings of members,

board and committee meetings and attendance, remuneration of directors and key managerial personnel, penalties

imposed on company, its directors and officers, and details of compounding of offences.

In relation to special business, disclosure of interest is required to be given in the explanatory statement in

relation to key managerial personnel in addition to that of directors and managers. Also, the threshold shareholding

of directors, managers and key managerial personnel in any other company affected by the special business is

sought to be lowered to 2% from the current 20%. Any benefit accruing to such persons owing to non-disclosure or

insufficient disclosure is required to be held in trust for the company and such persons are liable to compensate the

company to the extent of the benefit.

Framework for Fair Valuations

The Bill proposes to introduce a new concept of valuation through registered valuers for certain major corporate

actions, namely: (i) allotment of shares on preferential basis; (ii) non cash transactions involving directors; (iii)

arrangement with creditors and members; (iv) purchase of minority shareholding; and (v) valuation of assets in

case of winding up, etc. The framework would ensure a uniform basis of valuation for corporate actions, which is

totally unregulated under the provisions of the existing Act. Such valuers will be professionals, such as chartered

accountants, company secretaries, etc., and they are required to be registered with the Central Government. The

valuer would be appointed by the company for the valuation of any property, stocks, shares, debentures, securities

or goodwill, or the net worth of the assets of the company. A valuer would be required to be appointed by the audit

committee or in its absence by the board of directors of that company.

Class Action Suits

For the first time in India, the Bill introduces the right of one or more members, or class of members or creditors,

to file a class suit. This will empower any one or more members to take legal action in case of any fraudulent action

on the part of company and to take part in investor protection activities. It recognises submission of class action

suites in tribunal cases when shareholders or creditors are of the opinion that the management or control of the

affairs are conducted in a manner prejudicial to the interest of the company or its members or creditors, including

acts which are ultra vires to the articles or memorandum, passing of a resolution by suppression of material facts or

misstatement, or any act which is contrary to provisions of the company law or other laws.

Accounting / Secretarial Standards and Auditor

The Bill has given free reign to corporates on the number of subsidiaries they can have, but preparation of a

consolidated statement and presentation at the annual general meeting has been made mandatory, along with its

financial statements. The Central Government is proposed to assume power in consultation with the National Advisory

Committee on Accounting Standard to issue accounting standards. The company will not only be required to adhere

to accounting standards but also has to comply with auditing standards. The Bill also recognises secretarial standards

for first time and makes it mandatory for companies to comply with respect to board and general meetings.



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The statutory auditor can render only such services as approved by board or audit committee. The Bill has

notified a list of services as prohibited services that an auditor of a company can provide, such as, internal audit

functions, investment advisor, management services, actuarial services, accounting and book keeping etc. This is

will ensure independence of auditors.

Cross Border Restructuring and Simplified Mergers

The Bill envisages and provides for cross border amalgamation by mutual consent of a foreign company with

a company registered under the Bill or vice versa, and authorises the Central Government to make detailed

provisions and rules in this regard.

Further, the Bill also provides that the merger of two small companies having such share capital not exceeding

Rs. 50 million or turnover not exceeding Rs. 200 million as may be prescribed by the Central Government would

not require approval of the Court. Similarly, merger of a holding company with its wholly owned subsidiary

company would not require approval of the Court.

Offence and Penal Provisions

The Bill has substantially increased the amount of penalties. For example, for non submission of an annual return,

the company will be punishable with fine which shall not be less than 50,000 rupees but which may extend to

five lakhs rupees, and every officer of the company who is in default shall be punishable with imprisonment for

six months or with fines not less than 50,000 rupees but which may extend to five lakh rupees, or with both.

Similarly, in cases where the company fails to comply with any provisions with regard to charges, the minimum

penalty would be Rs. 1 lac which can go up to Rs. 10 lac and any officer of the company who is in default shall be

punishable with imprisonment for a term which may extend to six months or with fines not less than Rs. 10,000

and which may extend up to Rs. 1 lacs, or with both. Accordingly, the Bill indentifies a company as a separate

entity for imposition of monetary penalties from the officers in default.

Further, the statutory filing to the Registrar would be required to be submitted within a specified time period.

In case of delay, such statutory filing can be made within a period of 270 days upon payment of an additional fee.

However, in the case of default in submitting the document even after 270 days, the company and its officers in

default, shall, without prejudice to the liability for payment of the fee and for an additional fee, shall also be liable

for action or liability for such failure or default.

A more effective regime for inspections and investigations of companies is proposed, which lays down a

maximum as well as minimum quantum of penalty for each offence, with suitable deterrence for repeat offences.

In case of fraudulent activities or actions, provisions for recovery and disgorgement have been included.

Special Courts would be established to deal specifically with offences. The Special Court will deal with matters

such as mergers and amalgamations. Reduction of capital, insolvency including rehabilitation, liquidations and

winding up, are proposed to be addressed by the National Company Law Tribunal / National Company Law

Appellate Tribunal.

Conclusion

The present Bill is an extract of corporate developments over the past five decades, lessons learned from previous

failures, and an attempt to plug the loopholes of existing company law. The Bill proposes some far-reaching changes



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in the statutory framework to address the business and investor community’s desire for a more contemporary

framework. The Ministry of Corporate Affairs (MCA) with support of various forums has taken an initiative on public

debate and seeking recommendation on the proposed Bill. Accordingly, recommendations of earlier committees

on company law and various other recommendations – such as inclusion of specific governing provisions for joint

ventures companies, providing threshold limit for class action suits, minimum level of disclosures in explanatory

business for special business to shareholders, inclusion of specific provisions on issuance of differential voting

shares by the company, free transferability of shares of public company, etc. – have been made to the MCA for

its consideration for inclusion into the Bill. Further, upon legislature as law, corporates would see number of

regulations which would be notified on procedural aspects and would then bring more clarity on its actual impact

on corporate functioning and maintaining corporate governance.

Shardul S. Shroff is the Managing Partner, Inder Mohan Singh is a Partner and Alok Goel is a

Senior Consultant at Amarchand & Mangaldas & Suresh A. Shroff & Co.


Insider Trading and Corporate Governance

BY SHARDUL S. SHROFF, PUJA SONDHI AND RAMANUJ GOPALAN | AMARCHAND & MANGALDAS & SURESH A.

SHROFF & CO.

Concept of Insider Trading

Insider trading is a serious deterrent to the growth and expansion of capital markets. Regulation and prevention

of insider trading is of vital importance in terms of good corporate governance. In simple terms, insider trading

refers to the misuse of “unpublished price sensitive” information for private gain by persons who have access to such

information. Economists refer to insider trading as abuse of “information asymmetry” for economic gain.

The concept of insider trading was initially limited to the case where a company’s insider tipped off an outsider

and the outsider used that tip to trade in the company’s shares. This constituted a breach of fiduciary duty owed by the

insider to the company’s shareholders. This was commonly referred to as the “classical theory” of insider trading.

In 1997, the United States Supreme Court in the case of US v. O’Hagan, extended the scope of insider trading

by including the “misappropriation theory” which provided that a person commits insider trading when he obtains

material confidential information and uses it in securities transactions in breach of fiduciary duty or similar

relationship of confidence to the source of information but not necessarily to the shareholders of the company

whose stocks are traded.

The “misappropriation theory” has also been modified in some jurisdictions (including in India after recent

amendments to the law) as the “possession theory”, wherein any person who has received or has had access to

such “unpublished price sensitive” information may be made liable for “insider trading”. There is no requirement

under this theory of receiving such information in a fiduciary capacity or similar relationship of confidence to the

source of information.







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Importance in the Indian Context

The issue of regulation of insider trading is of particular importance in the context of as a large proportion of Indian

companies (both unlisted and listed) are family owned and controlled. The presence of a strong corporate governance

framework in terms of regulatory control and effective monitoring and enforcement of regulations is therefore essential

to protect the interests of the public at large and have effective systemic checks against corporate malpractices such as

insider trading.

An International Monetary Fund survey in 2003 found the incidence of insider trading relatively high in India.

However, in terms of insider trading complaints received, the figure is relatively low. In February 2009, the Indian

finance minister disclosed to the press that the capital market regulator in India, the Securities and Exchange Board of

India (SEBI) had received complaints of insider trading against a total of 19 companies in India in the last three years.

Even though the number of complaints filed in India for cases of insider trading is low, the same can be attributed

to the relatively nascent stage of shareholder awareness and activism in the country. There is therefore an even greater

need to have a regulatory and monitoring system to prevent insider trading in securities in India.

Existing Regulations Against Insider Trading in India

Background

The first governmental effort to regulate insider trading in India can be traced to the formation of the Thomas

Committee in 1947, which gave its recommendations in 1948. The Thomas Committee studied, among other issues,

the regulations in the United States on short swing profits under Section 16 of the Securities Exchange Act, 1934.

Pursuant to the recommendations of the Thomas Committee, provisions relating to insider trading were included

in Sections 307 and 308 of the Companies Act, 1956, which required shareholding disclosures by the directors and

managers of a company.

However, due to the unsatisfactory enforcement provisions in the Companies Act, 1956, the Sachar Committee

in 1979, the Patel Committee in 1986 and the Abid Hussain Committee in 1989, recommended a separate statute in

India for regulating insider trading.

The Harshad Mehta securities scam in India in 1992 prompted the government to enact the Securities and

Exchange Board of India Act, 1992 to provide statutory powers to SEBI to regulate the capital markets in India. SEBI

in 1992, with the previous approval of the Central Government, framed the Securities and Exchange Board of India

SEBI (Prohibition of Insider Trading) Regulations, 1992 (or the Insider Trading Regulations), which provide the

regulatory framework to prevent, monitor and penalise insider trading.

The Insider Trading Regulations have been amended a number of times to reflect the changing perceptions and

requirements to effectively deal with instances of insider trading. An interesting study into the development of insider

trading regulations in India can be made by examining the changes in the Insider Trading Regulations from 1992 to

the present day. In particular, the amendments brought to the Insider Trading Regulations in 2002 and 2008 may

be studied to trace the development of law in India. A short insight into the same is provided below.

The Insider Trading Regulations – 1992 to 2002

The Insider Trading Regulations which came into force in the year 1992 was the first comprehensive regulatory

framework to address the issue of insider trading in India.



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The Insider Trading Regulations in 1992 defined an “insider” as “any person who, is or was connected with the

company or is deemed to have been connected with the company, and who is reasonably expected to have access,

by virtue of such connection, to unpublished price sensitive information in respect of securities of the company,

or who has received or has had access to such unpublished price sensitive information”.

The Insider Trading Regulations prohibited an “insider” to: (i) deal in, his own behalf or on behalf of any

other person, the securities of a listed company on the basis of “unpublished price sensitive” information; (ii)

communicate any “unpublished price sensitive” information to any person with or without such request, except as

required in the ordinary course of business or under law; or (iii) counsel or procure any other person to deal ins

securities of any company on the basis of “unpublished price sensitive” information.

The Insider Trading Regulations also provided powers to SEBI to investigate cases where insider trading was

suspected and to pass directions such as restraining an insider from dealing in securities or restraining an insider

from communicating or counselling any person to deal in securities.

However, it was soon found that the Insider Trading Regulations in the then existing form had several

shortcomings and were not sufficient to empower SEBI to prevent and penalise instances of insider trading. In

several high-profile cases before appellate bodies, the decision of SEBI to penalise instances of insider trading

was overturned (Hindustan Lever Limited v. SEBI [1998] 18 SCL 311 (AA), Rakesh Agarwal v. SEBI [2004] 49

SCL 351 (SAT-Mum), Samir C. Arora v. SEBI [2005] 59 SCL 96 (SAT-Mum)). It was also felt that the existing

regulations were more punitive than preventive in nature and that a regular reporting mechanism should be

developed for significant shareholders, who may be insiders of the company, to inter alia monitor their trading in

the shares of the company.

The Insider Trading Regulations – 2002 to 2008

The Insider Trading Regulations were significantly amended in 2002 (SEBI (Prohibition of Insider Trading)

(Second Amendment) Regulations, 2002, with effect from November 29, 2002) to remove perceived lacunae in

the regulations as well as to bring in a stronger monitoring mechanism for trading in shares of the company.

Some significant changes brought through amendments to the law in 2002 included:

• The words “by virtue of such connection” were removed from the definition of an “insider” (Regulation

2(e) of the Insider Trading Regulations). Therefore, there was no requirement to establish that an insider

obtained “unpublished price sensitive” information by virtue of his connection with the listed company.

• A mandatory reporting system for any person (including a director of a company) holding more than 5%

shares in a company was introduced. This also included mandatory reporting obligations of such persons

of changes in their shareholding exceeding 2% shares (Regulation 13 of the Insider Trading Regulations) in

the company.

• All listed companies, and organisations associated with the capital markets, including recognised stock

exchanges, public financial institutions and professional firms were required to frame an internal code

of conduct and procedure as near thereto with the model code provided under Schedule 1 of the Insider

Trading Regulations for the prevention of insider trading.

• The SEBI Act, 1992 was also amended (SEBI (Amendment) Act, 2002, with effect from October 29, 2002)

to increase the penalty for insider trading from Rs. 5 million to Rs. 25 million or three times the amount of

profit made out of insider trading, whichever is higher.



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The Insider Trading Regulations – Recent Amendments

SEBI had issued three consultative papers in 2008 (published on January 1, 2008, March 4, 2008 and June 9,

2008) proposing amendments to the Insider Trading Regulations. Pursuant to the same, the Insider Trading

Regulations were again amended in 2008 (SEBI (Prohibition of Insider Trading Regulations) (Amendment),

Regulations, 2008 with effect from November 17, 2008). Some of the key amendments are given below:

• The definition of an “insider” has been split. An insider is now a person who holds or has access to “unpublished

price sensitive” information, whether or not he is or was connected to the company (Regulation 2(e) of the

Insider Trading Regulations). The earlier classical theory of insider trading may therefore be said to have

been changed to the “possession theory”.

• The earlier Insider Trading Regulations required all listed companies, and organisations associated with the

capital markets to frame an internal code of conduct and procedure “as near thereto” with the model code

provided under Schedule 1 of the Insider Trading Regulations for the prevention of insider trading. The

amendment now requires that the companies should have their internal code “which should not be diluting”

the model code provided in Schedule 1 of the Insider Trading Regulations in any manner (Regulation 12(1)

of the Insider Trading Regulations).

• The model code of insider trading given in Schedule 1 of the Insider Trading Regulations has been amended

such that all directors / officers / designated employees of a listed company who buy or sell shares, cannot

take part in a reverse transaction for the following six months. Further, such persons cannot deal at all in

the derivatives of a company (Clause 4.2 of Part A of Schedule 1 of the Insider Trading Regulations). This

prohibition is in addition to the prohibition on insider trading. It is interesting to note that promoters or

other insiders of a company have not been included in these restrictions (unless the promoters are also

directors / officers / designated employees).

• The disclosure requirement of directors and officers of a listed company has been extended to the dependents

of such directors and employees. The listed company has the responsibility of defining such dependents

(Regulation 13(2) and Regulation 13(4) and Clauses 3.3.1 and 4.1 of Part A of Schedule 1 of the Insider

Trading Regulations).

• The time limits for disclosures under Regulation 13 have been shortened for certain categories of disclosures

(Regulation 13 of the Insider Trading Regulations).

With the changes in law, the Insider Trading Regulations have been made more stringent in line with the laws

in developed countries. There also seems to be a clear emphasis on the monitoring, enforcement and prevention

of insider trading rather than only penalising insider trading, as is evident from changes such as disclosures for

dependents, barring of certain categories of trade for insiders etc.

The recent changes to the Insider Trading Regulations have been criticised by some commentators as being very

harsh. Sandeep Parekh, a former Executive Director and head of legal affairs department of SEBI, has criticised

the amendments for “turning the law on its head” and said that the “insider trading regulations should not become

a booby-trap” (Sandeep Parekh; “Insider trading laws should not become a booby trap”; Mint, December 8, 2008).

Using the examples of: (i) a journalist who actively attempts to uncover fraud in a company; and (ii) a person who

recycles paper from the trash of a listed company being categorised as “insiders” under the amended Insider

Trading Regulations, he has called the regulation “wholly unacceptable”.



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Another aspect of the amendments which may be debatable is the prohibition on opposite trade for six months

and the barring of derivative transactions, for directors / officers / designated employees of a listed company and

not extending that prohibition to promoters or other insiders (Clause 4.2 of Part A of Schedule 1 of the Insider

Trading Regulations). The amendments are also unclear as to the applicability of the restriction on trade for

shares acquired by directors / officers / designated employees of a listed company under an employees’ stock

option scheme or an employees’ stock purchase scheme.

Some Suggestions

As discussed above, the legal regime for preventing and penalising insider trading has been considerably

strengthened over the years and has even been criticised recently by some commentators as being too stringent.

The main problem in relation to prevention of insider trading in India is lack of an effective monitoring and

enforcement mechanism. Some suggestions to improve the monitoring and reporting mechanism in India is

provided below, with some comparisons of the system present in the United States (Neha Mirajgoaker and S.

Parvathy Raj, “Insider Trading”; September 8, 2008, JurisOnline.in).

• In the United States, the Securities and Exchange Commission (SEC) provides a reward or “bounty” to

individuals who help it to uncover instances of insider trading. This kind of reward for information may

provide incentives for individuals to report instances of insider trading and a similar provision may be

considered for India.

• In India, listed companies have the responsibility to formulate a code of conduct and to appoint a compliance

officer to check insider trading, but the stock exchanges do not monitor trading in relation to insider

trading. Neither SEBI nor the stock exchanges have technology to monitor large scale insider trading. In

the United States, stock exchanges have a regular surveillance mechanism to monitor the volume and price

movements of shares with the help of advanced software technology like Edgar (electronic data gathering)

and SWAT (stock watch automated tracking). If there are movements beyond the predetermined limits,

alerts are generated and the stock exchanges carry out preliminary investigation. If there is evidence of

insider trading, the stock exchanges may refer the matter to the SEC, which carries out further investigation

and has the power to initiate criminal prosecution.

• While SEBI can take the help of the CBI (Central Bureau of Investigation) in investigating and collecting

evidence, SEBI should also have the assistance of other government investigative agencies like Central

Economic Intelligence Bureau (CEIB) to investigate allegations of insider trading. In the United States, the

Federal Bureau of Investigation (FBI) has been very effective in aiding the SEC in inspecting cases of insider

trading and improving the conviction rates.

• A related issue is the lack of manpower of SEBI to effectively monitor insider trading. It is estimated that

SEBI employs a total of around 350 people. In the United States, it is estimated that the NASDAQ alone has

180 fraud detecting officers along with 12 persons specially tracking insider trading activities. The same is

supplemented by 350 direct employees of the SEC and around 940 support staff (Neha Mirajgoaker and S.

Parvathy Raj, “Insider Trading”’; September 8, 2008, JurisOnline.in).

The weak enforcement mechanism in relation to insider trading cases is reflected in the small number of cases where

SEBI has framed charges for insider trading. It is estimated that between 2004 and 2008, SEBI has detected 14



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cases of insider trading out of which it has framed charges in 6 cases. On the other hand, the SEC prosecutes more

than 50 cases a year on insider trading (Neha Mirajgoaker and S. Parvathy Raj, “Insider Trading”’; September 8,

2008, JurisOnline.in). There is therefore a need to develop an effective monitoring framework for insider trading

in India in line with the stringent legal provisions.

Shardul S. Shroff is the Managing Partner, Puja Sondhi is Director of Strategy & Law and

Ramanuj Gopalan is an Associate at Amarchand & Mangaldas & Suresh A. Shroff & Co.


Re-thinking the Audit Process Post-Satyam: From Rhetoric to Practice

BY SHARDUL SHROFF, DHARINI MATHUR, NATASHAA SHROFF AND RAHUL SINGH | AMARCHAND &

MANGALDAS & SURESH A. SHROFF & CO.

India has, over the past decade, made a sustained effort to strengthen its corporate governance norms. Indian

regulations have been influenced by developments in other parts of the world, particularly the Sarbanes-Oxley

Act, 2002 in the US and the Cadbury Committee Report in the UK. The effectiveness of these regulations has,

however, come in for scrutiny after the Satyam fiasco. By way of background, on January 7, 2009 the Chairman

of Satyam, Mr. Ramalinga Raju, confessed to falsifying the company’s accounts over a period of several years,

including the company’s revenues, profitability and cash balances. The impact of the confession caused the stock

price of Satyam to fall by more than 80%, thereby eroding the wealth of its shareholders.

Indian law prescribes checks and balances at multiple levels to detect this type of accounting fraud. Public,

listed companies (Public Companies) are required to have internal auditors who, in turn, report to the audit

committee which ensures that proper internal controls are in place. Then, pursuant to the provisions of the Indian

Companies Act, 1956 (Companies Act), every company is required to appoint statutory auditors to certify that

proper books and accounts, as required by law, have been maintained and present a true and fair view of the

company’s results.

In addition, the Companies Act requires the board to confirm that the balance sheet and profit and loss account

have been prepared in accordance with applicable accounting standards and the listing agreement between Public

Companies and the stock exchanges (Listing Agreement) mandates that the financial and cash flow statements of

Public Companies are to be certified by the CEO and CFO. In addition, the CEO and CFO are required to certify

to the board that they have established and maintained effective internal controls for financial reporting and have

evaluated the effectiveness of the financial control systems.

If such requirements exist on the rulebook, why did the Satyam fraud go undetected?

Level I - The Internal Audit

The Companies Act read with the Listing Agreement and the Companies (Auditor’s Report) Order, 2003, points

toward the requirement for an internal audit system. The Committee on Internal Audit set up by the Institute of







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Chartered Accountants of India (ICAI) has also issued Standards on Internal Audit from time to time. However,

companies have a choice between an in-house department and appointing an independent audit firm to carry out

this function. At Satyam, the internal audit function was carried out in-house and it has been suggested that this

could be one of the reasons the fraud went undetected.

Therefore, it has been suggested that the appointment of an independent audit firm to undertake the internal

audit of Public Companies be made mandatory. This proposal was considered by the SEBI Committee on

Disclosures and Accounting Standards (SCODA). In its discussion paper on proposals relating to amendments

to the Listing Agreement (SCODA Discussion Paper), the SCODA was of the view that the current mechanism

where the audit committee was given the responsibility of reviewing the performance of the internal auditor was

sufficient and provided adequate checks and balances in respect of the internal control mechanism.

While it is important that the internal auditors be able to discharge their responsibility independently and

without fear of management, mandating an “external” internal audit may increase cost of compliance, without

ensuring higher quality internal audits. The internal auditor, whether employed in-house or appointed as an

external consultant, is subject to influence by the management, simply on account of being appointed by the

management. What may be more useful is to have a requirement that the internal auditors (even where in-house)

be appointed by the audit committee and report directly to them and not to the CFO or CEO or similar functional

head. This would help ensure that the internal auditor has the freedom and ability to critically check and control

management’s decision-making processes without fear of the repercussions.

In this context, we believe it may be helpful to include a specific provision in the Companies Bill, 2009

(Companies Bill) which clearly sets forth the appointment, role and responsibilities of the internal auditors. As

mentioned above, the requirement for an internal audit system currently flows from multiple sources.

Level II - The Audit Committee

The Companies Act, read with the Listing Agreement, requires that Public Companies have a “qualified and

independent” audit committee comprised of two-thirds independent directors, with an independent director as

the chairman. The audit committee’s role includes overseeing the financial reporting process and reviewing the

adequacy of the internal audit function.

In the wake of the Satyam fraud, it has been suggested that audit committees should be made up only of

independent directors. Given that the Satyam audit committee was comprised only of independent directors,

we do not believe this would really enhance the functioning of the audit committee. We believe the current

requirement of a two-thirds independent audit committee would be sufficient, if each independent director on

the committee performed his or her role in the right spirit. However, in this context, an area in which we believe

a change may prove beneficial is the process of nomination and appointment of independent directors. Currently,

independent directors in India are essentially nominated, appointed and removed by the promoters and, hence,

may not exercise any real independence. This issue may have been in play on the Satyam board where, although

the independent directors raised questions regarding the proposed acquisition of the two related Maytas entities

– with some expressing strong reservations – none of them cast a dissenting vote disapproving the deal.

While the Companies Bill stipulates a list of disqualifications for appointment as an independent director, this

would not always prevent promoters from selecting persons who, while not falling foul of the disqualifications,

are generally favourably disposed towards the promoters. One possible solution, that may be incorporated into



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the Companies Bill, could be to establish an independent body to appoint independent directors to the board (and

audit committees) of Public Companies and set their remuneration.

Another proposal is that directors on the audit committee should have relevant financial and sectoral expertise

and understand the company’s business. The Listing Agreement already requires directors on the audit committee

to be financially literate and for at least one member to have knowledge in finance or accounting. However, there is

merit in additionally suggesting that members of the audit committee have a deep understanding of the company’s

business or sector. This ability could prove critical for audit committee members to spot anomalies and ask the

right questions based on experiential knowledge.

Level III - The Statutory Audit

The Companies Act requires that the statutory auditor issue a report certifying that proper books and accounts

have been maintained and that the financial statements of a company give a “true and fair view” of its state of

affairs. The ICAI has issued detailed Auditing and Accounting Standards providing guidance on how an audit is to

be conducted. However, the manner in which auditors are appointed and discharge their role have been topics of

discussion as these appear to take away from the effectiveness of the audit function.

For instance, under current law, while auditors are technically appointed by the shareholders, in reality,

shareholders merely endorse the choice of the promoter or the board. In any event, given their voting strength,

it is generally easy for the promoters to ensure that an auditor of their choice is appointed. In this context, while

the Companies Bill provides that the statutory auditor cannot provide a company a host of other services, such

a prohibition would not, by itself, ensure that a statutory auditor is entirely free from the promoter’s influence.

A possible solution, similar to the one above, could be to establish an independent body to appoint a technically

qualified and independent auditor for each Public Company. Alternatively, the audit committee, that is itself

appointed by an independent body, should appoint the statutory auditors. In this manner, it would be possible to

ensure that the statutory auditors are not incentivised to endorse the promoter’s actions.

Further, the Companies Bill stipulates that the statutory auditor may provide a company with such other

services as the board or the audit committee approve. In our view, such matters should only be considered and

approved by the audit committee (appointed as discussed above).

In addition, in order to ensure independence and lack of any undue influence on account of familiarity, it is also

essential that auditors be rotated and that the same individuals do not constantly work on a given client account.

Realising this, the ICAI has recommended that audit firms should change partners working on an audit account

of a Public Company once every five years. In our view, this recommendation should be made mandatory for all

Public Companies. It is relevant to note that SCODA in its discussion paper had recommended that SEBI should

stipulate that the audit firm partner signing the audited accounts of a Public Company should be mandatorily

rotated every five years . In the same vein, another suggestion is to require that audit firms themselves be rotated.

While several committees including the SCODA believe that this may not be practical, this requirement could

actually go a long way in ensuring the independence of the statutory auditor.

Further, under the Companies Act the statutory auditor is required to inspect documents and obtain information

and state whether adequate information has been received for purposes of the audit report. It appears that

Satyam’s statutory auditors placed blind reliance on the information provided by the company and did not seek

independent confirmations from the banks regarding bank balances. While we understand that it is not practical



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to have the statutory auditors independently verify every piece of information, at least sample checks in respect of

certain significant matters such as cash/bank balances should be undertaken. In addition, it is in this context, that

a strong case for a periodic “audit of audits”, as is undertaken by the Public Company Accounting Oversight Board

in the US, is made out. If audit firms’ work was subject to a layer of scrutiny, they may be additionally incentivised

to ensure that they discharge their functions more diligently.

In conclusion, while strengthening legal and regulatory provisions is important, in order to prevent another

“Satyam”, it appears to be equally important to emphasise the manner in which such requirements are implemented

and complied with. The individuals and institutions involved – be it directors on the audit committee, internal

or statutory auditors – must discharge their roles more sincerely and diligently and this will likely happen only if

such persons are afraid of the repercussions that would follow a lackadaisical approach. Frequent and thorough

checks and swift action against offenders by regulators such as SEBI, ICAI and the Ministry of Company Affairs

could ensure that such requirements are not merely met with a “check-the-box” attitude but instead to comply

with the spirit of the law.

Shardul Shroff is the Managing Partner, Dharini Mathur is a Principal Associate and Natashaa

Shroff and Rahul Singh are Associates at Amarchand & Mangaldas & Suresh A. Shroff & Co.


International Dimensions of Corporate Governance

BY SHARDUL S. SHROFF AND RAGHAV SHARMA | AMARCHAND & MANGALDAS & SURESH A. SHROFF & CO.

The Satyam scam represents the failure of the extant corporate governance regime in India and signals that a

significant transformation is on the anvil. The new provisions under the Companies Bill, 2009 (the “Bill”) envisage

far-reaching changes to strengthen corporate governance in India. Firstly, it provides statutory recognition to the

institution of independent directors and requires every listed company to have at least one-third of the board of

directors (the “Board”) as independent directors (Section 132 (3) of the Bill). The audit committee shall be required

to have a majority of independent directors (Section 158 (2) of the Bill). Secondly, it envisages stricter regulation

of auditors and prohibits them from offering services like internal audit which lead to conflict of interest (Section

127 of the Bill). Lastly, it establishes a limited private enforcement regime where any shareholder or creditor can

hold the company liable for mismanagement of its affairs (Section 216 of the Bill). These changes are a part of

the broader scheme of changes waiting to unfold. Going beyond the Bill, the SEBI Committee on Disclosures and

Accounting Standards has recently suggested mandatory rotation of partners of the statutory auditor firm every

five years for listed companies.

The aim of this article is to dwell upon certain new measures which are likely to emerge in the Indian corporate

governance regime. In the opinion of the authors, the Bill fails to redress a fundamental malady of the existing

regime: how to make independent directors truly independent and effective supervisors of the company’s

management. The idea of “true” independence will form the bedrock of future changes in Indian corporate









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governance. Significant changes likely to unfold are likely to include a realistic and workable liability regime for

independent directors and the institution of a supervisory board system for separation of the management and

supervision functions. Further, as India transforms into a preferred destination for foreign investment by Multi

National Enterprises (“MNE”) operating through complex structures of downstream subsidiaries, a new regime

providing for fixation of responsibility on the parent company for the acts of Indian subsidiary will be required.

Independent Director

Under Indian law, the liability of independent directors is limited and the enforcement is beset with practical

difficulties (this problem is not limited to Indian law, rather it is a generic problem of corporate governance

regimes globally). Section 5 of the Companies Act 1956 (the “Act”) limits the liability for contravention of the

Act only to those directors and other officers who are in charge of, or concerned with the management, or

are directly responsible for compliance with that particular provision of the Act that has been contravened.

Section 633 provides a broad defence of “honest and reasonable” conduct in case of negligence, default,

misfeasance or breach of trust. Under the Act, suits by shareholders lie against oppression by majority

(Section 397 of the Act) and mismanagement of affairs of the company (Section 398 of the Act) and

independent directors are unlikely to be sued on these grounds. Further, Indian courts may apply a different

standard to independent directors from that applied to a whole time director in respect of his obligation to

exercise skill, care and due diligence as a director (J. H. Doshi & Others v. Registrar of Companies, [1989]

2 Comp LJ 315.). In addition, Indian law follows the “loser pays” principle regarding the legal costs of a

suit, which deters shareholders from bringing large financial claims against directors. Thus, owing to the

reasons mentioned above, a shareholder willing to sue the directors would find it more advantageous to sue

the managing directors.

Under Indian law, there is no explicit affirmative duty owed by the independent directors to the company

for effectively supervising the actions of the management. Further, in case of a director’s breach of duty to

the company, the Board takes the decision of bringing the suit. A one-tier board system allows independent

directors to develop social and institutional solidarity with the managing directors and thus, enforcement

by the company rarely occurs.

The Bill extends the liability for contravention to every director who is aware of contravention or who

consents or connives in the contravention (Section 2 (zzi) of the Bill). It will only expand the liability of

independent directors leaving the problem of enforcement as it is. The new class action regime contemplated

under the Bill allows any shareholder to sue the company but not the directors.

The absence of any effectively enforceable liability makes the independent directors lax in their

supervisory functions. Thus, there is a need for clear-cut expression of the liability of independent directors

to the shareholders or creditors for negligence or failure in supervising the management in cases of

mismanagement of a company’s affairs. However, this liability should be confined to breaches of specific

duties to be spelt out for independent directors which are related to their supervisory functions, e.g., duty

to ask the management for information about the financial affairs of the company at regular intervals or

duty to inform the shareholders of apparent mismanagement of the company. This should be coupled with

the separation of the Board into two-tiers in order to reinforce the independence of non-executive directors

from the management.



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Supervisory Board

The Supervisory Board system prevalent in Germany, Netherlands and France envisages a two-tier Board for

public companies. In this system, the Board consists of a Management Board ( the “MB”) and a Supervisory

Board (the “SB”), resulting in the separation of management and supervisory functions. The MB manages the

day-to-day operations of the company and represents it in all matters. The members of the SB are appointed

and removed by the shareholders. The SB appoints the MB and oversees its functioning. The SB can neither bind

the company nor declare any dividends. The SB has the authority to specify types of transactions which would

be subject to its approval. It has a duty to keep itself well informed about the financial affairs of the company,

to examine the company’s books and call shareholders’ meetings when it is in the company’s best interests. No

individual can be a member of SB and MB of a company at the same time. The members of MB of controlled

enterprises are disqualified from membership of the parent company’s SB. Further, an individual can be a member

of not more than ten SBs. To protect the independence of the SB, its members are made liable only to the company

and its creditors.

The MB can sue the members of the SB on behalf of the company for breach of duties. However, in Germany,

the MB is not subject to the direct control of the shareholders and the concerns of the shareholders can be voiced

only by the SB. The SB has a duty to ensure that the acts of the MB are in compliance with the law. The SB can

institute action against the members of the MB for breach of duties owed to the company or shareholders. Thus,

the MB and SB serve as a system of checks and balances on each other.

The SB system ensures independent supervision of the company management, verification of its financials and

better protection of the interests of shareholders. It prevents the independent directors from becoming privy to

the acts of the managing directors and helps them to independently review their actions. The SB system clarifies

the duties and liabilities of independent directors. In the opinion of the authors, a reformation of India’s existing

Board system by mandating a two-tier SB system can help solve the problem of ensuring true independence of

non-executive directors to an extent. However, features of the German SB system like codetermination (presence

of worker’s directors) and insulation of managing directors from direct responsibility to the shareholders need

not be imported.

Liability Fixation in MNEs

Within the MNE structure, parent companies control highly complex multi-tiered corporate structures involving

hundreds of subsidiaries organised under different national laws and collectively conducting segments of a single

business. The economic reality is that an MNE is a single enterprise. However, law attributes juridical personality

to each of the subsidiary of an MNE with its own legal duties and liabilities separate and distinct from its parent

company and affiliates. The courts can ignore separate legal identity of a company by applying the doctrine of

“piercing the corporate veil”. However, this doctrine is limited in its application to cases where the corporate

personality is being used as a mere sham or a cloak or for fraud or improper conduct, for tax evasion and in

criminal or quasi criminal cases. The limited situations recognised under the doctrine of “piercing the corporate

veil” are not helpful in ensuring accountability of the parent company for actions of its subsidiaries.

The single economic entity theory recognises the economic reality that subsidiary is a mere conduit for parent’s

business in case of MNEs. The Indian courts are gradually recognising the “single economic entity” theory for

groups of companies. The single economic entity theory has been applied to even a partially owned subsidiary in



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Novartis AG v. Adarsh Pharma 2004 (29) PTC 108 (Mad). In the opinion of the authors, the gradual expansion of

single economic entity theory to fix responsibility of corporate compliance on foreign parents of Indian subsidiaries

within MNE groups is a necessary and expected development. Representation of local independent directors on

the Board of the parent companies may make MNEs more responsive and accountable for their local operations.

Conclusion

Corporate governance in India is in a state of evolution. Going forth, it will be essential to acknowledge that

formal independence does not ensure independence in fact and formal liability does not ensure enforcement. The

gaps have to be filled by a crystal clear liability regime for independent directors and creating firewalls between

them and the management. In addition, Indian law needs to move away from traditional legal jurisprudence of

treating companies within MNE groups as separate legal entities in matters of corporate compliance in order to

be responsive to the new corporate governance problems posed by the entry of MNEs.

Shardul S. Shroff is the Managing Partner and Raghav Sharma is an Associate at Amarchand &

Mangaldas & Suresh A. Shroff & Co.






www.executiveview.com | Singapore

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Audit Committees in Singapore

BY JEAN WAN | ALLEN & GLEDHILL LLP

The Singapore Companies Act (Chapter 50) (the “CA”) requires all Singapore-incorporated companies that are

listed on the Singapore Exchange Securities Trading Limited (“SGX-ST”) to have an audit committee (“AC”).

The Code of Corporate Governance 2005 (the “Code”) sets out principles of good corporate governance practices

which companies listed on the SGX-ST (“listed companies”) are encouraged to follow, which include the setting

up of an audit committee. All listed companies are required by the SGX-ST Listing Manual (“Listing Manual”) to

disclose their corporate governance practices and explain deviations from the Code in their annual reports. The

oversight of corporate governance of listed companies comes under the purview of the Monetary Authority of

Singapore (MAS) and the Singapore Exchange Ltd (SGX).

Composition

The Code provides that the board of directors of every listed company should establish an AC comprising at

least three directors, all non-executive, the majority of whom, including the chairman, should be independent.

At least two members should have accounting or related financial management expertise or experience. The CA

additionally provides that a majority of the AC should not comprise executive directors of the listed company or

any of its related corporations, close family members of an executive director of the listed company or any of its

related corporations, or any person having a relationship which, in the opinion of the board of directors, would

interfere with the exercise of independent judgment in carrying out the functions of an AC.

Role and Functions

In general, each AC should have its own written terms of reference which sets out its authority and limits, and

may regulate its own procedure as to meeting proceedings and the custody, production and inspection of meeting

minutes.

The functions of an AC are prescribed in the CA and the Code. The AC is also entrusted with certain duties

under the Listing Manual.

Functions of AC under the Companies Act

Under the CA, the AC has to review, together with the external auditor, the audit plan, the external auditor’s

evaluation of the system of internal accounting controls, the external auditor’s audit report, the assistance given

by the company’s officers to the external auditor, and the scope and results of the internal audit procedures. The

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AC’s functions under the CA include reviewing the balance-sheet and profit and loss account of the company and,

if it is a holding company, the consolidated balance-sheet and profit and loss account, prior to submission to the

directors of the relevant company.

The external auditor of the company is entitled under the CA to appear and be heard at any of the AC’s meeting

and must appear before the AC if the AC requires it to do so. On the other hand, if requested to do so by the

external auditor, the AC chairman has to convene an AC meeting to consider any matters the external auditor

believes should be brought to the attention of the directors or shareholders.

Functions of AC under Code

Under the Code, the AC is charged with nominating a person as the external auditor of the company and should

review the independence of the external auditors annually. The AC should also review the scope and results of the

audit and its cost effectiveness, and the objectivity of the external auditors. The AC is also charged with reviewing

the significant financial reporting issues and judgements so as to ensure the integrity of the financial statements

of the company and any formal announcements relating to the company’s financial performance.

An important role of the AC is to review arrangements by which staff of the company may, in confidence,

raise concerns about possible improprieties in matters of financial reporting or other matters. The AC’s objective

should be to ensure that arrangements are in place for the independent investigation of such matters and for

appropriate follow up action.

Another aspect of the AC’s functions under the Code is to review at least annually the adequacy and effectiveness

of the company’s internal financial controls, operational and compliance controls, and risk management policies

and systems established by the management to safeguard the shareholders’ investments and the company’s

assets (collectively “internal controls”). Such review can be carried out by the internal and/or public accountants,

provided that the AC should be satisfied of the public accountant’s independence where the public accountant is

also the external auditor of the company. The board should comment on the adequacy of the internal controls,

including financial, operational and compliance controls, and risk management systems in the company’s annual

report.

The AC is also responsible for reviewing at least annually the adequacy and effectiveness of the company’s

internal audit function. In this regard, the AC should ensure that the internal audit function is adequately resourced

and has appropriate standing within the company. The internal auditor’s primary line of reporting should be to

the AC chairman although the internal auditor would also report administratively to the CEO.

Functions of AC under Listing Manual

Chapter 9 of the Listing Manual sets out certain duties of the AC with respect to transactions between a listed

company, its subsidiaries or associated companies and their interested persons. Generally, the AC is responsible

for reviewing interested person transactions and should form a view as to whether such transactions are on normal

commercial terms and are not prejudicial to the interests of the listed company and its minority shareholders.

In relation to any sale of units of a listed company’s property projects to the listed company’s interested persons

or a relative of a director, chief executive officer or controlling shareholder, the AC of the listed company must

review and approve the sale and satisfy itself that the number and terms of the sale are fair and reasonable and are

not prejudicial to the interests of the listed company and its minority shareholders.



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A renewal of a general mandate for interested persons transactions would not require an independent financial

adviser’s opinion if the AC confirms that (i) the methods or procedures for determining the transaction prices

have not changed since the last shareholder approval, and (ii) the methods or procedures for determining the

transaction prices are sufficient to ensure that the transactions will be carried out on normal commercial terms

and will not be prejudicial to the interests of the listed company and its minority shareholders.

The views of the AC are also relevant in ascertaining whether certain joint venture transactions are exempted

from the requirement for shareholder approval. In the case of an investment in, or a loan to, a joint venture with

an interested person, such transactions do not require shareholder approval if, inter alia, the AC is of the view that

the risks and rewards of the joint venture are in proportion to the equity of each joint venture partner, and the

terms of the joint venture are not prejudicial to the interests of the listed company and its minority shareholders;

and in relation to the provision of a loan, the AC is additionally of the view that the provision of the loan is not

prejudicial to the interests of the listed company and its minority shareholders.

In announcements relating to interested persons transactions, the announcement of the listed company must

include a statement as to the AC’s views regarding the transaction, or that the AC is obtaining an opinion from

an independent financial adviser before forming its view. The AC’s opinion should also be stated in a circular to

shareholders seeking approval for an interested person transaction, if the AC’s opinion is different from that of

the independent financial adviser, or if the interested person transaction relates to the issue of shares or other

securities (other than a rights issue) for cash, or the transaction relates to the purchase or sale of any real property

(i) where the consideration is for cash, (ii) an independent professional valuation has been obtained for the

purposes of the purchase or sale, and (iii) such valuation is disclosed in the circular to shareholders.

Apart from reviews of interested persons transactions, the AC is obliged under the Listing Manual to report to

its board of directors, after discussion with the external auditor, any suspected fraud or irregularity, or suspected

infringement of any Singapore laws or regulations or rules of the SGX-ST or any other regulatory authority in

Singapore, which has or is likely to have a material impact on the listed company’s operation results or financial

position.

Audit Committee Guidance Committee

On 15 January 2008, the SGX, the MAS and the Accounting and Corporate Regulatory Authority (the “ACRA”)

jointly established the Audit Committee Guidance Committee (the “ACGC”). The ACGC is tasked with developing

practical guidance for AC of listed companies to assist them in better appreciating their responsibilities

and enhancing their effectiveness. Among other things, the guidance will focus on the practical aspects and

considerations of the work of ACs, including the implications of the requirements of the CA and the Code, and

identify and describe best practices of effective ACs.

Following the survey on AC members of listed companies, the ACGC issued the Guidebook for Audit

Committees in Singapore (the “Guidebook”) on 30 October 2009. The Guidebook strives to assist AC members in

achieving higher standards of corporate governance by setting out certain best practices for ACs. ACs are strongly

encouraged to adapt and modify the recommended best practices to make them relevant and applicable for their

company where necessary.

The Guidebook also contains practical tools such as FAQs, case studies, checklists and sample forms to provide

practical solutions and guidance to issues ACs commonly faced.



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The Guidebook is divided into two main sections, namely, a section on “AC Composition” and a section on

“Roles and Responsibilities of ACs”.

The section dealing with the composition of ACs aims to provide guidance for current and prospective AC

members to assess their independence and suitability for membership in the AC. The guidance in this section aims

to get the AC started off on the right footing, with directors who have the appropriate qualities to handle the job

and the time and resources to focus on their responsibilities and duties as AC members.

The section on the “roles and responsibilities of ACs” focuses on the key roles and responsibilities of the AC

including internal controls, risk management, internal audit, financial reporting, external audit, and other duties

and responsibilities which relate to interested person transactions, conduct of meetings, performance assessment,

whistleblowing and training. The best practices in this section attempt to clarify areas in which ACs often face

uncertainty, as well as provide practical solutions and guidance to issues ACs commonly face.

The Guidebook represents a key initiative in strengthening the corporate governance practices of listed

companies in Singapore, particularly as ACs play a central role in the governance and oversight of companies.

Jean Wan is a Partner at Allen & Gledhill LLP.


Rights and Remedies of Minority Shareholders in Singapore

BY CHRISTIAN CHIN | ALLEN & GLEDHILL LLP

The law provides for certain rights to which minority shareholders may have recourse. These rights seek to provide

protection from, and remedies against, the hegemony of majority shareholders.

Singapore is a common law country where well-established principles for the protection of minority shareholders

espoused by, primarily, the English courts – such as the rule in the oft-cited English case of Foss v Harbottle (also

known as the “proper plaintiff” rule which, briefly, states that the proper plaintiff in a suit for the enforcement of a

corporate right is the company itself) – are applicable. The rights of minority shareholders are also codified in the

Companies Act (the “Act”) to supplement those provided by the common law. This article outlines the main rights

and remedies of minority shareholders in Singapore.

Breach of the Memorandum and Articles of Association and Ultra Vires Transactions

The basic constitutional documents of a company are its Memorandum and Articles of Association. The

Memorandum of Association defines and limits the objects and powers of a company, whereas the Articles of

Association sets out the regulations by which the company is governed. The provisions in the Memorandum and

Articles of Association constitute a contract among the members inter se. Accordingly, if either the company or

its majority shareholders act in breach of the Memorandum and Articles of Association, a member may commence

legal proceedings based on common law (that is, contract) principles.

A company acting outside its objects and powers as set out in its Memorandum of Association would also be





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acting ultra vires (i.e., without authority) its Memorandum of Association. The Act enables (i) any member of

the company to commence legal proceedings to restrain a threatened ultra vires act; and (ii) the court (where the

court considers it to be just and equitable to do so and where all the parties to the contract are parties to the court

proceedings) to: (a) set aside and to restrain the performance of the contract, and (b) to award compensation for

the loss or damage sustained or may result from the action of the court in setting aside and restraining performance

of the contract, where an unauthorised act is being or is to be performed or made pursuant to a contract to which

the company is a party. The court is not, however, empowered to award anticipated profits to be derived from the

performance of the contract, as a loss or damage sustained.

Directors’ Duties

The powers of managing a company’s business and operations lies with its board of directors. Both the common

law and the Act prescribe rather strict rules in relation to the manner in which directors may exercise these

powers. The statutory, common law and equitable duties of a director may be summarised as follows:

• A director must act in what he honestly considers to be in the company’s interests and not in the interests

of some other person or entity. The interests of the company are not necessarily the same as the interests of

the shareholders. A minority shareholder may thus seek legal redress if the directors act in the interests of

the dominant majority shareholder in disregard of the interests of the company.

• A director must not place himself in a position where his duty to the company and his personal interests

may conflict. The conflict of interest rules need to be observed closely by a director who is either the majority

shareholder or holds office or employment in a corporate majority shareholder. Depending on what the

company’s Articles of Association provide, he may have to refrain from voting on matters of the company

in which the majority shareholder is interested. Related duties include: (a) a duty to disclose to the board

of directors the nature of any interest (whether direct or indirect, and including an interest of a member of

the director’s family) in any contract with the company; (b) a duty to disclose to the board of directors the

nature, character and extent of any conflict that may arise by virtue of any office held by him or by virtue of

his holding any property; and (c) a duty to refrain from voting on any matter involving a potential conflict

of interest.

• A director must employ the powers and assets that he is entrusted with for the purposes for which they were

given and not for any collateral purpose.

• A director must act with reasonable skill, care and diligence.

• A director may, when exercising powers or performing duties as a director, rely on reports, statements,

financial data and other information prepared or supplied, and on professional or expert advice given, by

certain persons, provided that the director acts in good faith, makes proper inquiry where the need for

inquiry is indicated by the circumstances and has no knowledge that such reliance is unwarranted.

The Act provides for civil and/or criminal liabilities to be imposed on a director who breaches his duties. These

include liability for any damage suffered by a company as a result of a breach of his duties, and punishment

ranging from fines of up to S$1000, to imprisonment of up to seven years.

A minority shareholder may also seek legal redress if a director acts in the interests of the majority shareholders

in disregard of the interests of the company. However, as a director’s duties are owed to the company and not to its


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shareholders, a minority shareholder who seeks redress against a defaulting director must commence his action

in the name of the company. The right to bring such derivative action is granted under section 216A of the Act, but

such right does not apply to companies listed on the Singapore Exchange Securities Trading Limited (the “SGX-

ST”). Members of a company listed on the SGX-ST will have to use the common law derivative action if they wish

to commence a derivative action. The principle of a common law derivative action allows a member of a company

to commence an action against the defendant himself where he can demonstrate that the case at hand comes

within one of two exceptions to the rule in Foss v Harbottle: first, in the case of ultra vires acts; and second, where

there is a fraud on the minority and the wrongdoers are in control of the company.

Investigations into the Affairs of a Declared Company

Minority shareholders may also apply to the Minister of Finance (the “Minister”) to appoint inspectors to investigate

the affairs of a company. Where the Minister is satisfied that it is desirable that the affairs of a company should

be investigated, the company will be deemed to be a “declared” company. This may be done on the following

(non-exhaustive) grounds: (i) a prima facie case has been established that an investigation is necessary for the

protection of the public, the shareholders, the creditors or the holders of interests other than shares or debentures;

(ii) it is in the public interest that allegations of fraud, misfeasance or other misconduct by persons concerned

with the formation or management of the company should be investigated; or (iii) for any other reason it is in

the public interest to have the affairs of the company investigated. Following this, the Minister may appoint one

or more inspectors to investigate the affairs of the company and to report its or their opinions. He may require

the production of books and documents in the custody of an officer or agent, and he may examine the officers

and agents on oath or affirmation. If, from the report of the inspector, it appears that the case is one in which a

prosecution ought to be instituted, the Minister may institute such a prosecution accordingly. All the company’s

officers and agents are required to give all assistance in connection with the prosecution which they are reasonably

able to give. The Minister may also apply for the winding up of a company after the inspector has presented his

report.

Oppression, Disregard of Members’ Interests and Prejudice

The most significant protection afforded to a minority shareholder is the common law principle that forbids majority

shareholders from acting in a “fraud on the minority”. The common law gives relief to minority shareholders who

have suffered oppression at the hands of the majority. This common law principle is entrenched in, and widened

by, section 216 of the Act. A member of a company may apply to the court for relief under section 216 of the

Act where: (i) the affairs of the company are being conducted in a manner oppressive to, or in disregard of the

interests of, one or more of the members of the company; (ii) the powers of the directors are being exercised in

a manner oppressive to, or in disregard of the interests of, one or more members of the company; (iii) some act

of the company has been done or is threatened to be done which unfairly discriminates against, or is otherwise

prejudicial to, one or more of the members of the company; or (iv) some resolution of the members (or any class

of them) has been passed or is proposed which unfairly discriminates against, or is otherwise prejudicial to, one

or more of the members of the company. The action is taken out in the member’s name, in contrast to the proper

plaintiff rule in Foss v Harbottle.

The court has wide powers under section 216 of the Act to render relief, bring an end to, or remedy, the matters


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complained of by the minority shareholder. Specifically, the court may: (i) direct or prohibit any act or cancel or

vary any act or any transaction or resolution; (ii) regulate the conduct of the affairs of the company in future; (iii)

authorise civil proceedings to be brought in the name of or on behalf of the company by such persons and on such

terms as the court may direct (i.e., a derivative action); (iv) provide for the purchase of the shares or debentures

of the company by other members or holders of debentures or by the company itself; (v) in the case of a purchase

of shares by the company provide for a reduction accordingly of the company’s capital; or (vi) provide that the

company be wound up.

Just and equitable grounds for winding up

In addition to the wide powers granted to the court under section 216 of the Act, the court is also empowered to

wind up a company under section 254(1)(i) of the Act on the grounds that it is just and equitable to do so. While

there has been a blurring of the lines between the court’s power to order a winding up under section 216 and

section 254(1)(i), it should be borne in mind that the relief under the two sections are founded on different bases.

While the categories of conduct that fall within the court’s purview under section 216 are limited to the conduct

of the company’s affairs, the exercise of the directors’ powers, the acts of the company and/or resolutions of

members, section 254(1)(i) is more general and requires only that “just and equitable” grounds exist to justify a

winding-up order – it is not limited to any particular category of conduct.

Conclusion

While the law provides for certain rights to which minority shareholders may have recourse, the fact remains

that a person who becomes a shareholder of a company does so on the basis that he may be outvoted. A minority

shareholder who cannot bear to be outvoted should sell out; he cannot normally look to the court to challenge the

majority’s decisions. The courts do not sit to hear appeals from management decisions honestly arrived at, or to

assume the role of policeman over the affairs of a company. Instead, the role of the courts is to strike a balance

between protecting the interests of the minority while preserving the principle of majority rule, which is not only

convenient and efficient, but also fair and just as a decision-making device. To the extent that judge-made rules on

the protection of minority shareholders against majority abuse have been found to be lacking, the Act has sought

to make good the same. It remains to be seen, however, if the traditional precepts and principles of the common

law with respect to minority shareholders’ rights have been rendered redundant or irrelevant by provisions of the

Act that are aimed at protecting minority shareholders from the injustices of majority rule.

Christian Chin is a Partner at Allen & Gledhill LLP.






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The Role of Directors of a Target Company in a Public Take-over in Singapore

BY CHRISTOPHER KOH | ALLEN & GLEDHILL LLP

This article provides an overview of the roles, duties and responsibilities of the directors of a company listed on

the Singapore Exchange Securities Trading Limited (“SGX-ST”) immediately prior to and during the course of

a take-over offer (the “Offer”) for the company (the “Target Company”). It is not intended to be exhaustive but

identifies and summarises certain rules and regulations which have practical relevance in the day-to-day conduct

of the directors in respect of the Offer.

The primary sources of the applicable rules and regulations in Singapore governing directors’ conduct

immediately prior to and during the course of the Offer are:

• the Singapore Code on Take-overs and Mergers (the “Code”), which is administered by the Securities

Industry Council (the “SIC”);

• the listing rules of the SGX-ST;

• in respect of SGX-ST listed companies which are incorporated in Singapore, the Companies Act (Chapter

50); and

• the Securities and Futures Act (Chapter 289) (the “SFA”).

The Code

The fiduciary duty of directors to act in the best interests of the Target Company and shareholders of the Target

Company as a whole remains applicable in the period immediately prior to the Offer, when the Offer is being

contemplated and during the offer period (the “Offer Period”) itself, save that the actions of the directors immediately

prior to and during the course of the Offer are subject to, and in certain instances, limited by the requirements of

the Code. The Offer Period commences with the announcement of the proposed or possible Offer.

Directors of the Target Company are expected to observe both the spirit of the Code, in particular the general

principles upon which the Code is based, as well as the precise wording of the rules of the Code. They should in

particular take note of the following general principles of the Code:

• except with the approval of its shareholders in general meeting, the board of directors of the Target Company

(the “Board”) must not take any action on the affairs of the Target Company that could effectively result

in the Offer being frustrated or the shareholders being denied an opportunity to decide on its merits. This

principle applies in a situation where the Board believes that the Offer is imminent;

• the Board should, in the interests of its shareholders, seek competent independent advice in respect of the

Offer. This principle applies in a situation where the Board is being approached with a view to the Offer

being made;

• the Target Company and its advisers must not give information to some shareholders that is not made

available to all shareholders. This principle does not apply to information provided in confidence by the

Target Company to a bona fide potential offeror or vice versa;

• shareholders of the Target Company should be given sufficient information, advice and time to reach an

informed decision on the Offer;



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• any document or advertisement addressed to shareholders containing information, opinion or

recommendations from the Board or its advisers should meet the highest standards of care and accuracy;

• the Board must use every endeavour to avoid the creation of a false market in the shares of the Target

Company or the offeror. Statements (whether in documents, advertisements, announcements, press calls

or conferences) may not be made if they might mislead shareholders or the market; and

• the directors should, in advising their shareholders, have regard to the interests of shareholders as a whole,

and not to their own interests or those derived from personal or family relationships.

Advice of an Independent Financial Adviser and Recommendation of Directors

The Board has to appoint an independent financial adviser (the “IFA”) to advise the directors of the Target Company

who are considered independent for the purpose of the Offer and the advice of the IFA must be included in the

circular to shareholders of the Target Company (the “Offeree Circular”) which the Target Company is required

to issue in connection with the Offer. The Code does not expressly set out what the IFA is expected to consider in

providing its advice. As a matter of practice, the IFA will commonly focus on the financial terms of the Offer in

assessing the merits of the Offer.

In addition to the advice of the IFA in the Offeree Circular, the directors of the Target Company are required to

recommend in the Offeree Circular the acceptance or rejection of the Offer. All directors are required to participate

in the recommendation unless they face an irreconcilable conflict of interest and have been exempted by the SIC

from making the recommendation.

Responsibility of Directors for Information Sent to Shareholders or Made Publicly Available

The Code requires all the directors of the Target Company to accept responsibility for each document or

advertisement addressed to shareholders and each announcement issued by the Target Company in connection

with the Offer (collectively, the “Documents” and each, a “Document”). Directors of the Target Company (including

any who may have delegated detailed supervision of the Documents) are required, on a joint and individual basis,

to take reasonable care to ensure that the facts stated and all opinions expressed are fair and accurate and, where

appropriate, no material facts have been omitted. A statement will have to appear in the Documents to the effect

that the directors have taken the reasonable care required and they jointly and severally accept responsibility.

As a consequence of the responsibility assumed by directors of the Target Company for the Documents and the

standard of care and accuracy required of the Documents under the Code, directors of the Target Company should

ensure that each Document is adequately verified. Typically, such verification, when it concerns Documents which

are particularly material in the context of the Offer, such as the Offeree Circular, will take the form of a formal

verification exercise, attended to by the directors of the Target Company, relevant members of the management of

the Target Company and the advisers of the Target Company.

Provision of Information to the Offeror(s)

In general, the Target Company is not obliged to provide information to an offeror or potential offeror. However,

immediately following the announcement of the Offer, the Target Company must, on the offeror’s request,

provide the offeror with information on its outstanding voting equity share capital and update the offeror on any

subsequent changes during the Offer Period.



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In addition, the Code requires the Target Company to provide, equally and promptly, any information, which

it has given to one offeror or potential offeror, to any other bona fide offeror or potential offeror, upon request by

such offeror, which is required to specify the questions to which it requires answers. This requirement under the

Code deals with the right of a competing offeror to have the same information as provided to the first offeror and

does not alter the position that the Target Company is generally under no obligation to provide information to

the first offeror. The foregoing requirement will usually apply when there has been a public announcement of the

existence of the offeror or potential offeror to which information has been given.

As a competing offeror or potential offeror may formally seek information from the Target Company, the Target

Company and its advisers should keep a record of the information which has been provided to the first offeror.

Announcements and Confidentiality

Before an approach is made to the Board, the obligation to make an announcement rests primarily with the

offeror. Following an approach to the Board, such primary responsibility shifts to the Board. The Code sets out

the circumstances in which an announcement must be made, including when the Board is notified of an intention

to make a possible Offer from a serious source. In such a situation, irrespective of whether the Board views the

possible Offer favourably or otherwise, it must inform its shareholders without delay. The Board must issue a paid

press notice or, where the offeror has published a paid press notice, an announcement.

SGX-ST may separately demand that the Target Company make an announcement under the listing rules of

SGX-ST, if the Target Company is subject of rumour or speculation about a possible offer, or if there is undue

movement in the share price of the Target Company or a significant increase in the volume of share turnover.

The Code provides that there must be absolute secrecy before an announcement. All persons privy to

confidential information, particularly relating to the Offer must treat that information as secret and may pass

it to another person only if it is necessary to do so and if that person is made aware of the need for secrecy. No

person who is privy to such information should make any recommendation to any other person about dealing in

the relevant securities. All such persons must conduct themselves so as to minimise the risk of an accidental leak

of information.

Meetings and Dealings with the Media

During the Offer Period, the Target Company may hold meetings with or briefings for shareholders of the Target

Company, analysts or fund managers, so long as no material new information is provided and no significant

new opinions are expressed. In addition, the Code requires a representative of the financial adviser to the Target

Company to be present at these meetings to confirm to the SIC within the prescribed timelines whether any

material new information was provided and whether any significant new opinions were expressed.

In the event any material new information is provided or significant new opinions are expressed at such a

meeting, the Target Company must issue a circular giving details and bearing the directors’ responsibility statement

referred to above to the shareholders of the Target Company immediately afterwards.

Given the requirements of the Code in respect of such meetings or briefings, the Target Company will

typically prepare the contents of such meetings or briefings (e.g., the script, presentation materials etc.) in strict

consultation with its advisers to ensure that no new material information is provided or significant new opinions

are expressed.



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The Code requires the Target Company (including its directors and management) to take particular care not

to release new information during interviews or discussions with the media, as any new information released

must be provided by the Target Company to all shareholders in the form of a circular to shareholders and, where

appropriate, through a paid newspaper advertisement.

In view of the requirements of the Code, the contents of any information given to the press in press conferences

or otherwise are usually monitored carefully and as a practical matter, the Target Company should limit the

number of people authorised to deal with the press and ensure that such authorised persons are familiar with the

requirements of the Code.

Shareholdings and Dealings by Directors

Dealing in the securities of the Target Company by persons with confidential price sensitive information may

constitute insider trading under the SFA, which may subject such persons to severe criminal and civil liabilities.

In addition, under the Code, any person, not being the offeror, who has confidential price sensitive information

concerning an actual or a contemplated offer between the time when there is reason to suppose that an approach

is contemplated and the announcement of the approach, the offer or termination of the discussions, shall not deal

in the securities of the Target Company.

The Code also contains detailed rules regarding the disclosure of dealings in securities of the Target Company

during the Offer Period by any of the associates of the Target Company (as defined in the Code), including directors

of the Target Company. As a practical matter, the directors of the Target Company are typically advised to refrain,

and to take steps to procure that the associates of the Target Company refrain, from dealings in the securities of

the Target Company during the Offer Period, without consulting in advance the advisers of the Target Company.

Liability for Misleading Statements and Other Actions

In addition to the provisions in the Code to the effect that all documents issued and statements made during the

course of the Offer are to be of the highest standard of accuracy, it is important to note that any misrepresentation

in such documents or statements may lead to responsible parties incurring liability under general tort and contract

law on misrepresentation. Further, directors of the Target Company may be subject to criminal liability under the

SFA if any misrepresentation in such documents or statements amounts to market manipulation or creation of a

false market.

Christopher Koh is a Partner at Allen & Gledhill LLP.






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Securities Regulatory Reform: Directors and Substantial Shareholders Disclosure Obligations of a Listed Corporation

BY SOPHIE LIM | ALLEN & GLEDHILL LLP

This article discusses the current disclosure regime governing directors’ and substantial shareholders’ interests in

securities of Singapore corporations listed on the Singapore Exchange Securities Trading Limited (“SGX-ST”). It

also highlights the pending legislative reform to these disclosure requirements.

Timely disclosure of information pertaining to the ownership structure of the company and its directors’

interests in securities of the company is a cornerstone for maintaining a transparent system that allows investors

and shareholders to make informed decisions about that company. Public reporting of information pertaining to

directors’ securities dealings can also operate as a deterrent against directors having a free reign to leverage off

confidential knowledge of the company’s affairs.

Singapore maintains a statutory framework that mandates the disclosure of interests of any (i) single shareholder

who has garnered substantial interests in the shares of a Singapore-listed company; and (ii) director of a company

who acquires interests in securities of a company, and where applicable, its related corporations. In January

2009, Singapore Parliament passed the Securities and Futures (Amendment) Act 2009 (the “Amendment Act”)

which broadly introduces streamlining changes by migrating the current notification requirements for substantial

shareholdings and directors’ interests in securities of Singapore-listed companies to the Securities Futures Act

(Chapter 289) (the “SFA”). The Amendment Act also expands the categories of persons to whom the disclosure

requirements apply, to include a chief executive officer (“CEO”). As of the date of this article, these legislated

changes have yet to come into force.

Disclosure of Substantial Shareholdings in Singapore-Listed Corporations

Regulatory framework: The disclosure regime governing substantial shareholdings in a Singapore-incorporated

company which is listed on the SGX-ST (“Listed Company”) is currently contained in the Companies Act (Chapter

50) (the “CA”), the SFA and the Listing Manual of the SGX-ST (non-statutory rules) (the “Listing Manual”).

When the relevant provisions of the Amendment Act become effective, the substantial shareholding notification

requirements will be migrated from the CA to the SFA. This move is also consistent with the Singapore Government’s

broader initiatives in consolidating securities market provisions under the purview of the Monetary Authority of

Singapore (the “MAS”).

Who should disclose: At present, a substantial shareholder (whether or not residing within Singapore) of a

Listed Company is required under the CA to disclose his interests in voting shares of the Listed Company, and

percentage level changes thereto. A person is a substantial shareholder if he holds an interest in one or more

voting shares to which the total votes attached to those shares comprise not less than 5% of the total votes attached

to all the voting shares of that Listed Company, excluding treasury shares (the “voting shares”). A substantial

shareholder includes a person who holds direct and/or deemed (indirect) interests in voting shares of a Listed

Company. The CA formulates a list of criteria for establishing whether a “deemed interest” in shares arises, and

this determination is relevant for ascertaining whether a person has an interest in voting shares for purposes

of the substantial shareholding requirement disclosure under the CA. The new SFA regime likewise prescribes



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a similar criterion for determining whether the “deemed interest” threshold has been met, to satisfy the same

objectives as articulated above.

As a result of the Amendment Act, the substantial shareholders reporting obligation will be extended to

substantial shareholders of foreign-incorporated corporations with a primary listing on the SGX-ST. This new

requirement, however, stops short of extending its coverage to foreign-incorporated corporations with a secondary

listing on the SGX-ST.

Timing for disclosure: Presently, a substantial shareholder must give written notice to the Listed Company

and the SGX-ST of his substantial shareholding within two business days after becoming a substantial shareholder

or ceasing to be one, providing his name, address, details of his shareholding and the circumstances by reason

of which he has that interest (as prescribed in the CA). Disclosure is also required when there is any change in

the percentage level of the interest in voting shares in the Listed Company held by a substantial shareholder.

Effectively, this means threshold bands of 1% based on the issued voting share capital of the company. There is no

change to this requirement under the Amendment Act.

The requirement for substantial shareholders to separately notify the SGX-ST will be removed under the

Amendment Act. It will then become incumbent upon the following listed corporations to report to the SGX-ST of

substantial shareholding notifications received from its substantial shareholders: (i) a Listed Company; or (ii) a

foreign corporation with a primary listing on the SGX-ST (collectively, the “Listed Corporation”).

Disclosure obligations of listed company: Currently, when a Listed Company receives a notice of acquisition,

change or cessation of substantial shareholding, it is obliged under the Listing Manual to immediately announce

such notification. To augment a Listed Corporation’s duty of disclosure in this aspect, there will be a new legal

requirement under the SFA for the Listed Corporation to announce such notices to the public.

Consequences of non-compliance: Failure by a substantial shareholder to comply with its disclosure

requirements attracts criminal sanctions. Likewise, a Listed Company which fails to make immediate disclosure

of any substantial shareholdings notification also faces criminal penalties for failure to comply with the Listing

Manual. The Amendment Act does not detract from the current position on criminalising omissions to report. The

offender may become subject to civil penalties imposed by the MAS under the SFA.

Disclosure of Directors’ Interests in Singapore-Listed Corporations

Who should disclose: The CA presently provides for the disclosure of interests in securities of a Singapore-

incorporated company by its directors. It is recognised that a CEO of a company also occupies an equally important

position that enables him to take advantage of confidential knowledge of the affairs of that company by dealing in

its securities. New provisions have therefore been enacted under the SFA to regulate the disclosure obligations of a

CEO of a Listed Corporation. Notably, this new requirement is not limited to the express designation of “CEO” per

se. A person whom irrespective of his corporate title, is principally responsible for the management and conduct

of business of that Listed Corporation, also falls within the definition of CEO under the SFA.

Nature of interests subject to disclosure: Under the CA, a director of a Singapore-incorporated company is

required to disclose both his personal and family members’ (spouse and infant children (including adopted and

step-children)) holdings of and dealings in shares, debentures, rights or options, units in collective investment

schemes, or contracts for delivery of shares, in the company or its related corporations (the “CA Disclosures”).

The list of discloseable interests applicable to the CEO of a Listed Corporation and director of a foreign



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corporation with a primary SGX-ST listing (collectively, the “New Disclosure Parties”) under the Amendment

Act is more limited than the CA Disclosures. Whilst the new reporting requirements are generally similar to the

existing CA Disclosures, the reporting categories pertaining to interests held by the New Disclosure Parties in

(i) units in collective investment schemes; and (ii) securities in related corporations of Listed Corporations, are

excluded from the list of discloseable items under the new SFA regime.

The categories of interests subject to disclosure under the SFA may be widened over time, given the MAS’

empowerment to prescribe other types of securities that should be disclosed by directors and CEOs of Listed

Corporations from time to time.

When and to whom to disclose: Presently, reporting of a discloseable interest is to be made within two business

days upon being appointed as director and subsequently, upon any changes thereto. The Amendment Act partially

relaxes this requirement by introducing a concept of knowledge-based disclosure, that is, the duty of disclosure

only arises upon a director or CEO becoming aware of a change in his discloseable interest.

Presently, directors of a Listed Company must separately notify the SGX-ST of their interests. As part of the

regulatory reform, a director will no longer need to separately notify the SGX-ST of his discloseable interests or

changes thereof. Instead, only the Listed Corporation itself will be obliged to report such notifications on behalf

of its director or CEO within the end of the business day following the date of receipt of that director’s or CEO’s

notification.

Disclosure obligations of listed company: A Listed Company has a duty under the Listing Manual to make an

immediate announcement of notifications received from its directors, reporting their discloseable interests and

changes thereof. When the Amendment Act comes into force, a Listed Corporation is legally obliged to disclose

such notices under the SFA.

Consequences of non-compliance: A director who fails to report a discloseable interest pursuant to the CA or a

Listed Company which fails to announce any director’s notification of interests is liable to face criminal sanctions.

Under the new SFA regime, criminal or civil liabilities will be imposed on the offending Listed Corporation, its

director or CEO who has failed to comply with the disclosure requirements thereunder.

Summary of Key Changes to the Disclosure Regimes

DISCLOSURE OF SUBSTANTIAL SHAREHOLDINGS IN LISTED CORPORATIONS

Current regime New regime under the SFA

Disclosure obligations set out in the CA and the SFA Disclosure obligations of substantial shareholders of

Listed Corporations consolidated under the SFA

Substantial shareholders must disclose their

shareholdings interests and changes thereof to both

the Listed Company and SGX-ST

Substantial shareholders must disclose their

shareholdings or changes thereof to Listed

Corporations only

Substantial shareholders and Listed Companies

subject to criminal liabilities for non-compliance

Substantial shareholders and Listed Corporations

subject to criminal liabilities or civil penalties for non-

compliance



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DISCLOSURE OF DIRECTOR’S INTERESTS IN LISTED CORPORATIONS

Current regime New regime under the SFA

Applicable to directors of Singapore-incorporated

companies

Applicable to directors and in addition, extends to

cover CEOs of Listed Corporations

Directors must disclose their interests to the Listed

Company and SGX-ST

Directors and CEOs of Listed Corporations must

disclose their interests to the Listed Corporations only

Directors and Listed Companies subject to criminal

liabilities for non-compliance

Directors, CEOs and Listed Corporations subject

to criminal liabilities or civil penalties for non-

compliance

Sophie Lim is a Partner at Allen & Gledhill LLP.





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South Africa’s New Companies Act

BY CARL STEIN | BOWMAN GILFILLAN

The New Companies Act, No. 71 of 2008 (“the Act”) replaces the Companies Act, No. 61 of 1973 (the “1973 Act”) in its

entirety, save in one instance. This watershed piece of legislation is expected to have a number of positive effects on the

manner in which business in South Africa is conducted.

This article examines the important new changes to South Africa’s company law, the reasons for them and their

probable effects.

Background

For centuries, the limited liability entity has played a vital role in all free market economies. Today, it is an essential

spoke in the free enterprise wheel. Company law governs the manner in which the most popular of all limited liability

entities, the company, is created, how it must conduct its activities throughout its existence and how it must eventually

cease to exist. Company law thus has a direct impact on the manner in which both local and global business is transacted.

It is therefore critical that South Africa’s company laws are structured in a manner which seeks to stimulate and support

economic growth, investor confidence and foreign investment.

In the more than 35 years since the 1973 Act was enacted, the manner in which business is conducted throughout

most of the world has undergone radical change, some of the main reasons being the demise of communism, the ease

of global travel and transportation of goods, and the telecommunication revolution, particularly within the realm of

electronic communication. These factors, among others, have resulted in an exponential increase in global and cross-

border transactions, and the emergence of stock markets as the vehicles through which trillions of dollars are invested

to enable people living in different countries to invest their money throughout the world.

Globalisation of business has also led to increased demands by business for harmonisation of the laws governing

cross-border transactions, of which company law forms an integral part. This process commenced some years ago, and

today one finds that the fundamental laws governing companies throughout most of the western world have become

increasingly aligned with one another.

We have also witnessed the emergence of the private sector as the key player in industries which were hitherto either

monopolised or dominated by State-owned entities, such as power, telecommunications and transport. Unfortunately,

the increased role and influence of the multinational corporation has led to abuse by many of them of their powers,

to the severe detriment of the public at large. Following the Enron scandal of 2001, governments and regulators

reacted to this abuse by adopting a far more aggressive approach towards corporate wrongdoings. They did so by

increasing considerably the disclosure of information required by companies and imposing more stringent accounting

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requirements, stricter regulation of public companies and more onerous rules as to the manner in which companies, and

directors in particular, discharge their duties and responsibilities to their investors, other stakeholders and the general

public. The trend over the past decade has been to introduce more laws to ensure that people manage their businesses

honestly, responsibly and diligently, and to impose more severe penalties on those that do not. In short, transparency,

proper corporate governance and accountability for wrongdoings now play a pivotal role in modern business practice.

This has manifested itself in a number of ways in South Africa, such as the publication of the King Codes of Corporate

Governance, more stringent requirements in relation to the appointment and independence of auditors and the

imposition of more onerous financial reporting standards on companies. In addition, a host of new laws having a bearing

on this subject have found their way into our statute books. These include the Financial Intelligence Centre Act, 2001,

the Securities Services Act, 2004, the Auditing Profession Act, 2005, the National Credit Act, 2005 and the Consumer

Protection Act, 2009.

The South African Company Law Reform Process

Before its repeal, the 1973 Act was subjected to a plethora of amendments, which occurred virtually each year since its

enactment. In general, however, these amendments did not materially alter the fundamental philosophies and principles

on which the 1973 Act was based, and by 2000 South Africa already had an outdated “cut and paste” piece of legislation.

Unlike most western countries, until now there has not been a major overhaul of the 1973 Act.

In the late 1990s, it became apparent to government that there was an urgent need to reform South Africa’s company

laws. The Minister of Trade and Industry put it this way: “The new horizons in the commercial world, developed in a

short period of 25 years resulting from a generation change, has undoubtedly made the present Companies Act somewhat

archaic in many respects and certainly cumbersome in operation.”

The government, through the Department of Trade and Industry (“DTI”), embarked on a process to develop a “clear,

facilitating, predictable and consistently enforced law” to provide “a protective and fertile environment for economic

activity”, as stated in the DTI’s detailed policy paper entitled “Company law for the 21st Century” published in 2004.

This policy paper speaks of developing a legal framework based on the principles reflected in the 1973 Act, the CC Act

and the common law. From 2004 to 2006, the DTI consulted with and drew on the experiences of many businessmen,

professionals, stakeholder representatives and institutions on “international best practice”. The result was the publication

of a first draft of a Companies Bill in 2007. This Bill was followed by a further three drafts before it was approved by

Parliament in November 2008. It was signed by the State President, and thus became law, on 9 April 2009. It will,

however, only come into operation on a date yet to be fixed by the State President, which the DTI expects will be on or

about 1 July 2010.

The DTI identified the following five “economic growth objectives”, and goals related to each of them, as being

necessary to achieve a company law regime that “would promote the competitiveness and development of the South

African economy”:

Simplification

• the law should provide for a company structure that reflects the characteristics of a close corporation, as one of the

available options;

• the law should establish a simple and easily maintained regime for non-profit companies; and

• co-operatives and partnerships should not be addressed in the reformed company law.



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Flexibility

• company law should provide for an appropriate diversity of corporate structures; and

• the distinction between listed and unlisted companies should be retained.

Corporate Efficiency

• company law should shift from a capital maintenance regime based on par value, to one based on solvency

and liquidity;

• there should be clarification of board structures and director responsibilities, duties and liabilities;

• there should be a remedy to avoid locking in minority shareholders in inefficient companies;

• the mergers and takeovers regime should be reformed so that the law facilitates the creation of business

combinations; and

• the judicial management system for dealing with failing companies should be replaced by a more effective

business rescue system.

Transparency

• company law should ensure the proper recognition of director accountability, and appropriate participation

of other stakeholders;

• public announcements, information and prospectuses should be subject to similar standards for truth and

accuracy;

• the law should protect shareholder rights, advance shareholder activism and provide enhanced protections

for minority shareholders; and

• minimum accounting standards should be required for annual reports.

Predictable Regulation

1. company law sanctions should be de-criminalized where possible;

2. company law should remove or reduce opportunities for regulatory arbitrage;

3. company law should be enforced through appropriate bodies and mechanisms, either existing or newly

introduced; and

4. company law should strike a careful balance between adequate disclosure, in the interests of transparency,

and over-regulation.

Each of these 18 goals is now manifest in the Act in various ways.

Regulations

There are over 130 matters in respect of which the Act empowers the Minister to “prescribe” regulations. The

DTI has stated that the Act will not come into operation until these regulations are finalised and gazetted. These

regulations will cover a very wide spectrum of matters, so they are expected to be voluminous. The DTI has stated

that it will publish draft regulations in November 2009 for public comment and that it expects the final regulations

to be gazetted by 31 March 2010.



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The Major Changes

The changes to South Africa’s companies legislation effected by the Act are both diverse and numerous. The most significant

of them may be summarised as follows:

• the Act replaces the whole of the 1973 Act except for Chapter 14, which deals with the winding-up and liquidation

of insolvent companies, and which will remain in force and unaltered until new insolvency legislation is enacted;

• the Close Corporations Act, 1984 (the “CC Act”) continues indefinitely, but will be phased out on the basis that no

new close corporations (“CCs”) may be formed, nor may companies be converted into CCs, after the Act becomes

operative. The Act does, however, enable companies having characteristics very similar to CCs to be formed;

• the fundamental common law principles of company law (as modified by the 1973 Act) remain intact, with some

notable exceptions;

• the Act modernises South Africa’s company law and brings it in line with best practices internationally, especially

in relation to public companies, communications and corporate governance;

• the Act makes company law simpler. The number of its sections is reduced from 450 to 225. It also introduces

simpler administrative procedures;

• the Act promotes transparency, high standards of corporate governance and accountability, particularly by directors

and other key officers;

• the Act codifies the common law duties and liabilities of directors;

• the Act introduces flexibility in the design and organisation of companies;

• significant amendments are made to the takeover/M&A provisions of the 1973 Act;

• the Act advances shareholder and stakeholder activism by giving considerably greater protection, powers and

remedies to minority shareholders and other stakeholders such as employees, including the ability to bring class

actions;

• a new business rescue regime akin to the Chapter II bankruptcy procedure of the United States replaces the judicial

management system;

• the Act brings South Africa’s companies legislation into harmony with overlapping legislation, in particular

the Securities Services Act, 2004, the Auditing Profession Act, 2005 and the Electronic Communications and

Transactions Act, 2002;

• South Africa’s companies legislation is decriminalised – over 120 criminal offences are replaced by a system of

administrative fines, as well as some new and expanded remedies which render the offender personally liable;

• the capital maintenance regime is changed from one based on maintenance of the amount of a company’s share

capital to one based on solvency and liquidity;

• in order to accommodate the small company, directors may be given certain powers which hitherto were vested

exclusively in the shareholders; and

• the Minister of Trade and Industry is given greater prescriptive powers.

Carl Stein is a Partner at Bowman Gilfillan.






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An Act Fit for the King?

BY KEVIN CRON AND CHRISTINA KOTZE | DENEYS REITZ

South African company law is governed, by and large, by the Companies Act, which was enacted in 1973 and first

came into force in 1974. On 9 April 2009 a new Companies Act was promulgated (“the New Act”), which will

replace the 1973 Act towards the latter half of 2010.

Although the New Act deals to some extent with corporate governance issues, South African companies rely

heavily on a code created by the Institute of Directors in Southern Africa, known as the King Code of Governance

Principles. Although the King Code does not have legislative force, the stock exchange in South Africa, the JSE

Limited, requires all listed companies to comply with the Code on a “comply or explain” basis. Listed companies

are required to include a statement addressing the extent of their compliance with the second King Code (which

is the Code currently in place) as well as setting out reasons for non-compliance with any of the principles of such

Code in their annual financial statements.

The third King Code was published on 1 September, and will replace the second Code on 1 March 2010.

While the date of commencement for the New Act has not yet been proclaimed, section 225 provides that such

commencement may not be before 9 April 2010.

Due to its nature as a code of corporate governance, the third King Code, or King III, as it is commonly referred

to, overlaps with and expands on the New Act in some respects. For instance, while the New Act in section 94

requires only public and state-owned companies to appoint an audit committee, King III recommends that all

companies appoint such a committee on a voluntary basis.

More than Money

Contrary to its predecessor, which relied heavily on the common law, the New Act sets out certain fiduciary duties

of directors (although it does not codify the common law, and as such the common law duties of a director remain

in place). One such duty is to act in the best interests of the company (section 76(3)(b)). King III echoes this duty

in principle 2.14, but also endorses the so-called “triple bottom line” or “triple context” principle (“people, planet,

profit”). This means that companies are required to take more than just the maximisation of profit into account;

social and ecological performance should be considered in addition to financial performance.

People

King III in Paragraph 16 of chapter 1 provides that a company is a “corporate citizen”, in addition to being an

“economic institution”. This confers “social and moral” responsibilities upon a company, and requires the board

of directors to be responsible for more than the company’s financial performance. Paragraph 17 of the same

chapter states that “the triple context approach enhances a company’s potential to create economic value”. It

envisages that a company will reap reputational (and therefore financial) benefits from living up to broader

responsibilities.

Other than this relatively idealistic wording, King III does not set out exactly what is meant by the “people”

tier of the “triple concept” principle. It does, however, refer to a “stakeholder inclusive” approach, in terms of

which the board of directors should “consider the legitimate interests and expectations of stakeholders other than



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the shareholders”. Stakeholders are defined in paragraph 6 of chapter 8 to include: “…shareholders, institutional

investors, creditors, lenders, suppliers, customers, regulators, employees, unions, the media, analysts, consumers,

society in general, communities, auditors and potential investors. This list is not exhaustive.”

This definition creates a very broad category indeed, and potentially places an onerous burden on a company.

It is unclear how the “legitimate interests” of a party who has very little to do with the company, such as potential

investors or the media, should be catered for. Paragraph 11 of chapter 1 of King III explains that this model of

corporate governance will ensure “the cooperation and support of all stakeholders the company depends on for

its sustainable success.” It is also not clear whether such responsibilities are intended to extend a company’s

existing obligations, particularly given that the relationship between a company and many of the parties listed

as stakeholders is governed by legal relations created through statute, the common law or through contractual

arrangements. For example, the relationship between a company and its shareholders is governed by the

Memorandum and Articles of Association of the company (called the Memorandum of Incorporation in the

New Act), and the relationship between a company and an employee may be governed by a specific employment

contract, as well as legislation such as the Labour Relations Act.

Planet

King III is not prescriptive as to how the “planet” tier of the “triple context” principle should be approached. It

does state that “responsible leaders build sustainable businesses by having regard to the company’s economic,

social and environmental impact on the community in which it operates”. It also provides that “responsible

leaders do not compromise the natural environment and livelihood of future generations” and that “it is unethical

for companies to expect society and future generations to carry the economic, social and environmental costs and

burdens of its operations”.

Myriad laws, such as the National Environmental Management Act, also cater for the “planet” tier. The New

Act, while not supporting this principle overtly, states in section 7(a), that one of its purposes is to: “promote

compliance with the Bill of Rights as provided for in the Constitution, in the application of company law”.

In the chapter of the Constitution dealing with the Bill of Rights, section 24 endows upon “everyone” the

right to: “have the environment protected, for the benefit of present and future generations, through reasonable

legislative and other measures that prevent pollution and ecological degradation; promote conservation; and

secure ecologically sustainable development and use of natural resources while promoting justifiable economic

and social development.”

It could therefore be argued that the New Act endorses environmentally sound corporate practices, although

it does not go so far as to require directors to consider the environmental impact of a decision before making it.

Profit

Having expressed certain aspirations with the “people” and “profit” tiers, the “profit” tier reverts to the cold, hard,

but inevitable truth: companies are mostly about making money. King III itself states in paragraph 14 of chapter

2 that in the South African “common law, as developed through jurisprudence, the best interests of the company

has been interpreted to equate to the best interests of the body of shareholders”. It is difficult to get past the fact

that the best interests of the body of shareholders align closely with their back pockets. It is also very difficult to

quantify the benefits received by saving the planet, and as a result, the success of a company is generally measured



159

by the financial return to shareholders.

By requiring the board of directors to take factors other than the maximisation of profit into account, the

company’s bottom line will unavoidably be affected. Balancing financial, social and environmental considerations

is difficult enough, and this is without taking conflicting issues within the tiers into account. King III offers

no guidance as to how to deal with a situation where, for example, the interests of a local community and the

environment diverge, or where the interests of two communities do not coincide. In addition, it is difficult to

determine to what extent a company is obliged to sacrifice its income. Companies operating on very low profit

levels might find it very difficult to take measures that affect their profitability at all, for fear of ceasing to be viable

economic enterprises. It could be argued that the “people” tier requires companies to stay operational, in the

interests of job-retention and economic development.

The purpose of this article is not to debate the pros and cons of drilling for oil in a fragile and unique ecosystem,

but the example serves to show the practical intricacies of a balanced world view in terms of King III.

Less than Perfect

Notwithstanding the aspirational principles of the “triple context” principle and King III as a whole, paragraph

24 of chapter 8 gives the board of directors a proverbial get-out-of-jail-free card. It reads as follows: “Board

decisions on how to balance interests of stakeholders should be guided by the aim of ultimately advancing the

best interests of the company. This applies equally to the achievement of the ‘triple context’ and the notion of

good corporate citizenship as described in Chapter 1. This does not mean that a company should and could always

treat all stakeholders fairly. Some may be more significant to the company in particular circumstances and it is

not always possible to promote the interests of all stakeholders in all corporate decisions. It is important, however,

that stakeholders have confidence that the board will consider their legitimate interests and expectations in an

appropriate manner and guided by what is in the best interests of the company.”

The board of directors may therefore, theoretically at least, discharge any obligations it may have under King

III by considering the issues of people and planet, but deciding to go with profit instead. While the guidelines

set out in King III are quite vague, presumably the requirement is that the board of directors at least attempt

a rational and reasonable approach, taking all factors, social and environmental, into account. Although King

III does not differentiate between the different stakeholders, presumably greater regard should be had for the

interests of stakeholders with a direct interest in the company, such as shareholders, creditors and employees.

Act II

While King III has been discussed in some detail, it is also important to examine the New Act’s view of the “triple

context” principle. Despite the New Act’s stated purpose of promoting the Bill of Rights, which in turn provides

for environmental protection, the tenets of the “triple context” principle are not expressly provided for in the New

Act. Section 159 provides protection for whistle-blowers exposing conduct that “has endangered or is likely to

endanger the health or safety of any individual, or damage the environment”, but no further reference is made to

the social or environmental responsibilities of companies. The New Act has generally kept with the more traditional

approach of companies being profit-driven, rather than reflecting the more modern view that what is in the best

interests of the environment and the surrounding communities will in the long run also be in the best interests of

companies operating in such environment and with such communities as its workforce.



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Conclusion

While King III is rather idealistic with respect to the “triple context” principle and is short on detail on how to

apply these principles and balance competing interests, it is surely correct that modern companies should look

towards creating a more socially and environmentally sustainable business plan. Taking into account that South

Africa is moving away from a resource-based economy into the terrain of tourism, as well as the global push for

big business to become accountable corporate citizens, the proclamation of a New Act was a sterling opportunity

to legislate for social and environmental responsibility. However, the New Act has stuck with the more traditional

profit-based approach, letting an opportunity to match South Africa’s very progressive Constitution with an equally

progressive Companies Act slip past, and leaving directors in a gray area as to their social and environmental

responsibilities. The New Act may not quite be fit for the King.

Kevin Cron is a Director and Christina Kotze is an Associate at Deneys Reitz.






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