COMMERCIAL LAW - firms, their functioning and regulations, Appunti di Diritto Commerciale

Scarica COMMERCIAL LAW - firms, their functioning and regulations e più Appunti in PDF di Diritto Commerciale solo su Docsity! CORPORATIONS AND THE LAW Business companies (corporations) are the main economic actors in today’s world. Companies and firms are two different concepts. The former is a legal concept, through which we focus on the legal tools provided by the law to give legal recognition and consideration to such an organization as a legal entity. The latter is an economic concept though which we focus on the organization of individuals and resources regardless of its legal implications. Corporations are always meant to run firms → they are a legal vehicle (made available by the law). On the contrary, a firm can be run by other legal entities (individual entrepreneurs; partnerships → simplest legal entity that can run a firm → small, usually family-run, sometimes one-shot businesses; trusts; business corporations → meant to produce profit; cooperative corporations → meant to produce value; the State; municipalities; …) other than corporations. THEORY OF THE FIRM A firm is an aggregation of individuals and financial and nonfinancial (i.e., IP), tangible and intangible, human and non-human resources to carry out a business activity. This organized combination of inputs (money, labor, managerial skills, know-how) produces outputs (goods, services) whose value is higher that the separate sum of values of each input. Resources (people, assets, skills, …) could be bought from their own markets and put together through individual contracts. However, this would be inefficient and highly costly. Indeed, firms exist for 2 main reasons: 1. TRANSACTION-COST HYPOTHESIS (Ronald Coase, Oliver Williamson) → firms can put together resources just like markets could do, but with lower transaction costs. They are a solution to o opportunism (satisfaction of own interest at the expense of others) → resources cooperate to reach a common goal o informational asymmetries → firms observe the quality of their inputs and inputs providers. Resources get to know each other. Moreover, firms can decide what info to retain and what to disclose o transaction-specific assets (assets whose role has become vital/essential to the firm) → there are some rules that prohibit these assets to leave the firm 2. PROPERTY RIGHTS HYPOTHESIS → managers have (full) property rights over assets and can direct them. Contracts are weaker, since they expire and must be renegotiated. On the other hand, property is permanent, and nobody can interfere with it; it grants safety and a long- term view. Firms have a central authority with property rights. o Tesla and lithium → the company incorporated the collection of lithium into the firm. If they kept getting it through contracts with other providers, they would have worried about providers supplying to competitors at lower prices, the counterpart realizing that such asset had become necessary and therefore charging higher prices, and contractors running out of resources and not disclosing such info. MAIN COPRORATE ACTORS o SHAREHOLDERS (the “OWNERS”) → they are a great number (hundreds, thousands, …). They provide the initial capital, and they vary among themselves. Why do they invest? Which are their interests? What protection do they need? o CREDITOS OR DEBTHOLDERS (e.g., banks) → they want to make profit off the interest in the loans they grant. They are out of the business the company runs; they hope that the business is safe. o EMPLOYEES → they are creditors (they receive a salary). However, they are there to stay. They are deeply involved with the firm. They have their own interests, different from those of other creditors. o MANAGEMENT – DIRECTORS AND OFFICERS → they coordinate resources. Usually, they are the first to be fired when something goes wrong. They themselves need protection or else they will not use their skills. o INTERNAL OR EXTERNAL SUPERVISORS → they make sure companies’ businesses are working correctly (no disclosure of false statements/info, no frauds, …). They check on the credibility of the company and are used as a protection device for all the other actors. ESTABLISHMENT OF COMPANIES – A MULTI-STEP PROCESS Companies first came un in the 17th century in the UK and in the Netherlands. Queens and Kings couldn’t finance expeditions to conquer new territories with their own capital and tax-payers money. Therefore, private individuals were asked to invest in these ventures. Charters (legislative acts) listed rules applicable to these new organizations. The Crown provided them with legal entity. These investors were granted limited liability → their private assets would have been kept out, shielded against losses. At the time, the creation of those companies was merely a sovereign concession; it was a privilege. Nowadays, creating a company is a right, and it can be done in a matter of days (digital forms and communications). People only need to comply with the law. 1. Shareholders and directors sign a corporate contract – charter or articles of association – binding on them. This contract contains provisions regulating the functioning of the company and the relationship between its constituencies. Moreover, it must contain the governance, structure, purpose, jurisdiction to which it is subjected, and other major details of the company. 2. The charter is then filed with the competent local administrative authority (e.g., a chamber of commerce). 3. The local authority enters the name of the company in a companies’ register publicly available for inspection by everyone. All corporations under that jurisdiction are here listed. 4. The company has now come to life – it has acquired legal personality. MAIN LEGAL CHARACTERISTICS OF THE PUBLIC COMPANY – LEGAL PERSONALITY Corporations enjoy full-blown legal personality and therefore are endowed with all the rights and powers that a jurisdiction ties to the concept of legal personality. o LEGAL CAPACITY → once a company gains legal personality, it gains the same legal capacity as a legal person. It can acquire rights, take on obligations, and act in its own name. Company managers are allowed (by law) to enter all kinds of contracts, sue third parties and be sued in court. They undersign contracts, but rights and obligations accrue to the company. Therefore, the counterpart is always the latter. The company is the one directly liable for contractual obligations entered in its name. It is the one who will face trial in court for breaches of contact and for damages following torts inflicted on third parties. Tortious acts may materially be committed by its managers or employees, but it is the company that becomes liable to those who get damaged. o STRONG-FORM ENTITY SHIELDING 1. Priority rule → conventional phrase describing a specific feature of the entity shielding applicable to companies and shared by most jurisdictions. It is a set of rules according to which a company’s creditors are given claims on its assets that are prior/senior to the concurring claims of the individual owners and those of their personal creditors. This means that creditors are entitled to be paid first, while shareholders and their creditors can seek satisfaction only after the former are (or may be) fully satisfied. This is because they need to be reassured that they will get their money back. Therefore, the firm’s assets are (by law) pledged as a security for its debts. Without these incentives, creditors would not lend to firms. All this stands if there’s something left. If not, we talk about bankruptcy. 2. Liquidation protection rule → conventional phrase describing a specific feature of the entity shielding applicable to companies and shared by most jurisdictions. Imagine if, as soon as the shareholders invest, they withdraw their part. Banks would not lend to them in the first place, since they would know this could happen. The liquidation priority rule is a set of rules which establishes a. shareholders’ withdrawal rights → to what extent they are allowed to withdraw from the organization before its expiry to obtain the monetary equivalent of their equity admitted to listing, they can be daily negotiated on stock exchanges. Companies whose shares are listed on organized stock exchanges are called “listed or publicly-traded corporations”. Corporations whose shares are not listed are called “unlisted or privately- held corporations”. While private companies have the tradability of their shares restricted, privately-held companies don’t face any legal impediment to the tradability of their shares but decide to not publicly trade them. o Widely-held companies have their shares distributed over a vast number of shareholders, each holding a small shareholding. Closely-held companies may have the same number of shares as widely-held ones but concentrated in the hands of few shareholders, each possessing a large shareholding. There are several types and combinations of all these characteristics. The same corporation may simultaneously be o open/public o listed / publicly traded o closely-held A few Italian listed corporations – società per azioni quotate – display these features. The opposite may be true as well. The same corporation may simultaneously be o private/close o unlisted / privately held o widely-held Cooperative corporations present these features. Tradability aims at enhancing the level of liquidity of shares. The more they are traded, the more liquid they are, becoming easier to exchange. More liquidity means reducing the spread between the price of sellers and the price of buyers, and hence transaction costs. A well-functioning stock exchange helps both companies to issue shares and get funding, and investors to find investment opportunities, thus easing the tradability of shares between investors. DELEGATED MANAGEMENT UNDER A BOARD STRUCTURE In partnerships, investors and managers coincide. Investing entails becoming a manager. That is because partnerships are usually small, not needing high level managerial skills. In the corporate world, it is unlikely that investors have the managerial skills required. It’s also true that managers don’t necessarily have resources to invest in the company. Furthermore, when shareholders are a great number, organizing would be unfeasible. That’s why, in companies, management is formally separated from the ownership of shares. Shareholders are left with limited managerial powers. They mostly have control powers. Almost all decisions are delegated to a board of directors – consiglio di amministrazione. This organ is periodically elected, exclusively or primarily, by the firm’s shareholders. Corporate law vests in this board principal authority over corporate affairs. Unlike other principles, which could be manipulated and changed, such delegation is mandatory and fixed in order to protect both shareholders and third parties. This is made flexible only if the interests involved are just those of the parties. Jurisdiction may deal with this process in different ways, but the basis is the same. The Delaware state is the most important business venue in the US. The law allows multiple layers of managers. The top management team is nominated by the board of directors and in turn appoint the lower management. The top management team is composed of different officers (as they are called in the US), each dealing with a specific sector of the firm. Each company can decide how many officers to appoint. The CEO – chief executive officer – is the head of the operative management. According to the complexity of the business more executive officers can be appointed. They are o COO – chief operating officer → daily operations of the company o CFO – chief financial officer → financial affairs and statements o CAO – chief administrative officer → human resources o CCO – chief compliance officer → legal and regulatory compliance issues They are often referred to as the “C-Suite” to signal their prominent status whining the firm. The board of directors may appoint its own members as chief executives. The Italian CEO is typically the amministratore delegato. Chief executives then appoint lower managers, and so on. This managerial system o creates legal certainty about who has corporate authority to act in the name and on behalf of the company. Third parties want to be ensured that they are dealing with someone who has such authority. Along with third-parties, also shareholders benefit from it, since they can identify who is accountable for all the decisions made o divides labor and allows the specialization of functions. In a complex system with more inputs creating one output, one person could not deal with everything. This way different processes and responsibilities are associated to different figures o results in a more efficient functioning of the decision-making process. Each officer is specialized in a sector and knows it better than the others o protects constituencies other than majority shareholders. SHAREHOLDER OWNERSHIP Ownership is defined by the right of free disposal and the right to enjoy the fruits of something. Shareholders enjoy voting, decision, and control rights, and have title to the firm’s profits. In corporations, typical ownership features are enjoyed by those who provide equity capital and are made residual claimants. Hence, shareholders are the owners. Their powers and rights are proportional to the size of their holding. A shareholder who owns 10% of the equity capital benefits from 10% of profits and 10% of voting rights – one share / one vote principle. Nevertheless, proportionality is not mandatory. The law allows charters to assign shareholders rights being more or less than proportionate to the size of their holdings, both for profit and voting rights and separately. Shareholder ownership is beneficial for o vertical relationship between shareholders and other stakeholders 1. it compensates equity investors with right to net earnings for the higher financial risk they bear. Indeed, they are residual claimants, which means that their claims over the firm’s assets are junior to all other stakeholders 2. grants rights to control to whom has best incentives to take value-maximizing decisions (shareholders make profit if the firm grows) 3. grants more coordination and less conflict. Shareholders all agree on maximizing the value of their shares and get as much profit as possible. They have the most homogeneous expectations. o horizonal relationship among the shareholders themselves 1. it defeats the risk of moral hazard 2. enhances the chance of value-increasing decisions. VARIATIONS ON SHAREHOLDER OWNERSHIP 1. Exception to the rule of control rights only to shareholders → the German codetermination – Mitbestimmung. Under German law, large firms must grant employees the right to appoint some of their representatives to the supervisory board along with those of the shareholders. 2. Exception to the rule of proportionality to equity capital → the cooperative corporation. In a cooperative, economic benefits don’t come in the form of pro rata profits but rather in that of low-price goods and services for the members of the firm or higher salaries. Moreover, each shareholder is usually entitled to only one vote, regardless of the size of their shareholding. No shareholder can exercise control over the company. Hence, control is diluted. This is because cooperatives would rather have many shareholders with little control than few shareholders with great stakes. PRIVATE LIMITED LIABILITY COMPANY – AN ALTERNATIVE CORPORATE FORM Private LLCs are a type of company that has some features in common with public corporations. These features mainly regard those rules that benefit third parties – firm’s creditors. However, LLCs enjoy utmost flexibility in shaping internal governance rules. Hence, they may differ from jurisdiction to jurisdiction. LLCs run mostly medium/small businesses. They have almost completely substituted partnerships and are usually the most popular business entity in any jurisdiction in which they are available. Partnerships still exist, but they are risky, especially when sizing up, and more expensive than LLCs. In Italy there are something like 1.500.000 LLCs – società a responsabilità limitata – while public companies – società per azioni – are only 50.000. o LLCs enjoy full legal personality. They possess both legal capacity and strong-form entity shielding. However, while the priority rule works the same, the liquidation protection rule is weaker. Indeed, withdrawal from the company is permitted to a larger extent than in public companies. That is because there is no other way to liquidation (no shares) and because LLCs may not require long-term financing. o Members of LLCs benefit from personal limited liability and retain ownership rights as do the shareholders of public companies. However, there is more flexibility when dealing with the rights to profits and to control the company (e.g., deviations from proportionality in allocating these rights among the members). o Ownership interests are generally not represented by shares, nor are they traded as financial securities by the law. However, there may be jurisdictions that allow the issuance of shares. Ownership interests are not necessarily standardized as are shares (they are not tradable). Although they are freely transferable in principle, they are not meant to be systematically traded and usually are not admitted to trading on public markets. This prevents investors from misbelieving that they are buying shares of public companies, expecting the same level of protection. Besides, free transferability of such ownership interests can be constrained to a larger extent or excluded altogether. Only contracts may decide who has ownership rights and to what extent. o LLCs benefit of a simpler management structure. As with public companies, the management is formally separate from the membership. The latter does not entitle per se to be a managing member or director of the corporation. However, unless the contract provides otherwise, the management must usually be vested in one or more of its members (no external people, which can happen in public companies), and the directorship can be vested in any member for an indefinite term (in public companies, directorship expires). Furthermore, management is not ordinarily subject to monitoring by internal or external supervisors. This is due to the smaller size and effects that these companies may have on public markets. HYBRID BUSINESS FORMS – NON-CORPORATE ALTERNATIVE BUSINESS FORMS o Limited liability partnership (US, UK) → in Italy and other countries, partnerships have unlimited liability. In the US and the UK, since creditors are let free to decide in which companies to invest, there is no need to prohibit these partnerships. If creditors don’t like this business form, they simply won’t invest in them. These partnerships benefit of weak-form entity shielding which can be made stronger by contracts. Ownership interest are neither freely transferable nor tradable. Management is not formally separated from ownership, but such separation could be achieved by contracts. o Statutory business trust (US) → in general, trusts are a special kind of organization that separates disposal and enjoyment of goods/things. Someone puts their wealth in the trust and appoints a trustee. The latter can dispose of this wealth as they will, but who will enjoy what this wealth will produce are the beneficiaries previously appointed by the original owner. In the US, statutory business trusts are mainly used for financial purposes. The greatest example are investment funds. These trusts benefit of full legal personality, with strong- form entity shielding, and limited liability of beneficiaries. The interests of the beneficial on a company based on the number of shares it is authorized to issue according to its own charter (capital base → CAPITALIZATION). On the assumption that companies grow, franchise taxes would also increase in monetary terms. Hence, states have interest in making companies grow. These taxes are important across US States, but they have been abolished in the EU to incentivize imprenditorship. 2. wealth-increasing fallouts → companies demand for local services, like legal counseling and arbitration chambers, and create business tourism. Moreover, since they pay taxes, they also contribute to the improvement of various public services offered by the State 3. overall national economic power → national champions can stabilize the economy during downturns and direct the production toward goals in the national interest in times of emergency 4. prestige → during the Covid 19 pandemic, healthcare companies from around the world raced for the first anti-Covid 19 vaccine. Competition in law, much like competition for other products, requires the existence of a single market, in which consumers can choose among alternative laws to meet the same need. That is, consumers face no barriers and only little cost to switch from one legal product to another. This situation most intensely occurs in single markets organized as federal systems or political unions, where more legislative powers may compete in regulating the same subject. The most prominent examples are the US and the EU. LEGAL AND REAL SEATS a. LEGAL SEAT – registered office → place where the company has been formed by the filing of the charter with the competent local authorities. b. REAL SEAT – principal place of business → place where the company has established its headquarters. The management is primarily located here. In most instances, real seat and legal seat coincide. Regulatory competition among different jurisdictions is mostly triggered when companies are given the chance to place the real seat in one jurisdiction and the legal seat in another one. Indeed, some jurisdictions may embrace the legal seat (incorporation) principle (UK), while others may adopt the real (company) seat principle (Italy, Germany, …) to establish a company’s nationality. The nationality further determines whether the local corporate law is applicable or not. a. Legal seat or incorporation principle → a company’s nationality and the applicable corporate law are determined by the location of the registered office, regardless of where the principal place of business is. b. Real seat or company seat principle → a company’s nationality and the applicable corporate law are determined by the location of the central administration or principal place of business, regardless of where the registered office is located. THE US The US is a federal country comprised of 50 States, with a double layer regulation. Each State has its own corporate law. According to the internal affairs doctrine, the law of the internal affairs of a corporation is state law, not federal law. Federal law only regulates what matter for interstate commerce. Hence, what is federal is securities law. It governs o the issuance of securities (shares, bonds) to the public and the trading of those securities on public markets (stock exchanges) o the protection of investors buying, holding, and selling those securities (listed companies’ disclosure requirements of sensitive information, financial statements, and their auditing; punishment of market abuses such as insider trading and market manipulation; public tender offers (takeovers) for listed securities). Non-publicly-traded corporations, public and private, are governed by state law only because they do not issue securities to the general public. Publicly-traded corporations are governed by state law with respect to their corporate structure and governance but by federal law with respect to issuance, trading of securities, and investor protection. STATE COMPETITION IN THE US State laws are required by the US constitution to adopt the incorporation principle. Each company can register with the competent authorities of whichever state (incorporation), while doing business freely in every other state. According to many US scholars, this freedom of establishment has sparked competition among the 50 States in attracting as many firms as possible. o In 1890, New York sought leadership by abandoning minimum capital requirements for newly formed corporations. o By 1894, New Jersey was arguably the favorite state for incorporation. Other States began to compete in a “race” to deregulate and overtake New Jersey, o In 1899, Delaware gained a dominant position, which it has consolidated ever since. By 1965, 35% of corporations listed on the NYSE were incorporated in Delaware; by 1973, this number had risen to 40%; by 2000, approximately 50%; by 2007, figures stand at 60% of US publicly-traded corporations and 60% of Fortune 500 companies (largest companies by market capitalization). New York, which ranks 2nd, attracts fewer than 5% of public firms. DELAWARE Delaware is the second smallest state in the US after Rhode Island. It is 96 miles long and ranges from 9 to 35 miles across, totaling 1,954 square miles. It is also ranked 45th in terms of population (864,764). Franchise taxes make up 60-70% of the State’s budget. It survives off taxes. Delaware o has a highly flexible corporate law, which is constantly updated by highly qualified legislative committees o benefits of high-quality judiciary and judges that have developed an unparalleled expertise in corporate issues (the best laws in the world would go nowhere without the right people applying them → things would backfire) o has courts whose decisions are predictable. This grants that the law is applied. The extensiveness and familiarity of Delaware’s case law reduce costs of planning transactions, obtaining legal advice, and assessing their value o offers the expertise of the corporate bar (legal advisors) o has a legislation shielded from constituencies (stakeholders) other than the managers and shareholders and from other politically-motivated interest group pressures and lobbying → most people are invested in the legal field, so there is no political crasher opposing laws. REGULATORY COMPETITION WITHIN THE EU Since the EU is comprised of 27 MS (28 before Brexit), there are 27 different corporate jurisdictions. The TFEU has the aim to create an internal market based on 4 fundamental freedoms. Before 1999, most MS embraced the real seat principle (France, Germany, Italy, Austria, Spain, Belgium), while very few countries adopted the legal seat principle (the UK, Ireland, Luxembourg). Some of the first states, jealous of their sovereignty, applied to the ECJ because the legal seat principle was creating obstacles to free movement. After several cases decided by the ECJ, all MS had to switch to the incorporation principle relative to EU companies. However, the ECJ rulings do not affect the standing of extra-EU companies. MSs are free to keep them under the real seat principle. o Centros, 1999 → a Danish couple having everything in Denmark wanted to set up an LLC in the UK (legal seat in the UK), leaving the real seat in Denmark. The State objected, since it adopted the real seat principle. Moreover, the UK had abolished the minimum capital requirements (it thought that asking such amount would stop people with great ideas but no capital from investing → who didn’t want to risk could simply not invest). Hence, Denmark (and similar countries) didn’t want its citizens to evade its laws and leave creditors/stakeholders uncovered. The ECJ said to the objecting States that they were wrong. If someone decides to move to another country, they cannot be forced to change their nationality. This can and must be applied also to legal persons. A company born as British can change where to conduct its business without having to change its nationality. All of this creates 1. forum shopping → EU companies are free to go shopping for the company law of the EU MS that best suits their needs 2. regulatory arbitrage → companies may escape domestic restrictive rules by choosing to place their legal seat in the MS of choice either at time of formation or later regardless of where the real seat is 3. (defensive) regulatory competition → MSs compete to avoid that domestic companies incorporate or reincorporate abroad and to attract firms originally incorporated abroad. FORCES SHAPING CORPORATE LAW WORLDWIDE – REGULATORY HARMONIZATION Harmonization can either occur spontaneously, when lagging jurisdictions want to imitate more successful ones, or be forced upon countries, when they belong to the same political union that is entitled to adopt rules and set goals applicable to each MS. In the first case, harmonization is a consequence of competition. In the second case, the companies of these states will look alike to foreign companies and investors. This grants faster and cheaper comparisons. EU authorities (European Commission, European Council, European Parliament) can legislate in the field of corporate law to speed up the process of harmonization. They can do so by means of different legal instruments 1. REGULATIONS (binding and relevant for corporate law) → toughest instrument. They don’t require a transposition process, and no objection is possible. They strike out national, inconsistent laws. They are simultaneously laws of the EU and of each MS. They are passed by the European Commission and Council. However, reaching an agreement between all the Heads of State is most times impossible, making regulations difficult to pass. 2. DIRECTIVES (binding and meaningful) → an internal law of transposition is required. Usually, there is room to vary the details. Directives set the results to be achieved, but each MS can decide the means to use to reach such goals. Directives far outweigh regulations. 3. DECISIONS (binding, but insignificant for corporate law) → they are usually issued as a penalty for breaches of other laws. There is no authority that supervises the application of corporate law. Hence, it provides for sanctions and judges that will deal with breaches of law. Decisions are issued by the European Commission. 4. RECOMMENDATIONS (non-binding, yet meaningful) → many times the European Commission, before making a recommendation to the European Council, speaks with companies. Formally speaking, companies are free not to commit to these recommendations. However, they are made aware that such recommendations may become something bigger. The EU may observe different recommendations to decide which to transform into regulations/directives. 5. OPINIONS (non-binding, of low impact) → given by committees of stakeholders. The EU wants to hear directly from them before acting. STATE OF THE ART IN THE EU – PUBLIC COMPANIES We can observe a trend toward regulatory harmonization regarding public companies and even a stronger one regarding publicly-traded companies. The shares of the latter are available to investors from all MSs, involving several markets. They raise capital from all over the world. Hence, they are very influential. Harmonization is mainly reached through directives and regulations. Approximately 40 directives have come into force, of which 10 specifically regulate listed companies. However, there’s still some room for MS to maneuver. In the early 2000s, EU authorities understood that it was quite difficult to deal with all the national corporation laws and impose full harmonization. To get over this problem and the various oppositions AGENCY PROBLEMS AND LEGAL STRATEGIES The ultimate goal of corporate law should be that of maximizing the aggregate welfare of all who (explicitly or implicitly) engage in contractual dealings within the firm – shareholders and directors – and with the firm – all stakeholders (managers, workers, creditors, suppliers, customers). To reach such goal, the law must achieve other intermediate objectives: 1. reducing transaction costs among the corporate constituencies by facilitating both contracting and coordination among all the factors of production (capital, labor) by means of a dedicated corporate legal entity, which becomes a stable, long-lasting counterparty for all providers of inputs (shareholders, creditors, workers, …) 2. solving at low cost the multiple conflicts of interest that arise from the multiple agency relationships that are established within and with the firm. This will make sure that all corporate constituencies may effectively work together for the common good. AGENCY RELATIONSHIPS In legal terms, an agency relationship arises out of an agency contract under which the agent is delegated by the principal to perform some predetermined activities on behalf of the latter (e.g., real estate agencies). In economic terms, an agency relationship arises whenever, whether by a formal agency contract or otherwise, somebody (the principal) relies on actions taken by somebody else (the agent) in order to enhance the welfare of the former based on the assumption that the agent knows better. 1. Shareholders (principal) vs directors/managers (agents) → it stems from the delegation of management 2. Majority shareholders (agents) vs minority shareholders (principal) → it stems from the majority principle applicable within the corporate form (as opposite to unanimity in partnerships). The majority always wins out and the minority always loses out in board elections and resolutions taken at shareholders’ meetings. However, the money of both is at stake. The majority is de facto delegated to manage the assets of the minority. 3. Company (agent) vs external constituencies (principals) → employees, suppliers and creditors in general are respectively owed wages, prices of goods and services, return of money lent to the company or damage awards. Such payments must be made from the corporate assets, which are managed both directly, by directors and officers, and indirectly, by the shareholders, which appoint the former. The company becomes the agent of all these creditors for the repayment of the debts. Customers invest money relying on the delivery and quality of products and services they buy from companies. Delivery and quality depend on actions taken by corporate managers on behalf of the company. AGENCY COSTS If an agency relationship gives rise to potential agency problems, the latter will give rise to potential agency costs. These costs weigh on firm value. They may arise from 1. time and resources used, and hence wasted, by principals to monitor agents to detect and deter wrongdoing on their part ex ante 2. time and resources spent by agents to assure principals of their good type – that they don’t belong to the category of disloyal agents and will always be loyal to the principals’ interests (i.e., financial statements and hiring rating agencies → informational intermediaries) 3. residual losses that occur when, despite the previous two costs (and precautions), an agent deviates from the right course of action and causes damages to the principal. The first two costs are somewhat inevitable. They cannot be avoided altogether and will always affect the value of the relationship. Indeed, a little monitoring will always be necessary. The law must ensure that these costs are reduced to the largest extent possible (i.e., by putting some bonding cost on the agents). The third type of costs can be avoided or significantly reduced in size and quality by an efficient system of punishment and deterrence against misbehavior on the part of the agents. The latter will be the only one facing the cost of the losses they cause, so that they will retain ex ante from wrongdoing. LEGAL STRATEGIES FOR MITIGATING AGENCY PROBLEMS – REGULATORY STRATEGIES Regulatory strategies are prescriptive. Once and for all companies, they directly dictate the substantive terms that will govern the agency relationship regardless of the subjective preferences of the principals → they dictate how agents will act towards their principals. These strategies impose obligations on the agents. There is no room to maneuver (i.e., agents are obliged to draft financial statements even if shareholders state that they don’t require to see them). o Regulatory strategies improve standardization (since they are mandatory). o Agents may take advantage of those principals that are weak, not optimally/enough informed, or unable to take advantage of their rights. Thanks to regulatory strategies, the trustworthiness of agents is increased. o Regulatory strategies lack in flexibility. The same strategy may work for 99% of firms and be even detrimental for that 1%. o These strategies may also cause either over-deterrence or under-deterrence. Indeed, lawmakers can make mistakes and miscalculate what strategy may be optimal. 1. AGENT CONSTRAINTS impose obligations on agents. o Rules → they prescribe ex ante a certain behavior or the omission of such behavior on the part of the agents. They are the most severe and least flexible legal strategy. They aim at protecting those that cannot obtain easy protection otherwise. An example of rule is the prohibition of market manipulation and inside trading. It’s better to incur in the costs entailed by these rules rather than leaving weaker parties unprotected. o Strategies → lawmakers cannot provide for all circumstances in which a company can be involved. Moreover, the faster economy and market change, the harder to impose specific actions. Standards are flexible and adaptable over time by way of judge-made law. They do not impose behaviors, but rather state a code of conduct, a benchmark against which actions will be evaluated ex post. Agents have a duty to behave in good faith, diligently, loyally, …, but they are not told how to. However, this entails an uncertainty about future outcomes. To behave in a certain way may have different meanings for different people. Assessing if someone has behaved in the appropriate way is difficult and subjective. Hence, the judiciary plays a crucial role in creating legal certainty. Corruption of judges is harder to spot when standards are used. 2. AFFILIATION TERMS are requirements governing agency relationships. o Entry → it regulates the initial terms and conditions on which an agency relationship can be established. Even if who enters the agency relationship is the principal, the outcomes of such entry may affect also third parties. Principals are not fully free to choose whoever they want as agents. There are some requirements that must be met. Since there may also be some public interests at stake, entry terms may strengthen public reliance. An example of entry requirements are those needed to service as directors of a company (be 18, …To be a shareholder, people don’t have to be 18. Indeed, being a shareholder entails holding an asset. Shareholders must be 18 only to exercise the rights and obligations arising from such ownership. If they are minors, they must have a tutor acting on their behalf). o Exit → principals can terminate the agency relationship by leaving the company or otherwise cancelling their contractual relationship with it. An example is the liquidation priority rule. LEGAL STRATEGIES FOR MITIGATING AGENCY PROBLEMS – GOVERNANCE STRATEGIES Governance strategies are based on principals’ active participation and intervention. They confer on principals the right and power to control their agents and take defensive measures in case agents do not advance their interests. Principals are free to decide whether to exercise this power or not based on the costs and benefits that would arise. o Weaknesses of regulatory strategies (no flexibility and miscalculation) are the advantages of governance strategies (flexibility and better thought-off actions). o Advantages of regulatory strategies (protection of weak principals) are the disadvantages of governance strategies (agents may act at the detriment of the principals). 1. AGENT INCENTIVES to maximize the wealth of the principals. o Trusteeship → individuals or authorities, internal or external to the company, are conferred oversight powers. Since they are most likely super partes and are not personally exposed to, or interested in, the outcome of the agency relationship, they may deserve trust from the principals. Being impartial entails acting in the interests of no one. The level of trust greatly depends on the functioning of the legal system. o Reward → it creates personal incentives (compensation) for the agents to act in the interest of the principals by aligning the interest of the former to that of the latter. However, if this alignment goes too far, it may backfire. 2. APPOINTMENT RIGHTS o Selection and removal → principals are given the rights to select, appoint, and remove their agents. Selection and appointment, in conjunction with some entry terms, give rise to the agency relationship. Removal rights, in conjunction with some exit terms, terminate such relationship. The first defendants of these rights are the principals themselves. They can select who they think is fit for them and remove who is not doing their job properly. Underperforming agents will not be punished by law. 3. DECISION RIGHTS o Initiation → most (if not all) business decisions are made by managers. However, decisions regarding the foundations of the agency relationship, which do not strictly require a preliminary action by management, are left to the shareholders (allocation of shares, nature – public or private – of the company, …). These decisions have nothing to do with the business, and everything to do with the infrastructure in which such business is conducted. Hence, principals have the right and power to make own proposals and resolve on these major corporate issues. o Ratification/veto → principals have the right to ratify or object to resolutions proposed or taken by the agents that require the approval of both to become effective. ENFORCEMENT Legal strategies are useful only if they induce compliance. This happens if the targets of a rule of law know they will face detrimental consequences in case of non-compliance. Compliance is assured by the prospect of the enforcement of the rule of law where it is violated, if and only if enforcement is perceived to be effective. According to the nature and quality of the enforcer, we can distinguish between three types of enforcement. 1. Public enforcement → performed by organs of the state. They are either criminal prosecutors or market authorities (Consob IT, US Securities and Exchange Commission, UK Financial Conduct Authority, France’s Autorité des machés financiers). The latter are specialized and dedicated, so they outweigh the former. Public enforcement is justified by the relevance of public interests at stake, or the inability of the parties affected by others’ wrongdoing to vindicate their rights. It mainly supports regulatory strategies and gives rise to penalties administered by courts and/or market regulators. The former delivers criminal sanctions (imprisonment and monetary penalties) and civil sanctions (claim for damages, indemnification shares required. Shareholders may also be either incapable or unwilling to nominate someone. Therefore, the board of directors acts as a back-up option. VOTING MECHANISM 1. PLURALITY (in Italy for listed companies) → nominees need to get more affirmative votes than the competing nominees to win – the most voted candidate gets the position. Votes against nominees cannot be cast and withheld votes do not count. If a nominee runs unopposed, they only need one affirmative vote to be elected. Shareholders may express their dissatisfaction with a nominee solely by withholding authority to vote their shares in their favor. However, this action has no legally binding effect. Should there be more nominees than posts on the board to fill, winning nominees are selected in descending order standing from the nominee who obtained the highest number of affirmative votes. Directors may not be liked by the shareholders, but it is better this way rather than leaving the company uncovered. 2. MAJORITY (in Italy for unlisted companies) → affirmative votes for a nominee must outnumber votes withheld and against. Should there be more posts on the board to fill, rounds equal to the number of spots available will be run, and each wining candidate will obtain the seat. This mechanism exposes the company to the risk of not finding anyone to fill the position. However, it grants continuity, support, and abilities of board members. Moreover, it makes sure that the directors elected are liked by the shareholders → their interests are favored. TERM IN OFFICE o Shorter term in office → it fosters the accountability of directors. The more frequent the meetings, the higher the control of shareholders over the directors’ actions. o Longer term in office → it fosters stability. Managers feel lower pressure and have a longer time to deliver. They can have a long-term view. Directors in staggered boards are grouped into classes that serve terms of different lengths. They are typically established to dissuade a potential hostile takeover bid. Only a portion of director positions at a time is opened to elections. Due to their negative impact on shareholders, staggered boards have been on the decline. REMOVAL OF DIRECTORS 1. In Italy, France, the UK, Japan, and Brazil, shareholders may gather in meetings and remove all or part of the directors in office at will at any time. A simple majority vote is sufficient. If removal is without a just cause, directors are entitled to request damages to be compensated for what they would have earned if they stayed until expiry of the term. 2. In Germany, removal of shareholder-elected supervisory board members is permitted, but with a 75% shareholder majority vote. Removal of management board members by the supervisory board requires a just cause (violation of law/duties). In this case, members are not entitled to any lost profits and may even be requested to compensate for the losses their actions have caused. A no-confidence vote by a simple majority of shareholders, albeit not forcing the supervisory board to remove the directors on the management board, meets the requirement of a just cause for early dismissal. 3. In the US (Delaware), removal without just cause is formally allowed, but shareholders cannot convene a dedicated meeting for resolving on removal, unless the charter so provides. This is because the short term in office paired with early removal would draft away too much from the management accountability. If a staggered board is in place, removal without cause is prohibited since shareholders have decided to keep managers 3 years instead of 1. The law believes that shareholders won’t exercise their removal rights recklessly, both because it is in their interest to keep competent directors and because removal without cause is costly. Moreover, finding new capable managers is time consuming. Therefore, it is better to allow early removal rather than not. Directors should feel the pressure so that they will deliver. DECISION RIGHTS Any decision rights granted to shareholders, other than contradicting the principle of delegated management may raise information and coordination problems. Nevertheless, if the management is conflicted or the contractual relationship between the firm’s owners is at stake, some decisions are more likely to be optimal if taken directly by the latter. o Initiation rights → the UK is the most shareholder-centric. A 75% majority shareholder vote may overrule the board on any matter without undermining the general principle of delegated management. In Brazil, the State is greatly involved in ownerships. Therefore, it is unlikely to decide not in its favor. Shareholders may decide by simple majority on any business matter and duly filed shareholder agreements are binding on the company. They can also reach out-of-meeting agreements to impose decisions from the outside. This fastens decision-making process. In Continental Europe and Japan, qualified percentages of shareholders may initiate and resolve on a wide range of organizational matters, including charter amendments, without the need for managerial approval. No small, irrelevant shareholders can take decisions. Delaware is the least shareholder-centric; it favors those who are the most important in key choices when the company is set up – directors. They are also the shareholders at the time of the inception of the company. In a world of high-dispersed owners, directors are the winning ones. Shareholders are barred from initiating charter amendments. It is unlikely that shareholders will exercise their initiation rights against managers. They are more likely to directly use their removal rights. o Ratification/veto rights → in Continental Europe, the UK, Brazil, and Japan, shareholders have ratification and veto rights over 1. approval of annual financial statements → there may be shareholders that have the adequate knowledge. In Delaware, since shareholders are not qualified, they have no saying about financial statements. Their approval is left to auditors 2. dividend and cash reserve distributions → since it’s the money of the shareholders, they must have a say. It is a way to control the management. In Delaware, the choice can be taken only by the directors, since they know about the business and its needs. Indeed, retaining cash is a way to finance the company 3. acquisition of own shares by the company → since dividend are taxed, acquiring own shares is a way to repay investors. Acquisitions are also used to increase demand and keep prices up. Through buy-backs, shareholders can exit the company even when there are no investors willing to buy shares. Once a company buys its own shares, they become silent. Therefore, the voting rights of the other shareholders increase. These shareholders may then decide to buy these shares when they are put back on the market 4. appointment of external auditors →they are recommended by directors and paid by the company. However, auditors are meant to look after the managers 5. transactions between the company and a director/officer (or their controlled companies) exceeding some monetary value 6. mergers, divisions, conversions → if shareholders do not agree with these changes, they can exit the firm 7. business matters that the charter reserves for shareholders’ approval In Delaware, shareholders have ratification and veto rights only over 1. mergers, divisions, conversions 2. charter amendments 3. business matters that the carter reserves for shareholders’ approval. COORDINATION MECHANISM FOR DISPERSED SHAREHOLDERS To reduce the costs of exercising their voting rights, sophisticated voting allows distant shareholders to cast their vote without dispersing resources. 1. Voting by mail → during the meeting, someone will be entitled to read out the votes arrived by mail 2. Electronic voting → shareholders are given credentials to enter the dedicated electronic platform. In these two cases, shareholders still must get informed and cast the vote themselves. They still must make an effort. To relieve shareholders from these burdens they can resort to 3. proxy voting through custodial banks → custodial banks hold deposits of shares. They can be delegated the authority to exercise the voting rights associated with the shares they hold. Shareholders can do so by filling a delegation form – proxy. Custodial banks have links with the companies that issued those shares and know how to better use voting rights. The proxy can be either detailed (shareholders instruct the bank on how to vote) or blind (banks can do what they believe is best). Even if the shareholders are relieved of the burdens associated with voting, they still must pay the bank that they’ve delegated. Moreover, banks are indifferent to companies’ businesses and decisions. Therefore, they don’t have the incentive to use votes in the best way possible 4. proxy solicitation by corporate partisans → partisans are other shareholders that want to use the votes of other shareholders to pursue their own agenda. A shareholder may receive a mail from a manager stating “I want to vote x at the following meeting. If you agree, you can simply delegate me your voting rights, which will be used to vote x, too”. This mechanism works for small shareholders. Proxy battles arise between shareholders to solicit the most proxies. Incumbents are the ones in power and seek action. Insurgents are the ones that want to renovate the board. SHAREHOLDER ACTIVISM Small shareholders are unlikely to be activists and impactful. They won’t make proposals and will rather follow others. On the other hand, those who may become activists are institutional investors. o SOFT ACTIVISM → investors must engage with the management, but they are unlikely to vote against it. They are more likely to write managers letters asking them to be more sensitive about certain subject matters. If they are not listened to, they will sell their shares, making their price to drop. Their threats are long-term. They are also unlikely to follow the business agenda, since they don’t care about managing the firm. Soft activists are public and private pension funds, mutual funds, private equity funds. They collect money from their customers and invest it to grant them secure future returns. Therefore, they engage in diversification to spread risks – they hold few shares in many companies. o HARD ACTIVISM → investors make real managerial proposals. They are the ones that will stage proxy battles and agitate change to pursue their own business agenda (they have expertise and knowledge). Hedge funds have opposite strategies with respect to soft activists. Indeed, they aim at concentrating shares and risk to enhance chances to make great profits. They accumulate substantial shareholdings. Hard activism is what makes management accountable. BARRIERS TO SHAREHOLDER ACTIVISM The goal of regulators is protecting shareholders. To do so, they also create, directly or indirectly, obstacles to activism. 1. Disclosure obligations for shareholders exceeding a predetermined threshold (≈ 5%) of voting rights in the aggregate (Europe and US). Disclosure is established through mandatory rules. Investors need to know who’s likely to have an impact on the governance of a company. These shareholders may be indifferent to issues that are important for investors or be focused on subject matters that are considered irrelevant. Along with investors, also market authorities NATIONAL CODES OF CORPORATE GOVERNANCE The law is costly to comply with. Therefore, it doesn’t impose the best practices, but rather addresses the average. Still, some investors may require higher standards, even if the law doesn’t impose them. National codes of corporate governance are examples of self-regulation or soft law – rules issued by self-regulatory organizations (usually stock exchanges) for market participants to attract them, foster best practices, and prevent the intervention of ordinary regulation. Compliance to these collections of standards is recommended but not mandatory. Companies that do not adopt these codes are required to explain and motivate why they’re not willing to do so. Some institutional investors may not be allowed to invest in these companies. CHAIRMAN VS CEO Codes of corporate governance worldwide recommend separating the role of CEO from that of the Chairman of the board. The board is responsible for guiding company strategies, monitoring management performance, and providing accountability to shareholders. The CEO is responsible for implementing company strategies and for day-to-day management. Since the latter is hired, remunerated, monitored, and can be replaced by the board, if one person occupies both roles, there would be a conflict of interest. The board must be independent in carrying out its responsibilities. Hence, a chairperson who is independent from management can better provide objective guidance. However, any conflict between the chairperson and the CEO may undermine investor confidence in the company. This separation could also be perceived as a lack of confidence in the abilities of the CEO. The law doesn’t take a side because, in some cases, concentrating authority in one person could be essential to effective management. If the company is successful, there is no reason to insist on a separate chairperson. BOARD COMMITTEES Oversight duties are themselves complicated. Internal supervisors (non-executive directors) are further divided according to their capability, role, and expertise. Each board committee presides over specific issues and can advise the board on collective action decisions. In Europe, board committees are established and regulated by directives, the European Commission Recommendation of 15 February 2005, and MSs’ codes of corporate governance. The Audit Directive (directive 2013/34/EU) imposes an Audit Committee, while the various codes also recommend the establishment of the Remuneration Committee and the Nomination Committee. In the US, the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010 introduced, respectively, an Audit Committee and a Compensation Committee. The various listing rules also recommend the establishment of a Nomination Committee. The two Acts are bi-partisan legislative acts. They have been approved by both the Democrats and the Republicans since the subject matters on which they legislate are of great relevance. o The audit committee supervises the internal auditing function, which embraces a wide range of activities from efficient risk management policies to regulatory compliance. Moreover, it also makes proposals for the appointment of an audit firm. o The remuneration (compensation) committee recommends managerial remuneration policies and packages to be approved by the board and/or the shareholders. o The nomination committee recommends slates of candidates for election to the board of directors of the company, its subsidiaries, and affiliates. INDEPENDENT DIRECTORS Independent directors are non-executive directors having no family and/or business ties with the company, its executive directors, senior executive officers and/or the controlling shareholders. This aims at making the role of non-executive directors more credible in the eyes of investors. Independent directors are urged to intervene in all the decisions and/or transactions that might give rise to a conflict of interest on the part of the managers, like internal audit, compensation, nomination, and conflict-of- interest transactions (e.g., a manager sitting at both sides of a selling/purchase contract between a company and its own controlling shareholders). Independent directors are subject to a compensation regime different from that of the executives. o Their financial interests are detached from those of the managers to avoid high-power financial incentives. o Their compensation is neither too high nor strongly tied to the mere financial performance of the company. o Subject to low-powered incentives, in that they principally are moved by ethical, reputational, or other professional concerns. The Sarbanes-Oxley Act of 2002 mandates audit committees entirely composed of independent directors. Indeed, since audit committees in the US are also in charge of appointing outside auditors for the auditing of the financial statements, this Act aims at avoiding that external auditors collude with the board. The Dodd-Frank Act of 2010 mandates compensation committees entirely composed of independent directors. NYSE and NASDAQ listing rules require listed companies to have boards mostly composed of independent directors. They also require that listed companies have nomination committees entirely composed of independent directors. The Audit Directive (Directive 2013/34/EU) imposes that audit committees must be composed of most IDs and have an independent chairperson. The EC Recommendation of 15 February 2005 states that the number of IDs on the board should be sufficient. MSs’ codes of best practice fall short of recommending most IDs on boards o UK → a half of board members o France → a half (or a third in controlled companies) o Germany → an adequate number o Italy → an adequate number They also fall short of recommending wholly-independent board committees. They are simply urged to be composed of at least most IDs. Europe is more reluctant than the US for two motives. 1. Positive perspective → the US place too much faith in independent directors. They are still humans and can develop friendships and love relations. 2. Negative/obscure perspective → in Europe, since among the shareholders there’s the State, it is aware of the power IDs hold and is scared they would work too well and damage it. REWARD STRATEGY – EXECUTIVE COMPENSATION Managers have their non-diversifiable human and labor capital invested in the firm. If they fail, they lose everything – they can be fired and could struggle to get hired elsewhere. This causes a misalignment between their interest and those of shareholders. Indeed, managers tend to be risk averse. They are likely to prefer low risk / low return projects that are unsatisfactory for shareholders, who prefer high risk / high return ones. Furthermore, if managers’ salary consists of a fixed and certain amount of cash, they are not disincentivized from shrinking (expend limited or no effort in improving the financial and operating performance of the company) and are likely not to work hard. All these are a form of agency costs that decreases shareholders value and increases the firm’s cost of capital. To solve this problem, a performance-based compensation could be adopted, gearing compensation to the financial performance of the company, measured by the meeting of some financial ratios (annual earnings per share, …) and/or the stock market value. This compensation would consist of 1. a fixed, cash-based component 2. a variable, performance-based o cash bonus → it is expensive, since this cash gets out of the profit of the company, reducing the number of dividends that can be paid o or stock option (equity incentive) → managers are offered the possibility to buy shares of the company after a vesting period has expired at a predetermined price (strike price). If the share price increases, managers can buy shares at the strike price and immediately sell them at the market price, which is higher. The marginal (trade) profit is potentially infinite. If prices fall, the option will simply not be exercised. If shareholders lose, managers lose, too (aligned interests). Stock options expose the company both to profit losses, since it is obliged to sell at a lower price than what it could charge on the market, and to dilution, since shareholders must make room for the manager exercising the option. Shareholders would no longer be granted 100% of profit/dividends/control. Nevertheless, even if the share of the pie for each shareholder decreases, the total size of the cake increases. Therefore, each share becomes more valuable. Many times, buy-backs are used to put stock in the treasury of the company. Other equity incentives may be o restricted stock → managers are immediately given the stock, but they cannot dispose of it as they will and must deposit it in a bank account until the vesting period is over o phantom stock → managers are given cash payments reflecting the changes in the underlying share price. Phantom stock is used when controlling shareholders are not willing to give ordinary stock options and lose their grip on the company. Stock options are historically more used in the US than in Europe. The weight of shareholder control over management (the former is weaker) ensues the need for financial incentives for managers. Moreover, to induce US companies to adopt more variable elements of compensation, payment is fully deductible only below the threshold of $1 million. The problem with stock options is that managers are encouraged to take on excessive risk. Indeed, in the worst scenario, they would still get the fixed component of their salary and would not feel the hit caused by their actions. An example can be found in the financial crisis of 2007- 2009. Managers had very short-term horizons and didn’t care about what their actions could cause once they were gone. No one noticed that the overall level of risk-taking was increasing until the bubble burst. LEGAL RESPONSES TO EXCESSES – THE US Where State law fails, federal law intervenes. o Thanks to the full disclosure of compensations individually paid to CEO, CFO, and three other most highly compensated executives, markets can identify companies that are paying too much. This would induce investors to back out, causing companies to lower the salaries they pay. o Companies must also disclose the total annual compensation of the median employee of the organization o and disclose the ratio between the two, which has become known as the CEO Pay Ratio. If this ratio is too high, the company may be taking on too much risk to afford paying the executive officers. o The disgorgement of CEO/CFO incentive compensation following a financial misstatement (SOX of 2002) imposes that, if it turns out that financial statements were false/misleading, the profits made by the CEO and the CFO must be put back on the market. o Corporate loans to senior executives to buy shares in the market or exercise stock options are prohibited (SOX of 2002). This is because, since banks may be willing to give them loans within some limits, executives would be tempted to turn to the company itself. o Prohibition of equity-based incentives in bailed-out companies with limited exceptions (American Recovery and Reinvestment Tax Act of 2009). In other words, companies that must be bailed-out with tax-payers (public) money lose all their equity incentives. MINORITY SHAREHOLDERS – RISKS AND PROTECTION CORPORATE CONTROL-ENHANCING MECHANISM This mechanism aims at leveraging voting powers without increasing the number of shares issued. 1. DEVIATIONS FROM THE ONE SHARE / ONE VOTE PRINCIPLE o Multiple voting shares → they are allowed without restrictions in the US and the UK, and subject to a cap on a maximum number of votes per share in Italy. Indeed, since prohibiting multiple voting shares puts companies into competitive disadvantage, many Italian companies threatened to relocate. Therefore, Italy decided to change its regulations and reintroduce multiple voting shares. However, it has done it with some restrictions to avoid abuses. Multiple voting shares are still prohibited in Germany and Brazil. o Multiple voting shares in dual-class structures → some individuals are granted firm power over the company without having to face increasing costs. These shares are used by Alphabet (Google), Facebook, LinkedIn, News Corporations, … a. Class A common stock carries 1 vote per share, is sold to outside investors, and is traded on markets. b. Class B common stock carries 10 votes per share, is held by inside shareholders, and is non-transferable. It is meant to stay with the founder. If they die or sell, a clause in the corporate charter converts their shares into class A stock. This is because they could become dangerous in the wrong hands. o Charter provisions leverage the voting power of special shareholders (named controlling in the charter). Their power/control is not contestable. o Fidelity/loyalty shares → they double the voting power if shareholders hold onto them for at least two consecutive years. Although these shares are usually justified as protecting the interests of long-term over short-term shareholders, they tend also to embed the power of controlling shareholders relative to outside investors. For instance, the French State has used its power as a government to increase its power as a shareholder. US companies have been slow to implement loyalty shares programmes because the US stock market is generally characterized by short-termism. Leveraged shares can be granted also by depriving other shareholders of their voting rights. o No voting and limited voting shares → they could pay higher dividends. These shares are allowed without restrictions in the US and the UK; they are capped at 50% of outstanding shares in Germany, Italy, and Brazil; they are capped at 25% of outstanding shares in France. o Voting caps in the charter to reduce voting power → when putting together shares, an investor cannot accumulate more than a certain number of voting shares. Those shares beyond this threshold cannot be exercised. This way, voting powers are crystallized. Other investors can only match this maximum % of voting shares that other shareholders may possess. No one can overtake the others. Voting caps are more commonly adopted where no controlling block exists, to dissuade the building of one, rather than to constrain the voting power of an existing block-holder. They are allowed in the US, the UK, Italy, France, Spain, and Brazil. They are prohibited in Germany and Japan. 2. SHAREHOLDER AGREEMENTS Shareholders A, B, and C each hold 17% of voting shares in company XY. They can enter a shareholder agreement whereby they undertake to vote at shareholder meetings at company XY according to what their internal majority has previously decided. A-B, B-C, or A-C may each time dictate their will on all shareholders, despite having a minority of shares. If they don’t form this majority coalition, the individual vote of the three shareholders may potentially cancel out, and therefore they will not be able to prevail alone, or even in couples. 3. PYRAMIDAL STRUCTURES – chain of companies An unlisted company A holds a controlling shareholding (51%) in unlisted company B, which in turn holds a controlling shareholding in unlisted company C, which further holds a controlling shareholding in LISTED company D (target company). Company D is forced to pay dividend to company C, which must pay dividends to company B, which further pays dividends to company A. Thus, holding company A fully controls company D but has an economic stake in it of only 12.75%. This exposes company A to disproportionate financial risk and returns from company D. In all layers, the company above owns 51% shares of the company below. Layers only go down, which means that the company below cannot buy shares in the company above. All these intermediate companies are shell companies. They only exist on paper and are not meant to conduct a business. They only aim at creating layers between the holding company (A) and the target company (D). Pyramidal structures are discouraged in the US by means of taxation of inter-corporate distributions. 4. CIRCULAR SHAREHOLDINGS Company A holds 51% of voting shares in Company B. The subsidiary (B) can in turn buy shares in its controlling company (A). If these shares (owned by B in A) could be voted, shareholders in company A could leverage their voting power by imposing minority shareholders in company B to exercise their votes in their favor. There is no business rationale for allowing circularity. Therefore, while buying shares in the controlling company by the controlled company is generally allowed, voting such shares is forbidden everywhere. 5. CROSS-SHAREHOLDINGS Companies buy shares from each other to create an alliance. Indeed, while agreements expire, cross-shareholdings grant long-term stability for the alliance (when owning shares, no one can be forced to sell). Company A holds some N% (< 51%) of voting shares in company B, which in turn holds some N% of voting shares in company A. However, the second mover (B) cannot own a % of shares above a certain threshold. This is to avoid that companies increase their reciprocal stakes too much as to compromise the alliance and act only in self-interests. If there are no votes attached to the shares, this problem doesn’t stand. In Europe, the % of shares that the second mover (B) can own in company A (first mover) varies from 3 to 5%. This means that company B cannot hold more than 3-5% in company A if the latter already owns more than 3-5% in company B. Should the threshold be crossed by company B, it is inhibited from voting company A’s shares in excess and must sell such shares. The same applies if the companies involved are three. MINORITY-MAJORITY SHAREHOLDER AGENCY PROBLEM MEASURES Dated empirical studies showed that the three jurisdictions (US, UK, and Japan) in which large corporations ordinarily have dispersed ownership also had low private benefits of control, while the countries in which concentrated ownership dominates (France, Italy, Brazil, less Germany) had moderate to large private benefits. The majority-minority shareholder agency problem used to be moderate to severe in the latter and small in the former. This problem can be measured by 1. share price differentials between high-voting and low-voting stock in dual-class structures. Suppose that one company issues 50 voting shares and 50 non-voting shares. They are all identical with respect to all other economic rights. If both kinds of shares are listed in a regulated market / stock exchange, and the market assessed their price differently, it is only due to the presence or absence of voting rights. In the US, this difference is minimal; in Italy, it is substantial. This is because voting rights, all held equal, have higher weight in Italy than in the US. In Italy, investors are not prepared to pay a lot for non-voting shares because they do not want to be at the mercy of controlling shareholders without even having a say. Voting rights count more in those jurisdictions where not having them puts shareholders in a disadvantageous position. 2. size of control premia in sale of controlling blocks. Some companies do not have a dual-class structure or do not issue shares on stock exchanges. Also, some investors may not want to buy and accumulate shares gradually. Indeed, if this was done in stock markets, shares prices would increase. Offerors should offer a premium over the market price to avoid that offerees buy from the market. Control premia tend to be higher in jurisdictions where shareholders with 51% of shares can easily take advantage of their voting power at the expense of minority shareholders (minority shareholders are powerless and it pays to be a majority shareholder). APPOINTMENT RIGHTS Minority shareholder representation on the board of directors can be achieved thanks to o the right to appoint at least one minority director (Italy, Brazil) → one board seat is reserved for the slate of candidates which obtains the second-highest number of affirmative votes. Parmalat scandal → independent directors were friends with the controlling shareholder. They believed, in good faith, that the founder would continue doing a great job, so they closed their eyes. However, he took on loans from banks and increased Parmalat’s debt exposure. He committed frauds pretending to have the money required. After this scandal, Italian lawmakers realized that they could not rely only on the independence of directors. Since the minority director owes its job to minority shareholders, they will act in the interest of the minority. o cumulative voting (US, UK) → minority shareholders can focus all their votes (number of voting rights x numbers of board vacancies to fill) on one or few candidates to increase their chances to win. For instance, if they do not exercise their voting rights for the first two candidates, they can use both the votes not exercised in the previous two sessions, and the ones available for the third, to vote on the third candidate. Cumulative voting has become rare because it is opaque. There are competing views about these measures. Indeed, they could o provoke conflicts in board meetings, slowing down the decision-making process. Moreover, investors may be pushed away by the presence of a split board where there is no clear command. o discourage candid business discussions. Indeed, a too harsh stance may deter transparency and scare minority directors, who could become timid and silent. o provide competitors with access to sensitive information. Minority investors may decide to become minority shareholders only to elect a minority director though whom have access to sensitive information. o not be able to represent all minority shareholders groups due to the latter’s heterogeneity. Indeed, the minority director is elected by the most powerful minority shareholder, which usually are institutional investors. They act in their own interests and not in that of the other minority shareholders. All these views depend on the experience and problems countries have experienced. Some countries mostly see net costs, while others see net benefits. DECISION RIGHTS 1. Minority shareholders have the right to initiate derivative actions against management in the name of the company. This means that minority shareholders can bring their managers to court asking for damages. This right is conferred to them because, if a controlling shareholder is also sitting on the board, they would not exercise derivative actions. Therefore, these actions cannot be left only in their hands. Minority shareholders can exercise this right despite what o Thanks to supervisory board participation (corporate law), employees have direct access to corporate information and strategies, which are no longer the exclusive province of the shareholders. The latter remain the owners of the firm, but their owners’ control rights are significantly diluted in favor of the constituency of Germany-based workforce. All eastern European countries somewhat employ this German codetermination. Employers’ and employees’ associations in Italy didn’t want this model to be introduced, even if some of them had shown interest in it. In some cases, over time, this codetermination/concentration/cooperation between so many parties can lead to clashes at the detriment of both shareholders and employees, and in the benefit of management. OTHER LEGAL STRATEGIES o Employees are not given decision rights, except in Germany, where works councils co- decide with management on several employee-sensitive matters. o Trusteeship → independent directors can act also in the interest of employees. o Reward → the equal sharing norm doesn’t apply unless employees are rewarded with stock options, turning into employee shareholders. In this case, it’s not the company that aligns its interests with those of employees, but rather the opposite. Since employees are the principal and the company is the agent, to align the interest of the latter with those of the former, employees are given fixed, contractual claims which are not contingent on the performance of the company. o The duty of loyalty was designed to protect shareholders. As its scope is expanded to encompass employee interests, its effectiveness is compromised. For instance, a manager could have to choose between 2 decisions, each benefitting either shareholders or employees. Either the law states that the manager has utter independence/discretion in making the decision without the risk of being held liable, or the duty of loyalty can be applied to preserve the interests of only one party – the shareholders. Empirical evidence is mixed and inconclusive about which model – the one-tier with no employee involvement or the German codetermination – works better. This is because the way these models work is hardly determined by the context in which they operate. PROTECTION OF NON-CONTRACTUAL CONSTITUENCIES Employees become constituencies by entering a contract. Non-contractual constituencies are all those that do not entertain contractual dealings with the company, but whose welfare is nonetheless affected by corporate business activities. They are o local communities because of plant closings, offshoring of industrial production, … o victims of tortious activities o competitors, their investors, and their employees due to constraints on competitive behaviors or unfair competitive behaviors o taxpayers because of corporate collapses o society at large due to environmental damages, violation of human rights, gender discrimination, growing inequality, systemic financial risks. DUTY OF LOYALTY The duty of loyalty is owed to the company, rather than to any of its constituencies. This is justified considering the public good and the social function of the enterprise in discharging such duty to the company. The UK, sec. 172, Companies Act 2006 states that a director of a company must act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members (shareholders) as a whole, and in doing so have regard, among other matters, to o the likely consequences of any decision in the long term o the interests of the company's employees o the need to foster the company's business relationships with suppliers, customers, and others o the impact of the company's operations on the community and the environment o the desirability of the company maintaining a reputation for high standards of business conduct o the need to act fairly between members of the company. To what extent are these provisions meant to be binding? Is it viable to consider all these matters? All this would only expand the discretion of managers in making decisions, and they would hence be excused for each decision they make. Therefore, many jurisdictions don’t expand the duty of loyalty. AFFILIATION STRATEGY This strategy is based on the terms under which an agency relationship is established (entry/exit). It requires the disclosure of companies’ non-financial information. This is useful to educate shareholders to think as stakeholders rather than turning the latter into shareholders. o US – listed companies One of the problems regulators tried to solve was group-thinking. Having many minds all thinking differently was one way to solve this matter and improve efficiency. Therefore, companies must disclose their diversity policies in director nominations for protection of women and minorities. They must also disclose the ratio of CEO compensation to that of a median employee to expose income inequalities. This is all stated in the Dodd-Frank Act of 2010. o EU – listed companies, unlisted banks, and insurance companies with more than 500 employees The Directive 2014/95/EU states that these firms must disclose their non-financial information in management reports, including their policy and performance with respect to environmental, social, and employee matters, respect for human rights, anticorruption, and bribery matters. They are not forced to act, but they must disclose how they approach these matters. This way, investors are educated to decide where to put their money also according to non-financial information. DECISION RIGHTS The easiest way to have the voice of stakeholders heard is State involvement. o GOLDEN SHARES in privatized companies → regardless of number of ordinary shares held in the company (few or even zero), the State reserves to itself veto rights over issues such as mergers, reincorporation, dissolutions, sales of assets, for the protection of strategic national interests (military defense, security, health, telecommunications and transportation, oil, and energy supply). Even if all the other shareholders saw their property rights damaged, golden shares complied with the constitution, which states that property rights are protected unless they serve a higher public interest. The ECJ then realized that these shares could be used to infringe the freedom of movement of capital within Europe, discouraging local and cross-border investments, and to protect the States’ own sovereignty with respect to others. Therefore, the ECJ stuck down golden shares and looked at other means to protect strategic national interests. o Direct State ownership of firms (Europe, Brazil, China) → the state holds either majority stakes or significant block holdings in firms. States must disclose which are the goals they are pursuing and how they want to use their power to achieve such goals. APPOINTMENT RIGHTS External constituencies other than employees are not directly given any appointment rights. Indeed, even if shareholders can appoint board members, they still must comply with some requirements. o Gender quotas (Europe) → in Italy, France, and Germany, 1/3 of board members must belong to the gender least represented on the board. o Professional – fit and proper – requirements for directors and officers serving at banks and insurance companies → they must have the knowledge, skills, experience, and reputation adequate to their position, they must make time commitments, they must have no conflicts of interest within and with the firm, and they must grant the collective stability of the board. o Interlocking directorates across financial institutions are prohibited in the US, in Germany, and in Italy. TRUSTEESHIP once again sees the use of independent directors. REWARD Executive compensation at listed companies is increasingly detached from financial incentives and tied to key non-financial performance indicators, such as customer satisfaction, product quality and safety, recorded worker injury frequency, level of greenhouse gas emissions, … The variable component of European banking executives’ pay is capped at 100% of fixed component, which may be increased to 200% by shareholder approval (Capital Requirements Directive IV). DISCUSSION ON THE 2 PAPERS – IS CORPORATE LAW FIT TO TACKLE BROAD, SOCIAL AND ECONOMIC MATTERS? Vedi sul quaderno. CREDITOR PROTECTION SHAREHOLDER-CREDITOR AGENCY PROBLEM Law has reached a compromise through asset partitioning. The priority rule (entity shielding) is an advantage for creditors and a disadvantage to shareholders, while limited liability (owner shielding) is the opposite. Asset partitioning brings about two problems. 1. EX ANTE MISINTERPRETATIONS In pledging corporate assets to firm creditors, shareholders may be tempted to show better firm creditworthiness by making ex ante misinterpretations. They may disclose o false information about the type of the company (partnership, private, public). For instance, a private company, which is more flexible in the benefit of insiders, may claim to be public, which is more rigid in the benefit of outsiders, to attract investors o false or misleading information about the governance of the firm o false or misleading annual financial statements (private and public companies) as well as semiannual and quarterly reports (listed companies) o false, misleading, inaccurate, incomplete additional financial and non-financial information provided to creditors and credit rating agencies upon their request. 2. EX POST ACTIONS TO THE DETRIMENT OF CREDITORS – AGENCY COSTS OF DEBT After pledging corporate assets to firm creditors, shareholders may be tempted to ex post reduce the cost of the pledge to them by de facto reneging on (backing out of) it. o Asset dilution or diversion → shareholders may siphon (drain) assets out of the corporate pool enriching themselves at the expenses of creditors. It is a form of wealth transfer. For instance, controlling company A of companies B and C may decide to transfer the assets of company C to company B. Company C becomes insolvent and its creditors are left with nothing. o Asset substitution / risk-shifting / overinvestment → shareholders may sell low-risk/low- return assets to buy high-risk/high-return assets. Increased riskiness and volatility of expected cashflows benefit shareholders, who gain in upside scenarios without losing more than the initial investment in downside scenarios, and harm creditors, who lose in downside scenarios while gaining nothing in upside scenarios. Indeed, they benefit from fixed claims, so the profits coming from high-risk actions only go to shareholders. Creditors’ interest is that the company does not undertake actions that could jeopardize their stake. o Debt dilution → shareholders may want to increase the overall firm’s borrowing. When new creditors and liabilities add to old ones, the financial leverage (debt-to-equity ratio) soars. The higher the leverage, the lower the chances of recovery for all creditors. However, while the latest creditors may seek compensation (e.g., security interest) for such increased riskiness, the older ones cannot do so anymore. o Underinvestment → once the firm is near insolvency, shareholders may lack incentives to invest. Indeed, in the worst-case scenario they lose more than they have invested, while in the best-case scenario, most profits must go to the repayment of creditors’ claims. The turnaround, if not positive enough, only benefits creditors. Therefore, shareholders might 1. The type of company must be specified by way of a suffix (inc = incorporated, ltd = limited liability, …). The name of the company must be followed by a predetermined, fixed suffix. They were originally meant to alert investors about what their claims would be if they became creditors and what limits they would suffer. 2. The charter must be filed with local authorities and in public registers, where key corporate information (name, legal capital, classes of shares, …) is disclosed to grant transparency before voluntary creditors. 3. Companies must file both individual and consolidated financial statements. i. Private and unlisted companies in the US have no duty to disclose financial statements to people other than their shareholders. Outsiders that really need this information will get it through direct relations with the company. Bank lenders will obtain financial information from corporate borrowers through relationship lending, which entails continuous screening and monitoring of debtors. ii. Europe thinks that the financial statements of private and unlisted public companies can be useful also to small trade partners that may not be relevant enough to get information themselves. Therefore, companies have the duty to disclose their financial statements. Nevertheless, the level of detail is proportionate to the size of the firm and the accounting principles that must be followed are local. iii. All listed companies have the duty to disclose not only their annual financial statements, but also their semiannual and quarterly reports. In drafting these statements, they are obliged to follow US general accounting principles (GAAP) and international financial reporting standards (IFRS) to solve the problem of comparability. Insider trading is also fought ex ante by imposing timely disclosure of all financial information bearing on the value of financial securities. Disclosure is costly, both in terms of time and money. The optimal solution tries to balance benefits and costs, considering that companies are different. Private companies are presumed to be small-medium size businesses with a lower number of counterparties that tend to be more concentrated and closely tied to the company. Therefore, they have the incentives and power to demand the information from the company, not needing mandatory disclosure rules. They can have timely information by themselves. On the other hand, publicly-traded companies are presumed to have large businesses and be involved with a great number of counterparties, each supplying a small proportion of the borrower’s debt finance. To prevent some of these counterparties from being left behind, not having access to the necessary information, lawmakers require mandatory disclosure. This distinction can be greatly seen regarding mandatory financial statements. When dealing with groups of companies, local creditors must understand how the subsidiary is governed and how the whole group is doing, as the individual statements of the subsidiary may be misleading and could expose creditor to shareholders opportunism. Therefore, groups of companies must prepare and disclose both individual and consolidated financial statements. Both listed and unlisted companies are required to disclose the effects of major intragroup transactions reported in financial statements. The former are required to disclose also all the details of major conflict-of-interest transactions. o GATEKEEPER CONTROL The quality of mandated disclosures can be enhanced through verification by trusted third parties – gatekeepers. 1. Outside auditors are mandatorily appointed at listed and large unlisted companies for the verification of annual accounts. i. In the US, they are appointed by the audit committee. ii. In Europe, where more decision power is put on shareholders, it’s them that appoint outside auditors. They do so upon suggestion of the board of directors and its audit committee. After the Enron scandal, the law must ensure that outside auditors are fully independent. This means that i. they cannot render other, non-audit services to multiply their fees ii. audit partners must be rotated (5 years in the US, 7 years in the EU). Indeed, over time they may become close to their clients, even without fully realizing they are losing their independence. Over time it becomes more difficult to say no iii. audit companies themselves must be rotated every 10 years (EU). 2. Credit rating agencies are optional. Companies are not forced to hire one. However, imposing limits on the risk institutional investors can take on, the law indirectly makes credit ratings necessary also for issuers. They also act as intermediaries to aggregate and disseminate information about borrowers’ credit history and creditworthiness. Just like outside auditors, credit agencies are prohibited to provide other services to avoid clouding their judgment. They must also be transparent regarding their rating methodology. They can be held liable for negligence, as their ratings, although being just an opinion, have a great impact on the decision-making of investors. Gatekeepers need a license provided by authorities scrutinizing their skills. This creates barriers to entry and hence a monopoly. They must also comply with operational standards and can be held liable in case of negligence. These measures provide a framework for dealing with gatekeeper failure. o RULES While mandatory disclosure helps creditors protect themselves, the rules strategy seeks to provide protection for them in a standardized form. Most jurisdictions require public companies to have a legal/nominal capital. Companies can be set up solely on condition that the legal capital requirement is fulfilled. Legal capital is a fraction of the equity capital (net worth = assets – liabilities) that shareholders pledge to maintain in the firm and not distribute to themselves in the form of dividends or otherwise until the company is liquidated and dissolved. Equity capital fluctuates as assets and liabilities change. When the former increase and the latter decrease, equity capital increases. When the opposite happens, capital decreases. The law requires that legal capital is always kept in the company, no matter what. Shareholders can allow equity capital to fluctuate as they want, yet not below the minimum legal capital requirement. By doing so, the law ensures that assets will always exceed liabilities and hence that liabilities will be repaid. It’s the value of assets that ultimately ensures that liabilities will be paid. Assets must always exceed liabilities by an amount equal to the legal capital requirement (acting as a buffer). Legal capital must not necessarily be cash. The larger the amount of legal capital, the bigger the distance between assets and liabilities, and hence greater the security. Legal capital can be changed only upon a formal shareholders’ resolution amending the charter and thereby raising or reducing it. It does not depend on the firm’s financial and economic performance. Protective measures based on the concept of legal capital are 1. MINIMUM LEGAL CAPITAL REQUIREMENTS In most countries (US, Brazil, Japan) all companies are free to establish the minimum amount that they want to indicate in their charter. In Europe, minimum requirements have been abolished for private companies. The UK was the first to do so. As the ECJ focused on the freedom of establishment, also the other MS decided to abolish these requirements. In the UK, minimum capital requirements for public companies stand at £50,000. In the EU, they stand at €25,000, but MS can provide for higher thresholds. Indeed, most do (Germany and Italy – €50,000; France – €37,000). The higher the amount of legal capital, the higher the chance that, despite a sudden decrease in assets or increase in liabilities, assets will still exceed liabilities. Therefore, creditors would like high levels of legal capital. Yet, higher requirements set barriers to entrepreneurial entry into the market. It’s complicated to find one amount that fits all businesses. 2. LEGAL CAPITAL DISTRIBUTION RESTRICTIONS Even in countries that do not provide for a minimum, shareholders must stick to the amount they decide. Therefore, dividends and cash reserves cannot be paid out to shareholders if net assets would fall below the stated measure as legal capital. In the US, the UK, and Germany, the same stands for any transaction that may threaten to let net assets fall below – disguised distributions. To be reliable in the eye of the creditors, legal capital cannot be freely reduced by means of a shareholder resolution amending the charter. Hence, European law requires the prior consent of creditors for amendments regarding the reduction of legal capital. Delaware law does not require prior consent, but decisions that impair the company’s ability to repay debts are unlawful. If debt repayment is guaranteed, companies can do whatever they please regarding legal capital requirements. 3. LEGAL CAPITAL MAINTENANCE REQUIREMENTS Equity capital can decrease for whatever reason, even if decision-makers are in good faith. Minimum requirements can be involuntarily breached. Legal capital can be used as an alerting measure to steer the company away from bankruptcy. Immediate intervention (shareholders’ meeting) is required i. if the (public) company keeps legal capital equal to the minimum amount required and net assets (equity capital) fall below this amount ii. if the (public) company provides for an amount of legal capital well above the minimum required and net assets fall below half of the stated measure the charter provides for, even if legal capital is still higher than the minimum provided by the law. That’s because such a substantial decrease in equity capital may make it difficult to go back to the previous level of liquidity. Such actions may vary from a recapitalization to a conversion into a private company. The main purpose of these measures is preventing insolvency by maintaining an adequate capital and prompting timely filing for bankruptcy. If shareholders fail to act, the company will face dissolution. DISTRESSED FIRMS The two situations in which firms are financially distressed are 1. firms confronting financial hurdles, such as temporary liquidity crisis. This is an intermediate state that can still be reversed. Assets are still higher than liabilities, yet the company struggles to find cash/liquidity to pay its liabilities. This is caused by a maturity mismatch that sees long- term assets, but short-term liabilities. Assets are illiquid 2. insolvent firms that i. have more liabilities than assets → balance-sheet or over indebtedness ii. are durably unable to pay back their debts as they fall due. Their assets may be not marketable – there are no investors willing to buy them → cash-flow test or commercial insolvency. The second type of distress is usually anticipated by the first one. CREDITORS AS NEXT DE FACTO OWNERS OF FAILING FIRMS When a company starts becoming financially distressed, shareholders are still on the driving seat. Formally, they are still in power and ownership in terms of governance rights is still on them. However, their incentives in running the firm become perverse. They may take on excessive risk (asset substitution) or forego profitable opportunities (underinvestment), appropriate asset value for themselves (asset dilution) or issue more debt (debt dilution). On the other hand, the economic ownership of the company shifts to creditors because of the priority rule. Shareholders’ claims are now