l1.

BUSINESS ORGANIZATIONS

(i) What is corporatelaw 2 (ii) Agency Problems and Legal Strategies, (i;;) The Basic Governance
Structure (excerpts from KRAAKMAN-DAVIES-I IANSMANN-I IERTIG-1IOPIi-KANDA-ROCK, The
Analoiny of CorporateLaw. A Comparative and FunctionalApproach, Oxford, 2004)
xvi Lzst of Authors
(1987-1995). He served as Visiting Professor at UCL (Louvam), ULB (Brussels),
Liège, College of Europe, Tokyo and practrced law as a member of the Geneva
bar. Recent publicatrons include Four Predzctuons about the Future of EU
Securitnes Regulation, wxth Ruben Lee (3 Journal of Corporate Law Studìes
359, 2003), European Economic and Busìness Law (de Gruyter 1996) and
European Business Law (de Gruyter 1991), both with Rmchard Buxbaum,
Alain Hirsch, and Klaus Hopt (eds.).
Klaus J. Hopt Is Director of the Max-Planck-Instìtut for Foreìgn and Private
International Law in Hamburg, Germany. Hìs main areas of specialization
include commercial law, corporate law, bankmng, and securìties regulation. He
has been Professor of Law in Tubingen, Florence, Bern, Munich, Visitrng Profes-
sor at numerous Universities and judge at the Court of Appeals, Stuttgart,
Germany. He served as a member of the High Level Group of Experts mandated
by the European Commission to recommend EU companv and takeover law
reforms. Recent publicatrons include Capìtal Markets and Cornpany Law, xxìth
Eddy Vmeersch (eds.3 (Oxford University Press 2003), Economnc Regulation
and Competìuon-Reguiation of Services in the EU, Germany andJapan, wxth
Jurgen Basedow, Harald Baum, Hideki Kanda, Toshìyukì Kono (eds.) (Kluwer
Law International 2002).
Hideki Kanda Is Professor of Law at the Universìtx of Tokvo. Hìs main areas of
specialization include commerciai laxxw, corporate laxw, bankmng regulation, and
securitres regulation. He served as Visiting Professor of Law at the Umxversity of
Chicago Law School (1989, 1991 and 1993), and Visiting Professor at Harvard
Law School (1996). Recent publìcatrons include Corporate Law (4th ed.,
Kobundo 2003-in Japanese), Comparative Corporate Governance, wìth
Klaus Hopt, Mark Roe. Eddy W7ymeersch and Stefan Prigge (eds.) (Oxford
Universitx Press 1998), Economics of Corporate Law, xxìth Yoshiro Miwa and
Noriyuki Yanagawa (eds ) (University of Tokyo Press 1998-in japanese).
Edward B. Rock Is the Saul A. Fox Distìnguìshed Professor of Busmness Law at
the Universitx' of Pennsylvanma Law School. He also serves as co-director of the
Institute for Law and Economics and has wrntten wxdely o0 corporate law, as
well as o0 the overlap betxeen corporate law and antitrust and labor law and on
the regulation of mutual funds. He has been Visitrng Professor at the Universìtres
of Frankfurt am Maìn, Jerusalem and Columbia and has practiced law as a
member of the Pennsylvanma bar. Recent publìcatrons include How I Learned to
Stop l01 1ox'ìng and Love the PM/I Takeover Law and Adaptive Behavior, xxìth
Marcel Kahan (69 University of Chicago Law Revxew 871, 2002), Islands of
Conscious Power: Lato, Norms and the Self-Governmng Corporation, wxth
Michael Wachter (149 Universitv of Pennsylvanma Law Review 1619, 2001).
L~
i
What is Corporate Law?
HENRY HANSMANN and REINIER KRAAKMAN
1.1 INTRODUCTION
What Is the conimon structure of the law of busmness corporatrons-or, as it
would be put in the UK, company law-across different national jurisdictions?
11
Although thìs question Is rarely asked by corporate law scholars, it Is critica y
iì
important for the comparative mxvestigation of corporate law. Recent scholar-
shìp emphasizes the divergence among European, American, and Japanese cor-
poratìons in corporate governance, share ownership, capital markets, and
busmness culture.' But, notwithstanding the very real differences across jurìsdic-
trons along these dimensions, the underlymng uniformir> of the corporate form Is
at least as impressive. Busmness corporations have a fundamentally similar set of
legal characterstrcs-and face a fundamentally similar set of legal problems-mn
all jurisdìctions.
Consider, in thìs regard, the basic legal characteristìcs of the busmness corpor-
ation. To anticipate our discussion beloxx, there are five of these characteristics,
most of xxhìch wxll be easily recoguizable to anyone familiar xx'ith busmness
affarrs. They are- legal personalirt, limited lìabìlitx, transferable shares, dele- i
gated management under a board structure, and investor ownership. These
characterrstics are-for reasons we illì explore-induced by the economic
exigencles of the large modern busmness enterprnse. Thus, corporate law every-
where must, of necessitx, provide for them. To be sure, there are other forms of
busmness enterprìse that lack one or more of these characterìstìcs But the
remarkable fact-and the fact that we wìsh to stress-Is that, in market econ-
omìes, almost all large-scale busmness firms adopt a legal form that possesses all
five of the basic characteristics of the busmness corporation. lndeed, most small
iointly-owned firms adopt this corporate form as xvell, although sometìmes wxth
devxatrons from one or more of the five basic characteristrcs to fit the specìal
needs of closelx held firms (Throughout thìs book, e x ill follow the usual
See, e g ,Ronald J Gilson and M\ark J Roe, Unde staidiig tbte Japaese Ke!,etsu Overlaps
Betvee a Co; poratoi Governaicea;id Inde stual Organizaitie, 102 YALE LAW JOURNAL 871 (1993),
Iark J Roe, Soie Dffereces lt Co; poraton Strtcturein ea a Japaa, ad tbe ULitied States,
9 ?
102 YALE LAWxJOLRNAL 1927 (19 3), Bernard S Black and John C Coffee, Hai> Britaznia I sta-
teioe al Investo, Begavior Un dei Limited Regulatioa. 92 MICHIGAN LAW REVIEW 1997 (1994),
Klaus J Hopt and Eddy Wymeersch (eds ),COMPARAI E CORioRrTE GOVERNANCE ESSAYS AND
NSLTERIALS (1997), and Mark J Roee POLITICAL DSTER.MINANTS OF CORPORATE GOVERNANCE
(2003)
i
i
ii
i
1
i
 3 I
What ls CorporateLaw?
2 fntroductroei
features of thìs form determine the contours of Its agency problems. To take an
practice of usmng the term ciosely held' to refer to corporatrons whose shares-
obvious example, the fact that shareholders enjoy lìmìted iiablity-while, say,
unhike those of pubhicly held' corporations-do not trade freely in impersonal
general partners in a partnership do not-has tradìtìonally made creditor pro-
markets, eìther because the shares are held by a small number of persons or it Is in partnershìp laxx. Simìlarly,
tecuton far more salìent m corporate law than
because they are subject to restrictions that limit their transferability )
Self-evidently, a prmncipal function of corporate law is to provide busmness the fact that corporate mxvestors may trade their shares is the foundation of
enterprìses wxth a legal form that possesses these five core attributes. By maikmng the anonymous tradìng stock market-an institutron that has encouraged the
this form widely avaìlable and user-friendly-i e., by altermng background prop- separation of ownershìp from control, and so has sharpened the management--
ertx rights 2 and provxdìng off-the-shelf housekeepmng rules-corporate lav- en- shareholder agency problem.
In this book, we explore the role of corporate law in mìnimizing agency
ables entrepreneurs to transact easily through the medium of the corporate
problems-and thus, makmng the corporate form practicable-in the most
entiry, and thus lowers the costs of business contractmng. Of course, the number
ìmportant categories of corporate actions and decisions. More particularly,
of provxsions that the typical corporation statute devotes to definmng the corpor-
Chapters 3-8 address, respectively, s1X categories of transactions and decisions
ate form Is hikely to be only a small part of the statute as a whole. Nevertheless,
these are the provxsions that comprise the legal core of corporate law that 1s that mxvolve the corporation, lts owners, ìts managers, and the other parties
with whom it deals. Most of these categornes of firm activity are, again, generìc,
shared by every ìurìsdiction. In thìs Chapter, we briefly explore the contractmng
rather than unmquely corporate. For exampile, Chapter 3 addresses the govern-
efficiencies (some familiar and some not) that accompany these five features of
ance mechanisms that operate over the firm's ordmnary business decisions, whìle
the corporate form, and that, we believe, have helped to propel the worldwide
Chapter 4 turns to the checks that operate on the corporatìon's transactrons wx ith
diffusion of the corporate form.
creditors. As before, however, ìf similar agency problems arnse in similar contexts
Lìke corporate law itself, however, our principal focus in thus book 1s not on
establhshmng the corporate form per se, but rather on a second, equally important across all forms of jointly-owned enterprse, the response of corporate law turns
function of corporate law: that is, constramung value-reducing forms of oppor-
in p art on the unique legal features that characternze the corporate for m.
tunmsm among the constituencìes of the corporate enterprìse. In particular, we
Taken together, the latter sIX chapters of our book cover nearly all o1 the
address three principal conflicts wìthin the corporation: those between managers
important problems in corporate law-apart, that IS,from the fundamental
and shareholders, those among shareholders, and those ben;een shareholders
project of estabiìshing the corporate form ìrself. In each Chapter, we describe
and the corporatìon's other constituencles, including credìtors and emplovees.
how the basìc agency problems of the corporate form mamfest themselves in the
All three of these generìc conflìcts give rise to problems that are usefully chárac- given category of corporate activity, and then explore the range of alternative
terized as what economists call agency problems.' Consequently, Chapter 2
legal responses that are avaìlable. We illustrate these alternative approaches with
exammnes these three agency problems, both in general and as thev arnse in the
examples from the corporate law of varlous prommnent urisdictions. WNe explore
corporate context, and surveys the range of legal strategìes that can be employed
the Datterns of homogeneìty and the patterns of heterogeneity that appear
to deal wxth those problems. Where there are signìficant dìfferences across jurisdictions, we seek to address
The reader might object that these agency conflicts-which, in our vxiex, both the sources and the consequences of those differences. Our examples are
occupy most of corporate law-are not unmquely 'corporate.' After all, arzx'
drawn prìncipally form a handful of major representative jurìsdìctìons, mncludmng
France, Germany, Japan, the U.S., and the UK, though we also make reference to
form of jointIy-owned enterprise must expect confàicts among Its owners, man-
agers, and trhrd-party contractors. We agree; mnsofar as the corporation Is onlv the law of other lurisdictions to make special pomnts
In emphasizìng a strongly functional approach to the issues of comparatnve
one of several legal forms for the jointlv-oxxned firm, it faces the same generic
agency problems that confront all ìomntly-owned firms. Nevertheless, the char-
law, thìs book dìffers from some of the more traditional comparative law
acteristìcs of rhis particular form marter a great deal, since it Is the form that Is
scholarship, both in the field of corporate law and elsewhere.4 We join an
chosen by most large-scale enterprises-and, as a practical matter, the only form
emergmg tendencv in comparative law scholarshìp by seekmng to give a highly
mntegrated vxew of the role and structure of corporate law that provìdes a clear
that widel held firms can choose in many lurisdìctions.3 Moreover, the unique
framexwork wxthmn whìch to orgaize an understandng of indnvìdual systems,
See Henro Hansmann and Rcuner Kraakman, The Essenttal Role of 0Oganarztìon1! LawE 110 both alone and in comparison with each other. Nioreover, while comparative
YALE LAW JOURNAL 387 (2000)
3 Only the corporate form is available in mam jurisdicions to the extent that large-scale enter-
Compare. e T- Axthur R Pinto and Gustavo Visenein (eds ),THE LEGAL BAsIS OF CORPORATE
prises are forced to look to the pubhe equie markets for financing Some jurisd9cions permit the
GO; ERINNCE IN PUBLICLY HELD CORPORATIONS, A COMPARATIE EAPPROACH (1998!
equiei of non-corporate entities co trade in the public markets as well for exaiple in the U S e the
partnersheps and emited labìlltx companics mav be S Other exampies of ths trend include Dennis C Nueller and B Burcci Yurtoglu, Coi try Legal
equinr secureties of so-called master' blted ECONOMIC RE IEI 187 (2000),
En-io1i1rents aod Corporate o:zest"a.e-t Perofr;ance. 1 GERMLAN
registered for pubhc tradìng
 4 Intrroducgìoee What ìs Corporate Law? 5
laxx scholarshìp often has a tendency to emphasize differences berveen ]uris- to those xx-ho simply xx'sh to have a more solid framexwork wxthmn wxhich to vxew
dìctions, our approach ìs to focus on similarìtìes. Doing so, we behexve, illumin- theìr own country's corporation law.
ates an underyming commonaliht of structure that transcends national boundaries. Likewxse, xx'e take no strong stand here in the current debates on the extent to
It also provides important perspective on the potential basis for the international which corporate law is or should be 'convergmng,' much less on wxxhat it might
integration of corporate law that must necessarily take place as economic activity converge to 7oThat Is a subject on whìch reasonable minds can differ. Indeed, it is
continues to become more global in scope in the decades to come. a subject on xxhìch the reasonable mmds that ha've wrrtten thìs book sometimes
We realize that the term 'functional,' which ve have used bere and in our titIe, differ.8 Rather, we are seekmng to set out a conceptual framexxwork and a factual
means dìfferent thmgs to different people, and that some of the uses to which basis with whìch that and other important issues facmng corporate law can be
that term has been put in the past-partnculariy in the field of sociology-have
frultfully explored.
made the term justifiably suspect. It *vould perhaps be more accurate to call our
approach 'economic' rather than 'functional,' though the sometimes tendentious
use of economic argumentation in legal literature has also caused many scholars, 1.2 WHAT 15 A CORPORATION?
particularly outside of the Umted States, to be as wary of 'economìc analysis' as
they are of 'functional analsisi.' For the purposes at hand, however, we need not As w-e noted above, the five core structural characterrstics of the business corpor-
commit ourselves on fine points of social science methodology. We need simply atron are' (1) legal personalito, (2) limited liabilirv, (3) transferable shares, (4)
note that the exigencies of commercial activity and organization present prac- centrahized management under a board structure, and (5) shared oxxnership by
tical problems that have a rough similarity in developed market economieì contributors of capital. In virtually all economically important jurisdictions,
throughout the world, that corporate lavv everywlAhere must necessarily address there is a basmc statute that provides for the formation of firms xxìth all of these
these problems, and that the forces of logic, competition, interest group pressure, characterrstics, at least as the default regime. Thìs ìs to say that firms formed
imitation, and compathbility tend to lead different jurisdìctions to choose under the statute xill have these characteristìcs unless ììf the statute permits)
roughly similar solutions to these problems. those who form the firm make expiìcìt provision for omittng one or more of
That is not to say that our objective here iSjust to explore the commonahity of them. As thìs pattern suggests, these characteristrcs have strongly complemen-
corporate law across jurisdictions. Of equal importance, xve wxsh to offer a tarx qualiies for many firms. Together, they make the corporation unmquely
commnneoe 1anguage and a general analytic framewo; k with which to understand attractive for orgamzing productìve actxvity. But these characterìstrcs also gener-
the purposes that can potentially be served by corporate law, and viith which to ate tensions and tradeoffs that lend a distrnctxvely corporate character to the
compare and evaluate the efficacy of dìfferent legal regimes in servig those agency problems that corporate law must address.
purposes 6 Indeed, it ISour hope that the analxsis offered in thìs book will be of While our principal focus mson companeìs that share all five of these core
use not only to students of comparative lawx, but that it will be equally valuable characterìstics, firms that have only some but not all of these characteristics are
also commornplace. Sometmes these firms are formed under a jurisdiction's basie
corporation statute, takmng advaniage of the statute's flexibìlìty to omìt one or
Rafael La Porta. Florencio Lopez-de-Silanes, Andrei Shbeifer and Robert W, Vishn, LaEw aerd Fnrce more of the characterrstics that are provxded for simply as defaults Other times
106 JOLRNAL OF POLITICAL EcoNo0y 1113 (1909S) Henrv Hansmann and Ugo Olenei, lte I-ore
tLons of Tost Lat
E Com-paative Legal Econo;,c
rrt e Anal'ses, 73 NE\WxYORK UNIVERSIT-Y LA
these firms are formed under special close' corporation statutes that, in addition,
REVIEW 434 (1998), Konrad Zexxgert and Hern Kotz, INTRODUCTION TO CONIPARAIrVELAW
(3rd ed provide mechanisms for restrrctrng the transferabhiiii of shares-such as those
translateed from the German bxTonvxXIeir, 1998) Ugo Mattei, COMPARATIVE LAWx AND ECONONIICS
(1997)
Coxpare Lucian A Bebchuk and lark J Roe, A TTeIofo Piath Deperndererer Corporate
6 In very general terms, our approach echoes that taken bx Dean Robert Clark in
treat!se, CORPOR TE LAW (19")6 and Frank Easterbrook aid Daoiel Fschel, inthehrhìsmore
important ur1zers4arrdGor ere, 2 STG1NFORD LAXXREVIEW 127 (1999), Willam M Bratton andjoseph
recent A McCaher, Coparatpree Co'po Go acrdthe Theory of the Firnz TIe CaseAgaest
Cte rernane
discussion of US I xa THE ECONONIIC STRUCTURE OF CoRToRATE LAW (1991) Hox ever, our Global Cross Refe1ene, 3S COLUIrceA JOLRNAL oF TRrNSNATIONAL LAe 213 (1999), John C
analysis differs from-and goes bevond-that offered bh these and other commentators rnse erai Coffee, The F'urie as Hrsto v TIe Pr spets fúor Global Coi ergerce in Corporate GoVerianee
kex respects Frst,and mostob louslTepresenta compparate canaly
0 thaeaddressesthecorporate aredirs sge1r Garce. 93 NoRxHWESTERN UNIVER5ixmLA-C REGIEGx 641 (1999), RonaLd J Gilson,
lavx of multpl'peoe iursdctons Second, we proxide an integrated furictional oxerne that
h tressec the Globalizzr'g CoGporte Goveriene Co;zvergezce ofFormro Ferree ,49 AMERICN JOURNALOF
ag e ncx prob.ems a, the core of corporate lax, rather than focusong on
more particular leeal inst- CoMPARGATIVE L,4W3 9(2i001, andAmo r Nx Leche The iMother of Al IPathDeI edeeies Torarda
tunon0s and soluaons Frnally,
iv offer a more expansive account than do other commentators of the CrOSS-ir tra TI of CoporaGe Govie r''iS 26 DEL.4WARE
'stes JOUR NAL OF COREOR4TE
functions of central features of the corporate form such as lirted labilebo and
the goxernance LAx 147(2001j
structure of the corporate board Our anaeoses, more cer is 0nformed not only by
a comparatmve The xexxs ofthe prncipae authors ofthis chapter are briefly set out In Heorrx Haesmaxn and
perspectr e across ju1sdctions, but also bo a comparateì e perspect eeacross legai
forms for busress Reir erKreakman, The Endof Htstoro'fo Co poiate Law, 89GEORGEoXXN LAWxJOLRNAL 439
enterprìse
¢2001)

L

6 hat msa corporatron?
Wb
governmng the German Gesellschaft mmit beschranktier Haftung (GmbH), the
French Société à responsabìlìté limitée(SARL), the Britìsh private corporation,
theJapanese close corporation, and the close corporation forms that are pro-
vided for in someU S. ìurisdìctions. M ost of the larger firms organzed under
these statutes are full corporations in precisely the sense thatwemntend But even
when a closely held firm drops a core feature of the corporate form (typically
the board of directors), it shares the remamnng characteristìcs and problems
of thìs form. Likewvse, our analhsis extends to important aspects of legal
regìmes addressed to the regulation of corporate groups, such as the German
Konzernrecht 9
Much ofwhatv e say here also apphies to firms that are governed by special
0 1
statutes-such asthose for limited liability companies1 or busmness trusts 1-
that omìt one or more of the core characteristrcs from theìr default regime
Whlie these statutes are not corporate law statutes,12 our analysìs offers ìnsìghr
into the interpretation of these bodies oflaw, and we shall occasionally address
them expiictlr
1.2.1 Legal personality
As an economic entitr, a firm fundamentally serves as a nexus of contracts: a
smngle contractmng party that coordmnates the actìvities of supphiers ofmnputs and
of consumers of products and servxces 1' The first and most important contrìbu-
9 \\hlìe group law is most deieloped in Germany, other nurisdictions have elements of group lax
as well S5eee g, Klaus j Hopt (ed !, GROUPS OF Compe iEs IN EUROPEAN L'avs LEGAL 0ND
ECoNOMIC AcALYSSEi ON MULTINATIONAL ENTERPRISES (1982), Cli M8 Schmìtbhoff and Frank
nooldrìdge (ds ), GROUPS OF COMPANIES (1991) See also lrfa 4 1 2
T' American
Ihe a mitedieadlitne company statutes,i hxch are ofrcatnr elxrecent oregin, are not the
equoaleni of the European close corporarion statutes, such as the German GmbH statute or the
French SARL statute Rather, the AmericaneImted habi1it compani is a ieghlx f exible hcbrìd of
corporate and partnershrp forms that does not impos eether delegated management under a board
structure or transferable shares as the default rege e See,e g. National Conference of Commission-
ers on Uniform State Lxxs ULiforn Limnted Lìabilite Companx Act £5203, 405, 502. 503 (1995)
The bushiess trust is a statutore form that has doxeloped in che UL as an ccolution of the basic
Anglo-Areriean prix atetrust In its contemporary form-perhaps best ollustrated bx the busiess trust
statute found mothe US state of Delaxxare-theform ices eintoalh an eeptx shell It procides forxxhat
cxterm belohxffirmaive asset parateoning, as xell as for licted hablite Other features of an
organization formed under the Act-includig the goxernance structure and rights to ecarngs and
assets-are left to be specified (in the cere5cate of crustibl the firm s organzersc cN ith vxrtuallx no
restramts imposed on the choices that cai be made For further discussion and references, seo
Hansmann and 1vIattei, supa note 5 Hansmann and Kraakman. sipa note 2
12 See infca 1 3 1
Ti tnexusofcontract image of thefironcrgonates th ichael Jensen and WlliamMeìklìng,
'zersp5ip 3 joURNAL OF
T,'7eory of the F irmMaSageira1 Beh.avto', Ageicy Costs adiOs Stctu'e,
FIN NCIAL ECONomics 305 (1976), buIlding on Armen Alchian and Haroio Demsetz, Proai'c'ono,
adeot.E i ì»cO re: cc er 62 AxEeRIC ' ECOrNxeIC RcIE; e 77 (1972) We
I ri e e coiCn Zzat
mean thos description hterall a firx is in fact, the comoeon legai counterpartc- in numerous contracts
x'rth suppiers, emploxees and customers W edo not comment on v hy production is organozed in this
fashìon, nor do ote h controvers oaer xhether relatconships among the firm and its pariciipants
contractual terms See, eg, Robert Clark, Agency Costs Veisus
can be described exhaustn eoiny
F'evC'ac. Dc,1es, in John W' Pratt and Rìchard J Zeckhauser (cds), PRINCIPALS ecoDA 1ENTS
What ls CorporateLaw? 7
tnon of corporate law, as of other forms of organizational laxx, is to permit a firm
to serve this role by providing for the creation of a legal person-a contractmng
party distìnct from the various ndìviduals xwho own or manage the firm, or are
suppiìers or customers of the firm.14
The core element of legal personaiity (as we use the term here) Is what the civil
law refers to as 'separate patrrmony.' This is the abhiìty of the firm to own assets
that are distinct from the properrt of other persons, such as the firm's mnvestors,
and that the firm is free not only to use and sell but-most importantly-pledge
to creditors. Elsewhere we have termed this asset-pledgmng effect of legal person-
ahty 'afftrmative asset partìtioning' to emphasize that it involves shìelding the
assets of the entiìy-the corporatron-from the creditors of the entity's managers
and owners."s
Where corporatrons are concerned, there are iwo relatìvely distinct rules of
law mxvolved. The first Is a priority rule that grants to creditors of the firm, as
security for the firm's debts, a clalm o0 the firm's assets that Is prior to the claims
of the personal creditors of the firm's owners. Thìs rule is shared by all modern
legal forms for enterprnse organization, mncludmng partnershìps. The consequence
of this priority rule ISthat a firm's assets are automatìcally pledged as securnty for
all contractual ilabliìtres entered into by the firm. Its obvìous advantage lS to
increase the credibiliìy of the firm's contractual commitments.
The second rule-a rule of 'liquidation protection'-provides that the individ-
ual owners of the corporation (the sharehoiders) cannot wxthdraw their share of
firm assets at wll, thus forcmng partial or complete liquidation of the firm, nor
can the personal creditors of an mdivxdual owner foreclose o0 the owner's share
of firm assets. Thìs liquidation protection rule serves to protect the going concern
value of the firm against destruction either by mdivxdual shareholders or their
creditors. In contrast to the prioritr rule just mentioned, it Is not found in some
other standard legal forms for enterprise organization, such as the partnershìp.
Legal entitìes, such as the busmness corporation, that are characterized by both
these rules-priority for business creditors and liquidation protection-can
to
therefore be thought of as having 'strong form' legal personaiiy, as opposed
personahity found in partnerships, which are characterized
the 'weak form' legal
only by the priority rule and not by liquidation protection.
The pattern of credìtors' rights created by strong form legal personality 1s, in
effect, the converse of that created by limited hiablìity. It protects the assets of the
THE STRUCIURE OF BUSINESS 55 (1984) What matters for our purposea s that the firm organizes
produetion in large part bx entering formal contracts with numerous other partits
persons, in
l sometimes saìd that partnerships (or trusts, or varlous other forms) are not legal
14 Ir
of legal personai tc
contrast to corporat0ons Jurìsts who take that x iex hax e, of course, a conception
xed in terms of the
that differs from ours Our ovxn xiew Is thar legal personalirt is most helpfully vxi
here Those mxho are uncomfortable wxth this use of the term
rules of creditors' rìghts xw describe
n itself and Is
'legal personaiti' can simpli inore our use of that term bere, wvhich iS not Important
anything broader than what x*e say, and focus imstead o0 the specific rules of lax
not meant to suggest
that wxedeseribe under that heading
'5 See Haonsmann and Kraakman, sup ca note 2

8 What rs a corpo;atrtn?
firm from the creditors of the firm's oxvners,whxle limmted liabiliry protects the
assetsof the firm's owners from the clamms of the firm's credators. Strong form
legal personahity remnforces the stabiiitx and credivmorthmness of the firm and,
when combmned wxth limmted liabmlity, isolates the value of the firm from the
personal financial affairs of the firm's owners sufficientiy to permit the firm's
shares to be freely traded.
The priority rule component of corporate legal personaiitv requires special
legal doctrmne to be effectxve. It could not feasibly be replhcated, in the absence of
such doctrmne, smmply by contractmng among a busmness's owners and their
credìtors because contracts among these parties cannot bmnd the mdivxduai
creditors of the firm's owners.16 The same Is true of the liquidation protectaon
feature of corporate law so far as it bmnds the creditors of a firm's owners. (The
owners could bmnd themselves not to liquidate the firm simply by contract, as
members of partnershmps in fact often do.) This distmnguishes legal personahity
from the other four basic elements of the corporate form discussed here, which
could all in theory be crafted by contractual means even if the law dmd not
provide for a standard form of enterprise organization that embodies them.17
1.2.2 Limìted liabriity
The corporate form effectxvely imposes a default term in contracts betveen a
firm and Its credmtors whereby the credmtors are lmmted to makmng claìms agamnst
the assets that are the property of the firm mtself, and have no further claim
agamnst the personai assets of the firm's shareholders (or managers). This limita-
tion of ownerhiability distmnguishes the corporate form from some other import-
ant forms of organization that have legal personahityx (as we define the latter
feature here), mncludmng in particular partnershmps.
Historicalli, limited lmablimty has not always been associated with the corpor-
ate form. Some important corporate ìurisdictrons long made unimmted share-
holder ilability for corporate debts the govermng rule.18 Nevertheless, today
16 To estabhsh the prioritr of busness creditors b contract, a firm's o;;iners wouid ha1e to
contract
v, ith cs bushness creditors to include subordinatcon pro iscons, wath respect to business assets, in all
contracts bereen individuai o'ners ano ind ivduai creditors Noc oni; v-ouod such proriscons be
cumbersome to draft and costly to monitor, but thev v ould be subnect to a hcgh degree oc moral
hazard-an indincdual o vner could breach her promise to subordvate the claims of her personal
credio on thefirm's assets rvth Impuntn snce thi promnse v ould be unenforceable aganst personai
credotors 'ho vcre not party to the bargain Sie Hansmann and Kraakmanr spra note 2 407-9
1 See id Authoric- doctrnes' which determie ahe n agent has powrer to bcnd her principiC to
contracts, and which form a component of the fourth characteristic (delegated managementj of the
corporate formc descrcbed here, arguabli also requore background rules of lae, and hence constrtute an
exceptcon to this statement See John Armour and M1chaei Whmncop, Tbe op7,cetar- ' Stroctvre of
Co porate LaoL (Working Paper 2001)
s Limted ihabiicty did nor become a standard feature of the Britesh law oi jocnt stock companies
untdi the did-nneteenth century, and in the American state of California sharcholders bore unimnced
personal hIablIirr for corporatcon obligatcons untlr 1931 Sec Paui L Davies, GoWER AND DAVIE55
PRINCIPLES OF MODoRi COMPANiY LAw' 40-46 (6th ed, 1997, Phillp Blumberg, L2imcted LiabclEi
a-d Coipo'ate Groi ps. 11 JOURNAL OF CORPORATE LA; 573 (198)6
What 1S CorporateLaw? 9
limsted liability has become a nearly universal feature of the corporate form. Thìs
evolution indicates strongl the value of limited ilability as a contractmg tool and
financmng device.
Elsewhere we have described hmuted liabilitv as 'defensive asset partitìonng'
to dìstingush it from the 'affirmative' partitiomng effects of legal personaiity.19
While legal personality permits the busmness to own assets, and thus serves as a
kind of floating hen favormng busmness creditors over the mdivxdual creditors of
mxvestors and managers, hmited liabiliry reserves shareholders' mdixvduai assets
exclusively for their personal creditors. Thus, legal personahiry and limited
liabìlìty together set up a default regime whereby a shareholder's personal assets
are pledged as security to his personal creditors, while corporation assets are
reserved for corporation creditors. In an enterprise of any substantial magnitude,
this allocation generally mncreases the value of both types of assets as security for
debt. It permìts creditors of the corporation to have first claìm on the corpor-
ataon's assets, wxhich those creditors have a comparative advantage in evaluatìng
and monitorìng. Converselv, it permits an mdivxdual's personal creditors to have
first clanm on personal assets, whhch those creditors are in a good position to
evaluate and monitor and which creditors of the corporation, conversely, are
not in a good position to check. As a consequence, legal personality and
limited liability together can reduce the overall cost of capital to the firm
and Its owners.
A related aspect of asset partitioanng is that limited hlability permits firms to
isolate different ines of busmness for the purpose of obtammng credit. By separ-
ately mncorporatmng, as subsidiaries, distirict ventures or lmes of busmness, the
assets associated with each venture can convenmently be pledged as security just
to the creditors v ho deal wxth that venture. Those creditors are commonly well
positioned to assess and keep track of the value of those assets, but may have
ittle ability to monitor the corporation's other ventures.
Finally, by virtue of limited hability, the formation of corporatrons and sub-
sìdiary corporations can be used as a means of sharmng the risks of transactions
with the parties wxth whom a firm contracts, in situations in which the latter
partres are in a better position to bear those risks. Thus, lìmìted liablhty can play
a valuable contractmng role even in smtuatrons where a corporation has a single
shareholder who does not require the corporate form to raise equity capital, as in
20
the case of the parent companx of a wholly owned subsidiary.
Bevond thìs function of defensmve asset partìtioning, lìmìted liability permìts
flexibmlity in the allocation of rìsk and return between equitrxholders and debt-
holders. reduces transactmon costs of collection in case of mnsolvency, and
Se Hansmann and Kraakman, sipra note 2 Note tha tthe dcfensaie asset partctìoning estab-
lìshed bRa rule of limnied icabolit- is less fundamental, in the sense that it can be achice ed by contract.
o ithout statutor fiae, t lowver cost than can the avfirmative asset partctionng estabchshed by the
dotroial element of legal persona0icc Id
Sec, e g , Rcchard Posner, The Reghts of Ciedttorsof Affiliated Corporatciocs,43 UNoc ERSITY OF
7°
CHICAGO LAkw REvIEw 499 (19-6), Henr; Hansmann and Reinier Kraakman, ToIard U1zil ed
Sbrreilgoler Lcabdit for Corpo ate Torts, 100 YALE LAW JOURNAL 1879 (1991l
-
 10 What ls a corporation?
smplhfies and subsrantially stabilizes the pricing of stock 2 '-something we shall
say more about below in the discussion of transferability of shares.
Limited liability also plays an important function-but more subtle and less
often remarked-mn facliitating delegated management, which Is the fourth of
the core characteristrcs of the corporate form. In effect, by shiftig downside
busmness risk from shareholders to creditors, hmited liability enhsts creditors as
rnonitors of the firm's managers, a task which they may be in a betrer position to
perform than are the shareholders in a firm in which share ownership Is widelv
dispersed. 2 2
We should emphaslze that when we refer to Imìted liablìhry, vve mean speci-
fically limnted liability in contract-thatIs, hmited ilabiiity to voluntary creditors
who have contractual claims o0 the corporation. The compellng reasons for
limnted liabhity in contract generallv do not extend to limited liabilityin tort-
that Is, Imuted shareholder liability to persons who are involuntary creditors of
the corporation, such as third parties xxwho have been injured as a consequence of
the corporation's neghigent behavior. Limited liablity to mivoluntary creditors is
arguably not a necessary feature of the corporate form, nor even a sociallr
valuable one, as we discuss more thoroughly in Chapter 4.
1.2.3 Transferable shares
Fully transferabie shares in ownership are yet another basic characteristic of the
busmness corporation that djstmngoshes the corporatron from the partnershìp and
from varlous other standard-form legai enhtrles as well. Transferability permrts
the firm to conduct busmness uninterruptedly as the identitv of Its owners
changes, thus avoidìng the compiìcatrons of member wxithdrawal that are
common among, for example, partnershìps, cooperatives, and mutuals. Thìs in
turn enhances the liquidity of shareholders' mnterests and makes it easìer for
shareholders to construct and maintamn diversified mxvestment portfohios.
Fully transferable shares do not necessarily mean freely tradable shares. Even
if shares are transferable, they mav not be tradable without restriction in publhc
markets, but rather just transferable among limìted groups of mdixdvduals or with
the approvai of the current shareholders or of the corporahion. Free tradabilitx
maximìzes the liquidity of shareholdmngs and the ability of shareholders tó
diversify theìr investrments. It also gives the firm maximal flexibìitrv in raisìng
capirai. For these reasons, all jurisdictions provide for free tradability as the
default regime for at least one class of corporations (sometimes referred to as
'open' corporations) However, free tradablirty can also make it difficult to
21 See. , Paul Halpern, \,ichael Trebilcock and Stuart Turinbull. An Econ- n Analysis
4c
Lirnited Labiliti in Co Poritzoi Leam, 30 UNIVERSìTY oF TORONTO LAWx JOUR.NAL 117 (1980,
Frank Easrerbrook and Daniel Fischel, Lz1izted Liabilrt and tbe Couporatzon, 52 UNIVERSITY
3 OF
CHicAGo Lkw REv Ew 89 (1985), Susan E Woodvs7ard, Leenited Ltability in te Theor
y of te Fi ìn.
141 JOURNAL OF INSTITUTIONAL AND THEORETICAL ECONOMICS 601 (198Si
22 See Haansmano and Kraakmoan, sipra note 2
W7hat ls CorporateLaw? 11
maintain negotiated control arrangements. Consequently, all jurisdictions also
provide mechanmsms for restrictrng transferabhiity. Sometimes this is done by
means of a separate statute, such as the special European statutes for close
corporations, while other jurisdìctions sìmply provide for restramnts o0 transfer-
ability as an option under a basic corporation statute.
Transferability of shares, as we have already suggested, is closely connected
both wxth the liquidation protection that is a feature of strong form legal
personahity, and wxth hmited liability. Absent either of these rules, the credìt-
worthmness of the firm as a whole could change, perhaps fundamentally, as the
identity of its shareholders changed Consequentily, the value of shares would be
difficult for potental purchasers to judge. Perhaps more importantly, a seller of
shares could impose negative or positive externaiities on his fellow shareholders
dependmng on the wealth of the person to whom he chose to sell. It Is therefore
not surprising that strong form legal personahitv, limited liablìitv, and transfer-
able shares tend to go together, and are all features of the standard corporate
form everyxx here. Thìs ìs in contrast to the conventional general partnershìp,
which lacks all of these features.
1.2.4 Delegated management with a board structure
Delegated management Is an attribute of nearly all large firms wxth numerous
fractional owners. Delegation permits the centralization of management neces-
sary to coordinate productive activity Equallv important, delegation of decision-
makng power to specific mdivxduals notifies third partres as to who in the firm
has the authority to make bìnding agreements. The authority issue, in particular,
quìckly becomes mntractable in a firm in which numerous owners and managers
are not distinct, as in a large general partnershìp that fails to allocate authority
by agreement and to signal thìs allocatron of authorìty clearly to third partres.
Organzational forms differ, however, in the way in whhch they delegate
management power and authority. The limited partnership and the common-
law private trust, for example, t pically mxvest full control rights in a general
partner or trustee who cannot be displaced wvthout cause By contrast, corporate
law typically vests principal authority over corporate affairs in a board of
directors or similar committee organ that is periodical1v elected, exclusively or
primarliy, by the firms' shareholers. More specificaili,. busmness corporations are
distinguìshed bv a governance structure in xxhich all but the most fundamental
decisioni are put m the hands of a board of directors that has four basic
features 23
First, the board is, at least as a formai matter, separate from the operational
of managers of the corporation. The nature of thìs separation varìes according to
This is not to sar that other legai entotnes, such as Dartnerships, business trusts, orl Inied
1iabl1nt
CO'xpanics cannot have a board structure similar to that of a txpipaicorporation, in
fact, they often
do Bur those forms, unhlce the corporation forn, do not presume a board of directors
as a matter
of law
1
1
1
t
t
-L-
12 Whbat zs a corporatron?
whether the board has one or tvvo tiers. In xxo-tier boards, top corporate officers
occupy the board's second (subordinate) tier, but are generally absent from the
first (supervisory) tier, which 1s at least nommnally mndependent from the firm's
hired officers u.e. from the firm's senior manageriai empioyees). In singie-tier
boards, in contrast, hired officers may be members of, or even dominate, the
board itself. Regardless of the actual allocation of power between a firm's
dìrectors and officers, the legal distìnction betxeen them formally divxdes all
corporate decisions that do not require shareholder approval mnto those requir-
mng approval by the board of directors and those that can be made by the firm's
hired officers on their own authority. This formal distinction bet veen the board
and hired officers facilitates a separation between, on the one hand, initiation
and execution of busmness decisions, which Is the province of hìred officers, and
on the other hand the mountormng and ratification of decisions, and the hìrìng of
the officers themselves, which are the province of the board. That separation
24
serves as a useful check on the quahity of decisìon-making by hìred officers. It
also performs the key function-noted earlher-of permittng third parties to rely
on a well-defined institution to formally bmnd the firm in ìs transactions with
outsiders
Second, the board 1s formally distinct from the firm's shareholders. This
separation econoumzes on the costs of decìsion-making by avoìding the need to
mnform the firm's ultimate owners and obtam theìr consent for ali but the most
fundamental decisions regardmng the firm Beyond this, a separately-constìtuted
board can also provide a check on opportunìstic behavxor by controlring share-
holders-either toward theìr fellow shareholders or toward other parties who
deal wxth the firm, such as creditors or emplovees-by provuding a convenient
target of personal liability for decìsions made by the firm Membership on the
board can likewise provide minority shareholders or other constituencìes, such
as employees or credrtors, wxth a means for obhamnmng credible access to mnfor-
mation or direct participatron in firm decisìon-making. Also, by assigning desig-
nated mdivxduals a specìfic role as decision-makers on behalf of the enterprnse,
the corporate form enhances the probabilit> that those mdivxduals will respond
in a prìncipled fashìon to the mnterests of all corporate constituencìes simply
thuough moral prìncìples and social pressure, quite apart from formal legal or
electoral accountability.
Third, the board of a corporation 1s elected-at least in substantial part-by
the firm's shareholders. The obvxous utility of thìs approach is to help assure that
the board remamns responsive to the mnterests of the firm's owners, who bear the
costs and benefits of the firm's decisions and whose mnterests, unhke those of
other corporate constituencìes, are not strongl> protected bx contract. Thìs
requirement of an elected board distinguishes the corporate fornx from other
legal forms, such as nonprofit corporatrons or busmness trusts, that permit or
Problems aid Residiìa' C1ZiS, 26 JOUIRNAL O
0 Age
' See Eugene Fama and 1nchae1 Jensen, acy
Lkv AND EcoNomics 327 (1983)
Wbat ls CorporateLaw? 13
require a board structure, but do not require election of the board by the firm's
beneficial) owners.
Fourth, the board ordinarily has multiple members. This structure-as op-
posed, for example, to a structure concentratmng authoriry in a single trustee, as
in many private trusts-facihrates mutual monitoring and checks idiosvncratic
decision-making. However, there are exceptions For example, most cdose cor-
poration statutes, such as those governmng Germanx's GmbH or France's SARL,
permnt business planners to dispense with a collective board in favot of a single
generai director or one-person board-the evxdent reason bemng that, for a very
small corporation, most of the board's legal functìons, mncludmng ìts service as
shareholder representative and focus of iability, can be discharged effectively by
a single elected dìrector who also serves as the firm's prtncìpal manager.
1.2.5 Investor ownership
There are tWo key elements in the ownershìp of a firm, as we use the term
'ownership' here. the rnght to control the firm, and the right to receive the
firm's net earnngs. The law of busmness corporations Is principally designed to
facilitate the organization of investor-ov7ned firms-that 1s, firms in which both
elements of ownership are tied to mxvestment of capital in the firm. More
specifically, in an investor-ouwned firm, both the rnght to participate in con-
trol-which generally mivolves votmng in the election of directors and votng to
approve mai or transactions-and the rtght to rececve the firm's residual eartnngs,
or profits, are typically proportional to the amount of capital contrtbuted to the
firm Busmness corporation statutes universally provide for thìs allocation of
control and earnmngs as the default rule.
There are other forms of ownership that play an important role in contem-
porarv econoumes, and other bodies of organìzatìonal law-mncludmg other bodìes
of corporate law-that are specifically desìgned to facilitate the formation of
those other types of firms.25 Por example, cooperative corporation statutes-
which provxide for all of the four features of the corporate form just descrìbed
except for transferabie shares, and often permit the latter as an option as weil-
allocate voting power and shares in profits proportionally to acts of patronage,
whìch may be the amount of mnputs supphied to the firm (in the case of a producer
cuuperative), or the amount of the firm's products purchased from the firm (in
the case of a consumer cooperative). Indeed, busmness corporations are effect-
ively a special kmnd of producer cooperative, in whìch control and profits are tred
tu supplv of a particular type of mnput, namely capitai. As a consequence,
business corporatìons could, in principie, be formed under a 'ell-designed
general cooperative corporation statute. But the law provxdes, instead, a special
For a discussion of the varieties of forms of oxvnership found in Contemporan economTic
and their resp-cml. economic roles, arn of the reiaronshdp be reen these forms and rhe differem:
bodìes of organizationai la; that govern them, see Henry Hansmaio, THE ONaERSHIP OF ENTER
PRISE (1996)
14 Wbat lS a corporatìon?
statutory form for corporations owned by mnvestors of capital ('capital coopera-
tuves,' as we might thmnk of them).26
Thìs specialization follows from the dommnant role that mxvestor-owned firms
have come to play in contemporary economìes, and the consequent advantages
of havmng a form that Is specìalized to the particular needs of such firms. and that
signals clearly to all mnterested partres the particular character of the firm xxith
which they are deahing. The dominance of mxvestor ownershìp among large firms,
in turn, reflects several conspicuous efficaency advantages of that form. One Is
that, among the varìous partìcipants in the firm, mxvestors are often the most
difficult to protect simply by contractual means.27 Another Is that mnvestors of
capital have (or can be mnduced to have) peculiarly homogeneous mnterests among
themselves, hence mrnimizìng the potential for costly conflict among those who
share governance of the firmn.'
Specialization to mxvestor ownership is yet another respect in whxch the law of
busmness corporations dìffers from the law of partnershìp. The partnershìp form
typically does not presume that ownership Is tied to contribution of capitali, and
though it Is often used in that fashion, it Is also commonly used to assign
ownershìp of the firm in whole or in part to contrnbutors of labor or of other
factors of productron-as in the prototypical two-person partnership in whìch
one partner supphies labor and the other capital. As a consequence, the busmness
corporation IS less flexible than the partnership in terms of assigning ownershrp.
To be sure, wìth sufficient special contractmng and mampulation of the form,
ownershìp shares in a busmness corporation can be granted to contrìbutors of
labor or other factors of production, or in proportion to consumption of the
firm's services. NlIoreover, as the corporate form has evolved, it has achieved
greater flexibility in assigning ownershìp, eìther by permitting greater devxation
from the default rules in the basìc corporate form (e.g., through restrìctions on
share ownershìp or transfer), or bv developmng a separate and more adaptable
form for closely held corporations. Nevertheless, the default rules of corporate
law are generally designed for mxvestor ownership, and devxation from thìs
pattern can be awkward The complex arrangements for sharng rights to
earnngs, assets, and control between entrepreneurs and mxvestors in hìgh-tech
start-up firms offer a familiar example.29
Somehìmes corporate law itself devxates from the assumption of mxvestor
ownershìp to permìt or require that persons other than mxvestors of capital-
for example, creditors or employees-particìpate to some degree in eìther con-
trol or net earnngs or both. Worker codetermination Is a conspicuous example
Cooperati e corporation statutes, in turn coirnonly prohibit the grant of omnershlp shares-
iotngrights
and rights to a share of profits-to persons Nvho s1rpIy contribut" capital to the firm,
thus pre' enting the formation of 1nyestor-o ned oirms under the cooperative corpora-non statutes
27 Sen,g.OIix rilam Coiporate Gov tae, 93 YALE LAx JOUaNAL 1197 (1984)
2S See Hansmann, slpra note 25
29 Stephen N Kapian and Per Stromiberg, Ftnanctal Co?2cracttig Taieo; Mees tic Reat Wo1 ld A
E- Ptrtcat A tal)szs of
a eItu7
t apitaI CGotr-acts, 70 REVIEW OF ECoNOtMIC STUDIES 281 (2003!
Wbat 1s CoirporateLaw? 15
The wxsdom and means of provxding for such non-imvestor participation remams
one of the basic controversies in corporate iax.7 We shall of course address this
subject further in Chapter 3.
Most jurisdictions also have one or more corporate forms-such as the U.S.
nonprofit corporation, the civil law foundation and association, and the L1K
company Imìted by guarantee-that provxde for formation of nonprofit firms.
These are firms in which no person may participate simultaneouslx in both the
right to control and the rìght to residual earnmngs (which is to say, they have no
owners). These nonprofit coraorations, however, lhke cooperative corporations,
wflI not be within the specific focus of our attention here. Thus, when we use the
term 'corporation' in this book, we refer only to the busmness corporation, and
not to other types of incorporated entities. When there Is potential for ambiguìty,
wCe Wxi exphicltly use the term 'busmess corporation' to make specrfic reference
to the mxvestor-owned company that Is our principal focus.
1 3 WsHAT DOES CORPoRATE LAWx INCLUDER
All jurisdìctions have a least one statute that establishes a basic corporate form
wxth the five characteristics descrìbed above. Nevertheless, corporate law as we
understand it here generally extends well beyond the bounds of thìs core statute.
1.3.1 Secondary and partial corporations forms
First, all major 3urisdictìons have muinple secondary or partial corporate law
statutes. Secondary statutes include separate statutes for special classes of firms
such as foreign firms or governmentally owned enterprise. Partial corporate lawx
statutes provide for separately defined statutory entitres that have, or at least are
permitted to have, some but not all of the five core characteristìcs descrnbed
above. Examples include limìted partnershìps, lìmìted liabilIty compames, and
statutory busmness trusts. To the extent that these forms include the core charac-
terìstìcs of the corporation, our discussion will help to illuminate theìr role and
structure.
We consider close compames-the German GmbH, the French SARL, the
japanese close corporation, the American close corporation, and the Brìtìsh
private corporation-to exhibit all of the canonical features of the corporate
form. They differ from pubhlc companmes chiefly because theìr shares, though
transferable at least in principle, do not trade freely in a publìc market By
contrast, statutes that merely permit busmness planners to create firms wxth the
legaI characteristìcs of busmness corporations, such as typìcal American Iimlted
lìablìity company statutes and busmness trust statutes, are not corporate law
statutes. Large scale enterprise, regardless of its statutory orìgìns. tends to
exhibit most or all of the core characterìstìcs of the corporation form. But a
body of statutory or decisional law belongs to corporate law only to the extent

16 'What does corporate law include?
that it provides for, or at least responds to, these characterìstics. It does not
belong to the extent that it is mereiy an empty vessel within which planners may,
by contractmng, create a contractually-devxsed corporate form On the other
hand, the analysis offered in thus book also offers insight Into the interpretateon
of those bodìes of law where they are used to form entìties that share the
characteristics of busmness corporations.
1.3.2 Additional sources of corporate law
There are bodìes of law that, at least in some jurisdlctions, are mncorporated in
statutes or decisional law that are separate from basic corporate law, and from
the alternative forms just described, but that are nonetheless exclusively con-
cerned with particular core characteristics of the corporate form as we define
them here.
To begin, the well-known German law of groups, or Konzerznrecht, quahfies
limìted labihity and hmìts the discretion of boards of directors in corporations
that are closely related through cross ownership, seekmng to protect the creditors
and mneorìty shareholders of corporations v ith controlring shareholders. Where
subsidiarics are organmzed under the open corporation statute (Aktnengesetz), the
rights of controlled compames are dehmìted by this statute itself, which provides
for the regulation of both contractually formahzed group relationships and de
facto control relationships among corporatìons. Where subsìdiaries are organ-
lzed under the close corporation statute (GmbH-Gesetz), the parallel laxx of
corporate groups is judge-made rather than statutory. Either way, however,
Konzermnrecht Is clearly an integrai part of German corporate laxw (We describe
the German Konzerrzrecht in greater detail in Chapter 4.)
Similarly, the statutory rules in many unrsdìctions that require emplovee
representanon on a corporatìon's board of directors-such as, conspìcuousl-,,
the German or Dutch law of codetermìnation-quali5- as elements of corporate
laxw even though they occasionally originate outside the principal corporate law
statutes, because they impose a detalled structure of employee parricipation o0
the boards of dìrectors of large corporations American securities law, which
applhes to large corporations, importantiy structures board representation by
establishing elaborate election procedures, regulatmng transferablixty of shares in
varìous contexts, and imposing detalied disclosure rules. Stock exchange rules,
which can regolate numerous aspects of the internai affairs of exchange-lhsted
firms, can also serve as an additional source of corporate laxx, as can other forms
of self-regulation, such as the UK's Cìty Code rules o0 takeovers and mergers 30
These supplemental bodies of law are necessarily part of the overall structure
of corporate law, and we shall be concerned here wxith all of them.
' Ve rerm such self-regulation a source of'law; in part because it is comonlm supported, directly
or indicecty, by la;; in the narro sense The seif-regulatora authoritn of the American stock
exchanges, for example, ISboth reinforced and constracned b5 the U S Securmtes Exchange Act and
the adninistratn e ruìes promulgated b>the Securite;s and Exchange Commission under that Act
Li
.4
IX hat lS Corporate Law? 17
1.3.3 Non-corporate law constramts
There are, of course, many constramnts imposed o0 companìes by bodies of law
designed to serve objectìves that are largely unrelated to the core characteristics
of the corporate form, and therefore do not fall within the scope of corporate law
as we define it here.
Bankruptcy law, or 'nsolvency laxwv,' as it is termed in the UK, Is an example. As
wehavenoted, a majorcontribution of the corporatron as a legal form Is the abihty
to partition assets for purposes of pledgmng them as security to different groups of
creditors. Bankruptcy laxx plays an important role in enforcmng the claìms that
derive from this partitionmng Nevertheless, the problems of bankruptcy presented
by corporatrons are often shared by other rypes of legal entities, and the elements
of bankruptcy law that address those problems are not, in many jurisdictions,
confined to entities formed as busmness corporations.31 Consequenry, we do not
treat most aspects of bankruptcy law here as part of corporate law
Similarly, although the types of firms that typìcally organize as corporations
present-particular problems for tort liabiit>y-especíally when it comes to the
liabìlity of the corporation for the acts of corporate employees-these and other
problems addressed by tort law are often presented by other types of entìtìes, and
we do not address them here directly. Much the same Is true, moreover, for the
types of issues traditionally considered within the realm of contract law, criminal
law, and labor law. Whlie, in each of those areas, firms organmzed as corporatìons
present, to some degree, particular problems, those problems are not so distìnct-
ively connected to the core features of a corporation as to lead us to address them
here as part of what we consider basìc corporate law.
There are, however, some exceptions. For example, the UK doctrmne of 'wrong-
ful tradmng' in insolvency, whlie formally an aspect of bankruptcy law, focuses
specafically on the dutres of corporate directors. The problems of labor contractmng
presented by large firms are, in some ìurisdìctions, addressed by specific regulation
of the basie elements of the corporate form as we have described them here, such as
the composition of the firm's board of directors. The extension of himited liabilrty
beyond contract to tort, which has come to be considered a basic feature of the
corporate form nearly evervxwhere, iS another exception. In cases such as these,
there IS a blurrmng of the boundarìes betxecen corporate law and other fields of
laxx-bankruptcv, labor, or tort law-that must be addressed here
1.4 WHAT IS THE GOAL OF CORPORATE LàwH
What is the goal of corporate laxw, as distinct from its immediate functìons of
defining a form of enterprise and contamnng the conflhcts among the particìpants
For example, the reorgarizanon pro isions under Chapter 11 of the U S Bankruptc Code,
while most commonlv ixoked bOcompane s, are not confined to such entcitis. but apply as well to
partnersh5ps and even indereduale.
 1

lo Wbat ìs the goal of corporate lawL Wbat is CorporateLaw? 19

in this enterprnse? As a normative matter, the overall objective of corporate To say that the pursult of aggregate social welfare Is the appropriate goal of
laix-as of any branch of law-is presumably to serve the mnterests of society corporate law msnot to say, of course, that the law always serves that goal.
as a whole. More particularly, the appropriate goal of corporate law Is te
advance the aggregate iwelfare3 ' of a firm's shareholders, employees, supphiers,
1 Legìslatures and courts are sometrmes less attentrve to overall social welfare than

and customers without undue sacnifice-and, lf possible, iith benefit-to thurd

partres such as local communities and beneficiaries of the natural environment
1 to the particular mnterests of some mnfluential constituency, such as corporate
managers, controlhng shareholders, or organìzed workers. More over, corporate
law every vhere contmnues to bear the imprnrt of the historecal path through
This is what economis ts would characterlze as the pursuit of overall social i whxch it has evolved, and reflects as well various non-efficiency-oriented intel-
efficiency. lectual and ideologicai currents that have sometrmes mnfluenced its formation.
It is sometimes sald that the goals of cotporate laiw should be narrower. In The corporate law of all jurìsdìctrons clearly shows, to a greater or lesser degree,
particular, it Is sometimes sald that the appropriate role of corporate law Is the wxeìght of these varìous mnfluences.
simply to assure that the corporation serves the best interests of Its shareholders
or, more specifically, to maxlmlze financial returns to shareholders or, more
specifically still, to maxìmlze the market price of corporate shares. Such clarms
can be viewed in two ways.
Flrst, these claims can be taken at face value, in which case they nelther
describe corporate law as we see it, nor do the> offer a normatively appeaing
aspiration for that body of law. There would be little to recommend a body of
law that, for example, permits corporate shareholders to enrich themselves
through transactìons that make creditors or employees worse off by $2 for
every $1 that the shareholders gain.
Second, such claims can be understood as saymng, more modestly, that focusing
principali> on the maxcimization of shareholder returns Is, in general, the best
means by which corporate law can serve the broader goal of advancmng overall
social v-elfare. In general, creditors, workers, and customers will consent to deal
with a corporation only lf they expect to be better off themselves as a result
Consequentl>, the corporation-and, in particular, Its shareholders-has a direct
pecunmart mnterest in makmng sure that corporate transactrons are beneficial, not
just to the shareholders, but to all parties who dea! with the firm. Xe behleve that
this second vieix Is-and surely ought to be-the appropriate iterpretatlmn of
statements by legal scholars and economists assertmng that shareholder value Is
the proper ebject of corporate law. i
i
Whether, in fact, the pursuit of shareholder value Is generally an effecrive i
means of advancmng social welfare Is an empirical question on ixhich reasonable
i
mmnds can differ. `NThlie each of the authors of thìs book have mdividuai iexws o0
i
thìs claìm, we do not take a strong position on it in the Chapters that followi. i
Rather, we undertake the broader task of offernng an analytic framework wxthìn 1i
wxhich thìs question can be explored and debated.
i1
1
Wheno7e speak here of advaxinaur- aiizing
32 oLe'aggregate elfare of societ n e are usig
i
ii
a meraphor that IS conceptually a u't ioose There is cohWerent 2ra to put a number on' soClCt.s
no u
i
aggregate xelfare, much less to maximize that number-and particulari, so xshen ranx benefits are in
apprecìable part non-pecunmary WVhat e are suggesting nere might be put more prec In the
language of xxejfare econominc as pursuing Kaldor-Hicks efficrencnxthin acceptable parterns of
dìstributuon
1i
i
i
1
1
-L-
 2
Agency Problems and
Legal Strategies
HENRY HANSMANN and REINIER KRAAKMAN

2.1 THREE AGENCY PROBLEMS

As we explamned in the precedmng Chapter,1 corporate iaw performs t vo general

functions: first, it establishes the structure of the corporate form as well as
ancillary housekeepmng rules necessary to support this structure; and, second, it
attempts to control confhlcts of interest among corporate constìtuencles, mnclud-
ing those betr een corporate 'insìders,' such as controlhing shareholders and top
imanagers, and 'outsìders,' such as minority shareholders or creditors. These
conflìcts all have the character of what economìsts refer to as 'agency problems'
or 'principal-agent' problems. For readers unfamiliar wxth the jargon of econo-
mists, an 'agency probiem'-ìn the most general sense of the term-arises
whenever the welfare of one party, termed the 'principal,' depends upon actions
taken by another party, termed the 'agent.' The problem lies in motxvating the
agent to act in the prìncipal's mnterest rather than simply in the agent's own
interest Viewed in these broad terms, agency problems arise in a broad range of
contexts that go well beyond those that would formally be classifiei as agency
relatronshìps by lawyers.
in particular, almost any contractual relationship, in whìch one party (the
agent') promìses performance to another (the 'principal', is potentially subject
to an agency problem The core of the difficulty is that, because the agent
commoiùly has better information than does the principal about the relevant
facts, the principa cannot costlessly assure himself that the agent's performance
Is precisely what was promiseed As a consequence, the agent has an incentive
to act opportunistrcall,2 skimpìng on the quahity of his performance, or even
divertìng to himself some of wxhat was promised to the principal. Thìs means, in
turn, that the vxalue of the agent's performance to the principal Wxli be reducesd,
elther directIy or because, to assure the qualhty of the agent's performance,
the principal must engage in costly monìtoring of the agent. The greater the

i SuPra 1 1
'We use the term opportunism' here, folloving the usage of O1ver Williamson to refer ro self-
interested behavaor that invoives some element of deception. mcsrepresentation, or bad falth See
Oliver W ilamson, THE EcONONIC INSTITUTIONS OF CAPITALSIsM 47-49 (1987!
 22 Tlr-ee agency problems Agency Problems and Legal Strategies 23
complexxty of the tasks undertaken by the agent, and the greater the discretion 2.2 LEGAL STRATEGIES FOR REDUCING AGENCY COSTS
the agent must be given, the larger these 'agency costs' are hikely to be. 3
As xxe noted in Chapter 1, three generic agency problems arise in busmness In addressmng agency problems, the law turns repeatedly to a basic set of legal
firms. The first mnvolves the conflict betxeen the firm's owners and Its hired strategies By 'legal strategx,' we mean a generic method of deploymng substantive
managers. Here the owners are the principals and the managers are the agents. law to mitigate the vulnerability of principals to the opportunmsm of their agents.
The problem hes in assuring that the mnanagers are responsive to the owner's These strategìes can be divided into two subsets, wx hich we term, respectxvely,
mnterests rather than snmply to the managers' own personal mnterests. The second regulatory strategìes' and 'governance strategìes.' Regulatory strategmes are
agency problem mxvolves the conflhct betxxween, on the one hand, owners xxho prescreptìve; thev dictate substantive terms that govern eìther the content of
possess the majority or controllmng mnterest in the firm and, on the other hand, the the agent-principal relationshmp, or the formation or dissolution of that relation-
minority or noncontrolhing owners. Here the noncontrolhing owners are the shìp. BV contrast, governance strategies bulid on the elements of hierarchx and
prtncipals and the controlhng owners are the agents, and the difficulty lies in dependency that commonly characterize agency relationshìps; they attempt to
assurmng that the former are not exproprmated by the later. The third agency protect principals indirectly, eìther by enhancing their power or by molding the
problem mivolves the conflhct betxeen the firm itself (including, particularly, Its ìncentrxes of ther agents.
owners) and the other parties with whom the firm contracts, such as creditors, Table 2-1 sets out ten strategies-four regulatory strategmes and six governance
emplovees, and customers. Here the difficulty lies in assurmng that the firm, as strategies-that, taken together, span the law's princmpal methods of dealhng wxth
agent, does not behave opportumstmcally towxxard these varlous other princpals- agency problems. These strategies are not limited to the corporate context They
such as by exproprìatìng creditors, exploìtìng workers, or misleadìng consumers. can be deployed to protect nearly anyx vulnerable principal-agent relationship
Law can plav an important role in reducing agency costs. Obvious examples Our focus here, however, will naturally be on the *vays that these strategmes are
are rules and procedures that enhance disclosure bv agents or facihtate enforce- deployed in corporate lawx.
ment actmons brought bx prmncipals agamnst dishonest or neghigent agents. Para-
doxicaly, in protectìng prmncmpals agamnst exploitatìon by their agents, the law
can benefit agents as much as-or even more than-it benefits the principals The 2.2.1 Regulatory strategles
reason is that a principal Wfl be wllimng to offer greater compensation to an Consider first the regulatory strategmes on the lefr hand side of Table 2-1.
agent when the principal Is assured of performance that IShonest and of high
quality To take a conspìcuous example in the corporate context, rules of law 2.2.1 1 Rules and standards
that protect creditors from opportunistic behavxor on the part of corporations The most famihar pair of regulatory strategles constrains agents by comrnandmng
should reduce the mnterest rate that corporanions must pay for credit, thus them not to make decisions, or undertake transactìons, that would harm the
benefitmng corporations as well as creditors Lìkewxxise, legal constraìnts on the miterests of theìr prìncìpals. Lawxmakers can frame such constramnts as rules,
abilitv of controlling shareholders to exproprìate minority shareholders should which require or Drohìbìt specific behavxors, or as general standards, whìch
reduce the cost of outside equity capital for corporations. And rules of law leave the precise determination of compliance to adjudicators after the fact.
that inhìbit insider tradmng by corporate managers should increase the compen- Both rules and standards attempt to regulate the substance of agency relatmon-
sation that shareholders are willing to offer the managers. In general, reducmng ships dmrectiy. Rules, whmch prescrne behavxors ex ante,5 are commonly used in
agency costs Is in the interests of all parties to a transaction, prìncmpals and
agents ahike. I
It followxs that the normatìve goal of advancmng aggregate social welfare, as Table 2-1. Strategies foi P:oteetíng Prncpals
dìscussed in Chapter 1,4 Is generally equnvalent to searchmng for optimal solu- Regulatoìy Strateges Goverinance Strategies
tions to the corporation's agency problems, in the sense of findmng solutions that
maximìze the aggregate welfare of the parties mxvolved-that Is, of both princ- Agent Affihiauoo Appontmrnent Decsiion Agent
pals and agents taken together. Constrai ats Termis Rig1ts Rtgkts Ioncentives
Ex ANTE RULES ENTRY SELECTION INITIAITION TRU STEES HI P
Se e g. Steven Ross, Thoe Eco'o7nrc Theon o, ensy TiFe PriaPa7's Pobleni, 63 A'eERICAN Ex POST STANDARDS EXIT RExOxVAL VETO RExx ARD
EcoNo:ic REVIEt 134 (1973), John 'Cì Pratt and Rchard J Zec1Ihauser ieds ) PRINCIIALS
' AIs'D
AGENTS THE STRUCTURE OF BUSINESS (1984), Paul M41grom and eohn Robcrts, ECONMICS,
ORGANIZATION AND N4NAAGE.MENT (1992)
4 ìe For the canonical comparisar of the mArits of rules and standards as regulatory techn1ques9 see
Sup.a 14
Lnuis K<aplow, Rules Versuss Stanldards An: EjononnTc Anralysis, 42 DuKE LAV/ REVIEWX557, 1992)
24 Legal strategìes for reducing agency costs
the corporate context to protect a corporation's creditors and public mxvestors.
Thus corporation statutes universally include creditor protectron rules such as
dividend restrictions, minimum capitalization requirements, or capital mainten-
ance requìrements.6 Similarly, capital market authoritres frequently promulgate
detaìled rules to govern tender offers and proxy votng.7
By contrast, few jurìsdictìons rely on the rules strategy as a principal device for
regularìng complex, mntra-corporate relations, such as, for example, self-dealhng
transactions inìtìated by controllmng shareholders. Such matters are, presumably,
too complex to regulate with a matrix of prohìbitions and exemptrons, which
threaten to codìfy loopholes and create pountless rigiditres. Rather than rule-
based regulation, then, intra-corporate topics such as insider self-dealhng tend to
be governed by open standards that leave discretion for ad;udicators to deter-
mine ex post whether vxolatrons have occurred.3 Standards are also used to
protect creditors and publìc investors, but the paradìgmatrc examples of stand-
ards-based regulation relate to the company's muternal affaìrs, as when the law
requires directors to act in 'good faith' or mandates that self-dealmng transactrons
must be 'entirely fan.'9
The importance of both rules and standards depends in large measure on the
vigor wìth which they are enforced. In princpie, well-drafted rules can be
mechanmcally enforced. Standards, however, inevitably require courts (or other
adjudìcators) to become deeply involved in evaluatmg and sometimes moldng
corporate decisions ex post. In thìs sense, standards he berween rules (which
simply require a decision maker to determine compliance) and another strategy
that wxe will address belox-the trusteeship strategv, which requires a neutral
decision maker to exercise his or her own unconstramned best judgment in
making a corporate decisìon.10
2.2.1.2 Setting the terms of entry and exit
A second set of regulatory strategìes open to the law is to dictate the terms on
which principals affiliate wxth agents rather than-as xxith rules and standards-
the terms oun x hich the principal-agent relatìonship develops mnternally. The laxx
can dictate terms of entry by, for example, requiring agents to disclose infor-
matron about the hkely qualrty of theìr performance before contractmng with
principali." Alternatrvelv, the law can prescrebe exìt opportunitres for princi-
pals, such as awardìng to a shareholder the rnght to sell her stock, or awarding to
a creditor the rìght to call a loan.
The entry strategv 1S particularly ìmportant in screemnng out opportunistc
agents in the public capital markets. 12 Ourside mnvestors know rttle about publhc
zfra 4 2 2-
iSee See, e g, ionfa 7o 3 (mandator; bìd) and 8 4 1 (listng requorenents)
See ifra 515 and 5 2 3 9 Seee g, fra 4 2 3 1 managerial liabolint ;is-à-ais reditor
Rules, too, mav be seen as akin to the trustecshìp strategy if the leglsiator is taken to be the
neutral decrsion mak'er The difference, of course, ISthat the legislator decides generically, whiie the
trustee (and the adoudicator) decides case-by-case
' See infra 4 241 and 8 2 12 Seeieefra 8 2
Agency Problemns and Legai Strategìes 25
companmes unless they are told. Thus it iS xidely accepted that pubhc investors
requcre some form of systematrc disclosure to obtam an adequate supply of
informanion. Legal rulei mandating such disclosure provide an example of an
entry strategy because stocks cannot be sold unIess the requisite information is
supphed, generally by the corporation ntself A similar but more extreme form of
the entry strategy iS a requirement that the purchasers of certain securitres be
'quahified mxvestors' who are wealthy or financially sophrsticated.
The exrt strategy, whìch Is also pervasive in corporate axw, allov.ws prìncipals to
escape opportumsitc agents ex post. Broadly speakmng, there are txo kmds of
exit rights. The first iS the rlght to withdraw the value of one's mnvestment. The
best example of such a rìght in corporate law ls the technmque, employed in some
jurisdictions, of awarding an appraisal rnght to shareholders who dissent from
certamn major transactions such as mergers.13 As we discuss in Chapter 6,14
appraisal permits shareholders xxho object to a significant transaction to
claim the value that theìr shares had p1iur to the dmsputed transaction-thus
avoxdng a prospectxve loss if, in themr vxexw, the firm has made a value-reducmng
decisuon
The second type of exìt rìght lS the rìght of tranvsfer-the right to sell shares in
the market-whìch Is of obvxous importance to pubhic sharehoiders. (Recall that
transferability Is a core characteristic of the corporate form.) Standmng alone,
a transfer right provides less proteciuon than a xxthdrawal rnght, since an
mnformed transferee steps mto the shoes of the transferor, and will therefore
offer a price that impounds the expected future loss of value from insider
mismanagement or opportunims. But the transfer rmght permits the replacement
of the current 'agent'-the management team in a widely held companv-by a
new one that may be more effectrve in exercìsing control. Thus, unmmpeded
transfer rìghts allow hostule takeovers in which the dìsaggregared shareholders
of a mismanaged company can sell theìr shares to a simgle actxve shareholder
with a strong financial mnterest in efficient management. Such a transfer of
control rights, or even the threat of it, can be a hìghlv effectxve device for
discmpimning management 1 Moreover, transfer rights are a prerequisite for
stock markets, which also empower disaggregated shareholders by providmng a
contmruous assessment of managerial performance (among rother thmngs) in the
form of share prices
13 The ithdrave al ribht is a dominant governance de; ice for the regulaion of some non-corporate
forms of enterprìse such asthe American partnershop ae will, whhch can be dissol; ed atari nme by anv
partner Business corporations sometemes grant semilar w;thdra;;al rights o ther mshareholders
ehrough special charter pro;1sions The most conspicuous example is pro;ìdcd b' iestement com-
ii panies, such as open-ended mutual funds inthe U 5, ;hich are frequenti; formed as busnness
corporatìons under the generai corporation statutes The unversal default regime i corporate la;;,
i however, pro; ides for a much more limited set of ; ithdra;ali rights for sharcholders, and in some
ii urisdicetons none at all
l'eIiía 6221
15 VieA ed thes ;;av, of course, legacrules that enhance transferablht serve not aust
as ei instance of
the exet strategy but, simultancousl ; a;aeinstance of the entry stratecgy and in entive strateg as sell
i The same lega! de re can ser e multople protectrve functons Seealso ifra 7 12 4
L-
26 Legal strategiesfor reducmng agency costs
2.2.2 Governance strategics
Thus far we have addressed the set of regulatory strategies that mìght be
extended for the protection of vulnerable parties in any class of contractual
relationships. Ve now turn to the sin strategìes that depend on the hierarchical
elements of the prmc'pal-agent relationship.
2.2.2.1 Selectuon and removal
Given the centrai role of delegated management in the corporate form, it iS no
surprise that appountment rigbts-the power to select or remove directors (or
other managers)-are key strategìes for controlling the enterprise. Indeed, these
strategies are at the very core of corporate governance. As we will discuss in
Chapter 3, moreover, the powver to appoint directors 1S a core strategy not only
for addressmng the agency problems of shareholders in relatron to mnanagers, but
also, in some jurìsdìctions, for addressmrg agency problems of mnuorìty share-
holders in relation to controlling sharehoiders, and of employees in relanonshìp
to the shareholder class as a vthole.
2.2.2.2 Initiation and ratification
A second pair of governance strategics expands the power of principals to
intervene in the nrm's management. These are decision r;ghrs, which grant
principali the power to initiate or ratìfy management decisioni Again, ìt is no
surprnse that this set of decision rights strategìes is much less prommnent in
corporate law than are appomtnment rights strategìes. This disparit> IS a logica)
consequence of the fact that the corporate formn IS desìgned as a xehìcle for the
delegation of managerial power and authnnty to the board of dìrectors. Only the
largest and most fundamental corporate decisions (such as mergers and charter
amendments) require the ratification of shareholders ex post under existing
corporation statutes, and no jurisdìction to our knowxledge requires shareholders
to initiate managerial decisions.iì
2.2 2.3 Trnsteesìhp and reward
Finally, a last pair of governance strategics alters the incentives of agents rather
than expandmng the powers of principali. These are incenltve strategies The first
incentìve strategy is the reward strategy, which-as the name implies-rewards
agents for successfully advancmng the interests of their principali. Broadly speak-
mng, there are two principal rewx ard mechanisms in corporate law, The more
common form of reward is a sbarìng rile that motivates loyalty by tying the
agentfs monetary returins directlr to those of the principai. A consplcuous example
norm,
1s the protecrion that minority shareholders enj oy from the equal treatment
of dividends.I' As a consequencé
wxhich requires a strnctly pro rata distriburion
of this rule, controlihng shareholders-here the agents'-have an incentive ro
16eS itfra 3 1 2 1 17 See tfra 6 4 2
Agency Problems and Legal Strategies
maxìmìze the returns of the firm's minonrty shareholders-here the 'principalsi-
at least to the extent that corporate returns are paìd out as dìvidends.
The reward mechanmsm that 1S less commonly the focus of corporate law ìs the
pa'- for-performance regime, in which an agent, although not sharmng in his
princpai's rerurns, 1S nonetheless paìd for successfully ad;vancmng her mnterests.
Even though no 1 urisdiction imposes such a scheme on shareholders, legal rules
often facilitate or discourage hìgh-powered incentrves of this sort.A8 American
iaw, for example, has long embraced incentìve compensation devices such as
stock optron plans, while more skeptical jurisdictions continue to piace obstacles
in the path of optron compensatron plans.
The second encentive strategy-the trtìsteeìs1bp stratezy-xworks on a quite
dìfferent princple. It seeks to eliminate conflicts of interest ex ante to ensure
that 'bad' behavxor by an agent vll not be rewx arded. Thìs strategy assumes that,
in the absence of strongly focused-or 'hìgh-powered'-monetary incentrves to
behave opportunìstically, agents xxvili respond to the 'low-powered' incentives
of conscience, pride, and reputation,19 and are thus more lìkely to manage in
the interests of theìr principali. Agents servmng as trustees may be interna!
to the corporation, as when dìsììterested directors must approve a self-dealmrg
transaction by a controllmng shareholder, or they may be external, as xxwhen the
law requires an investment banker, a state official, or a court to approve corpor-
ate action.
2.2.3 Ex post and ex ante strategics
The bottom row in Table 2-1 arranges our ten legal strategìes into five pairs, each
xwith an 'ex ante' and an 'ex post' strategy. Thìs presentation merely hìghlights
the fact that half of the strategics take full effect before an agent acts, while the
other half respond-at least potentially-to the quality of the agentis actìon
ex post In the case of the regulatory strategies, for example, rules specify what
the agent ma> or ma> not do ex ante, while standards specify the generai norm
agapirst whch ani agent's actions wll be judged ex post. Thus, a rule mìght
prohlbht a class of self-dealmg transactions outrnght, while a standard mìght
mandate that these transactions will be judged aganst a norm of fairness
ex post.2A Similarly, in the case of settrng the terms of entrv and exit, an entry
íSe tifra 1 i
W, use t 'hilgh-powered
ierms t centreis' td 'le powered centies as the; are conventeon-
19
11i used m the economct eiterature, to refer to the dìsincteon between econoenc incentn es on the one
| handanr et.ca or m ai
or
icentves oenthe other Econormc incenn es are tghb-powered in the ese
e g. Wlliaeson, Szpia note 1, 137-415 Bengt
that the; are concrete and sharpi focused See,
Holmstrom and Paue idvIegrome. TIe Fr. as a ìItcetive Syste'r, 84 AmaERi.eeN EcO mOMic R'V1 t'
972 !1994 Bv ' referrmn, to meraL norms as 'le;;-poeered' incentives ve do not meat to impei that
they are generally less important ingonermaig human behaveor than are monetarn incentives Suree1
e efeor imdi; eduais me ieosti clrcimstncc . t; e ppeite is true, and ce izateon w'ould not haie
gotten ery far if this
in ere not the case
2 Compare mfra 5f 14 (ex ante prohibìteons) and 5 1 5, S 2 3 (ex post standards)

28 Legal strategmes in corporate context
strategy such as mandatory disclosure specifies what must be done before an
agent can dea! wxth a principali, whLile an exit device such as appralsal rìghts
permìts the principal to respond after the quality of the agent's action Is
revealed. 21
The Six governance strategìes also fall into ex ante and ex post pairs If
principala can appomnt theìr agents ex ante, they can screen for loyalty;
ìfprincipals can remove their agents ex post, thev can punish disloyalty Simii-
arlv, shareholders might have the power to initiate a ma) or corporate transaction
such as a merger, or-as is ordinarily the case-they might be restricted to
2
ratifying a motmon to merge offered by the board of directorsa2 Finallv, trustee-
ship is an ex ante strategy in the sense that it neutrahizes an agent's adverse
mnterests prior to her appointment by the principal, whLile most reward strategìes
are ex post in the sense that their payouts are contmngent on uncertamn future
outcomes, and thus remamn less than fully specmfied until after the agent acts
We do not wxsh, however, to overemphasmze the clarrty or analytìc power of
this categorizatmon of legal strategìes mnto ex ante and ex post types. One couid
well argue, for exampie, that the rexvard strategv should not be consìdered an ex
poSr strategy but rather an ex ante strategy because, like the trusteeshìp strategy,
it establishes in advance the terms on which the agent will be compensated.
Likewxise, one couid argue that appomntment rights cannot easily be broken mnto
ex ante and ex post types, smnce an election of directors might mxvolve, smmultan-
eously, the selection of new directors and the removal of old ones. We offer the
ex postlex ante distmnction only as a classification heurmstrc that is helpful for
purposes of exposatmon.
Indeed, it is in the same heurmstìc spirmt that v.e offer our categorization of legal
strategìes in general. The ten strategies arrayed in Table 2-1 clearly overlap, and
any gìven legal rule might well be classmfied as an mnstance of two or more of
those strategies. Our purpose here is simply to emphasize the varmous wavs in
whìch law can be used as an mnstrument, not to offer a new formaiìstmc schema
that dmsplaces rather than alds functional understandmng
2.3 LEGAL STRATEGIES IN CORPORATE CONTEXT
The legal strategics just described can in principle be deployed to deal wxth the
agency problems presented by any type of organizaton Our mnterest here,
however, main the distmnctive wavs that those strategìes are deployed in the
context of busmness corporations.
The lavv does not apply legal strategics in the abstract but only in specmfic
regulatory contexts. For purposes of exposition and analysis, we have grouped
those contexts moto six basac categories of corporate decisaona and transactmons.
21 Compare, e znfr, 4 24L 5 1 1, 5 21, 8 2 (Tranxatorn disciosure), and
r 6 21 (appralsal)
a
22Sc ifr '6 2t1I
L
Agency Problems and Legal Strategìes 29
Each of the sIx chapters that follow focuses on one of those categornes. The
boundaries of these categornes are necessarly arbìtrary and overlapping. Never-
theless, each category has a degree of functional unmty, and the typical deploy-
ment of legal strategies in each Is moderately distinct.
Chapter 3 exammes the legal strategies at pla> in the regulation of ordinary
business transactions and decisions. Not surprisingly, governance strategies
predominate in thìs context. Chapter 4 turns to corporate debt relatìonships
and the problem of creditor protection-a context in whìch regulatory strategies
are common. Chapter 5 exammes the legal regulation of related party (or self-
dealng) transactìons; Chapter 6 mxvestigates the corporate law treatment of
`sìgnficant' transactions, such as mergers and major sales of assets; and Chapter
7 assesses the legal treatment of control transactions such as sales of control
blocks and hostle take overs. As the discussion below will demonstrate, 1urisdic-
tions adopt a fiuìd mix of regulatory and governance strategìes in all of the last
three transactional contexts. Finall, Chapter 8 turns to mnvestor protection and
the regulation of issuers on the pubhic market, where regulatory strategìes
predominate much as they do in the context of creditor protection.
Whlie we do not claim that these Six transactmonal and decisional categories
exhaust all of corporate law, they cover most of what IS conventìonally under-
stood to be corporate law, and nearly all of the mnterestìng and controversial
issues that the subìect presents today.
Within each of our six substantive chapters, our analysis proceeds functmon-
ally. We first describe the problems associated wmth the class of transactions in
question. We then analyze the primary legal strategìes-from among those
outlmed above-that are avallable to corporate law for deahing wmth those
problems. In all but one chapter, our anaiytic discussion IS organmzed by agency
problems and legai strategies. In Chapter 6, hoxxever, the analytic discussion IS
organmzed by categories of transactìons. Finally, to the extent that there are
sagnificant differences across 1urisdictions in the legal strategles employed to
regulate a given class of corporate decisiona, we attempt to assess the origins
of these differences. In particular, ve ask to *vhat extent these differences can be
understood as functional adaptations to differences in institutions, such as
tradmng markets and financial intermediaries, and how far they appear to be
hìstorìcal, cultural, or political artifacts xithout a dìrect functional basis.
2.4 THE ROLE OF LA-vr
We have been speakmng here of 'legal' strategmes The varìous strategìes arrayed in
Table 2-1 do not, however, necessarily require law for theìr implementation. N'ae
observed in Chapter i that, of the five definmng charactermstics of the corporate
form, only one-legal personahity-clearly requires special rules of lax. 23 The
23 Sxpra 1 2 1
30 The role of law
other characteristics could, m principle, be adopted by contract-for example,
through appropriate provìsions in the articles of association agreed to by the
firm's owners. The same Is true of the various legal strategies we havxe just
surveyed. If, for instance, a corporate board with a majority of outsìde directors
is an important means of mitigating the agency problem betwxeen controlling and
minority shareholders, this implementation of the trusteeship strategy could be
undertaken by mdividual corporatrons on their own by mncluding in share
contracts a commitment to a board xxwith that composition.
Wc need to ask, then, whether and why the various strategies described here
should be embodied in laxx. In addressìng this question, it is important to
distingush betxveen legal rules that are merely default rules, in the sense that
they govern only if the parties do not explicitl provide for somethmng dìfferent,
and rules of law that are mandatory, leaving parties no option but to conform
to them.
Much of corporate law consists of default rules. To this extent, corporate law
simply offers a standard form contract that the partres can adopt, at their option,
in whole or in part. A familar advantage of such a legaliy provided standard
form Is that it simpiìfies contractmng among the parties mxvolved, requiring that
they specify only those elements of their relatronship that deviate from the
standard terms. In serving this function, default rules of corporate law xwill
generally serve best if they reflect the terms that the parties themselves would
most commonly choose. Default rules can also, however, serve a protective or
information-revealing function. A rule that serves this function may not be the
one that well-mnformed parties wvould generally choose, but rather a 'penalty
default' that burdens the party most lhkel to have private information relevant
to the transaction. The purpose of such a rule is to force parties to reveal their
private information-in order to avomd the default outcome-and consequently
induce explicit contractmng between the parties that will lead to an outcome
superior to that which *vould otherwise be expected.2 4 A rule permitting veil-
piercìng in undercapitalized firms, 25 for example, can be seen as a penalty default
that creates an incentive for firms wxth low net capital to disclose that fact when
contractmng with potential creditors, so that the creditors wxlI be estopped from
piercing 26
There are also important rules of corporate law that are mandatory. Large
German corporatrons, for example, have no alternative but to gìve half of their
supervisory board sears to representatives of theìr emplo>ees, and publicli
traded U.S corporatrons have no alternative but to provide regular detafled
financial disclosure in a closely prescribed format.2_ The rationale for manda-
2SS illizngGapsziilnco;ìpleteCowitractsAnEco o 7iìcTaeoi;yof
oelan-kresandRobertGertnreF,
Default Rules, 99 YALE LAW JOURNAL 87 i1989)
See infra 4 2 (discuss ng el-pìercìng)
I
6 Ia Aares, kgA Dffeence The Conrt;actual Cotributms of Easte;brookaid Fischel, 59
UN IERSTY oF CHICAGo LAW REi IEW 13 91, 139 ,1992)
27 Sie ora 3 1ieodetermination) and 4 212 and 8 2 (d1sc1osurei
,L
Agency Problems and Legal Strategmes 31
tory terms of these types is, often, that some partres mìght otherwise be exploited
because they are not well mnformed, or that the moterests of thmrd partìes might be
affected, or that collective action problems (such as the notorious 'prisoners'
dilemma') might otherwise lead to contractual provxsmons that are mnefficient or
unfair.
Mandatory rules need not just serve a prescriptive function, however. In some
circumstances, they can serve an enabling function similar to that served by
default rules More particularly, mandatory rules can facilitate freedom of
contract by helpmng corporate actors to signal the terms they offer and to bond
themselves to those terms. The law accomplìshes this by creatmng corporate
forms that are to some degree inflexmble (i e., are subject to mandatory rules),
but then permrttmng choice among different corporate forms. There are uvo
prmncipal varmants to thms approach.
Fmrst, a gìven jurisdìctron can provide for a menu of dmfferent standard form
legal entrtres from whìch partres ma> choose in structurnng an organization. In
some jurisdictrons, for example, a firm wxth the five basic attrrbutes of the
busmness corporation can be formed, alternatveliy, as a pubhicly traded corpor-
ation, a closely held corporatron, a limìted hiability company, a limited hiablirty
partnershmp, or a busmness trust-with each form subject ro a separate statutory
regime. Each of these forms commonly exhìbits some rigidity, by virtue of
mandatory rules. Those rules, however, often vary from one form to another.
The result Is to enhance an entrepreneur's ability to signal, via her cholce of form,
the terms that the firm offers to other contracrìng partres, and to make credible
the entrepreneur's commitment not to change those terms Thus, paradoxìcally,
greater rigidmty within any particular form may actually enhance overall freedom
of contract in stru:turing prxvate enterprise, so long as there Is a sufficientI>
broad range of alternative forms to choose from
Second, even wxth respect to a particular type of legal entity, such as the
pubhiclv traded business corporatmon, entrepreneurs or managers may be permit-
ted to choose among different jurìsdìctrons' laws. In the Unmted States, for
example, the prevaìling choice of law rule permìts a busmness corporation to be
mncorporated under the law of any of the 50 mdivxdual states, regardless of where
the firm's prmncipal place of busmness, or other assets and actrvxties, are iocated.
Where, as in the U.S , such choice Is avaflable at low cost, a given jurisdìction's
corporatron statute simply serves as an item on a menu of alternatxve standard
forms avaflable ro the partres mxvolved As in the case where there is motra-
jurisdmctronal choice of alternative forms, mandatory rules in any gìven jurisdìc-
tion's corporatron law may serve not to constramo choice of form but actually to
enhance it, by makmng it easier for firms to signal, and to bond themselves to,
their choice among alternatìve attrrbutes.
 3
Tbe Basic Governance Structure
HENRY HANSMANN and REINIER KRAAKMAN

As we observed in Chapter 1, corporate law prototypcally deals with the baslc

agency problem between the firm's owners and lts managers by providng for a
multi-member board of directors that 1s elected (at least in major part) by the
firm's shareholders and that 1s distinct both from the body of sharehoiders and
from operational management.1
T
hile this governance structure 1s designed prìncipally to effectuate the mter-
ests of shareholders as a class, it 1s also a potentially useful mstrument for dealhng
with the tvo other basic agency problems that face a business corporation the
prospect that the majoritx or controlhng shareholders will behave opportunìstic-
ally toward non-controllng shareholders, and the prospect that the firm or its
owners will act opportunistically toward other parties wxith whom it transacts,
such as creditors and employees.
There are, however, important tradeoffs here. As we argue below, the more
responsive a firm's board 1s to the mnterests of the shareholder majortty, the less
hikely it 1s to serve as an effective buffer to protect the interests of elther minoriìy
shareholders or other contracting parties.
As one would expect, the law underpinning the corporate governance system
rehes heavxl on the governance-oriented strategies of Table 2-1j2 mcluding the
appomntments and decision rìghts strategìes. To a remarkable extent, however,
thìs laxx also draws on the other legal strategies hsted in Table 2-1. For this
reason, we organize our discussion not by legal strategy, but by the basic agency
problems attending the corporate form that were identifiein m Chapter 1. Section
3.1 examines strategìes for protecting the mnterests of shareholders as a class
Section 3.2 addresses the role of governance strategies in protectmng the mnterests
of minority shareholders. Lastl, Secrion 3.3 examìnes the role of the governance
system in safeguarding the mnterests of non-shareholder constituencies.

3 1 HowCGOVERNANCE STRATEGIES PROTECTI SHAREHOLDERS AS A CLASS

Twxvo core features of the corporate form underlie corporate governance The first
is mxvestor ownershlp, which ìmphes that shareholders-as residual clanmants-
have a significant rìght of control over theìr companmes The second 1s delegated

t See sup1a 1 2 4 2 See supra 2 t

34 How governance strategies protect sbarebolders as a class
management, which implies that shareholders generally exercise thìs control
indìrectly, by particìpating in the seiectmon or removal of directors-or
theìr closest equivalents in closed corporations.3 It folloxxws that the law
protects the mterests of the shareholder class in the first instance by structurtng
the selectìon and powers of the firm's directors The appointment strategy
1s thus the most basìc protection of the collective mnterests of the shareholder
class.
3.1.1 The appointment rights strategy
Corporate law enhances shareholder control over the company by shapng the
basìc structute, power, and composition of the board, and by establìshìng the
electoral ground rules that structure shareholder votmng. Our principal focus here
is on the relatìvely elaborate appomntment tules for large, open companmes,
although much of our discussion also bears on the appointments strategy for
closed corporations, such as the French Société à Responsabilité Lìmitée (SARL)
and the German Gesellschaft ma beschrankter Haftung (GmbH) (which can be
large and rather wdlely held as well as small, and so can be subhect to legal
requìrements sìmilar to those gov;erng open corporatmons).
3.1.1.1 The gross struoeture and composìtzon of the board
Democratìc govertnng structures in polìtical contexts often imolve a bicameral
legislature, and sometimes have a separately elected president as well, in an
effort to avold excessive responsiveness to speciai or temporary mnterests. In
contrast, corporate boards in almost all jurisdìctions are characterized by hìgh
responsìveness to the current electoral majortn, which Is facìlitated by a uni-
cameral assembly4 wxthout a separately elected executìve.
At least for wvdely held companmes, the law might have developed differently
Minarety shareholders might have been protected through a bicameral board
structure, for example, by hav;ng one board elected on a one-share-one-vote
basis and the other elected on a one-shareholder-one-vote basis Among the
reasons why thìs 1s not done, ptesumablv, are that such a bhcameral structure
would create sermous rtsks of deadloclk and that the mnterests of minority
3 Contonental European corporate l a.s generallv distnguish bebveen open' corporate forms,
which ha'e freelv transferable shares, and `closed' forms ir chxchtransferabilixv is restri eed and
often subjectto company or shareholder approvai Mlana eri I authorto isdele a'edto aboard inthe
former anddO one or more indxvidual ('aho max actuallk ce termed 'managers ) m the latter
77c generail use the term cioel held to refer to corporations whxse shares do not trade freely,
nbther because the, are held bc a small number of persons or because then are subJect to transferablcitv
restrietions Se sopra 1i1 and 12 3 (but compare ìfra 4 212 and 8 21 reguiatorc distinetions
between closel ield and pubhcl held' corporations mac differt
A cuntcameral legislative authebro is one that deliberates and cotes as a single chamber lI
cornrasts cnv'h mxo-chamber ('bicameral') legislative bodies, such as the separate house and senate
thari s tpica of national legslatures Een a xvo-tier corporate board structur i ucameral board
n the sense thar the board's xe o tiers are larget organìoed hierirchicallc, with the upper board-the
onlc one that is electei by the f rm s shareholders-haX mi authorin o er the lower board
The Basic Governance Structure 35
sharehoiders can be protected reasonably effectiveiy by the other strategles
discussed here. Similarly, other constutuencies-in particuiar, employees-
could have their mnterests represented through a separately elected board. Here,
however, the risk of deadlock would be even greater, since the mnterests of non-
shareholder constituencles are often so clearly in confhcrxwith those of the
company's shareholders.
To be sure, some major iurtsdìctions permrt a mwo-tier board structure for
open compames (such as France) or even require one (such as Germany and the
Netherlands). In those cases, however, the two boards are organmzed vertically
rather than hortzontally, with an elected supervisory board that, in turn, ap-
pomnts a 'managing' board whose members are the princpai managers of the
firm. Thus, the mtv.o boards are in a semi-hierarchìcai relationship. But this does
not mean that the management board is powerless in two-board jurisdictìons.
The German supervisory board, for example, cannot oust the management
board without cause, cannot make certain decisions reserved to the manage-
ment board, and-as a legal matter-may even be overruled by the management
board ilf the latter can obtam a three-quarters supermajority in a vote of the
shareholders 6
In the abstract, thìs two-tetr board structure is entrrely consistent wxth alle-
gliance to shareholder interests. Indeed, it mìght seem that a txo-tìer board
should be more responsive to shareholder mnterests than a single-tier board,
since the shareholder directors of the supervxsory board are required to be
ìndependent, non-executive directors in most rvo-tier jurisdictìons.7 Outsìde
dìrectors do not share management's strong self-mnterest in key corporate decì-
sions The value of this independence is suggested by the trend in sìngle-tier
jurisdìctions, mncluding in the I.S., toward assìgnng non-executive directors to
decide issues that mìght implicate executnve dìrectors in a conflict of interests.8 In
effect, these developments imitate decisìon-making in a two-tier board by usmng
committees of mndependent dìrectors on single-tier boards as quasi-supervisory
boards
In the principal mo-ttier jurìsdìctons, however, corporate law tends to under-
mine board responsiveness to shareholder mnterests rather than to enhance lt. But
the reason for this result has to do with the compos7tìon of these boards, not with
their structure. The laws of Germany and the Netherlands both restrict the
5 Under French ìao the soclété anooyrne (SA) .s governed by the one-rier coised d admristiaioio,
untess the charter pro ides that it shall be governed bc the cvo-tier dire ltoze et consed1 de siriezilanice
Art L 225-57 Code de commerce
6 5111 i' Aktiengesetz Sce also 5111 I ìsupervisory board oversees the management of the
company), 411 rv (management functcons cannot be transferred to thc supervisori board), and
76 I (the mana ageen boadman s the corpan-).
I' Those julsdictons, such as Germany and the Netherlands, that require a cvo-tcered board also
bar managers and other corporate emplovees from seriing on the upper board In France, c here the
Mo-tier board 1s op0ona0, up to one-thìrd of the members of the superc isoro board man be emplo;-
ees-and hence executoces-but not managing directors Arr L 225-74 and 725-35 Code de
commerce
Sece 'ìfra 3 1 13
 36 How governauce strategìes protect sharehulders as a class
power of shareholders to elect the directors of large corporations in order to
ensure the representation of labor's mnterests in the boardroom. 9
In many respects, the Netherlands presents the more extreme example in the
form of a remarkable-albeìt limited in scope and apparently short-lIved-
experiment in corporate governance. Dutch law currentlh estabhlshes a so-called
*structure regime,' under which shareholders of medium-to-large, domestically
orìented companies do not elect their directors at all 10 Rather, the supervisorr
boards of compames operatìng under this regime select their own successors,
who mai be opposed by eìther the shareholders or the employee wuorks councils-
but only on the grounds that these hand-picked successors are manifestly un-
qualìfied or fail to adequately represent the interests of labor or capital li Alone
in the worldwide menagerle of corporate forms, then, Dutch companmes falling
under the structure regime make very lirtle use of the appounrment strategy.
Nevertheless, the importance of this strategy to the corporate form Is under-
scored bh the fact that, after thirty years of expertmentatìon with the structure
regime, the Netherlands 1s movmng towards abandounng it in favor of a more
conventional supervisory board elected by shareholders wxth mmuorty employee
representation.12
German lawx, by contrast, relhes on the appomntment strategy to safe-
guard the interests of both shareholders and labor Under the German 'co-
determination' provisuons, discussed below,13 employees are entìtled to elect
up to half of the dìrectors on the upper-tier board of large companmes (although
shareholder directors can sull prevail in the event of an evenly divided
board vote by means of a second vote cast by the chairman of the super-
visory board).
9 The corporate lav in important curesdictons such as he L1K
and Dea a re wvoU appear to
allov, corporate directors to be selected by non-shareholders ifthe charter so requcred
Yet shareholder
saecenon is cliar1e che default rule from xwhach firms virtuali never opt out
° Compames sub<ect toche structure regime are roughIv those with more than 100 Dutch
empiovees and 25 emdlon guilders in capital Book 2, Art 153 Dutch Civil
Code Dutch multi-
naionai companies are exempt from mandatori inclusaon under the structure regime
because the
bulk of their empLoyees are outside the Netherlands
` Book2 Art 15 Dutchc vil Code The board can appomothe canddate in spte
of the objet0on
raised bl shareholders, if che [Commerc al] Court in Amsterdam declares che objectìon
unrfou-nded Id
Correlate civcehe shareholdershave the poxer to remove members of the super lson board
onlx vxith
cause, after a court heareng Book 2, Art 161 Dutch Cvil Code. Mart-i-;an Empel, D/el\iet.cla.
in Arthur R Pinto and Gustavo Visentini. THE LEGAL BAt oI OC oncesTE GoxeERNANCE
IN
PUBLICxY HELD CORPORArìONS 123, 135 1096) Note, hovIeer, that ehe scope
of the radicai
structure regime should not be exaggerated The majorti of Dutch compacmes,
small firms as wci,
as multenatconals, are go erned in the old-fashaoned xay, by boards appointed 6
shareholders
In 2001, the Social and Economc Committee ('SER' of the Dutch Goernment
recommended
the repacementr of the structure regime math a board e-ected a;vo-therds b6 shareho
ders and one-
thlrd bv employees In addition, che SER recommended that the sharcholders
meeting retacn
e p oNectod asmas teeen e baoar 5ee IclicamW I Bratton andjoseph A MlcCahere Restseciue' ig
tle ReIat onse-p betIeen Si2arekotdes aatd Ma'iagers (Working Paper
2001, arai1abie at
nllburgumnersit- nl)
13 See cxfra 3 3 1
The Basìc Governance Structure 37
3.1.1.2 The power to replace board members
In addition to the fundamental pnìncipies that shape the structure and compos-
ition of the board, numerous subsìdiary rules influence the board's responsive-
ness to shareholders by fixmng Its fine structure and further adjustrng Its
composition. Some of these rules bear on how easìly directors can be removed;
others affect responsiveness by shapmng the board's internal structure and
procedures
Consider first how easlv shareholders can mxvoke the removal strategy to
dispIace a director. One aspect of the removal powxer is the abhlity to remove a
dìrector at the end of her term in office. Thìs power turns on the length of the
director's term. Statutory limìrtatons on dìrectoral terms range from a low of Steo
years, in the case of Japan, to no statutory term lìmìts at all in the case of the U1K
(where private companmes occasionally appoumt dìrectors for lìfe).'4 U.S corpor-
ate law falls at the short end of this spectrum, wxith a one-year term as the default
rule and ordinariì a maxìmum term of three years for staggered boards.1ì By
contrast, Germany and France are long-term jurìsdictions, in whhch dìrectors
ma> be elected for terms of up to five and Six years respectively 16
A second aspect of removal power1s the ability to repiace directors mìd-term.
Brìrìsh and French lawx gìves the shareholder majority a strong non-waivable
rnght to remove directors w'thout cause.1» japanese, German, and U.S law
provide a weaker removal power. In Japan, the removal of a dìrector requires
the assent of rwo-thirds of the votng shares wxth the quorum of half the
outstandmg voting stock (the quorum may be reduced to one-thìrd by charter),
and in German>y, the assent of three-quarters of votmg shares.18 U.S. law adopts
a different tack. Some important U.S. jurisdictions make sharcholder power to
remove a director without cause a default provisìon; 19 others provide thìs powixer
as a mandatory right (unless the board Is classified), but lemit ìts scope by
den>mng shareholders the authority to call a special shareholders meeting unless
the charter expressly permits It.20
Houx important are these differences among jurisdìctions? Apart from
German>, the default rules of our major lurisdictions give shareholders roughly
I Art 256 Cocamerctal Code(japan), Paui Dwxes, GOEReND DAVIES PRINCIPEES OF ISIODERN
Cocxc ,NY LAvi30 j7th7 2
ed 003) iLETK)
35 In astaggered or 'classifiedboard, onoi afracteon-typicallì one-thrd -of the boardis elected
at
eaci year See, eg., 5141b) Delaxare General Corporation Lav;
6 102)1 Aktlene ecc Germany), Act L -2-18 Code de commerce (France)
5303 Companics Act (remosal wlthat term and a368(setting 5% threshold to call speial
meetings) IUK),
Art L 225-1S Code de commere (rmo
e alxwothin term! and 225-103 (setting5%
threshold to callspeciai meeing)(FranceE
Art c 257, 343 Commerctal Code (Japan), (103 1 Aktiengesetz (Germari-bue chethree-quarters
mao nti ts
a default rule)
` See I3SMWReSised tModel Business Corporatnon Act
20 See <,141(k) Delv care General Corporaton Law(sharcholders mayremor e directrs without
cause unoess board is classifidc- and '211(d)(charter must authoze sharehoLders to callspeciai
mectcng. Seealso §21i (b) (charter proe ision can elimi.ate shareholder rilht to take actton by m ritten
consent in icuof ageeral sharceholders meetengo

38 How governance strategìes protectshareholdersas a class
simliar removal pow-ers when all aspects of the removal strategy are considered.
For example, although U.S. law estabhishes a relatively weak removal rìght
(especially in the critical state of Delaware), it also fixes a shorter term of office
than do many other jurisdìctions. Converseli, Britamn and France permit lengthy
or even lifetime, terms of office, but offset this by provxdìng a strong removai
power that is easily mnvoked and cannot be waived. Japanese law provides for a
somewhat weaker removal power but sharply limits the director's term of office
By contrast, among our major jurisdìcrìons, only Germany provides both a
lengthy term of office for supervisoer directors and makes a weak removal
power mandatory-a combinatron that ìs especìally strrkng given that
Germany's lower-tier management board also en)oys legal protection from
removal.2i It should be noted, however, that the wxdespread use of staggered
boards among U.S public companmes extends directors' terms by charter, and
thus brings the U.S. closer to the attenuated German removal power than to the
robust powers of other major jurisdictions. 2 2
3.1.1.3 Th9e deciszon-inakingstructure of the board
Juresdictìonal differences in the deciseon-making characterìstecs of the board are
potentially more sìgnificant than differences in removal powers. There Is a
growm ng consensus among commentators that good corporate governance
depends on numerous 'best practices.' Chief among these are the size of the
board (small boards are better2 3), the committee structure of the board (inde-
pendent audit, compensation, and nomìnatìng commìttees are good), the fre-
quency of board meetngs (more meetmngs are better), and the ratio of insiders to
independent directors (a maiority of independent directors is good)
Smnce the U S. is the bmrthpiace of corporate governance reform, ìt is not
surprnsmng that the modal U.S. publhc company nowv follows manv of these
governance standards. U.S boards tend to be small by mnternationai standards
(although this ìs not legally mandated). They, also tend to have well-developed
commCttee structures. In contrast to the law of many luresdictmons, the U.S. (and
UK) permCt the full delegation of board powers to commìttees of the board.k4 In
addition, lstrng rules and legai pressure stronglv encourage a standard set of
committees In the 1970s, the New York Stock Exchange (NYSE) first requìred
lested companmes to appoìnt audit commìttees staffed by independent dìrectors.
In the wake of the recent Enron cohort of financial scandals, the major U.S.
',,84 Akriengesetz
71
On zhe contrast bet ven; strong UK and weak U S remor al rights, see Paul Davics, Shai I2o/dei
Valtc, Co ipaiiy Law and Seciiztws Market Law A iti lew, in Klaus J Hopt and Eddy
Wxmeersch (eds ),CAPITAE N'íARKE-T5 kND CozlizeY Lxxc 261 (2003)
'3 See Martir Lpron andja 'W Lorsch, A Modest P;oposalfor Icproved Corporate Goverai ce,
48 THE BUSINESS LANTER 59, 64-5 (1992) (opzìmal boards should not exceed 10 members)
24 5141(c)(2! Dela;;are General Corporat0on Law; 58 2'5 Revcsed ModeI Busoess Corporation
Act Or the 12K, see Dav is supra note 14, 320-1 and footnote 78 UK boards ma; delegate their
powers if, as is osual, the companv s artocies permìt them to do so
The Basc Governance Struectre 39
exchanges have proposed requirìng an absolute majority of mndependent direct-
ors on the boards of histed companies as well as establishmg board compensation
and nomination committees composed entirely of (NYSE), or, by a majority of
(Nasdaq t h), independent directors. In response to the same wave of scandals, the
Securities and Exchange Commission <SEC) has promulgated rules requiring all
pubhic companmes to disclose whether they have a 'financial expert' who IS
independent from management servmng on their audit committee (and if not, to
explam why not).26 It should be noted here, howevxer, that most U.S. companlee
have had a majority of nomnaliy independent directors since the 1970s without
any legal requìrement to this effect-and also with little hard evidence that these
directors have improved corporate performance 27
The corporate boards of other major jurisdictions are less regulated. The
boards of British public firms tend to be small, like their U S. counterparts, and
their articles now frequenrly require audit and compensation committees staffed
by non-executive directors, in keepmng with emergent norms of good governance.
But Brntsh firms nonetheless typically have fewer non-executive directors than
American compames, notwithstanding the 1992 recommendations of the miflu-
ential Cadbury Report.2 8 French companies, by contrast, are required by law to
lhmrt executive directors to one-third of the board.2 9 The ndependence of the
French board IS qualhfied, however, by the powerful statutory role of the French
présìdent dìrecreur-général (PDG), a combmned chairman of the board and chief
executive officer, who typically dominates other directors and may even have the
informai power to select them with the aid of controllmng shareholders.30
German and Japanese boards are even further removed from the contempor-
arv model of the U.S. board. Large corporations in both jurisdìctrons tend to
have unwleldy boards, albeit not for the same reasons. German law mandates
that the supervisory boards of all companmes with more than 20,000 employees
Nasdaiq stands for National Assocation of Securites Dealers Automnated Quotation System
See SEC Release N°33-8177 (2002), implementrng %406, 407 of the Sarbanes-ixlec Act
27 Sec, e g, Beojamìo E Hermaln and Mìchael 5 We sbach, The Effects of Board Comìpostoai70
ancd Direct Itcentives on Firm Perfocincance, 20 JOURNAL OF FINANCIAL NMANAGEMENT 101 (1991),
Sanlai Bhagat and Bernard Black, Tbe Unce tazi Relat2o2iskip Betwee' Board Coczposttio2i and FDic
Perfo2an0ce, 54 BIusNESS LAWIER 921 (1999)
28 Daves, sipra note 14, 319, 324 The Cadbur; Report recommendateons ha;e becn integrated
mnto the Combcned Code adopted by the London Stock Exchange
29 Art L 225-22 Code de commerce See aiso Art 225-17 (the board cannot number more than
18 members)
3' Eddv tWemeersch, A Status Repoit on Corpoate GovernaŽce Rules aad Practices 77 Some
Coniticental Eiiìopeac States, In Klaus J Hopt et al (cds ),COMeARATIA E CORPORATT GOcERN. 4NCE
THE SIATAOF THE ART AND EMIERGING REEMARCH 1045 1113-14 (1998) The Loi celative a7x
Noucelles Régilatzons Ecoomqies (NRE) of 15 Mav 2001. allows French open companies, if the;
so choose, to separate the offices of presideìt and dìrecteu egénéraln order to align theoe
o es
eo th
the enternatconal good governance' preseripton of sceparanng the CEO role from that of the chazr
manshzp of the board Art L 225-51-1 Code de commerce E;en ohen-and lf-French companis
choose to divide these offices, however, the dicectezur géneralis expected to contcnue to dominate
Freench boards See Pierre Henro Conac, The Separatcon of the Offices of Chacrzan ofte Boardead
Cizef Exective Officer ofthe Soczétés Azoi yces by the NRE (Workzng Paper 2001)
40 How governance strategìes protectshareholders as a class
3
must have at least 20 directors. 1 Japanese convention-not law-has led to
equally large boards, averagmng 25 dìrectors in one study and 19 dìrectors in
another but occasionally growing to as many as 54 dìrectors (though this Is
rapldly changmng) 32 In both cases large boards serve rmportant organizational
functions: accommodatmng empioyece dìrectors in German compames and
rewarding senior executives for a lifetime of service in Japan. Accordmngly, the
members of the German supervosory board are all non-executive directors, as we
have prevoously noted, whlie the Japanese directors are predommatelv upper-
level corporate insìders. But in eìther case, it IS doubtful that the full German or
Japanese board of a large company can be a searchmng monitor or a nimble
decision maker. 3 3
Thìs does not mean, of course, that Japanese and German compames lack an
effective governmng organ; it merely means that thìs organ IS not what we have
previously identified as the board. Arguablo, real governance in most German
compames occurs largeiy on the level of the management board.34 The supervìs-
ory board mìght be better analogìzed ro an amalgam of the audit, compensation,
and nominating commìttees on a U.S. board, with the additional funcrtons of
dìsclosing management pohcy to labor and arbitrating potential labor disputes.
The parallels among the German, Japanese, and other board systems becomes
still more suggestive iohen one considere that Japanese law requires shareholders
to elect a committee of 'statutory audìtors,' at least half of whom must be
corporate outsiders, to oversee management in close collaboration woth the
compano's outside accountmng auditors.35
These large menernum board sizes are required bv Germanyes codetermnateon laes The general
corporation statute itself ri res onIe that an Aktaiagesel1scafr (AG) must hate a mrerum of three
and a maximum of 21 members .95 Aktiengesetz Recent efforts to reduce the mandatory board scze
for large firms haFe been thcvarted bv the oppostion of orgamneid labor
Hideki Kanda, CEoparattie Coiporate Go eernanceCousrty Repoit Tipan, In Hopt et al,
stpra note 30, 921, 924 (anerage of 25 diretors), Yoshtro MiXva and J Miark Raiseyer, Wi o
Appoinrs Them, What Do they Do Ercdesice osi Outs!de Directo -rio JapaneNiorkirng Paper
2003, avatlable at lae upenn eduo (Tokl o Stock Exchange companres averaged 19 dirertors in 1985
vtha range upto 54) Note, howeverthatsinc 1997, when Son, the prominentJapans electrromncs
compane, reduced cts board size from 35 to 12, numerous other Japanese companres have followed
suet, ostensibly in order to enhance efficency by separatim the formulation of policr fromr ts
implementaron
3 See Dae d Yermack, Hìghe aMarketì cuatieeo/.Corimpaiescctce a Small BoaS d ofDoreito s.40
JOURNAL OF FIN4NCIAL ECONOMICS 185 (1996)
34 Thus, German lawe provides that it is the responsibilit of the management boaro, and the
management board aione, to manage the AG \'6 Aktrengesetz I The supervisorv board car veto
some transactions but-mn contrast to a U 5 V IK, or French board-cannot instruct the management
board to take are aecton v-th a minor excepteon necessari to implement the Co-determrnateon Act
sTartin Peirzer and Anthony G Hickinbotham íeds and translators), GER LAN STOCK COROIORATION
Acr tND Co-DTreRMINATIoN ACT 10 (1999)
5 Japanese statutory auditors (kaesayakz) are electeed at the general shareholders meeting and plae
a roìe that es broader than that of an audit committee or a U S board lalthough Japanese kacse yaki
are elected to be audetors, not directors) japanese statutoru auditors conduct both a financial audct of
the books and a compiance audit of thether the company rs complving teith applicable laes and
directors are comping ie ith the compare s charter and its o0 i fiducari dutces The audirors' report.
ohLch coneacs the results of both audets, must accomparv notce of the annual sharcholders meeting
The Basic Governance Structure 41
In sum, all of our major jurisdictions have a formal or informai managìng
board. Even when this managing board is not the legally-estabhished board,
moreover, the legai board could assume a management role and operate the
company in the mrterests of ìts shareholders equally weIl in every jurìsdìctron-
exceptmng, as always, the case of Germany. Thus, the typical Japanese board 1s
evidently a clumsy mnstrument for pohcmng the agency relationship betveen
shareholders and managers, because of both its size and lts composition of
loyal senior executives, but thìs result is not mandated by law. Japanese boards
could be much smaller and composed of independent directors or shareholder
representahives wìthout any change in the law, and in fact thìs 1s happening. The
PDG dommnates the boards of French compames partly as a result of French
corporate law, but the shareholder majority nevertheless holds the PDG at the
end of a short leash bo virtue of the majority's removal powers. 36 Although the
U S. and UK board structures are more open to management by shareholder
representatives than the other structures, shareholder passiviry can easily shìft
control of U S. boards to strong-willed CEOs. Only in Griermany are limitations
on effective shareholder representation on corporate boards at least partIy
attrrbutable to law-or, more particularlv, to the laws that mandate labor
representation and a stnìct separation of powers ben veen supervosory and
management boards.
3.1.1.4 Facilìtatung collectzve actlion
A final dimension of the extent of shareholder influence over corporate appomnt-
ments concerns the ability of the shareholder majority to surmount Its own
collective actron problem W7henever corporate ownership is spintered among
numerous shareholders, the lav can enhance or diminìsh shareholder influence
by facilitating or deflectmng collective action by the shareholder majority A
review of votmng procedures among the major corporate law jurisdictions sug-
gests that no regime has attempted to mmnimize the costs of participation in
corporate governance by disaggregated shareholders. Nevertheless, there are
clear differences among jurisdictions in how theìr procedures are hkely to affect
collective action by small and mìddle-sized shareholders
and be sent to shareholders n o w-eeks preor to the meeting. An alternative to the enstituton of
statutoro5 audtorsieas recently mntroduced by the 2002 amendrents to the Special Audet Act,
thich allows Japanese compranies to choose b tveen the traditional audetor structure and a board
committee structure silar to that of mann U S comparies More partecularv, 'large companies' mae
choose to replace tradetional sratutory auditors teth a structure of three neo board commqttees-the
audit comrmttee, the compensation committee, and the nomnatieng committei-prot idOg that each
of these three commettees IS comprcsed of a majoritt of independent directors A number of com-
panmes, includeng Sono, Toshiba, and Hitachi have alreado annourced their adoption of the new
struciure
36 In cases ir evhch the offices of chairman and CEO of French companies are di ided, sre siuPr
note 30, only the board teill be ableeto remone the CEO and-more seineEantifroe-ramoal wiill re
posseble only for cause, as eth the management boardin Germany Art L 225-55 Code de
commerce, 584 Aktiengesetz
42 How governance strategces protect shareholdersas a class
Votmng mechanisms are the most conspicuous example. Every major corporate
]urisdicrion provìdes a mechanmsm for allowing small shareholders to vote at
shareholders meetings without the need ro be present at the meetings. There are
three principal mechanisms. maìl votng,37 proxy solicitation bh corporate par-
tisans, and proxy votmng through deposìtory institutions. Large Japanese firms
with 1,000 or more shareholders must provide a form of 'mail voting' in which
shareholders receive a ballot from the company that can be returned by maìl in
lheu of giving a proxy or attendmng the shareholders meeting. 3 8 Likewise French
law provides for mail votmng for small and medìum-sized shareholders who leave
their shares on deposit vi ith a bank or broker, although thìs procedure is sald to
be complex and seldom used.39 A more radical alternative to maìl votmg Is a
universal ballot that presents all competmng candidates for the board at company
expense as in the new Russian statute, for example.
In the U.S., UK, and many other jurìsdlctions, proxies are solìcìted by corpor-
ate partisans themselves: by management alone in the case of an uncontested
vote, and by both management and itS opponents in the case of a contested vote.
This form of proxy solicitation is relatively unregulated in most of these iurìsdìc-
thons In the U.S., hov ever, heavy regulation of proxy solicitation has been a
major obstacle to shareholder action. A 1992 reform of the proxy system40
relaxed many of the regulatory barriers to shareholder communication, such as
filng and disclosure requirements. Nevertheless, sìgnificant barriers remain,
including a registration requirement for any 5% *group' of shareholders whose
members agree to coordinate their voteS. 4 1 In addition, wagìng a full-scale prox>
contest requires a multi-million dollar investment to satìsf3 the SEC's disciosure
requirements, obtam the target's shareholder lhst, hìre proxi solicitors and pubhic
relations experts, and defend agamnst hostrle litigation
The regulatory burden on shareholder action in the U S. law should not be
exaggerated, however. U.S. securitres law can also favor shareholder insurgency.
For example, the SEC's proxv rules can force mncumbent managers to make
sweeping and often embarrassmng disclosures, guarantee that mnsurgent solicita-
tnon materials will reach the company shareholders, and in some cases permit
37 Japanese and French lai pronides for mail voting Acr 21-3 Special Audìt Act (Japan) (manda-
tory) and Art 239-2 Commercial Code (Japan) (optional), Art L 225-107 Code de commerce
(France! (right rOote bv correspondence) Notethat both duicsdit0ons
also pro rede for proxy oting
is optional for smaller companies, ixhereasi otig xith electronic means is optional for all
8 This
companes
39 Maurice Cozian, Alain Viandier and Florence Deboìss, DROIT DES SocIÉTÉS N°S47 (lSth ed
2002) (pointng out cat, folloxxng the adoptco o the NRE, compar es mai amend theirarticleS and
allow for vodeoconferencìng and distance xoing) Note too that French laìx requires management to
send out forms for ma-i voting onlyif it mist request proxies,ohich it has no reason to do ifìsit
supporred bi a shareholder iarge enough to mect the quorum requerements of a sharceholder meeting
singie-handedlvinhoih mai be done oith no shares o0 a second call for an ordenan shareholder
meeting, and onuy 25i% of the shares outstandino for a second call or a special shareholder meetng
Ari L 225-93 and 225-96 Code de commerce)
Regulatcon of Communicatnon Among Shareholders SEC Reiease N°34-31326 (1992)
41 SEC Rule 13d-S
1
The Basíc Governance Structure 43
sharcholders to pìggyback proposals opposed by management at negligible cost
on management's own proxy solicitateon. In addition, there is a developed U.S.
case law to protect the ìntegrtry of shareholder voting from managerial manmpu-
lation. Fmnally, the U.S may be the only jurisdìction to permit corporations to
compensate successful insurgents ex post for their campaìgn costs.
The principal alternative to partisan proxy solicitation Is proxy management by
financial intermediarics and depositary institutions. In the U.S. and UI, financial
ìnstitutrons-such as pension funds, mutual funds, and unmt trusts-hold trtle to
shares and play a large and growing role in corporate governance. For the most
part, however, the stakes held by these institutions do not rise to a level where thec
qualhfy their holders as corporate insiders. By contrasti, the brokerage houses that
serve as depositare institutìons play lhttle role in corporate governance.
Matters stand dìfferently in Continental Europe, where deposìtory institutions-
banks or trusts-often manage the proies of small and middle-sized sharehold-
ers. In Germany, for example, corporate supervisory boards do not solicit
proiìes, and ir Is unclear whether they have the power to do su.42 insteaci,
small mivestors typìcally purchase shares through banks, leave theìr shares on
deposit in the same banks, and periodically assìgn theìr revocablei proxies to
these banks. The banks are under a statutory dury to ìnform theìr depositors houw
they ìntend to vote theìr deposìted shares, while the depositìng shareholder has
the rìght to direct a defferent vote 43 Nevertheless, sharcholders rarely dìsap-
proved their banks' recommendations in the past, wvth the consequence that the
banks-whìch routmnely vote with management-have mnsulated German com-
panies from hostìle takeovers or proxy contests.4 4 To reduce the proxy role of
depository institutuons, corporations have recently acquired the povier to desig-
nate thìrd partics to serve as shareholder representatives 45 It remains to be scen,
however, whether this change in the law wvillì empower shareholders or merely
shift voiong power out of the hands of the middleman and directlì into the hands
of management's hand-pìcked representatriieS. 46
The German case ìS hardly unique, moreover. Financìal intermedìarìes in
France channel the proxies of small sharcholders into management's hands
even more dìrectly. Under French law, sìgned biank prouies returned to the
company are automatically tallied as management votes at shareholder
meetgin.4' Thus, French companics sometimes contract with banks and other
42 See Karseen Schmidt, GCSELLSCHAFTSRECHI 854 (4th ed ,2002) Compare ULo HìIffec Aitien-
gesetz N'25 5134 (Sth ed 2002)
5128 Aknengesetz
44 lark J Roe, Soene D tiì Corporate Str ctvae ti, Ge7'ini)r Japoinad the Onzted
ifetecìies
States, 102 YALE LAVJOUR0NAL1927, 1942 (1 993) 5ee also 8tefan Prigge, A S5'bew oCe Get leii
Cor'orateGoverrazce, In Hopt et - a'' s-' a note 30, 943
5134 Aktiengesetz
On the contilìt of interests attending the designation of sharreolder representatrves bx the
companv, see Tiìeodor Baums (ed ec BERICHI DER RECIERUNGSKOiM115510N CORsoRAIE GO ERN
.ANcON '21-4 (2001)
47Art L 225-106 Code de commerce
 The Basic Governance Structuere 45
44 govrernance strategìes prorect sbareholdersas a class
How
mìght in theory
financial ìntermediarìesto solicìtblank proxies from holders of bearer shareso0 and probably more so. By contrast, a shareholder majority
8
have to 'a ait several years before it could remove the management board in
deposit.4

Dutchlaw goes even further. It permits the use of a depository intermediary to IGermany.s
strìp shareholders oftheìr vote entirely This intermediart is a specialrzedvotìng Jursdictìons group differently, in the architecture of their proxy systems.
trust(admiznzstratze Kanrtoor), authornzed by statute and establìshed by the Here, the principal distìnctìon Is between the U.S., UK, and Japan on the one
corporationitself,w hìch holds andvotes the corporatron's stock and ìssues the side, and France and Germany o0 the other. In the U.S. and UK, at least, the votes
rof small and middle-sìzed shareholders can actually decide
proxy contests. On
beneficial ownersof thisstock nonvo;tng trust certificates in rtS place.49 are tvpically swept
the Contient, however, the proxles of smaller shareholders
In addition to the proxy system, many other legal devices bear on protectmng
the pow er of theshareholder ma)ority through the appomntments strategy. These into the coffers of intermediary institutìons and ultrmately delivered into the
include lìmitations on the term s of written prox es, 50 statutorv provisìons hands of the mncumbent board. Two factors explamn these dìfferences among
grantmog (or w;thholding) access to shareholder lists,5 prohìbitìonso0 circular jurisdictions: the presence or absence of codetermination and the ownership
votng structures (the votmng shares
of that are dìrectiy or indirecrly owned by the structure of publìc compantes.
company itself),52 and quorum requìrements for shareholder action53 Al are Codetermination can account for the most strìking devìations from the modal
common measures that bear importantIv on the possibìlities for manmpulatmng organization form of the board as a single-tier body of shareholder representa-
theshareholdervote. tnves. In the case of the large German firm, codetermination has formahzed and
extended the pre-existìng mo-tier structure of the board. The supervisorv board
3 1.1 5 Reflecutrg on the appoìntment rzghts strategy has grown larger and more closely regulated, and the autonomy of the manage-
Weth the exception of Germany, the structure, com posìtion, condtrtons of re- ment board has mncreased. W7hether treotional or not, these developments are
moval, and decision-making characteristics of theboard of directors are broadly highly functional adaptations to the opposmng interests represented o0 the super-
similar across publie companmes in our maìor ìurisdìctions. A shareholder maior- ì visory board. A small and agile board, splht between employees and shareholders
of
ìty can remove a dìrector atleast aseasìly in France orJapan as it can in theU.S, and deeply engaged in management, 'aould experìence a, signìficant risk
difficulty in preservmng company secrets. By contrast, the
deadlock and great
large and relatìvely passive supervisory board of German companies todav
Is
4 Thrs i0 uncommon, it appears, prncrpaiy beause quorumrequirements are so iow that it rs
seldormneessar for management totake che extra stepof searchrgfor votes much less lìkely to face these problems. By assìgnìng management responsibil-
Dutch lawalloìsthe holders ofthesetrust cereificates amodrcumof torce re lheuofa voee For ìtìes exclusively to the management board, the law insulates the company's
example, certificate horders representig 10% caprtal have the right 4eo demand an 'ivestigateon'
(eqoete) into he polcy and conduct ofmanagement (Book 2, Art 3
6
Dutch Cvrl Code) and to operations from dissension ;;wthmn the supervisory board and further restrìcts
petitìon ehe commercial courtto call aspecai shareholders meeting (Art 110/2) Var Empel, sapra the need to share information wvth the supervisory board.
note 11 140, 142-7 Furthermore, indovrdual holders of certificates that have been issued sniththe The prìncipal alternative form of codetermìnatìon-the Dutch structure
cooperation of the omparì haìethe right to attend and address shareholders meieugs (Art 117/2,
1234), iereif thew cannot voce as sIaretolders regìme-ìnsulates the superv;sory board rather than management board from
oì
eFor
example, under German lae
5
t a v;retten prox canr be conferred to bankri for a maxlmum conflicts of mnterest while simultaneously attempìtng to reflect the mnterests
lo3 Il Aktkengesetz Under French oai1 a prorc is ordinar-l; ;a1id for one The Dutch techmique for
period of 15 months both labor and capital in corporate decision-making.
shareiolder meeting onlì Art 132 Dcret \067-236 du 23 mars 1967
5C Garnog access to lists ofbeneficial (or bearer) shareholders for purposes of xxagrng a prox fight domng this, of course, Is to deny appontment rìghts to both employees and
a
is dìfficult in most maor 0ur1sdictions shareholders (rather than grant nìghts to both as the Germans do) so favor of
52 Most euresdrctions forbod controlled subsìdiaries from voteng the shares of thehr parent com-
2
eArtL 33-31 Code de regime of self-appoìntìng boards.55
pames The control treshold can be ifet unspeccfied as it is in France
commerce) or it can be set at a ariet e of ownershp percentages as it is in Japan (Are 241 Commercai Unlìke codetermination, vahìch Is a politica} choice, the origins of ownershlp
structure are complex Nevertheless, ownershìp structure seems to influence the
0
Codei 25%o and Delaxare (5160(c) Delaware General Corporateon Laxx, 0 o) German law goes
furthere h barreng controlled subsodlarers from ownong the shares oftheir parents except in special orgamzation of proMv systems almost as much as codetermination shapes the
circumstances ( 10dALtiengesetz)
53 Reiance orn quorum requremernts dìffers midet among kev corporat 100uresdicetons The U 5
sa hi 14h-queumourisdiction See, e g >216Dela;x are Generai CorporatonoLauA lestabeshlng a 50%
defaule quorum and 33 3o mandatorv quorum) Other jurisdìcruons haxe louer quorum requore- 5 Of course
e U S shearholders can oce to entrench boards for at iast t *no;ears by adoptimg
staggered board and cumulatve votig pror isions in the chartee See also m-.ra 7 22, Lucian
ments in France the mandaton quorum is 25%, but if thes is not reached, there is no quorum
overFo ce of Stagge e
requirement for a second e iog (Art L 225-98 Code de commerce) in the UK emo members are a A Bebchuk, John Coates IVand Guhan Subramtanrao, The Poi.erfui AntIake
quorum uniess che charter specrfies otherxwìse (5 370-370A Compames Act), in Japan, the defaui. Boards Theory, Evidenice C Police, 54 STANFOED LA'v REviEi 887 (2002)
reso- strate-D at al, but
quorum is half theeotreg stock, uhich ehe charter cannot reduce beloxm 33 3% for ordinare 55 This device is, techically speakig, not an instance of the1 apponrtments
bar a distinct kinship
utions tuo lect direetors or audotors and for all extraordmary resolutrons (Art 239, 256-2, 280, 343 rather an example ofthe :rusteeseip serategy Nei erheiessi itS insolat ng effectse
ommerciai Code) io those o tihe semi-autonomous management board under the Germarn regime

i
- -IL-_
 i.
46 How governance strategìes protect sharekolders as a class
organization of corporate boards. Proxy systems matter in the U S. and the UK,
where the modal publhc company 1s widely held. Proxy systems matter less in
Continental Europe, where controfihng shareholders frequentlv dominate even
the largest listed firms.5 6 Japan stands between these hvo extremes, with a modal
ow nership structure that Is more dispersed than the tnpical European company
but less so than the typical American company, and a corporate law that Is
German at Its core but heavily uifluenced by an American prototype.57 There
IS, of course, an open question of causality in the relationship berween Iaw and
owrnership. It Is akways possible that a developed proxy system-together
wsith other legal innovations-might have made diffuse ownershìp more attract-
ve to imvestors. 5 5 'W7e take no stand on this issue other than to note that future
change in ownership structures, particularly in Continental Europe, will provide
important ìnsights Into the relationshlp between ownershìp structure and
the latv. We return to this theme, as well as the role of ownership codetermina-
hon in corporate governance, after revieìv ng the remaining governance
strategies.
3.1.2 The other strategies: Decision rights, trusteeship, mcentives, constraints,
and affliation rights
Although the appomntments strategy Is the dommnant mode of protectmng the
interests of the shareholder class, other strategies also play some role in address-
mng the management-shareholder agency problem.
3 1.2 1 The decision rights strategy
Direct voting in any company with numerous shareholders mnvolves high process
costs and may often result in poor decisìons since small shareholders have lhttle
incentive to mnform themselves. Consequently, corporate law sharply limits the
kinds of decLisions for 'which shareholder votes are required or encouraged As we
expIamn in later chapters, the la'w ordinarily encourages shareholders to partici-
pate directly in substantive decision makmng only when full delegation to man-
agement 15 clearlv inappropriate, as when directors or their equivalents in closed
56 See, e g. Fabrizio Barca and Maro Becht (eds j. THE CONTROL OF CORiORATE EUrOPE (2002)
Rafael L2 Porta. Florencio Lopez-de-Silanes and Andre Shulefer, Corporare t 0vers12p AYOUd ti2e
World, Ž4 JOURN:AL O FINNCE 471 (199S)
57 See, eE MI-isual-1 Okabe, CROSS SHAREHOLrINGS IN JAI'. (2002), Mark Rarseer and
íMinoru Nakazato, JAPINESE LAW AN EcOiOse c APPROACH 1 1 (1999! Japanese corporate laws
modeled or the U S 1933 rinoisBusiness Corporanon Actj
3s Some authors iave
siiggested that strong laiv encourages diffuse osoership E g, Rafael La
Porta, Florencio Lopcz-de-rianes, Andre ShIeifer and Robert W Visì1-n, 2w ard F:,ance. 106
JOURNAL OF POLITICAL ECONOMIY I1o (l998) Onr -lghtralso expectdiffuse owscerhipssructureto
simulate the legal protecton of shareholder rights The grosing importance of equo financing in
Contonental ELrope mav proide a narural experiment of sorts on the retaonship bretveen la and
share o00ership
1
The Basic Goveriance Structutre 47
corporations are personally mnterested in a matter (Chapter 5) or a corporate
decision fundamentally alters the enterprise (Chapter 6). 9
If the law seldom mandates dìrect shareholder deciscon making, however, it
may nonetheless permit such decision makmng. Consider open companmes first 60
Here the jurìsdictìon that does the most to restrict direct decision rights iS,
significarily, the U.S.-a suxprising observatìon given the otherwise permissuve
and shareholder-friendly character of U.S. corporate law. As we discuss in
Chapter 6, U.S. shareholders can ratifv fundamental corporate decisions such
as mergers and charter amendments but are powerless to mitiate them. 6 1 More-
over, routmne matters of corporate pohicy fall within the exclusive province of the
board's authority to 'manage' the corporation. 62 Indeed, ìt Is unhikely that U.S.
courts would permìt shareholders to decide substantive corporate issues even
under the aegis of a direct statutorv grant of decìsion-makìng authoritv, such as
the power of shareholders to amend the corporate bylaws. 63
By contrast, other jutisdictìons grant more authority to the general sharehold-
ers meetmngs of open corporations German statutory law appears to lìmìt
shareholder voting to a small number of fundamental transactìons such as
charter amendments or mergers, but ìt also requires the management board to
prepare a resolution un these matters if the shareholders meeting so requests 64
In addition, German case law holds that votmng rìghts extend beyond the express
statutory hist to include other significant transactions wìth majur impiìcatrons for
a shareholder's investment 65 Similarly, a shareholder resolution to amend the
articles of an open corporation can be placed on the agenda of the general
meeting bv a minorit of shareholders in Japan, France, and the UK, and
subsequently approved over the opposition of the board if it Is properly noticed
and receves the requisite supermajority vote. In addition, jurisdìctions other
than the U.S require shareholder votes on certain routmne but important decì-
sìons. For example, France, Germany, and the UK require the general sharehold-
ers meeting not only to approve the appontment of che company's audìtors, but
also to approve the distribution or reimvestment of the company's earfings. 66
59 Se s 1infra
D rmanagerial self dealing and compensation), 5 22 (relaced transactions by
controlhing shareholders), 6 21, 6 41
0For the dstinctlion bernveen open and ciosed compaies, s5e supea
note 3
i See iiìa 6 2 1
62 E g , 141a) Delasvare Generai Corporation Lawv
-' See eg , lO9e Delav are GeneraI Corporation Law 'While the marter is noi entirer settled,
parcularlc
o wth respect to efforts to amend corporare beeacvs to rcrose anto-taieoyer defenses, ew
commentators expec SUCh n efforts to succed in Delasare
6- Sec 5119 Aktienresetz (histg matters requiring sharEholder vote), 83 Aktiengesetz (requiriog
managerient board to prepare and implement shareholder resoiutions falhing s chin tre competency
of the shareholders meetiig)
65 See discussion of the Ho1zietínler case, iììfa
6 3
66 §119 and 5174 Aktiengesetz (Germany), Art L 232-12 and 225-28 Code de
comrerce
(France) Under German and French laii shareholders mav aiso approve the inancial statements
il
the corporate board (or boards) do noì See 5173 Aktiegcsetz and Art L 225-1 0 Code de
commerce respecr eis
48 How governance strateg.Ies protect shareholdersas a class
Equally important, all EU MJIember states have given shareholders the right to
appoint and to dismiss the auditors of hsted and larger non-listed companies, 67
while shareholders also eiect the 'statutory auditors' of Japanese companies.68
However, the most far-reaching applhcations of the direct votmng strategy are
found in the speciaiized statutes that govern closed companmes. A good example
1s the German iìmnted hiability company (GmbH). Whatever lts size (which may
be very large in capitalization and number of shareholders), the GmbH form not
only mandates shareholder approval of financial statements and dividends, but
authorizes the general shareholders' meeting to mnstruct the company's board (or
general director) on all aspects of company policy. 69 The default rule for the
GmbH form, then, 1s that shareholders have complete authority to govern the
company by direct votmng-unless the company Is subject to the codetermination
law by virtue of the size of Its workforce (over 500 employees).70 By contrast,
legal regnmes for closely held companmes in France and the U.S. generaliy specify
a distinction between shareholders and directors (U.S )-or 'managers' (French
SARL)-as the default option but allow the charter to specìfy close shareholder
supervision of the company.71
How ìmportant are dLrect decision rìghts as a strategy for protectmng share-
holder mnterests from managerial opportunnsm? And how important are differ-
ences in the scope of these righrs across jurìsdìctìons? The answer to both
questions is, 'not very important in most circumstances.' As a practical matter,
the logìc of collective actìon leaves the dtspersed shareholders of large companmes
with rttle alternative to delegating management powers By contrast, the owners
of small companmes do not need to delegate management, and controllmng share-
holders are always in a position no dominate company policy-even ìf thev must
sometnmes act indìrectly by replacmng the board
See Buropean Commrssion, Gieen Peper, Tie Role, the Poseton and the Liability of tie
Statutory Avditor vizti-n the European Union 23 (1996, aváilable at europa eu mticommr Howeeer,
n most listed companies shareholders merely ratif> the choice made bv the board (id 23) See also
Commiss1on Recommendation, Statutore Auditors Independenre in tie EU A Set of Fundamental
Principles [2002] OJ L 191/22 (auditor should consider he hethe the governance structure of the
audited entite provides safeguards to mitigate threats to hbs mdependence)
s Art: 280. 254 Commerciai Code (statutorv auditors appointed be general meeting of sharehold-
ers), Art. 279 (meetng or charter sets auditors' remuneration), Art. 269 meetmìg or charter sets
directors' compensation)
6 Schmdr osupia note 42, 1068, 546 GmbH-Gesetz (ficancial statements, profit distributìon),
38, 46 GmbH-Gesetz (shartholder astructnons)
-537,
GmbH
m0 subject to codetertunation must have a tvo-toer board and is subject to AG rules or the
die ision oí f untions bet oen the boards, and betv-een boards and shareholders Schmldt, supra note
42, 482-3 ClGarl, there is a need to specih the board s powier precerie if it is used to protect the
nterests of non-shareholders as well as shareholders
- The French closed corporat0on form. the SARL, vests power to tranage tie SARL in one or
more managers, absenr a charter protision to the contrara Art L 221-4 Code de commerce
There is no parallel to the German starutorn prot ision that binds the manager to folloNe shareholder
nstructrons in exerrising managerial powe r Whìle American closed corporation statutes generally
permit direct sharehoider management of the companx, thìs requires a specalized closed coriorate
form-the société pae ai-tonos seipmfiée (SAS)-in France See Art L 227-5 and 227-6 Code de
commerce.
The Basic Governance Structure 49
These simple observations nmcely explam the distribution of dìrect decision-
makmng rights, both among jurìsdictions and benteen closed and open com-
panme.s If the allocation of decisìon-makrng rights ben veen shareholders and the
board follows the natural logic of delegation, however, one might ask why It
should ever be necessary to limit sharehoider decision~making authority by la-w.
In fact, the power of the shareholder meeting 1s strongly restrncted in oniy tvo
mai or ìurisdictions. One of these is Germany, where the tmo-tier board structure
and codetermination create obvlous structural nmpediments to direct share-
holder management in publhc companmes.
The second jurisdiction that hobbles the pov-er of the shareholders meeting by
statute is the U.S. Here the reason is less straightforward, since one might
suppose that dìrect shareholder decision rights would actually improve the
governance of pubhlc companmes on the rare occasions when those rights wete
exercised by disaggregated public shareholders. The reason why these rights are
not avaìlable to U S. shareholders 1s,*ve suspect, the considerable political powxver
of corporate managers. In particular, if U.S. shareholders were able to shape
corporate polhcy by, for example, amendmng the corporate bylaws, they could
also dismantle the defensive tactics that management erects to ward off hostile
acquirers. 72
3.1 2.2 The truseteeshìp strategy
As discussed in Chapter 2, the trusteeshìp strategy places authority over the
mnterests of a vulnerable constituency in the hands of decision-makers who lack
strong conflìctrng ìnter ests 73 In the case of shareholders as a class, trusteeshìp
protection implìes a decìsion-making authority within the firm that does not
share the financial mnterests of hired managers. Naturally, trusteeship in this
context 1s a matter of degree. At one extreme, simpiv definmng a subset of the
firm's managers as dìrectors,' wìth powers and hiablirtnes not shared by other
managers, creates a menasure of trusteeshìp insofar as the new manager- drectors
take more of the credit when the firm does well and face more of the blame when
it does badlv. They have a greater incentive than other managers to respect the
mnterests of shareholders. At the opposite extreme, directors wxthout a manage-
ment role or other tìes to the company ha ve no reason not to respect shareholder
mnterests, and potent ethìcal and reputational reasons to do so.
In addition, the law can reinforce trusteeshìp roles by removing opportunìties
for confhict with shareholder mnterests. Thìs is done, not just by imposing restric-
tions on the ability of directors to enter into self-dealng transactions (restricetons
72 Sei, e g, Latrence A Hammermesh, Corpoiate Dei-oocracy and Sia eI oler-Adopted By-
Lazvs Taklíg Back the Streetni 73TULANE L'aw REwi 409 (1998) (professtonaI consensus is that
shareholder-adopted byla. to repeal a poison pell - ould veolate statutorv poi-ers of the board under
Delao arelat t remaìns to be seen tehether other jurisdictìons
0 llìalso come to restrect shareholder
management rights as shareholdings become more diffuse The case of the UK suggests that manage-
rialìst restriettons o0 shareholder power are not the ioex itable consequence of diffuse ownershEp, at
least not ohere ostitutional shareholders retam a maor role incorporate governance
73 Sìpra 2 2 2 3
 N
50 How governance strategìes protect shareholders as a class
that are similar in character to, though perhaps different in detasi from, those
imposed on managers in general), but also by completely separatmng dìrectors
and managers: that Is, by mandatmng that some directors cannot be salarìed
employees of the firm.
As noted above in the discussion of board committees, legal ìnstrtutions
encourage the appontment of at ieast some independent directors in all of
the principal corporate lawx jurisdictions including, arguabiy, even Japan§7
4
Germany bars managers from sittng on supervisory boards entirely. France
follows closely by providing that not more than one third of the directors elected
by shareholders may be employees of a French open company, thus preventìng
managers from dominating the board. 75 U.S. law, although not so categorical,
strongly encourages non-employee (and otherxwise independent) directors on
the boards of public compames,76 while U.S. exchange rules now require a
majority of independent directors on the boards of lhsted companmes. The UI
has been movxng in the same direction as the U.S., but this does not show up
so much in the statutory or decisional law as in the listing rules. (As a conse-
quence, a gap in governance opened up betx een histed and non-histed
public compames, whilch the UK Company Law Review has moved to close.)
The U1K Ieads the U.S , however, in dividing the roles of the CEO and chair of the
board of directors and assigning the powerful chairman's role to a non-employee
director. -
Like dìrect decision rìghts, the value of the trusteeshìp strategy for the protec-
tion of the mnterests of shareholders as a class is closely tied to oxx nershìp
structure If shareholders can organize no elect theìr own directors in a meanmng-
ful fashion, trusteeship Is a poor substitute for legal rules that encourage the
selecnon of directoìs who are strongly motxvated, financially or otherwise, to act
in the mnterests of shareholders Thus, the trusteeshìp strategy-to the extent that
it works at all-is potentially important as protectnon for shareholder mnterests
only for publie companmes wìth dispersed shareholders. Thìs means that trustee-
shìp as a device for controlling managerialism ìs most attractive for U S. com-
pames, where it 1s aiready a well developed institution, and perhaps also for
Japanese companmes, where it has only recently gamed a foothold 7s Even in the
'4 japanese Iaw now provides for the trusteasip strareg in the corm of a chorce betveen statutorv
auditors. a least half ofehom must be independent, or a tripartite structure of board committees
staffed bc malorities of mdependent directors See ipca note 63
5 See Art L 225-22 Code de commerce The charter of an SA ma> proe de for additional
emplo ec directors elected bv the emplovees themselves and not the sliarcholders Art L 225-27
Code de commerce (empIoveer mav elect directors eo not exceed 1/3 of other board members) As of
2002, ciaetion of employee directors became compulsory in France
ivhen emplovees hod in aggregate
more than 3% of a compar's capital Art L 225-23 Code de commerce
6 For example, approval bnidependent directors earns U S nanagers more relaxedrudiceal
remaiew of self-mterested decsioons, greater leverage oer the dismissai of shareholder sults, and even
elgibhlitr for favorable tax treatmient of management compensation plans
See Bernard S Biack and John C Coffee, Hail ßi aa;-,a?1 stzty oac Iifvestoi Bdbaveor Under
L2n4teá RegRInatìo, 92 I ICHIG LAW x REVIEW 1997 (1994)
Se, sitpa note 74
The Basie CGovernance Stru crore 51
U.S., howeever, it Isunclear howmuch independent directors actually contribute
to the improvement of corporate governance.'9
3.1.2.3 The reward strategy
a The Principal rewards to management for pursumng shareholder mnterests are
created by>contract rather than bylaw,notabI> through the vehìcle of compen-
saion contracts. Nevertheless, the laxv can facilitate a rexxards strategy, and
sometimes even mandates it. For example, although the sharmng strategy ls
wxdelv implemented through voluntary stock ownership plans that force top
executives and directors to share in the economicfate ofshareholders, at least
one jurisdìcton-France-mandates nominalshare ownershìp for directors by
Iaw;10
The more important reward strategyis pay-for-performance, vhich is xx dely
used in the U.S.-and is mncreasmngiy used elsewhere-to provxde managers wxth
high-powered incentives to create shareholder value. U S corporate lawx,in
particular, goes far toward facilitating performance-based compensation by
authorìzing the issuance of stock options, shadow stock, and other forms of
5
incentive compensation 81Ar the samne time, U.S. disclosure rules 2 and tax
regulations11 also favor performance-based compensation. At the other end of
the spectrum, the reward strategy has onI> recenti> emerged in German>, x-here
incentive compensation for corporate managers lsgenerally quite restrrcted, in
part because neither tax law nor company law have encouraged it-although
new reforms have begun to change thìs, for example, bv permitting 10% of
outstandmng shares in a pubhic company to be repurchased for the purpose of
underxxriting a stock option plan 84
Were we to predìct whìch jurìsdictìons rely the most on high-powered com-
pensation incentìves for managers xxrthout knoxwing about anythmng other than
differences in ownership structure (and perhaps somethmng about shareholder
organization) across jurisdictions, we would probably guess that countrìes with
large numbers of wxdely held companìes-the U.S., followed by the UK-x\vould
lead the rest. And we would be right. Less clear, however, is whv this should be
so. lt mìght be that high-powered compensation is a rational alternative to close
monmtornng bv powerful shareholders or by an active takeover market-or it
9Se supra note 27
5Ar L 225-25 and Art L 225--2 Code de commerce The minimai number oí sharesis -o te
determindd be the c but rav be as ore as 1 share-naking share o^ nership nore ikin to a legal
narter.
suggeseon than a requirement
'E g , 5157 Delaware General Corporaton Lave
s2 Securitics and ixchangeCommesseon Reginarcon S-K, Itemi402, Executve Co pensation)
83Inca Re enue Code n162(m}
54 5,71 ALtcingesetz ao
1997 reform to encourare option compensaton) reemption rits
e a" e
e or managerial compensation The EU seeks
been another important obstacre to share repurhases io
reduce this obstacie bc relax'ng shareholder approal and preemption nght requcremens Sce Art 19i
9
20 and 29 Second Compans Lav. Diretve [1977] OJ L 26/1 and [1 92] OJ L 34-/64, ìppicabie to
AG, SA, pubhic corrpanes, etc
52 How governance strategìes protect shareholders as a class
might be that generous compensation 1s the result of inefficìent shareholder
monitoring.85
3.1.2.4 The eonstratnts strategy
Generally speakmng, rules and standards play an important role in corporate
governance only in particular areas, typically ìnvolvmg related-party and con-
flict of mnterests transactions of the sort we address in Chapter 5.86 The only
standard that qualhfies as a general mnstrument of corporate governance is the
duty of care, whìch sets the mimmum quaiity threshold for managerial decisions
at some benchmark standard such as 'negligence' or 'gross negligence.' Definmng
and enforcing such a standard is notorlously difficult and, to our knowledge, 1s
not done rigorously anywhere for good reason: evaluatìng busmness decisions ex
post 1s difficult, and legal error in imposmg liability is lhkeh to make directors
overly rnsk averse ex ante r The rare case in wvhch the law appears to hold
directors liable for negligent decisions w ìthout evidence of bad falth or self-
dealhng generally involves extraordmnary and easily distinguìshabie circum-
stances that we consider in later Chapters, such as a sale or merger of the entire
company (Chapter 6) or the onset of insolvency (Chapter 4).88
3.1.2.5 The affihatzo rizghts strategy
Reguiation of the terms of entry and exir performs a corporate governance
funcnion in malor jurisdìctions, principally as a byproduct of facilìtating active
tradmg in shares. Share prices in large and liquid markets continuously aggregate
and assess information about firm performance, and mnstantly rebuke top man-
agers who appear to act contrary to shareholder mnterests. Securities law, lìstrng
rules, and the mandatory disclosure regime for public markets-all of which we
address in Chapter 8-contribute to the qualirt and speed with whìch infor-
mation about performance 1s reflected in share prices. In addition, corporate law
mnfluences governance through the entry and exit strategìes by mntervenmng in the
market to make hostile takeovers more or less difficult As we discuss in Chapter 7,
our major jurìsdìctions differ in the extent to which they allow managers to
defend agamst hostfle takeovers. In theory, most jurisdictions sharply restrrct
anti-takeover defensive tactìcs, although only the UK's City Code mandates
managerial passivitì in the face of a hostfle offer.8 9 In practice, ownershìp
structure and general prìncìples of corporate law (such as co-determination)
Se, e g. Marcel Kahan and Easvard Rock, Howv Learned toS top orrxvg aed Love the Pill
Adocpte e Res onses tO Takeover LaviJ, 69 UNIc ERSI Y OF CHICAGO CLAWREViEWi 871 (2002! eoption
compensateoni s a subststute for takeoeer pressure) But see e gi Lucian Bebchuk. Jesse Fred and
David Walker Execstz'e Coepenìs.tion.ì Aeria i OpttlCca ContraisigOí Extractìon oo Rents
(Norking Paper 2001, axailabee at ssrn com)
Seeìinfra 1 4 , leande52
See, e g, William T Allen and Reeeer Kraakman, COMIMENIARIES AND CASES ON HE L OF
BUSINESS ORGANIZAIION (2003. Chapter 8)
gS Sce :ioa 621,6 3and4231
See ìnfra 7 2 2
The Basìc Governzance Structure 53
obstruct hostile takeovers to varyng degrees in German,, France, and Japane90
But only the U.S. and the Netherlands specifically empower boards to block
hostfle bhds. Indeed, U.S. courts, in particular, have endorsed the so-called
'poison pill,' whìch precludes a hostfle bhd entirei over the obhection of a
defending board of directors.91
How can we explam these jurisdicrional differences? Again, ownership struc-
ture offers an answer. Untfl very recently, at least, hostfle takeovers have simply
not been a threat to most German, French, and Japanese companmes, which have
controllìng shareholders or cross ownershìp hìes that make other defensive
tactics superfluous. Thus, it is not surprìsing that these jurisdictions limit the
power of managers to interfere with the transferabhlitv of shares in contests for
corporate control. It 1s the U.S. and UK-the t;vo jurisdictions with the hlghest
percentage of widely held companìes-thar exhìbht the most takeover-frìendly
and rakeover-hostile legal regimes respectively. But perhaps ìt 1S not surprìsing
that when owxnershìp structure allows hostfle takeovers to have real bite as a
governance mechanmsm, the law eìther accepts them (as in the UK) or vigorously
rejects them (as in the US..). More than elsevvhere in corporate law, we suspect
that the decisive factor here is the greater political influence of institutional
investors in the U1K (as augmented by centralhzed and self-regulatory laviwmaklng)
as compared to the greater politicai power of managers in the U1S. (as augmented
by decentrahized lawmakmng by state courts and legislatures). 'We explore thìs
theme in the context of takceovers further in Chapter 7
3.1.2.6 Reflectìng ori the sharehol1der-managercon flìct
As the precedmng discussion suggests, the shareholder-manager conflict is more
acute in the U1.. rhan elsewhere. In tvo principal corporate law jurisdictions-
France and the UK-shareholders seem clearly to have the upper hand in
determinìng corporate policìes In France, concentrated ownershìp gives con-
troilhng shareholders the power to discipline managers without the need for
elaborate proxy fights or corporate takeovers. Lkewise, although o\A nership ìs
more fragmented in the UK, cooperation among institutuonal investors assures
that shareùolder ìnterests dominate in most public corporations
Japan and Germany are more complex. Although ownershìp 1s concentrated
in Japan, the ìmplications of thìs are unclear because so much ownershlp takes
the form of cross holdmgs and corporate coaiìtions. These forms of concentrated
ownershìp imply managerial dommance over shareholders rather than vice
versa. In Germany ownership 1s also concentrated, but the presence of labor
dìrectors deters shareholders from fully exertmng theìr control rnghts.
By contrast, the shareholder-manager conflict remamns active in the U S., which
may explam why many unique features of U1S. law seem to cut agaìnst effective
shareholder governance. These features include costly proxni and securities law
rules that burden shareholder collective actìon (although less so than in the past),
90 See infra 7 4 and 7 5 See . eS
fra 7e2 3 and, e g .Iahan and Rock, s'pa note 85
54 Protectung imnority sharebolders
comparatively cramped limitations on the proper subjects of shareholder action
at general shareholders meetmngs, and (as we discuss in Chapter 7) broad man-
agerial discretion to defend against hostìle takeovers.92 There are, of course, tvxo
possible interpretations of these managerìalst features of U.S. law. Some argue
that they are necessary to equwp managers to protect dispersed shareholders
agaìnst opportunistic or coercive takeovers, whìle others claim that they serve
managerial interests over those of sharelholders by cripplmg the market for
corporate control
3.2 PROTECTING MINORITY SHAREHOLDERS
Although the corporate governance svstem is prìncipally designed to effectuate
the mnterests of the shareholder class, it can-and to some extent must-also
address the other agency problems of the corporate form: the conflict betvxeen
minorìty and majority shareholders and that betxx een shareholders and non-
shareholder constituencies. \Ioreoxver, to the extent that law adapts the
mstruments of corporate governance to mitigate either of these agency problems,
it inevitably modifies the governance system in vays that reduce the power of
the shareholder majority for the benefit of minorttx shareholder and non-
shareholder constrtuencies.
3.2.1 The appomntment rights strategy
Consider hoxx appoìntment rights can be used to protect minority shareholders.
In general there are two possibilities. One technmque is to reserve seats on the
board of directors for minoritx shareholders A second techmque is to limit
the voting rights of large (and potentiallv controhing) shareholders
Turmnmg first to the board. it Is clear why large-block mìnorìty shareholders
n;ight xish to have reserved seats. Board seats aoe valuable even ìf a minority
shareholder actmng alone cannot determine corporate pohcy. They provide access
to irfoimation, a forum for articulating minority interests, an opportunmty to
pressure controlling shareholders, and perhaps a real chance to shape policy by
forming coalitions vxith independent directors on the company's board 93 More-
over, there Is a simple technmque for assunrng minority representation on the
board namelv, a proportnonal or cumulative votmng rule Such a rule permits anv
shareholder with holdmngs exceeding a critical threshold to select one or more
directors The power of these minority directors can be further mncreased by
assìgning them certam comn;ittee roles or selective veto powxvers on the board.
nzfra '2 3
9-See
A recent study that appe.s to confirmn tse tliar- of mnor-in boardi representatton finds that
msior mnvestors are ne ikely o haae board representato in closed corporations thar are
managed bv contr0oirg sharcholders than m those that are not Sce Moaten Bennedsen, Wk »o
/2ave boaadsH (Workirìg Paper 2002, aialabl- at ssrn comC
tri's
The Basìc Governance Structure 55
Thus, the newly adopted company law of the Russian Repubhc provides for
mandatory cumulative voting precisely in order to ensure board representation
for large-block minority shareholders.94
Despite the potentiai alue of proportional voting as a device for protectmng
minorty mnterests, however, none of the ma) or jurisdictions mandate cumulative
votmng. Japan comes closest, wxth a default rule permitting any shareholder to
demand cumulative voring-but almost all Japanese companies opt out of this
rule in their charters.9 5 In the U.S , mandatory cumulative votmng-xxhìch was
once common96 -survives today in only a couple of states.9 7 In most nuirsdic-
nìons, straight voting is the default rule, and some ]urisdictions, such as Germany,
ban proportional votmng entirely.95
Where proportional votmng seeks to ensure minority representation on the
board, the second minority protectìon technmque-inmìts on the aggregation of
control rìghts or xvote cappmng'-seeks to reduce representation for large share-
holders This device can take mto forms. Strong vote capp=ng reduces the votmng
rìghts of large shareholders below theor proportionate economie ownership, and
thus implicitly mnflates the voting powxxer of smaller shareholders: for example, a
stipulatron that no sharoholder, regardless of the size of her holdings, mav
exercise more than 5o% of the votes at the annual sharoholders meeting. Most
major jurisdictions apart from Japan and Germany permit votrng caps of this
sort, precisely because they promise to protect minority mxvestors by diluting the
power of large shareholders. Hìstoncally, voting caps were common among U.S
corporations in the first half of the nmneteenth centurv,99 among German com-
panmes until recently,1 00 and among Dutch, French, and SWiss corporahions today,
9 A.rt 66 Russian Joint-Stock Compames Lav prosides for mandatory- cumulative iotag 1f the
numsber of shareholders exceeds 1.000 If the company has iess than 1,000 the charter mav provide for
ciualative voting In addition, the Russian statute requcres disinterested d:rectors to unan:mousn v
approve a nariet of confnlcted transacttons, including those that implicate the interests of controlhing
shareholders Art 66Russianjoint-StockCIs G paniesLa aacumulatisevotang),Art 81-84(aterested
transactronsGConsequentCl, disinterested' maorit drectors can block all transactons betwveen the
cormpaa and its controlhng sharehoLders or managers
6
Art 241, 25 -3 Commerciai Code
N Gordon, ìl:tart-1nìr as Reateonal mLestors A Nero Look at CGmnìulative Voti rg, 94
f6Jeffre
COLU'1iA LAL WREViEW 124 (1994)
97Includìng Caiforma, swhere i: is requored for unasted compames See §708(a) Calìforna
Corporataon Code (mandator- cumulative moting), §301 5(a) authorozhng opt-out from cumulative
votmng for listed companìcs)
's See 101 Alt'engesetz (electing board memberst, Huffer, supranote 42, N°8 5101 Aktiengesetz
no proportionaa aortng for saares that are freclI transferable)
99See ColGeen A DuniaIa, Corporate Governairce rn the Late 19tG-Certu-r- Euiape and USA,
in Hopt ei a, sipanote 30, 5 ln the first half of the ninertenth centuro:, votanr caps and graduatec
a0tag scales were common in t: e special charters granted by the state legirslatures, and 'ere later
imposed by general legslation oa corporatrons in certaim industraes, such as banking, insurance, and
ratiroads )
' Voting caps ere abolished for German open companies in 1998 See Art 1 N°20 KonTraG,
g134 Aktìengesetz (still permiting motag caps in non-listed corporationsi as -elI as no-voting
'preference shares)
56 Protectrnzg mìnority sharebolders
where they are said to play an important role in stabilizìng controlling coalions
of shareholders and deterrnng hostile takeovers.101
By contrast, weak vote caps hmit the extent to which controlLhng shareholders
can exercise voting rnghts in excess of their economie stake in the firm. A familiar
example is a one-share one-vote rule. A weak voting cap protects minority
shareholders by assuring that a 'majority' shareholder cannot dominate a com-
pany without acquìring a commensurate claìm on its cash flow rights. To date,
Japan and Germany are the only major corporate lurisdìctions to adopt a
mandatory one-share, one-vote rule, 102 although the ments of such a rule
have been wxdely discussed in the EU At present, French law allows corpor-
ations to award double votmng rights (a mechanism that serves to deter takeovers
and enhances the power of the state as shareholder) to long-term shareholders
who have held their shares txo oears or more.103 The U.S. and UK do not
regulate multiple votmng rcghts at all, although exchange lostìng rules hmìt the
ability of firms to recapitalize in order to dilute the voting rìghts of publie
shareholders.
What, then, are we to conclude about the use of the appointment strategy to
protect minority shareholders? The main lesson iS that most jurisdìctìons permì:
its use, but it iS seldom employed as a mandatory protection. Mandatory
cumulative votmng is unpopular in all core iurcsdictions because, we suspect,
controllhng shareholders fear both strategic behavxor (hold-ups) by mmoritv
shareholders and higher decision-making costs arising from the cnsk of conflìct
and possoble deadlock on the board.
Voting caps remain popular in many iurisdietions, but theìr popularity does
not refloct a desire to protect minorety sharcholders. These caps have other
funetions as v-ell, mcludng deterrnng would-be acquirers and stabìlìzing rela-
tions among controllmng shareholders (to the possible detrìment of minorty
sharcholders).104 We suspect that it is these funetìons rather than solicitude for
minorxty shareholders that motvì ate most strong votmng caps in Northern Europe
and France. By contrast, the one-share, one-vote rule (noxw mandatory in
Germany and Japan) does reflect the concerns of mmority shareholders-and
thìs is why, we suspect, that it remains the votmng rule of choice for publhc
compames in all maior ]urisdictions
Q See Boock2, Art 118 4-5) Dutchh Civl Code (authorizng charterprovsons limitingnumber of
otes shareholders caco exercise), Art L 225-125 Code de commerce (same for French corporatsons),
vao Empel, s'pra note 11, 142 (showsng the complementar- role of other votng restrcetions in Dutch
corporations), Peter Bockli. SCHWEeIER A -cENRECHT N 1411 (2nd ed 1996) (use of x oing caps bv
Sxiss corporations)
` Arr 241 Japanese Commercial Code, '12 Aktsengesetz German lati xxas amended io bar
shares with multiple votsng rights only recentlv, in the 1998 KonTraG Japanese laxx allows for non-
voììng shares
Art L 225-123 Code de commerce
See also 7 22
.ifra iotngcaps in takeover contexts)
The Basoc Governauoce Struoture 57
3.2.2 The decision rights strategy
Mmoritv shareholder interests also recexve modest artention in the regulation
of fundamental corporate transactions thiat require a shareholder vote. No
ìurisdiction, to our knowledge, requires the approval of mmorxty shareholders
for any corporate decision (although, as we detail in Chapter 5, maiority-
of-mmority approvaI is strongly advisable for certain fundamental transactions
in the U.S.).10ì Mmorntyinterests are accorded a weaker form of deìsoon rìghts,
however, mnsofar as every major lurosdictìon requires an effective supermajoriti
vote to approve fundamental corporate decisiono As we discuss in Chapter 6,
the range of sognìficant decisiono subject to shareholder votmng varces, as does the
precise voting threshold required for approval.106 However, in every jur>sdction
thos threshold exceeds 50% of the voting shares.' 0 7
Arguablv, then, all malor corporate law jìurcsdìctions use the decision rcghts
strategy to protect mìnority shareholders, but only at the margin-to give large
minorìty shareholders (25% 1) a blocking rcght and prevent the 'bare ma)orty'
from trumpmng the wll of the 'near maiority.' Presumably the costs of such
protection are small, since a mmority that owxns 25% or more of a company is
unlhkely to harm it. But the benefits are lìmìted as vvell, since supermajocrty
requirements are unlhkely to aìd dispersed publie shareholders except in unusual
circumstances in hich turnout is low and small numbers of minority sharehold-
ers can carry the day. In most circumstances, supermajority votmng, like votino
caps or proportional votmng, is likely to matter chiefly in closeiv held compames
and public compames wxth concentrated ownership.
3.2.3 The trusteeship strategy
As wxth the appointment and decìsion-rights strategies, the extent to which core
corporate lawxìurisdictions employ the trusteeshìp strategy to protect mmority
105 See einfa 5 2 2
116 See :nfra 6 2 2
117 For example, Gerran) requires a 75'/o sote of shares represented at the meetng to approve
fundamental transactions for closed corporaeons See §53 GmbH-Gesetz (charter amendmient), 60
(disso1urionì, Ž50 UmxxandLungsgesetz (merger) And Germany imposes the same requarement for
open corporations See 5179 Akciengesetz (charter amendment), 5§182, 222 (increase or decrease
authorized capital), 5262 (dìssolutaon), 565 Umxxrandiungsgesetz (merger), §176 (sale of substaniall)
all assets), and 240 (change of legal form) Similarlc. companx iaxv in the UK requires a vote of75%
of represeted shares to pass excraordinari resolutaons', 5378(2) Compa ses Act Se Davses, saìpra
note 14. 343-4 France requares a t o-thcrds majorit of represented shares for charter amendments in
open corporatsons (Art L 225-96 Code de commerce); for increasno capirai by issuing nea shares
(Art L 225-129, x sth an exceptson for bonus shares) A 7,5% xote of shares represented at the
meeting is required for convertìng an SA into an SARL (Art L 225-245 and 223-30 The
last requirement is aeneral1y mandatory for closed corporataons See Ari L 223-30 Code de com-
merce (charter amendement, inereasing capi ai) Note, too, that the French securstics authoras
encourages a shareholder vote on all sìgnsficant corporate transactcons See Pierre-Henri Conac, LA
ReGULATIONT DES 0LxRCHos BOURSIERi PAR L4 COB ET LA SEC N 186-9 (2002) The Japanese
58 Protectìng mrnority shareholders
shareholders ìs limìted. Directors can usefully represent the ìnterests of the
shareholder class to the extent that they are mndependent from the corporation's
managers. But for these same dìrectors to serve as trustees for mnnorzry share-
holders, they must be mndependent not from managers but from the firm's
controllhng shareholders. The cost of such independence ìs clear. Dìrectors who
can successfully oppose the shareholder ma]oriy to ald the shareholder minority
can also oppose the mnterests of the shareholder class to pursue their own
mnterests.
There are several technmques by which directors can be given a measure of
independence from controllìng shareholders. One Is to weaken the rights of
shareholders as a whole over the appontment of board members. In the extreme,
shareholders can be strìpped of the power to appoint dìrectors on the model of
the Dutch structure regime In thìs case, dìrectors come to resemble the trustees
who manage charitable trusts and nonprofit corporatìons, and the company Is
only beneficaally owned by Its shareholders A second and (much) weaker
technìque for cultivatìng the independence of a company's dìrectors Is to dìsrupt
tther financial ties to the company's controllhng shareholder, as when parent
compames are barred from appomìtng their employees to the boards of their
partially held subsidìarìes 108
Fmallv, a thìrd-and even more modest-applicatìon of the trusteeshìp strat-
egy 1Ssimply to require board approval for important company decisions. For
example, the authority to initiate proposals to merge or dissolve the company
can be vested exclusively in the board of directors, as it Is under U S. law
Alternanìveiy, shareholders may be barred from dìrectly makmng any decìsions
about corporate polhcy wìthout the invitation of the board, as they are under
German law.1'09 These measures constrain the shareholder majortry from pursu-
mng Its polìcìes through directors who, although appoìnted by the majority,
nevertheless face a different set of responsibilitìes and porential lhabìlirìes by
virtue of their roles and financial stakes. Even if they are appointed by a
controlling shareholder, these dìrectors are lìkely to be less mnterested and more
solìcitous of the ìnterests of mìnority shareholders than the shareholder who
selected them.
None of these legal technmques for protectig minorit> shareholders are aggres-
sively developed by our major jurìsdìctìons, however In France, the UK, and
Japan, controllhng shareholders can easfly dismiss dìrectors and, ìf necessary,
CommercIal Code requires an approx ng xote of x o-thires of vornog shares ìih a quorum of alif of
all votmng shares (the quorum may be reduced to one-thcrd bli charter) for the approvaI of mergers and
other basic transactions Art 245 (sale of asset), Art 343 (charter amendment)i Art 405 (dissolutiono,
Art 408 (merger) Finally. even Delawvare cmplrcily mandates supermanorety approxal for mergers,
asset sales, dissolutcons, and charter amendments bx requereg the approxal of a maìoritx of orstand-
ìng shares for these deciscons See ,251 Delware General Corporatron Law (merger), §271 (sale of
assets), 5275 (dissoluton),05242 (charter amendment)
See aiso rinra 4 12 (drscussrng corporate groups)
51 19 II Aktcengesrz (shareholder max oniy vote on management issueso f asked bo tne manage-
ment board)
The Baszc Governance Structure 59
even take major corporate decisions loto their own hands. In Germany and the
Netherlands boards have more insulation from controlling shareholders, but
protectmng mmorrty shareholders falls well behmd the principal legal objective
of arbitrating conflicts berween labor and capital. In particular, German law
focuses on protectmng mmority shareholders chìefly withmn the context of corpor-
ate groups rather than individual firms (see Chapters 4 and 5)>110 Onl U.S. lavw,
which actrvely encourages mndependent directors to bargam with controll.ng
shareholders, makes signìficant use of the trusteeshìp strategy to protect minority
shareholder mnterests.
3.2.4 The reward, constrants, and affiliation rights strategies
V7e group together the remamnng strategies for protectmng mmority shareholders
because there 1s the least to say about them in a Chapter devoted to the
governance system. Consider first the reward strategy. A particular kmnd of
rewvard strategy-a norm of equal treatment or 'shared returns'-Is the principal
strategy employed by every jurìsdìctron to protect minority shareholders. All
ìurisdictions provide that dividends must be pard to shareholders pro rata wxthin
a given class of shares. It follows that corporate distrrbutìons that benefit
controllng shareholders must benefit mmority shareholders too. Other rules
that aìm at pro rata distributions are to the same effect. for example, rules
prohìbiting the firm from repurchasmng shares from selected shareholders to
the exclusìon of others, or coat-tafl rules that give minoritr shareholders an
option to piggyback on the sale of a control block of shares. N7e deal wlth these
rules in greater depth in Chapters 6 and 7.111
Legal constraints-princìpalIv in the form of standards such as the duty of
loyalty, the oppression standard, and the remedies for abus de ma1oraté-arealso
widely used in our ma>or jorisdìctìons to protect the mnterests of mmority
shareholders We examme these standards more closely i Chapter 5.112
Finallv, the entry and exit strategies are at least as important to minority
shareholders in our core ìorisdictions as they are to the shareholder class, albelt
not in the same way. The principal entry strategy Is, of course, mandatory
disclosure To the extent that disclosure, as a condition of entering the pubhc
markets, reveals controlhing shareholder structures and conflicted transactìons, it
enables market prices to reflect the risks of controller opportunisin and penalize
specific imstances of it. In additron, disclosure provides the information necessary
to support the protectìon of minorìty shareholders through other strategies, such
as dìrect votng or litigation to enforce fiduciary dutres. As we develop in
Chapter 8, all maìor jurisdictions provide signficant protection to minority
shareholders today, through mandatory disclosure rules, securtites lxws, and
o e c'ra 4222,4 233 and52
See, e g. nif.a 6 4 (corporate distributons) and 7 33 (mandator bcd
2Se -Tira 5 2 3
60 Protectmng eznorzty sbarebol1ders
hsting requirements-although the scope of mandatory disclosure requmrements
remamns most extensìve in the U S. and the UK. 1 3
By contrast, the exit strategy is used more spatmgly to protect mineity
shareholders. Permanency of mnvestment is a hallmark of the corporate form,
unlhke the partnershìp, for which exit-eìther through voluntary withdrawal or
hmìted terms of mxvestment-is a central governance device for protectmng mm-
oretv investors As we address in Chapters 5, 6, and 7, corporate law provmdes
hmited ext tights in some jurtsdictions, but oniy upon egreglous abuse of power
by a controllhng shareholder or upon the occurrence of major transactions that
threaten to transform the enterprise For example, the possibiliry of appralsal
rnghts (a mandatory buyout option) upon the occurrence of a fundamental
transaction in the U S or Janan;1"4 or the mandatory bhd rule trrggered by a
sale of control that is featured in the City Code and the company laws of several
major European jur1sdictìons.ììs
3.2.5 Reflectng on the mìnority-majority shareholder confhct
In some respects the protectnon of minority mnterests in the corporate governance
system is mxversely proportional to the power of shareholders as a class. In
France, concentrated oexnershìp and a sharehiolder-frnendly corporate laxx gire
the shareholder majority undisputed mastery over corporate poelcy in most
companmes; as we note in Chapter 5, large-block mneortty sharehelders can
protect their interests chiefly by petitìonmng the courts to appoent an mnspector
for suspect transactions 116 Board structure gives mieority shareholders only
marginally more leverage in Germany and Japan Although Japanese law
favors mneorìty shareholders on lts face, Japanese corporate practice-with
insider-domìnated boards-ìs deeply managerialìst. The German law of co-
determination dflutes the power of all shareholders as a class, but this is unlikely
ro dilute the power of controllhng shareholders vxs~à-as mnmoeity shareholders.
Fmnally, the dispersed ownershmp of most publhc companmes in the U.S. and
UK predictably reduces minority-maeority shareholder conflict. But thms
result folloews as a matter of owenership structure rather than law The wide-
open law of corporate gevernance in the UK hardly restrrcts the discretion
of controllhng shareholders. Only U S law aggressivxeh protects minority
shareholders by emphasizing independent directors, direct votmng rtghts, and
fiduciary duties
In short, jurisdìctional differences in minority protection seem less important
than the simple fact of dìfferences in ownershmp structure. In our vxiew, those xw'ho
I;Tffa 5 2 (mandatori disclosure for pubic issuersl See also ;sffe 4 21 (accounting and other
financial desclosure requarements for open and closed corporations) and 2 1 (disclosure
a of related
part transactions be controlling sharcholders
Infra
ì14 6 22 1
115 Inftra T/ 3 3
116 See tiz,-,- 5 2 2,
The Basme Governance Struicrte 61
expiamn the structure of share ownershìp in terms of the law must look beyond
the governance system for jurisdmctional dìfferences sturdy enough to carry the
explanatore burden.117 Indeed, the remarkable fact Is how little the prmncipal
corporate law jurisdictions are wxlling to bend corporate governance rules to
protect mneority shareholders, regardless of the modal ownershìp structure of
publhc companmes.
3 3 PROTECTING NON-SHAREHOLDER CONSTITUENCIES
Even though the corporate governance system gìves relatively rttle protectmon to
mimoritv shareholders, several European junsdictions rely heavily oen it to pro-
tect a ;ìeee-shareholder constìtuency: namely, the flrm's emploeees. In theory any
non-shareholder constituency could be protected by board representation, but in
practice only labor is protected by mt in some European jurisdìctions 118 By
contrast, to the extent that other non-shareholder constituencies are protected
by corporate law at all, it IS chiefly in the form of duties and standards that
exhort or mnstruct corporate officers and directors to consider the xwelfare of the
'enterprise' and all of ìts constituencies. We consider these standards below.
(Bear in mmd, however, that we focus on governance-based protections in
thìs Chapter, not on transacteon-based systems of regulatron such as creditor
protectìon, which are addressed in Chapter 4.)
117 La Porta et alr, sipa note 55, 1130-1 describe on anii-director' idex of Xielements of
corporate lav thit purports to measure legal protection of miaorin shareholder rights Of these, four
relate io the gac ernance sstem One is present in all of the core corporate la, iurisdictions (the right
to mail a proxs prior to a sharehoider mecring) Threen our i , are of mnemal importance (the
absence of a ban oa cumulative aoring, a 10% share threshold for caling exr ordìlarn meetengs, and
the requerement that bearer shares cannot be cvithd rai from the instatuion in whitch thev are
deposated for severa deays surrounding a sharcholcier otre The remainang teo aoppression remecl
and preemption rights) are transacnaonal constraets rather than goaernance marters E eni on the La
Porta scaie, ho ìen
it is noteaorthe that Delacare lac assumes the same mlddlig G aiues as doas
French lav (3 out of6)
To soae extent labor s interests are protected bc strateias other than appoantment rìghts and
trusteshe p case Fr exampie, the Europea Nearks Council Directì c,[1994] OJ L 254/641 r res
ehatMember states establish procedures for informangand consultinog mpovees in er firen ith ai
least 1,000 emp aees German and Dutch eorks councils also ha e lImìted d drect acisionrights
Sections et
i7 see of the German Betriebsverfassunosgesetz permwt m orks councils io co-decide
(vcith managemente matters such as the mternal workimg order of factories, daìlv aorkeng tìmes
health and safen reguaations and local pronciples ofremunerateon The Dutch l orks Councai Act has
simlar praovisions There are also instances of the recarc strategv in the form of legalle sanctaoned
sharing regimes For example, the U S has tax-fanored emplovee stock oc aership plans, sce
Henre Hansimcìnn, THE ONERsHIe OF ENTER'RISE 37 (1996) France oandates both extense
informateon and more alited profit sharing rights in all firms c-cth more than 50 vorIers See Art
L 431-1 432-1, and 442-1 Coae du traacal, CozCan et al, s'pra note 39, N°922-3 (emp1oUces
nforlataon rlghts are at leastequal ancigo sometames benoa those of sharehoders) and 929-31
(profitsmust cn1y be sharedìf the taxable return on on funds exceeds 5% and musa net be
distributed for 5 earse
62 Pcotectrng non-sbhaiehoiderconstitHeenCìes
3.3.1 The appointment rights strategy
The xxidespread introduction of employee directors to the boards of large
European corporations must be counted as the most remarkable experiment
in corporate governance of the post-War pernod. It is an experiment that has
taken many forms, from minor tinkermg with corporate boards at one extreme
to establhshmng a near parnty in appointment rìghts between capital and labor
at the other. Indeed, the only EU countries that have not introduced any
form of v orker representation on the board are Portugal, Belgium, Itaiv, and
the UK.
Consider the range of appomntment rights for labor on the Contmnent. At one
extreme, Ireland, Spain, and Greece only mandate employee directors for state-
ov ned enterprises. France is also conservative in this respect; it requires firms
with more than 50 employees to allow; two non-votng worker representahives to
attend board meetings, but permits firms to allow employees to elect up to one-
third of the board.119 The Scandìnavìan countrìes are more aggressive As an
example. Sweden requires compan> boards to include up to three labor directors
selected by the trade unions, although ìt also mandates that union dìrectors must
absent themselves when the board addresses contentìous ìssues of labor rela-
tions.120 Employees have an even larger presence on the board in countrìes that
fix employee directors at one-third of the board (Germany for companies with
betwaeen 500 and 2,000 emplo>ees, Austria, and Luxembourg21i) Finally, at the
far end of the spectrum, the 1976 German law of codetermination for companies
with over 2,000 employees establishes 'quasi-parity' ben; een employees and
shareholders in the composition of the board,122 thereby creatmng Europe's
strongest form of labor representation (apart from Slovenia, whìch has adopted
German corporate and codetermination la;123). Quasi-parìty under this statute
must be distinguished from the full parnhy of labor and shareholders establhshed
Art L 4o-ó6Code du travall mandates thatt vorepresentaties of the empio;ee committee-
coinité d'entreprise-ma; attend boarto meetigs) Art L 225-27 Code de commerce (charter can
pros ide that emplovees ma; appoint up to four directors-five in a listed SA-proxided not more than
one third of the diretors are elected by employ ees) Emplo;e directors are not conited in determin-
ng the legal mioirnum and maximum number of directors (Art L 225-1- Code de commerce)
120 19Z Act on Board Representation for Emplo'ees in the Private Sector. Unions mai elect two
directors in S'edish companies xxth 25 or more empio ees that are governed by a collectve
agreement, ther mav elect three directors in compaoes 'ith 1,000 or more emploxees ano multiple
acri itiis Unìon dìrectors cannot participate in board discussions of collective barganrg or industriac
actions (lockouts, strikes, etc i
Se Table i of the Davignon Report (Group of Experts, EUROnEiA'N SYSTEMS OF WORKER
I:VOLVEiMENT, Final Report, 1997) Note that the Netheriands seems poìsed to ìocn hlusgroup See
supra note 12
122 Klaus Hopt, a collaborator inthìs volume, offers the apt phrase of 'quasi-parnty'i o signal that
sharenolder representatives on the supe;r isoci board retaon ultimate po;er in the ì ent of a disagree-
cent oi er pohic Klaus J Hopt, Labor Repi rsecatzon on CorporateBoards l'zpacts cadPo ib1is
yor CorporateGoLerna-ice aod Econor,zzc lZt i iiE-ope,141NTERNATIONAL OF LAW
oE;
AND ECONOMICS 203, 204 (1994j
' See Rado Bohno and Stephen Ms Bambrhige, Corporate Gove- ance i1i Post-Pc% atzied Slo-
ieza. 49PAcMERICAN JOURNAL OF COMPARATeI E L.A; 49, 58-60 (2001
The Basìc Governance Structure 63
by the so-called Montan-Codetermination Statute of 1951, which presently
governs a relatìvel> small number of coal and steel companmes.
Under the quasi-par>ty regime established by the 1976 lawv, fully half of the
members of the supervisory boards of Germany's larger companmes must be
employee representatives.1 24 The term 'quasi-parìty' denotes the fact that
equal membership on the supervisory board does not mean equa! power because
the chairman of the board, who is almost alwxays elected from among the
shareholder representatìves, has the statutory power to cast tie-breakìng
votes.12' Nevertheless, employee representatives are by no means po;werless
since the> retamn a veto over the appomntmenti(and reappomntment) of the
management board, whìch mncludes the company's senmor executìves 126 In add-
ition, the 1976 starute allocates one seat on the all-important management board
to a non-managerial employee (appointed by the supervisory board)ì1.7
Given that even the principal German codetermination statute withholds
decisive power over corporate pohicy from labor's hands, how can board repre-
sentation further labor's mnterests? The answer ìs that, as w;th minority share-
holder representation on the board, it can protect employee mnterests in at least
three xavs.
First, employee dìrectors mav be able to influence corporate pohicy directi>
through the exercìse of voting power on the board, eìther through coaltnons
wxth other directors or by carefully vetting managers. For example, the po;wer of
German emplo>ee directors to approve or veto the reappomtment of semor
executìves to the management board clearly gìves important leverage over
corporate pohicy. Second, even when employee directors lack the formal votmng
powxer on boards to shape company polhc>, they ma> be able to shape polcy
indirectly ìt iooks and feels bad to have decisions made by strict party-lme votes
betwveen shareholder and labor representatìves Fmnally, in addition to influen-
cmng corporate polìcy through deliberation and votmng, labor representatives on
the board mav playan important informational role. Mutually wasteful strategic
bargamnng behavior, such as strikes and lockouts, occurs at least in part as a
consequence of imperfectlv shared information between the firm and partìes
who contract w-th it 125 Byconve>mng information to the other board members
1 1, Niìtbestimmungsgesetz 1976
12S In compameis iìth over 2,000 emploxes, board members elect a chair airth a ro-thcrds
majorit: If a ro-thirds majorin cannot be reached, the shareholder representatìes choose the
chair ,27 MIrdbestcmmungsgesetz When the board splits evenio on a decisono, the chacrman casts a
second, decidina T ote C29 hitbhrstcmmungsgesetz
126 Election to ohe management board iSbn a trio-thcrds majortn mote of the supervxsory board
(527X Metbhsemcmmungsgeseczi, whch gces empiovee representatcves a eto over the seimor managers
of the companì The German codetermìnation structure is a carefull crafted compromise For
discussion of ongms, s-e Katharma Pistor Co-Detci,7'matio;z Ta Ge-' an-y A Socio-
,its -egslatire
Polnìcal Modeli Gomerc-cae Exte7 na!itzes, in Margaret M Blair andMarc J Roe (cds
EBPLOYEESe N1 CORnOeATE GwnERNANCE 163 (1999)
-i33Mitbesrcmmungsgesatz
128 SeeJohn KeipannandRobertnilsoWinoBaga m
cixgtig i ixCocp:teI- iTi;ioratzon31JOURNALOF
ECOSl0Niic LITEFATURE 45 (1993i
64 Protectingnon-sharehoiderconsrìtuencìes
about the mnterests of the non-shareholder constituents, and even more import-
antly by conveymng credible information to those constituents about the firm,
non-shareholder representatxves can help to avoid such costly behavxor. Like-
wise, by dìsciosing credibie information about the firm's prospects and pohcies,
employee directors can reduce the firm's opportunirt to behave expIoltatxvely
toward its employees-for example, by xxwaìting untli the last minute to reveal
information to xvorkers about plant closmngs and accompanymng layoffs. Note
that both these considerations may create an incentxve for the firm's shareholders
themselves ro provide for non- shareholder representation on the board, since the
firm itself may benefit from the resulting increase in the efficiency wxth wxhich it
can contract wxth the mxvolved constituencies.
As xith minority shareholder directors, how ever, employee representahives on
the board can create s;gnificant costs as v-ell as benefits. One hikeiy source of
costs iS the difficulty of bridging sharpl divergent interests between the board's
constituent groups of employees and sharehoiders through the normal nstitu-
tions of corporate governance. Moreover, there may be important differences of
mnterest even among the employees themselves-for example, because they per-
form different functions, receive different levels of compensation, or expect to
retere at different times. \Votìng is a highly imperfect xxay of makmng decision; in
the presence of such differences of mnterest, since any> voting rule-including
particularly the malority rule commonly used by corporate boards-creates the
incentive and the opportunity for a dommant coalition to exploit the minority or
ro adopt highIv inefficient policies, and also runs the rnsk that the decision-
makng process itself wxx1 become hìghly cumbersome and costi>. The great
raritr of firms in xvhich, absent legai compulsion, empiloyees are gìven represen-
tation on the board of directors suggests that in generai these costs substantially
exceed the potential benefits in most cases.119
A second source of costs iS that labor representation on corporate boards I;
hikeiy to exacerbate the agency problem bet veen managers and shareholders as a
class. Managerial discretmon increases, even where share owxnership iS concen-
trated, if managers can approach labor directors to counter the power of share-
'29 If it vere othenrxse, one would at icast expect that some number of start-up firms aould
voluntarclt adopt a degree of empIoyee representaton ornthe board as a means of loxering its overall
labor costs lsince empio ees could be expected to reduce their overall compensaon demands in
return) More generai evioence car be foand in the fact that, thile all developed economies contamo
not onih rvestor-oatned firms but also large numbers of important firms that (ike proaessional service
firms) are empleee-oAned or that (ike mtual and cooperat le compan'esc are oned bh their
customers or suppliersc i is nearlt al~s the case that, in an' gnen firm. the group of persons
sharmag ownership is remarkable for irs homogeneIr of inerest Eoen Aothr investor-oaned firms.
for example, it is highi unusual
o for both preierred and common sharehoiders to share segnrficant
voting rights, and even xwith empioyee-ov ned firms it is rare for both managerial and aneemplovees
co share controm Sie Henry Hansrmann THE DWNERSHIP OF ENTERPRISPe1996) It appears that the
politica-np, goa ernance mechamnsms of corporations the appoontments strategy) cannot easily be
adapted to resolve sianificant conflcts of interest effectixelv-a point aireadx touched on in our
dascussion of the potential for usong board represenzta on for protectìng minoriti shareholders
interests ves-à-,iis those of the maiorit, sca1 3 21
1.
The Basìc Governance Structure 6S
I
hoider directors and vice versa. Managerial autonomy also increases because
superv ì;ory boards that are large and sp htbetween labor and shareholder 'seats'
are hard-pressed to monitor managers closely Managers are hkely to withhold
information from the supervisory board to hmit leaks to employees and com-
petitors, xxith the acquiescence of shareholders;.30 The board's committee struc-
ture is also hkeiy to reflect the labor-shareholder spht, as each side struggIes to
dominate the board committees that most matter to them.131
3.3.2 The trusteeship strategy
The costs of appointing directors who are dedicated to defending special inter-
ests on the board might seem to favor trusteeship over appomntments as the
strategy of choice for protectig non-shareholder interests. In pomnt of fact, of
course, the Netherlands offers a fully developed model of the trusteeshìp strategy
in the form of the 'structure regime' introduced carlier in thìs Chapter 132 The
boards of large corporations are self-selectmng under thìs regime. Both sharehold-
ers and the unions can challenge the board's self-selections under Dutch law as
unquahified or 'unrepresenmative,' but neither of these constituencies ca n veto the
board's selecuons. In the event of a dispute, the Commercial Court in Amster-
dam ultimately decides who will sit on the company's board.133
No other jurisdiction has pursued the trusteeshìp strategy wxth so much
convìction, although modest traces of this strategy can be found in all of our
major jurisdictions as well. (Indeed, even U S. boards can be viewed as trustees
for non-shareholders to the extent that they are protected from shareholder
pressure bv dispersed ownership and corporate law, including constituency
statutes. 134) The costs of the Dutch experìment in trusteeshìp appear to be
3 Se Pistor, supí a note 126, 183-91 Pistor also proatdes arn lluminating accourt of the practice
of codetermnationin German firms as forcgng a fractonalizatnon of the supeaisorv board into
emplovee and management benches,' thich meet together prior to board maetmigsan antaxs
present a comrnon front i formai mecnngs of the supervtsory board The comona practnce of forcmg
supervisora boards to ree ew the auditor's report at tl7e boa-d neetìting, but not permitting board
members to recivee a copy for close reviet, is emblematic of the informational restrictons placed bt
the management board or the supervasora board Id 401
131 Note that the empirical data on the benefits and costs of German codetermination is mixed Se3
Fehx R FitzRovand Kto;eius lraft, Econotic Effects of Codete i-oiatzoo-, 95 SCANDItaAVIAI-
JOURNAL oF ECONOMICS 365 (1993) (suggestig overall soc0l ga13s, but decreased firm letel profit-
ablin), Theodore Baums and Bernd Fricki Tle Marketval5/e ofthe CoeteramaiedFzra, n Blair and
Roa, sp2 a note 126, 207 (finding that codeterminaton does not influence stock pr1ces), Frank A
Schmid and Frank Seger, ti I aia -siO ni'ng, Allokatior
tosi 0 E1'tSCae1d'o iireC tid
7test
S1ea20lder Vli 'e,5 ZEIT5CHRIFT FOR BETRIEBS7iRTSCOAFT 453 (1998) (codetermination is coste
fcr sharcholder)
132 See supra 3 1 1 1
1i3 See supa note 11 If th charter so provides, moreover, Dutch ìaat also permts non-shareholder
interests in genera-i-cluding the state or local communiti s, banks, bondholders, or employees-to
appoint up to one-third of the supervisory board of smallr companes Book 2, Art 143 Dutch i
Code, tan Empel, supra note 11,13-4
'34 Se' 1'fma'7 5 (constituenct statutes) Foratrustee- keanal i;softheU 5 board seeMargaret M
Blaran dL nA Stout, ATeam ProductoaT/2eo15yf CorporaeLati', 35 aiRGNiA
LAXi
REViExt 247
(1999)
66 Proteetìng non-shareolderconstìtuencnes
heavy, however. Directors who are able to protect non-shareholder mnterests are
also able to protect their owxn mnterests. Thus it Is not surprtsìng that the avaflable
evidence suggests that companmes operatmng under the Dutch structure regime are
more managetìalist in practìce-and perform less well-than firms supervised by
shareholder-elected boards 135 This appears to be the principal reason that the
36
Dutch government has proposed abandonmng the structure regime.'
3.3.3 The constraints strategy
Finally, rules and partìcularIy standards are used in varymng degrees as govero-
ance technmques for protectmrg non-shareholder constìtuencìes. Thus, corporate
officers and dìrectors owe some duties to non-shareholders in most jurisdictions,
although the breadth of these duties varìes considerabI>. At the narroxw end of
the spectrum, the UK imposes a Iìmìted duty on directors not to engage in
xwrongful' trading when a director knew or should have known that her firm
was insolvent 137 Sìmliarlv, U.S. case law suggests that the fiduciary dutìes of
loyalty and care run to the creditors, rather than the shareholders, and U.S.
statutor> law in many states explicitl> permìts boards to consider the mnterests of
non-shareholder constituencìes when makmng major corporate decisions At the
broad end of the spectrum, Dutch law uses the standards strategy to protect
employees by permittrig unìons to petition the courts to investigate the conduct
of company directors and managers.1' Japanese law holds directors liable to
thìrd parties if thev act in bad faith or are grossly negligent in managmng the
company.139 Finally, German law for open companmes mandates that manage-
ment boards estabhish 'risk management systems' for the identificatron and
contanmment of developments that mìght threaten the survival of the com-
pany.140 Thìs intrtguìngl specific provision appears designed to ensure that
the risk preferences of all corporate constituencies, and especially employees,
are reflected in corporate decision-makìng at the level of the management
board. 14'
WXth the exceptìon of the UK's proscription agamnst tradmng in mnsolvency,
however, few of these governance duties owed to non-shareholder constìtuencies
carry a sertous risk of personal liablìrty for dìrectors. One reason, we suspect, Is
that courts would find it very dìfficult to adjudìcate quasì-fiduciary directorial
l3} See Bratton and MncCaher, sipra note 12, 553 2-3 4
i36 See supra note 12
13 5214 Insolencx Ac. (wrongful trading), xxhich isdscussed furthercifra 4 2 3 1
Book 2, Art 346 Dutch Ciil Code
Art 266-3 japanese Comnercial Code Similar dunes to third partics rheoreticaffi arlse under
French lax See Art L 225-251 Code de commerce tpersonal labìlitv of board members in open
conmpanies, Art L 223-22% isame lìabilit for managers in closed companwcs) However, French
courts 'irtuali neier ixmpose iabi1ito on directors on behalf of third parties as Long as the compain
solent Sce also Cozian et al srpi a note 39 NE368, and infra 4 2 3 1
14£,91 Il Aktiengesetz, mitroduced bx the 1998 KonTraG
141 The scope of this new prcsion remains unclear and controverseal See Hiffer, supra note 42
\CC £91 Akhiengesetz, Schridt, supa note 4 81 (mentioing e 'xrorimenta issaes)
12,
The Basìc Governance Structure 67
duties runnmng to non-shareholder constituencies that are different from, and
possibly in conflict with, the board's duty of ioyalty to shareholders.
3.4 PATTERNS OF CORPORATE GOVER1NANCE
Stepping back from the individual agency problems associated with corporate
governance, the question artses: How similar are the principal corporate laxx
jurisdìctìons in the xxway that they deploy legal strategies and how can we expIamn
their differences?
A review of major jurcsdìctions reveals that they often use the same strategìes
in fundamentally similar ways. For example, all major jurisdictìons require
shareholders to approve fundamentai changes in the company's legal personahty,
such as merger or dissolution; and all mandate that shareholders elect
the decisive majority of directors on the board or managers that serve as
director equivalents in closed corporations. Despite these major commonalities,
however, company laxws are not identicai. The governance system of each of
the major corporate law lurisdìctìons reflects a distinctive balance of power
among the principal actors in the pubhicly held, open corporation, and a dis-
trnctive set of tradeoffs among the three core agency problems of the corporate
form.
In the case of the U.S., the dommnant agency problem Is the manager-
shareholder conflìct and the most poowerful corporate constrtuency Is pro-
fessional management. Contrary to conventional wisdom, U.S. law-even
Delaware law-is relatxveli unfiìendly to the mnterests of the shareholder class
bv international standards. Under U.S. law, the general shareholders meeting has
less power to shape corporate policy than it does under the law of any other
major jurìsdiction wxth the exceptnon of the Dutch structure regime (and the
possible exception of the trtpartite division of power among governance organs
in Germanx corporations) U.S. boards of directors have far more latitude to
defend agamst hostfle takeovers than do the boards of other major jurisdictions.
In addition, U.S. securitìes law burdens consultation and procxv solicitation
among large shareholders more heavxly than the law of any other jurisdictron
To be sure, U.S. governance law Is also favorable to shareholder mnterests in
some respects. For example, U.S. law encourages hiah-power compensation
plans to motivate managers, and U.S securittes law attends to the rìghts and
participation of small pubhic mxvestors in corporate governance far more closely
than do most other jurisdìctions. But both of these charactetìstics of U.S law
seem to be as reflective of the weakness of dìspersed U.S. shareholders as they are
of the strength of these shareholders. Hìgh-poxxered compensatron Is partti a
substìtute for the close monìtorìng that occurs naturali> under the watchful e>es
of controllhng or large-block shareholders It Is a substìtute, moreover, that
corporate managers are hkely to find congenial and easy to abuse. SimilartI,
actìve participation of small mxvestors in corporate xvotmng, no matter how
68 Patterns of corporategovernance
laudable it 1s for ìts own sake, 1s lIkely to have much less effect on corporate
governance than coordmated pressure from small numbers of large shareholders
with the collective voting power to dispiace the board
The two remamnng agency problems-the protection of minority shareholder
and non-shareholder rights-receive little attention in the constitution of the
American corporate governance system. As v.-e detaìl in Chapters 5 and 8 below,
the protection of minority shareholders under U.S. law today is prncipally
transaction-based, rather than governance-based. The historical concern that
American law showed for the rìghts of minoritv shareholders in structurnng
corporate governance rules-a concern suggested by the wxdespread requirement
of mandatory cumulative votig at the begmnnmg of the txxentieth centurxv-Is
noxw long past. Similarly, xxhat IttIe attention U.S. corporate law pays to the
problem of shareholder opportunmsm toward non-sharehoider constituencies ìs
mnseparably tied to the mnterests of managers in the so-called 'constrtuency stat-
utes' that authorize corporate boards to defeat hostile bids in order to protect
litier alza the firm's non-shareholder constituencies.
In contrast to U.S. laxw, UK and French law seems relatively shareholder
friendly. Share ownership 1s sphntered in the UK as it is in the U.S. However,
unhke the U S , the community of institutional mivestors in the UK 1s at least as
influential as the managerial constituency It ISpresumably the cumulaative efforts
of thìs community that has gxven corporate governance in the UK ìts sharehoider-
friendly castr1 42 Shareholders in Brìtìsh firms enjov even greater discretion in
structurmng ther goxvernance institutìons than Delaware shareholders do because
the UK imposes none of the restrictìons on shareholder poxx er that characterize
Delaware lawx In the UIK, the general shareholders meeting can, on ìts own
motion, decide upon an extraordmnary resolution to make a fundamental dispos-
ition of corporate assets such as a mergertl 4 3 Collective action among large
shareholders IS not heavxlv regulated. And the self-regulatory Cìtx Code rules
that govern the market for corporate controi in the UK expressly bars managers
from ìnstrtutìng post-bid defensive tactìcs such as the poison p1i1 . 44
French law on corporate governance is shareholder-frìendl in a different
sense. Owneiship structure in France ìs concentrated. Moreovxer, the state has
traditionally been a large shareholder in numerous French enterprnses (although
thìs 1s changmng). French laxw permìts the controllhng shareholders of French
compames to appomnt strong managers *vho are hkely to dominate their boards.
The great majority of French firms opt for a single-tier board, chaired by a strong
mdivxdual *vho is chief executìve and presìdent of the company simultaneousl,
142Fordscussionof thepoitical economv of the po-cir ofinstttionalinestorsin the uK, relate
to thosnben U S, se Da; es, sapia note 2C,GeocfrexMilLer, Polcittcal Stíi ct -e a;zJCo; poraTE
Goi iriance Soie Poiznts of Contrast
a etwee the Un ted States aeed Eaagiad, COLUMBIA BUSINEsS
REvix x 51 (1998), Ronald J GlIson, Tke Poitica Ecology of Tr/e TPogts o-i Har- wi
6 oìv Co'ioraue
tle European Co;po;ate Goiernance Eziiro';nent, in Klaus J Hopt and EddeWeineerscbeds
EUROPEAN TAKEOVERs: LAW AND PRACIICE 49 i1992)
See iìfra 6 2 2 1
4Se Infra - 2 2
The Basìc Governance Structure 69
the so-called PDG-a structure mntroduced by the Vichy Regime to strengthen
state control over mndustry by identifying a single responsible manager for each
companr.
In the absence of concentrate d ownershìp, French g overnance would seem
strongly managerìalist. Given the power of a controllmng shareholder to sum-
marily dìsmiss even the PDG, however, the French system seems just the oppos-
ite: a powerful tool in the hands of the shareholder majorrty. Governance can be
managerìalìst under these circumstances only ìf the same personnel alternate
between representmng shareholders and serving as company managers-as when
élite bureaucrats who represent state holdìngs on corporate boards leave for the
prnvate sector. But even when the shareholder and manager roles fuse in thìs
fashion, the (still) dommnant position of the state in the French economy serves to
constramn the power of French managers and shareholders alìke.
In contrast to French, Britìsh, and U.S. law, German and Dutch lawx o
corporate governance takes the agency problem of opportunmsm toward employ-
ees as seriously as the basic manager-shareholder agency conflict. The strong
systems of employee participation adopted in the Netherlands and in Germany
especially may, to some degree, refiect a tradeoff betwxeen the power of the state
and the power of employees in corporate governance. Consider, in this respect,
the case of Germanyr. In contrast to France, general postrxar delegitimization of
govertnmental authorirx in Germany may help expIamn why empowerment of
employees, rather than empowerment of the govermnent, has developed as an
important check on the power of capirai and of managers. Indeed, when the
system of an upper-tier supervisory board mndependent of management was
orgnmallv instituted in Germany in 1870, ìt was mntended as a substìtute for the
state charter and contìnuous state control that wxere then abolished. 45
Whatever the orìgins of strong employee representarion under German law or
radicai trusteeshìp under the Dutch structure regime, the consequences of these
ìnnovatìons for the allocation of governance power are complex. In both Ger-
many and the Netherlands, the single most important consequence of codeter-
mination, after the protectron of employee mnterests, may be an increase in
managerial discretion. 146 Of course, the managermalism fostered by codetermin-
atron differs from a manageriaiìsm rooted in the collective actìon problems of
dìspersed shareholders. German shareholdmngs are relatively concentrated,
and German institutional sharehiolders-notably the major German banks-
are by no means xxweak. German management enjoys discretion not because it
ìs more pxowerful than German shareholders but because the puower of share-
holders 15 to some degree offset by the governance power of labor on the
supervisory board
,l Klaus J Hopt, Tle GeCinaTuoT-Ber Board (Au4fsijl-tsrat A Ge2mima>ì
Cove;;nance. m Klaus J Hopt and Edd; E cmeersh (ci i, COiMP ARATIVE CORPORATE GOVERNAoNCE
a, 6 (199-i
146 istor, sippa note 126. 190 (Gerrnan), Bratton and 1McCaher , s-pra note I2, 3 2 (the
etherlands)
70 Patterns of corporate governance
The tension between the law and the reahity of corporate governance IS
greatest in the case of Japan. Japanese law on corporate governance ìs at least
as friendlv to the mnterests of the sharehoider class as British or French law, and is
arguably more protective of the mnterests of mnoriry shareholders. Although
Japanese lavw blurs the distinction between top managers and directors, and in
this respect undercuts the ability of the board of directors to monitor managers,
it strongly protects the nghts of both shareholders as a class and minorit>
shareholders. To take only rnvo examples, Japanese law mandates one-share-
one-vote and bars common Amerncan defenses agamnst hostile takeovers such as
the poison pill-though recent amendments may have opened the door to it.147
The paradox of Japanese corporate governance is that, despite the shareholder
orientation of Japanese law, shareholders have remamed so quiescent durmng the
post-WVar period that ìt is sometìmes saìd that managers and employees are the
real 'owners' of Japanese enterprises In practice, if not in theory, Japan is
arguably the most manageriaiìst of the princpal corporate law jurisdìctions.
These observatìons naturally lead one to ask how far legal governance strat-
egìes actuall shape corporate governance-and how far, in contrast, they are
minor influences in comparison to such extra-legal factors as ownership struc-
ture, managerial culture, and the political power of managers and employees.
We return to this issue in the concludmng Chapter of this book Here we observe
only that the most managerìaiìst periods of U.S and-as we have just
suggested-Japanese corporate history have also been pernods of prosperitr
and rapìdly rising share prices It is at least possible that shareholders have ittle
incentive to exercìse their latent legal powers during such periods because their
mnrerests are already bemng well served. By contrast, shareholder power has been
very much in evidence in the U.S. since the crisis of confidence in U.S. companmes
durmng the 1980s, first in the form of a burgeonng rtakeover market and more
recently in the form of a movement for corporate governance reform. Whfle the
evidence is more limrted, in Japan too there are indications that shareholders
have begun to exercìse theìr strong latent governance powers much more force-
fullv since the onset of economic crisis and stagnation in the early 1990s.
'7 See, e g Todd Huckab,, Note Defensive Action to Host:ie Takeover Efforts irn apae The
Shwva Decisio s. 29 COLLMBIA JOUFNlL OF Tr hNSNATIONAL LAW 439 (1991) Other defens;ve
tactics remain open in japan, howe\ er Conspicuous among these is the extensv aebret dissoong
netrork of cross-holdìngs among Japanese fi rms Recent amendments o the Commercral Code mae
haee opened the door to some defensove measures Sce iifra 7:2 3
4
CreditorProtection
GERARD HERTIG and HIDEKI KANDA
Corporate creditors are the only non-sharcholder stakeholders that every com-
pany law protects. There are tno bases for this unique status. The first is that the
class of creditors 'ncludes not only banks and bondholders, but also the
members of other corporate constituencies, such as employees or supphiers,
who accept clalms on corporate cash flows in exchange for theìr goods and
servìces. Put differentIv, because the corporate form defines the pool of assets
that bond all corporate contracts, all partìes v-ho contract w'th corporations
benefit from creditor protectnons.
The need to protect corporate creditors, however, does not necessarily imply
that corporate law must do the protectmng: the job couild be left entirely to
contractng bet veen the partres or to the generai law of debtor-creditor rela-
tions. Thus, a second basis for placmng creditor protections in company law must
be that corporate creditors face a unique risk specìfic to the corporate form. This
risk, ìt is usually saìd, arìses from the power of shareholders to manipulate
limited liabliìty to the detriment of busmness creditors.
In thìs Chapter we address the legal strategìes employed by our major ]uris-
dìctions to protect corporate creditors. Section 4.1 explores the agency problem
faced by credìtors as a basìs for placmng supplementary protective measures in
company lan. It also exammes three contexts where the need for legal protection
is arguably greatest: insolvent corporations, corporate groups, and invoiuntary
creditors Section 4.2 exammnes varìous reguiatory strategies for protectrng cred-
itors in major corporate law ]urisdìctìons. As we will see, EU ]urisdictions and
Japan employ rules such as capitai maintenance provìsions to complement a
standards strategy for protectmng creditors. U.S. jurisdìctions, on the other hand,
rely primarily o0 standards to protect creditors. Nonetheless, Section 4.3 argues
that overall creditor protection is roughly sìmliar across jurisdìctions, despite
such differences in legal strategìes.
4.1 W7HY SHOULD CORPORATE LAW PROTECT CREDITORS?
At bottom, creditors of incdiedual debtors and creditors of corporate debtors
face the same forms of debtor misbehavior. Ex ante-before borrowing-
debtors may lie about their assets to obtam a loan. Ex post-after
borrown ng-debtors may violate the terms of their agreements, eìther by