The Anatomy of Corporate Law

A Comparative and Functional Approach

REINIER KRAAKMAN

PAUL DAVIES HENRY HANSMANN GERARD HERTIG KLAUS HOPT HIDEKI KANDA EDWARD ROCK

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UNIVERSITY PRESS

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© R. Kraakman, P. Davies, H. Hansmann, G. Hertig, K. J. Hopt, H. Kanda, and E. B. Rock, 2004

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Preface

This book results from a longstanding collaboration between seven authors from five countries, and many more colleagues from around the world who have provided helpful suggestions and criticisms. All of us—the authors—have taken principal responsibility for particular chapters in the book, but each of us have also contributed to the intellectual structure of the entire book and had a hand in editing each of its chapters. At the outset of this project, more than nine years ago, we shared a plan for a book based on a common vision of corporate law as an academic discipline. Both the plan and the vision have survived largely intact, even though both have evolved in the course of writing the book. In the end, we wrote the book we had hoped to write, although it took twice as long as we had hoped it would.

Four words summarize this book for the potential reader: it is 'international', 'functional', 'neutral', and not least, it is 'short'. It is international because its authors hail from disparate jurisdictions, and because it is predicated on the idea of a field of corporate—or company—law, with problems and legal strategies, at a mid-level of abstraction at least, that are independent of the laws of specific jurisdictions. Naturally, we must address particular national corporate laws to make this idea compelling. We therefore focus the book on the corporate laws of five major jurisdictions: France, Germany, Japan, the UK, and the U.S.A. But to the extent that we succeed in providing an integrated analysis of the company laws of these jurisdictions, the signal achievement of our book is to provide an analytical framework for corporate law that transcends particular jurisdictions.

The framework that we develop is also 'functional'. By this we mean that our book highlights the economic logic of corporate law. The corporate form, and the law to which it gives rise, are utilitarian institutions, which must be understood in the first instance in the light of their economic contributions to business life. Of course, this point should not be exaggerated. This book's authors do not believe that every aspect of corporate law is economically rational, still less that any particular corporate law is optimal. Politics and path dependence affect the law in every jurisdiction, as does the larger legal and business culture of the markets in which corporate law operates. Nevertheless, the play of non-economic factors in corporate law is constrained by global competition and an increasingly global business culture—themes that are addressed in Chapter 9. In addition, insofar as this book aims to illuminate the transnational themes of corporate law, it naturally highlights the law's rational elements, which tend to be widely shared across jurisdictions, rather than idiosyncratic legal elements that are often the residues of particular local histories.

This point leads to our third key descriptor: our book is 'neutral'—or at least it attempts to avoid evaluative comparisons among the corporate law systems of

our five major jurisdictions. In other words, we do not conclude that the U.S.A. and the EU ought to adopt the UK's City Code rules to regulate takeovers, or vice versa; or that Germany and France ought to abandon mandatory provisions for labor representation on corporate boards of directors, or vice versa. Although all the authors of this book have decided views on these issues, our views are not unanimous. And our project in writing this book was not to decide such con-tested issues—at least not here—but rather to establish a framework for examining the law that was at once economically grounded (i.e., functional) and still sufficiently capacious to accommodate the views of both sides on controversial issues of legal policy. No doubt each author of this book has unconsciously consulted his policy convictions while drafting his assigned chapters. But we trust that our lapses from neutrality are modest, and that a discerning reader will be able to correct for them.

'Short' is our book's fourth descriptor. Brevity is good for both writers and readers of collaborative works. Brevity has permitted this book's authors to redraft their individual chapters repeatedly, and to review and edit the book's entire text. We hope that brevity will also encourage our readers to open the book and stick with it until the end.

In particular, we hope that our brevity will attract the readers we had especially hoped to reach: our academic colleagues with whom we continue to discuss comparative corporate law; our students, who have long needed a functional overview of diverse corporate law systems; professors of business and economics, who might have needed a functional introduction to corporate law generally; and our law school colleagues in non-corporate fields, who might share our interest in private law and the interaction of law and economics. (Sad to say, this book will not aid practicing attorneys who require a detailed treatment of the substantive law in our major jurisdictions. Such an encyclopedic approach would have required a much longer book. Nevertheless, we hope that practitioners, as well as lawmakers and judges, will find this book a helpful guide to the policies and strategies at play in corporate law.)

In addition to sharing a common plan for this book, its authors also share a common vision of corporate law. That vision is elaborated throughout the book itself, but especially in its initial chapters. To summarize that discussion here would only be repetitive.

Nevertheless, two caveats are necessary in the interests of full disclosure. The first concerns the scope of the book. While we address issues of law enforcement, administration, and compliance throughout, we do not do so with the same consistency or emphasis that we bring to our comparative discussion of substantive law. We see this less as a weakness in the book, however, than as a challenge (to ourselves and others) to provide fuller analyses of the legal and market institutions affecting the operation of corporate law. There is much more work to be done.

A second caveat is that we do not articulate a political economy of legal convergence in corporate law. Our book as a whole offers persuasive evidence of convergence across our major jurisdictions, as we develop in Chapter 9. But we leave to our individual authors to analyze and explain the extent and nature of convergence in each of their subject matter areas, drawing on their own research and the fast-growing literature on comparative corporate governance. But here too, there is an invitation to continue the conversation about convergence within this book's framework of analysis, which we believe can give the debate a sharper focus.

Reinier Kraakman Harvard Law School 31 December, 2003

Acknowledgments

So many colleagues, friends, and institutions have contributed to the completion of this book over the years that it is virtually impossible to list them all, Nevertheless, we acknowledge below as many important supporters of our work as we, collectively, can remember. We ask those whose names have been inadvertently left off the list to forgive us. Naturally, we alone are responsible for any mistakes in the book.

Our supporting institutions over the years include the Harvard Law School John M. Olin Center for Law, Economics, and Business (for assisting in the financing of a mini-conference to critique earlier drafts of the book), ETH Zurich (for providing generous financial assistance throughout the writing of this book), and the Cambridge University Law Faculty Centre for Business Research, the Max-Planck-Institut Hamburg, the London School of Economics, the New York University School of Law, and Balliol College at Oxford University for providing institutional fora for discussion of the book as well as financial assistance.

We owe a special debt of gratitude to our hard-working commentators on this book project over the years. At the Paris Conference in 1999, these commentators included Bernard Black, Brian Cheffins, Wolfgang Gerke, Saul Levmore, and Rolf Skog. At the Frankfurt Conference of 2000, they included Guido Ferrarini and Julian Franks. At the London Conference of 2003, funded by the Suntory and Toyota International Centres for Economics and Related Disciplines at LSE, they included Luca Enriques (to whom we also owe special thanks for numerous excellent suggestions at other times), Jonathan Rickford, and David Skeel.

Individual colleagues and friends who have offered advice on a more ad hoc basis include John Armour, Robert Austin, John Coates, Pierre-Henri Conac (special thanks, especially for assistance with French corporate law), Eilis Ferran, Jesse Fried, Zohar Goshen, Henry Hu, Alain Hirsch, Guy Horsmans, Isaac Meier, Peter Nobel, Mark Ramseyer, and Eddy Wymeersch. We also thank the many participants in seminars and workshops who received early drafts of one or more chapters, and often provided valuable feedback. Among these were participants in a CEPR/CFS Workshop in Frankfurt, November 2000; the doctoral students at three Gerzensee Law and Economics Workshops (1997, 1998, and 2001); and the participants in a Workshop held at the University of Texas at Austin in 2001.

We should also thank our own home institutions for providing financial support to us personally as we worked on this book. Thus, we owe thanks to Balliol College of Oxford University and the London School of Economics (for funding Paul Davies), the Yale Law School (for funding Henry Hansmann), rhe Max Planck Institute—Hamburg (for funding Klaus Hopt), ETH Zurich (for

funding Gerard Hertig), the Harvard Law School John M. Olin Center for Law, Economics, and Business (for funding Reinier Kraakman), and the University of Pennsylvania's Institute for Law and Economics (for funding Edward Rock).

Finally, we thank our spouses and other family members, who have been generous with their moral support, and who have been hearing about this book for longer than they care to remember.

The authors

Contents

List of Authors xv

1 What is Corporate Law? 1

Henry Hansmann and Reinier Kraakman

1.1 Introduction 1

1.2 What is a corporation? ■ 5

1.2.1 Legal personality 6

1.2.2 Limited liability 8

1.2.3 Transferable shares 10

1.2.4 Delegated management with a board structure 11

1.2.5 Investor ownership 13

1.3 What does corporate law include? 15

1.3.1 Secondary and partial corporations forms 15

1.3.2 Additional sources of corporate law 16

1.3.3 Non-corporate law constraints 17

1.4 What is the goal of corporate law? 17

2 Agency Problems and Legal Strategies 21

Henry Hansmann and Reinier Kraakman

2.1 Three agency problems 21

2.2 Legal strategies for reducing agency costs 23

2.2.1 Regulatory strategies 23

2.2.2 Governance strategies 26

2.2.3 Ex post and ex ante strategies 27

2.3 Legal strategies in corporate context 28

2.4 The role of law 29

3 The Basic Governance Structure 33

Henry Hansmann and Reinier Kraakman

3.1 How governance strategies protect shareholders as a class 33

3.1.1 The appointment rights strategy 34

3.1.2 The other strategies: Decision rights, trusteeship,

incentives, constraints, and affiliation rights 46

3.2 Protecting minority shareholders 54

3.2.1 The appointment rights strategy 54

3.2.2 The decision rights strategy 57

3.2.3 The trusteeship strategy 57

3.2.4 The reward, constraints, and affiliation

rights strategies 59

Contents Contents xiii

3.2.5 Reflecting on the minority-majority shareholder conflict 60 6.2.2 The majority-minority shareholder

3.3 Protecting non-shareholder constituencies 61 conflict 139

3.3.1 The appointment rights strategy 62 6.2.3 The protection of non-shareholder constituencies 144

3.3.2 The trusteeship strategy 65 6.3 Sales of assets 145

3.3.3 The constraints strategy 66 6.4 Legal capital, share issues, and corporate distributions 145

3.4 Patterns of corporate governance 67 6.4.1 The manager-shareholder conflict 146

6.4.2 The majority-minority shareholder conflict 147

Creditor Protection 71 6.4.3 The protection of non-shareholder constituencies 151

Gerard Hertig and Hideki Kanda 6.5 Fully delegated decisions: Investment and debt 151

4.1 Why should corporate law protect creditors? 71 6.6 Explaining differences in rhe regulation of significant

4.1.1 Companies in the vicinity of insolvency 73 corporate actions 153

4.1.2 Corporate groups 74

4.1.3 Involuntary creditors 76 7 Control Transactions 157

4.2 Regulatory strategies for creditor protection 77 Paul Davies and Klaus Hopt

4.2.1 Mandatory disclosure—The entry strategy 79 7.1 Agency problems in control transactions 157

4.2.2 Rules governing legal capital and corporate groups 83 7.1.1 Control transactions 157

4.2.3 Fiduciary duties—The standards strategy 88 7.1.2 Agency issues 159

4.3 Explaining differences in creditor protection 97 7.2 Agency problems where shareholdings are dispersed:

4.3.1 The extent of divergence 97 Two models of regulation 163

4.3.2 The importance of divergence 98 7.2.1 Basic models 163

7.2.2 The first model: Non-frustration of the offer 164

Related Party Transactions 101 7.2.3 The second model: Directors controlling access to

Gerard Hertig and Hideki Kanda the shareholders 168

5.1 Conflicted transactions by managers 101 7.2.4 Rationales for the second model 170

5.1.1 Mandatory disclosure: The affiliation strategy 103

i 7.2.5 Comparing the two models 172

5.1.2 Disinterested board approval: The trusteeship 7.3 Agency problems of dispersed shareholders when a general

strategy 105 offer is made 173

5.1.3 Shareholder voting: The decision rights strategy 109 7.3.1 Information asymmetry: The affiliation strategy 174

5.1.4 Prohibiting conflicted transactions: The rules strategy 111 7.3.2 Pressure to accept the offer: The reward strategy 176

5.1.5 The duty of loyalty: The standards strategy 114 7.3.3 The mandatory bid rule: The exit strategy 178

5.2 Transactions involving controlling shareholders 118 7.3.4 Competing bids 181

5.2.1 Mandatory disclosure: The affiliation strategy 119 7.3.5 Acquisition of dissenting minorities 183

5.2.2 Board and shareholder ratification: The trusteeship 7.4 Agency issues where there are controlling shareholders 184

and decision rights strategies 121 7.5 Agency problems of non-shareholder groups 187

5.2.3 Fiduciary duties and fairness norms: The standards 7.6 Explaining differences in the regulation of control transactions 189

strategy 123

5.3 Explaining differences in the regulation of related party 8 Issuers and Investor Protection 193

transactions 128 Gerard Hertig, Reinier Kraakman and Edward Rock

8.1 Two objectives of investor protection 194

Significant Corporate Actions 131 8.2 The entry strategy: Mandatory disclosure 195

Edward Rock, Hideki Kanda and Reinier Kraakman 8.2.1 Jurisdictional variations 197

6.1 What are significant corporate actions? 131 8.2.2 Accounting methodology 201

6.2 Mergers and similar organic changes 133 8.2.3 Exiting disclosure requirements 202

6.2.1 The management-shareholder conflict 133 8.2.4 Why make disclosure mandatory? 204

8.3 Quality control: The trusteeship strategy 207

8.4 Quality control: The rules and standards strategies 208

8.4.1 The rules strategy 209

8.4.2 The standards strategy 210

8.5 Explaining differences in investor protection 212

9 Beyond the Anatomy 215

Paul Davies, Gerard Hertig and Klaus Hopt

9.1 Our approach 215

9.2 Putting our results into context 217

9.3 Existing commonalities 218

9.3.1 Robustness 218

9.3.2 Causes of remaining divergence 221

9.4 Roadmap for further research 222

Index 227

List of Authors

Reinier Kraakman is the Ezra Ripley Thayer Professor of Law at Harvard Law School. He teaches corporate law and corporate finance, and has written numerous articles on the economic analysis of the corporate form and corporate liability strategies. He is the author, with Willian T Allen, of Commentaries and Cases on the Law of Business Organization {Aspen 2003). He has also consulted on the reform of company law in the Republic of Russia and the Socialist Republic of Vietnam. Recent publications include Russian Privatization and Corporate Governance: What Went Wrong?, with Bernard Black and Anna Tarassove {52 Stanford Law Review 1731, 2000}, A Self-Enforcing Model of Corporate Law, with Bernard Black {109 Harvard Law Review 1911, 1996). Toward Unlimited Shareholder Liability for Corporate Torts, with Henry Hansmann (100 Yale Law Journal 1879, 1991).

Paul Davies is the Cassel Professor of Commercial Law at the London School of Economics. His main research interests are in the areas of labor law, company law, and securities regulation. He has been professor in the University of Oxford and has held visiting positions at Yale, at various universities in South Africa, and at Bonn, Bordeaux and Paris-I. Paul Davies was made a Fellow of the British Academy in 2000. His most recent books are Gower and Davies' Principles of Modern Company Law (7th ed., Sweet &c Maxwell 2003), Introduction to Company Law {Oxford University Press 2002), Labour Legislation and Public Policy, with Mark Freedland (Oxford University Press 1993).

Henry Hansmann is Professor of Law at New York University School of Law. He received both a J.D. and a Ph.D. in economics from Yale University and has written about a broad range of subjects, from markets for human organs to artists' moral rights, but has focused most extensively on the structure and economic functions of organizational law, including the law of non-profit, mutual, and cooperative organizations. He was previously Harris Professor of Law at Yale Law School {198"8-2003). Recent publications include Property, Contract, and Verification: The Numerus Clausus Problem and the Divisibility of Rights, with Reinier Kraakman (31 Journal of Legal Studies 373, 2002), The Essentia! Role of Organizational Law, with Reinier Kraakman {110 Yale Law Journal 387, 2000), The Ownership of Enterprise (Harvard University Press, 1996).

Gerard Hertig is Professor of Law and Economics at the ETH Zurich. He teaches intellectual property and specializes in corporate law and financial services. He was previously Professor of Administrative Law and Director of the Centre d'Etudes Juridiques Europeennes at the University of Geneva Law School

(1987-1995). He served as Visiting Professor at UCL (Louvain), ULB (Brussels), Liege, College of Europe, Tokyo and practiced law as a member of the Geneva bar. Recent publications include Four Predictions about the Future of EU Securities Regulation, with Ruben Lee (3 Journal of Corporate Law Studies 359, 2003), European Economic and Business Law (de Gruyter 1996) and European Business Law (de Gruyter 1991), both with Richard Buxbaum, Alain Hirsch, and Klaus Hopt (eds.).

Klaus J. Hopt is Director of the Max-Planck-Institut for Foreign and Private International Law in Hamburg, Germany. His main areas of specialization include commercial law, corporate law, banking, and securities regulation. He has been Professor of Law in Tubingen, Florence, Bern, Munich, Visiting Professor 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 company and takeover law reforms. Recent publications include Capital Markets and Company Law, with Eddy Wymeersch (eds.) (Oxford University Press 2003), Economic Regulation and Competition—Regulation of Services in the EV, Germany and Japan, with Jiirgen Basedow, Harald Baum, Hideki Kanda, Toshiyuki Kono (eds.) (Kluwer Law International 2002).

Hideki Kanda is Professor of Law at the University of Tokyo. His main areas of specialization include commercial law, corporate law, banking regulation, and securities regulation. He served as Visiting Professor of Law at the University of Chicago Law School (1989, 1991 and 1993), and Visiting Professor at Harvard Law School (1996). Recent publications include Corporate Law (4th ed., Kobundo 2003—in Japanese), Comparative Corporate Governance, with Klaus Hopt, Mark Roe, Eddy Wymeersch and Stefan Prigge (eds.) (Oxford University Press 1998); Economics of Corporate Law, with Yoshiro Miwa and Noriyuki Yanagawa (eds.) (University of Tokyo Press 1998—in Japanese).

Edward B. Rock is the Saul A. Fox Distinguished Professor of Business Law at the University of Pennsylvania Law School. He also serves as co-director of the Institute for Law and Economics and has written widely on corporate law, as well as on the overlap between corporate law and antitrust and labor law and on the regulation of mutual funds. He has been Visiting Professor at the Universities of Frankfurt am Main, Jerusalem and Columbia and has practiced law as a member of the Pennsylvania bar. Recent publications include How I Learned to Stop Worrying and Love the Pill: Takeover Law and Adaptive Behavior, with Marcel Kahan (69 University of Chicago Law Review 871, 2002), Islands of Conscious Power: Law, Norms and the Self-Governmg Corporation, with Michael Wachter (149 University of Pennsylvania Law Review 1619, 2001).

What is Corporate Law?

HENRY HANSMANN and REINIER KRAAKMAN