Учебный год 22-23 / Critical Company Law

124 Critical company law

the New Right’s response was to do nothing. Instead of introducing policies that would redress this balance of power, its response was to allow the market, in this case majority shareholders, to retain its hegemony. Likewise, the Bullock Report’s recommendation of shareholder and employee representation on the board of directors was legislatively expressed in the toothless s 309 of the Companies Act 1985, which states that ‘directors of a company are to have regard in the performance of their functions . . . the interests of the company’s employees in general, as well as the interests of its members’.

Labour’s vision of the company as an inclusive and socially responsible institution driven by concerns other than profit was not shared by the New Right.56 The Conservative Party wished to portray itself as a noninterventionist government presiding over a free market which emphasised individualism and the regressive nature of welfarism, and in so doing it reasserted nineteenth-century liberal philosophy. It chimed with Milton Friedman’s avocation of profit maximisation and shareholder primacy.57 According to Friedman, corporate social responsibility was the wrongful distribution of shareholders’ property. Managers were agents for shareholders’ interests, custodians of private capital. They were not, as post-war labourism maintained, a form of public servant.

NEO-LIBERALISM TRANSLATED INTO CORPORATE GOVERNANCE: THE PROBLEM OF MANAGEMENT IN THE BERLE–MEANS CORPORATION

From the 1980s onwards the predominant theories and policies on corporate governance continued to be based upon the Berle and Means control and ownership division. However, neo-liberal approaches to corporate governance in contrast to the previous era sought to reassert profit maximisation as the primary goal of the corporation and therefore the primary duty of a director. The new elevation of profit maximisation as the goal of the corporation was importantly politics driven. It was the reassertion of the rights of the owning classes over the employed classes.

This new political emphasis drove a fundamental change in corporate

56This perspective a ected other business organisations. Historically, the mutual building society was an institution that had been, in many ways, socially engineered in order to reify the rewards of thrift and hard work to working people. In the, albeit partisan, words of Sir Herbert Ashworth, former chairman of the Nationwide Building Society, ‘they are admirable institutions which have made a significant contribution to the welfare of the people of this country by fostering saving and promoting home ownership’.56 No mention of profitability here. Ashworth, H, The Building Society Story, 1980, London: Franey, Preface.

57Friedman, ‘The social responsibility of business is to increase its profits’, New York Times, 13 September 1970.

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governance perspectives and goals. While the corporate governance vehicle for ensuring equality and socialist political goals was pluralism and shared control, so the corporate governance vehicle for ensuring profit maximisation was the elevation of the shareholder. Indeed, there is little moral or even legal justification for the elevation of the shareholder otherwise.58

The connection of free market economics and the law where the latter was viewed as a mechanism to promote the former is the basis of the ‘law and economics’ movement which originated in the Chicago School of Economics.59 Its neo-liberal perspective determined that the only forum for ensuring the proper operation of business is the ‘free market’. Thus the free-market, neoliberal theories of the Chicago School, in the context of corporate law, emphasises the importance of a corporate law which promotes the free market. From a ‘law and economics’ perspective developed in the Chicago School, pro-market corporate laws may be ones which do little to inhibit the intentions or decisions of the ‘players’, those involved with the corporation, or conversely they may intervene in commercial arrangements in order to ensure free-market transactions.

The first theory which articulated neo-liberal theory in the context of the business corporation is generally thought to be held in Ronald Coase’s article ‘The nature of the firm’ written in 1937.60 In this article he characterised the corporation as a set of transactions between those involved in the business. The basics of this theory were developed by scholars within the law and economics movement referred to as contractarians.61 The application of Coase’s model of the corporation by the contractarians as just a set of arrangements between individuals and its corresponding denial of the corporation as an entity may be summarised in the notion that the corporation is merely a ‘nexus of contracts’. This term was first coined by Jensen and Meckling in their famous article of 1976.62 In their nexus of contracts model, individuals within a business engage in private market contracts, bargains which are overseen and guided by managers. As the company is only a legal fiction,63 the manager does not act as an agent for the company but for the shareholder.

Shareholders, particularly those in large corporations, are forced to rely on the honesty and competence of their managers, a situation which presents a constant or structural risk that managers will act in their own self-interest or

58See Ireland and Greenwood, below.

59Known simply as the Chicago School.

60Coase, R, ‘The nature of the firm’ (1937) 4 Economica 386.

61Given the hegemonous nature of the perspective it has featured in Chapters 1, 3, 5 and 6 of this book.

62Jenson, M and Meckling, W, ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, 3 J Fin Econ 305, 1976.

63The ‘personhood’ of a corporation is a matter of convenience rather than reality. Easterbrook and Fischel, ‘The corporate contract’ (1989) Columbia L Rev, Vol 89, p 1426.

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for interests other than those of their principal. The costs associated with reducing or annihilating this risk are called ‘agency costs’. These are borne by shareholders who have no fixed claim against the company, unlike creditors, but who are instead paid according to the available profit. If agency costs are high, then dividends will be reduced and stock will fall in price.

In this model corporate law’s raison d’être is the reduction of agency costs and accordingly, any law which fails to do this should be removed. For the most part, however, it is not the law which reduces agency costs but the market, which includes the financial markets, labour markets, and markets in managerial expertise. A manager that fails to reduce agency costs will quickly be exposed by corporate information such as share prices, which will jeopardise his relationship with his existing and future employers. Thus the market provides managers with a huge incentive to succeed. Furthermore, according to contractarianism the market also constructs corporate law itself, so that only rules which support the market will, and indeed should, survive. This is particularly true in America where the competition for incorporations noted in Chapter 1 means that states adopt the laws which are most desirable to incorporators, thus changes in corporate law are very quick and responsive to market needs. However, it is also demonstrable in Britain where both the judiciary and the legislator have attempted to create a marketand shareholder-friendly body of rules. Indeed, the stated aims of the reform process were to create a company law for a competitive economy.

From the contractarian perspective, as corporate governance (reconstrued as reducing agency costs) is largely achieved by the market, corporate law is often given a di erent role. For example, a director’s fiduciary duties would, from a classical legal perspective, be understood as a mechanism for ensuring that directors act in the interests of the company, usually understood to be shareholders’ interest as a whole. Such duties would therefore help ensure that the company was governed in the interest of shareholders. However, the contractarian approach to fiduciary duties reduces the function of fiduciary duties to that of perfecting the contract between agent (the manager/director) and principal (shareholders). According to Easterbrook and Fischel a contract between shareholders (‘holders of residual claims’) and managers exists, but the terms are impressionistic with no specific duties expressly stated. So, ‘to make such arrangements palatable to investors, managers must pledge their careful and honest services’.64 Thus shareholders receive the benefit of fiduciary duties in exchange for enduring no ‘explicit promises’, that is, no guarantee of dividend.

However, this is not to suppose that fiduciary duties will be carefully monitored at all times. To retain monitors of directors would involve creating

64 Easterbrook and Fischel, The Economic Structure of Corporate Law, Cambridge, MA: Harvard University Press, p 90.

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another layer of management which might itself fail to meet its remit but more importantly would create higher agency costs. The absence of monitoring, they argue, reflects the law’s protection of directors in their routine decision making while in other less routine circumstances, such as for self-dealing, heavily penalising them. A director might make wrong or negligent decisions, but the cost of bringing this to court would outweigh the benefits to the corporation and may result in the loss of an otherwise useful agent. Thus the business judgment rule, which protects directors from liability for negligent or costly decisions if they were made honestly, does so for the good of the business. On the other hand, self-dealing is likely to be a one-o act by a previous or outgoing director involving a large financial loss to the business. In that case it is cost-e cient to pursue a director for beach of a fiduciary duty and the law responds accordingly.

Likewise, Kraakman and Hansmann argue that in America, the law is a relatively weak mechanism for protecting shareholder interests. Even in Delaware, shareholders have little power compared to their international counterparts. They have ‘less power to shape corporate policy’, ‘US boards have far more latitude to defend against hostile takeovers’ and ‘US securities law burdens consultation and proxy solicitation among large shareholders more heavily than the law of any other jurisdiction’.65 Other mechanisms, such things as high compensation packages for directors, are much better at achieving shareholder primacy. The UK, they argue, di ers from the US in that the law is much more shareholder-friendly. Probably as a result of the power of institutional shareholders, they surmise, shareholders have greater control over corporate governance structures and greater facility to put forward important motions at general meeting such as those relating to mergers. Furthermore, the City Code places many important restrictions on manager decisions. Overall, though, they conclude that legal corporate governance mechanisms are much weaker on corporate governance than ‘ownership structures, managerial culture, and the political power of mangers and employees’.66

The notion that the free market provides corporate governance is encapsulated in the notion of the ‘market for corporate control’. For example the information produced by the market forces managers to constantly improve their performance. Indeed, ‘few markets are as e cient as capital markets’:67

Accurate price signals in capital markets contribute to the e ciency of labor markets. Share price information provides a relatively low-cost

65 Kraakman, R and Hansmann, H, The Anatomy of Corporate Law: A Comparative and Functional Approach, 2005, Oxford: Oxford University Press, p 67.

66Ibid, p 70.

67Op. cit., Easterbrook, p 96.

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method of evaluating the performance of corporate managers. Such information can be used (imperfectly) to set managers’ compensation within the firm as well as to measure their opportunity wage in external labor markets.68

Moreover, information on poor managerial performance will lead even the most inexperienced investor to pay less for shares in that company. Somewhat oddly, Easterbrook and Fischel argue that this is because ‘the more investors believe that their dollars will be used by those in control of firms in ways inconsistent with maximising the value of the firm, the less they will pay for shares’. This statement not only assumes that the purchase price of shares goes to the company (it does not, only the purchase price of IPOs goes to the company and the vast majority of shares are sold on the secondary share market), it recreates an entity, ‘the firm’, which has a value! Along similar lines, there is a great deal of literature which argues that poor managerial performance leads to low share prices, which lead to hostile takeover bids, which generally lead to the removal of the incumbent directors.

Hostile takeovers are those undertaken against the directors’ wishes and where the bidder directly approaches the ‘target’ company’s shareholders. The role of hostile takeovers in corporate governance was first mooted by Manne in his 1965 article.69 Manne argued that the radical deregulation of hostile takeovers would enable a market for corporate control which would benefit shareholders. Woven into a more contractarian model, this market for corporate control is justifiable because managers are agents of shareholders and are therefore obliged to welcome bids which produce the greatest value for shareholders. And although the nexus of contract model assumes that there are more players than just managers and shareholders and therefore more claims than those of shareholders, their interest is elevated above others because they are, as stated earlier, ‘residual risk bearers’. So, while successful hostile takeover bids might be against the interests of employees and directors who might lose their jobs, or the local community who may lose a useful industry and su er from the increased unemployment of its citizens, corporate law should protect, or at least not hinder, the ability of shareholders to make premiums from such bids.

This approach reflects Friedman’s assertion that the social responsibility of corporations is to make money. And as Easterbrook and Fischel make clear, takeover bids make money: ‘Stock prices rise, by 30 per cent and more. Investors in targets realised $346 billion in the decade 1977–1986 and investors in purchasers realised additional gains in the billions.’70 Furthermore,

68Ibid.

69Manne, ‘Mergers and the market for corporate control’, (1965) 73 J Pol Econ 110, 1965.

70Op. cit., Easterbrook, p 198.

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they argue that hostile takeover bids, while representing a small proportion of similar corporate activity (numbering, they estimate, around 40 to 50 per year) act as an important disciplining mechanism. This is because they tend to happen to firms that are producing lower than average profits, within industries that are as a whole ‘lagging behind the national average’.71

However, from a contractarian perspective, corporate law has failed to fully reflect and facilitate the market mechanism of hostile takeovers. In the case of Unocal v Mesa Petroleum Co, the Delaware Supreme Court, centre for the common law on corporations, held that it was a director’s duty to consider the negative e ects of a hostile bid on the enterprise as a whole.72 The court specifically emphasised that this would include the e ects on nonshareholders as well as shareholders. Furthermore, in response to some of the negative social e ects wrought by hostile bids, many states have adopted antitakeover measures. Additionally, many firms have adopted anti-takeover measures, most known as poison pills, and most states have signalled their approval of pills. The cost to Delaware firms, according to Easterbrook and Fischel, is about 2.6 per cent of equity value.73

Corporate governance under the contractarian model neatly sidesteps the issue of power within the corporation which characterises all other discussions on this issue. Ownership is not separated from control as there are no real owners and nothing real that may be owned. Instead, this model replaces owners with ‘residual risk takers’ who exchange money and relative financial vulnerability for managers’ loyalty. A non-negotiated standard form contract exists between shareholder and manager which is constructed by company law but most e ciently monitored by market mechanisms. By construing governance in this way, contractarianism attempts to neutralise the power relations within and outside a corporation. If all relations are contractual and contract is based on choice, freedom and the implicit equality of the players, then there can be no question of unfair distribution of wealth and exploitation. However, it is important to remember that no intellectual movement emerges from a vacuum. This is a theory which is entirely opposed to the interventionist, socially responsible society promoted by the left and dominant in the post-war years and has created a rationale for the promotion of its polar opposite, the free market. It is the intellectual basis for Gordon Gekko’s claim that ‘greed is good’, and the most influential body of scholarship on company law today.

71Ibid.

72493 A 2d 946, 955–56 (Del 1985).

73Op. cit., Easterbrook, p 197.

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POLITICS, LAW AND IDEOLOGY

In contrast to the contractarian approach of the law and economics thinkers a number of scholars have demonstrated that corporate governance is formed not through the logic of the free market but through other mechanisms – politics, law and ideology. In assessing each of these three factors in turn this section will discuss some of the work of Mark Roe, Paddy Ireland and Daniel Greenwood respectively. Mark Roe’s work shows how company law and the market are subject to the political policies of a national government, which he demonstrates through a comparative analysis of corporate governance in Europe, England and America. Paddy Ireland’s work shows how the law misconstrued shareholders in large companies as owners because of the way it developed historically and became constrained by its own internal logic. This he demonstrates by analysing the relationship between usury laws, partnership law and company law. Finally, Daniel Greenwood’s piece argues that shareholder claims to primacy and in particular to the profits of business is neither justified by law nor economics but instead represents an ideological victory for investors and managers over the competing interests of employees, consumers and the community at large.

Mark Roe

Roe maintains that the success of mechanisms for achieving corporate governance in England and America are dependent upon a particular form of government. Thus while market control mechanisms such as hostile takeovers might be e ective here, they are not easily translatable into the corporate activities of corporations in continental Europe. For example until 1999, when Vodafone took over Mannesmann, there had never been a successful hostile takeover in Germany. Roe argues that to di erent degrees the politics of social democracy stymied such market-based attempts at managerial discipline.

Hostile takeovers were notoriously harder in continental Europe than in the United States and Britain . . . they regularly foundered due to the political pressure one would expect in a social democracy, as workers campaigned to block the takeovers and politicians sided with employees and against capital owners.74

In France, hostile takeovers were more frequent than in Germany but such takeovers were always subject to some form of Ministry scrutiny. Roe notes that, ‘the Ministry rarely approved a takeover without a social plan in place,

74 Roe, MJ, ‘Political preconditions to separating ownership from control’ (2000–01), 53 Stanford L Rev 539, p 558.

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one that had the o eror renouncing laying o any employee at the target for two to five years.’75 Furthermore, the Minister of Finance in France stated his immediate aversion to very high priced takeovers because the buyer would be looking for a swift and immediate profit which could be detrimental to employees’ interests! In contrast, Anglo-American thinking specifically values high prices and immediate high profits and would not consider employee interests a factor, much less a deciding factor.

Roe maintains that it is the political context of corporate governance that determines whether managers will pursue shareholder interests in preference to other connected persons including themselves. European social democracies, he maintains, pressure managers to pursue goals which are not shareholder-orientated but are socially orientated. In particular, social democracies seek stability for employees, an aim, among others, which Roe maintains would be the natural, preferred option for managers. Problematically, the e ect of social democracies on corporate governance is to ensure the continuation of family firms, suppression of stock dispersal and to hamper capital development.

Germany is a prime example of social democracy’s promotion of employees’ interests. Here employees’ interests are pursued directly through employee representation on the company’s supervisory board and less directly through government policy. The former arrangement arose from the post-war agreement that Germany’s coal and steel industry would be codetermined equally by employees and shareholders. Later, the principle was extended to a one-third employee representation on the boards and then one-half of larger firms in 1976.76

The e ect of co-determination, Roe shows, has a direct e ect on share value. For example when the 1976 Act raised the minimum employee representation on boards in larger firms to one-half, one study cited by Roe estimated that the loss to productivity was between 13 per cent and 14 per cent while others estimated that co-determination reduced market-to-book ratio by 27 per cent.77 Even in the absence of co-determination, Roe maintains that Germany’s social democratic politics favour policies which protect employees’ interests to the detriment of shareholders’. For example, Roe cites an instance when Gerhard Schröder nationalised a steel mill rather than risk employees’ jobs in a possible restructuring by a foreign firm.78

75Ibid, p 559.

76Ibid, p 547, referring to an article by Katharina Pister, ‘Codetermination: A sociopolitical model with governance externalities’, in Blair, MM and Roe, MJ (eds) (1999) Employees and Corporate Governance 163, 167–69.

77Ibid, p 550, citing Roe. FitzRoy, FR and Kraft, K, ‘Economic e ects of codetermination’ (1993) 95 Scandinavian J Econ 365, 374, and Gorton, G and Schmidd, F, ‘Class struggle inside the firm? A study of German codetermination’, NBER Working Paper No W7945, 2000.

78Ibid, p 552.

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Roe maintains that social democracy reduced shareholder value first because its proemployee policies marry with a manager’s self-interest and second because the mechanisms which reduce agency costs in English and American companies are stymied in a social democracy. As managerialists Jenson and Meckling indicated, managerial goals, unhampered by shareholders’ interests, include empire building, protecting their professional position and personal popularity.79 The unencumbered manager will tend to use their discretion over the use of company profits to expand the company’s real and human capital, enhancing both their comfort and power. They will be risk-averse even though taking risks may increase profits, as risks may endanger their position. They will take more leisure time and larger financial rewards than shareholders might wish. They will avoid restructuring a business which would mean invariably shedding employees in times of economic crisis because it is both painful and unpopular. And while all of the above are contrary to the interests of shareholders, many of these dispositions, as Roe points out, ‘fit well with employees’ goals’.80 Like managers, ‘Employees also are averse to risks to the firm, as their human capital is tied up in the firm and they are not fully diversified. Employees also prefer that the firm expand, not downsize, because expanding often yields them promotion opportunities, whilst downsizing risks leaving them unemployed.’81

Thus, Roe concludes, a social democracy in pursuing the interests of employees reinforces rather than counters natural managerial goals. As shareholders’ interests are sidelined, so is the desirability of shares and shareholding as a form of outsider investment. Investment in shares only makes financial sense if one has a large controlling interest, and this is particularly so when social democracy is coupled with co-determination.

According to Roe, this explains why the majority of stock in German firms remains within a family group, and stock ownership does not become dispersed. He explains the scenario thus. In order to ensure that dividends remain an organisational goal of the business, family owners act directly as the firm’s managers and do not hire professional managers (who are likely to pursue managerial or social democratic goals). The profitability of the firm and by extension the value of their stock relies upon their direction and upon their commitment to monitoring business performance. If they wished to sell their stock they would not be able to receive its present value because that value is ensured by their active involvement in the running of the business. Their absence would reduce the profitability of the firm and the value of the stock. Alternatively, if they sought to compensate for their absence by creating a strengthened board, which undertook such measures as regular

79Op. cit., Jenson and Meckling.

80Ibid, p 551.

81Ibid.

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meeting, rewarding profit maximisation and engaging independent advisors82 the firm’s profitability would probably remain unchanged or even improve. However, given the social democratic pressure upon managers, there would be no guarantee that this profit would not return directly to employees. Indeed, says Roe, an identifiable percentage of 10–20 per cent would be likely to return to employees in some form of benefit.83 The choice for the family owner who wants to sell is to launch an IPO of their shares at a discount, or to sell the stock as a block to another individual or group that will take over the managing function. The former strategy would aid share dispersal in Germany but would mean sustaining a loss, which the latter choice would not. Not surprisingly, block sales are common in Germany. Roe concludes that ‘German social democracy, institutionalised in corporate governance via codetermination, induces this firm to stay private, so as to avoid the costs to shareholders of an enhanced labor voice inside the firm. Social democracy in the form of a supervisory board codetermination mixes badly with the public firm.’84 And, argues Roe, even without such co-determination as is found in German companies, social democracies successfully thwart ‘shareholder value’ and thereby sustain the continuance of large family holdings.

In contrast, he argues, America and to a lesser extent England have developed mechanisms for reducing the agency costs outlined above which have enabled a dispersed share market. Continental Europe, however, is unable to use these mechanisms because the very politics of social democracy undermines them.

Roe’s work here is interesting and informative. It amply illustrates how politics is at least nearly as significant as economics in informing company law. Thus, a separation of ownership from control may be enhanced by the economic requirement of capital which fuelled, for example, railway construction in England and railroads in America. But the conditions for this share dispersal must be a pro-shareholder political environment. Without this, the wealthiest in society cannot be sure that their interests will be pursued as a matter of course and will be obliged to maintain their majority stake.

Thus, extending from the themes developed in Roe’s paper, it is clear that share dispersal will not, in itself, result in a society dominated by managerial goals. Contrary to the views of Crosland and others it cannot result in a fully ‘socialised’ corporation, where managers will pursue the interests of employees, or follow the social policies of their government. This is because

82Measures that are part of the usual mechanism for ensuring shareholder value in AngloAmerican companies.

83Roe cites statistics which show that following the 1976 codetermination law this amount, on average, was lost to shareholder value.

84Ibid, p 550.