Учебный год 22-23 / Critical Company Law

64 Critical company law

identifiable in the articles and memorandum of association, and in s 33 issues. It will be argued that such contractual elements that do persist in this area of company law are small residues from companies’ historical relationship with partnership law. Furthermore, it will be argued that while these residues may continue to have some significance in respect of companies that are in both management and ownership terms much more like a partnership, they have no application in larger companies. In cases involving small companies, decisions may be made which indicate a direct contractual relationship between the parties which are not mediated through the company but such decisions will only be applicable in small quasi-partnership arrangements. It will finally be demonstrated through case law and statute that the company constitution is heavily prescribed by statute and any choices that are made by the incorporators are made within a strict statutory framework. This is particularly true in respect of public companies, where wide-ranging restrictions ensure the public nature of the plc.

CONTRACTARIANISM, THE COMPANY AND

THE CONSTITUTION

The contractual model for the company in this area of company law has been utilised with varying degrees of intensity by many legal thinkers. The primary concern in this chapter is with the modern variant of this, American contractarianism. It is, however, worth noting that as early as 1956 Professor Gower argued that the emergence of the English company from the (indisputably contract-based) partnership form has resulted in a continuing relationship between contract law and company law. The first English Companies Acts, he noted, were based on partnership law, indeed

it was this familiar form of organization which the legislation of 1844 and 1855 adopted, successfully conferring on it the boons of corporate personality and limited liability. Hence the modern English business corporation has evolved from the unincorporated partnership, based on mutual agreement, rather than from the corporation, based on a grant from the state, and owes more to the partnership principles than to rules based on corporate personality.4

These partnership principles, he argued, made English company law ideally suited for both a small private company and a large public company precisely because ‘the constitution of the English business corporation is still regarded

4Gower, ‘Some contrasts between British and American corporate law’ (1956) Harv L Rev June Vol 69 No 8, pp 1371–2.

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as essentially contractual . . . the British Companies Act relies far more on the technique of the Partnership Act, providing a standard form which applies only in the absence of contrary agreement by the parties’.5 This standard form, which for companies limited by shares was the well-known Table A,6 could be modified or substituted by the incorporators upon registration or altered in part by the company members at a later date.7 Under s 7 of the Companies Act 1985, in the case of a company limited by shares, articles of association could be registered with the memorandum of association but if they were not so registered Table A8 would be applied.9 So, at least on first blush, it appears that the articles of association may consist of terms that the incorporators construct and agree to and in that respect it conforms to contractual norms.

However, such contractual freedoms as seem to be o ered here were heavily restricted by statute. For example, s 310 of the Companies Act 1985 prohibited the inclusion of terms that purported to exempt any o cer of the company from ‘any liability which by virtue of any rule of law would otherwise attach to him in respect of any negligence, default, breach of duty or breach of trust of which he may be guilty in relation to the company’.10 This statutory provision overrode any attempt to freely write the terms of the ‘contract’ to provide such an exemption. Furthermore, it also seemed to override Article 85 of Table A which allowed a director to retain profits made from a contract between himself and a company to which he owes a fiduciary duty, provided he has disclosed his interest to the other directors. In other words, an Article 85 disclosure which claimed to exempt a director from this breach of duty would not seem to succeed under s 310.11

Gower further argued that the manner in which the English share is understood under English law reflects the contractual character of partnership law. He asserted that the law has ‘always regarded shares of stock as creatures of the company constitution and therefore as essentially contractual choses in action’.12 As such, he notes, English company law has consistently recognised the right of the members to include in the company constitution restrictions

5Ibid, p 1375.

6Table A is a model form of regulations pertaining to the management of the company, the articles of association. It is a default model and incorporators may choose to compile their own articles of association.

7Companies Act 1985. This has now been replaced by the Companies Act 2006, s 21.

8Prescribed by the regulations made by the Secretary of State: Companies (Tables A to F) Regulations 1985 (1985 No 805).

9Companies Act 1985, s 8(2).

10Companies Act 1985, s 310(1).

11This apparent contradiction was somewhat clumsily resolved in the case of Movitex Ltd v Bulfield [1988] BCLC 104.

12Op. cit., Gower, p 1377.

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on share transfers, to the extent of allowing unfettered share transfers.13 Thus if members wished to exclude strangers from membership or preserve a company as a purely family-owned company they could do so. The e ect, argued Gower, was to retain ‘the essentially personal nature of the association just as e ectively as in a partnership’.14 In contrast, he saw American corporate law as tending to strike down attempts to restrict share transfer, preferring the ‘property’ model of the share, ‘the alienation of which must not be unreasonably restrained’.15

The contrast with American company law principles is instructive. Modern American corporations originated from charter corporations and, as a result, that body of law contains none of the contractual norms of England’s part- nership-informed company law. American corporate law has delineated large companies from small companies much more successfully than in England, and has thus developed principles that are clearly intended to refer to a large company and those that are clearly intended to be for a small or ‘close’ company.16 In contrast, the common law principles that are established in England apply to all companies in theory and are part of the body of company law principles, but in practice they will often apply only to a small company. So the earlier example which Gower gives on the facility for incorporators to contractually restrict share transfers applies only to private companies. A public company cannot restrict share transfers in this way.

This sole application of principles to small private companies is particularly pronounced when the principle is contractually based. So in Ebrahimi v Westbourne Galleries 17 (discussed in detail in Chapter 6), the courts gave a remedy to a company member who relied on understandings which were implicit in the relationship between the parties. The court e ectively implied an agreement, which as its performance was thwarted meant that the court declared that the company should be wound up as it had ceased to exist for the purpose it was intended. This is a principle which could only apply to a very small company in which the relationships between the members were based on partnership’s mutual trust notions.

The merging of legal principles established in the context of a small company with those established with large companies in the canon of company law goes some way to understanding why company law per se is associated with contractual principles. It does not, however, provide the whole answer and nor does it explain why the USA, a country without a contract-based

13Tett v Phoenix Property & Investment Co Ltd [1984] BCLC 599.

14Op. cit., Gower, p 1378.

15Ibid, p 1378.

16According to Professor Gower, American law distinguished the corporation as a public body rather than as a creature of contract earlier than English law.

17[1973] AC 360.

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corporate law, is the one to have originated and nurtured a theory of the company based on contract.18

Typifying this American based response is the work of Frank Easterbrook and Daniel Fischel. In their important book The Economic Structure of Corporate Law Easterbrook and Fischel argue that the doctrine of separate corporate personality is ‘a matter of convenience rather than reality’.19 Rather, it was usually more sensible to consider the corporation as a ‘ “nexus of contracts” or a set of implicit and explicit contracts’.20 The corporation is, they remind us, a voluntary adventure in which individuals have chosen to engage, in accordance with terms they have agreed. According to the authors not only is contractarianism a better analysis of the law, but a corporate law which facilitates this voluntary character will be the most useful in promoting business success. Conversely, corporate law jurisdictions which have attempted to deviate from contractual norms invariably failed to meet business needs. In America at least: ‘the history of corporations had been that firms failing to adapt their governance structures are ground under by competition. The history of corporate law has been that states attempting to force all firms into a single mold are ground under as well.’21

Easterbrook and Fischel argue that the corporation is constituted by the voluntary, contractual arrangements of the participants. However, they argue, these contracts may not conform to a model which contract lawyers, would recognise. Instead the terms of the agreement may be fixed by managers or investors, leaving only the price to be negotiated. In other arrangements described by the contractarians as contracts the terms may be implied by the courts or the legislatures. To the lawyer and perhaps even the layman a relationship which is defined by the courts or the legislature describes the law, in this case company law, and its provisions as found in statute and in common law, rather than in a contract. Thus far from being ‘chosen’ by the parties in the way of a contract, the terms upon which individuals operate business in a corporation are in fact prescribed by law; quite contrary to the way contracts work. Easterbrook and Fischel’s answer to this is to argue that while these terms are provided by the law, they are ‘terms that would have been negotiated had people addressed the problem explicitly’.22 Accordingly,

18Gower cited an Indiana judge in an 1860 case who said: ‘A corporation is a creature existing, not by contract; but, in this country, is created or authorized by statute; and its rights, and even modes of action, may be and generally are, defined and marked out by statute; and when they are, they cannot be changed, even by the contract of the corporators.’

19Easterbrook and Fischel, The Economic Structure of Corporate Law, first paperback edn, 1996, Cambridge, MA: Harvard University Press.

20Ibid, p 12.

21Ibid, p 13. The term ‘firms’ is used here, and indeed by the ‘law and economics’ scholars, as a catch-all term for business organisations, which include partnerships as well as corporations. The legal meaning of a firm is a partnership.

22Ibid, p 14.

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they state, ‘We treat corporate law as a standard-form contract, supplying terms most venturers would have chosen but yielding to explicit terms in all but a few instances’.23 So why don’t these venturers simply negotiate as one might in the usual contractual manner? The answer is cost. The shareholder makes more money if it is not spent in costly negotiations. Thus, ‘corporate law should contain the terms people would have negotiated, were the costs of negotiating at arm’s length su ciently low . . . corporate law almost always conforms to this model’.24

Although this seems an unusual sort of contract, they insist that it is not merely a rhetorical device, like the ‘social contract’ of enlightenment political theory which underpinned the American constitution. Additionally, they argue that the corporation encompasses many ‘real’ contracts, including those with suppliers, contractors and employees, unlike the rhetorical social contract. Furthermore, they note, the articles of incorporation are agreed by the incorporators and changes in the corporation’s rules may be subsequently agreed by the majority investors. Controls over directors’ decisions may be exercised by majority shareholders who may ratify a breach of duty such as self-profiting from a corporate opportunity.25

These observations, however, militate against the nexus of contract argument rather than support it. The real contracts made with suppliers, contractors and employees are specifically made between them and the company, a legal entity that must be capable of making such arrangements. Contracts are not made between suppliers inter se, between managers and employees, and they certainly are not made between suppliers, contractors, employees and shareholders. A shareholder has no legal or practical role in these arrangements and will not be responsible for debts that arise in respect of them. Furthermore, breaches of duty such as self-dealing have emerged from and are imposed by common law and not from any contractual agreement.

Yet, perhaps somewhat oddly, what really clinches the contractual argument as far as the authors are concerned is not the ‘real contracts’26 but the contracts which have terms that are in place because the market has provided information as to their e ciency through the mechanism of price. Such a term is one which shareholders would have negotiated, if it is a term that enhances share value. Indeed it is better than a negotiated term (and perhaps therefore more contractual), because market price allows the most illinformed and least knowledgeable investor to make decisions about their investment: ‘Markets transmit the value of information through price, which is more “informed” than any single participant in the market.’27 Market price,

23Ibid, p 15.

24Ibid.

25See Chapter 5.

26Bargains which the lawyer would recognise as being a contract.

27Ibid, p 19.

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they argue, makes transparent the e ciency of non-negotiated terms more readily than any other mechanism. And, if finally these so-called contractual devices are not enough to represent the corporate participant’s interest, the law can supply terms which respond to or fill in the gaps. For Easterbrook and Fischel, the American common-law system is particularly useful as it can supply terms to meet situations which the contracting parties could not have envisaged when contracting. ‘Common law systems need not answer questions unless they occur. This is an economizing device.’28

Thus for these authors corporate law exists as di erent levels of contract law. It embodies so-called real contracts, it includes ‘contracts’ where the terms are determined by market price (a superior form of negotiated term), and includes a body of law which ‘finishes’ contracts between the corporate players (in a more economically e cient way than negotiation), through such mechanisms as fiduciary duties. A rather loose set of descriptions of the hitherto precise notion of a contract.

More recently Kraakman and Hansmann have developed a more sophisticated and arguably more insidious form of contractarianism, which draws in a comparative analysis of all business corporations internationally which exhibit ‘five core structural characteristics’. These are legal personality, limited liability, transferable shares, centralised management under a board structure and shared ownership by contributors of capital. The authors reserve the right to include in their analysis business forms which have most of the five, as this enables them to relativise the core features and relegate the key feature of a business corporation, separate corporate personality, to just one possible characteristic a business corporation might have.

In explaining away the separate legal personality of the corporation, the trickiest area of company law for the contractarian, Kraakman and Hansmann first assert that the corporation is indeed a nexus of contracts but one in which contracting is facilitated by the ‘creation of a legal person’.29 This aids contracting because the legal person, the corporation, can act as a middle man between those that ‘own or manage the firm, or are suppliers or customers of the firm’.30 Kraakman and Hansmann depict separate corporate personality as a legal construct rationally created by individuals engaged in business as the most e ective way of negotiating agreements, as if it were possible to have a large legally incorporated company without separate corporate personality. Furthermore, they argue that the main purpose of constructing this entity is to balance creditor interests and to protect both the

28Ibid, p 35.

29Kraakman, R and Hansmann, H, The Anatomy of Corporate Law. A Comparative and Functional Approach, 2005, Oxford: Oxford University Press, p 7.

30Ibid.

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assets of the business and the assets of the owners. This is achieved by constructing the business corporation as a productive, asset-owning entity. This allows separate corporate personality to facilitate two functions. First, as the corporation owns the assets it can pledge them to creditors, thus enhancing the contractual credibility of the firm. Here the authors characterise corporate creditors’ interests as a priority claim on assets over and above claims of the shareholder’s creditors who will be paid from corporate assets after corporate creditors. Second, it provides what they call ‘liquidation protection’, protecting the corporation from liquidation by disallowing shareholders from ‘withdrawing their assets at will’.31 In addition to this it protects the firm from the claims of the owner’s creditors, who cannot ‘foreclose on the owner’s share of firm assets’.32

Both supposed functions are based on a distortion of the basics of company law. In the normal course of business shareholders have no claim on the company’s assets and so clearly their personal creditors do not. Shareholders’ creditors do not have a low priority claim against the corporate assets, they have no claim at all against them. Likewise, they cannot foreclose on the shareholders’ share of the firm’s assets because the shareholders do not own the corporate assets and cannot withdraw corporate assets at will. The shareholder, as a clear matter of law and economic reality, owns shares which are a claim to dividends, not corporate assets.33 And, while it is true that upon liquidation the shareholder will receive any remaining liquidated assets after all creditors’ claims and other costs have been met, from which funds they may pay their personal creditors, this does not make their creditors the corporation’s creditors. It simply means that the shareholders are using their own money to pay back their own debts.

Unlike Easterbrook and Fischel, Kraakman and Hansmann do not expressly deny the separate legal personality of the company; instead they see it as a legal mechanism for making contracts e ective, and they read bargains into all aspects of company law. So while legal personality34 protects creditors’ interests by prioritising them, it is as part of an exchange for something that protects shareholder’s interests, that is, limited liability.

The pattern of creditors’ rights created by strong form legal personality is, in e ect, the converse of that created by limited liability. It protects the assets of the form from the creditors of the firm’s owners, while limited

31Ibid.

32Ibid.

33See Chapter 2 for a full explanation of this assertion.

34Which in corporations they describe as being ‘strong form legal personality’ as opposed to the ‘weak form’ legal personality of partnerships, or as we company lawyers characterise the latter, ‘no legal personality’.

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liability protects the assets of the firm’s owners from the claims of the firm’s creditors.35

And why does this bargain take place? Because, they state, this ‘isolates the value of the firm from the personal financial a airs of the firm’s owners su ciently to permit the firm’s shares to be freely traded’.36 This is ahistorical. As corporate legal history makes clear37 and the work of Paddy Ireland in particular details,38 it was the increasing transferability of shares which gave rise to the real separation of the shareholder from the corporation’s activity and the emergence of the doctrine of separate corporate personality, not the other way around. Again, Kraakman and Hansmann engage in distortions which attempt to construe separate corporate personality as a business choice, not a legal expression of an economic reality.

So the transferability of shares is understood as a reason for choosing separate corporate personality.39 Transferable shares require the ‘asset partitioning’ provided by a firm’s legal personality. They must represent only the firm’s assets and not the shareholders, because otherwise the value of shares would fluctuate according to the wealth or personal debts of its shareholders. And, as shares are frequently traded, a corporation’s shareholders could frequently change, thus making share valuation di cult to monitor. This assertion, while acknowledging that share values are not contingent upon the shareholders’ personal wealth, still a ects to connect the business assets with shareholder ownership. But in both law and in economics the company share is not a share of the company’s assets; they do not own the business in the way partners own a share of the business. Yet, according to this approach shareholders remain the owners but it is a more rational and market-friendly form of ownership which allows for free transferability and a stable valuation of shares.

The issue of limited liability causes fewer theoretical problems for Kraakman and Hansmann than it does for Easterbrook and Fischel, who find it di cult to justify the privilege given to shareholders at the expense of creditors within the contractual (and therefore fair) model. For Easterbrook and Fischel this problem is only resolved by rehabilitating the company as an entity that is responsible for a creditor’s debts. Kraakman and Hansmann characterise limited liability as a mechanism for achieving ‘defensive assets partitioning’ in that it enables shareholders to preserve their own personal assets for the benefit of their personal creditors. Conversely,

35Ibid, pp 7–8.

36Ibid, p 8.

37See Chapter 2.

38In Chapter 2 and below.

39A point made earlier by Easterbrook and Fischel, who stated that limited liability was key to maintaining the fungible nature of shares.

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separate personality partitions the assets of the company for creditors. So the combination of separate corporate personality and limited liability creates a rational bargain between creditor and shareholder which reduces the overall cost of capital. By viewing it this way Kraakman and Hansmann do not wander into Easterbrook and Fischel’s problem of limited liability appearing as an unfair advantage to shareholders and therefore not very contractual. Instead they view limited liability as something which enhances contracting. But as this characterisation is dependent on viewing all arrangements as balancing priorities between contracting parties, limited liability is attributed with facilitating the following mutually advantageous arrangements.

It permits creditors of the corporation to have first claim on the corporation’s assets, which those creditors have a comparative advantage in evaluating and monitoring. Conversely, it permits an individual’s personal creditors to have first claim on personal assets, which 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.40

Again, this is a distortion of economic and legal reality. Corporate creditors do not have the first claim, they have the only claim unless the corporation ceases to exist by being wound up and put into liquidation. Likewise, the personal creditors of shareholders do not have a priority claim to the latter’s assets over and above the corporation’s creditors, they have the only claim. A corporation’s creditors may only have a claim on shareholder assets if the veil is pierced and legal personality is set aside, and this is virtually impossible under English law although more common in American law.

The fourth characteristic of a business corporation, that of delegated management, is again construed as a rational and chosen arrangement between the contracting parties based on cost-e cient motives. The board is separate from shareholders because this ‘economizes on the costs of decision-making by avoiding the need to inform the firm’s ultimate owners and obtain their consent for all but the fundamental decisions regarding the firm’.41 So, while long-standing empirical evidence coupled with most scholarly work on corporate governance clearly indicates that shareholders are widely dispersed, passive recipients of dividends who know little about their company, do not vote or expect to be involved in any part of the management, Kraakman and Hansmann prefer to characterise shareholder detachment from management decisions as their choice. Collective decision making is a waste of money which shareholders choose to enjoy as dividends instead of wasting in management costs. In this characterisation shareholders are involved and

40Op. cit., Kraakman and Hansmann, p 9.

41Ibid, p 12.

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conscious investors in a business who realise that their interests as owners are best represented by a specialised central management, largely monitored by creditors who have a more direct relationship with asset preservation.

In examining the fifth feature of a business corporation, Kraakman and Hansmann make a final clinching bid for shareholder primacy. In corporate law, they explain, rights of ownership come only from investment in capital, unlike a partnership for example, where one may become a partner by dint of one’s employment and ‘typically does not presume that ownership is tied to contribution of capital’.42 In this, it is implied that shareholders possess a greater entitlement to ownership claims than partners who merely engage in every level of the business, jointly own partnership property and are jointly and severally liable for the partnership’s debts!43 In so doing they are appealing to capital as uniquely and normatively justifying ownership across any business form. Ownership, in their interpretation of the word, they explain, means the right to control the firm and the right to the net earnings of the business, both of which are entitlements arising from capital investment and are in proportion to the amount invested. Ownership, they argue, is so absolutely tied to investment that it would probably be more accurate to call a business corporation ‘a special kind of producer cooperative, in which control and profits are tied to supply of a particular type of input, namely capital’.44

They conclude that a specialised statutory form developed because of the popularity of business corporations, the ‘homogeneous interests’ of shareholders and the fact that shareholder interests are the most di cult to protect contractually (the implication being that they should be protected). Thus like Easterbrook and Fischel they characterise corporate law as a way of achieving contractual ends in a cost-e cient way. But their reanimation of the shareholder as a producer in a co-operative is probably the boldest and least justifiable claim made for shareholders in large corporations to date.

The contractarian model is consistently logical only if company law is distorted and corporate history is dispensed with. This is important because history demonstrates that legal developments express social realities and are not forms constructed by the corporate players. As Ireland argues, contractarianism in the context of the company simply goes against the grain of history. For, while English company law undoubtedly originated in partnership law, thus initially taking on the latter’s contractual and agency norms, it has since gone through a process of what he terms ‘decontractarianism’.45

42Ibid, p 14.

43Partnership Act 1890.

44Op. cit., Kraakman and Hansmann, p 13. They invite us to think of corporations as ‘capital collectives’.

45Ireland, P, ‘Property and contract in contemporary corporate theory’ (2003) 23 Legal Studies, p 453.