3.1.2.3 The reward strategy

The principal rewards to management for pursuing shareholder interests are created by contract rather than by law, notably through the vehicle of compensation contracts. Nevertheless, the law can facilitate a rewards strategy, and sometimes even mandates it. For example, although the sharing strategy is widely implemented through voluntary stock ownership plans that force top executives and directors to share in the economic fate of shareholders, at least one jurisdiction—France—mandates nominal share ownership for directors by law.80

The more important reward strategy is pay-for-performancc, which is widely used in the U.S.—and is increasingly used elsewhere—to provide managers with high-powered incentives to create shareholder value. U.S. corporate law, in particular, goes far toward facilitating performance-based compensation by authorizing the issuance of stock options, shadow stock, and other forms of incentive compensation.81 At the same time, U.S. disclosure rules82 and tax regulations83 also favor performance-based compensation. At the other end of the spectrum, the reward strategy has only recently emerged in Germany, where incentive compensation for corporate managers is generally quite restricted, in part because neither tax law nor company law have encouraged it—although new reforms have begun to change this, for example, by permitting 10% of outstanding shares in a public company to be repurchased for the purpose of underwriting a stock option plan.84

Were we to predict which jurisdictions rely the most on high-powered compensation incentives for managers without knowing about anything other than differences in ownership structure (and perhaps something about shareholder organization) across jurisdictions, we would probably guess that countries with large numbers of widely held companies—the U.S., followed by the UK—would lead the rest. And we would be right. Less clear, however, is why this should be so. It might be that high-powered compensation is a rational alternative to close monitoring by powerful shareholders or by an active takeover market—or it

74 Japanese law now provides for the trusteeship strategy in the form of a choice between statutory auditors, at least half of whom must be independent, or a tripartite structure of board committees staffed by majorities of independent directors. See supra note 68.

71 See Art. L. 225-22 Code de commerce. The charter of an SA may provide for additional employee directors elected by the employees themselves and not the shareholders. An. L. 225-27 Code de commerce (employees may elect directors to not exceed 1/3 of other board member?). As of 2002, election of employee directors became compulsory in France when employees hold in aggregate more than 3% of a company's capital. Art. L. 225-23 Code de commerce.

76 For example, approval by independent directors earns U.S. managers more relaxed judicial

review of self-interested decisions, greater leverage over the dismissal of shareholder suits, and even

eligibility for favorable tax treatment of management compensation plans.

77 See Bernard S. Black and John C Coffee, Hail Britannia? Institutional Investor Behavior Under

Limited Regulation, 92 MICHIGAN LAW REVIEW 1997 (1994).

7! See supra note 74.

79 See supra note 27.

,0 Art. L. 225-25 and Art. L. 225-72 Code de commerce. The minimal number of shares is to be determined by the charter, but may be as low as 1 share—making share ownership more akin to a legal suggestion than a requirement.

81 E.g., S157 Delaware General Corporation Law.

82 Securities and Exchange Commission Regulation S-K, Item 402 (Executive Compensation).

13 Internal Revenue Code S162(m).

B* S71 Aktiengesetz (1997 reform to encourage option compensation). Preemption rights have been another important obstacle to share repurchases for managerial compensation. The EU seeks to reduce this obstacle by relaxing shareholder approval and preemption tight requirements. See Art. 19, 20 and 29 Second Company Law Directive [1977] OJ L 26/1 and [1992] OJ L 347/64, applicable to AG, SA, public companies, etc.

might be that generous compensation is the result of inefficient shareholder monitoring.85

3.1.2.4 The constraints strategy

Generally speaking, rules and standards play an important role in corporate governance only in particular areas, typically involving related-party and conflict of interests transactions of the sort we address in Chapter 5.86 The only standard that qualifies as a general instrument of corporate governance is the duty of care, which sets the minimum quality threshold for managerial decisions at some benchmark standard such as 'negligence' or 'gross negligence.' Defining and enforcing such a standard is notoriously difficult and, to our knowledge, is not done rigorously anywhere for good reason: evaluating business decisions ex post is difficult, and legal error in imposing liability is likely to make directors overly risk averse ex ante.87 The rare case in which the law appears to hold directors liable for negligent decisions without evidence of bad faith or self-dealing generally involves extraordinary and easily distinguishable circumstances 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