14Fi Pistor, supra note 126, 190 (Germany); Bratton and McCahery, supra note 12, §3.2 (the Netherlands).

The tension between the law and the reality of corporate governance is greatest in the case of Japan. Japanese law on corporate governance is at least as friendly to the interests of the shareholder class as British or French law, and is arguably more protective of the interests of minority shareholders. Although Japanese law 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 rights of both shareholders as a class and minority shareholders. To take only two examples, Japanese law mandates one-share-one-vote and bars common American defenses against 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 remained so quiescent during the post-War period that it is sometimes said that managers and employees are the real 'owners' of Japanese enterprises. In practice, if not in theory, Japan is arguably the most managerialist of the principal corporate law jurisdictions.

These observations naturally lead one to ask how far legal governance strategies actually shape corporate governance—and how far, in contrast, they are minor influences in comparison to such extra-legal factors as ownership structure, managerial culture, and the political power of managers and employees. We return to this issue in the concluding Chapter of this book. Here we observe only that the most managerialist periods of U.S. and—as we have just suggested—Japanese corporate history have also been periods of prosperity and rapidly rising share prices. It is at least possible that shareholders have little incentive to exercise their latent legal powers during such periods because their interests are already being well served. By contrast, shareholder power has been very much in evidence in the U.S. since the crisis of confidence in U.S. companies during the 1980s, first in the form of a burgeoning takeover market and more recently in the form of a movement for corporate governance reform. While the evidence is more limited, in Japan too there are indications that shareholders have begun to exercise their strong latent governance powers much more forcefully since the onset of economic crisis and stagnation in the early 1990s.

147 See, e.g., Todd Huckaby, Note; Defensive Action to Hostile Takeover Efforts in Japan: The Sbuwa Decisions, 29 COLUMBIA JOURNAL OP TRANSNATIONAL LAW 439 (1991). Other defensive tactics remain open in Japan, however. Conspicuous among these is the extensive albeit dissolving network of cross-holdings among Japanese firms. Recent amendments to the Commercial Code may have opened the door to some defensive measures. See infra 7.2,3.

Creditor Protection

GERARD HERTIG and HIDEKI KANDA

Corporate creditors are the only non-shareholder stakeholders that every company law protects. There are two bases for this unique status. The first is that the class of 'creditors' includes not only banks and bondholders, but also the members of other corporate constituencies, such as employees or suppliers, who accept claims on corporate cash flows in exchange for their goods and services. Put differently, because the corporate form defines the pool of assets that bond all corporate contracts, all parties who contract with corporations benefit from creditor protections.

The need to protect corporate creditors, however, does not necessarily imply that corporate law must do the protecting: the job could be left entirely to contracting between the parties or to the general law of debtor-creditor relations. Thus, a second basis for placing creditor protections in company law must be that corporate creditors face a unique risk specific to the corporate form. This risk, it is usually said, arises from the power of shareholders to manipulate limited liability to the detriment of business creditors.

In this Chapter we address the legal strategies employed by our major jurisdictions to protect corporate creditors. Section 4^1 explores the agency problem faced by creditors as a basis for placing supplementary protective measures m company law. It also examines three contexts where the need for legal protection is arguably greatest: insolvent corporations, corporate groups, and involuntary creditors. Section 4.2 examines various regulatory strategies for protecting creditors in major corporate law jurisdictions. As we will see, EU jurisdictions and Japan employ rules such as capital maintenance provisions to complement a standards strategy for protecting creditors. U.S. jurisdictions, on the other hand, rely primarily on standards to protect creditors. Nonetheless, Section 4.3 argues that overall creditor protection is roughly similar across jurisdictions, despite such differences in legal strategies.

4.1 WHY SHOULD CORPORATE LAW PROTECT CREDITORS?

At bottom, creditors of individual debtors and creditors of corporate debtors face the same forms of debtor misbehavior. Ex ante—before borrowing— debtors may lie about their assets to obtain a loan. Ex post—after borrowing—debtors may violate the terms of their agreements, either by

'diluting' the assets available to satisfy their creditors or by pursuing risky projects that shift the risk of failure to their creditors.1 Limited liability exacerbates both of these risks. Ex ante, it assist shareholders in misrepresenting the value of corporate assets by falsely clainiing that the firm holds title to assets that shareholders control but that actually belong to other entities or to shareholders themselves in their personal capacity. Ex post, shareholders can siphon assets out of corporate solution directly, or do so indirectly by pursuing risky projects knowing that creditors will bear the costs if these projects fail. It follows that both creditors and shareholders can benefit from enhanced creditor protections that reduce the costs of raising debt capital through the corporate form.

As we suggested in Chapter 2,2 however, the fact that creditors—or any other corporate constituency—'need' protection does not necessarily justify legal intervention. Such intervention is merited only if the law protects creditors more efficiently than they might protect themselves by contract. Historically, rigid creditor protections were seen as a quid pro quo for granting limited liability to shareholders,3 an argument that remains influential even today.4 But commercial practice suggests that this argument is largely rhetorical. Today, major business creditors rely not on the law, but on contract, credit agencies and a host of other self-help measures to safeguard their interests. Formal legal measures under-protect or over-protect these interests. Why, then, include any one-size-fits-all protections for creditors in the company law?

The short answer is that the law can often provide a useful foundation and supplement for contractual protections. In the first instance, it can define the parties' background expectations. Standard legal protections can save costs in some cases by offering ready-made terms and in other cases by inducing explicit negotiation when default terms do not suffice. In addition, standard legal protections are essential when parties cannot negotiate protections for themselves. Here, three classes of cases are important: (1) when transactions are too small to support negotiation, (2) when creditors are too naive to protect themselves (leaving aside the question of which creditors might be naive), and finally, (3) when collective action problems prevent creditors from obtaining terms that might benefit all creditors ex ante, such as mandatory public disclosure or debtor registration of large corporate debts.5

We hasten to add that the benefits of legal protections for creditors come at a cost. In theory, they are supposed to reduce costs, but in practice, they can also

1 See, e.g., Lucian A. Bcbchuk and Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims m Bankruptcy, 105 YALE LAW JOURNAL 857 (1996),

2 Supra 2.4.

3 For a common law example, see Re Exchange Banking Company, Flitcroft's Case [1882] 21 CHANCERY DIVISION 518.

4 See Company Law Review Steering Group, Modern Company Law for a Competitive Economy: The Strategic Framework (1999).

■ 5 Other examples might include efforts to put creditors on the.same footing when the firm is near insolvency. See, e.g., John Armour, Share Capita! and Creditor Protection: Efficient Rules for a Modem Company Law, 63 MODERN LAW REVIEW 355 (2000).

increase transaction costs when they are overly rigid and intrusive. Here, as elsewhere in corporate law, the point is not to eliminate opportunism entirely but to bring its costs into rough equilibrium with the costs of controlling it. In particular, there are several circumstances in which the risk of shareholder opportunism is likely to be especially severe and, accordingly, the benefits of creditor protections particularly large. One circumstance is when a corporate debtor is near insolvency; another is when the debtor belongs to a corporate group; and the final circumstance is when the corporate creditor is involuntary.

4.1.1 Companies in the vicinity of insolvency

As companies approach insolvency, shareholder incentives to siphon away value or gamble on risky projects grow rapidly.6 To cabin these incentives, all jurisdictions have devised ways to induce insolvent firms to file for bankruptcy7 with reasonable promptness.8

Most jurisdictions require corporate boards to initiate bankruptcy proceedings upon the onset of insolvency.9 Germany and Switzerland include such a "requirement directly in their corporate laws.10 France and many other countries insert the same rule into the insolvency statutes (in France, the redressement judiciaire11). Other jurisdictions impose liability for failure to rake timely action in the event of insolvency. In the UK, where the fate of insolvent closely held companies has historically been resolved out of court,12 directors are liable for damages under the Insolvency Act for failing to respond adequately to the insolvency of their companies.13

* For an astute discussion of this opportunism risk, sec Brian R. Cheffins, COMPANY LAW: THEORY, STRUCTURE AND OPERATION 75-8 [1997).

7 Filing for 'bankruptcy* does not necessarily mean that the firm will be liquidated, as it also may lead to its reorganization and the continuation of corporate activities.

1 For a comparative discussion, sec Paul Povel, Optimal 'Soft' or Tough' Bankruptcy Procedures, 15 JOURNAL OF LAW, ECONOMICS AND ORGANIZATION 659 (1999).

s See Joren de Wachter, General Report, in Wtnfricd F. Schmitz, Joren de Wachter and Pckka Jaatinen (eds.), RESCUE OP COMPANIES. THE ROLE OF SHAREHOLDERS, CREDITORS AND THE ADMINISTRATOR 1-8 (1998). There is variety in the definition of insolvency, but two criteria predominate: a debtot is insolvent when hec liabilities exceed her assets (balance-sheet test) or when she is durably unable to pay her due debts (cash-flow test).

10 See $92 Aktiengesetz (managing board, Open corporanons); S64 Gesetz betreffend die

Gesellschaften mit beschranktcr Haftung (GmbH-Gesetz) (general manager, closed corporations);

Art. 725 Obligationenrecht (board, open corporations); Art. 817 Obligationenrecht (general manager,

closed corporations).

11 Art. L. 621-1 Code de commerce (applicable to open and closed corporations).

12 EU law recognizes that insolvency ptocecdings do not necessarily require judicial intervention:

see Regulation on Insolvency Proceedings [2000) OJ L 160/1. See also John Armour and Simon

Deakin, Norms in Private Insolvency: The 'London Approach' to the Resolution of Financial Distress,

1 JOURNAL OF CORPORATE LAW STUDIES 21 (2001) (importance of debt workouts for large public

companies).

13 $214 Insolvency Act, applicable to companies that have gone into insolvent liquidation,

following either a compulsory winding up court order or voluntary liquidation. Sec also lan

E Fletcher, THE LAW OF INSOLVENCY 661 (2nd ed. 1996).

By contrast, neither the U.S. nor Japan imposes specific duties on the boards of insolvent companies. Instead, these jurisdictions appear to induce bankruptcy filings by rewarding managers with a carrot rather than threatening them with a stick.14 In place of the European practice of substituting creditor- or court-appointed managers for the incumbent boards of insolvent companies,15 the U.S. Bankruptcy Code ordinarily leaves the incumbent board in place and even accords it the first opportunity to propose a plan of reorganization. Thus, American boards have an affirmative incentive to enter bankruptcy when—or even before—insolvency occurs.16 Similarly, Japanese law does not force boards to enter insolvency proceedings, but makes doing so more attractive by allowing boards to remain in office after these proceedings are initiated.17 (In practice, of course, both U.S. and Japanese managers often do lose their jobs in the wake of bankruptcies, but this outcome is neither immediate nor automatic.18)