4.1.3 Involuntary creditors

Like other creditors of insolvent companies, involuntary corporate creditors are peculiarly vulnerable to opportunism and negligence. Shareholders know they can avoid personal liability for the injuries of tort victims and capitalize their companies accordingly. Indeed, they may shift assets out of risky operating companies precisely in order to minimize their potential tort liability. Put differently, to the extent that the corporate form insulates shareholders from ton damages or fines, shareholders are free to opt out of the laws that control the negative externalities of production, including product liability law, environmental law, and tort law generally.25

13 A shareholder may leverage his equity holding e.g. by owning 51% of the voting rights in a company that owns 51% of the voting rights in several companies that themselves hold 51% of the voting rights in other companies, etc.

2* See supra 3.2.1.

25 See Yishay Yafeh and Tarun Khanna, Business Groups and Risk Sharing around the World

(Working Paper 2002, available at ssrn.com); Henry Hansmann and Reinier Kraakman, The Essential

Role of Organizational taw, 110 YALE LAW JOURNAL 387 (2000). See also supra 1.2.2.

26 See mfra 4.2.2.2.

27 See Phillip I. Blumberg, THE MULTINATIONAL CHALLENGE TO CORPORATION LAW 56-60

(1993).

28 See D. D. Prentice, Some Comments on the Law Relatmg to Corporate Groups, in Joseph

McCahery, Sol Picciotto and Colin Scott (eds.), CORPORATE CONTROL AND ACCOUHTADILTTY 371

(1993); Maurice Cozian, Alain Viandier and Florence Deboissy,-DROIT DES SOCIETES N"1950 (15th

ed, 2002).

29 See Brigitte Haar, Piercing the Corporate Veil and Shareholders' Product and Environmental

Liability in American law as Remedies for Capital Market Failures—New Developments and Impli-

This observation suggests that involuntary creditors need special protections even more than creditors of insolvent companies.30 Indeed, many such possible protective measures have been proposed. For example, involuntary creditors might be given priority over voluntary creditors in insolvency proceedings, or corporations might be required to purchase liability insurance at levels commensurate with their expected tort costs. Alternatively, shareholders might be held liable for excess tort liability—on a pro rata basis in every case of tort liability, or to the full extent of damages in cases in which shareholders control risky activities directly.31

To date, however, almost no specialized measures to protect involuntary creditors have been adopted anywhere.32 There are several possible explanations for this lacuna. One turns on historical inertia or 'path dependency': a distinction between voluntary and involuntary creditors has little traction in a model of the corporation that matured at the end of the nineteenth century, when tort law was undeveloped and mass torts unknown. Another explanation is that tort law is still 'undeveloped' in jurisdictions that lack class action lawsuits and a specialized plaintiffs bar. But a third—and in our view more credible—explanation looks to the political economy of tort liability. Since tort victims do not know that they will become victims, they have little incentive to lobby for corporate law reform before they are injured. After injury, however, it may well be too late to lobby for reform because their damages are fixed, and they can no longer benefit from a change in the law. Thus, involuntary creditors are left to share the legal protections of unsecured voluntary creditors, whatever they may be in particular jurisdictions.33

4.2 REGULATORY STRATEGIES FOR CREDITOR PROTECTION

Jurisdictions tend to employ qualitatively similar legal strategies to protect all corporate creditors, regardless of vulnerability to shareholder opportunism. In particular, our major jurisdictions rely primarily on three classes of strategies:

cations for European and German Law after 'Centros', 1 EUROPEAN BUSINESS ORGANIZATION LAW REVIEW 317 (2000).

30 See, e.g., Henry Hansmann and Reinier Kraakman, Toward Unlimited Shareholder Liability fo'

Corporate Torts, 100 YALE LAW JOURNAL 1879 (1991).

31 For a pro rata approach, see Hansmann and Kraakman, supra note 30; David W. Leebron,

Limited Liability, Torts Victims, and Creditors, 91 COLUMBIA LAW REVIEW 1565 (1991); for n

control approach, see Nina A. Mendelson, A Control-Based Approach to Shareholder Liability, 102

COLUMBIA LAW REVIEW 1203 (2002).

51 One notable exception is Russia, which has recently accorded involuntary creditors priority rights in bankruptcy proceedings (although the effectiveness of this innovation is debatable). Sec Ekatetina V. Zhuravskaya and Konstantin Sonin, Bankruptcy in Russia: Away from Creditor Protection and Restructuring, 9 RUSSIAN ECONOMIC TRENDS 6 (2000).

33 For example, U.S. courts may deem the corporation to be inadequately capitalized, and thus pierce the corporate veil, when liability insurance is not available to compensate tort victims: see Radaszewski v. Telecom Corporation, 981 FEDERAL REPORTER, SECOND SERIES 305 (8th Circuit Court of Appeals 1992).

affiliatiori rights (in the form of mandatory disclosure), rules, and standards.3'1 Reliance on a common set of strategies, however, does not imply a uniform level of creditor protection. To the contrary, conventional wisdom has it that the world divides into 'debtor-friendly' and 'creditor-friendly' jurisdictions. Thus, the U.S. is reputed to be debtor-friendly,35 while the UK and, to a lesser extent, Germany and France, are usually characterized as creditor-friendly.36 Japan is thought to fall somewhere between U.S. and EU jurisdictions in its legal protection of creditor interests.

Global explanations of why entire jurisdictions might be creditor- or debtor-friendly are easy to invent.37 Less certain, however, is whether any of these explanations can account for the fine structure of the law. There are significant variations within jurisdictions in the treatment of different classes of debtors and creditors. In addition, a jurisdiction's weighting of debtor and creditor interests evolves over time.38 For example, recent European reforms that encourage the early restructuring of failing companies diminish the differences between EU and the U.S insolvency regimes.39 Similarly, the willingness of U.S. courts to allow U.S. creditors to choose between U.S. and foreign insolvency regimes in international bankruptcies suggests a degree of convergence in the rights of corporate creditors.40

34 On rules and standards, see supra. 2.2.1.1. As discussed mfra 6.2.3, other strategies are some-rimes used to protect creditors in mergers and other significant transactions. In addition, France, Japan, and the U.S accord special protections to public bondholders, as when law requires bondholder trustees. See Art. L. 228-46 Code de commerce (France); Art. 297 Commercial Code (Japan); 1939 Trust Indenture Act, 15 U.S. Code S77jjj (U.S.).

31 In general, see Franks et al., supra note 14. See also Luca Enriques and Jonathan R. Matey, Creditors versus Capttal Formation; The Case Against the European Legal Capital Rules, 86 CORNELL LAW REVIEW 1165,1173 (2001) (European corporate law protects creditors while U.S. law gives flexibility to shareholders).

3* German and French civil law jurisdictions are said to offer mediocre protection for shareholders but strong protections for creditors. See Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny, Law and Finance, 106 JOURNAL OF POLITICAL ECONOMY 1113 (1998). Sec also Moody's Investors Services, BANKRUPTCY AND RATINGS: A LEVERAGED FINANCE APPROACH FOR EUROPE, UK VERSUS FRANCE AND GERMANY (March 2000) (creditors better protected by the UK than by Germany and France).

37 Thus, in addition to sheer historical inertia, some jurisdictions might favor debtors because the market already protects creditors, ot because politically dominant shareholders believe that strong creditot rights discourage entrepreneurship. Similarly, jurisdictions might favor creditors because banks are politically powerful while populist mistrust of 'capitalists' undercuts the influence of shareholders. Even firm size might play a role; if smaller companies often fail, demand for creditor protections may be greater in the fragmented EU market, with its traditionally smaller companies, than in the U.S. See Christopher M. McHugh (ed.) THE 2000 BANKRUPTCY YEARBOOK AND ALMANAC (10th ed. 2000) 332-3. See also Krishna B. Kumar, Raghuram G. Rajan, and Luigl Zingales, What Determines Firm Size (Working Paper 2000, available at ssrn.com).

31 See Erik Berglbf, Howard Rosenthal and Ernst-Ludwig von Thadden, The Formation of Legal Institutions for Bankruptcy: A Comparative Study of Legislative History (Working Paper 2001, available at www.hcc.unil.ch).

39 Sec Michelle J. White, The Costs of Corporate Bankruptcy: A U.S.-European Comparison, in

Jagdeep S. Bhandari and Lawrence A. Weiss (eds.), CORPORATE BANKRUPTCY 467 (1996).

40 See Lucian A. Bebchuk and Andrew T. Guzman, An Economic Analysis of Transnational

Bankruptcies, 42 JOURNAL OF LAW AND ECONOMICS 775 (1999).

To explore the ways in which our major jurisdictions are'—and are not— debtor- or creditor-friendly, we turn to the deployment of the three principal legal strategies for protecting creditor interests.

4.2.1 Mandatory disclosure—The entry strategy

Voluntary creditors often contract for an exit opportunity in the fotm of an acceleration clause that makes a debt due and payable upon the occurrence of a significant default.41 By contrast, corporate law eschews the exit strategy in favor of an entry strategy by requiring companies to publicly disclose certain basic information before borrowing funds. For example, all jurisdictions require companies to file their charters in public registers,42 which makes available information about legal capital, restrictions on director liability, and the.like— especially in the EU, where Member states must establish user-friendly registers.43 In addition, all jurisdictions require companies to keep appropriate accounting records.44

4.2.1.1 Closely held corporations6"5

U.S. corporate law limits the accounting obligation of closely held corporations to keeping financial accounts, which they are under no duty to disclose publicly.46 By contrast, the EU and Japan impose more sweeping accounting and disclosure duties on closely held corporations. In these jurisdictions, all companies must prepare financial statements in accord with minimum accounting standards, and—in theory at least—make their financial statements available for public inspection.47 In addition, EU and Japanese law require professional audits

**\

41 See Eilis Ferran, COMPANY LAW AND CORPORATE FINANCE 479-81 (1999).

42 The articles of incorporation filed by U.S. corporations include company names, authorized

shares, registered addresses, and incorporators" names and addresses. See, e.g., Revised Model

Business Corporation Act (hereafter RMBCA) 52.02(a)). In Japan, the major items of the charter

(but not the charter itself) as well as additional items must be recorded in the comcrcial registry. See

Art. 188 Commercial Code.

43 See Art. 2-3 First Company Law Directive [1968] OJ L 65/8.

44 See, e.g., 516.01(b) RMBCA (a corporation shall maintain appropriate accounting records). Art.

36 Commercial Code (Japan) (same).

45 Very generally, securities laws only apply to firms that have a minimum of shareholders, i.e., are

not closely held according to regulatory definitions. See also infra 8.2.1. The scope of corporate laws

is murkier. Closed corporations are usually, but not always closely held, whereas corporations that

opt for the open company form are potentially, but not necessarily publicly held. See also supra 1.1

and 3.1.

46 See, however, William J. Carney, The Production of Corporate Law, 71 SOUTHERN CALIFORNIA

LAW REVIEW 715, 761 (1998) [shareholders are entitled to receive annual financial reports in 41

states).

47 For the EU, see Fourth Company Law Directive [1978] OJ L 222/11 (accounting standatds); Art.

2(l)(f) First Company Law Directive (disclosure of balance sheet as well as profit and loss account for

each financial year). For Japan, see Art. 283(4) (5) Commercial Code (disclosure of balance sheet

for each financial year, applicable ro the open company form—kabushikigaisha) and Art. 16(2), (3)

Special Audit Act (disclosure of balance sheet as well as profit and loss account for each financial year,

applicable to large-scale kabushikigaisha with legal capital of 500 million yen or more or balance

sheet debts of 20 billion yen or more).

for companies that are 'larger* in an economic sense, even if they are closely held by a handful of shareholders.48

From a law-on-the-books perspective, creditors of closely held companies enjoy much greater access to financial data in the £U and Japan than they do in the U.S. In practice, however, this difference is less significant than it appears. One reason is that EU law generates less information than it seems to promise. EU Member states freely use their power to simplify accounting requirements for smaller corporations,43 and also permit closely held companies to flout EU public disclosure requirements.50

But a second—and more important—reason to doubt the significance of differences in mandated disclosure between the U.S. and other jurisdictions is that market institutions may already generate more useful disclosure for the U.S. creditors of small firms than legal mandates do for their European counterparts, For example, closely held U.S. firms must submit detailed financial data to credit rating agencies simply in order to gain access to financing in the ordinary course of business.51 We also suspect that even if the law does not compel 'large' privately-held companies to submit to Generally Accepted Accounting Principles ('GAAP') and professional audits in the U.S., the capital market does. It is difficult to imagine a U.S. bank or venture capitalist settling for anything less that a financial statement prepared in accordance with GAAP and audited by a reputable outsider.

Ironically, the one area in which some EU Member states may provide more creditor protection than do their U.S. counterparts lies in their rejection of EU accounting methodology in favor of older, creditor-oriented accounting principles. Germany, for example, still disregards the shareholder-oriented 'true and fair view' accounting standard that underlies the EU's Fourth Company Law

4* EU Jaw generally requires companies to obtain professional audits. Art. 51{l)(a) Fourth Company Law Directive. However, Member states are permitted to exempt smaller companies that satisfy at least two of the following tests: (1) a book value less than 3,650 million Euro, (2) an annual turnover less than 7.3 million Euro, or (3) 50 or fewer employees. See Art. 51(2) and Art. 11 Fourth Company Law Directive. These exemptions are widely used to relieve small companies of the burden of costly audits. Thus, even the 'creditor friendly' UK exempts companies with an annual turnover of less than £1,000,000 from the audit rules. JS249A-249E Companies Act. Exempted corporations, however, are still held to higher accounting standards than partnerships. See, e.g., Friedrich Kubler, GESELLSCHAFTSRBGHT $ifJ IV (5th ed. 1998). In Japan, the Securities and Exchange Act limits professional auditing requirements to reporting companies. However, non-reporting companies arc also subject to professional auditing under company law if they are 'large'joint-stock companies, i.e., companies with legal capita! of 500 million yen or more or balance sheet debts of 20 billion yen or more. Sec Art. 2 Special Audit Act.

w Art- 11 Fourth Company Law Directive.

50 Two authors estimate that 30% of French Sociites a responsabiliti hmxUe (SARL) and non-listed

Soctttis anonymes (SA), and 80%-95% of Germany's closely held corporations (GmbH), do not

disclose their financial statements. See Cozian ef al., supra note 28, N°413; Mathias Habersack,

EUROFAISCRES GESELISCHAFTSRECHT N*90 (2nd ed. 2003). Under EU pressure, Germany has re-

cendy adopted legislation to raise its compliance rates.

51 On U.S. and UK credit insurers and credit-rating agencies access to information, see CbefHns,

supra note 6, 519. Empirical investigation of the expansion of credit-rating agencies in the U.S. and

EU might help put the role of legally mandated disclosure for small businesses in perspective.

Directive in favor of a conservative approach that purports to be more protective of creditor interests.52 How much such accounting differences matter to creditors in comparison to, for example, shareholder guarantees or information about past credit histories remains an open question. We suspect that, overall, the accounts of closely held companies of similar sizes in the EU and U.S. resemble one another far more than either resembles the accounts of U.S. and European public companies.

4.2.1.2 Publicly held corporations53

In contrast to closely held companies, disclosure by public companies is more heavily regulated in the U.S. than in our other major jurisdictions.54 Under U.S. securities law, a company issuing publicly traded securities—including debt securities—must disclose all material information bearing on the value, of the issue and the issuer's financial condition in a registration statement filed with the SEC.55 In addition, public companies must periodically file financial statements that are prepared in accordance with U.S. GAAP, and immediately report on new material developments.56 Japan and the EU jurisdictions, with the notable exception of the UK,57 still impose much less demanding accounting principles and disclosure requirements.58

But do the Anglo-Saxon disclosure and accounting rules protect creditors of public companies better than their EU and Japanese counterparts? Again the answer is probably 'no,' as a result of differences in accounting priorities. In theory, U.S. and UK GAAP seek to protect shareholder interests by accurately depicting company finances. By contrast, continental Europe's accounting practices attempt to protect creditors by reliably signaling that a company's assets and revenue can cover its liabilities—or, if they might not, that creditors know it. We surmise that creditors can live equally well with either approach.

52 The German approach focuses on conservative evaluation of balance-sheet items, whereas

Anglo-Saxon accounting puts the emphasis on a true and fair profit and loss account. Sec also Klaus

J. Hopt, Common Principles of Corporate Governance in Europe?, in Basil S. Markesinis (ed.), THE

CLIFFORD CHANCE MILLENNIUM LECTURES 105 (2000). Regarding accounting methodologies, see

also mfra 8.2.2.

53 Publicly held corporations generally adopt the open corporate form, but this is not necessarily

the case. See supra note 45.

J* See also infra 8.2.

53 S? 1933 Securities Act.

56 See, e.g., $$401, 409 Sarbancs-Oxley Act; Regulation S-X; for the SEC's indirect control over

reporting through proxy rulemaking, see Louis Loss and Joel Scligman, FUNDAMENTALS OF SECUR-

ITIES REGULATION 175 (4th ed. 2001).

57 See UK GAAP. The UK is closer to the U.S., both because of the importance of London as .T

financial center and because the true and fair view principle is the overriding principle of UK

accounting law.

5g See, e.g.. Werner F. Ebke, Accounting, Auditing and Global Capital Markets, in Theodor Baums, Klaus J. Hopt and Norbert Horn (eds.), CORPORATIONS, CAPITAL MARKETS AND BUSINESS IN THE LAW 113,119-20 (2000); La Porta et al., supra note 36; Kare! van Hulle, International Harmonization of Accounting Principles: A European Perspective, 36 WIRTSCHAFTSPROFERKAMMER-MITTEILUNGEN 44 (1997). Note also that, while less unusual than in the past, publicly-traded debt is still rare in continental Europe and Japan.

Anglo-Saxon accounting gives better information;59 but continental accounting gives a more reliable assurance of solvency and solidity. In any event, differences are likely to be short lived: it seems that the capital markets and regulation are inexorably pressing European and Japanese companies toward the U.S./UK model of financial reporting.60

4.2.1.3 Reflecting on accounting rules and disclosure requirements

As the preceding discussion suggests, U.S. disclosure and accounting rules are indeed 'debtor friendly,' at least with respect to closely held companies, and those of European jurisdictions are actually 'creditot friendly' as well. However, this correlation is neither particularly strong nor especially meaningful. The UK—traditionally among the most creditor-friendly European jurisdictions—is the birthplace of shareholder-oriented accounting principles.61 The U.S., which is also oriented toward shareholder interests, gives strong protection to creditors as well as shareholders through its extensive financial disclosure requirements for public companies. Some creditor-friendly jurisdictions such as Germany and Japan, tie tax accounting to a company's external financial accounts, which gives companies in these jurisdictions a strong incentive to prefer conservative financial accounting principles.62 Finally, the market may improve upon the infor-mation generated by mandatory disclosure in jurisdictions such as the U.S., which support large numbers of credit-rating agencies.

The treatment of corporate groups for accounting and disclosure purposes is one area in which real differences remain among the U.S., Japan, and some EU Member states. All jurisdictions require groups of companies in which one member is publicly held to prepare (and disclose} their financial statements on a consolidated basis. Under EU law, however, this same requirement extends to closely held groups.63 Moreover, while most jurisdictions require public companies to disclose intra-group transactions as well,64 creditor-friendly German

ss The creditor protection value of disclosure for investor protection purposes is being recognized even in Germany: see Edgar Low, Deutsche! Rechnungslegungs Standards Committee 13 ZEITS-CHR1FT FUR BANKRECHT UND BANKWIRTSCHAFT 19 (2001).

60 All EU companies traded on EU regulated markets will have to follow International Accounting Standards (IAS) by 2005: see Regulation on the Application of International Accounting Standards 12002] OJ L 243/1. As of 2001, around 10% of the approx. 7,000 companies traded on EU regulated markets complied with either IAS or U.S. GAAP. See also Communication of the Commission, EU Financial Reporting Strategy, The Way Forward 5-6, COM(2000) 359 final. For Japan, sec Charles Smith, Called to Account, iNSTXrUTiONAL INVESTOR, December 2002, 62 (discussing recent accounting standards and regulation reforms). See also infra 8.2.2.

el On differences in accounting approaches and cultures (including between more standards-oriented IAS and more rules-oriented U.S. GAAP), see Christopher Nobcs and Robert H- Parker, COMPARATIVE INTERNATIONAL ACCOUNTING (7th ed. 2002).

*2 See Henry J. Lischer and Peter N. Mark], Conformity between Financial Accounting and Tax Accounting in the United States and Germany, 36 WmcHAjTSFRUFERKAMMER—MITTETLUNGEN 91 (1997).

63 See Seventh Company Law Directive.

M See for the U.S. Statement of Financial Accounting Standards (SFAS) 57, Related Party Disclosure; for the UK Financial Reporting Standard (FRS) 8 Related Party Disclosure; for Japan Ministry of Justice (MOJ) Commercial Code Regulation Ait. 107(l)(x). In France, recent regulatory reform group law curiously provides creditors with less protection than one might expect. Ap itt from the few companies that belong to so-called 'formal' contractual groups.65 German Konzernrecht merely obligates controlled firms to provide creditors with an audited summary of a more extensive report—termed the Abhangigkcitsbericht or 'dependence' report—that these companies must deliver to their supervisory board (but not to their creditors).66