Weekly Module 1 Introduction to Corporate Law

● Knowledge Clips:
- What is a corporation? (Video 1)
There are many ​different types of business forms​, we can divide them into 3 categories:
1. Corporations
- The course mainly focuses on this one, it is a term mainly uses in the US; ‘Company’ is
the term that is mainly used in Europe and particularly in the UK
- Corporations and companies are used interchangeably
2 types:
- Private Corporation (Closely-Held)
- Public Corporation (Open)

There is also ​a hybrid business form: Limited Liability Company (LLC)

- A business form that is commonly used in the US
- Hybrid; combined characteristics for corporation with partnerships and sole
proprietorship
- The owner of such a business is personally not liable for the company’s debt or the
company’s liability; However, they enjoy being taxed through partnerships using passing
through taxation

2. Partnerships (more than one participants)

3 most common types of partnerships:
- 1. General partnership:
→ Simplest
→ An agreement between partners to establish and run a business together
→ All partners are responsible for the business and are subject to unlimited liability of the debt

- 2. Limited partnerships
→ At least one partner possess unlimited liability
→ All other partners are limitedly liable, which are called silent partners (they cannot lose more
than the money they have contributed to the partnership)
→ General partners run the business, determine strategies whereas limited partners are not
involved in the active actions

- 3. Limited Liability Partnerships (i.e. LLP)

→ Often use for law firms or other professional service firms
→ All partners are allowed to be involved in the management
→ All partners enjoy unlimited liability

3. Sole proprietorship
- Simplest form, business own and run by one person
- This business contains one person who forms sole proprietorship
- Entrepreneurs do not have to undertake any actions to form such business
 - Like every business form, these owners need to obtain licenses and permits, comply to
tax rules too

Consider the GDP

- US and China are the largest countries in the world
- If we compare the GDP and revenue, we see the following:
E.g. Walmart is larger than Argentina and all countries that are smaller than Argentina
E.g. Royal Dutch Shell is larger than Israel and all the countries that are smaller than Israel

Corporations
- Corporation/Company: A firm with special legal attributes that can make it capable of
owning property into contracts independently of its owners → Also referred to as ​Legal
Personality
- Capital of the company or a corporation is owned by the firms and is divided in shares,
which means they are owned by the shareholders→ ​Share capital
- The share capital but also some other requirements are required before you can
incorporate​ it into cooperation
- Only when a corporation is correctly incorporated, which is the establishment of a
cooperation, legal personality and limited liability can be fully used
- Another requirement is to formulate the​ article of association​ which can be seen as the
core of the corporate contract; the articles of association are always made public
- Within the company, we can find different actors:
→​ Corporate board​: Directs and supervises the company, also represents the company
although the company has legal personality, it actually needs a representative to actually
engage in business and trajectory

There are two board models used worldwide when we discuss about the corporate board:
one-tier or two -tier board model; ​also there are different types of board members
→ e.g. ​executives or management board members ​who direct the company
→ e.g. CFO, CEO, COO ( Chief operating officer)
→ Some companies have CTO (Chief technology officer) and Chief legal officer
These executive officers determine the ​corporate strategy

Non-executives or supervisory board members: ​Monitor the executive/managerial board

members
The officiers all have particular duties to the company
- Duty of loyalty/ duty of care (hold for both executive and non-executives/supervisory
board members)

The capital of a company is divided in shares

- These shares are held by the shareholders
- Also called the ​investor ownership​: The ownership contains control and capital rights
- Control rights→ Appointment rights​: The shareholders can appoint a board member
- Decision-making rights
 - Residual claimants​: Shareholders are ​residual claimants​, which means they only get
paid when the fixed payment are paid (when the company is bankrupt)
- Shareholders benefited from having limited liability which means they are only liable up
to their committed investment
→ e.g. If apple go bankrupt, as a shareholder, you are not liable for any apple’s claim → ​Owner
shielding

Third parties: ​Have a contracting relationship with the corporation

Priority Claim​: Usually a fixed claim
Creditors are called​ fixed claimants

- What are the different jurisdictions that are going to be covered? (Video 2)
There is no global corporate or business law, these legal domain strongly depends on the
country and the situation; therefore, we will have a comparative focus in this course, but mostly
focus on exploring the rationale behind important business law rules

Main jurisdiction:
- UK (Common Law)
- US (Common law )
- Continental European countries (Civil law)

The main differences between common law and civil law:

Civil law: Statues predominate
Common law: Case law in the form of published judicial opinion, is the primary source of law
→ The differences are not that strict, mainly countries have both features

In Corporate law, the common law system is often linked to the shareholder privacy; whereas
the civil law system more constitutional or stakeholder approach

➢ Introduction to the Jurisdiction : US

- Has a federal government, therefore companies are governed by the states
- State governments

Courts:
Federal courts (federal level) on federal subject matters or interstate suits
→ e.g. Security Freuds

States courts: everything else, including corporate law

→ you can say internal corporate law matters, like the internal structure of the company are
parts of the state affairs in the US
E.g. Exception: Dodd-Frank act: Typical internal affair for a company; actually a federal act

- Companies in the US are free to incorporate in any state regardless of whether they are
doing business there or have any contact with this state
 - Most corporations are incorporated under the law of the state Delaware

Why Delaware?
- According to the literature: Delaware and its corporate statutes have a reputation to be
friendly towards corporations
- Political consensus to keep the Delaware Corporation law modern and up-to-date
→ e.g. Virtual shareholders’ meeting
- Low administrative burden (Large flexibility, only a few mandatory rules)
- Experienced judges (they can offer the best conflict resolution, network effect)
- Less Tax policy for corporation→ not really a corporate law reason

Overview of the main rules that are application to corporations in the US

- Delaware General Corporation Law
- Model Business Corporation Act → Refer to as the model act, main competitor of the
Delaware Corporate law statute, was introduced by the American Bar association. This
act is more conservative than the delaware corporation law
- Federal law, e.g. Sarbanes Oxley Act for public companies
- Listing Rules, e.g. NYSE, NASDAQ

➢ Introduction to the jurisdictions: Europe

- Member States have national statutory company law but are also subject to European
law
Regulations: a binding legislative act, must be applied in its entirety across the EU

Directives: Set out a goal that all EU countries must achieve. It is up to the member states to
devise their own laws on how to reach these goals

Recommendations: Not binding. A recommendation allows the institutions to make their views
known and to suggest a line of action without imposing any legal obligation on those to whom it
is addressed

US v.s. Europe jurisdiction

- Less regulatory competition in Europe than in the US; 2 reasons
1. Companies in the US has the abbreviation of inc/ cor
- In Europe, all countries have their own legal form
→ e.g. In the NL, BV for private companies, NV for the public companies
→ e.g. in the UK, limited (Lmd) for private companies , plc for public companies
- These business forms also enjoy a particular reputation in their home country

2. Two conflicting doctrines in Europe that make regulatory competition less prevalent in
Europe
- Doctrine of incorporation: Company laws applicable to the legal entity are those of the
jurisdiction in which the legal entity has been incorporated, irrespective of the ‘real seat’
 - Doctrine of real seat: The place where the company is effectively managed or operated;
Enables company to operate in a particular member state regardless of whether they are
actually doing business there (similar to the US; used in the UK and the NL)
→ A company cannot simply adopt the legal structure of a French company, or a FRench
company cannot simply move its business elsewhere

Soft Law Requirements

- Contains Corporate governance codes

Video 3: Article of Associations and the purpose of Corporate law

Articles of Association also referred to as the corporate charter; constitution of the company
- These documents outline the rules that regulate a company’s internal affairs
→ e.g. The number of board members

Incorporation=The formation of the company

Only when the company is correctly incorporated, the actors can enjoy the benefits of limited
liability

Articles of Association
1. Mandatory Rules
- Cannot be modified by contract/ by articles of association
- Usually aimed at protection of weaker parties e.g. Creditors/ employees

2. Default rules
- Applicable in case articles of association or another contract does not state otherwise
- Allows the founders to have a tailor-made internal structure for their company
→ e.g. In the NL, Article 2: 195 (1) DCC: Unless the articles of association provide otherwise, a
valid transfer of shares requires that the shareholder who wants to dispose of one or more of his
shares, firstly offers those shares to his co-shareholders in proportion to the number of shares
that is held by each of them at the moment that such offer is made

→ e.g. France, default rules is one-tier board structure for the corporate board; companies can
stipulate their article of association if they want to have a two-tier board structure so that the
default rule is not applicable to their company

The goals of corporate law

1. Provides the structure of the corporate form and ‘housekeeping rules’ to support this
structure
2. Control conflicts between corporate ‘insiders’ and ‘outsiders’ (also called agency
problem)

Methodology
1. Harmonization of law: Activity intentionally undertaken (e.g. the EU)
 2. Convergence: Used as a process leading to an approximation of law, has no element of
planning (the five characteristics)
3. Transplantation: Including legal transplants
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Week 2: Five Characteristics

● Podcast
➢ 5 Characteristics of Corporation
Why these 5 characteristics? What do they bring? Why these 5 attributes? What is the reason
for Business around the world to adopt them? What makes a corporation a corporation?

1. Legal Personality
- We know we enjoy certain kinds of rights and obligations under the law but what about
corporations?
- Having legal personality= the corporation is subject to legal rights, it can create contract,
it can sue, it can be sued
- Corporations can also have its own property
- Having legal personality is important notion when we talk about corporate liability in
crime

2. Limited liability
- It allows to make claims and not against the shareholders

3. Transferable Shares
- Transport the shares but in some cases, the shares can be traded freely

4. Central management
- The board is elected by the shareholders

5. Investor ownership
- As an investor you have the right to participate in the control, you will see in the
shareholder module

Knowledge Clip 1: Legal Personality and limited liability (the first two characteristics)
- Management directors are responsible for the management of the company
- Shareholders: own the shares in the company
- Third parties: Various types of creditors e.g. Suppliers (Creditors are the fixed claimant
who also holds a priority claim)

Company law is understood as a body of law enabling creation of an entity, with 5

characteristics
1. Legal personality
2. Limited liability
 3. Transferable Shares
4. Central Management under a board structure
5. Investor Ownership (Share ownerships by contributors of the capital)

Why are these characteristics so important?

- There is no such thing as a global corporate law
- Each jurisdiction has their own corporate law framework with diverging characteristics
- The author of a seminal book, the Anatomy of Corporate Law, identified these 5
fundamental corporate law characteristics as comprised the core of legal corporation
- The 5 characteristics provide contractual efficiency, making the corporate form attractive
for business activities, represented in the graph
- They correspond to the most important economic needs of modern corporations and
shared by every jurisdiction around the world
- On the one hand, these characteristics contribute to the attractiveness of the corporate
form
- On the other hand, they can generate different incentives and tensions between different
actors, corresponds to the 2 functions of corporate law

1. Establishing the structure of the corporation based on these 5 characteristics

- Including related rules that are necessary to support this structure

2. Aiming at controlling conflicts of interest between different corporate constituency that

are generated by these 5 characteristics and their related rules

Legal personality
- Implies that the corporation is a legal person
- Enables the corporation to operate as a single contracting party, distinct from the
corporate board and shareholders
- Shareholders: Owners of the shares not the assets **
- The corporation serves as the common counter party in contract with e.g. suppliers,
employee and customer
- The Corporation is a legal owner of the corporate assets which is separated from the
assets of the shareholders
- The creditors of the shareholders cannot claim the firm’s assets
- To enter contracts or use the entitlements of ownership, e.g using or selling the assets,
the corporation that enjoys legal personality still need representatives to act on its behalf
- As regard to the assets that they belong to the company, this separated a pool of assets
that is distinct from the shareholders→ Separate Patrimony

Hence, the corporate form is a set of features that enable a company to have an autonomous
life independent of its investors; separate patrimony (also called demarcation of a pool of
assets)

- Entity shielding: Consists of priority rules and liquidation protection

→ Priority rules entail that the creditors of the corporation have a first claim on the assets of the
corporation, the assets are automatically available for enforcement of contractual obligations by
its creditors

→ Liquidation protection includes that the shareholders/ the owner of the corporation/ the
creditors of the shareholders cannot withdraw the share of corporate assets at will, the assets ;
the assets will be concerned for the company’s interest and are protected against liquidation
protection by creditors of shareholders or shareholders

→ Creditors are fixed claimants that have a priority claim, shareholders are receiptual claimants,
receive all receiptual things after the fixed payments are paid

In economic literature, the corporation is often characterised as a nexus of contracts, companies

are efficient network of contract between all parties involved; this may be true; for the other 4
characteristics can be enable by a contract e.g. limited liability
→ Nexus: This is definitely not the case for legal personality
Legal personality requires special rules of law and cannot be simply established by a contract

2. Limited liability
- While legal personality protects the corporate assets against claims from shareholders
and their creditors
- Limited liability provides protection to the shareholders as the corporate owners
- Creditors of the corporation have no claims against the assets that are owned by the
shareholders
- Provides shielding to the shareholders; Shareholders are only liable up to their
committed investment: Owner shielding
- We can find limited liability in all corporate law statutes nowadays, e.g. DCFL 102 (b) (6)
- Advantages of limited liability: There are 3 advantages
1. The creation of new business is stimulated as founders will be limitedly liable when
choosing for the corporate form
2. Shareholders do not have to monitor every step of the business and their co-investor as
every shareholder is only liable for his own committed investment; if shareholders all be
unlimitedly liable, each of them will have great interest in the financial situation of the
other shareholders as they are all jointly liable

3. Enables portfolio diversification

- Used by many investors
- Investing in a large number of stock or the entire market
- Eliminate firms specific risks; these risks are specific for particular companies, including
the quality of corporate management and the strategic position of the company
- If you have to invest a large amount (1million euro) of money, would you invest all of
them in Facebook? What if no one uses Facebook anymore?
- Other companies would not be vulnerable to the risk if consumers started using other
social media
 - Diversification smooths out all individual stock movement, provide you with a market
return that is only related to market risks
- Hence, if you would have 100 million euro, that’s not clever to put it on Fb, you want to
diversify the firm specific risks; also called Diversification of risks

Diversification can be abstract to understand

- E.g. Assume that you have 3 options and you may select one at 0 costs, which one
would you choose?
A. Receive 2500 euro
B. 50% chance to receive 6000 euro and 50% chance to receive nothing
C. 100 coin flips, where for each ‘heads’ you would receive 60 euro and for each tails zero
Which one would you choose? Why?
C.

Asset Partitioning
Together, legal personality which entails entity shielding and limited liability which entails owner
shielding, constitute a framework of asset partitioning
Look at the relationships in the graph :
A. Shareholders cannot withdraw the assets at will, this also refer to as entity shielding
B. Another form of entity shielding, like the shareholders, the creditors cannot withdraw the
firm assets at will
C. Owner shielding, limited liability: Creditors generally cannot hold shareholder liable for
the claim they have for the company assets
D. The only claim that is valid under the construction of legal personality and limited liability;
creditors have a priority claim on the company’s asset

Effects of Limited liability:

There are effects on the relationship between shareholders and creditors

KC2:
3. Transferability of shares
- Permits the company to continue its business when the owner is changed
- Has a perpetual life independent from the shareholders; this is not the case with several
partnerships
- Partnerships can be dissolved if one of the partners leaves or dies
- Makes it easier to maintain the diversification of portfolio
- Since the corporation has legal personality which enables entities shielding, thus being
the owner of its own assets and the counterparty in transactions, and the shareholders
are only limitedly liable which constructs owner shielding, creditors have no interest in
having the same owner in a particular businessbecause credit worthless would not
change when the owner is changed

Fully transferable does not mean freely tradable share

 - Open/public corporation have freely transferable shares, some of them are listed
on stock exchange→ Listed companies, offer shareholders the highest possible
form of transferability and the highest possible form of liquidity
- Private companies have restriction on tradability of their shares, in these
companies, shares are usually held by a small number of shareholders that have
an important connection with the company e.g start-ups or family firms
E.g. Article 195 paragraph 1 on Dutch civil code: First offer shares to the shareholders

Listed companies--IPO Process

Steps:
1. Selecting lead underwriters and forming syndicate (deal with regulators during the IPO,
underwriting means the investment bank takes on the financial risk of the IPO for a
financial fee) Investment bankers usually works as an underwriting syndicate of multiple
banks that have to pay shares with their own networks of investor. The lead underwriter
is in charge of forming syndicate with other banks that are going to be marketing their
shares in the IPO to investors. The underwriter syndicate purchase the share from a
company for a fee, usually determined as a discount of the share price, and then sell the
share to the investors in the IPO. Underwriters will buy all the shares that are offered in
the IPO.
2. Due diligence: Usually in this step, a price range is determined for the share
3. Marketing the IPO: Managers meet and simulate the demand for IPO.
4. Final Price: Determining the final price
5. Shares start trading on a stock exchange

→ 2 important questions: 1. How many shares are going to be issued and at what price?
The total number of shares in an IPO and then afterwards are thus put in the market is called
the free flow
The final price is usually set the day before the initial public offering takes place

- In listed companies, the shares are traded in a stock exchange (a formal organisation
that is monitored)
- Stock or shares are called listed stock or listed shares e.g. NY stock exchange/
American stock exchange
- Each exchange sets standard and critters for listed companies, they must satisfy stock
exchange rules
- Usually distinction between primary market and secondary market
→ Whether the shares are newly at use or not
Primary market: For newly issued securities
Secondary market: Already issued securities (tradable insurance like a share or stock)

If you want to buy a share of Apple, you usually this share at a secondary market with many
suppliers and buyers

How does a listing work?

 - Via an initial public offering (IPO)
- Process in PPT, steps are listed above
- Select investment bank: Manages the whole IPO process

● KC3 : The last two characteristics

4. Delegated management under a board of structure
- All companies nowadays
- Allocation of powers in the hands of shareholders would be unworkable for companies
that have numerous and constantly changing shareholders due to limited liability and
transferability of shares
- Shareholders are able to hold diversified portfolios which shares that can be shared,
making the corporate ownership more fragmented; therefore, because shareholders and
other stakeholders would suffer from collective action problems, delegated management
considered a contractual efficiency in virtually all jurisdictions nowadays
- Also used for representation to notify third parties as to who in the company has the
authority to make binding arrangements
- Most of the decision powers are delegated to the centralised board of the directors in
corporate law; the board has a duty to act in the interest of the company
- E.g. Germany, company interested consisted of different holders e.g. employees etc
- The board is separated from shareholders on the one hand; the upper layer of
management on the other hand
- Shareholders elect a substantial part of the board members or all the board members
depending on the jurisdiction; the board is distinct from the share
- Has the principle authority over corporate affairs and is generally elected by the
shareholders

2 types of board structures around the world

1. 1-tier board
- All directors are part of the same board, they can be executives or non-executives that
monitor the behaviours of the executives board members on behalf of the shareholders
- Monitoring can never be delegated
- E.g. US, UK, Japan, Belgium, Singapore, is the default rule in France

2. 2-tier board
- The supervisory board members have a comparable functions to the non-executives
directors in the 1-tier board but they are formally separated from the so-called
management board members
- These management board members are similar to the executive directors in the 1-tier
board
- The supervisory board members sit in the different board than these management board
members;
 - Usually in a 1-tier board system, shareholders can elect both executive board members
and non-executive board members
- In the 2-tier board system, shareholders usually elect the supervisory board who in turn
elect the management board members
- In some jurisdictions e.g. Germany, employees can also partly elect the supervisory
board
E.g. German, NL, China

Since board members usually have more information about the corporate affairs, shareholders
might completely depends on their board members
- Adam Smith referred to this ‘agency problem’ in his work
- Board members may enrich themselves at the expense of shareholders
- Besides conflicting goals between shareholders and board members, different risk
preferences of the corporate actors can also create agency problems
- Board members may be able to use corporate fund for their own benefit, e.g. spending
less hour on the job, using company money for company jet, being incompetent
- The problem of free cash flow: A management or executive board member should only
be willing to invest in a project with a positive net person value, which means that the
costs are smaller than the benefit for a particular project and thus profitable for a
company
- However, if the company has a larger cash reserve than the number of projects that are
available with a positive net person value = the firm has a positive free cash flow
- Firms with larger free cash flow tend to have agency problems as the CEO may wish to
retain these free cash flow to invest in less profitable projects
- It is often argued that executive board members have a sured time horizon than
shareholders as they are typically hired for a period of 4 years and are paid according to
their performance during this period, they have a preference for projects that have a
higher gain in the short run
- Shareholders are entitled to all residual gains
E.g. UK: Board members are elected every year
- Board members are not only focus more on the short run regarding financial gain, it is
argued that they would risk more than shareholders because shareholders can do
diversification, they only put little money here, their money is spread in different countries
- Executives don’t have diversification so they invest a lot in the project
E.g. Employment contract is example of agency contract

Ownership related to shareholders means something different

- Ownership in this aspects include 2 elements:
1. The right to control the company with legal control rights
2. Capital rights to receive the company’s net profit

Share= bundle of rights

- Capital rights
- Control rights including decision-making rights
 - Shareholders want to maximize their claims

5. Investor ownership
- Although other form of ownership exists, the dominant rule of investor ownership in large
corporations reflect its advantages
- E.g. France: Shareholders granted double voting rights
- Ownership can be tied to labour, e.g. in Germany

Shareholder information and coordinator costs

- Actually making decisions
- Suboptimal decisions (fundamental but still need consent from the shareholders in order
to confirm the decision)
- Shareholders cannot engage in the daily management

Agency problem
- 1. Shareholder-manager agency problem
- 2. Large block holders: Neutralise the shareholder-manager agency problem
- But minority-controlling shareholder agency problem
- 3. Firm itself and various stakeholders like creditors

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Week 3 Introduction to Share Capital
● Podcast
- This week bundle is about money
- Money is the integral part of the success of a corporation
- More money more problems
What is the problem that money/capital brings? For whom is the problem?
- Limited liability: Shareholders are not responsible for the debts and not liability to fund
these losses, not liable for more than what they committed to invest
- When the shareholders have contributed, they are under no further obligation to
contribute more
- Even if the company goes bankrupt due to debts, shareholders are not liable to fund
these losses
- Brings clarity to the market
- Creditors of the company know exactly how many assets are available in the company
- Despite its major advantages, limited liability does not eliminate the risk of business
failure
- The equity owners will capture all the benefits while the downward risks are shared with
the creditors
- The shareholders will support the managers to select risky projects because the owners
can externalise part of their social costs
- In order to ensure that creditors can be paid, jurisdictions have legislated capital
protection rule to prevent the share capital misappropriated by the shareholders
 - This regulation is taken in 2 forms:
1. Capital formation rules
- Intended to make sure the creditors are paid, even if the company suffers substantial
losses

2. Capital maintenance rule

- Aims to control shareholders behaviour

● Knowledge clip 1
Focus on the financing aspect of the firm

➢ Share Capital Accounting

Assets =Liabilities + Equity
- The assets of the firm are anything that the firm owns, e.g. cash, motor vehicles
- Liabilities: anything that the firm owes, e.g. loan or mortgages
- Equity: Any investment that might be made in the firm e.g. the ownership of shares
2 fundamental concepts:
1. The firm assets is equal to the liabilities and equity
→ e.g. If the firm owns machinery that is worth 2000 euro which is in the asset side of the
equation, then the firm should also own either liabilities and/or equity of 2000 euro, both sides of
the equation must have the same value
- How the assets of the company is financed
- What is the source of the funding for this asset?
- Is it more equity? =More contribution from the shareholders
- Is it from liability? = Loans

2. The theory of economic claims

Assets-Liabilities =Equity
- Because of separate legal personalities, creditors have priority to claim on the assets of
the corporation; these assets are automatically available for the enforcement of
contractual obligations of the corporation by its creditors → Important to remember!
- As we will show in the lectures, the rules regarding the constitution and maintenance of
share capitals were largely passed in order to protect the assets of the company from its
appropriation and opportunistic behaviour by either the directors or the majority
shareholders to creditors
- By moving the liability bar to the left side of the equation, since the creditors are fixed
claimants will have priority claim, we end up with the new equation
- The shareholders who represent the equity part of the equation are set to be the residual
claimants because they receive all the remaining profits after the fixed claimants will be
paid
- Equity here is the net worth of the firm or the value of their assets which remain after the
firms’ liabilities have been paid. The owner of a firm only gets paid after all creditors have
been paid in full so as the owner of the firm you bare the risk that the firm faces
The Balance Sheet statement (Financial statement)
The balance sheet statement must always balance!!!
- The accounting equation always holds
- The balance sheet statement is one of the 3 main financial statements which firms are
required to prepare
- The other 2 are the income statement: Firm profitability and the cash hold statement:
Show the firm’s sources and uses of cash
- We will focus solely on the balance sheet
- The balance sheet is a statement of financial position; it provides a snapshot of the size
and value of the firm at a particular time/point
- The balance sheet reports on 3 main components of the firm: (1) assets; (2) Liabilities;
(3) Equity
- The preparation of the balance sheet is based on our accounting equation

Example: Andre’s lemonade business

● Knowledge Clip 2 : Debt vs. Equity

Corporate finance deals with the sources of funding and the capital structure of firms with the
aim of increasing and maximizing shareholder value

Capital Structure​:
- Structure of the firm’s long term capital which is typically some combinations of debts,
previous stock and common stock

E.g. Yellow ball company

- How can yellow ball finance its business?
- Financing can be done internally or externally
- Internal financing: Profits from previous period that the company has not distributed to
the shareholders but rather retained and reinvested in the firm

- External financing: Can be divided into borrowing and selling equity states
- Borrowing money creates liability while issuing and selling stock creates equity
- Note that at the moment you start a business, you cannot make use of internal finance
since you do not have profits yet; the general financing option for your startup business
then consists mainly of debts and equity

Creditors have a fixed claim that is prior to the claims of the shareholders which means they will
be paid first so they have the lower risks but also the lowest return

After the fixed claim has been paid, the shareholders can claim their residual, that’s why they
are called the residual claimants ; they bare the greatest economic risk because they will only
be paid after the fixed claimants are paid, they stand last at the financial distribution queue;
- If they bear the greatest risk they must be also compensated for the risk, high risk high
reward
Outside or external financing falls into two categories:
1. Debt financing:
- Borrowing a fixed sum (principal), which must be paid back with interest; the most
common form of debt is a loan, could be a loan from a bank, a family member or a friend
- The interest is regularly paid be the borrower; fixed percentage of the principal amount

2. Equity financing:
- Selling stock to an investor in exchange for capital
- Sale of stock called shares to investors who would then become shareholders
- The company sells a % of their business to an investor in exchange for that investor’s
capital

Most companies use a combination of both debt and equity financing; the choice between debt
and equity financing often depends upon which source of financing is most easily accessible for
the company
- Its cash flow and how important maintaining control of the company is to the principal
owners

The main advantage of equity financing is that (look at the graph p.15 of the pp)
1. There is no obligation to repay the money acquired
2. Equity in this respect is permanent; with debt, one needs to repay the principal amount
after an agreed period of time
3. The shareholders have a residual claim which means if the company made a lot of profit,
then there will be a lot of profit left to be distributed to the shareholders; this means that
if there is no profit after all fixed claims have been paid, then there’s nothing left to be
paid
4. Dividends depends on the company’s result; debt does not depend on the result

Creditors can impose contractual governance relating to the amount that banks have loaned to
the company; to protect their interest of the company from being misappropriated
→ Comes in a form of dividends payment

Capital structure has an effect on the profitability of the business = effect on the return equity
E.g. Company E

Leverage effect:
- Can be positive or negative
- If the company is doing very well and the profit is very high, then a relatively small
amount is paid for the interest and a lot of profit will be paid to the shareholders
- If the company is not doing well, the bank will still charge interest; after all the fixed
claims, there is nothing left for the shareholders
- The leverage effect can have huge benefits for shareholders but higher risks
Is leverage a bad thing?
- Unchecked leverage can lead to bad outcome
- Over leverage is a self-fulfilling prophecy
- Leverage is not a bad thing but you have to be careful and make sure that it does not
create the wrong incentive

Recap:
- There are different sources of funding for a firm to finance its business, a distinction can
be made between internal financing (retained earnings) and external financing (debt,
equity)
- The capital structure is the structure of the firm’s long-term capital, which typically
consists of a combination of debt and equity
- Debt is related to the ‘fixed claims’ of creditors, while equity is related to the residual
claims of shareholders
- There are some important differences in the characteristics of equity and debt financing
- Debt financing can create a leverage effect which means debt increases the return
equity for equity holders; it can be beneficial to shareholders but is highly risky

● Knowledge Clip 3: Share Capital Terminology

Share capital: Different terms

1. Share capital:​ Aggregate of all contributions from shareholders
- The incorporators have to specify the initial shared capital; if they decide to assign a par
value of the shares, we should also state this in the AOA
- =par value of shares x number of shares

2. Par value of shares ​( or face value or nominal value =they have the same meaning)
- Usually printed on the face of the certificate
- Usually very small amount, e.g. 1 euro; it’s called the nominal value because the price
shown are mostly symbolic value/token value rather than a realistic examination of the
price that is shared
- Abstract accounting concept
- Has no relation to the market price of a share
- Par value was originally used to ensure equal treatment of the shareholders; insiders
and incorporators have informational advantages to other subscribers or investors; they
may give themselves special advantages on the purchase price of the shares; so par
value gave an anchor on which the share capital can be objectively computed
- The par value ensures that each subscriber committed to invest a definite amount of
money to the firm
- In cases where the company is facing bankruptcy, any amount from this subscription can
be called upon by the creditors for payment
- Par value is purely accounting convention
 - Par value remains static throughout the life of the company; one way to account for the
actual value for share would be to have the investor pay a premium beyond par when
purchasing the share

3. Additional Paid-in Capital

- Premium paid above par value
- Usually paid in the reserved account which depends on the jurisdiction may or may not
be distributed to the shareholders as dividend
- Share capital is equal to the par value x number of shares, because the par value does
not change, this means that the shared capital remains static as well

4. Market value
- Market Price x number of shares
- The market price here as opposed to the par value means the forces of supply and
demand for the shares in the open market; therefore the market value for firm fluctuates
over time

E.g. Philips NV
- The share capital of the company is eight hundred million euro divided into two billion
with a par value of 20 cent euro.
- The market price per share of philips in the stock market is 37.25
- The par value has remained the same ever since the incorporation of the company while
the market price changes constantly over time to reflect the value of the company →
Market forces and investor sentiment

The concept of par value is considered to be arbitrary, serves little to no use, the US and
Germany to an extent allow shares with par value

E.g. Company A does not have par value shares, it can issue any number of shares in order to
reach the required additional capital
Watch the example of Company A and P!

● What is the share capital

1. Authorized capital: Maximum share capital that the company can issue and is stated in
the articles of association
→ Shareholders’ meeting
→ Not required in the UK/ US
- Companies still identify a authorized capital, make it higher than the issue capital, easy
way to raise fund, no need to go to shareholders to get a higher stock
- Broadest term used to describe the company’s capital; comprise every single
share of every category

2. Issue capital: Part of the authorized capital that is actually issued/subscribed to

shareholders
→ Shares outstanding: Shares that are held by investors
→ Treasury shares: Issued shares that are held by the company (buyback)
→ represent the maximum that a company can issue
Issues capital can be less than authorized capital but cannot be larger
- Can be further classified as outstanding shares or treasury shares depending on who is
currently holding sub-shares
- The shares outstanding are the shares that are actually held by investors
- Treasury shares are shares that already issued but held by a company for the process of
‘buy back’; first issued to the shareholders but subsequently repurchased by the
company; they are part of the issue capital because they have been subscribed before
but are now held by the company

3. Paid up capital: Actual amounts received by the company

- The part of the issued capital which is unpaid remains the liability of the shareholders of
the company; these unpaid amount can be called upon by the company for payment; if
such call has been made but the shares still remain unpaid, we call such shares as ‘calls
in arrears’

4. Calls in Arrears: Issued shares that remain unpaid despite a call for payment

E.g. Company X:
The authorized share capital of company X; that is the maximum amount of shares that
company X can issue; of this maximum amount, the value of shares that company X actually
issue is called the issue share capital; the amount of issue share capital is generally much lower
than the authorized capital; this means that company X has the opportunity to issue additional
shares later on without needing to go to the shareholders to increase the entire authorised
capital stock

Depending on the jurisdiction and the business in question, some companies may issue shares
to investors with an understanding that they will be paid on a later day. This allows a more
flexible investment term and may encourage investors to contribute more share capital than
they have to provide

Some jurisdictions provide certain % of the issue capital must be paid upon subscription; this
minimum amount or all of the amount received by company in exchange for share of stocks is
called the paid up capital

Even if investors have not paid the full issue price, he still enjoy full voting rights and economic
rights

● Knowledge Clip 4: Constituting the Company’s Capital

Legal solutions that lawyer come up with to answer the problems of money

Constituting the Company’s Capital

 - Capital formation rules: The rules regarding the constitution of capital aims at providing a
cushion intended to help ensure the creditors are paid even if the company suffers from
financial problems
- Specifically regulated by the European Company Law Directive
→ e.g. Article 45 of the Minimum Capital: The laws of the Member States shall require that, in
order for a company to be incorporated or obtain authorisation to commence business, a
minimum capital shall be subscribed the amount of which shall be not less than 25000euro

It can be found in all the EU member states: Minimum harmonisation to protect creditors and
problematic behaviour of the shareholders

It’s tradeoff, therefore the 25000 euro is just the bare minimum; member states can decide to
restrict their rules

Minimum share capital:

- Germany: 50000 euro
- UK: 45000 pound
- US No minimum capital requirement except for companies operating in the
insurance/banking sector
- The board of directors in the US companies disinterested the specific sum/state capital
in order for the business to commence
- But the law requires no minimum in the US

Among UK, US and Germany (Issued capital, paid-up capital and authorised capital)
Only Germany requires authorised capital; while the UK and US don’t require authorised capital
stocks
- Even if it’s not required, companies would still have authorised stock so they can easily
raise fund rather than going to their shareholders
- Paid-up capital: both Germany and UK required ¼ of issued be paid up or at least 12500
euro/pound
- US has no requirement for any kinds of capital

Should minimum share capital be abolished?

Supporter’s argument:
1. It protects creditors (against decision by shareholders; the distributed assets; secure the
company’s debt to themselves; the law protects the the share capital from shareholders
distribution or assets)
→ The capital acts as a security for the company’s debts

2. To reduce transaction costs

- Intends to reduce transaction costs, e.g. information gathering costs
- Specifying a certain amount of legal capital in a company’s article of association gives a
clearly intelligible signal of worthiness which serves to navigate informational asymmetry
for the creditors
 - Saves creditors the cost of incorporating restriction on distribution of dividence into their
agreement

3. Dues paid for limited liability

- Legal capital can be considered as payment in exchange for receiving limited liability for
shareholders
- Shareholders purchase limited liability by committing themselves to contribute a certain
amount of money

4. Acts as an entry barrier against new firms formed carelessly

- Minimum capital requirement screens out corporations and ensure the viability of the
company
- Protects investors and consumers from new firms that are set up carelessly and might
not be financially viable, and also are likely close soon after launching
- Minimum capital requirements enable prospective investors to consider investment more
carefully

Debate: (against minimum capital)

1. It deceives potential creditors
- Capital rules protect only distribution to shareholders but not the use of capital in other
ways e.g. paying for operating expenses of the company or converting assets to riskier
ones
- The legal capital can be used soon after incorporation of the company; the Minimum
capital requirement does not inform creditors about the assets of the company in the
longer term

2. If too high, can be prohibitive for new firms; if too low, fails to screen for unviable
business and protect creditors
- Minimum capital requirement discourage new entrance and start up companies to enter
the field
- Block potential entrepreneurs, resulting in a negative effect on innovation and economic
of the country
- One study shows negative correlation between minimum capital requirements and
entrepreneurship
- High minimum capital requirement destroy healthy competition by putting disadvantages
on entrepreneurs that have less financial capacity
- Even if the start up could put up the minimum capital, the funds tied up in the minimum
capital requirement particularly in economies where the amount is sizeable could impose
financial constraints of the company that has other needs , e.g. hiring, buying equipment
- If the capital requirement is too low, it fails to screen out potentially enviable businesses
- Low requirement does little to protect creditors if a company undergoes financial distress
- The requirement of minimum capital is nearly symbolic
3. Cannot cover all debts of the business
 - Minimum capital offers a fixed amount, that does not take account of the company’s
size/risk

4. Better ways of protecting creditors

- Voluntary and sophisticated creditors tend to based their decision on commercial risks
rather than government imposed minimum capital requirement
- Creditos prefer to evaluate business plan and other indicators
- They (Voluntary creditors) know the insufficiency of minimum capital would ask for
guarantees/ other governance for controlling the distribution of shareholders
- E.g. Insurance (won’t collect anything if the company goes bankrupt)

5. Complex and expensive procedure

- Capital rules which ensure contribution are complex and expensive
- Lawyers try to find loopholes to exploit capital requirements

The US adheres to the side that are against Minimum capital requirement
The EU favours Minimum capital requirement

In 2002 European High level: ‘about minimum capital’

Constituting share capital

Two options:
1. Cash payments= Monetary contributions of shareholders
2. In-kind payments =Non-cash assets as payment for shares
- The rules prevent shareholders from underpaying for stocks
- The share capital stands as the security for the company’s debt
- If the shareholders are able to underpay their subscription of shares, then effectively
there is less fund to pay for debts

EU v.s. US
EU:
- Article 47 of ECLD: Illegal to issue shares for less than par value
- Article 48: At least one-quarter of nominal value for cash, in-kind payments to be fully
transferred within 5 years
- Article 46: With respect to in-kind payments, only assets capable of economic
assessment, not an undertaking to perform work or to supply services

US:
- Recall, no minimum capital
- Also no numerical restriction on the amount that must be paid in at issue
- No restrictions to in-kind payments

Look at the table in ppt ( 3 jurisdictions about contributions)

UK allows contributions to be made other than English pound (any other currencies)
An interesting feature of the european company law directive is Article 52 on substantial
acquisition after incorporation
- Addressed the situation where a shareholder pays cash to the company for an issue of
shares so that the Minimum capital requirement is fulfilled and the company at an earlier
or later point in time purchase an asset from the shareholder= the cash coming back to
the shareholder again
- Must be accessed by an independent expert

Article 52 (1) of ECLD:

- Approval of general meeting is required
- At least 2 years from incorporation being established, the company contracts with an
incorporator or a shareholder who owns a stake of of more than 10% in the company to
purchase an asset that exists 10 % of the capital, this transaction would be considered
as a continuation of the incorporation process
- Company acquires any asset belonging to incorporator or shareholder
- Asset has value of at least 10% of subscribed capital
- Audit is required
- Prevent share capital that has been paid by the founders /shareholders, at the time of
incorporation from being withdrawn by entering into transactions of goods that are
detrimental to the company

Exceptions in (2) : Paragraph (1) shall not apply to

- The normal course of company’s business
- Acquisition affected at the instance or under supervision of an administrative or judicial
authority
- Stock exchange acquisition

Recap:
- Capital protection rules are a kind of solution for the risk that is shifted from the
shareholders to the creditors due to limited liability
- Capital protection rules in Europe include minimum capital, restrictions on paid-in capital,
and expert valuation of in-kind contributions
- In US there is no minimum capital, no numerical restrictions on paid-in amount and just a
board assessment for in-kind contributions
- Article 52 of the ECLD provides for a post-incorporation rule that aims at preventing cash
outflow from some transactions between corporation and shareholder/incorporator

● Case Law video 2

Share capital: When a company assets are comprised only of its shares, the value of its capital
is equal to the value of its shares

This case: You have the situation where the corporation is equal to the value of the cash and
assets which shareholders pay for the shares
Getting the value of the share capital: To get the exact value of the share capital, you simply
multiple the par or nominal value of each share by the total number of shares of the company

E.g. If you have a company with 100 shares with a par value of 50, then your share capital
would be 5000 and your company would be worth that much

Market value v.s. par value of shares: A share’s par value is its value in money which is usually
designated by the company’s board of directors during company formation;
- Most countries require a minimum par value, but countries like the US, specifically in
Delaware, do not
- The situation become tricky when a company has been operating for a while and then
value of its shares is determined not by the value assigned to it by the members of the
company or its accountants but by the market and this is the market value
- Book value: Is determined by the company’s accountants and is also a method of
valuing shares which is internal to the company → It is not determined by the market

A company should take care to ensure that the par value they designated for their shares or the
book value is not too different from its market value; otherwise, if the difference is too big, it
could be considered fraud on the part of the directors if coupled with other suspicious
circumstances
→ They could be sued for trying to overvalue or undervalue shares for matters like personal
gain

Terms mentioned in the case:

1. Derivative Shareholders Action: a case filed by an interested party (usually a
shareholder of the corporation) on behalf of the same corporation, against a third party
(usually an executive officer of director of the corporation)
- This case is usually filed when an officer or director of the corporation commits acts
which are detrimental to the corporation and are fraudulent or grossly negligent in nature

2. Convertible Debenture: A type of long-term debt issued by a Company (as a form of

credit instrument) which is convertible into shares of the Company’s equity stock

The holder of the debenture has the option to:

(1) Wait for the due date of the loan and therefore receive payment of the loan or
(2) Within a given period, convert the loan into shares of equity stock of the corporation
thereby transforming him into a shareholder and part owner of the corporation. Because
he ends up holding a portion of the corporation’s equity stock. The period to convert the
debenture is usually before the maturity of the loan
E.g. A acquires a convertible debenture from Company X for the amount of 1000 euro which is
the principle amount of the long term debt
The debt matures on 20 September 2021 but A has the option to convert his debenture on or
before 14 September 2021. If A converts on or before 14 September, he will own shares of
equity of Company X in an amount corresponding to 1000 euro. If he does not convert, he will
receive the payment to the loan (1000 euro in cash) on 20 September 2021.
----------------------------------------------------------------------------------------------------------------------

Week 4 Share Capital II

● Podcast
No creditor wants to hear that the company is not able to pay; at the same time we know that
the capital framework is not an insurance against bankruptcy
- Focus on capital maintenance rules

● Knowledge Clip 1-- Capital Increase

➢ Recap
- Internal financing: ​Use of the earnings from the past years for investment
- External financing​: Sources outside of the company, there are two ways that it can be
done→ (1) Debt, a form of loans or borrowings from creditor (2) Equity: Shareholders
contributions
This video focuses on share capital increases

➢ Increasing the Company’s Capital

1. How should the increase be approved?
2. How should
3. Do existing shareholders have so-called preemption right?

The rules applicable to capital contributions also apply to capital increases.

❏ What does it mean for the EU?

→ It is illegal to issue shares below par value
→ At least ¼ of the nominal value of the subscription needs to be paid at issue for cash
payments
→ For inclined contribution, an assessment from an expert is needed

❏ What does it mean for the US?

→ The par value shares have legal effect
→ There is no restriction on the amount that must be paid at issue
→ For inclined payment or subscription, the board of directors judgement after the value of such
consideration will be conclusive in the assets of actual fraud

★ Who approves an increase? Will the current shareholders have the right to the
new issuance?
European framework:
- An increase in the issued share capital by issuing more shares is only possible with
shareholders approval in the general meeting
- The shareholders can also delicate the power to issue shares to the board of directors
for a maximum period of 5 years
 - The dedication facilitates the effectiveness and responsiveness of the capital increase
→ e.g. The company suddenly found a new venture that requires capital immediately, in this
case the board needs to undergo shareholder meetings (the process of holding a general
meeting can be at least 21 days for the UK and 30 days for Germany) so the delegation of
power (giving the power to the board) allows the company to react to urgent capital needs
(increase their ability)

The advantage of being able to issue shares to the market quickly is balanced out but the
disadvantage of increasing the shareholders cost

- Because of the EU directive, Germany and the UK have similar rules that require
shareholders approval for the increase or delegation for such increase

❏ Capital Increase : Germany (2 staged process)

- First stage: Approval of the increase
- Second stage: Public charter

Issuing new shares beyond the amount indicated in the article would also requires the
amendment of the Articles to reflect this kind of change
→ The resolution for the approval of increase and the resolution for the amendment of the
article will be passed and approved by the shareholders at the same meeting
- The requirements should approve the capital increase [ Authorized capital increase 202
et seq. AG)
→ Shareholders’ meeting and amendment to corporation’s charter (Art. 182)
‘A resolution to increase the share capital against contributions shall require a majority of not
less than ¾ of the share capital represented at the passing of the resolution. The articles may
provide for a different capital majority’.
This qualified majority threshold is difficult to meet and thus gives considerable power to
minority shareholders;

See 182 et seq. AG:

- Shareholders’ meeting and amendment to corporation’s charter
- Or Conditional capital increase
- Or Authorised capital increase
- Registration in Commercial Register

E.g. A German public company who wanted to increase the share capital, a person has
authorized capital of 50 thousand euros divided into 50 thousand common shares; the company
complied with the minimum capital requirement and issued all of the shares to raise 50
thousand euros for its capital. We assume that there are no treasury shares so the entire 50
thousand euros represent the outstanding capital stock. During the shareholders meeting for the
approval of the increase, shareholders representing 40 thousand euros of the capital attended
the meeting, the other shareholders did not attend. This was still enough as 80 % of the total
stock is present, where do we apply the ¾ rule?
→ To the 40 thousand euros represented by 40 shareholders who attended the meeting; in
order to increase the capital of this company, you need to have 75% of the 40 thousand or 30
thousand to vote affirmatively for the increase

- The delegation power also requires shareholders approval and follow the ¾ voting rule
discussed above

German corporate law provides 2 forms of delegation:

1. Authorised capital increase
- Shareholders can delegate the power to increase the capital to the director generally for
a maximum period of 5 years; it cannot exceed 50 % of the outstanding shares; because
of this, it allows management to offer the shares to the market at the later bit when
conditions are more favourable
- It is limited and it can increase the shareholders monetary cost because they have to
guard against further dilution and they should also scrutinise the process of such capital
increase for being utilised
- Straight-forward increase: Shareholders are given opportunities to study if the reason of
the increase is legitimate; after studying, if they decided that the reason is not valid, they
can vote against such increase;
- Within the 5 years, the board can issue new shares and raise new capital without
shareholders obstacles
- Lead to the board behaving opportunistically to the detriment of the shareholders

2. Conditional capital increase

- Gives shareholders the flexibility of approving an increasing advance while still limiting it
to the extent that it is actually needed because such increase in capital can only be used
in 3 specific cases provided for by law
1. For the grant of congressional rights
2. Preparation for merchant transactions
3. Employee’s stock option plans
This avoid monetary cost because the board does not have unlimited choices on how to spend
the increased capital; once the conditional increase is registered, capital is increased further
without registration as each new shares is issued

❏ Capital Increase : UK
- Also follows the EU directive rules on capital increase
- Similarly require shareholders approval but the UK company acts only require a simple
majority, so 50% +1 of the shares represented during the meeting about the increase
- The power to increase capital by issuing shares can also be delegated to the board of
directors of a maximum period of 5 years; same simple majority voting rule

Sec. 551(1) CA 2006:

- Ordinary resolution, simple majority
- Authorisation of max 5 years (AoA, general meeting)
 - Registration in Commercial Register
- Recall that UK companies are not required to have an authorised capital
- But if they do, then approval of general meeting

❏ Capital Increase : USA

- An increase in the authorised capital of a Delaware company also requires a vote of
simple majority of the stockholders present at the meeting to approve such increase
- But the US company can avoid the approval procedure by providing for a huge amount
of authorised capital since there are no rules on the required minimum pay-up capital
- Companies do this because section 161 DCGL:
‘ The directors may, at any time and form time to time, if all of the shares of capital stock which
the corporation is authorized by its certificate of incorporation to issue have not been issued,
subscribed for, or otherwise committed to be issued, issue or take subscriptions for additional
shares of its capital stock up to the amount authorised in its certificate of incorporation’
→ Very broad power given to the board of directors, comparable as the delegation of the power
in the EU setting but with very distinct differences
1. There is no shareholders approval in order to use shares from the authorised capital
stock; The power to issue shares out of the authorised capital stock is automatically
given to the board of US corporation; unlike the EU where the board can only exercise
this kind of power when it is expressly delicate by the shareholders
2. There is no limit for the amount that can be issued except up to the maximum of the
issued part of the capital; different from Germany (50% of the current capital)
3. No time period for the exercise of the board power unlike in Germany and the UK where
there is a limit of 5 years
→ The power does not expire with the passage of time
The US presents a completely different picture of the EU rule in this respect because it gives
more power to the board.

What if the authorised capital is not sufficed?

- See 242 DCGL
- Amendment of ‘certificate of incorporation’
- Simple majority vote

❏ Dilution of stakes
- E.g. Company RBG issues 100 shares to stockholders X, Y, Z; X owns 52 shares while
Y and Z each own 24 shares. In this set up, stockholder X holds a majority of shares;
this gives him considerable control in directing the affairs of the company. After the
second round of financing, 15 new shares were issued to stockholder A and B,
subscribing 25 shares each. Because the total amount of shares increased, the % of
ownership of the 3 initial stockholders also changed. With the entry of stockholder A and
B, the new shareholding structure now is as follow

A and B each holds 17%; X and Y each holds 16%; X holds 35 %

→ X lost his majority stake!!
In order to prevent the dilution of existing shareholders, some jurisdiction provide pre emption
rights:
➢ Preemption rights: ​Rights of existing shareholders to purchase newly issued stock in
proportion to their current shareholdings
➢ In the EU
- Article 72 of the European Company Law Directive: Whenever the capital is increased,
the shares should be offered on a preemptive basis to the shareholders in proportion to
the capital represented by their shares; In EU, existing shareholders have a right to
purchase any new shares that the company issues in proportion to their current
shareholding on the same or more favourable terms than 3rd parties

- But blocks inflow of outside capital (the process of preemptive rights is time-consuming,
might hinder the ability of the corporation to quickly update resources; the law must
therefore strike a balance between the protection of existing shareholders and the ability
of the corporation to pursue its optimal financial structure

- Pricing issues (14 days, see article 72(3)) → During the period that shareholders are
allowed to exercise their preemption rights, the price of the stock can fluctuate. Existing
shareholders will not subscribe to the shares if the issued price exceeds the market price
at the time of issue. What the company will do is to set the issued prices at a discount,
major shareholders can take advantage to increase his or her ownership position and
simultaneously decreasing the minority shareholder ownership position

- Shareholders may waive their preemptive rights through a resolution; the company
needs a shareholder resolution in order to waive them

➢ Pre Emption rights: US

- More of the exception rather than the rule
- The DGCL: ‘No stockholder shall have any preemptive rights to subscribe to an
additional issue of shares of any class of stock of the corporation or to any security
convertible into such stock’ (unless such rights is expressive granted for particular a
shareholder)

Recap​:
- An increase in share capital by issuing more shares (equity financing) will lead to
dilution, unless existing shareholders have a preemption right
- In EU, a share capital increase must be decided on by general meeting, while in the US
this is at board’s discretion
- In EU, shareholders may authorised the board for share capital increase for a period of
up to 5 years
- Delaware Law replaces the various ex ante rules on payment for shared found in EU law
with the ex post control of the fiduciary duties of directors

● Knowledge Clip 2 -- Dividends and Repurchases

Capital protection rules
Why the rules on maintaining capital?
- There is an inherent conflict of interest between the shareholders and the creditors (who
have an equally strong interest in not having the corporate capital excessively repeating
by such dividend distributions)
- The key feature of equity is that it drags behind the claim of other stakeholders in the
distribution of a corporation assets
- Equity is also the first part of a corporation fund that will be deducted by losses

Rules about:
1. Constituting the company’s capital
2. Increasing the company’s capital
3. Maintaining the company’s capital
- Constituting and increasing capital rules are designed to ensure that funds paid or
assets contributed have the promised value
- Maintenance rules seek to protect unsecured creditors by preventing shareholders from
paying those corporate assets to which such creditors look to for repayment out to
themselves

Maintaining the company’s capital (Capital maintenance rule)

- Seeks to enforce the order of priority of different group of stakeholders by restricting the
distribution to shareholders
Dividends in Europe:
- In the EU, the distribution of dividends is also partly harmonised in the capital directive
but the voting item is somewhat different among Member States
- The Directive does not require shareholders approval for the distribution of dividends but
some Member States still require a shareholder vote
Diverging interests
→ Creditors: ‘Value preservation’
→ Shareholders: ‘Value maximization’

Retain profit or distribute profit?

➔ Article 56 of European Company Law Directive: provides 2 cumulative tests in
determining whether dividends can be paid out by the company
If it can’t: How much dividends can it be declared?
- The two requirements must both be met in order for the company to validly pay out
dividends

Test 1: The Balance Sheet test

- Can you pay a dividend?
- Aims to determine whether the payment does not result in the equity being lower than
the non-distributable reserves;
- Net assets should be greater than or equal to the subscribed capital and reserves
Test 2: Liquidity test
- How much dividend can you pay?
- The company should have sufficient liquid assets to make payment of the liability in the
following years;
- Profit and loss statement
- Dividends may not exceed the profits + profits brought forward +sum drawn from
reserves - losses brought forward -sums placed to reserves

What happens if article 17 is being violated?

- In event that dividends was made in violation, shareholders must return any distribution
unless under circumstances they could not have been aware that the distribution was
prohibited
- Directors may also be liable (insolvency)

➢ EU jurisdictions:
Germany: ​Shareholders of a public company have more control over the amount they will
receive as dividends when compared to the UK or US because the board may place no more
than one half of the profit to reserves; not possible for the board to put all the profit to the
reserve and retain it to investment, they must distribute half of it
- Maximum one half of profit to reserves (shareholder freedom)
- Freedom of shareholders is compensated by limiting the potential volume of distribution
per shareholders
- You may distribute but not that much
- Shareholders have dividend right, required approval for distribution
- The termination of distributable profit depends heavily on the company’s liabilities,
assets or process through accounting principles
- The higher the value the assets and the lower the liabilities, the greater the amount can
be distributed as dividends
- They ascribe the lowest value of asset possible and the highest liability, so the available
profit is minimised, less room for shareholders distribution
- The balance sheet must first exceed its liability, the shareholders equity and the
mandatory reserves; the profit is calculated on the basis of the profit or loss, which
distribution has to be made, such profit will exist when they exceed that they carry over
in the previous years

UK:
- The full procedure of determining and declaring dividends is not set out in Company Acts
2006 (only default), left to AoA
- The model article currently gives authority over the process to both members and
directors; Directors will recommend the specific portion of the profit be paid out as
dividends and the shareholders will declare the dividend by ordinary resolution
- Accounting principles are based on the true and fair value therefore it’s likely that the
higher figure for distributable profit can be seen in UK financial statements
- Shareholders have divided right, required approval for distribution
US​:
- Directors almost have full control over the distribution of dividends
- Less restrictive compared to EU
- Does not believe that the minimum capital requirement is necessary for the protection of
creditors
- Delaware law uses two tests (170 DGCL):
1. Capital impairment test: Dividends may be taken from capital surplus
- Directors stand between shareholders and creditors
- Capital surplus can be created anytime by reducing the par value or the amount
designated to serve as stated capital; issuing dividends is easier in the US

2. Net profit test: Dividends may be taken from net profits (also preceding year!)
- Dividends may be paid out out of the net profit you made in the previous years ‘Nimble
dividends’

→ These two tests are not cumulative requirement, it is sufficient to meet one of the two

Involuntary creditors are in the worst position because they became the creditors by force and
by chance so they cannot negotiate their relationship with the company in advance; the financial
governance negotiated by the larger creditors, they exercise the function of actual trustee for
small creditors; if the financial governance between the company and the bank controls the
distribution of assets to shareholders, this safeguard also benefits the creditors who cannot
bargain with the company; even without the presence of mandatory law on asset distribution,
small creditors remain protected -- As long as there is enough money in the company to settle
all the creditors’ claim

Not enough money? Large creditors have security claims and have priority in payment; they
may waive their financial governance in exchange for more favourable terms or higher payment

Recap​:
- Capital maintenance rules aim at preserving the capital of the company
- The division of power between shareholders and directors regarding the decision to
declare dividends differs significantly in our three jurisdictions
1. Germany: Shareholders control the distribution of dividends by resolution subject only to
the figure for distribution profits, which is usually determined by directors
2. UK: The board recommends the value of the dividend declaration which will then be
approved by the shareholders
3. US Delaware: The management has sole discretion whether to declare dividends,
subject only to the threat of not being re-elected
- It is debatable whether the capital protection framework benefits involuntary creditors.
Though capital maintenance rules preserve the capital for creditors, there may be other
more effective means of protecting small and involuntary creditors
 ● Knowledge Clip 3: Repurchase of shares/ Dividends or repurchase
➢ Repurchase of shares
- Most significant non-cash transaction affected by the capital protecting rules
- When a company repurchases its own shares, it transfers company assets (the
purchase price) to the shareholders from whom the shares are purchased
→ Alternative to dividends (should be subjected to the same kind of limitation)
→ Treasury shares

- Effects on Creditor protection

→ Decrease in assets available for repayment of debt
→ Decrease in number of shareholders that could potentially be held liable

- Corporate Governance and Control rights (no voting rights tho)

** Share repurchases involve not only creditor protection issues but also corporate governance
and security law: How are the creditors related to protection if we compare to dividend
distribution?

Dividend distribution: Enforcing the fact that creditors should be paid first prior to the
shareholders, profit should not be distributed to the shareholders to dividend as there will be
insufficient money for creditors to cover their debt

Share repurchases have a duo effect

- The repurchases are financed by the firm own cash
- Decrease the number of shareholders that could be liable in case of veil piercing

If share repurchase would not be regulated, company management could under some
circumstances use repurchase to reserve power for itself, the strategic use of share
repurchases can grant control right to management
→ e.g. If the company would buy some of its shares, it will have some control on overable
treasury shares although the management does not have voting rights, at least this repurchase
of the shares are no longer in the hands of the shareholders so they cannot vote anymore. The
danger of share repurchases is that directors have authority to repurchase company shares or
through delegation from a shareholder; they can use the power to protect themselves against
shareholders who are seeking to replace them/ Management can also buy out the shares from
shareholders; Redeemable shares (can be repurchased as contractually agreed upon in
advance between these parties, repurchase can sometimes be achieved without the voluntary
consent of the seller)

→ e.g. The company has a profit of 20 thousand euros (obtained after all creditors and fixed
claimants have been paid) The number of outstanding shares is 2000. 20 thousand / 2thousand,
10 euro for each share (shareholder gets)

If a company buys back 1000 of its share, 20 thousand/ 1 thousand, 20 euro for each share!
Why?
- To pay shareholders (instead of dividends)/ increases shareholders value without doing
much work, higher earning per share
- To avoid higher taxes on dividends
- To increase stock price
- To manipulate the share price (make it look like there is a steady demand of the shares)

EU​:
Article 60 of European Company law Directive:
(1) Authorisation is given by the general meeting;
(2) cannot have the effect of reducing the net assets below the amount referred to in Article
56
(3) Only fully paid-up shares can be included in the transaction

US​:
Do not provide any detail requirement for the repurchase of shares except that it should not
impair the capital of the corporation
- Focus on protecting equity investors
- 160 Delaware law (ppt p. 32)
- No creditor protection rules but abundance in security provisions for protecting market
investors through rules that cover market manipulation

For public listed firms, more detailed rules with the SEC like extensive disclosure rules or other
federal rules like trade-based market manipulation

➢ Recap
- Repurchases have a similar effect as dividends in that both distribution to shareholders
reduce the company’s assets available for creditors
- Share repurchases also have effects on the corporate governance and securities
markets which may be an argument on why it should be more regulated than dividends
- The divergence in creditor protection framework between the EU and the US.
- EU: provides for rules regarding share repurchase while the US gives a free rein on the
company itself to decide on repurchases
-----------------------------------------------------------------------------------------------------------------

Weekly Module 6: Committee Boards of directors

● Podcast
- Delegation of power to a central management = characteristic of all big corporations
- The structure and composition of corporate board
 ● Knowledge video 1: The board of directors
You will have agency problems: Adam Smiths’
‘ However if somebody provides power and authority to another person it does create an agency
problem’

Agency costs
1. Cost of monitoring and structuring the relationship
2. Bonding cost: Agent has to show to the principal that it is executing the tasks, duties that
need to fulfill in accordance with the need of the principle, showing that it is going along
with what the principal wants him or her to do
3. Residual losses: Always residual losses

The board of directors

Corporate law helps reducing these agency costs with rules and standards, providing them a
structure:
1. Cost of monitoring and structuring the relationship
E.g. Board structure, can be one tier board and two tier board structure;
providing the monitoring system, procedure for electing the directors→ e.g. the board of
directors is preparing for the general meeting of the shareholders → Provide substantial amount
of info for the shareholders, all the items that the shareholders need to approve are explained

2. Bonding cost
- To provide the mandatory rules in order to distribute information from the agents to the
channel meeting of the shareholders or even the public
- E.g. Reporting lines
- UK Companies Act→ Make sure the shareholders receive the information of how the
company performed over the previous accounting period, very detailed information,
mandatory for the board to provide this to the public through their website and the
shareholders
- The board of directors also have to come up with a remuneration policy

3. Residual losses
There are still residual losses.
E.g. Nike: In the board of directors of nike, Mr Knight is a director since 1968, more than 50
years he is a board of director of Nike. He probably has very skillful expertise for Nike. One can
question when a decision needs to be taken by the board of directors, if you are the shareholder
of the company that invested in Nike because you believe they are a good company and they
must provide good services, very long term perspective.
Decisions to be taken are not optimal: Your belief and your wishes have a perspective of 40
years but this would create residual losses because this residual might be good but they might
be better aligning your interest when there would have been somebody else taking into account
(not Mr Knight)

Board Structures
One tier board
- E.g. McDonalds
- Delaware General Corporation law Title 8: ‘The business and affairs of every corporation
organised under this chapter shall be managed by or under the direction of a board of
directors’ → US: one tier board structure

One tier: Board of directors are responsible for managing the company

UK, Spain, Australia: One tier structure

France and Belgium: Give them choices, companies can opt for either one tier or two tier, but
most of them have selected the one tier board structure

Two tier board​:

- Shareholders → Supervisory Board → Managing Board → Managers
- E.g. Zalando, Typical German company
- Stock Corporation Act of Germany, session 76 ‘The management board shall have direct
responsibility for the management of the company’ and session 111’The supervisory
board shall supervise the management of the company’

Two tier is the main structure in many countries, e.g. China, Poland, Austria
It is common in some other countries, e.g. Netherlands, Hungary, Columbia

E.g. Specific model: Italy (Japan has a similar model to Italy)

- Has a traditional model between one and two tier, managed by a sole director or a board
of directors composed of two or more directors, all appointed by the shareholders. The
board of statutory auditors, appointed by the shareholders, supervises the work of the
directors
- One tier or monistic model: The company is managed by a board of directors (appointed
by the shareholders) and the board elects the management control committee
- Two -tier (Dualistic model): The company is managed by a management board whose
members are appointed by the supervisory board. The members of the latter are
appointed by the shareholders. → Resemble the German system

● Knowledge video 2: The Board of directors: Composition

Remember there are boards in different shapes and forms: one tier boards, two tier supervisory
and management board and specific systems (like in Italy)
But what about composition?
- Flexibility for non-listed companies to structure the board in the way they consider as
optimal:
Delaware: (141) The board of directors of a corporation shall consist of one or more members,
each of whom shall be a natural person. The number of directors shall be fixed by, or in the
manner provided in, the by laws

UK: Session 154 of the Companies Act of the UK

Companies required to have directors
- A private company: At least one director
- A public company must have at least two directors

155 Companies required to have at least one director who is a natural person
- A company must have at least one director who is a natural person

157: Minimum age for appointment as director

- A person may not be appointed a director of a company unless he has attained the age
of 16 years

Composition
- However for listed companies:
1. Executive/ non-executive and independent director
- There are non-executive directors in both one tier board and two tier board
- In one tier board: At the same time an executive director and a non-executive director;
by nature of the level of the supervisory board, members are considered as the
non-executive board. Supervisory board shall not manage the company on a day to day
basis.
- Managing board is executive
- EC recommendation 15 Feb 2015
2.3 ​Executive director​ means any member of the administrative body (unitary board)
who is engaged in the daily management of the company
2.4 ‘​Non-executive director​’: have a board position but do not work for the daily
management of the company; could be people of different background e.g. investor/
politician; non-executive director means any member of the administrative body (unitary
board of a company other than an executive director
2.5 ‘​Managing director​’ means any member of the managerial body (dual board) of a
company
2.6 ‘​Supervisory director​’ means any member of the supervisory body of a company

(Non) executive and independence

- EC Recommendation 13. Independence
- 13.1 A director should be considered to be independent only if he is free of any
business, family or other relationship, with the company, its controlling shareholder or
the management of either, that creates a conflict of interest such as to impair his
judgement of (the judgement of directors)

Rules/Standards on independent directors to be found in:

1. The Companies Act
E.g. Belgium (The companies Act)
A director in a listed company is to be considered independent if she does not maintain a
relationship with the company or with a major shareholder that jeopardize her independence
If the director is a legal person, then the independence must be assessed at both the level of
the legal person as well at the level of its permanent representative

2. Corporate Governance Code

Germany: A Corporate Governance Code
- Shareholder and employee representatives

3. Listing rules of a stock exchange

US: You find so called requirements of the composition in listing rules but not in Company Act
But why independent directors?
EC Recommendation 15 Feb 2005
- It is considered as a means of protecting the interests of shareholders and other
stakeholders
- A mechanism that makes sure the interest of the company should be taken on board by
these independent directors

● Gender diversity
- Germany 96(2) Aktiengesetz: In case of listed companies which are subject to the
Co-determination Act, the supervisory board shall be composed of at least 20 percent of
women and at least 20 percent of men
- France: Art. 225 -18-1 Code de Commerce: The proportion of directors of each gender
may not be less than 40% in stock exchange listed companies, there are also specific
rules that make sure companies comply with the rule, at least 40% women and 40 %
men

● Employee participation e.g. Germany

People’s opinion should be heard in the company’s decision bodies
- In some countries, there are explicit provision for employee participation
- E.g. German law: There should be a sufficient number further define employees that are
also taking part that are also taking part as a full member of the supervisory board, so
next to the shareholders
- Composition of the Supervisory board (Maxim 96)
(1) The supervisory board is composed of :
In case of companies subject to the Co-determination Act, of supervisory board members of the
shareholders and the employees

Section 7 Codetermination Act 1976

The supervisory board of a company
1. With generally no more than 10000 employees, consists of 6 members representing the
shareholders and 6 members representing the employees
2. With generally more than 10000 but not more than 20000 employees, consists of eight
members representing the shareholders and 8 members representing the employees
3. With generally more than 20000 employees, consists of 10 representing the
shareholders and 10 members representing the employees
 - The system of employee representation in the (supervisory) board of directors also
exists in other countries like Sweden, Austria, Hungary and France

2. Specificites like financial expertise

- Many countries have specific issues stock listed companies must deal with
E.g. Nasdaq listed companies
Audit Committee Composition
- Each company must have, and certify that it has and will continue to have, an audit
committee of at least three members, each of whom must be able to read and
understand fundamental financial statements, including a company’s balance sheet,
income statement, and cash flow statement

● Knowledge video 3: The board of directors: Board committees

Within the board of directors, there are specific rules about the establishment within the board of
directors of sub-committees of the board of directors
- Subcommittees
- Board exists in different shapes and forms and especially listed companies must comply
with many composition rules

- Within the board of directors, there are 3 subcommittees

1. Nominating Committee
- Responsible for the selection and the procedure for selecting new candidates for the
board of directors
- Always strive to have the top people working in the company
2. Compensation committee
3. Audit committee
In a European Context: EU Directive
- Require an External auditor
----------------------------------------------------------------------------------------------------------------------

Weekly Module 7: Board duties

● Podcast
- Could we trust the management?
- Is there a risk that they would be unloyal?
- Should we trust their decisions, are they allowed to take risks?
- Look into the role of the board and their responsibilities, duties of loyalty, good faith
- Differences between rules and standards
- Legal differences between a director and mismanagement

● Knowledge Clip: 1 -- The Board of Directors: Assessing duties

The form of directors is in line with the standard.
- When things go wrong, how to approach business decisions, other decisions and
transactions that the company has entered into?
When is a decision or transaction of such a nature that it is to be considered as being taken with
insufficient care:
- If afterwards, you end up in court and the court has to assess whether appropriate care
has been taken into account by the board of directors; due to decisions whereby board
of directors will be considered as liable for badly taking decisions too fast
- Consequently board members might become too anxious when doing something which
is not optimal for economy because optimal is always taking risks; that’s the essence of
business and entrepreneurship
- Courts and boards of directors have to be extremely careful when deciding whether they
take the risks or not

How to execute its duties:

Company law provides in a system
→ Many make use of some form of the ​Business Judgement Rule (BJR)
US: ‘A presumption that in making a business decision the directors of a corporation acted on
an informed basis​, in ​good faith ​and in the ​honest belief​ that the action was in ​best interests
of the company​’ (Aronson v. Lewis 1984)→ If you combined these three elements, you will
considered that the decision is in line with the loyal behaviour
→ These elements are used to find out : Whether or not there is a breach of your duty

Germany: ‘BGB section 93 Duty of Care and Responsibility of Members of the Management
Board’
(1) ‘In conducting business….’
- They would not have violated the duty if they have reasons to show that they were acting
for the interests of the company
- Similar does not mean identica​l in a german perspective compared to the US
perspective
- More careful and strict than the US
UK: Section 172 Duty to promote the success of the company
(a) A director of a company must act in the way he considers, in good faith, would be most
likely to ​promote the success of the company ​for the benefit of its members
→ Deed

E.g. NL is not familiar with the business judgement rule.

● Knowledge Clip: 2 --What role and the duty is of the board the directors and
individual directors
- Under delaware law, the board of directors is the one that manages the company, either
itself or make sure the company is well-managed under its directions → Section 141
- It’s the board of directors’ role to manage the company and make sure that the company
is well-managed

What is management? (contains…)

 1. Running the company:
- E.g. Suppose a company runs a car production plan;
- the board of directors is responsible for either directly managing the plan or under its
direction
- Directing the plan means → it shall define how many cars will be produced, how many
robots will be used and how many employees will work on it, how many models will be
produced? What kind of computers will be used in the cars, what kinds of material will be
used in the car?
→ these decisions need to be taken by the board of directors or under the management of the
board of the directors

2. (a) Execute the duties prescribed by the (company) law

German Company Act: Section 121 (1) ‘The shareholders’ meeting shall be called by the
management board, which shall resolve thereon by a simple majority of votes’
- The management board in such a two tier board structure is responsible for calling a
shareholders meeting; make sure that they comply with the requirements and every year
call the shareholders to gather together in the meeting

UK Companies Act 2006: s. 420 Duty to prepare directors’ remuneration report

(1) The directors of a quoted company must prepare a directors’ remuneration report for
each financial year of the company
- Directors’ duty to prepare for the vote and annual report

(b). Not doing what is forbidden by the (company) law

- Another organ is competent: UK COmpanies Act 2006 s. 439 (1)
A quoted company must, prior to the accounts meeting, give to the members of the company
entitled to be sent notice of the meeting notice of the intention to move at the meeting, as an
ordinary resolution, a resolution ​approving the directors’ remuneration report​ for the financial
year.

- Forbidden like German Aktiengesetz section 88 (1) Prohibition of Competition

Absent the consent of the supervisory board, members of the management board may neither
engage in any trade nor enter into any transaction in the company’s line of business on their
own behalf or on behalf of other
→ Management board cannot into any trade and transaction that is in line with the company’s
business, e.g. you can’t start a side-business that is the same as your company

3. Represent the company

- Corporations are legal fictions and cannot do anything their own but do have a
corporate purpose
- It needs an agent to strive for reaching this corporate purpose
- The agent needs authority which is put in the (management) board
- E.g. German section 78 Representation (1) The management board shall represent the
company in and out of court
 - E.g. if the company is sued in court and they are liable for that, the management board
has to go to the court and represent the company

Collectively: German section 78 -- The management board shall represent the company in and
out of court

Individual: The Netherlands Civil Code Article 2: 130 Power of representation

1. The board of Directors represents the corporation as far as the law does not provide
otherwise
2. Each director may also individually represent the Corporation

- If the representation beyond powers (ultra vires) give contractual rights to the third
parties but also raise internal actions against the directors

- If the principal (company) gives impression of authority (apparent) to agent and third
party can reasonably rely in good faith on this impression, the company can be bound
too
→ Impression of authority is addressed in contract law, not here
→ Suppose you have a large company, you have many employees, there will be employees
that are retired, even the management board can’t do it all, this provides possibility of delegating
representation rights through chain of authority

- Representation rights can be further delegated through chain of authority

In sum, the board’s role: Running a company, represent a company and how would it be
executed (are there decisions that you are taking into account is mandatory requirement you
have to do, all there decisions that can be done without taking into account the specificity of how
to manage

● Knowledge Clip: 3 -- What role and the duty is of the board the directors and
individual directors
- How should the board of directors do his job, how to perform?

Duties to do and prohibitions embedded in rules must be complied with (rules)

Managing: Standard : Directors must act in accordance with the standards of due care and
loyalty → Trying to identity what the reasons and standards are are quite substantial but also
difficult to answer in accordance with the company’s act

A number of elements that would be helpful → Directors are considered fiduciary appointed by
shareholders (and sometimes others like employees) to manage the assets of the company
(and the company is beneficiary). Fiduciary duty exists when one party, e.g. agent acts on
behalf of another party and executes discretion with respect to a resource of the beneficiary
The agent is not exactly provided with very specific instructions how to execute it, there is a
level of discrete that can be used by the agents in this case by the board of directors
Duty of loyalty:
Related to the behaviour that a director has to show to make sure that he does not end up in a
situation where he ends up having conflicts of interest
- Avoid as a director to enter into a situation whereby you have a conflict of interest with
the company
- For whom does the board of directors have to execute these duties and to whom is it
responsible to
- E.g. contractual counterparty (you will have opposing interest), competing with the
company → breaching the duty of loyalty
- (Partially) codified in many countries but there are so many situations where you will end
up in a conflict

E.g. Germany:
- Proper and prudent managers who must focus on doing good for the company
- Further regulating some conflict-laden situations:
- Duty of confidentiality
- Duty not to compete
- Approval procedure for loans (could be provided by the company)
- Approval procedure for service contracts of members of management board
- Approval procedure for contracts with members supervisory board

E.g. UK
- Act in good faith in the interest of the company
- Note that in the UK considers fiduciary duty and duty of care whilst in US fiduciary duty
includes duty of care and duty of loyalty. Consequently BJR is differently applied
- Partially codified in Companies Act 2006 in s. 171-175, and 177-231
- E.g. 175: ‘A director of a company must avoid a situation in which he has, or can have, a
direct or indirect interest that conflicts or possibly may conflict, with the interests of the
company’ → Could occur. There are many questions due to this phrasing in section 175,
e.g. what should be considered as an indirect interest, what is possibly may conflict etc?
Need to be interpreted!

E.g. US
- Different regimes
- Delaware similar to the UK: A director must act in the good faith belief that her actions
are in the corporation’s best interest
- S. 144: Procedure for protecting a transaction that might include a conflict
- Facts related to the interest of director are disclosed and
- Approval by disinterested directors/shareholders or is fair to the corporation at the
moment of authorisation, ratification or approval

Duty of care
- Best illustrated in s 174 UK Companies Act 2006
 - (1) A director of a company must exercise reasonable care, skill and diligence
- (2) This means the care, skill and diligence that would be exercised by a reasonably
diligent person with --
- (a) the general knowledge, skill and experience that may reasonably be expected of a
person carrying out the functions carried out by the director in relation to the company,
and
- (b) the general knowledge, skills and experience that the director has
→ There are of course difficulties to find out whether the duty of care has been breached. Skills
of directors are not defined, to what extent we can take into account the specific skills and
knowledge of a specific director?

If something goes wrong, would a clever director have expected that? → Tricky

To whom do directors owe their duties?

- Directors duties run to the company
- Companies contain various constituencies
- Companies have shareholders so their interests must be part of the idea that
development of decisions that are taken by directors when they are running the
companies
- Employees, creditors, customers, suppliers also need to be taken on board
- Operating a company in society/ local community might have an impact too
Delaware: Practical purposes a duty to serve the interests of the shareholders

UK: goes beyond the shareholders in the codified company act. Promote the success of the
company for the benefit of its members as a whole, and in doing so have regard to (b) the
interests of the company’s employees, (c) the need to foster the company’s business
relationships with suppliers, customers and others, (d) the impact of the company’s operations
on the community and the environment

Germany: Unternehmens Interesse includes minimally interests of shareholders, creditors and

employees
-------------------------------------------------------------------------------------------------------------------

Weekly Module 8 Introduction to shareholders

● Podcast
1. Investor ownership: What is a shareholder?
2. Matters on which shareholders vote
- Appointment rights
- Decision-making rights e.g. amendment, company structure
- Shareholder proposal

Chapter 10: Broad definition of a shareholder, as well as the nature of shareholder ownership
Chapter 18:
A. Shareholder voting rights
B. Rationale Behind and Definition of Voting Rights
C. Case Law

Chapter 19: Shareholders’ right to information; the right to vote and the right to information go
hand in hand

A. Three basic forms of the Right to Information

1. Information upon request → usually for smaller companies
2. Routine mandatory disclosure → Info which must be regularly released by the
corporation without the need of a request from the shareholders e.g. accounting
information and potential conflict of interest
3. Ad hoc Disclosure of Significant Events → see p.655 of the book

B. The policing of these violations and regulations

Chapter 20: Shareholder Meetings

- Maybe physically or virtually
- Shareholders can attend the meeting himself or by a Proxy: through a representative
a. Important sub-topics
b. Case Law: Schnell v Chris-Craft industries

● KC 1: First Agency Problem and the Role of Shareholders

- Investor ownership: Shareholders information and coordination costs: Actually making
decisions and suboptimal decisions
- Delegated management: Shareholder-manager agency costs

Most of the decision making powers are delegated to the corporate board

Shareholder-manager agency problem

- The “Berle and Means Company”
- The corporation is owned by many shareholders, none of them is able to control the
board members so the board members can do what they want
- They can treat it as if it’s their own company, make all the major decisions → Worrisome
- Corporate managers are able to pursue their own interests
- From a legal perspective, corporate managers means managers who have very high
position, right below the board level; the non-executive directors merely have a
monitoring function to overcome this agency problem
- Agency theory suggests that delegation has benefit but also create agency cost
- Economic literature focus on this agency problem
Legal Strategies
- Legal strategies: ​Mitigate the vulnerability of principles to the opportunism of their
agents →Agents: Corporate board members and the manages
 - ‘Regulatory strategies’​ (agent constraining) → Prescriptive, constrain the agent’s
behaviour; authorities should have sufficient knowledge as to what extent the agent
companies with the prescription
- ‘Governance strategies​’ (Principal empowering)--> Facilitating the principle control over
the agents, providing them more control rights; provide shareholders as the principle with
more control rights and decision-making rights; only works when shareholders are also
able to use their control rights, e.g. decision-making rights, then they can exercise them
effectively

Europe: Many shareholder rights, as we will see in one of the next videos
US: More focused on judicial evaluation (underlying reason Business Judgement Rule, BJR
allows the board to take risk)

Developments - role of shareholders

- Corporate governance scandals in the beginning of 2000
- Shareholder activism
- Current/ modern corporate law:
→ Shareholder responsibility and checks and balances
→ Stewardship (institutional investors)--> Reflected in recent years, as special code of
conduct

Institutional investors
- Distinction between asset owner and asset manager
- Different definitions are used
- In this course: Institutional investors are both asset owners and asset managers
- Proxy advisers have great power, note that they can affect the voting rights of
many shareholders

Asset managers, including:

- Mutual funds → Use maths calculation and see which company they should enter or
leave
- Hedge fund → Special type of investment funds, usually only available to specific
parties, take higher risks, aggressive ; play a major role in split up in companies; play a
huge role in shareholder activism literature (Risk takers)
- ETFs (Exchange Traded Funds): Special investment funds, also known as passive funds
→ Follow an index, so they are called index trackers.

Revised Shareholders Rights Directive (EU2017/828)

- Relevant articles: article 3g: Engagement policy
- Article 3h (Arrangements asset managers) and 3i (disclosure asset managers)
- Other regulation at European level too, e.g. IORP II for pension funds

● KC 2: Investor Ownership
What are shareholders in a legal perspective
Shareholders ownership includes two elements:
1. The right to control the company e.g. Decision-making rights
2. Capital rights to receive the company’s profit (e.g. dividends, profit)

Share = bundle of rights

- Shareholders are the employers of the corporate board and the owners of the
corporation yet they don’t own the corporation but they own the share
- From a legal perspective, they are definitely not the owner of the corporate asset

Shareholders do not own the corporation. Rather, they own a type of corporate security
commonly called ‘stock’/’shares’
- Legal personality (entity shielding and asset partitioning): The company itself is the
owner of the assets, not the shareholders
- Entity shielding consists of the priority rule and liquidation protection rule.
→ Liquidation protection includes that the shareholders cannot withdraw their shares of the
corporate assets.

Three levels of proprietary interests:

1. A person who owns a share and in this way becomes the shareholder
2. The share is a negotiable instrument that embodies certain property rights in the
company → Shareholders do have some property rights but what type because we just
said that they don’t own the assets?
→ See property as a bundle of rights
→ Right to use, manage, exclude, the income, the capital, security etc
→ Right to residuarity; specified in a framework

Sometimes ownership rights expire or maybe abandon, when this is the case, the
corresponding rights may become exercisable by someone else. The residual right-- this person
may be considered as the owner even though the person who really has the right is not present.

Residual claim:
1. Pro rata right to the residual assets upon dissolution
2. Entitlement to exercise residual rights of control:
“The rights to control over all states of the world which are not specified by law or contract ex
ante. Residuary matters because it is still possible to allocate residual rights even if specific
directions about what should (not) be done in particular circumstances cannot be written or
enforced)

Residual rights not only include the residual claim but also the residual ownership of rights; this
matters because contracts are by definition complete.

In some jurisdictions, the principle or residuarity is explicitly clarified → NL 2:107CC

Shareholder ownership is not like owning a bike, a share is a very abstract asset.

Why do shareholders have voting rights?

1. Doctrinal theory, e.g. Germany, ‘the entitlement to vote is an essential component of
membership’
→ May not be transferred to another person without the transfer of the share itself
Other jurisdictions: Allow for sale of votes→ In the US
- Hewlett v. Hewlett-Packard ‘Shareholders are free to do whatever they want with their
votes, including selling them to the highest bidder’
NL: Shares of the company are issued to the legal owner of the ownership rights and voting
rights; there is no control right issue to the larger public

This theory is not complete.

2. Economic theory: ‘Residual claimants’

- Right incentives: Maximise profits
In practise, often the economic claimant and the voting right is not entirely match

3. Political theory
Analogy to democracy
- Scholars, politicians: Call for increased shareholder rights
- From a public law perspective
- It is important that as many vote from the shareholders are represented

● KC 3: Decision Rights (Shareholders)

Chapter 18 (p. 575-604), 19 (640-646), 20 (680-683)
- Don’t need to know all the procedural aspects of AGM

Voice and Exit

Hirschman: Voice and Exit are alternative options for shareholders
Voice and Exit: ‘Wall Street Walk”

Discontent with the management?

- Exit= economic solution → Managers generally want to avoid exit.
→ Exit =sale and share in the market
- Voice= political solution; improve the corporate governance, the check and balance in a
company
- Voice refers the control right for the shareholders that are provided by corporate law, e.g.
voting to approve managerial transactions
- Voice is expensive for small shareholders, asset strategy is feasible for small
shareholders; small amount of shares is unlikely to have impact on shared price in a
liquid market
Although voice is preferred, small shareholders may have no incentives to engage in direct
monitoring
- Marginal effect ~ zero
- Costs are non-zero: ‘Sit down after work some evening and read a 150-page proxy
statement’
- Free-rider problem: Public goods
→ Shareholder monitoring is considered as public goods, not rival and non-excludable; it’s
impossible or expensive to prevent another consumer from using the goods
Private good, e.g. chocolate and bike, it’s excludable and rival
Public good affect everyone
Larger holdings can generate higher financial returns but small shareholders don’t have an
impact from their vote so they would rather exit than using their voice. Voice is costly.

Shareholder voting in AGMs (Annual general meetings)and EGMs

Fundamental decisions: Not delegated and are still with teh shareholders
1. Appointment rights
2. Decision rights

Shareholders are able to exercise their voting rights in the annual meeting of the shareholders.
If important decisions need to be made by shareholders and cannot wait for the next annual
meeting, then we will have EGMs, (extraordinary general meetings), EGMs only occur in special
cases, e.g. fundamental change to the structure of the company. Usually EGMs are only held
when shareholder approval is required and the decisions cannot be postponed to the next
AGMs.

E.g. In France, the General meetings are divided into sessions. They use different terms too.

2 types of proposals that are added to the agenda of general meetings:

1. Management proposal
- Proposals that are from the corporate board that require approval of the shareholders in
veto or ratification
- Decisions that need formal shareholders approval, e.g. requiring funding

2. Shareholders proposal (initiation)

- Voting items that are initiated by the shareholders
- Also called the agenda rights/ shareholders proposal rights, allow them to add proposal
in the agenda so they can vote

In addition to the decision making function of the AGMs, it also has a form and information
function
Shareholders can ask questions, they can also make commence, ask questions and engage in
discussion with the board.
E.g. Europe: Article 9 SRD I → Shareholders rights to ask questions related to items in the
agenda

E.g. US: No article but it’s common practice for board members to answer questions

Shareholders often have their opportunity to voice their opinion behind the scene.
Often, actual decision making takes place outside the AGMs, behind the scenes.

Appointment rights
- Shareholder vote on the selection of directors
- One-tier and two-tier boards; one tier board shareholders vote on all board members;
two tier board, they can only elect the supervisory board depending on the jurisdiction
→ In NL, companies have a mandatory supervisory board to elect the management board
members, shareholders only elect the supervisory board members but it depends on the
structure regime to what extent they adopt it. Many difference in shareholders rights related to
appointment rights and different jurisdictions
- Codetermination Act in Germany

Appointment right is usually a ratification right based on the nomination of candidates from the
board of directors.

What about the nomination of directors?

- Including the removal of directors
E.g. Germany: Shareholders can remove the shareholder elected members from the
supervisory board without cost but they need 75% majority in terms of vote; in contrast,
shareholders may not remove the labor representatives and the supervisory board members
cannot remove the management board member without a cost

E.g. UK: Shareholders can remove the board members at any time without any cost with an
ordinary resolution → ordinary resolution = 15% vote +1

Appointment rights
- Shareholders vote on the selection of director
- One-tier and two-tier boards
- Codetermination in Germany
What about the nomination of directors?
Including the removal of directors

US Shareholders appointment rights (Delaware)

- ‘Plurality’ voting rule: When an election is uncontested, that is, the number of candidates
equals the number of directors to be elected --any number of votes suffices to elect a
nominee to a board seat (section 216 (3)); one vote is sufficient! Shareholders have no
power over board appointment because of this rule
Heavily criticised
- Shareholder inability to case an effective vote against director candidates
- Call for ‘vote no’ campaigns by Grundgest (1993) in Stanford Law Review

Activist shareholders pushed for adopting the strict majority standard

- 2005: 9 companies of S&P 100 use majority voting
- 2014: 90% of S&P 500
→ Less practical impact now due to stronger shareholder power in the US

Decision-making rights
Including:
- Increasing the share capital
- Waiver of pre-emption rights
- Repurchase of shares
- Nachgrundung
- Amending articles of associations (Shareholder rights in many countries)
- Alter the corporate contract (Shareholder right in many countries)
- Large transactions, mergers and demergers (Shareholders have a trade in transactions
in most of the countries)
- Related to external auditor
- Annual financial statements (Difference in countries about this)
- Dividends
- Say on Pay
- RPT (Related party transactions) → Transactions between the company and related
company, e.g. board member or large shareholder, this transaction has a large risk;
extra disposure is always required
- Discharge → Shareholders usually discharge their director for conduct, in every country,
the legal impact is difference, the discharge is an act of general meeting, the decision to
discharge only limit internal liability for the conduct, known upon approval of the annual
account, it’s also an act of trust, it’s exceptional that discharge is not granted because it
really shows the act of discontentment to the board
E.g. ING exceptional situation
→ Discharge is void in the UK!!

Say on Pay
- Shareholders have a say
- Executive remuneration is a debate
- Executive pay packages: Can be in cash or shares, loans and guarantees, other types of
grants, benefits from perks e.g. company jet
- Executive pay as a solution for agency problem but it’s increasing cost so it will be
another type of agency problem

Can contain an advisory or mandatory vote

 - Advisory: Shareholders can have a vote but the board is not required to follow their
decision--non binding
- Mandatory: Shareholders vote is required and the corporate board cannot act against it;
binding vote

Ex ante: Say on Remuneration Policy → Usually consist of binding votes

Ex post: Say on Remuneration Report
----------------------------------------------------------------------------------------------------------------------

Week 9 Minority shareholders

● Podcast
E.g. Apple has serious shareholder issue, they were afraid apple suppressing human rights
considering the production in China

E.g. Line having a deal that is not good for the minority, minority shareholders are not to be
undermined.

- Rights and what kind of rights our jurisdiction gives to minority shareholders; central to
theory of shareholders probation.--> Protecting interest of minorities

- Duties shareholders have

● Knowledge Clip 1 --Shareholder individual rights (Proposal rights)

Required Readings:
- Ch. 19 (don’t need to know all the rules, just the general sense of shareholder rights
would be sufficient)
- Ch. 20 (related to the lecture topic, don’t need to know how each vote is counted in each
jurisdiction)

Shareholder (individual) rights

Annual general meeting is a formal decision making body in a corporation, together with the
board of directors. The corporate board determines the corporate strategy. E.g. Appointment
rights. Most of these matters shareholders vote on are management proposals which means
proposals that are made by the corporate boards, e.g. they need formal shareholders approval
for a particular decision. Approval is then provided by the shareholder meeting. In addition to
individually exercising voting rights, they together make decisions in AGM.

Individual shareholders also have some other rights: e.g. initiation rights to add things in the
agenda
Shareholders also have:
- Voting
- Shareholder proposals
 - Questions and information rights, related to the AGM, in the AGM they can ask
questions and receive information in the form of annual report, including the financial
statements
- Informal: one on one and other interaction behind the scenes; discuss matters with the
corporate board behind the scenes, is not legal right but practical right, also called one
on one on phone call. In the communication between the shareholders, investors and
the company. These interactions are taking place behind the scene so this is hard to see
the actual impact of these meetings but sometimes the effects are shown.
→ e.g. Unilever backed down on plans to move headquarters from the UK in 2008; Unilvever
has dual structure, one in the UK and one in the NL. They planned to have an extraordinary
meeting to vote on the simplified structure and the movement to the NL. Yet, some large
institutional investors did not agree with it so they discussed it with the corporate board behind
the scene. Eventually, the extraordinary meeting was cancelled and their headquarter did not
move to the NL but moved to London this year which was approved by the shareholders

3 different levels of rights

1. Inspection rights
2. Routine regular disclosure
3. Disclosure of significant defence

Note that in the discussion of Germany and UK, he links this request to the right to ask
questions → part of Article 9 EU Directive
In Europe, shareholders have the right to ask questions in general meetings. Some countries
use the corporate website for commonly asked questions and allow questions in writing.
E.g. France

US: Shareholders can ask questions too but this question right is not codified.

Individual shareholder duties

- In general: Shareholders can give priority to their own interests

- But:
→ Limitations:In stakeholder orientation countries, they have limitations. E.g. Netherlands.
Shareholders can give priority to their own interests but they have to keep into account of the
principle of reasonableness and fairness in relation to the company

→ Large shareholders: Minority shareholder protection

The larger the interest in the company, the larger the stake of the shareholder, the greater the
responsibility in the company these shareholders have.

Corporate block holder- Another term for shareholders with large stake

US (Delaware)
- Shareholder proposals and proxy access:
 - Rule 14a-8: Including a proposal related to inclusion of a specific individual in the
company’s proxy materials for election of the board of directors
- Social and precatory proposals dominate
- Shareholders can make use of the firms’ proxy statement/material, which are used to
inform all shareholders on which items they can vote in the AGM and how they can vote
their shares. They are also filed with the SCC, Security Change Committee.

Most shareholders do not vote in the meeting but vote electronically before the meeting takes
place → Proxy voting. If there is a shareholder proposal, shareholders should be notified that
they can vote on these matters. You can imagine that if you as a shareholder, you want to add a
proposal to the agenda and you cannot use the companies’ proxy materials that are distributed
to the shareholders containing information about what and how they can vote, setting up these
all by yourself is quite costly. Under rule 14a-8, shareholders may request distribution of a
proposal if they have at least 2000 USD in market value, in terms of shares or 1% of the
company’s voting shares for at least 1 year before submitting the shareholder proposal.
Although these requirements are compared to EU rules, in terms of ownership stakes, the main
problem here is the groups for exclusion--corporate management can refuse to distribute most
proposals, thus to adopt them or add them to their proxy statements.
- There are 13 grounds for exclusion in the US, including the exclusion if a proposal
concerns ordinary business operations, the SCC has recommended the shareholders to
make use of advisory proposals, which merely contain recommendations. Hence, in
practise we often see Environmental Social Governance proposals or advisory proposals
on highly debated corporate governance issues that boards can ignore formally. Boards
are forced by the media or larger public to adopt these advisory proposals after all.

Note that using rule 14a-8, a company may seek no action relief from the SEC staff to exclude
the shareholder proposals from its proxy materials if the proposals fail to meet a requirement of
these rules. One of these grounds for exclusion has been board elections. The exclusion ground
of a specific individual in the company proxy material for election to the board of directors. When
we talk about the US shareholder proposals right related to these board elections, we need to
address the term proxy access. Proxy access is the general notion for the shareholder rights to
place nominees, their own candidates for being elected as board members, or the company
proxy materials without having to circulate their own proxy materials. If you use your own proxy
material to nominate your own candidate, this is called a​ proxy contest/ proxy fight​.

Note that we are mainly considering here shareholders proposals related to board elections
because this refers to the term proxy access. It has been the mostly debated issue in the US.
More specifically, it can be stated that historically the SCC has regarded the nomination of
candidates for election to the board as hostile to the corporate management. Therefore, it
considers that this action could be better placed in a proxy context, for which the shareholders
have to pay unless their board members are actually elected to the board.

- Section 971 Dodd Frank; failure of rule 14a-11

Although rule 14a-8 allows companies to request the SCC to be able to exclude these proposals
from the proxy material, the Dodd Frank Act of 2010 granted the SCC power to make rules
facilitating inclusion of shareholder nomination in the corporate proxy material. The SCC
adopted rule 14a-11, stating that a shareholder jointly holding 3% of the voting capital for 3
years then can place nominees on the agenda of the general meeting, fire the firm's proxy
materials so you have proxy access if you fulfill the requirement of rule 14a-11 that shareholders
hold. Individually or jointly, this 3% of voting capital for 3 years. Nonetheless, lobbying by the
business round table can be seen as an influential group of CEOs of the largest US companies.
The DC circus ruled against this rule for several years now. Rule 14a-11 was dismissed by the
court. Despite the failure of 14a-11, shareholders may still file shareholder proposals, seeking
proxy access at a company level. Not a federal rule but shareholders can individually at a
company level seek proxy access to have contractual part of corporate law to have the rights
included in the corporate charter.

Although these proposals are non-binding, since 2015 proxy access is widely adopted by
largest firms, or listed firms in the US due to coordinated action of institution investors and you
can see the increase in proxy access adoptions on the sheets. Particularly, those proposals that
followed the original requirement of rule 14a-11 are actually successful.

When shareholders cannot use their company proxy materials, they need to use their
own -- when this is about director elections → Proxy contest

Proxy contest: Shareholder proposals solicited using shareholders’ proxy materials at

shareholders’ expense, e.g. to nominate own directors
This is about taking over control of a company. --Replacing the incumbent corporate
management with your own board member and in that way taking control over a company

A trend of shareholders proposals in the US

- Quite some ESG resolutions, comply with the 14a-8 rule
- As regard to governance issue, some of them related to proxy access and the adoption
of sale and pay, cumulative voting, removal of a poison pile

Amendment to rule 14a-8

- Very recent
- These rules will apply to shareholders proposals as to January 2022.
- Note that the round table with an important CEO was involved in these changes. These
CEOs are lobbying for more board power
- Shareholder proposals are considered a burden by US board members therefore it is not
much of a surprise that these amendments are restricted for shareholders proposals.

Following amendments:
1. The rules are replacing the current ownership threshold (required at least 2000 USD of
market value or 1% voting share for at least 1 year. These thresholds will not be linked to
the holding time of these shares. There are different thresholds, 2000 USD of company
 shares when the holding is held for at least 3 years but 15 thousand of the company
shares when holding is held for at least 2 years and even 25 thousand when a
shareholder holds shares for at least 1 year. Increase in the requirement for the
ownership holding ---
→ Rules in Europe are even stricter

2. One of the paragraphs of rule 14a-8 is amended in a way that the proposal should have
a certain level of support in order for shareholder to resubmit their proposals again
during the AGM next year, e.g. a proposal would need to achieve support by at least 5%
of the voting in shareholders in the first submission in order to be eligible for
resubmission somewhere in the following 3 years. Proposals that were submitted 2 and
3 times in the prior 5 years would need to achieve 15 and 25 % support respectively for
resubmission in the following 3 years to be allowed.

Although the thresholds are not restricted, the ground for exclusion and new amendment
make it hard for shareholders to use their agenda rights. Yet, as seen in the figures,
there is a different culture in the US compared to Europe for shareholder proposals.

Europe
Shareholder proposals rights:
- Contains in the European Shareholder Rights Directive (2007/ 36/EC), namely article 6
- Generally costly (5% of the share capital --ownership requirement as a maximum
requirement, member state can set lower requirement, NL: 3%) --Ownership requirement
is high in Europe compared to the US
- But no extensive restrictions, they can easily nominate their own directors, just have to
comply with high ownership stake
- Also the right to call a meeting

In Italy, the number of shareholder proposals is quite high because they have a system where
minority shareholders are encouraged to nominate their directors.

Remark: The European shareholder proposals rights is used less but when it is used, it is
addressing important corporate law issues, e.g. director elections. Because proposals can be
added to proxy materials if they only have advisory nature, in the US we can see more ESG
(environmental social governance) proposals.

- Proxy fights are allowed. But calling a specific meeting is usually only for the board

● Knowledge Clip 2-Concentrated ownership: Controlling stakes and minority

shareholders

Last week:​ ​Shareholder-manager agency problem

Large block holders: Neutralise the shareholder-manager agency problem
But: Minority controlling shareholder agency problem (this week) --Solution to the first agency
problem

Large shareholders do not have large information in coordination cost but they cause the
second agency problem.
In agency problems there are always outsider and insider.

First agency problem, the corporate board is the insider party. Shareholders only have a small
stake are the outsiders.
Second agency problem between block holders and minority shareholders: Large shareholders
are insiders and small shareholders are outsiders.

‘Ownership Around the World ’

- The Berle and Means image of the modern corporation has begun to show some wear
- Berle and Means: Widely dispersed companies and The Separation of Ownership and
Control, large number of shareholders
-
The aim of this research was to look at the reason behind different ownership structures of
companies in different countries. The author claimed that in countries with good investor
production, you see lower ownership concentration than in countries with less investor
production.

- How common are widely held firms in different countries?

- What are the characteristics of significant owners?
- How do these owners maintain their power?
- What explains ownership differences?
→ Link between ownership structures and shareholder protection?
→ Link between control arrangements and shareholder protection?

Based on the analysis on:

- 27 countries, 540 large firms and 691 firms in total
- Worldscope and various other data sources

The authors categorised countries in 2 panel ”Anti Director rights”

1. More shareholder rights( Panel A)
2. Less shareholder rights (Panel B)
Next, they measured the ownership structure to see whether a company was widely held or had
a controlling shareholder. The controlling shareholder is defined as having a 20% stake or more.

Hence when a company had a 20% shareholder, it was considered a controlling shareholder
structure. Panel A is more widely dispersed than panel B because shareholders do not have to
accumulate ownership because they were protected by the law. In countries with less
shareholder protection, they have to accumulate ownership because that would provide them
necessary control to be able to avoid influence by the board.
 - These authors received a lot of criticism on their methodology. e.g. they forgot to include
european law in their framework. They made substantial contributions to the existing
literature on ownership structures. As from this period onwards, ownership structures are
more concentrated than in the US and the UK
-
When is there a controlling shareholder?
What is control? Control can depends on the entire ownership stakes
LLS: 'The idea behind using 20% of the votes is that this is usually enough to have effective
control of a firm'
e.g. Three shareholders, holding respectively 47%, 49% and 4%. How is control divided?
You can claim that shareholders have equal power if they vote on simple majority voting rules.
Because you always need 2 out of 3 to have a decision being made, it does not matter which of
these 3.
Control enhancing mechanisms​- Also called 'controlling minority structure'
1. Pyramid structure: A controlling minority shareholder holds a controlling stake in a holding
company that, in turn, holds a controlling stake in an operating company
--> A shareholder holds a stake of 50% in a holding company and that company in turn holds a
stake of 50% in an operating company. In this situation, you only need 25% to operate control.
e.g. Company from a rich Hong Kong family Li Ka Shing. They don't use this company structure
anymore.
e.g. Heineiken

2. High voting shares: relate to the discussion of different share classes in Ch. 10
Dual class structure: Low and high voting shares
- Loyalty shares e.g. France : Now default rule with introduction Loi Florange
- Past restrictions on dual class shares in listing rules, including NYSE, Tokyo Stock exchange
- Banning from indices : Including S&P, FTSE Russell
Low voting shares are typically common shares or ordinary shares that carry one vote per
share. High voting shares have more than one vote per share e.g. France, Italy and Belgium --
loyal shares, 2 votes per shares. Note that creating share classes is a Contractual matter within
the boundaries of the law in jurisdictions. Usually we have preference shares that contain extra
capital rights or extra voting rights, if they have the rights that dividends are accumulated for
every year when a firm cannot pay.

High voting shares: A wretch is created between cash flow and control right because
shareholders who have high voting rights have more control for lower capital stake. Pyramid
structure creates these wretches.

Nowadays, stock exchanges have made amendment to their rules to welcome tech giants, like
Alibaba and Facebook

Why would large shareholders would like to have a controlling stake in the first place?
 - Diversification and liquidity is preferable; it is stupid to invest all your money in one
company but if this is the case, why would large investors exist? Look at Private benefits
of control.
- But: Private Benefits of Control = the gain resulting from exercising controlling
shareholders at the expense of non-controlling shareholders
How can they have private benefits of control?
1. Opportunistic behaviour (tunneling = the transfer of resources out of a company to its
controlling shareholders)
2. PBC are a necessary cost of incentivizing efficient monitoring and good performance
3. Control is needed to pursue an idiosyncratic vision (entrepreneurial); e.g. Henry Fourth?
→ Information problem between the entrepreneur and outsider investor can lead to
disagreement how the business should be conducted

Minority Shareholder Protection

Appointment and decision rights (including deviations from OSOV)
Many rules relate to director elections; different rules in different jurisdictions
- Minority shareholder appointment rights:
→ Cumulative voting (e.g. 100 votes in total, shareholder A 60 votes, B 40 votes and 3 directors
up for election) → e.g. China and the US; votes are accumulated over all directors that can be
elected, shareholders can use their votes in every way they like. They can use how to use these
votes

Cumulative voting example: A--3*60=180 votes in total; B-- 3*40=120 votes in total
The outcome of the board structure using this rule can be uncertain

→ Slate voting (Voto di Lista)

- E.g. in Italy: Minority shareholders who are fulfilling certain requirements can propose a
slate of directors then the majority directors will be selected from the slate that receives
the highest number of votes but one or two directors are selected from the so-called
minority slate. Most directors are elected from these majority slate but one or two are
selected from the minority slate.

- Majority of Minority decisions

→ To pass the proposal, you need a majority of the vote of non-controlling shareholders, i.e. the
majority of the minority. e.g UK: In companies where shareholders holding more than 30% of
the shares, this rule is used and the non-controlling shareholder need to provide approval for
independent directors to be elected

- Qualified majority requirements (75% two thirds, etc v.s. Simple majority rules of 50% of
the votes)
→ Make it easier for non-controlling shareholders to block resolutions that they don’t agree with
thus forming some kind of protection.

Minority shareholder protection

Trusteeship strategy​: Independent directors -- considered as a solution to all agency problems
including the second agency problem because they are independent from the company, the
directors and independent from controlling shareholders and they have financial or family ties.
These directors can independently monitor and manage directors but also control shareholders
in a good way. E.g. more rules appear after a crisis

- Originated in the US
→ Seeks to remove conflicts of interest ex ante
→ do not profit from opportunistic behaviour
→ Not tied by financial incentives but motivated by ethical and reputational concerns

- Requirements (Scandal or economic crisis drives):

→ NYSE: Independency requirements for audit committee
→ SOX: Fully independent audit committee
→ Audit Directive: Majority and chair independent audit committee
→ Dodd-Frank: Fully independent compensation committee
→ Corporate Governance Codes and listing rules

** This independency argument sounds very nice but also has some problems
E.g. You can ask yourself when is it exactly when a director is independent? What are the
requirements?
A panacea to mitigate almost every problem of company law (including the second agency
problem)

Criticism includes:
- Arbitrary criteria (Criteria of independency)
- No conclusive evidence on effect on firm performance
- Their role during the financial crisis has been criticised (lack of expertise is the main
argument because there has been research showing that independent directors actually
worsen things during a financial crisis)
- What about their incentive structure?
- How to compensate them if they only have low power incentives?

There is a general consensus in corporate law that independent directors are useful but the
company has to safeguard sufficient expertise at the board level to monitor efficiently, which
include requiring financial background in the audit committee.

● Knowledge Clip 3: Enforcement of shareholder duties

Outline:
1. Readings and other materials
2. Shareholders’ duties (a) fiduciary duties and (b) reporting duties (aimed at creating
transparency when it comes to shareholders structure)
3. Enforcement of shareholders’ duties
Readings
- Chapter 21 and 22 (p. 743-748)
- Additional readings (non-mandatory)

Shareholders’ duties: Fiduciary duties

- (p. 713 C&D)
- Exist between a corporate director and a shareholder
- However there are other types of relationships that might require similar fiduciary duties,
e.g. controlling and non-controlling shareholders.

Rationale behind shareholders’ duties

Beneficiaries of shareholders’ duties:
1. Shareholders
- Decisions taken by controlling shareholders affect the value of the company, thus, the
non-controlling shareholders; fiduciary duties: ensure that shareholders do not abuse the
power to make decision which could have an effect on the minority because they are
pursuing their own interests
- Limitation of the duties to the common purpose of promoting the value/welfare of the
company
- In contrast, this duty does not expand to any sort of private interest of individual
shareholders e.g. if a minority wants the dividend to be paid out at the end of the year
but the controlling shareholder says no, would fiduciary duty kick in? No. Even if some of
the shareholders depend on the income, they won’t do it. This duty only relates to the
common purpose of promoting the company. Only in the value of the company, then
fiduciary duty will kick in, we have it for the purpose of promoting the company but not
protecting the minority shareholders.

2. The company
- Merely a reflection of the duties shareholders owe to the other shareholders
- Imagine if there is only one shareholder, would it make sense to enforce fiduciary duty
on him? Will the company sue him back if he decides to sell his shares? No! It will only
make sense in situation where there are more shareholders

3. Creditors
- Benefit because damage to the company could impair the value of their claim; it is again
a mere reflection of shareholders protection, what they gain;
- However, no standing in court to sue for breach of fiduciary duties. If such breach has
caused harm to the company and indirectly to the creditors

Purpose of shareholders fiduciary duties:

- Prevent abuse of voting rights: Exercise of the voting right is not guided by interests
contrary to the interests of enhancing the value of the company
→ Voting rights are essential so that shareholders participate in the governance of the company
to promote the value of the company
→ The use of voting rights for purpose other than promoting the success of the company which
contributes an abuse
→ shareholders benefit from the success of the company as they are residual claimants; their
state will also be wiped out first if the company fails
→ Therefore, they are given rights to hire good managers
→ The fiduciary duties ensure that the exercise of voting rights is not guided by interest
unrelated or even contrary to the interests of enhancing the value of the company
- Prevents shareholders opportunism: Corporate governance has changed: Institutional
investors are dominant and are no longer passive investors
→ Historically the view of the widely dispersed corporation assumed that shareholders are
passive however this has changed. Although they do not have large stakes in public companies,
shareholders have enough shareholdings to have an incentive to be engaged in corporate
governance, they are no longer passive. They engage with the corporation so they can exercise
control over the company

Criticism on shareholders’ duties (4 arguments against imposing fiduciary duties on

shareholders)
1. Shareholders (even controlling ones) have no direct control over the corporate assets
- They can only indirectly impoint the corporation through the control of their shares

2. Controlling shareholders paid (control premium) for their position so they have right to
benefit from it
- Control premium: Pay a premium to obtain a majority interest or controlling position in
the company so they have the right to benefit from it if they paid for it. In a company
were shareholders with substantial influence, if they buy this company they have to get
votes from the majority

3. It can disincentive investment by imposing additional costs on shareholders

- Knowing that they would have fiduciary duty, future investors will discount on the price
they are willing to pay for the shares, lowering their control premium or not investing at
all

4. It can disincentivize shareholders to take up an active role in governance

- If they know they can be held responsible for decisions that might harm the minority,
they may choose not to exercise their votes at all and not participate in governance, so
they can prevent from any legal actions that might be against them

Thoughts: Should minority shareholders also owe fiduciary duties?

Shareholder’s fiduciary duties: US​ (Great differences between jurisdictions, why? No clear
answer to this but one can say that because the ownership is more typical for the US whereas
in Europe has a higher degree of concentration of ownership, fiduciary duties would be more
relevant for European jurisdiction. In theory, there may be opportunities of misconduct from the
shareholders. In europe, the legal construct is less developed.)
US- Controlling shareholders owe a general fiduciary duty to the minority (established in case
law Southern Pacific Co v. Bogart)
- To be interpreted as controlling shareholders are precluded to extract material economic
benefit at the minority’s expense
- Applied ‘entire fairness standard’-- A standard that a transaction should make, a product
of fair dealing and the deal is fair price.
- The doctrine is usually applied in closely-held corporations (not always) because
shareholders in closely-held corporations do not have easy access. Public corporation
they can trade their shares easily in secondary markets, the option of exit is not easy for
private or closely held corporations

Shareholder’s fiduciary duties: UK

- No Fiduciary Duties but…
- The minority has the power to alter the memorandum and the AoA (Association): If there
was a fraud at the expense of the minority → Only in case of fraud
- ‘Unfair Prejudice’ remedy in the Companies Act 2006, s. 994
“A member of a company may apply to the Court by petition for an order… on the ground (a)
that the company’s affair are being or have been conducted in a manner that is unfairly
prejudicial to the interests of members generally or of some part of its members (including at
least himself) or (b) that an actual or proposed act or omission of the company (including an act
or omission on its behalf) is or would be so prejudicial.

This remedy has two elements:

1. The conduct must be causing harm to the interest of a member or some part of it of the
company (as in the case of part of the shareholders)
2. Must be unfair → what is fair or unfair is decided in the case law

Shareholders’ duties: Reporting duties

Registration of share transfer ensures transparent shareholding structures
- Transparency rule

Why do we have these duties? Why do we want clear shareholding structure?

The issue of all these disclosures rules (summarised):

- The threshold at which disclosure must be made:
- Percentage of capital, percentage of voting power, or percentage of a class;
- The dimension of a change in the holding that triggers a new reporting duty;
- The details of the disclosure (content and timing)

Stock echaves often require that shareholders register as a financial intermediary, e.g. a bank.
Individual investors cannot just go to the company and buy shares, they have to contact an
intermediary or bank to do so.
Enforcement of shareholders’ rights
Minority also have voting rights, they can ask for more information. But what happens when this
is not enough? E.g. Minority voting rights are not enough to prevent abuse from the majority?

3 different forms of actions (private actions = part of the shareholders sue another part of the
shareholders for breach of fiduciary duty)

- Direct action -- injured person asks court to order the perpetrator to stop the harmful
conduct and or pay damages for the harm suffered → Straight forward
- Derivative actions-- a party brings action to court on the basis of an injury suffered by
another person → Usually happen when some subsets bring a claim against another
member that the respective member harmed the company, suing them on behalf on the
company
- Class action-- when injury is suffered by an entire class of persons

Which actions to take? Depends on the incentive.

Incentives are triggered when there is contingency fee = A lawyer works in return for a
percentage of the final reward not for hourly wage. Economically good as they make each suit
much more feasible for the plaintiff but they can bring wrong incentives too.

Enforcement of shareholders’ rights: example

In the context of a ‘derivative’ action -- 1% shareholder were to sue to a 99% shareholder for an
action that allegedly damaged the company

a. Where is the award going to go? Not going to the 1% shareholder. It will go to the
company. Who is going to share it? The 1% shareholder will have to share the reward
with the 99% shareholder. It does bring wrong incentives

E.g. 1% shareholders were to file a claim against 99% shareholders in order to stop a takeover
transaction
→ Takeover transactions are very time-sensitive, they are regulated. If deadline does not meet,
it cannot happen

b. Can the minority abuse their position by filing a suit against the majority?
Yes. If the majority approves a merger then the 1% shareholder can file a suit against the
majority and stop the merger. They can ask for high price for their shares if they want to
continue the major transaction

Public enforcement: Force company to behave; compensation to the victims would be the
primary concern
Conclusion: Enforcement of shareholder duties is not easy task, when you take into account
that usually it involves cross-border transactions
--------------------------------------------------------------------------------------------------------------------
Week 10 Mergers and Acquisitions
Readings:
- Chapter 23: Introduction video, asset purchase, stock purchase
- Chapter 26, 27: Tender Offers and Hostile Takeovers

● Chapter 23 (p. 767-800)

- Broad definition of M and A

FAQ:
1. What is a merger?
- Happen when two companies come together (usually amicably) to form a third company
- Happen when two companies come together to join assets and liabilities and they end
up forming a third company

2. What is an Acquisition?
- When usually a larger company acquires the assets and liabilities of a smaller company
and absorbs the smaller company into its existing entity
- Takeovers, hostile are usually under the general umbrella of acquisition
- Because of the negative connotation of the word acquisition has on shareholders, some
companies call it a merger even though what is really happening is an acquisition

3. Why are mergers sometimes described as ‘one-company being absorbed (or merging)
into another one? Isn’t this clearly an acquisition?
- In reality, what is being described is more of an acquisition, but in practise, a lot of
companies call it a merger because of the negative connotation that the word
‘acquisition’ has to shareholders

4. Why are the two discussed together?

- They are both types of business combinations

Chapter 23 (Topics and sub-topics) --Basic Nuance of M&A

A. Structure for transaction (p. 768) --methods by which business combinations are made
- Purchase of Assets --Purchase of one, some, or all of a company’s assets
→ Generally becomes a method of acquisition when a company gains ownership/control over
another through the purchase of the later’s assets

- Purchase of shares of stock-- Generally becomes a method of acquisition when the

purchasing company gains ownership/control of another company (Through the
purchase of shares of stock)

- Statutory Mergers --Once the merger is registered with the appropriate body, all the
effects of the merger will take place by operation of law
→ Called ‘statutory’ merger because the consequences of the merger are already expressly
provided for by the applicable statute
 B. Deal Protection Tools (p. 782-785) --tools by which parties are assured of a safe and fair
transaction; deal protection tools are methods usually contractual provisions, by which
parties to mergers and/or acquisitions are assured of a safe and fair transaction
- Confidentiality Agreement → don’t talk about it
- Duty of Good Faith Negotiations → Don’t be a jerk about it
- No talk and no shop agreements → don’t look for other deals when you already have
one
- Termination Fee → Don’t flake on our agreement otherwise you pay me money
- Fiduciary Out Clause → I can opt out if it will contradict my fiduciary duties as a board
member

Test Yourself (p. 785 and practise questions)

Chapter 24 --Rules Governing M&A’s

A. Three types of Governance Techniques for M&A’s (p. 801) --aimed at protection
shareholder rights during M&A → The right to know and decide, not be treated differently
and the right to compensation
- Mandatory disclosure: Transaction must be disclosed and approved by majority (or
supermajority of shareholders) except if the impact of the transaction to the company is
small → Right to know and decide
- Management + controlling shareholders must not discriminate against other
shareholders when conducting the transaction → Right to not be unfairly oppressed by
those in power
- Shareholders opposed to the transaction (but did not win the vote) must be given a fair
price for their shares. This allows dissenting shareholders to just sell out instead of
becoming a part of a new company that they did not sign up for or intend to invest in →
Right to fair compensation for their investment

Chapter 26 -- Regulation of takeover bids and prices

A. What is a Take-over? --EU: Public offer to the shareholders of a listed company to
purchase their stock (No statutory definition in the US)
- Hostile takeover-- when the acquisition is done against the wishes of the management of
the target company
- Stock purchase vs Take Over --Takeovers are public in nature, aimed at gaining control,
and usually having far reaching consequences. Not all stock purchases are public or
result in gaining control
→ EU: Takeovers are facilitated through ‘take over bid’. See EU Takeover Directive (p. 885)
→ US: Takeovers are facilitated through a tender offer (p. 885)
- Common characteristics of take over bids and tender offers (p. 886) -- an offer made
publicly to a number of shareholders for the purpose of acquiring a significant portion of
a listed (or registered) company’s capital
- How hostile takeover takes place?
Takeover bids and tender offers usually involve these steps: 1. A call for a bid from the target
company; 2. A bid offer from the purchaser company, the bid offer usually consists of cash or
alternatives to cash such as stock options or cash or stock options together in exchange for the
shares of the target company; 3. The bid offer is then made directly to the shareholders and it is
the shareholders then decide whether or not they will take this offer.
If enough shareholders sell in order for the bidder to gain a majority or a greater percentage in
some circumstances, then the take over bid or tender offer is successful.
- Management has the prerogative to decline a substandard bind offer but on the other
hand, they cannot decline a bid offer if this will result in a bad deal for their shareholders
- If management is given a bid offer which they cannot refuse because of a large bid price,
then they have to accept it even if they do not like the bidder otherwise they are
breaching their fiduciary duty to their shareholders

B. Why do we need to regulate takeover bids/ tender offers?

- Public nature -- Made to a large number of people who have limited information about
the bidder and the offer, and have little bargaining power

C. Treatment of Remaining Shareholders (Focus on this)

- UK: p. 895
- Germany p. 899
- US: p. 905
● Knowledge Clip 1: Asset purchase
Merger v Acquition (M&A’s)
- The two terms are increasingly used in conjunction
- However, if any difference is made:
We can think of mergers as fusion of two or more companies voluntarily to form a new entity
Mergers​: 2 different types of mergers
- Absorption: One company merges into another company
→ e.g. A Ltd. + B Ltd. => B Ltd.

- Consolidation: Two companies merge into a third company

→ e.g. A Ltd. + B Ltd. => AB Ltd.

Acquisition​: One company acquires all assets or shares of another company

- It is also possible to acquire less than all shares→ Partial acquisition
- There is no company involved to dissolve or ceases to exist, just changing the owner

Rationale of M&As
1. Operating synergies:​ One of the reasons. There are two types of synergies.
- Economies of scale​: Reduction in the average cost of production, more goods can be
produced on a larger scale with fewer costs. E.g. Receiving korting according to the
volume you buy
 - Economies of scope​: Production of one good reduces the cost of producing the other
related good. E.g. Use the same freezer to sell not only kroket but also burgers,
milkshake and other food

2. Financial synergy​: Combination of two firms together results in greater value than they
operate separately
- Improvement on the financial matrix, better revenue, less cost of capital, more
profitability

3. Diversification​: A strategy to expand company’s product and service offerings by

merging two companies who operate those in different sectors.
E.g. Google expanded its business beyond interest search and advertising.

4. Technology​: Each company may have access to information technology for operational
efficiency if required for use by another firm. E.g. One firm developing a cheap stuff that
could be used in another product by another firm

5. Growth​: Grow your business without having to wait for years for your marketing strategy
to pay off

6. Market power​: Entity has a greater market power -- helps increasing competition of the
market

Basic Transaction Structures

- How to transfer all or part of a company to a new owner?
A. Asset Purchase: Governed by mostly private contract, between the companies and
shareholders
B. Purchase of stock: Some or all company shares are purchased by new owner
C. Statutory Merger: About merger governed by certain state statutes

These 3 are the basic transaction structures. Which one to choose depends mostly on the goal
of acquisition.

Asset Purchase
- All or selected portion of the assets of the target company (e.g. inventory, land, accounts
receivable, business division and intellectual property rights and other intangible assets
as well) are sold to the buyer
- In an asset purchase all, part of or none of the liabilities of the target company are
assumed by the buyer
- The buyer may also choose to buy the liabilities, e.g. he may not have enough cash so
he will buy liabilities instead

- Corporations have separate legal personalities. Although shareholders own the

corporation, the corporation owns its assets. Only the company can sell any or all of its
 assets of liabilities through the board of directors. BoD represents the company and thus
negotiations the sale. However, may be subject to a shareholder approval or veto

Diagram-- Acquire wants to purchase assets from the target company, the BoD negotiates the
deal. After the buyer pays in cash or stock, the target company transfers the purchased assets.
Shareholders do not have any roles in asset purchase in principle. However, they may have
approvate right if the deal concerns old assets of the company because this might change their
investment in the company.

Asset purchase: Advantages v.s. Disadvantages

Advantages Disadvantages

Tax treatment for the buyer but not the seller. Consent of counterparty boD required

Allows for cherry picking: Buyer can choose Possibly high transaction costs/
which individual assets to purchase, e.g. time-consuming
license, trade names, etc.

Excluding liability: Just take over the assets Transfer of ownership in contractual assets:
and leave the liability.

● Knowledge Clip 2: Stock purchase

Stock purchase: ​When one company purchases the outstanding shares of another company
directly from the shareholders
- Shareholders are the sellers as they own the stocks and have complete discretion to
decide on the sale
- BoD is permitted to adopt defensive measures in some cases, mostly when the bid is not
friendly
- Public offer for the shares because of large number of dispersed shareholders may fall
under takeover regulation, e.g. EU Takeover regulation
- Purchasing the shares from the shareholders transfers control over the business of the
target company
Pre-deal diagram:
- The acquirer makes an offer to the shareholders of the target company, the shareholders
have full power to decide on the sale. The board is not involved but they may adopt
defensive measures. The shareholders give their stock in exchange for cash or other
assets

Post-deal diagram
- The Target Company does not disappear. It becomes a subsidiary of the Acquirer. Still
exist, only change the owner.

Advantages and disadvantages of stock purchase

 Advantages Disadvantages

Simple compared to asset purchase Buyer receives both assets and liabilities. No
cherry picking

Transactional saving Additional management cost of owning a

subsidiary (a follow-up merger would be one
way to eliminate such administration cost)
E.g. Re-negotiation

Contractual clauses (change of control)

● Knowledge Clip 3: Statutory mergers (Governance Techniques)

Statutory merger: ​Two or more companies, which are separate legal entities, become one
company --one legal entity
- Operation by law, rather than private contract or other action by parties; other
consequences are provided in the statute of the respected jurisdiction and take effect
after filing or special register

Three types:
1. Merger by absorption
2. Merger by consolidation
3. Triangular merger (forward and reverse): Carry out to a subsidiary, established
specifically and only for the purpose of the merger, just an empty shell.
- Forward triangular merger: The target company disappears or it is absorbed by the
empty shell subsidiary
- Reverse triangular merger: The subsidiary disappears in the target company

Why triangular merger? Retain limited liability by separating the target company and the
subsidiary. Escape costly negotiation with the shareholders

Statutory merger: Absorption

In a merger deal, both the board of directors of the acquired company and the board of directors
of the target company come together to negotiate. They prepare the terms of agreement and
put the deal before their shareholders. Both the shareholders of the acquired and the target
company need to approve the merger. If they both agree, the other shareholders and minority
need to surrender their stock to the acquired, they have no say to hold it. The buyer
compensates the target shareholders by giving them cash or stock or other consideration. At
last, the target company will be absorbed and it seizes to exist. All assets and liabilities of the
target company are going to be directly reflected on the balance sheet of the acquired.

Triangular merger: Forward

The acquiring company sets up a shell --Subsidiary A, the BoD negotiates the deal. The
acquirer offers cash or stock of the acquirer to the shareholders of the target company. Once
the acquirer buys the stock from the shareholder, the subsidiary but not the acquirer is merged
to the target company. The subsidiary survives the transaction and the target company is
absorbed.

Post-deal diagram
- Target Company merges into Subsidiary A (All sub A and Target Company assets and
liabilities). Subsidiary A survives as a subsidiary of the Acquirer.

Triangular merger: Reverse

Basically the same thing. The only difference is that instead of the target company being
absorbed by Sub A. It is Sub A being absorbed by the target company.

Post-deal diagram
- Sub A merges into Target Company. Target Company survives and becomes a
subsidiary of the Acquirer.

Meger v Asset Purchase Summary

Merger Asset Sale

Transferring Control By operation of law Control over target company

is not transferred

Transfer of Assets By operation of law By asset purchase

agreement

Transfer of Consideration Direct distribution to target May not be distributed to

shareholders shareholders

Transfer of liabilities Yes, by operation of law Not necessarily

Shareholders’ Approval Required in both companies Required only in target

company

M&A Process: Protection Tools

- Process: Developing strategy, finding a target, due diligence, closing of the deal,
integration
- Many risks involved in each stage, e.g. time sensitive

Risks in due diligence (Exchange information) stage:

- Information usually related to the assets, legal business operations of contract
- This stage enables the investors to access whether the price they are going to pay for
the company is justified
- What can go wrong here? It can happen that they move certain opportunities to a more
aggressive competitor. In a transaction, usually the buyer inquire the transaction cost in
 negotiating the target value. Once the target board has considered and discussed with
the shareholder, a competitor steps in and save the cost of transaction, he gets the
information for free, save the initial cost and offer slightly higher price for the target
company
- To avoid losing a transaction in this way, we have protection tools:
1. Confidentiality agreement: Avoid competitors knocking on your target’s door. Keep
confidential until the manager is sure that the deal will go through.
2. Duty of good faith negotiations: To avoid parties walk away from the deal, impose a
binding obligation to conduct good faith negotiation
3. No talk, no-negotiation and no-shop clause: The target company is prohibited to
approach competitors of the bidders and ask for a better price
4. Termination fee: If one of the parties exit the deal in bad faith, need to pay a substantial
fee to compensate the other party for all the opportunities it misses -> E.g. AT&T paid
billions to T-mobile
5. Fiduciary-out clause: Director thinks of a better company/ a match is there to conclude
the deal with so he finds himself on the one hand breaching his fiduciary duty and on the
other hand having to pay termination fee. Therefore, a fiduciary-out clause allows the
management to escape its obligations under a no-shop when fiduciary demand. Protect
the deal from creating situations that force the management to violate fiduciary duties

Governance techniques
- Goal: To protect the interest of the shareholders
3 Techniques:
1. Transaction must be disclosed to and approved by a majority (or supermajority) of the
shareholders
2. The management (and the controlling shareholders) must not discriminate against the
other shareholders
3. Shareholders who unsuccessfully vote against the transaction must be given a right to
be bought out at a fair price
Different requirements regarding disclosure and approval by shareholders between
jurisdictions

USA DE UK

Asset Purchase Approval by Approval not required Approval not required

shareholders not unless any transfer of unless the safe of
required unless ‘all of company’s ‘entire ‘assets’ would like
substantially all assets’ change the corporate
assets’ object

Merger Approval necessary Approval necessary Approval necessary

(Negotiations are by both target and by both target and by both target and
always done by the acquirer shareholders acquirer shareholders acquirer shareholders
managers of both (must reach BoD negotiates the - Both BoDs
companies) independent deal and drafts the must prepare
 decisions) merger agreement draft terms of
merger
- Usually - Three-quarter
supermajority s majority
approval is required to
needed approve the
transaction

**Short-form Corporation may Corporation may Short-term mergers

mergers decide unilaterally to decide unilaterally to available but need to
(Exists in all 3 merge with its own merge with its own be submitted to a
jurisdiction) 90% subsidiary 90% subsidiary court for a review and
= Unilaterally approval
merging with its
own subsidiary

Shareholder appraisal rights

- The right to be bought out
- Right of a dissenting shareholder to be bought out for fair price by the company in case
he is dissatisfied with the proposed transaction (merger)
- Apply in case of merger and also sale of all or substantially all assets
US (Delaware)
- Appraisal rights available to shareholders who unsuccessfully vote against a merger
- However, not available for listed companies
Germany
- Appraisal rights for shareholders is available in case a merged entity has different legal
form or a listed company is merged with an unlisted company. Shareholders must vote
against the transaction and then file an appraisal suit in a court
UK
- Does not explicitly provide for appraisal rights
- However, in case the shareholder suit is filed (for unfair price) the court has a power to
compel company to a buy-out for determined ‘fair price’

● Knowledge Clip 4: Takeover regulation

There is no uniformed definition of what a takeover is.
E.g. In the EU Takeover Directive, definition is laid down
We can also say that ‘Takeover or a ‘tender offer’ is an offer made publicly to a number of
shareholders for the purpose of acquiring a significant portion of a listed company’s capital’

Tender offer: Acquirer negotiates directly with the target shareholders. The approval of the BoD
is not required but the board may choose to engage.

Hostile v. Friendly takeovers

- Friendly: Target board and management support the bid
- Hostile: Target board and management contest the bid
Hostile: 2 options
- Tender offer: Takeover the shares→ 1. Target is listed; 2. Interest in acquisition of
control; 3. Public offer--- bidders seek to purchase shares directly from shareholders of
the target company at the premium, that is above the current market price. This offer has
a limited time frame for shareholders to accept.
- Proxy fight: Takeover the votes; persuades shareholders to use proxy vote to get new
managers that would be favourable to the deal

Some possible reasons for management to resist:

1. The price is unsatisfactory
2. Management of target considers that the company will perform better on its own
3. Management is seeking to entrench itself/ simply afraid to lose his position after the
takeover

Defensive measures and responses:

What can a board do against a hostile takeover?
- White knight: The management looks around and searches for friendly bidders, who
would offer better prices. The board opens up the company for sale so they get more
bidders

- Pac Man: The target board can make counter offer; but the target shareholders are
resisting it, they don’t like it, they will have to borrow money to make the bid, leaving the
company in debt

- Golden Parachutes: Define the benefits that an employee would receive if their
employment is terminated after the takeover. Change in incentives→ If there is a
valuable offer, they are not going to be against it

- Selling crown jewels: Selling some of the most profitable business lines of the company
so the company itself is not a nice target for the bidders anymore. Bidders go away.

- The poison pill: BoD and senior managers quit the company so the bidder would have a
subsidiary under its control but without the senior manager, it would be difficult to
manage the company then. Flipover: The current shareholders will have the option to
purchase stock of the bidder after the takeover, the number of shares held by the
unfriendly bidder will be diluted.

Interference by management
- Possible conflicts of interest: Shareholders receive a better price for their shares
- US law entrusts managers with the duty of protecting the company
- EU Takeover Directive mandates board neutrality

Hostile takeover as an external governance mechanism

 - ‘Market for corporate control) by Manne
- Potential return can be enormous for shareholders

Takeovers as a corporate governance tool

- Classical arguments for takeovers as a necessary corporate governance tool:
1. Ordinary governance is not effective: The shareholders can be disengaged, they won’t
spend the time and money to enforce the management
2. The stock price reflects the true value of the firm under the relevant management: If
managers want to escape hostile takeover, they have to perform well and keep the stock
price up
3. Concentrated holdings bring strong incentives: New owner has the power to run the
company
4. Gains to selling shareholders demonstrate value of takeovers

However, these arguments have some defects.

Why are the solutions of takeover only temporal?
- Dispersed holdings: Poor governance→ Bidder Purchase all dispersed shares→ Bidder
owns 100% removes the board → Board prepares IPO→ Public purchases shares in
IPO→ Go back to Dispersed holdings poor governance

Why regulate?
- Takeover bids are made to a large number of people who may or may not have
bargaining power
- Who have limited information about the bidder and the offer (the shareholders will
receive stock of the bidder, value may be difficult to determine and cost transaction time)
- Little bargaining power

Why regulate? Solutions!

1. Disclosure → Bidder should provide correct and complete information about offer of a
company; opinion of an independent expert
2. Time Requirement → Give shareholders enough time to inform themselves and make a
resonated decision
3. Uniform Pricing: Bidder pays the same price to all sellers in and around the offer

Minority Shareholder Protection

- Fiduciary duties of large shareholders
- Appraisal rights (mergers)
- Independent directors (non-executives and supervisory board members)
- Mandatory bid rule
- Sell out rule
- Cumulative voting
- Veto on the appointment of independent directors (UK)

EU Takeover Directive: Principles

 - All holders of securities of the target company must be treated equally
- They must have sufficient time and information to reach a properly informed decision on
the bid
- The offeror may only announce a bid if they have sufficient financial resources
- To protect minority shareholders, anyone gaining control of a company must make a bid
at an equitable price at the earliest opportunity to all holders of securities

EU Takeover Directive: Mandatory Bid

- Article 5: Equal treatment of shareholder : Equitable price
If a bidder gains control over the company, it needs to make a bid for the shares of the minority
shareholder at a fair price.

** The Mandatory Bid rule does not exist anywhere, e.g. not in the US.

Mandatory Bid Rule outside Europe

The rule triggered when the bidder acquires an amount from the company, e.g.
- Australia and Canada 20%
- China and Hong Kong 30%
- Japan and Switzerland 33%
EU Takeover Directive: Board Neutrality Rule
- Article 9: The target company cannot adopt defensive measures without the approval of
the shareholders

TAKE A LOOK AT THEM FOR YOUR EXAMS!

EU Takeover Directive: Squeeze out and Sell out

- Article 16: Sell out rule
→ Member States shall ensure that a holder of remaining securities is able to require the
offeror to buy his/her securities from him or her at a fair price under the same
circumstances as provided for in article 15(2)

- Article 15: Squeeze out rule when 90% of the voting rights
→ Member states may set higher threshold up to 95%
→ Squeeze out the minority by buying their shares at fair price
----------------------------------------------------------------------------------------------------------------------

Theme 10: Criminal Liability

● Knowledge Clip 1: Corporate v Individual Liability

Network approach: Methodology that researchers use.
→ To the French system. A graph that presents the network. In the middle is the criminal court.
It can also be seen as the central to the French legal system and crossing point for many legal
domains. Crime and Punishment.
Basic Elements of Crime
4. Main elements: (remember not all crimes are the same) → The elements are simplification of
reality and very general
1. Actus reus
2. Mens rea
3. Concurrence
4. Causation
Working definition: ​Consider a crime as any act that is of criminal offense under the
jurisdiction

Actus reus (the physical part of the crime):​ The duty act. There is no crime without the
criminal act. Without actus reus, there is no crime even though there is mens rea.
- You must have a guilty mind, a guilty act
- Act must be voluntary
- Defendant must choose to act
- If the defendant has some sort of convulsions, that cannot support actus reus, e.g.
sleepwalking won’t be called voluntary.
- King v. Cogdon --- Defendant killed daughter while sleepwalking
- A person commits an offence only if he voluntarily engages in conduct, including an act,
an omission or possession
Act→ Physical movement, not thoughts or status.

Mens rea (mental part of the crime, blameworthiness)​: Guilty mind/ criminal intent. Guilty
thoughts must be linked to an act. Criminal justice system occasionally recognised offensive act
that may be committed in the absence of guilty mind

Concurrence​: Between the act and the intent. Act and Intent usually happen at the same time,
they can also be divided by time. E.g. Imagine that last week someone wanted to murder you
for not uploading the video on time. You enjoyed the video so you love me again. But by
accident, you hit me with a bike. Would you be chraged with murder? Probably but there you
won’t be charged with the degree of intention, there is no concurrence between your intention
and the act

Causation​: Causal relationship between the act and the harm done to the victim

White-Collar Crimes
- White Collar -- First time the term is used in ‘White-Collar Criminality (Edwin Sutherland,
1940)
- Not a legal term but we define it as a crime committed by a person of high social status
in the course of his occupation

Criteria:
1. A crime
2. Committed by a person of respectability and high social status
 3. In the course of his/her occupation

E.g. Theft, Bribery, Embezzlement, Tax evasion, Misappropriation of funds, Insider Trading
(When an employee of the company trade shares using the inside information that he has, this
is usually forbidden by moral security law)

Corporate Crimes
- No precise definition
- Covers a very wide range of offences
- Definition by K. Williams, ‘Illegal act of omission or commission, punishable by a criminal
sanction, which is committed by employees of a legitimate organization, and which is
intended to contribute to the achievement, goals or other objectives thought to be
important to the organisation as a whole or some sub-unit within it, and which has a
serious physical or economic impact on employees, the general public, consumers,
corporate organizations or government’
→ Need to be presence of a legitimate organisation
E.g. Cartels, Environmental pollution, Faulty manufacturing of dangerous products, corruption of
public office, falsification of financial statements

White-Collar v. Corporate Crime

Distinction: Who gains?
→ who is the party that potentially gain from this

White-collar crime: Violation of trust --crime against the corporation, the individual benefit
→ Punishment for an individual

Corporate crime -- Crime committed for the corporation, the corporation will at the end gain
→ carry liability for the corporation itself

Corporate liability v. Individual liability

- Main goal of both forms of liability: Deterrence
- Sanctions on the corporation for the acts of its managers and employees
- Shareholders bear the consequences
- Shareholders can influence the behavior of corporation managers and employees
- Make sure no such wrong doings occur. However, monitoring the managers and hiring
outsider are expensive and it’s rarely doable because you can’t monitor them 24/7 all
year long

Liability= legal responsibility

The main goal of both forms of liability is deterrence. You want to prevent corporate agents to
committee wrongs in the future.
- Corporate liability means that we will put sanctions on the corporation where's individual
liability holds the individual responsible. Corporate liability does not work in such a direct
manner, rather in an indirect way.
Corporate liability
Some arguments for imposing corporate liability:
- Agents are judgment-proof → individuals do not have enough assets to cover damages
mentioned by the court. Victims should receive appropriate compensation. In this case,
maybe it’s better to punish the corporation, they have more assets.

- Risk-sharing between principles and agents → If the manager is to bear the full legal
risk, they would ask for an appropriate compensation already up front, e.g. high salary to
cover any potential legal risks. Economically, if shareholders are to bear legal risk, it will
be cheaper for the corporation because investors can diversify their risks, they would not
be compensated as high as managers would be.

- Sometimes individuals are not identifiable→ not easy to point a finger in a corporation

- Can address issues that arise from misconduct from mid-level employees but driven by
senior management→ Most corporate crimes are initiated by the high-managers but
sometimes they are not directly involved. They know how to protect themselves, they are
smart. They either knew and participated in the criminal act or they knew but they didn’t
do anything to prevent this from happening

- Provides incentives to implement effective compliance programs

- Hard to prove that directors did not fulfill their duties

● Knowledge Clip 2: Corporate Criminal Liability

After deciding to punish the corporation, there is a decision to be made: Whether to enforce
criminal or corporate civil liability for the wrongful act

Corporate criminal liability v. Corporate civil liability

Four arguments in favour of ​corporate criminal liability:

1. Strong procedural protection for the defendant: Both in the pro or against argument of
corporate criminal liability. The defendant enjoys more procedural rights, in criminal law
we have to prove something beyond reasonable doubt, make sure no innocent person
receives the punishment. Argue in this case: WE are just imposing an unnecessarily high
burden on the prosecution. Therefore, the lower civil standard may be more desirable in
this context.

2. More powerful enforcement: Especially in cases where private enforcement is not likely.
E.g. Environmental pollution, residents may have no idea that their water is polluted.
They don’t have proper instruments to measure it, very expensive for one person to
bring a case. Many people have to join the case, contamination cost etc.

3. More severe sanctions

 4. Greater message-sending role Social stigma. When something is said to be a crime, it
has more consequence for the reputation of the corporation. If the corporation went to
court with another party, it’s something normal for us.

Criticism of imposing criminal liability:

1. Some of the sanctions under criminal law make no sense for corporations, e.g.
imprisonment. If you are criminally liable, you face some jail time but we can’t jail
corporations!

2. There are equally severe sanctions under civil law: We are mostly working with fines.
Fines are equally big, licenses can be removed under civil liability as well.

3. Administration costs are larger for criminal litigation: Take criminal proceeding more
seriously, the cost for society is higher too.

4. Discrepancies between enforcement powers in public criminal and public civil cases are
negligible: Enforcement power is quite high, police can enter premises, people can be
detained, something we don’t have under misconduct. These powers are already
negligible.

Civil liability: Refer to the situation or possibility of private people to sue for damages or personal
injury from another person in court. These are very basic distinctions. Civil liability can also be
enforced by public bodies.

Sanctions
- Legal sanctions: ​Fines, corporate probation, loss of license etc (Imprisonment is not
applicable in the corporate context)

- Social sanctions: ​e.g. lost of reputation or stigma on the corporation and its
management e.g. Anderson scandal. Although the court still allow them to run the
business, the company is dissolved because no one trusts them anymore

Some sanctions are harsh on the corporation and ceases its existence, destroy their business
eg. loss of license. Social sanctions reserved for criminalising the conduct of the corporation.

Corporate Criminal Liability

- In the early 16th-17th century corporations could not be criminally liable both in US and
in the EU
- Aggregate theory
- Corporation has its own rights, obligations, assets and liabilities
- 4 obstacles:
 1. Attributing acts to juristic fiction
2. No moral blameworthiness necessary to commit a crime of intent → Also a consequence
of aggregate theory
3. Ultra vires doctrine: Since the life of the Corporation is determined by its Charter, every
act that is outside the Charter is outside the power of a corporation
4. Literal and understanding of the judges of the criminal procedure: The defendant needs
to be put to jail

** First two very hard to overcome

Court now look at the conduct of the agent

Early 20th century: Court extended criminal liability to crime of intent → Criticism: The
punishment of the morally wrong individuals, corporate criminal liability rewrites the legal
construct of liability. Liability that is attributed not to personal fault

Civil liability also exists and operates with a similar doctrine. Why do we need criminal liability?
It’s the only way to punish not only the person but also the corporation

Alternatives to Corporate Criminal liability

- Administrative sanctions
- Corporate civil liability
- Managers’ personal liability (Civil and criminal)

Whether individual liability is better than corporate liability: We should argue which liability
regime defers? Managers or employees better

Most jurisdictions use a mixture of all of these when addressing a wrongful conduct. E.g.
Volkswagen case.

● Knowledge Clip 3 (Corporate criminal liability US, UK, AU)

US Criminal liability
- Very broad scope of criminal liability
- Corporations can be criminally liable for almost any crime with some exceptions e.g.
murder or rape
- Mechanism: Attributing the acts of the corporate agent to the corporation

3 elements: to attribute criminal liability to the corporations in the US

1. Corporate agent must have committed an illegal act (actus reus) with the requisite state
of mind (mens rea)
2. Agent acted within the scope of his employment e.g. there is a corporate charter that
says many employees should not bribe public officials yet one of them does so would
discount corporate crime. Can we attribute the act to the corporation?
3. Agent must have intended the benefit the corporation: Many times it is the agent
benefiting themselves, mostly won’t be a corporate crime
EU Criminal liability
- Originally in Europe criminal liability of corporations has not been recognized. There was
an understanding: Corporations cannot process duty minds necessarily for criminal
liability.
- More restrictive in scope than in the US
- FR and NL amended their codes only in 1990s; they include corporate criminal liability
- Germany still does not recognize criminal liability for corporations although right now
there is a proposal planning on this matter

Standard differs: How you attribute the act of the agent to the corporation: it’s still a contribution
or an attribution of the act of the agent to the corporation, it’s still the same mechanism

UK Criminal liability
- Less risk of criminal liability for corporations than in the USmodel
- Tesco principle from a case Tesco Supermarkets Ltd. Nattrass → Tesco offering
washing powder, once the discount is over, they put the normal one and charge the
customers normal price → fault advertising
- However Tesco argued that the act of the manager cannot be attributed to the
corporation because the manager did not represent the company as a whole, he was not
a director/ CEO/ senior level, he was just a local manager, following orders. Therefore
the Tesco principle established that: Mens rea and actus rea could be only attributable if
they could be traced directly to the upper layers corporate hierarchy, e.g. board of
directors and senior management who actually have decision making power

Australia Criminal liability

- Australian Criminal Code Part 2.5
- Corporate fault for the offence can be established, if the corporation: ‘expressively,
tacitly, or impliedly authorized or permitted the commission of the offence’
- Captures corporate culture that failed to promote compliance or tolerated
non-compliance (e.g joking about race, sex etc)
- ‘Mindset’ of the entity
- Strong incentive for self-regulation and self-monitoring own culture that is fair and won’t
lead to undesired behaviour
- There is no need of an express comment for the hierarchy, the word tacit serves the
purpose of fault corporate culture

● Knowledge Clip 4: The Volkswagen Emission Scandal

Fact of the case:​ VW intentionally re-programmed their diesel engines
- Affected 11 million cars from 2009-2015
- Emissions are harmful to human health and the environment
- First allegations come from the US Environmental Protection Agency
- VW blame it on some engineers and software people within the company
- VW’s Annual Report --EUR 16.4 billion for clean-up and legal costs
 - VW stock price fell with 40%
- VW suffered reputational losses

VW Legal proceedings: US
- VW was charged with
1. Conspiracy to defraud the US
2. Wire fraud
3. Violations of the Clean Air Act
4. Obstruction of justice
5. Entry of goods by false statements

VW legal strategy -- settlements

9 VW people including former CEO face criminal charges in the US

VW legal proceedings: Germany

- Public prosecution under 30 para. 1, 130 para. 1 of the German Act on Regulatory
Offenses (administrative fine of 1.2 billion euro)
- Former CEO faces fraud charges together with other executives and stock market
manipulation charges
- Class-action lawsuit (470000 owners of VW are suing VW)
- There is no corporate charges in Germany

In both jurisdictions, there is a mixture between corporate and individual liability.

Why engage in a corporate crime at all?
Committing a crime is a function of:
1. Probability to be caught
2. Level of punishment
3. Attitudes to risk

Why would the CEO do it?

Managers commit crimes because of incentives:
1. Their reward is tied to the performance of the company (the stock price of the
corporation, increases revenue)
2. Supervision may be misguided, they don’t have the incentive to properly monitor the
managers
3. Corporate governance may not be fit to address corporate externalities: Make sure the
corporate agents behave well towards the corporation but these mechanisms were not
designed to address corporate externalities