Corporate Law and Economics 1 Corporate Governance Codes

Corporate Law and Economics 1: Corporate Governance Codes and Directors Duties Simon Deakin University of Cambridge Lectures at Moscow State University, September 2013

Corporations: the legal view • • • Legal personality and asset partitioning Limited liability for shareholders Delegated management under the board Transferability of shares ‘Investor ownership’: voting, control and income rights of shareholders

Corporations: the economic view • The corporate form as ‘multi functional’ • A space for contracting: the company as ‘nexus of contracts’ (agency theory) • An ‘asset pool’ against which different groups (shareholders, creditors, employees, the state) have claims of different kinds (property rights theory) • A structure of governance: the corporation as a set of rules and conventions which shape bargaining and exchange (transaction cost economics) • The corporation as ‘associational cognition’: a structure for the organisation and retention of learning

What is governance? • ‘a governance system is the complex set of constraints shape the ex post bargaining over the quasi rents generated in the course of a relationship’ (Zingales) • Ex post bargaining matters because of ex ante incompleteness • Sources of governance: implicit and explicit contracts, property rights, default rules, external regulation, all make up the ‘institutional environment’

Elements of corporate governance • • • Allocation of residual ownership and control rights Capital structure of companies Board structure and composition Shareholder rights Institutional investors Takeovers Managerial incentives Employment contracts Insolvency law and creditors’ rights [and more…]

Varieties of corporate form • Investor-orientated: the company limited by share capital as a ‘capital cooperative’ • Customer-orientated: mutuals (retail cooperatives, friendly societies, industrial and provident societies, credit unions, mutual insurers, building societies) • Producer-orientated: professional partnerships (law firms, accountancy firms), employee cooperatives, producer cooperatives

Why ownership and regulation matter • Property rights confer ex post discretion on the holders of the ‘residual interest’ to adjust contracts in such a way as to maximise the surplus from production: hence different corporate forms correspond to a different set of ‘residual owners’ • In practice, though, property rights are subject to regulation, much of which is concerned with regulating inter-stakeholder conflicts and protecting third parties (insolvency law, employment law, tax law, enterprise liability – tort law, environmental law)

Justifications for shareholder rights in ‘open’ corporations • ‘shareholders are the residual claimants’ (Fama and Jensen) • ‘shareholders have most at risk’ (Williamson) • ‘shareholders’ claims cannot easily be contracted for externally’ (Hansmann, 1) • ‘governance costs are least for shareholders since their interests are most homogeneous’ (Hansmann, 2) • corporate forms minimise the sum total of (1) external contracting costs and (2) internal governing costs

Hansmann’s predictions • ownership is rarely pooled among different stakeholders • where factors (1) and (2) point in the same direction, that group will emerge as the residual claimants • where factors (1) and (2) point in different directions, it may be efficient to allocate control to ‘passive’ owners who at least have the assurance that no other group can then claim residual ownership • or, assign control to no single group: the ‘non-profit’ form

The separation of ownership and control • Advantages of separation: division of labour, reduced monitoring costs, better risk distribution • Disadvantages: high collective action costs of shareholder activism, managerial entrenchment, expropriation of minority shareholders, expropriation of non-shareholder stakeholders • Role of company law: (1) to facilitate separation (through limited liability and corporate personality) and (2) to compensate for its potential disadvantages • What is the role of the capital market? A public market for securities reduces shareholder lock-in and alters the balance of power between shareholders and managers, and between shareholders and other stakeholders

The firm as an entity: Robé • Need to distinguish the firm as a productive entity from the corporation as a legal device that shapes the business enterprise, both positively (by endowing it with organisational capacity) and negatively (by allowing regulatory avoidance and ‘gaming’) • The legal structuring of the firm’s management function is to be found in employment law • Health and safety law, product liability law as expressions of ‘enterprise liability’: legal recognition of CSR and multi-stakeholder governance?

Boards and shareholders The forms and functions of boards Directors’ legal duties Corporate governance codes Monitoring in practice: the role of NEDs; Enron The Japanese case: the companies with committees model • Responding to takeover bids: Takeover Code; recent Japanese experience • • •

Forms of boards • Anglo/American model: unitary board with mix of executive and non-executive directors; elected by shareholders • Continental European model: two-tier structure, management/supervisory boards; supervisory board contains nominees of employees, communities, etc. • Japanese model: traditional supervisory model (‘statutory auditors’); new company with committees model

Directors’ duties • Duty of loyalty: directors must avoid situations in which their interests conflict with those of the company (subject to a disclosure/approval rule) • Duty of care: directors must perform their tasks according to certain minimum standards of competence • Strategic decision-making: directors must act ‘in good faith in the interests of the company’ when taking decisions

Duty of loyalty • The ‘no conflicts’ rule applies to situations where a director exploits an opportunity for profit which properly ‘belongs’ to the company, or where the director engages in ‘self-dealing’ through the company; ‘insider dealing’ may give rise to possible breaches of these rule • Note however that the impact of many of these rules can be deflected if there is adequate disclosure and/or approval by the board and/or shareholders

Duty of care • In principle all directors, including NEDs, owe the same duty of care to the company, but the ‘subjective’ standard in re City Equitable (see also the Marquis of Bute’s case) means that the function and expertise of an individual director will be relevant in setting the requisite standard. • But this has beenchanging: s. 214 Insolvency Act 1986; Law Commission recommendations; s. 174 Companies Act 2006

The business judgment rule • In the United States, the courts have articulated the ‘business judgment’ rule, according to which the courts will not, in general, review decisions of the board taken in good faith in the interests of the company, with adequate information, and according to normal standards of prudence (similar conventions operate in the UK). • But the rule will not apply where there is selfdealing; and takeover bids may be special cases.

The duty of care in English law • In English law, directors’ duties have been framed so as to reflect the differing functions directors might perform in particular contexts • Traditional subjective test: Marquis of Bute’s case (1892) and City Equitable Fire Insurance case (1935), ‘decided with nonexecutive rather than executive directors in mind and, moreover, on the basis of a view that the non-executive director had no serious role to play within the company but was simply a piece of window-dressing’ (Davies, 2008) • New combined objective/subjective test; Re D’Jan of London Ltd. (1994); Law Commission report on directors’ duties (1997); DTI Company Law Review; now, s. 174, Companies Act 2006 • Company Directors Disqualification Act 1986

The new standard of care • Under s. 174 CA 2006, directors must exercise ‘the skill, care and diligence that would be exercised by a reasonably diligent person with (a) the general skill, knowledge and experience that may reasonably be expected of a person carrying out the same functions carried out by the director in relation to the company, and (b) the general knowledge, skills and experience that the director has’. • ‘although directors, both executive and non-executive, are subject to a uniform and objective duty of care, what the discharge of that duty requires in particular cases will not be uniform’ (Davies, 2008) • Higher standard for executives, but the objective standard for nonexecutives still requires them ‘to take reasonable steps to place themselves in a position to guide and monitor the management of the company ‘ (Daniels v. Anderson CA NSW, 1996)

Delegation • Delegation inevitable in practice, and recognised as such by the courts • But, directors (including non-executives) must put an effective internal control system in place (Turnbull Report (1999) informing Combined Code on Corporate Governance) • Disqualification of directors for failing to put effective controls in place: Re Barings plc (No. 5) (2000)

The Turnbull Report • Internal audit: the board has the duty to put in place an internal reporting and auditing system in order to enable it to make an appropriate assessment of risk • In practice this is more important than the duty of care in enhancing accountability of the board • Cf. Caremark case in US: only a sustained or systematic failure to exercise oversight will result in legal liability

Litigation against directors in the UK • Armour et al. (2009): only 24 claims against directors of plcs in 2004 -6 of which 6 involved listed companies; 3 of these were disqualification actions; of the remaining 3 only one was a claim for damages and it was struck out by the court (note, around 2, 000 listed companies in the UK) • In the US, there are (according to Armour et al. ) around 50 reported cases a year involving litigation against directors of publicly traded companies • ‘we cannot say with confidence that directors of UK publicly traded companies face no risk of being named as a defendant in a claim in English courts under UK company law, but we can say with reasonable confidence that the risk is very low’ • In fact, ‘directors of cross-listed UK public companies could be at a greater risk of being sued under corporate law in the US than in the UK’, e. g. , RSL Communications v. Bildirici (SDNY, 2006).

Disqualification in practice • There around 1, 500 disqualifications each year but hardly any affect listed companies, because they hardly ever become insolvent • Between 2004 and 2006, only 3 cases against directors of listed companies, involving 6 directors, only one of whom was a non-executive (Armour et al. , 2009) • Only one of these cases resulted in a disqualification, of an executive director for 10 years • In the US, no director disqualification regime, but SEC enforcement results in around 25 cases of individuals being barred from serving in listed companies each year (Karpoff, Lee and Martin)

Reactions to the financial crisis • Failure of 3 major banks in 2007 -8: Northern Rock, HBOS, RBS • Walker report: recommends additional powers for non -executives and strengthened internal controls • No evidence to link corporate failure in US to noncompliance with corporate governance standards (Cheffins, 2009); probably also true for UK • But, there is evidence that the very strong shareholdervalue orientation of UK banks was a consequence of demutualisation and increased competition in financial markets during the 1990 s and 2000 s (Cook, Deakin and Hughes, 2003)

Governance at Lehman Bros. • In the months prior to its bankruptcy, Lehman Bros. used SPVs and ‘repo’ transactions to give a false impression of earnings and profits • ‘Accounting engineering’ was acknowledged as such by senior executives • Nevertheless, the bankruptcy examiner has concluded that the Lehman board will most likely not face liability for breach of the duty of care: ‘in monitoring risk issues, the Board justifiably relied entirely on information provided by management’.

Questions arising from the Lehman bankruptcy • What could the board have done to ensure that they were more fully informed on the use of SPVs? • While (arguably) not committing a breach of the legal duty of care, did the board fail in its wider responsibilities to shareholders and other stakeholders?

US developments (source: Gordon) • Remarkable Empirical Fact: shift in board structure 1950 -2005 from 20% Independents to 75% Independents (under increasingly rigorous definitions of ‘independence’) • Cross-sectional empirical studies do not offer good explanations • What can explain this long term trend? • Two explanations tied to the entrenchment of the shareholder wealth maximizing paradigm

The Empirical Evidence on the rise of independent directors 28

Declining percentage of stock price variation explained by overall market movements, 1926 -1995 Source: Morck et al 29

Growth in 10 K’s, 1951 -2004 30

Corporate governance codes: the UK model • The Cadbury, Greenbury and Hampel codes • Pivotal role of the board: separation of CEO and Chairman roles; audit and remuneration committees; growing role for NEDs • Principle of accountability of management to shareholders, via the board • No formal voice for other stakeholders

The Cadbury Code • Separating management (execution) from governance (monitoring, oversight and stewardship) • Board structure: separation of chairman and CEO roles, increased role for non-executive directors (but not a majority: at least one third of the board should be non-executive, and the majority of the non-executives should be independent) • Formal internal audit: duty of board to inform itself of company’s risk profile (Turnbull report) • Shareholder value: Cadbury stressed accountability of managers to shareholders via the board; other stakeholders not mentioned; but some versions of the Code model do refer to stakeholder interests (OECD) and UK company law now makes a concession to them (‘enlightened shareholder value’: s. 172, Companies Act 2006)

Comply or explain • The Cadbury code gave companies the choice of complying with its guidelines, or explaining why they had not complied: voluntary compliance but mandatory disclosure, as a condition of stock exchange rules (now the UK Listing Rules) • Most countries adopting the UK model have a version of comply or explain but some make disclosure a legal duty

Background to Cadbury Code • Indirect US influence (Cadbury Committee aware of Penn Central case and US reaction to it) • But some elements of US practice missing: no poison pills, no shareholder litigation, so why did companies adopt the independent director route? • Institutional shareholder pressure highly focused in UK (cf. Armour/Skeel paper on takeover code) • Threat of legislative intervention in the background • Tradition of ‘self-regulation’ or ‘principle-based regulation’ established by City Code on Takeovers and Mergers (1960 s) • Comply or explain approach obviated need for mandatory law while appealing to managers and shareholders alike as a ‘market based solution’

Board structure in practice • Vast majority of listed companies have complied with the recommendation for a significant presence (after 2004 a majority) of independent directors on the board and have split the chairman/CEO roles, but many retain both present and former executives as board members • ‘Mixed’ board of executive and independent members is the norm, rather than the US-board with only the CEO representing management

Definition of ‘independence’ in Combined Code, A. 3. 1 • Board must identify the NEDs it ‘considers to be independent’ • Board must state why it considers a director to be independent if (inter alia) that person has recently been an employee of the company, has or has had a close business relationship with it, is or represents a major shareholder, has close ties with other directors (e. g. cross-directorships), receives remuneration in addition to a director’s fee, has been on the board for more than 9 years

Comply or explain in practice • No statistical link between compliance and performance (numerous studies) and some evidence that firms with a sizable number of independent directors perform worse than average • But, firms which do not comply and fully explain their noncompliance do better than those complying • Firms which complied only as a result of Cadbury do worse than those which were already complying • But, the stock market does not incorporate information about explanation, as opposed to compliance, in prices (Arcot and Bruno, 2007)

Developments in Japan • Background: weak performance of economy in 1990 s blamed, in part, on poor CG (‘lost decade’) • Traditional legal model: unitary board, but monitoring by ‘corporate auditors’ (similar to supervisory board in German model but with far fewer legal powers: no power to elect or dismiss directors; sole functions to review financial statements and monitor compliance with the law; in principle elected by shareholders but nominated by the board) • New model: company with committees law, 2002, but only optional, and auditor system strengthened at the same time (in both cases because of opposition to ‘global template’ from industry interests and skepticism from political class)

The ‘company with committees’ law of 2002 • Unitary board (no ‘corporate auditors’) based on separation of management and governance (new ‘corporate executive officer’ category below board level based on Sony model of late 1990 s) • Subcommittees for nomination, audit and remuneration • Requirement to have at least 3 directors on each committee, with a majority of outside directors on each • No requirement for the main board to have a majority of outside directors • Definition of outside directors did not mandate ‘independence’: ‘outside director’ could have affiliation with the parent company, or another subsidiary, or with a major shareholder of the company • Structure entirely optional (with no ‘comply or explain’ rule)

Interpretation • 2002 law not well suited to ‘screening’ or ‘signalling’ effects which could have separated shareholder-orientated firms from the rest, because of definition of ‘outside director’ (Gilson and Milhaupt, 2005) • But, the law did serve as a ‘catalyst’ for change, helping to reform and streamline managerial processes (Buchanan and Deakin, 2007) • Practice in ‘reformed’ and ‘unreformed’ companies quite similar; renewing the ‘community firm’? • ‘In order to stay the same, everything must change’ (or some things, at least)