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Course Number: LAWS 4010, Fall 2009

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LAWS4010 Business Associations I: Readings 1 TABLE OF CONTENTS Table of Contents..........................................................................................................2 INTRODUCTORY THEMES..................................................................................5 Introductory Themes: Introductory Stakeholder Analysis.......................................6 "Total disaster?...

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Business LAWS4010 Associations I: Readings 1 TABLE OF CONTENTS Table of Contents..........................................................................................................2 INTRODUCTORY THEMES..................................................................................5 Introductory Themes: Introductory Stakeholder Analysis.......................................6 "Total disaster? Absolutely", The Age, 12 September 2001 (http://www.theage.com.au/news/national/ 2001/09/12/FFXLBLXKGRC.html).......7 NSW launches inquiry into asbestos compensation........................................................10 How a devastating inquiry brought a firm to order.........................................................12 Directors: to whom do they owe care? ...........................................................................13 Thompson, R, "Preparing the Corporate Lawyer: Norms, Economics and Cognitive Learning", (2000) 34 Georgia Law Review 997 ......................................................16 Stokes, M, "Company Law and Legal Theory" in Wheeler, S (ed), A Reader on the Law of the Business Enterprise (1994), 80 at 80..............................................................20 Introductory Themes: Regulatory Goals and Approaches......................................21 Allen, W, "Contracts and Communities in Corporation Law", (1993) 50 Washington & Lee Law Review 1395..............................................................................................23 Allen, W, "Our Schizophrenic Conception of the Business Corporation", (1992) 14 Cardozo Law Review 261 at 262-270.......................................................................29 Corbett, A, "A Proposal for a More Responsive Approach to the Regulation of Corporate Governance" (1995) 23 Federal law Review 277 at 277-281...................34 Smith, D G, "The Shareholder Primacy Norm" (1998) 23 Iowa Journal of Corporate Law 277 at 277-278 and 280-283.............................................................................36 Blair, M and Stout, L, "Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law" (2001) 149 University of Pennsylvania Law Review 1735 at 17371745 and 1807-1810.................................................................................................39 Parkinson, J E, Corporate Power and Responsibility: Issues in the Theory of Company Law (1994) at 3, 21-25.............................................................................................45 White, B, "Feminist Foundations for the Law of Business: One Law and Economics Scholar's Survey and (Re)view" (1999) 10 UCLA Women's Law Journal 39 at 5164..............................................................................................................................48 Introductory Themes: Regulatory Environment......................................................53 Kingsford Smith, D, "Interpreting the Corporations Law -- Purpose, Practical Reasoning and the Public Interest", (1999) 21 Sydney Law Review 161................54 Whincop, M, "The Immanent Conservatism of Corporate Adjudication: Thoughts on Kingsford Smith's `Interpreting the Corporations Law' (2000) 22 Sydney Law Review 273...............................................................................................................65 CORPORATE EXISTENCE.................................................................................72 Corporate Existence: Bringing a Company into Existence.....................................73 Woodward, S (et al), Corporations Law: In Principle (5th ed) (2001) at 16-21..............74 Bottomley, S, "The Birds, the Beasts, and the Bat: Developing a Constitutionalist Theory of Corporate Regulation" (1999) 27 Federal Law Review 243....................78 Corporate Existence: Bringing a Company to a Close.............................................85 Miscellaneous Newspaper Reports................................................................................86 2 Costello, P, Second Reading Speech, Corporations Amendment (Repayment of Directors' Bonuses) Bill 2002, 16th October 2002, Hansard....................................92 Woodward, S (et al), Corporations Law: In Principle (6th ed) (2003) at 449-450..........94 CORPORATE DECISION-MAKING....................................................................................96 Corporate Decision-Making: Introduction...............................................................97 Stapledon, G, Institutional Shareholders and Corporate Governance (1996) at 7-9........98 Roe, M, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance (1994) at 3-17..............................................................................................99 Stokes, M, "Company Law and Legal Theory" in Wheeler, S (ed), A Reader on the Law of the Business Enterprise (1994), 80 at 80-84.......................................................106 Corporate Decision-Making: The Board of Directors...........................................110 Stokes, M, "Company Law and Legal Theory" in Wheeler, S (ed), A Reader on the Law of the Business Enterprise (1994), 80 at 85-98, 103...............................................111 Corporate Decision-Making: General Meeting of Shareholders...........................116 Ford, HAJ, Fords Principles of Corporations Law (2002) at 7.590-7.595.................117 CORPORATE PERSONALITY..........................................................................................123 Corporate Personality: General Principles.............................................................124 Cheffins, B, Company Law: Theory, Structure, and Operation (1997) at 496-508.......125 Corporate Personality: Implications for Tort and Criminal Law........................132 Walkovsky v Carlton (1966) 223 NE 2d 6....................................................................133 Fisse, B and Braithewaite, J, Corporations, Crime, and Accountability (1993) at 1-16 138 Ford, HAJ, Fords Principles of Corporations Law (2002) at 16.100-16.280.............145 Corporate Personality: Implications for Contract Law ........................................159 Ford, HAJ, Fords Principles of Corporations Law (2002) at 13.010-13.421.............160 CORPORATE GOVERNANCE..........................................................................................193 Corporate Governance: Introduction to Corporate Governance Theory and Issues ....................................................................................................................................194 Millon, D, "Communitarianism in Corporate Law: Foundations and Law Reform Strategies" in Mitchell, L (ed), Progressive Corporate Law (1995) 1 at 1-13.........196 Blair, M and Stout, L, "A Team Production Theory of Corporate Law", (1999) 85 Virginia Law Review 247 at 257-287.....................................................................205 Millon, D, "New Game Plan or Business as Usual? A Critique of the Team Production Model of Corporate Law" (2000) 86 Virginia Law Review 1001 at 1001-1004 and 1024-1042...............................................................................................................215 Hill, J, "Deconstructing Sunbeam -- Contemporary Issues in Corporate Governance", (1999) 67 University of Cincinnati Law Review 1099...........................................225 Corporate Governance: Introduction to Directors' Duties and Shareholder Remedies....................................................................................................................236 Redmond, P, "The Reform of Directors' Duties" in (1992) 15(1) University of New South Wales Law Journal 86 at 90-94 (footnotes omitted).....................................237 Blair, M and Stout, L, "A Team Production Theory of Corporate Law", (1999) 85 Virginia Law Review 247 at 287-292.....................................................................240 Blair, M and Stout, L, "A Team Production Theory of Corporate Law", (1999) 85 Virginia Law Review 247 at 298-305.....................................................................243 3 Hanrahan, P, Ramsay, I and Stapledon, G, Commercial Applications of Company Law (2002) at 322-324...................................................................................................247 Ramsay, I, "Corporate Governance, Shareholder Litigation and the Prospects for a Statutory Derivative Action", (1992) University of New South Wales Law Journal 149 at 151-156 (footnotes omitted).........................................................................249 Corporate Governance: Directors' Duties (1)........................................................252 Stokes, M, "Company Law and Legal Theory" in Wheeler, S (ed), A Reader on the Law of the Business Enterprise (1994), 80 at 98-103.....................................................253 Corporate Governance: Directors' Duties (2)........................................................257 Blair, M and Stout, L, "A Team Production Theory of Corporate Law", (1999) 85 Virginia Law Review 247 at 305-308.....................................................................258 Corporate Governance: Directors' Duties (3)........................................................261 Corporate Governance: Directors' Duties (4)........................................................262 Corporate Governance: Directors' Duties (5)........................................................263 Corporate Governance: Shareholder Remedies (1)...............................................264 Corporate Governance: Shareholder Remedies (2)...............................................265 Corporate Governance: Shareholder Remedies (3)...............................................266 Morgan v 45 Flers Ave Pty Ltd (1986) 10 ACLR 692 at 704.......................................267 Coombes v Dynasty Pty Ltd (194) 14 ACSR 60 ..........................................................268 Corporate Governance: Conclusion........................................................................270 CONCLUSION..............................................................................................................271 Conclusion: Corporate Groups (1)..........................................................................272 Companies & Securities Advisory Committee, Corporate Groups: Final Report (May 2000) at 1.1-1.57 (http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/CASAC_FINAL_REP ORT.pdf/$file/CASAC_FINAL_REPORT.pdf).....................................................273 Conclusion: Corporate Groups (2)..........................................................................288 Companies & Securities Advisory Committee, Corporate Groups: Final Report (May 2000) at 2.1-2.64, 2.74-2.76, 2.94-2.116 (http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/CASAC_FINAL_REP ORT.pdf/$file/CASAC_FINAL_REPORT.pdf).....................................................289 4 INTRODUCTORY THEMES 5 INTRODUCTORY THEMES: INTRODUCTORY STAKEHOLDER ANALYSIS This first set of readings introduces you to the array of skills you will need to solve corporate law problems. Throughout the Business Associations I course, you will be required to develop, test and finetune your own approach to corporate law problemsolving. Arguably, one basic step is to identify who are the human players -- the stakeholders, if you prefer -- who might be implicated in any corporate law problem. It is only by identifying who the stakeholders are, what their goals and interests are, and how these may intersect or conflict with what other stakeholders might want that you can begin to formulate the relevant legal issues. The media reports on the collapse of Ansett and the James Hardie matter provide some primary source material for tackling such a stakeholder analysis. The reading by Thompson reinforces the importance of stakeholder analysis for transactional lawyers. Thompson argues that stakeholder analysis requires the lawyer to interpret the personal, economic and psychological reasons why people enter into corporate transactions. The reading by Stokes --which you will revisit in fuller form later in the course -- suggests that, once the stakeholders are identified and potential legal issues formulated, technical mastery of corporate law doctrine is the next, logical step. Stokes (do not worry about the specifics of her argument, this will be revisited later) places a high value on the ability to both theorise about why the law is the way that it is and to evaluate whether or not corporate law is fulfilling its mission. All this suggests that corporate law problem-solving requires a mix of stakeholder analysis, doctrinal mastery, critical reflection on the core values and goals of the law, and expert evaluative judgment on the regulatory failures -- or successes -- of the current law. In Business Associations I, you will be assessed on all these skills, albeit in different combinations and permutations, in the assessment scheme. 6 "Total disaster? Absolutely", The Age, 12 September 2001 (http://www.theage.com.au/news/national/ 2001/09/12/FFXLBLXKGRC.html) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. As we now know, Ansett does not have cash to burn. Even so, in May this year it put aside $10 million to retrain staff. And what was it that required such radical re-alignment? They were saying "yes", instead of "absolutely". Ansett chief executive Gary Toomey gave an explanation to journalists. "If someone asks to hang up a coat, we say, `absolutely'," he said. "It's another way of saying, yes, sure, can do, undoubtedly, positively. In other words, absolutely." At the time, Ansett was losing about $1.3 million a day. In ordering staff at huge expense to change the way they spoke, Mr Toomey could have been accused of fiddling while Rome burnt. But what else could he do? Mr Toomey had joined Ansett just five months earlier, after a long career at Qantas. When he arrived and opened the books he would have found an airline in a parlous state. Ansett had gone from having a 56 per cent share of the domestic market six years ago to 39 per cent. It faced a projected loss of $400 million in the year to June, 2001. Essentially, it had been left to rot by the previous owners, TNT and News Ltd, which knew that Ansett needed new planes but did not want to invest $4 billion to buy them. Each sold its share. Mr Toomey set about trying to fix the mess, but just as he was thinking of ways to do it, the Civil Aviation Safety Authority grounded its fleet of 767s, citing "maintenance issues". The grounding was disastrous. Ansett had to borrow aircraft from its Star Alliance partners to move people around. The grounding cost $236,000 a day, and it was eight days before an Ansett 767 could fly again. On that day, Mr Toomey strode into Melbourne Airport, shaking the hands of customers that stayed loyal. Nervous staff stood around, serving cheese and crackers to passengers. But the damage was done. People had lost confidence in Ansett. Business clients, in particular, were leaving in droves, not least because Qantas sent out a team of sales people, determined to get them to move their accounts. Mr Toomey called an 7 emergency meeting of marketing staff and ordered Ansett's advertising agency, George Patterson Bates, to come up with a new, $20 million campaign to win back customers. The agency came up with a campaign around the slogan: "Absolutely everybody!" But they had only three days to film the new ads, then six days to get them to air. Decisions were made on the hop, in the backs of cars, and in aircraft hangars. Mr Toomey was working 20 hours a day. He did 150 media interviews in a week. The advertising journal Ad News reported in a front-page article that agency staff were complaining about working marriage-wrecking hours to meet Ansett's demands. At short notice the agency signed a few celebrities, mostly in exchange for free flights. The ads went to air, but the response was not good. According to some market research, one in five people surveyed did not recognise any of the celebrities. Mr Toomey realised it would need more than that to win back customers, and began toying with the idea of dumping the Ansett brand altogether and merging the airline with Air New Zealand to create a new image. One suggested name for this "hypothetical" airline was Pacific Sky. Mr Toomey sent Ansett's marketing people into Melbourne's leading advertising agencies to brief them on a "hypothetical" airline. Agencies that received the brief in early July complained that it was obscure, incredibly long and filled with typographical errors. One told Ad News: "These guys couldn't run a bath, let alone a major pitch." Mr Toomey then began another round of media interviews designed to show how committed he was to the company. He told The Age that he liked to keep an eye out for chewing gum on the floor, or worn carpet in the arrivals halls, because he was big on detail. Meanwhile, the company was spiralling closer to insolvency. In an effort to stay afloat, Mr Toomey then tried to buy Virgin Blue from Richard Branson. The deal would have given him new planes, and a cheaper operation. Sir Richard considered the offer, and then called a press conference in Sydney last Tuesday, where he pretended to accept it. But instead of selling out, he tore the "cheque" for $250 million into little pieces and let it fall to the ground like so much confetti. Ansett was horrified, but so, too, was Singapore Airlines, which is a partner with Sir Richard in Virgin Blue. So Mr Toomey played his last card, frantically lobbying the NZ Prime Minister to let Singapore Airlines buy more of Ansett's parent, Air New Zealand. His plan was to give Singapore Airlines shares in Air NZ in exchange for cash so he could save Ansett. But the New Zealand Government, which needed to approve the deal, let it slip that Ansett was losing $1.3 million a day, before tax, and before interest on its debts, and Singapore Airlines baulked. 8 This, then, was how it came to pass that Mr Toomey had to ask his former colleague, Geoff Dixon, at Qantas, to buy Ansett. Mr Toomey's offer to sell Ansett to Qantas was an admission that Ansett, as a business, was dead. Its parent company does not want it, and neither does Singapore Airlines. The Federal Government cannot bail it out. Only the Australian public, it seems, holds Ansett dear. This alone is unlikely to keep it aloft. 9 NSW launches inquiry into asbestos compensation Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. [This is the print version of story http://www.abc.net.au/worldtoday/content/2004/s1053967.htm] The World Today - Thursday, 26 February , 2004 12:18:51 Reporter: Nick Grimm HAMISH ROBERTSON: To a special commission of inquiry that's been set up in New South Wales to establish whether victims of asbestos-related disease were short-changed when the company which manufactured most of Australia's products containing the deadly fibre packed up and moved offshore. Three years ago James Hardie Industries moved its corporate headquarters to the Netherlands after setting up a charitable trust to fund outstanding compensation payouts. Now, after a blow out in compensation claims, the parent company denies any continuing liability for the health problems that its products have caused. Nick Grimm reports. NICK GRIMM: Once considered a wonder-product, asbestos has left a terrible legacy. Worst of all for the victims, it's usually taken the form of a slow and painful death. But as yesterday's announcement of an inquiry by the New South Wales Government demonstrates, its something those who were responsible for its mining, manufacture and use also find difficult to put behind them. PETER MACDONALD: Good evening everyone and welcome to the James Hardie conference call. I'm Peter Macdonald, CEO of James Hardie. NICK GRIMM: The Chief Executive of James Hardie Industries has not been available for interview since the announcement of the inquiry, but he did take part in a telephone link-up with the company's investors last night. PETER MACDONALD: James Hardie does expect and welcomes the commission as an opportunity to, as you like, clear the air about a lot of things that have been said and, we believe, have been said incorrectly. We'll cooperate and we expect to make submissions to the commission. NICK GRIMM: The New South Wales Government has announced its inquiry will examine the way in which, it says, James Hardie Industries quarantined itself from further liabilities by setting up an independent trust to fund compensation payouts. $300-million was set aside to meet those obligations, which are now estimated to be closer to $1-billion. But Peter Macdonald is adamant that the parent company is not liable for damages caused by its former subsidiaries. PETER MACDONALD: The establishment of a foundation was fair, legitimate and 10 transparent. The former parent company, that's James Hardie Industries Limited, board took expert advice at the time to determine the funds that should be provided and it did use the best available information. There was extensive consultation with acknowledged experts such as actuaries and other interested parties. The interests of claimants and shareholders were balanced and this was a very difficult decision, but the board of James Hardie Industries Limited at the time took that decision and made that balance, I think very responsibly. NICK GRIMM: And Peter Macdonald told investors that the new James Hardie parent group, known as JHINV, is now entirely independent of the company's old asbestos liabilities here in Australia. PETER MACDONALD: JHINV was not involved at all in the creation of the foundation. JHINV has not ever been involved in any asbestos claims and we cannot see any avenue by which JHINV can be involved in these matters. NICK GRIMM: Victims of asbestos-related diseases wish they too could be quarantined from the damage caused by the deadly fibre. Ella Sweeney has the lung disease asbestosis, which she believes she developed while working in a hospital during the 1970s, which was being renovated. ELLA SWEENEY: Well at the moment there's been a real epidemic. People that were being diagnosed, in particular with mesothelioma were men that were in their 60s, 70s, and 80s. Now it's men and women that are in their 30s, 40s and 50s. You know, all of these children that was around when people were still washing dad's clothes or renovating without even considering what the house was made of. NICK GRIMM: A former president of the Asbestos Disease Foundation of Australia, Ella Sweeney says the money James Hardie Industries set aside in the charitable foundation three years ago was always going to be inadequate. ELLA SWEENEY: Well I said the day that they had the media release on that, they rang me and asked me would I back them on it, and I said no I certainly would not, that as far as that was concerned or anybody with an asbestos-related disease, Hardie knew for decades before they stopped making asbestos products that are still being used today and are still in every house in Australia today, that the money that they had was pennies in comparison to the number of victims that are expected in the future. HAMISH ROBERTSON: Asbestosis sufferer and former president of the Asbestos Foundation of Australia, Ella Sweeney. That report from Nick Grimm. 11 How a devastating inquiry brought a firm to order Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. By Elisabeth Sexton August 14, 2004, www.smh.com.au Over four months of public hearings, David Jackson's devastating examination of the conduct and culture of James Hardie Industries produced some extraordinary moments of courtroom drama. He listened impassively as witnesses conceded to misleading asbestos victims, the NSW Government, the Supreme Court and the stock exchange. But the biggest revelation came just half an hour before the QC retiredto begin writing the report due on September 21. James Hardie's barrister, Tony Meagher, SC, must have known his client had one last chance to influence the outcome, and it needed to be good. Mr Jackson, 63, a specialist in High Court appeals, had driven the inquiry with energy and an unblinking response to the company's impressive legal firepower. Yesterday Mr Meagher said his client offered an open-ended sum to compensate everyone who developed asbestos diseases from the group's products. Some conditions are attached to how each case will be decided. But for the first time the offer is politically acceptable. It would not be an understatement to say the company was drawn kicking and screaming to that point. Since setting up a charitable trust to handle asbestos compensation in February 2001 it has maintained that it had no obligation to meet asbestos claims. On the contrary, directors had a duty not to "give away" shareholders' money if there was no legal call to do so. The first crack appeared in May when James Hardie cancelled a dividend to distribute proceeds of the sale of a US business. It would be "inappropriate to proceed with a return of capital to shareholders" while the inquiry was under way, said the chief executive, Peter Macdonald. However, the decision on dealing with the surplus cash was merely "deferred until later in the year". In June shareholders were warned that the outcome of the inquiry might involve "material costs" from lawsuits against the company. The first, vague, offer to contribute shareholder funds to asbestos victims came on July 14. Version two was put on the table on Thursday. The fact that the decisive rendition came as a cliffhanger finale to the public hearings reflects how much credit for the turnaround must go to Mr Jackson. Unions and asbestos groups have been fulminating against James Hardie since the trust was set up in 2001. The ammunition they needed to get their campaign on the national political agenda was provided by the painstaking work done by Mr Jackson and the team of investigators led by counsel assisting, John Sheahan, SC. The company's bravado visibly withered as the weeks wore on. Mr Jackson yesterday acknowledged that James Hardie's series of offers had been roundly criticised."But if one casts one's mind back to the commencement of the inquiry, the possibility then of their being made would have seemed remote." 12 Directors: to whom do they owe care? Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Elisabeth Sexton examines this difficult question in the light of the James Hardie case, July 4, 2005 http://www.smh.com.au/news/business/directors-to-whom-do-they-owecare/2005/07/03/1120329328502.html# If all goes well, within a month James Hardie Industries will sign an agreement with the NSW Government to compensate all those who fall ill from exposure to its asbestos products. The deal will end the anxiety that thousands of Australians suffering from fatal diseases for decades to come would be left financially vulnerable. But the sorry saga will not be over once the new source of funding is in place. Ten days ago, a federal parliamentary committee called for submissions on how to improve "corporate responsibility" for a report to be published in November. And the Howard Government has asked its statutory adviser, the Corporations and Markets Advisory Committee, to review the law on "directors' duties and corporate social responsibility". Such inquiries inevitably follow a scandal as big as Hardie's three-year refusal to meet the $1.7 billion shortfall in its previous compensation arrangements. The business sector is bracing itself for a push for fresh, unwelcome, regulation to satisfy the community's anger and provide reassurance that nothing similar will happen again. The political heat could dissipate if the 10-month-old investigation by the Australian Securities and Investments Commission leads to tough enforcement action. But the painstaking nature of such work means a result could come too late to influence the law reform drive. ASIC chairman Jeff Lucy told a Senate Estimates hearing last month that it could take another one to two years to gather all the necessary electronic information and it was "very early days as yet" in ASIC's review of the 200 boxes of paper documents already collected. In the meantime, the business lobby is distancing itself from the interpretation of the Corporations Act that Hardie relied on to justify walking away from asbestos victims. And even Hardie's chairwoman, Meredith Hellicar, is backing away from the previous company line that directors were prevented by their duties to shareholders from spending company funds on asbestos compensation. Both committees take this as their starting point. Last year's special commission of inquiry into the underfunding and headed by David Jackson, QC, discovered that the issue had long exercised the minds of Hardie executives and lawyers. Five years ago, when the company was exploring how to "separate" the modern, profitable, global building products operations from the "legacy" of two subsidiaries which had made asbestos products from 1937 until 1987, it consulted Tom Bathurst, QC. A Hardie executive, Wayne Attrill, took notes as Bathurst discussed the implications if the two subsidiaries became insolvent before all asbestos compensation claims were met. "If the parent company put no money into [the asbestos subsidiaries], fact of life," Attrill's notes record Bathurst saying. Thanks to the doctrine known as "the corporate veil" which limits the liability of group companies to meet each other's debts, there was no obligation to prop up the subsidiaries. Crucially, Bathurst added the rider that there was no legal barrier to doing so. "Directors could not be criticised for putting money into a subsidiary to enable it to pay its debts - no one would criticise them," he said. But this view from one of Sydney's top commercial barristers 13 apparently made little impression on his client. The top in-house lawyer, Peter Shafron, who rose to chief financial officer before he resigned at the height of the furore last October, explained to the Jackson inquiry how he had approached the issue in late 2000. "I was concerned that directors' duties owed to [the parent company] may not allow directors to resolve to give away value to the detriment of its shareholders and that doing so could expose them to legal actions, possibly a class action, by or on behalf of shareholders," Shafron's written witness statement said. When ownership of the two subsidiaries was transferred to a charitable foundation in February 2001, the tone was similar. Hardie said in briefings to stockbroking analysts and journalists that no further funds would be available if the money ran out. When that possibility was raised privately just two months later and became public in October 2003, Hardie stuck to the line that the Corporations Act constrained directors from relieving the financial plight of asbestos sufferers. "There can be no legal or other legitimate basis on which shareholders funds could be used to provide additional funds to the foundation and the duties of the company's directors would preclude them from doing so," Hardie told the stock exchange. But is the legal position so simple? "I don't think it's a universally held view," says the chief executive of the Australian Institute of Company Directors, Ralph Evans. "The duties of a director call for the director to bear in mind the interests of the company in its entirety and that means things like its reputation and its ability to carry on business in the community," says Evans, whose organisation boasts 20,000 members from large and small businesses. "If you take a long view of the interests of the company, it's quite appropriate for directors to take into account the circumstances in which the company operates and anything that might harm those interests in the long term." The Business Council of Australia comprises directors and executives from Australia's 100 largest companies. Its general manager, government and regulatory affairs, Steven Munchenberg, has been canvassing members as he prepares submissions to the two committee inquiries. "I haven't been able to find anyone who believes their duties to shareholders preclude them from taking into account the interests of other stakeholders to the extent that it's relevant to the business," says Munchenberg. "It's in a company's interests to be on good terms with the community within which it operates because when you are on bad terms with that community it manifests itself in poor sales and poor relations with government and therefore more regulatory problems. "It all erodes shareholder wealth if you don't have a constructive relationship with the community within which you operate." Hellicar, a director of Hardie since 1992 and chairman since August, concedes the company "completely misjudged that people would get up in arms". The company's public statements on duties to shareholders were "badly drafted", "inflammatory" and "not accompanied with any real communication with anyone", she says. But she argues they were needed to buy time to work out how to address the shortfall without running the risk that shareholders would abandon the company. "Directors' duties do constrain you because you can't send the company bankrupt and that's what people were asking us to do," she says. "No one can change legislation to make a company say 'we don't know how much it will be, we do know it's going to be paying for [legal and administrative costs] that shouldn't be there, we don't know if the company can afford it, we don't have a system for doing it that will make it legally effective, but we are signing a blank cheque'." She agrees all these issues could have been tackled much earlier. The foundation alerted Hardie to the problem in April 2001. It told the company it was approaching the NSW Government in February 2003, which set up the Jackson inquiry a year later. Hardie did not commission an expert actuarial study until June 2004. A month later the board suggested for the first time letting shareholders decide the issue for themselves. If the recent recovery in the Hardie share price is any guide, the meeting is likely to vote in favour 14 of devoting shareholders' funds to asbestos compensation. Such an outcome would undermine even more the original stance taken by the board. It would also give rise to the question of why the two committee inquiries now under way are focusing on the issue of shareholders' interests versus "stakeholders"' like asbestos sufferers. Reform of the law governing directors' duties to shareholders was not recommended by Jackson in his final report. He said there was no legal obligation on Hardie to fund the liabilities of the two asbestos companies "simply because they were its subsidiaries". However, if Hardie's directors thought it were in the best interests of the company to "separate" the subsidiaries because of their connection with asbestos, "it is hard to see why it would not have been in the interests of [the parent company] to provide the funding which was necessary to enable that to be done effectively". The chorus of views that Hardie's interpretation of the law was simply wrong suggests the two committees have set themselves an easy task. It also implies that the business community can relax, in the hope that a bit more humiliation of those responsible for the asbestos debacle will put the issues to rest. But there is a sleeper. While silent on the topic of directors' duties, Jackson did find that the Hardie case exposed "significant deficiencies in Australian corporate law". "The circumstances have raised in a pointed way the question whether existing laws concerning the operation of limited liability or the "corporate veil" within corporate groups adequately reflect contemporary public expectations and standards," he said. Legally, Hardie and its shareholders had the option of walking away from the asbestos subsidiaries and the compensation they owed the ill and dying. But Jackson questioned whether that should be so when the parent company "still has in its pockets the profits made by dealing in asbestos and those profits are large enough to satisfy most, perhaps all, of the claims of victims of James Hardie asbestos". Limited liability and the use of corporate groups governs many aspects of business life and plays a key role in encouraging productive risk-taking. The furore over Patrick Corp's use of subsidiaries to pursue its industrial relations strategy prompted reforms to enhance the rights of employees. In the unpredictable arena of politics, the Hardie scandal could put this topic back on the agenda. 15 Thompson, R, "Preparing the Corporate Lawyer: Norms, Economics and Cognitive Learning", (2000) 34 Georgia Law Review 997 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Just as law has particular relative advantages as compared to other professions and academic disciplines, the Business Associations course is suited to introduce particular knowledge and skills to law students. This Essay addresses three such areas beyond core corporate law doctrine: first, the extra-legal conditions and norms beyond the law that shape individual behavior in a business setting; second, economic models based on rational choice theory; and third, the learnings of cognitive disciplines that seek to provide a richer model of human behavior.... All three make a helpful contribution to the education of a transactional lawyer. 1. BEHAVIOR SHAPED BY LIMITS OTHER THAN LAW The study of business associations is necessarily a transactional course and often a student's first sustained exposure to markets. It necessarily requires students to look beyond the legal rules to understand the parties' motivations for entering into a business and into a particular business transaction. The first year of law school teaches a student to "think like a lawyer," including being able to organize large bodies of information and discern what is important and what is not. These skills and disciplines are quickly shown to be incomplete and inadequate without a basic understanding of relationships between parties that exist beyond the law. This lack of understanding can be vividly illustrated by the issues presented in corporate cases like Ringling v. Ringling Brothers-Barnum & Bailey Combined Shows, Inc. A student's brief might identify the issue in that case as whether a vote-pooling agreement among shareholders is illegal because it ties the hands of the shareholders contrary to usual corporate norms that prefer unfettered group decisionmaking. Even that phrasing of the issues, however, makes no sense unless students probe deeper to understand what led the two shareholders to make this contract and what caused one of the shareholders to dishonor the contract. John Ringling, the most flamboyant of five Ringling brothers, had sent the circus spiraling toward disaster by borrowing to purchase a competitor who had secured the traditional opening dates of the season at the old Madison Square Garden. The purchase unfortunately occurred on the cusp of what became the Great Depression. The ensuing financial debacle left the banks with significant control over the circus, much to the consternation of the family. It took a wonder-kid from the next generation, John Ringling North, to regain family control. His arrogance as savior, however, offended the two women who had inherited the remaining two-thirds of the stock of the circus following the death of all the members of the founding generation. These two controlling shareholders are the parties to the agreement at issue, and they worked in harmony for a short time to exclude North. It was the Great Hartford Circus Fire of 1944 that undid their alliance. The husband of one, who happened to be on the scene at the time of the fire, went to jail. The son of the other, who happened to be away at the time of the tragedy, did not and apparently showed little sympathy for the plight of his co-venturer. John 16 Ringling North saw his opening and went to jail on visiting day. The result was a defection of one shareholder, which led to the question about the agreement's enforceability. To be an effective lawyer, it is clearly insufficient only to know the law. Under Dodge v. Ford Motor Co., it is crucial to know that the complaining minority shareholders, the Dodge boys, were seeking to build their own car and Henry Ford was refusing to share the wealth. In a more recent case, Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., one must understand that the cosmetics firm was facing the indignity of a takeover by a grocery chain. The first thing, therefore, that ... students should take away from a Business Associations course is a thirst for understanding the environment outside the law. This approach has the additional advantage of permitting the students to see and appreciate the trade-offs between law, markets, and private ordering as alternative means to organize collective behavior. In addition, this approach allows them to recognize that the existence of an effective legal remedy lessens the need for markets or contracts, or vice-versa. Shareholders who have a means for exit will have less need for voice. This knowledge only comes when students understand both the legal environment and the non-legal environment. This approach leads naturally to a systematic discussion of norms and how human behavior is shaped by rules outside the law.... II. ECONOMIC PRINCIPLES AS A FOUNDATION FOR BUSINESS ASSOCIATIONS The Business Associations course provides an effective vehicle to give ... an understanding of the business environment using economic principles. Economics offers a simple, elegant, testable model that is generalizable, robust, and of sufficient magnitude to explain a useful number of situations. It presumes that people are able to assess and rank outcomes in terms of expected utility, and it assumes choices based on maximizing individual utility. The focus of economics on the capacity to accumulate and process available information complements the skills that students traditionally develop during the first year of law school. The economic approach and its focus on rational actors is useful to define a variety of repeat problems that arise in a business associations context and to suggest likely answers. For example, collective action problems abound throughout a Business Associations course. The rational apathy we attribute to public shareholders has been a core part of the central corporate governance problem for decades.... Generally these concepts from economics provide a systematic way to address when we should rely on law and still recognize what is left to private ordering. Transaction costs are frequently a part of these discussions. III. COGNITIVE LEARNING AS A BASIS TO ENRICH THE RATIONAL CHOICE MODEL For many, rational choice economics seems insufficient to describe the real world; there has been much effort of late to couple it with the learning of cognitive disciplines. This movement is motivated by the systematic deviations from the rational choice model that are observed in human behavior, including the demonstrated inability of individuals to follow axioms of rationality in at least some of their behavior. Some view the outcome of these challenges as chaos or irrationality. At the intersection of law, economics, and cognitive learning, however, the focus is on a richer version of the now traditional model in order to construct a better and more robust model that aspires to a fuller, more textured model of human decisionmaking. .... 17 [Psychologists have learned that human beings rely on mental shortcuts, which psychologists often refer to as "heuristics," to make complex decisions.] Many of these heuristics or shortcuts of behavioral economics are well-known and frequently applied outside corporate law. Those versed in statistics know of the impact of anchoring,1 availability and representativeness2 on how people process information. Hindsight bias3 will likely resonate with most readers, and there are other examples of heuristics that we regularly apply in processing information. Over-optimism is apparent in how people underestimate their risk potential and overestimate their own capabilities. The familiar application of these principles is one of many examples of how we conform new information to paths previously constructed. Perhaps the most ubiquitous contribution of this literature to the legal discussion in recent years has been the framing effect.4 The framing effect links outcomes to how questions are posed, for example as gains instead of losses or adding an irrelevant third option. .... Examples of how these heuristics might [explain particular doctrines in corporate law] ... include the following: the business judgment rule5 has been described as a response to the possibility of hindsight bias; the tendency for investors to overestimate some risks might be a factor supporting limited liability, at least in tort cases involving those kinds of risks. More generally, given the learning that regret is a common heuristic, limited liability serves as an incentive to address that heuristic; the heuristic that leads directors to be less critical in reviewing work of other directors was developed by the interdisciplinary work of Cox and Munsinger that goes beyond traditional concerns in corporate law to require that courts monitor self-dealing transactions more closely than duty of care transactions, to the point that the Delaware Supreme Court has talked about the risk of subconscious abuse. Donald Langevoort has more recently provided a richer model of how over-optimism can create the context in which managers make erroneous decisions. "Groupthink" can effect organizational decisions in a way that may add to biases. Business decisions evidence the mental accounting aspects of behavioral economics. Certain events are processed differently from uncertain events. This is a reasonable explanation for why limited liability and tax concerns trump governance issues in deciding choice of business form questions, for example, as between the use of a corporation, a partnership or limited liability company. The benefits of tax and limited liability are immediate and more certain. The benefits of governance rules are more distant and subject to influence by over-optimism and other heuristics such that participants can be expected to pay less attention to the consequences of governance rules in choosing a business form. ... ... Rational choice remains an accessible description of many behaviors and is worthwhile for students to understand as a generalizable model with limits. There are cognitive biases that cause decisionmakers to depart from such a model and prospective lawyers must be aware of those biases. Some can be countered by organizations or experts. But not all will. 1 2 [Anchoring is making estimates based on irrelevant starting points] [Representativeness is ignoring important background statistical information in favour of individuating information] 3 [Hindsight bias is perceiving past events to have been more predictable than they actually were] 4 [Framing is treating economically equivalent gains and losses differently] 5 [The business judgment rule allows directors a safe harbour from personal liability in relation to honest, informed and rational business decisions.] 18 Organizations bring their own biases, which remain relatively understudied. In addition, some heuristics may be "hard-wired" by nature. Some impose transaction costs that default rules or penalty default rules might better overcome. This cognitive model is not as simple and elegant as the rational choice model and to that extent is not as appealing to academic theorists, but then neither is the world. Figuring out what should be the relative relation between law, markets and private ordering is what transactional lawyers do best. That is the particular relative advantage of the Business Associations course. Adding behavioral economics and cognitive psychology to a rationalchoice model provides a fuller model that lets our students explain more of the world they will see as transactional lawyers.... 19 Stokes, M, "Company Law and Legal Theory" in Wheeler, S (ed), A Reader on the Law of the Business Enterprise (1994), 80 at 80 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Students of company law very often complain that the subject is technical, difficult and dull. This is not without some justification. The reason can perhaps be found in the fact that company law as an academic discipline boasts no long and distinguished pedigree. The result is that company lawyers lack an intellectual tradition which places the particular rules and doctrines of their discipline within a broader theoretical framework which gives meaning and coherence to them. One object of this essay will be to suggest such a theoretical framework. The framework aims to provide a tool for analysing and explaining many of the fundamental rules of company law. It will be argued that one of the central features of the business company is the way in which it centralizes the authority to manage the capital which it aggregates from its investors in the hands of corporate managers. Clearly the nature and extent of the power thus vested in the management of a company vary according to the type and size of the company. But whatever its extent the power of corporate managers poses a problem of legitimacy. This essay will seek to explain the nature of that problem. It will also endeavour to illustrate how much of company law can be understood as a response to the problem of the legitimacy of corporate managerial power. Thus the theoretical framework takes the legitimation of corporate managerial power to be one of the underlying and unifying themes of company law. More concretely, those areas of company law which are best viewed as a response to the problem of the legitimacy of corporate managerial power will be examined. Thus it will be shown how the changing popularity of a number of theoretical models of the company can be linked to the need to offer an explanation for the power which the company vests in corporate managers. Similarly, the rules allocating power between shareholders and directors and those imposing fiduciary duties on directors will be analysed in terms of the need to confer legitimacy upon the power of corporate management. A second object of this essay will be to show how the law's attempt to justify has failed. This in turn will lead us to an examination of how corporate law scholars have sought to offer new ways of legitimating corporate managerial power and how these too prove to be unequal to the task. Finally, some fresh methods by which managerial power might be justified will be explored. 20 INTRODUCTORY THEMES: REGULATORY GOALS AND APPROACHES The readings for this class introduce you to some basic theories about corporations and their regulation. These theories are important, because they offer a framework for explaining -- and even evaluating -- how the law manages the divergent interests of a company's various stakeholders. In this respect, this class builds on the previous class about stakeholder analysis: now that we have identified who the stakeholders are, the next task is to identify some possible policy options for how to organise and prioritise these competing interests. Theories about corporations and their regulation can serve two functions -- they may explain why the law is the way that it is (a descriptive function) or they may propose criteria for arguing what the law ought to be ( a normative function). Both are indispensable to corporate law problem-solving. The first assists the problem-solver see the `big picture' of corporate law and not get lost among all the technical details. The second helps the problem-solver evaluate the effectiveness (or otherwise) of the legal response to a certain problem and, if necessary, make a convincing case for reform. Such skills form part of the intellectual toolset necessary for value-added lawyering, effective policy-making, creative business decision-making or just informed participation in public debates. To make full use of the descriptive and normative potential of corporate law theory, corporate problem-solvers need to grapple with three key questions posed in the theoretical literature: First, what is the corporation? By characterising and contextualising the corporation, the subject of corporate law, lawyers can make sense of the structure of the law and assess whether it is fulfilling its regulatory promise; Second, how might the law regulate corporations? Lawyers need to identify the full range of potential methods for regulating the corporation to interpret the current regulatory design of the law and, if necessary, suggest alternative approaches. Third, what values or goals inform -- or should inform -- corporate law? The significance of this question lies in uncovering possible explanations for, and critiques of, the policy preferences underpinning corporate law. The first two extracts, both by Chancellor Allen of the Delaware Court of Chancery, provide a broad-brush sketch of the competing conceptions of the corporation. In the first article, Allen explains how the intellectual traditions of liberalism and socialism have spawned two alternative models of the corporation. In the second, Allen describes in greater depth these "private" and "social" conceptions. The third extract by Corbett overviews three approaches to regulation -- deregulation, "command and control" regulation and responsive regulation -- and explores how these different styles find expression in various parts of the (then) Corporations Law. Does Corbett suggest that subscribing to a particular conception of the corporation might lead to preferring one regulatory style to another? The final set of short readings articulate what "norms" -- or values -- underpin corporate law. Smith describes an economic rationale for corporate law based on wealth maximization. Blair and Stout pursue a behaviouralist line of argument, submitting that the law is aimed at facilitating trust and trustworthiness between and among 21 stakeholders. Parkinson submits that the function of corporate law is to serve the public interest. White, in a survey of the feminist literature on company law, outlines how the law embraces "masculinist values of separation, abstract rules, rights, and entitlements [rather than] the feminist ethic of care, connectedness, and responsibility." 22 Allen, W, "Contracts and Communities in Corporation Law", (1993) 50 Washington & Lee Law Review 1395 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Every general field of law embraces materials from which analysis can unearth the deepest questions that our social life recurringly presents to us. In some fields of law such questions lie near the surface, barely disguised by legal terminology and procedure. Most clearly, this is the case with the field of constitutional law, in which contests between claims of individual autonomy and claims of community are commonplace. But it is hardly less true of criminal law, with its basic questions of culpability and punishment, or of tort law or contract. Other fields of law -- one thinks of the various fields of commercial law, of intellectual property, or of taxation -- appear or are more technical, more narrowly "legal." In such fields, legal problems may seem less pregnant with potentialities and answers may seem, and thankfully sometimes are, less controversial. It is easy in such fields to lose sight of -- indeed it may sometimes be difficult to ever catch a first glimpse of -- the contestable philosophical or political presuppositions that lie at their foundations, buried beneath the legal superstructure. Corporation law is such a field. In this short essay I offer, in brief summary, some thoughts about the controversial philosophical foundations of contemporary corporation law.... I. I begin with the observation that a fundamental (if perhaps primitive) taxonomy of our intellectual life might perceive two contrasting models of human action, each bottomed on a different view of what it means to be a human being in society. Complex and contradictory real life, of course, cannot be fully captured by either model. A. The Liberal-Utilitarian Model The first of the two competing paradigms can be represented as the classical liberal paradigm. Finding its roots in the work of Hobbes, Locke, and Smith, and importantly shaped by the work of Bentham and Mill, this perspective reached full development in the thought of Herbert Spencer. The classical liberal paradigm describes the social world as populated by individuals rationally (if sometimes imperfectly so) pursuing their own vision of the good life. In this model -- ideally -- legal institutions keep the peace, define and protect property and contract and ameliorate problems that individuals cannot effectively resolve through bargaining. For classical liberals, the law is positivistic and should be utilitarian. Thus, ideally, the law should be a clear set of rules that facilitate the private ordering of human affairs. If the law comprised such a set of clear rules, individuals would have maximum control over their condition, and presumably free bargaining would lead towards better states of the world. An incidental cost of a system of clear rules will be that attempted transactions will occasionally fail to comply with the rules and will, as a result, collapse, causing unexpected disappointment or even injury. That fact is regrettable, of course, but classical liberals also see it as a necessary cost of a beneficial system of clear rules. Distribution of gains and losses is a secondary concern in this model. 23 Under the liberal-utilitarian model, the law creating and protecting property rights and the law enforcing contracts is the law of greatest importance to our welfare. The legal value of the highest rank in this classical liberal view is, I suppose, human liberty, and the greatest evil is oppression by the leviathan state. B. The Social Model The classical liberal mind-set found its widest and deepest acceptance in English and American thought of the nineteenth century. I think of the contrasting approach as being grounded in the dominant concepts of continental Europe and a yet earlier age. If, with respect to economic relations, Spencer is the most complete liberal-utilitarian, Emile Durkheim is the most important voice of the contrary view. This alternative paradigm describes the world as populated not by atomistic rational maximizers, but by persons of limited rationality who lead lives embedded in a social context, in a community. That context includes traditions from which persons draw valued ethnic or religious identification. It includes communities or groups with worked-out moral codes, claiming various degrees of solidarity with the individual, and it includes affective relationships with others such as families and neighbors. This alternative paradigm is the social model of human action. For those holding this perspective, individual autonomy and rationality are a part of the truth of human life, but their significance can easily be exaggerated. While proponents of the social model of human life would concede that property and contract law are useful in promoting productive social life, those holding this perspective see them as partial and assert that their utility rests in part on presupposition of shared norms including those of fairness and trust. Those holding this perspective are more willing to regulate and define the legal institutions of property and contract in service of social values. For them, for example, legal protections for fallible or disadvantaged persons, such as limitations upon the enforceability of bargains, are appropriate. While the liberal model seeks rules that are clear ex ante in order to facilitate future transactions, the social model of law can tolerate ambiguity in rules in order to promote outcomes that, when viewed ex post, are seen as fair. Standards and principles are seen as more useful than rigid rules. Instead of clarity, rules, under this model, may sensibly require individuals to act "reasonably" or may void "unconscionable" contracts; courts may apply "balancing tests." Indeed, the social model may sometimes regard rules as less important than relationships. The centuries-old law of fiduciary duty is the best example in our law of what I have called the social paradigm. In the law of fiduciary duties, the integrity of relationships of trust and the protection of dependents by a relatively openended, morality-based fiduciary duty of loyalty have great importance. In the social model, courts are not solely concerned with building and maintaining a system of general rules that is justified by its future utility to private bargainers. Rather, doing justice among the parties to a lawsuit based upon the very particular facts of the case is seen as a purpose of adjudication. An adjudication is seen as an end in itself in a sense, not a heuristic or pedagogic device intended to guide future conduct of others. The social model therefore may tend towards pragmatism, in the sense that "just" results are seen as crafted things that result from the responsible use of all of the available and pertinent materials, but not in any predetermined way. Compared to a liberal positivist, a judge who modeled her professional actions on the social model would be less afraid to find her perceptions of the general moral sentiments of the community to be relevant to her judgment. For such a judge, the law would be a constant working out of the just solution in a highly particular, but principled way. Except where legislation excluded all ambiguity, legal rules would be treated as "general rules" subject to growth and development in future particularized contexts. 24 I suppose that the legal value of the highest rank in the social model is not liberty, but justice, and the bete noire is not suffocation or slavery, but alienation. II. Until rather recently the liberal-utilitarian explanation and prescription for the social order of our economy did not focus upon what happened (or what should happen) within corporations. The "market" focus of the perspective implied that the internal operation of corporate actors was no more interesting than the internal operation of human actors. In a long ignored but now famous 1937 article, Ronald Coase for the first time offered a theory that looked inside the firm. Coase asked why some transactions are accomplished within firms while others are accomplished in markets. This question and Coase's efficiency-based answer to it were finally taken up by economists in the 1970s, most notably by Armen Alchian and Harold Demsetz, Oliver Williamson, Michael Jensen and William Meckling and others. This work re-energized the field of institutional economics. This scholarship employed two related perspectives -- transaction cost economics and agency cost economics -- to generate both a conceptual account of why firms exist and why they are structured as they are, and a prescriptive account of how they should function. When applied by legal scholars to the institutional detail of corporation law, the agency cost perspective supplied for the first time a unified theory of corporation law. This work was carried on by a number of brilliant legal scholars. Perhaps most prominent in that effort have been Judge Frank Easterbrook and Professor Daniel Fischel, the authors of The Economic Structure of Corporate Law. The work of the law and economics scholars has come, I believe, to dominate the academic study of corporate law, even if some of the field's most respected minds remain among the unconverted. This work has left academic corporate law far more coherent than it had been and constitutes a substantial intellectual accomplishment. A. Nexus of Contracts The dominant legal academic view does not describe the corporation as a social institution. Rather, the corporation is seen as the market writ small, a web of ongoing contracts (explicit or implicit) between various real persons. The notion that corporations are "persons" is seen as a weak and unimportant fiction. The corporation is regarded as a minor utilitarian invention designed to reduce the costs necessary to plan, coordinate and accomplish the complex contracts that large-scale ongoing projects would require. Since the corporate contract governs an ongoing venture, there is much that cannot be specified before the relationship among the real persons involved commences. Thus, a corporation can be seen as a form of relational contract, in which rather large contractual gaps will necessarily exist. The essence of the corporate form may therefore be seen, on this view, as the identification of structures or processes by which (1) persons will be designated to make certain sorts of discretionary judgments, and (2) those so designated will be monitored. Thus, in the dominant view, a corporation may be said most fundamentally to be a contractual governance structure. Corporate law is seen as a way to provide a standard set of instructions for the operation of such a governance structure. In the corporate charter much of this standard set can be replaced by terms better suited to the perceived needs of the parties involved, if that is efficient and desired, but the cheaper, "off-the-rack" terms set forth in the corporate statute will often serve well enough. United States corporate law is thus chiefly enabling in character, not regulatory. The transaction costs that corporation law can reduce include costs of negotiation and documentation of the corporate form, but in the dominant academic vision, most importantly 25 they include other so-called agency costs. Agency costs are all the costs incurred by a principal by reason of the utilization of an agent to manage the principal's property. In the nexus of contracts model, the principals are the residual risk bearers -- shareholders -- and the agents are directors and management. Agency costs include market rate salaries and other irreducible costs, but more importantly they include various forms of sub-optimizing behavior by agents. Certain implicit costs, for example, will arise from a disjunction between the kinds and amounts of investments made by agents and their principals and the returns available to each. In addition, shirking, empire-building or venal diversion of corporate property or prospects all constitute agency costs of the corporate form. It is, of course, a simplification to speak of a single economics-inspired theory of corporations. There is diversity and richness among the economists, too, running from those most closely associated with a neo-classical position (such as Michael Jensen, Easterbrook and Fischel) to those whose micro-analytic techniques and assumptions move them some distance from the liberal-utilitarian core (such as Williamson). These models, however, all share a view of persons as "undersocialized," self-interested maximizers. B. The Realist or Institutional Model Such is the dominance of the nexus of contracts model of the corporation in the legal academy that this symposium on new directions in corporate law can be understood only in opposition to this paradigm. One of the marks of a truly dominant intellectual paradigm is the difficulty people have in even imagining any alternative view. This is often the case in the legal academy with respect to the nexus of contracts model of the corporation. For many corporation law scholars this view is indisputably correct; its statement is seen as one of fact. Corporations, we are told, do not really exist; when we refer to one -- General Motors or RJR Nabisco, for example -- we are just using a rhetorical shortcut to refer to the vast network of contracts or implicit contracts that is the "reality." There is, of course, force in this position. But, as my simplistic analysis suggests, another view of corporations is possible. In opposition to the philosophical nominalism of economics stands the philosophical realism of sociology. To the philosophical realist, to call a corporation a network of contracts is to overlook an essential part of the empirical reality of social interactions "within" corporations. It implies that the circumstances that any participant in the enterprise may confront at any moment are fully accounted for by reference to one or more earlier negotiated (or implicit) bargains he or she made. This, to realists, is a palpably impoverished way to interpret much of what goes on within corporations. Contract, for example, can provide only a thin and weak account of the experience of long-term stockholders of a large public corporation that has recently started paying grossly excessive compensation to its senior management; or whose management wants to deploy a newly created "poison pill" to foreclose a hostile tender offer. Or consider an instance in which employees work especially diligently in order that a team, department or division can reach a production goal. It very plausibly could be the case that contract would provide only a very partial and inadequate explanation of their behavior. On the realist view corporations can be, indeed inevitably are, more than contracts. Actual bargains, explicit or implicit, provide an incomplete account of the social order we find in organizations. That social order can exist only because contracts are embedded in a social context that permits trust and expectations of fair dealing. More than a network of contracts, corporations are seen by realists as collective entities that have identities apart from those of any of the individuals who temporarily fill roles within them. The history of such an institution, the "culture" and values it comes to embody and the institutional goals it formally and informally moves toward affect in every sense (legal, social 26 or economic) the relationships among those who participate in the corporate enterprise. Such an institution to succeed over time must employ learning (about markets, about technology, about organization and about improving human skills). It must create and sustain an evolving capacity to learn to recall, to plan and to coordinate action. Achievement of corporate goals may depend importantly on the trust and loyalty of the human actors involved in circumstances in which monitoring and incentives are difficult and costly to establish and implement. The provision of pre-defined roles and rules in the ongoing organization and the socialpsychological processes of identification that successful organizations promote are seen by some as vital components of economic organizations that simply are not visible to the "network of contracts" vision of the firm. When Judge Easterbrook and Professor Fischel, for example, state that "everything to do with the relation between the firm and the suppliers of labor ... is contractual," they underline the word "everything." Those who tend towards the social model of human behavior see this sort of description of corporations as brittle, partial and flawed. Some of those who hold a social or realist perspective tend normatively to be concerned with a corrosive effect that interpreting social life as a continuous, self-interested negotiation may have. Thus they do not accept the assertion that corporate management owes a duty to exercise discretion so as to maximize financial returns to stockholders. Rather, they look for ways in which workers can participate in firm governance and thus gain a greater sense of the meaning of community membership. Perhaps incidentally, it is sometimes urged that steps that will increase worker engagement and responsibility will also increase corporate productivity. Seeing the business corporation as a social institution can supply justification for a variety of organizational forms that differ from the share value maximization model promoted by the dominant academic conception of the corporation. The social model, in one of its weaker forms, is highly consistent with the managerialist concept of the corporation that has, in fact, dominated the real world of business and politics since the great depression. That view sees senior management as empowered to give fair consideration to workers, communities, and suppliers as well as to suppliers of capital. The statutory law in more than half of the U.S. jurisdictions has arguably come to reflect the managerialist concept of the corporation. Equally evidently the social model of philosophical realists is consistent with various forms of worker involvement in management, such as may accompany an Employee Stock Ownership Plan (ESOP), and with worker representation, such as is present in the German codetermination structure. At its most extreme, this conception may yield more "radical" forms of corporate organizations, such as the kibbutz or other worker communes. .... IV. ... In the United States the liberal-utilitarian account of and prescription for corporate law is the dominant legal academic model and will remain so for some time. The coherence and power of the economic model, as it is applied to corporations, have for many an all but irresistible appeal. Moreover, in our pluralistic society, it may be especially difficult to formulate any alternative comprehensive theory of corporations that takes its animating power from a conception of human connectedness and responsibility. Finally, in an age of global competition and fading expectations, the plausible claims of greater efficiency (wealth 27 maximization) that the nexus of contracts theory makes also render this way of thinking powerfully attractive. Indeed, so powerful and pervasive are our concerns about global competitiveness that a more realistic and complex conception of corporations and corporate law could successfully be advanced only if it were premised on a plausible claim that such a model could lead to more productive organizations in utilitarian terms. Thus, while tensions arising from the fundamental divergence between self and community will continue in our corporation law, as elsewhere, my own supposition is that in the immediate future tentative resolution of this tension will not be worked out in a substantially different way than it has been in the past. But while I therefore doubt that we have yet come to a turn in the road of corporate law, it does not follow that it is not important for some academics to test and challenge the dominant paradigm and especially to try to broaden the base of social science data and theory that informs academic corporation law. The social sciences that attempt to grapple with the complexity, ambiguity and contradictions of rounded human actors in real life will probably be more difficult for legal academics constructively to employ than neo-classical economics has been, but some bridge-builders should be working on those spans now. The papers reported here and the work to which they refer offer hope to those who would welcome the articulation of legal theories of the corporation, and rules and principles of its governance, that take into account the complexity and contradictions contained within these organizations. 28 Allen, W, "Our Schizophrenic Conception of the Business Corporation", (1992) 14 Cardozo Law Review 261 at 262-270 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. My, assignment is to share some of. my thoughts about corporation law -- that body of statutes and case precedent that governs the internal organization and functioning of the legal. form within which the greatest part of our economic activity takes -- place.... While I want to be true to that specific purpose, I would like as well to use this occasion -- and these corporate law materials -- to try to make a broader point. That broader point which will seem trite to scholars is offered principally to the students. It is this: Corporation law and, indeed, the law generally, is not simply what it may seem at first, a comprehensive system of legal rules. While it is that, it is also a great deal more. People who think of law as a system of legal rules alone fail to understand that law is a social product, inevitably complex, at points inescapably ambiguous, and always dynamic -- always becoming something new. Of course, it is essential for the student of corporation law or of commercial law or constitutional law, to understand the legal rules that at any moment constitute the most elemental part of that body of law. But far more is necessary than that to achieve understanding of our legal order or of any part of it. In order to grasp the dynamic feature of legal rules, it is necessary to see them in their historical and social context. For while in one sense, legal rules exist "out there," constituting shared interpretations of our common legal culture, they are, as well, continually re-created within that culture through interpretation. We cannot begin to understand the processes of law, unless we try to place law in its rich historical and social context. The evolution of the concept of the corporation can help us see that.... I. TWO MODELS I want to discuss this most basic question: What is a corporation? I suggest that at least over the course of this century there have been, in our public life and in our law, two quite different and inconsistent ways to conceptualize the public corporation and legitimate its power. I will call them the property conception and the social entity conception.... Two inconsistent conceptions have dominated our thinking about corporations since the evolution of the large integrated business corporation in the late nineteenth century. Each conception could claim dominance for a particular period, or among one group or another, but neither has so commanded agreement as to exclude the other from the discourses of law or the thinking of business people. In the first conception. the. corporation is the private property of its stockholder-owners. The corporation's purpose is to advance the purposes of these owners (predominantly to increase their wealth), and the function of directors, as agents of the owners, is faithfully to advance the financial interests of the owners. I call this the property conception of the corporation, because it sees the corporation as the property of its stockholders. This model might almost as easily be called a contract model, because in its most radical form the corporation tends to 29 disappear, transformed from a substantial institution into just a stable corner of the market in which autonomous property owners freely contract. The second conception sees the corporation not as the private property of stockholders, but as a social institution. According to this view, the corporation is not strictly private; it is tinged with a public purpose. The corporation comes into being and continues as a legal entity only with government concurrence. The legal institutions of government grant a corporation its juridical personality, its characteristic limited liability, and its perpetual life. This conception sees this public facilitation as justified by the state's interest in promoting the general welfare. Thus, corporate purpose can be seen as including the advancement of the general welfare. The board of directors' duties extend beyond assuring investors a fair return, but include a duty of loyalty, in some sense, to all those interested in or affected by the corporation. This view could be labeled in a variety of ways: the managerialist conception, the institutionalist conception, or the social entity conception. All would be descriptive, since the corporation is seen as distinct from each of the individuals that happens to fill the social roles that its internal rules and culture define. The corporation itself is, in this view, capable of bearing legal and moral obligations. To law and economics scholars, who have been so influential in academic corporate law, this model is barely coherent and dangerously wrong.... Let me dilate upon these different views of the nature of the corporation.... A. The Property Conception At least by the mid-nineteenth century, when the movement to enact general laws of incorporation had become firmly planted, the corporation was seen in this country as an artificial creation of the state designed to enable individuals to associate together for state approved purposes. The emphasis was on the individuals -- the shareholders who had been constituted a corporation. There was a sense, but only a weak sense, of a distinctive, artificial corporate entity. The leading corporation law treatise of the mid-nineteenth century regarded corporations as similar to limited partnerships, in that each member exercised some control over the body's interests through his vote. When, for example, the Supreme Court of the United States in 1856 was asked by a shareholder to review the constitutionality of a state tax laid upon his corporation, the Supreme Court did not pause long on the question whether the individual had, in the circumstances, any right to assert the claim. The Court, unconcerned about the existence of a legal entity, marched very quickly to the merits. Consistent with a weak sense of a distinctive entity, corporate shareholders during this period did not enjoy the protection of limited liability to the same degree as they modernly do. Some state corporation statutes, for example, imposed liability on corporate shareholders in a variety of circumstances, Massachusetts being the famous example. Drastic corporate action, such as merger or sale of all assets, when authorized, required unanimous shareholder approval. The dominant perception was that the corporation; while an artificial entity, was essentially the stockholders in a special form. This perception colored the way in which the role and power of the board of directors was seen. When compared to what they would become, corporations in the mid to late nineteenth century appear to have been relatively frail conceptually, with boards of directors limited in power. Directors were seen as agents of stockholders. Thus, if towards the close of the last century one would have asked to whom directors owe a duty of loyalty, a confident answer could have been expected: The corporation is like a limited partnership; its property is equitably the property of the shareholders, The directors are elected by shareholders and it is unquestionably on their behalf that the directors are 30 bound to act. This view, with its genesis in the mid-nineteenth century, was plainly expressed in the law and, I suppose, was the view held beyond the legal community as well. This perspective is perhaps most pointedly captured. in the 1919 Michigan Supreme Court case of Dodge v. Ford Motor Co. You may recall the case. The Dodge brothers had sued Ford Motor Company in their capacities as shareholder. They complained that Henry Ford, who controlled the board of directors, was not sufficiently concerned with shareholder welfare. After paying out $1.2.million in dividends on $2 million of capital, Henry Ford had decided that Ford Motor Company would suspend further dividend payments indefinitely. The company was retaining $58 million in profits to be used to expand its business and lower the price of its products. Mr. Ford was quoted in the press as saying that the purpose of the corporation was to produce good products cheaply and to provide increasing employment at good wages and only incidentally to make money. The Dodge brothers asserted that the shareholders owned the enterprise and that they were entitled to force the directors to pay out some of those accumulated profits. The Michigan Supreme Court agreed: There should be no confusion ... of the duties which Mr. Ford. conceives that he and the stockholders owe to the general public and the duties which in law he and his codirectors owe to protesting, minority stockholders. A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of' the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes. The court commanded Ford to pay dividends. Dodge v. Ford Motor Co reflects as pure an example as exists of the property conception of the corporation. In this conception, the corporation is seen as it is in its nineteenth century roots, as essentially a sort of limited liability partnership. The rights of creditors, employees and others are strictly limited to statutory, contractual, and common law rights. Once the directors have satisfied those legal obligations, they have fully satisfied all claims of these "constituencies." This property view of. the nature of corporations, and of the duties owed by directors, equates the duty of directors with the duty to maximize profits of the firm for the benefit of shareholders This model of the public corporation is highly coherent and offers several alternative arguments to support the legitimacy of corporate power in our democracy. The first argument in favor of the property concept is political and normative. It is premised on the conclusionary notion that shareholders "own" the corporation, and asserts that to admit the propriety of nonprofit maximizing behavior is to approve agents spending other people's money in pursuit of their own perhaps eccentric, views of the public good. This can be seen as morally wrong without more. On a broader level, proponents this view assert that is repugnant to our democratic ideals to have corporate oligarchies determining which of many competing claimants for financial support should be awarded that support. Economists such as Kenneth Arrow, Fredrich Hayek, and Milton Friedman have asserted this view with conviction. This first argument in favor of a property conception of the corporation is weakest when it asserts that shareholders "own` corporate property and that it is, therefore, normatively wrong to expend their property for the benefit of another without shareholder consent. The premise of ownership simply assumes but does not justify an answer. This argument is strongest, however, when it asks whence comes the authority of corporate directors to make decisions on the basis of the public good. The second rationale for the property model is that the model and action consistent with it, maximizes wealth creation. This rationale asserts that the purposes of business corporations is 31 the creation of wealth, nothing else. It asserts that business corporations are not formed to assist in self-realization through social interaction; they are not formed to create jobs or to provide tax revenues; they are not formed to endow university departments or to pursue knowledge. All of these other things -- job creation, tax payments, research, and social interaction -- desirable as they may be, are said to be side effects of the pursuit of profit for the residual owners of the firm. This argument asserts that the creation of more wealth should always be the corporation's objective, regardless of who benefits. The sovereign's taxing and regulatory power can then address questions of social costs and re-distribution of wealth. Thus, profit maximizing behavior is seen as affording the best opportunity to satisfy human wants and is the most appropriate aim of corporation law policy. This second argument for the legitimacy of the corporation as shareholder property is not premised on the conclusion that shareholders do "own" the corporation in any ultimate sense, only on the premise that it can be better for all of us if we act as if they do. B. The Entity Conception The property conception of the corporation was the conception generally held during the nineteenth century and, as Dodge v. Ford Motor Co. reflects, in the early part of this century as well. But the last quarter of the nineteenth century saw the emergence of social forces that would oppose the conception of business corporations as simply the property of contracting stockholders. The scale and scope of modern integrated business enterprise that emerged in the late nineteenth century required distinctive professional management skills and huge capital investments that often necessitated risk sharing through dispersed stock ownership. National securities markets emerged and stockholders gradually came to look less like flesh and blood owners and more like investors who could slip in or out of a particular stock almost costlessly. These new giant business corporations came to seem to some people like independent entities, with purposes, duties, and loyalties of their own; purposes that might diverge in some respect from shareholder wealth maximization. Henry Ford's losing position in Dodge v. Ford Motor Co. reflected an idea that was in the air. Others saw these new corporate social actors as different. Owen Young, the President of General Electric, for example, stated in a public address during the 1920s as .follows: Managers [are] no longer attorneys for stockholders; they [are] becoming trustees of an institution. If you will pardon me for being personal, it makes a great deal of difference in my attitude toward my job as an executive officer of the General Electric Company whether I am a trustee of the institution or an attorney for the investor. If I am trustee, who are the beneficiaries of the trust? To whom do I owe my obligations? Mr Young went on to give his answer: As the chief officer of General Electric, he acknowledged an obligation to stockholders to pay "a fair rate of return"; but he also bore an obligation to labor, to customers, and lastly to the public, to whom he saw a duty to make sure the corporation functioned "in the public interest as a great and good citizen should." The secure wisdom of the nineteenth century, while convincing to the Michigan Supreme Court, was not strong enough to contain this alternative view of corporations as independent social actors who do not simply owe contract or other legal duties to those affected by its operation, but owe loyalty in some measure to all such persons as well. This social entity conception sees the purpose of the corporation as not individual but as social. Surely contributors of capital (stockholders and bondholders) must be assured a rate of 32 return sufficient to induce them to contribute their capital to the enterprise. But the corporation has other purposes of perhaps equal dignity: the satisfaction of consumer wants the provision of meaningful employment opportunities, and the making of a contribution to the public life of its communities. Resolving the often conflicting claims of these various corporate constituencies calls for judgment, indeed calls for wisdom, by the board of directors of the corporation. But in this view so single constituency's interest may significantly exclude other from fair consideration by the board. This view appears to have been the dominant view among business leaders for at least the last fifty years. The principal bases for a claim to legitimacy of director power under the entity theory is premised on utility claims. According to this view, managerial expertise and discretion is the essential ingredient for the effective functioning of the large-scale, multi-division business corporation. Our need for productive business enterprise commits us to the entity view, it is claimed, because it is corporate management, with its special organizational skills, that knows how to balance the claims made on the corporation in order to make large scale enterprise productive over the long-term. For the common good, those managements cannot be hobbled by a short-sighted orientation geared exclusively to stockholders. In claiming that management's unique expertise enables it to maximize corporate performance, and that its expert judgments about long-term value creation are more dependable than market valuation reflecting investor decisions, this utility basis for the legitimacy of the entity view directly challenges the premise of many economist critics that markets in widely traded securities value future prospects more dependably than does internal management. Thus, not surprisingly, proponents of both conceptions of the corporation base a claim to the validity of their view, in part, on a claim that accepting their perspective will enhance the economic productivity of corporations. 33 Corbett, A, "A Proposal for a More Responsive Approach to the Regulation of Corporate Governance" (1995) 23 Federal law Review 277 at 277-281 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. One of the primary consequences of the difficulties experienced by companies and by regulators in the decade of the 1980s has been a greater focus on corporate governance. The precise meaning and content of this expression is far from clear. It seems to be a term used to describe a number of related phenomena that are influencing the way in which companies are being managed, governed and regulated. The mode of governance of companies is being influenced by the growth in institutional investment, an increased focus on the role of the board of directors, increased levels of disclosure of financial information, as well as by the changing and developing roles of regulatory bodies such as the Australian Stock Exchange (ASX), the Australian Securities Commission(ASC), and the Australian Competition and Consumer Commission (ACCC). Amidst these concerns about corporate governance there is a deepening level of anxiety about some of the often used and well accepted approaches to regulation. In particular, a number of writers have focused on the tendency for regulatory authorities and governments to move between policies of de-regulation and what is often referred to as "command and control regulation". Policies of de-regulation are often concerned with reliance upon market mechanisms in order to ensure efficient production and delivery of goods and services. When the market mechanism is deemed to have failed, the policies of market regulation are replaced by policies which seek to interfere with, control or impede the operation of the relevant markets. The mechanisms for such interference are most often the imposition of rules upon specific participants and the enforcement of those rules by reliance on the application of sanctions or penalties. Many writers have now asked whether either of these regulatory "moves" can be viable or successful. They have also suggested that this approach to regulation produces a fundamental misunderstanding of the potential effectiveness of any form of regulation. This awareness of the failings of command and control regulation has led to a "search for a new conceptual basis for policy". There is no generally accepted view of what the "new conceptual basis" for regulation should be, but there is a range of ideas which are present in the proposals which seek to define the basis for a new approach. These proposals call for "responsive regulation" or regulation based upon a "constitutive" conception of the market. Underlying these proposals is the recognition of the limited capacity of law to modify or coerce participants to adopt different patterns of behaviour. This limited capacity of law to modify conduct is matched by the recognition that in any area of human conduct there is a range of regulatory mechanisms and that regulation by and through law is only one such mechanism that must integrate with, and compete with, these other mechanisms. In varying ways, these writers propose that regulation be concerned with identifying the framework of the market by defining the parameters within which participants make decisions and engage in transactions. Law in this sense is used as a guidance mechanism that establishes a process for defining the outlines of a market. 34 The debate about the appropriate form of regulation of corporate governance is following these divergent trends. Some recent changes to the Corporations Law, in particular the introduction of Part 3.2A dealing with the giving of financial benefits to related parties, are examples of the use of a command and control form of regulation. By contrast, an initiative such as the adoption by the ASX of Listing Rule 3C(3)(j), requiring disclosure of those corporate governance practices that have been adopted by companies, is an example of a more responsive form of regulation. The adoption of this listing rule is a form of responsive regulation in the sense that it recommends the establishment of a process to encourage the development of more effective systems of corporate governance. The central thesis of this article is that the debate about corporate governance in Australia is at an important turning-point. There is a general level of awareness concerning the failings of command and control regulation. The relatively broad acceptance of some of the advantages of "fuzzy law" arose out of an appreciation of the inherent failings in a "black letter law" approach. There is also an incipient awareness of the possibility of adopting new approaches. The changing view of the role of the ASX is an example of the broadening of the horizons of thought about approaches to regulation. The challenge at this point in the debate about the future structure of corporate governance is to identify a wider range of mechanisms for implementing a "responsive" or "constitutive" approach to its regulation. This challenge to adopt new approaches to the problem of regulation comes at an important time. This is made clear in Strictly Boardroom: At some point over the last several years the debate about what boards of directors ought do and be responsible for took a wrong turn. In almost every other area of economic life the debate has been about how various participants can improve the quality and volume of their productive contributions ... In contrast, the debate about directors has become preoccupied with criminality, fraud, negligence and minimum standards. The worry about the rotten apple -- and there have been a number -- has deflected attention from the main game of wealth creation which is, in turn, the driver of new investment and job creation. The remainder of the report proceeds to outline strategies for enhancing corporate governance without reference to the legally defined minimum standards. While it may be possible to disagree with Strictly Boardroom's statement of what the "main game" is, there is little doubt that the report is correct in stating that the focus on command and control regulation has diverted attention from the main game. The challenge to identify a wider range of ways to introduce a responsive or constitutive approach to the regulation of corporate governance is important precisely because it has the potential to integrate law and regulation into the main game. This itself is important not just because, from a lawyer's perspective, it is difficult to accept that the law is a peripheral point on a large map, but also because there will arguably be a better system of corporate governance if there is a wider range of institutions that are part of the overall matrix of corporate governance. 35 Smith, D G, "The Shareholder Primacy Norm" (1998) 23 Iowa Journal of Corporate Law 277 at 277-278 and 280-283 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. I. INTRODUCTION The structure of corporate law ensures that corporations generally operate in the interests of shareholders. Shareholders exercise control over corporations by electing directors, approving fundamental transactions, and bringing derivative suits on behalf of the corporation. Employees, creditors, suppliers, customers, and others may possess contractual claims against a corporation, but shareholders claim the corporation's heart. This shareholder-centric focus of corporate law is often referred to as shareholder primacy. Although shareholder primacy is manifest throughout the structure of corporate law, it is within the law relating to fiduciary duties that shareholder primacy finds its most direct expression. Corporate directors have a fiduciary duty to make decisions that are in the best interests of the shareholders. This aspect of fiduciary duty is often called the shareholder primacy norm. Although the shareholder primacy norm has had myriad formulations over time, the one most often quoted by modern scholars comes from the well-known case Dodge v. Ford Motor Co.: A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes. Legal scholars generally assume that the shareholder primacy norm is a major factor considered by boards of directors of publicly traded corporations in making ordinary business decisions and that changing the shareholder primacy norm would have an effect on the substance of those decisions. Stephen Bainbridge captured the prevailing sentiment exactly, asserting that "the shareholder wealth maximization norm ... has been fully internalized by American managers." ... II. THE SHAREHOLDER PRIMACY NORM IN PUBLICLY TRADED CORPORATIONS A. The Shareholder Primacy Norm in Legal Scholarship The assumption that the shareholder primacy norm is a major factor in the ordinary business decisions of boards of directors of modern, publicly traded corporations is pervasive in modern corporate law scholarship. The influence of the shareholder primacy norm seems so obvious that arguments among corporate law scholars typically leapfrog over descriptive aspects of the debate and rush straight to the normative question: should corporate law require 36 profit maximization? Perhaps the most surprising aspect of this debate is that scholars on all sides seem to embrace the assumed power of the shareholder primacy norm. The most frequent defender of the shareholder primacy norm in recent scholarship has been Stephen Bainbridge. In an article-length analysis of the normative implications of shareholder primacy, Bainbridge began with a descriptive assertion about the place of shareholder primacy in corporate law: "Despite a smattering of evidence to the contrary, the mainstream of corporate law remains committed to the principles espoused by the Dodge court." In a later article, Bainbridge made the link between the legal norm and business practice explicit, asserting that "the shareholder wealth maximization norm ... has been fully internalized by American managers." In fairness, Bainbridge recognizes that directors are not hell-bent on shareholder wealth maximization and sometimes consider the interests of other corporate constituencies. However, in Bainbridge's opinion, that the shareholder primacy norm "matters" seems beyond question. Bainbridge is an unabashed proponent of the contractarian view of corporate law which dominated scholarship in the 1980s. In recent years, contractarians have been subjected to a normative attack by a small group of self-proclaimed "communitarian" or "progressive" corporate law scholars. These scholars do not dispute the contractarians' descriptive claim that corporations are usually operated in the best interests of shareholders. What rankles the progressives is that the descriptive claim represents a state of affairs that they find repugnant. The primary item on the agenda of the progressives, therefore, has been to change corporate law in a way that accounts for the needs of nonshareholder constituencies. This agenda item has manifested itself most forcefully in the debate over nonshareholder constituency statutes. David Millon often writes as if the shareholder primacy norm were a major factor considered by directors in making ordinary business decisions. Millon believes "it is still clear that shareholder primacy has served as corporate law's governing norm for much of this century." Yet, Millon recognizes that corporate decision making is not based exclusively on shareholder primacy. He writes, "corporate law has always understood -- though usually only dimly -- that truly relentless pursuit of shareholder wealth maximization is inconsistent with actual business practice and socially unacceptable in any event." Despite this recognition, Millon maintains that this governing norm heavily influences corporate decision making, as illustrated by the following: Shareholder primacy mandates that management -- the corporation's directors and senior officers -- devote its energies to the advancement of shareholder interests. If pursuit of this objective conflicts with the interests of one or more of the corporation's nonshareholder constituencies, management is to disregard such competing considerations .... Efforts to maximize shareholder wealth are often costly to nonshareholders and often come at the expense of particular nonshareholder constituent groups. For example, a corporation may find that one of its several plants can no longer be operated profitably. Management's duty to the shareholders mandates that it consider closing the plant in order to avoid further losses. Doing so will result in lost jobs. Other members of the community in which the plant is located will suffer as well. Tax revenues will decline, as will charitable giving and other contributions of the corporation and its employees to the life of the community; established creditor, customer, and supplier relationships will be terminated, perhaps leading to further unemployment; and lost jobs will impose added strain on social services budgets. Shareholders gain (by avoiding losses) at the expense of these nonshareholders, many of whom have made nontransferable investments of human and financial capital with the reasonable expectation of a continued, long-term corporate relationship. Nevertheless, from a corporate law standpoint, none of these clearly foreseeable harms to nonshareholders are relevant to management's decisionmaking. Instead, management's duty is to focus solely on the interests of the corporation's shareholders, weighing the likely costs and benefits to them alone of closing the plant. 37 Many who study corporate law do not identify themselves as either contractarians or progressives, but they still express faith in the shareholder primacy norm. The American Bar Association's Committee on Corporate Laws, for example, seems to find no divergence between the aspiration of shareholder fidelity and director behavior when it states that "directors have fiduciary responsibilities to shareholders which, while allowing directors to give consideration to the interests of others, compel them to find some reasonable relationship to the long-term interests of shareholders when so doing." Modern corporate law scholarship, therefore, seems to have achieved consensus on this fact: the shareholder primacy norm is a major factor considered by boards of directors of publicly traded corporations in making ordinary business decisions. 38 Blair, M and Stout, L, "Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law" (2001) 149 University of Pennsylvania Law Review 1735 at 17371745 and 1807-1810 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. INTRODUCTION A corporation is a collective enterprise. Shareholders and creditors provide financial capital, while managers and employees offer up expertise, loyalty, and long hours. In making these contributions, individuals who participate in corporations often expose themselves to great risk of loss from other participants' failures or misbehavior. Yet investments are made, companies are built, and value is created from complex joint production. How is this done? Contemporary legal scholarship generally assumes that shareholders, creditors, managers, and employees cooperate with each other because the market and the law give them incentives to do so. In accord with conventional economic analysis, these parties are presumed to be rational actors concerned only with maximizing their own gains. Thus the primary factors thought to discourage corporate participants from stealing, shirking their duties, or otherwise mistreating each other are market incentives and legal rules, including contract rules. These assumptions are embedded in the modern view that the corporation is best understood as a "nexus of contracts," a collection of express and implied agreements voluntarily negotiated among the rationally selfish actors who join in the corporate enterprise. In this Article we take a different approach. Although we do not abandon economic analysis, we revisit one of its basic assumptions -- the assumption that people always behave in a rationally selfish fashion. We posit that corporate participants cooperate with each other not just because of external constraints, but because of internal ones. In particular, we argue that the behavioral phenomena of internalized trust and trustworthiness play important roles in discouraging opportunistic behavior among corporate participants. (Because these two behaviors are so closely linked, we sometimes refer to the combination as "trust behavior," or simply "trust." We contend that people often trust, and often behave trustworthily, to a far greater degree than can possibly be explained by legal or market incentives. Although this picture of internalized trust conflicts with the neoclassical portrait of homo economicus as a hyperrational, purely self-interested actor, it is supported not only by casual observation but by an overwhelming amount of empirical evidence. Decades of experimental work on human behavior in "social dilemmas" establishes that trust is a reality. This work also demonstrates that people do not trust randomly. To the contrary, a variety of factors have been identified that predictably elicit greater or lesser degrees of trust. One of the most important is social context -- individuals' perceptions of others' motivations, beliefs, likely behaviors, and relationships to themselves. By manipulating social context, experimenters can reliably produce everything from nearly universal trust to an almost complete absence of trust among subjects in social dilemmas. 39 These behavioral findings have enormous importance for a wide range of social and legal relationships and institutions in which cooperative, other-regarding behavior is of value. Examples include marriages, nonprofit firms, "relational" contracts, even the community as a whole. In this Article, however, we focus on one particular institution in which we believe trust plays an especially critical role -- the business corporation. We believe that an understanding of the role of trust and of the variables that encourage or discourage it is essential for understanding both the business world and much of corporate law. Focusing on the role of trust sheds light on a number of debates and difficulties in corporate scholarship. Examples include the nature of corporate fiduciary duties, the ways in which corporate case law constrains and directs behavior, and the puzzling persistence of cooperative patterns of behavior in firms in circumstances in which legal and market sanctions are ineffective or unavailable. Accordingly, we suggest there is tremendous value to be added by incorporating the phenomenon of trust into legal scholarship. There is also danger in failing to do so -- danger not only for academics but for lawmakers, practicing lawyers, and businessfolk. This is because one of the most important lessons of trust is that cooperation is not always best promoted by promising rewards and threatening punishments. To the contrary, attempts to employ external incentives can often reduce levels of trust and trustworthiness within the firm by eroding corporate participants' internal motivations. We begin our analysis in Part I by defining what we mean by "trust" and "trustworthiness." We describe trust as a willingness to make oneself vulnerable to another, based on the belief that the trusted person will choose not to exploit one's vulnerability (that is, will behave trustworthily). We then develop the idea of trustworthiness as an unwillingness to exploit a trusting person's vulnerability even when external rewards favor doing so. Our focus is on the importance of internal factors -- tastes, preferences, intrinsic character -- in producing trustworthiness that in turn encourages trust in others. We then turn to the question of why trust and trustworthiness may have special importance in business institutions. It is widely recognized that one of the most pressing economic problems associated with doing business in the corporate form is the "agency cost" problem of encouraging managers, employees, and other corporate agents faithfully to serve the firm's interests rather than their own. We have also recently argued elsewhere that a second key economic problem in corporations is the "team production" problem of encouraging corporate participants to make mutual investments that expose them to each other's opportunism. Market incentives and legal sanctions can reduce agency costs and foster team production to some extent. But markets and law work best when the situation is transparent and opportunistic behavior can be detected and punished. Trust can work even when the situation is opaque. As a result, business firms that cultivate and support trust can enjoy a competitive advantage over those that do not. This reality is well-recognized among management theorists and business consultants, who have produced an extensive literature on the importance of creating and maintaining trust within and between business organizations. The centrality of trust to business firms has been overlooked, however, by contractarian corporate scholars who emphasize market incentives, enforceable contracts, and other external constraints on opportunism within firms. Why is this so? Part of the answer may lie in the observation that trust behavior in business firms often occurs in circumstances in which cooperation is consistent with, rather than contrary to, external legal and market incentives. When a manager refrains from stealing, she may do this because she is intrinsically trustworthy, but she may also do it because she is afraid of being fired or ending up in jail. As a result, it can be tempting to assume that external incentives cause all the cooperative, coordinated behavior we observe. Legal scholars may be particularly prone to jump to this conclusion. Legal analysis focuses on case law, and case law usually involves situations in which trust and cooperation have broken down and the 40 parties seek to invoke legal sanctions. Hence, it may be especially easy for legal scholars to assume that it is the threat of the law that reins in misbehavior in all situations. We demonstrate in Part II that such an assumption is mistaken. We do this by reviewing the extensive empirical evidence that has been developed on trust, focusing particularly on experimental studies of behavior in "social dilemmas." Social scientists use the phrase "social dilemma" to refer to situations that present incentives resembling those in the more familiar "prisoner's dilemma" game, such that cooperating is the worst strategy for the individual but the best for the group as a whole. Experimental evidence of behavior in social dilemma games is highly relevant to trust for two reasons. First, the optimal outcome requires the players both to trust (to make themselves vulnerable by cooperating) and to be trustworthy (to refrain from "defecting" and exploiting the vulnerability of the other players). Second -- and in marked contrast to the business world, where trust behavior often is consistent with external incentives -- a social dilemma experiment can be structured to eliminate any possibility of external incentive for cooperation. Social dilemma experiments thus isolate and highlight the pervasive and powerful effects of internalized trust. What do social dilemma experiments teach us? Over the past four decades, experimenters have conducted hundreds of these studies. Five interesting and consistent results have emerged from these efforts. First, social dilemma experiments irrefutably demonstrate that human beings do not behave in the strictly individualistic and self-interested way that economic theory often implies they do. Rather, they behave as if they sometimes have a preference or "taste" for cooperative, other-regarding behavior generally and for trusting and trustworthy behavior specifically. Second, the evidence suggests that different individuals vary in their willingness to trust and to be trustworthy in new situations. Thirdly, these differences seem due at least in part to differences in experience, hinting that trust may be a learned behavior. But even among those inclined toward trust, their inclination is not absolute. A fourth fundamental finding of the social dilemma studies is that trust is socially contingent. Individuals in social dilemmas decide to cooperate or defect not primarily by calculating their individual payoffs but instead by looking at and trying to decipher others' beliefs, likely behaviors, and social relationships with themselves. For example, experimenters have found that cooperation in social dilemmas is dramatically enhanced when the experimenter states (or even hints) that the players ought to cooperate, when the players share a sense of group identity, and when the players expect their fellows to behave cooperatively. These are striking findings because such social variables do not change the economic structure of the game. Defecting remains the optimal strategy for the self-interested player. The observation that social context plays a critical role in determining whether individuals trust or distrust should not be taken to imply, however, that economic variables are irrelevant. A fifth significant finding of social dilemma experiments is that, even while people cooperate far more than the homo economicus model would predict, trust behavior does respond to economic incentives. In particular, as the personal cost of choosing cooperation over defection rises for individual players, the likelihood of cooperation decreases. Although most people are willing to behave in an other-regarding fashion when the social context is right and the personal sacrifice involved is relatively small, as the cost of trust rises, trust tends to disappear. Taken as a whole, the experimental evidence consequently indicates that most people behave as if they have two personalities or preference functions. In some social contexts they are competitive and behave selfishly. But when the social conditions are right, their cooperative, other-regarding personalities emerge. Social "framing," tempered by considerations of personal costs, plays a critical role in determining whether or not individuals choose to trust and be trustworthy. 41 In Part III, we consider how the insights developed in Parts I and II shed light on three enduring puzzles in corporate scholarship. The first is the nature and meaning of the concept of fiduciary duty. We argue that the phenomenon of trust aids our understanding of the elusive idea of fiduciary obligation because it suggests that the essence of a fiduciary relationship is the legal expectation that the fiduciary will adopt the other-regarding preference function that is the hallmark of trustworthy behavior. Moreover, the law encourages fiduciaries to do this not only or even primarily by threatening punishment but by framing the relationship between the fiduciary and her beneficiary as one that calls for a psychological commitment to trustworthy, other-regarding behavior. This approach offers important insights into the bitter and ongoing debate between "contractarian" and "anticontractarian" corporate scholars over whether officers' and directors' fiduciary duties ought to be thought of as just another set of negotiable provisions in the nexus of contracts that supposedly makes up the firm. In particular, it supports the anticontractarian position that allowing corporate fiduciaries to "opt out" of their loyalty duties would undermine the principal function of the fiduciary concept -- to trigger trust behavior by signaling that the social context calls for trust. We then turn to a second mystery of corporate law -- the puzzling relationship between the corporate director's duty of care and the business judgment rule. Case law supposedly requires directors to exercise due care. This requirement, however, is rarely enforced. While judges frequently moralize about the importance of care, the business judgement rule and a variety of other doctrines and arrangements ensure that careless directors are largely immune from any realistic threat of monetary liability. If one views directors as purely self-interested actors, this inevitably raises the question of why directors of publicly held corporations (who are often significantly insulated from shareholders' -- or anyone's -- control) should be expected to exercise due care. The phenomenon of trust offers an answer. By articulating a social expectation that directors will exercise due care, judicial opinions on the duty of care may influence directors' behavior not so much by changing their external incentives as by changing their internal preferences. This approach explains the schizophrenic quality of modern case law on the duty of care, which generally exhorts directors to meet a high standard of behavior while simultaneously declining to impose liability for failing to meet that standard. Finally, we consider how trust highlights the potentially limited importance of law in promoting cooperation in firms. To illustrate, we consider the case of the closely held corporation. It is widely recognized that participants in closely held corporations face a high risk of loss from their fellow participants' opportunism and that legal and market incentives provide imperfect solutions to such mutual vulnerability. We explore how other forces can supplement the market and legal rules as means of deterring misbehavior in closely held firms. In particular, we consider how processes of self selection and partner selection may favor the participation of high-trust individuals in closely held firms while working to exclude those who are less likely to trust and be trustworthy. This approach suggests how cooperative relationships can develop and thrive in the absence of law or markets. It also illustrates how using legal rules, including contract, to discourage opportunistic behavior can, in some situations, be not only unnecessary but counterproductive, increasing the likelihood of the very sort of misbehavior against which it was intended to protect. We conclude in Part IV that the time has come to incorporate the reality of trust behavior into the analysis of corporations and corporate law. One of the most important lessons of the experimental evidence on trust behavior is that trust often depends on social context. Case law, statutes, lawyers' memoranda, and even scholars' writings are part of that context. When lawmakers, scholars, and practicing attorneys fail to take account of trust, they may not only fail to understand behavior within the firm -- they may distort it. 42 .... CONCLUSION Economic theory has yielded great insights into the nature of the business firm and the role the law plays in shaping it. At the same time, conventional economic analysis has proven inadequate to resolve a number of important debates and questions in corporate law. These include the nature of corporate fiduciary duties, the mechanism by which judicial opinions influence corporate participants' behavior, and the puzzling persistence of cooperative patterns of behavior in business situations (most obviously closely held firms) in which legal and market forces seem too feeble to rein in opportunism. In this Article we offer an explanation for these and other riddles of corporate law. Our approach does not reject economic reasoning. It does, however, reexamine one of its standard assumptions: the assumption that people always behave like homo economicus. We argue to the contrary that people often behave as if they care about costs and benefits to others. In support of this claim, we review the extensive empirical evidence that has been developed on human behavior in social dilemma experiments. This evidence demonstrates that most people shift readily from purely self-interested to other-regarding modes of behavior depending on past experience and present social context. Under the right circumstances, people can be counted upon with some degree of predictability to trust and to behave trustworthily, even when presented with economic incentives to do otherwise. Relaxing the assumption that people are always self-interested in favor of the more realistic claim that people have a capacity for socially contingent, other-regarding behavior opens new channels for analyzing a wide variety of relationships in which the law seeks to encourage cooperation and discourage opportunism. These include not only relationships within families and among citizens in the broader community but also business relationships like partnerships, relational contracts, and (our focus here) incorporated firms. We emphasize that we are not suggesting that legal rules, explicit contracts, and market sanctions are unimportant in governing business relationships. Social science confirms what most of us already know -- not everyone can be counted upon to engage in cooperative, other-regarding behavior, no matter what social cues they are given. Moreover, even among people inclined to behave cooperatively, trust-based relationships sometimes break down, and competitive behavior sometimes yields better individual and group outcomes. In many situations, external incentives are still important and perform exactly the function contractarian theory assumes they perform -- to promote cooperation and rein in uncooperative, untrustworthy behavior. But the experimental evidence on trust teaches that human behavior can be influenced in a number of ways that are not captured by the standard nexus of contracts analysis. This observation carries important implications for corporate scholars, for it suggests that an understanding of trust behavior may be an essential foundation for a solid understanding of corporate law. Without taking account of trust, we cannot fully comprehend or explain the substantive structure of corporate law, how it channels behavior, or where its limits lie. This is a matter of concern not only for academics but also for judges, legislators, practicing lawyers, and businesspeople. Mistaken assumptions about the role and importance of external incentives in furthering cooperative behavior can lead not only to mistaken descriptions but also to mistaken prescriptions. In particular, the experimental evidence warns that attempts to provide external motivations for cooperative behavior can instead reduce cooperation by undermining corporate participants' internal motivations. In this Article, for example, we have explored why making it easier to sue corporate directors for breach of the duty of care might actually reduce levels of care, if a proliferation of such lawsuits carries the unintended 43 message that carelessness is common behavior. Similarly, we have suggested that using formal contracts to constrain shareholder opportunism in closely held firms can increase the likelihood of exploitative behavior by interfering with the natural filtering effect of selfselection under conditions of mutual vulnerability. Indeed, trust can be undermined not only by using external incentives but even by using the language of external incentives. The experimental evidence demonstrates that individuals trying to decide whether to trust and behave trustworthily are exquisitely sensitive to the social signals they receive about what sort of behavior is expected and appropriate in a given context. Language is such a signal. As a result, language can promote trust. We have argued here, for example, that judicial opinions encourage trustworthy behavior among corporate participants not only by promising external rewards and punishments but also by describing certain relationships within the firm as fiduciary relationships that call for other-regarding conduct. But language can also erode trust. In particular, employing the rhetoric of contract can undermine trust among corporate participants by implying that trustworthy behavior is not important, not common, and not expected. This last observation raises troubling questions about the dominance of contractarian talk in corporate law scholarship. What is needed is a more tempered and nuanced approach to analyzing corporate law, an approach that recognizes the multidimensional quality of human nature. Human beings are individualistic and social creatures. They are capable of acute rationality and cognitive error. They are driven by self-interest and (in the right circumstances) by concern for others. They can be suspicious, greedy, and untrustworthy, as conventional economic analysis assumes. But they are also capable of trusting and being trustworthy, and reliably so. A solid understanding of the social and economic circumstances that elicit trust behavior is accordingly vital to our understanding of a wide range of social and legal institutions, including corporations and corporate law. 44 Parkinson, J E, Corporate Power and Responsibility: Issues in the Theory of Company Law (1994) at 3, 2125 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. CORPORATE POWER The purpose of this chapter is to describe some of the ways in which companies exercise power and to examine the relevance of the possession of power to the concerns, or what should be the concerns, of company law.... Corporate Power and the Need for a Public-Interest Justification ... [T]he purpose of this book is to examine certain aspects of company law from a particular point of view, one which takes the relevant rules to be part of the machinery by which power, and particularly what we have called social decision-making power, is sustained and regulated. The legal duties and control structures imposed or sanctioned by company law shape the criteria by which companies exercise social decision-making power. Some advocates of corporate social responsibility (the turn is deeply ambiguous ...) maintain that companies should allow their decisions to be influenced not only by profit, but also by social policy factors. This causes them to argue for a loosening of the legal duties that define the objectives of management decision making, which currently emphasise the maximisation of shareholder wealth, to enable a broader range of purposes to be pursued. And in some cases there is support for more elaborate reforms to ensure that social-welfare considerations are given appropriate weight in decision-making and are not left merely to managerial discretion. Critics of these views, on the other hand, insist that the public interest is properly served only where companies pursue the traditional goal of profit maximisation. These positions have in common that they express a view about how company law should regulate corporate power in the public interest: by introducing social-welfare considerations as explicit decision-making criteria, or by excluding them and relying instead on the benign effects of the invisible hand, guided where necessary by external legal controls.... In this section the object is to examine in some detail the important preliminary issue of why the debate should be one about the public interest in the first place, and why company law should not be seen instead as being solely concerned with the furtherance of the interests of shareholders and the protection of creditors. It should also be emphasised at this point that references to the "public interest" are not intended to imply that there is a consensus about what constitutes the public good or that it is objectively determinable. The discussion in this chapter and throughout the book is less concerned with what the public interest actually is (though the issue cannot be ignored) than with appropriate mechanisms for securing it. Nor in referring to the "public interest" is it necessarily intended to suggest that there is an interest that should be served that transcends the interests of the individuals who are affected by corporate activity. Rather the term is meant to refer to some defensible balancing of the interests of affected groups, be they for example employees, customers, suppliers, the local community, or the community at large on the one hand, with on the other those of the shareholders and creditors that are the more traditional concern of company law. 45 A well-established approach denies that the public interest is the relevant standard, or at least the primary standard, by which company law should be assessed. It sees companies as purely private organisations, existing for whatever purposes their members intend. There is no assumption that they should serve the public good, though the approach recognises that their operations are, in fact, highly beneficial to society. From this perspective proposals to redefine corporate decisional criteria in the public interest are misplaced. External regulation, at least in a form that applies to all citizens equally, is legitimate, but state intervention beyond that constitutes an illicit curtailment of individual freedom. The point then is not that reforms will necessarily fail in their object of furthering the public good (though this is normally supposed), but that inference in company affairs for that purpose is morally impermissible. We intend to reject this approach, and instead to embrace Dahl's claim that "every large corporation should be thought of as a social enterprise; that is, as an entity whose existence and decisions can be justified only insofar as they serve public or social purposes. The reason large companies should be viewed as social enterprise is relies, it is suggested, on the political theory about the legitimacy of private power. That theory holds that the possession of social decision-making power by companies is legitimate (that is, there are good reasons for regarding its possession as justified) only if this state of affairs is in the public interest. Since the public interest is the foundation of the legitimacy of companies, it follows that society is entitled to ensure that corporate power is exercised in a way that is consistent with that interest. To describe companies as social enterprises is thus to make a claim about the grounds of their legitimacy, and its practical significance is to hold that the state is entitled to prescribe the terms on which corporate power may be possessed and exercised. It should be stressed at the outset that maintaining that large companies are social enterprises involves no necessary finding that the root principle beneath the current rules of company law, that companies exists to make profits for the benefit of shareholders, is unsatisfactory. It is quite possible that the arrangement is the one that is most conducive to the public good. But the point is that making profits for shareholders must now be seen as a mechanism for promoting the public interest, and not as an end in itself. It follows that society is entitled to insist, for example, and companies are equipped with government structures adequate to enforce a commitment to profits on the part of management and to promote the efficient operation of the business. And the detailed rules of company law must be tested, not just to see how well they serve the interests of shareholders, but also how well they serve the interests of society in having an efficient and productive economy stopped a separate dimension of the social enterprise perspective is that if we view the company is a public or social body, RBS under private control, Ben's directors and managers should be left to requirements of disclosure and standard that ethical conduct appropriate to those carrying out public functions. Galbraith has described the denomination of corporate enterprise as "beginner telex privates into Gaelic enterprise" as "a formula for hiding public business behind cloak of corporate privacy quote; it is a device were diverting the eyes of government and the public to general public "from things like executive compensation, lobbying, political activity by executives and employees, profits, and bureaucratic error or not decent". If we reclassified companies as beginner telex social into a telex enterprises such issues are then not only matters of legitimate public concern about which the public has a right to information, but also matters in which the state is entitled to intervene in order to safeguard the public interest and to ensure compliance with publicly acceptable ethical standards. It may be, on the other hand, that profit maximisation within the law is too limited a formula for aligning corporate decision-making with the public good. Without examining at this stage the measures that might be necessary to improve the responsiveness of companies to the interests of the various groups that make up "the public", we should note that the social enterprise perspective supplies a justificatory foundation for the relevant programme of reform. That foundation is analytically stronger than one relying on the casual observation that since companies possess power, they must use that power "responsibly". Rather, because 46 the public interest is taken to be the roof of corporate legitimacy, compliance with whatever "social responsibility" demands is seen as a prerequisite, a defining condition, for the position of power. It follows the changes to the legal framework that are deemed necessary to encourage or induce the desired behaviour should be viewed as permissible even though a substantial curtailment of shareholder rights may be involved. Social responsibility is thus not merely a matter of a voluntary adoption of changed standards. Further, because the public interest is a foundation of corporate legitimacy, demands for responsibility need not be confined to the avoidance of obvious forms of social harm, such as might result from pollution, dangerous products, or false advertising, but potentially embrace all exercises of social decision-making power by companies, for example, in relation to plant closures or policy on research and development, and the various other manifestations of corporate discretion that were considered earlier. 47 White, B, "Feminist Foundations for the Law of Business: One Law and Economics Scholar's Survey and (Re)view" (1999) 10 UCLA Women's Law Journal 39 at 51-64 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. III. TACKLING BUSINESS LAW Feminist theory generates challenging new perspectives for analysis of legal phenomena generally, even in the unlikely area of corporate law. [...] B. The First Kathleen A. Lahey and Sarah W. Salter's article Corporate Law in Legal Theory and Legal Scholarship: From Classicism to Feminism is one of the first to recognize that feminist analysis could be used constructively in an area that was not normally thought of as a woman's issue. The article also serves as an interesting foundation for a discussion about the ways in which feminist theory might be used to address concerns about corporate conduct. Reviewing the literature they consider relevant to a feminist analysis of corporate law, Lahey and Salter portray a progression of feminist consciousness about the corporate world. It begins with a liberal approach emphasizing the goals of equal treatment and success for women comparable to that enjoyed by men in the business environment. Addressing first the "survival" manuals (i.e., guides for women on how to succeed in the corporate world), Lahey and Salter show that even in the context of seeking equal treatment for women in the work place, the scholarly development in that arena inevitably turned to a critique of the work place itself and its negative effects on the individual. What the authors observe about analyses of gender concerns in the business world parallels the development of feminist thought itself as it moved from the liberal goals of equal treatment for women to a general critique of our social structure that emerged in both radical and what subsequently came to be called cultural or relational feminism. Arguing in favor of continuing the progression of critical analysis of the working environment, Lahey and Salter set forth an agenda for feminist thinking about corporate law. Publishing in 1985, midst a prolific and prodigious period of feminist jurisprudential thought in general, the authors distinguish three feminist schools: liberal, socialist, and radical. They characterize the liberal school, as others since have, as one that emphasizes strategies to overcome barriers to equal workplace treatment for women. The socialist perspective discerns and critiques the corporate culture itself for its appropriation of the individual's sense of self and the corporate demands on the individual to subordinate his or her individual and familial interests in favor of corporate needs. The authors feel, however, that it is left to the radical feminist perspective to pick up the gauntlet of corporate law analysis because this perspective is the only approach with the capacity to address what they consider to be the core issues. The radical perspective requires us to examine how the current corporate structure is supported by the legal system that generates it and what ethical and moral values drive that legal system. Lahey and Salter view the legal system as embodying the dominant ethic of patriarchy that drives the system's social ills. Feminist theory is especially adept at 48 recognizing those ills and understanding patriarchal dominance and only radical feminism will explore the implications of that ethic fully. Applying radical feminist analysis, the authors observe that there are two dimensions of corporate structure that render it problematic: its structural mode and its ethics, both of which are driven by "masculist" patriarchal values. The corporate structure mode is one of centralized hierarchy. This creates an atmosphere of isolation, depersonalization, and separation among the individuals connected with the firm. By limiting an individual's access to information, the corporate structure disempowers individuals at all levels of the hierarchy, manifesting dominance over them. Such an atmosphere not only discourages cooperative efforts to the benefit of all, but also fosters among other ills ethnic and gender discrimination. Lahey and Salter argue, however, that changing these corporate behaviors is not enough since many corporations have already adopted alternative forms of organization -- job rotation, ethnic and gender diversity, and group cooperation. Yet we observe that they still retain their "essential character." What Lahey and Salter charge is that the core of the corporation -- its moral value -- has to change as well. The ethics of the corporation must replace the masculist values of separation, abstract rules, rights, and entitlements with the feminist ethic of care, connectedness, and responsibility. Thus, the role of feminist theory in general -- and radical feminist analysis in particular -- is not to address solely women's concerns in business law. Feminist theory instead can reach for more fundamental solutions, being uniquely capable of providing a systemic critique of the business law structure as it affects society. In particular, it can assess what the ethical core of corporate law is and what it ought to be in order to enhance the welfare of all members of the community as a whole. Lahey and Salter wrote during a period in which the growth of feminist insight was rapid. The division of feminist thought into distinct perspectives was still in process. Today, as those classifications are more distinct, adherents to the different perspectives often see their view as not only preferable to others but also adverse to them. In retrospect, one can look back at what the authors describe as the behavioral manifestations of corporate culture, the hierarchical structure, as an analysis of the role of dominance that came to be the focal point of what is now classified as radical feminism. The authors' assertion of the need to change the ethical core to the ethic of care, however, is an analysis that is currently identified with cultural or relational feminists. In fact, the authors cite directly to the works of Carol Gilligan and Nancy Chodorow as their sources for the feminist ethic of care -- two authors who are now distinctly identified as cultural feminists. Thus, though Lahey and Salter identified themselves as radical feminists, their analysis in fact contains the salient elements of what are now considered two distinct schools of thought. More recently, those who identify themselves as radical feminists focus almost exclusively on the issues of dominance and changing or at least modifying the behavior that that attitude brings. Some radicals actually reject the relational aspects of the feminist ethic of care because they see it as a trap. Cultural feminists on the other hand, though they acknowledge the importance of addressing dominance, emphasize the importance of the ethic of care. They advocate persuading the mainstream that the ethic of care is a better ethic and makes for a better community. An implication of Lahey and Salter's work is that at the very least we should adopt the feminist goals of both today's radicals and culturalists, that is, to end dominance behavior and substitute the ethics of care for society's morality. There is even the suggestion that culturalists' goals are more essential. Modification of dominant behavior will only be patchwork; only if the moral core is changed will there be a fundamental change. As selfidentified radical feminists in 1985, Lahey and Salter posit the importance of substituting 49 alternative values as well as ending dominance behavior. One wonders if the synergistic force of feminist analysis has suffered as feminist thought refined into the separate and distinct schools of radical and cultural feminists. Lahey and Salter argue that feminism can inform corporate law (and, by extension, business law) analysis in a powerful way. They suggest that a feminist approach can do more than look at issues of gender and discrimination; feminist thinking can provide the framework by which business law itself can be revamped for the benefit of all. Feminist analysis cannot only uncover inherent problems, but it can also provide the medium and basis for remedying those ills of business culture that cause society and all its members to suffer. [...] D. Towards a General Theory Ramona Paetzold, in her article, Commentary: Feminism and Business Law: The Essential Interconnection, suggests that "an ultimate test of the feminist impact on law ... will be whether feminist perspectives come to be addressed throughout typical 'business law.'" She puts forth what she considers the essence of feminist theory to critically evaluate business law. She stresses the importance of moving beyond specific legal issues of women's concern and towards recognizing that all law is gendered. Feminist theory is an analysis of power and in particular the power engendered by patriarchy. One significant change resulting from the application of feminist analysis, she suggests, will be that judges shift from a detached, "objective" approach, usually identified with patriarchy, to one that is empathic and careful ... of those who are powerless. Her call for feminist thinking and the reasons for its need echoes what Lahey and Salter asserted ten years earlier, but Paetzold has the advantage of ten more years of development in feminist thought in feminist jurisprudence. The analytic themes suggested by Lahey and Salter of the mode of dominance and the ethic of care have been bolstered by feminist legal methods to uncover imbalances of power, excluded voices, and to usher forth a concern for the "other." In advocating analysis of power and the concern for the "other," Paetzold suggests that business law use feminist methods such as context analysis, the narrative form and the development of new language. Business law should at least adopt the feminist recognition that the traditional language may fail in its communication of the experience of the oppressed because it embodies the perspective of the oppressor. Paetzold is concerned also about how feminist jurisprudence is taught. Organization by areas of interest to women's issues such as women and work, women and the family, and women and their bodies, may give the impression that feminism is solely about women's issues when in fact it is a systemic analysis of our legal foundations. Feminism needs to be approached as a coherent theory of all law, and discussions should turn on aspects of what feminist jurisprudence implies for remaking law. Paetzold argues for advancing feminist jurisprudential analysis of business law beyond the specific confines of women's concerns in business. She does, however, still anchor the feminist jurisprudence potential along gender lines: "all law ... is a feminist concern[,] ... our entire legal system is gendered." Her perspective is certainly understandable because the dominant focus of feminist jurisprudence has been the patriarchal (read: male) values of our legal system. This leaves open the question as to whether the analytic framework and techniques developed by feminist analysis can transcend even the patriarchal/feminist dichotomy it has focused on thus far. Such transcendency certainly is not necessary for feminist analysis to make a significant contribution to business law. Paetzold suggests what feminist analysis can offer business law within a gendered framework. Even within Paetzold's own discussion of 50 feminist jurisprudence, however, lie the seeds of a larger, more global perspective for feminist thought and that is as an analysis of power and its allocation. An analysis of power does not need to be anchored to an analysis of how patriarchy allocates power. An analysis of power should be able to address all forms of allocations. Patriarchy is just one form of allocation. Thus a new question arises: Does feminism have the power to address allocations in general? Ronnie Cohen's article, Feminist Thought and Corporate Law: It's Time to Find Our Way Up From the Bottom (Line), published in the same year as Paetzold's, focuses more on the potential role for the feminist ethic of care in business law. Cohen addresses the potential impact of the feminist ethic of care on corporate conduct (as Lahey and Salter suggested). Cohen first notes that the philosophical perspective underlying current corporate law parallels quite remarkably the "masculine" liberal view of the law pertaining to the individual. Liberal analysis sees the individual as self-interested, accumulating for his own welfare, and naturally aggressive towards others. The law serves to place limits on behavior to the extent necessary to protect individuals from one another's pursuit of happiness. Cohen observes that the current view of corporations is analogous: corporations are seen as wealth accumulating profitmaximizers, aggressive in the market place and towards competitors, and "corporate law provides a check on corporate behavior in the same way that criminal and civil law provides checks on individual behavior." Cohen asserts that just as current corporate law tracks the liberal view of the individual, feminist critiques of corporate law ought to draw from feminist critiques of the liberal view of the individual. Just as feminist jurisprudence criticizes the liberal view of man for not recognizing the social element of individual behavior, corporate law similarly fails to recognize the social component of the corporation in its role in society. Social concern, she says, should be the primary focus of a feminist examination of corporate law. Her premise is that given the "enormous collective power" of the corporate entity, the legal justification for the corporate form must be "the advancement of social good as well as the enhancement of ... profit." "A feminist theory of corporations would ... be a theory of corporate social responsibility." The concern Cohen then raises is how to render a corporation socially responsible. Scholars writing from other jurisprudential perspectives who find the corporation's social obligation to extend beyond its level of productivity typically feel baffled as to how to motivate corporate social sensibilities. Cohen states, "it is here that feminist theory can make its greatest contribution to the discourse." Drawing on aspects of relational and radical models of feminism, Cohen suggests quashing the separation between private and public spheres, and emphasizes the need to articulate and focus on how people are connected to one another. To achieve that end, Cohen draws on the work of others. She argues that those individuals ruling the corporation should participate directly in the consequences of the corporation's actions rather than merely relieving its burden through monetary dispensation. This personalized experience might induce the managers to create an environment in which the feminist ethic of care could develop at the corporation's core. Cohen notes that recommendations to create that empathic connection are the threads that run through the work of other feminist writers in the business area. Cohen offers some interesting suggestions of her own to induce the ethic of care in corporations. Cohen's work suggests a three-prong approach for feminist scholarship to affect business law: a method of analysis, an establishment of policy goals, and recommendations for the type of actions that implement those goals. Her method of analysis is to extend the feminist jurisprudence criticisms of the law of the individual to the law of corporations. Drawing on feminist jurisprudence in general and focusing on the feminist ethic of care in particular leads her to the policy goal of rendering corporations socially responsible beyond issues of economic productivity. Cohen then suggests a strategy for imbuing the corporation with that 51 sense of social responsibility by requiring individuals responsible for corporate conduct to be personally involved in redressing the conduct's consequences. Though Cohen offers a concrete strategy for feminist theory to have a positive impact on the social and legal treatment of corporate matters, the extent to which her analysis is and is not gendered is not that clear. Certainly her focus on the ethic of care, social responsibility, and collaborative approaches emerges from the gendered critiques of the patriarchy system. So in one sense, Cohen's analysis can be viewed as anchored in gendered approaches. On the other hand, the specific behavioral changes she suggests -- involving corporations with the victims of their harm, imbuing shareholders and management with a personal sense of responsibility, and revamping typical adversarial business situations into co-operative ones -- are not generalizations of women's issues. They are not generalized from specific women's concerns such as equality of pay and opportunity, health benefits, and child care. Cohen's policy concerns are more transcendently about human concerns, questions that affect both men and women. Thus her work can be seen as having one foot in a gendered analysis and one foot beyond it. Paetzold's and Cohen's articles represent the first forays towards a general theory of feminist analysis of business law, building on the foundation laid ten years earlier by Lahey and Salter. Each foray focuses on a different dimension of feminist thought: one on the allocation of power, the other on the ethic of care. 52 INTRODUCTORY THEMES: REGULATORY ENVIRONMENT The readings for this class introduce you to the legislative history, administration and interpretation of the Corporations Act 2001, the key legal document regulating corporations in Australia. A familiarity with the regulatory environment is critical to successful corporate law problem-solving. The Casebook at paras 2.70-2.100 gives you some insight into how Australian corporate law has evolved from a state-based, then a cooperative and, now, a federal legislative regime. The legislative history to the Corporations Act discloses some intriguing political and constitutional roadblocks to a national scheme of regulation. Can you think of why there has been so much resistance to centralised regulation? And, even now that corporate law is embodied in a Commonwealth Act, do you think it is any more "settled" than previously? See ss 3, 4, 5 and 5D-H of the Corporations Act for clues. The Casebook at paras 2.110-130 also describes the key institutions responsible for enforcing the Corporations Act, the most important of which is the Australian and Securities and Investment Commission. See s 5B of the Corporations Act and ss 1(2), 11, 12, 13, 14 of the Australian Securities and Investment Commission Act. An essential skill of a corporate lawyer is the ability to navigate around, and interpret the provisions of, the Corporations Act. Note how the Act is divided into Chapters, Parts, Divisions and Schedules. Note, too, the aids to navigating the Act, such as the Contents, Table of Provisions (in each Chapter) and the Index. For example, you will learn later in the course that there are restrictions on a director providing a "financial benefit" to his or her spouse (a so-called "related party"). Can you find out what these restrictions are by using the navigation aids to locate the relevant provision(s)? But even if you are able to locate a provision that deals with the problem at hand, how do you interpret its language? The text of corporate law can be open-ended and ambiguous. See ss 180(1) and (2), 181 for some classic examples. Should the Act, then, be interpreted "purposively", as Kingsford Smith argues? Or, as Whincop submits, more traditionally according to the "private law baselines" of the law? 53 Kingsford Smith, D, "Interpreting the Corporations Law -- Purpose, Practical Reasoning and the Public Interest", (1999) 21 Sydney Law Review 161 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. 1. INTRODUCTION A. The Corporations Law as a Modern Regulatory Scheme We live in the 'Age of Statutes', and the vast bulk of Australian corporate law, is now of legislative, delegated legislative or administrative origin. Most new laws about corporations are of this type. The trend is evident in primary legislation, and in rule and policy making powers of administrative bodies empowered to implement legislation. The `statutorification' of the Australian corporations law reached a new level in 1990, with the creation of the Australian Securities Commission: a national agency, with wide-reaching powers, to administer the national Corporations Law scheme for companies and securities regulation. A national legislative scheme, administered by the Australian Securities and Investments Commission (ASIC), consolidated a number of changes in the legal control of corporations and securities in Australia. Creation of ASIC and passage of the Corporations Law were a national priority to restore confidence in Australian companies and securities markets after the failures of the 1980s. This draws attention to the first element of this type of modern regulatory scheme which is distinctive. This type of regulation is created to achieve some end or goal; it is made in the public interest. As Rubin argues, legislation is a deliberate act of transformative social policy. By contrast, doctrines of equity and contract capture private interests, which may be `unacceptable because of [their] inconsistency with the fabric of the modern regulatory state.' In the Corporations Law, with investor protection as a cardinal object, it may not always be appropriate to refer to norms of private law such as party autonomy, or to assume equality of information. Interpretation of regulatory rules should recollect the purposes for which Parliament created the regulation in the first place; it should be `public regarding.' Secondly, legislation and rules dominate in an area that was the province of open-textured principles of equity and contract. Once we could say `the Corporations Law, like other legislation, is only a lot of patches on the coat of the common law,' but the reverse is now closer to the truth. We cannot ignore the volume and complexity of legislative rules governing companies and securities. It has been argued that as a result the Corporations Law lacks transparency to ordinary readers, that its complexity increases the costs of investment and innovation. Reasons have been given for this proliferation of rules and responses suggested. Even those who desire a return to the elegant conformations of equity and contract must accept that the modus operandi of modern regulation is rulemaking. This is not to suggest that rules cannot be more effective; this is one important aim of the study of regulation. Rather than resisting rules, we should inquire into their juridical nature, into their interaction with general law principles, and take notice of the results of research about what sorts of rules work in particular regulatory circumstances. 54 Much modern regulation such as the Corporations Law, is expressed in terms of wide grants of discretion. Indeed many regulatory rules are made in the course of `structuring' and elaborating discretions. Discretions are granted to a body or agency, empowered by Parliament, to implement the social or economic program of the regulatory scheme. Under the Corporations Law that body is ASIC. Parliament cannot anticipate, and lacks the time and expertise to legislate for, all the circumstances which might fall within the legislation even broadly expressed. Ideally, the underlying policy of the legislation will be realised through the rulemaking and adjudicative acts of the body given responsibility for implementation of the legislation. Discretions allow flexibility, responsiveness and autonomous action by the implementation authority, guided by the purposes and objects underlying the legislation. This role is quite different to that of the courts, as they have acknowledged. Courts react to particular litigants and not a larger problem, and they are ill equipped and reluctant to make policy. The role of the courts in the regulatory state is one of review and appeal, and much less central than in the creation and implementation of general law. This change from general law to legislation, is evident more widely than just company law; it has prompted one writer to ask `Has the Common Law a Future?' Whatever the answer, policies implemented through legislation and administrative regulation represent a qualitative shift in the control of corporations and financial markets. Behind them lies a social and political consensus in the public interest and legitimacy of such regulation, which supplies different values to those emanating from the general law and the market. These two forms of control give priority to values reflecting the private interests of corporate and market participants. Although it co-exists with general law and market forces of control, regulation elevates a public interest which sometimes subordinates those private interests. When this occurs there is a clash or at least a tension, between the background values which we reach for to make sense of, or interpret, the rules to be applied in a particular case. These tensions will never disappear as long as we maintain, as we should, a mixed economy. The rest of this article is directed to how these public and private values might co-exist. Instead of looking at every word as if the purpose of statutory interpretation is to advise Oliver Wendell Holmes' `Bad Man', it suggests a method that approaches interpretation with good will towards the text, in deference to the collective authority of public legislation. B. The implications of the Modern Regulatory Scheme for Statutory Interpretation .... A model to guide interpretation is useful for a number of reasons. To begin with, section 109H of the Corporations Law requires that it be interpreted to promote the `purpose or object' underlying the Law. While requiring a purposive approach, section 109H does not specify any content or method for the identification of `purpose or object'. It is this failure which has left open the possibility of using general law principles to supply meaning for public legislation. This article argues that the approach to statutory interpretation proposed by Eskridge with Phillip Frickey, can supply a content and method that furthers statutory purpose, in a fashion relevant to the public interest ideals of modern regulation.... Last of all, the model brings into account and suggests a way of using, a variety of sources or interpretive factors pertinent to the creation and implementation of modern regulation. Elaborating this practical aspect of the model against the current law of interpretation, is the major concern of the second part of this article. In summary, this article argues for a practical reasoning approach to purposive interpretation of legislation of the distinctive variety which establishes modern regulatory schemes. It 55 approaches the interpretive task with goodwill towards the legislative text, because the text expresses public values with the imprimatur of collective authority. By demonstrating the weaknesses of the sceptical public choice approach to legislative process and statutory interpretation, it makes room for an interpreter to look for the public values inherent in legislation, and suggests a practical method for doing so. Moreover, the argument made is illustrated by elaboration of a list of interpretive factors, supported by Australian judicial authority. Together the hope is to supply a content and method to operationalise the purposive approach required by section 109H of the Law. Although the argument is located in the Australian Corporations Law, and the role of ASIC, it is hoped the approach may also be relevant to other regulatory statutes, and even more widely. .... 4. PURPOSIVE INTERPRETATION .... [One purposive] approach to interpretation is William Eskridge's `dynamic interpretation'.... [D]ynamic interpretation has a hermeneutic method, which it combines with practical reasoning.... Eskridge argues that interpretation is the process of attribution of purpose by the interpreter, constrained by the history and context of the text, to assert that interpretation should be `evolutive'. As we have seen, the idea that interpretation is a process of attribution of meaning, is hardly novel in contemporary interpretive practice. Instead of canons, coherence or interpretive communities as a constraint on meaning, Eskridge develops a scheme of interpretive factors to be taken into account by the interpreter. These factors are familiar in interpretive arguments -- the statutory text, extrinsic materials and legislative antecedents, operational factors and policy. These factors are marshalled using techniques of practical reasoning to attribute a meaning to a statutory provision. They also operate to constrain statutory meaning. Crucially they acknowledge the primacy of legislative authority, the weight given to those factors closest to the legislative process being the greatest. Signifying the authority of Parliament, the text of the statute will have more weight than other factors such as post-enactment policy. But statutory text will not always prevail, if there is an accumulation of strong contrary factors. Eskridge and Frickey argue that an interpreter will look at a number of interpretive elements: text and its antecedents, structure of the statute and any statement of purpose, extrinsic materials, operational factors and possibly, post-enactment policy. The interpreter will derive an initial view of the statute, and then test the view against all the relevant interpretive factors. Which factors are eventually most persuasive will depend jointly on their closeness to the legislative process and the strength of the arguments supporting them. In easy cases the text and all the other interpretive factors will point in the same direction. In hard cases the text may have to be read down, strained, supplemented or even substituted because other factors point to a meaning that is closer to the purpose of the provision, but away from its literal meaning. Practical reasoning asserts that it is possible to come to a right answer to a problem, without an overarching theory or explanation of how the answer is arrived at. The process of practical reasoning is one of taking a number of factors present in an actual situation into account, and developing a number of possible alternative answers. These possibilities are then weighed against the factors relevant to the reasoning process, until the best explanation for the situation is understood. In the absence of an alternative explanation that illuminates the problem better, the best explanation is then accepted as the right one. 56 The philosopher John Wisdom describes this sort of practical reasoning: In such cases we notice that the process of argument is not a chain of demonstrative reasoning. It is the presenting and re-presenting of those features of the case which severally co-operate in favour of the conclusion, in favour of saying what the reasoner wishes said, in favour of calling the situation by the name which he wishes to call it. The reasons are like the legs of a chair, not the links of a chain. Both Twining and Miers and Eskridge and Frickey use practical reasoning as a basis from which to better understand the variability and fragmentation of the practice of purposive interpretation. Attention to practical reasoning is important, because as Twining and Miers point out, it has strong affinities with the approach to statutory interpretation already in use. Eskridge and Frickey's model of dynamic interpretation, already outlined, has as a crucial component a practical reasoning approach to the use of the interpretive factors. It identifies and weights interpretive elements and is predicated on the reasoning involved in statutory construction being complex. It recognises that it is impossible and futile to prescribe in advance the relative weight of the elements in every case. These will be indicated by the nature of the statute, its context and the values at stake in the interpretive exercise. Practical reasoning is apt for interpretation of the Corporations Law, because of the heterogenous nature of its provisions. Practical reasoning is flexible and adaptive. The interpretive significance of the different styles of provision can be reflected through arguments drawn from any of the interpretive factors about to be discussed. The rest of this article will argue that Eskridge's dynamic interpretation model and the practical reasoning dimension introduced in his work with Frickey, provides a method to give substance to the direction in section 109H of the Law that interpreters promote the purpose and object underlying the Law. .... 8. PURPOSE, PRACTICAL REASONING AND THE CORPORATIONS LAW A. The Text of the Statute Although other factors may challenge the text, the words of the statute remain the single most important guide to its meaning. Their `ordinary and grammatical meaning' is the place to start. However, `no part of the statute can be considered in isolation from its context -- the whole must be considered. That said, some cases disclose a view that seems antithetical to the practical reasoning model. In circumstances where the words of a provision `are reasonably capable of only one construction' there will be no operation for section 109H of the Corporations Law, which it will be recalled, operates to give priority between competing interpretations. Although not expressed as such, it may be that this view really operates as a presumption that is relatively easy to rebut by introduction of other interpretative factors. In practice, there will probably be very few instances where the introduction of other factors at the first level fails to raise a second reasonable construction. There are a number of other matters which might appear, on first impression, to diminish the likelihood of arriving at the ordinary grammatical meaning of statutory words, as signified by their context. The literal tradition in Australia gave an understandable prominence to the rules or canons of construction. The inflexible application of these does not fit well with practical reasoning and the purposive approach. The canons are only approaches and assumptions which have been developed as `aids to interpretation'. In legal terms they are rebuttable assumptions, and may be ousted by implication. 57 The fact that some Corporations Law provisions have established meanings which owe more to the general law of companies, than their place in a modern regulatory statute, should not be a permanent obstacle to a purposive approach informed by practical reasoning. The doctrine of precedent is less binding in statutory interpretation than in other areas of law. Justice Gummow pointed this out in Brennan v Comcare. So if an appellate court particularly, thinks that an interpretation is wrong, despite its longevity, it will depart from the earlier interpretation. Finally, traditional presumptions have developed, designating which words of a printed statute may be referred to in the process of interpretation, and which not; some of these are now found in legislative rules of interpretation. For example, it was not permissible to rely on marginal notes as a source of meaning. In most jurisdictions, for printing convenience marginal notes have now become section headings, footnotes or endnotes. Traditionally, the legal effect of not being part of the act has been to deny marginal notes any effect in the process of interpreting the sections to which they were adjacent. All of these rules must now be considered as operating subject to the requirement to seek the purpose or object of the provision under interpretation. An alternative route to the use of headings to chapters, parts and section headings etc in the process of interpretation is provided by the extrinsic materials provision, section 109J of the Law. Section 109J treats material included in the act as printed, but which is not part of the act, as extrinsic material. This would allow reference to section headings etc as part of the context of the statute in which the text under interpretation appears. The point of this is to ensure that as many parts of the printed act as possible are available as context. Then they can assist in establishing the meaning of a provision, even if they do not have the same weight as the text of the statute. This discussion about the parts of an act raises starkly the question of what weight should be given to the authorised text of a statute. Even the shift to seeking purpose from all parts of the printed act does not remove the distinctive character of the authorised text. The text retains an authority and weight, which no other element commands, in the matrix of interpretive factors. As Eskridge and Frickey put it: a persuasive textual argument is a stronger thread than an otherwise equally persuasive current policy or fairness argument, because of the reliance and legislative supremacy values implicated in following the clear statutory text. And a clear and convincing textual argument obviously counts more than one beclouded with doubts and ambiguities. But, as they also point out, text is not trumps, and ordinary grammatical meaning may be influenced or made to resound in a particular way: Each criterion is relevant, yet none necessarily trumps the others. Thus while an apparently clear text for example, will create insuperable doubts for a contrary interpretation if the other evidence reinforces it ... an apparently clear text may yield if other considerations cut against it. It is to these other considerations that we now turn. B. Structure of the Statutory Scheme and Legislative Antecedents In Morley we have seen already how a detailed study of the legislative antecedents of the insolvent trading provision of the Corporations Law was a powerful influence in revealing the purpose behind section 556, and its eventual interpretation. Examination of the statutory scheme as a whole, and identification of other provisions with similar subject matter and purpose, had the same effect. 58 Although not described as such, the use of the structure of the statutory scheme, or the context of the statute, is a traditional source of meaning for statutory provisions... Clearly, a statement of legislative purpose such as in the previous section 161 Corporations Law, or reference to the statutory preamble, will assist in identifying meaning. It has also become a regular feature of interpretative practice to use the overall structure or scheme of a statute or statutes which together create a scheme, as material from which to derive evidence of purpose, and identify meaning. .... Another factor which has become an important source of meaning for sections of the Corporations Law is the legislative antecedents of a provision. In recent Australian cases legislative antecedents have been analysed, interposed with extrinsic materials such as explanatory memoranda and commissioned reports. This creates a narrative of the development of a provision, elaborating its form and the policy which informs it, by contrast with what has gone before. This has been called the `legislative history' of a provision or Part.... What conclusions can we draw from this use of statutory structure or context, and legislative antecedents? Firstly, being part of the statute as legislated, the various characteristics which make up the statutory structure or context are a powerful and weighty source of legislative meaning. They show that a statute is a potent source of its own meaning. Being part of the statute, the features of the statutory structure have a good claim to being weighty in the reasoning of the interpreter towards the meaning of the words under construction. Legislative antecedents have perhaps less force, being past forms of the legislation. However, they are immensely useful as a source of corroboration of purpose and meaning of existing provisions. They, like extrinsic materials, form another `leg of the chair' in the process of practical reasoning, towards the final interpretation of words. C. Extrinsic Materials What extrinsic materials may a court refer to in the search for meaning, and what weight should they bear? Should they, as has been suggested is the case in the United States, be as influential as the statutory text itself. Or should extrinsic materials be just another type of evidence of the imputed purpose of Parliament, as Eskridge and Frickey suggest? If so, should all extrinsic materials bear the same weight, or are there good reasons why some might be weightier than others? No Australian decisions give to any type of extrinsic material the same status as the text of the legislation. This is so, even when extrinsic materials are used to add to, or strain, the text of a provision. In all instances there have been other factors, such as structure of the scheme, legislative antecedents or operational factors operating with the extrinsic materials, to suggest the reading which prevailed. If we accept, then, that extrinsic materials provide evidence of purpose, Eskridge and Frickey's model would suggest that the closer to the legislative process the materials have their origin, the greater weight they have.... .... [C]ourts seem to adopt or dismiss extrinsic materials, ... on the basis of the relevance of their content to the issue in question. In Newcastle City Council v GIO General Limited Brennan CJ found `that question is not assisted, in my respectful opinion, by reference to the Explanatory Memorandum laid before Parliament when the Bill for the Act was debated', and 59 preferred to seek meaning from the preamble. By contrast in Morley, Justice Ormiston put some reliance on the terms of the Explanatory Memorandum. In some cases, the courts have followed the American habit of quoting treatises and academic works in search of statutory purpose. At the other end of the scale, even a reasonable statement of purpose made by a Minister in a second reading speech, may not be given priority. In R v Bolton; ex parte Beane general law principles were applied in interpretation, to negative an unambiguous statement by the Minister that the legislation under construction was to apply to persons in the appellant's position .... Along with these judge made rules concerning the use of extrinsic materials, the Corporations Law itself supplies rules to govern the use and weight to be given to extrinsic materials during interpretation. Section 109J gives a legislative permission to the interpreter to refer to materials outside the statute. By contrast with the judge made rules governing the availability of extrinsic materials in interpretation, section 109J is restricted. The provision allows regard to be given to extrinsic materials only when `the provision is ambiguous or obscure' or leads to `a result that is manifestly absurd or is unreasonable'. This means that the ordinary meaning of a provision is not open to challenge by the introduction of alternative possible interpretations, unless there is ambiguity or absurdity. As we have seen, under the judge made interpretive rules alternative interpretations may be introduced by a variety of factors including extrinsic materials, whether or not there is an ambiguity at the beginning of the process of interpretation. D. Operational Factors As well as being the case that is generally considered to have established the purposive approach to interpretation in Australia, Cooper Brookes (Wollongong) Pty Ltd v Federal Commissioner of Taxation is also the authority which first gave prominence to operational factors in Australian interpretation. Operational factors have continued to be influential in ascertaining meaning in recent High Court decisions. The importance of operational factors lies in the ability of the court to consider alternative meanings to statutory words that are suggested by observing the operation of a provision. If one meaning of a provision would result in an `inconvenient or improbable operation' of the statute, and another would not, the court may choose the meaning facilitating favourable operation. In an extreme example, one meaning renders a provision virtually inoperable, and another promotes the purposes of the statute. A purposive approach, informed by operational factors, allows the court to depart from the literal meaning of the words to avoid rendering a provision inoperable. .... Operational factors have particular significance in relation to the interpretation of the Corporations Law. As was evident in Kingston v Keprose the court had difficulty in determining a meaning of section 43 of the Companies (NSW) Code, because of the complexity of the background circumstances in which the provision operated. In cases involving, for example, markets in complex securities and derivatives, the careful elucidation for the Court of the context in which a provision operates will have a large impact on the final interpretation of the provision. It is clear that operational factors are now an established interpretive factor. It makes sense to heed judicial suggestions that the parties, or ASIC as amicus curiae, might assist the court with evidence about the operation of a provision under construction. Finally, operational factors, though only a consequence of statutory provisions, tend to be weighty and influential in judicial reasoning. At the initial stage of interpretation, they are 60 important in pointing up alternative meanings to the literal meaning. In the process of identifying purpose and final meaning, operational factors are influential again. Although courts search for extrinsic materials or other factors to corroborate a meaning suggested by operational factors, cases like Cooper Brookes, Newcastle City Council v GIO and Qantas Airways v Christie demonstrate how powerful this interpretive factor may be in the final identification of meaning. E. Governmental and Regulatory Policy It is necessary to make an initial distinction between pre-enactment and post-enactment policy, in order to clarify discussion. Pre-enactment policy informs the legislation, before it is passed. Post-enactment policy arises from legislative or agency activity after a statute is passed. We have already seen a number of ways in which pre-enactment policy is influential as an interpretive factor. There is high authority supporting the use of policy as ascertained from provisions of an act, as one factor in statutory interpretation. Policy may be evident from the structure of a provision and its legislative antecedents... It may be evident from the scheme as a whole, or from other provisions in the act... Pre-enactment policy may also be distilled from extrinsic documents.... Extracted from some or all of these interpretive sources, policy becomes an important factor in determining the `purpose and object' of a statute: an important factor, but not the only one. As we have seen in ... Eskridge and Frickey's model, interpretive factors work together to corroborate a particular interpretive conclusion, and policy is no different. In discussing the rich variety of meanings which `purpose' carries, Barnes points out that it sometimes means `reason' or `motive', which is closely related to the idea of policy. Despite this easy congruence of meanings, policy is insufficient alone to show legislative purpose. .... As this article argues, there are now a number of reasons which make it important to include policy in statutory interpretation. In doing so, we should not overlook the difficulties in using policy in interpretation raised by Justice Mahoney, especially in a statute as diverse as the Corporations Law. What, for example, is to be done with the provision that is informed by two, potentially conflicting, policies? In Metal Manufacturers Ltd v Lewis, Justice Mahoney argues that the use of policy in statutory construction gives judges unacceptable latitude in interpretation.... ... If policy were the only guide to purpose, its protean and open-textured nature may allow an unacceptable degree of interpretative discretion. But the requirement that policy be only one factor in the interpretative matrix, that statutory text and statutory structure be much weightier considerations, does much to quell concerns about judges introducing their own views in the process of interpretation.... .... If the use of pre-enactment governmental policy is still an uncertain art, what case can be made for using post-enactment policy, made by ASIC, as an interpretative factor? As we have seen, the structure of the regulatory scheme of the Corporations Law contemplates the implementation by ASIC of aspects of the Law, under discretions granted by Parliament. The reasons for the grant of powers and discretions to ASIC are complex, and in exercising the discretions ASIC is inevitably required to interpret the provisions of the Law under which it acts. Further, for reasons of good administration, ASIC will `structure' its discretions by the promulgation of regulations, policy (often presented in the form of rules), and class orders. 61 Clearly, in making these rules, ASIC will reflect the interpretative conclusions it has arrived at about the scope and content of the provisions of the Corporations Law, under which it acts. The interpretative question is the extent to which interpreters other than ASIC should take into account ASIC's view of the meaning of the Law, and ASIC's regulations and policy, in the process of interpretation. Given that Parliament has, by the creation and empowerment of ASIC, contemplated that the agency will have both interpretative and law creation roles, there is little weight in objecting to ASIC's views as interpretative factors, just because they are post-enactment. The promulgation by the agency, of interpretations, rules and policy contemplated by the scheme of regulation, is another example of Mitchell Franklin's point that major pieces of legislation are potent sources of their own meaning. There is also authority from tax law that in ascertaining a legislative scheme subordinated legislation may be called in aid. The question is, what legal significance should the rules and policy promulgated by ASIC have? It has been one of the important foundations of this article that those concerned with the interpretation of regulation such as the Corporations Law must consider the role of the implementing agency. The High Court accepts that agency policy may be influential or even dispositive of the legal limits of discretion, and that intimately entwined is the construction of the statute. It should not be too difficult to also accept that agency policy, and the agency's view of the proper construction of the empowering provision, should be important considerations in the process of statutory interpretation. This conclusion has the benefit of fitting well with the current Australian treatment of postenactment agency policy. It also accords with the variable weight accorded to interpretive factors in Eskridge and Frickey's model of practical reasoning. 9. CONCLUSION This article was stimulated by the observation that in interpretation of the Australian Corporations Law courts can not always be relied on to carry forward the Law's public purposes in preference to the private values inherent in the general law of companies. That this is not a new observation demonstrates how resilient these general law values are, after half a century's experience of the regulatory state. Perhaps one reason for this lies in the fact that the general law sometimes moderates its operation, but not its underlying values, in line with adjacent statutory changes. A second may be the use in the Corporations Law of provisions that are statutory analogies of existing general law doctrines, which make it difficult to determine whether or not the legislature intended to break with pre-enactment values. A third reason is that the regulation we have been discussing is, desirably, of a mixed economy, where both public and private values coexist. The point of this article is, emphatically, not to deny the importance of private transactions and the values they embody. Rather, it is to argue that there is often a public interest in the regulation of undesirable by-products of otherwise beneficial private transactions. Therefore, it cannot be assumed that the meaning of regulation such as the Corporations Law will naturally be found in pre-enactment doctrines of private law. After all, the purpose of the enactment is to change the law to more adequately reflect the public interest in the corporate or financial activity in question. Or it is in response to collective opinion, which in a democratic system is entitled to respect from both Parliament and its interpreters. Another reason for the resilience of general law interpretive approaches may well be that while the significance of policy, discretions and administrative rulemaking have been well explored in the judicial review literature, their significance in statutory interpretation is not 62 well developed. For like reasons Rubin identifies the need to develop our understanding of the nature and the juristic techniques of legislation, and its implementation. An example of the development of interpretation in regulatory circumstances is Twining and Miers' point about the standpoint of the interpreter, which we can imagine personified as an officer of ASIC interpreting the Law. This expressly recognises the role of the regulator, a distinctive feature of the `Age of Statutes'. It invites us to think about how the law should treat an interpreter who can never approach the task in the same way as a judge. What limits, if any, should there be, on the interpretive factors an ASIC officer may consider? Should an ASIC officer be able to give post-enactment policy greater weight than a court? What interpretive latitude should an officer have, especially given the additional avenues of accountability to which they are subject? Perhaps the single most important factor in identifying and promoting the purpose and object underlying a statute, is settling a method of interpretation which is adapted to the features of the regulatory state. As Dworkin points out, it is a commonplace of contemporary interpretation that, although heavily constrained by context and practice, interpretation is a process of attribution of meaning, not discovery of pre-existing meaning. It is the legislative and administrative processes of regulation which provide the context from which these constraints derive. These processes produce a lot of interpretive material, such as antecedent provisions, extrinsic materials and post-enactment policy. As all of these are more closely connected to the primary legislation than pre-enactment doctrine, they commend themselves as better able to illuminate statutory meaning. The complexity and variability of factors inherent in responding to any regulatory context, commends a type of reasoning or method, which is not totally reliant on deriving meaning from existing principles. That method must be free to include, and if necessary give substantial weight to new factors, which have not been taken into account before. The introduction of operational factors in the process of practical reasoning, is a strong example of this. It is not enough simply to direct that an interpreter shall `promote the purpose or object underlying the act'; as we have seen purposive interpretation is a `black box', and there have been many attempts to elaborate its contents. It is surely a better guarantee of the realisation of the public purposes of statutes such as the Corporations Law to develop a method and context for interpretation which addresses the complexity, the changes of meaning over time and the perspectives of different interpreters involved in the implementation of regulation. The alternative is to go by default, and hope that busy judges and ASIC officers will resist the temptation to delve into familiar bodies of general law doctrine for answers to problems that, by definition, the general law has been unable to solve. Judicial latitude, and how to curb it, is an enduring theme of literature on statutory interpretation. The insight that indeterminacy of meaning is an inevitable condition of communication is liberating, in the sense that we no longer have to be wedded to narrow techniques of interpretation, such as literalism. These techniques, in asserting that meaning is patent from statutory terms, can operate to obscure the public purpose of legislation, which may only be obvious from context. On the other hand Parliamentary sovereignty is a core value of our system of government, and for both judicial and agency interpreters, organisational restraints may be insufficient; nor do they provide transparent criteria for accountability. Most criticism that Australian judges `put their own ideas of justice or social policy in the place of the words of the statute' complains of radicalism, and of judicial attitudes outstripping community values and Parliamentary purpose. In the interpretation of the Corporations Law the reverse seems to be more the case. Although recognisable interpretive factors are now appearing in Australian interpretive practice, especially in the High Court and Federal Court, there has been a reluctance to apply these consistently in Corporations Law cases. Instead the values of the market, captured in precedent from the general law of 63 companies, have persisted through interpretation. What the argument presented here suggests is a method of practical reasoning, seeking meaning from the context of the Corporations Law itself. It commends itself as a method which will both constrain the idiosyncracies of all interpreters of the Corporations Law, and promote its public-regarding purposes and objects. 64 Whincop, M, "The Immanent Conservatism of Corporate Adjudication: Thoughts on Kingsford Smith's `Interpreting the Corporations Law' (2000) 22 Sydney Law Review 273 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Churchill once said that anyone who was not a liberal at the age of 20 lacked a heart; anyone who was not a conservative at the age of 40 lacked a brain. The history of statutory interpretation is an analogous story of generation and ideology gaps. It represents a clash between new policy and the venerated common law. Conservatism and literalism can blunt the sharp edge of liberal policy, but whether that is good or bad depends hugely on perspective. In her powerful article in this Review, Dimity Kingsford Smith considers this issue in the context of the interpretation of corporate statutes. She observes, in common with other scholars, that regulation has changed greatly in the twentieth century, becoming more complex and more pervasive. She argues that the processes and aspirations of the modern regulatory state should be brought to bear on the sympathetic interpretation of statutory law. In so doing, Kingsford Smith advocates an approach, based on `practical reasoning', which applies the purposes of enactments to interpret legislation in a `public-regarding' way. In this reply to her article, I will often abbreviate this method to PPR interpretation..... Kingsford Smith claims that the interpretation of corporate statutes in Australia has not been PPR. Rather, in cases such as Mesenberg v Cord Industrial Recruiters Pty Ltd and Bank of New Zealand v Fiberi Pty Ltd, courts confronted by these statutes have inappropriately emphasised the general law of companies inherited from common law and equity. The general law `contains "private law baselines" or values, and is not public regarding, unlike the underlying "purposes and objects" of modern corporate regulation.' .... .... [In my view,] scholars and regulators must work to develop better positive theories of their subject, which can function as the basis for establishing presumptions about how particular types of legislation can operate. The best developed theories of corporations we have now are economic. They explain much of corporate law's immanent conservatism. At the end of this paper, I attempt to transcend the conservative/public-regarding logjam by seeking to develop explicit and focused interpretive principles in order to improve the quality and predictability of corporate adjudication. .... 3. THE ONCE AND FUTURE BASELINES OF CORPORATE LAW Kingsford Smith asserts that judges often desert policy for coherence with the `private law baselines' of corporate law. This prompts me to explore what exactly those baselines are.... [B]ehind particular legal principles are a range of adjudicatory biases. These are mostly structural, in the sense that they establish processes, responsibilities and powers. If these are respected, the law tends to be indifferent as to the actual outcomes -- an attitude best described as passivity. These biases are broadly consistent with the sorts of legal principles 65 appropriate to the governance of long-term relational corporate contracts. Their appeal and persistence across time suggests their suitability, rather than any ideological conservatism. After identifying and explaining them, I will demonstrate how they might be reformulated as focused interpretive principles for corporate adjudication. A. Private Ordering Economists hold that corporations represent a network of the contracts associated with the functioning, financing and governance of a particular firm. The most important contract to corporate lawyers is between shareholders and managers. Managers have extensive discretion to manage the firm, which is difficult to observe or govern. Substantial moral hazard problems therefore arise. Various economic analyses of long term contracts hold that the parties will make discriminating alignments between attributes of their contract and possible forms of opportunism, and the mechanisms of governance that they select. Because the forms of opportunism vary between contracts, the freedom to contract in relation to matters of governance is strongly desirable. There is ample doctrinal proof that until statute intervened and gradually removed those freedoms, the law took a highly enabling approach to governance, including changes to or amendments of legal principles and duties. The law was also characterised by a strong preference for resolving particular issues by ongoing private ordering and dispute resolution. It did this in two ways. First, the courts regarded corporate organs such as the board and the general meeting as the appropriate forum to resolve many concerns or disputes.... Second, a party seeking to acquire a right not recognised as belonging to him under either the general law or constituting contracts was compelled to contract for those rights with the person or group entitled to them.... Thus, the corporation is not a static contract, but a product of ongoing contracting within the parameters of the original contracts and the law. The normative implications of a bias favouring private ordering are straightforward. I will formulate them as tentative canons: 1. Resolve interpretive doubts about the contractibility of legal rules or the waiver of rights by favouring their contractibility. 2. Resolve interpretive doubts about governance and changes in entitlements by treating as dispositive the decision of the appropriate corporate organ acting intra vires. .... B. Passivity A pervasive feature of relational contracts is that parties accumulate substantial information about each other, and the nature and value of each other's performance under the contract. That information is typically difficult to verify to third parties such as courts. For instance, in a closely held corporation, the shareholders may have a good idea of how much the managerial services of the current chief executive are worth, but they may find this very difficult to demonstrate to other people. Alan Schwartz has shown that under these circumstances courts should, and usually will, adopt a passive approach to adjudication. Lacking vital information, they will refrain from asserting an active managerial or supervisory jurisdiction over these contracts. Schwartz argues that a hallmark of this form of adjudication is that legal rules will tend to binary in quality -- they will either accord complete discretion, or no discretion, or will generally prohibit or generally permit. Balancing approaches and standard-like adjudication will be eschewed. Because corporations, especially closely held corporations, fit the relational description very well, we should not be surprised that corporate adjudication has long been passive in quality. In discussing private ordering, we have already seen one instance of passivity the 66 unwillingness of courts to interfere with or pre-empt the operation of the organs of internal management of the corporation, except for two special cases where intervention has strong efficiency justifications. There are, first, overreaching and self-dealing, and second, violations of the `pro rata' entitlement between shareholders (traditionally called `fraud on the minority'). These have been prohibited absolutely, rather than permitted according to standards of `fairness', but subject to the entitlement of the two sides to cut a deal which accords with the private ordering bias. Second, the law traditionally adopted deliberately biased principles applying to managerial discretion, by using standards of care that are difficult for any shareholder to successfully plead against an honest director. The contrast between duties of care and fiduciary duties are typical of passivity in the law -- the law either entrusts all discretion, or no discretion. I will demonstrate below that even today, this principle has some influence on the law applying to director negligence. Third, where the law recognised a breach of duty, a cause of action tended to prefer orders reinstating the antebellum status quo. The principal examples are the preference for rescission in cases of interested transactions between a director and the corporation, and between the promoter and the corporation. The parties are restored to their pre-contract position... These traditional approaches require courts to have less information than other orders. It is easier to take a transaction apart than it is to attempt to value an asset, particularly assets with unique or `transaction-specific' properties where market proxies do not exist. Moreover the remedy may be efficient because it minimises the amount of litigation necessary, since rescission will only ever be sought where the cause of action is made out, and the value of the transaction turns out to be negative. The corporation does not have a wasteful incentive to seek compensation from transactions from which it gains. Thus, the general law has been absolutely unprescriptive, substantially enabling, exceptionally prohibitive, and largely anti-litigious. Economic analysis holds that passivity of this sort suits renegotiation because it establishes clear threat values (payoffs if parties cannot reach agreement). The incentive to renegotiate reinforces the private ordering bias, by favouring ongoing contractual solutions to the relational problems that the parties experience. The clear allocation of property rights used in the general law also makes it likely that if litigation does begin, settlement will occur because of the lower degree of substantive uncertainty in outcome. Closely related to these `rational choice' arguments is the possibility that passivity and conservatism counteract cognitive biases in adjudication. To take an example, the current s232(4) enacts a duty of care which officers must comply with. How should it be interpreted? The adjudication of negligence is never easy because of the heterogeneity of underlying case types, the need to respect business judgments, differentiation in managerial processes across corporations, and so on. There is a high risk that judges may hold directors were negligent when in fact they were not (a type II error). The only negligence cases that will be adjudicated are those in which sufficiently substantial loss has been sustained to warrant the commencement of litigation. This may give rise to two types of effects -- a hindsight bias and a salience bias. Hindsight biases involve the ex post overestimation of the ex ante likelihood of an event occurring, as a result of the knowledge of the fact that the event did occur. Salience biases distort the estimation of ex ante likelihood because of the estimator's ability or inability to recall instances of the event to mind. Because the sample of litigated negligence cases is likely to be excessively weighted to calamity situations, judges may overestimate the likelihood of such events transpiring. This will in turn lead to overestimation of the requirements of due care. A standard biased against findings of negligence -- as the general law was, with its references to gross and subjective negligence -- is a rough, but possibly effective control on these biases. Its effectiveness is perhaps reflected in the Corporate Law Economic Reform Bill's proposal to introduce a business judgment rule. 67 The following canons of interpretation are therefore suggested: 3. Favour statutory interpretations that limit the extent to which legal rules encourage active judicial review or intervention in the management of corporations. 4. Where two constructions of statutory provisions (not concerned with fraud or overreaching) are possible, prefer the one that does not create personal liability for directors. 5. Favour statutory interpretations that prohibit particular forms of behaviour outright (such as overreaching), rather than by reference to standards or discretionary tests, at least where the prohibition is subject to private ordering. 6. Where a statutory provision contemplates a remedy, prefer the construction which would restore the status quo ante. .... C. Disclosure Information disclosure has a central role in modern regulatory strategies, in corporate law and elsewhere.... The need for disclosure is of course intensified by the growth of securities markets; it is an article of faith that some level of mandatory disclosure is required for efficient capital markets. Information disclosure strategies are partially hindered by the fact that the information is unverifiable. Nonetheless, in many relational contracts, information may still be observable, meaning that the recipient can ascertain whether the information is true, even if unable to verify it to a third party. If information is observable in this sense, directors forced to disclose will often disclose truthfully, because of the risk of informal `punishment' for falsehood under implicit contracts. The following canon is therefore suggested: 7. Where two constructions are possible, favour the one requiring material information to be disclosed to shareholders, or other parties with the benefit of the duty. D. Equality There must be some limit on the bias of courts not to review the operation of internal management. Otherwise, majorities will use their voting power to expropriate minority shareholdings. Contracts, of course, provide the principal means of preventing this from occurring, but naturally contracting is incomplete and costly. The development of effective institutions, such as norms and legal rules that supplement contracts, are important. What limitations should exist? It follows from my earlier analysis that the use of reasonable expectations as a principle of limitation is inappropriate. Such expectations are rarely verifiable and permitting them to be pleaded is likely to increase the amount of strategic behaviour in corporations. A preferable approach is an `equality' or `pro rata' norm, which requires equal gains sharing, subject to whatever contractual arrangements the parties have executed. This prevents majorities from controlling distributional arrangements to impoverish minorities. It also reinforces incentives to maximise the value of the corporation, since gains will only normally be harvested by increments to the value of the equity or by pro rata dividends. I maintain that the fraud on the minority principle expresses the equality norm. 68 An equality norm does not endorse a principle that requires a majority shareholder to share equally the gains from a sale of control, or to enable the minority shareholder to have the same opportunity to exit a closely held corporation. A sale in control does but change the identity of the majority shareholder; that new majority shareholder remains subject to the same prohibition against distributing gains solely to himself. Equal opportunity principles increase the cost of changes in control or decrease the liquidity of investments -- neither principle is desirable. The canon takes the following form: 8. Favour statutory constructions that require, subject to contract, equality in the distribution of gains between shareholders. The equality norm occasionally requires limited interference with internal management, lest it be trivialised. For example, a majority faction cannot vote themselves salaries far exceeding a reasonable market rate of return, as that would enable them to violate the equality norm. To do that, a court must take evidence as to market rates of return for chief executives in corporations of similar size and related industries. Errors will inevitably be made, but shareholders' agreements and compensation committees provide a means of limiting allocative inefficiencies of possible errors. E. Evaluation In this section, I have clarified some of the historic biases of corporate adjudication, and demonstrated their broad suitability given the institutional limitations necessarily placed on courts. Yet in formulating them as canons, it might seem that I am doing something that seems contrary to PPR interpretation not only am I imposing a conservative limitation on policy, I am elevating it to canonical status. This is an incomplete picture. I have already argued that it is difficult to give meaning to public regarding interpretation in corporate law because of the absence of third party effects. Therefore, what I am doing is giving content to the central contracting norms of corporate law, in a manner that suits the administration of justice by a court of limited competence with access to attenuated information. The canons also sift what is important from what simply happens to be old. Not everything that is old is admirable. The canons clarify what parliaments should express if they have different ideas about corporate norms, or the means for serving accepted ends. PPR interpretation allows us to try to understand the situations where that is what parliament wants to do, and to interpret old and new norms in a coherent way. This is preferable to obstinate conservatism or unstructured purposive interpretation. 4. CONCLUSION Let me traverse the arguments in this paper once more. First, I have argued that publicregarding analyses in corporate law often run aground, because interest group activity is often relatively limited and because genuine externalities are not pervasive. Public-regarding approaches are often stripped of `publicness', except in adherence to policy. Second, I have shown why judges appear to have a conservative bias -- not because of explicit Burkean conviction but because of the limits on adjudication in corporate law. The appeal of passivity and the persistence of functional norms in corporate doctrine reinforce the need for continuity with past practices of judging. Third, I have tried to wed the immanent conservatism of corporate law with an approach which accepts that statutes do not have pre-interpretive meanings. The best way to do this is by explicit canons, which draw on our best positive accounts of the regulated phenomena. I outlined a number of canons, addressing disclosure, liability, rescissionary remedies, 69 passivity, equality, and private ordering. Wedded to PPR interpretive method, we have, I hope, the best of both worlds -- a method which is designed to elucidate policy in a sympathetic manner, balanced with an approach to the application of that policy which is likely to result in more effective regulation. Like any good system of presumptions, it offers two very substantial advantages -- clarity of adjudication and explication of underlying biases. We should not be so conservative to demand that the origins and motivations of our praxis need suppression. On the contrary, recognising the instrumental worth of the old, while adopting a forward-looking approach to the alternatives is the essence of responsible pragmatism. 70 71 CORPORATE EXISTENCE 72 CORPORATE EXISTENCE: BRINGING A COMPANY INTO EXISTENCE The readings for this class focus on why people might use the corporate vehicle for conducting their business, how they bring a company into legal existence, and whether or not company registration -- or "incorporation" -- justifies state intrusion into the way corporations run their "private affairs". The company is not the only organisational form available to run a business --indeed, depending on the circumstances, other forms may be more appropriate. The first issue, then, is to identify what are the available structures for conducting a business enterprise. Read the extract by Woodward (et al) for an overview of the main "non-corporate" forms of association: the sole trader, the partnership, the trust, the unincorporated notfor-profit association, and the unincorporated joint venture. Read the Casebook at paras 3.80-3.140 for a description of the different types of `company' which may be formed under the Corporations Act. You should review Corporations Act ss 112 (types of companies) and 113 (description of the proprietary company). The next issue is to decide which form of association is the most appropriate. Read the Casebook at paras 3.30-3.60 for the factors affecting the decision to incorporate a company. See also Corporations Act ss 250N, 293-294, 314-316, 327 and 345 (the main continuing obligations once the company is set up); see also Pt 1.5 (Small Business Guide) para 4. You might also want to revisit the Thompson article (assigned for class one) -- in addition to the "rational" economic reasons in favour of incorporation, are there personal or psychological reasons why business-people might prefer the company as the vehicle for their business? Once a decision has been made to set up a company, the next issue is how to do so. Read the Casebook at paras 3.65-3.75 for the procedure and paras 3.160-3.180 for a description of how the company is funded. See also Corporations Act Pt 1.5 (Small Business Guide) para 3 and Pts 2A (registering a company), 2B.6 (company names), and 2H.1/2H.3 (shares). Finally, what are the regulatory implications of the statutory process of incorporation? Is the state justified in regulating companies, because corporate powers are a "privilege" bestowed on companies by state legislation? Or is mandatory regulation unjustified, since incorporation simply "formalises" the private arrangements reached among the corporators? This `public' vs `private' debate has real implications: at stake is whether companies should be subject to broader social responsibilities -- such as compliance with environmental standards -- or be allowed to pursue its business activities free from unnecessary "red tape". The reading by Bottomley canvasses the arguments. 73 Woodward, S (et al), Corporations Law: In Principle (5th ed) (2001) at 16-21 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Commerce (whether for profit or not) can be conducted using a variety of organisational forms. Each form of association can be classified as "corporate" or "non-corporate". Factors such as size, profit motives, taxation treatment, liability and ease and expense of set up affect the decision as to which form of association is the most appropriate for any given activity. There can also be more than one form of association used and, within that group, a mix of corporate and non-corporate bodies. For example, a company (corporate) may also act as the trustee of a trust (non-corporate) and enter into a partnership (non-corporate). This topic outlines, in brief, the various types of non-corporate structures that are commonly used.... NON-CORPORATE FORMS OF ASSOCIATION The main non-corporate forms of association are: (a) (b) (c) (d) (e) ... In order to understand the nature of a company, the following is a general outline of each of these non-corporate forms of association. That is, what a company is not! sole trader partnership trust unincorporated not-for-profit association; and unincorporated joint venture Sole trader Operating as a sole trader is the simplest form of business organisation. Nothing is required to establish a structure -- one person simply "owns" the business, although they may employ others and operate under a business name. Because there is no separate body, the assets and liabilities of the business cannot be separated from those of the individual owner. The form of organisation has the attraction of simplicity and control. Profits do not have to be shared and no-one (for example, members) has to be consulted or informed about how the business is running. Unlike a company or an incorporated association, there are no public filing requirements -- except the need to obtain an Australian Business Number (ABN) and, if necessary, register for the goods and services tax (GST) -- so commercial privacy is protected. 74 Partnership ... The general definition of a "partnership: is the relationship that exists between people (which includes companies) who carry on business in common with a view to profit making: see, for example, s5(1) Partnership Act 1958 (Vic). A partnership can be seen as an aggregate of individual traders who have come together for a joint, profit-making business purpose. They have an agreement (that is, a contract) between them as to how they will conduct this common business. The partnership agreement can be partly or wholly: written or oral; express or implied. The rights and obligations of each partner are governed by that agreement, by general law and by State or Territory legislation. Each State and Territory has its own Act with different numbering, but for practical purposes the substance of each Act is almost identical. A partnership is not an entity in its own right -- that is, the "partnership" does not exist separately from the partners themselves. As a result: each partner pays tax at her or his individual rate (a return is lodged for the partnership, but only for the purpose of ascertaining each partner's share of the profit or loss); a partnership is automatically dissolved on the retirement, death or bankruptcy or a partner unless the partnership agreement provides otherwise; and a partner can assign her or his interest in the partnership but, unless all the other partners consent, the assignee only has the right to receive the assignor's share of profits and has no right to take any part in the management of the firm. Retiring partners remain liable for debts incurred while they were partners unless creditors agree to a release. As with a sole trader, formation of a partnership does not require any formal steps such as registration and there are no on-going public filing requirements, except for those applying under the GST. The partners can employ people and trade under a business name. There is a size limitation for partnerships, however, with s115 of the Corporations Act limiting the number of members to 20. There are some exceptions -- for example, a maximum of 400 for lawyers and 1000 for accountants. Any partnership that exceeds this size must register under the Corporations Act. People are often keen to argue that they are not in partnership. The main reason for this is that a partner can be liable for the actions of a fellow partner even when that partner has acted contrary to their express agreement: see, for example, ss 9, 13-16 Partnership Act 1958 (Vic) .... Limited liability partnerships Limited liability partnerships may be formed in New South Wales, Queensland, Tasmania, Victoria, South Australia and Western Australia. Unlike ordinary partnerships, they must be registered and a registration fee is payable.... Limited liability partnerships are like other partnerships but have two classes of partners. Active (general) partners run the business and are in the same position as partners in an ordinary partnership. Silent (limited) partners contribute capital to the partnership but, as long as they o not take any active part in running the business, they have the benefit of limited liability. Their liability is limited to the contribution they have made to the firm's capital. This encourages investors to contribute capital. 75 Limited partnerships were starting to become popular because of their ease of setting up, simpler documentation and ability to keep information confidential. However, since 1992 limited partnerships have been treated as companies for taxation purposes, which means that a limited liability partner can no longer claim a tax deduction for partnership losses. More recently, amendments to the Corporations Act have meant that all but the smallest limited partnerships must now comply with the fundraising provisions... These changes have greatly reduced the popularity of limited partnerships. Trust In its simplest form, a trust exists when one party (the trustee) is required to hold or invest property on behalf of another (the beneficiary). There are many types of trusts. In business, the most common form is a unit trust. A unit trust bears a superficial resemblance to a company. In both forms of association, ownership is divided into parcels. In a company they are called shares and in a unit trust they are called units. Like a company, a unit trust can be either private in nature of used to attract investment from the public. It is also common to have a company as the trustee, and it is possible for the beneficiaries to be companies. However, the fundamental difference between a company and any form of trust is that a trust is not a separate legal entity. While the trustee and the beneficiaries are separate legal persons, the "trust" is not. Many of the disadvantages of using a trust compared with a company flow from this point. A trust, like a corporation, cannot sue or be sued as a separate entity . The "trust" itself cannot incur debts and liabilities -- the trustee is personally liable. For this reason, the trustee is often a company. Generally, a trustee will be protected by an indemnity from the trust fund, but only for liabilities properly incurred in the administration of the trust. The terms of the trust deed will usually exclude ay right to claim an indemnity for any shortfall in the trust assets from the beneficiaries.... For taxation purposes, a trust is not recognised as a separate entity. Tax is either payable in the hands of the beneficiaries or, if income is not distributed in any year, the trustee is personally liable for tax at penalty rates. Aside from public unit trusts ..., a trust does not require any formality (although sometimes evidence in writing is required). There are no on-going public filing requirements. There are no limits to the number of beneficiaries and the death of a beneficiary does not affect the existence of the trust. However, a trust cannot continue indefinitely. A trust can only exist for the duration of the life of a nominated person plus 21 years (this is a general law rule known as "the rule against perpetuities"). In some States an alternative period of 80 years will usually apply. UNINCORPORATED NOT-FOR-PROFIT ASSOCIATION The simplest form of unincorporated organisation is an unincorporated not-for-profit association such as a social or sporting club. Because there is no intention to share profits among the members, they are not a partnership and do not have to register as an "outsize partnership" under the Corporations Act: s 115. These associations are not regarded as separate entities for legal purposes. 76 UNINCORPORATED JOINT VENTURE There is often a fine line between an unincorporated joint venture and a partnership. "Joint venture" is not a technical term with a single legally defined meaning. Traditionally, if several people agree to work together on a single project rather than on a continuing basis, this was likely to be considered a joint venture rather than a partnership. However, this distinction is no longer always valid and a "joint venture" may often be a partnership: see UDC Ltd v Brian (1985) 59 ALJR 676. Unincorporated joint ventures are frequently used in the mining and petroleum industry for taxation and liability reasons. A typical example would be where a promising mineral deposit has been found and two or more companies agree to develop the mine together and to share the ore extracted from it. Each company would then use its own separate facilities to refine and sell the minerals and make separate profits. The parties in a joint venture generate a product which is shared between them, in contrast to partners who carry on business in common and share profits.... CONCLUSION The main point to draw is that none of these non-corporate forms of association is a "separate legal entity" -- that is, an entity recognised by law as being separate and distinct from the individual(s) who formed it or who manage it. By contrast, consider corporations. 77 Bottomley, S, "The Birds, the Beasts, and the Bat: Developing a Constitutionalist Theory of Corporate Regulation" (1999) 27 Federal Law Review 243 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. INTRODUCTION One of Aesop's fables tells the story of a war between the Birds and the Beasts, and the problems which this posed for the Bat. Whilst sharing characteristics in common with each set of protagonists, the Bat nevertheless did not belong to either side. Unfortunately this subtlety was not noticed by the warring parties who each dismissed the Bat as an enemy. This image of the Bat's difficult position captures what I am attempting to do in this article. I examine the debate ("war" is too strong a word for it) between the two dominant justificatory theories of corporate governance and regulation in Australian corporate jurisprudence -- the concession theory and the contract-based theories. I argue that although this debate has offered some important insights, ultimately it has proved to be either too simplistic (offering one-dimensional pictures of corporate life) or too restrictive (limiting our conception of how corporate governance and regulation might be improved). I sketch out an alternative justificatory theory which I call "corporate constitutionalism". This theory draws on aspects of both the concession and contract-based theories but, as I will show, it is not simply an amalgamation of them nor a compromise between them. Like the Bat, it has a separate and unique place in the debate. The question of whether and, if so, to what extent the state has a role in regulating corporations has always excited debate. At the time Salomon v Salomon & Co Ltd was decided there was intense argument about whether the facility of the incorporation procedures found in the Companies Act 1862 (UK) should be available to small businesses. One hundred years later there is considerable debate about the extent, if any, to which the state should impose mandatory regulations on any company, regardless of its size. Obviously the details of these debates differ, as do the concerns which motivate them. In the late nineteenth century, the debate was about regulatory coverage: what range of business enterprises should be covered by companies legislation? In the late twentieth century, when the corporation has become one of the dominant forms of association in business, social and political life, the debate is about regulatory method: what is the best way of regulating corporate activity? As can be seen, there is a common theme underlying these different questions -- a concern to clarify the state's role in relation to corporations. And therein lies the problem: despite the differences in the debates about corporate regulation, not only is the underlying theme the same, but so too are the assumptions and concepts from which competing answers are constructed. In the debate about state regulation of corporations, we have not really moved all that far in the one hundred years since Salomon's case. The concern which motivates this article is not all that startling: ... we need to develop a justification for corporate regulation which takes appropriate account of the role of the corporate form in contemporary society. We must develop a new and relevant conceptual approach which will enable us to transcend the restrictions of current debates. 78 In more specific terms, I will argue that this new approach (although, as will be seen, it is not all that "new") must strike a balance between the interests of corporate members and managers on the one hand and the interests of society on the other-hand. I will do this by extracting some of the key elements in the history of thought about corporate theory and corporate regulation. I should point out that I will not be presenting this history in any detail; indeed mine will be a fairly crude summary. The elements I will refer to are concession theory .... and the neoclassical economic theory of the firm. I will then construct the new approach, taking into account the concerns of concession theory (in so far as it requires a role for the state in corporate regulation) and those of contractualist theories (in so far as they require that the interests of corporators be respected). In the process I will add my support to those writers who seek to abandon the tired dichotomy between mandatory regulation and facilitative deregulation which continues to restrict the debate on corporate regulation. The plan of the article is as follows. First ... I consider the waning support for the concession theory of corporate regulation, moving on to look at the empirical and ideological objections to that theory. Next I examine the basis of these objections and the shortcomings of the philosophical and political picture on which they are based. Finally I offer an alternative justification for state regulation based on the idea of corporate constitutionalism, and I outline what the aims of that regulation should be. .... CONCESSION THEORY The concession theory of corporate regulation entails two related claims. Each claim has a weak and a strong version. The first claim (I will call it the status claim) is that the creation of a body corporate and the legal incidents that are usually associated with incorporation (such as separate legal status, perpetual succession, and limited liability of members) is a concession which is granted by the state. Another way of putting this is to describe the state grant of corporate status as a privilege, thereby underlining the state's claim to control over the process of incorporation and its subsequent use. A contemporary illustration of this view and its consequences is found in the judgment of Cooke J in Nicholson v Permakraft Ltd where he stated that: [L]imited liability is a privilege. It is a privilege healthy as tending to the expansion of opportunities and commerce, but it is open to abuse. Irresponsible structural engineering -- involving the creating, dissolving or transforming of incorporated companies to the prejudice of creditors -- is a mischief to which the courts should be alive. The weak version of the status claim is limited to the proposition that a corporation owes its legal existence and powers to the grant of corporate status from the state. The weak version therefore seeks to avoid the metaphysical question "what is a company?" by confining itself to the legal aspects of corporate status. The strong version is that the corporation is an artificial entity which owes its very existence to the state, thereby inviting a much wider debate. .... The second claim (the regulatory claim) can be read as a quid pro quo for the grant of corporate status. As a consequence of being created by the state there is a presumption in favour of state regulation of a company's post-incorporation activity. This presumption purports to give the state control over both the extent of the corporation's legal capacity and the exercise of that capacity. This is the weak version of the regulatory claim. It is occasionally framed in stronger terms, requiring not just compliance with public regulations but also an affirmative duty to act in the public interest or in a socially responsible manner..... 79 CRITICISMS OF CONCESSION THEORY Most of the criticisms of concession theory are drawn from contract-based theories of the corporation (especially neoclassical economic theory).... [While] concession theory is aligned with arguments in favour of public regulation, even with organic/holistic visions of the community, ... neoclassical economic theory advocates the private and individual ordering of private affairs. Contract-based criticisms of concession theory combine a number of claims, all of which seek to minimise the role of the state in the creation and regulation of corporations. One such claim is empirical: concession theory does not fit the facts of modern corporate life. It may be that concession theory made sense at a time when corporate status could only be obtained by the grant of a special charter or by a special Act of Parliament. However, the advent of general incorporation laws in the late nineteenth century ... and the availability of standardised corporate structures, mean that concession theory has long since "lost its vitality"..... [T]he consensus amongst the critics is that the theory continued to lose explanatory power the more that incorporation became an administrative registration process. As Bratton puts it, "[o]nce equal and substantially free access to the corporate form became the norm, the notion of 'concession' no longer described the practice of incorporation." Most commentators, whether contractualist or not, agree that on this ground the concession theory of corporate regulation no longer has any theoretical use. A second set of claims takes a stance in favour of private ordering. A good example is Butler and Ribstein's argument that: because corporations are not wards of the state, and because the capital markets that discipline corporate contracts do not require more legal intervention than other markets, it follows that there is no justification for subjecting corporate arrangements to a higher level of regulation than other contracts. Hessen takes a similar approach in his attack on concession theory.... Hessen seeks to show that the three features most commonly associated with the corporate form -- separate entity status, perpetual succession, and limited liability -- can each be achieved through ordinary contract or trust arrangements and therefore that the state has no special role to play in the creation or continued regulation of corporations. In Hessen's view statutory incorporation requirements are merely a record-keeping procedure imposed by the state, just like registering the birth of a child; they do not represent an act of creation by the state. Read together, these criticisms juxtapose the idea of the corporation as a "ward of the state" with that of the corporation as a product of freely-constructed contractual agreement. .... In general terms, the fate of concession theory and the fate of state regulation of corporations have been tied to each other, at least in the eyes of neo-classical contractarian critics. In what follows I try to prise these two ideas apart. Whatever the current status of concession theory, I will argue that there is a strong argument in favour of a system of corporate regulation that is in part state-based. A CRITIQUE OF THE CRITICISMS In this section I present some criticisms of the anti-concession theory arguments. This is not because I want to defend concession theory -- I do not intend to side with the Birds or the Beasts. Rather, my purpose is to isolate some themes and issues in the debate which will help us move on to developing an alternative theoretical framework. 80 The fundamental problem with the debate between concession theory and contract-based theories ... is that it gives us only a limited choice.... Moreover, the choice we are offered is between stereotyped positions. [Concession theory] favours state regulation which has the aim of protecting and enhancing the public interest and the interests of investors. It is an argument which relies on the idea of positive liberty, in which it is the state's role to assist individuals in enhancing their social and economic freedom. Detractors characterise this position in terms of state interference with individual choice, enforced through coercive means. From this perspective, mandatory laws are assumed to go hand-in-hand with a command-control style of enforcement in which the state metes out prescribed sanctions for proscribed conduct. [Neoclassical economic theory] emphasises private ordering in place of state regulation. It stresses the value of individual rights and freedoms founded in consensual, contract-like agreements. It tells us that corporations: are created and sustained by freedom of association and contract, that the source of freedom is not governmental permission but individual rights, and that these rights are not suddenly forfeited when a business grows beyond some arbitrarily defined size. Mandatory laws are said to be opposed to ideas of freedom of contract. This view tends towards a position which is suspicious of appeals to "the public interest" -- a suspicion which ultimately extends to the role of state regulation in general. Butler and Ribstein provide an example: their critique of mandatory corporate law rules reads as an attack on the capacity of courts and legislators to govern private relations in general. Ultimately this whole argument is grounded in the philosophical ideal of negative liberty, in which the state's role is strictly limited to protecting the freedom of individuals to conduct their affairs without unwarranted interference. As a result we find that the idea of deregulation is offered as a counter to the command-control style of enforcement that is associated with mandatory corporate laws. .... It might help to summarise the argument so far. The traditional concession theory traces the source of all powers of the company, its managers and its members, to the state. The predominant reaction to this centralist picture has been to argue that those powers are largely, if not exclusively, the product of contractual arrangements between the corporators. Neither of these positions is tenable. Concession theory places too much responsibility and control in the hands of the state, regarding the corporation primarily -- if not exclusively -- as a legal institution. It leads to often inappropriate command-control styles of corporate regulation and gives insufficient weight to the importance of private interests and concerns in forming and running companies. On the other hand, the main contract-based approach leaves too much to market forces and to the whim of private individuals. Despite the claims, the market has not been successful in controlling the conduct of corporate managers. For all of its supposed deficiencies, the state's involvement in corporate life has not withered away, and it cannot be dismissed simply as an historical anachronism. In the end, therefore, neither perspective helps us understand the complexity of corporate life and corporate regulation, yet at the same time each perspective contributes something to our understanding. In the next section I outline an alternative theoretical model which seeks to move beyond these restrictions. AN ALTERNATIVE THEORY: CORPORATE CONSTITUTIONALISM The alternative theory of corporate governance and regulation begins with the proposition that the dichotomy between the public, concession, mandatory, command-control perspective and the private, contractual, enabling, deregulatory perspective is not very helpful. Fortunately, 81 this is something which some corporate lawyers and regulatory theorists have begun to recognise in recent years; what follows is a contribution to that work. The alternative theory accommodates something of both the concession and contractual perspectives, but it is not locked into the either/or choice which they present. On the one hand (for reasons which I explain below) the theory recognises that there is a role for state regulation of corporations -- a role which goes beyond merely supplying "off the rack" contractual terms in order to save corporators the costs of complex negotiations. At the same time, however, the theory acknowledges that corporations are institutions in which individual choices are formed and collective decisions are made. In short, corporate law has both an external dimension, dealing with relations between corporations and society, and an internal dimension, dealing with intra-corporate relations. As Bratton has put it: Corporate law is not an entirely 'private' proposition, even though it tends to lie on the private side of the broader continuum of public and private law. [...] Corporate law conversations, like all legal conversations, are public events. The way in which I attempt to link these external and internal dimensions is to think of corporations as constitutional arrangements. The theory of corporate constitutionalism begins with the proposition that corporations are more than just artificially created legal institutions (contrary to the suggestion of concession theory) and they are more than just economic institutions (contrary to the argument of contract-based theories). Corporations have both of these dimensions, but they are also social enterprises and they are polities in their own right. Beginning with this proposition, corporate constitutionalism argues that the means by which corporations are governed and by which they govern should be constituted by state and corporate inputs. Consider, first, state inputs and the role of state regulation. A corporate constitutionalist framework proposes that there are justifiable constraints and costs which the state, via the legal system, can impose on corporate activity. The basis of this proposition is derived from contemporary republican theories about the role of the state. In republican political theory the state has a unique role in protecting and furthering public values as they are defined by the broader political community: [E]ach individual has some subjective notion of the common good -- a notion that embodies public values shared with others in the community. Civic republicanism requires that the government base its actions on these public values rather than on the private desires that citizens bring into political discourse. A consequential proposition is that state action which seeks to deter behaviour which is inimical to these norms or public values need not be regarded automatically as an affront to individual freedom. This is not to say that state regulation is an unqualified good -- governments, laws, and the agencies which administer those laws can be oppressive and unfair, and thus we require processes and structures which will constrain state action. But the republican message is that state regulation should, and can, be beneficial for society as a whole. A particular concern of government should be the potential threats to liberty which can arise when private organisations exercise private power. It is the role of the government and the courts to "play a role in limiting the power of such organizations without denying the importance of their continued existence." The republican message is that we can think favourably about a system of government which gives the law and the state a considerable range of responsibilities regarding corporate regulation, and which operates to challenge unaccountable accumulations of power and authority. 82 Bringing this message to bear on the regulation of corporations, we return to the idea that corporations are not entirely private associations. As John Parkinson puts it, they are also social enterprises: [C]ompanies are able to make choices which have important social consequences: they make private decisions which have public results. It is possession of this kind of power that gives rise to a distinct need for justification, and which forms the basis for the claim that companies must be required to act in the public interest. Parkinson goes on to argue that the "practical significance [of this claim] is to hold that the state is entitled to prescribe the terms on which corporate power may be possessed and exercised." Joining this idea with the republican perspective on state regulation, we can say that a system of corporate law should be concerned to protect public values such as the avoidance of oppressive behaviour; the use of objective, not merely subjective standards in the evaluation of corporate behaviour; and the importance of accountability in the exercise of power within and by corporations.... State regulation of corporations by reference to these sorts of values is justified because corporations are significant and powerful actors within the wider community. Corporations interact with citizens within the community, either externally (as in contracts for the supply of goods and services), or internally (as when a person is a member of a corporation). But corporations are also polities in their own right, and so the second feature of the theory -- the other part of the governance and regulatory framework -- is supplied by the private ordering of the corporators. While corporate constitutionalism entails a claim that the status of corporations as legal actors is dependent on state action this is not to say that the state is the sole source of corporate governance rules. A corporation is not simply a microcosm of society at large; corporate relationships are structured by their own sets of values. One implication of this is summarised by Eells as follows: The governmental system of a corporation derives essentially from the permissive action of states, by legislation, through administrative rulings, and in judicial interpretation of charters and general corporations law. Eells highlights the permissive nature of this action because of the capacity which corporations have to amend terms of their constitution after incorporation -- that is, the capacity to engage in private constitutional ordering. If corporations are thought of as polities it then becomes easy to see why the corporators should have space to determine and pursue their conception of the corporation's best interests. It is important to be clear about the relationship between state regulation and private ordering in this framework. Unlike the command-control model of regulation, the state does not occupy centre-stage in this regulatory scheme: it is, in Clifford Shearing's terms, "decentred". Nor should state regulation be regarded as superior to, or having automatic precedence over, private ordering. To quote Shearing again: "the state's claim to the apex of a regulatory hierarchy with private regulators performing no more than delegated roles is unfounded". Similar comments apply to private ordering: this framework differs from contractarian theories in that private ordering is not seen as an alternative to state regulation, much less an inherently preferable alternative. State regulation and private ordering are each necessary but neither of them alone is sufficient. One point to emerge from this description is that the label "corporate constitutionalism" carries a double meaning. First, it reminds us that corporations operate within a constitutional 83 setting in which the state has responsibilities and powers. Secondly, at the same time it proposes that corporations are themselves constitutional arrangements. To put it another way, a corporation is an institution which, via its constitution, mediates public and private interests and values. .... CONCLUSION Since the time of Salomon's case corporate law has grappled with a conflict that is fundamental to all liberal legal systems -- the contest between the role of the state and the rights of individuals. One hundred years after that decision one of the few certainties in the debate is that the public regulation of corporate activity has not withered away. In this article I have proposed a theory of corporate governance regulation which tries to avoid this two-sided debate, which incorporates public and private regulatory perspectives, that pays attention to community values and to interests from within individual corporations. The theory depends upon the idea of corporations as constitutional arrangements. I suggest that by locating corporations within a constitutional framework we have a more readily understood explanation for the role of public laws which regulate corporate activity. It is, I suggest, an explanation which is more acceptable in doctrinal and political terms than one which treats corporate law as a set of default contract terms or as a public version of a private agreement. It is not the purpose of this theory to suggest a wholesale reconstruction of the corporate regulatory system. On the contrary, this theory sets out to address the same issues and questions which confront contract-based theories: questions such as the extent to which corporations should be able to write their own rules, and the role of the courts in deciding internal corporate issues. The aim of corporate constitutionalism is to provide a different conceptual framework within which to answer these sorts of questions, and to supply a different set of criteria with which to evaluate corporate and state actions. 84 CORPORATE EXISTENCE: BRINGING A COMPANY TO A CLOSE The readings for this class provide an overview of the ways in which companies in financial difficulties may be saved or, if hopelessly insolvent, brought to an end. These methods, collected together in Corporations Act Chapter 5, are referred to as methods of "external administration" since the directors must relinquish the company's affairs to outsiders (receivers, administrators, provisional liquidators and liquidators). Briefly, struggling companies may face: Voluntary administration Appointment of a receiver or controller Liquidation (or winding up) A creditors' scheme of arrangement Stakeholder analysis is important in this topic. When a company is financial difficulties, whose interests are placed at risk? What protections, if any, does the law provide to protect these interests? How does the law prioritise multiple stakeholder claims to the corporate fund? The Casebook at paras 3.185-3.215 provides a succinct treatment of the external administration of companies. After you review the law, look at the problem at the end of the readings: how would you advise Albert Side in relation to his funeral business? The newspaper reports are about companies in financial distress. Can you place the events in these reports in their relevant legal context, explaining what has transpired -- and what might transpire further down the track -- by reference to Corporations Act Chapter 5? Finally, note the outline of the Corporations Amendment (Repayment of Directors' Bonuses) Bill (now section 588FDA). What difficulties might arise in the application of these provisions? (Recall your understanding of the regulatory arrangements for the Corporations Act why was consent of MINCO necessary?) 85 Miscellaneous Newspaper Reports "FROGGY SCHEME CRAZY, GREEDY: ADMINISTRATOR", SYDNEY MORNING HERALD, 4 DECEMBER 2001 (WWW.SMH.COM.AU/0112/04) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. The investment scheme run by Froggy.com founder Karl Suleman was "just craziness, it's just greed", the administrators of Karl Suleman Enterprises said yesterday. The administrators, Neil Cussen and Paul Weston, met with management of the Froggy group yesterday morning to discuss a "sensible" way of retrieving $13 million in loans. Mr Cussen, of Horwarth Chartered Accountants, said the unsustainable investment scheme offered 200 per cent on investor contributions. The allegedly illegal scheme raised $131 million from 2062 investors since it began in late 1999. About $45 million has been repaid. The recovery of an eastern suburbs property, overseas assets, a Lamborghini and a Ferrari, and aircraft owned or leased by Mr Suleman will go only a small way to cover what is owed to them, investors have previously been told. Mr Weston said he had not seen a business plan for the investment scheme and that the company's only trading activities were in a trolley collection business. He said the company's books and records were "in an extremely poor state" and could not be relied upon. Mr Weston said they would investigate whether Karl Suleman Enterprises had breached a number of sections of the Corporations Act, including failing to provide sufficient books and records and trading whilst insolvent. It was important the company was placed into liquidation to give investors the best chance of retrieving their money, he said. "We need those sorts of powers to go out and examine and get banking records to find out what has happened to the money and verify investors claims," he said. 86 "CREDITORS VOTE TO WIND UP SMART COMMUNICATIONS", AAP, 21 DECEMBER 2001 (HTTP://WWW.IT.MYCAREER.COM.AU/BREAKING/ 2001/12/21/FFX6LRFUGVC.HTML) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Smart Communications Group has been wound up, leaving behind a pending damages claim against the company's directors and a company shell on sale for $500,000. Creditors of the formerly listed computer cabling company rejected a proposed deed of company arrangement from directors and voted to wind the company up, said joint liquidator Max Prentice, of insolvency firm Prentice Parbery Barilla. Mr Prentice said he would seek damages of around $900,000 against Smart directors for alleged insolvent trading in October 2001, immediately before administrators were appointed. He said he planned to sell the company shell for $500,000, and to sell off its remaining assets. Prentice said he had rejected a proposed a deed of company arrangement from Smart directors which included a $100,000 injection, doubled to $200,000 shortly before the creditors meeting. The sum was insufficient and accepting the proposal would prevent the pursuit of the damages claims and selling the company shell. He could faster secure employee entitlements if the company was in liquidation, he said. Prentice said Smart had lost an average of $417,000 per month since listing in August 2000 but the company had traded profitably for three months since listing. The company had been declared insolvent because it had drawn insufficient sales on inadequate margins. As well, the company had an "inappropriately large and expensive corporate infrastructure given the size of the business", Prentice said. The insolvency was also influenced by the company's poor financial reporting systems and job costing, together with Lucas's failed takeover and unwillingness to inject working capital into the group. 87 "NOMAD SALE BELIEVED TO BE CLOSE", THE AGE, 14 MARCH 2001 (HTTP://WWW.THEAGE.COM.AU/BUSINESS/2001/03/14/FFXWYWUG8K C.HTML) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Receivers and managers handling the failed Nomad Telecommunications group are believed to be close to selling the Melbourne-based business, crystallising losses of as much as $6 million for ANZ Bank. The receivers, Peter Yates and Andrew Beck, of Deloitte Touche Tohmatsu, fielded at least two formal offers for Nomad's business, and the offer now under consideration is believed to represent a market value of about $4 million. Mr Yates yesterday confirmed he expected to sell the business soon, but declined to discuss details. Nomad was placed in receivership by ANZ Bank in mid-January as it sought to retrieve a debt of more than $9 million. Nomad chief executive Carlton Taya has asked the receivers for a further extension in preparing his report on the company's position. Mr Taya was left as the sole director in early November when three Nomad directors, including chairman David Greatorex, quit following a hostile meeting of shareholders and note holders. A court-appointed liquidator, Graham Bendeich, of Harts in Brisbane, who is acting for the unsecured creditors, is anxious to hear from individuals and companies who believe they are owed by Nomad. The liquidator wants funds to support an investigation into company's affairs. Nomad was placed in receivership on January 18 by ANZ Bank after at least 12 months of shaky trading. The company, which bought telecommunications equipment to service big new facilities contracts with corporates and government departments, failed to raise sufficient funds to support its expansion. Several sources who contacted The Age said Nomad never invoiced them for telecommunications equipment and services, or that bills were several months late arriving. Others said the company's network of mobile phone stores was left chronically short of stock, and payments of commissions to dealers were tardy or unpaid. 88 "MILLIONAIRE MOVES TO DUMP ASSETS AFTER COURT PAYOUT", SYDNEY MORNING HERALD, 29 JANUARY 2002 (HTTP://WWW.SMH.COM.AU/NEWS/0201/29/NATIONAL/NATIONAL18.HTML) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. An 82-year-old Sydney multi-millionaire hotelier, Cyril Maloney, has moved to place two of his companies into liquidation after one of them was ordered to pay about $650,000 to a man badly beaten at Cremorne's Metropole Hotel seven years ago. Brad Robinson was set on by two men while playing in a pool tournament at the Military Road pub in May 1995. The head and neck injuries he received forced him to spend more than $70,000 in medical bills. On December 19, NSW District Court Acting Judge Alan Hogan ruled the hotel had failed to organise adequate security and ordered the owners at the time of the attack, C G Mal Pty Ltd, to pay Mr Robinson $646,127 and costs. Cyril Maloney, who debuted at $110 million on to last year's BRW Rich List, is listed as the sole director of C G Mal and owns 1000 of its 1002 shares. He boosted his wealth by selling the hotel in 1998, according to the magazine, and in 1999 paid $16 million for four Bennelong apartments at East Circular Quay, describing his occupation of the Toaster's entire 11th floor as a reward for years of hard work. Today's creditors' meeting will decide if C G Mal should be voluntarily wound up. An adviser for the Maloneys, taxation consultant Chris Batten, said Mr Maloney was away but confirmed today's creditors' meeting. The Metropole was insured at the time of the attack by HIH. Mr Robinson's solicitor, Geoff Adelstein, wrote to C G Mal in December, advising of the court ruling and that the company might be eligible to make a claim against the HIH rescue package. Shortly before time limits which could have enabled Mr Robinson to initiate winding up C G Mal to retrieve his money, the company's solicitors contacted Mr Adelstein indicating Mr Maloney was overseas and not due back until January 16. They asked Mr Robinson to hold off until they could meet Mr Maloney on January 17. "I accepted those assurances in good faith and was prepared to give the requested time extension because it seemed in Mr Robinson's best interest," Mr Adelstein told the Herald yesterday. On Thursday, Mr Adelstein received a letter advising him of a creditors' meeting to have C G Mal placed into liquidation. 89 Documents he has since obtained show that on January 18, Mr Maloney met Hall Chadwick, accountants specialising in insolvency and proceeded to appoint them administrators of C G Mal. The same day, Mr Maloney signed a statement of assets and liabilities disclosing that while the company had assets of $4,131,207, none of these could be recovered. On speaking to Hall Chadwick, Mr Adelstein learned C G Mal had lent another Maloney company, CMaloney Pty Ltd, $4.1 million. The second company was wound up on January 18. Mr Adelstein has sought information over the timing of the loan and the liquidation of the second company. "I have written to both liquidators seeking clarification. The liquidator of C G Mal says that the issue is one for the CMaloney liquidator to pursue, but I wonder why it is not the administrator of C G Mal who would have himself an interest in unravelling the situation," Mr Adelstein said. Mr Robinson has declined to comment. 90 "PRESTON DIGS ITSELF OUT OF DEBT HOLE", SYDNEY MORNING HERALD, 18 JUNE 2001 (HTTP://WWW.SMH.COM.AU/NEWS/0106/18/BIZTECH/BIZTECH13.HTML) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Despite being suspended from the Australian Stock Exchange for almost two years, nickel hopeful Preston Resources claims to be on the verge of resolving its financial problems. Preston's chairman Mr Colin Ikin said the planned recapitalisation of the company might be completed as soon as this week. "If you ask me I'd say this week -- but I've been saying that for a while," Mr Ikin said. It had been a "terrible" two years as Preston struggled to finalise an agreement with its major creditors aimed at preventing the company slipping into administration, he said. Preston is one of the three new generation nickel miners that have run into financial trouble due to unexpected technical problems with their WA nickel laterite mines. The company has been suspended from the ASX since October 1999 when its share price was just 27c. Preston's major creditors are the same US bondholders who placed Mr Joseph Gutnick's Centaur Mining & Exploration into receivership in March after cash-flow problems caused the company to default on several interest repayments. Preston has also defaulted on interest payments on the $US185 million ($353 million) notes it secured to finance its Bulong nickel mine and plant. But Mr Ikin claimed the planned recapitalisation of Preston had the support of the bondholders as well as Preston's major banker, Barclays. "There is approximately $60 million in outstanding debt but we don't have any chance of raising that money," Mr Ikin said. "If we go ahead with the scheme of arrangement we will live to face another day. We will have 5 per cent of the project [Bulong] and no debt." Preston has proposed a scheme of arrangement under which the company hands 95 per cent of Bulong over to the US bondholders in return for them writing off any outstanding debt owed by the company. Mr Ikin said the Bulong mine was making good progress and was cash-flow positive, generating a profit of $4 million for the month of May. Preston is also close to finalising due diligence which is expected to release Bulong's previous owner, Resolute Ltd, from $150 million worth of warranties related to the project. 91 Costello, P, Second Reading Speech, Corporations Amendment (Repayment of Directors' Bonuses) Bill 2002, 16th October 2002, Hansard. Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. OUTLINE This is a bill to amend the Corporations Act 2001 to permit liquidators to reclaim unreasonable payments made to the directors of insolvent companies. The object of the bill is to assist in the restoration of funds, assets and other property to companies in liquidation for the benefit of employees and other creditors, where unreasonable payments have been made to directors in the lead-up to liquidation. BACKGROUND In the wake of the collapse of One.Tel, the government announced it intended to pursue an amendment to the Corporations Act to enable the recovery of bonuses paid to the directors of companies that later collapse. In this bill, the government delivers on that commitment. The Corporations Act already contains a range of measures, known as the voidable transaction provisions, that allow a liquidator access to moneys paid out by a company. The provisions permit the reversal of certain transactions entered into by an insolvent company in the lead-up to a liquidation. The Bankruptcy Act provides trustees with similar powers in relation to personal insolvency. In certain limited circumstances, liquidators can attack payments made while a company is still solvent. This bill adds to those circumstances, by explicitly extending them to include unreasonable payments made to directors of companies. The amendments cover transactions made to, on behalf of, or for the benefit of a director or close associate of a director. To be caught, the transaction must have been unreasonable, and entered into during the four years leading up to a company's liquidation, regardless of its solvency at the time the transaction occurred. PROVISIONS OF THE BILL The main provision inserted by the bill is new section 588FDA, entitled `Unreasonable director-related transactions'. Subsection 588FDA(1) outlines the kinds of company transactions caught by the bill. It targets transactions that a reasonable person in the company's circumstances would not have entered into. The reasonableness of the transaction is determined with regard to a number of factors. They include the respective costs and benefits of the transaction to the company, and the benefits received by the recipient. 92 The meaning of `transactions' is broadly described to prevent avoidance. It includes a payment made by the company, as well as conveyances, transfers and other dispositions of property. It also includes the issue of securities, including options. Further, incurring an obligation to enter into any these transfers in the future would be a `transaction' for the purposes of the bill. The focus of the bill is transactions entered into by the company with its directors, and accordingly the recipients covered by it include directors of the company. The bill covers two further categories of person. It includes company transactions with close associates of a director. A `close associate' is defined under the bill to mean a relative or de facto spouse of a director, as well as the relative of a director's spouse or de facto spouse. It will also apply to transactions entered into with third parties, where they are made on behalf of, or for the benefit of, either a director or close associate. This will prevent people avoiding the new provisions through restructuring or redirecting transactions. Subsection 588FDA(2) provides that the reasonableness of entering into the transaction is determined at the time the company actually enters into the transaction, regardless of its reasonableness at the time the company incurred the obligation to enter the transaction. This enables liquidators to recover payments where the true magnitude of the unreasonableness involved only becomes apparent when the company actually makes the payment, even if it appeared reasonable at the time the company agreed to make the payment. [...] The bill provides that an unreasonable director-related transaction is voidable where it was entered into or given effect to within four years of the relation-back day. That day is usually the date of filing of an application to wind up the company, and is the usual point in time for measuring the reach of voidable transactions. APPROVAL OF MINCO In accordance with the Corporations Agreement, I can advise that the government has consulted with the Ministerial Council for Corporations in relation to the bill. The council provided the necessary approval for the text of the bill, as required under the agreement for amendments of this kind. CONCLUSION This bill makes amendments that will provide a valuable addition to the existing range of powers available to the liquidators of insolvent companies. It permits the restoration of funds and property to a company for the benefit of employees and other creditors. It also gives a strong statutory expression of the government's intention that directors do not receive unreasonable remuneration, particularly when creditors, employees and shareholders are at risk. Directors are in a better position than most to know the true state of affairs of the company in the short to medium term, and should not profit from this knowledge at the expense of employee and ordinary creditors. 93 Woodward, S (et al), Corporations Law: In Principle (6th ed) (2003) at 449-450 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. PROBLEM FOR DISCUSSION Albert Side took over his father's funeral business in the early 1980s and soon set about updating its products and image. He changed the name of the principal operating company to "The Other Side Pty Ltd" (TOS) and, within a few years, TOS had: 10 funeral parlours throughout Australia, all of which are rented; a substantial quantity of equipment (including hearses and cremators) leased from finance companies and secured by personal guarantees from Albert and his wife; and three subsidiaries as follows: - Dearly Departed Pets Pty Ltd (Pets); - Creative Coffins and Stonemasonry Pty Ltd (Coffins); and - TOS Embalming and Cryogenics (Cryogenics). In the more austere 1990s, it was much harder to persuade people to spend money on funerals for pets so Pets has been running at loss for several years. This is unlikely to change in the foreseeable future. Coffins is a very profitable business and operates out of a factory in Geelong that it owns outright. However, most of its profits have been drained off to cover the losses in Pets and to fund the start up costs in Cryogenics. Those start up costs have been substantial so, for the time being, Cryogenics is a significant drain on the rest of the TOS group. But independent marketing consultants have reported that the future for the Cryogenics industry is very promising and, as one of the only suppliers of these services in Australia, there is a realistic prospect that in one or two years, the investment in Cryogenics will pay substantial dividends. TOS itself is profitable but only just. It too is suffering from the drain on funds caused by Pets and Cryogenics and its 80s image is starting to pale with the customers. The group is financed by loans totalling $10 million from Eastpac Bank. Eastpac has security in the form of standard fixed and floating charges over all the assets of each company, except the Coffins' factory site. The local manager of Eastpac agreed to release this from the bank's charge when Albert told him the group was planning to enter into a sale and leaseback arrangement to raise more funds. This has not yet been implemented. The loans form Eastpac are also secured by personal guarantees from Albert and his wife. Albert is concerned that he may not be able to keep things afloat long enough for the profits from Cryogenics to come on stream. He is particularly worried about his personal exposure under the guarantee he and his wife have given and about his personal exposure under the guarantees he and his wife have given and about the welfare of his employees who have been very loyal during difficult times. TOS has been late in the payment of rent on its flagship parlour in Sydney each month for the last seven months but has managed to find the 94 necessary funds, usually at about the time the second threatening letter has arrived. One or two of the cheques sent to the landlord have bounced the first time they were presented. His debt of $2,090 to the local church choir is way overdue. One of the choristers is a law student and has helped the vicar to prepare and send a statutory demand. The 21 days expired yesterday. Albert has approached an insolvency practitioner who has in turn sought your assistance in advising Albert about he should do. One option he is considering is selling the Geelong factory site to his family company for less than its full market value. You are asked to advise Albert about his options and what factors might influence the ultimate outcome of any decision he takes. In particular, your advice should consider what Eastpac bank is likely to do. 95 CORPORATE DECISIONMAKING 96 CORPORATE DECISION-MAKING: INTRODUCTION The readings for this class introduce you to how business decisions are made within the company. Several core issues arise: Who exercises decision-making powers in the company? Where do these decision-making powers derive from, that is, what source -- or sources -- determines how decision-making powers are vested within the company? Why has this decision-making structure emerged to become the paradigm in modern corporations? Does such a structure pose potential problems for decision-making accountability? Does the comparative evidence point to alternative models for achieving accountability? How would you evaluate this model of corporate decision-making? Is it efficient? Is it consistent with broader liberal democratic ideals of accountability for decisionmaking? The first two issues can be quickly dealt with. Thus, the first extract by Stapledon describes the two main players -- or "organs" -- responsible for corporate decisionmaking in the modern company: the board of directors and the general meeting of shareholders. The Casebook at paras 3.145-3.150 and 5.95-5.100 explains how the corporate constitution is the key source for determining which organ can exercise what decision-making powers within the company. See, also, Corporations Act ss 134-141 and 198A. The third issue -- how has the current system of decision-making emerged to become the prevailing model -- is taken up by the Casebook at paras 2.155-195. In particular, the Casebook refers to the separation of ownership and control -- that is, those who run the company do not have significant ownership interests in it, and those who do have an ownership stake in the company do not control it -- and explains the economic reasons for this development. The Casebook goes on to evaluate the extent to which the separation of ownership and control is evident in contemporary Australian companies, and questions whether the rise of institutional investors -- eg, fund managers such as BT -- might create a new decision-making paradigm. The extract by Roe explains in greater detail the economic history behind the separation of ownership and control. More importantly, the extract explores the accountability implications of the separation of ownership and control. Roe argues that the separation of ownership and control in the United States has lead to an "outsider" system of corporate governance; that is, the primary form of accountability imposed on managers and the board comes from outside the company, eg, securities and product markets. He contrasts this with the "insider" system of governance -- more typical in Germany and Japan -- in which management decision are carefully monitored and controlled within the company, namely, by a small number of large blockholders. Finally, the extract by Stokes offers a critique of the prevailing pattern of decisionmaking -- a paradigm she dubs as "managerial power". Stokes argues that managerial power offends fundamental liberal democratic ideals. Over the next few classes, we will track how Stokes develops this thesis. 97 Stapledon, G, Institutional Shareholders and Corporate Governance (1996) at 7-9 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. THE POWER STRUCTURE IN LARGE COMPANIES The company statutes of ... Australia contain a model of corporate management and control involving two main organs: the board of directors and the general meeting of members. However, the standard articles of association allow for the board appoint and confer any of their powers up on one or more executive (or "managing") directors, which in effects allows the creation of a third organ -- executive management -- if it is required. Under the companies legislation, and standard articles of association (as interpreted by courts in the 20th century), the board of directors is the most important day-to-day organ in the company. The board is given the power to manage the business of the company, and the general meeting is not permitted to interfere with his exercise. The general meeting does, however, retain ultimate power in that it has the right by simple majority to remove the directors without cause, and by three-quarters majority to change the articles. The board of directors of a quoted public company usually consists of non-executive (i.e. part-time) directors as well as executive directors (who are employed as full-time officers of the company). The board, as an organ, would very rarely manage the business of such a company. In practice, the board of the average quoted company delegates to the chief executive (or "managing director") and other executive directors the responsibility for day-today management of the company's business. It is the executive directors and other executive officers (who are not also members of the board), collectively called the executive management, who manage the company's business. A company's strategy is developed by the executive management, although it is normally necessary for the approval of the board to be obtained for major transactions or changes in strategy, and sometimes necessary for shareholder approval to be obtained as well. The board usually meets monthly, and performance (or is supposed to perform) the functions of reviewing strategy and monitoring the performance of the executive management. This division of functions between the shareholders, the board, and the executive management is an inevitable consequence of the large size and scale of operation of most quoted companies. Under ... Australian company law, directors and senior executives owe their fiduciary and other duties to the company as a legal entity separate from its shareholders and creditors. However, under the general law the "interests of the company" means, whilst the company is solvent, the interests of the shareholders, present and future, as a group. Although most industrialists, and any commentators, consider that the interests of large companies are an amalgam of the interests of a number of stakeholders such shareholders, creditors, employees, customers, suppliers, management, and indeed the community, the general law still considers the company's interests to those of the collective body shareholders.... 98 Roe, M, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance (1994) at 3-17 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. DIFFUSE OWNERSHIP AS NATURAL ECONOMIC EVOLUTION The public corporation -- with its distant shareholders buying and selling on the stock exchange -- is a dominant form of enterprise in the United States. Why? Technology dictated large enterprises as an engineering matter. The large throughput technologies that developed at the end of the 19th-century -- doubling the diameter of the pipe quadrupled the pipe's throughput -- meant that cheaper production accrued to the firm with the larger scale. Only the United States had a continent-wide economy with low internal trade barriers, providing a market to those who could achieve the technologically feasible large-scale efficiencies. But getting the tremendous outputs from the new economies of scale eventually required large capital inputs to build the facilities and distribution system. Where could that capital come from? Some of it came from internal growth as the firm retained its earnings; some of it came from investors. But individuals, even a small group of them, lacked enough capital. Alfred Chandler describes the railroads as the first of the modern business enterprises: Ownership and management soon separated. The capital required to build a railroad was far more than that required to purchase a plantation, a textile mill, or even a fleet of ships. Therefore, a single entrepreneur, family, or small group of associates was really able to own a railroad. Nor could that many stockholders or their representatives manage it. The administrative tasks were too numerous, to varied, and to complex. That required special skills and training which could only be commanded by a full-time salaried manager. Only in the raising and allocating of capital, in the setting of financial policies, and in the selection of top managers did the owners or their representatives have a real say in railroad management. Even John Rockefeller in his heyday -- the richest man in the worlds -- held only a fraction of Standard Oil. New technologies allowed for vertical integration of several steps in production and distribution; transactions that once occurred across markets -- making raw materials in one firm, manufacturing them into a final product in another, and distributing them in yet another -- were brought inside single firm, with managers visibly coordinating the steps are production. Managers had to avoid shortages at each stage of production and ensure a smooth flow from raw materials to find sale; management became as important to production as marketplace trading. Eventually these new large-scale enterprises had to draw capital from many dispersed shareholders, who demanded diversification.... [E]ventually not investors, but salaried managers with specialised, often technological, skills took over day-to-day control the operations. This combination of a huge enterprise, concentrated management, and dispersed diversified stockholders shifted corporate control from shareholders to managers. Dispersed shareholders and concentrated management became the quintessential characteristics of the large American firm. 99 This then became the pattern for constructing America's large enterprises in the 20th century. Entrepreneurs would founder business, succeed, and make the business grow. Frequently banks would lend capital. Eventually the successful firm would go public, issuing new stock (or selling the founders' stock) to the public. For some firms, the stock market's role was to raise new capital; the many others, its role was to provide the founders and their heirs an exit when they wanted to diversify and cash out.... Although descendants sometimes took over running the firm from the founders, more frequently hired managers did, and stock dissipated into fragmented holdings as the heirs sold off the inheritance and the managers raised new capital in public markets.... Although the defects of separation are today in the spotlight -- without their own money on the line, managers can pursue their own agendas, sometimes to the detriment of the enterprise -- separation of ownership and control was historically often functional (and still lives), because it allows skills managers without capital to run the firm and separates unskilled descendants from control of the firm they could not run well. Sometimes successful founders became poor managers, because their accumulated wealth allowed them to slack off but still live well, as historically was a problem in Britain. They held on to control, but failed to infuse dynamism into the enterprise, whereas in the United States, separation may have created some agency costs, but it put newer, ambitious managers in place. Competitive and organisational mechanisms made the separated firms run, overall, as well as they could. Dispersed individuals would hold the stock, frequently in hundred-share lots. And "[w]hen people observe that firms are very large in relation to single investors, they observed the product of success in satisfying investors and customers. .... [A]s a formal matter shareholders elected to the board of directors, and the board appointed the CEO. But everyone knew that in the public firm the flow of power was the reverse. The CEO recommended nominees to the board. Board members were often insider-employees or other CEOs, who have had little reason to invest time and energy in second-guessing the incumbent CEO. The CEO's recommendations for the board went out to shareholders, whose small shareholdings gave them little incentive --or means --to find alternatives.... The CEO dominated the election and the firm. Even today, many directors "feel that they are serving at the pleasure of the CEO-Chairman." The Berle-Means Analysis; Atomization This fragmentation and shift in power were analysed in the 1930s, in Berle and Means's The Modern Corporation and Private Property, which became the classic analysis of the large American firm. Berle and Means announced what came to be the dominant paradigm: "[T]he central mass of the 20th century American economic revolution [is a] massive collectivisation of property devoted to production, with [an] accompanying decline of individual decisionmaking and control, [and a] massive dissociation of wealth from active management." This restructuring turns corporate law on its head: stockholders, the owners, become powerless. A "[s]tockholder [vote] is of diminishing importance as the number of shareholders in each corporation increases-- diminishing in fact to negligible importance as the corporations become giants. As the number of stockholders increases, the capacity of each to express opinions is extremely limited." As a result, corporate wealth is held by shareholders as a "passive" investment, and managers control the corporation. The paradigms is not solely that shareholders and managers separate, or as Berle and Means put it, "massive dissociation of wealth from active management. The paradigm depends on atomisation. Most public companies are held by many shareholders owning only small stakes. In the Berle-Means era, shareholders were mostly individuals; even today, individuals directly own half of all stocks in US companies.... Because of atomisation, an active shareholder 100 cannot capture all of the gain from becoming involved, studying the enterprise, or sitting on the board of directors, thereby taking the risks of enhanced liability. Such a shareholder would incur the costs but split the gains, causing most fragmented shareholders to rationally forgo involvement. In the language of modern economics, we have a collective action problem among shareholders -- despite the potential gains to shareholders as a group, it's rational for each stockholder when acting alone to do nothing, because each would get only a fraction of the gain, which accrues to the firm and to all of the shareholders. This shareholder collective action problem is then layered on top of a principal-agent problem -- agents, in this case the managers, sometimes don't do the principal's, in this case the stockholder's, bidding perfectly. Adaptations The problems of fragmented ownership, and shift in power to the CEO, and suppression of large owners did not threaten the public firm as an organisational form because of several economic features. First, even if the structure had some bad features, its strengths were overwhelming. It facilitated economies of scale and professionalised management -- advantages large enough to offset weakened incentives and weakened coordination between managers and shareholders. Managerial discretion, when it was less than absolute, was functional: for managers to build large complex organisations capable coordinating nationwide production and distribution, they needed the day-to-day discretion. The advantages from economies of scale and complex organisational capabilities dwarfed the organisational costs. When the United States had the only content-wide economy in the world, nowhere else could economies of scale and geographically big distribution system be attained smoothly. Since nowhere else could firms easily achieve such economies of scale, the smaller organisational costs were hidden. Second, competition -- in product markets, managerial labour markets, and capital markets -- reduced the severity of occasional managerial derelictions. In the 1930s, 1940s, and 1950s, United States was the world's only continent-wide open market, allowing several firms to reach economies of scale. Nowhere else in the world could firms reached arable economies of scale and have workable competition and political stability. Markets abroad were closed, other nations were too small, transportation and communication costs were too high, and political upheaval was common. In prior decades American oligopolistic competition allowed large American firms to show good returns to shareholders. Product market competition is, in the long-run, a severe constraint on managers and their firms. If the manager cannot sell products, the firm will not last. Workable even if oligopolistic competition prevented serious productive lapses, while oligopolistic slack gave shareholders a cushion of extra profits. .... Firms with dispersed ownership survived because organisations adapted, solving enough of the governance problems of the large unwieldy structures that technology and capital needs created.... [E]ach adaptation tended to help improve the firm's organisational abilities. In the conventional story, the large public firm is an efficient response to the economics of organisation; and that part of the conventional story -- at least when one assumes American financial laws and politics to be fixed and immutable -- is surely correct. FRAGMENTATION'S COSTS General Motors lost billions in the 1980s and early 1990s, laid off tens of thousands of employees, and saw a big part of its once huge share of the American automotive market go 101 to foreign competitors. Its managers were said to be out of touch and its board inattentive until GM lost an awesome $7 billion in 1991 in core North American automotive operations. Although ownership structure could not explain all of GM's problems, it might explain some of them, particularly its decade-long slowness in reacting to crisis. Could the costs of some of the problems afflicting firms with dispersed ownership had been reduced by concentrating ownership? ... I'll outline here the basic costs of organising our large firms as we do. The costs fall into three categories: problems with managers, problems with securities markets and problems with organising industry. Problems with managers are obvious. Dispersion in small holdings creates a collective action problem for shareholders, making managers less accountable in the way that can hurt performance, particularly when the firm faces unusual problems. Senior managers in the large public firm are among the least directly accountable in American society. While other groups also have low direct accountability tenured faculty at solvent universities come to mind -- few of them have tasks as important as those of senior managers at leading firms. Problems with securities markets arise from the difficulty of transmitting complex, proprietary, and technological information from inside the firm to the American securities market. If scattered shareholders cannot understand complexity, and if managers cannot be rewarded for what shareholders cannot understand, firms may abandon some long-term, technologically complex projects. Overlapping ownership -- a financial institution that owns a big block in both a supplier and its customer -- can sometimes improve the organisation of industry. Firms, suppliers, and customers will need to coordinate their activities, and in the United States often do so in big, vertical firms. Overlapping ownership would allow them to stay separate. It could help keep firms smaller and nimbler, reducing the number of slow-moving vertically integrated behemoths. Flat organisation of the top might work better when technological change quickly makes many managers' training obsolete. Psychological and sociological theories indicate that nonhierarchical forms may function better in some new industries in today's world. My point is not that we have theory or data to prove the superiority of other organisational forms, but that there is just enough data, and just enough theory, to tantalise. Had there been a contest between organisational forms, concentrating ownership might have had enough going for it to have been one of the survivors. Alternative forms -- such as those prevailing in Germany and Japan -- seem, despite their own distinctive defects, able to do just about as well as the American forms. Unwatched managers as the problem? Complaints are heard that shareholders fail to monitor managers. Managers build empires and pursue bad strategies without shareholder intervention until matters are so out of hand that the ultimate outcome is the violence of the hostile takeover or the bloodshed of a fired CEO or the instability of the leveraged buyout or the waste of the bankruptcy.... It is not just that with stockholders scattered, a few managers could pursue their own agendas: building the empires, pursuing quieter lives, or persisting in failed strategies because they were familiar. It is also that in trying to do well, some managers did not adopt the best technologies and strategies for the future. That most managers do well is both a tribute to their being professionals and a sign of the other constraints on managers' doing badly, of the adequacy of existing structures. The question is whether different ownership structures in some firms could have induced even better performance. 102 Weaker boards have historically been a debility of the large American firm. Board membership has come by invitation from the CEO, who typically invited insiders and CEOs from other firms. CEOs as directors have disadvantages: the time is constraint, they lack of financial incentive to be inquisitive, and psychologically, they do not want the board to intrude on the CEO's authority any more than they want their own boards to intrude on their own authority. Board members are typically neither large shareholders with an independent base and interest in the firm nor representatives of large stockholders, owning, say, 5 or 10 percent of the firm, because such stockholders rarely exist in American firms. Weak monitoring and low shareholder involvement depends partly on Berle-Means fragmentation. It's just not worthwhile for a shareholder with a small block to incur the expenses of involvement. It's easier to sit the crisis out, or sell of the shareholding. To implore an owner of $10 million of the stock of a $10 billion industrial firm to be active may do no good. Such a shareholder can capture only one-thousandth of the corporation's gain. The shareholders should rationally declined to invest $100,000 of his or her time and wealth, even if that $100,000 would yield a $100 million gain for the corporation. The blocks must be big enough to give the shareholder both the incentive and the means for action. The large shareholder, able to capture and bigger part of the gains than can fragmented shareholders, would have a great incentive to act. A $100 million shareholder would spend more than a $10 million blockholder, because it could capture a tenfold greater part of any gains. And incentives are not enough. Although even a $10 million stockholder has some incentive, it may lack of the means to bring about change. Managers can, and often do, deflect the activist, who needs a large holding as a percentage of the firm's stock either by itself or in alliance with other large holders to get the power to be effective. .... The Difficulty of Building Long-term Financial Relationship: Shortterm Securities Markets as the Problem? Maybe managers are not the problem, but shareholders are. Managers complain that shareholders are transients, uninterested in the firm's long-run health.... [W]ith small blocks the norm among ... investors, if they discover a problem early, they have an incentive to dump the stock and run, rather than hanging in to help fix the problem..... Maybe there's no systemic problem with managers at all. [P]erhaps there is another problem to be remedied, a systemic defect that undercuts managers. Perhaps securities markets are the weak link, transmitting their debilities into operating firms, weakening them by pushing managers into simple short-run strategies, because operating managers cannot transmit proprietary, complex, and technological information well to distant, atomised shareholders. If this happens, senior managers who expect to retire in a few years and cash in their stock options by then could shun long-term investment, and industry would underinvest in research and development as well as human capital, because these investments are too difficult for distant shareholders to understand. These informational problems are highly speculative, cast against the usual belief that American securities markets are informationally efficient, and so far lacked strong empirical backup. For these reasons mandated change to end a speculative, unproven problem isn't sensible. But there is just enough suspicion in the business world that securities markets induced short-term behaviour, and just enough plausibility to link this to the American scattered ownership structure.... 103 Industrial Organization as the Problem? Organising industry is complex and subtle. When separate business firms invest in factories that relate to one another the engine company makes auto engines for the auto assembler and the auto assembler makes auto bodies into which the engine will fit the relationships governing the separate steps in production cannot all be written down in a perfect contract, because too many unexpected things can happen over the lifetime of the contract. To reduce the conflicts that can arise here, American industry has often brought these different steps in production into a single, vertically integrated firm. Vertical integration in a single firm has costs, sometimes creating a stultifying bureaucracy and a sluggishness in responding to market signals. Separate firms could avoid bureaucracy and the fast, but the arms'-length contract they would need to govern their relationship over a number of years could be too hard to figure out and write-down. A loose ownership relationship between the supplier and customer might work better than either contract or vertical integration alone. Instead of one firm's being a division or subsidiary of the other, each would be partially owned by an overlapping group financial institutions. Neither would be a controlled subsidiary, but there would be connections, information exchange, and, if there were disputes, a financial "escrow agent," a mediator, to settle those disputes. When financial institutions cannot take big blocks and help to coordinate these relationships, the likely results seems to be more vertical integration and bigger, perhaps slower firms. These three costs of fragmentation less accountable managers, short-term securities markets, and weaker industrial organisation ... [mean that] we should ... ask whether we can improve [the American system of corporate governance]. The evidence from abroad comes in two packages, one clear, one not. The clear one is that ownership structures that contrast starkly with American fragmentation can exist and survive. None of the 15 largest American firms has an institution or group holding 20 percent of the firm's stock not GM, not Exxon, not IBM. None. In Japan, every large firm has a financial group holding an aggregate of 20 percent of the company's stock: Toyota, Fujitsu, Mitsubishi every one. Germany is more complicated, ... but closer to Japan than to the United States. The differences and persistence of the different structures ... are clear, but it is unclear whether the different corporate governments structures helped or hurt the foreign firms. The weaknesses that arise when lenders are major stockholders conflicts of interest, institutions protecting errant managers who "buy" them off are not trivial. Moreover, key tests of foreign governance are only now beginning. Whether those at the top of foreign firms will be better than US boards at reacting to crisis and avoiding misspending on capital projects when the firm's franchise deteriorates easier to be seen, because the industrial crises that hit a mature competitive economy are only now coming to afflict Germany and Japan. The early evidence ... indicate that boards dominated by institutions are far from perfect. The task of seen whether they are better that is, institutional voice only had to cut two years off of GM's 10-year delayed reaction to crisis to have made an improvement, even an imperfect one is still ahead. .... Costs and Benefits To assert that there are costs to fragmentation is neither to assert that these costs outweigh benefits nor that policymakers can eliminate those costs without creating other problems. The benefits of the Berle-Means corporation in managerial specialisation, capital-raising ability, and organisational flexibility especially in raising capital for new entry into many industries are quite high. Those benefits may exceed any of the costs. 104 Moreover managers work in several markets and social structures. The internal organisation of the boardroom and its relationship with institutional shareholders is only one. Professional pride makes managers and directors try hard even if the organisational constraints acting on them are weak. The embarrassment of media attention (or fear of it) will help correct egregious errors. Product markets, capital markets, managerial labour markets, employee labour markets, and corporate takeover markets constrain managers. This is all another way of saying that corporate governments is only one dimension of competition. The question then is whether fragmentation sometimes has enough costs whose elimination could pay for the costs of concentration. Had a GM board with representatives from five or six institutional owners of GM reacted strongly in 1982, instead of 1992 (when the board did reacted strongly), the gains might have been measured in billions of dollars, paying for more than a few institutional errors. Even if most firms are better off the way they are (and I think most probably are, and the costs of change for many would be too high), some firms might be better run if they had concentrated owners. Other nations have them sometimes; the United States, really.... [T]o say that one waste energy from the heat of the light bulb does not tell us much. We have a cost, but if it's a technological requirement, it's a necessary cost of getting light. But if we learn that we can use alternative technologies to make light, and that the choice of technologies depends on nonengineering factors (such as a nation's politics) then the possibility of avoiding waste becomes a real one. 105 Stokes, M, "Company Law and Legal Theory" in Wheeler, S (ed), A Reader on the Law of the Business Enterprise (1994), 80 at 80-84 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Students of company law very often complain that the subject is technical, difficult and dull. This is not without some justification. The reason can perhaps be found in the fact that company law as an academic discipline boasts no long and distinguished pedigree. The result is that company lawyers lack an intellectual tradition which places the particular rules and doctrines of their discipline within a broader theoretical framework which gives meaning and coherence to them. One object of this essay will be to suggest such a theoretical framework. The framework aims to provide a tool for analysing and explaining many of the fundamental rules of company law. It will be argued that one of the central features of the business company is the way in which it centralizes the authority to manage the capital which it aggregates from its investors in the hands of corporate managers. Clearly the nature and extent of the power thus vested in the management of a company vary according to the type and size of the company. But whatever its extent the power of corporate managers poses a problem of legitimacy. This essay will seek to explain the nature of that problem. It will also endeavour to illustrate how much of company law can be understood as a response to the problem of the legitimacy of corporate managerial power. Thus the theoretical framework takes the legitimation of corporate managerial power to be one of the underlying and unifying themes of company law. More concretely, those areas of company law which are best viewed as a response to the problem of the legitimacy of corporate managerial power will be examined. Thus it will be shown how the changing popularity of a number of theoretical models of the company can be linked to the need to offer an explanation for the power which the company vests in corporate managers. Similarly, the rules allocating power between shareholders and directors and those imposing fiduciary duties on directors will be analysed in terms of the need to confer legitimacy upon the power of corporate management. A second object of this essay will be to show how the law's attempt to justify has failed. This in turn will lead us to an examination of how corporate law scholars have sought to offer new ways of legitimating corporate managerial power and how these too prove to be unequal to the task. Finally, some fresh methods by which managerial power might be justified will be explored. The problem of the legitimacy of corporate managerial power The reason why company law should have been so concerned to legitimate the power of corporate managers is that this power potentially threatens the political-economic organisation we associate with the liberal democracy. We make a distinction between public and private power. This distinction reflects the separation of the state of the individual in a liberal society. Liberal democracy has been concerned most explicitly with legitimating the power of the state, or public power. This is because the assumption is made that all important power in society is concentrated in the 106 hands of state. The arguments used to justify public power are very familiar. They are that the system of representative democracy gives authority to the legislature to make law, and that the power conferred upon all administrative or public bodies is legitimate as it is derived from the legislature. However, in a liberal society a democratic system of government is not considered sufficient by itself to legitimate public power. Liberalism is hostile to the existence of centres of unbridled power, believing that power unless limited and control may threaten the liberty and equality of the individual with are the two fundamental tenets of liberalism itself. Thus it is sought to subject public power to the Rule of Law. At its broadest, the Rule of Law aims to impose limits, controls, and checks on the exercise of power. Power must be prevented from being used arbitrarily. Arbitrariness is a difficult concept to define. It will be used to mean the exercise of power for purposes alien to those which it was conferred. Notice the structure of the argument legitimating public power. It breaks down into two parts. We are concerned, first, to provide a justification for power being vested in the state; and then, secondly, we seek to demonstrate that there are constraints upon the exercise of that power which prevent it from being used to infringe the liberty or equality of individuals. As we have seen, the power vested in the state is justified by a system of democratic government; and the assurance that the state's power is subject to constraints which prevented it from being used arbitrarily is found in the adherence to the ideal of the Rule of Law. The structure of this argument is important because we find it repeated when we look at the traditional ways in which it is sought to legitimate private power. Although the theory is that more important power is concentrated in the hands of the state, this has not meant that the individual has been regarded as powerless. It has always been acknowledged that a system of private property ownership confers upon the owners of property private economic (and perhaps political and social) power. Indeed, one of the justifications of private property takes as its premise the idea that property ownership confers power. This provides a necessary bulwark against the danger of an allpowerful state invading the individual's liberty. In other words private property serves to protect the individual's freedom. Private ownership is also justified because by permitting individual property owners to pursue their own self-interest in a competitive market it is argued that we achieve an optimal allocation of society's resources. It is not enough to suggest justifications for the existence of private ownership. If private property is to be legitimate within the framework of a liberal society it is also necessary to show that there are constraints which prevent it from becoming a source of power which threatens the liberty of the individual or rivals the power of the state. Two arguments are used for this purpose. First, it is claimed that the economic power associated with the ownership of property does not threaten liberty because it is not concentrated in the hands of an individual or small group of individuals. Everyone is entitled to own property. It is true that the actual distribution of property in society is far from equal; but it is not so skewed as to give any individual a monopoly of economic power. The power of each property owner is checked by the corresponding power of each other property owner. Thus the distribution of property is not so unequal that it can threaten the liberty of the individual. Private economic power differs in this respect from the public power of the state. The state has a monopoly over the use of coercion which is perceived to be legitimate only because those exercising such power have been democratically elected or derive their authority from a democratic legislature. The second argument has traditionally been used to reassure us that the economic power derived from the ownership of property is subject to constraints. It is claimed that economic power is constrained by the competitive market. In a competitive market the bargaining power of the owner of a particular commodity is limited. Because many others own identical 107 commodities or commodities which are close substitutes which they are willing to sell, the owner will not be free to charge any price he chooses for his commodity. Rather the price will be determined by the demand for and the supply of that commodity. In addition, if a property own is manufacturing and selling goods in a competitive market he will be obliged to produce any given level of output of those goods at the lowest cost possible. And the quantity of goods which he produces will be such that the marginal cost of production is the same as the price of the product. If he fails to follow these simple rules the consequence will be economic failure. This follows from the assumptions made by the model of perfect competition that the individual entrepreneur maximises his profits, that there is a price taker and that there is freedom of entry and exit from the industry in which he is producing goods. It is true that this model does not purport to describe accurately the way in which the market economy actually functions. Nevertheless, the model of economic theory is often taken to embody in an ideal form many of the characteristics of the actual market economy. Because this market controls and discipline the economic power associated with property ownership it first legitimates the power within the framework of liberalism. An analogy can be made here between the market and the Rule of Law. The market is the mechanism which has traditionally been invoked to limit, control and thereby legitimate private power, whereas the mechanism by which it has been sought to control and justify the exercise of public power has traditionally been the ideal of the Rule of Law. Both mechanisms can be viewed as part of the liberal response to the threat to freedom which it is believed is posed by the existence of untrammelled power, be it public or private. The economic power of the company was not thought to pose any particular difficulty within this framework of legitimation. Although the corporate form together with limited liability enabled large sums of capital to be aggregated for a common purpose, this was not perceived as problematic. Economic theory assumed that the company, like the individual entrepreneur, behaved as a profit-maximising unit. It was obliged to do so if it was to operate within a competitive market where there were a sufficient number of firms producing the same or a substitutable commodity so that each firm was incapable of influencing the price of the commodity by adjusting its output. Thus the firm in economic theory behaved identically and was subject to the same constraints whether it took the form of an individual proprietorship, a partnership or a company. Theory was, however, divorced from reality. The reality was that the growth of corporate enterprise shattered three of the assumptions which underlay the belief that economic power of the company was regulated and thereby legitimated by the competitive market. First, the growth of corporate enterprise falsified the theory that in any given industry there were numerous small firms so that each firm had no market power but was obliged to accept the market price for its products. The company facilitated the aggregation of vast sums of capital from numerous small investors and this together with changes in technology and organisational techniques led to a vast expansion in the size of the firm and a reduction in the number of firms operating in any particular industry. As a result the market structure very often ceased to be purely competitive, becoming monopolistic or oligopolistic. The consequence was that the company no longer had to accept the market price for its products but could affect that price by varying the output of the product. Secondly, the assumption that the company behaved as a profit-maximising unit of production just like an individual entrepreneur or a partnership was manifestly open to doubt. One of the essential features of the company is that it separates out the functions of ownership and management. Those who manage the company do not own company. If the managers of the company display the characteristics which economic theory credits to all other individuals they will be concerned to maximise their own utility rather than the profits of the company. Adam Smith himself understood this problem. He was hostile to the joint-stock company and the medium through which to carry on business enterprise. 108 The directors of such companies being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.... Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such company. Of course, it was the oligopolistic character of product markets which gave those who ran the company discretion to pursue goals other than profit-maximisation. In a world of perfect competition it would not be possible for managers to deviate from the profit-maximisation norm for any length of time even if they were tempted to pursue their own rather than the shareholders' interests. The failure of the market due to imperfect competition to regulate the company as an economic unit is thus indissolubly linked with the increased and potentially unconstrained power of corporate managers. It is for this reason that we can treat growth in perfect competition in the separation of ownership and management as creating a problem for the legitimacy of corporate managerial power. Thirdly, one of the cardinal features of the market model of legitimation was that economic power was exercised through exchange transactions in the market. Yet as the company grew in size it was claimed that much economic activity was being withdrawn from the sphere of the market and being replaced by a hierarchical, bureaucratic organisation within the company. The invisible hand was being replaced by the visible hand. The effect these three changes brought about by the growth of corporate enterprise was that the market could no longer be viewed as regulating and thereby legitimating the exercise of corporate power. The power conferred upon corporate managers by the business company was potentially unchecked and hence illegitimate within the framework of liberal democracy. At a deeper level the concentration of economic power brought about by the growth in the size of companies in the oligopolistic nature of product markets undermined some of the traditional justifications for private ownership itself. The concentration of power in the hands of the managers of the largest companies could not be seen as the necessary bulwark against the power of the state. Nor could it be argued that private property ensured an efficient allocation of resources since the market no longer resembled the model perfect competition. 109 CORPORATE DECISION-MAKING: THE BOARD OF DIRECTORS In the last class, you learnt that decision-making powers are shared between the board of directors and the general meeting of shareholders. The readings for this class focus on the powers of the board of directors. The Casebook at paras 5.105-115 outlines the scope of the board's powers. The Casebook at paras 5.265-305 goes on to detail how the board exercises its decisionmaking powers collectively and the types of information which board members are entitled to access. See further Corporations Act ss 198A-F (powers of directors), 248AG (conduct of board meetings) and 290 (access to information). But how is the composition of the board determined? The Casebook at paras 5.210-235 and 5.240 and 5.245-260 explore who may be appointed to the board (and who may not) and how board members may be later disqualified or removed from office. How does all this ensure the integrity of the board's decision-making processes? See further Corporations Act Pts 2D.3 (appointment and termination) and 2D.6 (disqualification). Note that the Casebook refers to the interesting scenario of an executive director on a fixed-term service contract who is axed before the expiry of his or her contractual term. Both contract law and corporate law battle for regulatory supremacy over this issue -- which succeeds? Why? Finally, how effective -- or desirable -- is the current set of legal rules regulating board decisions? In the last class, you read an extract of Stokes' thesis in which she expressed the concern that "managerial power" poses a threat to the values of liberal democratic society. In the extract for this class, she goes on to explore whether or not the law subjects "managerial power" to sufficient checks and balances to ensure that management does not exercise its powers arbitrarily. 110 Stokes, M, "Company Law and Legal Theory" in Wheeler, S (ed), A Reader on the Law of the Business Enterprise (1994), 80 at 85-98, 103 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. The response of the law to the problem of the legitimacy of corporate managerial power How did the law respond to the crisis of legitimacy of the business company? .... Company law focused its attention on the problems created by ... the separation of ownership and control. This feature of the company together with the increasing substitution of the organization of economic activity within the company rather than through the market suggested that there had been enormous growth in the power of corporate management.... [T]hat power was relatively uncontrolled by the market. There are two ways in which company law set about tackling the problem of legitimacy of corporate managerial power which was thus posed. First, company law sought to explain and justify why broad discretionary authority was conferred upon corporate managers. And, secondly, company law set about the task of demonstrating that the power of corporate managers was not limited but was subject to checks and controls which ensured that it could not be used for the manager's own purposes or for any other arbitrary end.... .... The traditional legal model of the company The traditional legal model of the company originally treated the directors of the company as agents of the company. This meant that their authority was limited since it could at any moment be revoked by the shareholders. Furthermore, the shareholders as the principal were entitled to issue specific instructions to the directors which as agents they were obliged to implement. The beginning of the twentieth century saw the abandonment of this theory of the relationship between shareholders and the directors. Instead of being perceived simply as agents of the shareholders the board of director came to be viewed as an organ of the company which for many purposes could be treated as the company. Directors were given the exclusive right to manage the day-to-day business of the company. Shareholders were precluded from intervening in the ordinary business of the company, no longer being entitled to issue instructions to the directors as to how to exercise their powers. The courts justified this vesting of managerial autonomy over the everyday business of the company in the hands of the directors by arguing that it flowed from the construction of a company's articles of association which formed a contract between the members of the company. Although the shareholders no longer exercised the direct control of principals over the directors as their agents, the model nevertheless asserts that any danger that the directors might use their considerable discretionary powers to manage the business in their own interest 111 is precluded. It is precluded because the model gives power to the shareholders to appoint and dismiss the directors and power to supervise them once they are in office. A system of indirect control and accountability is thereby established over the directors as those responsible for the management of the company.... The legal model's legitimation of the vesting of broad discretionary power to manage the company in the hands of the directors .... Quote clearly the conception of the company explicitly adopted by the legal model is ... contractual... The company is simply treated as an organization constituted by the contract between its members. That contract confers power on the directors of the company to manage the company.... [T]he conclusion that the powers vested in directors are to be exercised exclusively by the directors is arrived at by a careful analysis of the wording of the article giving to the directors of the company general managerial powers which is found in the constitution of most companies. By adopting a contractual conception of the company the legal model gives as the reason for the vesting of centralized authority to manage the company in the board of directors the contractual agreement of the owners of the company. Thus by invoking the idea of the freedom of a property owner to make any contract with respect to his property the power accorded to corporate managers appears legitimate, being the outcome of ordinary principles of freedom of contract. It reassures us that the hierarchy created within the company does not threaten individual liberty because it is the outcome of a voluntary consensual arrangement.... The use of the contractual conception of the company to give legitimacy to the vesting of managerial power in the directors of the company encountered ... difficulties... [One such difficulty] ... was the increasing artificiality of this analysis as the size of companies grew and the shareholders became increasingly passive investors. Any notion that the internal division of power within a company was the result of consensual arrangements between the shareholders seemed purely fictional. The difficulties associated with the contractual model of the company led academics in the early decades of this century to adopt instead in their writing the natural-entity conception of the company [-- the view that the company was distinct from its shareholders].... [A] new justification [was] given for the vesting of very extensive discretionary power in corporate management... This justification is that the managers of the company have the time, information, organizational skills, and other expertise to manage the business which justifies their being treated as the brain of the company, formulating corporate policy to further the ends of the enterprise.... The legal model's attempt to legitimate corporate managerial power through subjecting it to checks preventing it from being exercised arbitrarily The discussion thus far has focused on the reasons given in legal doctrine to support the legal model's centralization of the power to manage the company in the hands of the directors of the company. I have argued that company in its attempt to establish the legitimacy of corporate managerial power has been concerned also to show that the power conferred on manager is subject to controls which prevent it from being used arbitrarily. These controls are 112 necessary if the business company is not to threaten the traditional liberal distrust of unconstrained power normally encapsulated in the adherence to the Rule of Law. As we have seen the legal model adopts two mechanisms for ensuring that the directors of the company are subject to the control of the shareholders. The directors are, first, made accountable to the shareholders by structuring the internal division of power within the company so that the shareholders have the power to appoint and dismiss directors and to supervise them whilst in office. Secondly, directors are treated as fiduciaries required to act in the best interests of the shareholders. These mechanisms share in common the following features. Both mechanisms accept and endorse the separation of the management of the company from its ownership. They accept that it is no longer plausible to assume that those operating the business have their freedom of action constrained by the competitive market or their own self-interest. It is more probable that the managers will seek to pursue their own goals rather than subject their decisions to the norm of profit-maximization. Thus the common aim of both legal mechanisms is to force managers to maximize profits for their company and prevent them from maximizing their own utility. If this can be done successfully the company will once again correspond to the profit-maximising firm of economic theory. Corporate managers' discretion will be legitimated since their power will be severely limited by the requirement that all their decisions must aim simply at profitmaximizing.... The internal division of power within the company as a means of controlling managerial power The traditional legal model divides power within the company between directors and the shareholders. The object is to organize the internal structure of the company so that, whilst the directors as the managers of the company are given ample discretionary power to operate the company effectively, they are nevertheless obliged to exercise that power in the interests of the owners of the company. The legal model of the company is often treated as establishing a basic constitution for the company, defining the powers of the different organs of the company and regulating the relationship between them. An analogy is drawn between the company and the state. The argument is that just as direct democracy is ruled out by the size of the modern state, so too once companies grow beyond a certain size it is no longer possible to involve all their members directly in the decisions concerning the running of the company. In both cases therefore a system of representative democracy is adopted. This system relies upon the ability of the electorate to elect and dismiss leaders at periodic intervals. It is this which establishes the control of the people over their political leaders or of the shareholders over their directors. Thus the shareholders in the company are treated as the electorate, and the directors are regarded as the legislature. The legal model envisages the board of directors as actually carrying out the day-to-day business of the company so there is no separate executive organ within the legal model. But once the size of companies expanded further it was very easy to accommodate the fact that whilst directors remained responsible for the formulation of the overall policy of the company the ordinary management was entrusted to executives. For the corporate executives could be viewed (as their name suggests) as executives implementing the broad objectives set by the directors as the legislature. ... The power conferred by the legal model on the shareholders can be analysed neatly in terms of the analogy between the constitution of a company and the constitution of a nation-state. Shareholders as the electorate are given the power to elect and dismiss their leaders, the directors. They are also given power to vote on fundamental structural changes to the company, such as altering the memorandum and articles of association or merging with 113 another company or dissolving the enterprise which are thought to resemble constitutional issues. In addition the received legal model of the company gives powers to the shareholders to ensure that the directors once in office do not use their powers for their own self-interest. Thus the law insists that a director who wishes to enter into a transaction where there is any possibility of a conflict between his own interest and his duty to act in the best interests of the company must disclose the transaction to the shareholder sin general meeting and obtain their consent to it. The shareholders are thereby given the power to judge for themselves whether the directors are using their managerial powers for their own benefit at the expense of the company and if this is so to veto the transaction or at least hold the director liable for any profits thereby made. How effective is this constitutional structure of the company in ensuring that directors do not use their powers arbitrarily? The constitutional framework makes the shareholders responsible for monitoring and supervising the directors of the company. Its efficacy depends on the shareholders performing this task. Yet the reality is that it is only in companies where each shareholder has a sufficiently substantial stake in the company make it worth his or her while performing the tasks of monitoring and supervising the behaviour of the director that this constitutional framework can hope to provide an adequate control on the behaviour of directors. In the large public company it is now accepter as part of the conventional wisdom that the shareholding is so widely dispersed that each shareholder does not own a significant enough proportion of the company to perform any of the functions of monitoring and supervising the directors that the legal model casts upon him. The consequence in the terminology of Berle and Means is that there is a separation between ownership and control. The managers become a self-selecting body and cease to be effectively monitored by the shareholders once in office. Control is vested in their hands rather than the shareholders'. The legal model of the company which separates ownership and management but still asserts that ultimate control resides with the owners of the company no longer corresponds to the realities of the modern large public company. Yet company law doctrine has failed to acknowledge this. Indeed, the obstinacy with which company law has clung to the traditional legal model of the division of power in the company between managers and the shareholders has sometimes had the effect of concealing from us the fact that company law regulates a variety of different sorts of companies. It is only by looking outside legal doctrine itself that we are made aware that neither the small closely-held company (where there is no separation of ownership and control) nor the large public company (where there is a separation of ownership and control) conform to the legal model. Because company law fails to differentiate in any consistent fashion between these different sorts of companies all are treated as regulated by the traditional framework which we have been examining. The result is that there is a tendency to assume that corporate management are adequately controlled by the shareholders in all companies, including the large public company.The problem of legitimacy posed for liberalism by the fact that in reality the managers of a large public company wield power which is unconstrained by the shareholders is quietly ignored by legal doctrine itself. ... Outside legal doctrine itself there has been a greater willing ness to accept that in the large public company the shareholders may not perform the task of monitoring and controlling the management of the company, so that the managers are potentially left in a position of unchecked power. Several attempts have been made, however, to breathe new life into the traditional model which relies on structuring the internal organization of the company appropriately to ensure that controls are exercised over corporate managers. It is sometimes argues that the rise of institutional investment and the decline of individual direct investment in large public companies means that the traditional model of the 114 shareholder controlling the directors of the company is once again a realistic one. Although each institutional investor may still only own a very small percentage of the issued share capital of the company, nevertheless, they have the requisite skills to monitor management effectively, and can act collectively to exert pressure on the managers of the company, thereby overcoming the problem that there is little incentive for the individual shareholder to spend the necessary time and money to inform himself of and perhaps challenge the actions of the directors as the managers of the company. The empirical evidence suggest, however, that the supervision which institutional investors exercise over the management of a company is minimal and cannot be regarded as a sufficient control over the managers of large public companies. Others have argued that the traditional legal model overlooks a significant development which has taken place in the large public company. The legal model assumes that the board of directors manages the ordinary business of the company. Yet the truth is that the board of directors will only rarely be involved in the day-to-day running of the company which is instead usually entrusted to the officers and executives of the company. Even the policymaking functions will generally be carried out by the executives rather than the board itself. The role of the board within the company needs to be re-examined. Since it is not involved in the management of the company it is in a position to monitor and check the performance of the executives actually managing the company, to ensure that they act only in the interests of the shareholders. This role can best be fulfilled by the board if the majority of directors are independent of the executive over whom they exercise a supervisory, checking function. This model of the internal structure of the company acknowledges that the shareholders do not control those who manage the company and instead entrusts this task to a reconstituted board. As a means of assuring us that the management of large public companies do not wield arbitrary power it is unsatisfactory. First, it represent no more than a proposal for reform of the internal structure of the public company and not an accurate description of how the board at present functions in such a company. Secondly, even if implemented, the question would arise as to whether adequate checks existed to prevent the reconstituted board form exercising its powers in an arbitrary fashion. Without such checks the old problem arises of who is to be responsible for monitoring and supervising the supervisors. The conclusion that must be drawn is that corporate management in the large public company are not controlled by the shareholders exercising the powers accorded to them by law to appoint, dismiss and monitor the directors of the company. Unless there are other effective ways in which the managers of the public company are constrained, it would seem that the power of corporate management threatens liberalism's ideal that all power should be limited or subjected to checks. .... We can conclude that so far the law's quest to subject the power conferred on corporate managers to controls to prevent it from being exercised arbitrarily has not been successful. The internal organization of the company does not provide an adequate safeguard against the power of the managers being used for their own ends.... 115 CORPORATE DECISION-MAKING: GENERAL MEETING OF SHAREHOLDERS Over the last two classes, we have considered the division of decision-making responsibilities between the board of directors and the general meeting of shareholders. In the last class, we focused on the powers of the board. We now turn to a more detailed treatment of the powers of the general meeting of shareholders. The Casebook at paras 5.120-135 it explains how the powers of the general meeting have eroded over time; and at 5.140-190, it describes the residual powers of the general meeting. (To help you make sense of the cases extracted at paras 5.160-190 of the Casebook, you are invited to refer to the extract by Ford on the informal corporate acts doctrine -- note: this is optional reading only.) The Casebook at paras 6.90-6.120 outlines what information shareholders are entitled to access as part of exercising their powers. Once you have read the relevant parts of the Casebook, revisit the reading by Stokes in the readings for last class: what is her view of the effectiveness of these provisions and powers in constraining the arbitrary exercise of managerial power? Finally, read Corporations Act Pt 2G.2. What are the procedural requirements for the general meeting of shareholders? 116 Ford, HAJ, Fords Principles of Corporations Law (2002) at 7.590-7.595 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of the University of New South Wales pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. DOCTRINE OF UNANIMOUS ASSENT [7.590] Three views of the doctrine In Salomon v Salomon & Co Ltd [1897] AC 22 at 57; [18959] All ER 33; [1896] WN 160, Lord Davey said that a company is bound in a matter intra vires by the unanimous agreement of all its members. It cannot be doubted that one or more legal doctrines produce this general effect. Indeed, s 249A(7) recognises the existence of some such doctrine. It is much more difficult to identify the doctrine or doctrines which operate in this way, and to define their conceptual boundaries. On a limited view, the law may simply say that if all the members actually meet without the proper formalities of notice, they may expressly or impliedly waive those formalities and remove the consequent irregularity, so that the meeting can proceed to make decisions as a properly constituted meeting. This view, which is consistent with Re George Newman & Co [1895] 1 Ch 674; [189599] All ER Rep Ext 2160, requires a physical meeting, and the court must examine the evidence to determine whether there is an express or implied waiver on the facts. On this approach, the doctrine is a common law approximation to s 1322, which provides a procedure for curing a broader range of irregularities but requires a court order. A somewhat wider view is that the doctrine is an example of genuine equitable principles of estoppel, and is therefore available to prevent any of the assenting members from subsequently asserting invalidity: Herrman v Simon (1990) 4 ACSR 81 at 845; 8 ACLC 1094 per Meagher JA. As was noted in Re George Newman & Co, the estoppel doctrine would not equate informal assents given separately with a decision at a properly constituted general meeting, but would merely estop the assenting participants from asserting invalidity, so that the decision would not be treated as a formal decision for other purposes, including proceedings involving third parties (or a liquidator of the company). Both the first and second views would apply only where the members have the authority under the Law and the constitution of the company to take the substantive decision which is at issue. They would not permit the members to usurp a function which is allocated under the constitution to the directors. That is, on these views the doctrine of unanimous assent operates within the constitutional division of powers already described: see [7.070]ff. An even broader view would treat the doctrine of unanimous assent as an example of lifting the veil of incorporation. On this approach, an informal decision of members is treated as a decision of the company, rather than as a decision of a particular organ of the company to which limited functions are assigned under the Law and the constitution. The members acting unanimously could thus transcend the division of powers and make decisions on matters of management allocated to the directors by the constitution, and could do so whether or not a physical meeting occurs. This appears to be Professor Gower's view. 117 The English Court of Appeal in Re George Newman & Co insisted on a physical meeting. This is consistent only with the narrowest of the three views. However, the case is distinguishable as turning on ultra vires. In Re Express Engineering Works Ltd [1920] 1 Ch 466 five directors, who were the only shareholders, resolved at a directors' meeting that the company should purchase certain property from a syndicate in which they were interested. A director was disqualified by the constitution from voting as a director in relation to any contract in which he was interested. In proceedings by the liquidator to avoid the transaction it was held that the agreement of the five to the making of the contract bound the company, since they were the sole shareholders and they had assented (see also E H Dey Pty Ltd (in liq) v Dey [1966] VR 464). Although there was a physical meeting, the court expressed the doctrine in terms which did not demand that a meeting take place. In Parker & Cooper Ltd v Reading [1926] Ch 975 Astbury J held that a meeting was unnecessary if all the members assented, assuming the transaction to be intra vires and honest, especially if the transaction was for the benefit of the company. It did not matter that the assent was given at different times. The Privy Council in EBM Co Ltd v Dominion Bank [1937] 3 All ER 555 at 566 said that they found it unnecessary to express any view as to the correctness of the Parker & Cooper case as to assent given otherwise than in a meeting. However, the Parker & Cooper case has been applied for the proposition that unanimity of incorporators makes up for informality: Perseus Mining NL v Landbrokers (Perth) Pty Ltd [1972] WAR 12; Re Fletcher Hunt (Bristol) Ltd [1989] BCLC 108; Versteeg v R (1988) 14 ACLR 1. See also Bobbie Pins Ltd v Robertson [1950] NZLR 301. In Re Duomatic Ltd [1969] 2 Ch 365 the question was whether the liquidator of a company could recover from the directors amounts which they had received as remuneration for their services. They had no contracts of service. The constitution required that the remuneration of directors be determined by the company in general meeting, but no such meeting was held. The directors simply withdrew sums from the company's account from time to time as their personal needs required, and at the end of the year they added up their drawings and showed them in the accounts as a global sum, "directors' salaries". Buckley J held that the remuneration could not be recovered by the company. In respect of some of the years in question, he was able to identify a physical meeting of directors who, at the relevant time, held all of the voting shares, and who could have constituted themselves a general meeting. In respect of the period after 30 April 1964, there appeared to have been no physical meeting of the voting shareholders, but they all knew of and agreed to the for remuneration which were then in place. Buckley J followed the Parker & Cooper case. See also Multinational Gas and Petrochemical Co v Multinational Gas and Petrochemical Services Ltd [1983] Ch 258; [1983] 3 WLR 492. The Parker & Cooper and Duomatic cases are inconsistent with the narrowest view of the doctrine, which would limit it to curing irregularities in a physical meeting. To the extent that the Duomatic case holds that the informal assent of members without a meeting binds a liquidator, it implies that the doctrine is not merely based on estoppel of members, and tends to support Professor Gower's view that an informal decision by all members is a decision of the company. While Duomatic is consistent with the division of powers between members in general meeting and directors, since the power to approve remuneration was vested by the constitution in the members in general meeting, the Express Engineering case could be seen as overriding the division of power. In that case the approval of the transaction was a matter for the board, but the court held that the liquidator was bound by the unanimous decision of the members (who were also the directors). However, the Express Engineering case can be reconciled with the concept of division of powers on the ground that under the company's constitution, the directors were disqualified from voting as such because they were each personally interested in the transaction, and in such a case the general meeting has a reserve power to determine a matter of management because of the inability of the directors to act. For the most part, Australian courts have followed a doctrine of unanimous consent without finding it necessary to specify which version (or, possibly, versions) is correct: E H Dey Pty 118 Ltd (in liq) v Dey [1966] VR 464; Re Compaction Systems Pty Ltd [1976] 2 NSWLR 477; (1976) 2 ACLR 135; CLC 40-313; Swiss Screens (Aust) Pty Ltd v Burgess (1987) 11 ACLR 756; 5 ACLC 1076; Northside Developments Pty Ltd v Registrar-General (1987) 11 ACLR 513; 5 ACLC 642 (Young J); Sutherland (as liq of Sydney Appliances Pty Ltd (in liq)) v Robert Bosch (Aust) Pty Ltd (2000) 33 ACSR 680; BC200000469; [2000] NSWSC 32; Our Lady's Mount Pty Ltd (as trustee) v Magnificat Meal Movement International Inc (1999) 33 ACSR 163 at 1801; BC9906780; [2000] QSC 319. However, in Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279; (1990) 3 ACSR 649; 9 ACLC 324 (on appeal (1991) 6 ACSR 464) Ormiston J reviewed the authorities and held that the doctrine applied to a case where there was assumed to be no physical meeting of the members, and that accordingly the company was bound by a deed of guarantee and indemnity to which the members had assented. This conclusion was reached even though the constitution of the company provided that the seal should not be affixed except by authority of a resolution of the directors, and presumably also vested in the directors the power to determine whether to enter into guarantees and indemnities. The decision therefore appears to be compatible only with Professor Gower's view, that the doctrine of unanimous consent enables the court to disregard the division of powers and treat the assent of the members as a decision of the company, binding the company vis--vis third parties. This is inconsistent with the approach of Meagher JA in Herrman v Simon (1990) 4 ACSR 81; 8 ACLC 1094, according to which the doctrine goes only to waiver of formalities (semble, it is a case of estoppel of members). In Poliwka v Heven Holdings Pty Ltd (No 2) (1992) 8 ACSR 747 at 7868; 10 ACLC 1759, Ipp J stated that the doctrine of unanimous consent depends upon the existing constitutional arrangements for the division of powers between the board of directors and the shareholders in general meeting. The power of the members, however, to bind a company is dependent upon its constitution. In my view, nothing that was said in Re Express Engineering Works Ltd and the subsequent authorities to which I have referred detracts from this proposition. In none of those cases were the members precluded by the articles from binding the company to the contracts in question (ACSR at 787). However, the company in question in Poliwka had a provision of its constitution similar to what was reg 66 of Table A. His Honour concluded that, as a result of this provision, the board of directors was exclusively vested with general powers of management and the shareholders in general meeting were not empowered to authorise any person to sign the document in question on the company's behalf. Although Australian law is in an uncertain state, the following observations may be made. First, the proposition that the members may, while all being physically present together, expressly or impliedly waive the formalities for convening a general meeting and then do whatever a formally constituted general meeting could have done, effectively binding the company with respect to third parties, seems to be generally accepted by the courts, whatever the precise conceptual basis for that proposition may be. Secondly, normal principles of equitable estoppel would prevent a member who has informally assented to a decision which is then relied upon by other members (and third parties, if they are aware of the assent) from subsequently resiling. Thirdly, Australian courts have generally adopted a very cautious view towards lifting the veil of incorporation, and no Australian case has expressly treated the doctrine of unanimous assent as an example of lifting the veil to treat the members as equivalent to the company (rather than equivalent to the members in general meeting). Consequently Professor Gower's view may not represent Australian law, whatever implications might arise from the Brick and Pipe case. 119 Limitations on the doctrine Whatever be the proper conceptual basis of the doctrine, it is subject to the following limitations established by cases: the doctrine requires actual, not merely potential assent; the member's assent must be informed assent; assent must be given by everyone who would be entitled to notice of a members' meeting; the members' decision must be within power and for a proper purpose; it seems that the members acting as such cannot take decisions on matters which are the exclusive province of the directors; arguably, if there is a requirement that corporate assent be expressed under seal, unanimity of the members will not overcome the absence of a seal; and possibly, unanimous assent will not overcome a statutory requirement that the company's decision be taken at a meeting. These limitations are further explored in [7.595]. [7.595] Limitations on the doctrine The cases have considered certain limitations to the doctrine of unanimous assent. Some of the limitations are independent of the question of the proper conceptual basis of the doctrine, while others seem to depend upon that issue. The limitations will now be discussed. The doctrine depends on actual, not merely potential, assent Whatever be the proper conceptual basis of the doctrine, it cannot be relied upon to supply every missing step in the expression of a company's will. In Re ABC Plastik Pty Ltd (1975) 1 ACLR 446 a husband and wife were the only shareholders in a company. The husband sold the company's assets and did not account to the company for the proceeds, in the belief that the company's assets were his property. When the liquidator, proceeding under UCA s 367B, sought an order that the husband account to the company for the proceeds, the husband argued that the company could have paid a dividend equal to the proceeds. He argued that since the wife would have agreed to a dividend, the principle of informed consent should justify an assumption that a dividend had been paid. The argument was rejected. Informed assent Herrman v Simon (1990) 4 ACSR 81; 8 ACLC 1094 stands for the proposition that the doctrine of unanimous assent can be applied only where all of the members, though not formally notified of the proposed decision, are sufficiently informed that they are in a position to make a decision. See also Re Freehouse Pty Ltd; Jordan v Avram (1997) 26 ACSR 662 at 677. This proposition applies whatever the conceptual basis of the doctrine. Unanimity of persons entitled to notice of meeting The doctrine applies to registered shareholders: Jalmoon Pty Ltd (in liq) v Bow (1996) 15 ACLC 233. Must holders of non-voting shares assent? In Re Duomatic Ltd [1969] 2 Ch 365 the holder of non-voting redeemable preference shares had not assented to the directors' remuneration. Buckley J held that the doctrine could nevertheless operate, because it required only that all shareholders who have a right to attend and vote at a general meeting must assent. In Re Compaction Systems Pty Ltd [1976] 2 NSWLR 477; (1976) 2 ACLR 135; CLC 40-313 Bowen CJ held that the doctrine required that everyone entitled to a notice of meeting must assent, including those who are entitled to notice but have no right to vote or (semble) to attend. There have been dicta suggesting that the assent of the auditor is also needed in relation to matters that concern the auditor in the capacity of auditor, since the auditor is 120 entitled to notice of any general meeting and to be heard on any part of the business which concerns the auditor as such: s 249V; Re Compaction Systems Pty Ltd, above; Re U Drive Pty Ltd (1986) 10 ACLR 565; 5 ACLC 117. But the absence of notice to the auditor may be a "procedural irregularity" curable under s 1322: Re P W Saddington & Sons Pty Ltd (1990) 19 NSWLR 674; 2 ACSR 158; 8 ACLC 657. In Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279; (1990) 3 ACSR 649 at 688; 9 ACLC 324 Ormiston J rejected the suggestion that the assent of the auditor was needed; and in Sung Li Holdings Ltd v Medicom Finance Pty Ltd (1995) 13 ACLC 955 (SC(NSW)), Young J was inclined toward the same opinion. The resolution of this issue seems to depend upon which conceptual view of the doctrine is taken. If the doctrine is about curing irregularities at a physical meeting, there is a case for saying that an irregularity constituted by a failure to notify the auditor cannot be cured without the auditor's assent. If the doctrine is simply an example of estoppel, the auditor's assent seems irrelevant. If the doctrine pierces the corporate veil and treats the assenting members as the company, again the auditor's assent seems immaterial. Decision must be intra vires and for a proper purpose Lord Davey insisted, in Salomon v Salomon & Co Ltd [1897] AC 22 at 57; [18959] All ER 33; [1896] WN 160 that the doctrine related only to a matter intra vires the company. In Buchanan Ltd v McVey [1954] IR 89 at 96 Kingsmill Moore J stated as another proviso that the transaction should be honest. The condition that the matter must be intra vires dates from the time when a statement of the company's objects in its constitution was obligatory and defined its capacity. Now under legislation amending the doctrine of ultra vires an objects clause does not go to capacity. However, a unanimous vote of members for other than proper corporate purposes may be ineffective: ANZ Executors and Trustees Co Ltd v Qintex Australia Ltd (recs & mgrs apptd) [1991] 2 Qd R 360; (1990) 2 ACSR 676; 8 ACLC 980; Jalmoon Pty Ltd (in liq) v Bow (1996) 15 ACLC 233. These limitations would appear to be applicable whatever the conceptual basis for the doctrine Division of powers between board and general meeting The question whether the doctrine permits members by unanimous assent to take decisions which according to the constitution are the exclusive province of the board of directors, was discussed above, because it goes to the fundamental nature of the doctrine. In addition to the Express Engineering and Brick and Pipe cases, mention should be made of Swiss Screens (Aust) Pty Ltd v Burgess (1987) 11 ACLR 756; 5 ACLC 1076. In that case it was held that, where the members are the only directors, their informal assent could sanction action required to be taken by the board of directors. Decisions affecting substantive rights In Herrman v Simon (1990) 4 ACSR 81; 8 ACLC 1094 Meagher JA expressed the view that the doctrine goes to waiver of formalities rather than of substantial rights (an example of the latter being a decision to amend the constitution by adjusting the rights of holders of classes of shares). But in the Brick and Pipe case, 3 ACSR at 684, Ormiston J rejected the view that the doctrine was confined to internal disputes. If the doctrine applies only where there is a physical meeting and the members expressly or impliedly consent to waive deficiencies of convocation, then it necessarily is a doctrine confined to procedural irregularities. However, Meagher JA took the view that the doctrine was based upon waiver. If that is correct, it is hard to see why it needs to be limited to 121 procedural irregularities. If the doctrine is based on lifting the corporate veil, no such limitation would be appropriate. Decisions under seal E H Dey Pty Ltd (in liq) v Dey [1966] VR 464 is authority for the proposition that unanimous assent of members will not satisfy a requirement that corporate assent be expressed under seal members' assents under their individual seals cannot constitute an assent under seal by the company. However, in the Brick and Pipe case, 3 ACSR 649 at 683ff, Ormiston J applied the doctrine to answer an argument that the seal of the company had been affixed to a deed of guarantee and indemnity without the authority of a resolution of the board of directors. Statutory requirement for a meeting As a matter of construction a provision of the Corporations Law may, in prescribing a requirement for a meeting of members, imply that the members should come together physically. If that is the correct construction, there is no room for anything other than the narrowest version of the doctrine of unanimous consent. Indeed, that version of the doctrine might also be excluded if the statutory provision as construed exhibits a legislative intention that all members be given proper formal notice. Nevertheless, courts have sometimes found that statutory requirements for members' meetings can be satisfied by the doctrine of unanimous assent. Thus, in Re Oxted Motor Co Ltd [1921] 3 KB 32 unanimous assent at a meeting to a resolution for voluntary winding up was effective although the notices required by the relevant legislation had not been given, and in Re Sander's Ltd (1932) 49 WN (NSW) 220 Long Innes J reached the same conclusion. In Re M Dalley & Co Pty Ltd (1968) 120 CLR 603; 1 ACLR 489 one issue was whether informal acquiescence gave rise to an effective increase in authorised share capital, the statutory provision requiring a resolution passed in general meeting. The judge at first instance answered in the affirmative. The High Court decided the case on another point, but Barwick CJ doubted whether the lack of a resolution duly passed to increase the capital could be overcome by unanimous acquiescence (CLR at 614). It has been suggested that an alteration to the objects clause requires a meeting (Re U Drive Pty Ltd (1986) 10 ACLR 565; 5 ACLC 117, Young J referring to s 73 of the Uniform Companies Code), and there is English authority that a meeting is required for the special resolution needed under English law for a reduction of capital (Re Barry Artist Ltd [1985] 1 WLR 1305) although Young J in Re P W Saddington & Sons Pty Ltd (1990) 19 NSWLR 674; 2 ACSR 158; 8 ACLC 657 referred to the possibility of a special resolution which may be invalid because of an irregularity being validated under s 1322 as a procedural irregularity where all members of the company are present at the meeting. There is a line of cases, apparently based on estoppel, to the effect that alterations of the constitution not properly passed but acquiesced in by all the members over a long time are regarded as binding on the members: Ho Tung v Man On Insurance Co Ltd [1902] AC 232; Atherton v Plane Creek Central Mill Co Ltd [1914] St R Qd 73; Re Meyer Douglas Pty Ltd [1965] VR 638 at 649; Cane v Jones [1981] 1 All ER 533; Morgan v 45 Flers Avenue Pty Ltd (1986) 10 ACLR 692 at 702; 5 ACLC 222. 122 CORPORATE PERSONALITY 123 CORPORATE PERSONALITY: GENERAL PRINCIPLES The reading for this class introduces you to the notion of the "separate legal personality" of the corporation. This means that the corporation has an independent personality (or persona/identity) to the various stakeholders that make up the corporation. In addition to grasping the concept of corporate personality, we also must explore when that personality is a facade and when an apparently corporate act is really an act of one of the human stakeholders (this is known as piercing the corporate veil). This, in turn, requires us to re-examine the scope of "limited liability", a legal protection shareholders enjoy when they purchase equity in a company -- if separate corporate personality is a facade, what are the financial implications for the shareholders? Read the Casebook at paras 4.05-65 for the relevant law. What are the relative advantages and disadvantages of limited liability? The Casebook at para 4.15 lists the economic advantages. The reading by Cheffins goes on to explore in greater detail the financial ramifications for creditors. 124 Cheffins, B, Company Law: Theory, Structure, and Operation (1997) at 496-508 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. CREDITORS: THE LAW'S TREATMENT OF THEIR RELATIONS WITH SHAREHOLDERS AND MANAGERS In the ordinary course, a company's shareholders, directors, and officers are not personally liable for the company's debts. As far as shareholders are concerned, this occurs because the vast majority of incorporated companies offer, pursuant to the Companies Act 1985, limited liability to their members. In terms of directors and officers, the case law indicates that the company is an entity which is distinct from those who run it. Correspondingly, individuals who manage a company are not in the ordinary course under any legal duty to use their personal wealth to discharge its financial obligations. Since shareholders and managers are not personally liable for corporate debts, when a company ceases to carry on business and is unable to pay all that it owes, all or some of the creditors will fail to receive payment in full for what is due to them. Thus, in the financial sense, creditors bear much of the risk associated with business failure. Though the law's treatment of shareholders, directors, and officers poses some difficulties for creditors, in a variety of ways the legal system offers assistance. By virtue of common-law doctrines and a number of statutory provisions, a company's directors and, to a lesser extent its members, can sometimes be held accountable for its debts. As well, the Companies Act 1985 requires companies to file annually audited accounts, thus making it easier for those who lend money or extend credit to assess the risks involved. Also, a variety of statutory measures regulates specified corporate transactions in the manner designed to preserve assets for creditors. Finally, the Company Directors Disqualification Act 1986 authorises the courts to disqualify an individual from acting as a director in circumstances where he is not shown a sufficient regard for creditors' interests while running a company. This chapter analyses the legal system's response to the risks which creditors face. To start, we will consider whether company law rules should be altered so as to increase the extent to which shareholders are personally liable for the company's debts. Next there will be an analysis of whether the audited disclosure requirements which the Companies Act 1985 imposes on smaller companies are too lax or too strict. Finally, we will assess whether statutory measures regulating those who manage companies provide useful protection for creditors or simply impose unnecessary restrictions. I. Limited liability -- asset or liability The case for reform Limited liability is often characterised as the doctrine which shifts the risk of business failure away from shareholders to creditors. The basis for this characterisation is that a company's members bear no responsibility for corporate debts if matters work out badly and yet, as the company's "residual claimants", are entitled to the net profit flow if everything turns out well. Describing the situation as one where there has been a shift of risk is, however, somewhat misleading. Limited liability is an arrangement under which the loss lies where it falls. This is because when a company fails, the creditors swallow the loss instead of shifting it to the 125 members. A situation where there would be a shift in the risk would be one where there was unlimited shareholder liability. In these circumstances creditors could pass along the burden involved by suing the company's members to recover what was owing. Regardless of whether limited liability shifts risk or not, two factors heighten concern about the impact which limited liability has on creditors. First, shareholders have an incentive to gamble with creditors' money. Take the example of the company which has issued share capital of 100, which means that the members have paid this amount to receive the shares which the company has issued to them. Those running the company then borrow 10,000 on its behalf. If everything goes well, the shareholders reap much of the benefit if they are the residual claimants. On the other hand, if things go awry shareholders only lose the value of their 100 investment while the creditors might end up receiving little, if any, of the 10,000 which the company owes. Because of these circumstances, investing in the companies are shareholder can be characterised as a "heads we win, tails creditors lose' situation. Shareholders correspondingly have an incentive to adopt a casual attitude to what creditors have at stake. Secondly, the distribution of losses between creditors seemingly prejudices those who are least able to endure the consequences. Sometimes those who sell inventory and supplies on credit retain title until payment to achieve some measure of priority against other claimants. Still, trade creditors rarely take a charge over all a customer's assets. In contrast, banks acting as lenders commonly require a company to grant such security. Consequently, when a company fails, the bank will be in a position to sell the assets on its own behalf and retain the proceeds, thus leaving the trade creditors with little or nothing. The impression which this outcome creates is that those with economic power and influence pass along much of the risk associated with company failures to less sophisticated commercial actors. Despite the adverse effects which limited liability can have on creditors, neither Parliament nor the courts have abrogated in a systematic fashion the basic rule that a member in a limited company is under no legal obligation to repay the company's debts. The only provision in the Companies Act 1985 which specifically deems shareholders to be liable to creditors deals with a situation where the number of members of the company falls below a prescribed minimum. Furthermore, the judiciary will only declared that shareholders are personally responsible for corporate debts in exceptional situations, such as when they have used the company to perpetrate a fraud or to evade contractual obligations undertaken personally. Some have argued that changes should be made to the law to reduce the protection which exists for members. We will see now, however, that limited liability has a number of positive features which weaken considerably the case for reform. The positive attributes of limited liability One of the attractive attributes of limited liability is that it facilitates the operation of equity markets. For those who invest in companies, owning a diversified portfolio of shares is a sensible risk-reduction strategy since the volatility associated with share prices is reduced considerably. In addition, an investment in the equity of the company which is listed for trading on the London Stock Exchange is usually highly liquid in nature, which means a shareholder can readily sell his equity if chooses to do so. The situation could be considerably different if members were jointly and severally liable for a company's financial obligations. Diversification would become an unwise strategy because the more firms an investor added to his share portfolio, the more likely he would be called upon to use his personal assets to satisfy corporate debts. As for liquidity, the costs associated with share transfers would increase since prospective buyers would have an incentive to investigate the financial standing of a company's existing members. Potential investors will be in this position because if incumbent shareholders own few other assets, the risk of being exposed to ruinous personal liability will be greater than it would if those already owning equity were well off. 126 Another positive feature with limited liability is the impact it has on the distribution of risk associated with business failure. As mentioned, some concern exists that with companies, powerful lenders such as banks gain at the expense of other creditors. Nevertheless, in important ways limited liability helps to distribute risk away from poor risk bearers in favour of those better positioned to deal with the consequences. People are usually risk averse in the sense that they fear a disastrous loss. Indeed, they typically will forgo a greater risk-adjusted return to minimise the likelihood of such an occurrence. An investor who is personally accountable for the debts of a business can be financially ruined if the enterprise fails while heavily in debt. He thus qualifies as a poor risk bearer. The situation will be particularly troubling for an investor who would prefer not to become involved in managerial matters. Under such circumstances he will have no control over the events which expose him to the risk of financial catastrophe. Even an individual who participates actively in day-to-day decision-making has reason to be concerned. Contingencies will inevitably arise over which he has little or no influence. Consequently, he will be uncomfortable with the prospect of facing a loss the magnitude of which he cannot predict. Limited liability helps to address the concerns of investors since they will know that, in the absence of special circumstances, they will not have to use their personal assets to indemnify creditors. Indeed, survey evidence indicates that for those in charge of small UK companies, the most important reason for incorporating is limited liability. Still, individuals in such enterprises commonly provide personal guarantees for corporate debts. This is, at first glance, a paradox: individuals who attribute substantial weight to limited liability at the same time often waive its benefits. The inconsistency is not as great as it appears. With the personal guarantee a shareholder will be responsible only for what is owed to a single debtor. If the same individual is fully liable for all corporate debts, the amounts involved are less predictable and may be substantially greater. The fact that limited liability insulated poor risk bearers only tells half of the story. The arrangement will only have beneficial risk-distribution effect of creditors are better positioned to absorb the losses involved. The evidence suggests that this is the case. An important consideration is that creditors can take precautionary measures when negotiating debt contracts to deal with the burden of limited liability. To start, a lender can always engage in "screening", which entails acquiring information to determine the probability of default and then refusing to proceed if the risks are too great. Such evaluations occur commonly; they explain in some measure why banks are more willing to lend money to large, well-established enterprises than to small companies. In addition, creditors, being aware of the implications of limited liability, can extract a price concession in exchange for the increased risk imposed upon them. There is little evidence which directly supports the proposition that such an adjustment occurs. In other context, however, the rate of return which creditors charge varies in accordance with the risk that there will not be full repayment. For instance, banks charge greater interest rates too high risk corporate borrowers. Presumably, creditors, when they negotiate terms with debtors, take the impact of limited liability into account in much the same way. Another approach parties lending money and extending credit can use is to negotiate terms which improve the likelihood of being repaid what they are owed. Various strategies are available. These include demanding a personal guarantee from those who run the company, taking security against designated assets, curtailing the debtor's capacity to carry out transactions that increase the risk of default and requiring that the company supply information, such as financial statements, which demonstrate continuing creditworthiness. Some factors other than negotiations with debtor companies serve to ensure that creditors are suitably positioned to deal with burdens of limited liability. One consideration is that many creditors are well-diversified, in the sense that each debt contract has only a small impact on their financials status. A typical lender is not ordinarily well-suited to absorb the loss associated with the failure of a single business enterprise. Trade creditors will be in this situation because they usually have numerous customers and banks are similarly positioned 127 because they almost invariably lend money to a large number of business enterprises. Lenders are uncomfortable in a general way with bearing the risks involved with default or are concerned about sustaining a large loss from a particular key customer may have an additional option, which is taking insurance. Suppliers and manufacturers can, for instance, obtain from specialist private insurers cover against losses arising from the insolvency of their customers. Creditors are also usually reasonably well positioned to ensure the costs associated with limited liability because they often have interests on both sides. Take the example of a company operating as a supplier to retail stores. It extends credit to corporate customers but at the same time is in debt to those from which it buys inventory. For those owning shares in the supplier, limited liability will have an adverse impact because of the increased likelihood of non-payment by customers. At the same time,, however, the members benefit in the sense that limited liability ensures they are not personally accountable to the supplier's creditors. This sort of balancing of costs and benefits, together with other factors which affect limited liability's impact on creditors, helps to ensure that the commercial community accepts the spread of risk which exists with companies. Since limited liability facilitate the operation of equity markets and has a beneficial impact on the distribution of risks of business failure, if it were not possible to offer this feature by incorporating under legislation such as the Companies Act 1985, those operating businesses would probably attempt to establish limited liability by contract. History bears this out. Prior to the enactment of the first companies legislation in the United Kingdom in the mid-19th century, unincorporated partnerships organised as joint-stock companies commonly employed a variety of devices designed to give those owning stock limited liability. The devices in question were, however, cumbersome complex and their legal effectiveness was not fully settled. If Parliament repealed all companies legislation and remove the option of incorporating under statute, the situation probably would not be much different. Negotiating and drafting contractual clauses which were binding on all creditors would be timeconsuming and costly and the enforceability of such arrangements in the courts would probably be open to question. This brings to light a further beneficial effect of the existing legislative treatment of limited liability: cost savings. Parliament has, by enacting companies legislation, authorised the use of limited liability under a format which is on a sound legal footing and is reasonably straightforward to employ. Those who have decided to carry on business via the medium of a company incorporated pursuant to such legislation have correspondingly benefited from lower transaction costs and reduced risk of litigation. A topic which has recently attracted attention in academic circles illustrates that present legislative treatment of limited liability yields cost savings. Some commentators have spoken in favour of the regime under which shareholders are personally responsible for company debts, but only in proportion to the percentage of the equity which they own. To illustrate, assume a company has three shareholders and its debts exceed its assets by 20m. Two of the investors are judgment proof since they did not have any assets and the third, who is wealthy, owns 5% of the shares. If the wealthy investor is jointly and severally liable, he would owe 20m. Under a pro rata rule, however, he would only be liable for 1m (5% of 20m). Potentially attractive features of this system are that shareholders would not face the same risk of catastrophic liability associated with a joint and several rule and yet would be accountable in some measure for corporate debts. Regardless of whether shareholder liability for corporate debts was pro rata instead of joint and several, investors and firms would probably incur significant costs engaging in evasive strategies. Wealthy investors would not face the same risk of financial ruin. Nevertheless, they would likely arrange their affairs so as to minimise the adverse consequences in the event that financial disaster befell the companies in which they had invested. A likely strategy would be to shield assets by transferring ownership to family members or by removal 128 overseas. As well, companies would likely take the time and trouble to structure what would otherwise be equity investments as debts. The incentive would be that those providing financing would probably agreed to more favourable terms in return for being categorised as a lender rather than a shareholder. The advantage to being classified in this matter would be that as lenders they would not be under any sort of legal obligation to repay the company's other debts. The use of such evasive strategies is unnecessary which shareholders have limited liability. It follows that a system under which a limited liability company can be incorporated gives rise to substantial cost savings as compared to a regime under which investors are liable for corporate debts, even if this is only on a pro rata basis. Areas of concern The fact that limited liability has a number of important benefits indicates that wholesale reform would be ill-advised. Still, even though the present regime should remain intact, its operation gives rise to consequences that cause concern and might merit special legal treatment. One is where there has been deliberate and blatant misuse of limited liability and the corporate form. If individuals who operate a business via a limited liability company conceal this fact, a creditor may proceed when he otherwise would not. Even if he would have gone ahead regardless, he may nevertheless fail to bargain for the appropriate risk-adjusted rate of return and/or for suitable contractual protection. Creditors will face similar difficulties if those running a company misrepresent its activities, financial condition or future prospects. A strong case can be made that misleading conduct pertaining to a company's status should be regulated. It those who act on behalf of companies can misrepresent the risks involved with impunity, too much credit will be advanced to support unreliable types of business activity and not enough will be channelled towards valuable and productive users. Furthermore, creditors, if representations are unregulated, will take increased precautions to protect their interests. The added costs will be wasted from a social standpoint to the extent that the conduct could have been prevented at lower cost by regulation. While a case can be made for regulation where there has been deliberate misuse of the corporate form, it is not clear what the appropriate focus for the relevant laws should be. An obvious step is to impose sanctions against those who acted on a company's behalf and participated in the misconduct. Much more doubtful is where the shareholders who have had nothing to do with the fraud, misrepresentations, or related conduct should be adversely affected. When investors fall into this category, the issue that arises is which non-culpable individuals -- the passive shareholders or the creditors -- should bear the loss arising from the misdeeds involved. With the passive shareholders they arguably should have monitored those running the business more closely. In addition, they stood to benefit if the misconduct had gone undetected since the company would have borrowed money on terms not otherwise available. With creditors, the weakness in their position is that they will have dealt directly with those acting on the company's behalf. They thus will have been well positioned to evaluate what was going on at the time the fraud or misrepresentation was taking place. Though argument can be advanced in favour of the contrary position, the law favours passive shareholders and allocating the loss caused when there has been misuse of the corporate form. Section 349 of the Companies Act 1985 illustrate this. It applies were a company fails to signal by using the suffix "limited" or "public limited company" in its name that the company's members are not personally accountable for its debts. If there is a breach, the company and those responsible for the error face sanctions but passive shareholders remain free to enjoy the benefits of limited liability. As the case law doctrines, it is well established that the court can "lift the corporate veil" and declare a shareholder personally liable for company debts in circumstances where there is evidence of an unlawful purpose or deliberate concealment of the true state of affairs. The position of passive shareholders and litigation of this type has not been scrutinised in detail by English courts. Still, an empirical examination of US "lifting the veil" cases published in 1991 illustrate that such individuals are unlikely to 129 be adversely affected. The study indicates that with the public corporation, which is the type of enterprise most likely to have passive investors, courts really disregard corporate personality. As for closely held companies, defendants were less likely to be successful targets of "veil piercing" suits if they did not serve as directors or officers. Also, in the few cases where a judge explicitly characterised a defendant as a passive shareholder, the court almost always found no liability. Another area in which the consequences of limited liability can cause concern is with loss arising from negligent or otherwise tortious conduct. Problems exist both with compensation and deterrence. In terms of compensation, if total tort damages exceed a company's assets, by virtue of limited liability the victims will not be able to recover the shortfall by suing the company's members for what is owing. As for deterrence, limited liability can influence corporate activity in a negative fashion. When a company's operations cause injury, this will be a cost associated with doing business. So long as there are no prior contractual negotiations, market factors are unlikely to bring the accident costs home to those involved in the company. Tort litigation will redress the situation somewhat. Nevertheless, the shareholders' wealth will only be at risk to the point where accident costs render the company insolvent. Since this is the case, companies may well have an attenuated incentive to make the expenditures necessary to implement optimal safety precautions. It is widely acknowledged that limited liability cause problems for creditors and some have argued that legislators should reform the law to allow victims, in at least some circumstances, to recover from shareholders personally. It is not entirely clear, however, that changes are needed. One consideration is that limited liability has the beneficial attributes discussed previously. Another is the limited liability's adverse impact on tort creditors is not likely to be as dramatic in practice as it appears to be in theory. Only a small fraction of tort victims ever seek any formal legal redress. When tort claims the pursued, the vast majority are settled out of court by the defendant's insurer. In both sets of circumstances the presence or absence of limited liability will be irrelevant to the victim. Admittedly, situations can arise where victims are likely to sue and outside insurers are not obliged to cover the loss, at least fully. This can occur, for instance, with an accident in which many are killed or injured (e.g., a plane crash) or suffer adverse effects from using a defective product (e.g., drugs). Nevertheless, even with these types of "mass tort", the limited liability which shareholders of a defendant company enjoyed in unlikely to have a substantial impact on the amount available for recovery. A key consideration is that such occurrences really bankrupt companies. The tortfeasors in such instances are usually large enterprises, which means they will probably have substantial assets available to satisfy claims. As well, such companies often set up a "captive" in-house insurer to provide cover for any losses not dealt with by outside insurance. Furthermore, to the extent that tort liability does push a large enterprise to the brink of financial collapse, management has every incentive to strike some form of compromise with the tort creditors. The impetus is that if one of the formal procedures available under English law for dealing with distressed companies (receivership, administration, and liquidation) is invoked, the executives will have to step aside in favour of a licensed insolvency practitioner. Even when situations arise where suing a company may not provide suitable redress for tort victims, allowing them to sue shareholders personally might not yield much benefit in practice. With mass torts, since the defendant company will likely be a large one, it will probably have publicly traded shares. Under such circumstances, the victims or alternatively the company's trustee in bankruptcy, could likely and quite readily sue and enforce judgments against domestically based institutional investors. Taking proceedings, however, against foreign shareholders would probably involve important procedural and logistical difficulties. Also, suing and collecting from individual members would be cumbersome. Locating such people will be time-consuming and serving them with all the court documents would be an 130 expensive and inconvenient exercise. Furthermore, if judgment were obtained, costly and troublesome proceedings would probably be required to recover what was owing. Problems suffered by the Lloyd's of London insurance group in the first half of the 1990s illustrate the difficulties. Lloyd's has sought to recover over 1 billion owing from about 14,000 names, these being investors that had pledged the whole of their wealth to meet claims arising from the risks which Lloyd's underwrote. Lloyd's set up a special debt collection department and investigated in detail names' bank accounts, investments, and possessions. Lloyd's nevertheless did not recover the bulk of what was owing and its efforts to do so were undermined by complex legal proceedings involving names who have alleged that they were entitled to compensation because of negligent conduct by those managing ill-fated insurance syndicates. While readjusting the rules associated with limited liability is unlikely to provide a satisfactory solution to the problems which torts pose, this does not foreclose arguments relating to regulation. The issues instead need to be addressed from a broader perspective. To the extent that the plight of tort creditors merits regulation, a possible alternative strategy would be to enact legislation to provide such individuals with special priority in insolvency proceedings. Another would be to make compulsory for companies to carry insurance in designated situations. The Employers' Liability (Compulsory Insurance) Act 1969 is an example since it requires businesses to insure against tort liability to their own employees. We must leave it to others, however, to evaluate the merits of these proposals. 131 CORPORATE PERSONALITY: IMPLICATIONS FOR TORT AND CRIMINAL LAW The readings for this class look at the regulatory implications of the twin concepts of separate legal personality and limited liability for the law of torts, crimes and contracts. Thus, the first extract, the American case of Walkovsky v Carlton (1966) 223 NE 2d 6, highlights the potential impact limited liability has on the law of torts. According to the judgments in this case, what types of barriers might tort creditors -- such as victims of accidents or defective goods -- face when pursuing their tort claims against limited liability companies? The second reading by Fisse and Braithewaite highlights the regulatory challenges of holding corporations accountable for corporate crimes. Read the Casebook at paras 4.130-190 for the relevant legal principles relating to corporate crime. (The third reading by Ford, which is optional only, provides a useful structural framework for making sense of the cases extracted in the Casebook.) To what extent are the legal principles on the criminal responsibility of corporations faithful to the Salomon doctrine? 132 Walkovsky v Carlton (1966) 223 NE 2d 6 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. [This was an action against a cab driver, the corporation owning the cab and Carlton who owned the stock of 10 taxi corporations each owning 2 cabs and carrying the minimum insurance. The complaint alleged that the corporations were operated as a single entity and that the structure constituted an attempt to "defraud" members of the public. Carlton moved to dismiss for failure to state a cause of action. The trial court granted the motion, the Appellate Division reversed and Carlton obtained leave of the Appellate Division to appeal that order. The Court of Appeals in turn reversed the Appellate Division's order.] FULD, J.: The law permits the incorporation of a business for the very purpose of enabling its proprietors to escape personal liability ... but, manifestly, the privilege is not without its limits. Broadly speaking, the courts will disregard the corporate form, or, to use accepted terminology, "pierce the corporate veil", whenever necessary "to prevent fraud or to achieve equity".... In determining whether liability should be extended to reach assets beyond those belonging to the corporation, we are guided, as Judge Cardozo noted, by "general rules of agency"... In other words, whenever anyone uses control of the corporation to further his own rather than the corporation's business, he will be liable for the corporation's acts "upon the principle of respondeat superior applicable even where the agent is a natural person".... Such liability, moreover, extends not only to the corporation's commercial dealings.... In the case before us, the plaintiff has explicitly alleged that none of the corporations "had a separate existence of their own" and, as indicated above, all are named as defendants. However, it is one thing to assert that a corporation is a fragment of a larger corporate combine which actually conducts the business.... It is quite another to claim that the corporation is a "dummy" for its individual stockholders who are in reality carrying on the business in their personal capacities for purely personal rather than corporate ends.... Either circumstance would justify treating the corporation as an agent and piercing the corporate veil to reach the principal but a different result would follow in each case. In the first, only a larger corporate entity would be held financially responsible ... while, in the other, the stockholder would be personally liable.... Either the stockholder is conducting the business in his individual capacity or he is not. If he is, he will be liable; if he is not, then, it does not matter -- insofar as his personal liability is concerned -- that the enterprise is actually being carried on by a larger "enterprise entity"... At this stage in the present litigation, we are concerned only with the pleadings and, since CPLR 3014 permits causes of action to be stated "alternatively or hypothetically", it is possible for the plaintiff to allege both theories as the basis for his demand for judgment. In ascertaining whether he has done so, we must consider the entire pleading, educing therefrom "'whatever can be implied from its statements by fair and reasonable intendment....'" Reading the complaint in this case most favorably and liberally, we do not believe that there can be gathered from its averments the allegations required to spell out a valid cause of action against the defendant Carlton. 133 The individual defendant is charged with having "organized, managed, dominated and controlled" a fragmented corporate entity but there are no allegations that he was conducting business in his individual capacity. Had the taxicab fleet been owned by a single corporation, it would be readily apparent that the plaintiff would face formidable barriers in attempting to establish personal liability on the part of the corporation's stockholders. The fact that the fleet ownership has been deliberately split up among many corporations does not ease the plaintiff's burden in that respect. The corporate form may not be disregarded merely because the assets of the corporation, together with the mandatory insurance coverage of the vehicle which struck the plaintiff, are insufficient to assure him the recovery sought. If Carlton were to be held individually liable on those facts alone, the decision would apply equally to the thousands of cabs which are owned by their individual drivers who conduct their businesses through corporations organized pursuant to section 401 of the Business Corporation Law and carry the minimum insurance required by subdivision 1 (par. [a]) of section 370 of the Vehicle and Traffic Law. These taxi owner-operators are entitled to form such corporations ..., and we agree with the court at Special Term that, if the insurance coverage required by statute "is inadequate for the protection of the public, the remedy lies not with the courts but with the Legislature." It may very well be sound policy to require that certain corporations must take out liability insurance which will afford adequate compensation to their potential tort victims. However, the responsibility for imposing conditions on the privilege of incorporation has been committed by the Constitution to the Legislature (N. Y. Const., art. X, 1) and it may not be fairly implied, from any statute, that the Legislature intended, without the slightest discussion or debate, to require of taxi corporations that they carry automobile liability insurance over and above that mandated by the Vehicle and Traffic Law. This is not to say that it is impossible for the plaintiff to state a valid cause of action against the defendant Carlton. However, the simple fact is that the plaintiff has just not done so here. While the complaint alleges that the separate corporations were undercapitalized and that their assets have been intermingled, it is barren of any "sufficiently [particularized] statements" ... that the defendant Carlton and his associates are actually doing business in their individual capacities, shuttling their personal funds in and out of the corporations" without regard to formality and to suit their immediate convenience...." Such a "perversion of the privilege to do business in a corporate form" ... would justify imposing personal liability on the individual stockholders.... Nothing of the sort has in fact been charged, and it cannot reasonably or logically be inferred from the happenstance that the business of Seon Cab Corporation may actually be carried on by a larger corporate entity composed of many corporations which, under general principles of agency, would be liable to each other's creditors in contract and in tort. In point of fact, the principle relied upon in the complaint to sustain the imposition of personal liability is not agency but fraud. Such a cause of action cannot withstand analysis. If it is not fraudulent for the owner-operator of a single cab corporation to take out only the minimum required liability insurance, the enterprise does not become either illicit or fraudulent merely because it consists of many such corporations. The plaintiff's injuries are the same regardless of whether the cab which strikes him is owned by a single corporation or part of a fleet with ownership fragmented among many corporations. Whatever rights he may be able to assert against parties other than the registered owner of the vehicle come into being not because he has been defrauded but because, under the principle of respondeat superior, he is entitled to hold the whole enterprise responsible for the acts of its agents. In sum, then, the complaint falls short of adequately stating a cause of action against the defendant Carlton in his individual capacity. The order of the Appellate Division should be reversed, with costs in this court and in the Appellate Division, the certified question answered in the negative and the order of the Supreme Court, Richmond County, reinstated, with leave to serve an amended complaint. 134 KEATING, J. (DISSENTING) The defendant Carlton, the shareholder here sought to be held for the negligence of the driver of a taxicab, was a principal shareholder and organizer of the defendant corporation which owned the taxicab. The corporation was one of 10 organized by the defendant, each containing two cabs and each cab having the "minimum liability" insurance coverage mandated by section 370 of the Vehicle and Traffic Law. The sole assets of these operating corporations are the vehicles themselves and they are apparently subject to mortgages. From their inception these corporations were intentionally undercapitalized for the purpose of avoiding responsibility for acts which were bound to arise as a result of the operation of a large taxi fleet having cars out on the street 24 hours a day and engaged in public transportation. And during the course of the corporations' existence all income was continually drained out of the corporations for the same purpose. The issue presented by this action is whether the policy of this State, which affords those desiring to engage in a business enterprise the privilege of limited liability through the use of the corporate device, is so strong that it will permit that privilege to continue no matter how much it is abused, no matter how irresponsibly the corporation is operated, no matter what the cost to the public. I do not believe that it is. Under the circumstances of this case the shareholders should all be held individually liable to this plaintiff for the injuries he suffered.... At least, the matter should not be disposed of on the pleadings by a dismissal of the complaint. "If a corporation is organized and carries on business without substantial capital in such a way that the corporation is likely to have no sufficient assets available to meet its debts, it is inequitable that shareholders should set up such a flimsy organization to escape personal liability. The attempt to do corporate business without providing any sufficient basis of financial responsibility to creditors is an abuse of the separate entity and will be ineffectual to exempt the shareholders from corporate debts. It is coming to be recognized as the policy of law that shareholders should in good faith put at the risk of the business unincumbered capital reasonably adequate for its prospective liabilities. If capital is illusory or trifling compared with the business to be done and the risks of loss, this is a ground for denying the separate entity privilege." In Minton v. Cavaney (56 Cal. 2d 576) the Supreme Court of California had occasion to discuss this problem in a negligence case. The corporation of which the defendant was an organizer, director and officer operated a public swimming pool. One afternoon the plaintiffs' daughter drowned in the pool as a result of the alleged negligence of the corporation. Justice Roger Traynor, speaking for the court, outlined the applicable law in this area. "The figurative terminology 'alter ego' and 'disregard of the corporate entity'", he wrote, "is generally used to refer to the various situations that are an abuse of the corporate privilege... The equitable owners of a corporation, for example, are personally liable when they treat the assets of the corporation as their own and add or withdraw capital from the corporation at will ...; when they hold themselves out as being personally liable for the debts of the corporation ...; or when they provide inadequate capitalization and actively participate in the conduct of corporate affairs". Examining the facts of the case in light of the legal principles just enumerated, he found that "[it was] undisputed that there was no attempt to provide adequate capitalization. [The corporation] never had any substantial assets. It leased the pool that it operated, and the lease was forfeited for failure to pay the rent. Its capital was 'trifling compared with the business to be done and the risks of loss'". 135 It seems obvious that one of "the risks of loss" referred to was the possibility of drownings due to the negligence of the corporation. And the defendant's failure to provide such assets or any fund for recovery resulted in his being held personally liable.... The policy of this State has always been to provide and facilitate recovery for those injured through the negligence of others. The automobile, by its very nature, is capable of causing severe and costly injuries when not operated in a proper manner. The great increase in the number of automobile accidents combined with the frequent financial irresponsibility of the individual driving the car led to the adoption of section 388 of the Vehicle and Traffic Law which had the effect of imposing upon the owner of the vehicle the responsibility for its negligent operation. It is upon this very statute that the cause of action against both the corporation and the individual defendant is predicated. In addition the Legislature, still concerned with the financial irresponsibility of those who owned and operated motor vehicles, enacted a statute requiring minimum liability coverage for all owners of automobiles. The important public policy represented by both these statutes is outlined in section 310 of the Vehicle and Traffic Law. That section provides that: "The legislature is concerned over the rising toll of motor vehicle accidents and the suffering and loss thereby inflicted. The legislature determines that it is a matter of grave concern that motorists shall be financially able to respond in damages for their negligent acts, so that innocent victims of motor vehicle accidents may be recompensed for the injury and financial loss inflicted upon them." The defendant Carlton claims that, because the minimum amount of insurance required by the statute was obtained, the corporate veil cannot and should not be pierced despite the fact that the assets of the corporation which owned the cab were "trifling compared with the business to be done and the risks of loss" which were certain to be encountered. I do not agree. The Legislature in requiring minimum liability insurance of $10,000, no doubt, intended to provide at least some small fund for recovery against those individuals and corporations who just did not have and were not able to raise or accumulate assets sufficient to satisfy the claims of those who were injured as a result of their negligence. It certainly could not have intended to shield those individuals who organized corporations, with the specific intent of avoiding responsibility to the public, where the operation of the corporate enterprise yielded profits sufficient to purchase additional insurance. Moreover, it is reasonable to assume that the Legislature believed that those individuals and corporations having substantial assets would take out insurance far in excess of the minimum in order to protect those assets from depletion. Given the costs of hospital care and treatment and the nature of injuries sustained in auto collisions, it would be unreasonable to assume that the Legislature believed that the minimum provided in the statute would in and of itself be sufficient to recompense "innocent victims of motor vehicle accidents ... for the injury and financial loss inflicted upon them". The defendant, however, argues that the failure of the Legislature to increase the minimum insurance requirements indicates legislative acquiescence in this scheme to avoid liability and responsibility to the public. In the absence of a clear legislative statement, approval of a scheme having such serious consequences is not to be so lightly inferred. The defendant contends that the court will be encroaching upon the legislative domain by ignoring the corporate veil and holding the individual shareholder. This argument was answered by Mr. Justice Douglas in Anderson v. Abbot ... where he wrote that: "In the field in which we are presently concerned, judicial power hardly oversteps the bounds when it refuses to lend its aid to a promotional project which would circumvent or undermine a legislative policy. To deny it that function would be to make it impotent in situations where historically it has made some of its most notable contributions. If the judicial power is 136 helpless to protect a legislative program from schemes for easy avoidance, then indeed it has become a handy implement of high finance. Judicial interference to cripple or defeat a legislative policy is one thing; judicial interference with the plans of those whose corporate or other devices would circumvent that policy is quite another. Once the purpose or effect of the scheme is clear, once the legislative policy is plain, we would indeed forsake a great tradition to say we were helpless to fashion the instruments for appropriate relief." (Emphasis added.) The defendant contends that a decision holding him personally liable would discourage people from engaging in corporate enterprise. What I would merely hold is that a participating shareholder of a corporation vested with a public interest, organized with capital insufficient to meet liabilities which are certain to arise in the ordinary course of the corporation's business, may be held personally responsible for such liabilities. Where corporate income is not sufficient to cover the cost of insurance premiums above the statutory minimum or where initially adequate finances dwindle under the pressure of competition, bad times or extraordinary and unexpected liability, obviously the shareholder will not be held liable.... The only types of corporate enterprises that will be discouraged as a result of a decision allowing the individual shareholder to be sued will be those such as the one in question, designed solely to abuse the corporate privilege at the expense of the public interest. For these reasons I would vote to affirm the order of the Appellate Division. 137 Fisse, B and Braithewaite, J, Corporations, Crime, and Accountability (1993) at 1-16 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. CONTEMPORARY PROBLEMS OF ACCOUNTABILITY FOR CORPORATE CRIME Two major problems of accountability confront modem industrialised societies in their attempts to control wrongdoing committed by larger scale organisations. First, there is an undermining of individual accountability at the level of public enforcement measures, with corporations rather than individual personnel typically being the prime target of prosecution. Prosecutors are able to take the short-cut of proceeding against corporations rather than against their more elusive personnel and so individual accountability is frequently displaced by corporate liability, which now serves as a rough-and-ready catch-all device. Second, where corporations are sanctioned for offences, in theory they are supposed to react by using their internal disciplinary systems to sheet home individual accountability, but the law now makes little or no attempt to ensure that such a reaction occurs. The impact of enforcement can easily stop with a corporate pay-out of a fine or monetary penalty, not because of any socially justified departure from the traditional value of individual accountability, but rather because that is the cheapest or most self-protective course for a corporate defendant to adopt. The central aims of this book are twofold: to examine the extent to which existing theories help to resolve the problems of non-prosecution of individuals and non-assurance of internal corporate accountability; and to advance a more responsive program for achieving accountability for corporate crime. ... (A) Non-prosecution of individuals The problem of non-prosecution of individual representatives of companies for offences committed on their behalf has become increasingly visible. The problem of non-prosecution of individual persons implicated in corporate crime was highlighted by the Hutton affair in the United States (US). E. F. Hutton and Co., a brokerage firm, engaged in a widespread fraudulent scheme in which its bank accounts were overdrawn by up to $US270 million a day without triggering debits for interest; approximately 400 banks were defrauded of $US8 million. E. F. Hutton and Co. pleaded guilty to 2,000 felony counts of mail and wire fraud and, under the plea agreement, agreed to pay a $US2.75 million fine and to reimburse the banks. No individuals were prosecuted despite the admission of the Justice Department that two Hutton executives were responsible for the fraud "in a criminal sense". The explanation given by the US Assistant Attorney General was this: In assessing the manner in which this case ought to be handled, our prosecutors started from the proposition that individuals ought to be held personally responsible for their criminal misconduct. This is our normal policy from which we deviate only when faced with a compelling reason to make an exception. Pursuing in court in this case the known individual authors of the swindle would have had some merit, but not at the expense of foregoing the opportunity to dictate the key terms of and seize without delay this extraordinary settlement. To prosecute the individuals would have required 138 us to drop the settlement in favor of a protracted court fight that would have taken years to complete. That was the choice. This explanation was severely criticised by the Subcommittee on Crime of the House of Representatives Committee on the Judiciary. In the opinion of the Subcommittee: The Department has, in prosecuting other cases, shown great tenacity and willingness to ignore cost considerations and significant adverse odds. Yet in Hutton, the prosecutors seemed overwhelmed by the fact that discovery would be time-consuming, ... that the case would be complex, and that it might take months to try. ... The Hutton plea contributed to a decrease in public confidence in the fairness of the criminal justice system -- a pervasive feeling that defendants with enough money and resources can 'buy' their way out of trouble. There have been other conspicuous compromises of individual accountability in the US. One of the more glaring was the deal made in 1981 to settle the McDonnell Douglas bribery affair concerning sales to Pakistani Airlines. Fraud and conspiracy charges against four top McDonnell Douglas Corp executives were dropped in return for a guilty plea by the company to charges of fraud and making false statements. Under the plea agreement, McDonnell Douglas incurred a fine of $US55,000 and agreed to pay $US 1.2 million in civil damages. This agreement was entered into at a meeting between the US Assistant Attorney General and representatives of the company. The prosecutors in the case (who had not been invited to the meeting and who subsequently resigned from the Justice Department) were of the view that the liability of the four executives had been "bought off" by the settlement. Contrary to the orthodox line of prosecutors that their priority is to proceed against individuals and with corporations only secondary targets, the statistics reveal a significant incidence of cases where individuals have not been prosecuted or, in the event of prosecution, have not been held liable. In Clinard and Yeager's study of the incidence of corporate crime among large companies in the US in the late 1970s, it was found that in only 1.5 per cent of all enforcement actions was a corporate officer held liable. Moreover, in addition to the E. F. Hutton case and other well-known instances of failure to proceed against individuals, any corporate crime-watcher's pile of newspaper clippings will contain numerous reports of cases where enforcement is directed at corporate entities rather than against their personnel. Non-prosecution of corporate executives is also prevalent in many other countries. In Canada, the pattern of enforcement under the Competition Act 1986 has been heavily oriented toward corporate defendants, although Criminal Code offences are usually enforced against individuals. Corporations are the targets of antitrust law enforcement in the European Community (EC). In England, the conventional wisdom is that corporate criminal liability is of little practical significance as compared with individual criminal liability, but there have been numerous cases in which companies alone have been prosecuted. Moreover, the reputation of the English criminal justice system for holding individuals to account was blackened by the so-called Oilgate scandal surrounding the failure of the authorities to prosecute any of the persons responsible for the planned and persistent evasion by British Petroleum and Shell Oil of the British embargo on exporting oil to Southern Rhodesia. Systematic data are available from Australia where a study was made of the enforcement policies of 96 major business regulatory agencies. Top management of each agency was asked if it had "a policy or philosophy on whether it is better to prosecute the company itself as opposed to those individuals who are responsible within the company. Twenty agencies said that they preferred to target the individuals responsible; for 41, the preferred target was the corporation; five said they consistently tried to proceed against both the corporation and personnel concerned; and 30 had no policy or philosophy on the matter. The 20 agencies with a preference for individual liability were mostly in the areas of mine safety (where legislation often focuses liability on managers and supervisors) and in maritime safety and maritime oil 139 pollution regulation (where there is a tradition of viewing the ship's captain as the preferred target). Thirty-eight of the 96 agencies had not proceeded against an individual during the previous three years (1981-84). De facto immunity from individual criminal liability for corporate crime is also prevalent in Continental jurisdictions. In Germany, where the principle of individual responsibility for crime is so firmly entrenched that corporations are not subject to criminal liability, the difficulty of prosecuting corporate officials is well recognised. This has come about partly as a result of the Flick bribery case.... Today in Germany, administrative sanctions have become a mainstay of corporate regulation, especially in antitrust and environmental protection and, where administrative sanctions are used, the usual targets are corporations, not individuals. The same dependence on administrative sanctions is apparent in EC enforcement, where total reliance is placed on corporate liability. A stronger commitment to individual responsibility for organisational wrongdoing was often claimed of the old communist jurisdictions, but it is unclear whether this was more the official line than a reflection of practice. In environmental enforcement, some Eastern European countries made extensive use of administrative penalties imposed on the enterprise. At some level of abstraction government agencies often assert a policy to proceed against individuals as a matter of priority, but such policies are generally a mystification. The frequent non-prosecution of corporate officers in practice is our concern, together with the implications of adopting a policy that is more honoured in the breach than in the observance. We do not suggest that prosecutors have no justification for targeting corporations rather than individuals. On the contrary, there are many reasons, theoretical as well as practical, why there is often little or no choice but to focus on corporate defendants. There are of course numerous instances where corporate officers have been prosecuted, often successfully. One notable US example is the widely publicised prosecution and conviction for murder of three executives of an Illinois company, Film Recovery Systems, whose operations had resulted in the cyanide poisoning of a worker. In this case, however, the company was a small concern and it was much easier for the prosecution to obtain incriminating evidence against the top managers than is typically the position where a large- or medium-sized corporation is involved. Another well-known English example is that of Ernest Saunders, the managing director of Guinness plc, who was convicted and sentenced to jail for offences relating to the manipulation of Guinness share prices to thwart a takeover by the Distillers Group. The main actors in this skulduggery were easy to identify; as in most cases of defensive measures against takeovers, relatively few people were in a position to call the shots. Compare these cases with Union Carbide's Bhopal disaster in India in 1984: investigating exactly what happened at all relevant points down the company's lines of accountability for production plant safety would require a sizeable task force of investigators, and even then the location of individual responsibility would not necessarily be clear. The same is true in many other contexts, some of the more obvious of which include the operations of the Bank of Credit and Commerce International (BCCI), the savings and loan scandal in the US, the deceptive practices of numerous government contractors in the US defence industry, the Zeebrugge ferry disaster, and the insurance-selling scam perpetrated by insurance companies against Australian Aboriginal people in North Queensland. Non-assurance of internal accountability within corporations The second major problem of accountability for corporate crime is non-assurance that sanctions against corporations will result in due allocation of responsibility as a matter of internal disciplinary control. 140 In theory, the type of sanction usually deployed against corporations -- the fine or monetary penalty -- is supposed to pressure corporate defendants into taking internal disciplinary action. An initial difficulty in some countries, including England, Australia and Canada, is that corporate criminal liability depends on the 'directing mind' principle, in which in practice means that large corporations are virtually insulated from criminal liability for serious offences. This was in fact what happened in the Zeebrugge ferry case, where the prosecution in England failed largely because of the insuperable obstacle of establishing that a directing mind had been criminally negligent. Putting aside that obstacle, however, there is no guarantee that monetary punishment will trigger any form of internal accountability. This is a dark side of corporate self-regulation about which little is known by outsiders. A high degree of trust has been reposed in corporations to maintain internal discipline. It is readily apparent, however, that companies have strong incentives not to undertake extensive disciplinary action. In particular, a disciplinary program may be disruptive, embarrassing for those exercising managerial control, encouraging for whistle-blowers, or hazardous in the event of civil litigation against the company or its officers. Sometimes these incentives may be veiled by the claim that the problem has been sufficiently investigated and resolved by public enforcement action. These factors have been discussed in the literature, but the law has failed to provide adequate means for ensuring that corporate defendants are sentenced in a manner directly geared to achieving internal accountability. The classic illustration of the ease with which corporate defendants can pay a fine and walk away from internal disciplinary action was the reaction of the Westinghouse Corporation upon being convicted and sentenced for its role in the US heavy electrical equipment pricefixing conspiracies of 1959-6l. Westinghouse decided against disciplinary action, partly on the ground of a watered-down version of the defence which failed in the Nuremberg trials: "anybody involved was acting not for personal gain, but in what he thought was the best interests of the company." By contrast, the internal discipline by General Electric in response to the heavy electrical equipment conspiracies was relatively severe. All persons implicated in violations of corporate antitrust policy were disciplined by substantial demotion long before any of them were convicted. Those who were later convicted were asked to resign because "the Board of Directors determined that the damaging and relentless publicity attendant upon their sentencing rendered it "in their interest and the company's that they pursue their careers elsewhere". Another prominent example was the refusal of American Airlines to blame publicly any individuals within the company when it incurred civil penalties of $US1.5 million for violations of Federal Aviation Administration aircraft maintenance requirements. One of the violations had been committed by flying an 'unairworthy' plane from which an engine had fallen when struck by a piece of ice from an unrepaired leaky toilet. A spokesman for the company said that no one had been fired as a result and indeed no one could be identified as accountable for the maintenance breakdowns because 'management systems' had been involved. As Colman McCarthy observed, the buck stopped with the corporation: Under this general absolution, we are asked to believe that no living, breathing humans were responsible for designing and maintaining the planes. Nor was it the failure of any live human employees to fix the leaky toilet that caused the engine to fly off over New Mexico. That was a 'design malfunction.' This playing down of individual accountability is in line with the comparative puniness of the fine. The FAA [Federal Aviation Administration] has collected $1.5 million from a company that had operating revenues of $5.3 billion in 1984 and record profits of $234 million for the first half of 1985. Not a dime came out of the paychecks of the invisible managers. .... 141 Non-assurance of internal accountability within corporations is hardly a uniquely American legal phenomenon. A telling Australian illustration is Trade Practices Commission v Pye Industries Sales Pty Ltd -- a decision of the Australian Federal Court. Pye was found to have committed resale price maintenance in violation of the Australian Trade Practices Act, and the court adjourned the matter for sentence. At the sentencing hearing the court was able to conclude that, at the time of violation. "there was an almost total lack of supervision or interest by the board of directors in the conduct of their management and executives in relation to resale price maintenance". However, the court was uninformed as to the nature of the company's disciplinary and other responses to the violation: "the company itself had not come forward with relevant evidence, and the evidence that had emerged from the trial related to the issue of whether a violation had been committed." The court, after describing the violation as 'ruthless', and yet having made no finding as to the adequacy or otherwise of the company's disciplinary reactions, imposed a penalty of $A 120,000. The extent to which corporations fail to insist on accountability in response to being fined is now impossible to say. Empirical research in this area has been limited and some companies refuse to divulge what has or has not been done to punish insiders. This dark side of corporate self-regulation usually becomes visible only if a company is forced out into the open by public pressure or by threats from enforcement agencies.... Sporadic attempts have been made by the law to enter the black box of corporations by means of non-monetary sanctions aimed directly at achieving effective internal accountability. Mandatory injunctions have been used for this purpose from time to time, most notably by the US Securities and Exchange Commission (SEC) in its campaign against bribery in the mid1970s. A number of corporations were required to establish special review committees for the purposes of conducting investigations and initiating appropriate internal action. The most celebrated example is that of the Gulf Oil Corporation, a special review committee of which prepared a 298-page report detailing the misuse of $US 12 million for payment to US and foreign officials, and the role played by various Gulf Oil officials. Why accountability for corporate crime is important These problems of accountability are hardly pin-pricks; they sap the social control of corporate crime. Individual accountability has long been regarded as indispensable to social control, at least in Western societies, but today is more the exception than the rule in the context of offences committed on behalf of larger-scale organisations. Given the gravity with which corporate crime is increasingly perceived, this is a remarkable state of affairs and one which awaits responsive solutions. The danger of 'headlessness' in systems of collective social accountability has repeatedly been stressed. Recollect John Stuart Mill's advice, as given in Considerations on Representative Government: As a general rule, every executive function, whether superior or subordinate, should be the appointed duty of some given individual. It should be apparent to all the world, who did everything, and through whose default anything was left undone. Responsibility is null, when nobody knows who is responsible. Nor, even when real, can it be divided without being weakened. To maintain it at its, highest, there must be one person who receives the whole praise of what is well done, the whole blame of what is ill. Mill's concern has often been echoed by politicians, not only in the context of ministerial or administrative responsibility, but also in relation to criminal liability. In a message to 142 Congress on 20 January 1914, President Wilson severely criticised the failure of the Sherman Act 1890 to strike at what he took to be the real villains behind antitrust offences: We ought to see to it, and the judgement of practical and sagacious men of affairs everywhere would applaud us if we do see to it, that penalties and punishments should fall not upon the business itself, to its confusion and interruption, but upon the individuals who use the instrumentalities of business to do things which public policy and sound business practice condemn. Every act of business is done at the command or upon the initiative of some ascertainable person or group of persons. These should be held individually responsible, and the punishment should fall upon them, not upon the business organization of which they make illegal use. When the Supreme Court in United States v Park imposed a demanding standard of care and supervision upon corporate executives under the Food, Drug and Cosmetic Act 1938, some commentators saw this as the coming of a much-needed new deal in personal accountability: The just allocation of fault is an essential ingredient in building a credible, healthy society. Ile growth of giant corporations with their multiple layers of bureaucratic responsibility has significantly complicated the critical process of fixing blame. 'Me faceless quality of contemporary bureaucracies has had an important, though largely unexplored, impact on law enforcement. Fixing responsibility on a single manager or a small group of managers has received only passing attention from law makers and law enforcers. More recently, the E. F. Hutton scandal provoked many reaffirmations of the value of individual responsibility. In the opinion of Senator Howard M. Metzenbaum, the nonprosecution of any Hutton executives meant that "something has gone awry" at the Department of Justice. "What kind of a department is this?" he asked. "If you wear a white collar you don't get prosecuted." More philosophical was the reaction of Thomas Donaldson, a leading writer on business ethics: What we're seeing, as corporations get larger and larger, is a breakdown in the lines of accountability. We've created some superstructures in business that are wildly complex, and we haven't tamed them yet. Perennial as the hope of individual accountability has been, the law has turned a blind eye to reality. The way in which legal liability is structured today often confers a de facto immunity on corporate managers, who are typically shielded by a corporate entity which takes the rap. This is a fundamental difficulty of the deepest social significance. If the corporate form is used to obscure and deflect responsibility, whether intentionally or unintentionally, the growth of corporate activities in industrialised societies poses an acute risk of escalating breakdown of social control. This breakdown is already patent in domains like tax compliance and toxic waste regulation. Buck-passing is increasingly fostered not only by a burgeoning corporate birthrate (measured by new certificates of incorporation) but also by tendencies for the majority of the population to work in corporations of increasing size and complexity. A corporate society finds it easier to hide its skeletons in closets, and in a big corporation the closets are more numerous and more obscure. Unless corrected, this danger is bound to increase because, as Christopher Stone has pointed out, there is a growing tendency in modem society for things to be done by and through corporations: When something goes wrong, whether a toxic spill or a swindle, chances are good that a corporation will be implicated ... the design of social institutions, once focused almost exclusively on how to deal with individual persons acting on their own account, has to be reconsidered in the light of a society in which bureaucratic organizations have come to dominate the landscape, and when persons are accounted for, if at all, not simply as individuals but as officeholders. 143 Towards accountability for corporate crime The analytical thrust of this book is straightforward. We take the three predominant theoretical domains of thought about allocation of responsibility for corporate crime and critically assess the worth of what they have to say. Those domains of thought are individualism, ... law and economics ... and organisation theory. From these diverse and promiscuous sources we extract a range of desiderata for the allocation of responsibility for corporate crime.... The theme of this book is the antithesis of orthodox cynicism. The quintessential cynic derives inspiration from Ambrose Bierce's definition of the corporation as "an ingenious device for the maximisation of profit and the minimisation of responsibility". Our inspiration lies not in Bierce's barb but in the possibility that corporations can be harnessed as useful workhorses for assuring responsibility. The central theme we defend is that all who are responsible should be held responsible and that this ideal is attainable only if legal systems recognise corporate systems of justice and fully utilise their power. We are led to this theme by two key observations: corporations have the capacity but not the will to deliver clearly defined accountability for law-breaking; courts of law, obversely, may, have the will but not the capacity. Hence, the solution may lie in bringing together the capacity of the firm's private justice system -- to identify who was truly responsible -- with the will of the public justice system to demand accountability that is just rather than expedient. To achieve this, the law should hold an axe over the head of a corporation that has committed the actus reus of a criminal offence. This may be almost literally an axe that ultimately can deliver the sanction of corporate capital punishment -- liquidation, withdrawal of the licence or charter of the firm to operate. The private justice system of the firm is then put to work under the shadow of that axe. The axe would not fall if the private justice system of the corporation does what it is capable of doing -- a self-investigation that fully identifies the responsible corporate policies, technologies, management systems, and decisionmakers and that comes up with a plan of remedial action, disciplinary action and compensation to victims that can satisfy the court. Should, however, the corporation cheat on its responsibility to make its private justice system work justly -- by offering up a scapegoat, for example -- then the axe would fall. These are the bare bones of the Accountability Model.... 144 Ford, HAJ, Fords Principles of Corporations Law (2002) at 16.100-16.280 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of the University of New South Wales pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. CRIMINAL WRONGS [16.100] The subjection of companies to criminal law There is legislation defining criminal wrongs that can be understood as extending to companies and other bodies corporate as well as natural persons. There are even some common law crimes defined in terms which reach bodies corporate. Many statutes expressly provide that when the word "person" or a similar word is used, bodies corporate are included. See for example, [Corporations Act] s 85A. Even if a particular statute does not refer to bodies corporate, there is usually a provision in the relevant Interpretation Act of the particular jurisdiction under which "person" is defined to include a body corporate. Given that a particular legal command could be read as extending to a company, is any useful purpose served by punishing the company as an entity when the individuals whose acts make it liable are themselves personally liable to be punished? Would it not suffice to ensure that under civil law the company compensates persons who suffer loss caused by a wrong? There is no concept of trusts being subject to criminal liability, however large they may be. Nor are partnerships made liable unless a statute so requires: Bishop v Chung Bros (1907) 4 CLR 1262. Subjection of bodies corporate to criminal law owes something to the equating of them to natural persons.... The punishment usually appropriate to a corporation is a fine. If directors of a company are the sole shareholders and the actors in crime, a fine imposed on the company is an indirect way of doing something which could have been done directly. In a large company where the shareholders have no real control over the acts of management, the fine falls on innocent people. But in a company where the members might be expected to have some control over management the court may think it appropriate to impose such a fine as will deter others and ensure proper management: Hinch v A-G (Vic) [1987] VR 721. Where the fine is commensurate with the damage done to society by the crime, or with the profit made by the company out of the crime, the fine on the company has some justification, but even here, the fine is only a rough and ready means of compensating society by burdening those who would gain, since shares may have changed hands in the meantime: R v Wattle Gully Gold Mines NL [1980] VR 622. There may be a justification for the imposition of criminal liability upon corporations as a means of obtaining a conviction where no individual offender can be detected. Where the offence consists in improperly allowing some state of affairs to exist, such as some harm to the environment, parliament may have to provide that a corporation is liable where it is clear that someone in the corporate organisation must have been at fault, but it is impossible to identify that person: Howard's Criminal Law 5th ed (1990) by B Fisse p 591. On that basis it 145 would seem to follow that the corporation should not be liable if it is possible to convict the individual offenders. [16.110] Categories of corporate criminal liability There are three classes of crimes for which a company may be convicted: (1) Crimes constituted by acts of employees of the company within the scope of their employment for which the company is penalised simply because the company is their employer. These crimes are mainly the creatures of statute. (2) Crimes constituted by the company's failure to perform a duty imposed by the statute where the duty is non-delegable and the company's liability is absolute or strict. These are also created by statute. (3) Crimes constituted by acts of directors, employees or agents which by a fiction are treated as acts of the company. These can include common law crimes as well as crimes created by statute. Category (1) is reminiscent of the vicarious liability of an employer for civil wrongs of employees. The criminal act is that of the employee but the employer is made liable to pay the penalty. Categories (2) and (3) relate to primary liability of the company itself for what are deemed to be its wrongs rather than simply making the company punishable for the wrongs of others. [16.120] Vicarious criminal liability As to the first class, the imposition of criminal liability on a corporation is part of the imposition of vicarious criminal liability generally, ordering one person to pay a penalty for the acts of another. Vicarious criminal liability is exceptional at common law. In general, the common law did not impose a penalty on persons merely because of some particular relationship they had to another person such as that of employer and employee: R v Huggins (1730) 2 Ld Raym 1574; 92 ER 518. This is in contrast to the civil side of law under which an employer, whether corporate or not, can be liable to pay compensation for a wide range of civil wrongs committed by employees while acting within the scope of their employment. Common law vicarious criminal liability At common law, vicarious criminal liability has applied only in the crimes of public nuisance and criminal libel: R v Kellow [1912] VLR 162. The common law immunity of employers from vicarious criminal liability has, however, been eroded by developments in statute law. Statutory vicarious criminal liability Some statutes simply address commands to employers, both corporate and non-corporate, in terms which make it clear that the employer can be liable to pay a penalty if an employee acting for the employer does not observe the command. Social necessity has required legislation subjecting employers to laws creating social welfare offences, such as legislation about pure foods and liquor licensing legislation. Many statutes were susceptible to a construction that employers should be liable to a penalty for the acts of their agents or employees without guilty intent on the employer's part. Whether a statute has that effect may not be spelled out clearly in the statute. According to Atkin J in Mousell Bros Ltd v London and North-Western Railway Co [1917] 2 KB 836 at 8456: 146 To ascertain whether a particular Act of Parliament has that effect or not regard must be had to the object of the statute, the words used, the nature of the duty laid down, the person upon whom it is imposed, the person by whom it would in ordinary circumstances be performed, and the person upon whom the penalty is imposed ... The penalty is imposed upon the owner for the act of the servant if the servant commits the default provided for in the statute in the state of mind provided for by the statute. Once it is decided that this is one of those cases where a principal may be held liable criminally for the act of his servant, there is no difficulty in holding that a corporation may be a principal. No mens rea [guilty mind] being necessary to make the principal liable, a corporation is in exactly the same position as a principal who is not a corporation. In R v Australasian Films Ltd (1921) 29 CLR 195, the High Court adopted the reasoning in Mousell's case when holding that a corporate principal was liable for various offences under the Customs Act. The offences required proof of acts with intent to defraud. The company was liable where its employee or agent in the course of his or her employment had done the particular act and that employee or agent, or some superior employee or agent by whose direction the act was done, had an intent to defraud. See also Ex parte Colonial Petroleum Oil Pty Ltd (1944) 44 SR (NSW) 306. Where the corporation is vicariously liable it does not matter whether the employee or agent occupies a senior or junior position in the company. It is enough that the employee is acting within the scope of the employment and doing something for the benefit of the employer. The legislation simply makes the principal liable regardless of the principal's lack of culpability. [16.130] Fault, strict or absolute criminal liability Some statutes have created offences of absolute or strict liability. Their special nature can be seen in the following classification. Statutory offences are of three kinds in relation to how far a guilty mind is required: 1. those in which the prosecution has to prove beyond reasonable doubt not only the accused's act but also that the accused had a guilty mind; 2. strict liability offences where the prosecution does not have to prove a guilty mind, but if it appears from the evidence that there could have been an honest and reasonable mistake or that the accused acted reasonably to prevent the harm, the prosecution must rebut that beyond reasonable doubt; or 3. absolute liability offences where a person can be convicted of an offence without the prosecution having to prove guilty mind and lack of guilty mind will not excuse: Chiou Yaou Fa v Morris (1987) 46 NTR 1. It became established that a person under an absolute duty could not delegate the duty. Hence in the example the occupier would be liable if a discharge of oil were caused by an employee or even an independent contractor: Goodes v General Motors Holdens Pty Ltd [1972] VR 386; Allen v United Carpet Mills Pty Ltd [1989] VR 323. One of the problems about imposing on a corporation traditional criminal liability which required proof of guilty mind was that, being an artificial person, it was thought to lack a mind. As will be seen at [16.140] and [16.180]ff, the law gets over that difficulty by imputing the state of mind of certain senior agents and employees to the corporation. But even if the difficulty could not be overcome in that way, the growing number of offences in which proof of guilty mind was unnecessary fostered the development of corporate criminal liability. The terms of the statute in effect could enable the development of something like vicarious criminal liability imposed upon a corporation. 147 [16.140] Primary criminal liability by attribution This class of criminal liability of a company developed in unenacted law. It rests on a premise that a company can be culpable and have a primary liability for crimes, even crimes which can only be committed with a particular state of mind. To reach this result it is necessary somehow to find that the company, though merely an artificial person, has a mind. The solution has been to focus on certain categories of people who have power to commit the company. Having found them, it is a matter of looking at their acts and their state of mind. Through them a corporation can have knowledge, intention, opinion ( Lloyd v David Syme & Co Ltd [1986] AC 350 at 366; (1986) 63 ALR 83 at 91 ), belief or purpose. Rules about a corporation's mental state will be dealt with in the last part of this chapter, since they operate for purposes beyond criminal liability. .... [16.170] Company and actor: co-principals or accomplices? Where an agent or employee has acted in breach of a law imposing a criminal penalty it is necessary to determine the respective liabilities that are attracted to the company and actor respectively. It can be important to determine whether a person is liable as a principal or as an accessory, because there can be cases where principal offenders are liable regardless of their state of mind whereas accomplices will not be liable unless they know the facts that make up the contravention: Yorke v Lucas (1985) 158 CLR 661; 61 ALR 307; (1985) ATPR 40,622. But it does not have to be proved that accomplices knew those facts amounted to an offence. In the abstract, the possibilities as to the effect of the law creating the offence appear to be as follows: the law addresses itself to the company directly so that it is the company which is contemplated to be the principal offender and the actor will be liable only for aiding and abetting; the law speaks to the actor and contemplates that the company is vicariously liable for the act of the actor in which case both can be principals; or the law speaks directly to the actor so that any liability of the company will be that of an aider and abettor. An example of the first category of liability occurred in Hamilton v Whitehead (1988) 166 CLR 121; 82 ALR 626; 14 ACLR 493; 7 ACLC 34. A proprietary company was charged with offering to the public certain investment opportunities known as "prescribed interests" in breach of the Companies (WA) Code. Only a public company could lawfully make such an offer. The company's managing director was charged as an accessory knowingly concerned in the company's offence within the terms of s 38(1) of the Interpretation Code (now the governing provision would be the general accessory provision in the Crimes Act 1914 (Cth) s 5). Given that the company was convicted as a principal offender under the doctrine which allowed the acts of the managing director as its directing mind and will to be attributed to it, could the managing director be convicted as an accessory? The High Court in rejecting the view that it was wrong and oppressive to prosecute the managing director for the identical acts as were relied on as the acts of the company, accepted that it was a logical consequence of the decision in Salomon v Salomon & Co Ltd [1897] AC 22; [18959] All ER 33; [1896] WN 160. As a variation of the first category, legislation making the company primarily liable may not only also make an officer liable, but may go further and assist the prosecution by reversing the onus of proof as to the knowledge of the officer of the essential matters that make up the contravention. Typical legislation provides that where a corporation contravenes the 148 legislation, every director of the corporation is deemed also to have contravened it and to be liable to a penalty, unless the director proves that the contravention occurred without his or her knowledge and that he or she used due diligence to prevent its occurrence. Examples include the Crimes Act 1914 (Cth) s 85A; Taxation Administration Act 1953 (Cth) s 8Y; Money Lenders Act 19161979 (Qld) s 17B. An example of the second category of liability is in Mallan v Lee (1949) 80 CLR 198; [1949] ALR 992. There the Income Tax Assessment Act 1936 (Cth) s 230 made it an offence for any person, or any company on whose behalf its public officer acted, to understate the amount of any income of anybody. Charges were laid against a company and its public officer. The public officer was charged as an accessory under the Crimes Act s 5. The High Court held that he should have been charged as a principal because the first part of s 230 was addressed to him. Section 230 also made the company vicariously liable. The third category can exist by a rigorous application of the theory that a corporation is a legal entity separate from its controllers. A company has been held liable for aiding and abetting its manager, and the manager has been held liable as a principal: Lewis v Crafter [1942] SASR 30. An accomplice is a party to the offence. It is not correct to regard the accomplice as having committed another person's offence because provisions like s 5 of the Crimes Act 1914 (Cth) state that the accomplice "shall be deemed to have committed the offence". Hence, the accomplice, as well as the principal offender, is caught by a statute providing that "a person convicted of an offence" may be ordered to make reparation: Hookham v R (1994) 125 ALR 23. For contraventions of the [Corporations Act] itself the Act in some places indicates that any person "involved" in a contravention will commit an offence. Section 79 explains the meaning of "involved" in terms similar to those in the general accessory liability provision in the Crimes Act 1914 (Cth) s 5. Sometimes legislation imposing duties in relation to companies puts special responsibility on a particular company officer to see that the company performs the duty. For example, under the [Corporations Act] s 188 a secretary of a company is deemed to have contravened: s 142(1) requiring a company to have a registered office; s 145 requiring a public company's registered office to be open; s 205B requiring a company to lodge with ASIC details of directors and secretaries; or s 345 requiring a company to lodge annual returns with ASIC, unless the secretary is able to show that they took all reasonable steps to ensure that the company complied with the section. In a proprietary company with no secretary, the duty is imposed on each director and they have a similar defence: s 188. A COMPANY'S STATE OF MIND [16.180] Who is a company's directing mind and will? At common law in order to fix primary liability on a company it is necessary to consider the mental state of the person or persons who constituted its directing mind and will. In ascertaining those persons the search is for those people who, although some of them are employees or agents for many purposes, are charged with such a high degree of responsibility 149 for the management of the company that they can be said to be acting as the corporation rather than for the corporation. As we have seen, this organic approach was first adopted in connection with a civil wrong in Lennard's Carrying Co Ltd v Asiatic Petroleum Co Ltd [1915] AC 705. It has also provided a widening of criminal liability for corporations. In Tesco Supermarkets Ltd v Nattrass [1972] AC 153 at 1701 Lord Reid described the person who is the "directing mind and will": He is not acting as a servant, representative, agent or delegate. He is an embodiment of the company or, one could say, he hears and speaks through the persona of the company, within his appropriate sphere, and his mind is the mind of the company. If it is a guilty mind then that guilt is the guilt of the company. On the matter of ascertaining that person, Lord Reid said that: It must be a question of law whether, once the facts have been ascertained, a person in doing particular things is to be regarded as the company or merely as the company's servant or agent ... Normally the board of directors, the managing director and perhaps other superior officers of a company carry out the functions of management and speak and act as the company. Their subordinates do not. They carry out orders from above and it can make no difference that they are given some measure of discretion. But the board of directors may delegate some part of their functions of management giving to their delegate full discretion to act independently of instructions from them. I see no difficulty in holding that they have thereby put such a delegate in their place so that within the scope of the delegation he can act as the company. The High Court has recognised the validity of the Tesco reasoning in Hamilton v Whitehead (1988) 166 CLR 121; 82 ALR 626; 14 ACLR 493; 7 ACLC 34. Perhaps the clearest case of a human mind being treated as the company's mind is in a proprietary company where the mental state of a majority shareholder who is also a director and who treats the company's affairs and transactions as his own is imputed to the company: see Bernard Elsey Pty Ltd v FCT (1969) 121 CLR 119 at 121. An example of applying the Tesco principle is S & Y Investments (No 2) Pty Ltd (in liq) v Commercial Union Assurance Co of Australia Ltd (1986) 85 FLR 285; 44 NTR 14. In the Court of Appeal of the Northern Territory, Asche J (with whom Kearney J concurred) considered whether the acts and intention of a manager of a hotel company were acts and intention of the company. The manager had shot an intruder in circumstances of manslaughter. His Honour held that the employer-company could not be guilty of manslaughter because of his act. A licensing ordinance provided that, for its purposes, the manager was the license of the company's hotel and that the company as well as the manager was liable for penalties for licensing offences. That legislation was an example of legislation imposing an absolute liability on the principal. His Honour held that the manager's special position under that legislation was only for the limited purpose of licensing control and did not justify imputation of his acts and intention to the company for the purposes of the criminal law generally. There was no evidence that the manager was given responsibility for the internal management of the company to such a degree that his acts could be regarded as the company's acts. Not every act of even the principal executive officer makes the company liable under criminal law. The problem is to avoid applying wide principles of vicarious liability which may be appropriate to civil wrongs but which are out of place in criminal law. For example, suppose the managing director of a company in Geelong is urgently required to attend a company 150 meeting in Melbourne and in his hurry to get there he drives recklessly through a crowded street and kills a pedestrian. The company may well be civilly liable in damages because he was acting within the scope of his employment, but is the company to be convicted of manslaughter? The Tesco principle can apply not only to establish liability but also to exculpate from liability. An example is where a statute provides a defence for accused persons who prove that they did not know a certain fact and the only person in the company with that knowledge was not a "directing mind and will": Universal Telecasters (Qld) Ltd v Guthrie (1978) 32 FLR 360; 18 ALR 531. Primary, general and special rules of attribution Recognising that in some of the earlier cases when courts identified the directing mind and will they had gone too far beyond the board of directors and members deciding unanimously the Privy Council, in Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500; [1995] 3 NZLR 7; [1995] BCC 942, on appeal from the New Zealand Court of Appeal, said that there was more than one formula under which acts and knowledge of persons could be attributed to a company. Acts and knowledge of persons who could not be identified with a company's directing mind and will might still be attributed to the company. The Privy Council spoke of: primary rules of attribution peculiar to companies as artificial entities under which acts of organs of the company (usually the board of directors or unanimous members) are attributed; general rules of attribution equally applicable to natural persons, namely, the principles of agency; and special rules of attribution, to be fashioned by the court for applying particular substantive rules (statutory or otherwise) by interpreting that rule to see whose act or knowledge was intended by the Legislature (in the case of statute) or, presumably, contemplated in a case-law rule, to count as the act or knowledge of the company. In the process of interpretation the law's policy has to be considered. In Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500; [1995] 3 NZLR 7; [1995] BCC 942 an investment officer of an investment management company who had authority to buy securities bought securities in a company ENC in the name of Meridian, ostensibly for the benefit of Meridian but really as part of a private scheme of his own. The quantity of shares was such as to make Meridian a "substantial security holder" in ENC within the meaning of the New Zealand Securities Amendment Act 1988. Under that Act a substantial security holder who knew, or ought to have known, that it had become a substantial security holder was obliged to notify the issuer of the security. Notice was not given to ENC. The Privy Council held that despite the fact that the investment manager was acting corruptly his knowledge of the quantity of securities acquired could be attributed to Meridian so that it had failed to comply with the Act. It was not necessary to consider whether the investment manager was part of Meridian's directing mind and will. His knowledge could be attributed to Meridian because the Privy Council read the Securities Amendment Act as if it said that "a company knows that it has become a substantial security holder when that is known to the person who had authority to do the deal." As the Privy Council said, a contrary view would frustrate the policy of the Act by encouraging organs of an investment company (the directing mind and will properly so called) to delegate tasks involving knowledge of acquisitions of securities to others and to pay as little attention as possible to what its investment managers were doing. We shall see at [16.280] that Legislatures sometimes expressly provide that the mental state of employees and agents are to be attributed to their employer even if they are not the directing mind and will of the company. The Meridian case is a reminder that there is judicial readiness to find that Legislatures can make the same provision by implication. 151 A recent example of the formulation of a "special rule of attribution" is contained in the judgment of Austin J in AAPT Ltd v Cable & Wireless Optus Ltd (1999) 32 ACSR 63; 17 ACLC 974. The case concerned the predecessor of s 636(1)(c) of the [Corporations Act]. Section 636 sets out the requirements which must be contained in a bidder's statement in relation to a takeover. Section 636(1)(c) requires the statement to set out particulars of the bidder's intentions regarding: the continuation of the business of the target company; any major changes to be made to the business of the target company, including any redeployment of the fixed assets of the target company; and the future employment of the present employees of the target company. In AAPT one of the issues before the court was identifying those officers of the bidder company whose intentions could be attributed to the bidder. Austin J stated that evidence about the intentions of the directors of the bidder and evidence about the intentions of any person who can be considered the directing mind and will of the bidder can safely be regarded as evidence of the intentions of the bidder company. However, in relation to other corporate officers whose intentions are capable of being attributed to the company for the purposes of s 636(1)(c), Austin J devised a special rule of attribution. He held that the intentions of those corporate officers who are responsible for planning an acquisition or the integration of the target company may be attributed to the bidder company for the purposes of establishing the bidder's intentions which must be disclosed under s 636(1)(c), having regard to the policy underlying that section which is to put shareholders in possession of the information required to enable them to make an informed and critical assessment of the bid and an informed decision as to whether to accept it: at ACSR 88. ... [16.190] A corporation's knowledge Apart from determining the mental state of a company for purposes of imposing primary liability there can be other occasions when it is necessary to consider whether a company had knowledge in particular circumstances. An example is a civil claim that the company be made liable as a constructive trustee to pay compensation where it has knowingly assisted a dishonest breach of fiduciary duty by a trustee, agent, director or other fiduciary and caused loss to a beneficiary or principal. A corporation can have knowledge through two categories of natural persons: under the organic theory, persons who constitute the company's directing mind and will; and under the law of principal and agent, individual directors, employees and other agents who have authority to receive and communicate relevant information to the company. [16.200] Knowledge through the directing mind and will Because the board is the primary organ of the corporation for directing the conduct of the everyday affairs of the company and there is no higher body in the company to whom the board should relay information in the day-to-day management of the company's affairs, knowledge possessed by the board collectively is automatically imputed to the corporation: Houghton (J C) and Co v Nothard, Lowe and Wills Ltd [1928] AC 1 at 1819; [1927] All ER Rep 97. A company can be fixed with the knowledge of a person who with the acquiescence of its board has assumed control of the company: Re Rossfield Group Operations Pty Ltd [1981] Qd R 372 at 377; (1980) 5 ACLR 237 at 242; (1980) CLC 40710. In Yore Contractors Pty Ltd v Holcon Pty Ltd (1990) 2 ACSR 663 a managing director employed by Y company tendered for work through H company, of which the managing director and his wife were the shareholders and directors. H company used resources of Y company in doing the work. H 152 company was held to know of the managing director's breach of fiduciary duty owed to Y company so as to be liable to pay Y company equitable compensation on the principle that third persons who knowingly assist a fiduciary in a dishonest breach of duty are liable for loss caused by the breach of duty. The Yore Contractors case was applied in Linter Group Ltd v Goldberg (1992) 7 ACSR 580 at 623; 10 ACLC 739. [16.210] Knowledge through agents Where the person, call him X, with the information is not the directing mind and will, the company is, in general, fixed with X's knowledge where all the following conditions are satisfied: X is an agent of the company; X has authority from the company to receive the information for it; X is not under a duty to another person to refrain from communicating the particular information, as where, for example, X is a director of another company with no authority to communicate its information; in a case other than one in which the agent is employed by the company to inquire (Taylor v Yorkshire Insurance Co Ltd [1913] 2 IR 1 ), the knowledge was not acquired privately (Societe Generale de Paris v Tramways Union Co Ltd (1884) 14 QBD 424 ) or in the course of a previous transaction; and the knowledge would not disclose a fraud committed by the person of which the company is the victim. Some of these limitations were considered in El Ajou v Dollar Land Holdings Plc by Millett J at first instance ([1993] 3 All ER 717). The case went to the Court of Appeal ([1994] 2 All ER 685). The plaintiff owned funds controlled by a Swiss investment manager who improperly invested them in fraudulent schemes operated by certain Canadians. The operators of the schemes loaned the funds to the defendant (DLH), an English company controlled off-shore by Americans unconnected with the fraud and their agent S. DLH was a holding company with directors who were mere cyphers doing the bidding of the overseas proprietors and S in the signing of whatever documents they were instructed to sign. The plaintiff sued DLH for a declaration that it was liable as a constructive trustee of the funds for the plaintiff on the grounds that it had received the funds knowing that they had been transferred out of the plaintiff's account by the Swiss investment manager in breach of fiduciary duty. The only basis for showing that DLH knew of the breach of duty was that F, its chairman of directors, knew of it. But F acquired the knowledge when acting for the Canadian operators of the fraudulent scheme and not when acting as an agent of DLH. Millett J held that DLH was not fixed with F's knowledge. The alternative basis for attributing knowledge was not present because, in the view of Millett J, F was not the directing mind and will of DLH. He exercised no independent judgment. He was chairman of a board of mere nominee-directors. On appeal, the Court of Appeal reversed on the issue of whether F was the directing mind and will. The Court of Appeal focused attention on the transactions by which DLH obtained the funds. The activity of F, even though under the direction of others, in signing documents and otherwise committing DLH was enough to make F the directing mind and will. Ordinarily, the off-shore proprietors and S could have been seen to be the directing mind and will. Presumably, the view that F was the directing mind and will did not negate that. The decision owed something to DLH being a holding company with no business of its own save being a conduit from its proprietors to subsidiaries which did have businesses. But even so, the decision takes an expansive view of the concept of directing mind and will. 153 The condition for attribution that the knowledge should not disclose a fraud of the agent against the company is subject to an exception where relevant legislation, on proper construction, shows an intention that a fraudulent agent's knowledge should be attributed: Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500; [1995] 3 NZLR 7; [1995] BCC 942 digested at [16.180]. [16.220] Knowledge through common directors A distinction has to be drawn between the case where the director is a controller of two companies and where the director is only one of several directors of two companies. In the former case each company will know what the other knows because they each have the same directing mind and will: attribution of the director's knowledge to each company does not depend on the existence of a duty but on the director being identified with each company as its directing mind and will: see Endresz v Whitehouse (1997) 24 ACSR 208 at 2289; 15 ACLC 936; Morlea Professional Services Pty Ltd v Richard Walter Pty Ltd (in liq) (1999) 169 ALR 419; 34 ACSR 371 at 38283; BC9908650; [1999] FCA 1820. Where a person is director of two companies, C1 and C2, but not the directing mind and will of both and acquires information in the course of acting for C1, that knowledge is not automatically imputed to C2: Re Marseilles Extension Railway Co (1871) LR 7 Ch App 161. That is so even when C1 and C2 are mutually transacting a matter: Re Hampshire Land Co [1896] 2 Ch 743 applying Re Marseilles Extension Railway Co (1871) LR 7 Ch App 161; Re Fenwick Stobart & Co Ltd [1902] 1 Ch 507. Ordinarily, in civil proceedings, for the knowledge to be imputed to C2 the director must: be under a duty to C1 to communicate the knowledge to C2; and under a duty to C2 to receive the knowledge: Re Hampshire Land Co [1896] 2 Ch 743; Re Fenwick Stobart & Co Ltd [1902] 1 Ch 507. In Re David Payne & Co Ltd [1904] 2 Ch 608 K, director of C1 also had an interest in C2. K learned at a board meeting of C2 that C2 proposed to raise a loan for purposes outside its business. K induced C1 to make the loan which C2 applied beyond its business. The English Court of Appeal held the director's private knowledge was not to be imputed to C1. The court considered that in lending the money C1 was not bound to inquire as to how C2 proposed to apply the money. Therefore K was under no duty to tell C1 what he knew. In Harkness v Commonwealth Bank of Australia Ltd (1993) 32 NSWLR 543; 12 ACSR 165; 11 ACLC 501 the State Bank of Victoria was a creditor of the Spedley company and received payment within 6 months before the commencement of the winding up of Spedley on the ground of its insolvency. Spedley was insolvent when it paid the bank. If the bank had reason to suspect at the time it was paid that Spedley was insolvent, it would have received an undue preference. It would have to disgorge the payment to the liquidator of Spedley and be content to receive whatever payment out of the insolvent estate of Spedley could be made to unsecured creditors generally. The bank had a representative on a committee of Austraclear Ltd, a company which cleared loan transactions on the short-term money market. Spedley participated in that market. The bank's representative learned facts suggesting that Spedley had failed to meet an obligation and mentioned the matter to other officers of the bank. It was held (applying Bennetts v Board of Fire Cmrs of NSW (1967) 87 WN (Pt 1) (NSW) 307 that the officer's knowledge was not to be imputed to the bank. His duty to Austraclear to maintain confidentiality prevented that. In some decisions there is a qualification that if C1 and C2 are transacting business and a common director learns while acting in C1 that the transaction could cause harm to C2 (or its wholly-owned subsidiary), as where the transaction it is entering is illegal, the director is under a duty to inform C2 and, hence, C2 can be deemed to know what the director knows. In 154 Belmont Corp Finance v Williams Furniture Ltd (No 2) [1980] 1 All ER 393 directors of C1 who knew in their capacity as directors of C2 that a company transaction with C2 was wrongful were held to be under a duty to inform C1 through its board about the wrongful nature of the transaction. C1 was deemed to know the illegal nature of the transaction; see also ZBB (Aust) Ltd v Allen (1991) 4 ACSR 495 at 5067; 9 ACLC 687 in which the common director's knowledge that C1 was in financial difficulty was information he was duty-bound to tell C2 when C2 was transacting with C1. That could lead to C2 being deemed to know C1's financial position. See also Spedley Securities Ltd (in liq) v Greater Pacific Investments Pty Ltd (in liq) (1992) 30 NSWLR 185; 7 ACSR 155 at 174. It has been held that where the director is acting totally in fraud of the company his or her knowledge is not imputed to the company. If the director's conduct is not totally in fraud of the company and the company benefits partly from the fraud, the knowledge of the director in the transaction will be attributed to the benefiting company: Beach Petroleum NL v Johnson (1993) 43 FCR 1; 115 ALR 411 at 574; 11 ACSR 103 per von Doussa J; see also Farrow Finance Co Ltd (in liq) v Farrow Properties Pty Ltd (in liq) (1997) 26 ACSR 544 at 587; 16 ACLC 897 in which Hansen J applied that reasoning beyond fraud to breach of fiduciary duty. See [16.240] for further discussion. It may be noted, in passing, that in some cases a duty on a director of C1 and C2 to inform C2 of information learned as a director of C1 may cause no embarrassment. There may be a case where C1 appointed the director knowing that he or she was also to be a representative of C2 who was expected by C2 to report on C1's affairs. Several companies may be in a relationship which requires their respective boards to know what is happening in the other: Re Rossfield Group Operations Pty Ltd [1981] Qd R 372; (1980) 5 ACLR 237; (1980) CLC 40-710, as explained in TNT Australia Pty Ltd v Normandy Resources NL (1989) 53 SASR 156; 15 ACLR 99; 7 ACLC 309. But there may be other cases where the common director cannot perform a fiduciary duty of confidentiality to one corporation and a fiduciary duty to inform the other: see, for example, Fitzsimmons v R (1997) 23 ACSR 355; 15 ACLC 666 discussed at [8.065]. Where that problem is foreseen, the director should not take part in the transaction if it is possible for other directors to act. Otherwise, the director should resign from one of the companies. [16.230] Composite knowledge of multiple agents What is the position when some facts are known to agent X and other facts are known to agent Y? Where the two agents are part of the company's directing mind and will their combined knowledge will be known to the corporation: Entwells Pty Ltd v National and General Insurance Co Ltd (1991) 6 WAR 68; 5 ACSR 424; Krakowski v Eurolynx Properties Ltd (1995) 130 ALR 1 at 16. In respect of other persons a corporation will not necessarily know something which is a composite of a number of items of information each known independently to several of its agents: Re Chisum Services Pty Ltd (1982) 7 ACLR 641 at 650; 1 ACLC 292. The corporation may have the composite knowledge where an agent knowing one item had a duty to the corporation to make inquiries which might have elicited the other items: Brambles Holdings Ltd v Carey (1976) 15 SASR 270; 2 ACLR 176 at 181. It may also be fixed with composite knowledge where one agent knowing a fact had a duty and opportunity to communicate to the other agent who knew the second fact: Re Chisum Services Pty Ltd (1982) 7 ACLR 641 at 650; 1 ACLC 292. A company will not have knowledge which is a composite of different items of knowledge each possessed by different individuals where the separate items are contradictory: Brambles Holdings Ltd v Carey (1976) 15 SASR 270; 2 155 ACLR 176. As Bray CJ said in that case: "It is rational belief, not schizophrenia, which is to be attributed to it". The principle which allows the composite knowledge of multiple agents to be attributed to the corporation cannot be used to justify the aggregation of the knowledge of a number of persons who are individually unaware of fraud, or facts which ought to disclose the fraud, to impose knowledge of dishonest intent on the corporation: Macquarie Bank Ltd v Sixty-Fourth Throne Pty Ltd [1998] 3 VR 133 at 144 per Tadgell JA, at 1602 per Ashley AJA. [16.240] Fraud to the prejudice of the company The knowledge of a person in either category, whether organic theory or principal and agent, is not imputed to the corporation where that person's knowledge is an element of his or her fraud against the corporation: per Brooking J (dissenting on other issues) in R v Roffel [1985] VR 511 at 525; (1984) 9 ACLR 433; Beach Petroleum NL v Abbott Tout Russell Kennedy (1999) 33 ACSR 1; BC9907249; [1999] NSWCA 408 at [93][95]. See also R v Gomez [1993] 1 All ER 1 at 40 where Lord Browne-Wilkinson stated that acts and intentions of those persons who are the directing minds and will of the company will not be imputed to it where a criminal charge is that those persons will have themselves committed a crime against the company. Where a controller of a company commits a fraud on a third person he may incidentally also be in breach of some duty to his company by causing it also to be liable to the third person. The fact that he would not wish to tell his company of that breach of duty, if he were aware of it, does not prevent his knowledge being imputed to his company where he was purporting to act for it. In Beach Petroleum NL v Johnson (1993) 43 FCR 1; 115 ALR 411 at 574; 11 ACSR 103 von Doussa J stated that the exception to the rule that the knowledge of a director will be attributed to his or her company applies only where the director was acting totally in fraud of the company: it would not apply where the director's activities were partly for the benefit of the company. Beach Petroleum was applied in Cashflow Finance Pty Ltd v Westpac Banking Corp BC9904226; [1999] NSWSC 671. In Farrow Finance Co Ltd (in liq) v Farrow Properties Pty Ltd (in liq) (1997) 26 ACSR 544 at 587; 16 ACLC 897, Hansen J extended the criteria of fraud referred to in Beach Petroleum to breach of fiduciary duty. In Aequitas v AEFC (2001) 19 ACLC 1006 at 1062, Austin J stated that the criteria of fraud in Beach Petroleum is capable of including equitable fraud arising out of a breach of fiduciary duty, at least where the fiduciary's conduct is morally reprehensible. In Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500; [1995] 3 NZLR 7; [1995] BCC 942 digested at [16.180] the Privy Council attributed the knowledge of a corrupt investment manager to his corporate employer despite the fact that he acted without telling his employer because he did not want the employer to find out. There was no reference to the substantial amount of case law denying attribution where the employee is acting in fraud of the employer. The explanation may be that on construction of some legislation, of which the substantial security holding legislation in the Meridian case is an example, there may be found a legislative intention to attribute the agent's knowledge to the principal regardless of whether the agent was acting in fraud of his or her principal. .... [16.280] Modern legislation widening corporate liability Parliaments have in some instances found the common law attribution of criminal liability to corporations, as it has been understood following the Tesco case ([16.180]), to be inadequate and they have expressly provided statutory rules of attribution. They widen the primary liability of the corporation by attributing to it in some circumstances the acts and, where necessary, the mental state of any employee, agent or officer, not just those who are the 156 "directing mind and will". Examples have included Trade Practices Act 1974 (Cth) s 84 and [Corporations Act] s 762 for the purposes of Ch 7 in which offences relating to securities are created. As to s 84, see Trade Practices Commission v Tubemakers of Australia Ltd (1983) 47 ALR 719. Even without an express statutory provision for attribution it may be possible to infer from the policy of particular legislation an implied intention to attribute on a wider basis than that indicated by the Tesco case: see the decision of the Privy Council in Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500; [1995] 3 NZLR 7; [1995] BCC 942 noted at [16.180]. Express statutory provisions are exemplified by the Criminal Code Act 1995 (Cth), which is expected to come into operation in late 2001. The Act provides rules of statutory attribution applicable in relation to any offence created by Commonwealth laws. Among other things the Act meets the case where, although it may be clear that conduct associated with a corporation's activity should be penalised, it is impossible in the circumstances to impose criminal liability on the corporation under the common law principles. It may be a case where an individual whose conduct is in question cannot be shown either to be part of the corporation's directing mind and will or to have had even tacit authority under a chain of authority stemming from the persons who constitute the corporation's directing mind and will. Attribution of physical element of an offence Under the Criminal Code Act the physical element of an offence is to be attributed to a corporate principal where it is committed by an employee, agent or officer acting within the actual or apparent scope of his or her employment or within his or her actual or apparent authority: s 12.2. Attribution of fault element If the constitution of an offence requires a physical element accompanied by a fault element (intention, knowledge, recklessness or negligence), the Criminal Code Act states rules for attributing that fault element to the corporation. Authorisation through "corporate culture" Section 12.3(1) of the Criminal Code Act 1995 (Cth) provides that where a relevant offence requires proof of an element of fault the required element will be attributed to the corporation where it has "expressly, tacitly or impliedly authorised or permitted the commission of the offence". The Code goes beyond the Tesco principle in providing in s 12.3(2)(c) for deeming a corporation to have authorised the commission of an offence on proof that "a corporate culture existed within the body corporate that directed, encouraged, tolerated or led to noncompliance with the relevant provision". See also s 12.3(2)(d) referring to proof that "the body corporate failed to create and maintain a corporate culture that required compliance with the relevant provision". The Act refers to factors relevant to proving a corporate culture conducive to commission of the offence or the absence of a corporate culture requiring compliance. They include whether the employee, agent or officer believed on reasonable grounds, or entertained a reasonable expectation, that a high managerial agent of the corporation would have authorised or permitted the commission of the offence. Under such legislation one result is to catch cases where despite a corporation's formal documents appearing to require compliance, the reality was that non-compliance was expected. 157 Where negligence is an element The Criminal Code Act states rules for cases where negligence is a fault element of an offence. Even if the physical act of an employee, agent or officer is not accompanied by a required fault element of negligence on his or her part the corporation can still be found to have been negligent if its conduct is considered negligent after looking at the conduct of the company's employees, agents or officers viewed as a whole. Negligence on the part of the corporation may be found where the prohibited conduct was substantially attributable to: inadequate corporate management of the conduct of employees, agents or officers; or failure to provide adequate systems for conveying information within the corporation. 158 CORPORATE PERSONALITY: IMPLICATIONS FOR CONTRACT LAW The reading for this class takes up the contract law implications of the doctrine of separate legal personality. The common law of agency makes contracts with companies possible, by holding that an "authorised" officer of the company effectively enters into contracts on the company's behalf. In this class, we turn also to additional legal mechanisms for making companies parties to contracts, this time when the corporate officers are not authorised to enter into contracts on the company's behalf. Read the Casebook at paras 5.310-60 and 5.370-80 for these mechanisms, which include the equitable doctrine of ostensible (or apparent) authority, the common law indoor management rule, and the statutory provisions of ss 128-129. Based on your reading, do ss 128-129 reinforce, modify, abrogate, or add to the legal protections afforded third party contractors under the doctrine of ostensible authority and the indoor management rule? Here, you will need to dust off your knowledge of basic legal system and process to fully appreciate the interaction between the common law, equitable and statutory principles! To assist you make sense of the cases in the Casebook, the extract by Ford is included as optional reading. 159 Ford, HAJ, Fords Principles of Corporations Law (2002) at 13.010-13.421 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of the University of New South Wales pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. AUTHORITY TO ACT FOR A COMPANY [13.010] The scope of this chapter A company will be bound in transactions entered into by persons having authority from it and who enter the transactions on behalf of the company. This chapter is concerned with the rules under which individuals can commit a company to a contract, disposition of property or other legal transaction. .... The main matters dealt with in this chapter in the light of Ch 12 are as shown in the following diagram. [13.015] Policy issues The law regulating the authority of officers and agents to act for a company needs to balance two competing interests. Mason CJ described these in Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146 at 164; 93 ALR 385 at 395; 2 ACSR 161; 8 ACLC 160 611. The first is the need to promote business dealings and business convenience which would be at risk if persons dealing with companies were put to the expense and inconvenience of investigating the authority of those acting for a company each time a transaction is undertaken. The second interest is the need to protect innocent shareholders and creditors of companies. If those persons dealing with companies are always protected, and do not have to make any enquiries, this may allow those purporting to act for the company to engage in fraud at the expense of shareholders and creditors. Balancing these interests generally results in protecting those who deal with the company. This result: ... recognise[s] the fact that the innumerable business transactions with corporations, so fundamental to our economy and form of society, cannot ordinarily require the proof of formalities concerning compliance by the company with its own internal rules and requirements. The weak link in the chain of corporate life cannot be the ordinary transactions and dealings of the companies themselves. Rather, if one or more of the officers of a company purport to bind that company, but do so without authority or fraudulently, it is that company which should ordinarily bear the loss, and not the party innocently dealing with the company. The policy of "business convenience" requires that the efficacy [of] business transactions generally [is] put above the financial and other interests of the innocent officers, members and creditors of a particular corporation. For the legislature to adopt such an approach to the validity of apparently regular corporate activity would not be irrational, nor even surprising: per Kirby P in Bank of New Zealand v Fiberi Pty Ltd (1993) 14 ACSR 736 at 741-2; 12 ACLC 48. However, where the person dealing with the company is put on notice about an irregularity then it is appropriate to place an obligation upon that person to make further inquiries. The cost to the person of making these further inquiries or obtaining proof of authority for the particular transaction in question would not be expected to be large. Moreover, according to Mason CJ in Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146 at 165; 93 ALR 385; 2 ACSR 161; 8 ACLC 611, "such a principle will compel lending institutions to act prudently and by so doing enhance the integrity of commercial transactions and commercial morality". Finally, it is said that persons who are in business should be taken to have knowledge of what is customary authority in the industry in which they work. "For virtually all businessmen will in fact have such knowledge; it is desirable to encourage them to have it; and a rule based on what each third party believed would simply invite litigation and perjury": R Clark, Corporate Law, New York: Little, Brown & Co (1986) p 121. The general law of principal and agent [13.020] Authority to act for another person: the law of agency generally The law about individuals making a company liable is really a branch of the more general law of principal and agent. Before considering persons who act on behalf of a company it will be useful to look at the general law of principal and agent. Suppose that a person professes to act as agent for a particular named principal in negotiations with a third person. The third person will want to know: whether the agent has authority from the principal; and the extent of any such authority. For example, is it only an authority to negotiate or does it extend to going further and making a contract on behalf of the principal? There are two kinds of authority: (1) actual authority; and (2) apparent authority (sometimes called "ostensible authority"). 161 [13.030] Actual authority Actual authority exists where the principal has given consent to the agent to act for the principal. For some transactions the law requires that the principal's consent be expressed in a particular form. For example, where an agent is to execute a deed on behalf of a principal, in general, the authority must be given in a deed: Powell v London and Provincial Bank [1893] 2 Ch 555.... Implied actual authority The principal's consent need not be given expressly.... [C]onsent can be implied from statements made by the principal or even from conduct of the principal. Where a person who has not been appointed agent nevertheless assumes to act as agent for a principal and over a period the principal, knowing what is going on, acquiesces in the "agent" continuing to act for the principal in new transactions, the conduct of the principal gives authority for the new transactions by implication. The authority so given can amount to actual authority.... Extent of actual authority Where a principal has expressly appointed an agent the extent of the agent's actual authority will appear from interpretation of the deed or writing or, where the appointment is oral, from the oral statement of the principal. The extent of actual authority conferred can be implied. For present purposes, the implications are as to: incidental authority; and usual authority going with appointment to a particular position. Incidental authority On appointment of an agent to perform certain acts, it is inferred that the principal gave authority to do whatever is necessarily or normally incidental to the particular acts authorised. For example, there can be a question whether an express authority to sell an asset includes an implied authority to receive the purchase money on behalf of the principal. The answer depends on the kind of asset and the usual way in which the purchase money is received in sales of that kind of asset. Usual authority On appointment to a particular position of a standard kind which involves acting on behalf of the appointor, it is implied that the appointee has authority to do things usually done by a person in that position. An appointee as a general manager of a business has implied authority from the appointor to do those things which experience has shown are usually done by a general manager of that kind of business. The range of authority depends on the type and scale of the business but, for example, the engagement of employees will often be within the usual authority of a general manager. [13.040] Apparent authority Whereas actual authority does not exist without the consent of the principal, apparent authority can arise as a matter of law even where the principal did not give consent. The basis 162 of apparent authority is that if persons so act as to give a reasonable person the impression that they are appointing an agent with a certain range of authority and the person receiving that impression deals with the agent within that range of authority, the persons creating the impression cannot deny that the agent was authorised to deal. Any person giving the impression is said to be estopped from denying that the agent had authority. Apparent authority is only one application of the broad doctrine of the law of evidence called estoppel: Rama Corp Ltd v Proved Tin and General Investments Ltd [1952] 2 QB 147 at 148 9. Under the doctrine of estoppel, where a person (the representor) represents to another (the representee) that a certain state of things exists and the representee, acting reasonably, acts on the faith of the representation, the representor cannot deny as against the representee that the state of affairs existed. The authority is called "apparent authority" because although the agent may have lacked actual authority to enter the particular transaction with a third person, there is an appearance of authority. The most common case of apparent authority is where a principal appoints a person to a position carrying a usual authority wide enough to include a transaction between the agent and the third party but, unbeknown to the third party, the principal expressly limited the agent's actual authority so that it is less than the usual authority. For example, an owner of a business may have appointed a general manager. The usual authority of the general manager of that type of business may extend to making any contracts for the purchase of goods used in the business to any value but the principal only authorised purchases up to a certain value. A seller of goods beyond the limit of value who deals with the agent may be able to obtain the price from the principal on the basis that the principal by appointing the general manager represented that the general manager had the usual authority of a general manager of that type of business. In such a case the law takes the position that, as between the principal and the third party any loss caused by the agent's disregard of the limits of authority should fall on the principal. There could be cases where no actual authority is given but a "principal" so acts that reasonable persons could receive the impression that actual authority was given. An example would be where the owner of a business conveys, without meaning to do so, an impression that he or she has appointed a general manager. A third person receiving that impression and reasonably acting on the faith of it by dealing with the supposed general manager may be able to rely on there being an apparent authority. A significant difference between implied actual authority and apparent authority Where an agent who professes to be acting for a principal transacts business with a third party and the agent has actual authority to transact that business, the third party will come into a contractual relationship with the principal. That will be so whether or not the third party at the time of the transaction knew of the existence of the actual authority. In many cases the third party will not know of the actual authority. There is no need for the third party to have received any communication from the principal. All that matters is that the principal gave actual authority, whether expressly or impliedly. The principal is bound by his or her consent. On the other hand, before there can be apparent authority the person dealing with the agent must have done so on the faith of some representation from the principal made to the third party. The principal cannot be bound on the basis of consent but can be bound on the basis of having misled a third party. 163 It was stated earlier that implied actual authority could be given where a person stood by while an "agent" acted as if authorised and the person acquiesced in the assumption of authority. Once that acquiescence appears, persons thereafter transacting business with the agent can have a contract with the principal on the basis of there being actual authority. Hence it can happen that a person transacting with the agent can make a contract with the principal even without knowing of the previous acquiescence. But, if there has been no history of acquiescence, then for a third party transacting with a person whom he or she supposes to be an agent to obtain a contract with the alleged principal depends on proof of a representation made to the third party by the alleged principal. No apparent authority where third party is put on inquiry or knows that no actual authority has been given Obviously the third party cannot claim a contract with any supposed principal where the third party knows that no actual authority was given. Nor can the third party argue for an apparent authority if a reasonable person in his or her position would have had doubts as to whether the "agent" had the authority to enter the transaction. Authority to act for a company [13.050] Application of agency rules to companies The rules about actual authority and apparent authority can apply where a company is the principal. But they are supplemented by provisions in the Corporations Act 2001 (Cth) and, in cases where those provisions do not apply, by a special company law rule known as the "indoor management rule" (or the rule in Royal British Bank v Turquand (1856) 6 El & Bl 327; 119 ER 886 ). Attention will first be directed to the operation of the rules of actual authority and apparent authority in relation to companies. [13.060] Actual authority to act for a company An individual gets his or her power to give actual authority to an agent from the mere fact of being a person of full age and having the necessary legal capacity. In the case of a company, an agent's actual authority can stem directly from an internal governance rule stated in the Corporations Act 2001 (Cth) (for example, the replaceable rule in s 198A(2) authorising the board of directors to exercise the powers of the company) or stated in any constitution the company may have adopted. Alternatively authority may arise from consent given on behalf of the company by individuals (such as the board of directors) having actual authority to give consent. Actual authority of directors The sources and extent of the actual authority of directors of proprietary companies varies according to whether the company has only one director or not and whether the company has more than one shareholder. The reference in the Corporations Act 2001 (Cth) to a company with only one shareholder probably means a company in which only one person holds all the shares issued: see [4.060]. Proprietary company with one director who is the only shareholder ... The sole director/shareholder derives actual authority to act for the company from s 198E(1) under which the director of a proprietary company who is its only director and only shareholder may exercise all the powers of the company except any that the Corporations Act 164 2001 (Cth), or the company's constitution (if any), requires the company to exercise in general meeting. Section 198E(1) also provides that the business of the company is to be managed by or under the direction of the director. Section 198E(1) is the only possible source of the director's authority since s 198E cannot be replaced simply by contrary provision in a company's constitution. The director's authority is limited; a transaction must be one required for the conduct of the company's business and affairs..... Proprietary company with only one director who is not sole shareholder While a proprietary company has only one director who is not its only shareholder s 198E(1) will not apply and that single director will derive power from s 198A or from a replacement provision in a constitution adopted by the company.... Section 198A provides that the business of a company is to be managed by or under the direction of the directors and that the directors may exercise all the powers of the company except any powers that the Corporations Act 2001 (Cth), or the company's constitution (if any), requires the company to exercise in general meeting. Section 198A is a replaceable rule and the company may have a constitution making other provision as to who is to exercise powers of the company.... Proprietary companies with more than one director and public companies The authority given by the replaceable rule in s 198A is a wide authority to be exercised by the directors collectively as a board. The board's authority is limited: a transaction must be one required for the conduct of the company's business and affairs. Also under s 198A the board is denied any powers which the Corporations Act 2001 (Cth) requires the company in general meeting to exercise.... The authority given by s 198A includes the power to appoint other persons to act for the company but not to do those things which the Corporations Act 2001 (Cth) or any constitution of the company requires the directors to do themselves. .... Actual authority to act for an old company with a constitution consisting of a memorandum and articles Before the amendments made by CLRA in 1998 the powers of a board of directors were stated in an internal governance rule, to be found either in the company's articles of association or, if the company did not have comprehensive articles, in a model management regulation contained in Table A reg 66 (if the company was a company limited by shares), or Table B reg 50 (in the case of a no liability company), in Sch 1 of the Corporations Law formerly in force. Even when a company had comprehensive articles, the directors in most companies were usually empowered in terms similar to the statutory regulation or a corresponding provision in earlier legislation. A company which has not repealed its memorandum and articles continues to have those instruments as its constitution: s 1415. Regulation 66(1) and constitutional provisions like it gave the board a wide power of management. Subject to the [Corporations] Law and to any other provisions of these regulations, the business of the company shall be managed by the directors, who may pay all expenses incurred in promoting and 165 forming the company, and may exercise all such powers of the company as are not, by the Law or by these regulations, required to be exercised by the company in general meeting. Regulation 66(2) authorised the board: ... to exercise all the powers of the company to borrow money, to charge any property or business of the company or all or any of its uncalled capital and to issue debentures or give any other security for a debt, liability or obligation of the company or of any other person. After amendment by CLRA and subsequent re-numbering by CLERPA from s 226A the Corporations Law in s 198A(2) provided that "the directors may exercise all the powers of the company except any powers that this Law or the company's constitution (if any) requires the company to exercise in general meeting". See now s 198A(2) of the Corporations Act 2001 (Cth). When s 198A refers to any constitution of the company that can be a constitution adopted after CLRA took effect or it can be the memorandum and articles of a company in existence when CLRA took effect so far as they have not been repealed or modified: s 1415. Implied actual authority attached to a company position [13.070] Managing director Where the board of directors of a company having several directors, having power to do so, appoints a person to the position of managing director, the directors may confer on the appointee any of the powers that the directors can exercise: s 198C(1). Even if the directors do not specify the powers conferred on the appointee there is an implied grant of power to "do all such things as fall within the usual scope of that office": Hely-Hutchinson v Brayhead Ltd [1968] 1 QB 549 at 583; [1967] 3 All ER 98; Crabtree-Vickers Pty Ltd v Australian Direct Mail Advertising & Addressing Co Pty Ltd (1975) 133 CLR 72; 7 ALR 527. A managing director's usual task is "to deal with every day matters, to supervise the daily running of the company, to supervise the other managers and indeed, generally, be in charge of the business of the company": Entwells Pty Ltd v National and General Insurance Co Ltd (1991) 6 WAR 68; 5 ACSR 424 at 427 per Ipp J. A managing director may engage others to provide services for the company (Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2 QB 480) and authorise agents to make contracts on behalf of the company of the kind that the managing director could make: Crabtree-Vickers Pty Ltd v Australian Direct Mail Advertising & Addressing Co Pty Ltd, above. A managing director of a trading company has no usual power to enter a transaction that cannot be characterised as an ordinary trading transaction: Corpers (No 664) Pty Ltd v NZI Securities Australia Ltd (1989) ASC 55714.... [13.080] Individual director In any company, whether public or proprietary, with several directors a director acting individually had no usual authority to bind a company: Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146 at 205; 93 ALR 385 at 425; 2 ACSR 161 at 201; 8 ACLC 611; Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279 at 303; (1990) 3 ACSR 649 at 672; 9 ACLC 324 on appeal [1992] 2 VR 279 at 361; (1991) 6 ACSR 464 at 476; 10 ACLC 253 ; Perkins v National Bank Ltd (1999) 30 ACSR 256. See also Re Haycraft Gold Reduction and Mining Co [1900] 2 Ch 230. 166 In such a company a director's normal power is to bind the company only by joining with other directors in a collective resolution of the board of directors. If a director is to have power, as a single director, to bind the company, he or she must either have that power as an agent, delegated by the appropriate organ, or sometimes, in a family company have predominant power under the company's constitution as a governing director: see [7.300]. An individual director may be expressly authorised by the company to carry out formal functions for the company, such as executing a document on behalf of the company, but whether the transaction underlying it binds the company depends on whether it was authorised by some person or persons with sufficient authority. That remains true of a director in a public company for a public company must have a board of at least three directors. Proprietary company with only one director In a proprietary company with only one director/shareholder that director cannot have any lesser authority than the wide authority given by unreplaceable s 198E(1). Hence there is no need to consider any usual authority of such a director/shareholder.... [13.090] Chairman of the board In a company with more than one director it will be necessary for meetings of directors to be presided over by a chairman. Large public companies usually have a standing office called "chairman" to which the directors elect one of themselves. That person may be the managing director or a non-executive director. Questions as to the usual authority attached to the office of chairman arise when the chairman is a non-executive director. It was said in AWA Ltd v Daniels t/as Deloitte Haskins & Sells (1992) 7 ACSR 759 at 867; 10 ACLC 933 at 1015 that: The chairman is responsible to a greater extent than any other director for the performance of the board as a whole and each member of it. The chairman has the primary responsibility of selecting matters and documents to be brought to the board's attention, for formulating policy of the board and promoting the position of the company. In discharging his or her responsibilities the chairman will cooperate with the managing director if the two positions are separate or otherwise with senior management. The chairman's essential function is to preside at board meetings and general meetings and to ensure that the proceedings are properly conducted. In all but small companies the chair often speaks for the company to the outside world. In many companies the chair has the main responsibility for choosing the company's chief executive and sometimes for removing him or her. The chair's usual functions do not involve business operations, such as making contracts on behalf of the company. In Hughes v NM Superannuation Board Pty Ltd (1993) 29 NSWLR 653; 11 ACLC 923 the chairman of a company purported to authorise the company secretary to send a fax to the trustee of a company superannuation fund notifying the company's intention to terminate the fund. The Court of Appeal held that the chairman lacked authority to do that. There are dicta in cases to the effect that the chair has no more authority to bind the company than has any other director acting singly: eg Hely-Hutchinson v Brayhead Ltd [1968] 1 QB 549; [1967] 3 All ER 98; State Bank of Victoria v Parry (1990) 2 ACSR 15 at 29; 8 ACLC 766. It may be wrong to take those statements as meaning more than that the act in question in the particular case was beyond the usual authority of a chair. Chairs commonly receive more remuneration than other directors and there may well be some things that the chair of a public 167 company is impliedly authorised to do beyond those within the usual authority of a single director. The extent of a chair's authority may depend on whether the company has a managing director. In Camelot Resources Ltd v MacDonald (1994) 14 ACSR 437 an executive chairman acted as managing director. The acts in question were, however, beyond the usual authority of a managing director. [13.100] The secretary of a company A public company is required by s 204A(2) to have at least one secretary. After amendment of the Corporations Law by CLERPA it became optional for a proprietary company to have a secretary: s 204A(1). The secretary of either kind of company must ordinarily reside in Australia. If a company has several secretaries, at least one of them must ordinarily reside in Australia. The secretary is responsible for all the record-keeping within a company such as maintenance of the registers required by the Corporations Act 2001 (Cth) and preparation and keeping of minutes of meetings of directors and members. Notices of directors' meetings and of meetings of members are sent out by the secretary. The secretary is one of the company's officers who, under s 127, can sign documents or witness the affixing of the company's seal (if any) to a document so that the company can be taken to have executed the document. The secretary also has to ensure that the company performs its statutory obligations to manifest its existence and to provide information about the company for the benefit of the public. They are the obligations: to maintain a registered office; in the case of a public company, to keep its registered office open to the public during certain hours as required by s 145 (cf Invention Finance Pty Ltd v Flavel (1988) 13 ACLR 99; 6 ACLC 408, a case on earlier legislation); to lodge the company's annual return with ASIC; and to lodge notices about the personal details of the company's directors and secretaries with ASIC. A secretary is within the definition in s 9 of "officer" of a corporation. One result of that is to attract to the secretary various duties in Ch 2D, including duties of care and diligence, good faith, avoidance of improper use of position and improper use of information: see [8.310]ff, [8.070]ff and [9.280]ff. .... Implied actual authority of a company secretary According to older cases (for example, Barnett, Hoares & Co v South London Tramways Co (1887) 18 QBD 815 at 817; George Whitechurch Ltd v Cavanagh [1902] AC 117 at 124; Ruben v Great Fingall Consolidated [1906] AC 439 ), a company secretary had a very limited authority to make any contracts or representations on behalf of the company. Older cases treated the secretary as being little better than a clerk. However, the English Court of Appeal, speaking in 1971, thought times had changed and that a company secretary had become much more important. In Panorama Developments (Guildford) Ltd v Fidelis Furnishing Fabrics Ltd [1971] 2 QB 711 Panorama conducted a business of hiring out prestige cars, Rolls Royces and Jaguars. B was employed by Fidelis and was appointed its secretary. In the absence of the managing director B fraudulently hired cars as secretary for Fidelis. Fidelis refused to pay the bill. Counsel for Fidelis argued on the basis of older cases that a company secretary played only a humble role which did not include authority to make contracts or representations on behalf of the company. The Court of Appeal rejected this argument, saying that the secretary by 1971 had considerable responsibilities 168 under companies legislation and in business practice. Lord Denning said that a company secretary had usually authority to sign contracts connected with the administrative side of a company's affairs, such as employing staff and ordering cars. Salmon LJ referred to the secretary as the chief administrative officer of the company. Hence when a company appoints a secretary, it is certainly taken to be granting authority to make contracts connected with the administrative side of the company's affairs. See also Donato v Legion Cabs (Trading) Co-op Society Ltd [1966] 2 NSWR 583. The secretary is the proper person to give information about the officers of the company: Re Scottish Loan and Finance Co Ltd (1944) 44 SR (NSW) 461 at 466. But a secretary does not have implied authority to manage the company. A decision to institute legal proceedings in the name of the company for the recovery of property is outside the secretary's usual authority, even where the company lacks a board of directors: Club Flotilla (Pacific Palms) Ltd v Isherwood (1987) 12 ACLR 387; 5 ACLC 1027; cf Holpitt Pty Ltd v Swaab (1992) 33 FCR 474; 105 ALR 421; 6 ACSR 488; 10 ACLC 64.... [13.110] Other company executives Particular executives below board level may have an implied actual authority arising from the usual authority attached to their office. If a person is appointed manager of an insurance company which has been accepting a wide variety of risks, the manager is impliedly authorised to carry on all those classes of insurance business in which the company has been writing business or holding itself out as willing to write: Wilson v Gilbert (1965) 39 ALJR 384 at 350. In AWA Ltd v Daniels t/as Deloitte Haskins & Sells (1992) 7 ACSR 759 at 861; 10 ACLC 933 at 1010 Rogers CJ in Comm D held that a person appointed by a large electronics company to be a money market manager and foreign exchange dealer had a usual authority to enter into contracts to borrow foreign currency from banks. The dealer in trading in foreign exchange without adequate supervision caused loss to the company of nearly $50m. Although managers in a bank below the level of managing director or general manager may not have authority to conclude a particular transaction, they could have a usual authority to communicate to a customer such things as head office approval of a loan; the customer would not have to check with the managing director that approval had in fact been given: First Energy (UK) Ltd v Hungarian International Bank Ltd [1993] BCLC 1409. [13.120] Actual authority implied from acquiescence If a person presumes to act as an agent for an individual without a grant of authority, that individual, on hearing of the "agent's" presumption, may be prepared to ratify the unauthorised act and become a party to the transaction. That may happen because it is to his or her advantage to accept some benefit from the transaction entered into by the "agent". If similar transactions follow and it is seen that the principal has reached the stage of usually ratifying various transactions entered into by the agent, there may be scope for an inference that the principal is content for the agent to enter transactions of the same type on behalf of the principal. In other words, there is an implied actual authority by acquiescence. Companies are more prone than individuals to get into the situation where there is an implied grant of actual authority by acquiescence. This can happen where a board of directors is not vigilant and leaves an opportunity for an individual, such as a major shareholder or a dominating personality, to do business on behalf of the company without having been appointed an agent. 169 Before it could be found that a board of directors had conferred an implied actual authority there would have to be not only the acquiescence of the individual board members but evidence of communication by words or conduct of their respective consents to one another and to the agent: Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2 QB 480. The corporate excesses in Australia in the 1980s produced several cases where persons not authorised by a board created obligations which the company had to discharge because implied actual authority existed. In Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279; (1990) 3 ACSR 649; 9 ACLC 324 all shares in Brick and Pipe Industries Ltd, a publicly listed company, had been taken over by a company belonging to a group of companies controlled by an entrepreneur, G. Brick and Pipe thus became the wholly-owned subsidiary of G's company. The board of Brick and Pipe continued to include persons who had been directors before the takeover and G and his associate, F, were added to the board. To make the takeover G's company had borrowed large sums of money. In rearranging the loan and to meet requirements of the lenders for more security and guarantees, G, without the knowledge of the Brick and Pipe board, caused Brick and Pipe to give a guarantee of loans made to a company in the G group. The common seal of Brick and Pipe was applied to the guarantee which stated that the application of the seal was attested by G as a director and by F as secretary. The board of Brick and Pipe had never appointed F to be secretary of Brick and Pipe but, in the presence of G, a finance executive employed in the G group had told the lender's lawyers that F was secretary of Brick and Pipe. After the financial collapse of the G group the board of Brick and Pipe sought declarations from the Supreme Court of Victoria that Brick and Pipe was not bound by the guarantee. Ormiston J gave judgment for the lenders and that decision was affirmed by the Appeal Division. If the application of the common seal was attested by a director and a secretary, Brick and Pipe would be bound. One issue was whether Brick and Pipe had made a representation to the lender that F was secretary. If it had, F would have had apparent authority to attest as secretary. The most appropriate source of a representation by Brick and Pipe would have been the board. There was no evidence that the board knew anything about F being thought to be secretary. However, the court found that Brick and Pipe by acquiescence of its board in previous matters had given G actual authority to act generally for it. The board had never appointed G as an agent but it had allowed G, who controlled the parent company, to act as if he had been appointed managing director of Brick and Pipe. The facts justified a conclusion that G had implied actual authority to make representations on behalf of Brick and Pipe. Hence when the finance executive employed in the G group stated in G's presence and hearing that F had been appointed secretary and G did not intervene, G was taken to be making a representation on behalf of Brick and Pipe. In Equiticorp Financial Services Ltd v Equiticorp Financial Services Ltd (1992) 9 ACSR 199 affirmed (1993) 32 NSWLR 50; 11 ACSR 642; 11 ACLC 952 , two companies in the Equiticorp group of companies, EFL and EFSA, had about $50m on deposit with the bank. After they went into liquidation their respective liquidators sued the bank for the deposit. The bank had applied the deposit against a debt owed to it by a third company in the group. The bank relied on the fact that the chairman of the group, H, agreed to the bank applying the deposit in that way. H was director of EFSA but not of EFL. If there had been no further evidence, the bank could have been liable because neither EFL nor EFSA had authorised the application of the deposit. H, as chairman of the group, or as a director of EFL, would not have had a usual authority wide enough to commit EFL and EFSA. But there was evidence that the affairs of companies in the Equiticorp group were conducted under the general authority of H and that all questions of significance in the running of the group were 170 referred to him. Giles J of the New South Wales Supreme Court held that H had implied actual authority from EFL and EFSA which was wide enough to cover his agreement with the bank. The Court of Appeal (Kirby P dissenting) saw no reason to disturb that finding. Kirby P, dissenting, thought that the finding of implied actual authority was wrong: (1) There was no implied actual authority wide enough to cover what H had done. The evidence did not support a finding that the boards of EFL and EFSA had acquiesced with knowledge of any conduct of H so serious as the misapplication of the deposit. (2) There could not be implied actual authority to dispose of an individual company's assets for a purpose not in the interests of the company. This view rested on stressing the separate personality of each company in the group. To recognise "the realpolitik of corporate control" in a group so far as to find that H had implied actual authority to agree to misapplication of a member-company's resources was to "debase the integrity of company law": at ACSR 677. 2. See also Greater Pacific Investments Pty Ltd (in liq) v Australian National Industries Ltd (1996) 39 NSWLR 143. There may be a company whose function is limited and in which there is so little business to be done that there would be no need to appoint a managing director. In that case the fact that the board allows one of their number to act for the company is not so readily taken to be a grant of implied actual authority appropriate to a managing director. In Bank of New Zealand v Fiberi Pty Ltd (1992) 8 ACSR 790; 10 ACLC 1557 two people, D and A, formed F company to hold title to their principal family home and they were appointed its directors. D, without the knowledge of A, caused the company's seal to be affixed to a mortgage and guarantees in relation to debts owed by other companies controlled by him. The affixing of the seal was attested by D and his son, who purported to be secretary of F company although he had never been appointed. The trial court rejected an argument that A had by acquiescence given D implied actual authority to the extent of the usual authority of a managing director. The reason was that there was no need for the company to have such an officer in the light of the company's limited function. An appeal was dismissed by the Court of Appeal without reference to this point: 14 ACSR 736; 12 ACLC 48. The High Court refused special leave to appeal: 12 ACLC 232 Common law apparent agency for a company [13.130] Common law principles Nowadays the common law doctrine of apparent agency will not normally be needed for companies because one of the operations of s 129 covers the same ground. However, in questions of agency for some corporations other than companies there may be no statutory equivalent of s 129. In addition interpretation of s 129 may require reference to the common law. Moreover, even in the case of companies if the transaction in which the agency is critical occurred before 1 January 1984, s 129 and its predecessors do not apply. Just as an individual can represent to a third party that another person has a certain extent of authority, so also a company can make such a representation. If the third party hears of the representation and, acting reasonably, transacts business with the apparent agent on the faith of it, the company will be estopped from denying the representation. The person held out by the company will be treated as having had apparent authority. In Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2 QB 480, K, a property developer, agreed to buy an estate with a view to reselling it at a profit. K had insufficient money and H agreed to provide some. Instead of H merely lending his money, it was agreed that a private company be formed to acquire the land, develop it and resell it. K and H subscribed the capital in equal shares and the company acquired the land. The directors were K, H and a nominee of each. H went abroad. The development of the estate for sale was left to K. The plaintiffs, a firm of architects, were engaged by K on behalf of the company. They sued the company for their fees and the issue was whether the company was liable since the engagement of the plaintiffs was not authorised by the 171 board of directors and K had not been appointed managing director, although the articles empowered delegation by the board to a managing director. The trial judge found that K had, to the knowledge of the other directors, been employing agents, trying to find a purchaser and generally conducting the affairs of the company on his own. It was held that the company was liable to pay fees to the plaintiffs because the directors had held out K as a managing director and K's act in engaging the plaintiffs was within the authority usually enjoyed by a managing director. The Court of Appeal affirmed the decision. The case was one of apparent authority rather than implied actual authority because the facts did not justify a finding that the board's acquiescence amounted to a conferring of actual authority. The conferring of actual authority would in the words of Diplock LJ "have required not merely the silent acquiescence of the individual members of the board, but the communication by words or conduct of their respective consents to one another and to" K. In Freeman & Lockyer's case, Diplock LJ stated four conditions of a contractor's entitlement to enforce against a company a contract entered into by an agent who had no actual authority: A representation that the agent had authority to enter on behalf of the company into a contract of the kind sought to be enforced was made to the contractor. The representation was made by a person or persons who had "actual" authority to manage the business of the company either generally or in respect of those matters to which the contract relates. The contractor was induced by such representation to enter into the contract, that is, that he in fact relied upon it. Under its constitution the company was not deprived of capacity to enter into a contract of the kind sought to be enforced or to delegate authority to enter into a contract of that kind to the agent. In Australia this last condition would not go to corporate capacity of companies because companies have the capacity of an individual. Other limitations on the exercise of corporate power in the constitution of a company would not affect outsiders unless they knew of them. Section 130 excludes the doctrine of constructive notice. However, for corporations other than companies this fourth condition could be important even for a contractor who did not know of the limitation. The decision was approved by the House of Lords in British Bank of the Middle East v Sun Life Assurance Co of Canada (UK) Ltd [1983] BCLC 78. See also Ebeed v Soplex Wholesale Supplies Ltd [1985] BCLC 404. In Australia, Freeman & Lockyer's case was approved by the High Court in Crabtree-Vickers Pty Ltd v Australian Direct Mail Advertising & Addressing Co Pty Ltd (1975) 133 CLR 72; 7 ALR 527 and Northside Developments Pty Ltd v RegistrarGeneral (1990) 170 CLR 146; 93 ALR 385; 2 ACSR 161; 8 ACLC 611. For an example of the application of Freeman & Lockyer's case to a small company, see Entwells Pty Ltd v National and General Insurance Co Ltd (1991) 6 WAR 68; 5 ACSR 424, digested at [16.060]. [13.140] Persons who can make corporate representations Representation can be made by the board The clearest case of a representation being made by a company is where the board of directors makes it. Representation by sole director of a proprietary company If a proprietary company has only one director, that director can make a representation. 172 Representation can be made by members A representation binding a company can also emanate from the members in a situation where they are not trespassing on the management province of the board or sole director. This can happen where no directors have been appointed but the members represent that certain persons can act as directors. In Mahony v East Holyford Mining Co (1875) LR 7 HL 869 a bank received from a person acting as secretary of the E company a notice setting out what purported to be a resolution passed by the initial subscribers to the memorandum. They appeared to have appointed certain persons directors and authorised them and him, as secretary, to draw on the company's account. The bank acted on the faith of that notice and honoured cheques drawn by the persons named. In fact no resolution had been passed. The articles provided that "the first seven persons who sign these articles, or a majority of them, shall appoint the first directors". The directors were to appoint the secretary. No proper appointments were made. The House of Lords held that the company was bound by the notice received by the bank. As explained by Diplock LJ in Freeman & Lockyer's case, the conduct of the majority of the initial subscribers in acquiescing in the assumption by usurpers of the position of directors was a representation that they were properly appointed. Those shareholders, by their acquiescence, had also represented that the person acting as secretary, was appointed secretary. Where all members of a company agree in something done by their company there can be a wider basis for holding that the company is bound by a contract or disposition without recourse to representations about agency. Under the doctrine of unanimous assent (see [7.590]), sometimes called the "Duomatic rule" (Re Duomatic Ltd [1969] 2 Ch 365 ) where all members give informed consent to a transaction entered into by their company the company can be bound. In the Brick and Pipe case Brick and Pipe was a wholly-owned subsidiary of a company controlled by G. Ormiston J accepted an argument that the guarantee given by Brick and Pipe bound Brick and Pipe because its parent company had approved it. The parent company had approved it because G, who sanctioned the giving of the guarantee, controlled the parent. For a case where the Duomatic rule was applied, where the company had only one director who was its sole shareholder, see Sutherland (as liq of Sydney Appliances Pty Ltd (in liq)) v Robert Bosch (Aust) Pty Ltd (2000) 33 ACSR 680; BC200000469; [2000] NSWSC 32. A representation can be made by a person with actual authority A representation can also be made by a person having actual authority delegated from the board, whether given expressly or by implication. As we have seen in the Brick and Pipe case, the court held that G had implied actual authority to represent that F had been appointed secretary. G was able to make a representation binding Brick and Pipe. In the Brick and Pipe case the representation that F was secretary was made by another person, G. Suppose the only person who made the representation had been F. No representation binding the company would have been made simply because F made the representation. It was necessary to trace back through G to the acquiescence of the board before the representation could bind the company. G had implied actual authority to make a representation but F did not. There can be cases where the only representation appearing to the third party is made by the person whose authority is in question. If it later appears that the board had by acquiescence in earlier transactions given implied actual authority, that authority may extend to making representations as to authority: Hely-Hutchinson v Brayhead Ltd [1968] 1 QB 549 at 593; 173 [1967] 3 All ER 98 per Lord Pearson; Crabtree-Vickers Pty Ltd v Australian Direct Mail Advertising & Addressing Co Pty Ltd (1975) 133 CLR 72 at 78; 7 ALR 527 at 531. But in the absence of any such acquiescence a purported "agent" cannot make a representation as to his or her own authority so as to make it a representation of the company. That person's acts cannot bind the company until it is found that the company made a representation. There is a suggestion by Greer LJ in British Thomson-Houston Co Ltd v Federated European Bank Ltd [1932] 2 KB 176 that a person can make an effective representation as to his or her own authority, but the House of Lords in Houghton (J C) and Co v Nothard, Lowe and Wills Ltd [1928] AC 1; [1927] All ER Rep 97 held that such a representation could not bind the company. See also Freeman & Lockyer's case; Re Blackbird Pies (Management) Pty Ltd [1969] Qd R 387; Armagas Ltd v Mundogas SA [1986] AC 717; [1986] 2 All ER 385. The knowledge and inaction of an employee of a corporation can constitute a standing by with knowledge on the part of the corporation so that the corporation will be estopped under the common law doctrine of estoppel on matters not confined to agency. In Corpers (No 664) Pty Ltd v NZI Securities Australia Ltd (1989) ASC 55714 an employee without actual or apparent authority to approve the making of a particular loan contract knew that the intending borrower believed that the loan had been approved and stood by while the intending borrower incurred detriment in reliance upon the mistaken assumption. The employer company was held to be estopped from denying that the loan had been approved. A representation of authority cannot be made by a person who has only apparent authority This was so held by the High Court in Crabtree-Vickers Pty Ltd v Australian Direct Mail Advertising & Addressing Co Pty Ltd (1975) 133 CLR 72; 7 ALR 527. In the Crabtree-Vickers case the main issue was whether a purchase order signed by an employee bound the company where the employee purported to act on the authority of a person who had been appointed managing director. The company had limited the actual authority of the managing director in such a way that the managing director did not have actual authority to make the purchase in question. Because he had been appointed managing director there was a representation that he had the usual authority of a managing director. Under the usual authority the managing director would have had authority to sign the purchase order. If the purchase order had been signed by the managing director, the company would have been liable because of his apparent authority. The High Court held that because the managing director lacked actual authority to sign the purchase order, he could not represent that anybody else had the company's authority to sign. Hence the company was not liable on the purchase order. If there had been evidence that the board had acquiesced in past transactions in the managing director exceeding the limited actual authority expressly given to him, that evidence might have supported a finding of implied actual authority beyond the original limits. That implied actual authority would have enabled the managing director to make a representation on behalf of the company that the employee had authority. The case would have been like the later Brick and Pipe case. See also Perkins v National Bank Ltd (1999) 30 ACSR 256. Proof that a company gave authority: the indoor management rule [13.150] Common law indoor management rule Before looking further at the doctrines of agency as applied to companies we need to examine a special rule of company law which has assisted outsiders to show that a company has given authority, whether implied actual authority or apparent authority. The rule developed at 174 common law and has been put into statutory form. The statutory form does not cover all the cases catered for by the common law rule. We shall look first at the common law rule. The devolution of authority from a company to an agent can be more complex than the granting of authority by an individual. When the board of directors of a company wants to give actual authority to an agent there are procedural conditions to be fulfilled. On a strict approach these conditions include requirements that the directors must have been properly appointed, there must have been a properly convened meeting of the board, the board members must be properly informed and there may be a requirement that a quorum be present before directors can decide anything: Northside Developments Pty Ltd v RegistrarGeneral (1990) 170 CLR 146 at 178; 93 ALR 385 at 406; 2 ACSR 161 at 182; 8 ACLC 611 per Brennan J. Can a third party outsider be expected to prove that all these and any other conditions were fulfilled? Under a common law rule applicable to companies a third party is relieved from the need to check on whether internal action necessary to fulfil conditions has been taken. The third party is allowed to assume that all necessary steps internal to the company have been taken. The rule of law allowing the assumption is called the rule of indoor management because it covers all those matters inside the management of the company which are not public. The rule as stated in Halsbury's Laws of England 2nd ed vol 5 at 423 (see now, 4th ed vol 7 para 737, re-issue vol 7(1) para 980) in a form approved by the House of Lords in Morris v Kanssen [1946] AC 459; [1946] 1 All ER 586 and the High Court in Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146 at 1545 171 207; 93 ALR 385; 2 ACSR 161; 8 ACLC 611 is as follows: [But] persons dealing with a company in good faith may assume that acts within its constitution and powers have been properly and duly performed and are not bound to inquire whether acts of internal management have been regular. The rule is sometimes called the rule in Turquand's case: Royal British Bank v Turquand (1856) 6 El & Bl 327; 119 ER 886. There a bank lent money to a company on the security of a bond signed by two of its directors on which the seal of the company had been affixed. The company's deed of settlement (the equivalent of a modern company's constitution) permitted borrowing by directors in that way only when authorized by an ordinary resolution of a general meeting. The company alleged that no resolution of the kind required had been passed. The Court of Exchequer Chamber held that the company was bound by the contract since the bank was entitled to infer that the necessary ordinary resolution had been passed. Although the occasions for applying the common law rule mainly involve persons contracting with a company, it can be applied to assist persons having other dealings in relation to a company: Australian Capital Television Pty Ltd v Minister for Transport and Communications (1989) 86 ALR 119; 7 ACLC 525. Even though the rule is old, dating from the mid-19th century, it is still needed.... The balancing of interests The rule is required for business convenience and is another outcome of the law's balancing of the interests of third parties as against the interests of proprietors and existing creditors of companies. It has been said, "The wheels of business will not go round unless it is assumed 175 that that is in order which appears to be in order": per Lord Simonds in Morris v Kanssen [1946] AC 459 at 475; [1946] 1 All ER 586 at 592. Mason CJ described the competing policy considerations in Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146 at 164; 93 ALR 385 at 395; 2 ACSR 161 at 171; 8 ACLC 611. The precise formulation and application of that rule call for a fine balance between competing interests. On the one hand, the rule has been developed to protect and promote business convenience which would be at hazard if persons dealing with companies were under the necessity of investigating their internal proceedings in order to satisfy themselves about the actual authority of officers and the validity of instruments. On the other hand, an overextensive application of the rule may facilitate the commission of fraud and unjustly favour those who deal with companies at the expense of innocent creditors and shareholders who are the victims of unscrupulous persons acting or purporting to act on behalf of companies. .... [13.160] Theoretical basis of the indoor management rule Can the indoor management rule be related to some more general legal doctrine or is it only a special rule peculiar to companies and similar organisations? The general legal presumption that things are in order There is a general rule of evidence, traditionally referred to by its Latin form omnia praesumuntur rite esse acta meaning "the presumption that things are in order". It has been suggested that the indoor management rule is only an aspect of this presumption of regularity: Morris v Kanssen [1946] AC 459 at 475; [1946] 1 All ER 586 at 592 per Lord Simonds; Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146 at 177; 93 ALR 385 at 404; 2 ACSR 161 at 180; 8 ACLC 611 per Brennan J. However, the presumption of regularity is merely a rebuttable presumption. A party with an interest in proving that things were not in order is free to do so. The presumption of regularity simply puts the evidential burden of proof on the person who denies that things are in order. By contrast the indoor management rule gives rise to an irrebuttable presumption. It bars the company from denying against an outsider that things were in order. 1. Estoppel Another basis that has been suggested is the doctrine of estoppel, a doctrine of the law of evidence. Under the doctrine of estoppel, where a person (the representor) represents to another (the representee) that a certain state of things exists and the representee, acting reasonably, acts on the faith of the representation, the representor cannot deny as against the representee that the state of affairs existed. But this cannot be the basis of the indoor management rule. Although a provision in a company's constitution may represent that an officer appointed to a particular position will have a higher level of authority if a condition is satisfied, the company does not represent that the condition has been satisfied. The "closed door" rationale According to some judgments (for example, Smith v Hull Glass (1852) 11 CB 897 at 9278; 138 ER 729 at 741; Pacific Coast Coal Mines Ltd v Arbuthnot [1917] AC 607 ) the rule exists to assist outsiders because outsiders lack access to the company's internal records. An outsider has no legal right to see such records as minute books containing ordinary resolutions and directors' resolutions of the kind which do not have to be notified to ASIC. In Morris v Kanssen [1946] AC 459 at 475; [1946] 1 All ER 586 Lord Simonds said, "It is a rule 176 designed for the protection of those who are entitled to assume, just because they cannot know, that the person with whom they deal has the authority which he claims." Kirby P of the NSW Court of Appeal in Registrar-General v Northside Developments Pty Ltd (1988) 14 NSWLR 571; 14 ACLR 543 at 548 criticised this justification on the basis that an outsider will often be able to exert commercial pressure to insist upon access. That is true in large financing transactions negotiated over a period where the outsider might reasonably be expected to insist on access. However, in the multitude of everyday commercial transactions it is not so clear that there should be that expectation. Is it a special rule of company law supplementing the law of agency in its application to agents for a company? Another view of the indoor management rule that currently has some judicial support is that it is a special concession to outsiders dealing with companies through persons who have been given usual or apparent authority by the company. Outsiders can assume the company is bound by what appears to the outsider as an exercise of usual or apparent authority that is only potential: potential because of some condition to be fulfilled. On this basis the rule can only apply where the outsider can show a grant of actual authority or a representation of authority. As between these explanations, the weight of authority seems to favour the "closed door" rationale. [13.170] Application of the rule beyond a company's constitution In the period of development of the indoor management rule the internal management of a company was mainly regulated by the company's articles of association or by regulations set out in an appendix to the relevant Companies Act, an example being former Table A applicable to companies limited by shares. Clearly the rule can apply where some internal procedure is required by any constitution that the company may have adopted. There seems to be no reason why the indoor management rule cannot be relied upon by an outsider in relation to some internal procedure required by a replaceable rule in the Corporations Act 2001 (Cth) that is applicable to the company. Even when a provision in the Corporations Act 2001 (Cth) is not replaceable, the rule should still apply in respect of any internal procedure required by the Act. So, for example, a person dealing with a company in a matter whose validity depends on the company in general meeting giving approval could assume that members were given the notice of meeting required by s 249J(1). The indoor management rule may not apply where the required procedural step is the passing of a special resolution of a kind which the Corporations Act 2001 (Cth) requires to be lodged with ASIC. A lodged resolution is, in general, available for public inspection under s 1274(2) and the "closed door" rationale of the indoor management rule is not present. But where the special resolution is not required to be lodged the reason for the rule is not displaced.... Cases where the common law indoor management rule does not apply ... 177 [13.190] Persons aware of irregularities Clearly, persons who have actual knowledge that there is an irregularity cannot rely on the rule: Howard v Patent Ivory Manufacturing Co (1888) 38 Ch D 156. Actual knowledge here means subjective knowledge. Actual knowledge exists where the evidence shows directly that the person knew or the evidence supports an inference of fact that the person knew as where eyes are wilfully shut. [13.200] Persons with constructive notice after being put on inquiry In addition even when the evidence will not support an inference of subjective knowledge, a person "cannot presume in his own favour that things are rightly done if inquiry that he ought to make would tell him that they were wrongly done": Morris v Kanssen [1946] AC 459 at 475; [1946] 1 All ER 586 per Lord Simonds. See also Progress Advertising (NZ) Ltd v Auckland Licensed Victuallers Industrial Union of Employers [1957] NZLR 1207; Custom Credit Holdings Ltd v Creighton Investments Pty Ltd (1985) 3 ACLC 248. In the Custom Credit case an officer of a finance company accepted leases purporting to be executed by a company after being told that one of the two directors had not approved the execution and that his solicitor doubted the validity of the execution. The officer was held to have been put on inquiry with the result that his employer could not be given the benefit of the indoor management rule. In Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146; 93 ALR 385; 2 ACSR 161; 8 ACLC 611 a lender took a sealed "mortgage" from company Y over Y's land (its most significant asset) to secure a loan to an unrelated company, X, controlled by a director common to Y and X. Negotiations for the loan had been conducted by that director and the impression of Y's genuine seal was attested by that director, as director, and his son, as secretary. But the board of Y had not authorised the giving of the mortgage or the impression of the seal. Nor had the son been appointed a secretary. The articles required the board's authority for impressing the seal and attestation of the sealing by a director together with another director or with the secretary. It was held that the mortgage was invalid. The lender could not rely on the indoor management rule because the High Court considered (disagreeing with the NSW Court of Appeal (1988) 14 NSWLR 571; 14 ACLR 543) that it was put on inquiry by knowing that the company was entering into a transaction which appeared to be unrelated to the purposes of its business and from which it appeared to gain no benefit. At the time when the mortgage was taken there were no provisions like ss 128129 under which certain assumptions as to authority can be made in the absence of knowledge or suspicion that the assumption would be incorrect. See further [13.050]ff. In another case a bank was held to have been put on inquiry where it knew that a company giving it a guarantee had the sole function of holding title to a family home and the guarantee was not for the benefit of the company but for the benefit of companies controlled by one of the guarantor's directors that were indebted to the bank: Bank of New Zealand v Fiberi Pty Ltd (1992) 8 ACSR 790; 10 ACLC 1557 affirmed by the Court of Appeal (1993) 14 ACSR 736; 12 ACLC 48. The High Court refused leave to appeal: 12 ACLC 232. A different conclusion might follow where the director's financial affairs are intermingled with those of the company to the knowledge of all shareholders: Story v Advance Bank Australia Ltd (1993) 31 NSWLR 722; 10 ACSR 699 at 709; 11 ACLC 629 per Gleeson CJ. The Northside case shows that even though the person cannot be found to have in fact known about an irregularity he or she may be supposed as a matter of law to have known what was discoverable where a reasonable person would have made inquiries after being prompted to do so by something learned. Cases of failure to inquire after being put on inquiry can differ according to the strength of certitude that the facts known would have conveyed to a reasonable person. In one case the facts known may be such as would make it obvious to a reasonable person that something was certainly wrong. In another case the facts known may only raise a question in the mind of a reasonable person as to whether something is wrong. 178 Under the common law rule of indoor management failure to inquire in either of those cases would prevent the outsider assuming that all was well. As the Northside case also shows, among facts that will usually trigger an expectation that a reasonable person would be prompted to make inquiries is an apparent absence of benefit to a principal of an agent or a beneficiary of a trust, as where, eg: a company's asset is being charged to secure a loan to an unrelated company at the request of a common director without any apparent benefit to the charging company, or a trust asset held by a trustee company is being charged (in exercise of a power to give security) to secure a loan to an unrelated company controlled by a director of the trustee company without any apparent benefit to the beneficiaries of the trust: Koorootang Nominees Pty Ltd v Australia and New Zealand Banking Group Ltd [1998] 3 VR 16. Consideration of whether an outsider is put on inquiry will be affected by the type of company involved. A donee of a gift from a commercial company where the gift seems unrelated to promotion of the company's business could be expected to inquire. However, a donee of gift by a charitable company limited by guarantee is less likely to be expected to inquire when the gift is the type of gift which that type of company might be expected to make.... The difference between subjective knowledge proved as a fact on the one hand and the objective knowledge attributed under the doctrine of constructive notice is stated by Lord Esher MR in English and Scottish Mercantile Investment Co Ltd v Brunton [1892] 2 QB 700 at 707-8: The doctrine of constructive notice is wholly equitable; it is not known to the common law. There is an inference of fact known to common lawyers which comes somewhat near to it. When a man has statements made to him, or has knowledge of facts, which do not expressly tell him of something which is against him, and he abstains from making further inquiry because he knows what the result would be -- or, as the phrase is, he "wilfully shuts his eyes" -- then judges are in the habit of telling juries that they may infer that he did know what was against him. It is an inference of fact drawn because you cannot look into a man's mind, but you can infer from his conduct whether he is speaking truly or not when he says that he did not know of particular facts. There is no question of constructive notice or constructive knowledge involved in that inference; it is actual knowledge which is inferred. Constructive notice ... is contrary to the truth. It is wholly founded on the assumption that a man does not know the facts; and yet it is said that constructively he does know them. ... The statutory rule of indoor management [13.280] The statutory rule generally In some cases persons dealing with a company have more protection than under the common law rule of indoor management. This added protection is given by ss 128129. 1. Section 128(1) provides: A person is entitled to make the assumptions in section 129 in relation to dealings with a company. The company is not entitled to assert in proceedings in relation to the dealings that any of the assumptions are incorrect. The assumptions in s 129, stated broadly, are about: compliance with the company's constitution and any replaceable rules in the Corporations Act 2001 (Cth) that apply; 179 authority of a director or company secretary appearing to be such from ASIC records available to the public and based on information from the company; authority of a person held out by the company to be an officer or agent of the company; proper performance of duties by officers and agents of the company; due execution of documents by the company; authority of an officer or agent of a company authorised to issue a document to warrant that it is genuine. Take, as an example, the assumption in s 129(1) about compliance with the company's constitution and any replaceable rules in the Corporations Act 2001 (Cth) that apply. Suppose that the replaceable rule in s 248F applies so that the board may act only if a quorum of two directors is present. The person having dealings with the company may in relation to those dealings, assume that the necessary quorum was present. In proceedings in relation to those dealings the company cannot be heard to deny that. For another example, see Beach Petroleum NL v Johnson (1993) 43 FCR 1; 115 ALR 411 at 593; 11 ACSR 103. Sections 128129 serve a function similar to that of the common law rule of indoor management. 2. But, as discussed in [13.300], s 128(4) differs from the common law rule as to the state of mind of a person dealing with the company which will disqualify that person from entitlement to make the statutory assumptions. Other differences are noted at [13.340]. A person who wishes to rely on ss 128129 in any legal proceedings must claim the benefit of the section: Bell Resources Holdings Pty Ltd v Cmr for ACT Revenue Collections (1990) 22 FCR 178; 93 ALR 354 at 370; 2 ACSR 211, a decision on comparable earlier provisions. The position before CLRA Where a person had dealings with a company before 1 July 1998 (the commencement date of the Company Law Review Act 1998 (Cth)) the relevant law is in the old s 164 of the old Corporations Law. Section 164 differed from the new ss 128129 in respect of the state of mind which disqualified a person from being entitled to make assumptions under s 164: see [13.300] where it deals with the position before CLRA. Section 164 provided that a person having dealings (see [13.281]) with a company was, subject to some exceptions to be noted later, entitled to make, in relation to those dealings, a number of assumptions. The section went on to provide that in any proceedings in relation to those dealings, any assertion by the company that the matters that the person was so entitled to assume were not correct was to be disregarded. One of the matters that could be assumed was that, at all relevant times, the company's constitution had been complied with. Hence, for example, if the constitution provided that the board could act only if a stated quorum was present, the person having dealings with the company could, in relation to those dealings, assume that the necessary quorum was present. In proceedings in relation to those dealings the company could not be heard to deny that. That is similar to the common law rule. However, the terms of s 164 differed from the common law rule in an exception relating to the state of mind of the person dealing with the company. Under the common law rule, a person dealing with the company cannot get the benefit of the rule where that person knows facts that would put a reasonable person on notice that the internal procedures may not have been followed. Under s 164(4) persons dealing with the company who were not connected with or related to a company would be entitled to make the assumption unless they had "actual knowledge" that the matter was not correct. If they had "actual knowledge" of irregularity, the company was free to assert the irregularity. 180 The company had the burden of showing that the outsider had actual knowledge. [13.300] Persons who know, or suspect, that an assumption would be incorrect are not entitled to make that assumption In proceedings related to dealings with a company the company can assert that a person who claims to be entitled under s 128(1) to make any one or more assumptions in s 129 is not so entitled, if the case falls within s 128(4). Section 128(4) withholds entitlement to make an assumption from persons who, "at the time of the dealings", "knew or suspected that the assumption was incorrect". Section 128(4), if read literally, posits persons making an assumption that something is correct at the same time as they know it to be incorrect. Clearly, parliament's intention is to deny the benefit of an authorised assumption about some state of affairs referred to in s 129 when the person knows or suspects something that is inconsistent with the authorised assumption. In a case raising s 128(4) the burden of persuasion that a person knew or suspected would appear to be on the company. Under earlier comparable legislation the company was treated as having the burden in Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279; (1991) 6 ACSR 464; 10 ACLC 253. Contrast the burden on a recipient of company property of proving the equitable defence of bona fide purchaser of a legal interest for value without notice which, according to the better view, is on the purchaser: Meagher, Gummow and Lehane Equity: Doctrines and Remedies, 3rd ed, Butterworths, Sydney, 1992, para 860; Eromanga Hydrocarbons NL v Australis Mining NL (1988) 13 ACLR 804; NinetyFive Pty Ltd (in liq) v Banque Nationale de Paris [1988] WAR 132; cf Re Dover Pty Ltd (1981) 6 ACLR 307 at 310. Unlike the old s 164(4) the new provision in s 128(4) applies the same test of knowledge or suspicion to all persons who seek the benefit of assumptions regardless of whether they are connected with or related to the company.... Knowledge or suspicion disallowing one statutory assumption may not disallow others It was held that the former s 164(3)(e) (like current s 129(6)) was separate from s 164(3)(a) (like current s 129(1)) and that outsiders were not prevented from relying on s 164(3)(e) because their actual knowledge of the company's constitution precluded reliance on s 164(3) (a) in respect of some lack of authority unrelated to authority to fix the company seal and attest it: Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279 at 3623; (1991) 6 ACSR 464 at 478; 10 ACLC 253. Knowledge or suspicion at the time of the dealings To be disqualified from making an assumption the person must know or suspect at the time of the dealings that the assumption was incorrect. That is the time when the person entered a transaction with the company rather than the time when a step is taken unilaterally by either party in the course of or pursuant to the transaction. So if the transaction is a contract for the sale of goods, knowledge of an irregularity first acquired later than the time of making the contract does not alter the entitlement of the person to the benefit of the assumption made when the contract was entered into: Barclays Finance Holdings Ltd v Sturgess (1985) 3 ACLC 662, a decision on the former provision in old s 164. But if a variation of the contract were to be negotiated after acquiring the knowledge, it may be that the person would not be entitled to make the same assumption in relation to the variation. 181 Only actual knowledge or suspicion disentitles The words of s 128(4) require the company to persuade the court to make a finding of fact that persons claiming to make an assumption actually knew or suspected that the assumption was incorrect. Knowledge rather than notice While the common law rule of indoor management appears, like the equitable doctrine of notice, to deny protection to a person who is negligent without being dishonest, s 128(4) when it uses the words "knew or suspected" does not refer to the notice which a person is deemed to have as a matter of law under the two limbs of the equitable doctrine of constructive notice failure to make usual inquiries and failure to follow up when put on inquiry: cf Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279 at 359; (1991) 6 ACSR 464 at 475; 10 ACLC 253, a decision on legislation using the expression "actual knowledge". When a court finds by inference that a person has actual knowledge it is a conclusion of fact. When a court says that persons have notice of a fact it treats them as if they knew the fact but without any finding that they in fact knew. It is worth repeating the words of Lord Esher MR in English and Scottish Mercantile Investment Co Ltd v Brunton [1892] 2 QB 700 at 7078: The doctrine of constructive notice is wholly equitable; it is not known to the common law. There is an inference of fact known to common lawyers which comes somewhat near to it. When a man has statements made to him, or has knowledge of facts, which do not expressly tell him of something which is against him, and he abstains from making further inquiry because he knows what the result would be or, as the phrase is, he "wilfully shuts his eyes" then judges are in the habit of telling juries that they may infer that he did know what was against him. It is an inference of fact drawn because you cannot look into a man's mind, but you can infer from his conduct whether he is speaking truly or not when he says that he did not know of particular facts. There is no question of constructive notice or constructive knowledge involved in that inference; it is actual knowledge which is inferred. Constructive notice ... is contrary to the truth. It is wholly founded on the assumption that a man does not know the facts; and yet it is said that constructively he does know them. The construction of s 128(4) as requiring subjective knowledge or subjective suspicion is suggested by what courts have done when faced with legislation referring to a person "knowing" something. Although a construction of particular words in one statute will not necessarily be adopted for the same words in a different statute, there is nothing in the context of s 128(4) to suggest that the construction of "knew" and the process of finding knowledge that the courts have adopted in relation to various other statutes should not apply to s 128(4). Proof that a person knew or suspected an irregularity may be by evidence showing directly that they knew or, more usually, by evidence of facts from which the judge or jury can infer that they knew, despite their affecting not to know. The inference may be made on the basis of the person's statements and conduct, his or her circumstances and facts certainly known to that person from which he or she could make conclusions of fact by deduction. A consideration of the behaviour of a hypothetical reasonable person can be part of the process of proof. Section 128(4) does not refer to a person "who knew, or ought to have known, or suspected, or ought to have suspected". Those words would have required a court to make a conclusive finding of knowledge (or suspicion) once the company proved that the person knew some fact that would make a hypothetical reasonable person know (or suspect). Under such an objective test of knowledge, it would not be open to the person to avoid the effect of s 128(4) by persuading the court that he or she did not in fact know (or suspect). But the court, in arriving at an inference that the person had knowledge, may take into account the conclusions that a hypothetical reasonable person in the same position would have drawn from facts known. The court may then presume that the actual person would have reached the 182 same conclusions. But unlike the fully objective test of knowledge posited by legislation using the formula "ought to know" the court's view of what a reasonable person would know cannot be conclusively attributed to the person where the legislation like s 128(4) requires actual knowledge: Vines v Djordjevitch (1955) 91 CLR 512; [1955] ALR 431; RCA Corp v Custom Cleared Sales Pty Ltd (1978) 19 ALR 123 (CA(NSW)); Hooi v Brophy (1984) 52 ALR 710; 71 FLR 338. Persons claiming to assume under s 129 can deny that they knew or suspected that an assumption would be incorrect and it is then a question of whether the court believes them. Proof by the company of the person's opportunities for knowledge The New South Wales Court of Appeal said in RCA Corp v Custom Cleared Sales Pty Ltd (1978) 19 ALR 123 at 126: In inferring knowledge a court is entitled to approach the matter in two stages; where opportunities for knowledge on the part of the particular person are proved and there is nothing to indicate that there are obstacles to the particular person acquiring the relevant knowledge, there is some evidence from which the court can conclude that such a person has the knowledge. However, this conclusion may be easily overturned by a denial on his part of the knowledge which the court accepts, or by a demonstration that he is properly excused from giving evidence of his actual knowledge. In Perkins v National Bank Ltd (1999) 30 ACSR 256, a case under the former s 164, Debelle J of the South Australian Supreme Court considered (ACSR at 264) that a bank which was in possession of a company's articles of association was to be "deemed to have actual knowledge" of a particular article. Knowledge can be inferred from dishonest failure to inquire In another context, that of liability for knowing participation in another's breach of fiduciary duty, the New South Wales Court of Appeal in United States Surgical Corp v Hospital Products International Pty Ltd [1983] 2 NSWLR 157 (reversed on appeal (1984) 156 CLR 41; 55 ALR 417) noted (at 253) that Stephen J in Consul Development Pty Ltd v DPC Estates Pty Ltd (1975) 132 CLR 373; 5 ALR 231 had excluded from actual knowledge "that species of constructive notice which serves to expose a party to liability because of negligence in failing to make inquiry". The Court of Appeal referred approvingly to three elements of actual knowledge posited by Stephen J. The Court of Appeal said Stephen J had regarded the requirement of actual knowledge as being satisfied only by the party's knowledge of (1) the circumstances which imposed the fiduciary duty together with (2) knowledge of the facts constituting the breach and, in addition, (3) the recognition that the facts did bear that character. The Court of Appeal thought that a calculated omission to inquire, for fear of unearthing fraud or breach of duty, or the unreasonable failure to recognise fraud or breach of duty, may well be equivalent to actual knowledge. Such an omission or failure may make good the third of the elements previously mentioned, that is, the recognition that the facts known constitute the impropriety in question. Hence, it would seem that a dishonest failure to enquire something going beyond mere negligence will lead to an inference of actual knowledge. In such a case ignorance of the irregularity is a "mere affectation and disguise": The Zamora No 2 [1921] 1 AC 801 at 812. 183 Proof that a person "suspected" The company may not be able to persuade the court that the person had the critical knowledge. But it will be enough if the person is shown to have suspected that an assumption would be incorrect. What degree of apprehension on the part of the person is required to raise an inference that he or she suspected? In Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266; [1966] ALR 855 there was a question whether a payee "knew or had reason to suspect" that the payer, a debtor, was "unable to pay [its] debts as they became due" within the meaning of s 95(4) of the Bankruptcy Act 1924 (Cth). Kitto J explained the meaning of "suspect": A suspicion that something exists is more than a mere idle wondering whether it exists or not; it is a positive feeling of actual apprehension or mistrust, amounting to "a slight opinion, but without sufficient evidence", as Chambers' Dictionary expresses it. Consequently, a reason to suspect that a fact exists is more than a reason to consider or look into the possibility of its existence. Although s 128(4) differs from s 95(4) in not referring to "reason to suspect", Kitto J's statement about "suspicion" seems applicable to "suspected" in s 128(4). Take, for example, the assumption in s 129(2) as to the validity of the appointment of a managing director who acted for the company and his possession of authority. A person dealing with the company through that director might have wondered whether he was properly appointed and whether he had the usual authority of a managing director. That in itself would not amount to suspicion where the person just did not know the position and had no opinion on the matter. What if it can be inferred that the person had learned something which would prompt a reasonably prudent person to make inquiries? That still would not produce a case of suspicion. The person could be alerted to make inquiries without having formed any incipient opinion that the managing director was not properly appointed or that he lacked the usual authority. If the person were asked what his opinion was, he might well have replied, "I just do not know, one way or the other." Compare Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279; (1991) 6 ACSR 464; 10 ACLC 253, where a representative of a party dealing with a company, had shown concern as to whether a particular person, F, had been appointed secretary. He was assured by a person held to have implied actual authority to make a representation binding the company that F had been appointed secretary. F had not been so appointed. On the question whether the representative could be said to have had "actual knowledge" that F had not been appointed it was considered by the Appeal Division of the Victorian Supreme Court (at 362, 478) that he could not be said to have had actual knowledge one way or the other. In the context of s 128(4) it seems arguable that a person will be found to have suspected only when it can be seen, usually by inference, that the person had formed a positive opinion, however weak, that there was something irregular about the appointment or the scope of authority. While every case of suspicion in the Queensland Bacon sense would be a case of being put on enquiry, not every case of being put on enquiry amounts to suspicion. There is a contrast between s 128 and the common law rule of indoor management considered earlier at [13.200]. As we have seen, an outsider who sees something which would make a reasonable person inquire cannot rely on the common law rule of indoor management to justify an assumption that all is well. Consideration of the particular person's circumstances and ability to learn that an assumption would be incorrect The New South Wales Court of Appeal in the RCA Corp case referred to the need to consider whether there are obstacles to the particular person acquiring the relevant knowledge. Hence in examining whether there is a basis for drawing an inference of knowledge (or suspicion) attracting s 128(4) the court may take account of the experience and general knowledge 184 possessed by the person who claims to make a statutory assumption. If that person is a commercial lawyer or a bank official with experience of corporate financing transactions, an inference of knowledge (or suspicion) may be made with more justification than where the person lacks that experience. For example, if examination of a company's constitution would show that a particular company officer could not have had authority to commit the company to a dealing and it is proved that a commercial lawyer had an opportunity for knowledge when he knowingly held a copy of the constitution, an inference that the commercial lawyer had knowledge of the lack of authority might arise although it might not have arisen against an inexperienced lay person in possession of the constitution. But as noted earlier, the commercial lawyer is free to try to persuade the court that the inference of knowledge or suspicion should be abandoned because he did not in fact have knowledge or suspicion. Section 128(4) in requiring proof that a person actually knew or suspected does not in terms embody any expectation that a person dealing with the company will as a matter of prudence typical of reasonable persons initially make enquiries on the matters on which assumptions can be made under s 129. It is open to persons dealing with a company to make no enquiries about those matters so long as nothing in the state of affairs at the time of dealing would lead a court to draw an inference of knowledge, or suspicion, of an irregularity where it is not persuaded by a denial. Although s 128(4) does not embody an expectation of prudent conduct, there may in some circumstances be such an expectation which is enlivened when the court assesses the evidence. Suppose that an experienced loans officer of a bank approves a loan to company X to be secured by a mortgage over property of company Y, knowing that the person acting for company X is a director of both companies and that the loan is for the benefit of company X alone. If ss 128 and 129 did not exist so that the only possible protection for the bank lay in the common law indoor management rule, the court would probably hold that the bank could not rely on the rule because its officer was put on enquiry by what he knew. Under s 128(4) there would be an issue whether the bank officer in fact suspected irregularity. The court would probably think that a hypothetical bank officer with the same experience would have made enquiries but would it think he would have done so because he had merely a doubt or because he had a suspicion? A court in weighing evidence of a denial might well expect experienced loans officers to be suspicious. That expectation would favour the drawing of an inference that the actual officer suspected and would dispose the court to disbelieve a denial by the officer that he suspected. Similar considerations arise where a person denies having drawn a legal conclusion from known facts. For example, a person can under s 129(2) assume that anyone who appears, from information provided by the company that is available to the public from ASIC, to be a director has been duly appointed. Before a person is disqualified by s 128(4) that person must have known or suspected that the assumption was incorrect. In the example it is the matter of due appointment that may be assumed and it is knowledge that that matter is not correct which disqualifies. Due or undue appointment is a legal conclusion from certain facts. Suppose that the company's constitution requires appointees to a directorship to hold a minimum number of shares before they are eligible to be appointed. Will a person's knowledge of the provision in the constitution and the fact that the purported "director" owns no shares be taken to be knowledge that the assumption of due appointment was incorrect? In another example, should an outsider who deals with a no liability company be taken to know that if it enters a transaction quite unrelated to mining purposes, its representatives are transgressing a restriction in its constitution? Should an outsider dealing with a company who knows that the company has not adopted a constitution be taken to know that the internal management of the company is governed by replaceable rules in the Corporations Act 2001 (Cth)? Under s 128(4) the person is entitled to have the court consider his or her denial of knowledge or suspicion arising by deduction from known facts. But in weighing that denial the court may more readily infer knowledge or suspicion by deduction on the part of, say, a commercial lawyer than a lay person lacking commercial experience.... 185 The position before CLRA Where a person had dealings with a company before 1 July 1998 (the commencement date of the Company Law Review Act 1998 (Cth)) the relevant law is in the old s 164. Section 164 differed from the new ss 128129 in respect of the state of mind which disqualified a person from being entitled to make assumptions under s 164. Pre-CLRA: knowledge that disentitles from assuming Former subss 164(4) and (5) make one provision for persons dealing with a company who are connected with or have a relationship with the company and a different provision for other persons. Persons having a connection or relationship with the company will be disentitled to make an assumption if their connection or relationship is such that they ought to know that the matter, they would be otherwise entitled to assume, is not correct. Other persons will be prevented from assuming that all is well only if they have actual knowledge that a matter is not correct. Pre-CLRA: who are connected or related persons? The class of persons whose relationships are envisaged would obviously include directors and secretaries of the company: Story v Advance Bank Australia Ltd (1993) 31 NSWLR 722; 10 ACSR 699 at 710; 11 ACLC 629 at 638-9, per Gleeson CJ. In recognition of the close relationships in groups of companies the class of connected persons can include persons concerned with the operation of a group of companies in relation to a company in the group: Bell Resources Holdings Pty Ltd v Cmr for ACT Revenue Collections (1990) 22 FCR 178; 93 ALR 354 at 365; 2 ACSR 211. The class probably includes a shareholder who holds enough shares to control the composition of the board and, possibly, certain agents and employees who could be expected to be aware of internal arrangements and delegations of authority. The class can extend to persons outside the company with whom the company has built up a business relationship not only in previous dealings but also where there has been no previous relationship. Otherwise there would have been a short answer in Story v Advance Bank Australia Ltd (1993) 31 NSWLR 722; 10 ACSR 699; 11 ACLC 629. Pre-CLRA: connection formed in the irregular transaction The weight of authority stemming from New South Wales and Victoria accepts that a connection or relationship can arise in the very dealing thought to be affected by irregularity. The NSW Court of Appeal held in Bank of New Zealand v Fiberi Pty Ltd (1993) 14 ACSR 736; 12 ACLC 48 that a bank dealing with a company can become a person connected with the company: see also Pyramid Building Society (in liq) v Scorpion Hotels Pty Ltd (1996) 136 ALR 166 at 189; 20 ACSR 214; 14 ACLC 679; Koorootang Nominees Pty Ltd v Australia and New Zealand Banking Group Ltd [1998] 3 VR 16. Contrast Lyford v Media Portfolio Ltd (1989) 7 ACLC 271 at 281 per Nicholson J (SC(WA)). In Bank of New Zealand v Fiberi Priestley JA said at 751 that: ... the words "connection or relationship" in [s 164(4)(b)] should not be considered in an abstract way; that is, the approach should not be first to characterize the connection or relationship (as for example by classifying the person involved as the company's director, or solicitor, or bank manager or mortgagee) and then to ask whether a person having that connection or relationship ought to know 186 a particular matter. It is sufficient to see what the actual facts of the relationship between the person in question and the company were at the relevant time. By actual facts ... I mean all the facts of the dealings between [the company and the person]. Pre-CLRA: the meaning of "ought to know" In Bank of New Zealand v Fiberi Kirby P was of the view that these words imported the concept of being "put on inquiry" as expounded in Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146 at 198; 93 ALR 385 at 420; 2 ACSR 161; 8 ACLC 611. Priestley JA differed and said that the concept in the words "ought to know" is slightly different from the concept of being "put upon inquiry", although there is some overlap between them. Clarke JA indicated that he found the test in par (b) elusive but for the reasons given by Priestley JA he agreed that the Bank's appeal should be dismissed. Priestley JA said: The meaning of "ought to know" in par (b) to my mind requires the court to assess what the person in the particular situation acting reasonably would have known, whereas the concept of being "put upon inquiry" involves the court in asking were there features of the particular situation which required the person in question to make further enquiries. In Koorootang Nominees Pty Ltd v Australia and New Zealand Banking Group Ltd [1998] 3 VR 16 Hansen J preferred the view of Priestley JA, because it paid closer regard to the words of the section and because it was also consistent with a passage from the decision of the Victorian Appeal Division in Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279 at 359; (1991) 6 ACSR 464; 10 ACLC 253 per McGarvie, Marks and Beach JJ: Although [s164] was undoubtedly inspired by the rule in Turquand's case and is in a sense a codification of it, the section does not incorporate the concept of being "put on inquiry" and we are obliged to have regard to the assumptions, as defined by the section, which the respondents were entitled to make subject to the exceptions in subs (4). Relationship of the common law rule to sections 128129 [13.340] Differences between the common law rule and ss 128129 For the most part ss 128129 operate less widely than the common law rule. Sections 128 129 are not a code and the common law rule can still operate: Australian Capital Television Pty Ltd v Minister for Transport and Communications (1989) 86 ALR 119; 7 ACLC 525. Sections 128129 apply only in relation to corporations that are companies. The common law rule is not confined to dealings with companies: it can apply to dealings with corporations generally. Sections 128129 do not apply where some person other than the company asserts that there was an irregularity in an earlier dealing with a company. It seems that the common law rule can apply in that case. An example that has been suggested is where A sues B for damages in tort for inducing company X to break its contract with A, and B denies formation of the contract on the ground of an irregularity in the internal management of company X: Australian Capital Television Pty Ltd v Minister for Transport and Communications, above, per Gummow J. The plaintiff, A, could possibly rely on the common law rule. Putting it another way a person who has had a dealing with a company in the past can rely on the indoor management rule in relation to that dealing against a third person who questions whether the company became bound in the dealing. 187 Moreover, ss 128129 apply only in favour of a person having dealings (see [13.281]) with the company or with a person who has acquired title to property, or purports to have acquired title, from the company: Australian Capital Television Pty Ltd v Minister for Transport and Communications, above. In that case Gummow J said that the indoor management rule is not confined to benefiting persons who contract with the company. The assumption as to compliance with requirements as to internal management in the company in s 129(1) is narrower than that allowed under the common law rule. The assumption allowed by s 129(1) relates only to requirements in the company's constitution and those provisions of the Corporations Act 2001 (Cth) that apply to the company as replaceable rules. It has been submitted earlier (see [13.170]) that the common law rule goes beyond this to allow assumptions about compliance with requirements in provisions of the Corporations Act 2001 (Cth) that govern internal management and are not replaceable rules. For example, the requirements in s 249J(1) as to notice of a meeting of members and the requirements of s 112(4) about tribute agreements in no liability companies. It may appear that ss 128129 could operate more widely than the common law rule where the person seeking to rely on an assumption is an insider: see [13.260]. But in some circumstances the fact of being an insider may more readily lead to an inference of fact that the insider knew or suspected that the assumption was incorrect than in the case of an outsider. Statutory deeming of authority in favour of persons dealing with the company [13.350] Statute permitting persons dealing to assume authority exists When in 1983 the indoor management rule was adopted in what is now s 129(1) it was also provided in what is now s 129(2) and s 129(3) that the person having dealings could make assumptions about authority of persons acting for the company. We can now examine this statutory form of authority which is additional to common law apparent agency. [13.360] Statutory permitted assumptions as to authority Section 129 permits assumptions as to authority in several situations. The first is where the company has informed ASIC that someone is a director or company secretary of the company. The second is where someone is held out by the company to be an officer or agent of the company. Section 129(2) deals with the first situation and provides: A person may assume that anyone who appears, from information provided by the company that is available to the public from ASIC, to be a director or a company secretary of the company: (a) has been duly appointed; and (b) has authority to exercise the powers and perform the duties customarily exercised or performed by a director or company secretary of a similar company. Section 129(3) deals with the second situation by providing: A person may assume that anyone who is held out by the company to be an officer or agent of the company: (a) has been duly appointed; and (b) has authority to exercise the powers and perform the duties customarily exercised or performed by that kind of officer or agent of a similar company. 188 [13.370] Assumption stemming from information provided to ASIC Under the Corporations Law before it was amended in 1998 by CLRA the assumption could be made only where the company had stated that a person was a director or secretary in certain specified returns to the Commission. That limitation no longer applies. The means by which information could be provided as to who are a company's directors and company secretaries include: a notice of the personal details of directors and secretaries given under s 205B; a notice of resignation or retirement given by a director or secretary under s 205B(4); or the company's annual return under Pt 2N.1. The information referred to in s 129(2) is information available to the public at the time of the dealing. That the time of dealing is the critical time is shown by s 128(4) under which persons are not entitled to make an assumption if "at the time of the dealing" they knew or suspected that the assumption was incorrect. From the viewpoint of members of the company ss 128129 put a premium on prompt lodging with ASIC of a notice of a change of director or company secretary. It is appropriate that as between a company and a person dealing with it any inconvenience flowing from failure to notify promptly should rest on the proprietors of the company who have elected to operate through the corporate form. Under s 1274C ASIC may certify that a person was a director or secretary of a company at a particular time or during a particular period. In the absence of evidence to the contrary, a certificate is proof of the matters stated in it. Position before CLRA Where a person was having dealings with a company before 1 July 1998 (the commencement date of the Company Law Review Act 1998 (Cth)) old s 164 will apply instead of ss 128-129. Under s 164(3)(b) the reference to information available from the Commission was less general than the reference in s 129(2). The reference was to: returns about officeholders lodged under former s 242 (Particulars and Changes of Particulars in Register of Directors and Secretaries); notices lodged under former s 242; and annual returns lodged under former s 335. [13.380] Must the outsider know of the return? If s 129(2) were no more than a legislative adoption of the common law doctrine of apparent agency, outsiders could not rely on information available from ASIC unless they had seen it. Common law apparent authority is a branch of the law of estoppel which requires that a representee should have acted on the faith of a representation made by the representor. Section 129(2) does not in terms require the appearance of authority provided by the information to be known to the person dealing before that person can get the benefit of an assumption. Does it follow that a person dealing may assume without reason that a person is a director and yet have the assumption made uncontestable by the company because the company had named that person as a director in its last return of which the outsider is unaware? It has been said of a predecessor of s 129(2) that it is the assertion by the company that an assumption was not correct that brings what is now ss 128-129 into operation: not proof that the assumptions were in fact made: Lyford v Media Portfolio Ltd (1989) 7 ACLC 271. See also Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279 at 308; (1990) 3 ACSR 649 at 678; 9 ACLC 324. 189 A possible reason why persons dealing with the company do not have to prove a representation made to them is that the lodging of a return creates an implied actual authority and that there is no need to see s 129(2) as being concerned with apparent authority. If the outsider has in fact seen the return, it is a case where implied actual authority and apparent authority co-exist. But see Hughes v NM Superannuation Board Pty Ltd (1993) 29 NSWLR 653; 11 ACLC 923 where the lodgement of a Form 61 stating that C, the chairman of the board, was appointed principal executive officer, there having been no formal appointment, did not in the view of the Court of Appeal justify an implication that C had the authority of a managing director. To read s 129(2) as requiring the person to have been influenced by a representation from the company seems wrong in light of the provisions of s 129(3) which deal with the company holding out (or in other words representing) that someone is an officer. A further argument that s 129(2) does not require a representation to have been made to the outsider rests on the Explanatory Memorandum to the Companies and Securities Legislation (Miscellaneous Amendments) Bill 1983 which introduced the provisions now in ss 128129. Paragraph 205 states that the purpose of what is now s 129(2) is to "restate the common law rule that the protection afforded to persons under the `indoor management rule' is not affected merely because the directors etc have not been properly appointed". The indoor management rule did not involve a representation to the outsider. Paragraph 205 also stated that what is now s 129(2) extends the protection afforded by former s 226 (see [15.020]) by negating the distinction between a defective appointment and a non-existent appointment that was drawn in Morris v Kanssen [1946] AC 459; [1946] 1 All ER 586. Former s 226 did not require any representation to the person seeking to rely on it. Similar legislative purposes were stated to underlie what is now s 129(3). For judicial recognition of the reasons for introduction of what is now ss 128-129, see Barclays Finance Holdings Ltd v Sturgess (1985) 3 ACLC 662 at 667. [13.390] Extent of statutory authority under s 129(2) Section 129(2), states the extent of the authority of a person appearing from ASIC information to be a director or company secretary as "authority to exercise the powers and perform the duties customarily exercised or performed by a director or company secretary of a similar company". Like implied usual authority under unenacted law ([13.030]), the authority under s 129(2) depends on the particular office held, the type of company and the kind of business it conducts viewed against what is customary or usual in a similar office in a similar company carrying on a similar business. For example, the authority of a chief executive officer of a charitable company will usually be narrower than that of a managing director of a large public commercial company. Again, a sole director of a proprietary company will have a wider customary authority than an individual director of a large public company. The managing director of a bank, unlike the managing director of an entertainment company, may lack authority to make a contract to purchase theatre lighting equipment. To the extent that the company's business limits the authority that may be assumed to exist the position is comparable with that under partnership legislation dealing with the powers of partners to bind the firm by an "act for carrying on in the usual way business of the kind carried on by the firm". If in regard to a proposed transaction there is doubt as to the authority of the relevant officer in the light of the company's apparent business, there is a question whether proof of authorisation by the board should be sought. But if the authorisation by the board, or even all the members, appears to be for a purpose unrelated to the company's business, even that authorisation may not be effective: ANZ Executors and Trustees Co Ltd v Qintex Australia Ltd (recs & mgrs apptd) [1991] 2 Qd R 360; (1990) 2 ACSR 676; 8 ACLC 980.... 190 Position before CLRA Where a person was having dealings with a company before 1 July 1998 (the commencement date of the Company Law Review Act 1998 (Cth)) old s 164 will apply instead of ss 128-129. The extent of the authority that could be assumed under s 164(3)(b) was stated in language different from that in s 129(2) but there may be no difference in effect. [13.400] Statutory assumption about officer or agent held out Section 129(2), discussed in the preceding paragraphs, will cover many cases in which a person has dealings with a company but there can be cases outside it where the purported agent is not a director or secretary disclosed by information provided by the company to ASIC. Section 129(3) may then be relevant: Re Madi Pty Ltd (1987) 12 ACLR 45; 5 ACLC 847; ANZ Banking Group Ltd v Australian Glass and Mirrors Pty Ltd (1991) 4 ACSR 14; 9 ACLC 702; AWA Ltd v Daniels t/as Deloitte Haskins & Sells (1992) 7 ACSR 759 at 862; 10 ACLC 933 at 1011. Section 129(3) allows an assumption that "anyone who is held out by the company to be an officer or agent of the company: (a) has been duly appointed; and (b) has authority to exercise the powers and perform the duties customarily exercised or performed by that kind of officer or agent of a similar company". Section 129(3) does not state that the holding out must be to the person having dealings with the company. Section 129(3) could include a case where the person held out has implied actual authority because in the past the board has acquiesced in that person exercising authority: see [13.120]. In that case it does not matter that the person now having dealings with the company has not received a representation of authority from the board. But if there is no history of holding out, s 129(3) cannot operate as statutory implied actual authority like s 129(2). There is then a question whether the outsider must have received such a representation. There must be a holding out to someone. It is possible that there is a contemporaneous holding out to another person but not to the person dealing. According to the Explanatory Memorandum to the 1983 Bill which introduced what is now ss 128129, the reasons for the enactment of what is now s 129(2) also applied to what is now s 129(3). (See above [13.380].) Those reasons suggest that the person dealing with the company could rely on a holding out to another person. [13.410] Authority of person holding out For s 129(3) to operate the holding out must be "by the company". The outsider must show that there was an express or implied holding out by the company through an appropriate organ, either the company as a whole constituted by its members or by an organ appointed pursuant to the Corporations Act 2001 (Cth) or the company's constitution, such as the board of directors: Bank of New Zealand v Fiberi Pty Ltd (1992) 8 ACSR 790; 10 ACLC 1557 affirmed (1993) 14 ACSR 736; 12 ACLC 48; Pyramid Building Society (in liq) v Scorpion Hotels Pty Ltd (1996) 136 ALR 166; 20 ACSR 214; 14 ACLC 679. At common law there can only be a holding out by someone with the company's actual rather than apparent authority. Does that limitation on the common law doctrine of apparent authority, as confirmed by Crabtree-Vickers Pty Ltd v Australian Direct Mail Advertising & Addressing Co Pty Ltd (1975) 133 CLR 72; 7 ALR 527 apply in relation to s 129(3)? In Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279; (1990) 3 ACSR 649 at 681; 9 ACLC 324 Ormiston J in applying the forerunner to ss 128129 accepted that a person held out could himself hold out but on appeal the Appeal Division took Ormiston J to have found 191 that it was a case of a person with actual authority who was holding out: [1992] 2 VR at 361; (1991) 6 ACSR 464 at 477; 10 ACLC 253. Under a combination of s 129(2) and s 129(3) it might be possible to attribute to the company a holding out by a managing director listed in the last return to ASIC that another person has authority even though the company had denied actual authority to the managing director to make that representation. By lodging the return the company could be regarded as giving the managing director implied actual authority to the extent of usual authority. The matters upon which a person dealing with a company can make assumptions referred to in s 128 are cumulative: s 129(8). [13.420] Extent of authority that may be assumed to exist under s 129(3) To find the extent of the authority that the person held out may be assumed to have under s 129(3) one applies the same considerations as are applied under s 129(2). Those considerations are discussed at [13.390]. [13.421] Sections 128129 do not displace the general law If there should be any cases of holding out not covered by s 129(2) or s 129(3), the doctrine of holding out developed in unenacted law may assist the outsider. There is nothing in the legislation to indicate that the doctrine in unenacted law is excluded. Sections 128129 are not a code: Australian Capital Television Pty Ltd v Minister for Transport and Communications (1989) 86 ALR 119; 7 ACLC 525. 192 CORPORATE GOVERNANCE 193 CORPORATE GOVERNANCE: INTRODUCTION TO CORPORATE GOVERNANCE THEORY AND ISSUES This class provides an introduction to corporate governance the techniques by which the divergent interests of managers and shareholders are governed or `kept in check'. The readings for this week develop a framework for considering the corporate governance debate by offering a few different theoretical models for conceptualising corporate governance. All this is not simply "academic". The class serves several important functions by: providing a framework --a `bigger picture', if you like -- for making sense of subsequent classes on corporate governance; affording some insights into the reasons behind the successes -- and failures -- of high-profile businesses reported in the media; offering sets of criteria for evaluating the adequacy of current law and practice on corporate governance, an essential skill for value-added lawyering, business administration, policy-making or informed participation in civic affairs; and presenting an intellectual suite of tools from which to develop new ideas on improving corporate decision-making. This class revisits ideas raised earlier in the course about theories of the firm, approaches to regulation and strategies for interpreting corporate law. These ideas serve as a springboard for constructing more applied conceptual models about corporate governance pursued in the classes on corporate governance. The first part of the class explores different theories about corporate governance. Read the Casebook at 2.210-235 for an introduction to these theories. Although the literature on corporate governance is rich and varied, the readings are confined to three competing models, which may be roughly described as follows: One is that directors must only consider shareholders' interests (the law-andeconomics model); Another is that directors must consider the interests of all stakeholders and not just shareholders (the communitarian model); and The middle view is that directors may consider the interests of all stakeholders by exercising their discretionary judgment (team production theory). Thus, the first two readings, by Millon and Blair/Stout, outline the law-and-economics argument. They each critique this model and outline what they consider better alternatives, namely the communitarian and the team production models respectively. (The next reading, a later piece by Millon, is optional, criticising the team production theory.) The second part of the class explores the practical implications of these different models. Read the Casebook at 5.10-25 for an introduction to corporate governance mechanisms. The Hill reading considers the real-life case of Sunbeam to highlight current debates about corporate governance. When reading this article, you should try to imagine how law-and-economics scholars, communitarians and team production theorists would respond to the issues raised by Hill. For example, is the rise of institutional investors (a) a promising developing, offering a potential to improve monitoring of management decisions and thereby enhance shareholder returns; (b) an unwelcome development, arguably reducing corporate commitment to philanthropy and employee welfare; or (c) largely irrelevant, simply heralding a new player among the existing subset of stakeholders seeking to capture the favour of directors? You could 194 also look at the Casebook at paras 5.30-90 for a discussion of the role of the board in corporate governance (this is optional reading only). 195 Millon, D, "Communitarianism in Corporate Law: Foundations and Law Reform Strategies" in Mitchell, L (ed), Progressive Corporate Law (1995) 1 at 1-13 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. THE PROBLEM OF NONSHAREHOLDER VULNERABILITY Recently, a diverse group of scholars has challenged corporate law's traditional commitment to the shareholder primacy principle. Shareholder primacy mandates that management -- the corporation's directors and senior officers -- devote its energies to the advancement of shareholder interests. If pursuit of this objective conflicts with the interests of one or more of the corporation's nonshareholder constituencies, management is to disregard such competing considerations. For much of this century, corporate law's principal task has been to develop rules that increase the likelihood that management will act in the interests of shareholders. Shareholder voting rights and defined fiduciary duties enforceable by shareholder derivative actions are particularly important. Imperfect though these mechanisms may be, they reflect an effort to develop corporate governance structures designed to strike a balance between shareholder accountability and managerial discretion. Those scholars who have challenged the shareholder primacy principle may be referred to as communitarians, because -- as will appear more fully below -- their work focuses on the sociological and moral phenomenon of the corporation as community, in contrast to the individualistic, self-reliant, contractarian stance that dominates current academic discourse in corporate law. The catalyst for this communitarian turn in corporate law has been concern about the harm to nonshareholders that can occur as a result of managerial adherence to the shareholder primacy principle. Efforts to maximize shareholder wealth are often costly to nonshareholders and often come at the expense of particular nonshareholder constituent groups. For example, a corporation may find that one of its several plants can no longer be operated profitably. Management's duty to the shareholders mandates that it consider closing the plant in order to avoid further losses. Doing so will result in lost jobs. Other members of the community in which the plant is located will suffer as well. Tax revenues will decline, as will charitable giving and other contributions of the corporation and its employees to the life of the community; established creditor, customer, and supplier relationships will be terminated, perhaps leading to further unemployment; and lost jobs will impose added strain on social services budgets. Shareholders gain (by avoiding losses) at the expense of these nonshareholders, many of whom have made nontransferable investments of human and financial capital in the reasonable expectation of a continued, long- term corporate relationship. Nevertheless, from a corporate law standpoint, none of these clearly foreseeable harms to nonshareholders is relevant to management's decisionmaking. Instead, management's duty is to focus solely on the interests of the corporation's shareholders, weighing the likely costs and benefits to them alone of closing the plant. The problem of nonshareholder vulnerability emerged starkly during the hostile takeover explosion of the 1980s. Shareholders clearly benefitted from an active market for corporate control. Bidders offered substantial premiums over market prices, and even shareholders whose corporations were not targets arguably stood to gain from the heightened managerial diligence that the threat of a change in control encouraged. However, hostile takeovers, built 196 upon mountains of debt, imposed unprecedented pressures on corporations to generate current income and cut operating expenses. Employees in particular were threatened by abrupt layoffs or plant closings, and other nonshareholder constituencies often suffered as well. The social costs of hostile takeovers highlighted a problem lurking within corporate law's traditional commitment to shareholder primacy. Management's duty of exclusive regard to shareholder interests necessarily threatened nonshareholder interests in any situation in which there was a conflict. While hostile takeovers seemed the most likely arena in which such conflicts might emerge, any corporation faced with real financial pressures might find it necessary to sacrifice nonshareholders on the altar of shareholder wealth maximization. Certainly heightened international competition in product markets and the technological transitions necessary to meet (or foster) changes in consumer demand only increase the likelihood of such trade-offs. THE CONTRACTUAL CORPORATION During the last ten years or so, a positive and normative theory of the corporation has grown increasingly influential in legal academic circles. This theory dismisses the idea of the corporation as a real entity -- a distinctive "thing" having an existence separate from its component parts -- as nothing more than a convenient fiction. Instead, it describes the corporation as a "nexus of contracts" among all suppliers of inputs (such as capital, labor, materials, and services) that contribute to the production process. The corporation is decomposed into a web of self-seeking, bilateral market transactions. Many of these contracts include terms that address the circumstances and preferences of the parties. Suppliers of labor, materials, services, and credit enter into contracts with corporate management that specify with particularity the extent of nonshareholders' claims against corporate assets. These contracts are more or less tailor-made, regardless of whether the terms are actually negotiated between the parties. In contrast to these nonshareholder contracts, shareholders typically contract with management by entering into the standard-form agreement supplied by the relevant state corporate law code and corpus of common law. This "off-the-rack" contract includes a collection of terms that shareholders would typically prefer, so including them greatly reduces transaction costs. Many (though not all) can be modified by express contract if the shareholders so desire. As residual claimants, shareholders subject themselves to the risk that they will earn no return on their investment once all nonshareholders' fixed claims against corporate assets have been paid. It is therefore in the shareholders' interest that management maximize the corporation's profits. Accordingly, one key term in the shareholders' contract with management is the openended injunction that management act in "the best interests of the corporation and its shareholders." This term is necessarily vague, because it is impossible as a practical matter to specify ex ante precisely what management ought to do in concrete situations. Voting rights and fiduciary duties imposed on management (enforceable by the shareholder derivative suit) are designed to allow shareholders to hold management accountable, and shareholders alone benefit from these accountability mechanisms because of the uniqueness of their position within the corporation's nexus of contracts. The neoclassical economic analysis on which the contractarian position rests acknowledges that nonshareholders may be affected negatively by managerial pursuit of shareholder wealth maximization. Conceptually, such effects are a negative externality incidental to shareholders' efforts to maximize return on their capital through the use of professional managers acting on their behalf. However, the fact that nonshareholders may suffer as a result of corporate efforts 197 to maximize shareholder wealth does not necessarily establish a legitimate claim for legal protection. Many people routinely suffer losses from the operation of market forces. This is the fate of the firm unable to produce as efficiently as a competitor. The constant transitions necessitated by a dynamic market economy impose costs on many affected parties. As far as the law is concerned, much of this is noncompensable; it is damnum abseque injuria. Contractarians insist that employees, creditors, and other vulnerable nonshareholder constituent groups can protect themselves from such externalities through contract and should do so to the extent that protection is desired. For example, employees concerned about uncompensated layoff can bargain for explicit promises of long-term job security, severance pay and reimbursement for retraining costs, or other forms of protection. Failure to insist upon such protection implies ex ante consent to the possibility of layoff whenever necessary to serve shareholder interests, presumably in return for other more highly valued benefits. Accordingly, ex post judicial intervention on behalf of nonshareholder constituencies who have not bargained for protection represents an illegitimate wealth transfer from shareholders to the benefitted nonshareholder group. Nonshareholders gain a benefit they have not bargained for, and the gain comes at the shareholders' expense. From the contractarian perspective, such transfers are unjust because they cannot be justified on the basis of shareholder consent. The contractarian position rests on an underlying commitment to the sanctity of shareholder property rights. Share ownership implies broad freedom to maximize share value. The law should not require shareholders to yield this right unless they have consented ex ante, to limitation. In other words, if third-parties suffer from shareholder efforts to exploit the value of their property, the burden should be on the affected parties to self-protect by means of legally enforceable contract. That normative conclusion follows from the positive vision of the corporation as nothing more than a web of bilateral exchanges among self-seeking property owners. THE COMMUNITARIAN TURN There are three elements to the communitarian critique of the contractarians' view of corporate law. The first challenges key assumptions about the feasibility of nonshareholder self-protection through bargain. The second is more fundamental. It asserts that, even if selfprotection through bargain were entirely feasible in a technological sense, disparities in bargaining power would prevent at least some nonshareholder constituencies from obtaining adequate protection from the costs of shareholder wealth maximization. This argument appeals to a conception of justice that insists that people are entitled to more than merely what they can bargain and pay for. Or, stating the same idea in terms of obligation rather than entitlement, community members owe each other duties of mutual regard and support. Finally, communitarians have offered a positive vision of corporate relationships that differs from that of the contractarians and has correspondingly different normative implications. This perspective grounds obligation on a rich foundation of mutual trust and interdependence rather than limiting it to the bare bones of actual contractual terms and rests on a vision of the corporation as a community rather than a mere aggregation of self-seeking individuals whose relationships are defined solely by contract. The Inadequacy of Self-Protection Communitarians assess the social costs of shareholder wealth maximization more broadly than do contractarians. The contractarians' economic approach tends to focus on more obviously monetizable considerations, disregarding more amorphous but no less real costs. For example, the cost of a worker's layoff may be more than just the discounted present value of the income that he or she would have earned, less any offset due to reemployment. Despair 198 and low self-esteem may follow layoff, and even the worker who finds another job may suffer from heightened feelings of insecurity and incur psychological difficulties in adjusting to a new work environment. These transition and morale costs are surely difficult to value in dollar terms, but they are no less real for that reason. They too should be factored into the welfare calculation, such that even a laid-off worker who finds another job at comparable pay may be worse off for having been laid off. Likewise, the morale costs of a lost job in one locality would not necessarily be offset fully by creation of a new, comparably compensated employment opportunity elsewhere. Communitarians also tend to define more broadly the universe of people potentially affected adversely by shareholder wealth maximization. A plant closing, for example, may involve more than employee layoffs and termination of various commercial relationships. Consumers may also lose access to distinctive products, and the local community will often lose tax revenues and charitable contributions. Management-level employees may also have significant involvements in civic and social activities. Communitarians draw an important lesson from their fuller appreciation of the magnitude and complexity of the social costs of shareholder wealth maximization. There appears to be more at stake than contractarians are typically willing to acknowledge. The costs of transactions undertaken for the benefit of shareholders represent a problem of genuine social and political significance, rather than more or less trivial -- and therefore readily disregarded -- inevitabilities of productive activity. One might still respond that, however big the problem might be, shareholder property rights still put the onus on nonshareholders to protect themselves by contract. Bargaining will then generate efficient levels of nonshareholder protection. Communitarians respond that effective nonshareholder self-protection through bargain often is not practically feasible. Particular kinds of conduct likely to be harmful to nonshareholders may be difficult to foresee and to specify contractually with adequate precision. This may result from informational advantages enjoyed by management, which has direct access to confidential strategic plans and has no incentive to disclose them voluntarily to employees or other nonshareholder constituencies. Workers may be totally unaware of plans to shut down a plant and shift production to another location, and may have been misled by statements or other behavior seemingly suggesting a long-term commitment to their welfare. Even if there is some sense that such shifts are always possible, even in the face of management indications to the contrary, employees are much less likely to bargain for protection than they would be if they knew of management's actual plans to close a plant or of a more general corporate policy to lay off workers whenever it is in the shareholders' interest to do so. In addition to informational disparities, our competitive market economy demands constant product innovation and technological change. Developments likely to benefit shareholders and harm nonshareholders may be unforeseeable to management and nonshareholders alike. Even complete candor on the part of management may leave nonshareholders in a position of significant vulnerability. While the general risk may be apparent, the precise parameters are unknowable. Nonshareholders must therefore bargain about such matters in the dark, or, more likely, simply disregard them because the risk cannot be valued. Even where future contingencies are foreseeable, the parties may choose not to bargain about them, believing that the remoteness of the risk does not justify the time needed to decide ex ante how the costs should be apportioned. They may also choose to leave particular matters unresolved because of the difficulties involved in assessing accurately the costs that various hypothetical scenarios are likely to generate. The parties may also recognize that their respective attitudes toward various future events may themselves change over time, devaluing the benefits of ex ante investments in bargained-for solutions. 199 Even with full knowledge of risks and preferences, individual nonshareholders may face serious problems in negotiating for protection because the terms of their relationship to the corporation often will not be subject to individualized bargaining. This is typically true of investors in corporate bonds, who must accept the terms already negotiated by an investment bank, as well as for lower-level employees, who typically must accept a standardized package of compensation and work assignment terms. Collective bargaining over compensation, working conditions, and the like is still possible in the unionized sector, but that sector is already very small relative to the workforce as a whole, and it continues to shrink. Absent a union, members of nonshareholder constituencies who share common interests and preferences would encounter difficulties in coordinating their bargaining efforts. Organization is costly, and might be met by management resistance. Free-rider problems are also likely when a particular contract term stands to benefit all members of the group regardless of their investment in the bargaining effort. Bargaining difficulties such as those sketched above make it significantly less likely that agreements that might otherwise be reachable will in fact occur. Under the current property rights regime, affected nonshareholders-who may be numerous-bear the costs -- which may be substantial -- of such failures. Communitarians are disturbed by such market failures, and believe they are common enough to warrant legal intervention. In their assessment of the prevalence and costs of market failure, communitarians differ from contractarians. Bargaining Power Scepticism toward contractarian assumptions about the technological feasibility of adequate self-protection through contract is an important aspect of the communitarian stance. There is a far more fundamental level of disagreement, however. What really separates communitarians from contractarians is the communitarians' refusal to accept the position that bargain, even if technologically feasible, should be sufficient to determine the extent of nonshareholder protection from the costs of shareholder wealth maximization. Simply put, protection adequate to satisfy minimal notions of justice may in some cases be too expensive for nonshareholders to afford. Communitarians reject the view that nonshareholders are entitled only to those protections they are capable of bargaining and paying for. The fundamental normative assumption underlying the contractarians' insistence on nonshareholder self-protection through contract is the familiar libertarian idea that consent should be the sole basis for obligation. Unless shareholders have consented to limit their wealth maximization efforts, they should be under no obligation to temper those pursuits for the sake of nonshareholder interests. Absent such consent, obligation becomes a matter of coercion. Coercion offends liberty, which is defined in terms of individual autonomy. Autonomy is valued because it implies opportunity to pursue individualized notions of selfrealization. A legal regime dedicated to freedom of contract (and to freedom from unconsented-to obligation) will best further this objective. And, if wealth is enhanced through unconstrained voluntary exchange, maximizing freedom of contract will also maximize social wealth. It is this libertarian premise that the corporate law communitarians reject. They reject it because, as a fact of life, freedom of contract is insufficient to provide all citizens with minimally adequate opportunities to define and pursue their own notions of self-realization. Because the corporate law contractarians offer nothing more than vaguely articulated libertarianism as the basis for their insistence on the primacy of contract in defining all intracorporate relationships, corporate law communitarians find the contractarians' normative agenda to be morally deficient, and quite obviously so. 200 The communitarians begin by pointing out that bargaining power is a function of wealth. If shareholders' obligation is defined solely by reference to consent, nonshareholders' ability to protect themselves from the costs of shareholder wealth maximization will depend entirely on their ability to bargain and pay for necessary protection. Suppose that nonshareholders had full knowledge of all the ways in which they are vulnerable to managerial pursuit of shareholder welfare, and also understood fully the likelihood of the various possibilities, the costs associated with each possible scenario, and their future attitudes toward those costs. Suppose also that the process by which nonshareholders bargained with management (acting as the shareholders' representatives) was cost-free. Even in such a world there would be untranscendable limits to the protections that nonshareholders could obtain through contract. These limits would be a function of nonshareholders' bargaining power. Their ability to extract particular promises from management would depend on their ability to pay for them, and that in turn would depend on their wealth and their assessment of the value of these promises in relation to other valued goods. Some highly valued contractual terms would simply be too expensive even to consider; others would require sacrifices resulting in unacceptable hardship. While libertarians might acknowledge that bargaining capability is a function of wealth, they nevertheless insist that coercive interference with individual autonomy is unjust. The corporate law communitarians respond by affirming the contractarians' ultimate concern with individual liberty. However, communitarians see liberty as involving a positive component, rather than merely as freedom from coercion. This positive vision of liberty recognizes that individual autonomy and dignity require satisfaction of basic human needs. Without adequate physical comforts, opportunities for intellectual, emotional, and moral growth, and stimulating and nourishing social interactions, individuals cannot hope to exercise effectively the freedom to define and pursue for themselves their own conceptions of a good life. For communitarians, all people are entitled to minimally adequate living conditions. If some are unable to provide themselves with whatever is necessary to achieve that standard, the larger community owes it to them to help. The libertarians' notion that people are entitled only to what they can bargain and pay for ignores the fact that people enter this world with widely differing packages of advantage and disadvantage. Many are born into family circumstances that assure far more than the minimal conditions needed for effective self-realization. For them, such conditions are readily available. For many others, however, accidents of birth mean that self-realization cannot simply be a matter of self-reliance. Only the truly exceptional can extricate themselves from the circumstances of material poverty and moral decay in which they find themselves at birth. And even these fortunate few cannot succeed without government-sponsored educational and social services programs and the voluntary kindnesses of relatives and strangers. In order for ideas like individual autonomy and freedom of choice to have real meaning, society must create environments that will allow all people to develop the capacities to be truly free. Leaving people solely to whatever they can achieve through private, bilateral transactions cannot possibly achieve this goal. In the context of corporate law and the problem of nonshareholder vulnerability, communitarians are concerned that even if self-protection through contract were more feasible than it often appears to be, the results of the bargaining process would leave nonshareholders with less protection than an acceptable understanding of basic human needs would indicate. For example, communitarians might argue that a combination of adequate compensation, healthful and pleasant working conditions, some amount of control over work, and job security are necessary for the achievement of self-realization in the workplace. Yet current market conditions may render these goods unattainable for many employees. The mere fact that no market failures stand in the way of such bargains would not suffice as an argument against legal intervention. Communitarians would recognize that bargaining power disparities are involved and would be eager to entertain arguments for law reform aimed at 201 addressing bargaining outcomes that are substantively unfair. The communitarians' refusal to embrace the market as a sufficient institutional means for achieving justice lies at the core of their disagreement with the contractarians. The Communitarian Normative Vision It is not enough simply to state that the market alone is inadequate to satisfy basic human needs for many people and that, accordingly, the larger community is obligated to pitch in. Something more needs to be said about the content of obligations that participants in corporate activity owe each other and what the justifications for those obligations are. Communitarians have met this challenge by proposing a positive vision of the corporation that differs fundamentally from the contractarians' model of a web of bilateral market transactions. This conceptualization has emerged gradually and inductively as scholars critical of mainstream assumptions about corporations and corporate law have undertaken a variety of particularized studies of various legal issues. It emphasizes the relations of mutual trust and interdependence, developing over time, that support expectations of stability and fair dealing. The relationships among nonshareholders and shareholders within the corporate enterprise differ from the arm's-length routine of the market. The normative content of these relationships -- which cannot be reduced to bare terms of actual contracts -- provides the basis for according legal recognition to nonshareholder protection from the costs of shareholder wealth maximization. Professor Joseph Singer's pathbreaking article on plant closings eloquently articulated a communitarian perspective on the problem of nonshareholder vulnerability. Nonshareholders often find themselves involved with shareholders in longstanding relationships that have given rise to dependence and vulnerability to opportunistic exploitation. Singer argues that reliance by employees on such relationships should provide the basis for legal protection from the heavy costs of plant closings. (Singer's argument also refers to other nonshareholder constituencies, but it is concerned mostly with employees and appears to apply most strongly to their situation.) Employees, as participants in a common enterprise involving shareholders, managers, and others, reasonably rely on expectations that business will continue to be conducted in a manner that accords due regard to nonshareholder as well as shareholder interests. These expectations for the future are grounded on a history of cooperative endeavor, mutual regard, and common purpose; obligations "emerge over time out of relationships of interdependence." Abrupt decisions to terminate employment and deny other expected benefits, solely for the good of shareholders and without compensation, should not be permitted. The duty of fair dealing that Singer seeks to construct is not a matter of bargained-for contractual rights. Rather, it is based on a "social relations" conception of property rights, which accords moral or ethical significance to the content of actual relationships. The normative vision thus rests on a positive, empirically observable conception of the real-life relations among corporate actors. The content of these relationships is much richer and therefore more meaningful than attention to the terms of real or imagined contracts would indicate. For example, while a typical employment contract may include an express or implied at-will limitation, a history of more or less consistent employee retention (perhaps coupled with non-contractual suggestions of job security) may generate reasonable -- and therefore legitimate -- expectations of long-term employment. The case may be strengthened by firm- or location-specific capital investments by employees (such as acquisition of specialized knowledge or skills or financial or other commitments to a particular community) coupled with productivity benefits enjoyed by shareholders resulting from employee loyalty and a stable workforce. Accordingly, Singer's argument for legal recognition of a reliancebased interest in job security seeks to ground worker protection in rules of positive law that 202 would exist independently of -- and perhaps even in derogation of -- rights specified contractually. Communitarians thus reject the view that contract alone can create obligation and property rights. That perspective leaves nonshareholders unduly vulnerable to harm at the hands of shareholders. Communitarians also reject a model of the corporation that sees the firm as a market in which autonomous individuals come together only to pursue self-interest through the medium of fully specified contracts. Communitarians instead see the corporation as a community of interdependence, mutual trust, and reciprocal benefit. This different, more realistic understanding of the character or quality of relationships among participants in corporate activity informs communitarian thinking about the obligations that participants in corporate activity owe each other. In particular, this understanding provides the conceptual basis for according protection to nonshareholders from the costs of shareholder wealth maximization, and defines the parameters of such protection. As such, the communitarian perspective on what corporations are provides the foundation for communitarian proposals about how corporate law ought to be reformed. COMMUNITARIAN LAW REFORM For the reasons just discussed, communitarians find serious flaws in the contractarian premise that self-protection through contract sufficiently addresses the problem of nonshareholder vulnerability. While communitarians may acknowledge the benefits that can flow from a market-based approach to social regulation, they insist that there are limits to the normative sufficiency of that model. As to some problems, additional legal structures must reinforce and supplement whatever gains people can achieve through contract. Accordingly, communitarians have been exploring corporate law reforms that would yield protections for nonshareholders regardless of their ability to obtain them through contract. The Multifiduciary Model To date, communitarian corporate law scholarship concerned with nonshareholder vulnerability has focused on redefining the duties of the board of directors. The general thrust of this work has been to expand corporate law's understanding of the legitimate beneficiaries of managerial decisionmaking. Traditionally, in keeping with the shareholder primacy principle, the board's fiduciary obligation has run to "the corporation and its shareholders," which has meant in practice a duty to maximize shareholder wealth. Critics concerned about the potentially harmful impact of this mandate on nonshareholders have sought to inject nonshareholder considerations into corporate management's decisional calculus. Several communitarian scholars have begun to develop new models for specification of the board's responsibilities, taking their cue from the new "directors' duty" (or "nonshareholder constituency") statutes passed by approximately 30 states so far. These statutes take varying forms, but they share a common agenda. Each declares that the board of directors, in the course of making corporate decisions, may (or, in one case, must) consider various enumerated nonshareholder interests. For example, Indiana's statute, which is typical, provides that: A director may, in considering the best interests of a corporation, consider the effects of any action on shareholders, employees, suppliers, and customers of the corporation, and communities in which offices or other facilities of the corporation are located, and any other factors the director considers pertinent.' Some of these statutes limit concern for nonshareholders to management actions in defending against hostile takeovers, but most apply generally to corporate decisionmaking. No one yet 203 knows how state courts will interpret these statutes or how corporate boards will respond to their mandate. On their face, the statutes seem to herald a potentially radical departure from the traditional shareholder primacy principle, but the statutes' vagueness allows room for a range of interpretive possibility. Professor Lawrence Mitchell has argued for a reading that would require shareholders to internalize the costs that managerial pursuit of corporate profit maximization imposes on nonshareholder constituencies. Shareholder primacy remains the basic norm of corporate law, but the board assumes "a duty to act reasonably to avoid injury to nonshareholder constituent groups in the process of corporate decision making." Mitchell rejects the view that nonshareholders should protect themselves from harm through contract. "[T]he law abdicates its function as a socializing tool when it leaves the redressing of individual and societal wrongs to the forces of competition .... The suggestion ... that directors consider the interests of all corporate constituents ... recognizes both the interdependence of corporate actors and the desirability of treating participants in a common enterprise as if they share common goals, rather than placing them in selfish competition with one another." I too have suggested an interpretation of the directors' duty statutes that is not based on contractarian premises. My suggestion reads the statutes as mandating three broad (and admittedly somewhat vague) principles. Management should not seek or allow short-term shareholder gains (such as takeover premiums) if doing so would frustrate legitimate nonshareholder expectations. Instead, management should pursue profit-seeking strategies that harmonize shareholder and nonshareholder interests where possible. Where conflict between these interests is unavoidable (as in the case of a money-losing plant, for example), management should adopt solutions that fully compensate nonshareholders for their losses. This analysis, like Mitchell's, acknowledges that redefining directors' duties in this mariner provides nonshareholders with rights they have not (and perhaps could not have) bargained for. Nevertheless, this and other communitarian readings of the new directors' duty statutes seek to find in them protection for nonshareholder constituencies vulnerable to losses resulting from managerial pursuit of shareholder wealth maximization. The conceptual basis for these reform proposals is the vision of intracorporate relationships sketched above. Proposals to redefine management's duty so as to embrace regard for nonshareholder as well as shareholder interests have been dubbed "multifiduciary." The suggestion is that management is now to serve as fiduciary to several beneficiaries rather than simply to shareholders, as under the traditional shareholder primacy regime. Some communitarian proposals do speak in fiduciary terms, though others (such as mine and Mitchell's) do not attempt to cast management as trustee for all groups (shareholder as well as nonshareholder) involved in or affected by corporate activity. The characterization issue is unimportant insofar as the objective is concerned. What unites these various communitarian approaches to the problem of nonshareholder vulnerability is the basic conviction that corporate law can do more than simply provide a framework within which the various participants in the corporate enterprise define their respective rights and duties through bargain. Corporate law can also protect people from harm regardless of bargain. The multifiduciary label conveniently captures the idea that nonshareholders as well as shareholders ought to be the beneficiaries of managerial decisionmaking.... 204 Blair, M and Stout, L, "A Team Production Theory of Corporate Law", (1999) 85 Virginia Law Review 247 at 257-287 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. I. ECONOMIC THEORIES OF THE CORPORATION One of the central questions in economic theory is: Why do firms exist? In other words, why organize work through hierarchical governance structures rather than through a series of market transactions? In the wake of Ronald Coase's seminal piece on the nature of the firm, the literature on this question has developed along three main paths, each of which focuses on a different aspect of organizing productive activities. The first path explores contracting problems that arise when one actor hires another to act on her behalf (the principal-agent problem). The second path examines problems associated with coordinating productive activities where it is too costly to write and enforce complete contracts, focusing especially on the role played by property rights as a solution for closing contractual gaps (the property rights approach). The third path considers the role hierarchy may play in policing against shirking problems that may arise in coordinating team production (the team production approach). The existing law and economics literature heavily emphasizes the first two tracks, and indeed these ways of thinking about organizing production have provided valuable insights into the internal workings of firms. We believe, however, that when applied to public corporations, the principal-agent and property rights approaches are incomplete in critical ways. Thus the hitherto neglected team production approach can shed much needed light on both the fundamental economic nature of modern public corporations and the governance problems likely to arise in them. In particular, we outline how a theory of the public corporation as a solution to team production problems can explain key aspects of corporate law that scholars who favor the principal-agent and property rights approaches have found troubling. Before doing so, however, we briefly outline the prevailing principal-agent and property rights theories and demonstrate how these theories have contributed to the rise of a model of the corporation we call the "grand-design principal-agent" model. A. Conventional Economic Analyses of the Firm 1. Principal-Agent Analysis Principal-agent analysis deals with bilateral relationships of a particular kind: Typically, a "principal" who wants to accomplish some project she cannot do by herself hires an "agent" to do that project on her behalf. Agency relationships of this sort can pose efficiency problems if the principal cannot monitor the agent easily or well (as when the principal cannot accurately judge the quality of the agent's work) or when there is a significant component of chance in the link between what the agent does and how well the project turns out. The problem, then, is how the principal can write a contract that motivates the agent to do his best to accomplish the principal's goals. 205 Although principal-agent analysis has been very useful in analyzing certain kinds of contractual relationships, it ignores several problems we think are often important to production within corporations. Principal-agent analysis generally assumes that the problem of interest is getting the agent to do what the principal wants. But the mathematical models used to study this problem typically do not address the opposite possibility -- that the agent might have trouble getting the principal to perform her end of the deal. Nor do they address situations in which part of the agent's job is to figure out what needs to be done (a situation we suspect is the norm rather than the exception in most public corporations). A related point is that the principal-agent model assumes that it is clear who the principal is, and who the agent is in the particular relationship or transaction under study. Yet many of the most important relationships inside corporations may be more ambiguous, in the sense that both parties may be contributing productive inputs and neither may have authority over the other. In fact, as we argue below, this fundamental ambiguity underlies the basic structure of corporate law and provides the foundation for a more useful theory of public corporations. 2. Property Rights Analysis A second interesting organizational problem arises when parties deal with each other over the course of a long-term productive relationship. Writing "complete" contracts that explicitly provide for all contingencies can often be costly or even impossible. Hence, economic and legal theorists have shifted their attention in recent years to the study of "incomplete" contracts, and particularly to how parties in a working relationship can fill in the gaps in their understandings about who does what and who gets what in the course of a long-term productive relationship. One mechanism that has been identified is assigning property rights to one of the parties to the contract that give that party a residual right of control over the assets used in the joint enterprise. Building on this idea, some economists define the firm as a bundle of assets under common ownership (and therefore, common control). When applied to public corporations, this way of thinking about firms sets up a sharp dichotomy between the "owners" of a firm -- generally presumed to be the shareholders -- and all other input providers, who are "hired." In this view, the degree of control and the share of joint output granted to contributors of hired inputs is understood to be clearly delineated ex ante by explicit contracts, while the "owner" is understood to retain all residual rights of control and to receive all the residual output after contractual obligations have been met. The property rights view of the firm provides a powerful insight and may be a reasonable description of the way many proprietorships, partnerships, and closely held firms are organized. But it is not a theory of corporations: Corporate law is clearly not needed to achieve common ownership of assets. More importantly, the property rights view seriously misstates the nature of shareholders' interest in public corporations. If "control" is the economically important feature of "ownership," then to build a theory of corporations on the premise that ownership (and, hence, control) lies with shareholders grossly mischaracterizes the legal realities of most public corporations. Viewing the firm as a bundle of assets owned by shareholders also seems odd once we recognize that one of the key assets a corporation uses in production is "intellectual capital" -- that is, the knowledge and experience residing in the minds of its employees, rather than the hands of its shareholders. 3. Combining the Principal-Agent and Property Rights Approaches: A Theory of Hierarchy (But Not of Public Corporations) In introducing the principal-agent and property rights approaches to the theory of the firm, we have tried to suggest some concerns that caution against relying upon them as foundations for a theory of public corporations. Nevertheless, these models have been used, sometimes explicitly and sometimes implicitly, to bolster a conventional view of the corporation.... 206 In this view, there exists in every firm some principal who is the ultimate "owner" of the bundle of assets used by the firm in production. The owner is understood to delegate residual control rights to her agents (in the corporate context, the board of directors) who in turn are charged with managing the assets in the principal's interest, perhaps through several more layers of delegation. All the relationships of interest in the production process are vertical, however. Individuals at the upper levels of the hierarchy may delegate control over some assets to individuals below, but all ultimately work for (are "agents" of) the principal at the top. Thus the principal is understood to be the owner of the firm, as well as the residual claimant who receives all profits -- that is, economic rents -- left over after her contractual obligations to all the agents below her have been met. In the rest of this Article, we refer to this conventional model of the firm as the "grand-design principal-agent model." With one small modification -- substituting a body of shareholders for a single owner at the top -- this model has been the basis for most theoretical discussions about public corporations in recent years. And because the shareholder/owners at the top of the pyramid have been understood to be the residual claimants to all profits left over after all the corporations' contractual obligations have been met, the model has been used to argue that directors should run the firm for the sole purpose of maximizing the shareholders' interests. It should be noted that the grand-design principal-agent model incorporates a form of hierarchy. Economic theorists have only begun to study the many functions of hierarchy in detail, but much of what has been done generally supports the principal-agent interpretation of hierarchy's role. Thus hierarchy has been described as benefitting the principal at the top of the pyramid, for example by providing a mechanism by which information can be gathered by large numbers of people in the lower ranks of the hierarchy, aggregated and summarized and passed upward to those individuals at the higher levels who can best understand the big picture and make optimal decisions. Similarly, in the corporate context, shareholder delegation of decisionmaking authority to the board of directors has been defended as in the shareholders' best interests on the grounds that it allows for more efficient processing of information and decisionmaking. We agree that hierarchy in corporations can play an important role in gathering and processing information and in ensuring expert decisionmaking (although we believe that hierarchy can serve another critical function as well, which we discuss shortly). We are sceptical, however, about the emphasis in previous work on how hierarchy benefits the principal at the top of the hierarchical pyramid. We believe this emphasis misses the mark in describing what a public corporation is and why production is organized in corporations. The heart of the matter may lie in recognizing that some productive activities depend at least as much upon horizontal relationships as vertical ones. Put differently, some kinds of outcomes can only be achieved through joint effort -- sometimes the joint effort of large numbers of people. If the activities and inputs of those participants are adequately coordinated, their collective output can be qualitatively different and vastly larger than the sum of what each individual could produce separately. Yet, transaction costs and other market imperfections often make it impossible to achieve the required coordination through impersonal individual exchanges in markets or even through a set of explicit contracts. Our break with previous work is to stress the importance of the coordination that happens not from the top down, but in the lateral interaction among team members. Hierarchical governance may still be needed in this context, but the role such governance serves is to mediate horizontal disputes among team members that may arise along the way. Thus when theorists simply substitute a body of undifferentiated shareholders for the single owner at the top of the grand-design principal-agent model, they gloss over some of the most interesting and vexing problems of organizing team production. Closer analysis of corporate law reveals that it accomplishes something much richer and more interesting than merely chopping up the 207 role of the principal at the top of the pyramid into smaller pieces. In particular, the law of public corporations appears to actually eliminate the role of the principal, imposing in its place an internal governance structure -- the mediating hierarchy -- designed to respond to problems of horizontal coordination inherent in certain forms of team production. B. Team Production Analysis of the Firm .... 2. Reexamining the Team Production Problem: What are the Sources of Surplus? To understand our argument, it is necessary to return to Coase and Oliver Williamson and to reexamine their reasons for stressing the hierarchical nature of firms. The essence of team production is that the whole can be made bigger than the sum of the parts. But how does that happen? Both the grand-design principal-agent model examined earlier and the Alchian and Demsetz monitor-employee model focus on the gains to be had from vertical coordination between a principal/monitor and her agents/employees. We believe that such vertical coordination can be an important source of gains, but we are inclined to believe that the horizontal interactions among team members are also quite important. With very few exceptions, however, economists who have modeled horizontal interactions among team members have focused on destructive pathologies in these interactions, such as collusive side agreements among team members seeking to cheat a principal. Thus horizontal interactions among team members generally have been viewed as things that need to be constrained (e.g., by the "grand design" contract) in order to keep the members of the organization focused on the principal's goals. Yet in many instances, it seems likely that horizontal interactions among team members may be the most important reason that teams are able to produce more than the sum of their individual inputs. In these horizontal relationships, there is no clear "principal" and no clear "agent." Stout and Blair, for example, are jointly writing this Article. Neither of us is the "agent" to the other's "principal." Instead, we collaborate because we believe there are gains to both of us from collaboration, and we work out the details between us about who is responsible for what and who gets what out of the deal. We know vastly more about how to do what we are trying to do, and which of us is better situated to do which parts of the work, than any supervisor could know. We suspect that a great deal of economic production actually operates this way. To observe that horizontal interactions in teams are probably an important source of economic gains is not to deny that there can also be destructive forms of horizontal interaction, especially wasteful rent-seeking behavior among the team members. To theorists who rely on a principal-agent model of the firm, however, the problems of collusion, side agreements, and rent-seeking are viewed primarily in terms of the harm they do to the principal. And they have been treated almost exclusively as problems to be solved by the principal through the clever design of incentives in a grand contract. There is another way to think about the problem, however. Because shirking and rent-seeking can erode or even destroy the gains that can be had from team production, it is also in the collective interest of the team members to minimize such behavior if the terms of the relationship among the team members call for them to share in any rents. How can the team members save themselves from their own opportunistic instincts? We believe that when the potential for shirking and rent-seeking is especially pronounced, team members as a group might prefer to relinquish control over both the team's assets and output to a third party -- a 208 "mediating hierarch" -- whose primary function is to exercise that control in a fashion that maximizes the joint welfare of the team as a whole. 3. The Mediating Hierarchy as a Solution to Certain Team Production Problems In making this argument, we rely heavily on insights developed in a recent paper by Raghuram Rajan and Luigi Zingales. In that paper, the authors modeled the team production problem that confronts two people, A and B, who want to pursue a joint enterprise. In formulating the problem, however, Rajan and Zingales modified the team production analysis in a subtle but critical fashion. Specifically, they assumed that team production requires each member of the team to make an irrevocable commitment of resources to the joint enterprise. As an economist might put it, each must make a "firm-specific" investment. Thus, for example, if A and B are researchers trying to develop a new pharmaceutical, each may have to invest time and skill that will be wasted if the venture fails. When team production requires more than one party to make such a firm-specific investment, and when it is difficult to specify in advance the precise terms of each person's role in the enterprise, A and B face a dilemma. They must each make an irrevocable investment of resources if they want to maximize their potential for profit. Yet once they have done so, A and B will each find themselves at the other's mercy. Each party's specialized investment has little or no value outside the joint enterprise; neither can walk away from the venture and realize the value of the investment by selling it elsewhere. As a result, A and B have no choice but to deal with each other when deciding how to divide any profits they realize if the venture is successful. How can they make that joint decision? If only one party is given control over the division of profits, the other will be reluctant to invest. Thus, for example, if A is given control over the joint enterprise and its assets, A can use that power to keep for herself all the rents over and above the minimum amount she must pay to keep B involved in the venture (generally, B's opportunity cost in a competitive market). Thus B will have reason to fear that he will not enjoy any of the economic surpluses that flow from his firm-specific investment. As a result, the party without control rights will be discouraged from making necessary firm-specific investments. If A and B agree to share decisionmaking authority, they run the risk that all their rents will be dissipated in ex post haggling. And if they agree in advance to a sharing rule, then they will both have incentives to shirk. Scholars who adopt a property rights analysis have argued that, if both parties' investments are difficult to monitor and measure and to reduce to explicit contracts, the best solution is to allocate control rights over the joint venture ("ownership") to the party whose specialized investment is most critical to the success of the enterprise. (Indeed, it can be argued that exactly this solution is implicit in most closely held corporations, where share ownership and managerial control both tend to be concentrated in the hands of a small group of individuals whose contributions are critical to the venture's success.) Thus, if A's contribution to the research effort is more vital than B's, the best we can do is to protect and encourage A's investment by making A the "owner" of the enterprise. B will then be left to negotiate the best contract he can, but since his contribution, too, is complex and difficult to reduce to contract, B will probably invest suboptimally since he cannot get full contractual protection for his firm-specific investments. Rajan and Zingales note, however, that assigning ownership to A not only does not ensure optimal investment by B -- it also may not ensure optimal investment by A. In particular, even if A has control rights, A might not have sufficient incentive to make the specialized investment if, instead, she can capture a significant share of the rents from the enterprise simply by selling her stake to someone else who might want to run the firm. Thus, if A is given ownership of the pharmaceutical research venture, she might decide to profit from B's 209 irrevocable investment not by adding her own efforts, but by threatening to sell the entire venture to C. This analysis suggests that a property rights solution to certain team production problems suffers from a serious shortcoming. Although property rights can protect at least one team member's specialized investment, they can also empower that "owner" to capture rents by exploiting the other member's specialized investments without bothering to make such investments herself. As an alternative solution, Rajan and Zingales suggest that both team members might improve their welfare by agreeing to give up control rights to a third party, an "outsider" to the actual productive activity. This outsider makes no firm-specific investment herself. She is, however, given control over the team's assets, as well as the right to allocate output among team members and to fire individual team members or even break up the team. In return, the outsider is rewarded with a nominal share of the team's output. As a result, the outsider has an incentive to choose an efficient and productive team (that is, the team whose members all make the necessary firm-specific investments). Meanwhile, team members also feel they can now safely invest. This idea is intriguing for several reasons. First, unlike Alchian and Demsetz's theory, it emphasizes that individuals will only want to be part of a team if by doing so they can share in the economic surplus generated by team production. Second, it recognizes that team members intuitively understand that it will be difficult to convince others to invest firmspecific resources in team production if shirking and rent-seeking go uncontrolled. Thus, they realize that it is in their own self-interest to create a higher authority -- a hierarch -- that can limit shirking and deter rent-seeking behavior among team members. In other words, team members submit to hierarchy not for the hierarch's benefit, but for their own. Let us explore how this idea might apply to corporations. The Alchian and Demsetz explanation for the emergence of hierarchy assumed away any productive advantages from horizontal interactions among specialized team members. Thus their solution gave all the rents to the monitor, leaving employees with no stake in the enterprise and no firm-specific investment. Similarly, the grand-design principal-agent model assumes that a firm is formed when a single entrepreneur willing to make a specialized investment (perhaps by contributing a unique idea or machine) wants to expand production beyond what she can produce by herself. The entrepreneur hires others to carry out her orders, but remains in control of the firm-specific investment that is the source of the surplus in the planned production. Yet if all the potential value of an enterprise truly emanated from the firm-specific investment of a single individual, why would that individual need to form a public corporation to hire workers and expand production? Presumably, she could use simple employment contracts or adopt an alternative business form such as a limited partnership or closely held company. This fact suggests that the typical public corporation may reflect a quite different -- and we believe quite common -- scenario. In reality, the public corporation is not so much a "nexus of contracts" (explicit or implicit) as a "nexus of firm-specific investments," in which several different groups contribute unique and essential resources to the corporate enterprise, and who each find it difficult to protect their contribution through explicit contracts. In this scenario, a number of individuals come together to undertake a team production project that requires all to make some form of enterprise-specific investment. Perhaps one individual brings critical technical skills to the table, while another has a talent for management, and a third provides marketing insights. They may lack financial capital, however, so they seek out wealthy friends or family members to put up initial funding. Thus, a team is born. Undertaking team production, however, requires each of the members to make irrevocable investments that leave them vulnerable to opportunistic exploitation by other team members. The marketing specialist, for example, must develop specialized knowledge and personal contacts (firm-specific human capital) whose value is vulnerable to actions and 210 decisions of the team as a whole-likewise for the technical specialist. And while the cash contributions of financial investors may initially be generic and fungible, once those funds have been used to purchase specialized assets or to pay wages, they effectively become sunk in the firm. Despite their mutual vulnerabilities, the team members expect for the most part to be able to get along with each other and figure out how to allocate tasks and divide up rewards as they go. When disputes arise, however, they want a decisionmaking procedure in place that all believe will be fair. The solution? They form a public corporation. C. The Public Corporation as a Mediating Hierarchy Let us see how forming a public corporation can be understood as creating a mediating hierarchy. When a productive team incorporates, one of the first tasks the law demands of the team is to select a board of directors to be given authority to make decisions for the corporation. This board may include several team members or their representatives, but it may also include (and in public corporations almost invariably does) several outsiders. The board enjoys ultimate decisionmaking authority to select future corporate officers and directors, to determine the use of corporate assets, and to serve as an internal "court of appeals" to resolve disputes that may arise among the team members. The net result is that, by forming a corporation, the original team members all agree to give up control rights over the output from the enterprise and over their firm-specific inputs. Providers of financial capital -- shareholders and even, potentially, some creditors -- are, by this agreement, just as "stuck" in the firm as are providers of specialized human capital. The act of forming a corporation thus means that no one team member is a "principal" who enjoys a right of control over the team. To the contrary, once they have formed a corporation and selected a board, the team members have created a new and separate entity that takes on a life of its own and could, potentially, act against their interests, leading them to lose what they have invested in the enterprise. Knowing that incorporating means losing influence over the corporation's future and over the division of the rents the corporation generates, why would any of the team members do this? The answer is that team members understand they would be far less likely to elicit the full cooperation and firm-specific investment of other members if they did not give up control rights. Thus, ex ante, they judge their chances of capturing some of the significant rents that can flow from team production to be greater if they give up control to a decisionmaking hierarchy, than if they attempted to write detailed contracts with the other participants. This analysis suggests that hierarchy can perform a third function in addition to the two economists have identified (streamlining information-gathering and decisionmaking, and controlling shirking through the cascade of sequential principal-agent contracts). This third function is encouraging firm-specific investment in team production by mediating disputes among team members about the allocation of duties and rewards. Our argument suggests that it is misleading to view a public corporation as merely a bundle of assets under common ownership. Rather, a public corporation is a team of people who enter into a complex agreement to work together for their mutual gain. Participants -- including shareholders, employees, and perhaps other stakeholders such as creditors or the local community -- enter into a "pactum subjectionis" under which they yield control over outputs and key inputs (time, intellectual skills, or financial capital) to the hierarchy. They enter into this mutual agreement in an effort to reduce wasteful shirking and rent-seeking by relegating to the internal hierarchy the right to determine the division of duties and resources in the joint enterprise. They thus agree not to specific terms or outcomes (as in a traditional "contract"), but to participation in a process of internal goal setting and dispute resolution. Hence the 211 mediating hierarchy of a corporation can be viewed as a substitute for explicit contracting that is especially useful in situations where team production requires several different team members to make various kinds of enterprise-specific investments in projects that are complex, ongoing, and unpredictable. The net result is a corporation whose structure looks much more like Figure 2 [figure not reproduced] than the grand-design principal-agent structure... Within the firm, there are several layers of hierarchy, and in each layer the relevant hierarch (the "boss") has authority to resolve disputes among members at lower levels. The peak of the pyramid is occupied not by some owner/principal, but by a board of directors whose job includes serving as the final arbiter in disputes that cannot be resolved at lower levels. At any point in time, members at lower levels who are unhappy about a boss's decision -- whether the board's or some lower manager's -- can choose to leave the firm. If they leave, however, they lose the value of their firm-specific investments and can no longer share in the residual rents generated by the enterprise. Similarly, if the hierarchy so decides, dissenting team members can be forced out of the coalition and cut off from sharing in future rents. Thus if they choose to stay, team members must abide by the decisions of the hierarchy about the division of duties and rewards. When the mediating function is added to the story of what hierarchy accomplishes, it is no longer obvious that employees should be viewed as agents of the hierarchs to whom they report, as the grand-design principal-agent model suggests. Instead, it can be argued that hierarchs work for team members (including employees) who "hire" them to control shirking and rent-seeking among team members. This is true at each level in the organization, from first level managers up to the board. Thus, the primary job of the board of directors of a public corporation is not to act as agents who ruthlessly pursue shareholders' interests at the expense of employees, creditors, or other team members. Rather, the directors are trustees for the corporation itself -- mediating hierarchs whose job is to balance team members' competing interests in a fashion that keeps everyone happy enough that the productive coalition stays together. Before we explore the implications of this view for corporate law further, it is important to note that the mediating hierarchy model is subject to several important caveats. First, the model applies primarily to public -- not private -- corporations. As we demonstrate in Part II, directors of public corporations with widely dispersed share ownership are remarkably free from the direct control of any of the groups that make up the corporate "team," including shareholders, executives, and employees. Although directors have incentives to accommodate the interests of all these groups, they are under the command of none. In contrast, in a closely held firm, stock ownership is usually concentrated in the hands of a small number of investors who not only select and exercise tight control over the board, but also are themselves involved in managing the firm as officers and directors. Thus the typical private corporation adheres more closely to the grand-design principal-agent model of the firm than to the mediating hierarchy model. This in turn suggests that the choice to "go public" may be driven in part by team production considerations. For example, when a single individual or small group of individuals conceives, creates, operates, and contributes much of the initial capital necessary to start a business, they will likely prefer to keep their firm closely held. In time, however, the individual or group may seek a relationship with another group willing to invest substantial firm-specific resources (say, outside investors to contribute equity capital, or outside professional managers to take on the burdens of day-to-day administration of the firm). At this point, the original entrepreneurs may conclude that it is in their best interest to opt into the mediating hierarchy model by going public. In other words, rational entrepreneurs prefer doing business as a private firm when team production inefficiencies are less of a problem, either because one individual's or group's firm-specific investment is more critical to the enterprise's success than any other's, or because there are relatively few obstacles to explicit contracting over the division of any surplus. 212 Second, it is important to recognize that, by suggesting that directors serve at the top of the pyramid of authority that comprises the public corporation, the mediating hierarchy model does not imply that directors actually manage the corporation on a day-to-day basis. To the contrary, we expect that most corporate decisions are made collegially among team members at lower levels. Indeed, the existence of a mediating hierarchy may heighten incentives for team members to work out conflicts among themselves because the alternative is kicking the problem upstairs to a disinterested -- but potentially erratic or ill-informed -- hierarch. Thus an independent board of directors may be able to encourage shareholders, executives, and employees to invest in corporate production not because these team members expect the board to determine which group gets what portion of the resulting economic surplus, but because the possibility that the board could make that allocation discourages the more egregious forms of shirking and rent-seeking among team members. Only rarely is it necessary for directors to fire an executive officer for paying herself an immense salary while corporate profits are declining. In most cases such blatant opportunism will be discouraged by the executive's knowledge that the board could fire her. Third, the mediating hierarchy model does not imply that all the individuals and groups that make firm-specific investment in a public corporation will receive equal, or fair, shares of the surplus generated from team production. It is important that each team member whose firmspecific investment is essential to the corporate enterprise receive at least some portion of the economic surplus; otherwise, any member excluded from the surplus could do just as well by exiting the coalition and investing his resources elsewhere. However, so long as each member of the coalition receives even a modest premium over his opportunity cost, he has incentive to remain in the team. Thus -- and especially when the rewards from team production are very large -- there can be significant disparities in the share each team member receives without threatening the team's existence. These disparities, moreover, may be driven more by political power than by economic factors. Fourth, by suggesting that corporate directors serve as disinterested trustees charged with protecting the interests of all the members of the corporate coalition, the mediating hierarchy model does not require directors to be unselfish altruists. Directors are compensated, often quite handsomely, for their services to the coalition. This gives them an incentive to try to maintain their positions by satisfying the minimum demands of all of the important corporate constituencies, lest some critical constituents withdraw and the coalition fall apart. (After all, if the team falls apart, the directors lose their jobs.) Although this is not a tight constraint, it discourages extreme abuses, and later we discuss in greater detail other influences that may also help to keep directors faithful. More importantly, discouraging extreme abuses may be enough. In arguing that a mediating hierarchy can be an efficient response to problems of contracting over team production, we do not intend to suggest that it is a perfect solution. Most obviously, placing ultimate control of a business enterprise in the hands of a board of directors whose members have little or no direct stake in the firm exacerbates principal-agent problems. Nevertheless, team members who adopt a mediating hierarchy may in some cases gain more from constraining shirking and rent-seeking than they lose to agency costs. For example, suppose a lazy or careless board of directors wastes fifty percent or more of the economic rents that flow from team production. Team members might still regard themselves as better off in a public corporation managed by a board of directors than they would be under an alternative system (such as a closely held firm controlled by one of the team members) if the alternative so discouraged firm-specific investment by other team members that virtually all of the benefits of joint production were lost. In other words, if the likely economic losses to a productive team from unconstrained shirking and rent-seeking are great enough to outweigh the likely economic losses from turning over decisionmaking power to a less-than-perfectly-faithful hierarch, mediating hierarchy becomes an efficient second-best solution to problems of team production. 213 This sort of second-best solution, moreover, is surprisingly common. Corporate boards of directors are only one of many institutions in our society that rely upon some form of disinterested hierarch to resolve disputes between parties for whom resolution through explicit contracting is too costly. Other examples include the referee in a football game; the trustee who administers a trust for multiple, competing beneficiaries; and the judge who renders a decision in litigation between parties. This observation raises a final question about applying the mediating hierarchy model to public corporations -- namely, why should we put the board of directors (instead of, say, a judge) at the top of the hierarchical corporate pyramid? The mediating hierarchy model of the public corporation necessarily implies that authority for making some allocative decisions -- those that take place "within" the firm -- ultimately rests with the board of directors, whose decisions cannot be overturned by appealing to some outside authority, like a court. This claim should not be read too broadly. When members of the hierarchy behave in ways that threaten the hierarchy itself (as when corporate directors violate their duty of loyalty to the firm through self-dealing), courts will intervene. Similarly, courts generally enforce explicit contracts among team members allocating rights and duties (such as contracts with creditors or employees) and external laws that set minimum terms or ground rules for transactions within firms (such as minimum wage laws). Courts will not normally intervene, however, to settle an internal dispute over transfer prices between two units or subsidiaries of the same corporation, or between two individuals in a firm over work assignments, promotions, or division of a bonus pool. As Williamson has put it, "the implicit contract law of internal organization is that of forbearance." This forbearance reflects the fact that in many situations where team members find explicit contracting too costly, there are a variety of reasons to prefer mediation that stops at the level of the board. Internal mediation has great advantages over courts and other external dispute resolution mechanisms, particularly in situations that involve repeated interactions among the contending parties and between the contending parties and the mediator. For example, internal decisions are made by people who know more about the special circumstances of any dispute, and who generally have a stake in seeing that the resolution truly settles the dispute and reduces the tensions created by the dispute. Internal decisionmaking processes and decisions can be less formal, more flexible, and better able to deal with subtleties. Whereas court decisions tend to be zero-sum, internal decisionmakers can use tradeoffs that avoid or side-step zero-sum games ("I can't give you the raise this month, but I'll go ahead and give you the larger office now, and in the next fiscal year, I can probably give you the raise."). Or they can pressure team members to work it out among themselves, under the threat that either or both could be "fired" (or reassigned or otherwise punished) if they fail to work it out. The mediating hierarchy model consequently suggests that the public corporation can be viewed most usefully not as a nexus of implicit and explicit contracts, but as a nexus of firmspecific investments made by many and varied individuals who give up control over those resources to a decisionmaking process in hopes of sharing in the benefits that can flow from team production. We realize that this approach may seem odd -- even counterintuitive -- to corporate theorists accustomed to thinking of corporations in terms of a grand-design principal-agent model where shareholders are the principals and directors are their agents. Nevertheless, our claim that directors should be viewed as disinterested trustees charged with faithfully representing the interests not just of shareholders, but of all team members, is consistent with the way that many directors have historically described their own roles. Our claim also resonates with the views of legal scholars who argue that directors should view their jobs in these terms. Most importantly, our model of corporations is consistent with the law itself. Thus we argue in the rest of this Article that public corporation law can be best explained in terms of the mediating hierarchy model. 214 Millon, D, "New Game Plan or Business as Usual? A Critique of the Team Production Model of Corporate Law" (2000) 86 Virginia Law Review 1001 at 1001-1004 and 1024-1042 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. In an important article published last year in the Virginia Law Review, Margaret Blair and Lynn Stout present a new economic theory of the corporation and of corporate law. This is the team production model ("TPM"). Their analysis is important because it effectively challenges the currently dominant analytical approach to corporate law, which is the principal-agent model of the relationship between the corporation's shareholders and its management. According to the principal-agent model, management's duty is to maximize the wealth of the shareholders, who are the owners of the corporation. The task of corporate law is to promote that goal. This understanding of corporate law has come to be known as the "shareholder primacy" model. It stands in stark contrast to competing normative theories that reject shareholder primacy in favor of the idea that management owes duties to all the corporation's various stakeholders or of broader notions of corporate social responsibility. These rival theories, though they have found favor with state legislators and a few judges, have made only limited headway in the legal academy, where shareholder primacy and its narrow vision of corporate management's obligations continue to predominate. Blair and Stout now introduce a sophisticated economic argument for rejection of shareholder primacy and -- at least by implication -- for a more spacious understanding of the board's role. Conceiving of the various participants in the corporation as a team, TPM describes the directors as independent "mediating hierarchs whose job is to balance team members' competing interests in a fashion that keeps everyone happy enough that the productive coalition stays together." Because Blair and Stout confront the dominant paradigm on its own law-and-economics turf, their work promises to succeed where other noneconomic arguments have failed to make significant headway.... Even if Blair and Stout's descriptive claims are overstated or inaccurate, TPM could still make a valuable contribution if it were read as a normative theory justifying rejection of the shareholder primacy orthodoxy... [This article] therefore will raise more fundamental concerns about TPM's conception of the board of directors as an independent "mediating hierarch." As elaborated by Blair and Stout, TPM contends that extralegal pressures (which the authors term "political") rather than corporate law determine the board's division of corporate revenues (or rents) among shareholders and nonshareholders. (If TPM is better viewed as a normative theory, the claim would be that politics rather than law should determine rent allocation.) Because TPM does not contemplate insulation of the board from these extralegal pressures, the fact (if it is a fact) that the board is not legally committed to shareholder primacy is not necessarily of any practical significance; political pressures may influence the board's decisionmaking every bit as much as legal rules. Distributional outcomes need be no different than they would be if dictated by the shareholder primacy principle. 215 The board's lack of independence from extralegal pressures has potentially important efficiency consequences. First, it encourages team members, including shareholders and employees, to engage in costly rent-seeking activities as they compete with each other to obtain the largest possible share of corporate revenues. Second, political control of the board by shareholders may be inefficient because it leads to allocation decisions that forfeit potential productivity gains (or "X-efficiency").... [I] will then take up an issue of greater importance from a progressive perspective -- the distributional implications of TPM's conception of the board's role. Because the board is supposed to make decisions about rent allocation in response to political pressures rather than legal rules, a corporation's shareholders, workers, and other team members earn only those shares of production surplus that are obtainable through the exercise of political power targeted at the board. In this regard, TPM mirrors the shareholder primacy model's standard view of intracorporate relations, the fundamental premise of which is the principle that nonshareholder rights are limited to whatever can be bargained and paid for. Thus TPM does not advance progressive efforts to construct a broader understanding of management's responsibility to nonshareholders aimed at improving distributional outcomes currently available through market interactions. Despite its apparent critical promise, TPM turns out to be an elaborate justification for the status quo. .... III. TPM AND THE BOARD'S DUTY TO NONSHAREHOLDERS A. The Allocation Problem 1. TPM's "Political" Solution According to TPM, the board's role as independent mediator is to divide the revenues (or economic rents) flowing from joint production among the various contributors of inputs to the production process. Contributors obviously need to receive a return equal at least to their opportunity costs; otherwise they will be unwilling to continue to participate and the firm sooner or later will fall apart. Furthermore, a firm that develops a reputation for underpayment will be unable to attract potential team members. If production yields revenues in excess of the participants' opportunity costs, however, an independent board faces a virtually infinite array of choices about how to allocate shares of this surplus among team members. The allocation problem often arises when a corporation is doing well. How are rents to be divided among shareholders and employees, for example? A corporation may face a different kind of challenge when it is struggling. Suppose one among a corporation's several plants cannot produce sufficient value even to pay its workers their opportunity wages. Should the board continue to operate the plant, subsidized by other, more productive plants? The subsidy, of course, is paid for by the workers at those other plants, who otherwise might receive a higher wage, or by the shareholders, who otherwise might receive a higher return on their invested capital, or, more likely, by both. Alternatively, the board might decide simply to close the plant. In that case, the displaced workers lose not only their incomes, which in theory can be replaced, but also the value of firmspecific human capital investments, which is not recoverable. There is, however, a corresponding benefit to the other, more productive members of the team, who are relieved of the burden of the underperforming workers. If the board chooses to close the plant, it must also decide whether to spend corporate funds on employee retraining and relocation in order to minimize transition costs. Compensation for lost human capital investments is also a possibility. These benefits to the discharged workers come at the expense of lower returns for other members of the workforce and for the 216 shareholders. Thus, not only must directors make allocation decisions in times of prosperity, they must also do so when confronting losses. Whether a corporation is flourishing or foundering, one intuitively supposes that allocation decisions should somehow be made according to the principle, "to each according to his or her due." That idea is not helpful by itself since it begs the question at issue: What constitutes just deserts? By its nature, the output of team production is nonseparable: It is typically impossible to identify after the fact the various team members' relative contributions to the value generated by the finished product. The board must therefore use some measure other than the value of the participants' respective inputs in making its allocation decisions. Similarly, losses often occur for reasons that are complex and insufficiently clear for assignment of responsibility. As developed by Blair and Stout, TPM offers the board no guidance as to how such decisions should be made. It provides no rules or principles by which to structure board decisionmaking; the model is agnostic on the question of just deserts. Instead, an independent third party -- the board -- has unconstrained authority to divide the pie. And in the absence of any constraints imposed by substantive norms, TPM envisions these allocation decisions as "political." What does this imply in the way of actual behavior? The availability of markets presenting alternatives to investors of human and financial capital encourages the board to return at least the value of these opportunities to team members. Beyond those market-driven baselines, however, the board is expected to decide who gets what according to the pressures that the various claimants can bring to bear upon it. Blair and Stout are vague about the mechanics of this process, but suggest the use of several "political tools," including "vote trading, coalition formation, public relations campaigns, organizing to reduce obstacles to collective action, and appeals to regulatory agencies and congressional investigative committees." The point seems to be that the participants can use these tools to threaten, cajole, or persuade the board to respond to their demands for larger shares of surplus (or smaller shares of losses) at the expense of their fellow team members. It is, in other words, a matter of power rather than principle. Seeing the matter in this light reveals an important feature of the TPM. While it effectively asserts the need to free the board from the demands of shareholders and a legal regime that privileges their interests over those of the various other contributors to corporate production, it disclaims any insights into the fundamental practical and theoretical question of how the board should exercise its broad powers. By endorsing the adequacy of political outcomes, the model implicitly assumes that the board's role is to validate existing, exogenously determined power relationships among employees, shareholders, and other stakeholders. Moreover, TPM tacitly accepts the possibility that extralegal pressures might lead the board to behave no differently than it would if operating under the constraints of a shareholder primacy legal regime. Two difficulties result. First, Blair and Stout overlook the potential inefficiencies implicit in this feature of TPM. Second, they fail to offer any explanation or justification for their implicit rejection of a role for the board that might yield distributional outcomes other than those dictated by power. Before turning to these problems, it is first necessary to consider how extralegal pressures affect board decisionmaking. 2. Extralegal Constraints on Board Discretion If political pressure shapes the board's rent allocation decisions, the fortunes of shareholders and nonshareholders depend on their ability to exert leverage or otherwise persuade the board to look favorably on their claims. Employees and shareholders bring to this political contest bargaining leverage that is determined in part by supply and demand in the markets for their inputs. Under conditions of relative scarcity and relatively high demand, one party may find itself in a more or less advantageous position in relation to the other. Other institutional mechanisms (like labor unions) or techniques (such as coordination among owners of large 217 blocks of stock) may enhance the ability of one team member to extract larger shares of surplus than would otherwise be possible. Social norms can also influence allocation decisions, as would, for example, a conventional assumption that boards are supposed to assign priority to shareholder interests. The nature of the parties' involvement in the corporation also influences bargaining power, and here the effect is to tip the balance in the direction of the shareholders. To the extent workers have made firmspecific human capital investments, the very fact of their employment by the corporation may place them at a bargaining disadvantage they would not be under if negotiating an employment agreement for the first time. Once they have invested in nontransferable knowledge and skills, the threat of defection loses value as a bargaining tool because departure entails forfeiture of the investment. Shareholders, in contrast, have an easy and much lower-cost exit option. If the board is unwilling to give them the return they demand, they can sell their stock and reinvest their capital elsewhere because no portion of their investment is firm-specific. (This is so regardless of whether the corporation has invested its equity capital in firm-specific assets.) If enough shareholders choose this course of action, share prices will fall, and market prices can fluctuate in any event, so their exit option is not cost-free. Nevertheless, even if share prices have dropped, sale is likely to be far less costly than defection by workers who must forfeit the entirety of their firm-specific human capital investments. Moreover, investors of financial capital can hedge against these losses by diversification, a strategy unavailable to investors of human capital. Differences in the cost of exit are not the only advantages enjoyed by shareholders. The existence of a shareholder-driven market for corporate control is what gives their threat of exit its bite. Because shareholders alone enjoy the legal authority to elect (and remove) the board of directors, shareholders can back up their demands for higher returns by threatening to sell their stock (or to grant voting authority by proxy) to someone who will use voting control to install a new board. Workers and other nonshareholders cannot make those threats because they have no voting rights. Although expensive and less active (for the time being) than in its heyday in the late 1980s, the market for corporate control still presents a credible threat to incumbent boards. Current law provides directors broad leeway in defending against hostile tender offers, typically by deploying a so-called "poison pill." However, discretion is not unlimited, and under certain circumstances target company boards are required to maximize share value by auctioning the corporation to the highest bidder. Even in situations where the target board can resist without breach of its fiduciary duty, an insurgent can mount a proxy contest aimed at replacing the board with directors who will redeem a poison pill and allow a bid to proceed. Large blocks of stock in the hands of institutional investors can increase the likelihood of success. Despite a downturn in takeover activity at the end of the 1980s and into the early 1990s, recent events indicate that the market for corporate control is alive and well. This is important because it means that corporate directors who are insufficiently attentive to shareholder demands face a credible threat of removal. In the words of one commentator, "directors serve shareholder interests, 'or else,' as the saying goes." Even if Blair and Stout are correct in their conclusion that corporate law does not lead boards to favor shareholder interests, there is good reason to believe that the extralegal incentives discussed here are having that effect. The evidence strongly suggests that shareholders are winning the rent allocation contest. Since 1970, manufacturing productivity (output per hour) has more than doubled. Shareholders have earned generous returns; since 1990 alone, for example, the Dow Jones Industrial Index has quadrupled in value. Nevertheless, at the lower end of the income scale, presumably populated more heavily by noninvestors, the gains have not been nearly as impressive. From 1970 to 1997, family incomes at the twentieth percentile grew by less than 4% and those at the fortieth percentile by only 11.3%. This trend continues. During the last quarter of 1999, factory productivity grew by 10.7%, while hourly 218 compensation rose only 4.3%. Meanwhile, the stock market continues its remarkable advance and the gap between rich and poor continues to widen. Data like these imply that shareholders are reaping the lion's share of gains in corporate productivity and suggest that they wield greater influence over the board of directors than do workers. Whether corporate boards are independent of shareholder control as a matter of law, they evidently are not independent as a matter of fact. To the extent that rent allocation decisions depend on politics rather than law, shareholders possess substantial leverage that privileges them in relation to workers and other stakeholders. These extralegal advantages may be more effective than a legal regime that imperfectly accords priority to the claims of shareholders. As discussed in the next sections, directors' deference to shareholder interests has important practical implications both for efficiency and for the distribution of wealth between shareholders and nonshareholders. B. Efficiency Implications of the Board's Allocation Decisions 1. The Costs of Rent-Seeking A principal advantage of TPM's conception of the board as an independent mediator among the various claimants to the firm's revenues is said to be the reduction of the costs that otherwise flow from the parties' efforts to maximize their shares of the pie. These costs can arise from ex ante efforts to draft contracts as well as from ex post squabbling and opportunistic rent-seeking. A board of directors with sole authority to allocate shares of the joint product has the potential to reduce or even eliminate these costs. To do this, however, the board must be sufficiently independent of external pressures so that rival team members would have no reason to expend resources attempting to influence the board's allocation decisions. Otherwise, the rent-seeking arena simply shifts from competition among the claimants themselves to equally costly competitive efforts to influence the board. Far from insulating the board from external pressures, TPM's political solution to revenue division actually rewards costly rent-seeking behavior. As envisioned by Blair and Stout, the corporation's participants employ a variety of techniques to exert pressure on the board. The costs generated by these activities could be even greater than they would be under a legal regime that structures board decisionmaking, because legal limits on board discretion can reduce incentives to attempt to extract outcomes that are proscribed by law. More concretely, a legal regime that limits nonshareholder claims to contractually defined payouts (leaving the residue for the shareholders) discourages workers from attempting to extract a higher rate of return on their contributions to production. At the same time, shareholders have no incentive to seek rents that the board is contractually obligated to distribute to workers. In contrast, if the board owes no legal duty to any corporate constituency, everything is potentially up for grabs and everyone therefore stands to gain from efforts to influence the board's allocation decisions -- no one can afford to stand on the sidelines. If rent-seeking activities are sufficiently vigorous (which in turn depends in part on how large the likely payoffs are), it is possible that the aggregate net benefits to team members under TPM could be less than they would be under a legal regime of shareholder primacy because the value of each person's share of the pie would be reduced by the costs required to obtain it. If TPM is to benefit all team members by lessening the costs of rent-seeking, liberation from legal rules rendering the board accountable to particular constituencies is not enough. In addition to freedom from the threat of legal liability for its rent allocation decisions, the board also would need to be free from extralegal, political pressures to favor the demands of some constituencies over others because its susceptibility to these pressures generates the incentives to engage in rent-seeking. Is it possible to conceive of a set of legal rules capable of establishing this state of ivory tower autonomy? At the very least, the board would need to be 219 fully protected from shareholder efforts to influence its behavior through the threat of removal by hostile tender offers or proxy fights. In addition, boards would need to be selfperpetuating, rather than subject to selection by shareholders or senior managers. Senior management should also be excluded from board membership as long as executive compensation includes elements (such as stock options) that align management's interests with those of the shareholders. In other words, if one of TPM's virtues is the abatement of rent-seeking, it does not go far enough by focusing solely on legal independence from shareholder control. 2. Potential X-Efficiency Gains A regime relying on rent allocation dictated by political pressure may also be inefficient for a different reason. As economist Harvey Leibenstein has argued, there appears to be a linkage between worker compensation and worker productivity. An important determinant of a firm's productivity is the amount of effort that workers are willing to exert in the performance of their jobs. While monitoring compliance with established standards can yield baseline levels of productivity, whether workers will work harder than the baseline remains within their own discretion. Workers may choose to expend the least amount of effort necessary to avoid discharge, or they may work to their fullest capacity on behalf of the firm's interests, or their effort level may fall somewhere in between. Management's decisions about compensation and working conditions have a significant impact on worker motivation. Here, too, choices must be made. Management can offer a package of pay and working conditions that is generally equivalent to that available from other employers for similar work; it can be more generous, providing the best deal possible under the firm's circumstances; or it can attempt to get away with the bare minimum needed to prevent mass defection. Following Leibenstein, it is possible to model the interactions among these choices as a prisoner's dilemma game. Leibenstein describes the game as involving workers and management, employing the standard assumption that management's job is to act on behalf of the shareholders. Because TPM conceives of management as operating independently rather than as an agent of the shareholders, Leibenstein's prisoner's dilemma framework can be recast to substitute the shareholders themselves for management. The game therefore involves shareholder decisions about how large a share of the pie they are willing to allow the board to allocate to the firm's workers. Shareholders thus must decide whether to put pressure on the board to obtain for themselves the greatest possible portion of production revenues that will not trigger worker defection. Alternatively, they may allow a generous share to go to the workers, demanding for themselves a bare minimum return on their investments. The third option is some point intermediate between these poles. From the perspective of both workers and shareholders, the optimal outcome is one in which workers put forth extraordinary effort in return for the best possible compensation package. Greater firm productivity makes it possible for workers to earn higher wages and allows shareholders to realize higher profits than would otherwise be available. As Leibenstein illustrates with his prisoner's dilemma framework, however, even though this result is optimal for both workers and shareholders, it is unlikely to occur as a result of arms' length bargaining between the parties. If workers see that shareholders are willing to allow a high wage, they can maximize their utility by low effort in return for that higher wage. At the same time, low effort protects workers from the risk that the shareholders will end up insisting on low wages and high profits after all, and attempt to grab for themselves the productivity gains that would flow from high effort. Shareholders assess the situation similarly. If they allow workers to receive a high wage, workers may respond with low effort; the low wage option reduces the costs of low effort. Rational choice thus would appear to drive both workers and shareholders toward the low-effort, low-wage result. In fact, Leibenstein argues, effort and wage 220 conventions (or social norms) shape outcomes that are superior to the prisoner's dilemma result, but these conventions nevertheless tend to be suboptimal. The result is less than optimal productivity, which Leibenstein has termed "internal inefficiency" or "Xinefficiency." TPM's reliance on political pressure as the basis for rent allocation disregards the potential impact of the board's decisions on X-efficiency. As a neutral third party, the board may have the potential to break the prisoner's dilemma impasse of distrust and move workers and shareholders closer to an optimal mix of effort, wages, and profits. For example, an independent board committed to enhancing the firm's productivity might offer wage increases subject to review and downward adjustment if no increase in productivity is observed. Promises of "fair" compensation that would confront credibility difficulties if made by shareholders who stand to gain from opportunism could have a meaningful effect on worker behavior if made by a board that has no interest of its own at stake. Ex ante guarantees of high wages in return for greater effort may result in shirking and free-riding, but worker perceptions of a reliable connection between pay and productivity could encourage workers to monitor each other's performance. More importantly, the experience of placing themselves in positions of vulnerability and escaping unscathed, combined with the higher returns generated by cooperation, may result in conventions or habits of high effort that take on normative power and thereby reduce the incidence of employee opportunism and the need for monitoring. At the same time, experience should reduce shareholder scepticism about the benefits of higher wages. In other words, an independent board may be able to facilitate development of trusting relationships between workers and shareholders that would not arise spontaneously. Workers who trust shareholders can work harder in the expectation that they will receive appropriate compensation; likewise, shareholders can count on higher effort for higher pay. For the board to play a facilitating role in cultivating trust between workers and shareholders, both parties must be willing to trust the board itself. They must believe in its neutrality; the board must not be perceived as acting solely or primarily on behalf of one party or the other. Otherwise, a party's distrust of the board will have the same effect as mutual distrust between the parties themselves, resulting in unwillingness to make the commitments necessary to achieve consummate cooperation. One apparent virtue of TPM's conception of an independent board is the possibility that the players might be willing to accord the board a measure of trust that they are otherwise unwilling to extend to each other. If, however, the board's rent allocation decisions are determined solely by political pressure, X-efficiency gains flowing from cooperation are likely to be unattainable. Shareholders motivated by assumptions about the risk of worker opportunism may use their power to prevent the board from offering higher wages in return for higher effort. This is especially likely where the potential benefits are uncertain to begin with, and not readily demonstrable ex ante. Where long-run net benefit could be shown with some plausibility, some investors (including large institutions) might still prefer to receive a higher rate of return more immediately. Equally important, regardless of actual shareholder attitudes, workers might well refuse to put forth higher effort if they assume that their work will go unrewarded by a board subject to shareholder control. Conventional distrust of shareholder motives coupled with a perception of shareholder control can result in distrust of a board even in the absence of a shareholder primacy mandate. TPM's conception of the board as passive reactor to political power thus precludes a role for the board as agent for the promotion of X-efficiency. The result is lower returns for workers and shareholders alike. As discussed above, complete independence from extralegal as well as legal pressures might reduce the costs of rent-seeking by removing the incentive to seek rents. However, it is unlikely that independence alone would be sufficient to improve Xefficiency. While true independence might allay distrust of the board and make it possible for the board to facilitate 221 mutual trust between shareholders and workers, independence alone would create no incentive for the board to do the hard work necessary to improve productivity by building trusting relationships. Perhaps the board needs the legal assurance that it will participate in productivity gains. Under TPM's minimalist conception of the board's job, however, the board discharges its duty simply by responding to political pressures in ways that are adequate to keep the team together. There is no reason to expect it to do more. C. TPM's Distributional Implications Despite the possible efficiency shortcomings discussed in the previous sections, TPM may still appear attractive to partisans of nonshareholders for distributional reasons. Even if the pies end up being smaller, perhaps the shares to be distributed to workers and other stakeholders could be larger than they are now. TPM appears at least initially to hold great promise in this regard because, by claiming to free the board of directors from the shackles of shareholder primacy, it puts the distributional question at the center of corporate governance. An independent, neutral board would have the power to allocate larger portions of corporate revenues and accord other benefits to workers, even if that meant lower returns for shareholders. On closer inspection, however, the promise proves to be empty. Because TPM does nothing to improve the extralegal status of nonshareholders in relation to shareholders, there is no reason to expect improvements in distributional outcomes. Thus, from a progressive perspective, the element of TPM that seems most appealing ends up being the most disappointing. The remainder of this Essay considers these questions. 1. Distributional Outcomes Under TPM TPM's political solution to rent allocation leaves nonshareholders to their own devices in extracting the best deal they can get from the board of directors. After the board has divided rents among workers, shareholders, and other participants in amounts minimally sufficient to keep them from quitting the team, any surplus will then be up for grabs. Because workers' interest in maximizing their wages and other benefits conflicts with the shareholders' desire for the highest possible investment return, they must confront each other in the political arena, using whatever muscle they have available to persuade the board to favor their claims. Similarly, if the board must decide whether to take action that will benefit the shareholders but harm nonshareholders (such as closing a struggling plant), such decisions also will be determined by the parties' relative ability to exert influence on the board, as will the question of whether workers and other affected nonshareholders receive compensation for their losses. Under current law, nonshareholder returns depend on contract terms. Likewise, protections such as job security or severance pay must be bargained and paid for, presumably in the form of lower wages. To give workers anything more than they can bargain for would amount to breach of the fiduciary duty owed by the board to the shareholders. This means that the exchange value of the parties' existing endowments (such as capital or the ability to work), supplemented by bargaining power, fully determines distributional outcomes between shareholders and nonshareholders. From the nonshareholders' point of view, TPM's vision of a political contest with the shareholders replicates the existing market-or contract-based framework for determination of the structure and content of intra-corporate relationships. Both models envision a competitive process in which the board must mediate rival claims to limited resources. As a normative matter, there can be no basis for claiming a right to distributional outcomes other than the results of this contest: "might makes right." As a practical matter, the parties lack the ability to obtain anything more from the board than it is willing to allocate in light of the strength of competing claims. In this regard, whether one conceives of the process as political or contractual does not make any difference. Outcomes should be essentially the same, because 222 TPM's political contest serves the same function, and is likely to yield the same results, as the parties' engagements in the market. It is horse-trading either way, and the same horses are being exchanged. In other words, what is missing from TPM is a conception of the board's role that would make it possible for nonshareholders to do better than this. Seen in this light, TPM emerges as a sophisticated justification for the current distribution of income among shareholders, workers, and other corporate constituencies. If Blair and Stout are correct that corporate law already reflects TPM's view of the appropriate relationship among the board and other members of the corporate team, obviously there should be no need to consider legal reform. Corporate law and the distribution of the costs and benefits of corporate activity are fine as they are. Even if TPM is better understood as a normative argument for repeal of the shareholder primacy principle, the model's vision of board decisionmaking as a function of the team members' respective political power implicitly legitimates distributional outcomes likely to be no better than those that exist today. At this point one might ask whether it is fair to fault Blair and Stout for failing to embrace a progressive, redistributive agenda that they presumably do not support. The criticism seems justified for two reasons. First, the authors themselves suggest that TPM "resonates" with the work of progressive corporate law scholars. Although Blair and Stout are careful to point out TPM's different policy implications, readers struck by TPM's rejection of shareholder primacy may overlook this qualification. A proper understanding of TPM's distributional implications should leave no one in doubt on this score. The recent progressive (or communitarian) critique of corporate law, although a large and diverse body of work, shares common ground in its opposition to a strictly contract-based approach to the definition of nonshareholder rights. TPM's apparent resonance with progressive scholarship in fact is discordant. Criticism of TPM on the grounds presented here may also be appropriate for a second reason. Regardless of whether TPM reflects the core concerns addressed by progressive corporate law, readers may infer from its rejection of shareholder primacy that workers and other nonshareholders would be better off under TPM than they are today. For the reasons stated above, that would be a serious mistake. It now remains to consider more closely whether TPM has any utility for the progressive corporate law project. 2. TPM and Progressive Corporate Law Assuming that TPM is actually a normative theory rather than an explanation for the law as it exists today, what is TPM's relationship to progressive corporate law scholarship? I have already emphasized TPM's endorsement of an essentially contractarian approach to the determination of nonshareholder rights, a stance that I consider to be in sharp conflict with the progressive agenda. Nevertheless, TPM does share common ground with the progressives' rejection of shareholder primacy in favor of broader notions of director responsibility. This section evaluates progressive law reform proposals and then assesses whether TPM can remedy their shortcomings. Of course, the entire progressive project is objectionable to defenders of the shareholder primacy status quo, but even sympathizers may discern a deficiency in progressive law reform proposals. I refer to the critics' inability to give firm content to their new conceptions of board responsibility. In particular, progressives have yet to devise a sufficiently rigorous analytical framework to structure director decisionmaking in cases in which shareholder and nonshareholder interests conflict. Appeals to fiduciary responsibility, fairness, or respect for legitimate expectations suffer from a degree of indeterminacy that probably renders them inadequate to the large tasks of reorienting the board's sense of priorities and providing guidance in making tough choices. However supportive one might be of the reform agenda, reliance on excessively general principles may simply leave the board free to fall back on traditional assumptions about responsibility to shareholders. 223 The task of redefining the board's duty to the corporation's various constituencies in cases of conflict may in fact be intractable. Epistemic limitations and practical exigencies (such as drafting costs) probably make it impossible to provide in advance for the countless contingencies that will emerge in the future. One strength of the traditional fiduciary concept has been its adaptability to unforeseen challenges. However, when the decisionmaker must balance conflicting interests, the fiduciary idea may not be up to the task. It is ill-suited to situations in which a steward must figure out how to serve two masters at the same time. Generality therefore yields discretion that in turn threatens to frustrate the original objective. I may be overly pessimistic in my reading of the work that has been done so far and there is surely more to be said, but the indeterminacy criticism appears to me to be serious and perhaps fatal. Quite different approaches to the distributional problem may be possible. In the meantime, however, TPM has little to offer to the progressive effort to redefine the board's responsibility. The model includes no affirmative injunction intended to redirect director attention to nonshareholders; to the contrary, it envisions a board beholden to no one. By itself, removal of shareholder primacy as a legal requirement will not yield benefits for nonshareholders as long as other, extralegal incentives to favor shareholder interests remain effective. Responsiveness to political pressures can serve just as well as -- if not better than -- legal doctrine to keep directors focused on shareholders. So too can conventions or social norms. Lacking an affirmative duty to nonshareholders (even if vaguely articulated) and also legal (or other) incentives to distribute more to employees than they can obtain through their own efforts, TPM does not even go as far as existing progressive law reform proposals. Even if TPM were more ambitious than it is and sought board independence from extralegal as well as legal pressures to favor shareholders, it still would be insufficient to improve distributional outcomes for workers and other nonshareholders. Simply put, there is no reason to assume that directors would act more generously even if they believed themselves free to do so. TPM, relying on political pressures, includes no incentives to encourage director regard for nonshareholders. If progressives are serious about a conception of the board's distributional authority that does more than just respond to the parties' leverage, the need remains to devise a new legal regime that defines the board's duty to nonshareholders in terms that are concrete enough to make a difference. These new principles must redress existing bargaining disadvantages in language that is sufficiently determinate to provide meaningful guidance to directors and also to courts called upon to evaluate director decisionmaking. TPM does not purport to address these challenges.... 224 Hill, J, "Deconstructing Sunbeam -- Contemporary Issues in Corporate Governance", (1999) 67 University of Cincinnati Law Review 1099 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. I. INTRODUCTION A beginning, a muddle, and an end. Philip Larkin Ubiquitous though it may be in late 1990s legal discourse, "corporate governance" is hardly a clear concept. At one level, ambiguity exists as to the scope of corporate governance -- whether it encompasses only the relationship between shareholders and managers, or whether it is more expansive, involving the relationship between a broader range of stakeholders and the board.... At a more fundamental level, however, there is tension between two competing visions of the role of corporate governance -- whether corporate governance should be concerned primarily with ensuring managerial accountability or with enhancing corporate performance and efficiency. Although early proponents of practices of good corporate governance stressed the accountability rationale, presenting corporate governance as a viable alternative to governmental regulation, in recent times, the pendulum appears to have shifted perceptibly toward an efficiency rationale. The implications of the events that occurred at Sunbeam during 1998, involving the untimely removal and replacement of Chief Executive Officer ("CEO") Albert Dunlap, are themselves somewhat ambiguous. It has, for example, been suggested that Dunlap's removal from office after the revelation of the company's poor performance itself demonstrates the effectiveness of Sunbeam's corporate governance practices concerning outside directors. On the other hand, it could be argued that the need for such dramatic intervention might have been caused by deficiencies in governance techniques, which could have prevented or contributed to earlier detection of the Sunbeam's problems. Also, although most commentators welcomed the new regime implemented after Dunlap's removal from office, there are a number of problematical aspects of that new regime from a corporate governance perspective. The events at Sunbeam raise, and shed light on, a range of key issues in contemporary corporate governance debate, including board composition, the role and responsibilities of outside directors, remuneration of executives and directors, and the role of major shareholders in corporate governance. II. THE SUNBEAM SAGA Show me a hero and I will write you a tragedy. F. Scott Fitzgerald Prior to Al Dunlap's arrival at Sunbeam in mid-1996, the company had a history of problems and poor performance. At that time, Sunbeam's two major shareholders were Michael Price 225 and Michael Steinhardt, who held forty-three percent of shares between them and controlled two board seats. In 1992, then CEO, Paul B. Kazarian was removed by Price and Steinhardt and subsequently sued Sunbeam, receiving a settlement of $160 million. Al Dunlap became CEO and Chairman of Sunbeam in July 1996. Dunlap, a.k.a. "Chainsaw Al," had acquired something of a commercial aura, most recently from his success in reviving Scott Paper Company, making $100 million for himself when Kimberly-Clark Corporation acquired the improved version of Scott Paper in December 1995. The market immediately responded positively to the appointment of Dunlap at Sunbeam. On the day of his appointment, Sunbeam stock rose by fifty percent. Initially, Dunlap entered a three-year contract with Sunbeam at an annual salary of $1 million, together with options to purchase 2.5 million shares and one million shares of restricted stock, a deal that was considerably more generous than Dunlap's package at Scott Paper. By the beginning of 1997, Dunlap's familiar cost-cutting techniques were well-evident at Sunbeam. He had laid off half of the twelve-thousand person workforce at Delray Beach, Florida and divested a number of non-core sections of the business. During his tenure as CEO of Sunbeam, Dunlap would ultimately shut down or sell approximately eighty of Sunbeam's plants, offices, and warehouses. By mid-1997, it appeared that Sunbeam was experiencing a substantial turn-around in its fortunes. Whereas the fourth quarter results report for January 1997 had disclosed a loss of $234.7 million, second quarter earnings released in July 1997 more than tripled. However, the meteoric climb in share price did not continue. In January 1998, the price of Sunbeam's shares fell by 9.5%, after fourth quarter earnings fell short of analysts' expectations. In spite of this setback to the company's performance, Dunlap negotiated a new three-year contract with Sunbeam, doubling his base salary to $ 2 million per annum. As part of the renegotiated package, he also received 3.75 million options, reportedly one of the ten largest option grants given in corporate history. In early March 1998, Dunlap departed from his traditional image as cost-cutter to pursue a growth strategy for Sunbeam. In one day, Sunbeam paid $ 1.8 billion to acquire three companies with synergy potential. One of these companies was the camping company, Coleman Co. As consideration for the sale of his eighty-two percent stake in Coleman, Ron Perelman received $ 160 million in cash and 14.1 million shares in Sunbeam, making Perelman the second largest shareholder in Sunbeam with fourteen percent. Although a number of Wall Street analysts argued that Sunbeam had "grossly overpaid" for the Coleman acquisition, the acquisition initially had a positive effect on Sunbeam's share price, which rose a further twenty-four percent. Stock in Sunbeam, which had traded at $12.50 on the day that Dunlap became CEO, rose at this time to $53, reflecting an increase of over three-hundred percent. In May 1998, in response to the announcement of a $44.6 million first quarter loss, Dunlap announced that he planned to cut another 5,100 jobs and was assembling a new management team. In spite of these pronouncements, Sunbeam shares had lost fifty percent of their March value, now trading at around $25, with further downward pressure as investors continued to sell off the stock. One stockholder, who was unhappier than most, was Ron Perelman. Perelman had taken part payment for his stake in Coleman by way of shares in Sunbeam, although he did not seek board representation. Perelman held the stake in Sunbeam through his closely-held company, MacAndrews & Forbes. These shares, which at the time of the Coleman deal were valued at $643 million, were by June 1998 worth only $323 million. 226 One major factor contributing to the developing crisis at Sunbeam was the appearance in early June 1998 of a report in Barron's, which suggested that the company's 1997 rebound had been an illusion, created by accounting gimmickry, including the technique of "channel stuffing," or artificially inflating earnings of one quarter at the expense of later quarters. Specifically, the Barron's article alleged that Sunbeam had enhanced 1997 fourth quarter sales, by recording $50 million in sales of cooking grills under "early buy" terms, which were unusually favorable to purchasers. What appeared to presage a major rise in the barbecuing habits of Americans in fact left Sunbeam "with the double curse of falling sales and shrinking margins." The Barron's report hypothesized that the incentive for creating this illusion of growth was to repeat the Scott Paper story, by enticing a buyer to take over Sunbeam, but that, paradoxically, Dunlap's success in elevating the share price foreclosed the possibility of a buy-out. Sunbeam simply had become too expensive to take over at that time. Barron's conclusion regarding the Sunbeam accounts was savage: "Deconstructing Al Dunlap is a daunting task. But to save our gentle readers the effort, our total estimate of artificial profit boosters in 1997 came to around $120 million compared with the $109.4 million profit the company actually reported." Dunlap himself convened an extraordinary board meeting on June 9, 1998 to discuss and rebut the accounting concerns raised in the Barron's article. Although a partner from Arthur Andersen reassured board members about the company's accounts, Dunlap offered to resign if the board would buy him out of his contract. At that time, the board apparently had not yet seriously considered removing him from office. Over the next few days, the directors discovered that sales for the second quarter were $60 million below expectations and decided to remove Dunlap as CEO at a board meeting on June 13, 1998. Jerry Levin, who had been CEO of Coleman before its sale to Sunbeam and who possessed his own commercial luster through salvage work at Revlon in 1991, was appointed as Dunlap's replacement. Ultimately, Sunbeam was the worst performer out of one-thousand corporations in 1998, with reduction in stock price of eighty-four percent. III. BOARD STRUCTURE AND COMPOSITION AS A CORPORATE GOVERNANCE TOOL Ut desint vires, tamen est laudanda voluntas -- Though the strength is lacking, yet the willingness is commendable. Ovid A major theme in contemporary corporate governance debate is the structure of the board of directors, and a range of proposals have emerged for improving the board's efficacy. It is interesting to assess the profile and structure of Sunbeam's board at the time of Dunlap's removal against the backdrop of this corporate governance debate. One of the noteworthy features of the board that removed Al Dunlap from office was its size. The board was composed of seven directors and was therefore small by U.S. standards. There has been a commercial evolution in the United States toward smaller, more accountable boards. According to Korn/Ferry International's 25th Annual Boards of Directors Study, the boards of U.S. public companies, which have been shrinking in recent years, typically comprise eleven directors. Even this figure is relatively high in comparison to some other countries. Empirical evidence exists suggesting an inverse relation between firm performance and board size. On the other hand, when actual failure of firms is at stake, there is some research showing that those with relatively large boards may have a greater survival rate. Nonetheless, there is a strong perception that accountability decreases when boards are too large. In another recent corporate accounting scandal, the board at Cendant Corp. was 227 comprised of eighteen members during the period when systematic accounting irregularities were occurring within the firm. Five of the seven directors on the Sunbeam board were outside directors. They were Howard G. Kristol, who had been Dunlap's personal attorney for many years; William T. Rutter, managing director for private banking at First Union National Bank of Florida; Charles M. Elson, a law professor at Stetson University; Faith Whittlesey, the head of a charitable foundation, the American Swiss Foundation; and Peter A. Langerman of Franklin Mutual Advisers Inc, who was Michael Price's representative on the board. All except Langerman were said to be friends of Dunlap, who was chairman of the board. The value of independent outside directors is one of the most important, and controversial, issues concerning board structure in contemporary corporate governance debate. Several international committees and associations have recommended that boards of public companies should contain a sufficient proportion of independent outside directors to exert a real level of influence on the board. Similarly, in the United States, the assumption that outside directors are superior monitors operates at a judicial and regulatory level. The general trend toward public company boards with a majority of independent outside directors has led increasingly to "supermajority-independent boards." Of the eleven directors which typically comprise U.S. public company boards today, nine are outside directors. A number of distinct possible roles for independent outside directors exist, but are rarely differentiated. Originally, the primary role envisaged for the independent director was that of monitor of managerial integrity, with much emphasis on the independent director's value arising from concerns about corporate misconduct and accountability. In the United Kingdom, for example, the influential Cadbury Committee, which recommended a major role for outside directors, was established to counter lack of public confidence in financial reporting and audits. This resulted from the absence of a governance framework to ensure that directors established and reviewed controls in their organization, malleability of accounting standards, and the erosion of auditor independence. Similarly, in the United States, interest in independent directors originally arose to police managerial self-dealing and constrain perceived abuses in, for example, the area of takeover defenses and excessive compensation. Today, the dominant role envisaged for the independent director is that of monitor of efficiency and maximizer of shareholder wealth. In accordance with this vision, corporate governance debate has shifted to the issue of whether there is a positive correlation between the presence of independent directors on the board and firm performance. There has long been an implicit assumption in corporate governance debate that such a correlation exists, and many commentators assert that firms with activist boards, which are independent monitors of management, will contribute to higher returns to shareholders than passive, management dominated boards. Such a vision of the role of the outside director also underlies, for example, the proposal for greater use of professional directors, who are independent of management, but dependent upon their appointors, namely institutional investors. Although a decade ago there was little empirical research on the question of whether board structure enhances firm performance, there has been a surge in recent studies. Most studies, however, have produced inconclusive results, failing to establish a correlation between board composition and firm performance. One recent study by Professor Klein, which like earlier ones finds virtually no association between overall board structure and firm performance, does nonetheless find a correlation between firm performance and the composition of board committees. Specifically, the study finds a positive relation between firm performance and the percentage of inside directors on finance and investment committees, suggesting that "inside directors provide valuable information to boards about the firm's long-term investment decisions." 228 The role of independent directors is multi-faceted. Although the issue of the relationship between board composition and firm performance is an important one, independent directors also occupy a vital role in assuring investors that "the governance process has integrity." Thus, their role of monitoring managerial decision-making is not limited to performance issues, but also includes assuring investors that the managers "are complying with the legal duties, regulatory requirements, and ethical imperatives associated with the operation of a public company." Share price alone may not be a particularly revealing guide to such issues. The board of directors at Sunbeam demonstrates both the strengths, and possible limitations, of boards comprising a super-majority of independent outside directors in corporate monitoring. First, an important role for independent directors is to discipline or remove an underperforming CEO. The board of Sunbeam demonstrated that, when faced with evidence of poor company performance, it was sufficiently independent from management to remove Dunlap from office swiftly and decisively. One financial commentator suggested that the creation of such an independent board was one of the few commendable things that Dunlap may have done in his tenure. On the other hand, from reports of the events at Sunbeam, the board may have been less successful as general monitors of the company's financial position. It is, for example, not apparent from reports of Dunlap's removal that board members harbored any suspicions concerning accounting accuracy before the appearance of the article in Barron's and the subsequent impromptu board meeting called by Dunlap himself. This accords with some studies, which suggest that majority independent boards may be more effective in certain specific tasks, such as removal of CEOs for corporate underperformance, than in a general monitoring and advisory role. A study by Professor Weisbach has shown, for example, that boards which are dominated by independent directors are more likely to dismiss the CEO of a poorly performing firm than insider-dominated boards. Nonetheless, the study also shows that, for companies with above average stock price performance, the reverse held true -- boards dominated by independent directors were less likely to replace the CEO. It has been suggested that an explanation for this reticence is the fact that independent outside directors, who necessarily know less about the firm than inside directors, will rely more strongly on observable and publicly available performance criteria, such as stock price, and will be less likely to adopt an activist stance "when these indicators remain respectable." This is a matter of concern in the light of the events at Sunbeam, the message of which might well be that appearance does not always reflect reality. The problem is exacerbated by the incentives for manipulation of accounting figures to maximize a CEO's compensation, which may exist under some contemporary performance-based pay structures. The concept of "independence" is a critical element in many recommendations supporting the use of outside directors in corporate governance, in that directors who are "independent" outside directors, as opposed to "affiliated" outside directors, will possess greater autonomy in fulfilling their governance role. Yet "independence" is itself a vague concept, capable of a range of different meanings and nuances. In its narrowest incarnation, independence may be satisfied by the technical requirement of lack of financial interest in a transaction. Increasingly, however, institutional investors stress the need for more than merely formal independence, as a range of other matters and affiliations can challenge the board's autonomy. There are numerous well-chronicled factors, both social and psychological, that may undermine the autonomy and effectiveness of directors who technically qualify as "independent." These factors include the following: often directors will be appointed by the chairman, who may be a member of management; 229 psychological research shows that people tend to have loyalty toward their appointors and that continuing relationships in small groups will result in conformity of approach and ideas; outside directors will generally try to balance any adversarial role with constructive teamwork; some outside directors may also be executives in other companies and participate in similar social circles; and outside directors may remain in office for a long period of time. Other factors, which may compound outside directors' difficulty in monitoring management effectively, include lack of detailed knowledge about the firm's operations, limited time that can be devoted to the firm's affairs, and lack of independent staff. Also, the financial incentives may be inappropriate -- either too low to trigger diligent monitoring or too high to ensure disinterested monitoring. Several of these obstacles to effective monitoring had potential resonance in the case of the Sunbeam board. Perhaps an even more critical factor in the ability of Sunbeam's independent outside directors to operate as effective on-going monitors of management was the fact that Dunlap occupied the position of chairman of the board. Many commentators and reports on corporate governance advocate separation of the roles of CEO and chairperson as a necessary check on an unacceptable concentration of power within one person in the organization. Another danger is that combination of the roles of CEO and chairperson can provide a clog on the flow of information to the board exacerbating the general informational asymmetry between management and board, and making it virtually impossible for outside directors to detect problems within the corporation. Although it has been argued that no conflict necessarily exists between the themes of efficiency and accountability, the possible divergence between the two is apparent on this issue. Within an efficiency framework, for example, it has been recognized that there may be substantial costs to the separation of the roles of CEO and chairperson. And undoubtedly some successful corporations are run by commercial autocrats. Nonetheless, decentralization of power at board level can be an important check in the array of checks and balances that operate as corporate safety valves. Although separation of the roles of CEO and chairperson has become an article of faith in some countries, there has been great resistance to this trend by U.S. corporate management, which has resulted in the less radical development of appointment of a leader from among the independent directors. It seems that the cult of the charismatic CEO continues to have a powerful, but potentially dangerous, hold on U.S. commercial psyche in light of the events, not only at Sunbeam, but also at Cendant and Oxford Health. The level of Dunlap's influence over the board of Sunbeam was therefore problematical from a monitoring perspective, particularly where the board had a supermajority of outside directors for whom observable criteria, such as stock price, may have been central. Level of influence may also manifest itself in the CEO's remuneration, which, in Dunlap's case, greatly increased in early 1998. Some studies have suggested that compensation for CEOs and other executives tends to be higher in firms with a high percentage of outside directors. Another study has found that the level of a CEO's pay is directly related to the level of influence that the CEO has over the board, which increases when the CEO is also chairman and the board is predominantly comprised of outside directors. One view of corporate governance has traditionally taken the position that, although outside directors are responsible for removing poorly performing management, they rarely have the incentives to do so. Much has therefore been made of Sunbeam's remuneration practice of paying its outside directors, not in cash, but rather in Sunbeam shares, and the fact that the directors were required to purchase a significant tranche of Sunbeam stock from their own 230 funds before their appointment to the board. It has been argued that this practice enhanced the directors' independence from Dunlap, providing a strong counterpoint to possible existing personal ties. As an antidote to board passivity, one board member, Charles Elson, had been a long-time supporter of alignment of interests of directors and shareholders through an equitybased approach to directors' remuneration. Nonetheless, the issue is a controversial one in contemporary corporate governance, with counterclaims that substantial share ownership by outside directors may compromise, rather than enhance, independence, may lead to entrenchment of directors, and may give directors little incentive to monitor when the share price is high. The audit committee has assumed a higher profile in recent times, becoming a focal point of corporate governance. Sunbeam's audit committee comprised three outside independent directors, Charles Elson, Howard Kristol, and William Rutter. As the role of outside directors has shifted to a role of monitoring efficiency, the audit committee has increasingly been viewed as monitor of financial integrity and the company's internal controls. It is also a crucial link between the corporation and its outside auditors. The sanguine assessment of the audit committee is that it presents a potential solution to the problems of effective monitoring by outside directors, in that it can function as the board's "structured and professional vertical probe." In spite of the faith placed in the audit committee by contemporary corporate governance, there is growing recognition that many of the traditional obstacles to effective monitoring by the board may be replicated in the arena of the audit committee and that, in some circumstances, the audit committee's role will be symbolic at best. This recognition has prompted recent proposals for increasing the power and independence of audit committees, by, for example, requiring that they be composed entirely of outside directors and that a significant proportion of members be financially literate. Other proposals suggest that audit committees should have greater control over the outside auditors, particularly in ensuring that they are free from conflicts of interest. .... V. THE COLLECTIVIZATION OF SHAREHOLDER AND MANAGEMENT INTERESTS AT SUNBEAM I'm in lock step with the shareholders. Albert Dunlap Virtue itself turns vice, being misapplied. William Shakespeare In many ways, Sunbeam conformed to a central tenet of 1990s corporate governance, namely that the main goal of corporate governance is to align the interests of shareholders and management. An array of mechanisms was employed at Sunbeam to accomplish precisely that goal. Dunlap's substantial salary was predominantly performance-based, and the salary of directors was paid entirely in shares. Moreover, as a precondition to joining the board, directors were required to purchase a prescribed level of stock in Sunbeam. Thus, remuneration was structured to create a self-executing governance technique and to ensure undivided managerial attention to performance through the "collectivization" of stockholder and management/board interests. The rise of pay for performance itself represents a shift in corporate theory from a traditional approach, which treated remuneration as essentially a fiduciary problem, to an approach in which remuneration was recast as a problem of misalignment between the interests of principal and agent. 231 The events at Sunbeam in 1998 have to some extent been dismissed as aberrant and extreme. Nonetheless, they are a reflection and important reminder of a number of dangers and perverse incentives, which may be created under the model of governance adhered to by Al Dunlap. A. Corporate Governance and Wealth Distribution The generosity of Dunlap's original and re-negotiated remuneration package inevitably prompts consideration of the question of executive remuneration, which has become a key component of contemporary corporate governance debate. Both the process by which the compensation of executives is determined and the levels of remuneration have become a major issue in the United States and other countries, including Australia. Even Dunlap took the view that "most CEOs are ridiculously overpaid," adding, however, that "I deserved the $ 100 million I took away when Scott merged with KimberlyClark." Neither the advent of powerful institutional investors and their preferred form of remuneration, pay for performance, nor the era of independent directors appear to have hindered the upward spiral of executive pay. Indeed, some research shows, perhaps paradoxically, that a high proportion of outside directors on the board often correlates with higher compensation for the CEO. Under an alignment of interests model of executive remuneration, the actual level of pay is unproblematical. Some recent statistics, however, have caused commentators to reflect on the social and distributional impact of high levels of executive compensation. Statistics, for example, show that, in 1997, the average American CEO earned 326 times the pay of an average factory worker and 728 times the pay of a minimum wage earner. It has been argued that excessive executive remuneration can be damaging to worker morale within the corporation and to the economy as a whole. At a more fundamental level, there is increasing concern that these developments have contributed to massive inequality in the distribution of wealth in society, which can impair social unity and result in political backlash. According to one commentator, the pay gap in America has grown so wide as "to undermine our sense of ourselves as a nation of equals." Skewed wealth patterns are also reflected at the level of shareholders and workers. One of the goals of performance-based pay for executives is to foster wealth maximization for stockholders, and returns to stockholders have indeed been high in recent years. Professor Gordon notes that corporate profits increased by 250% between 1980-1995. Nonetheless, during that same period, wages of average workers in the United States, where the majority of workers are nonunionized, effectively declined, creating a social environment in which there is a significant disjunction in wealth distribution between shareholders and workers. Some commentators criticize the single-minded focus on shareholder return, epitomized by Dunlap's preferred model of corporate governance on the basis that improving shareholder wealth does not necessarily improve social wealth, can create undesirable incentives toward short-termism, and can result in ethical problems in, for example, the environmental area. They also argue that the "fixation" with alignment of the interests of corporate management and shareholders is misguided and that a range of other interests count in ensuring the longterm health of the corporate enterprise. With the benefit of hindsight, there has been criticism of the tactics employed by Dunlap in his attempts to revive Sunbeam and his limited repertoire of actual managerial skills. In the late 1990s, management theory stresses the need for entrepreneurs to create close ties with workers, to manage organizations strategically, and to innovate. Yet, Dunlap's "hatchet" tactics were certainly not unexpected, were entirely consistent with his view of corporate governance, and, for a time at least, were applauded by Wall Street. The CEO of one of Sunbeam's competitors, commenting on issues relating to social responsibility arising from the events at Sunbeam, said of Dunlap: "He is the logical extreme of an executive who has no 232 values, no honor, no loyalty, and no ethics. And yet he was held up as a corporate god in our culture. It greatly bothered me." B. Some Dangers of Performance-Based Pay In spite of its widespread acceptance, a number of criticisms are sometimes made of pay for performance. One such criticism is that the claimed congruence between management pay and shareholder interests is sometimes more apparent than real. One of the prime justifications for pay for performance was that there was previously little downside for managers who performed badly. There seems, however, to be a considerable gap between the rhetoric of pay for performance and its application in the real world. In spite of greater recognition of the importance of fine-tuning the structure of pay for performance packages, they are often very favorable to management, with inappropriate or unduly low performance levels and generally far greater "upside than downside elasticity." There is also scepticism about whether there is any causal connection between pay and performance -- the extent to which increased corporate profits come about because executives are actually doing a better job as a result of the incentives in performance-based remuneration. Nonetheless, the upside elasticity in performance-based pay is usually substantial. Some pay for performance schemes encourage managers to focus on short-term profits, rather than longterm growth. An even more fundamental danger, however, is that pay for performance may encourage managers to create the illusion of profitability and corporate success. Some performance-indicators, such as a rise in the share price, are open to manipulation by management, creating perverse incentives for corporate managers to engage in precisely the type of misrepresentation of firm performance through accounting irregularities, as occurred at Sunbeam and Cendant. The dangers of abuse in relation to timing of disclosure of corporate information may also be more acute in these circumstances. Where the exercise of options is pegged to share price, for example, there may be strong incentives created as to the timing of favorable (or unfavorable) corporate announcements. Following Dunlap's removal from office, the Securities and Exchange Commission (SEC) commenced an investigation of Sunbeam's accounting practices, and SEC chairman Arthur Levitt has recently commented on the danger of accounting manipulation in these terms: "Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks ... As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; Integrity may be losing out to illusion." C. Post-Dunlap Relational Investing Some recent corporate models have stressed protection of shareholder interests through greater participation by them in corporate governance matters. Under Professor Pound's political model of corporate governance, for example, shareholder rights in the age of institutional investors are entrenched under a scheme of shared power between the stockholders and the board. This scheme of shared power is viewed as a desirable reassertion of owner control and managerial accountability to shareholders. Not everyone, however, is confident that sufficient incentives exist for institutional investors to undertake the role envisaged under Pound's model. One shareholder whose relationship with management changed substantially over the course of events at Sunbeam was Ron Perelman. When Perelman originally took stock in Sunbeam as part of the Coleman deal, he was a classic passive investor. The shares were obtained as a substitute for cash payment. Fungibility was essential. The deal was structured to facilitate 233 exit from the company; Perelman could sell some of his stock after three months and all of his stock after nine months. It has been suggested that one of the reasons why Perelman did not take a position on the Sunbeam board at the time of the Coleman deal was that adopting a dual role in the company could have reduced Perelman's flexibility as an investor by potentially fettering his ease of exit should insider trading issues arise. After the removal of Dunlap, however, Perelman shifted into a different role, closer to that of "managerial partner" envisaged under Pound's model of governance. With the appointment of his close associate Levin as CEO, Perelman and his team had virtual control of Sunbeam at a managerial level. Though some regarded Perelman as having rescued Sunbeam through his engagement as an active shareholder, the post-Dunlap events themselves reflect a substantial danger of relational investing -- namely, that the interests of the relational investor may not be congruent with those of other shareholders. Soon after Levin took over as CEO, Perelman considered bringing legal proceedings against Sunbeam for losses resulting from the Coleman deal. The board was placed in the difficult position of potentially losing the company's new management team if no settlement could be reached. Ultimately, the board agreed to grant Perelman warrants to buy twenty-three million shares of Sunbeam stock at $7 per share, which could raise his stake in the company to twenty-eight percent. Although the Vice President of MacAndrews & Forbes issued a statement saying that its interests were aligned with all other shareholders in Sunbeam, this was open to substantial debate. Perelman had suffered a loss of over $500 million on the original value of his shares in Sunbeam. Yet, this was the result of his making what has been described as a "rookie's mistake" in the Coleman deal with Dunlap, by taking shares in part payment and by failing to include a collar provision in the contract to protect himself from any decline in value. Perelman, in contrast to other shareholders in Sunbeam and the directors who had been paid only in shares, was potentially able to salvage much of what he had lost in the Coleman deal. VI. CONCLUSION Every hero becomes a bore at last. Ralph Waldo Emerson The message of this paper is that the Sunbeam/Al Dunlap saga should not be dismissed as a vainglorious individual's fall from grace, or an isolated event that is unlikely to recur. A commercial culture, which stresses short-term profit maximization, together with current remuneration orthodoxy based on the alignment of managerial and shareholder interests, may provide strong incentives for manipulation of accounting records. Furthermore, Sunbeam highlights possible limitations on a number of protective governance mechanisms, including board structure and directors' duties. Although the board of directors of Sunbeam acted decisively in removing Dunlap from the office of CEO after revelation of poor performance, a range of other governance mechanisms were clearly flawed in their ability to prevent, or promptly recognize, the company's problems. The Sunbeam saga does not demonstrate that any single mechanism, such as an equity-holding board, is a governance panacea. Rather, it suggests that corporate governance is indeed a complex matter, that its role relates not only to issues of efficiency but also accountability, and that because many mechanisms are flawed, it is desirable to have a system of overlapping checks and balances. 234 235 CORPORATE GOVERNANCE: INTRODUCTION TO DIRECTORS' DUTIES AND SHAREHOLDER REMEDIES This class continues our introduction to corporate governance. Two techniques feature prominently in corporate law: duties imposed on directors to ensure that they exercise their managerial discretions appropriately; and remedies granted to shareholders to reverse or nullify company decisions that represent an abuse of managerial discretion or otherwise run counter to particular shareholders' interests. This class is an introduction to directors' duties and to shareholder remedies. Subsequent classes explore directors' duties and shareholder remedies in greater depth. For an overview of the legal structure to directors' duties, read the Casebook at paras 7.10-25. Then read the extract by Redmond which describes the relationship between directors' duties and the different theoretical conceptions of the company. Redmond also critiques other mechanisms for monitoring management. What legal consequences flow from breach of directors' duties? You should review CA, Part 9.4B, the civil penalty regime and read the Casebook at paras 7.55-65. Then read the first short extract by Blair and Stout, in which the authors contrast two possible rationales for directors' duties: shareholder primacy theory and team production theory. The second short extract by Blair and Stout questions whether these general law duties are explicable on the basis of shareholder primacy or team production. Which theory do you think has greater explanatory force? The issue of shareholder remedies invariably arises when: the directors mismanage the company and the majority shareholders -- most likely the directors themselves in their capacity as shareholders -- either refuse to bring corrective action or go so far as to forgive (ratify) the mismanagement; the majority shareholders pass a resolution in general meeting that effectively excludes the minority from proportionate participation in corporate management or diminishes the value of the minority's investment. In both scenarios, shareholder remedies appear to be a means of resolving conflicts between majority and minority shareholders. Read the Casebook at paras 8.05-10 for an account of why tensions might exist between majority and minority members, especially in small private companies. More broadly, given that majority members can appoint themselves or their representatives to the board, shareholder remedies also function as a check on corporate management. The extract by Hanrahan et al consider further why managerial indiscretions might pass unchallenged without shareholder remedies and outline the range of shareholder remedies (these we will be pursuing in detail in later classes) available. What is the effect of shareholder remedies on corporate governance? Are they an effective monitoring device on management? Ramsay considers this issue. 236 Redmond, P, "The Reform of Directors' Duties" in (1992) 15(1) University of New South Wales Law Journal 86 at 90-94 (footnotes omitted) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. THE FUNCTIONS OF DIRECTORS' DUTIES Managerialism and Directors' Duties What functions are served by the imposition of legal duties upon directors and senior management? The answer depends in part from the conception or theory of the corporation underlying the response. Under managerialist theories of the corporation, the prescription of legal standards protects against hazards inherent in a firm structure that has one group managing the funds of another the dual dangers of self-dealing and shirking by the managers. These dangers are the more egregious where the funds are contributed by numerous dispersed investors whose individual stakes are insufficient to justify close monitoring of the common fund, even if that lay within their capacities as holders. Protection against management self-dealing is afforded by fiduciary duties of loyalty which impose obligations of good faith and conflict avoidance upon directors and senior officers. Duties of care and diligence are directed towards the problem of shirking. In relation to both species of duty, the general law obligation is reinforced by a statutory duty in similar terms but with wider sanctions and remedies. Under managerialist theories therefore, legal duties, serve to insinuate an accountability mechanism to constrain management power and to strengthen shareholder controls. This strategy of strengthening shareholder influence and establishing appropriate modalities for management accountability has been the leitmotif of corporate law reform in North America, the United Kingdom and Australia during the past half century. [...] The Diminished Role of Legal Standards under Contract Theory A second body of theory of the corporation has gained considerable influence in policy discussion during the past decade and a half, particularly in the United States. Contract based theories were stimulated by economic writing in the 1970s developing Coase's conception of the firm as an alternative to contracting for production through the market. Under this theory the corporation is deconstructed to reveal no more than a `nexus of contracting relationships' between (inter alia) shareholders and managers. The corporate firm is contract, not hierarchy, and does not differ in the slightest degree from ordinary market contracting between any two people. The firm is simply a `highly specialised surrogate market'. Under contract theory, since the firm is no more than a web of contracts drawn from these markets, the view of the corporation as hierarchy disappears and with it the problem of management accountability and legitimacy. The optimal form of agency cost reduction is that determined by market exchanges between corporate issuers and investors. The role of corporate law and state regulation also declines since the contracting parties as rational utilitarians are entitled to structure their relations as they wish. The corporation being contract and not state concession, disciplinary constraints upon management should be left to the invisible hand of market forces although corporate law is useful to catch the non-repeat 237 instances of self-dealing and as a standard form contract which reduces the transaction costs of negotiating a fresh contract for each incorporation. In consequence, under contract theory corporate law is permissive and supplementary. It should not prevail over actual bargains and parties to the corporate contract should be entitled to opt out of the standard form contract, including that portion imposing civil duties upon management. Other Disciplinary Constraints The imposition of legal duties upon directors serves as but one device to reduce the agency costs which result from the divergent interests of principal and agent. They take their place along with bonding expenditures voluntarily incurred by managers to demonstrate their fidelity to shareholder welfare (such as the adoption of audit committees and the appointment of directors independent of management), shareholder monitoring to detect self-dealing or shirking and the discipline of markets to which the corporation is subject. A brief review of these non-legal mechanisms indicates the significance of legal rules as a management accountability mechanism. There are substantial limits upon the effectiveness of shareholding monitoring and enforcement as a constraint upon management. For a dissatisfied shareholder exit through the stock market will usually be far easier than exercising the protective remedies of company law. The logic of individual utility is sometimes expressed in the Wall Street rule under which it is assumed that a shareholder who is unhappy with a company's performance will simply sell the shares. Its logic arises since the gains from shareholder monitoring and agitation will be public goods accruing to all shareholders. The individual shareholder derives benefits from expenditures on monitoring and enforcement only rateably in proportion to his or her interest in the capital fund. Other shareholders who bear none of the costs of agitation also reap the benefits. The dominance of institutional share-ownership, however, carries the prospect that the investment institutions will monitor management to the advantage of the general body of shareholders. The calculus of advantage under the Wall Street rule appears profoundly different since the costs of organising collective action by institutional shareholders should be lower (bigger holdings and few holders with greater monitoring skills) and the benefits of exit appear diminished (institutions' holdings are often large in a relatively thin market). In practice, however, institutional shareholders have shown little inclination to monitor for the general body of shareholders. Indeed, several factors discourage them from closely monitoring portfolio companies, even in their individual interest. First, investment institutions are under intense performance review pressure from those (such as trustees of pension funds) who have committed funds to their management. Short term performance is, therefore, continuously on the line. Second, in a small investment community such as Australia there are numerous financial relationships with fund sponsors, clients and portfolio companies which may inhibit direct intervention or too close an examination of portfolio company management. Third, there are numerous potential conflicts between the interests of the general body of shareholders and those of the fund beneficiaries. Trends in institutions' investment theories also militate against the ownership impulse to monitor individual portfolio companies. As in the United States, the efficient capital markets hypothesis has considerable influence among Australian fund managers. This hypothesis assumes that stock markets work efficiently to quickly impound into the price of a security all available information affecting its value. The logic of the hypothesis is that over the medium and long term fund managers cannot `beat' the market by active trading and that comparable returns can be achieved at lower cost by simply `holding' the market, that is, by holding an investment portfolio whose composition matches that of the stock market as a whole. Monitoring individual companies within such a broadly diversified portfolio, even if feasible, 238 would squander the transaction cost savings of indexed investing. Hence, in United States collective action by institutional investors has largely been directed towards improving the corporate governance system generally, rather than monitoring and intervention in the affairs of individual companies. There are also substantial limitations upon market mechanisms as governance mechanisms. Thus, it is argued that if corporate managers pursue their own interests or act inefficiently or incompetently, the markets to which the corporation is subject will exact a corrective discipline. For example, the market for corporate control will provide an incentive for third parties to acquire control of an ill-managed company for a price less than its value under superior management. Further, such a company will need to bid a higher price for new capital by reason of its inferior management and will suffer in its product markets. Further, the reputational capital of its executive will be diminished in the wider market for managerial services. The theoretical force of each of these market disciplines is impaired, however, by a range of factors. Thus, the discipline of the market for corporate capital is diminished by corporate reliance upon internally generated funds as a substantial source of finance. The market for corporate control is at best a blunt and expensive instrument for management accountability. The markets for the corporation's products and executive services generally appear to assure only limited disciplinary force. 239 Blair, M and Stout, L, "A Team Production Theory of Corporate Law", (1999) 85 Virginia Law Review 247 at 287-292 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. .... II. A TEAM PRODUCTION ANALYSIS OF THE LAW OF CORPORATIONS During the past two decades, corporate scholarship has been dominated by a "contractarian" or "law and economics" approach that generally adopts some version of the grand-design principal-agent model of the firm and, as a consequence, also takes as given that corporations should be governed according to the norm of shareholder primacy. Thus, most contemporary corporate scholars tend to assume that directors' proper role is to maximize the economic interests of the corporation's shareholders. Recent years, however, have seen the rise of a second, opposing camp of theorists known as "communitarians" or "progressives." These scholars object to shareholder primacy on normative grounds, and argue that directors ought to be required to run corporations with due regard for the interests of other potential stakeholders such as employees, creditors, customers, suppliers, or the local community. Despite their many differences and disagreements, both the law and economics scholars and their progressive opponents share a common assumption: that, as a descriptive matter, American corporate law follows the shareholder primacy model. In other words, both camps believe that directors are controlled by, and owe extracontractual legal duties only to, shareholders. Two important features of U.S. corporate law appear to support this assumption. The first is the "derivative suit," a legal procedure that allows shareholders in some circumstances to file suit on behalf of the corporate entity against directors accused of breaching their duties to the firm. Because such substitute standing is usually granted only to shareholders, the derivative suit can be viewed as evidence that directors owe fiduciary duties to shareholders but not to other stakeholders, such as creditors and employees. The second feature of U.S. corporate law that seems to argue for shareholder primacy is shareholder voting rights. Unlike other stakeholders, shareholders are nominally entitled to elect (and, under some circumstances, to remove) corporate directors, and to vote on "fundamental" corporate changes. These voting rights appear to give shareholders a unique measure of control over how the firm is run. Because only shareholders normally enjoy voting rights and derivative standing, it seems natural to infer that corporate law intends directors to be subject only to shareholders' control and to serve only shareholders' interests. We argue below, however, that a more careful inspection of American corporate doctrine reveals compelling reasons to question this description of the relationship. Corporate law does not treat directors as shareholders' agents but as something quite different: independent hierarchs who are charged not with serving shareholders' interests alone, but with serving the interests of the legal entity known as the "corporation." The interests of the corporation, in turn, can be understood as a joint welfare function of all the individuals who make firm-specific investments and agree to participate in the extracontractual, internal mediation process within the firm. For most public corporations, these are primarily executives, rank-and-file employees, and equity investors, but in particular 240 cases the corporate team may also include other stakeholders such as creditors, or even the local community if the firm has strong geographic ties. We explore this interpretation of "the corporate interest" below and conclude that it offers a more accurate picture of American statutory and case law than does the shareholder primacy assumption. In particular, we argue that public corporation law encourages directors to serve the joint interests of all stakeholders who comprise the corporate "team" by generally insulating them from the demands of any single stakeholder group, including the shareholders. While in certain limited circumstances shareholders enjoy special rights not granted to other stakeholders, these rights are merely instrumental. Shareholders enjoy special legal rights not because they have some unique claim on directors, but because they often are in the best position to represent the interests of the coalition that comprises the firm. Thus, when directors breach their fiduciary duties and seek to profit personally at the firm's expense, shareholders sometimes can take legal action on the firm's behalf. As a general rule, however, the benefits of such derivative actions inure not just to shareholders, but to all stakeholders. Similarly, shareholders' limited voting rights may operate to benefit other stakeholders in the firm. We conclude that -- unlike the grand-design principal-agent model, which seems at odds with much of American corporate law -- the mediating hierarchy approach provides a solid theoretical foundation for the basic structure of public corporation law. This conclusion, moreover, contains both positive and normative components. From a positivist perspective, the way corporate law actually works in practice is consistent with the notion that directors are independent hierarchs whose fiduciary obligations run to the corporate entity itself and only instrumentally to any of its participants. From a normative basis, a team production analysis suggests that this is how the law ought to work. By preserving directors' independence and imposing on them fiduciary obligations that run to the firm as a whole and not to any particular team member, corporate law reinforces and supports an essential economic role played by hierarchy in general, and by corporate boards of directors in particular. A. Directors' Legal Role: Trustees More than Agents In exploring the relative advantages of the mediating hierarchy model of the public corporation, we begin by examining one of the greatest weaknesses of the prevailing granddesign principal-agent approach: its assumption that directors are agents of the firm's shareholders. The notion that directors are shareholders' agents has exerted enormous influence in the theoretical literature. Nevertheless, as Dean Robert Clark has pointed out, from a legal perspective it is a highly misleading description of the relationship between directors, shareholders, and the firm. Clark summarizes the law on the question as follows: (1) corporate officers like the president and treasurer are agents of the corporation itself; (2) the board of directors is the ultimate decision-making body of the corporation (and in a sense is the group most appropriately identified with "the corporation"); (3) directors are not agents of the corporation but are sui generis; (4) neither officers nor directors are agents of the stockholders; but (5) both officers and directors are "fiduciaries" with respect to the corporation and its stockholders. As this description reveals, corporate directors are not agents in a legal sense. The rules of agency provide that an agent owes her principal a "duty of obedience" -- in other words, the principal enjoys control over, and has the power to direct the actions of, the agent. Corporate directors depart radically from this model. As the ultimate decisionmaking body within the firm, they are not subject to direct control or supervision by anyone, including the firm's shareholders. Moreover, this fundamental principle of directorial discretion cannot be explained away as a legal response to the practical difficulties associated with shareholder voting. Even if a firm's shareholders were to pass a unanimous resolution directing the board 241 to pursue some course of action -- say, declaring a dividend, or firing a particular executive -- the board has no legal obligation to comply. Shareholders can elect directors and, under some circumstances, remove them -- but they cannot tell them what to do. Because American law does not permit shareholders to command the board to action, describing directors as shareholders' "agents" grossly misrepresents at least the legal nature of their relationship. In the eyes of the law, corporate directors are a unique form of fiduciary who, to the extent they resemble any other form, perhaps most closely resemble trustees. Like trustees, directors, once elected, become the ultimate decisionmaking authority within the firm, constrained primarily by their fiduciary duties. And like trustees -- whom the law permits to represent beneficiaries with conflicting interests -- directors are allowed free rein to consider and make trade-offs between the conflicting interests of different corporate constituencies. In other words, the prevailing academic wisdom that corporate law adheres to a shareholder primacy norm turns out to be mistaken. As we demonstrate below, American law in fact grants directors tremendous discretion to sacrifice shareholders' interests in favor of management, employees, and creditors, in deciding what is best for "the firm." This broad delegation of authority is both explained and supported by the mediating hierarchy model. If directors are to act as hierarchs, it is essential for them to hold the ultimate decision making authority within the firm and to be allowed full discretion to represent competing interests. If the board were instead subject to the direct command and control of one or more of the corporation's constituencies, that constituency could use its power over the board to seek rents opportunistically from other members of the productive team, thus discouraging team-specific investment. Accordingly, giving directors ultimate control over the corporation's assets serves economic efficiency by allowing coalitions that hope to benefit from team production but fear that their gains will be squandered in rent-seeking squabbling to "tie their own hands" for their mutual advantage. 242 Blair, M and Stout, L, "A Team Production Theory of Corporate Law", (1999) 85 Virginia Law Review 247 at 298-305 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. II. A TEAM PRODUCTION ANALYSIS OF THE LAW OF CORPORATIONS .... C. The Substance of Directors' Fiduciary Duties The preceding analysis of derivative suit procedure and standing suggests that corporate law permits shareholders to bring derivative suits primarily to protect the interests of the corporate entity, rather than the interests of shareholders alone. Once we move beyond procedure to look at the substance of derivative suits -- the rules that define the fiduciary duties derivative suits seek to enforce -- it becomes even more clear that these suits serve "the firm" rather than its shareholders. A survey of cases where directors have been charged with breach of fiduciary duty reveals a curious pattern: Corporate law only permits shareholders to bring successful derivative claims against directors in circumstances where bringing such claims benefits not only shareholders, but other stakeholders in the coalition as well. This pattern comes into sharp relief in examining the very limited factual circumstances under which directors can be sued successfully for breach of fiduciary duty. As we explore further below, case law generally divides directors' fiduciary duties into two forms: the duty of loyalty, and the duty of care. In both cases, directors generally will be subject to liability only for conduct that harms not just shareholders, but the corporate coalition as a whole. 1. The Duty of Loyalty Although on first inspection, the idea of a "duty of loyalty" sounds rather broad, in practice, American law has interpreted the duty quite narrowly. Indeed, case law has held directors liable for breach of the duty of loyalty only in two sorts of situations. The first involves selfdealing of the most obvious and egregious kind, as when a director enters into a transaction with a firm in her personal capacity or through a business entity she owns and controls. The second context involves directors taking a "corporate opportunity" by reaping profits from personal business ventures that either are in the same line of business as the firm's, or became available to them because of their corporate position. Despite its narrow focus, the duty of loyalty has teeth, and sets important substantive limits on directors' behavior. Nevertheless, the duty applies to only a very limited subset of all the possible situations where directors might use their corporate powers to serve their own interests. Most obviously, the duty of loyalty does not apply in circumstances where directors make strategic business decisions that provide nonmonetary benefits to themselves at shareholders' expense, a category Clark has labeled "corporate action with mixed motives." Thus directors do not breach their duty of loyalty when they use firm funds to build a lavish headquarters, or to make donations to their favorite charities. 243 In the next Section we will return to reconsider this peculiar limitation of the duty of loyalty. For the moment, we observe that case law on the duty of loyalty appears consistent with the mediating hierarchy model we are espousing. This is because the duty of loyalty, as conventionally and narrowly defined, protects employees, creditors, and other stakeholders just as much as it protects shareholders. After all, when directors use their corporate position to steal money from the firm, every member of the coalition suffers. Allowing shareholders to sue derivatively in loyalty cases thus conforms to the mediating hierarchy model by benefitting all who make up the corporate "team." 2. The Duty of Care, the Business Judgment Rule, and the Best Interests of "The Corporation" In addition to the duty of loyalty, corporate directors, in theory, owe their firms a duty of care. We say "in theory" because, while the idea of a duty to be careful at first appears to impose significant constraints on directors, in practice the duty of care is all but eviscerated by a legal doctrine known as the "business judgment rule." Because this doctrine seriously undermines directors' accountability to shareholders by virtually insulating directors from claims of lack of care, it seems inconsistent with the view that directors are shareholders' agents. The mediating hierarchy model we propose, however, suggests that the business judgment rule may serve an important economic function. In particular, the rule may help prevent coalition members (and especially shareholders) from using lawsuits as strategic devices to extract rents from the coalition. This is because the business judgment rule works to ensure that directors can only be found liable for breach of the duty of care in circumstances where a finding of liability serves the collective interests of all the firm's members. To earn the protection of the business judgment rule, directors must show that a challenged decision satisfied three requirements: (1) The decision was made "on an informed basis"; (2) the directors acted "in good faith"; and (3) the directors acted "in the honest belief that the action taken was in the best interests of the company." Although a requirement that directors inform themselves 125 before taking action obviously benefits shareholders, it also seems likely to benefit employees, creditors, and other stakeholders. Similarly, while case law provides little guidance on what if anything the requirement of "good faith" adds to the existing duty of loyalty, "bad faith" seems likely to pose a threat to all who contribute to the coalition known as the firm. Most importantly, however, the business judgment rule also requires directors to demonstrate that they honestly believed they were acting in the best interests of "the company." It is this third prong that most clearly suggests that American law views the corporation as an entity with interests of its own, and not just a proxy for shareholders' interests. This is because case law generally interprets the "best interest of the company" to include nonshareholder interests, including those of employees, creditors, and the community. Commentators who take shareholder primacy as a given may be inclined to view this claim with suspicion. Indeed, a number of nineteenth- and early twentieth-century cases appear to support the shareholder primacy norm by limiting directors' abilities to consider nonshareholder interests. The 1919 decision in Dodge v. Ford Motor Co. is one of the most frequently cited cases in support of the shareholder primacy view. In that case the Dodge brothers, minority shareholders of Ford Motor Company, sought to compel the highly profitable company to pay out a large dividend. The board of directors resisted, largely in response to Henry Ford's demand that the company's huge profits be used to create more jobs by expanding production and to benefit consumers by reducing Ford's car prices. The Michigan Supreme Court's opinion came down firmly on the side of shareholder primacy, declaring that "[a] business corporation is organized and carried on primarily for the profit of the stockholders." 244 As a number of scholars have pointed out, however, Dodge v. Ford Motor Co. was a highly unusual case. The Dodge brothers wanted cash dividends from Ford in order to start a competing business, and there was strong evidence of Henry Ford's hostility toward them as potential competitors. Accordingly, Ford's unapologetic claim that he wanted to retain cash to benefit other stakeholders may have been simply a provocative red herring. The real tension in the case may not have been between shareholders and stakeholders, but between two groups of shareholders. The latter possibility is especially important because the Ford Motor Company was, at the time, a closely held corporation. Shareholders in close corporations typically act not just as investors but also as managers involved in the day-to-day operations of the firm. As a result, shareholders in close corporations are often tempted to use their managerial powers opportunistically to exploit their fellow shareholders, with whom their interests are frequently in conflict. To address this problem, the law of close corporations calls for heightened fiduciary duties that run not from directors to the firm, but from shareholder to shareholder. Thus, the decision in Dodge v. Ford Motor Co. is most accurately construed as a statement about the special duties shareholders owe each other in closely held corporations, not about the relationship between shareholders and other stakeholders in a corporation. More importantly, even if Dodge v. Ford Motor Co. applied to public corporations, case law has evolved significantly since 1919, and in a direction that disfavors the shareholder primacy view. As early as the 1930s the conflict between shareholder primacy and the emerging stakeholder perspective was highlighted in a famous debate in the Harvard Law Review between two prominent legal scholars, Adolf Berle and E. Merrick Dodd. 138 By the 1950s, Berle was ready to concede that, as a matter of law, "[corporate] powers [are] held in trust for the entire community." Berle's retreat is supported by a series of mid- and late-twentiethcentury cases that have allowed directors to sacrifice shareholders' profits to stakeholders' interests when necessary for the best interest of "the corporation." Thus judges have sanctioned directors' decisions to use corporate funds for charitable purposes; to reject business strategies that would increase profits at the expense of the local community; to avoid risky undertakings that would benefit shareholders at creditors' expense; and to fend off a hostile takeover bid at a premium price in order to protect the interests of employees or the community. As these examples illustrate, modern corporate law does not adhere to the norm of shareholder primacy. To the contrary, case law interpreting the business judgment rule often explicitly authorizes directors to sacrifice shareholders' interests to protect other constituencies. Some legal commentators and some cases explain this approach as being in shareholders' interests in the "long run." This explanation makes little sense, however, under a grand-design principal-agent model that views shareholders' interests as meaning the interests of the shareholders of the particular firm whose directors are at that moment favoring other constituencies. Consider, for example, the common scenario in which a court upholds a board's discretion to reject a takeover bid at a substantial premium in order to protect the interests of the firm's employees or the community. How can rejecting a premium offer benefit the long-run interests of the present pool of shareholders if -- as modern financial theory holds -- today's lower market price reflects the best possible estimate of those shareholders' future returns under current management? In contrast, the mediating hierarchy model predicts that shareholders benefit from granting directors discretion to favor other constituencies, because it suggests that shareholders' "longrun interest" should be interpreted to mean the long-run interests of all the shareholders who hold, have held, or will hold stock in the firm, including those original investors who bought their shares when the firm first went public. Opportunistically exploiting the firm-specific investments of corporate stakeholders (say, violating employees' expectations of job security by moving the firm's manufacturing plants to Mexico) may well benefit, in both the short and the long run, those individuals who happen to hold shares in the corporation at the time the 245 decision to move is made. If the firm's employees anticipated this sort of conduct ex ante, however, they might well have demanded higher wages -- or been more reluctant to invest in firm-specific human capital -- in earlier years. The mediating hierarchy model thus lends intellectual content to the argument that treating directors as trustees charged with serving interests above and beyond those of shareholders in fact can be in shareholders' "long-run interests," because a shareholder decision to yield control rights over the firm to directors ex ante -- that is, when the corporate coalition is first formed -- can induce other participants in the team production process to make the kind of firm-specific investments necessary to reap a surplus from team production in the first place. Thus, a broad interpretation of the business judgment rule that permits directors to sacrifice shareholders' interests to those of other corporate constituencies "ties the hands" of shareholders in public corporations in a fashion that ultimately serves their interests as a class, as well as those of the other members of the corporate coalition. 246 Hanrahan, P, Ramsay, I and Stapledon, G, Commercial Applications of Company Law (2002) at 322-324 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. OVERVIEW OF REMEDIES What are the remedies What are the remedies available to members? Some are statutory remedies while others are general law remedies (that is developed by the courts). The statutory remedies include: taking legal action to obtain any of a wide range of remedies for oppressive conduct: Part 2F.1; seeking to wind up the company because it is just and equitable to do so, or because the directors are acting in their own interests: s 461; seeking an injunction to stop a director, member or other person contravening the Corporations Act: s 1314; seeking to prevent a variation of any rights attached to the shares of the member: Part 2F.2; taking legal action for a breach of a general law duty owed by a director or other officer to the company. We have seen that, because general law duties are owed to the company, it is the company, it is the company which will bring legal action to enforce a breach of the duty. However, ... in some circumstances, the court will allow an individual member to bring the legal action because the company will not do so. This is called the member's statutory derivative action: Part 2F.1A. The general law remedies available to a member include: seeking to enforce a personal right of the member (for example, the right to vote) where the directors or majority members are attempting to take away this right; and taking legal action because the majority members have, by exercising their voting power in an improper way, breached the equitable limitation on majority voting power. [...] Why are remedies needed? Why do minority members need these remedies? There are many actions of directors and the majority members which can harm minority members. For example, ... majority members may: amend the company's constitution in a way which disadvantages the minority (for example, the constitution may contain a provision giving a class of minority members a right to appoint their own director and the majority endeavours to delete this provision); or vote to approve the sale of assets of the company to themselves at a price which is below the market value of the assets. Actions of directors may also harm minority members. For example, the directors may: pay themselves excessive remuneration and, at the same time, refuse to have the company pay dividends to members; 247 divert business opportunities away from the company to themselves so that the company and its members suffer financial harm; or issue shares in the company to themselves with the objective of becoming majority members and reducing the proportion of shares held by other members. A minority member who is disadvantaged by actions of majority members or directors may elect to sell their shares. However, ... this is not always possible. While this may be possible in a company which has its shares listed on the Stock Exchange and there is a liquid market for their shares, most companies do not have a liquid market for their shares. It is common for small proprietary companies to have a provision in their constitutions limiting the right of members to sell their shares. This is because the members of those companies want control over who become members. A restriction often found in constitutions of proprietary companies is one which requires a member to obtain the permission of directors prior to the member selling their shares. This means that a minority member who is disadvantaged by actions of directors or the majority members may be unable to sell their shares. In these circumstances, the legal remedies available to the minority members are very important. Difference between the member's derivative action and other remedies One of the remedies we examine ... is the member's derivative action. A derivative action is a legal action which should be brought by the company, for example where there is a breach of a general law duty. We have seen that this duty is owed to the company and therefore it is the company which should bring legal proceedings for breach of the duty. Where the company does not bring the legal proceedings we will see that in some circumstances, the court allows an individual member to bring a derivative action on behalf of the company. The member's legal action derives from the company's legal action. There is an important difference between: the member's derivative action; and the member's statutory remedies and the member's personal action. The derivative action is brought by a member but it is based on a legal action which the company has (for example, a breach of duty owed to the company). This means that if the derivative action is successful and the director is ordered by the court to pay compensation, the compensation is paid to the company and not to the individual member. This is because it is the company which has the right to bring the legal action and although the court has allowed an individual member to bring the legal action, the member is bringing the action on behalf of the company. Although the member who brings the successful legal action will not directly receive the compensation which the director is ordered to pay, the member will benefit indirectly because the compensation is paid to the company. In relation to the statutory remedies of members and the personal action available to members, these legal actions are brought in a personal capacity because the member has a personal right or is affected individually. The member does not bring the legal action on behalf of the company. This means that if the individual member is successful in the legal action, then it is the member who directly receives the benefit of any order made by the court. 248 Ramsay, I, "Corporate Governance, Shareholder Litigation and the Prospects for a Statutory Derivative Action", (1992) University of New South Wales Law Journal 149 at 151-156 (footnotes omitted) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. SHAREHOLDER LITIGATION AND CORPORATE GOVERNANCE One of the major themes of corporate law concerns the tension between control and accountability. In large public companies managers are given significant discretion in the running of the business. Indeed, this discretion is so broad that it effectively means management control of these companies. This control can lead managers to act in their own interests rather than in the interests of shareholders. Consequently, much of the existing corporate regulatory structure concerns itself with endeavouring to ensure the accountability of managers without unduly encroaching upon their discretionary powers. The divergence of interest between managers and shareholders results in costs (agency costs) that can be divided into several categories: Monitoring costs incurred by shareholders to ensure that managers are acting in the interests of the shareholders. Bonding costs incurred by managers with the purpose of assuring shareholders that their interests are being pursued. According to one commentator "[t]he derivative suit is a monument to the problem of agency costs; it would make no sense to allow a shareholder to bypass the corporate management in bringing a suit against an officer if one could be confident that management always acted in the shareholders' interest". The American Law Institute has argued that the shareholder derivative action reduces agency costs in a number of ways. First, it operates to deter mismanagement (by imposing the threat of liability) and therefore aligns the interests of managers and shareholders. Second, it can reduce one part of the agency costs; namely, monitoring costs incurred by shareholders. Both because the plaintiff's attorney is typically a specialist in such litigation and because shareholder coordination is not necessary in the case of the derivative action, it seems reasonable to believe that the availability of this action economizes on costs that would otherwise be necessarily incurred if shareholders were required to take collective action. [...] However, there are a number of ways in which agency costs can be reduced other than by shareholder litigation. These include shareholder voting, the work of corporate regulators and market forces. In order to understand what role should be assigned to shareholder litigation, it is necessary to consider both the advantages and the limits of these other mechanisms. Corporate regulators such as ASIC and the ASX play an important role in deterring mismanagement and thereby reducing agency costs by enforcing the corporations law and the Stock Exchange Listing Rules. Yet it is impractical to rely exclusively on public enforcement. This has to be balanced by private enforcement for several reasons. First, limits on the 249 funding of corporate regulators means that they cannot, of necessity, pursue all breaches of the law. Second, there is no reason to believe that the priorities established by a corporate regulator for enforcement are necessarily the correct ones. This dictates a role for private enforcement. Third: ...When the legal system assigns a substantial enforcement role to private litigation, there is less need to rely on public agencies and in turn the tendency of such public agencies to expand their jurisdiction is less likely to produce excessive bureaucratic regulation of private enterprise. In addition, absent private enforcement, the State holds a monopoly on the access to remedies and it can determine, sometimes arbitrarily or for political reasons, not to enforce rights or duties it had previously guarded. Thus, private enforcement serves a fail-safe function and ensures greater stability in the application of the law. It might be argued that an enforcement mechanism available to shareholders, other than litigation, is the right to vote. In other words, managers will act in the interests of shareholders because otherwise shareholders might vote for their removal. However, it is now widely recognised that shareholder voting in large public companies tends not to be a potent force. The reason is that it suffers from a collective action problem. The act of voting, and becoming informed enough to vote intelligently requires an investment of time, which is a scarce resource. Yet the shareholder's vote is unlikely to affect whether a proposal wins or loses. The cost and futility of becoming informed leads shareholders to choose rational apathy: they do not take the time to consider particular proposals, and instead adopt a crude rule of thumb like "vote with management". Collective action theory also tells us, the critics argue, that shareholders will not make economically motivated proposals or actively oppose manager proposals unless the potential gains are much larger than the cost of the effort. A shareholder proponent bears most of the cost of a ... campaign, but receives only a pro rata share of the gains from success, while other shareholders free-ride on her efforts. Free-rider problems work in tandem with rational apathy of the free riders to discourage shareholder proposals from being made. There are a number of other ways whereby shareholders or managers may reduce agency costs. For example, it is claimed that independent directors are an effective means of ensuring management accountability to shareholders ... . Some commentators question such calls for increasing the number of independent directors on the basis that these directors increase the cost of running companies because of their lack of familiarity with the business. However, there is empirical evidence that the appointment of independent directors does result in an increased share price and therefore is perceived to be a positive development by shareholders. Other ways in which managers provide assurances to shareholders that their interests are being pursued include the voluntary disclosure of corporate information and the use of accountants and auditors to verify this information. ... It also needs to be recognised that there are a number of market forces that, depending upon the circumstances, operate to align the interests of shareholders and managers. These include the product market, capital market, market for corporate control and the labour market for managers. While these market forces can operate to reduce agency costs they are subject to limitations. For example, ... the market for corporate control may have little or no application to private companies. Yet private companies constitute the vast bulk of companies in Australia. The Corporations Act requires a private company to restrict the right of the market for corporate control. A number of other factors may limit this market including defensive tactics employed by managers of companies which are potential takeover targets. More generally the activeness of the market for corporate control can vary significantly. [...] In addition, Coffee has argued that the market for corporate control applies within a limited range. Companies in which the degree of inefficiency is not extreme enough to create a 250 sufficient reduction in the share price to cause a takeover and companies in which the degree of inefficiency is so extreme as to preclude a takeover because it is such a risky undertaking, fall outside this range and the market for corporate control may only weakly discipline these companies. In support of Coffee's argument, it is easy to identify a number of public companies in Australia, shareholders in which have sustained systematic losses. Finally, the market for corporate control may be inadequate to deal with one-time defalcations by managers. This discussion means that there is a role for shareholder litigation in reducing agency costs. However, shareholder litigation needs to be viewed as one of a number of mechanisms that have this goal. Moreover, it should not be assumed that shareholder derivative actions are an unqualified good. Not all derivative actions brought on behalf of the company will be in the interests of that company. In addition, a common argument made opposing shareholder litigation is that it deters legitimate risk-taking on the part of managers. [...] It should be noted that empirical studies have found that the view that there is excessive shareholder litigation in the United States is an exaggeration. [...] A final issue warrants discussion. The argument that the primary role of shareholder derivative actions is the reduction of agency costs assumes that such actions deter mismanagement. However, it has been argued that civil actions (including shareholder civil actions) cannot yield the optimal level of deterrence and indeed, that this level is very difficult to estimate. Coffee and Schwartz note that United States courts have generally assumed that a compensatory rationale underlies the derivative action. They argue that compensation cannot be the main purpose of derivative actions for three reasons. First, the change in compensation of shareholders means that shareholders at the time of the injury who subsequently dispose of their shares prior to a court ordered recovery do not obtain compensation while incoming shareholders receive a windfall gain. Second, the injury to the company resulting from, for example, a breach of directors' duties, is not necessarily the same as the injury suffered by shareholders. Third, it is noted that in the typical derivative action, while the total amount of recovery may be significant, it is generally de minimis on a per share basis. [...] Coffee and Schwartz conclude that while these arguments do not imply that compensation is an illusory goal, they do indicate that the main goal for the derivative action is a deterrence rationale. This goal of deterrence can be viewed as a key element in reducing the agency costs inherent in the management of public companies. 251 CORPORATE GOVERNANCE: DIRECTORS' DUTIES (1) This class -- and the seven that follow it -- explore corporate governance in greater depth. The first series of five classes focus on particular types of directors' duties (see Corporations Act s179); the next series of three classes examine different shareholder remedies. The readings for this class examine the duty of care, skill and diligence and then examine the duty to prevent insolvent trading. First, read the Casebook at paras 7.70-100 for the case law on the duty of care, skill and diligence at general law and under the Corporations Act. Notice how the duty has developed, particularly with the Daniels decision. Then read the case book at paras 7.105-130 for an analysis of the business judgment rule. See also the Corporations Act s180, and Pt9.4B. Read Corporations Act, ss 189, 190 and 198D and consider what scope there is for directors to delegate and to rely on others for advice and information. The extract by Stokes critiques whether directors' duties, such as the general law duties of care, skill and diligence, are effective in curbing the power of managers. Do you agree with her analysis? Finally, read the Casebook at paras 7.135-190 on the duty to prevent insolvent trading. See also Corporations Act ss 588G-Z (especially ss588G and 588H) and Pt5.8A on employee entitlements. 252 Stokes, M, "Company Law and Legal Theory" in Wheeler, S (ed), A Reader on the Law of the Business Enterprise (1994), 80 at 98-103 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Fiduciary Duties as a Mechanism for Controlling Managerial Power The second mechanism for controlling managerial power ...[is] fiduciary duties imposed upon the directors and officers of the company. These duties can be formulated as three distinct rules. Directors owe a duty of care and skill; a duty of loyalty; and a duty to act bona fide in the best interests of the company and not for any improper purpose. One analysis of the function of these duties is that they ensure that the directors of the company have sufficient discretion and flexibility to be able to manage the company efficiently, whilst precluding them from exercising this discretion contrary to the interests of the shareholders. Much of the same problem has arisen in administrative law. Here the problem is one of balancing an administrative body's need for substantial discretion to make choices between different courses of action and the desirability of giving the courts power to intervene to prevent the discretion being exercised contrary to the intention of the legislature. Judicial review of the exercise of discretionary powers by administrative bodies has been selfconsciously based on the need to ensure that the intention of the legislature is implemented and that discretionary power is subjected to some sort of control in the name of the Rule of Law. The review of directors' managerial decisions can be viewed as being motivated by a similar desire to ensure that directors exercise their powers only in accordance with the will of their constituents (the shareholders) and that they are subjected to the controls often associated with the Rule of Law to prevent them from using their power arbitrarily. The idea that there is a strong parallel to be drawn between judicial review in administrative law and company law is further strengthened by the similarities between standards of review used in these two fields. Where broad discretionary powers have been conferred upon public authorities the courts take it upon themselves to review the exercise of those powers to ensure that the body does not make decisions which are so unreasonable that no reasonable body could have come to such a decision; to ensure that the decision-makers are not biased and that decisions are not made mala fide or for any improper purpose. It can be suggested that the fiduciary duties imposed on directors subject them to similar standards of review by the courts. Thus the duty of care prevents directors acting wholly unreasonably; the duty of loyalty ensures that their decisions are not biased; and the duty to act bona fide in the interests of the company and not for any improper purpose is almost identical in its formulation as a standard of review to the administrative law test striking down decisions which are taken for an improper purpose. In administrative law the theory is that the courts are simply implementing the will of the legislature by subjecting the exercise of discretionary power to these standards of review. In company law it can be equally argued that by casting trustee-like duties on directors so that they are required to act only in the interests of the shareholders the law aims to ensure that the will of the shareholders is implemented. If this is the object of imposing fiduciary duties on directors it fails. This is because in considering what are the interests of the shareholders the 253 directors are not obliged to actually consider when the subjective desires of the shareholders might be. The interests of the shareholders become an objective standard to govern the actions of the directors. Yet it is an objective standard which the directors themselves define, and not one that is imposed upon them by the courts, who regard it as illegitimate to substitute their own view of what constitutes the best interests of the company or the shareholders for that of the directors of the company. So the injunction to directors is that they must act bona fide in what they, and not the court, thinks are the best interests of the company. In conclusion, the argument that the duty of directors to act only in the interests of the shareholders operates to ensure that the will of the shareholders is implemented by the managements of the company is fundamentally flawed because the directors have considerable discretion in defining exactly what the interests of the shareholders are. Sometimes it is argued that the interests of the shareholders can provide the directors of the company with a purely objective standard on which to based their decisions if the interests of the shareholders are equated with profit-maximization. Apart from the fact that this ignored the possibility that shareholders may have other objectives in investing (such as opposing investment in countries practising apartheid, or opposing the manufacture of armaments or cigarettes, etc.) the profit-maximization norm does not provide a hard guideline as to how directors should exercise their discretion. They still have discretion to determine whether it is long-term or short-term profitability that they should be striving to achieve and discretion as to how to go about realizing that goal. Thus even if we accept that the duty of directors to act in the best interests of shareholders can be equated with a duty to maximize profits this does not provide us with any real assurance that the wishes of the shareholders are being executed by the directors or that we have a satisfactory way of controlling the discretion accorded to directors in the name of the Rule of Law. Another analysis of the function of imposing fiduciary duties on directors is that these duties are designed to ensure that directors act only within the ambit of their special expertise. It has been seen that the modern justification for conferring broad discretionary power upon both corporate managers and administrative agencies is their special expertise. Not only is expertise the justification for giving broad discretionary power to both corporate managers and administrative bodies, it also supposedly limits and controls the exercise of their power. The theory is that the range of decisions open to managers and administrative agencies is limited because a set of criteria derived from their expert background and training governs their decisions. The function of fiduciary duties is to provide the courts with standards of review that enable them to guarantee that corporate managers do not act outside the limits of their special competence. Once again a similar argument exists in administrative law -- namely that the function of judicial review is to ensure that public bodies only take decisions which are within the scope of their expertise. Thus it can be argued that although the courts proclaim that in reviewing the decisions of an administrative body they are merely attempting to keep the body within the jurisdiction conferred upon it by Parliament, in fact they do sometimes explicitly justify their decisions by reference to the expertise or lack of expertise of the body whose decision it is sought to review. There is an ambivalence in the expertise theory. There are two views of the purposes for which corporate managers will ensure that they use their expertise. One view is that the expertise of the managers will ensure that they use their broad discretionary power to maximize the profits of the company in the interests of the shareholders. By preventing management from straying outside their competence fiduciary duties act as an alternative mechanism to the internal organization of power within the company for forcing managers to maximize profits. The common aim is to bring the company back in line with the profitmaximizing firm of the model of perfect competition. An alternative to this view is that corporate managers use their expertise to help define and implement the broad purpose of the organization, which is assumed to be that of furthering the public interest. This view is part of the corporatist vision of the company which will be more fully examined later. The contrast I 254 wish to draw here is between an image of the corporate manager as an expert profitmaximizer and an image of him as a trained public servant. It is the former image which the courts have tended to have before them when reviewing the decisions of corporate managers. Both these version of the expertise theory assure us that the special expertise of directors at once justifies conferring upon them the discretion to run the business and imposes a restraint on how they exercise that discretion. Directors will only act according to professional standards of behaviour and the range of decisions available to them will be indicated by their own expertise. In theory it would be possible to rely simply on the professional background and training of corporate managers to act as a self-imposed limit on their discretion. Instead, however, we rely on the courts to review managerial decisions as a means of double checking that the directors are acting professionally (that is impersonally and for ends related to that of their organization). The courts' own role in reviewing managerial decisions is in turn defined by their own expertise. They are not competent to make business judgments but they have a special skill in detecting and thwarting management self-dealing. Hence they will not substitute their views as to the proper management of a company but they are prepared to articulate standards of review which are designed to catch self-dealing on the part of managers. The duty of loyalty has generally been invoked to prevent directors from having a personal financial interest in a decision, whilst the duty to act not for any improper purpose has sometimes been invoked to rule out decisions where directors have some other sort of personal but not directly financial interest in the decision. The difficulty encountered by the expertise theory in trying to demonstrate the legitimacy of corporate managerial power by showing that there are restraints on the discretion of the managers stems from its attempt to combine a deference to the judgments of business managers with an insistence that corporate managers as subject to fiduciary duties that prevent them from exercising their power for their own purposes or for other non-corporate ends. The problem is there is no satisfactory way of drawing a line between decisions of corporate mangers which ought to be respected because they are based solely on the expertise of the directors and those which should be challenged as based on personal considerations or other non-corporate purpose. This is well illustrated by the controversy in the case-law about the legitimacy a company's board of directors taking defensive action against a threatened take-over bid by issuing shares to someone who can be relied upon to support the incumbent management. The Canadian position is that the board of directors, provided it is acting in what it considers to be the best interests of the company, must have the discretion to take defensive measures against an imminent take-over. The assessment of the bidder's capacity to run the target company is, in other words, something which lies within the range of the directors' expertise. By contrast, the position ultimately reached in the English cases is that if the primary reason for issuing new shares is to fend off a potential bidder for the company then the decision of the directors will be one that the courts can overturn even if the directors are acting bona fide in the best interests of the company. It can be argued that the English courts have concluded that the danger that the judgment of the directors might be swayed by their own personal interest in retaining control of the company takes the decision outside the province where we should defer to their skill and judgment. Thus there is enormous difficulty both in defining precisely what we mean by expertise and in marking out what decisions will be considered to be taken for personal other non-organizational ends. This difficulty in drawing a line between those decisions that are based on expertise and those that are influenced by personal or other non-corporate considerations means that we have become suspicious of legal argument. Arguments based on deference to the judgment of corporate managers or those based on the finding of a personal interest or a non-corporate purpose on the part of the directors have the appearance of mere slogans to justify either judicial restraint or intervention. This in turn can lead us to query the legitimacy of judicial review, since it appears to be an ad hoc affair rather than a process governed by any firm and coherent standards. 255 There is one further practical consideration which suggest that fiduciary duties are ineffective in constraining the discretion of directors. Fiduciary duties depend on their enforcement on the shareholders taking action against the wrongdoing corporate managers. Yet we have seen that due to the dispersion of shareholding in the large public company they have no incentive to inform themselves of the actions of their managers or to seek a remedy against them. We can conclude that so far the law's quest to subject the power conferred on corporate managers to controls to prevent it form being exercised arbitrarily has not been successful. The internal organization of the company does not provide an adequate safeguard against the power of the managers being used for their own ends; and the imposition of fiduciary duties does not ensure that the discretion of the managers is only exercised either in accordance with the wishes of the shareholders or in accordance only with the expertise of the managers, since both these concepts prove impossibly difficult to define. Added to this is the doubt whether, because of the wide dispersion of shareholding in the large public company, shareholders can be relied upon to invoke the legal remedies at their disposal. The legal model's attempt to equate corporate managers with ordinary entrepreneurs acting so as to maximize the profits of the company should be recognized for what it is -- a failure. 256 CORPORATE GOVERNANCE: DIRECTORS' DUTIES (2) The readings for this class examine the directors' duty to act bona fide for the benefit of the company as a whole. Read the Casebook at 7.215-50 for an overview of this duty. Then read paras 7.255 and 7.265 and 7.280-295 for the relevant case law. See also Corporations Act ss 181, 184, 187, 189 and Pt 9.4B. Finally, read the extract by Blair and Stout for an explanatory account of this area of the law. How might law-and-economics scholars and communitarians respond to their analysis? 257 Blair, M and Stout, L, "A Team Production Theory of Corporate Law", (1999) 85 Virginia Law Review 247 at 305-308 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. II. A TEAM PRODUCTION ANALYSIS OF THE LAW OF CORPORATIONS 3. Director Adoption of Takeover Defenses and Other "Mixed Motive" Cases The discussion above suggests that case law extending the business judgment rule to situations where directors opt to sacrifice shareholders' returns for other constituencies fits neatly within the mediating hierarchy model of the firm, which views directors as a form of third-party trustee charged with balancing the competing interests of the many stakeholders who comprise the firm. The mediating hierarchy model also may offer a potential explanation for another interesting aspect of corporate law that has puzzled commentators: why courts apply the protections of the business judgment rule -- not the far more restrictive loyalty analysis -- to "mixed motive" cases where directors appear to be using their corporate powers not to benefit the firm, but to benefit themselves. Because the duty of loyalty limits obvious self-dealing or takings of corporate opportunities, corporate law makes it difficult for directors to extract any monetary gain from their position with the firm beyond their agreed-upon compensation. However, this narrow interpretation of the duty of loyalty ignores the obvious reality that directors often can use their corporate powers to provide themselves with nonmonetary benefits, such as an increase in their own authority, security of position, and quality of life. For example, directors may decide to retain corporate earnings and build empires instead of paying shareholders dividends; to avoid risky ventures even when accepting risk might substantially increase the firm's expected profits; to resist hostile takeovers even at premium prices; and to choose the "quiet life" over a hardnosed approach of confrontations and conflicts with bondholders, employees, and community leaders. Courts generally decline to treat these sorts of cases as loyalty issues and instead apply the liberal business judgment rule to such actions. This judicial tolerance is hard to reconcile with a shareholder primacy norm. The mediating hierarchy model, however, helps explain why corporate law declines to intervene in directors' decisions, even in these mixed motive cases. The reason is that the pursuit of directors' nonmonetary interests in mixed motive situations often benefits other stakeholders in the firm, even as it harms shareholders. Consider the example of a board's decision to reduce the volatility of a firm's earnings by acquiring an unrelated business or by using derivatives for hedging. Modern portfolio theory teaches that reducing such firm-specific or unique risk does not benefit diversified shareholders. Reducing unique risk does, however, benefit directors by decreasing the likelihood that their firm will become insolvent and they themselves might lose their positions. Yet, in addition to benefitting directors, reducing unique risk also benefits other corporate constituents -- including managers, rank-and-file employees, and creditors -- who have a stronger interest than the shareholders do in ensuring that the firm remains solvent. 258 A second example arises where a board chooses "the quiet life" by granting concessions to labor unions or creditors. While such a strategy obviously is contrary to shareholders' interests, it just as obviously benefits other members of the coalition that make up the firm. Thus, a broad interpretation of the business judgment rule that permits directors to sacrifice shareholder wealth in this fashion again may serve the interests of the corporate coalition even though it allows directors to serve their own nonmonetary interests. The evident unwillingness of judges to second-guess directors' decisions even in such cases is strong evidence that corporate law protects directors' discretion to favor nonshareholder constituencies, even when directors may abuse this discretion to serve themselves. Perhaps the most interesting example of the law's tolerance for director actions with mixed motives can be found in case law applying the business judgment rule to a board's decision to fight off a hostile takeover bid at a premium price. A board's decision to resist a hostile offer often can protect the expectations of the firm's employees, creditors, managers, or other team members who have made firm-specific investments, especially when the bidder appears poised to alter the structure of the firm by downsizing, recapitalizing, or simply replacing existing management. At the same time, because a takeover also threatens the principal benefit directors reap from being directors (their positions on the board), this situation presents the potential for conflict not only between the board and the shareholders, but between the board and other stakeholders as well. Interestingly, Delaware courts have modified the business judgment rule in takeover situations, in recognition of this threat of directorial self-interest. In the landmark 1985 case of Unocal Corp. v. Mesa Petroleum Co., the Delaware Supreme Court held that directors of public corporations who wish to resist a hostile takeover bid cannot claim the protection of the business judgment rule unless they first demonstrate that the proposed takeover poses a threat to the "corporation." The Unocal decision also made clear, however, that in deciding whether there is a threat to the corporate entity, the directors of the corporation are invited to consider "the impact on...creditors, customers, employees, and perhaps even the community generally." In other words, Unocal squarely rejects shareholder primacy in favor of the view that the interests of the "corporation" include the interests of nonshareholder constituencies. Unocal's reformulation of the business judgment rule in the takeover context is itself subject to an exemption that provides intriguing -- if tentative -- evidence in favor of the mediating hierarchy model. Less than a year after deciding Unocal, the Delaware Supreme Court was again called upon to apply the business judgment rule in a takeover context in the case of Revlon, Inc. v. MacAndrews & Forbes Holdings. In that case, the directors of Revlon corporation adopted defensive strategies that favored a friendly bidder over a hostile bidder, citing in part a desire to protect the interests of certain creditors of the firm. The Delaware Supreme Court held that the directors had violated the business judgment rule because when "break-up of the company was inevitable ... the duty of the board ... changed from the preservation of Revlon as a corporate entity to the maximization of the company's value at a sale for the stockholders' benefit." Thus, the court held that "the directors' role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company." On first inspection, this language appears to support shareholder primacy. Closer analysis suggests, however, that Revlon may in fact support the mediating hierarchy model. Although the Revlon opinion did not clarify what it meant to say that a company's "break-up" was "inevitable," in subsequent cases Revlon has been interpreted to apply "when a majority of a corporation's voting shares are [to be] acquired by a single person or entity, or by a cohesive group acting together." In other words, Revlon applies when a formerly publicly held corporation is about to become essentially a privately held firm. As noted earlier, in closely held firms subject to the control of a single shareholder or group of shareholders, directors enjoy relatively little independence and can no longer function effectively as mediating 259 hierarchs. Thus the Revlon exception to the general rule may reflect an intuitive judicial recognition that when a firm "goes private," it abandons the mediating hierarchy approach in favor of a grand-design principal-agent structure dominated by a controlling shareholder. 260 CORPORATE GOVERNANCE: DIRECTORS' DUTIES (3) The readings for the next two classes focus on the duty of directors to avoid conflicts. This duty comprises three overlapping principles, the first of which will be the subject of this class and the other two the subject of the next class: company directors must not, in any matter failing within the scope of their service, have a personal interest or inconsistent engagement with a third party, except with the company's fully informed consent (the conflict rule) company directors must not misuse their position for their own or a third party's possible advantage, except with the company's fully informed consent, and therefore they must account to the company for any gain which they make in connection with their fiduciary office (the profit rule) company directors must not misappropriate the company's property for their own or a third party's benefit (the misappropriation rule). The fiduciary nature of the duty to avoid conflicts, and a general discussion of its equitable implications, is canvassed in Chan v Zacharia (Casebook at para 1.155). Although this case is about a partnership, the discussion in the judgments applies in equal force to companies. Read the Casebook at paras 7.340-80 and paras 7.505-30 for the relevant legal principles concerning the conflict rule more specifically. These principles deal with (i) when a conflict might arise; (ii) how such conflicts might be cured; and (iii) what remedies might be pursued against directors who breach the conflict rule (and, indeed, the profit and misappropriation rules). See also Corporations Act ss181-184, 189, 191-196 and Pt9.4B. 261 CORPORATE GOVERNANCE: DIRECTORS' DUTIES (4) The reading for this class continues from last class the discussion on the duty to avoid conflicts. In this class, we turn to the profit and misappropriation rules. Read the Casebook at paras 7.455-500 for the relevant legal principles. You will note that most of the cases involve instances of secret profit-making as well as misappropriation of company property, thereby invoking both rules. See also Corporations Act ss 182-183 and Pt9.4B. 262 CORPORATE GOVERNANCE: DIRECTORS' DUTIES (5) The reading for this class brings to a close the discussion on directors' duties. The class deals with three key topics: The special conflict avoidance rules imposed on directors of public companies, namely, related party transactions; Indemnification, release and ratification of directors' breaches of duties; and Directors' duties owed to individual shareholders. The first topic flows on from the two previous classes on the duty to avoid conflicts, by raising a special type of conflict avoidance imperative that is imposed on directors of public companies only. Read the Casebook at paras 7.415-50 and see Corporations Act Pts 2E and 9.4B. The second topic then questions whether or not -- and to what extent -- directors may be forgiven for breaching their duties of care, good faith or conflict-free decisionmaking. For example, shareholders may ratify directors' breaches of duties. Read the Casebook overview on ratification at para 8.25. Alternatively, the company may indemnify, exempt or insure against breaches of directors' duties. Read the Casebook at paras 7.545-560 and see Corporations Act Pt2D.2 on the statutory provisions regulating this form of forgiveness. The final topic is on directors' duties to individual shareholders (as opposed to shareholders as a class). Read the Casebook at paras7.535-540. [This topic serves as a pathway into the next three classes on shareholder remedies. After all, these individual duties are, from the point of view of the shareholder, personal rights, which, if interfered with, may ground a personal action against the company.] 263 CORPORATE GOVERNANCE: SHAREHOLDER REMEDIES (1) In this class and the next two we turn to consider that other mechanism of corporate governance, shareholder remedies, briefly considered in the introductory classes on corporate governance. As you may recall, one source of shareholder remedies can arise when the majority members attempt to abuse their power to the detriment of the minority members. One example of a shareholder remedy is fraud on the minority where minority shareholders can challenge a resolution passed by the majority shareholders for an `ulterior purpose'. Re-read the Casebook at paras 8.05-10 to remind yourself of the general issue here. Read the Casebook at paras 8.15, 8.45 and 8.55-65 to discern the approach of the courts. 264 CORPORATE GOVERNANCE: SHAREHOLDER REMEDIES (2) The readings for this class explore further remedies available to shareholders. The first remedy which we will consider is the statutory derivative action which entitles a shareholder to bring litigation in the name of the company. This will be in respect of a breach of a duty owed by a director to the company. As you will recall, shareholders do not normally have the right to litigate in the company's name but the derivative action recognises that there may be circumstances where the company is prevented from litigating. Read the Casebook at paras 8.70-105 for an account of the derivative action, including a recent case, Swansson at para 8.105. Read also Corporations Act, Part 2F.1A. A shareholder may also have a personal right at general law to bring proceedings if his or her rights have been infringed. Read the Casebook at paras 8.110-130 A shareholder also has a statutory right to seek an injunction to prevent a breach of the Corporations Act. Read the Casebook at para 8.135 and the Corporations Act, s 1324. 265 CORPORATE GOVERNANCE: SHAREHOLDER REMEDIES (3) The reading for this class concludes the discussion on shareholder remedies by focussing on statutory remedies granted to the shareholder personally. These remedies are designed to protect the interests of minority shareholders in circumstances where there may be, for example, oppressive conduct. We will consider first the compulsory liquidation remedy. Read the Casebook at paras 8.140-155 for a review of the principles which the courts will apply and read para 8.160. Read also the Corporations Act, ss 461-462, 467(4) and 233. The final remedy we will consider is the remedy for oppression. Read the Casebook at paras 8.180-230 and the Corporations Act Pt2F.1. See also the following short case extracts included in these readings: Morgan v 45 Flers Ave Pty Ltd (1986) 10 ACLR 692 at 704 (for a definition of "oppression"); Coombes v Dynasty Pty Ltd (194) 14 ACSR 60 (for an example of a court granting the oppression remedy) 266 Morgan v 45 Flers Ave Pty Ltd (1986) 10 ACLR 692 at 704 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. YOUNG J ... It was first put by counsel for the plaintiff that the section involves four elements and that the plaintiff can succeed if he shows that the company's affairs are being conducted (a) oppressively, (b) unfairly, (c) in a discriminatory way and (d) in a manner that is contrary to the interests of the members as a whole. I again over-simplify the submission. Later, I think properly, this particular analysis was abandoned. I say properly because in my view as a result of the decisions in New Zealand in Thomas v H W Thomas Ltd [1984] 1 NZLR 686; 2 ACLC 610; in England in Re Bovey Hotel Ventures Ltd (Chancery Division, Slade J 31 July 1981 unreported); Re R A Noble & Sons (Clothing) Ltd [1983] BCLC 273 at 290; and Re London School of Electronics Ltd [1985] 3 WLR 474 and in Australia in Wayde v NSW Rugby League Ltd (1985) 10 ACLR 87; 61 ALR 225 it has been accepted that one no longer looks at the word "oppressive" in isolation but rather asks whether objectively in the eyes of a commercial bystander, there has been unfairness, namely conduct that is so unfair that reasonable directors who consider the matter would not have thought the decision fair: see Wayde's case per Brennan J at ACLR 94 and at ALR 235; per majority at ACLR 91 and at ALR 231. In my view a court now looks at sub-s 2(a) as a composite whole and the individual elements mentioned in the section should be considered merely as different aspects of the essential criterion, namely commercial unfairness. In the light of Thomas' case and Wayde's case, earlier cases such as Re A Company [1983] Ch 178 and Re G Jeffery (Men's Store) Pty Ltd (1984) 9 ACLR 193 which adopted a narrow approach to s 320 may not now be of assistance, though their result would not be affected..... 267 Coombes v Dynasty Pty Ltd (194) 14 ACSR 60 Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. FEDERAL COURT OF AUSTRALIA GENERAL DIVISION VON DOUSSA J 7-11, 14-18, 21-25 March, 6-7 April, 6 June, 8 July 1994 Adelaide Oppression Minorities Shareholdings Dilution of minorities interests Provision of information Sufficient notice of meetings Purchase of minority's shares Valuation of shares Corporations Law s 260. C was a minority shareholder of D Pty Ltd. Over the course of the history of the company the majority of shares came to be held by interests associated with T. D claimed that T had caused the affairs of D to be run in a manner oppressive and unfairly prejudicial to C. Among the complaints were the unfair nature of a proposed restructuring of D, the failure to keep C informed of the affairs of the company and of meetings of the company and the use of money said to be owed by C to the company as a means of exerting leverage over C to purchase his shares for an amount less than their full value. C sought an order that compulsory purchase of his shares be pursuant to s 260 of the Corporations Law. Held ordering terms on which the shares of the applicant should be purchased: (i) The test as to whether conduct is oppressive is whether, objectively, in the eye of a commercial bystander, there has been unfairness, namely conduct that is so unfair that reasonable directors who consider the matter would not have thought the decision fair. Morgan v 45 Flers Avenue Pty Ltd (1986) 10 ACLR 692; Wayde v New South Wales Rugby League Ltd (1985) 10 ACLR 87; 59 ALJR 798, applied. (ii) The restructuring of the company was done in a manner which disregarded the minority shareholder's rights. This included the watering down of the interest of the minority shareholder and the use of company assets as security for a project associated with the majority shareholder was oppressive and unfairly prejudicial. Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324, applied. (iii) Failure to provide financial information, to notify annual general meetings and to disclose information about recent valuations was further evidence of oppressive conduct. (iv) Similarly, the way a debt allegedly owed by the minority shareholder was held over his head to persuade him to sell his shares on favourable terms was also evidence of oppression. (v) An order for relief from oppression by means of a capital reduction should not be made when there were significant creditors or at least should not be made without notice to them. Quinlan v Fiboze Pty Ltd (1988) 14 ACLR 312, referred to. 268 (vi) The only relief available which was likely to give adequate protection and remedies were orders from compulsory purchase. (vii) An order for compulsory purchase of shares should not be refused because a mechanism for disposal of shares was provided in the articles. R v Dalkeith Investments Pty Ltd (1984) 9 ACLR 247, referred to. 269 CORPORATE GOVERNANCE: CONCLUSION There is no reading for this class. Your teacher may use this class to catch up on material that had not been covered fully in previous corporate governance classes, to run a general `Q and A' or review session, take a class off, or forge ahead with the rest of the course. Your teacher will let you know how he or she will proceed. 270 CONCLUSION 271 CONCLUSION: CORPORATE GROUPS (1) The course concludes with a discussion of corporate groups -- clusters of companies that are inter-related with one another. This topic neatly concludes the course because it revisits all the previous themes -- corporate existence, corporate decision-making, corporate personality and corporate governance -- that, to date, were considered in the context of individual (stand-alone) companies. How does the law address these issues when dealing with a corporate group? The readings for this class focus on questions of existence and personality. What constitutes a corporate group? Why might people use corporate groups to conduct their business? What implications does separate legal personality pose for regulating corporate groups? Read the Casebook at paras 4.75-95 and 4.120-125 and see the Corporations Act ss 4650, 50AA, 187, and 259E. Then read the extract of the CASAC report examining the regulatory challenges posed by corporate groups. 272 Companies & Securities Advisory Committee, Corporate Groups: Final Report (May 2000) at 1.11.57 (http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/CASAC_FINA L_REPORT.pdf/$file/CASAC_FINAL_REPORT.pdf) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. METHODS OF REGULATING CORPORATE GROUPS This Chapter examines the role of corporate groups in Australian commerce and the economic and business benefits that the group structure offers. It discusses different ways of defining a corporate group, reviews the application of fundamental corporate law principles to a group, and examines the relative merits of viewing a group either as a collection of separate legal entities or as a single enterprise. The Chapter also reviews the regulation of corporate groups in various overseas jurisdictions and the extent to which those jurisdictions have applied either separate entity or single enterprise principles. The Chapter recommends that corporate groups be regulated by a general control test rather than holding/subsidiary and related company tests and that wholly-owned corporate groups be permitted to choose to be regulated solely by single enterprise principles. THE NATURE OF CORPORATE GROUPS 1.1 Many medium to large commercial enterprises in Australia are structured as corporate groups. The size and complexity of some corporate groups may not be readily apparent, given that they may present a public image of a unitary organisation operating under a single corporate identity. 1.2 The University of Melbourne's Centre for Corporate Law and Securities Regulation conducted a study of the group structures in Australia's Top 500 listed companies in 1997. The study showed that: 89% of the listed companies surveyed controlled other companies the greater the market capitalisation of a listed company, the more companies it was likely to control. This ranged from an average of 72 controlled companies for those in the largest market capitalisation quartile to an average of 9 controlled companies for those in the smallest quartile. The overall average was 28 controlled companies 90% of those controlled companies were wholly-owned. The remaining 10% of controlled companies consisted of 9% that were 50% to 99% owned and 1% that were less than 50% owned the number of vertical subsidiary levels in a corporate group chain ranged from one to eleven, with an overall average in the two largest market capitalisation quartiles of three to four subsidiary levels. 1.3 There are few legal restrictions on the ability of businesses to conduct their affairs through corporate groups and determine their own group structure. Managers or controllers of a corporate group may plan, instigate and co-ordinate its managerial, operational and financial activities on a group basis, while conducting them through individual group companies. Some corporate groups may have a primarily hierarchical structure, with succeeding layers of parent and controlled companies. Other groups may maintain a more lateral structure, with many sibling group companies, often with a high level of cross-ownership between them. 273 1.4 From an economic perspective, corporate groups could be organised horizontally (for instance, several group companies operating at the same level in a production or distribution process) or vertically (group companies operating at different points in that process). Also, groups may be formed as, or develop into, "conglomerates", whereby group companies conduct a diverse range of businesses in unrelated fields. 1.5 The degree of financial and decision-making autonomy of group companies can vary considerably. Some group companies may be active trading entities, with primary responsibility for their own business goals, activities and finances. For instance, conglomerate groups may operate under a highly decentralised structure, given their involvement in a range of industries. In other groups, strategic and budgetary decisions may be centralised, with group companies effectively operating as divisions of a larger business and exercising little independent discretion within this cohesive economic unit. A parent company may exercise close control by allocating equity and loan capital to group companies through a central group treasury mechanism, prescribing their operational and financial policies, setting their performance targets, choosing their directors and other key personnel, and continuously monitoring their performance and staffing. 1.6 The "power centre" of some corporate groups may be the ultimate holding company. More commonly, companies the next step down the group chain may effectively direct a group's operation, with the ultimate holding company owning the key corporate group shares, but not having any direct productive or managerial role. 1.7 The degree of economic and organisational integration of different corporate groups can be compared according to various organisational, market and public image criteria. WHY CORPORATE GROUPS EXIST 1.8 There are many economic and commercial benefits in conducting an enterprise through a corporate group structure. These include: reducing commercial risk, or maximising potential financial return, by diversifying an enterprise's activities into various types of businesses, each operated by a separate group company preserving intangible commercial property of existing companies by acquiring the companies themselves to expand an enterprise or increase market power. A corporate group may wish to continue operating an acquired company as a separate group entity to utilise its corporate name, goodwill and public image. Also, it is frequently preferable, for taxation reasons, to acquire companies as a going concern, rather than merely their assets attracting capital without forfeiting overall control. A group controller may want outside investment in only part of its overall business. This can be achieved by incorporating that part of the business as a separate subsidiary and allowing outside investors to acquire a minority shareholding in it lowering the risk of legal liability by confining high liability risks, including environmental and consumer liability, to particular group companies, with a view to isolating the remaining group assets from this potential liability providing better security for debt or project financing. For instance, a lender may require that the borrower shift specific assets into a separate company incorporated for that purpose, thereby ensuring that the lender has a first charge over the whole or most of the new company's property. Likewise, a separate group company may be formed to undertake a particular project and obtain additional finance by means of substantial charges over its own assets and undertaking 274 simplifying the process of partial sale of an enterprise. It is often easier, and more tax effective, to transfer the shares of a group company to the purchaser, rather than sell discrete assets as would be necessary if the enterprise were conducted through divisions of one company complying with various regulatory requirements. Some enterprises may need to maintain separate subsidiaries to satisfy prudential or other statutory requirements. In the case of multinational groups, the domestic law of particular countries in which those groups wish to conduct business may require that the local businesses be conducted through separate subsidiaries (sometimes subject to minimum local equity requirements). 1.9 A corporate group may also develop incidentally where, for instance, the group acquires an outside company which itself is a holding company of various other companies. Also, some companies whose shares are undervalued may be attractive takeover targets, and therefore be acquired by a corporate group merely as an investment. 1.10 Some corporate groups may become excessively large and unduly complex as a result of direct and incidental growth, but nevertheless not be simplified due primarily to the taxation disincentives for corporate group reconstructions. THE LEGAL CONCEPT OF A CORPORATE GROUP 1.11 Australian courts have acknowledged the concept of corporate groups. The High Court has said that: "The word `group' is generally applied to a number of companies which are associated by common or interlocking shareholdings, allied to unified control or capacity to control." 1.12 More recently, another Court has commented that: "close and common management links, as well as an interlocking web of complex mutual shareholdings are features sufficient in de facto terms to constitute the various companies in question within the group as being properly described as such, being responsive to the needs and interests of each other as corporate entities through their management". 1.13 UK Courts have also recognised that a corporate group may operate as a common economic unit and have an identifiable corporate image and reputation which can be protected in law. LEGAL DEFINITION OF THE CORPORATE GROUP Two approaches 1.14 The Corporations Law does not specifically define corporate groups. In one sense, the phrase `corporate group' is an umbrella concept which covers a large number of different forms of economic organisation using corporate combinations. However, the legislation applies two corporate group concepts: holding, subsidiary and related companies parent companies and controlled entities. Holding, subsidiary and related companies 1.15 Company A is a holding company of Company B (and Company B is a subsidiary of Company A) if Company A: 275 controls the composition of the board of Company B (including by exercise of any power to appoint or remove all, or a majority of, the directors of Company B) is in a position to cast, or control the casting of, more than 50% of the total voting shares of Company B holds more than half of the issued share capital of Company B or is the holding company of any holding company of Company B (this also applies where there are any number of intermediate holding and subsidiary companies between Company A and Company B). 1.16 In Australia, holding companies and all their subsidiaries are related companies, thereby forming a corporate group. The New Zealand legislation includes in its definition of related companies an additional and less definite "intermingled business" test of related companies, namely: "the businesses of the companies have been so carried on that the separate business of each company, or a substantial part of it, is not readily identifiable". 1.17 There can be difficulties with applying the holding/subsidiary and related company tests to corporate groups. For instance, whether one company controls the board of directors of another company turns on a legal, rather than de facto, power. Also, the potential liability of an ultimate controlling company for the insolvent trading of a group company far removed down the corporate chain may turn on whether all intermediate group companies satisfy the holding/subsidiary company definition. Parent and controlled companies 1.18 Australian accounting standards and the Corporations Law currently apply control tests to corporate groups for particular purposes. These tests are broader than the holding/subsidiary and related company tests. 1.19 Under the control test in the accounting standards, control is defined as: "the capacity of an entity to dominate decision-making, directly or indirectly, in relation to the financial and operating policies of another entity so as to enable that other entity to operate with it in pursuing the objectives of the controlling entity", while "capacity" is defined as: "ability or power, whether direct or indirect, and includes ability or power that is presently exercisable as a result of, by means of, in breach of, or by revocation of, any of or any combination of the following: (a) trusts; (b) relevant agreements; and (c) practices; whether or not enforceable". 1.20 Whether control exists is therefore determined by the substance of the relationship between the entities, rather than reliance on strict legal form. This emphasis on substance ensures that the test applies to all entities whose financial and operating policies are being dominated by the parent entity. 1.21 A comparable control test is set out in the Corporations Law, as follows: "(1) For the purposes of this Law, an entity controls a second entity if the first entity has the capacity to determine the outcome of decisions about the second entity's financial and operating policies. (2) In determining whether the first entity has this capacity: (a) the practical influence the first entity can exert (rather than the rights it can enforce) is the issue to be considered; and (b) any practice or pattern of behaviour affecting the second entity's financial or operating policies is to be taken into account (even if it involves a breach of an agreement or a breach of trust)." 276 1.22 This control test does not require that control be actively exercised. What is relevant is the practical influence that the controlling company can assert. Therefore, "the mere fact that an entity acts in a manner consistent with the interests of a `controlling' company may be sufficient to indicate control". The test may therefore encompass de facto forms of control not within the scope of the holding/subsidiary and related company tests. 1.23 The accounting and Corporations Law control tests may better identify de facto control than the holding/subsidiary company test. For instance, there is no requirement that control depend on shareholding or control of the composition of the board of directors. The control tests could be applied to corporate group structures employing a series of interlocking shareholdings, each less than the holding/subsidiary company threshold, or vertical corporate groups that do not have a holding/subsidiary company continuity. However, some of the criteria used in the control tests may be less precise in their application than those used in the holding/subsidiary company test. Other legislation Australia 1.24 The corporate group concept is recognised in other commercial legislation. For instance, the Trade Practices Act defines a corporate group by reference to holding/subsidiary and related company tests similar to those in the Corporations Law. That Act recognises that in some instances its provisions could be avoided unless the activities of all group companies are taken into account. In other instances, the legislation may work unfairly if corporate group activities are not exempted. 1.25 Australian tax law also identifies corporate groups for various purposes. For instance, the taxation legislation currently provides relief for some transactions within wholly-owned corporate groups. In this context, a company will form part of a wholly-owned group only where all of its issued shares (including any of its other securities that have been converted into shares) are owned, directly or indirectly, by the parent company of the group. The current tax legislation does not here apply any of the "control" tests found in the Corporations Law. By contrast, some State payroll tax legislation treats companies as a group where they are related companies (as defined under the Corporations Law) or where their businesses are integrated either through common control by the same persons or through the sharing of employees. That legislation acknowledges that companies can operate as a single economic unit, even where they are not related companies. .... Law reform options 1.28 Currently, the Corporations Law predominantly applies holding, subsidiary and related company tests to corporate groups. However, the question arises whether it may be appropriate to have increasing resort to a control test in the regulation of corporate groups, for instance in the following areas. Disclosure of emoluments. Currently, a specified percentage of shareholders may require a company (the first company) to disclose the emoluments and other benefits received by the directors of that company or of any subsidiary. This obligation does not extend to any other company that the first company controls, but which is not its subsidiary. Directors' indemnification and insurance. Currently, there are restrictions on a company or a related body corporate indemnifying an officer or auditor or paying insurance premiums in respect of certain liabilities for those persons. These provisions do not apply to companies that are not related, but nevertheless may come within the broader test of control. 277 Financial assistance transactions. Currently, there are restrictions over a company (the first company) financially assisting a person to acquire shares in itself or its holding company. These restrictions do not apply where the first company provides financial assistance for the acquisition of shares in a company that controls the first company but is not its holding company. Insolvent trading. A holding company which ought to suspect the insolvency of its subsidiary can be made liable for the debts of that subsidiary incurred when it was insolvent. This liability does not apply to a controlling company that is not the holding company of the insolvent company. 1.29 One possible consequence of applying a control test, particularly in the context of insolvent trading, is that, theoretically at least, more than one group company could control another group company. Presumably, if a control test were adopted for insolvent trading, all the controlling group companies could be held to be jointly and severally liable in the insolvency of a controlled group company, subject to one or more of the controlling group companies establishing a defence, as provided by the Corporations Law. Issue 1. Should a control test, rather than a holding/subsidiary and related company test, apply to: disclosure of emoluments directors' indemnification and insurance financial assistance transactions insolvent trading respectively? Alternatively, should a control test be added to the holding/subsidiary and related company tests in relation to any of the above? Should a control test substitute for a holding/subsidiary and related company test in any other areas of the Corporations Law? Alternatively, should a control test be added to the holding/subsidiary and related company tests in any other areas of the Corporations Law? If a control test is to be applied (either by itself or in addition to a holding/subsidiary and related company test), should it be the test applied for consolidated financial accounts or the test under s 50AA? .... Advisory Committee response to submissions on Issue 1: Draft Recommendation 1 1.39 The control test is preferable to the holding/subsidiary and related company tests. The former test may better identify all forms of de facto control, as it is not limited to control through majority shareholding or control through composition of the board of directors. A control test should apply in all circumstances. Accordingly: The Corporations Law should have a single uniform control test, to be introduced in lieu of the holding/subsidiary and related company tests. That control test should be as set out in s 50AA. Issue. Are there any areas where the holding/subsidiary and related company tests should be retained? .... Advisory Committee response to submissions on Draft Recommendation 1 1.41 The Advisory Committee maintains the view that the general control test in s 50AA should apply in all instances in lieu of the current holding/subsidiary and related company 278 tests, which should not be retained, even as part of the general control test. A control test focuses on real power and influence, rather than on the sometimes more formal criteria in the holding/subsidiary tests. Recommendation 1 The test of control under the Corporations Law s 50AA should apply throughout the Corporations Law in lieu of the holding/subsidiary and related company tests, which should be repealed. REGULATION OF CORPORATE GROUPS Two approaches 1.42 Regulation of corporate groups in different countries is generally based on one of two approaches, or a combination of them: the separate entity approach the single enterprise approach. The separate entity approach 1.43 Corporate law in common law countries has developed from the separate entity approach. In essence, this involves three inter-related principles, originally developed for single companies, but subsequently applied to corporate groups, namely: separate legal personality of each group company (corporate autonomy) limited liability of shareholders of each group company directors' duties to the separate group company. Corporate autonomy 1.44 Each company in a corporate group is a separate legal entity with its own rights and duties, even when controlled or wholly- or partly-owned by another company and collectively engaged in the business of the group. This has various consequences at common law, including: the debts incurred by each company are debts of that company, not of the controllers of that company or of the corporate group collectively. The assets of the group cannot be pooled to pay for these debts parent companies are not automatically parties to contracts entered into by other group companies with external persons a parent company cannot take into account the undistributed profits of other group companies in determining its own profits a group company may breach its obligations to an external party if it passes confidential information about that party to its parent company. 1.45 The application of traditional corporate autonomy principles to corporate groups partly protects unsecured creditors of solvent group companies by avoiding the financial loss which those companies might incur if they could be held liable for the debts of other group companies. Arguably, to deny corporate autonomy and impose joint or ultimate liability for the group's debts on a parent or controlling company could make the extension of credit to that company more costly. Prospective creditors of a parent company might need to investigate the creditworthiness and debt burden of all the group companies. However, the benefits to a corporate group of corporate autonomy can be overstated, given that it is 279 common for creditors to require security on a group basis, for instance by intra-group crossguarantees. 1.46 At common law, unsecured creditors of particular group companies are at risk to the extent that assets of their debtor company can lawfully be moved to other group companies. For instance, unsecured creditors of a parent company have no general right to assets held by subsidiaries or other controlled companies (except for rights under relevant liquidation provisions or by virtue of the parent company's share or security holdings in those controlled companies). However, the ability to move assets between corporate group companies with a view to maximising group commercial opportunities or profits is one of the significant benefits of operating through a group structure. 1.47 One means of protecting unsecured creditors of group companies is to look behind the separate corporate personality of those companies and hold the group controllers (typically the immediate or ultimate holding company within a corporate group) liable for the actions or debts of the group companies ("lifting the corporate veil"). 1.48 In Australia, the corporate veil has been lifted if the corporate form has been used improperly, or if one company is the agent, trustee or partner of another company. However, control or domination of a subsidiary by a parent, or other forms of close economic integration within a corporate group, has not sufficed to justify disregarding the separate legal personality of each group company. In consequence, courts have not displayed any greater willingness to lift the corporate veil merely because they are dealing with a corporate group. 1.49 In the United States, the main grounds for lifting the corporate veil in the corporate group context are fraud, failure to follow the formalities of treating group companies as separate legal entities, inadequate capitalisation of particular group companies and commingling of assets and control of those group companies. Also, US courts may be increasingly willing to find a parent company directly liable for the torts of its controlled companies. However, the role of under-capitalisation as a factor in lifting the corporate veil in the corporate group context remains unclear and controversial. 1.50 In the United Kingdom, the corporate veil can be lifted where the corporate structure is merely a faade. However, the courts have generally accepted the use of the corporate group structure in commerce. They have been unprepared to lift the corporate veil merely because a group has conducted some of its business through wholly- or partly-owned subsidiaries or has arranged the group structure to ensure that any legal liability in respect of particular activities will fall only on one group member. Also, UK courts (like US courts) have been reluctant to accept that under-capitalisation of particular group companies justifies lifting the corporate veil. For instance, in one recent case the Court held that: "Neither agency nor nomineeship -- nor, still less, sham or something akin to sham -- is to be inferred simply because a subsidiary company has a small paid-up capital and has a board of directors all or most of whom are also directors or senior executives of its holding company". In some cases, the UK courts have lifted the corporate veil to confer a benefit on the corporate group. Limited liability 1.51 At common law, shareholders of a limited liability company are not personally liable, as shareholders, for the debts of that company, except to the extent of any unpaid capital on their shares. Only their capital investment can be called upon to discharge the company's debts. 1.52 Limited liability achieves various economic goals: 280 facilitating enterprise. Limited liability facilitates investment and otherwise encourages economic activity by separating investment and management functions and shielding investors from any corporate loss in excess of their equity capital. This protection for investors reduces the costs of raising capital. Also, corporate controllers may be more willing to undertake entrepreneurial activity through their controlled companies, given that, as shareholders of those companies, they are shielded against unlimited liability for the debts of those companies reducing monitoring. Limited liability decreases the need for shareholders to monitor the managers of companies in which they invest. The risk to those shareholders of a company's failure is confined to the loss of the equity invested promoting market efficiency. Limited liability promotes the liquidity and efficient operation of securities markets, as the wealth of each shareholder of a public company is irrelevant to the trading price of its shares. This allows shares to be freely traded, as their price is set by factors other than their owners' wealth. The free transfer of shares may in turn promote efficient management, given that shares in a poorly managed company may trade at a discount, creating the climate for a takeover and the replacement of incumbent management encouraging equity diversity. Limited liability permits investors to acquire shares in a number of companies. This might not be possible for particular investors if the principle of unlimited liability applied and they could lose all or most of their personal wealth through failure of one company in which they held equity. 1.53 Application of these economic grounds to corporate groups. The economic justifications for limited liability are particularly strong when applied to companies in isolation. However, they do not necessarily have equal force when applied to corporate groups. 1.54 In the context of corporate groups, the reducing monitoring ground is valid mainly where shareholding in a particular group company is widely dispersed. It would be impractical, as well as unduly costly, to impose any monitoring obligation on shareholders in those circumstances. However, this argument is less convincing where a group company is effectively controlled by its parent company. The parent can use its shareholding to control the decisions of any wholly-owned subsidiary or otherwise monitor the activities or financial performance of other controlled companies. Limited liability can operate in this context as a disincentive for a parent company to closely monitor its group companies. 1.55 The market efficiency argument is relevant to listed group companies whose shares are publicly traded. It has no application to closely or wholly-owned subsidiaries whose shares are not tradeable. Nor is the equity diversity argument relevant where shares in a group company are issued primarily to control that company, rather than to invest equity capital in it. 1.56 Possibly the strongest argument for limited liability in the corporate group context is its role in facilitating enterprise. Without limited liability, controlling shareholders of wholly- or even partly-owned subsidiaries may risk all or much of their wealth through the activities of these subsidiaries. Nevertheless, permitting parent companies, as controlling shareholders, to rely on limited liability can increase the risk of "moral hazard",68 or displacement of business risks to outsiders, in some circumstances: "If limited liability is absolute, a parent can form a subsidiary with minimum capitalization for the purposes of engaging in risky activities. If things go well, the parent captures the benefits. If things go poorly, the subsidiary declares bankruptcy [to the detriment of its outstanding unsecured creditors], and the parent creates another [subsidiary] with the same managers to engage in the same activities. This asymmetry between benefits and costs, if limited liability is absolute, would create incentives to engage in a socially excessive amount of risk activities." 281 Directors' duties 1.57 The orthodox common law position is that directors of a company in a corporate group owe fiduciary duties to that company and not to other entities in that corporate group. The interests of other group companies may be taken into account only to the extent that this furthers the interests of the directors' own companies. However, directors would breach their fiduciary duties if they sought to put the interest of the corporate group above that of their companies. 1.58 Directors of a group company may face difficulties in balancing their fiduciary duties to that company against the overall commercial and financial interests of the group. This problem may arise, for instance, where directors of a particular group company consider that to advance, or preserve, the corporate group requires the financial support or sacrifice of their company by providing other group companies with loans, assets, securities or guarantees. The single enterprise approach 1.59 This approach recognises and attaches considerable legal significance to economic integration within a corporate group. In its pure form, it treats the corporate group as a unitary economic enterprise functioning to further the interests of the group as a whole, or those of its dominant corporate body. 1.60 The single enterprise approach may more closely reflect the economic functioning and organisational structure of those corporate groups that operate under a highly centralised governance system. Managers of some corporate groups may structure the operations and activities of group companies on a single enterprise basis, for instance by: borrowing as a group and using group treasury arrangements to offset the credit and debit balances of each group company permitting one or more group companies to operate at a loss, or be undercapitalised, for reasons related to the overall group financial structure and strategy moving assets and liabilities between group companies, as the need arises. This may involve moving resources between group companies under the description of "interest", "dividends" or "management fees", or providing intra-group loans, guarantees or other financial arrangements on uncommercial terms. 1.61 The financial and other resources of the group may therefore be directed primarily to maximising the profit, or ensuring the survival, of the group enterprise as a whole, rather than its individual constituent companies. As one commentator has pointed out: "There are no economically compelling reasons why the profit centres within the group should correspond with the centres of legal right and entitlement, namely, the individual companies". 1.62 A single enterprise approach may also better reflect the expectations of any creditors dealing with a corporate group who have been led to believe that they are doing business with the group as a whole and can rely on the creditworthiness of the overall group rather than that of an individual group company. 1.63 In contrast to a separate entity approach, a single enterprise approach might adopt the following governing principles: the dominant company in a group is entitled to operate companies it controls for the benefit of the corporate group collectively, even if this is contrary to the interests of particular controlled companies or their minority shareholders directors of corporate group companies owe their fiduciary loyalty primarily to the parent company or to the corporate group collectively, not to their individual group companies 282 the parent is liable for all the debts of its insolvent controlled companies, whether or not wholly-owned (possibly subject to any contrary voluntary arrangement with particular lenders). 1.64 The problem in applying these principles is to accommodate the organisational complexities of corporate groups. If applied inflexibly, they may expose a parent company to full liability for all the group's debts, even where group governance is decentralised and particular group companies exercise considerable autonomy. They may also encourage managers to structure the group in a highly hierarchical and centralised manner, even where this is inefficient, to reduce the parent's financial exposure. Also, the value of the recovery rights of unsecured creditors of a parent company could be diminished through that company's exposure to the financial risks of all the group's activities. At the same time, creditors of controlled group companies could gain a windfall from the parent company providing, in effect, a form of liability insurance against any defaults by its group companies. .... Application of separate entity and single enterprise approaches in common law countries Australia 1.72 Australian corporate law, like UK company law, has traditionally applied the separate entity approach to corporate groups. It does not permit the controllers of a corporate group to treat the group as a single enterprise for the purpose of their entrepreneurial activities. Instead, the separate legal personality of each company must be maintained. 1.73 However, the Corporations Law contains various provisions that override the strict application of the separate entity approach. It specifically regulates corporate groups in a number of areas, including: consolidation of corporate group accounts. A company must prepare consolidated accounts for itself and any controlled entity. That company must also list in its annual report the entities that it controls. These requirements seek to enhance the ability of users of financial reports to assess the overall performance and financial position of corporate groups, rather than having to rely on the accounts of individual group companies. They also seek to ensure that the true financial position of various group companies cannot be concealed by intra-group transactions designed to artificially create profits or conceal losses in particular group companies, or otherwise manipulate the balance-sheet of individual group companies. However, each group company must, in addition, maintain its own accounts concerning its assets and liabilities. For instance, one group company cannot lawfully declare a dividend based on profits generated, and held, by another group company. related party transactions. A public company is prohibited from giving a financial benefit (including any intra-group loan, guarantee, indemnity, release of debt or asset transfer) to a related party unless that transaction has been approved by the fullyinformed disinterested shareholders of the public company or is otherwise exempt. These provisions are designed to protect shareholders of public companies from the possibility of their company's assets being eroded, or its financial position otherwise undermined, through undisclosed intra-group dealings. cross-shareholding. Companies are generally prohibited from acquiring, or taking a security over, the shares of any controlling company or issuing or transferring their shares to any controlled company. Also, there are controls over a group company providing financial assistance for the acquisition of shares in its holding company. Some of these provisions are designed to prevent entrenchment of control in a holding company through indirect self-acquisitions (by a controlled company holding 283 shares in a controlling company) or group controllers using group assets to influence the market price of shares in particular group companies. insolvent trading. The Corporations Law has sought to reduce the "moral hazard" problem of corporate group structures being used to displace entrepreneurial risks to outside creditors. It provides that a holding company which ought to suspect the insolvency of its subsidiary can be made liable for the debts of that subsidiary incurred when it was insolvent. The rationale for this rule is that the ability of a holding company to control the affairs of its subsidiary should give rise to some positive duty of the holding company to prevent harm to the subsidiary's creditors. 1.74 Some transactions by group companies require the consent of the controlling company. In other circumstances, directors of group companies are relieved of some reporting obligations or have their involvement in a group company taken into account. In the takeover context, the voting power of all group companies must be aggregated. Also, ASIC has a Class Order relieving wholly-owned subsidiaries from statutory financial reporting and audit requirements if the holding company and the wholly-owned subsidiaries choose to enter into a deed giving appropriate cross-guarantees. ASIC has issued a considerable number of these class orders. The Australian Stock Exchange Listing Rules also regulate some intra-group transactions involving listed public companies. .... Future possible regulatory direction 1.81 Australia and overseas common law countries have adopted corporate law rules which apply differing mixtures of separate entity and single enterprise regulatory principles to corporate groups. Only Germany has introduced an integrated single enterprise regime for some of its corporate groups. 1.82 Australian corporate law could be reformed to better accommodate corporate groups and the interests of those who deal with them by: permitting wholly-owned corporate groups to choose whether to be consolidated or non-consolidated. Consolidated groups would be regulated by single enterprise principles leaving non-consolidated wholly-owned, and all partly-owned, corporate groups to be regulated by a mixture of separate entity and single enterprise principles, but with greater selective use of single enterprise principles where appropriate. Consolidated corporate groups Method of regulation 1.83 Under this proposal, directors of the ultimate holding company of a wholly-owned corporate group109 could choose to adopt the consolidated corporate group structure. For groups that "opt in", a term such as "consolidated corporate group company" would have to be included on all public documents of the group companies, thereby indicating to outsiders the status of that group. 1.84 These corporate groups would be regulated by single enterprise principles in the following manner: the Corporations Law would treat the corporate group as one legal structure directors of group companies could act in the overall group interest without reference to the interests of their particular group companies the holding company and each group company would be collectively liable for the contractual debts of all group companies, subject to any contrary agreement 284 group companies could merge merely at the discretion of the directors of the holding company ASIC would be given the power to provide appropriate relief from accounting and any other residual separate entity requirements. Incentive to become a consolidated corporate group 1.85 Presumably, the controllers of a wholly-owned group would only favour consolidating it if there was some net gain in doing so, given that, at least for contractual purposes, the group would be taking on collective liability, contrary to common law separate entity principles. This incentive issue would arise particularly with directors' duties, tort liability, sale of individual group companies, and consolidated corporate groups seeking to "opt-out" from that status. 1.86 Directors' duties. One possible incentive is that the directors of each wholly-owned group company could act in the overall corporate group interest without reference to the interests of their particular group company. This would overcome the problems concerning intra-group financial dealings discussed in Chapter 2 of this Report. However, the Corporations Law already permits directors of solvent wholly-owned group companies to act solely in the interests of the holding company. The relevant provision eliminates these problems for all wholly-owned corporate groups, whether or not consolidated. 1.87 Tort liability. On one view, a consolidated corporate group should be collectively liable under single enterprise principles for the tortious, as well as the contractual, liabilities of any of its group companies. The opposite view is that, unless an exemption from collective tortious liability applied, few wholly-owned corporate groups would choose to be consolidated corporate groups, unless collective tort liability applied to all corporate groups, whether or not consolidated. 1.88 This disincentive problem might be overcome by permitting selective opting in, that is, a holding company could nominate which of its wholly-owned subsidiaries to include in one or more consolidated corporate groups. Various subsidiaries could be excluded from consolidation in view of their potential tortious exposure, or to overcome any residual liability problems should they in future be sold to an outsider. However, it may sometimes be very difficult to identify in advance the potential tort liability of particular companies, and therefore the potential cost implications of any decision to form a consolidated corporate group. 1.89 Sale of group companies. The holding company and each group company in a consolidated corporate group would be collectively liable for the contractual debts of all group companies. This raises the question of whether any wholly-owned company in a consolidated corporate group could be sold to an outside party and, if so, what, if any, residual rights should existing creditors of that company have against the corporate group under the collective liability principle. 1.90 On one view, any prohibition on selling off a wholly-owned group company in a consolidated corporate group would be a considerable disincentive to opting in. However, without some residual group liability, the creditors of that group company could be seriously disadvantaged by the sale. This would particularly affect those creditors who had originally contracted with a particular group company in reliance on collective group liability of the consolidated corporate group, rather than the assets of that company. 1.91 Consolidated corporate groups "opting-out" from that status. A consolidated corporate group may wish to deconsolidate some or all of its group companies. Without this right, 285 wholly-owned corporate groups might be reluctant to become consolidated, as they would be irrevocably governed by single enterprise principles, regardless of any change in the group's overall financial circumstances or internal functions. If deconsolidation is permitted, the question arises (as with the sale of group companies) of what, if any, residual rights should existing creditors have against each company in the previously consolidated corporate group. Other corporate groups 1.92 Non-consolidated wholly-owned, and all partly-owned, corporate groups would continue to be regulated by a mixture of separate entity and single enterprise principles, both to assist the operation of these corporate groups and to better protect the interests of any minority shareholders and outsiders who deal with them. The remaining Chapters of this Report examine a range of areas where greater specific use of single enterprise principles may be appropriate for these groups. Issue 2. Should the Corporations Law provide that a wholly-owned corporate group can "opt-in" to be a consolidated corporate group governed solely by single enterprise principles (as defined in para 1.84)? If so: should a wholly-owned corporate group be permitted to "opt-in" in relation to some only of its wholly-owned group companies should a consolidated corporate group be collectively liable for the torts of any group company should a consolidated corporate group retain a residual group liability for the debts of any group company incurred before its sale to an outsider should a deconsolidated corporate group retain a residual group liability for the debts of its group companies incurred before the deconsolidation? .... Advisory Committee response to submissions on Issue 2: Draft Recommendation 2 1.105 Wholly-owned corporate groups should have the option of operating as a consolidated corporate group under single enterprise principles (as defined in para 1.84). Accordingly: The Corporations Law should provide that a wholly-owned corporate group can "opt-in" to be a consolidated corporate group governed solely by single enterprise principles for all or some of the group companies, by resolution of the directors of each relevant group company. All companies that choose to be in a consolidated corporate group should be required to disclose on all public documents and on the ASIC database that they are members of that group. A consolidated corporate group should not be collectively liable for the torts of any group company merely by virtue of the consolidation. A consolidated corporate group may deconsolidate by resolution of the directors of all relevant group companies, but may not otherwise sell any of its group companies. Companies in a group that has deconsolidated should each retain a residual liability for the debts of all the group companies incurred before the deconsolidation. 1.106 The restriction on the sale of group companies within a consolidated corporate group would avoid the problems of whether there should be any residual group liability upon a sale 286 and how to properly account for the sold company if the consolidated group did not keep separate accounting and other records of that company. 1.107 To impose collective tort liability on all group companies may be a fundamental disincentive to adopting the consolidated corporate group structure. However, retaining residual liability for the debts of group companies upon a deconsolidation would protect those creditors who did not obtain cross-guarantees. (The prescribed ASIC Deed of CrossGuarantee would not assist these creditors: see paras 2.65 ff, post). Also, residual liability would avoid difficulties that may arise from any lack of separate accounts for group companies before their deconsolidation. ... Advisory Committee response to submissions on Draft Recommendation 2 1.109 The Advisory Committee continues to support the Draft Recommendation. It considers that it may not always be practical for wholly-owned group companies that wish to consolidate to voluntarily liquidate and operate as divisions of one company. Wholly-owned corporate groups should have the option of opting-in to be consolidated corporate groups. 1.110 The Committee confirms its view that consolidated corporate groups should be collectively liable for contractual, but not tortious, liabilities. Distinctions are frequently drawn in practice between these types of liabilities. Recommendation 2 The Corporations Law should provide that a wholly-owned corporate group can "opt-in" to be a consolidated corporate group for all or some of the group companies, by resolution of the directors of each relevant group company. All companies in a consolidated corporate group should be governed by single enterprise principles in the following manner: the Corporations Law would treat the consolidated corporate group as one legal structure directors of group companies could act in the overall consolidated corporate group interest without reference to the interests of their particular group companies (cf s 187) the parent company and each group company would be collectively liable for the contractual debts of all group companies, subject to any contrary agreement group companies could merge merely at the discretion of the directors of the holding company (cf Recommendation 15) ASIC should have the power to provide appropriate relief from accounting and any other residual separate entity requirements. All companies that choose to be in a consolidated corporate group should be required to disclose on all public documents and on the ASIC database that they are members of that group. A consolidated corporate group should not be collectively liable for the torts of any group company merely by virtue of the consolidation. A consolidated corporate group should be permitted to deconsolidate by resolution of the directors of all relevant group companies, but not otherwise sell any of its group companies. Companies in a group that has deconsolidated should each retain a residual liability for the debts of all the group companies incurred before the deconsolidation. 287 CONCLUSION: CORPORATE GROUPS (2) The reading for this final class looks at corporate governance problems as they may arise in the specific context of corporate groups. Two issues are particularly relevant: the fiduciary loyalty problems directors might face when entering intra-group transactions; and the duties of nominee and shadow directors -- (special classes of directors who represent the sectional interests of particular shareholders) -- especially when they serve the interests of another [group] company and not the company on whose board they sit. Read the Casebook at paras 7.315-325 (on the application of the good faith duty to corporate group directors) and paras 7.195-205 (on the application of the duty to prevent insolvent trading to corporate group directors). Then read the Casebook at paras 7.35-50 and 7.330-335 (duties and liabilities of shadow and nominee directors). The policy issues underlying these two topics are succinctly discussed in the extracted CASAC report. 288 Companies & Securities Advisory Committee, Corporate Groups: Final Report (May 2000) at 2.12.64, 2.74-2.76, 2.94-2.116 (http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/CASAC_FINA L_REPORT.pdf/$file/CASAC_FINAL_REPORT.pdf) Copyright Regulations 1969 WARNING This material has been copied and communicated to you by or on behalf of [ insert name of university] pursuant to Part VB of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under the Act. Any further copying or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. DIRECTORS OF GROUP COMPANIES This Chapter examines three areas that affect the powers and duties of directors of group companies. The Chapter first discusses the fiduciary loyalty problems that may face directors in entering into various intra-group financial transactions. It recommends giving directors of partly-owned group companies greater latitude to act in the interests of the corporate group if so authorised by minority shareholders of those companies. The Chapter next examines the position of nominee directors. It recommends that all directors be required to disclose all situations that may put them in positions of conflict of duty and interest. This would be in lieu of any statutory provisions defining nominee directors and imposing specific disclosure obligations on them... INTRA-GROUP FINANCIAL DEALINGS Application to wholly- and partly-owned group companies 2.1 Directors owe their fiduciary duties to their companies, not to individual shareholders. These duties apply to intra-group financial dealings, whether they involve wholly- or partlyowned group companies. Liquidators of wholly- or partly-owned companies, as well as minority shareholders of partly-owned companies, can seek remedies for any breach of those duties. 2.2 These remedial rights may be modified by shareholder ratification. The ownership structure of a group company can affect this ratification process, given the different implications of unanimous and majority ratification. Unanimous ratification 2.3 In general, shareholders of a solvent company may unanimously ratify, either prospectively or retrospectively, particular actions of directors which could otherwise constitute a breach of fiduciary duty. This ratification would cover common law and, possibly, statutory fiduciary duties. This ratification process could be used to protect directors in entering into intra-group financial dealings. Unanimous ratification would be a mere formality in a solvent wholly-owned group company, but could not be guaranteed for a solvent partly-owned group company. Majority ratification 2.4 A majority of fully-informed shareholders who vote at a general meeting may, in some instances, ratify directors' actions which otherwise breach their duties. The controlling 289 shareholders of a partly-owned group company could use this power to ratify intra-group financial transactions. However, majority ratification cannot authorise any irregular act of directors that would be oppressive or unfairly prejudicial to the minority shareholders. Also (as with unanimous ratification), the company must be solvent, taking into account the transaction to be ratified, given that directors may need to have regard to the interests of creditors where the solvency of a company is at risk. Shareholder ratification cannot override that separate duty to creditors. 2.5 In summary, the fiduciary duty issues concerning intra-group financial dealings, while theoretically applicable to all group companies, are more likely to arise for partly-owned group companies. disclosure to the shareholders. SEPARATE ENTITY OR SINGLE ENTERPRISE FIDUCIARY LOYALTY The problem in practice 2.6 Directors of group companies owe fiduciary duties of loyalty to their companies, including to act in good faith for the benefit (or in the interests) of their companies as a whole. Those directors may also wish to make decisions and act for the group's overall benefit. This may place them in the dilemma of seeking to balance their fiduciary duty of loyalty to act for the benefit of their group companies against the possibly competing economic goals or needs of the corporate group collectively. 2.7 A few examples of where this problem could arise in practice are: a group company providing a loan to another group company, or acting as a guarantor or itself providing a third party mortgage for a loan to be taken out by another group company one group company entering into an agreement with another group company to transfer its business or assets, or surrender a corporate opportunity, to the latter company, or to contract with that company on disadvantageous terms rather than contract with an outside party on much better terms a group company entering into cross-guarantees with its other group companies to assist the group to more effectively utilise its total assets in financing the group's operations. 2.8 Some of these transactions may be related party transactions, requiring approval by disinterested shareholders. However, shareholder approval of related party transactions does not relieve directors of their fiduciary duties in entering into them. Intra-group loans and other transfers 2.9 Group controllers or group company directors cannot treat the group as a single unit for the purpose of internally transferring funds or other assets or providing security. The separate legal entity of each group company must be respected. 2.10 These general common law principles are set out in the leading High Court decision of Walker v Wimborne. In that case, the directors of a group company authorised it to lend funds to various other group companies. In determining whether the directors had breached their fiduciary duty to act in good faith for the benefit of the lending company, the High Court stated that: "... the emphasis given by the primary judge to the circumstance that the group derived a benefit from the transaction tended to obscure the fundamental principle that each of the companies [within the corporate group] was a separate and independent legal entity, and that it was the duty of the 290 directors of [one of the companies within the corporate group] to consult its interests and its interests alone in deciding whether payments should be made to other companies [within the group]. In this respect it should be emphasised that the directors of the company in discharging their duty to the company must take account of the interests of its shareholders and [where the solvency of the company is an issue] its creditors." 2.11 The High Court held that the directors of the lending company had breached their fiduciary duty of loyalty to that company, given that it did not receive any commercial benefit or advantage from advancing the funds. It did not suffice that the payment could have been for the benefit of the corporate group collectively. The directors were not entitled to sacrifice the interests of their company for the overall benefit of the group. 2.12 The High Court nevertheless gave a degree of recognition to the way in which corporate groups operate. Directors would not be obliged to ignore that group structure. The interests of the group may be relevant in determining the interests of a particular company. For instance, `downstream' loans or other intra-group financial transactions151 are permitted if the parent company acquires a direct or derivative commercial benefit from them (for instance, an eventual enhanced dividend return): "... the payment of money by company A to company B to enable company B to carry on its business may have derivative benefits for company A as a shareholder in company B if that company is enabled to trade profitably or realize its assets to advantage. Even so, the transaction is one which must be viewed from the standpoint of company A and judged according to the criterion of the interests of that company." [italics added]. Therefore, directors of a parent company may take into account a subsidiary's interests, to the extent that their own company will receive such benefits. 2.13 The more difficult issue is whether directors of a group company can take into account the overall interests of that group in entering into `upstream' or `lateral' intra-group transactions, for instance by mortgaging its assets as a security to support borrowing by a parent or sibling group company (a third party mortgage) or itself providing a loan to that company. 2.14 The test employed in the UK case law (known as the Charterbridge principle) is: "whether an intelligent and honest man in the position of a director of the company concerned, could in the whole of the existing circumstances, have reasonably believed that the transactions were for the benefit of the company." 2.15 Applying that principle, the UK courts have upheld upstream or lateral security transactions where the past and continuing stability of the group company providing the security depended on the continuing survival of the recipient group company. However, directors of a group company providing an intra-group security would breach their fiduciary duty to act in good faith for the benefit of that company if it received no real commercial benefit from that transaction and undertook security obligations which those directors knew (at the time of providing the security) would be enforced, thereby stripping the company of its assets. 2.16 The Charterbridge principle has been applied in Australian case law. Directors must exercise their powers for the benefit of the company they direct. Nevertheless, in determining whether to enter into an upstream or lateral intra-group loan or security transaction, directors of group companies may have regard to any direct or derivative commercial benefits to be derived by their company, and the extent to which their company's prosperity or continued existence depends on the well-being of the group as a whole. To that limited extent, directors may consider the wider interests of the group. Therefore: 291 "...actions carried out for the benefit of the group as a whole may, in particular circumstances, be regarded as benefiting as well one or more companies in a group." 2.17 The test is whether an intelligent and honest person in the position of a director of the particular company could have reasonably believed that the intra-group transaction was for the commercial benefit of that company, not merely the corporate group collectively. In applying this test, directors of group companies should also take into account any reasonably foreseeable detriments to the company from entering into the intra-group financial transaction. 2.18 The same fiduciary duty test applies to intra-group asset or opportunity transfers. Directors should determine whether their group company would receive any direct or derivative commercial benefit from transferring a company asset to another group company. Directors have a similar duty in considering whether their company should surrender a corporate opportunity to another group company, or contract with that other group company on terms that are disadvantageous to their own group company, rather than contract with an outside party on much better terms. 2.19 In addition to these fiduciary duty principles, directors may have a duty to consider the position of the company's unsecured creditors. This obligation arises if entry into these transactions could affect the solvency of the company providing the intra-group benefits. Intra-group guarantees 2.20 It is relatively common for corporate groups to have a system of intra-group guarantees. For instance, group cross-guarantees typically contain "cross-default" provisions which render all the companies who are party to the cross-guarantees liable if any one of those companies defaults in its obligations as a borrower or as a guarantor. These cross-guarantees may also provide that events of default include any of the borrowers or guarantors in the corporate group being placed in receivership, voluntary administration or liquidation. 2.21 Cross-guarantees allow corporate groups to employ their total assets more effectively in financing the overall group operations. They also overcome some of the problems faced by creditors in dealing with corporate groups by ensuring that, irrespective of the identity or financial position of the contracting company, the creditor can also prove against the assets of guarantor group companies. ASIC also provides some accounting relief where holding companies and their wholly-owned subsidiaries enter into prescribed cross-guarantees. 2.22 US corporate law recognises the role of intra-group guarantees, whether they be downstream, upstream or lateral. Downstream guarantees may enhance the financial position of a controlled company, and therefore the parent company's investment in it. Upstream guarantees are recognised where there is some economic integration of the business of the two companies and the guarantee may further the long-term interests of the controlled company. Likewise, cross-guarantees between sibling group companies are valid where there is a business relationship between these companies and the financing is related to the business interests of both of them. However, a guarantee granted by a controlled company may be invalid if it furthers only the interests of the parent company or the personal interests of a common controlling shareholder that are unrelated to the business of the group. 2.23 Australian corporate law does not prohibit intra-group guarantees. However, directors of a group company may sometimes risk breaching their fiduciary duty to act for the benefit of their company as a whole in entering into these guarantees. An upstream or lateral guarantee should promote the group company's own corporate purposes and be issued in consideration of some commercial benefit to it. Also, entry into a guarantee may constitute oppressive conduct, particularly if the interests of majority and minority shareholders of the group 292 company diverge. For instance, if the financial circumstances of the principal debtor company, or a would-be guarantor group company, are in a poor state, a guarantor may gain no commercial benefit. Entry into that guarantee would not be for a proper corporate purpose. Any attempt by a holding company to have a wholly- or partly-owned group company enter into such guarantees in these circumstances may be invalid. 2.24 The effect of a cross-guarantee is to make the assets of the guarantor company available for distribution to the creditors of another group company, to the possible detriment of the unsecured creditors of that guarantor. Entry into a particular cross-guarantee may therefore breach the requirement that arises when a company is insolvent or nearly insolvent, that the directors must take into account the interests of the company's creditors. This obligation might therefore be breached if entering into a guarantee threatened the company's solvency or impaired its practical ability to discharge its own debts as they fell due. 2.25 An intra-group guarantee entered into by directors in breach of any of their fiduciary duties is voidable against any party seeking to enforce it who had actual knowledge of the breach. 2.26 In some circumstances, a cross-guarantee given by a company that subsequently goes into liquidation may be set aside as an "uncommercial transaction". Also, entry into some cross-guarantees may create a "debt", thereby exposing directors to potential personal liability if the company is already insolvent or becomes insolvent by entry into that guarantee. Law reform options 2.27 Australian corporate law may not fully resolve the difficulties facing directors of a group company, in their intra-group financial dealings, in balancing their fiduciary duty to act in good faith for the benefit of that group company against the economic necessity of considering the group's overall financial interests. It seems commercially unrealistic to require these directors in these dealings to ignore the organisational structure within which the group company operates. However, this may leave directors of a group company in a difficult legal position, particularly if they consider that to preserve the overall group interests requires a considerable degree of financial support or sacrifice by their group company. An intragroup financial transaction which may be sensible commercially from an overall group perspective may not necessarily be consistent with the legal obligation of directors to consider the interests of their individual group company. The problem arises where there is no immediately ascertainable direct or derivative commercial benefit to the group company in entering into these transactions. 2.28 Any law reform should ideally provide greater flexibility for directors to take into account the overall group interest, while ensuring that creditors and any minority shareholders do not suffer undue detriment from intra-group financial dealings. 2.29 There are various possible approaches for achieving a proper balance of interest. One approach, as found in European proposals, is to adopt the principles in the French Cour de Cassation "Rozenblum" decision whereby the directors of a group company can act in the interests of the overall corporate group, and subordinate or sacrifice the interests of their own company, if: the corporate group has a balanced and firmly established structure the company took part in a long-term and coherent group policy, and the directors in good faith reasonably assumed that any detriment suffered by their company would in due course be made good by other advantages. 293 Another approach is to permit directors of a group company to act in the interests of a holding company provided this does not prejudice the group company's ability to pay its creditors and the directors are authorised, either under the constitution (for wholly-owned group companies) or by minority shareholders (for partly-owned group companies). Wholly-owned group companies 2.30 The Corporations Law s 187, introduced in March 2000, permits directors of whollyowned subsidiaries in some circumstances to take into account the interest of the holding company in performing their tasks. It provides as follows: "A director of a corporation that is a wholly-owned subsidiary of a body corporate is to be taken to act in good faith in the best interests of the subsidiary if: (a) the constitution of the subsidiary expressly authorises the director to act in the best interests of the holding company; and (b) the director acts in good faith in the best interests of the holding company; and (c) the subsidiary is not insolvent at the time the director acts and does not become insolvent because of the director's act." 2.31 Use of this provision might assist external lenders to wholly-owned corporate groups. At common law, any guarantee or third party mortgage that is not in the interests of a whollyowned subsidiary providing it may be unenforceable, and the lender may be a constructive trustee for any benefit it has obtained from that guarantee or mortgage, if the directors of that subsidiary have breached any of their fiduciary duties in entering into it (for instance, the transaction provided no direct or derivative commercial benefit for that company) and this breach was known or suspected by the lender. 2.32 The effect of s 187 is to reduce the likelihood of a challenge to the enforceability of a guarantee or third party mortgage given by a wholly-owned subsidiary, by deeming the directors of that subsidiary to have acted in its best interests, notwithstanding that the mortgage or guarantee was provided solely or primarily to assist the holding company. However, the provision would not overcome the possibility that the guarantee or third party mortgage could be set aside as an insolvent transaction in the event of the subsequent liquidation of the subsidiary. 2.33 Section 187 requires that the wholly-owned subsidiary be solvent at the time the director acts and "does not become insolvent because of the director's act". This differs from the predecessor initial provision in the Corporate Law Economic Reform Draft Bill (1998) which referred to the subsidiary not being insolvent "at the time, or immediately after, the director acts". The requirement in the Corporations Law is intended to avoid protecting a director whose actions do not precipitate an immediate insolvency but instead lead to a protracted insolvency, that is, the director acts in a way that, while it may be in the interests of the holding company, effectively runs the subsidiary down, leading to its eventual insolvency. 2.34 A remaining question is whether s 187 is necessary, given the power of shareholders to unanimously ratify the actions of directors (the Pascoe principle). There are some differences between s 187 and the Pascoe principle, though they may have little effect in practice. For instance, the Pascoe principle requires unanimous shareholder ratification, whereas this is not necessary in s 187. Conversely, s 187, but not the Pascoe principle, requires that an express permissive power be included in the constitution of the wholly-owned subsidiary permitting the directors to act in the best interests of the holding company. However, each of these prerequisites should merely be a formality in a solvent wholly-owned group company. 2.35 Possibly the strongest argument for s 187 having a role independent of the common law turns on the possible inherent limitations on common law unanimous shareholder ratification. 294 There is strong authority for the proposition that shareholders, at common law, can ratify any breach of common law duty. Less certain is whether shareholders can ratify any breach of statutory duty. By contrast, s 187 applies to the directors' statutory as well as common law duties to act in good faith in the best interests of their company as a whole, thereby avoiding the uncertainty whether common law ratification covers statutory duties. Partly-owned group companies 2.36 The New Zealand Companies Act contains an additional provision which could be applied to "upstream" financial transactions within a partly-owned corporate group. A modified version of that provision was contained in the initial Corporate Law Economic Reform Draft Bill (1998), but was subsequently omitted, for further review by the Advisory Committee. This draft provision is as follows: "A director of a corporation that is a subsidiary, but not a wholly-owned subsidiary, of a body corporate is to be taken to act in good faith in the best interests of the subsidiary if: (a) the constitution of the subsidiary expressly authorises the director to act in the best interests of the holding company; and (b) a resolution passed at a general meeting of the subsidiary authorises the director to act in the best interests of the holding company (no votes being cast in favour of the resolution by the holding company or an associate); and (c) the director acts in good faith in the best interests of the holding company; and (d) the subsidiary is not insolvent at the time, or immediately after, the director acts." 2.37 In effect, this draft provision would allow a director of a partly-owned group company to act in the interests of the holding company, provided the stipulated conditions were met. The requirements for independent shareholder approval and that the company be solvent at the time the director acts are intended to protect its minority shareholders and any unsecured creditors. 2.38 The possible benefits of the draft provision would include: protecting directors of a subsidiary group company who wish to act in the interests of the holding company but without any clearly discernible direct or derivative net commercial benefit to their own company. Theoretically, under the existing law, they could seek prospective or retrospective shareholder ratification of their actions, though there are significant restrictions on this right of ratification. This draft provision resolves these ratification problems improving financial efficiency in some corporate groups by overcoming some of the possible legal restrictions on intra-group financial transactions better protecting lenders to a corporate group, particularly where they seek guarantees or third party mortgages from partly-owned group companies. 2.39 The possible detriments of the draft provision would include: eliminating the need for directors of partly-owned group companies to consider whether their company will receive any benefit from entering into the transaction. This could provide too much protection for these directors, compared with the possible detriment to the group company and its minority shareholders permitting those directors to act even when they had a personal interest in the holding company, given that the test of good faith in the draft provision only refers to acting in the best interests of the holding company reducing the rights of minority shareholders. It would be doubtful whether dissenting minority shareholders would still be eligible to initiate an oppression action concerning a resolution under the draft provision that was approved by a majority of that minority. 295 2.40 The draft provision also raises a series of further policy issues that would need to be considered Information to minority shareholders. The draft provision would permit only the minority shareholders of the subsidiary to vote on the resolution (given the exclusion of the holding company and its associates). At common law, shareholders are entitled to such information as is necessary for them to make an informed judgment on any proposal requiring their consent. What constitutes full disclosure under this draft provision may not always be clear, particularly the extent to which directors should inform shareholders of the anticipated consequences for the company of approving any resolution permitting the directors to act in the interests of another company. This problem of shareholders understanding the full ramifications of a proposed resolution could particularly arise if general prospective approvals were permitted (see below). Prior or retrospective approval. The New Zealand legislation, on which the draft provision is based, expressly stipulates that directors may only act with the "prior agreement" of the minority shareholders. By contrast, the draft provision does not make clear whether retrospective, as well as prior, approval is permitted. It may be preferable that this matter be expressly clarified, one way or the other. Approval of each action or a general approval. The draft provision does not indicate whether shareholders must approve each specific act of the directors, or whether a general approval for all the directors' actions is permissible. If the former interpretation is correct, the provision may be largely unworkable, as it could require constant shareholder meetings. However, if general prospective approval is permitted, minority shareholders may be asked, in effect, to surrender, or place in jeopardy, many of their future interests, both foreseeable and unforeseeable (for instance, directors of the subsidiary may determine that it is in the interests of the holding company to fundamentally change or run down the business of the subsidiary company or sell off its key assets). The information on which shareholders should base their decision may need to fully explain and emphasise the potential implications of any approval. Implications of a "no" resolution. On one view, the directors could still proceed with intra-group financial transactions, taking into account the interests of the holding company, provided that there was some direct or derivative benefit to their own partly-owned group company. However, another possible view is that the draft provision, if enacted, would constitute an exhaustive code and the directors could only act in the interests of the holding company (notwithstanding that there may be some benefit to the subsidiary company) if they received shareholder approval. The draft provision would need to make clear whether or not it is an exhaustive code. Implications of a "yes" resolution. A related concern is whether the draft provision might be interpreted as the only way that directors could take into account the interests of another group company, thereby putting in doubt the current legal principles regulating nominee directors. One suggestion is that any legislation should put beyond doubt that the current rights of nominee directors to take into account the interests of their nominators without further authorisation by their group company remain in force. Withdrawal of consent. The draft provision makes no reference to how a consent, once given, may be withdrawn. The general common law principle is that any shareholder resolution can only be overturned by a further shareholder resolution. If the principle were applied in this context, shareholder approval may give directors the power for an indefinite future time to act in the interests of the holding company, rather than their own company. One possible control might be to introduce a statutory "sunset" limitation on any resolution (say one year), with directors having to obtain a further resolution from minority shareholders to continue to act in the interests of the holding company. In seeking any further approval, a statutory obligation could be placed on directors to report to shareholders on how they have previously exercised 296 their power to act in the interests of the holding company and its financial and other material implications for the subsidiary company. Good faith in the best interests. The draft provision refers to the directors acting "in good faith in the best interests of the holding company". It is not clear whether this constitutes one or two requirements. On one view, directors should be required to act both bona fide and in the interests of the holding company. Also, the reference to the "best" interests of the holding company might suggest that the provision only applies to decisions that are the best possible for the holding company. By contrast, the usual formulation is that directors must act in the interests of their company. Solvency of the subsidiary. The solvency requirement in the draft provision looks at the circumstances of the partly-owned group company at the time that its directors act, not necessarily when the resolution was passed. This solvency obligation is designed to protect the company's unsecured creditors. However, the requirement in the draft provision that the company be insolvent "at the time, or immediately after, the director acts" would not cover financial transactions or other decisions (for instance, a decision to transfer assets or a corporate opportunity to another group company) which may eventually, but not immediately, lead to the subsidiary company's insolvency (the "run down" problem). These transactions can be set aside in the liquidation of the subsidiary company in only limited circumstances. A number of alternative policy options could be employed to deal with this problem. One policy option would be to replace the solvency requirement with a test found in the share capital reduction provisions, namely that any transaction entered into under the draft provision "does not materially prejudice the company's ability to pay its creditors". An alternative approach would be to adopt the language in s 187 (dealing with wholly-owned subsidiaries) which requires that the subsidiary be solvent at the time the director acts and "does not become insolvent because of the director's act". Another, or additional, approach, which is applied in New Zealand, would be to empower the courts to make mandatory contribution or pooling orders, each of which could deal with the types of transactions that are permitted by the draft provision but nevertheless lead to the eventual, though not immediate, insolvency of the company. The merits of these additional powers are discussed elsewhere in this Report. Protection of minority shareholders. The draft provision does not prevent the holding company and its associates from voting on any proposal to include the permissive power in the subsidiary company's constitution. However, they are excluded from voting in support of any shareholder resolution authorising directors to exercise that power. The possibility remains, however, that the long-term interests of minority shareholders of the partly-owned group company could be sacrificed through this procedure. One response to these concerns may be that the related party provisions protect minority shareholders of partly-owned group companies. Certainly, directors of some group companies would have to obtain minority shareholder approval under those provisions for intra-group financial dealings, in addition to any approval they may have to act in the interests of the holding company (if the draft provision were introduced). However, the related party provisions would not cover decisions by directors either not to act (for instance, not to compete with another group company for a corporate opportunity), or to change the role of the company (for instance, by selling the company's assets externally either to run it down or to convert it into a "cashbox" for the group). Also, the related party provisions do not require that shareholders consider the interests of creditors. Consideration of the position of minority shareholders raises the question whether all, or at least the non-assenting, minority shareholders should have buy-out rights where 297 a resolution is passed. An argument against any buy-out right would be that its exercise could create financial disincentives to using the provision, given that dissenting minorities could require a buy-out once a resolution was passed. A contrary argument is that a buy-out right could act as a discipline on directors of a partly-owned group company to seek a minority shareholder resolution only where there was clearly no direct or derivative benefit to that group company from a proposed transaction. The buy-out right would therefore only apply where the minority shareholders approved the directors acting against the interests of their own company. The recommended buy-out procedure is discussed elsewhere in this Report. Liability of the holding company. The draft provision does not discuss the circumstances, if any, in which a holding company should be liable for the actions of a director of a partly-owned group company who has acted in the interests of the holding company, to the financial detriment of the group company. On one argument, the attraction of this provision for corporate groups could be seriously undermined if the courts interpreted it as giving them a direct or indirect power to lift the corporate veil and give creditors of the subsidiary access to the assets of the holding company. The contrary argument is that, where a power is exercised for the benefit of a holding company, that company should be prepared to carry some of the financial consequences of this action. Similar matters are discussed elsewhere in this Report. Upstream and lateral group transactions. The draft provision refers to a director of the subsidiary acting in the best interests of the holding company. This would clearly cover "upstream transactions" such as a subsidiary lending money to, or providing a guarantee for the benefit of, the holding company. What is less certain is whether the provision does, or indeed should, cover "lateral" transactions, such as loans, guarantees or the provision of securities between sibling group companies. On one view, the draft provision should apply to all intra-group dealings, whether or not the holding company is a party. To restrict the provision to upstream transactions could undermine its usefulness to corporate groups. However, to include all lateral transactions raises the issue of whether, or in what circumstances, a sibling group company that has benefited from a transaction to which the draft provision applies should also assume some financial responsibility for its consequences. Issue 3. Should a provision similar to that found in the New Zealand Companies Act be introduced to permit directors of a solvent partly-owned group company to act in the interests of the parent company where the minority shareholders of the former company pass a resolution, in accordance with its constitution, that approves the directors so acting? If so, should the provision, or other related provisions: stipulate what information is necessary for minority shareholders to make a fully informed decision permit minority shareholders to give retrospective, as well as prior, approval to the directors' actions only permit approval to be given for specific actions of directors or, alternatively, allow for minority shareholders to give a general approval make it clear whether the proposed procedure sets out the only circumstances in which directors can act in the interests of the parent company 298 stipulate a time limit on the operation of any minority shareholder resolution? If so, should directors who seek further minority shareholder approval be required to report to shareholders on how they have previously exercised their power under the provision refer to directors acting "in good faith and in the interests of the holding company" rather than "in good faith in the best interests of the holding company" cover actions that would eventually, but not immediately, lead to the insolvency of the partly-owned group company? If so, should the provision require that any relevant transaction not materially prejudice the company's ability to pay its creditors or, alternatively, that the subsidiary be solvent at the time the director acts and not become insolvent because of the director's act give all, or at least the non-assenting, minority shareholders buy-out rights where a resolution is passed set out the circumstances, if any, in which a parent company should be liable for the actions of a director of a partly-owned group company who has acted in the interests of the parent company, to the financial detriment of the group company extend to transactions for the benefit of sibling group companies and, if so, provide for the circumstances in which those sibling companies should accept liability for those transactions? ... Advisory Committee response to submissions on Issue 3: Draft Recommendation 3 2.59 The Advisory Committee sought public comment on a provision based on the New Zealand legislation. The Committee expressed reservations about the provision, in particular whether minority shareholders would ever wish to approve a resolution of this nature. However, the Committee proposed that any provision, if introduced, should deal with the matters raised in the discussion of Issue 3 in the manner set out in the following Draft Recommendation. A provision should be introduced to permit directors of a solvent partly-owned group company to act in good faith and in the interests of the parent company where the minority shareholders of the former company pass an ordinary resolution, in accordance with its constitution, that approves the directors so acting. That provision should: not stipulate what information is necessary for minority shareholders to make a fullyinformed decision (given that there are adequate common law principles) permit minority shareholders to give retrospective, as well as prior, approval to the directors' actions permit minority shareholders to give a general approval make it clear that the proposal is additional to, not in substitution for, the current common law principles permitting directors to act in the interests of their company and permitting shareholder ratification not stipulate a statutory time limit on the operation of any minority shareholder resolution, but leave that to the terms of the resolution apply the principle, found in the capital reduction provision (s 256B(1)(b)), that the action of directors in exercising the power should not materially prejudice the company's ability to pay its creditors (this formulation may be preferable to the s 187(c) formulation) permit all minority shareholders who have not voted in favour of the resolution (that is, dissenting shareholders and shareholders who failed to vote) to exercise buy-out rights (see further Recommendation 10) not impose any additional liability on a parent company for the actions of the directors of a partly-owned group company not extend to sibling group companies (this appears to be unnecessary, as transactions between sibling companies would nevertheless directly or indirectly benefit the parent company and therefore be covered by the provision) 299 stipulate that the oppression remedy should not apply to any resolution passed in accordance with this proposal (given that any non-approving shareholders would have buy-out rights). ... Advisory Committee response to submissions on Draft Recommendation 3 2.62 The Advisory Committee continues to support the Draft Recommendation, albeit that minority shareholders may not often wish to approve a resolution of this nature. 2.63 The Committee maintains its view that, in accordance with common law principles, minority shareholders should be able to give retrospective as well as prospective approval. It also confirms that the provision need not expressly extend to sibling group companies, as transactions between sibling companies would nevertheless directly or indirectly benefit the parent company and would therefore come within the provision. 2.64 The purpose of the Draft Recommendation is to permit directors of partly-owned group companies to act in the interests of the holding company without this constituting a breach of their fiduciary duties. This is a separate issue from the price of minority shares. Also, the interests of creditors would be protected by applying the principle that exercise of the power "should not materially prejudice the company's ability to pay its creditors". Recommendation 3 The Corporations Law should permit directors of a solvent partly-owned group company to act in good faith and in the interests of the parent company where the minority shareholders of the former company pass an ordinary resolution, in accordance with its constitution, that approves the directors so acting. That provision should: not stipulate what information is necessary for minority shareholders to make a fullyinformed decision permit minority shareholders to give retrospective, as well as prior, approval to the directors' actions permit minority shareholders to give a general approval make it clear that the proposal is additional to, not in substitution for, the current common law principles permitting directors to act in the interests of their company and permitting shareholder ratification not stipulate a statutory time limit on the operation of any minority shareholder resolution, but leave that to the terms of the resolution apply the principle, found in the capital reduction provision (s 256B(1)(b)), that the action of directors in exercising the power should not materially prejudice the company's ability to pay its creditors permit all minority shareholders who have not voted in favour of the resolution (that is, dissenting shareholders and shareholders who failed to vote) to exercise buy-out rights not impose any additional liability on a parent company for the actions of the directors of a partly-owned group company not extend to sibling group companies stipulate that the oppression remedy should not apply to any resolution passed in accordance with this proposal. NOMINEE DIRECTORS OF GROUP COMPANIES 300 Application only to partly-owned group companies 2.74 A nominee director is a person appointed to represent a sectional interest, rather than the company as a whole. This concept does not directly apply to wholly-owned group companies, given that there is only one shareholder. However, the concept is relevant to those partlyowned group companies where one or more directors are appointed by the controlling shareholder to represent its interests on the controlled company's board. Role of nominee directors 2.75 Within the context of partly-owned corporate groups, a nominee director has a dual role, namely to represent the nominator and to direct the controlled company. This dual role raises four related issues: disclosure of nominee directors fiduciary duties of nominee directors nominee directors passing on information to their nominators liability of nominators. ... Fiduciary duties of nominee directors Current law 2.94 Nominee directors appointed to a group company by a parent company owe fiduciary duties to the group company. These fiduciary duties include not fettering their discretion, avoiding conflicts of interest, and acting in good faith for the benefit of their company as a whole. For instance, nominee directors of a group company may breach their duty to actively exercise their discretion if they undertake to follow their nominator's instructions or wishes on all matters to be considered by the group company's board. However, a company's constitution or a shareholders' agreement may define or modify the scope and nature of the fiduciary duty owed by nominee directors of that company. 2.95 Subject to these principles, there is case law authority that nominee directors can advance their nominator's interests provided that in so doing they have an honest and reasonable belief that they are acting consistently with the interest of their group company. Nominee directors would breach their duty only if, when faced with a conflict of interest, they knowingly sacrificed their company's interests for those of their appointor. The actions of nominee directors are "not reprehensible unless it can also be inferred that the directors so nominated would so act even if they were of the view that their acts were not in the best interest of the company". 2.96 While the above formulation probably represents the predominant view, the legal position of nominee directors is not beyond doubt, given some contradictory case law in Australia, as well as in the UK and Canada. For instance, some courts have adopted strict separate legal entity principles to conclude that the overriding duty of nominee directors is to the company, not to their nominators. In the event of any conflict of interest between the company and those nominators, the nominee directors are "bound to ignore the interests and wishes of their [nominators]". Law reform options 2.97 On one view, the role of nominee directors contradicts the undivided fiduciary loyalty owed by directors to their company. The ability of nominee directors to carry out their duties in the interests of the company as a whole might be compromised by this divided loyalty. The contrary view, in the corporate group context, is that it may be in the interests of a group 301 company to have one or more directors on the board nominated by, and acting in the interests of, the controlling, or another, group company. 2.98 Some common law countries give express legislative recognition to the dual loyalties of nominee directors. An early model, drafted by Professor Gower, a leading UK commentator on company law, states: "In considering whether a particular transaction or course of action is in the best interests of the company as a whole, a director, when appointed by, or as a representative of, a particular class of members, employees or creditors, may give special, but not exclusive, consideration to the interests of that class." 2.99 In Australia, the dual loyalty issue was considered by the Companies and Securities Law Review Committee, which recommended legislation to clarify that in certain circumstances nominee directors may expressly have regard to the interests of their nominators without breaching their duty to the company. This would reflect the commercial raison d'tre of nominee directors, namely to protect the interests of the appointor. The proposal was relatively narrow. The protection would only apply to companies administered under a relevant shareholders' agreement or where all the shareholders of the company had given their prior informed consent. Also, that protection would only extend to decisions made by directors whilst a company was solvent. 2.100 The New Zealand Companies Act gives broader protection to nominee directors by permitting the directors of a partly-owned group company to act in the interests of the controlling company where this is authorised by the company's constitution and a resolution to that effect has been passed by the shareholders. Particulars of the nominee director's appointment and the extent of the interests of the nominator must be publicly disclosed. This disclosure is designed for the benefit of other directors, shareholders trading in the company's shares and creditors and other persons dealing with the company. 2.101 A similar provision was contained in the initial Corporate Law Economic Reform Draft Bill (1998), with the additional requirement that the subsidiary be solvent at the time, or immediately after, the director acts. It was subsequently omitted, for further review in this Report. The provision is discussed in detail elsewhere in this Report. 2.102 Another policy option would be for the Corporations Law to state specifically that nominee directors would breach their fiduciary duties to their group company by taking into account the interests of their nominators, or acting in accordance with their instructions, only where: in so doing they did not have a bona fide belief that they were also promoting, or acting consistently with, the interests of the group company as a whole, or no honest and reasonable director could have formed that belief. This would recognise and clarify the prevailing view in Australian case law, thereby overcoming residual uncertainty. It would also go further than the Companies and Securities Law Review Committee recommendations or the New Zealand provisions, to cover circumstances where there was no express provision in the company's constitution, or any relevant shareholder approval. 2.103 In US law, controlling shareholders of a company owe equitable fairness duties to minority shareholders. In the corporate group context, a parent company which is a controlling shareholder owes these duties to minority shareholders of a controlled company. If that approach were adopted in Australian law, the problem of the possible divided loyalty of nominee directors appointed by a controlling company could be resolved by permitting them to act in the interests of that controlling company, which in turn would have a "fair dealing" obligation to the minority shareholders of the group company. 302 Issue 6. Should the law be amended to clarify the fiduciary duties of nominee directors of partly-owned group companies? If so, should it: permit nominee directors to give special, but not exclusive, consideration to the interests of the class they represent (Option A), or permit nominee directors to act in the interests of their nominators where this is authorised by the company's constitution and a resolution to that effect has been passed by the shareholders (Option B), or provide that nominee directors would breach their fiduciary duties by taking into account the interests of their nominators, or acting in accordance with their instructions, only where in so doing they do not have a bona fide belief that they are also promoting, or acting consistently with, the interests of the company as a whole, or no honest and reasonable director could have formed that belief (Option C), or impose on a parent company a fair dealing obligation to minority shareholders of a partly-owned group company in lieu of any controls over a nominee director acting in the interests of the parent company (Option D), or adopt some other approach (Option E)? ... Advisory Committee response to submissions on Issue 6: Draft Recommendation 6 2.114 Consistently with the Advisory Committee's views expressed in the discussion leading up to Recommendation 5, there should be no separate codification of the fiduciary duties of nominee directors. The fiduciary duties of these directors should not differ from those of other directors. Any modification of the fiduciary duties of nominee directors may also give them a legal advantage over other directors. Furthermore, to create a statutory "safe harbour" under any of the options set out in Issue 6 may be inappropriate in particular cases. Accordingly: The Corporations Law should not contain specific provisions dealing with the fiduciary duties of nominee directors of partly-owned group companies. These directors should be subject to the same fiduciary duties as all other company directors. ... Advisory Committee response to submissions on Draft Recommendation 6 2.116 The Advisory Committee maintains the approach in the Draft Recommendation. Recommendation 6 The Corporations Law should not contain specific provisions dealing with the fiduciary duties of nominee directors of partly-owned group companies. These directors should be subject to the same fiduciary duties as all other company directors. 303

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