Company Law in Context

Company Law in Context Text and Materials David Kershaw London School of Economics David Kershaw is a Senior Lecturer in Law at the London School of Economics. He qualified as a solicitor at Herbert Smith and practiced corporate law with Wolf Theiss, Vienna and in the Mergers & Acquisitions Group of Shearman & Sterling in New York and London. He holds degrees from the University of Warwick and Harvard Law School. OXFORD UNIVERSITY PRESS

CONTENTS IN FULL Preface vii Guide to the Book x Guided to the ORC xii Table of Cases xxvii Table of Legislation xxxvii Acknowledgements xliii PART I INCORPORATION AND SEPARATE LEGAL PERSONALITY 1 An introduction to the context and consequences of incorporation 3 I Bob's Electronics as a sole trader 3 1 The business idea 3 2 The inputs required to run the business 4 3 Sole-trading/sole proprietorship 4 4 Running Bob's Electronics: decision-making by a sole trader 5 5 What does it mean for Bob to own the business; what is his equity in the business? (, 6 Investing in Bob's Electronics; an introduction to risk and return 6 6.1 Risk and return 7 6.2 Risk and the nature of the investment 8 6.3 An acceptable return in light of the risk and expected return calculation 8 7 The limitations of sole trading as a way of carrying on a business 9 II Introduction to incorporation 11 1 Incorporation options 11 2 Formation basics 14 3 From Bob's Electronics to Bob's Electronics Ltd 15 III The consequences of incorporation 17 1 Separation of personal and business assets: entity shielding 17 2 Introduction to limited liability 20 2.1 Why does law provide for limited member liability? 20 3 Managing succession 28 2 The entity doctrine 30 I Reality and incorporation 30 1 The entity doctrine: Salomon v Salomon 30 2 The implications of separate legal personality 41 II Piercing the corporate veil 46 1 Questions that cannot be answered by incorporation 47 2 Evading existing obligations 54 3 Agency 57

Xviii CONTENTS IN FULL 4 Single economic unit " 5 The facade concealing the true facts 70 6 Doing justice to the facts 74 7 Summary '$ 3 The corporate constitution/the mechanics of the general meeting 79 A The corporate constitution 79 I Introduction 79 1 What is a constitution and does a company have one? 79 2 The constitutional documents 0 3 The Model Articles of Association 81 4 Amending the articles of association 83 II The legal status of the constitution: the corporate contract 85 III Enforcing the corporate contract 87 1 Qua member and only qua member? 87 2 Internal irregularities versus personal rights 89 IV Shareholders' agreements 93 B The mechanics of the general meeting 96 I How do members act? 96 1 Resolutions 96 2 Shareholder meetings 97 3 Voting at general meetings 98 II Shareholder action through informal consent 100 4 Corporate actions 105 I Introduction 105 II Capacity 106 III Contract and the company 109 1 Primary and general rules of attribution 109 2 The common law of agency: actual authority 112 3 The common law of agency: apparent authority (sometimes referred to as ostensible authority) 115 3.1 The structure of the apparent authority doctrine 120 3.2 An alternative lens: the constructive notice doctrine 122 3.3 The indoor management rule 123 4 The Companies Act 2006 and apparent authority 126 4.1 The effect of section 40 127 4.2 Substantive and procedural limitations 129 4.3 The preconditions to the application of section 40 130 4.4 Shareholder action in relation to unauthorized transactions 131 IV Tort and the company 132 1 Attributing tortious acts to the company 132 1.1 Vicarious liability 132 1.2 Vicarious liability or vicarious attribution? 135 2 Directors as the embodiment of the company: the identification doctrine 138 3 Liability of directors and officers for acts undertaken on behalf of the company 139

CONTENTS IN FULL X1X V Crime and the company 547 1 Attributing crimes to companies: special rules of attribution 147 2 Corporate manslaughter I54 PART II CORPORATE CONTROL AND ACCOUNTABILITY 5 The corporate agency problem 163 I The problem of non-aligned interests 163 II The language of economic agency costs 167 1 The economist's view of the principal-agent problem 167 2 Managerial agency cost categories 169 2.1 Direct transfers of value 169 2.2 Indirect agency costs 170 III Private and regulatory responses to managerial agency costs 171 1 Shareholder responses to the managerial agency problem 171 2 Regulatory responses to the managerial agency problem 175 IV The problem of authority 178 6 The balance of power between the board, management and the shareholder body 179 I Introduction 179 II Decision rights 179 1 Who should make corporate decisions? 179 2 The basic distribution of decision-making power in UK company law 181 2.1 The default distribution of decision making power 182 2.2 Exercising instruction rights 185 2.3 The enforcement of the distribution of power 190 3 Shareholder veto and approval rights 194 3.1 Significant transactions: who is best placed to make a decision? 195 3.2 UK significant transaction regulation 197 1.3 Other shareholder approval rights in UK company law 197 4 Changing the distribution of power 199 5 The formal distribution of power between the board and management 199 6 Decision rights in the US 202 6.1 Corporate law in the US 202 6.2 The distribution of decision rights in Delaware law 203 6.3 Delaware companies: veto rights in significant value transactions 204 6.4 Delaware companies: other shareholder approval rights 204 6.5 Delaware companies: the distribution of power between the board and management 205 6.6 Delaware companies: amending the distribution of power 205 7 Decision rights in German corporate law 205 7.1 Management board and supervisory board decision rights 205 7.2 Significant transaction and other shareholder approval rights in German law 207 III Appointment and removal 208 1 Appointment and removal rights in theory 208 2 Appointment and removal rights in UK company law 209 2.1 Appointment 209 2.2 Removal 210

xx CONTENTS IN FULL 3 Removal rights in comparative perspective 216 3.1 Removal rights in the US 216 3.2 Removal rights in Germany 218 IV Shareholder versus director primacy 218 7 Board composition and structure regulation 222 I Introduction to board function and composition 222 1 The core functions of the board 222 2 The board's managerial role and the number of executive directors 224 3 The function, number and characteristics of non-executive directors 227 3.1 How many non-executive directors? 229 3.2 The independence of the non-executive directors 231 3.3 Board activity to be controlled by the non-executive directors 233 3.4 Chairing the board of directors 235 II Board structure and composition regulation: the Combined Code 237 1 The number and independence of non-executive directors 239 1.1 The number of non-executive directors 239 1.2 The definition of independence 241 2 The independence-knowledge trade-off 244 3 The structure of the board and the role of the non-executive director 246 3.1 The Combined Code's committee structure 246 3.2 A comparative note on NYSE committee structure 248 4 Separation of chairman and CEO 248 4.1 The Combined Code's separation recommendation 248 4.2 A comparative US note on separation of chairman and CEO roles 252 5 Other Combined Code recommendations to enhance the monitoring function 254 HI The relationship between board composition regulation and company performance 256 8 Regulating directors'remuneration 261 I Introduction 261 1 The objectives of remuneration 261 2 The executive remuneration problem 262 II The types and trajectory of remuneration for executive directors 263 1 Types of executive pay and benefits 263 2 The structure and trajectory of executive pay for listed companies 266 III Legal strategies to ensure that pay is not a managerial agency cost 271 1 The regulation of conflicts of interest and executive directors' pay 272 2 Remuneration committees 272 3 Disclosure and shareholder voice 274 4 Executive remuneration arrangements subject to shareholder approval 278 5 Has UK executive pay regulation been successful? 279 IV Remuneration for service as a non-executive director 282 V Regulating executive remuneration across the Atlantic 285 9 Introduction to directors' duties 288 I Rules versus principles 288 II Designing behavioural expectations 289

CONTENTS IN FULL XXI III Introduction to the key duties owed by directors 290 IV The sources of directors' duties 292 V Who owes the duties? 294 VI To whom are the duties owed? 299 10 Regulating discretion I: acting in the company's interests 303 I The pre-2006 Act common law duty to act in good faith in the best interests of the company 303 1 What are the company's interests at common law 304 1.1 Does the company have its own interests? 304 1.2 The company's interests as shareholders'interests 305 1.3 The 'interests' of other constituencies 307 2 Evaluating director's actions 308 3 judging with hindsight 313 4 Why is the standard for evaluating directors' decisions so low? 315 5 Evaluating the failure to consider the company's interests 317 6 Restricting discretion in the best interests of the company 320 II Rethinking what is in the company's interests 325 1 The interests of the company's'owners' 325 2 Contract and company interests 330 3 Justifying state regulation of company interests: trusteeship and social responsibility 334 3.1 Objections to multiple-interest approaches to the company's interests 339 3.2 Social responsibility means maximizing shareholder value 341 4 Justifying regulation: could multiple interest trusteeship increase the size of the economic pie? 344 5 The UK reform debate on the company's interests 346 HI The Companies Act 2006 349 1 The duty to promote the success of the company 349 1.1 Key points to note on the duty to promote the success of the company 349 1.2 To what extent does section 172 change the existing law? 351 2 The duty to exercise independent judgment 352 11 Regulating discretion II: using corporate powers for proper purposes 354 I The development of the improper purpose doctrine: from rule to principle 354 II Can good reasons ever make an improper purpose proper? 364 III The Companies Act 2006 369 IV A US comparison 371 12 Competence and the duty of care 375 I Introduction 375 1 Directors'decision-making activity and function 375 2 What does taking care involve in a company context? 376 3 The structure and design of a duty of care 382 II The duty of care at common law 384 1 The common law position prior to the 1990s 384

xxii CONTENTS IN FULL 2 The evolution of the common law position in the 1990s 394 3 Monitoring and reliance on management and employees 397 III The duty of care and the Companies Act 2006 403 IV Indemnifying directors for breach of duty 406 1 Company waivers, indemnities and insurance 406 2 Court discretion to grant liability relief 408 V The duty of care in US comparative perspective 411 1 The standard of care 411 2 The standard of review for business decisions 412 3 The standard of review in relation to the decision-making process 413 4 The standard of review and board monitoring 426 VI Does the UK have a business judgment rule? 428 13 Regulating conflicts I: self-dealing I Introduction 431 II Strategies for regulating self-dealing 431 1 Introduction 431 2 Regulatory strategies 432 2.1 Prohibition 432 2.2 Disclosure 433 2.3 Ex-ante approval mechanisms 434 2.4 Ex-post court review 435 III Self-dealing and the common law: the duty of loyalty 436 1 The common law 436 2 Opting out of shareholder approval and Table A 444 IV Self-dealing regulation under the Companies Act 2006 446 1 Ex-ante board disclosure 446 1.1 Background to reform 446 1.2 The disclosure requirement pursuant to section 177 447 1.3 Is there a continuing role for disinterested directors? 449 1.4 Is section 177 a safe harbour or a mandatory approval rule? 450 2 Mandatory ex-post disclosure 451 3 Shareholder approval and substantial property transactions 453 4 Loans to directors 457 V Self-dealing regulation beyond the Companies Act 459 1 Additional self-dealing regulation for listed companies 459 2 Ex-post disclosure and accounting regulation 459 VI UK self-dealing regulation in comparative US perspective 462 14 Regulating conflicts II: corporate opportunities 468 I Introduction 468 1 An opportunities hypothetical 468 2 Strictness versus flexibility/deterrence versus fairness 472 II Opportunities and the common law 473 1 Regal (Hastings) v Gulliver 473 1.1 The no-profits-rule 477 1.2 Capability facts and financial capacity 478 2 Boardman v Phipps 479 4^1

CONTENTS IN FULL 2.1 No-profit versus no-conflict 4g6 2.2 What is the nature of'possible conflict'? 488 2.3 Accounting for profits and the scope for an equitable allowance 491 3 The no-conflicts approach and the company's interests 493 4 Approval mechanisms at common law 507 5 Resignation of office in order to take the opportunity 508 5.1 The resignation problem 508 5.2 Post-resignation opportunities regulation 509 III The Companies Act 2006 517 1 Section 175(1) 5lg 2 Section 175(2) 519 3 Section 17S(4)(b) 519 3.1 Board rejection of the opportunity 520 3.2 Area of business restrictions 521 4 Approval mechanisms under the 2006 Act 521 5 The status of the no-profit rule 521 6 Former directors 522 IV Directors competing with the company and holding directorships in competing companies 523 V Strictness versus flexibility in US comparative perspective 526 15 Enforcing directors'duties 535 I Introduction 535 II 1 Only the company can enforce rights owed to the company 535 2 Which corporate body should make the decision to commence litigation against a director? 535 3 Choosing between the regulatory options 540 Control of the litigation decision by the board or the general meeting 541 III The common law's regulation of derivative actions 546 IV Derivative actions under the Companies Act 2006 551 1 The new statutory derivative action mechanism 551 2 Structure and ground rules of the derivative claim 554 2.1 Who can bring a derivative claim? 554 2.2 Who can a derivative claim be brought against? 556 3 Permission to continue the derivative claim 556 3.1 Situations in which the court must refuse permission to continue the derivative claim 557 3.2 Actual ratification or authorization 557 3.3 The court's business judgment 558 3.4 Situations in which the court has a discretion to allow the derivative claim to be continued 563 4 Turning company-initiated litigation into derivative litigation 567 V Funding derivative claims 568 1 The relationship between legal cost rules and the effectiveness of the derivative claim 568 2 Costs rules in derivative claims 570 2.1 Company indemnities 572 2.2 Contingency fees and conditional fees 574

XXIV CONTENTS IN FULL VI Reflective loss: enforcing the priority of the company's claim 576 1 Introduction 576 2 The reflective loss principle 577 16 Minority shareholder protection 582 I Introduction 582 1 The controlling shareholder agency problem 582 2 Regulating controlling shareholder actions 585 2.1 Regulating the shareholder vote 585 2.2 Controlling shareholder activity outside of the general meeting 586 II Common law regulation of controlling shareholders 587 1 Common law limits on shareholder voting 587 1.1 Shareholder votes to ratify breaches of duty: common law oppression 587 1.2 Amending the articles of association: acting bona fide in the interests of the company 590 2 Regulation of controlling shareholder activities where they do not exercise corporate power 603 III Statutory regulation of controlling shareholder power 608 1 Just and equitable winding-up 609 2 The unfair prejudice remedy 615 2.1 Conducting the company's affairs 616 2.2 Unfair prejudice to members' interests 617 IV The unfair prejudice remedy beyond the equitable considerations category 625 1 The move towards independent illegality 625 2 Testing the boundaries of the independent illegality requirement 628 V The remedies available through an unfair prejudice petition 631 1 The available remedies 631 2 Encouraging out-of-court settlements: buy-out offers and unfair prejudice 633 3 Corporate remedies for breach of duty, the unfair prejudice remedy as a 'derivative action' 635 VI Listed company-related party transactions 638 VII Minority shareholder protection beyond this chapter 640 PART III CORPORATE FINANCE 17 Shares 643 I Introduction 643 1 Shares as financial contractual claims 643 2 Shares and control rights 646 3 Choice of finance: equity versus debt; ordinary shares versus preferred shares 649 II Issuing shares 650 1 Who should make the decision to issue shares? 650 2 The regulation of share issues in UK company law 652 2.1 Basic concepts and vocabulary "52

CONTENTS IN FULL XXV 2.2 The distribution of the corporate power to allot, issue and attach rights to shares 653 2.3 Authority to allot shares 654 2.4 Pre-emption rights 657 2.5 Pre-emption rights in practice 660 2.6 Consideration paid for the shares 663 2.7 Registration; return of allotment and the statement of capital 668 III Class rights 668 1 Variation of class rights 668 2 What rights are class rights? 671 3 Variation in rights versus detriment to class interests? 674 4 Protecting minority class shareholders 674 IV Share buy backs 676 1 Why would a company repurchase its own shares? 676 2 Regulation of share buy backs at common law 679 3 Regulation of share buy backs pursuant to the Companies Act 2006 681 3.1 Purchase of the company's own shares 681 3.2 Treasury shares 683 3.3 Issue and redemption of redeemable shares 684 V Financial assistance 685 1 Introduction 685 2 The prohibition on the provision of financial assistance 687 2.1 The prohibition 687 2.2 The meaning of'financial assistance' 688 2.3 Prohibited financial assistance 696 2.4 Exceptions and exemptions 698 PART IV CREDITOR PROTECTION 18 Company law and creditor protection 705 I Introduction 705 II Problems generated by limited liability 706 1 Transferring risk from members to creditors 706 2 Limited liability and the opportunistic transfers of wealth from creditors to shareholders 708 3 Limited liability and incentive to invest in hazardous activities 710 III Reconsidering unlimited liability for tort victims 715 IV Creditor-regarding obligations 721 1 Introduction 721 2 Directors' duties and creditor protection 722 2.1 Creditor regarding duties in insolvency 722 2.2 Creditor regarding duties when approaching insolvency 724 3 Fraudulent trading 727 4 Wrongful trading 729 4.1 When does section 214 apply and how does it protect creditors? 730 4.2 When is there 'no reasonable prospect' of avoiding insolvent liquidation? 730 4.3 Taking steps to minimize creditor losses 734 4.4 Mediating between directors' duties and section 214 liability 736 4.5 Section 214 and financial agency costs 737 4.6 Who does section 214 apply to? 7^8

XXVI CONTENTS IN FULL 4.7 Nature and quantum of contribution for breach of section 214 739 4.8 The effect of section 214 in practice: funding section 214 applications 739 V Directors' disqualification 739 19 Regulating legal capital 745 I Introduction 745 II Minimum capital requirements 746 1 Do minimum capital requirements protect creditors? 746 2 UK and European approaches to minimum capital 750 III Distributions 751 1 Approaches to distribution regulation 751 2 UK distribution regulation prior to 1980 754 3 Distribution regulation under the Companies Act 2006 761 3.1 The accumulated profits test 762 3.2 The 'net assets' test 763 3.3 Comparing the effects of the accumulated profits test and the net assets test 765 4 Creditor protection through post-1980 distribution regulation 766 5 Reforming the distribution rules 770 5.1 The logic of reform if distribution rules protect only adjusting creditors 770 5.2 The costs of the distribution rules 772 6 Distributable profits and share buy backs and redemptions 777 7 Liability for unlawful distributions 778 7.1 Shareholder recipient liability 778 7.2 Director liability for unlawful dividends 780 IV Reducing capital 786 1 Court confirmation capital reduction procedure 787 2 Solvency statement and the board approval strategy 790 2.1 Should boards rather than courts determine solvency? 790 2.2 Board solvency approval of capital reduction under the Companies Act 2006 791 2.3 Board-approval solvency approach to share repurchase out of capital 793 3 Classes of shares and capital reductions 796 4 Will private companies continue to use the court-confirmation procedure or the share-repurchase procedure? 797 V Structuring around capital and distribution regulation 797 1 Legal engineering 797 2 Substance over form in distribution regulation 798 Glossary 803 Index 809