Corporations A Comparative Perspective

SUMMARY OF CONTENTS
............. ....................... ......... ......... ..........

AUTHORS ' NO'l'E
.................. ................. VII
....... ... ...... ....... .•. .. IX
FOREWORD ... .•.... . .. ............. .. ..•..... .•.•.. .... .... ... .... ... ... ........ ..........
....... .. ......... .... ... XIII
ABolJT THE AlJTHO RS .. .. ... ....... ... •... ... ... ...... •... .. ....... ..... .. ... .... .. ..
.. ... .... .. ..... ..... ..... ... .. XXIII
TABLE OF CASES .. ..... ... .... ....... ... ........ ............. ..... ... ... ........
I METHODOWGICAL LvrRODUCTIO N (DO NO'rSKIP THIS)

......... .............. ........... XXV
s ............ 1
Chapter 1. Comparative Corporate Law: The Building Block
............. 1
Why Study Comparative Corporate Law ? .............................................
Comparative Corporate Law and Legal Families; Convergence of
" ... 16
Corporate Law and the (Questionable) Search for the "Best System
............... 24
Ownership Structures of Corporations in Different Legal Systems
atory
Chapter 2. Choice of Applicable Corporate Laws and Regul
Competition ........................................................ ......... .......... ... ................ 29
................ 29
Introduction ......................... ...................................................... .........
.......... ... ...... 34
Freedom of Incorporation ............................................. ..................
ean
The Real Seat Approach and Its Gradual Abandonment in the Europ
........ 57
Union .................. .................................................................................
......... . 91
Japan's New Liability -Based Approach ............. .................. ...................
atory
Race to the Top or to the Bottom? A 1-fore Theoretical View of Regul
.......... ...... 94
Competition ................................................... .............................
Chapter 3. The Incorporation Process and Limitations on

Limited Liability ...................................................................................
103
..... .. 103
Introduction ...................................... ................... ................... ...................
......... .......... 105
The Incorporation Process ........................ ............ ........................
........... 118
Minimum I..egal Capital ......... ................. ................... ...........................
.. ....... 125
Piercing the Corporate Veil ....................................................................
and
Some Final Considerations on Veil Piercing: Empirical Evidence
.......... ...... 156
Conflict of Uws ......... .............. .................................................
....... 159
Chapter 4. Financing the Corporation .............................................
............... 159
Introduction ...... ....... ...................... .................. ............ ~ .....................
................ 160
The Rights of Shareholders and Classes of Shares ......... ...... .........
............... 176
Class Voting and Pre -emptive Rights ..................................... .........
.................. 200
Bonds and Debentures ....... ......... .......... ................. ........................
.................. 213
Equitable Subordination of Shareholders' Loans ...... ....... ...........
... 219
Chapter 5. Corporate Governance ......... ...................................... .........
........ ...... . 219
Introduction ....... ................. ........................ .......................................
.. ............. 219
Corporate Governance Models .................. .......................................
xv
MMARYOF CONTENTS~-----------
SU ························· ··········· ··········· · 229
xv i of Dir ector s .. .... ... ............. .......... .................... 246
om osition of the Boardhareholders ··········· ·······
8
C P f D. ectors vs. . D utie s ...... .. ......... ........ 267
Powers o ir . bT ty and Fidu c iar y ..... ... ...................... . 267
Ch ter 6. D1rec. tors' Lia i i ....... .... ... ... 2
ap . ......................... . . . . . . . . .. . . . ··········· ········ ····· .. . . . . . . . . . . . . . . .. . . . . ... ... 68
. . . .
I t oduct10n............ .. ··· ···· · .... .· · · · ··· ········· 288
;u ;y of Care ··················· · ::: ::::: . ··• ·· ···· ·· ·· ·· · : :::::: :::: ::::: ...... · .... ··· .. ····· 304
Al
Duty of Loyalt y ............. ··:·· Toward Creditors· ·······
Fe
Dir ectors' Fiduciary Duties ..... ........ ... .... ................ 317
A:
h O lders ' Litigation ···· ··········· ····· ····· ··· ... .. .. ·············· 317
Chapter_7. Share
In trod uction ····················· ·············
·········
· ·····
· ····
s st ems : T 8 · ·h· ····
u ·s··;~·d the U.K . ............. 319 3
T.
. S ·t
Derivative m s m . . . Common Law y
E opea n Systems . . ... .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . .. . 350 N
. tive
· Suit
Derivative
Deriva
sui·t ss in
in Civil
Asia
Law ur
. ....................... ................· ·· ·· ·· ·· · ··
. . .... . . . . . . . . .... . . .. . . . ....... 65
d 'Agreements ....................... .. ..... . ······ ················ 375 3

Chapter 8. Sharehol ers . ..... . . ... . .. . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . .. . . . .. 75
In tr?du? tion ·············~
·~~.T~~~
·~
f~;~biii~; of t he Shar es .... .. ... .. ... .. ··· ········ ······ · 376
Limitation s on the F ....... ........... ....... ... ........ ..... 394
Voting Agreements· ······················ ·h·ii·····; ·A~; ~~·~ ent s- In ter n at ional
Disclosure and Duration of Share o ers .. ..... .. .............. 412
Law Aspect s···· ········ ······························ ··········· ····· ·····_-······· 416
Focus on Shareholder s , Agreemen t s m · Listed Corporation s .... .. · · · · · · ·· ·· · · ·· ····
Chapter 9. Mergers an d Acqu1s1

· ·t1·ons............................ . ......................... 421
Introduct10n
. ·················· ······ ············· ··:··:········· ······· ························· ·················· 421 421
An Overview of Mergers and Acqms1t10ns ............. ....... ·.. ·. ·· · · · ·· · · · · · · · · · ·· · · · ·· ·· · ··
Sales of All or Substantively All the Assets ................................... .... .. . ·. ·. · · · ·· 432
Leveraged Buyouts ............ ...................... ................ ...... ................. ..... ... ....... ... 441
Freeze-Outs, Cash-Out Mergers , and Going Private Transaction s .............. 444
Chapter 10. Takeovers and Tender Offers, Hostile Acquisition s,

and Defensive Measures ........................................ ............. ................ 469
Takeovers: The Economic and Legal Basic Ideas ...................... ...... .. .. .. ... ..... 469
Tender Offers and Defensive Measures: Unintended Consequence s? .... .. .... 478
TakeoverRegulation,Harmonization,Regulatory Competition, and
LegalTransplants:Europe,U.S., China, India, and Brazil .................. 515
Final Thoughts............................................... 527
INDEX...................................
....... ·························
···················
··· 531
........................................................
...............
CHAPTER 1
COMPARATIVE CORPORATE LAW:

THE BUILDING BLOCKS
•••
WHYSTUDY COMPARATIVE
CORPORATELAW?
The question mark at the end of the title of this section should
probably not be ther~. The reasons to learn about comparative corporate
law should be self-evident, and they are both practical and theoretical.
On the one hand, there are practical reasons. "Globalization," to
employ an abused term, has blurred national boundaries: international
commerce , multinational corporations , cross-border transactions are
growing and dominate the economy. In this scenario, most lawyers,
businesspeople , economists, judges, regulators, and legislatures deal
regularly with corporate activity that has an internationa l dimension.
Unfortunately, both in the U.S. and in other countries, there is still a lot
of ignorance of foreign legal systems. This is partially due to the
traditional "local" and "domestic" dimension of most legal professions. If
on the one hand it is essential for jurists to know their own systems like
the back of their hand, we can no longer afford to ignore at least the
basics of corporate law in different legal systems. Of course none can be
an expert in corporate law in all legal systems, and when dealing with
complex transactions or litigation , local legal counsels are not only legally
and ethically required, but also necessary as a matter of fact. Legal
scholars, lawyers, executives, judges, policy makers, should however be
able to interact intelligently with their foreign counterparties, to
understand what the key issues are, and to be able to ask the important
questions. The goal of this book is to offer a general framework and some
specific technical insights about different corporate law systems that
should help you, when facing an international problem , to understand
where the "red flags" could be. We will explain and discuss specific rules
and approaches in a quite technical and detailed fashion, also putting
them in their economic and socio-political context, but most importantly
we will try to offer a methodology, a way of looking at business problems
that should enrich your ability to operate internationally. Imagine you
I are negotiating an international merger, litigating a ~ase i_n~olving
t directors' liability in a multinational corporate group settmg, s1ttmg on
1
VE CORPORATE LAW: CH. 1
COMPARATI G BLOCKS
THE BUILDIN . . .
2 t" drafting new legislation m
£ · corpora ion, 1 1 systems can
the board of directors of a or~li~ ·ty with different ega
s. fami iari
the area of ta k eover . . .
certainly make you more effective. 1 w course have however also
This book and a comparative corTpor~~d; different legal sy_stems, lto
h f 1 and pedagogical goals. o ·c phenomena different Y,
t edoret1acand why they regulate similar econdomti and of statutory and
un ers . 1 of prece en s b th
and to question the rationa e . . d' tions are unique ways to o
regulatory provisions from different
understand better your own
JU~l
system ,da
t: think "out of the box" and not
"mental library'' of cases and
take anything for granted. It e~pan s :?u; r advocate more effectively.
A Japanese case, for example, mig

~i
rules that might be useful to thm_k~~eo~f::e an idea if you are invol~ed
.. y f the German Corporation
£ ·n Mexico· a provision o gument in a trial in the
Law_mig~t
U ..
8 , an 1nsig
:
~u~;e::
in regu1atory re orm i
0
' f
/r~~!o:~:la~a:~g:: :: useful to lobby for legal
reform in Singapore, and so on.
Interestingly enough, if you think about it, even in the basi~ course
on Corporations there is almost always an element of comp~rative law.
This is for sure the case in the United States: corporate law 1s re~lated
by the states, and only partially by the federal government, with the
consequence that there are 50 different corporate law systems . Of course
the differences among them are not extremely profound, also because
several states follow the Model Business Corporation Act, and of course
there are some particularly important jurisdictions, such as Delaware ,
New York, and California on which often the course focuses. But some
differences exist and when you study corporate law in the U.S. (as well as
with many other courses) you are, in a way, already engaging in a
comparative exercise. Similarly, in the European Union, corporate law is
regulated at the state level, but it has been partially harmonized through
~e~era_lEuropea~ directiv~s. In addition, regulatory competition and
imitat10n · · · the circulation of legal rules and mod e1s a 1so 1n
Itdetermine ·
E
uro~e. is m~v1table als_o in these systems to consider, at least
occas10nally, foreign law. This book expands this approach o-i • ·t
even more global dimension. o"' ving 1 an
Some scholars have in fact ar d th · .

should be included also in , a b ~e at comparative corporate law
j
1
..
' ! discussed if this is desirable ny .f ~: ~ corporate law course. It can be
'
>
division course to comparati~eor 1 1 is preferable to dedicate an upper-
~
i contribute to clarify the rel corporatfe law, but the reasons they offer
. evance o compar t·
anyone dealmg professionally 'th b . a ive corporate law for
from_th e £o11
owing excerpt. wi us1ness law ·
_ _ lSSues, as you can gather
~
10 . COMPARATIVE CORPORATE LAW:
~
11lll_ CH. 1 THE BUILDING BLOCKS 3
C&ll_
LAWRENCE A. CUNNINGHAM, COMPARATIVE CORPORATE
GOVERNANCE AND PEDAGOGY
~ also
34 Ga . L. Rev. 721 (2000) 1
s, to
lltly , "Co~par~tive corporate governance" [... ] is the collection of
a11d mechamsms m_ use in selected parts of the world to regulate those in
both contro_l. of busmes~ organizations, with attention to the origins and
durabil~ty of the differences between countries or regions. The United
llot
States 1s commonly compared to countries such as the United Kingdom
and and those in continental Europe, in Asia (chiefly Japan), and to a lesser
·e1Y. extent Australia, Canada, Israel and South Africa.
Ved
Comparisons of these models typically emphasize their finance
10:n
characteristics. In the United States and· the United Kingdom, capital
the traditionally has been supplied by debt financing offered by banks and
gal other financial institutions while equity financing is offered by public
investors in organized stock markets and private placements
·se (characteristics that may be changing). In Germany and other European
nations capital historically has tended to be supplied by banking
W.
institutions that offer both debt and equity financing for their industrial
~d clients. Ownership of industrial companies therefore tended to be ~-.
1e
:e
. fragmented in Anglo-Saxon countries and concentrated on the Continent .
Corporate governance regimes in these countries
•f
e differed
substantially as a result of this relative fragmentation or concentration,
e
t
i
at least in the abstract. United States and United Kingdom managers
·, r
I were to focus on the shareholder interest according to a complex system of
? checks and balances intended to compel them to put shareholders first.
German and other European corporations were to operate not by putting
shareholders first but by commanding corporate boards and managers to
operate the firm in the best interests of all its constituencies.
The traditional Japanese model is different yet again, with the
system of lifetime employment and interlocking corporate ownership
(keiretsu) contrasted to the Anglo-Saxon tradition of employment-at-will
f and the United States aversion to concentrations of power (which also
,.f may be waning). The list of potential comparative countries is increasing
as privatization breaks out the world over, and could go on to include
countries in economic and political transition such as former republics of
the Soviet Union, former members of the Soviet Union's Council for
Mutual Economic Assistance (COMECON), and former republics of
t' Yugoslavia.
As these transitions ·go forward, new variations on governance
approaches are emerging, often blending aspects of the models usually
treated as polar. Those polar models may also be seen to be converging
1 Footnotes omitted.
f
(
I
I
CORPORATE LAW". CH. 1
COMPARATIVE BLOCKS ---
THE BUILDING =-- · gly dominate
. ·ncreasm CH. l
4 . 1 corporations i one of the most
with one another as transn;:~:~ markets. Ind!=t~hip has been the alterna i
global capital, labor and ~f corporate-law sch~t seems to pose to the view a~
. rtant recent corners d the challenge the cou
impo h convergence an
question of sue . f modular polarity. . relatim
abstract conceptiono which c
. comparative corporate from a
[... ] e benefits of introduc~ng t least some general [. ..]
An assessment of ~h calls for making a . h Apart from
· the basic course . . d d to accomp 1is · . Tl
governance m h t the course 1s mten e s training 1n case perha1
assumptions about V:tad with most law school c1asse tation advocacy, policyi
b · tives associa e
t h e o Jee t t tory interpreta wn,
t· argumen '
the basic course m
. intern
law ~nalysis, ~ agu critical thinking, and so o_n-students a firm but Statei
analogical reasomn ' b bl is supposed to give . 1 tes in recov«
business organizations pro a Y f and its organizationa cogna
d. g of the corpora ion State :
broad understan m . . d social contexts.
their legal, business, pohtica 1' an simil:
d t t function in professional King,
The basic course shou eqm ld ·p the stu °
end therwise) ·
and busmess
settings where busmess aw . 1 (corporate an ° should give the stu d en t a
h . h · t rn means the course
issues arise , w ic m u . 1 d unusual role the business 1awyer
sense of business and of the spec1~ an at least in addition to-that of (and
plays as business advisor rather t an~r d with most typical law school in di
advocate or litigator (the model ~ssocia ~-cle for conveying the basics of corp,
subjects). Ul~im~t:lyd
corpora_tean re a e .
f~: ~~u~:~P~:; ;:;ents
.bly political
understand that law f~om
glob
bore
theoretical, normative, poss1 ' and certainly practical
on t
perspectives . all ,
So how, if at all, would including comparative corporate gov_ern _anc~ crrn
in the basic course advance these broad . an~ gener~l obJecti':es. Ch1
Unexceptionally, the basics of business orgamzation law 1n the United Pet
I States can best be taught by covering United States law. But part of that
I
I I exercise is often at least a comparison of the ways different states deal to

li with similar issues, or between how, say, Delaware or New York and the ea:
Revised Model Business Corporations Act (R.M.B.C.A) deal with those
subjects, as well as some understanding of the relationship between state
business organization law and various federal laws, particularly the
securities laws. Common questions in such an inquiry are why these gc
states have adopted different laws, whether one or the other is better, and tl
-t ' ultimately how the variations reflect (and how the federal presence bears) cl
on the competition a~_ong states for attracting business organizations Ir
.. and. how th~t competition bears on bedrock principles like the internal e:
; j affairs doctrme . c,
! !
• I [... ]
I~troducing a_ comparative perspective could shed light on such

C
questions and eqmp the students with a greater range of examples and
~
l&te COMPARATIVE CORPORATE LAW:
CH. 1 THE BUILDING BLOCKS 5
lost
the a~ternati~es to inform the kinds of. argument necessary to sustain one
the view agamst the other. Understanding managers as the central actors in
the c?urse: it is ~lways important to convey their role and their power in
rel~honships with shareholders, markets, and government officials,
which can vary substantially ,across 728 geographic borders. The variance
lte from a global perspective can furnish a very powerful basis for argument.
'.'&j [... ]
Ill}
These sorts of questions can be elevated to a more political or
Se perhaps geopolitical or policy level as well. There is a tendency of
:y, policymakers around the world to look elsewhere for answers when
ll} internal problems arise, whether intractable or otherwise. The United
.lt States tended to look toward Japan in the 1980s for lessons about how to
ll recover from its economic malaise. Then Japan looked to the United
States in the 1990s as the situations of these economic powers reversed. A
similar back-and-forth has gone on for many years between the United
l] Kingdom on the one hand and much of the rest of Europe on the other.
s [... ]
:l
r For the practical minded, as so many students in the basic course are
f (and teachers should be and mostly are), globalization must be considered
[ in deciding whether and, if so, to what extent to introduce comparative .
corporate governance in the basic course. Merger activity is increasingly
global in scale and scope, with 1998 marking the largest number of cross-
border deals and involving the largest dollar amount of transactions ever,
on the heels of the second largest year ever in 1997. Nearly one-fourth of
all deals involving United States companies in 1998 also involved some
cross-border element, including such mega-deals as the merger of
Chrysler with Germany's Daimler and of Amoco with Britain's British
I Petroleum.
This increasing global activity means many more students are likely
to encounter businesses organized outside the United States during the
early stages of their professional careers.
[... ]
Other benefits can accrue from introducing comparative corporate
governance in special circumstances, such as where students from around
the world are in the class [... ]. This presence could further enrich
classroom discussion of comparative issues. Contrariwise, it may be even
more important for students at schools that are more homogenous to get
exposure to the international arena through some treatment of
comparative corporate governance.
[... ]
[There is] the common problem of finding suitable materials. No
corporate law casebooks I have reviewed treat comparative corporate
LAW·
IVE CORPORATE . CH. l
r ______
coMPARAT
THE BUILD
ING B5JL~O~C:::.!K~S~---
few cases specifically raising CH.:
6 . addition, there are
ance as a topic._In porate governance. .
govern f rnparat1vecor
questionso co *** .
. 11 answered this last of o
at least partla y Cor
·th this book, to have . 'sto
We hope, wi · ham d ·
f Professor Cunning · t law and how oes it an
concern o h0 ever is comparative c?rpora e and legal scholars? leg
Wha\:x:r~!~ed ;, la~yers, courts, leg~sl::~~:Sieading c~mparative de !
affect, or . rpt by Klaus J . Hopt, on ·nteresting ideas, also th ,
The following exce f times offers some i CO'
corporate law scholars o _our ' .
Ill
from an historical perspective. ,
cc
COMPANY LAW IN THE 11
KLAUS J. HOPT, CoMP~rJ'~oMPARATIV E LAW cc
OXFORD HANDBO d ) Oxford 2006, 1161 ffl p
(Mathias Reimann & Reinhard Zimmermann, e s. ' ' , .
i
modern. . It is
. y law 1.s at once very old and very first existe d
Comparative compan .
since compames an
d company laws , '
j
very old because ever . f ntries and states. The persons

trade has not stopped at the frollntierslo coukers had to look beyond their
·r we as rue-ma ,
.o~n city, counbtl7Y, rules, an
nse of the pu ic company a
n:
conce~ned,pract1 ioners as d 1 ws. This became even more true after the
the early company acts in the first half of
the nineteenth century. Ever since, company lawma ers ave pr
k h ofited
from comparison.
1
I But comparative company law is also very modern. Most comparative
work has focused on the main areas of private law, such as contract and
• I' torts, rather than company law. While the law of business and private
i I
t organizations was covered in voluminous International Encyclopedia of
Comparative Law, and national company law books and articles
occasionally also provided some comparative information, an
internationally acknowledged standard treatise on comparative company
law has not yet emerged. Company law and comparative company law
w~rk remained a task for professionals. The few academics who joined in
this work tended also to be practitioners such as outside counsel
arbitrato~s, or advisers to legislators, who were less interested in theor;
..and doctrme.
[... ]
Loo~ng across the Border in Company Law: Leo-isl t

Academics, Judges . . o... a ors, Lawyers,
' l
I 2
Footnotes omitted.
' !
COMPARATIVECORPORATELAW:
CH. 1 THE BUILDING BLOCKS 7
(a) Legislators
ual understanding
One important aim of comparative law is the mut
altruistic purposes.
of other P~ple and nations. But this serves not only
an enrichment of the
Comparative law has always been considered to be
rience. Some speak of
'stoc#kof legal so!utions' and a wealth of actual expe
nce experiments'. The
an. ecole d~ verite, some even of real 'social scie
centuries were already
legislators ~n the _nineteenth and early twentieth
pany law statutes on
demonstrating this when they prepared their com
experiences of other
the basis of thorough comparisons of the laws and
the second half of the
countries. The major company law codifications in
ed away from the state
nineteenth century, when European countries mov
an Company Act of
concession system, testify to this. Before the Germ
law opinions were
1937 was drafted, many preparatory comparative
tute in Berlin, the
commissioned from the Kaiser Wilhelm Insti
burg. One of the most
predecessor of today's Max Planck Institute in Ham
lish company law was
impressive opinions dealing with American and Eng
ident of the European
written by Walter Hallstein, who later became pres
Institute in Berlin and
Commission, while he was still an assistant at the
rt of Appeals, the
Referendar (legal trainee) at the Berlin Cou
Kammergericht.
law, the use of
In the United States, where company law is state
mon in so far as one
comparative company law by the legislator is com
other American states
state will take into account the company laws of
taken the lead since
when reforming its own company law. Delaware has
state for American
it became, and remains, the major incorporation
lators is a well-kno~n
companies. The competition of state company legis
omenon., _Yet_ its
and, until recently, largely indisputable, phen
to th_e top ~s. highly
interpretation as a 'race to the bottom' or a rac~
s leadmg positi?n-. be
controversial, and the precise reasons for Delaware
ers and specialized
it its company law, or rather its company lawy
courts-remain disputed.
thing. More or less
Merely learning from foreign company laws is on~
even press~re
d f th m either voluntarily or under moral suas10n or although its
~ op itnhg Je an is one of many examples. M China is another, be
ap tl th
1s ano er. diffe rent in important respects. ost rece n y e s~m e ca1:
osition is h,
p · f th Middle and Eastern European countries whic
d or are reforming their
seen ~n m;ny 1~ e f the Soviet Union, reforme
joining the Euro~ean
following t e co~f:et~e aim, sooner or later, of n
co~pany law~ ntext it is also important to mention the Americ~
-Union. In this co t . s particularly strategic ones such as Russia
h is sometimes secured
Influence. on these stco~;s ~; the Soviet Union, whic
and certain former a . . The Japanese company law of 1893
a draft by the German
with the help of financial pr~mi~~s. nt extent on
bined elements of the
(Kyu-shoho) wa~ ba~ed Htoa s1gn1::esler ' and com
scholar Carl Fr1ednch ermann
CORPORATE LAW".
I COMPARATIVE
THE BUILDIN
G BLOCKS
CH.I
d of the German CH. l
I 8 ainly as to its formJl a(concerning many
(c
French Code de commer ;a~r;Je lsgesetzbuch of }81899 (Sh6h6) was close
I Allgemeines D_eu~sches he later company la~ o_ts revised form of 1884, .A
substantive prmc1ples). \aw revision of 1870 ~nl{ d on the German Stock comp:
to the German compa~nyf 1938 was closely mo e ~ anese company law devel
and the revised Shoho9~7 After World War II, ap law principles, in treat'
Corporation Act of 1 d ~he United States
ation
comi~~;3
Act o
This was because -
ma~der for the Allied
tradi
thesE
reform closely f?llo_w;usiness Corpor
particular the Illm?is fficial of the Suprem e C~-?1 Such historical certa
the relevant Amer~can:ned to come from ~
1
~ag 0
~n and this is also but
Powers (SCAP) appore often than is general y ni° 'reform some of alwa
coincidences happ~n m Modern Japanese compan y aw_ e com~ar ison of the ·
true i~ co1:1pany ~~- ut at present , is based on extens1 v
. .
com
which is bemg car~ie o o ean company laws. Con
both United States and Eur p d . terest in comparative fore
h h been renewe m law
Most recently t ere as nee of European company 1aw
company law, partly because of the emerg:nce movement has sharpened Em
and partly because the corpora te governt . The German ministries of unc
·t · ith other coun ries. t" con
the sense of competi wn w h missioned several com para ive
justice and finance, for example,h ave ~~m Max Planck Institute when
I
'
law studies from, amont~t h~t erstrov:rsial questions such as
prepari
to
statement s.
their rs
makengdirecto liableonto I~mves
refo~m ors for untrue or
Y ~on
whethe
misleading financial
r me
he
mi
ob
(b) Lawyers and Legal Counsel . . co
E1
The role of lawyers · and legal counsel in compar_ativ~ law is m
traditionally underrated, since they do their work for their che~ts and cc
-· enterprises on a day-to-day basis. Yet they are the real ~x~erts m both
I
E
conflict of company laws and of foreign company laws. This is even m~re
true now that the forces of globalization have also reached law firms, with
the consequence that the top layer of firms in all major countries has C
I become international either by merger or by cooperation. Occasionally
C
of
some of their comparative work is published, often only in the form
l
I
1
practical advice, but sometimes also with fully legitimate academic
claims. The creation of companies abroad and their subsequent control
is
tax law
I common practice today. Working out the best company and
structures for international mergers, and forming and doing legal work
, I
i- 1
for groups and tax haven operations, is a high, creative art. . . .
f ·i
;! Much_more in the public eye is the comparative company law work of
! : !
J !1 I the Amencan Law Institute, aimed at drafting uniform company laws
r
and model. codes. .Notable results are the Principles of Corporate
:
i ,
1. I
Governance. Anal!':'1s and Recommendations of 1992 (2 vols ., 1994) and

I ' I
i j the Federal Secunties Code of 1978 (2 vols., 1980). ,

I
i I
'" 1
CH.1 THE BUILDING BLOCKS 9
(c) Academia
As ~tated above, traditionally only a few have engaged in
comparative company law work. In all industrialized countries with well-
devel_oped companies there are, of course, standard company law
trea~i~es, many ~f the~ highly knowledgeable and some at the peak of
traditional doctrinal wisdom. Yet, what is conspicuous about most of
these leading texts is their restriction to national law and practice. This is
certainly the impression for Germany, France, and the United Kingdom,
but also for smaller countries where looking beyond their borders has
always been more natural, such as Switzerland. Exceptions seem to prove
the rule, but even they are usually confined to areas such as conflict of
company laws, that is, national law, and, more recently, to European
Community company law, or to the occasional use in a general text of
foreign literature and comparative observations. Comparative company
law work is rarely addressed in these leading texts as a prerequisite of
European company law harmonization or to provide a better
understanding, and to aid the development, of one's own national
company law.
Of course, the state of comparative company law is different as far as
more specialized monographs and articles are concerned. It is impossible
here to go into detail; it would not only be futile, but also unjust to the
many works which could not be mentioned. Some more general
observations must suffice. First, of course, there is much comparative
company law work in the context of conflict of laws and, more recently, of
European company law. As to the latter, there were initially quite
influential collections of texts on European company law, which included
comments and some case law. Since then impressive treatises on
European company law have been developed in most member states.
Second, in many countries American company law has had a
considerable influence on legal literature. This is not surprising for those
countries mentioned above where American company law and securities
regulation was broadly followed. But similar trends can be discerned, for
example , in Germany after World War II, where contacts with German
emigres were rekindled and whole gener~tions of young academi~s
studied in the United States and wrote their doctoral theses and their
Habilitationen on comparative American and German company law.
Some of these works happened to stand at the beginning of the
development of whole new areas in their respective national laws. At a
later stage there were even treatises and handbooks on American
company law written by non-~me~icans i~ G_e~manand other languages,
which provided much insight into its peculiarities.
Third the influence of international networks has been important for
comparati~e company law. Some examples of organized efforts include
10
. L the work of international
International Encycloped w o . fC mparative aw ,
. t'tutions such as the Interno . al FacultY of CorPora t L d
ins 1 at1 on t' al e aw an ab
Securities Regulation an d the 1nterna 10n Ac ad emY of Comparative en
Law, f Tt ted by internat1.ona 1 ins
· t' t t'
or the research which w~s ac\
such as the European Un ' a Institute in Florence , 1 u ions tb
iver;' Y anies, corporate where b~
comparative work on group O governance, m
s ~omt
directors' ha. b'l" .1es,an d the. harmon1za10pn of companies was done and
11t s
the so-calledgr!l<lnbook senes wa st t d Other such networ k s resu 1ted
from private m1t1atives, for s ar1: between the United States, 1
examP dB Jgiuxn Ital y and
Germany,and Switzerland;_ the United t
Germany an e '
States or within Scandinavia. t
F;urth, the Jaw and economics t
movement in the U_nited Sta
abroad Jed to a new and increa tes and 1
sed interest in comparative com
This will be dealt with in more pany law .
Fifth this new interest in com det ail bel ow .
parative company Jaw was
perinane~tly coveredby a few nat not only
German Zeitschrift fii.r Unt<rneh ional company Jaw reviews such as the
mens-und Gesellschaftsrecht
Italian Rivista della SocU?tit, (ZGR) , the
and to a certain degree als
Revue des Societes, but a num o the French
ber
on the market such as the of new specialized law reviews appear ed
English International and
Corporate Law Journal (ICCJ Comparative
),that seemed for a while to ha
for the Journal of Corporate La ve made wa y
w StudU?s (JCLS), the Du
Busillf!ss Organiza_tion Law tch European
Review (EBOR), the Germ
mea_ntimemternationa!ly based, an, and in the
European Company and Fin
Review (E~FR)_,~nd the !Eu
ropean Compan y Law (ECL), ancial Law
by the Umvers1ties ofLe1den, Utr pu bli shed · ointl
echt, and Maastricht.
J y
. -;~ law In sucvie
h wasofthe
the UN
golden age of the ela
IDROIT p . . 1bora t'mn of
common prm. c1p
,..)
Contracts and the Principles of . les of

\. i.
Ennc1p es Cof International
that similarly successful work Commercial
company law. ha uro~ea~ b ontract Law, it
is
s no ye een undertaken in astonishing
the area of
(d) Courts
In
reluctantneatorlyloo
all countries it is the
k to comparative co~ourts wh .
ich have been particularly
:xceptions. It is clear that Un
ited Star~y law. There are
.! w~J:otr~1:a.deal with the com some obvious
i pany la: o~o:'."tdecisions on
' ! true, ~houg;:s of oth{r states company law
of the Unio:e .;:spect1ve sta
: ! Apart from thesaem1·nules te, but also
ct ser degree, within .the ef
w1· tzerland wh· h s ances ' 1·t 1· h same was and still is
'
l'
orm
!
[
S s1'd s t e cou rts of er C
con eration. Th ic are mor l'k 1 ommonwealth.
is is sm
e ' ely to take f . coun t .a ler
countries are general] becaus nes such as
e the academics ore1gn
m their larger neighb~ ~ore decisions into
open to looking to thand law
rm. g states · But even then te wealth yerfs in such
. o experi · e
l. :
' I
he fact that they enc look
' I
; ~.I
! ~
I i 1
u
nal CH. I THE BUILDING BLOCKS 11
nd
lVe abroad rarely results in the actual citation of foreign company law in
ns court decisions themselves. One reason for this may be the traditional
ire theory in Continental Europe that judges simply 'find the law' as enacted
~e, by the legislature. This, of course, is not true, as is shown very clearly by
many cases decided by the Second Senate of the German Federal
Supreme Court, which is responsible for disputes in company law.
A similar observation can be made for the European Court of Justice.
Ninon Colneric, the German Justice on that Court, remarked recently
that comparative law plays a much higher role in the decision-making of
the Court than one might assume from reading its decisions. The fact that
d the Court does not cite literature does not mean that it does not take legal
'· literature into consideration. Quite the contrary is true: sometimes even
special research notes on the treatment of a legal question in the member
y states are commissioned by the Court. Of course, the European Court of
Justice is special due to its nature and jurisdiction; it needs to consider
not only the law of the member state concerned in a specific case, but
more broadly the acceptability of its decision in all member states.
While company law has long been the domain of national courts in
the EU, this is no longer true. The European Court of Justice has
rendered quite a number of important decisions in the fields of company
law and accounting. For a long time, national courts were rather
reluctant to refer questions concerning harmonized company law and
accounting to the European Court of Justice. In the meantime, however,
the relationship between the judiciaries has become more relaxed. Most
recently, one of the landmark cases in company law and conflict of
company laws was the Centros decision of the European Court. Combined
t with the decisions in the subsequent cases of Uberseering and Inspire Art,
j this marked an end, at least within the European Union, to the seat
I
theory that had been so dear to German lawyers for so long. These cases
allow free incorporation in any of the EU member states, which has
binding effects in all member states under the incorporation theory.
. In concluding this section, it should be mentioned that, according to
some observers, the real impetus toward comparative company law is
provided by the forces of financial and other markets, with their scandals;
the needs of these markets do not stop at national frontiers. Although
true to a considerable extent, this is not the whole story. Comparative
company law is conceived, practiced, and reformed by persons such as
those dealt with in this section. Their actions and reactions depend on
many influences, not only on market forces. Yet the observation that
company law reforms, like many others, are driven by scandals (and
therefore often come too late and overreact) can be verified throughout
the history of company law and investor protection, and was seen most
recently in the Enron scandal and the shock waves which it sent through
company law in the United States and abroad.
TELAW:
I CORPORA
COMPARATIVE ING BLOCKS ------- Ca.1
I 12 --~
THE BUILD
***
. s the 1 relevance nd
of comparative
courts. Let's
CH.l
l
I " or Hop
Pro1ess
t law ior
s
. explam
t ' analysis
" leo-islatures,
d mies
aca e e concre a wyers, a·ally wit. h respect
' t e, espec1al business ) 1aw t
i:,~ • even mor e gener . h' h
corpora e th·s discussion te (and mor ·tuations in w ic of dj
howevermake ~mparative corporat?In addition t~ s~ diction, in which colle
rts Does c in cour · ~cc nt Juns b d
to cou . ecific relevance I ws of a duiere d courts look a roa follo
have any sp d t apply the a £ ·go Jaw, o 1 ?
courts are require o d to understand ore1 e persuasive va ue.
obviouslythey are fo~ce precedents have som . d Mathias Siems
. ? Do foreign · Gelter an
for gmdance. ticle Martm d Superfluous, or
I n an interestin~ recenCtar~s-Illegitimate anp L 35 (2014)), have
Fi ign ou AM. J . COM . . b
(Citations
· .d ble'2 . ore from Europe,
toEvidence h 62the use of foreign precedents y
I Unavoi a . empirical researc on
condu~d t~~Ynote in the introduction (c1
.tations omitted):
.al whether courts
I
I
courts. s
!:0
~:
. h" hly controversi
U ·t d States it is ig
b;•;lowed, or::~: ::~ ;;:'e1~
from foreign courts. Th If. divided on
0
d to refer to prece en s
academ_ic_debat;i:a~:
whether it is lef
d t
US
U.S. Supreme Co~rt itse \: the interpretation_ of t e . .
I to consider foreign law . I reference to foreign sources by

Constitution, and the occas10:a t of congressional hearings a~d
some judges has been the su Jee 11 as in legal scholarship.
debates in the Blogosphere as we 11 d "the most dangerous
Justice Kennedy has actuall~y bbeencaseeof his endorsement of
· A · " inter a ia ecau h ]
man m menca, , dd. t' the state of Okla oma
citations of fo~eign cases. I~- a ; ioe:plicitly prohibiting state
attractefd conls•trabl,;oa~~: :;;al ~recepts of other nations ?r
courts rom oo mg · 11 a d Shana
cultures" specifically mentioning intemat10n:1 aw n "th
i
., J
I
Law; other states have passed or are debatmg measures w1
.I similar intentions.
In Europe, the discussion about the desirability of c~oss-citations
I is less politically contentious. A possible explanation could be

that due to E.U. law (as well as the European Convention on
Human Rights) it may just be natural for national courts to
consider the case law of other member states. But the European
Union is not (yet) akin to a federal state. A study comparing the
European Union with twenty federal states found that the
former provides significantly less legal uniformity than the
latter. Thus, for topics largely uninfluenced by E.U. law it may
be a bit questionable if, say, an English court cited a Spanish
one. S~ch reluctance may be related to the diversity of European
countnes m terms of legal traditions, languages and cultures.
Europe thus makes an interesting testing ground for assessing
the frequency and desirability of cross-citations.
Considering a large number of cases decided by the Supreme Courts
of different European countries between 2000 and 2007, the data they
collected and studied offer important insights. Consider, for example, the
following table (elaboration from Gelter & Siems (2014), 48):
citing cited court

court total
Austria Belgium England France Germany Ireland Italy Netherlands Spain Switzerland
Austria - 0 I 4 447 0 3 0 0 21 476

Belgium 0 - 0 37 6 0 0 6 0 1 50
England 2 1 - 9 10 7 0 6 2 0 37
France 0 2 0 - 3 0 1 1 0 1 7
Germany 34 0 1 2 - 0 1 1 0 2 41
Ireland 0 1 228 2 0 - 0 2 0 0 233
Italy 0 2 0 2 3 0 . 0 0 0 7
Netherlands 2 13 5 9 54 0 1 . 0 6 90
Spain 0 1 0 1 14 0 0 0 . 0 16
Switzerland 3 0 2 11 42 0 0 1 0 ,
. 59
total 41 20 237 77 579 7 6 16 2 31 1016
The most cited courts appear to be the ones of Germany, followed by

England, even if this data is strongly inflated by the high number of
citations from one single neighboring country, Ireland . The courts that
seem to be more outward looking, at least in terms of citations of foreign
judgments, are Austria (which not surprisingly very often cites German
precedents), Ireland (but once again, looking almost exclusively at
England), and the Netherlands . There are interesting paths that can be
observed. For example, smaller countries, which have a relatively lower
number of cases, consider foreign jurisprudence relatively often: this is .>
the case of Switzerland , which often cites German or French precedents
r (also in the light of the legal, cultural, and linguistic commonalities), and
f Belgium, which often cites French, German, and Dutch precedents. The
Italian and the French Supreme Courts are quite inward looking, by
comparison.
An interesting fact also concerns the legal areas more often cited
when courts look abroad. The following graphs, again an elaboration on
Gelter & Siems (2014), 61-62, illustrate this point with respect to the
same countries and courts considered previously from 2000 to 2007.
14 THE BUILDING BLOCKS CH. 1
Total number of citationsof foreign courts

500
450
400
350
311
300
250
200
150
100
50
0
constitutional
law administrative
law corecivillaw criminallaw procedural
law commercial
law
Of course, as the authors mention, these data are sometimes difficult

to collect because often citations concern different fields, but it is
undisputed that the greatest number of foreign citations are in the area of
commercial law, which includes corporate law. This is not surprising in
the light of the international nature of business activity, but it confirms
the practical and theoretical importance of comparative corporate law.
Interestingly enough, also in fields traditionally considered less open to
the international debate, such as criminal law, administrative law, and
procedural law, judges need or want to take a comparative perspective.
Gelter & Siems (2014) also offer a further breakdown of citations of
foreign cases by sub-fields of law: consider for example the following data
concerning the Austrian Supreme Court.
Foreigncitationsof the AustrianSupremeCourt
international
law, 16
,,.-generalprivatelaw,
139
civilprocedu~ 32}
unfaircompetition,45
Talking about the use by courts of foreign sources, we must mention
one interesting but bizzare experiment in legal history. The 1769
Portuguese Lei da Boa Raz<ioprohibited the (then common) use of Roman
law sources to resolve commercial disputes. This statute, however,
indicated that Portuguese courts, when applicable national rules could
not be identified, had to apply the laws of other "enlightened and polished
Christian nations" (interestingly enough, a commentator in the XIX
interpreted the reference as including all other European countries, but
not Turkey). In other words, courts were obliged to engage in a
comparative analysis, and apply foreign law. Contradicting the nomen
omen adage, the statute led quickly to irrational, contradictory and
arbitrary results. It was unclear which systems would be relevant, which
rules should be selected, and it was obviously impracticable for
Portuguese and Brazilian judges, lawyers and parties to understand and
apply foreign law. This approach was abandoned both in Portugual and in
Brazil, but not before several decades. None suggests replicating this
bizzare experiment, but we wanted to mention it because it is very telling
about the possible role of comparative law. It also confirms that, as we
observed beforehand not surprisingly, smaller countries with a limited
number of cases tend to be more outward looking than bigger systems.
For more on the Portuguese experiment and generally on the history of
corporate law reforms in Brazil see Mariana Pargendler, Politics in the
Origins: The Making of Corporate Law in Nineteenth-Century Brazil, 60
AM.J. COMP. L. 805, 815 (2012).
Another interesting and more recent example of courts of one country
relying or at least attentively considering decisions and scholarship of
another system is offered by Israel, whose judges often take into account
U.S. and specifically Delaware law. This is probably due to both the
extensive cultural connections between the two jurisdictions, in light of
the significant number of Israeli jurists studying and teaching in the
U.S., and the economic relationships between the two countries. Whether
this consideration for U.S. law is always correct and desirable is debated:
for a discussion focused on how Israeli courts have used the notion of
"good faith" in corporate law, see Itai Fiegenbaum & Jana Rabinovich,
Lost in Translation: "Good Faith" in Israeli and Delaware Corporate Law,
in Festchrift for Prof. Joseph Gross (A, Barak, Y. Zamir, D. Libai, eds.,
forthcoming in 2015 in Hebrew).
.•,,.
LAW'
IVE CORPORATE . CH. l
COMPARAT ING BLOCKS
L-----~T[!CORP
t6
H~ORAT
E~B~ U:I
ANDL:D
E LAW RPO
:-:,
LEGA L ; CH.
RATE
C~
LAW
!it t~i ;~N VQ E~.~E
~::i~~
AR:i?
CHE~ ma3 ,
also
AND THE ( "BEST SYSTEM - relic
. FOR THE . ht already be familiar with
ou reading this b~ok mig taken a general course on dis
Many ofl y enerally You might hav\ ) include a comparative mo
comparat~vela: gor other. courses ~hat l(ofen International Business COi
comparative a '
h as European Un10n aw,d mestic law courses your ex :
elemen\io~~c and the like. Also in pure 1y p:rative law aspects. It is pr
Transac , ed you to com th
m
. structors might have expos d legal families, for a t 1eas t th ree pl
1 few war s on
nonetheless usefu to say a h t h e no backgroun d in . compa f
ra ive S)
reasons: to familiarize the ~nes t a ;vthe methodological perspectives c~
law with the field; to clar1!y so~_ea~d to discuss some specific general Cl
shared by the authors of this bool ' d some economic data concerning c1
.
issues on comp~rative corpor
b . ateth'aw discuss
an
ion will provid . . . h
e 1ns1g h
ts t at C
different countries. We e1ieve is .
will be useful throughout the course.
1
The human mm · d eds to organize and systematize information,
ne .
even at the cost of some simplifications . In comparative law~ on~ of the
most important systematizations aggregates legal systems 1n d1ffere~t
legal families based on shared features. ?f course one of the basic
distinctions is between common law countries (generally, the U.K., the
U.S., Australia, New Zealand, and other former British colonies) and civil
law countries; civil law systems are also generally divided into French
civil law traditions and German civil law traditions (some comparativists
distinguish a ''Roman" and a "Germanic" tradition). Several other
important legal families exist that cannot be easily accommodated in the
common law/civil law distinction: examples are Scandinavian systems
(Denmark, Finland, Norway, and Sweden), Socialist or "non-market''
econom~es(the relevance of this group is fading for obvious reasons) and
also Asian systems ha~e distinctive features. In Africa and other pa~ts of
the world, together with the legacy of colonialism trad·t· 1 t 'b
legal t d ·t' ·
ra i wns are important, especially in certain , areas i -such 10na or ri a1
law. And of course non-secular legal as famil
t . Y
secular ones: in Arabic and Musli:s ems ~1so exist or co-exist with
j,
relevant. There are also syste th t count~ies Sharia is extremely
practitioners, must be consid:r:d ~~i acc~r~in? t? ~ome scholars and
I
elements of both common la d . . xed Jurisdictions that present

Um·t ed States and Scotland. wAnothe an c1v1l law s h
r £ . ' _uc as ouisian L . . .
a in the
common law country partially based asci~~ting example is Israel, a
however there are profound . fl on British common law in which
Ge
rmany, Ottoman law had m a
uences from . ·1 1
. . civi aw countries' such as
govern some meanin gful imp t
aspects of family law M ac , and religious norms
. ore recently U.S. law has also had a
L
major role in shaping Israeli corporate law and securities regulation, and
also on legal · scholarship in these areas in light of the extensive
relationships between Israeli and American law schools.
Focusing on the divide between common law and civil law, the
distinctive features are often identified in the sources of the law, the
model of legal education, and the approach to legal thinking. More
concretely, differences often pointed out, and too well known to be here
examined analytically, are the fact that in common law systems judicial
precedents are particularly important and often technically binding, and
that common law countries did not experience the codification of their
private law in the eighteenth and nineteenth centuries; in civil law
systems, on the other hand, statutory law seems to be more relevant than
case law, precedents are not binding, and codification played and plays a
crucial role in the development of the legal system. The role of the jury in
common law systems is also often mentioned as a basic difference with
civil law systems, as well as the way in which judges and justices are
appointed (generally, elected in some kind of political fashion in common
law, and selected through a purely technical exam in civil law countries).
We believe that these differences, which exist and are relevant, are
however often overemphasized and are, in any case, fading. For example,
if you are a lawyer in a civil law system and you need to research a legal
issue, of course you will look at the applicable statutory provisions, but
you will immediately also look at precedents and how courts interpret the
law. Even if precedents are technically not binding, they have a strong
persuasive authority, especially the ones of the higher courts. Keep also
in mind that, differently from common law countries, in civil law ones,
only a small percentage of cases are published and easily accessible in
legal journals. Similarly, statutory and regulatory law is becoming more
and more pervasive also in common law countries, especially in complex
technical areas such as commercial law or securities regulation; and even
in these systems it is often easy to distinguish a case from a precedent,
therefore reducing the binding value of the precedent. The role of the jury
in common law systems is also often exaggerated. In the U.S., for
example, approximately 2% of litigation actually goes to trial (most is
settled or dismissed before trial); and one of the most important
f. jurisdictions for corporate law, Delaware, has a Chancery Court that
l
decides without a jury. In addition, in many commercial contracts jury

waiver provisions or arbitration clauses exclude the possibility to try the
case in front of a jury. As for ''legal education" and "legal reasoning," to
the extent that these slippery concepts can be discussed, most lawyers
and judges-and definitely the most successful ones-now study and
practice not only in their home country, but also abroad, and they develop
and bring with them different styles of legal thinking. As for codification,
several common law systems have gone through legislative developments
CORPORATE LAW:
COMPARAT IVE CH. l
THE BUILDING BLOCKS
18
ificati on at leas t m· certai.n a reas of the law, ·and ·
bl
that resem e co d ' ·£ . 1 Code or the securities
Comm ercia h
'd ·n this respect the Um orm th development of t e Model
~~::i i~r :he U .S. but also, in our area, e -
Business Corporation Act. . .
d . t' nguishmg an d classifying. differ ent
All we W ant to say is that is i . kly and effective 1y some
legal families is useful, an d cap tures qmc
be carefu l in using it· too ngi· ·dl Th'
relevant differences, but one should 1 in the very area of corpo y. is
ra~e law
is also true just looking at stat~tory a:: Italy is a good exam
ple:
and financial markets regulation , t . portant statutes regula m t~e
Italian Civil Code and in the mos i; tmg this
hand German influences can
field as we will see in this book, clea\ re~c literally copied from
foreign
be s~otted (sometimes even rules.ca mdos des the influence
· 11Y in the last 1ew eca of U.S. law,
sources), but especia . th
and European law inspired by Br1tis 1aw . . h (for exam ple 1n e area of
takeovers) has been profound.
' ·1·
d' .d' the world
Another reas_onof caution whenhi::r~~;lly primarilyintowith legal fam1 ies
respect to
is that comparative law deve}oped le constitutional laws, the usual
private _law. In other ar~ast ~::x:i:!ents do not apply. For instance,
disti~dct10Cns btasled~ns~:~:a lmerican systems: while their legal origins
consi er en ra an in
terms of private law can be traced to civil law coun t nes · (S · Portugal
p~1n,_ '
and to some extent Italy), in many cases the U.~. Cons~
itu~10n had a
particularly significant influence in shaping their constituti?n
s. In a
similar vein, it is also interesting to point out that. some very
important
differences concern procedural rules. In fact, one idea share
d by many
scholars and lawyers is that diffe!ences in civil procedure
rules are .as
relevant as differences in the substantive laws to understand
comparative
differences. Think , for example , of the importance of disco
very, class
actions, contingency fees, and the absence of the loser-pays
rule to explain
how legal rules develop in the U.S. and the attractiveness of
[ the U.S. as a
' forum for plaintiffs. Unfortunately, for historical and
somehow self-
evident reasons, scholars and jurists specializing in procedural
law tend
to be very focused on domestic law (with few notable excep
tions, such as
Italian scholars Michelina Taruffo and Vincenzo Varan
o, Professor
Joachim Zekoll from Germany, and Mirjan R. Damaska
at Yale Law
School); procedural law courses at most law schools aroun
d the world
rarely include a comparative or international perspective; and a few
procedural rules are often neglected by comparativists. The
result is tha t
there is a lot of work that should be done to under
stand better ·
comparative differences in the area of civil procedure.
Interestingly
enough, the first Max Planck Institute in law established
outside of
~e 7many, in Luxembourg, has among its research goals
also comparative
civil procedure, under the directorship of Professor Burkhard
Hess.
COMPARATIVE CORPORAT E LAW:
CH. l THE BUILDIN G BLO CKS
19
To lig?ten up a ~it our disc~ssion, allow us a little fun quiz. Look at
the following map w1tho_utreading what is written below it (you would
see t~e answer and spoil the exercise). It divides countries based on a
very 1~portant legal rule, _one that you should always be aware of when
travelling to those countries, no matt er what your business is Can yo
tell the difference before looking at the answer below? · u
So what is the different applicable rule?

/
In lighter -gray countries people drive on the right side of the street ,
and in darker-gray countries people drive on the left side. In general,
former British colonies follow the second rule, but a notable exception is
the United States (by the way, the historical roots of this difference are
interesting, and there are conflicting theories: we do not have space to
discuss them here, but if you are curious you should look it up). This little
example suggests how one should be careful in distinguishing different
legal families .
Having said that , in this casebook we will focus primarily on two
common law countries, the U.S . and the U.K., and on several civil law,
continental European countries (in particular France, Germany, and
Italy), and Japan, but occasionally we will also consider cases and
materials from other jurisdictions including Asia, Latin America, and
Eastern European countries. In our analysis we will often start from the
U.S. perspective, and then examine comparative differences with other
l systems. This is not due to an "America-centric" bias, but because we

believe it is useful to have a clear and consistent starting point. Focusing
I
t
on the jurisdictions we mentioned, which often represent the legal origins
l
I
·:
\
CORPORATE LAW: C
~------~c~o:M~P~A~R~A1
±20 THEBUILDIN
.al eriod), we believ_e,allows
ecially due to th~ c?lom_ ~or orate law regimes and
of other systems (es~
t the existing variat1~ns ;f£ !nt rules. The econornic
us to cap~ure moS : basis to discuss specific_~ ;: focus also justifies the spe
offers a rich enoug f the countries on wh1c effi
importance of some o . att
attention that we give them. U S. and the European Umon ~n pre
b ic distinction between the_ . d briefly, also because we will a ,
One as ces of law must be ment10ne ters In the U.S., corporate dit
termsbof kso: this issue in the followingtclhapthe federal legislature has "a :
. tate law even I·r mor e recenth Y internal a f~1.airs of rist ed
come ac · de
!aw ~s s d some' rules that affect e Jl
cess or composition of the
p1
intro
corpora utc1~ons
, for example in terms of
. 0 f th Sarbanes- x proxOy laecy
Act and the Dodd-Frank n,
board of directors (thmk _ elaws of the single member states govern C<
A t) In Europe, the national f h monization has been made
c . . .fiicant effort o1 tions ar It is obvious 1y 1mposs1
. "ble C
I corporations, but a s1gm a
I through European directives and regu al p~cts of EU. law, but suffice C
here to offer a eras h -course on the db generath asEuropean Umon. . an d must be t
I it to say that directives_are enact\ Y t :es with a statute

implemented by the smgle ~em er s a tain degree of flexibility in how
. t d.1fferent opt10ns or a cer .
(and often
d" 1
I directives presen . 1 t" are directly and 1mme iate y
to implement them), while . re~ a I~nsaddition the European Court of
applicable
J t.
in all the membe: sta es. n:erning European law, has also
hich decides on issues co l
us ice, w_
played an important roe m e 1 . th development of European
b corporate
d aw,
·11
as mentioned in the excerpt from Professor Hopt a ove, an as we w1
discuss more extensively in Chapter 2.
***
Some people are obsessed with rankings. Not surpri~ingl~, eve1: i~
the area of corporate law, people debate whether there 1s a _superior
system, at least vis-a-vis certain specific pre-defined goals.
One important and controversial attempt to "rank" both single
I jurisdictions and legal families has been made by four economists: Rafael
La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W.
Vishny (their work became so famous that they are sometimes collectively
I
i
referred to as "LLSV''). In a series of papers starting in the mid-1990s,
LLSV have extensively studied the level of investors' and creditors'
protection in different countries and tried to correlate it with different
legal origins (in particular, English -origin, French-origin, German-origin,
and Scandinavian-origin).
. One article of these authors is particularly interesting in this respect:

Law and Finance, 106 J. POL. ECONOMY 1113 (1998). Their methodology
is fairly straightforward, at least in theory. In a nutshell and somehow
simp~g, they identify a set of variables that indicate the level of
protection of shareholders and creditors, in particular the existence of
specific legal rules, and other variables including ownership structure,
efficiency of the judicial system, corruption indexes, and others, and
attribute a value to each of them. More specifically, for legal rules
protecting shareholders or creditors they give to each country considered
a value of 1 if the rule is present, and a value of O if it is not (they use
different measures when applicable, for example they cumulate different
"antidirector rights" in a single measure that ranges from O to 6
depending on the presence of several rules protective of shareholders)
.
Just to give an example, they verify if a given legal system provides for
pre-emptive rights in favor of existing shareholders in case of issuance of
new shares and, considering this rule protective of investors, give 1 to
countries that have such a rule and Oto countries that do not have it (see
Chapter 4 for a discussion of pre-emptive rights). They then calculate the
average value for the four different legal families considered: English-
origin, French-origin, German-origin , and Scandinavian-origin , and rank
them.
Let's take a look at some of their results in the following graphs,
which are elaborations on the data contained in the cited article for
shareholders' rights (Table 2, page 1130 f.).
Data on Shareholders Rights from LLSV ( 1998)

1
I .. ~ ~
,,...
, ' ,
..,,,.,,, ~ ' /
English-origin
French-origin.
Scandinavian-origin
0.00 0.20 0.40 0.60 0.80 1.00
• preemptiveright new shares. .

• protectioosfor _oppress_ed_mmonty
• cumulativevoting or s1m1lar
• sharesnot blockedbeforemeeting
•proxy by mail allowed
Based on these and other data, LLSV concluded that "countries

whose legal rules originate in the common-l~w tradition tend ~o.prote~
t
investors considerably more than the countries whose laws originate
in
e
.,
~
[
CHAPTER2
CHOICE OF APPLICABLE CORPORATE

LAWS AND REGULATORY COMPETITION
••• •
INTRODUCTION
Any time you are faced with a corporate law problem, the first
question you have to ask yourself is what are the applicable laws
governing the issue at hand . In essence, what you have is a choice-of-law
determination, whereby you must determine which statutes and case law
precedents govern the internal affairs of the corporation. This question is
not only crucial from a practical point of view, but is also important, and
perhaps even more interesting, from a theoretical standpoint, because it
affects the way corporate law develops and influences both the legislature
and the judiciary in their rulemaking activity at a substantive level.
I
l
In the United States, corporate law is largely within the competence
of the states. While the federal legislature has adopted some governance
rules that are applicable to publicly held corporations, the internal affairs
of a corporation are for the most part subject to the laws of the state of
l incorporation. For obvious reasons concerning the common cultural and
historical background of the states, harmonizing initiatives such as the
enactment of the Model Business Corporation Act, and also a
phenomenon of imitation among states, there are significant similarities
among both the corporate law statutes and case law of the different
states; but meaningful differences still exist .
. As in the U.S., corporations in the European Union are regulated at
the level of the single Member States. From a comparative perspective,
however the differences that exist among different jurisdictions within
'
the European Union are more profound than the differences that can be
found in the United States among different states. Language and cultural
barriers and the path-dependency of legal systems affect, and to some
extent hinder the harmonization of European corporate law. In an effort
to harmonize 'Eu:r:opean corporate law, the European Umon . has enacted
several directives and regulations. These directives and regulations cover,
for example, the regulation of legal capital, financial statements, mergers
and divisions, shareholders' rights, takeovers, etc.
The starting point of our analysis in this chapter is that, generally
speaking, there are two choice-of-law principles that can be adopted in
29
'',.
CHOlCE OF APPLICAULI~ COHl'OHA'l'I~ LAW:-!ANU
~3~0
_______ l~tY
~ C~(!!
)M !.!.!..
_!:R~F~,(~m~I~.A~1~'(:!_:) P!:!
l•:'
.!.
1'.l'l
:..:
:'l.:..:
..:O;.:..
N:,________ 11.:J.
.
c.c;.,;.
"
"d t"f appli"c"'blecorporate lnw ruloA.'.l'ho fir1-1t,

or der t o 1 en 1 Y
t,vpi1 :11llyl'cntnr\
t I ... , , 111 1t ·111
CA • •
in the U.S . and in other common law count.r.,t:A,lA • ~o •. mwr ~'. , 1~ !, t.ho "1
· · l e,,, a Iso re1erre
prmcip r d to as the "freodom of mcorporndon
'f . (' . .
pun c1p1,u. cont.n
Under the "incorporation principle," th e intornnl !'I ·nm~ o II cor11o;utu,_n for ll
laws of the state in which tho corpornt.10111.R 'l'hiM
are governed bY th e . . . . .. . ·I , l 1·
·1ncorpora t ed, meaning the 1\1r1 s
. · d1ct10n m which the pro ct < ur o to CHtn> 11-1h
.. .. t t ti · ·1
rlll,(U I
the corporation as a legal entity has been pe! foct.t•d. 11 . ur sunn o 11s ru < , corp,
th em· ternal affairs of a corporation are subJoct to .th0 lnws of lh Ht.nt.o of
. t Irn t sl.1h0• , nn cJ,
in H:'
· orporation even if the corporation does no bwnn oss m
inc no meaningful contacts with th e state, best'd os .h nvrng
has . .
rncorporntoc l
inco
there. The historical rationale for this rule is probably root •d in _th curt
colonial period, when England want ed to be able to r 'guluto _e n\ orprtROS cnn'
primarily doing business abroad'. as l_ongas t~ey_w~re_crca~cd 1~ hn~ land. acli
The formal process of incorporation, m these Juri sd1ct10ns, 1s quit e sunplo. rlll,(
In order to incorporate, it is generally sufficient to file the governing mi~
documents of the corporation (charter and bylaws) with the Secretary of in I
State or other similar office, and to pay a small fee. --.. 1.m
..fr
The second choice-of-law principle, which prevails (or us ed to pr evnil) Stf
in continental Europe, and more generally in civil law systems, is the so- 0f\
called "real seat approach." According to this rule, a corporation is subj ect of
to the laws of the state with which it has the strongest physic al sr
connection. This physical connection is known as the corporation' s "real ll .l
seat." The real seat of a corporation is defined in a variety of ways in rl
different systems, for example based on where the "center of th e Cl
administration" is located, which is determined by where the corporat e a
bodies (board of directors or shareholders' meeting) meet; or alternatively, 1
a corporation's real seat is located in the jurisdiction where most of the t
corporate purpose is carried on. A corporation doing business primarily in
France, for instance, would have to incorporate in France and would be
regulated by French law. The consequences of the real seat approach to
choice-of-law can be significant. For example, using again the ca se of a
corporation with its real seat in France, but which is formally
incorporated in the U.K., a French judge might conclude that the
corporation is subject to French law, and since the corporation did not
properly incorporate in France, it might even be treated as a partnership,
with members potentially facing unlimited liability for the obligations of
the corporation; in addition, several issues concerning the internal affairs
of the entity would be governed by French law, notwithstanding
incorporation in the U.K.
As you can see, these two choice-of-law principles have very different
effects. In a system based on the incorporation principle, corporations are
free to choose the state in which they prefer to incorporate indep endentl y
of where they are physically located or where they do business. In other
words, they can engage in regulatory arbitrage. On the other hand, under
~
CHOICE OF APPLICABLE CORPORATE LAWS AND
nd CH. 2 REGULATORY COMPETITION 31
on
~-,, the "real ~eat" app~oach, since the applicable law depends on physical
contacts with _aspecific jurisdiction, it might be impossible, or inefficient,
for_a corporat10n to choose incorporation in one jurisdiction over another.
This means that i~. countries that follow the incorporation principle, a
e, regulatory competlt10n can develop among states in order to attract
)f ~orporations . This type of regulatory competition, however, is much rarer
m systems following the real seat principle.
d
d Why do states compete to attract corporations under the
e
incorporation principle? Since a corporation can choose to incorporate in a
certain state without carrying on any business activity there, the answer
s
cannot simply be that a state is acting in order to attract more business
activity. There are probably two major reasons why states engage in
regulatory competition. One has to do with tax revenues. Because there
r)
might be state taxes or other fees that apply to corporations incorporated
f in a given jurisdiction, the desire for increased revenues can make it very
important for a state to attract corporations. In the U.S., for example, a
"franchise tax ," which is based on the shares issued, must be paid in the
state of incorporation (attention, this is not an income tax based on
earnings!). The proceeds from these taxes can be an important percentage
of the state's budget, especially in states with a smaller economy. It
should be observed that in some systems, however, these kinds of taxes
are not permitted, which is a potential disincentive for the development of
regulatory competition. The second reason for state regulatory
competition is that having a large number of corporations incorporated in
a state, and therefore subject to its laws, can be very profitable for the
local legal services industry. Lawyers and other legal constituencies can
therefore be particularly invested in regulatory competition for
incorporation.
You deserve a warning, however. The common wisdom that States,
especially in the U.S ., compete to attract and retain corporations, possibly
with the exception of Delaware, is questioned by some scholars. In a
brilliant article, Marcel Kahan of New York University and Ehud Kamar
of Tel Aviv University (but at the time of the article at the University of
Southern California) have argued that the existence of fierce competition
among states in this area is largely an urban legend. They list several
reasons to support their claim. As a side research project, find this paper
I
and keep it in mind as you continue reading: The Myth of State
Competition in Corporate Law, 55 STANFORD L. REV. 679 (2002).
Interestingly enough, both the incorporation and the real seat
principles often have exceptions. For example, even in the U.S., where the
incorporation principle prevails, there are some states that have adopted
so-called "pseudo-foreign corporation statutes." These statutes mandate
the application of some local state rules to corporations incorporated
elsewhere, if the corporation is primarily doing business within the state.
CHOICE Ol~ APPLI CABL E COIU'ORA'fl!~ LAWS AND
32 REGULATORY COMPETITION CH,2
One question we will discuss is whether these types of provisions are CH.2
compatible with the U.S. Constitution . There ar e similar exceptions with
~egard to the real seat approach. In Europe, whore the real seat principle internal
is or was followed in many countries (for example, France, Germany, exampl e
Italy), the principle ha s been eroded by the jurisprud ence of th e European r elatioru
govern e,
Court of Justic e, which-to put it briefly-considers it in conflict with the
law. Of
freedom of establishm ent principle set forth by the European tr eati es. In wh ereir
this chapter, we will consider th ese possible "exceptions" to the of a cor
incorporation and real seat principles. pi ercin1
In the U.S., the state of Delaware is the clear "winner" in the "market which,
for corporate charters," as the majority of the listed and the largest third p
corporations are incorporated there. Delaware snatch ed the competitive also ad
advantage in incorporation originally enjoyed by the neighboring stat e of A1
New Jersey . In considering the success that Delaware has had in wh eth
attracting the incorporation business, one question that comes to mind is the "g
how it maintains its competitive advantage over other jurisdictions. top" (
Wouldn't it be easy for other jurisdictions to simply "copy" Delaware 's mark1
corporate law statutes, therefore becoming more attractive? After all, effici e
there is no copyright on statutory materials. stake·
mino1
The answer to this question is, obviously, that simply copying comp
statutory materials is not sufficient to attract corporations. While by st
Delaware's statutory rules can be copied by other jurisdictions fairly craft
easily, one might argue that the real advantage of Delaware (and other man:
successful states in the incorporation market) is not so much in its ("rac
statutory provisions, but rather in the sophistication, specialization, and freec
efficiency of its judiciary. Delaware courts are highly specialized in shar
corporate law matters, partially as a consequence of the large number of regt
important and complex cases that they decide. This level of specialization not
of the judges, and the extensive body of corporate law precedent, is much oth1
more difficult for another state to replicate than Delaware's statutory pro
'' ' fill
provisions. Another reason that might make Delaware an attractive
inc
forum for corporate litigants is the fact that the Delaware Court of
me
• i Chancery is historically a court of equity, and therefore there are no jury ·.
COJ
trials.
.,i efl
; /
I As we have discussed, the "internal affairs" of a corporation can be di
·I
regulated by either the laws of the state of incorporation or by the laws of tr
the state where the real seat is located. The "internal affairs" of a rr
corporation generally concern relationships V
among shareholders,
relationships between shareholders and the corporation, relationships 1
between the corporation and directors, the inner workings of corporate
!
' bodies, etc. It is important, however, to understand precisely what t
l'
I
l corporate actions are included in the definition of "internal affairs." For
j
i example, a bond indenture, a contract concerning the issuing of bonds to
! obtain financial resources, is generally not included in the definition of
2
CH.2 REGULATORY COMPETITION 33
internal affairs (at least in the U.S.). Therefore it can happen, for
exa~ple, .that a Delaware corporation will issue bonds and the
relat10nsh1p between the corporation and the bondholders will be
governed by a contract subject to New York law, rather than by Delaware
law. C?f_course, there are always issues that fall into a "gray area,"
wherem it can be debated whether the issue concerns the internal affairs
of a corporation or not . One example of this "gray area" is the doctrine of
pie:cing the corporate veil (Chapter 3), which deals with the situations in
which, contrary to the general rule, shareholders might be liable toward
third parties for the obligations of the corporation . In this chapter we will
also address this question.
Another policy question that we will address in this chapter is
whether regulatory competition-famously defined by Roberta Romano as
the "genius" of American corporate law-results in either a "race to the
top" or a "race to the bottom." In other words, does a competitive
marketplace for rules lead to the development and enforcement of more
efficient rules, rules that are sufficiently protective of the different
stakeholders involved with the life of the corporation, and particularly
minority shareholders and creditors ("race to the top"); or does
competition lead to excessive laxity in corporate law rules, brought about
by state legislatures and judges, who in order to attract corporations,
craft rules aimed solely at pleasing corporate decision makers such as
managers and controlling shareholders who decide where to incorporate
("race to the bottom")? Does regulatory competition simply result in
freedom of contract, flexibility, protections for directors and controlling
shareholders against liability? Prominent scholars have argued that
regulatory competition results in excessive freedom of contract and does
not provide adequate protection for minority shareholders, creditors, and
other stakeholders. Others advocate, however, that if a state is not
protective enough of investors and other stakeholders (again, especially
minority shareholders and creditors), they will not invest in a corporation
incorporated locally or, at least, ask for a higher return to compensate for
increased risk, therefore resulting in a higher cost of capital for the
corporation. Following this view, regulatory competition produces
efficient rules that strike an optimal balance between the needs of the
different corporate constituencies. We will have to discuss, therefore, if
the "market for rules," in corporate law, works well or is plagued by
market failures. It is quite interesting, also from a methodological point of
view, to look at the process of rulemaking as a "market" in which
legislatures, policy makers, and courts compete.
· One final caveat. The principles we discuss in this chapter concern
the substantive corporate law rules applicable to a corporation. They are,
as mentioned, choice-of-law rules, and must be distinguished from the
l
f
I issue of jurisdiction. Jurisdiction concerns the court or courts that have
34 CH. 2
REGULATORY COMPETITION
different
th_e power to adjudicate corporate disputes, and can follow
federal
criteria. It is therefore possible that the courts of s~ate X (or t
apply
courts) have jurisdiction over a certain dispute, even if they ~uS
s our
the substantive laws of state Y. This possibility further complicate
~o
analysis, and raises also strategic procedural questions on where
that 1s
litigate. This is an issue that must be taken into account and
addressed in some of the cases presented.
FREEDOM OF INCORPORATION
y,
As we discussed in the Introduction, under the incorporation theor
state
the internal affairs of a corporation are regulated by the laws of the
of the
of incorporation. The incorporation theory provides that the laws
ration,
state of incorporation regulate the internal affairs of a corpo
in that
regardless of whether the corporation is in fact headquartered
is
state or has business connections therein. This rule, however, which
is not
generally followed in the U.S. as well as in other jurisdictions,
adopted
without possible exceptions. For example, some U.S. States have
es."
statutes commonly referred to as "pseudo-foreign corporations' statut
ular
These statutes are designed to require the application of a partic
ent
state's law when a corporation, although incorporated in a differ
In other
jurisdiction, has significant connections with a particular state.
seat
words, these rules tend to achieve a similar legal effect as the "real
e" is
approach." A famous example of a "pseudo-foreign corporation statut
§ 2115 of the California Corporations Code. Pursuant to this
provision,
it is
when a corporation meets certain requirements that indicate that
rate
predominantly doing business in California, some California corpo
sions.
law rules will apply. Other jurisdictions have adopted similar provi
these
In the U.S. t~ere has been a lively debate on the legitimacy of
the U.S.
-~ ~ statut_es, . specifically .on whether they are compatible with
following
1t Cons~1tution and/or v10late the "internal affairs doctrine." The
,.:1
lent exam ple of the application of§ 2115 of the C a 1·£ ·
1·1 case 1s an· excel
cd · 1 orn1a
'I
Corporat10ns o e to a business entity incorporated in Utah , b u t th a t was
,I
i · b us1ne
d 01ng · Ca i·fi
· ss 1n . .
1 orn1a
I
'I
'/ RESOURCES INC.
I Ross A. WILSONV. Lou1slANA-PACIFIC
iI Court of Appeal, First District, Division 2, California, 1982 '
! 138 Ca1.App.3d 216
GRODIN, P. J.
l . ·.
The question presented by this a
ss~on and
considerable significance, is whethe~pet:' o~e of first im~re
constitutionally impose its law r . ~ tate of ~ahforn1a may
shareholders upon a corporation whiche!u~r1n~ ·1cud mlulative voting by
om1c 1 e e sewhere, but whose
corporation was located, i.e., where the board of directors met, to determine
the applicable law. The decision mandates the application of French (tax) law
le) to businesses that are established under French law and have a meaningful
1n connection with France. In this respect, even if the case presents peculiar
~d aspects, it can be considered a forerunner of the real seat approach.
ts 2. Do you think it might make sense to apply the laws of one state to
ts the internal affairs of a corporation and the laws of a different state to tax
re transfers of shares or to tax income? In other words, when do you think there
·e
d I is a rationale to decouple corporate law and tax law?
***
As discussed in the Introduction, several continental European
3 countries used to follow-and to some extent still do-the "real seat"
~ approach. Under the "real seat" approach, the internal affairs of a
corporation are regulated by the laws of the jurisdiction where it has its
"real seat." "Real seat" can be defined in different ways, but the definition
is primarily based on elements of "physical" contact between a
corporation and a particular jurisdiction. For example, the real seat of a
f corporation might be the state where most of the corporate business is
I
I
f
conducted or where the governing bodies of the corporation (especially the
board of directors) meet . One consequence of the real seat approach is
that corporations must incorporate according to the rules of the state
where their real seat is located. If they fail to incorporate properly in the
jurisdiction where the real seat is located-even if they are duly
t incorporated in a state in which they do not operate-there may be very
l serious consequences for shareholders, including denial of the benefits of
limited liability and/or treatment as partners of an unincorporated
business entity.
Beginning in the late 1990s, the European Court of Justice began
"attacking'' the real seat approach, arguing that it might be contrary to
the "freedom of establishment" principle set forth by the European
f Treaty. The Centros case below opened the door toward the abolition of
the real seat rule in Europe.
CENTROS LTD. V. ERHVERVS- OG SELSKABSSTYRELSEN
I Judgment of the Court of 9 March 1999

Case C-212/97
l Summary
It is contrary to Articles 52 and 58 of the Treaty for a Member State
to refuse to register a branch of a company formed in accordance with the
law of another Member State in which it has its registered office but in
which it conducts no business, where the branch is intended to enable the
company in question to carry on its entire business in the State in which
that branch is to be created, while avoiding the need to form a company
t
60 REGULATORY COMPETITION CH. 2
there, thus evading application of the rules governing the formation of CH.2
companies which, in that State, are more restrictive as regards the
paying up of a minimum share capital. Given that the right to form a regist 1
Anpar
company in accordance with the law of a Member State and to set up
branches in other Member States is inherent in the exercise, in a single Ii
market, of the freedom of establishment guaranteed by the Treaty, the "·
fact that a national of a Member State who wishes to set up a company simih
chooses to form it in the Member State whose rules of company law seem Euro1
to him the least restrictive and to set up branches in other Member States I
cannot in itself constitute an abuse of the right of establishment. regis1
' '
That interpretation does not, however, prevent the :3-uthorities of the 1
Member State concerned from adopting any appropriate measure for Cent :
preventing or penalizing fraud, either in relation to the company itself, if to es
need be in cooperation with the Member State in which it was formed, or c1rcu
in relation to its members, where it has been established that they are in ofm
fact attempting, by means of the formation of a company , to evade their 1991
obligations towards private or public creditors established in the territory
of the Member State concerned.*** refu
THE COURT, gives the following Judgment
judt
Grounds Hoj-
By order of 3 June 1997, received at the Court on 5 June 1997 the
Hojesteret referred to the Court for a preliminary ruling under Article con
177 of the EC Treaty a question on the interpretation of Articles 52, 56 the
and 58 of the Treaty. for:
That question was raised in proceedings between Centros Ltd, a De
private limited company registered on 18 May 1992 in England and thE
Wales, and Erhvervs- og Selskabsstyrelsen (the Trade and Companies
Board, 'the Board') which comes under the Danish Department of Trade, fo1
concerning that authority's refusal to register a branch of Centros in es
Denmark. VO
El
It is clear from the documents in the main proceedings that Centros pl
has never traded since its formation. Since United Kingdom law imposes tr
no requirement on limited liability companies as to the provision for and SC
the paying-up of a minimum share capital, Centros's share capital, which N
amounts to GBP 100, has been neither paid up nor made available to the
co~pany. It i~ ~ivid~d into two shares held by Mr and Mrs Bryde, Danish Ct
nationals res1dmg 1n Denmark . Mrs Bryde is the director of Centros, b
wh~se registered office is situated in the United Kingdom, at the home of 0
a friend of Mr Bryde. I
Under Danis~ la~, . Centros, as a 'private limited company', is I
I
regarde~ as a foreign hm1ted liability company. The rules governing the
of CH.2 REGULATORY COMPETITION 61
1e
a registration of branches ('filialer') of such companies are laid down by the
lp Anpartsselskabslov (Law on private limited companies).
le In particular, Article 117 of the Law provides:
Le "1. Private limited companies and foreign companies having a
y similar legal form which are established in one Member State of the
n European Communities may do business in Denmark through a branch ."
'S
During the summer of 1992, Mrs Bryde requested the Board to
register a branch of Centros in Denmark .
e The Board refused that registration on the grounds, inter alia , that
r Centros, which does not trade in the United Kingdom, was in fact seeking
f to establish in Denmark, not a branch, but a principal establishment, by
r circumventing the national rules concerning, in particular, the paying-up
l of minimum capital fixed at DKK 200 000 by Law No 886 of 21 December
1991.
Centros brought an action before the Ostre Landsret against the
refusal of the Board to effect that registration.
The Ostre Landsret upheld the arguments of the Board in a
judgment of 8 September 1995, whereupon Centros appealed to the
Hojesteret.
In those proceedings, Centros maintains that it satisfies the
conditions imposed by the law on private limited companies relating to
the registration of a branch of a foreign company. Since it was lawfully
formed in the United Kingdom, it is entitled to set up a branch in
Denmark pursuant to Article 52, read in conjunction with Article 58, of
the Treaty.
According to Centros the fact that it has never traded since its
formation in the United Kingdom has no bearing on its right to freedom of
establishment. In its judgment in Case 79/85 Segers v Bedrijfsvereniging
voor Bank- en Verzekeringswegen, Groothandel en Vrije Beroepen [1986]
ECR 2375, the Court ruled that Articles 52 and 58 of the Treaty
prohibited the competent authoritie 's of a Member State from excluding
the director of a company from a national sickness insurance scheme
solely on the ground that the company had its registered office in another
Member State, even though it did not conduct any business there.
I The Board submits that its refusal to grant registration is not

contrary to Articles 52 and 58 of the Treaty since the establishment of a
branch in Denmark would seem to be a way of avoiding the national rules
on the provision for and the paying-up of minimum share capital.
Furthermore, its refusal to register is justified by the need to protect
private or public creditors and other contracting parties and also by the
r need to endeavor to prevent fraudulent insolvencies.
rt
('
In those circumstances, the Hojesteret has decided to stay

proceedings and to refer the following question to the Court for a
preliminary ruling:
"Is it compatible with Article 52 of the EC Treaty, in conjunction with
Articles 56 and 58 thereof, to refuse registration of a branch of a company
which has its registered office in another Member State_ and has been
lawfully founded with company capital of GBP 100 (approximately DKK 1
000) and exists in conformity with the legislation o~ that Me~~er St:3-te,
where the company does not itself carry on any busin_ess but_it is d_esired
to set up the branch in order to carry on the entire busin~ss 1n the
country in which the branch is established, and where, instead of
incorporating a company in the latter Member State, that p~ocedur_emust
be regarded as having been employed in order to av01d paying up
company capital of not less than DKK 200 000 (at present DKR 125
000)?"
By its question, the national court is in substance asking whether it
is contrary to Articles 52 and 58 of the Treaty for a Member State to
refuse to register a branch of a company formed in accordance with the
legislation of another Member State in which it has its registered office
but where it does not carry on any business when the purpose of the
branch is to enable the company concerned to carry on its entire business
in the State in which that branch is to be set up, while avoiding the
formation of a company in that State, thus evading application of the
rules governing the formation of companies which are, in that State, more
restrictive so far as minimum paid-up share capital is concerned.
As a preliminary point, it should be made clear that the Board does
not in any way deny that a joint stock or private limited company with its
registered office in another Member State may carry on business in
Denmark through a branch. It therefore agrees, as a general rule, to
register in Denmark a branch of a company formed in accordance with
the law of another Member State. In particular, it has added that, if
Centros had conducted any business in England and Wales, the Board
would have agreed to register its branch in Denmark.
~ccord~ng to the D~nish Gove~nment, Article 52 of the Treaty is not
applicable 1n the case 1n the main proceedings, since the situation is
purely internal to Denmark. Mr and Mrs Bryde, Danish nationals have
formed a c_ompany in th~ United Kingdom which does not carry ~n any
actual business there with the sole purpose of carrying on business in
De?ma~k through a branch and thus avoiding application of Danish
legisl~t10n on ~he formation of private limited companies. It considers
that 1n such circumstances the formation by nationals of one Member
State of a company in another Member State does not amount to a
•2
:ly
a relevant external element in the light of Community law and, in
particular, freedom of establishment.
In this respect, it should be noted that a situation in which a
company formed in accordance with the law of a Member State in which it
has its registered office desires to set up a branch in another Member
State falls within the scope of Community law. In that regard , it is
immaterial that the company was formed in the first Member State only
d for the purpose of establishing itself in the second, where its main, or
e indeed entire, business is to be conducted (see, to this effect, Segers
1f paragraph 16).
t That Mrs and Mrs Bryde formed the company Centros in the United
p Kingdom for the purpose of avoiding Danish legislation requiring that a \
5 minimum amount of share capital be paid up has not been denied either
in the written observations or at the hearing. That does not, however, \
mean that the formation by that British company of a branch in Denmark
is not covered by freedom of establishment for the purposes of Article 52
and 58 of the Treaty. The question of the application of those articles of
the Treaty is different from the question wheth er or not a Member State
may adopt measures in order to prevent attempts by certain of its
nationals to evade domestic legislation by having recourse to the
possibilities offered by the Treaty.
As to the question whether, as Mr and Mrs Bryde claim, the refusal
to register in Denmark a branch of their company formed in accordance
with the law of another Member State in which it has its registered office
constitutes an obstacle to freedom of establishment, it must be borne in
mind that that freedom, conferred by Article 52 of the Treaty on
Community nationals , includes the right for them to take up and pursue
activities as self-employed persons and to set up and manage
undertakings under the same conditions as are laid down by the law of
the Member State of establishment for its own nationals. Furthermore,
under Article 58 of the Treaty, companies or firms formed in accordance
with the law of a Member State and having their registered office, central
administration or principal place of business within the Community, are
to be treated in the same way as natural persons who are nationals of
Member States.
The immediate consequence of this is that those companies are
I entitled to carry on their business in another Member State through an

agency, branch or subsidiary. The location of their registered office,
central administration or principal place of business serves as the
connecting factor with the legal system of a particular State in the same
way as does nationality in the case of a natural person (see, to that effect,
Segers, paragraph 13, Case 270/83 Commission v France [1986] ECR 273,
paragraph 18, Case C-330/91 Commerzbank [1993] ECR l-4017, CH.2

paragraph 13, and Case C-264/96 ICI [1998] I-4695, paragraph 20).
establishn
Where it is the practice of a Member State, in certain circumstances,
a Membe :
to refuse to register a branch of a company havi~g its regis~ered office in inherent
another Member State, the result is that compames formed m accord~i:ice establishr
with the law of that other Member State are prevented from exercising
the freedom of establishment conferred on them by Articles 52 and 58 of In t1
harmoniz
the Treaty. always 01
Consequently, that practice consti~~tes an obstacle to the exercise of by Articl•
the freedoms guaranteed by those provis10ns. In a1
According to the Danish authorities, however, Mr and Mrs Bryde a compa1
cannot rely on those provisions, since the sole purpose of ~he _company has its 1
formation which they have in mind is to circumvent the application of the State w
existenc
national law governing formation of private limite~ companies an_d
Membe1
therefore constitutes abuse of the freedom of establishment. In their
Commu
submission, the Kingdom of Denmark is therefore entitled to take steps to
prevent such abuse by refusing to register the branch. Ace
compan
It is true that according to the case-law of the Court, a Member State which
is entitled to take measures designed to prevent certain of its nationals intend{
from attempting, under cover of the rights created by the Treaty, host S
improperly to circumvent their national legislation or to prevent nation:
individuals from improperly or fraudulently taking advantage of capital
provisions of Community law. [... ] it pre ·
However, although, in such circumstances, the national courts may, estabr
guara 1
case by case, take account-on the basis of objective evidence-of abuse or
fraudulent conduct on the part of the persons concerned in order, where T
appropriate, to deny them the benefit of the provisions of Community law m qu
on which they seek to rely, they must nevertheless assess such conduct in DaniE
the light of the objectives pursued by those provisions. [... ] r
In the present case, the provisions of national law, application of Cour
which the parties concerned have sought to avoid, are rules governing the argu•
and ·
formation of companies and not rules concerning the carrying on of
reinf
certain trades, professions or businesses. The provisions of the Treaty on
publ
freedom of establishment are intended specifically to enable companies beco
formed in accordance with the law of a Member State and having their thos
registered office, central administration or principal place of business prot
within the Community, to pursue activities in other Member States frau
through an agency, branch or subsidiary. cap i
That being so, the fact that a national of a Member State who wishes
to set up a company, chooses to form it in the Member State whose rules thiE
of company law seem to him the least restrictive and to set up branches in intJ
other Member States cannot, in itself, constitute an abuse of the right of
~
17, CH. 2 REGULATORY COMPETITION
65
establishment. The right to form a c9mpany in accordance with the law of

es , a Member State and to set up branches in other Member States is
m inherent in the exercise, in a single market, of the freedom of
tee establishment guaranteed by the Treaty.
ng
In this connection, the fact that company law is not completely
of
harmonized in the Community is of little consequence. Moreover, it is
always open to the Council, on the basis of the powers conferred upon it
of by Article 54(3)(g) of the EC Treaty, to achieve complete harmonization .
In addition, it is clear from paragraph 16 of Segers that the fact that
ie a company does not conduct any business in the Member State in which it
1y has its registered office and pursues its activities only in the Member
State where its branch is established , is not sufficient to prove the
existence of abuse or fraudulent conduct which would entitle the latter
1e
td Member State to deny that company the benefit of the provisions of
Ir Community law relating to the right of establishment .
;o
Accordingly, the refusal of a Member State to register a branch of a
company formed in accordance with the law of another Member State in
;e which it has its registered office on the grounds that the branch is
.s intended to enable the company to carry on all its economic activity in the
r, host State, with the result that the secondary establishment escapes
t national rules on the provision for and the paying-up of a minimum
,f capital, is incompatible with Articles 52 and 58 of the Treaty, in so far as
it prevents any exercise of the right freely to set up a secondary
establishment which Articles 52 and 58 are specifically intended to
guarantee.
r
The final question to be considered is whether the national practice
in question might not be justified for the reasons put forward by the
Danish authorities .
Referring both to Article 56 of the Treaty and to the case-law of the
Court on imperative requirements in the general interest, the Board
argues that the requirement that private limited companies provide for
to
and pay up a minimum share capital pursues a dual objective: first ,
reinforce the financial soundness of those companies in order to protect
public creditors against the risk of seeing the public debts owing to them
become irrecoverable since , unlike private creditors, they cannot secure
to
those debts by means of guarantees and, second , and more generally,
ting the risk of
protect all creditors, whether public or private, by anticipa
fraudulent bankruptcy due to the insolvency of companies whose initial
capitalization was inadequate.
The Board adds that there is no less restrictive means of attaining
by
.this dual objective. The other way of protecting creditors , namely
l
introducing rules making it possible for shareholders to incur persona
liability, under certain conditions, would be more restric~ive than the CH.2
requirement to provide for and pay up a minimum share capital. justify
It should be observed, first, that the reasons P':t forward do not f~ll its reg
within the ambit of Article 56 of the Treaty. Next, it should be b?rne m T
mind that, according to the Court's case-law, national measures hable to contr:
hinder or make less attractive the exercise of fundamental freedoms to re{
guaranteed by the Treaty must fulfill four conditions: th~y 1;1ust be anotl
applied in a non-discriminatory manner; they must be JUS!ified by cond1
imperative requirements in the general interest; they must be suitable for comr
securing the attainment of the objective which the_y ~mrsue; and they that
ther ,
must not go beyond what is necessary in order to attam it. [. · .]
com 1
Those conditions are not fulfilled in th[is] case . ... First, the practice payi
in question is not such as to attain the objective of protecting creditors how
which it purports to pursue since, if the company concerned had ado
conducted business in the United Kingdom, its branch would have been eitl
registered in Denmark, even though Danish creditors might have been Me
equally exposed to risk. wh
of i
Since the company ... holds itself out as a company governed by the or
law of England and Wales and not as a company governed by Danish law, COJ
its creditors are on notice that it is covered by laws different from those
which govern the formation of private limited companies in Denmark and
they can refer to certain rules of Community law which protect them,
such as the Fourth Council Directive 78/660/EEC of 25 July 1978 based
on Article 54(3)(g) of the Treaty on the annual accounts of certain types of J·
companies (OJ 1978 L 222, p. 11), and the Eleventh Council Directive
89/666/EEC of 21 December 1989 concerning disclosure requirements in
respect of branches opened in a Member State by certain types of E
company governed by the law of another State (OJ 1989 L 395, p. 36).
Second, contrary to the arguments of the Danish authorities it is
'
possible to adopt measures which are less restrictive, or which interfere
less with fundamental freedoms, by, for example, making it possible in
law for public creditors to obtain the necessary guarantees.
, Lastly, the fact that a Member State may not refuse to register a
~;
ii branch of a company formed in accordance with the law of another
t
Member State in which it has its registered office does not preclude that
I first ~~ate from a~optin_g any ~ppropriate measure for preventing or

penahzu!'g fr~ud, either m relat10n to the company itself, if need be in
coo~eration with the Member State in which it was formed, or in relation
to its n:iembers, where it has been established that they are in fact
att~mp_tmg, by means_ of the formation of the company, to evade their
obhgatwns towards private or public creditors established on the territory
of a Member . State concerned. In any event, combating fraud cannot
CH. 2 REGULATORY COMPETITION 67
justify a practice of refusing to register a branch of a company, which has

its registered office in another Member State.
The answer to the question referred must therefore be that it is
contrary to Articles 52 and 58 of the Treaty for a Member State to refuse
to register a branch of a company formed in accordance with the law of
another Member State in which it has its registered office but in which it
conducts no business, where the branch is intended to enable the
company in question to carry on its entire business in the State in which
that branch is to be created, while avoiding the need to form a company
there, thus evading application of the rules governing the formation of
companies which, in that State, are more restrictive as regards the
paying up of a minimum share capital. That interpretation does not,
however, prevent the authorities of the Member State concerned from
adopting any appropriate measure for preventing or penalizing fraud,
either in relation to the company itself, if need be in cooperation with the
Member State in which it was formed, or in relation to its members,
where it has been established that they are in fact attempting, by means
of the formation of a company, to evade their obligations towards private
or public creditors established in the territory of the Member State
concerned. [... ]
On those grounds,
THE COURT,
in answer to the question referred to it by the Hojesteret by order of 3
June 1997, hereby rules:
It is ' contrary to Articles 52 and 58 of the EC Treaty for a Member
State to refuse to register a branch of a company formed in accordance
with the law of another Member State in which it has its registered office
but in which it conducts no business where the branch is intended to
enable the company in question to carry on its entire business in the
State in which that branch is to be created, while avoiding the need to
form a company there, thus evading application of the rules governing the
formation of companies which, in that State, are more restrictive as
regards the paying up of a minimum share capital. That interpretation
does not, however, prevent the authorities of the Member State concerned
from adopting any appropriate measure for preventing or penalizing
fraud, either in relation to the company itself , if need be in cooperation
with the Member State in which it was formed, or in relation to its
members, where it has been established that they are in fact attempting,
by means of the formation of_ a compan~, to ~vade their _obligations
towards private or public creditors established 1n the territory of the
Member State concerned.
82 REGULATORY COMPETITION c~
. 'COMI. is CH.2
proceeding with universal effects. Additionally, compames
· ·
presumed to comcide · regis· t er ed office , unless the
wit· h t h eir has yet
contrary is· proven. N owa d ays, h oweve r , companies can often . market" l
transfer their registered office throughou t the European Umon.
Whi]
Additionally, pursuant to ECJ case law, the refe~ence date to assess
the tran:
the insolvency competence is the date of filing, with the consequence Member
that, if a company relocates its registered office abroad before t~e the tran
filing, the new jurisdiction becomes competent !o g?ve~n its corporat
st
insolvency, unless creditors prove that the COMI is ill m the limitatic
original State." "immigi
What rationale-if any-do you think might justify stronger ~imitations to recog
to regulatory arbitrage and competition in inso~vency law than with res~ect in the (
to substantive law governing the internal affairs of a ~olvent corpo_ratio~? 9641). I
Why do you think that European law, at least accordmg to Mucciarelli s precluc
analysis, does not fully prevent this phenomenon? ?hould the Eur?pean incorpc
legislature, or Member State, do something to avoid forum shoppmg of anothe
bankruptcy laws? If so, what, based on the few information offered by the by thE
short excerpt from Mucciarelli? decisic
of esb
*** limit 1
Centros and Uberseering marked the beginning of a fundamental ownl:
shift in the interpretation of the principle of freedom of establishment by move
the ECJ. Soon after these two decisions were issued, the number of (
English "Private company limited by shares" in other Member States of
the European Union began to grow. The growth in the number of English
companies occurred primarily in Member States where access to the
corporate form was difficult due to administrative barriers. Response to
the growing influence of English corporate law in Europe was different in
each Member State.
ml
After Centros, the Netherlands adopted a law allowing foreign
Ami
~· companies to move their real seat to the Netherlands, but required them reni
;
/:
to comply with certain provisions of Dutch corporate law. The ECJ plai
rejected this approach in the Inspire Art case in 2003. In Inspire Art, the
:
/
i ren
court held that the law at issue similarly violated the freedom of the
establishment (30.9.2003-C-167/01, ECR 2003 I-10155). After Inspire sea
Art, it became obvious that European Member States would have to
·l
. I
I sh:
··/
I compete with English corporate law. As a consequence several States C01
'
?egan undertaking massive reforms of their national cor~orate law codes de
m an effort to keep pace with English corporate law. These reforms Tl
focused. ~specially on s~eeding up the incorporation process and pl
' I
mode~mzm~ ~ules regardmg the protection of creditors, in particular (C

reducmg mm1mum legal capital (for a more detailed discussion see
~hapter 3). Hence, as a result of the decisions of the ECJ' the
"mcorporation market"-as it had been known in the United St~tes-
came to the European Union. To this point, however, the European Union
CHOICE OF APPLICABLE CORPORATELAWS AND
CH.2 REGULATORYCOMPETITION 83
has yet to experience a one state domination of the "incorporation

market" like the U.S. has with Delaware.
While the Centros, Uberseeringand Inspire Art cases all focused on
the transfer of the real seat of a corporation from the perspective of the
Member state of the real seat, it was not entirely clear if limitations to
the transfer of the real seat adopted by the Member State where the
corporation is incorporated were admissible. These are, so to speak,
limitations to "emigration" imposed by the home jurisdiction, not to
"immigration" imposed by the jurisdiction of destination. The ECJ refused
to recognize such a limitation as a violation of freedom of establishment
in the Cartesio case decided in 2008 (16.12.2008-C-210/06, ECR 2008 1-
9641). The ECJ held that Art. 43, 48 EC are to be interpreted as not
precluding legislation of a Member State under which a company
incorporated to limit the ability of the corporation to transfer its seat to
another Member State, whilst retaining its status as a company governed
by the law of the Member State of incorporation . With the Cartesio
decision, the ECJ established a confusing two-tiered approach to freedom
of establishment. Under this two-tiered system, each Member State can
limit the transfer of the real seat of corporations created according to its
own law, yet it has to accept that corporations from other Member States
move their real seat to its own territory.
Consider the following German case.
GERMAN FEDERAL COURT OF JUSTICE, 13 MARCH 2003

13 March 2003, VII ZR 370/98, BGHZ 154, 185
Facts
Plaintiff is a Dutch corporation (Besloten Venootschnap [BV]) founded
in 1990 and which is registered in the [Dutch] companies' register in
Amsterdam and Haarlem. In 1992, plaintiff asked the defendant to
renovate a motel. After defendant rendered the promised services,
plaintiff refused to pay the remuneration and claimed that some of the
renovation work was poorly performed. After the defendant refused to fix
the alleged defects, the plaintiff did it. In 1994/95 plaintiff moved its real
seat from the Netherlands to Germany because the corporation's two
shares were acquired by two German nationals who were mainly
conducting plaintiffs business in Germany. Soon thereafter, plaintiff
demanded payment of 1.163.657,77 DM from the defendant as damages.
The trial regional court (Landgericht) dismissed the suit, holding that
plaintiff lacked legal capacity to bring the suit. The appellate court
(Oberlandesgericht) affirmed.
representatives in Japan (Art. 933(2)) before it engages in business (Art.
818(1)). Individuals violating this requirement are jointly and severally liable
with the foreign corporation for any obligation that has arisen from such
transactions (Art. 818(2)). Also, a registered foreign corporation, which is
equivalent to a Japanese stock corporation, must publish its financial
statements annually (Art. 819(1)).
RACE TO THE TOP OR TO THE BOTTOM? A MORE

THEORETICAL VIEW OF REGULATORY
COMPETITION
As briefly mentioned in the Introduction, it is debatable whether the
regulatory competition that stems from the incorporation theory leads to
a "race to the top" (i.e., the development of efficient rules that maximize
the interests of the different stakeholders), or a "race to the bottom" (i.e.,
a situation in which some corporate actors-typically controlling
shareholders, directors, and managers~an extract private benefits
through regulatory arbitrage). The following classical articles argue the
two theses with respect to the U.S. "market for corporate charters." But
their framework can also be relevant-with the necessary distinctions-to
discuss regulatory competition in other systems and fields.
WILLIAM L. CARY, FEDERALISM AND CORPORATE LAW:

REFLECTIONS UPON DELAWARE 4
83 Yale L. J. 663 (1974)
Delaware is both the sponsor and the victim of a system contributing

to the deterioration of corporation standards. This unhappy state of
affairs, stemming in great part from the movement toward the least
common denominator, Delaware, seems to be developing on both the
legislative and judicial fronts . In the management of corporate affairs,
state statutory and case law has always been supreme, with federal
intrusion limited to the field of securities regulation. Perhaps now is the
time to reconsider the federal role.
[... ]
Some of the features of Delaware law demonstrating liberality have
been recited in publications for practitioners. These include: greater
freedom to pay dividends and make distributions; greater ease of charter
amendment and less restrictions upon selling assets, mortgaging, leasing,
and merging ... freedom from mandatory cumulative voting; permission
to have staggered boards of directors; lesser pre-emptive rights for
shareholders; [and] clearer rights of indemnification for directors and
officers. . . . ·
4
Footnotes and paragraph numbers have been omitted.
CHOICE OF APPLICABLE CORPORATELAWS AND
CH. 2
REGULATORYCOMPETITION 95
[... ]
. ~ few illustrations of the legislative approach reveal the Delaware

~ositlon. For ~xample, shareholders meetings may now be dispensed with
if
. a consent
d d . 1s signed bY th e num b er of votes necessary to take the
inten e_ actwn,. thus offering a technique to avoid disclosure. Protection
from this abuse 1s provided through the proxy rules under federal law but
they do not apply to firms that are unlisted or have less than 500
sharehol_ders and _minimal assets. Under § 109 of the Delaware law any
corporation may m its certificate of incorporation confer the power to
amend or rep_e~ _by_-lawprovisions upon the directors and thus possibly
foreclose any initiative outside the management.
[... ]
Judicial decisions in Delaware illustrate that the courts have
undertaken to carry out the "public policy" of the state and create a
"favorable climate" for management. Consciously or unconsciously,
fiduciary standards and the standards of fairness generally have been
relaxed. In general, the judicial decisions can best be reconciled on the
basis of a desire to foster incorporation in Delaware. It is not clear,
however, that the revenue thermometer should replace the chancellor's
foot. This trend should be reversed.
[... ]
Mansfield Hardwood Lumber Co. v. Johnson-A Point of View
Mansfield Hardwood Lumber Co. v. Johnson states the attitude of
critics toward Delaware decisions. It involved the purchase of a minority
interest without full disclosure and the company's subsequent liquidation
for the benefit of the insiders. The first opinion of the Fifth Circuit,
affirming the decision below, ordered a rescission of the stock sales and
granted plaintiffs a pro rata portion of the assets realized upon
liquidation. It was based upon general fiduciary principles under the law
of Louisiana and upon the failure to disclose the facts concerning the
asset values of the company.
Although the acts occurred in Louisiana, i1:1~ew of the fact ~hat the
corporation was organized in Delaware a petition for a rehearing was
filed, claiming among other thing~ that such a fiduciary ~elation~hip did
not exist in the state of incorporat10n and must be determined by its laws.
In its second opinion the Fifth Circuit noted a num~er of decisions
hold" that "the conflict of laws rules of the forum require that court to
re£ mg ·
t th 'law of the State of incorporat10n · to determine· t h e ...
er o e d kh Id , " Th .
relationship between corporation an stoc o ~r... . e court said
further, "Apparently Delaware imposkesh ndofid~ciabry~uty on kthfepart of
1
of~
11cers or d"irec tors or maJ·ority stoc
,, o ers in uying stoc rom the
minority or individual stockholders.
Nevertheless, it concluded that "[t]hose decisions are, however, in our CH.2

opinion, either inapplicable or unsound where the only contact point with has re1
the incorporating state is the naked fact of incorporation .... " Applying subsidi
conflicts of laws principles, it decided that "where neither the charter nor these d
the statutory laws of the incorporating state are applicable and all for inv,
contact points are in the forum, we believe that the laws of the forum of pro
should govern." After discussing a number of decisions in the federal indepe
courts, the court said that "most of the other cases listed ... involve Sinver
situations where the courts were seeking to impose the fiduciary rule of expan :
the state of incorporation in order to escape the inequitable rule of the {.
forum (generally Delaware)." It therefore denied the petition for
The£
rehearing.
C
Today such an action would almost certainly be grounded on Rule low s1
lOb-5 and brought in the federal courts under the Securities Exchange duty
Act of 1934. Thus the court would reach the same result without on bE
concerning itself with refinements of conflict of law principles. fixin1
[... ] comi
indic
Fairness between Parent and Subsidiary pena
The Delaware courts have tended to encourage freedom of action on equi
the part of parent companies incorporated in that state and have
indicated little concern over the fairness of dealings with subsidiaries. part
The consistent philosophy favors controlling shareholders and leaves or c
fiduciary questions to the business judgment of an indentured board. The dut;
old concept that each party is "entitled to what fair arm's length the
bargaining would probably have yielded" has been enveloped in a new alle
and labyrinthine rationale. Ho'
wa:
The most recent example in the Delaware Supreme Court is Sinclair chf
Oil Corp. v. Levien. Sinclair totally dominated Sinclair Venezuelan Oil
Company (Sinven), in which it held 97 percent of the stock. Plaintiff
fin
represented the three percent minority interest suing derivatively. At pe
Sinclair's direction Sinven paid out over six years $108 million in SU
dividends ($38 million in excess of earnings). Thus Sinven's activities di
declined; there was no opportunity for expansion despite Sinclair's a
company-wide policy of developing through its subsidiaries new sources of h:
revenue. · s~
Recognizing that by reason of Sinclair's domination, Sinclair owed
Sinven a fiduciary duty, the Delaware Supreme Court nevertheless held
that the transactions should be tested by the business judgment rule n
under which a court will not interfere unless there is a showing of gross 1:
and palpable overreaching. The chancellor in the court below had applied C
the intrinsic fairness test and ruled against Sinclair. The supreme court, t
on the other hand, reversed and said, "[T]he basic situation for the
application of the [intrinsic fairness test] is the one in which the parent
has .r~ceiv~d _a benefit to the exclusion and at the expense of the

subsidi~ry._ Si~ce all the stockholders received the dividends pro rata,
the~e dis~ributio~s did not represent self-dealing, an essential ingredient
for mvokmg the mtr~nsic fairness test. The plaintiff, bearing the burden
?f proof, proved neither that business opportunities came to Sinven
u~dependently nor that Sinclair took to itself or denied opportunities to
Smven: It woul~ have been surprising for Sinclair to generate new
expans10n when its whole motive was to drain the cash from Sinven.
[... ]
The Directors' Duty of Care
Graham v. Allis-Chalmers Manufacturing Co. is an example of the
low standard that Delaware shares with most other jurisdictions as to the
duty of care on the part of directors. Graham involved a derivative action
on behalf of Allis-Chalmers in connection with the much publicized price-
fixing conspiracy involving electric equipment in the late 1950's. The
company, together with four nondirector defendants, pleaded guilty to the
indictments and as a result had been subjected not only to fines and
penalties but to treble damage actions brought by purchasers of the
equipment.
In this case it was impossible to establish actual knowledge on the
part of any officers, but it was claimed that they should have had notice,
or constructive knowledge, of what was happening. One reason why a
I
duty might arise here is that in 1937 (19 years before the illegal action)
the Federal Trade Commission had issued a cease and desist order from
alleged price-fixing in connection with the sale of many of the same items.
However, the point was made by the vice-chancellor that such an order
was "entered at a time when none of the Allis-Chalmers directors here
charged held a position of responsibility with the company."
The supreme court upheld the lower court's ruling for the defendants,
finding that since the company's directors could not investigate
personally all of the company's employees they were entitled to rely on
summaries, reports, and corporate records. No one would expect the
directors to have personal knowledge of all corporate activities. However,
a student Note suggests that a state less hospitable than Delaware might
have imposed upon directors the duty of installing an internal control
system to prevent repeated antitrust violations.
***
Professor Cary was clearly very critical of the role of Delaware, and
more generally regulatory competition, ~n the development of corporate
law. In the article excerpted above, m fact, ~e also advocates the
opportunity of the intervention of the federal legislator in order to c~rb
the race to laxity in corporate law. Other scholars have taken an opposite
98 REGULATORY COMPETITION
-
Ca.2
per~pect_ive,arguing that freedom of incorporation leads to a more flexible

regime, 1n which more efficient rules can be established and applied. One
of the underpinnings of this reasoning is that if in one jurisdiction
shareholders, creditors, or other investors do not receive sufficient
protections, they will not engage in business with a corporation
incorporated in that jurisdiction, or at least require a compensation for
the increased risk they perceive. The consequence is that legislatures and
judiciaries that are inclined to attract corporations cannot disregard the
interests of other stakeholders, but will rather have to find an optimal
balance between the interests of corporate insiders and other
stakeholders. This is an interesting argument; it implies, however'
information efficiency: stakeholders must, in other words, be well
informed on the applicable corporate rules, and able to properly interpret
them, a condition that can be questioned. In any case, the following
article argues that the incorporation theory, and the resulting regulatory
competition in the U.S., is more beneficial than harmful.
One interesting issue is to what extent, in a system based on
regulatory competition among states to attract corporations, federal or
international law can impose minimum standards in order to avoid
"market failures." A similar role can be played by the federal government
in the U.S., and by European law in the Old Continent . One author,
Professor Mark Roe from Harvard Law School, has in particular argued
that the policy makers in Delaware do not only face ''horizontal"
competition from other States, but also potential '\rertical" competition
from the federal legislature. Fear of federal intervention that might
displace Delaware law could, in fact, operate as an incentive to Delaware
policy makers to take into account the need of protection of minority
shareholders, creditors, and other corporate stakeholders. The following
excerpt from Mark Roe illustrates this point .
***
MARK J. ROE, DELAWARE'S POLITICS 5

118 Harv. L. Rev. 2491 (2005)
The standard story is that states make corporate law, with state
competition critically determining its content. This may be so, but
perhaps the relationship between the states and Washington is just as
determinative, because federal authorities can displace the states and
often do so on big issues. Corporate law issues can always go federal or
attract federal attention. The SEC is always on stand-by, and Congress
takes up issues that deeply affect the economy or the opinion polls . ·
[. ..J
11 Footnotes omitted .
~
)le
ne
on Al_th ough managers historically are often seen to have had the upper
ha nd m fDelaware, they don't fully dominate there. This is not just
nt · · n. Delaware d oesn 't
· o,f state competit10
· · spite
)D
because o ' and. perhaps ism
~et;~em hdommate--or they themselves choose to be moderate-because if
or ~t i , t e game could move to Washington, where new players could
1d md~~e new results. Hence, local interest groups compromise and local
1e decision ~akers are evenhanded, even if local politics doesn't demand
al compromise or evenhandedness.
~r
Sometimes, the issue is so big-generating headlines in the media
r, and fears for the economy-that it necessarily attracts federal attention.
II Different coalitions can, and do, emerge at the federal level. When
~t cor~o.rate la':' stays in Delaware, the state limits the range of the first
.g decision-making stage by excluding corporate outsiders and public
y policymakers; sometimes managers and investors can make their deal in
Delaware and then unite at the federal level to fight off other forces. L
i .
n Probably more often than not, their interests are sufficiently similar that
both want the states and not the federal authorities to make corporate
r
law. But sometimes Delaware loses control of the agenda , usually when ..r";·.,"
:l the public is sufficiently motivated, because the economy is weak or !-'.>
•I • ~ :
t ~...~,...
because scandals dominate the media, and Congress acts. Congress t ,,' .
ousted Delaware most recently with Sarbanes-Oxley, after the Enron and t !, ....!-:
.
-... . .. .
. !' '
l WorldCom scandals hit the headlines. 1· ·. I' J . .. ;:
\,-- . - ,c
Look at what we have done here. We've reversed the conventiona l

analytic form for Delaware, in which the making of public law governing
the corporation is analogized to a market-one of competing states. We've
turned that analysis inside out, into a public law perspective, with
interest groups and political institutions. Instead of seeing Delaware as
solely the upshot of a market of competing states, we also see it as like a
federal agency-captured by its interest groups-that can only move as
far as Congress allows. That range of movement is wide, but not
unlimited. ·
By thus viewing Delaware, we have uncovered rich public choice
explanations for the core nature of Delaware and American corporate law.
While these public choice explanations do not let us precisely explain
statute after statute or exact judicial holdings , they mark off the broad
boundaries of corporate lawmaking. First, we have explained Delaware's
moderation Delaware's dominance, and the conservative , boardroom-
centered n~ture of American corporate law via federal-state interaction,
without relying solely on the state-to-state race for franchise tax
revenues. Second, we have interpret ed th e sta~e c~rporate franchise tax
as not just motivating Delaware to do a ~ood Job m the abstract, bu~-
subtly refocusing the emphasis-as excludmg many players from making
corporate law. Third, we've shown how Delaware's structural differences
with Congress arise not merely from the presence or abs ence of
CH.2
competitors, but also from the differing interest groups and ideologies
very al
that affect each. Fourth, we've seen how the internal affairs doctrine This lE
reflects deference to some interest groups and not others. And we've seen tail of
how the Delaware-federal sequence is an agenda-setting structure. develo
Delaware is only a state, embedded in a federal system that has more harde1
going on than just interstate competition for charters. It has only two so strc
with t
senators and one representative. Its law can be replaced and its acts risk
listed
reversal at the federal level by Congress, by courts, and by the SEC. comp 1
When the issue is big, one of these federal institutions often acts, without scare
paying much attention to Delaware. Each of these institutions responds, U.S.
however clumsily, to its own voters and inputs, and those inputs are not what
identical to those that are powerful in Delaware. Delaware can usually pOSSl
create the initial rule, to which the federal players react, but it cannot coun
consistently control the final results in making American corporate law. scho ·
stocl
NOTES AND QUESTIONS of r,
lawi
1. Compare and contrast the positions of Professors Cary and Roe dev•
concerning the effects of regulatory competition in the corporate area. What this
do you think are the most compelling arguments? If regulatory competition is Dm
an efficient and effective regulatory tool, wouldn't it be advisable simply not Ma
to regulate corporations at all, to allow the corporate contract (charter and (to1
bylaws) to set all the rules governing the internal affairs of the corporation, ''bo
with no limitations or constraints set by statute? Could you argue that, as str
long as the governing documents are public, investors could evaluate the IG
rules and the risks they pose, and decide whether to invest? In other words lSS
and more generally, if a market for rules works when states compete to
attract corporations, can't it work when issuers compete to attract investors
based on their governing rules?
a<
2. Consider the emphasis put by Professor Roe on the role of the ''i
federal government or, better, of fear of federal intervention. Do you think his w
thesis reinforces the argument in favor of a "race to the top" or of a "race to s·
the bottom"? Is the U.S. federal government more or less prone than state t
legislatures or regulators to be influenced by business lobbies? l:
3. It is not always true that corporations look for more lax rules, and E
therefore are attracted by jurisdictions and rules that favor flexibility and E
limited protection of investors. For example, lots of corporations located in

certain systems, for example Brazil, Israel, but also some European and
Asian countries, cross -list or dual-list in the U.S., meaning that they become
listed companies exclusively or also in the U.S., often on the NYSE. Among
the reasons there is certainly the desire to access the very liquid and efficient
American stock exchange, but one interesting theory is the so-called "bonding
hyp~thesis." According to this perspective, corporations list abroad exactly to
subJect_themselves to the-generally quite rigorous-U.S. disclosure regime,
somethmg tha~ allows them to signal to investors the quality of their
governance, a high level of protection of shareholders, and more generally the
AND
CHOICE OF APPLICABLE CORPORATE LAWS
REGULATORY COMP ETITI ON CH. 2
102
decision extensively in
(488 A.2d 858 (1985)). We will discuss this
Chapter 6, but to briefly summ arize, the Delaw are Supreme Court
of directors of a
affirmed the liability of the members of the board
in appro ving a corporate
corporation for a breach of their duty of care
Amer ica, and many
merger. The decision sent shivers through corporate
reinc orporating in
large corporations incorporated in Delaware considered
created by this
other states to avoid the risk of directors' liability
precedent.
the fears of
The Delaware legislature promptly stepped in to quell
of the Delaware
corporate directors. The legislature enacted § 102(b)(7)
the articles of
General Corporation Law, which provided that
limiting the liability
incorporation of a corporation can include a provision
reacti on by the Delaware
of outside directors. This rule was considered a
derai l, or hinder ,
legislature to a judicial decision that could potentially Tb
ing corporations. A
Delaware's competitive edge in attracting and retain be
between a state's
form of "regulatory competition" can therefore also exist co
legislature and the judiciary. di
gE
The provision, in relevant part, states as follows: fe
forth in the
"(b) In addition to the matters required to be set Ii
section, the
certificate of incorporation by subsection (a) of this e:
any or all of the
certificate of incorporation may also contain
following matters:
s
[... ] C
liability of a
(7) A provision eliminating or limiting the personal
monetary
director to the corporation or its stockholders for
ded that
damages for breach of fiduciary duty as a director, provi
liability of a
such provision shall not eliminate or limit the
loyalty to the
director: (i) For any breach of the director's duty of
ions not in
corporation or its stockholders; (ii) for acts or omiss
or a knowing
good faith or which involve intentional misconduct
(iv) for any
violation of law; (iii) under § 174 of this title; or
transaction from which the director derived an improper
or limit the
personal benefit. No such provision shall eliminate
ring prior to
liability of a director for any act or omission occur
references in
the date when such provision becomes effective. All
refer to such
this paragraph to a director shall also be deemed to
a provision of
other person or persons, if any, who, pursuant to
141(a) of this
the certificate of incorporation in accordance with§
s otherwise
title, exercise or perform any of the powers or dutie
this title."
conferred or imposed upon the board of directors by
***
CHAPTER3
THE INCORPORATION PROCESS AND

:ll's Of LIMITATIONS ON LIMITED LIABILITY
LWai:,e
·s Of •••
bility
Ware INTRODUCTION
1der This chapter is dedicated to two separate, yet closely related issues.
1S. A' The first issue we discuss is differences in the incorporation process
ate's between countries. In discussing this issue, we will provide a quick
comparative overview of how the incorporation process functions in
different systems. The second issue we will consider is exceptions to the
general rule of shareholders' limited liability. One of the distinctive
features of a corporation is the fact that, normally, shareholders are not
liable for the obligations of their corporation . This rule, however, has
exceptions: most notably, the common law doctrine of "piercing the
corporate veil" or ''lifting the corporate veil." In addition to "veil piercing,"
there are other rules in different jurisdictions, which provide for
situations where shareholders might be held liable for the debts of the
corporation. These rules generally apply when there is some kind of
"abuse" of the corporate structure.
One key idea linking the discussion of these two issues is the relative
ease of the incorporation process in a particular country. In common law
systems that follow the incorporation theory, the incorporation process is
generally easy, quick, and inexpensive. In these countries, it is often
sufficient to file very brief articles of incorporation with the Secretary of
State or other similar office. The articles filed often contain minimal
information about the corporation. The costs associated _with filing are
relatively low, and there are no-or very few-specific ex ante controls on
the content of the articles of incorporation. In addition, with the exclusion
of corporations in some regulated industries (such as banks), there is
generally no minimum legal capital (or very low capital) required to
incorporate. Thus, it is possible to incorporate with even a nominal
capital of $1. The evaluation of po_ssibl~ contributio~s in kind is qu~te
flexible, and basically left to the discretion of the directors. The entire
procedure is also very fast: it is o~ten ~ossible to ii_icorporate in less than
24 hours and, in some cases, even m mmutes (e.g., m New Zealand).
On the other hand, traditionally, in civil law countries (and .-more
generally under European law), the incorporation process is more
103
TION PROCESS AND
-_Q~_____ iT~H~E!:!l~N~CC!OQR ~PEO~R~A~!:,~IM~IT!:!E~D~L~I~A~B~IL~I~T~
_!04 LIMITATIO NS ON ~ Y~=::::-::C~3
. these systems there are often specific CH.3
· es more time · 1nt f the articles f ·
complex and requir o mcorpora t·10n and
rules on the form and the ~onten oante control on the legality of the On tl
bylaws. Additionally, there is an ex f on conducted by public or quasi "difficult,
governing documents of th e corpor:a~y public Minimum legal capital is corporat{
public officers, such as judge_sor ; no di tors and in part for the protection very nar
also required for the protect wn _0 tchreE u ' a minimum capital of 25,000 Example
1e m
of share h olders. For examp . ' t a ejoint· ·•
stock corporation · , an d m · some "domina1
euros is necessary to mco~pora e ary Furthermore, specific and more (e.g ., in
t . higher sum is necess . . . d h. h comply,
coun r1es, a h f n of contributio ns m km , w 1c often
1
rigid rules apply to t. e. evabua inoindependent expert appointed by the corporat
· a fairness opm10n Y a . · narrow
reqmre
t In these systems, even 1·f the duration of the mcorporati .
on process
f
German
cou~ · . . h .
varies, it m1g t eas11y t a k e a few weeks ' and to incorporate is o ten more the corp
expensive than in common law systems. . In
In many c1v aw· il 1 countries however these strmgent rules have require
, ' stakehc
ast partially relaxed, probably as a consequence of
recen tl y b een at le . f . d. .d
o m ivi ua 11egis
·increase d latory competitio n and the desire . 1t some a1
regu . . . 1 · a ures
to create incentives for business activities. One n?table ex~mp e is J apan,
h. h abolished its minimum legal capital reqmrement m 2005. Japan,
; ~~ver, still requires articles of incorporation to be certified by a n?tary Tl
0
public and contributions in kin_d _to b_e evaluated ~Y a court-appomted ''body.'
expert. Despite recent changes, it is fair to say that m these systems the notion
incorporation process is still strictly regulated. ''body''
were c
These different approaches to incorporation are partially reflected in
the l
the rules on piercing the corporate veil. Simplifying the issue, it can be corp01
observed that in jurisdictions where it is "easier" to incorporate, courts as otl
f are often more willing to pierce the corporate veil on an equitable basis corpo:
.·i / when the plaintiff can establish some kind of abuse of the corporate Diffm
structure. Differences still exist even within common law jurisdictions. them
For example, U.S. and U.K. case law differ substantially on this issue, sever
with veil piercing being quite more common in the U.S. In fact, piercing of mode
the corporate veil is one of the most commonly litigated issues in U.S. - corp<
corporate law. In the U.K., on ·the other hand, piercing is less frequent. shar ,
For example, a leading British case of the 1990s, Adams v. Cape bodi1
Industries plc, held that piercing is appropriate ·only in case of fraud, or shar
when the corporation is established to avoid an existing obligation . A free ]
similarly restrictive approach was followed in three subsequent cases:
Ord v. Belhaven Pubs Ltd (1998), Prest v. Petrodel Resources (2013) and orig
VTB ~apital plc v. Nut:itek Inte:national (2013). In VTB Capital plc, one ope:
of t_heJ_udges obse~ved: 'The not10n that there is no principled basis upon The
which 1t can be said that one can pierce the veil of incorporation con
receives
some support from the fact that the precise nature basis and meaning of Eli:
or
t~ie principle ~re a~l somew~at obscure, as are 'the precise nature of
cor
circumstances m which the principle can apply".
CH. 3 LIMITATIONS ON LIMITED LIABILITY 105
On the other hand, in civil law countries where incorporation is more

"difficult," judges and policy makers are quite reluctant to go beyond the
corporate veil. If judges decide to pierce the corporate veil, it is usually on
very narrow grounds, often explicitly regulated in statutory provisions.
Examples of such provisions include when a parent corporation
"dominates" a subsidiary and takes inequitable advantage of its position
(e.g., in Germany and in Italy), or when a single shareholder does not
comply with the rules concerning the formation or the maintenance of the
corporate capital. There are, however, some exceptions to this more
narrow approach to shareholders' liability, and we will discuss the
German concept of "Durchgriffshaftung," the local equivalent of "piercing
the corporate veil."
In this perspective, we will also consider if minimum legal capital
requirements can really be considered protective of creditors and other
stakeholders, or are just an ineffective and inefficient relic of the past, as
some authors have argued.
THE INCORPORATION PROCESS

The word "corporation" comes from the Latin word "corpus," meaning
''body." The etymological origins of the word "corporation" evoke the
notion that a group of people is joining forces to create a separate legal
''body'' in order to conduct business. In fact, however, early "corporations"
were created for all sorts of purposes, often not for profit. For example, in
the Middle Ages, churches and universities were organized as
corporations, and it is fairly well known that the City of London-as well
as other local governments in different jurisdictions-is technically a
corporation (its first recorded charter dates back to the eleventh century).
Different types of business organizations, with specific rules governing
them, have almost always existed, but it is only since the early
seventeenth century, during the colonial period, that the prototype of the
modern corporation came into existence. · The features of the modern
corporation are four key elements: legal personality; limited liability of
shareholders; a formal governance structure with specific corporate
bodies (typically, a shareholders' meeting and a board of directors); and
shares representing shareholders' investment that can be more or less
freely transferred and traded.
· It has been argued that the world's first commercial corporation
originated in Sweden. The corporation, known as Stora Kopparberg,
operated a copper mine and obtained a charter from the king before 1350.
The progenitors of the modern corporation, however, are usually
considered the · British East India Company, established by Queen
Elizabeth I in 1600, and the Dutch Vereenigde Oost-Indische Compagnie,
or VOC ("United East India Company"), formed in 1602. These
corporations were created especially to exploit the new trading routes I
THE INCORPORATION PROCESS
AND
106 LIMITATIONS ON LIMITED LIABIL
ITY C~
with the colonies, and both prt~~': ted some of the above-mentioned
First of all, investors were issu
I
elements of the modern corpof b · trad
certificates (shares) that coud d"efnctiv
ed. Second, they both had a
ed
governance structure that ha 1 e features, but would still be

is rate person . In addition, investors
recognized by a contempo~affru~:::~iabi
(shareholders) were gra~te lity, in the sense that they ~ere
t ibution and could not be held hable
only responsible for th eir ow~ con{his
acc~ptance of limited liability is
for the debts of the corporationthe trad
itional approach was that joint
?articular~y import~nt b~c:u~:siness ent
erprise should be liable for the
investors 1n the ~apita~~th a few except
ion s. It became cl~ar, howeve
debts of the busmess, t O finance colonial enterprises were r,
that the resources nece~~ary ly be effi so
cie ntly obt
:Y
significant that th cou 0~ r of inv
~hares to. a fairly ~:g~nnu;;; t~e corpor
ain ed by offering the
estors that would not be directly
ation, but whose maximum loss
involved in the hm~ . ~t· gl i·nvestment
as capped In order to be able to accomplish
w. task . bat t e1r 1n1iasary to grant .
1hty to s h are h old ers.
. . .
this 1t ecame neces limited hab
The~e early corporations were also ofte
n given monopoly rights on
the tra de w1·th some parts of the world or on some goods. For exa
British East India Company had the exc .mple, the
lusive right to ~rade with all_the
tern ·torie· s eas t of the Cape of Good Hope
.
therefore being able to exploit the lucrati . (today . 1n South Africa),
ve sp~ce and tea ~rades. Beyond
monopoly rights, these companies
also enJoyed quasi-governmental
owers. In some cases, they ruled the
colonies on behalf of the ~onarch.
iursuant to their status as "ruler" of
a colonial possession, their powers
even included the right (and duty) to
maintain an army and wage war, or
at least conduct police operations.
Limited liability, monopoly, and qua
si-governmental powers were
clearly seen as exceptional attributes
and as a result, the granting of
corporate charters was originally very
limited. The British Bubble Act of
1720, for example, explicitly prohib
ited the creation of joint-stock
companies without a royal charter.
In some countries, including the
United States, it was necessary that
the state legislature would pass a
specific statute to creEtte a corporation.
When the industrial revolution star
ted to gain steam, however, it
became clear that limited liability cou
ld be a good, indeed a necessary,
idea to foster economic prospe
rity and facilitate technological
development. Especially in the light
of the great risks associated with
modern industrial activities (consider
for example building and operating
railroads), limited liability was necess
ary in order to attract the resources
needed to finance the industrial rev
olution. At the same time, the ide
that corporat~ charters could be gra a
nted exclusively and with discretion
by the sovereign or by the legislature
, started to come under criticism,
both for its impracticality, and for
its unfairness and allegations of
corruption, nepotism and favoritism . As a result in the nineteenth

century, th e first "general incorporation statutes" ~ere enacted. Under
thes~ st atutes, anybody who met certain pre-determined statutory
r_eq~nre~en~~could establish a corporation and enjoy the benefits of
hmited hab~hty. Among the first U.S. states to adopt this approach were
Pennsylvania (1836) and Connecticut (1837), as well as New York, which
enacted a general incorporation law in 1811, yet largely ignored it for over
20 years .
While the trend toward general incorporation laws spread quickly
almost everywhere, different states followed different approaches. Civil
law countries, for example , especially countries in continental Europe,
allowed general incorporation laws, but were concerned about possible
abuses of the corporate structure, and therefore considered it preferable
to retain some kind of public check of the lawfulness of the incorporation
process. This control was, however, taken away from the executive or
legislative powers, and given to courts, perceived to be more independent
and apt to perform a simple control over the legality of the incorporation,
with no discretion to deny the right to incorporate . In the last few years,
several countries that still required judges to control the legality of the
incorporation process went one step further toward a more liberal
approach, entrusting public notaries with this preliminary control (Italy,
for example, took this step in 2000). In these countries , even if
significantly simplified, the incorporation process is still more strictly
regulated than in common law systems. There are specific and more
extensive rules concerning both the form and the content of the governing
documents of the corporation, either courts or notaries must control the
lawfulness of the charter and bylaws, and the incorporation process can
require several days, if not weeks.
On the other hand, in most common law systems, and certainly in the
U.S ., the incorporation process is extremely streamlined. It is sufficient to
file with the Secretary of State of the chosen jurisdiction a simple form
representing the charter of the corporation, pay a small fee, and often in a
matter of hours the corporation is formally established, with very little ex
ante controls. Actually, to reincorporate in Delaware, very often out-of-
state corporations simply merge with and into empty-shell corporations
kept in existence by lawyers and specialized agents solely fo~ this
purpose.
While some countries, such as Japan, recognize only one governing
document, most countries distinguish the "articles of incorporation," also
referred to as the "articles of association" or "charter," from the ''bylaws."
The "articles of incorporation" is basically the contract expressing the will
of the parties to create a corporation , and it includes some minimum
information such as the name of the first shareholders and directo rs, the
' -
amount of the capital, the agent for service of process, the business
ON PROCESS AND
THE INCORPORA~JMITED LIABILITY
lOS LIMITATIONS ON
C~
th other hand, are generally a CH.3
purpose, and so forth. ~h~ byl: 7sth°: sp:cific rules appli
longer document, contain~n~ 1 cable to the
. · ance rules on sharehold ers' IN
1
corporation. In particu ar_I t inclu des govern
e the procedure to ca11 a meeting, . herein
meetings and board of directors ( .g., . g different class certific a
. .t ) rules concermn es of shares,
quorum, and maJO rIY' c bTty of the d
. . t· t the free trans1era I I share s , an so on.
11m1t a10ns O " t tegic" considerations concerning
I. Before spending a few word s on_ts.ra seful to take a look

the drafti.ng of ch ar t er and bylaw
db s1• i is(selec
u ted provi
simple examples of ?barter an Y aw:he "governing sions
corporation, collectively known as docu
) f
at two very
o a De1aware
ments" of the
corporation.
State of Delaware ARTH
Certificate of Incorporation S,
A Stock Corporation Count
1. The name of the corporation shall be · · · s
place :
· tere d ff" ·n the State of Delaware is located at ...
2. Its regis o ice i . . dA in Direc
- - -the city o ... , coun t y of ... , Zip Code . . . and its Regis
- - · f tere gent at corpc
such address is ...
ART:
3. The purpose or purpo~es of the corporation shall
be ...
4. The total number of shares and par value the :
of stock which the
corporation shall be authorized to issue is : ... witb
5. The powers, preferences and rights an~ mee
the qualifications, witl
limitations or restrictions thereof shall be determmed
by the board of , meE
directors .
6. The name and address of the incorporator is as
follows: ... the
7. The Board of Directors shall have the power to adop hol
t, amend or
repeal by by-laws. at
8. No director shall be personally liable to the Corp tin
oration or its an
stockholders for monetary damages for any breach
of fiduciary duty by m,
such director as a director. Notwithstanding the foreg
oing sentence, a st,
director shall be liable to the extent provided by appli
cable law, (i) for "a
breach of the director's duty of loyalty to the
i Corporation or its
stockholders, (ii) for acts or omissions not in good faith
or which involve pi
intentional misconduct or a knowing violation of law,
(iii) pursuant to h
Section 174 of the Delaware General Corporation
Law or (iv) for any r1
transaction from which the director derived an impro
per personal benefit. s
No amendment to or repeal of this Article Eighth
shall apply to or have t
any effect on the liability or alleged liability of
any director of the s
Corporation for or with respect to any acts or omis
sions of such director
occurring prior to such amendment.
\

IN WITNESS WHEREOF , the undersign .
. . being .
·n be£ ed, the incorporator
h er ei.fi t ore · ·
f. named ' h as executed signed and acknowledged this
cert i ica e o incorporation this ... dayo f ...
BY: (Incorporator)
ByLawsi
of
"Company Name"
A Delaware Corporation
ARTICLE I-Offices
Section 1. The registered office of this corporation shall be in the
County of County, State of Delaware.
Section 2. The corporation may also have offices at such other
places both within and without the State of Delaware as the Board of
Directors may from time to time determine or the business of the
corporation may require.
ARTICLE II-Meetings of Stockholders
Section 1. All annual meetings of the stockholders shall be held at
the registered office of the corporation or at such other place within or
without the State of Delaware as the directors shall determine. Special
meetings of the stockholders may be held at such time and place within or
without the State of Delaware as shall be stated in the notice of the
meeting, or in a duly executed waiver of notice thereof.
Section 2. Annual meetings of the stockholders, commencing with
the year ... , shall be held on the . . . day of . . . each year if not a legal
holiday and, if a legal holiday, then on the next secular day following, or
at such other time as may be set by the Board of Directors from time to
time, at which the stockholders shall elect by vote a Board of Directors
and transact such other business as may properly be brought before the
meeting. Meetings may be held by telephonic conference call provided all
stockholders are present telephonically, or have expressly declined to
"attend."
Section 3. Special meetings of the stockholders, for any purpose or
purposes, unless otherwise prescribed by st~tute or by the Articles of
Incorporation, may be called by the President or the Secretary by
resolution of the Board of Directors or at the request in writing of
stockholders owning a majority in amount of the entire capital stock of
the corporation issued and outstanding and entitled to vote. Such request
shall state the purpose of the proposed meeting.
1 Sample Bylaws available at http://fileonline.biz/UserFiles/docs/bylaws/de/

_!l_!lQO
_____ _!LilM~I1!!'A~T~I~O~N~S~OQ:N~L~I~M~I~1'~E!:!.D~L~I~A~B~I~L:=-:IT~Y~--~~-Cc:_H~-:1
. . f meetings shall be in writing and sign~d by CH.3
Section 4. Notic~s O . or the secretary or an Assistant
the President or a Vice-President r persons as the directors shall standi
Secretary or by s~ch 0 ~~i ~e;so;eo purpose or purposes for which the
designate. Such notices s a . s a e d the place which maybe within or
any s
befori
· ·
meeting is ca11ed a nd the .ttime an ' c;
. t be held A copy ..
of such notice shall be
~ithout t~is State, whe~f \oi~r ~hall be ~ailed, postage prepaid, to each be re
either delivered persona Y t t such meeting not less than ten in w
stockholder of record entitled to vo e ah t' If mailed it shall be desiE
nor more than sixty days before sue mee mg. ' pers1
·
directed to a stockh old er a t hi·s address as it appears upon· thethrecords · of one
· an d
the corporation upon such mailing of any such · notice,
h 11 b ·e service
t writ
thereof shall be complete and the time of the noti~e s ~ egm ? run inst
from t h e da t e up On Whi.ch such notice is deposited . f m theh mail· for
sha·
· ·
transmiss10n o sut ch stockholder · Personal delivery o any sue bnoticef to bee
. .
any officer of a corporation or association, or_ to any mem er o_ a ins 1
partnership shall constitute delivery of such notice to such corporation, the
· t·10n or p artnershi'p . In the event of the dee
associa . transfer of stock
. . after
delivery of such notice of and pr~or to_the holdmg o! the meeting 1t shall of
not be necessary to deliver or mail notice of the meetmg to the transferee. IDE
Section 5. Business transacted at any ' special meeting of

stockholders shall be limited to the purposes stated in the notice.
Section 6. The holders of a majority of the stock, issued and
outstanding and entitled to vote thereat, present in person or represented
by proxy, shall constitute a quorum at all meetings of the stockholders for s1
the transaction of business except as otherwise provided by statute or by s
the Articles of Incorporation. If, however, such quorum shall not be
present or represented at any meeting of the stockholders, the
stockholders entitled to vote thereat, present in person or represented by
proxy, shall have power to adjourn the meeting from time to time,
without notice other than announcement at the meeting, until a quorum
shall be present or represented. At such adjourned meeting at which a
quorum shall be present or represented, any business may be transacted
which might have been transacted at the meeting as originally notified. ·
Section 7. When a quorum is present or represented at any
meeting, the vote of the holders of a majority of the stock having voting
power present in person or represented by proxy shall be sufficient to
elect directors or to decide any question brought before such meeting,
unless the question is one upon which by express provision of the statutes
or of the Articles of Incorporation, a different vote is required in which
case such express provision shall govern and control the decision of such
question.
Section 8. Each stockholder of record of the corporation shall be

entitled at each meeting of stockholders to one vote for each share of stock
THE INCORPORATIONPROCESS AND
CH.3 LIMITATIONSON LIMITED LIABILITY 111
st an cl~ng
any s och
f!s
~~O name on the books of the corporation. Upon the demand of
e~, th e vote for directors and the vote upon any question
before t e meet~ng shall be by ballot.
Section 9 . At any meeting of the stockholders any stockholder may
?e rep~:sented and vote by a proxy or proxies appointed by an instrument
m ~riting. In the event that any such instrument in writing shall
designate two or more persons to act as proxies, a majority of such
persons present at the meeting, or, if only one shall be present, then that
on: shal~ have and may exercise all of the powers conferred by such
~ritten mstrument upon all of the persons so designated unless the
instrument shall otherwise provide. No proxy or power of attorney to vote
shall be used to vote at a meeting of the stockholders unless it shall have
been filed with the secretary of the meeting when required by the
inspectors of election. All questions regarding the qualification of voters,
the validity of proxies and the acceptance or rejection of votes shall be
decided by the inspectors of election who shall be appointed by the Board
of Directors, or if not so appointed, then by the presiding officer of the
meeting.
Section 10. Any action which may be taken by the vote of the
stockholders at a meeting may be taken without a meeting if authorized
by the written consent of stockholders holding at least a majority of the
voting power, unless the provisions of the statutes or of the Articles of
Incorporation require a greater proportion of voting power to authorize
such action in which case such greater proportion of written consents
shall be required.
ARTICLE III-Directors
Section 1. The business of the corporation shall be managed by its
Board of Directors which may exercise all such powers of the corporation
and do all such lawful acts and things as are not by statute or by the
Articles of Incorporation or by these Bylaws directed or required to be
exercised or done by the stockholder~.
Section 2. The number of directors which shall constitute the
whole board shall be three (3). The number of directors may from time to
time be increased or decreased to not less than one nor more than fifteen
by action of the Board of Directors. The directors sha~l be _electe~ at the
annual meeting of the stockholders and except as provided m Section 2 of
this Article, each director elected shall hold office until his successor is
elected and qualified. Directors need not be_stockholders. _
Section 3. Vacancies in the Board of Directors including those
caused by an increase in the number of Directors, may be filled by a
majority of the remaining director~, though less than a quorum, or by ~
sole remaining director, and each director so elected s~all hold _officeuntil
his successor is elected at an annual or a special meetmg of the
_!l_!l!2
_____ _!L~I~M~IT~A~T!:!I~O~N~S~O~N~L~IM~IT~E~D~L~IA~B~I:=L:=..IT::...:Y=------~C~li:_!
CH
The holders of two-thirds of the outstanding shares of stock
stockh olders. ·1 t · te the term Of Offi by
entitled to vote may at any time peremptori Y _ermma ice
of all or any of the directors by vote at a meetmg call~d f?r such purp?se hir
·tt n statement filed with the secretary or, m his absence, with as(
or by a wn e · · d· t 1 re1
any other officer. Such removal shall be effective 1mm~ ia e Y, even if
simultaneously and the vacancies on the Board de
successors are not elected kh at
of Directors resulting therefrom shall be filled only by the stoc old~rs. A
m
vacancy or vacancies in the Board of Directors shall be _deemed to e~1stin dE
f the death resignation or removal of any directors, or 1f the
O tl
casteh . d numbe; of directors be increased, or if the stockholders fail at sl
au onze h" h d"
any annual or special meeting of stockholders at w 1c an?' 1rector or
directors are elected to elect the full authorized number of d1rec_torsto be
I1
voted for at that meeting. The stockholders may elect a director or
directors at any time to fill any vacancy or vacan~ies ~ot filled ?Y the f
directors. If the Board of Directors accepts the resignation of a director
tendered to take effect at a future time, the Board or the stockholders
shall have power to elect a successor to take office when the resignation is
to become effective. No reduction of the authorized number of directors
shall have the effect of removing any director prior to the expiration of his
term of office.
ARTICLE IV-Meetings of the Board of Directors
Section 1. Regular meetings of the Board of Directors shall be held
at any place within or without the State which has been designated from
time to time by resolution of the Board or by written consent of all
members of the Board. In the absence of such designation regular
meetings shall be held at the registered office of the corporation. Special
meetings of the Board may be held either at a place so designated or at
the registered office.
,
Section 2. · The first meeting of each newly elected Board of
Directors shall be held immediately following the adjournment of the
meeting of stockholders and at the place thereof. No notice of such
meeting shall be necessary to the directors in order legally to constitute
the meeting, provided a quorum be present. In the event such meeting is
not so held, the meeting may be held at such time and place as shall be
specified in a notice given as hereinafter provided for special meetings of
. the Board of Directors. · . .
. Section 3. Regular meetings of the Board of Directors may be held
~ithout call or notice at such time and at such place as shall from time to
time be fixed and determined by the Board of Directors.
Sectio~ 4. Special meetings of the board of Directors may be called
b! the Chair1?an or the President or by any Vice-President or by any two
dir~ctors. Written notice of the time and place of special meetings shall be
delivered personally to each direct?r, or sent to each director by mail or
3 THE INCORPORATION PROCESS AND
CH.3 LIMITATIONS ON LIMITED LIABILITY 113
·k
,e °
b?-7th er ~orm of writte~ c?mmunication, charges prepaid, addressed to
e him at. his address as 1t 1s shown upon the records or is not readily
b. ascertamable, at the place in which the meetings of the Directors are
f regul~rly ~eld . In ~ase such notice is mailed or telegraphed, it shall be
l deposited m the _Umted States mail or delivered to the telegraph company
i. at le~st forty-eight (48) hours prior to the time of the holding of the
me~tmg. In case such notice is delivered as above provided, it shall be so
dehvered_at least twenty-four (24) hours prior to the time of the holding of
the meeting. Such mailing, telegraphing or delivery as above provided
shall be due, legal and personal notice to such director.
Section 5. Notice of the time and place of holding an adjourned
meeting need not be given to the absent directors if the time and place be
fixed at the meeting adjourned.
Section 6. The transactions of any meeting of the Board of
Directors, however called and noticed or wherever held, shall be as valid
as though had at a meeting duly held after regular call and notice, if a
quorum be present, and if, either before or after the meeting , each of the
directors not present signs a written waiver of notice, or a consent to
holding such meeting, or an approval of the minutes thereof. All such
waivers, consents or approvals shall be filed with the corporate records or
made a part of the minutes of the meeting.
Section 7. A majority of the authorized number of directors shall
be necessary to constitute a quorum for the transaction of business,
except to adjourn as hereinafter provided. Every act or decision done or
made by a majority of the directors present at a meeting duly held at
which a quorum is present shall be regarded as the act of the Board of
Directors, unless a greater number be required by law, or by the Articles
of Incorporation. Any action of a majority, although not at a regularly
called meeting, and the record thereof, if assented to in writing by all of
the other members of the Board shall be as valid and effective in all
respects as if passed by the Board in regular meeting.
· Section 8. A quorum of the directors may adjourn any directors
meeting to meet again at a stated day and hour; provided, however, that
in the absence of a quorum, a majority of the directors present at any
directors meeting, either regular or special, may adjourn from time to
time until the time fixed for the next regular meeting of the Board .
[.. .]
ARTICLE IX-Certificates of Stock
Section 1. Every stockholder shall be entitled to have a certificate
signed by the President or a Vice-President an~ the Treasurer or an
Assistant Treasurer, or the Secretary or an Assistant Secretary of the
corporation, certifying the number of shares owned by him in the
,,,,

_!l!l_i4
_____ _!Li!IMM~IT~A~T~I~O~N~S~O~N~L~IM~I~T:..!:E:'.!:D:..
~I_L_ITY
______ C~~
..:L::.1:.:.A:.:.B
(
. If the corporation shall be authorized to issue more than one
corpora t ion. · f lass the design f
class of stock or more than one series o. any c h' . 1 . ah1ons,
~ d 1 t've participating optional or ot er specia ng ts of
pre1ere~ces anl re a l f 'stock or seri~s thereof and the qualifications
the various c asses o £ th · f '
. . . or res t r1c
· t·ions of such rights ' shall be set
limitations . · h orh m ull . or
summarize · d on the i,~ace or back of the certificate wh1c t e corporation
shall issue to represent such stock.
. 2
Sect ion If a certificate is signed (a) by a transfer agent other
. . or ·ts employees or (b) by a reg1s . t rar oth er th ant he
t h an t h e corpora t ion 1 ffi
corporation or its employees, the signatures of the o 1cer~ of the
corporation may be facsimiles. In case any officer w?o has signed or
whose facsimile signature has been placed upon a certifica_te shall cease
to be such officer before such certificate is issued, such certificate may be
issued with the same effect as though the perso1; ~ad not ceased to be
such officer. The seal of the corporation, or a facs1m1le thereof, may, but
need not be, affixed to certificates of stock.
Section 3. The Board of Directors may direct a new certificate or
certificates to be issued in place of any certificate or certificates
theretofore issued by the corporation alleged to have been lost or
destroyed upon the making of an affidavit of that fact by the person
claiming the certificate of stock to be lost or destroyed. When authorizing
such issue of a new certificate or certificates , the Bo.ard of Directors may,
in its discretion and as a condition precedent to the issuance thereof ,
require the owner of such lost or destroyed certificate or certificates, or
his legal representative, to advertise the same in such manner as it shall
require and/or give the corporation a bond in such sum as it may direct as
indemnity against any claim that may be made against the corporation
with respect to the certificate alleged to have been lost or destroyed.
Section 4. Upon surrender to the corporation or the transfer agent
of the corporation of a certificate for share duly endorsed or accompanied
by proper evidence of succession, assignment or authority to transfer, it
shall be the duty of the corporation, if it is satisfied that all provisions of
the laws and regulations applicable to the corporation regarding transfer
and ownership of shares have been complied with, to issue a new
certificate to the person entitled thereto, cancel the old certificate and
record the transaction upon its books.
Section 5. The Board of Directors may fix in advance a date not
exceedin~ sixty (60) days nor less than ten (10) days preceding the date of
any meetmg of stockholders, or the date for the payment of any dividend,
or the date for the allotment of rights, or the date when any change or
conversion or exchange of capital stock shall go into effect or a date in
connection with obtaining the consent of stockholders for a~y purpose, as
a record date for the determination of the stockholders entitled to notice
THEINCORP
PROCESS AND
CH.3 L IMITATIONSORATION
ON L
IMITED LIABILITY 115
of and to vote at any such m t" .
entitled to receive payme t f ee mg, and any adJournment thereof, or
n
and in such case, such stockh ° any such diV1 · sueh consen t ,
· ·den d, or t o give
be stockholders of reco d holders, and only such stockholders as shall
and to vote at such r:ee~i: t e date so ~xed, shall be entitled to notic~ of
ayment of such dividend g, or any ~dJournment thereof, o~ to receive
p · h . h ' or to receive such allotment of rights or to
exercise sue rig ts or to g· h '
notwithstanding an tra ive sue consent, as the case may ~e,
Y nsfer of any stock on the books of the corporation
a fter any sue h record date fixed as aforesaid .
. Section 6 -. The corporation shall be entitled to recognize the person
regi st ered on its_book~ as the owner of shares to be the exclusive owner
for all purposes mcludu~g voting and dividends, and the corporation shall
not be bound to recognize any equitable or other claim to or interest in
such share or shares on the part of any other person, whether or not it
shall have express or other notice thereof, except as otherwise provided by
the laws of Delaware.
ARTICLE X-General Provisions
Section 1. Dividends upon the capital stock of the corporation,
subject to the provisions of the Articles of Incorporation, if any, may be
declared by the Board of Directors at any regular or special meeting,
pursuant to law. Dividends may be paid in cash, in property or in shares
of the capital stock, subject to the provisions of the Articles of
Incorporation.
Section 2. Before payment of any dividend, there may be set aside
out of any funds of the corporation available for dividends such sum or
sums as the directors from time to time, in their absolute discretion,
think proper as a reserve or reserves to meet contingencies, or for
equalizing dividends or for repairing or maintaining any property of the
corporation or for such other purpose as the directors shall think
conducive to the interest of the corporation, and the directors may modify
or abolish any such reserve in the manner in which it was created.
Section 3. · All checks or demands for money and notes of the
· corporation shall be signed by such officer or officers or such other person
or persons as the Board of Directors may from time to time designate.
Section 4. The fiscal year of the corporation shall be fixed by
resolution of the Board of Directors.
Section 5. The corporation may or may not have a corporate seal,
as may from time to time be determined_ by resolutio~ of ~he Board of
Directors If a corporate seal is adopted, 1t shall have mscnbed thereon
the n · f the corporation and the words "Corporate Seal" and
ame o . · f · ·1
"Delaware." The seal may be used by causmg 1t or a acs1m1 e thereof to
be impressed or affixed or in any manner reproduced.
_!l!1~6
_____ __!L~I~M
·'l'~A~T~IO
~l~ ~N~S~O~N~L~I::::.M~I~T=E:::: C.::.:~ _T_Y
_____D-=L:=.:I'-A_B_IL_I
[... ] ~
ARTICLE XII-Amendments and
pre1
Section 1. The Bylaws may be amended by a majority vote of all
onl:
the stock issued and outstanding and entitled t_ovot~ at a1:y annual or sys
special meeting of the stockholders, provided notic~ of mtention to amend Co:
shall have been contained in the notice of the meetmg. del
Section 2. The Board of Directors by a majority _vote ~f the whole an
Board at any meeting may amend these bylaws, mclud1_ng Byl~ws pr
adopted by the stockholders, but the stockhol~ers may from time to time SE
specify particular provisions of the Bylaws which shall not be amended by
the Board of Directors. cc
t<
APPROVED AND ADOPTED this ... day of ... ,
n
0
C
Secretary
l
***
A well-drafted corporate charter and bylaws, as any contract, can be
a work of art. A bad one can be a receipt for disaster. A complex mix of
different skills is necessary in drafting the governing documents of a
corporation: negotiation skills, the ability to fully understand the intent of
the parties, the ability to foresee problems or specific needs that might
arise in the future, etc. There are some very important strategic
considerations that you need to make when drafting charters and bylaws.
The first one concerns which provisions should be included in the articles
of incorporation and which provisions should be included in the bylaws,
when there is a choice between the two. In some legal systems, for
example, there might be provisions that can only be included in one of
these documents in order to produce specific legal effects. An example is
the provision limiting the liability of directors included in article 8 of the
sample charter above that, pursuant to section 102(b)(7) of the Delaware
General Corporation Law, must be included in the articles of
4 incorporation.
, '
·-.
!,
I; You should also keep in mind the rules concerning future
amendments to the governing documents. Who has the authority to make
'r. the amendments and what procedural rules shall be followed? This can
' f,
'!J obviously be extremely important for your client, because she might want
, 1,
I to be sure that a certain provision will not be changed or erased without
her consent. For example, in most U.S. state jurisdictions, shareholders
must approve amendments to the charter, but the directors must initiate
I the amendment and require the vote of the shareholders. This implies
i that it might be difficult to quickly obtain an amendment of the charter if

the directors oppose it. On the other hand, generally both the directors
'
f
•
j,
-
·. 3
CH.3
LIMITATIONS ON LIMITED LIABILITY 117
and ~he sh~reholders have a concurrent power to amend the bylaws . More
preci~ely, m s?me sta~es, such as Delaware, directors have this power
only if t~e art_icles_of mcorporation specifically grants it to them (opt-in
systems),_ while i~ other states that follow the Model Business
Corporat10n Act, directors have the power to amend the bylaws as a
default rule, unless the charter provides otherwise (opt-out systems) . In
e any ?~se, also ~ased on the bylaws, shareholders can sometimes indicate
s
prov:i,sionsof this documents that directors cannot amend (see Article XII,
Sect10n 2, of the sample bylaws above).
e
r In_ other countries, especially continental European civil law
countries and Japan, shareholders have a more central role with respect
to amendments of the charter and bylaws. A vote at the shareholders'
meeting is (almost) always necessary to approve such amendments, and
often shareholders, at least if they own a minimum threshold of shares,
can unilaterally call a shareholders' meeting to propose an amendment.
Keeping in mind what we discussed at the end of Chapter 1 concerning
ownership structures, this central role of shareholders is also a reflection
of concentrated ownership.
You should also pay attention to the procedural rules applicable to
amendments to the articles or bylaws. For example , if you are assisting a
minority shareholder who owns 20% of the voting shares of a closely-held
corporation, and there is one provision in the bylaws that is particularly
important for him (for example, a right of first offer in case other
shareholders intend to sell their shares), you might negotiate that this
provision can only be amended with a supermajority (for example, 85%),
in order to give your client a veto power over the amendment of the
clause. An interesting application of this strategy will be discussed in
Chapter 8 with respect to limitations to the transferability of shares.
A third element to consider is whether both the charter and the
bylaws are public documents, accessible to everybody, and also if a
provision included in the governing documents is enforceable toward
shareholders that have not voted in favor of it, future shareholders, or
third parties more generally. This depends of course on the_jurisdiction.
In the U.S., for example, the bylaws are not necessarily a public
document, · especially in closely held corporation~. Bylaws' prov~s~ons
might not be binding for a third party, and sometimes ~hese provi~ions
are only binding for shareholders that ap~roved the_m_.This also applies to
charters in Japan. On the other hand, m other civil law countries, the
governing documents are generally publicly available and, for this reason,
enforceable against third parties.
offer included in the. bylaws
Consi·d er, £or example , a right of first
. h . h
providing that shareholders, before sellmg t e1r s _ar~s to a third party,
must offer them at the same conditions to other existmg shareholders. If
.!:.1.!:.1~8
_____ _2:L~I.:!:M~IT~A~T~I~O~N~S~O~N~L::!:I~M~
_____ ....::C~~
l:...:::T..:::E=D:.... :L:=I:::.A::::B'--I_L_IT_Y
a shareholder violates this provision and sells the shares t~ a third Party
breaching the pre-emptive right of his fellow shareholders m the U.S., he inc
might be liable toward the other existing shareholder~, but the buyer of joi
the shares, especially if he ignored in good faith the existence of th: right
of first offer, will surely become a shareh~lder_ and ~e able to exercise his
co
rights as such. In some civil law countr_i~s, i~ ":'hich the. bylaws are a
m
public document, the fact that the provis10n is mclude~ m the bylaws
w
creates a sort of unrebuttable presumption that the third-party buyer a:
knew (or could have known) about the limitation. to the free r•
transferability of the shares. As a consequence, the third party that li
bought the shares can be pre~ented ~rom exercising shareho~d~rs' rights C
(he might have a cause of act10n agamst the seller, but thats irrelevant C
for his position vis-a-vis the corporation). 1
MINIMUM LEGAL CAPITAL

As mentioned above, one important comparative distinction must be
drawn between countries that require a minimum legal capital for the
incorporation and operation of a corporation, and countries that have
abolished this requirement. In Europe, the Second Directive (now
directive 2012/30/EU), requires a public corporation to have a minimum
legal capital of 25,000 euro (roughly $25,000 in March 2015). This
provision applies to joint-stock corporations, for example, "public company
limited by shares" in the U .K. and Ireland; "societe anonyme" in France,
Belgium, and Luxembourg; "Aktiengesellschaft" in Germany; "sociedad
an6nima" in Spain; "societa per azioni" in Italy, etc. This provision,
however, does not apply to other limited liability companies roughly
equivalent to an LLC in the U.S., such as a "Gesellschaft mit
beschrankter Haftung'' or "GmbH" in Germany; or a "societa a
responsabilita limitata" or "s.r.l." in Italy. In many E.U. Member States,
the minimum capital is even higher than the 25,000 euro threshold set by
the directive. In Italy the minimum capital requirement is 50,000 euro
(120,000 until 2014). It should be pointed out that systems based on
minimum legal capital also provide for quite detailed rules concerning
eligible contributions (often services are not admissible), as well as a
quite rigid system for the evaluation of contributions in kind, payment of
contributions, and rules concerning capital maintenance (with respect to
distributions to shareholders, and capital loss).
The basic idea behind such a requirement is that a minimum legal
capital must be maintained throughout the life of the corporation to
protect creditors. In theory, a minimum capital requirement should i
ensure that the value of the assets exceeds the liabilities at least by the
amount of the - minimum capital. As a consequence, at least in theory, if
all assets are sold, their value should exceed the value of the liabilities,
and creditors could be satisfied. Additionally, the minimum capital also
rty THE INCORPORATION PROCESS AND
he
of ~n.dicates a certain "seriousness" and "commitment" of shareholders to the
ht Jomt enterprise.
tis
Many le?a! systems, however, have completely abandoned the
a co:n,~ept of m1mmum legal capital. In the U.S. there is generally no
\TS m~mmum capital required, and it is possible to incorporate a corporation
9r with a v~ry low, purely nominal, capital. In 2005, Japan followed the U.S.
~e and abolished the minimum legal capital requirement, which before the
lt r_ef~rm ~as_ ~0 million JPY for stock corporation and 3 million JPY for
hm~ted hab1hty corporation, while preserving other rules related to legal
Lt cap1t~l s1:1chas limitation on eligible contributions, rigid evaluation of
contr1but10ns in kind, and restrictions of distributions to shareholders
based on the amount of legal capital. ·"
Several scholars argue that minimum legal capit~l should be
abolished in other jurisdictions. These scholars often observe that
minimum legal capital does not protect either creditors or shareholders,
and it is simply a relic of the past that causes inefficiency by setting forth
complex, yet ineffective rules and increases the costs of incorporation
without any real benefit. In a nutshell, one key argument is that
minimum legal capital does not really protect creditors because the actual
value of the assets of the corporation can easily decrease also in systems
with minimum legal capital, or because unexpected liabilities (such as for
a mass tort) can burn all the assets . Consider the following example: a
corporation is incorporated in Spain with a capital of 200,000 euro,
entirely paid in cash by the shareholders. A few days after the
incorporation, the directors use the 200,000 euro in cash to purchase an
asset that they believe worth roughly 200,000 euro, but that in fact is a
bad investment. The actual value of the asset is 50,000 euro. In the
financial statements, the asset should be valued at 50,000 euro, but also
assuming that the directors are capable and willing to recognize the lower
value of the assets, financial statements might not be prepared and
,published for several months. Creditors, therefore, might contract with
the corporation mistakenly believing that its net worth is at least 200,000
euro, when in fact it is only 50,000.
Critics of minimum legal capital also point out that it does not in any
way ensure an adequate capitalization of the corporation because , in fact,
25 000 euro or even a higher statutory threshold might be completely
in~dequate also based on th~ type of ?usiness (consider a corporation ~~at
builds and sells airplanes with a capital of 25,000 euro) . Moreover, critics
point out that minimum legal capital. imposes higher costs. on
co orations and barriers to new and competmg entrepreneurs that might
rpt to enter the market (this last critique, however, could be partially
wan
inconsistent ·
with the observation t h at t h e mimmum
· · 1ega 1 capita
· 1
required is often "trivial").
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While these criticisms are not unfounded, the
case can be made that
minimum legal capital is not completely ~sel
ess, at least if all the
applicable rules are followed. For example_, i~
mo~
minimum legal capital, a "recapitalize or liquidate ; systems _that follow
rule applies (see, for
example, Article 2447 of the Italian C~vi_lCode.
In cont~ast, Japanes~ law
did not have such a rule even when mmimum
legal capital was required).
Simplifying the issue, pursuant to these p:ov
ision~, director~ must
monitor the financial situation of the corporat
ion and if at any time the
capital is reduced below the minimum statutory
threshold, they must
immediately call a shareholders'. me_eting in
o~der _to eith~r :eca?italize
the corporation with new contributi?ns, or
wmd it UJ? hqu~datmg the
assets and paying the creditors. Failure to
comply with this rule can
result in civil and criminal liability for the
directors. In the previous
example of the corporation created with a
capital of 200,000 euro,
therefore, as soon as the directors realize that
the real value of the assets
is 50,000 euro, they should activate the
"recapitalize or liquidate"
procedure.
Of course, critics of minimum legal capital obje
ct that these rules are
of little, if any, consequence for creditors. Ima
gine for instance a bank
that has loaned 100,000 euro to the corporat
ion, relying on a purported
capital of 200,000 euro. If the corporation is
liquidated, and the proceeds
from the sale of the (only) asset are just 50,0
00 euro, the bank, as a
creditor, will not be satisfied. It should not be
forgotten, however, that the
recapitalize or liquidate rule might play a role
as an "early red flag'' that
things are going south, and might be helpful,
at least, in reducing the
amount of potential damage to creditors, as
well as put shareholders on
notice that the corporation is losing money.
Some authors (for example,
the Italian scholar Francesco Denozza) have
also argued that mandatory
rules concerning the protection of creditors
are desirable in terms of
fairness, because they reduce the different
treatment of sophisticated
creditors that can fend for themselves,
such as banks, and weaker
creditors such as employees, or the victims
of a tort that had no chance of
negotiating with the corporation any spec
ific guarantee before the
accident.
The debate goes on. The following excerpt offers a basis for the
discussion.
;. · ..
. .
,.
•c ·,
LUCA ENRIQUES AND JONATHAN R. MACEY, CREDITORS

VERSUS CAPITAL FORMATION: THE CASE AGAINST THE
EUROPEAN LEGAL CAPITAL RULES
86 Cornell L. Rev. 1165 (2001) 2
[... ]
The Second Directive's minimum initial capital requirement provides
no meaningful protection for creditors. The amount required, euro 25,000,
is trivial. It is also meaningless because it is unrelated to the debt that a
company may incur and to the sorts of business activities that a company
may pursue. Clearly, it makes no sense for a highly leveraged company
that transports radioactive waste to have the same minimum capital
requirement as a company with little leverage that designs software.
The legal capital doctrine assumes, falsely, that the fixed amount of a
firm's legal capital informs current and potential creditors of the
resources that a firm possesses and may not freely distribute to its
shareholders. In the real world, however, creditors (and potential
creditors) care neither about these resources nor about the legal capital
rules that are supposed to signal these resources.
The primary reason that creditors do not give significant weight to
legal capital is that as soon as a firm starts to operate, it can use its
capital to purchase assets that decline in value. Because a firm may
immediately begin to incur losses, either merely in the normal course of
business or by entering into one of the many kinds of unfair transactions
that Article 11 of the Second Directive does not cover, the initial paid-in
capital is a meaningless amount. In other words, creditors willing to
inform themselves about a firm's existing equity cushion must examine
its entire balance sheet. Moreover, creditors must consider the current
value of the firm's assets, not the value of such assets at the time of
purchase. The legal capital entry on the right-hand side of a corporation's
balance sheet thus provides no useful information to creditors. Even if it
did, creditors could just choose to deny credit to firms without satisfactory
amounts of paid-in capital. ·
Even assuming that creditors care about how much equity
shareholders really injected into a venture at its outset, requiring an
expert report on contributions in kind is of little benefit to them. First,
evaluation techniques leave experts with a very wide range of discretion.
This is true even when the expert must explicitly state "the methods of
valuation used," as the Second Directive requires. Second, experts can
never really be "independent." Even when a third party (like a judge)
chooses the expert, that expert will be a professional offering her
accounting and valuation services on the market. Normally, she will
122
.
LIMITATIONS ON LIMITED LIABILITY
her normal services than from her Article 9

-
CH. 3
derive more p~o~its fromh she must constant

valuation activities. Furtl erm~res, Hence she will ly attract and retain
. £ not risk losing her
clients or th ese norm a service . '
. r t by acting too independently in .
current or prospe~1ive; ien :ecause of motivating prof the valuation
essional interests,
of non-cas~ consdietra ionr.ove any contribution in
experts will ten °app d
kind that is not so
·
d
outrageously overva1ue that a non-expert coul surmise t h at the
company had watered its stock.
[... ]
The "recapi·talize or liquidate" rules of individual European Union
Member States are undeniably much more eff ectiv · t ·
e a protectin g
d ·t than the other legal capital rules, at least so long as
ere i ors such rules
are easily enforceable. However, because these rues 1 pena 1·1ze ns· k -t aki~g,
they are highly inefficient and severely retard the
growth of equity
markets.
First of all, from a more formalistic point of view
, _such rules are
inconsistent with the very concept of limited liability
. In a hypothetical
world in which every single company abided by thes
e rules, no company
would ever become insolvent because every com
pany would either
liquidate or reorganize before that. This, in turn, wou
ld mean that there
would be no operational role for limited liability.
Second, rules requiring a company to liquidate or reca
pitalize when
the value of the company's net assets falls belo
w some preordained
minimum level create the potential for opportu
nistic shareholder
behavior. Shareholders can, in fact, take advantage
of such provisions in
disputes with other shareholders.
Third, majority shareholders may use such rules in
order to get rid of
financially constrained minority shareholders. If the
company's capital
falls to zero, a shareholder who is unable or unwillin
g to contribute more
money to the venture will lose her shareholder statu
s.
Another reason why these rules are inappropriate is
because they are
based on unreliable balance-sheet data. The rele
vant legal inquiry is
whether the value of a firm's net assets as shown on
its balance sheet has
fallen below the requisite statutory minimum. A
company with a real
economic value significantly higher than the min
imum legal capital
amount will nonetheless have to undergo the radi
cal restructuring that
these rules require because its balance sheet does
not reflect the true
ec.onmi:iic value of its assets. In order to avoid liquidation, such
a company
will either have to transform itself into a priv
ate limited-liability
~ompany (thereby losing the opportunity to access
issue more equity. outside financing) or
If the ~ompany ~n question really does face financial risks, then the
cost of equity ~nancmg will be very high. Controlling shareholders may
not have sufficient funds to contribute and will face a Robson's choice of
either liquidating the company or diluting their control positions by
finding other investors willing to subscribe to the new issue. Ex ante, the
prospect of having to choose between contributing more funds to a
company in distress and diluting one's own control will be a disincentive
for people to found new companies.
Finally (needless to say), if liquidation is the only result of this rule,
then creditors as well as shareholders will suffer. After all, the assets of
the company will, ipso facto, devalue in liquidation.
[... ] One interest group that benefits from the legal capital regime is
· incumbent management. In Europe, incumbent managers tend also to be
either aligned with controlling shareholders, or as is more usually the
case in continental Europe, major blockholders themselves. Management
benefits from a system that limits dividend payments and share
repurchases; these limitations give management more freedom to reinvest
the company's profits, even when there are no available positive-net-
present-value investment projects. Management will make such
inefficient investments as long as the opportunity cost of capital is offset
by the higher private benefits derived from controlling a larger company.
The higher the legal limitations on distributions, the more opportunity
this interest group has to make inefficient investments.
Two other interest groups that clearly benefit from the Second
Directive's status quo are accountants (who provide the required
valuation services) and lawyers (who must guide managers through the
labyrinth of needlessly complicated legal capital rules). Lawyers, who
play a critical role in influencing the shape of the European company law
directives, and benefit from them professionally, defend European legal
capital rules. They do so both because it is in their self-interest and
because they often lack sophistication in finance and economics and may
honestly but erroneously believe that the legal capital rules are an
efficient tool for creditor protection. Furthermore, most European
corporate lawyers have invested significant human capital in becoming
familiar with the legal capital rules. Repealing these rules would destroy
the value of that human capital.·
Additionally, incumbents in the various product markets, and
especially those in the most mature markets, benefit from the Second
Directive's legal capital rules. This is because these rules make it more
difficult for new competitors to enter the market. As legal capital rules
create obstacles to capital formation, they are especially costly for start-
up companies.
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.!124
. ca ital rules benefit banks. Banks take a_dvantage of · CH
Fmally, lega 1 1 p ·t 1 rules reduce the risk that their corporate
the fact tha_~/e~aba~~~:t. More importantly, ho~ ever, ban~s have an St i
borrower~ WI g . like the legal capital doctrme, which SO!
. terest m preserving ru 1e 8 '
:gatively affect equity markets and thereby protect ban k mar k et power be
m:
in the European financial markets.
NOTES AND QUESTIONS

1. Do you find the arguments of Professors Enriques and Macey
V,
convincing? C
2. What do you think about the argument that the evaluation of C
ributions in kind will always be flawed because no expert can really be
cont
"independ ent "? Is this a sufficient reason to abo 1·1sh mm1mum
· · 1e?a 1 cap1·t a1, or
is it more a problem of how to ensure, protect, and enforce the mdependence
of the experts?
3. The authors opine that the recapitalize or liquidate rule is not only
useless, but also dangerous, among other reasons , because it might give
majority shareholders the occasion to liquidate the corporation and get rid of
minority shareholders that do not have financial resources to subscribe new
shares. Is this critique convincing? Can 't a controlling shareholder , in the
absence of minimum legal capital rules, decide in any case--or make
directors decide-to liquidate the corporation and reincorporate without
minority shareholders? Isn't it possible for a controlling shareholder, at least
in some jurisdictions, to freeze out minorities through a cash-out merger?
4. Adopting a somewhat cynical perspective, Enriques and Macey
observe that minimum capital rules are adyantageous for specific interest
groups, such as managers (and controlling shareholders), lawyers and
accountants, and banks. Do you share this view? With resp ect to managers,
for example, the argument is that these rules help them to avoid
distributions to shareholders and promote reinvestment in the corporation . Is
this consistent with the argument that these rules are ineffective? Are there
other and more important legal strategies that should take care of conflicts of
intere st of the managers?
5. Minimum legal capital might represent a barrier to new start -ups .
In fact, as was discussed in Chapter 2, since the 1990s, several closely held
corporations located in countries with rigid minimum legal capital rules (for
example, Germany) decided to incorporate in the U.K. also because of more
~e~ible capital requirements. This trend was clearly a consequence of the
Jur1sp:udence of the European Court of Justice concerning freedom of
es~abhshment that we considered in the previous chapter. It is interesting to
porn~ out that one effect of European regulatory competition is that several
contmental _countries, including Germany, France, Spain, and Italy, have
recen_tly reVIsed the rules on minimum legal capital applicable to an LLC (as
mentrnned above, not covered by the Second Directive). In these Member
\

! of CH.3 LIMITATIONS ON LIMITED LIABILITY 125
ate
an States, it is i:-ow possible to create an LLC with a very limited capital. And in
.ch some countries also ~ules governing the capital of other corporations have
'er become less demandmg. Do you think this trend confirms the inutility of
minimum legal capital?
PIERCING THE CORPORATE VEIL

As we pointed out in the Introduction of this chapter, in systems
where it is "easier" to incorporate and where there is no minimum legal
capital requi_red, courts developed the equitable doctrine of piercing the
corporate veil. According to this doctrine under certain circumstances,
,e shareholders can be held liable for the debts of the corporation when
-r there is some kind of "abuse" of the corporate structure. On the other
e hand, in systems characterized by more extensive controls at the
incorpo~ation stage, and minimum legal capital, piercing is generally
, more difficult, and often possible only under narrowly defined statutory
circumstances.
According to a famous remark by Benjamin Cardozo, piercing the veil
is a doctrine "enveloped in the mist of metaphor" (Berkey v. Third Ave. Ry.
Co., 155 N.E. 58, 61 (N.Y. 1926)). As with many equitable doctrines
developed through case law, the precise elements that allow a court to go
beyond the corporate veil are confusing, and often misinterpreted or
misapplied. Basically, courts, especially in the U.S., try to ascertain if two
elements are met in order to justify piercing. The two elements are: (1) if
there is such a unity of interest and ownership between the corporation
and the individual shareholders that they no longer exist as separate
entities; and (2) if the acts are treated as those of the corporation alone,
equity would not be satisfied (see, e.g., Laya v. Erin Homes, Inc., 177
W.Va. 343 (1986)). Some courts have also considered a third element: the
veil should not be pierced if the creditor in contract could have conducted
an investigation on the financial soundness of the corporation. If such an
investigation was possible, the assumption could be that the creditor
accepted the risk of undercapitalization of the corporation.
To make these elements somehow more concrete, case law indicates
the following typical indicia for piercing: (a) commingling of funds
between the corporation and the shareholders; (b) lack of corporate
formalities; (c) gross undercapitalization of the corporation; (d) fraud.
Often one single element is insufficient to pierce, especially when it comes
to undercapitalization. More c_ommonly, courts ten~ to _lookat the tot~lity
of the circumstances, somethmg that also makes it difficult to precisely
define the scope of the doctrine.
One particular version of the veil piercing doctrine in the U.S. is the
so-called enterprise liability approach, or alte: eg? app:oach, acc_ording to
which the veil can be pierced when a corporat10n is entirely dominated by
_!1~2§_6
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· · f th d ctrine could sometimes (but not C

one shareholder. This versi~n
1 )b ·d d
°
particular
e of
case o commi
·ngling of funds or lack f
o
a ways e consi ere a . · ht also be specific statutor
corporate for1:1ali~ies.Occasionally the~ :uiiederal statutes, such as th~
grounds for piercmg, for example base · d L" b . .
Compreh ens1ve · Environmen
· tal Response , Compensation, an ia 1hty
Act of 1980 (CERCLA).
. · 1s
Piercmg · genera 11 Y used when the debtor corporation) d is insolven
k t, (
and therefore creditors try to reach the ~opefull y eeper ~oc ets of
sh are h oIders. It 1s · teresti·ng , however ' to pomt out that · sometimes
· 1n 11 · h there
are a Iso st r ategi·c procedural reasons to pierce . ·, ·especia Y f m t e dU.S. b
Consider, for example, the case of a West V1r~ma corpora 1~n sue y
West Virginia creditors for an alleged tort (this kexaFml pld~
' rethers to t~e
tragic but interesting case of the "Buffalo ~ree oo ; e 1awsu1t
following the disaster is powerfully recounted m a great book by Gerald
M. Stern one of the attorneys for the plaintiffs, a must-read fo: lawyers).
In this 'situation, only a West Virginia State Court _m1?ht have
jurisdiction over the dispute . Imagine, however, that the plaintiffs would
prefer to sue in Federal Court, for examp_le because they are c~ncerned
that the local judiciary could be biased 1n favor of a corporation that
invests heavily in the state , or because they might want to take
advantage of federal rules of civil procedure. If the defendant corporation
is the subsidiary of a New York corporation, and the plaintiffs can argue
that the veil should be pierced and the holding corporation should be held
liable, they might be able to assert federal diversity jurisdiction . More
generally, piercing when the shareholders and the corporation are from
different states or nations might affect jurisdiction and allow plaintiffs to
litigate in a forum perceived as preferable for a number of easy-to-
imagine tactical reasons.
It should be mentioned, finally, that the liability of a controlling
shareholder could also be based on other legal theories. One good example
is to argue that the controlling shareholder was the principal and the
controlled corporation the agent, and therefore, according to agency law ,
the principal might be liable for the acts of the agent. It might however be
impossible, or more difficult, to establish an agency relationship and to
assert the basis for liability.
. Piercing in the U.S., as we will see shortly, i~ far from uncom~on.

The two following cases, however, were decided in favor of the defendant
(the corporate veil was not pierced). They are very instructive of the U.S.
a~pr~ach, and can be considered leading cases often used to illustrate veil
piercmg.
--..:::: a
Ca.
,t not CH. 3 LIMITATIONS ON LIMITED LIABILITY 127
tck of
1tory BAATZ V. ARROW BAR
Supreme Court of South Dakota
3 the 452 N.W .2d 138 (19 89)
>ility
SABERS, JUSTICE.
·ent, Kenny and Peggy Baatz (Baatz) appeal from summary judgment
dismissing Edmond, LaVella, and jacquette Neuroth, as individual
s of defendants in this action.
1ere
J.S. Facts
by Kenny and Peggy were seriously injured in 1982 when Roland
the McBride crossed the center line of a Sioux Falls street with his
uit automobile and struck them while they were riding on a motorcycle.
dd McBride was uninsured at the time of the accident and apparently is
·s). judgment proof.
ve Baatz alleges that Arrow Bar served alcoholic beverages to McBride
:ld prior to the accident while he was already intoxicated . Baatz commenced
~d this action in 1984, claiming that Arrow Bar's negligence in serving
:1t alcoholic beverages to McBride contributed to the injuries they sustained
~e in the accident. Baatz supports his claim against Arrow Bar with the
n affidavit of Jimmy Larson. Larson says he knew McBride and observed
e him being served alcoholic beverages in the Arrow Bar during the
d afternoon prior to the accident, while McBride was intoxicated.
Edmond and LaVella Neuroth formed the Arrow Bar, Inc. in May
1 1980. During the next two years they contributed $50,000 to the
corporation pursuant to a stock subscription agreement. The corporation
purchased the Arrow Bar business in June 1980 for $155,000 with a
$5,000 down payment. Edmond and La Vella executed a promissory note
personally guaranteeing payment of the $150,000 balance. In 1983 the
corporation obtained bank financing in the amount of $145,000 to pay off
the purchase agreement. Edmond and La Vella again personally
guaranteed payment of the corporate debt. Edmond is the president of the
corporation, and Jacquette Neuroth serves as the manager of the
business. [.. .] [T]he corporation did not maintain dram shop liability
insurance at the time of the injuries to Kenny and Peggy.
In 1987 the trial court entered summary judgment in favor of Arrow
Bar and the individual defendants. Baatz appealed that judgment and we
reversed and remanded to the trial court for trial. Baatz, supra. Shortly
before the trial date, Edmond, LaVella, and Jacquette moved for and
obtained summary judgment dismissing them as individual defendants.
Baatz appeals. We affirm.
. .•r
I
_!1!2§.8
_____
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CH.3
Individual liability by piercing the corporate veil.
Baatz claims that even if Arrow B~r, Inc. is the licensee, the capital
l corporate ve1·1 sh ould be pierced ' leavmg. theA Neuroths,. · as the
corporf
shareholders of the corporation, individually ha?le. ~o~poration shall be not ex
considered a separate legal entity until there 18 s7:fficient reason to the reason
persor
contrary. When continued recognition ~fa c~rporat10n as a separ~te legal $150,(
entity would "produce injustices and meqmtable conseq_uences, then a no e,
court has sufficient reason to pierce the corporate veil. Factors that inade
indicate injustices and inequitable consequences and allow a court to to
pierce the corporate veil are: unde
1) fraudulent representation by corporation directors; corp<
dete1
2) undercapitalization; simi:
3) failure to observe corporate formalities; so.\
pree
4) absence of corporate records;
5) payment by the corporation of individual obligations; or forr
6) use of the corporation to promote fraud, injustice, or illegalities. tha
req
When the court deems it appropriate to pierce the corporate veil, the cor
corporation and its stockholders will be treated identically. sp1
Baatz advances several arguments to support his claim that the st~
corporate veil of Arrow Bar, Inc. should be pierced, but fails to support ab
them with facts, or misconstrues the facts. UI
cc
First, Baatz claims that since Edmond and La Vella personally E
guaranteed corporate obligations, they should also be personally liable to s1
Baatz. However, the personal guarantee of a loan is a contractual a
agreement and cannot be enlarged to impose tort liability. Moreover, the r
personal guarantee creates individual liability for a corporate obligation,
the opposite of factor 5), above. As such, it supports, rather than detracts
from, recognition of the corporate entity.
Baatz also argues that the corporation is simply the alter ego of the
Neuroths, and, [that accordingly] the corporate veil should be pierced.
Baatz' discussion of the law is adequate, but he fails to present evidence
that would support a decision in his favor in accordance with that law.
When an individual treats a corporation "as an instrumentality through
which he [is] conducting his personal business," a court may disregard the
corporate entity. Baatz fails to demonstrate how the Neuroths were
transacting personal business through the corporation. In fact, the
evidence indicates the Neuroths treated the corporation separately from
their individual affairs.
Baatz next argues that the corporation is undercapitalized.
Shareholders must equip a corporation with a reasonable amount of
'l' HE I NCORPORATION PRO CFSS AND
CH . S L IMITATIO .,
NS ON LIMITED LIABILITY 129
cl:lpital ~or th nat ur e of th . . .
corpornt1on was sta rt ed with e busmess . mvolv<.-! d. Dnatz claims ih e
not explain how thnt . . only_$5,000 m borrowed capitul, but doos
11
reasonable amount of am~)tU t failed to equip the corporation with a
capi a 1: In add"t'1 10n, B aa t z fui ·1s to cons1'd er th e
personal guarantees to a
$150 ,000 , and the $SO o6o
y off
st0
th0 pu:ch_ase contract in the amount of
no evidence that th~ cor ck_su?scnption agreement. There simply is
inadequate for the O t' poration s capital in what ever amount was
to individual hperah10n of th~ b':1~iness.Normally questions relating
s are
h ld o1der hab1htY resu lt'mg from corpora t e
undercapitalizati
corporate liabilit ors SdOU ~Ot be reac~ed until th~ p~imary question of
. t· Y etermmed . Questions depending m part upon other
d.et ermma ions
. are not normall Y rea dy £or summary Judgment
· . However,
1
simp ~ assertmg tha~ the corporation is undercapitalized does not make it
so. Without ~ome evidence of the inadequacy of the capital, Baatz fails to
present specific facts demonstrating a genuine issue of material fact.
Fi~~lly, Baatz argues that Arrow Bar, Inc. failed to observe corporate
formalities be_cause none of the business' signs or advertising indicated
that the busmess was a corporation. Baatz cites SDCL 47-2-36 as
requiring the name of any corporation to contain the word corporation,
company, incorporated, or limited, or an abbreviation for such a word. In
spite of Baatz' contentions, the corporation is in compliance with the
statute because its corporate name-Arrow Bar, Inc.-includes the
abbreviation of the word incorporated. Furthermore, the "mere failure
upon occasion to follow all the forms prescribed by law for the conduct of
corporate activities will not justify'' disregarding the corporate entity.
Even if the corporation is improperly using its name, that alone is not a
sufficient reason to pierce the corporate veil. This is especially so where,
as here, there is no relationship between the claimed defect and the
resulting harm.
In addition, the record is void of any evidence which would support
imposition of individual liability by piercing the corporate veil under any
of the other factors listed above in 1), 4) or 6).
In summary, Baatz fails to present s~eci~c facts that w?uld allow the
trial court to find the existence of a genume issue of matenal fact. There
· · d'cation that any of the Neuroths personally served an alcoholic
1s no m i 'd N · h ·d
beverage to McBride on the day of the acci ent. or _1st .ere any evi ence
· d' t· th a t the Neuroths treated the corporation m any way that
m 1ca mg . .
would produce the injustices and meqmtable conseque~ces necessary ~o
· 'f · · th corporate veil. In fact, the only evidence offered 1s
sti
Jllh Y _piercTinhg £e we affirm summary judgment dismissing the
ot erw1se. ere ore,
Neuroths as individual defe nd ants.
130 LIMITATIONS ON LIMITED LIABILITY
Ctt. 3
***
WALKOVSZKYV. CARLTON
Court of Appeals of New York
18 N.Y.2d 414 (1966)
FULD,J.
This case involves what appears to be a rather common practice in
the taxicab industry of vesting the ownership of a taxi fleet in many
corporations, each owning only one or two cabs.
The complaint alleges that the plaintiff was severe!~ injured four
years ago in New York City when he was run down by a taxicab owned by
the defendant Seon Cab Corporation and negligently operated at the time
by the defendant Marchese. The individual defendant, Carlton, is claimed
to be a stockholder of 10 corporations, including Seon, each of which has
but two cabs registered in its name, and it is implied that only the
minimum automobile liability insurance required by law (in the amount
of $10,000) is carried on any one cab. Although seemingly independent of
one another, these corporations are alleged to be "operated ... as a single
entity, unit and enterprise" with regard to financing, supplies, repairs,
employees and garaging, and all are named as defendants. The plaintiff
asserts that he is also entitled to hold their stockholders personally liable
for the damages sought because the multiple corporate structure
constitutes an unlawful attempt "to defraud members of the general
public" who might be injured by the cabs.
The defendant Carlton has moved to dismiss the complaint on the
ground that as to him it "fails to state a cause of action".
[. ..]
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 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
a THE INCORPOR
CH.3 LIMITATIONS o:~ON PROCESS AND
. IMITED LIABILITY 131
the corporat10n as an age t .
· · I b t d"
prmcipa u a 1fferent result n and pier · t h e corporate veil to reach the
cing
. would foll · ~ach case. In the first, only
ow m
a 1arger corporate entity would b
the other, the stockholder e held financially responsible while in
stockholder is conducting th bwo':1ldb~ personally liable. Either 'the
. be liable·e·f husmess
. h e will m h.is m .
. d.iv1dual
not. If h e 1s, 1 . capacity or he is
as his personal liability is' e Is not, then, it does not matter-insofar
being carried on by a larger" co~cer~ed-that the enterprise is actually
en erprise entity"
[.. .] .
Reading the complaint in th·
do not believe that th is case most favorably and liberally, we
allegations required to ere can . re d from 1·t s averments
be gathe th e
defendant Carlton. 11
spe out a vahd cause of action against the
The individual defendant is char ed . . " .

managed, dominated and " g with havmg orgamzed,
. controlled a fragmented corporate entity but
there .are no allegat10ns. that he was conduct·mg busmess · 1n · d"1v1
· h"1s 1n "dua 1
. capacity. Had the . taxicab fleet been owned b y a smg e corpora 10n, 1·t
· 1 t·
b
wou~d : readily ~pparent that the plaintiff would face formidable
barriers. m, attemptmg to establish personal liability on the part of the
corporat10n s st~ckholders. The fact that the fleet ownership has been
deliberately spht up among many corporations does not ease the
p!aintiffs 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 the Business Corporation Law and carry the
minimum insurance required by the Vehicle and Traffic Law. These taxi
owner-operators are entitled to form such corporations and we agree [... ]
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 in~u~ance which will afford ade~~~te
compensation to their potential tort ~~tims. Ho~ever, the_responsibihty
for imposing conditions on the privile_ge of mcor~oration has b~en
committed by the Constitution to the Legi~lature a~d 1t may n~t be fairly
i 1· d f y statute that the Legislature mtended, without the
mp 1e , rom an , . f · · h h
slightest discussion or debate, to reqmre o taxi corporations t at t ey
·1 1· bi·11·ty insurance over and above that mandated by the
carry au t omo b 1 e ia
Vehicle and Traffic Law. ' ·
[... ]
THE INCORPORATIONPROCESS AND
1:.1~32~----~L~I~l\~ll:!.TA~T~I~O'..::N~S~O~N~L~I~M~I~T~
____ ~~
ED:::...:::L:.=IA :.::B=-:I~L_IT:
This is not to say that it is impossible for the plaintiff to ~tate
a valid
cause of action against the defendant Carlton. H~wever, the su~p
le fact is
that the plaintiff has just not done so here. Whi~e t?e complaint
alleges
that the separate corporations were undercapitahzed and
that their
assets have been intermingled, it is barren. of _any "suf~
ciently
particular[ized] statements" (CPLR 3013; see 3 Weinstein-Korn-Mi
ller, N.
Y. Civ. Prac., par. 3013.01 et. seq., p. 30-~42 et. ~eq.) ~hat t~e
~ef~~dant
Carlton and his associates are actually doing business in their
individual
capacities, shuttling their personal funds in and out of the corpo
rations
"without regard to formality and to suit the~ im~ediate conv
enience."
Such a "perversion of the privilege to do business in a corpo
rate form"
would justify imposing personal liability on the individual stock
holders.
Nothing of the sort has in fact been charged. [... ]
In point of fact, the principle relied upon in the complaint to susta
in
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 eithe
r illicit
or fraudulent merely because it consists of many such corporatio
ns. The
plaintiffs 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.[ ... ]
In sum, then, the complaint falls short of adequately stating
a cause
of action against the defendant Carlton in his individual capacity.
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 share
holder and
organizer of the defendant corporation which owned the taxic
ab. The
corporation was one of 10 organized by the defendant, each f
containing
two cabs and each cab having the "minimum liability'' insurance
mandated by the Vehicle and Traffic Law. The sole asset
operating corporations are the vehicles themselves and
apparently subject to mortgages.*
coverage
s of these
they are I
From their inception these corporations were inten
tionally
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,
w~i~h affords those desiring to engage in a business enter
prise the
priVIlege of limited liability through the use of the corporate
device, is so
Ca. 3
--...::::: THEINCORPOR
CH. 3 LIMITATIONS o:~ON PROCESS AND
valid . . IMITED LIABILITY 133
tct is strong that 1t will permit th ..
eges · 1s
1t · a buse d, no matter ho at · pr1v1lege t O contmue. no matter how much
heir matter wh at t h e cost to thewpubl'irrespo nsi'blY the _corporationis operated,
no
ntly Under the circum t ic. 1 do not believe that it is.
·, N . heId m . d'lVl 'dually liables ances
to th .of this. c_ase t he shareholders should all be
ant least, the matter should not b isdplamtiff for the injuries he suffered. At
uaJ of the complaint. If a corpo/ /sp~sed of o~ the pleadings by a dismissal
)Us without substantial capital i a io~ is organized and carries on business
:e ." have no sufficient assets ava1:l s::t a way t~at the corporation is likely to
m" shareholders should set up si \ e to_meet its debts, it is inequitable that
rs. liability. The attempt to d uc a flimsy or~anization to escape personal
sufficient basis of financial :e:o~o~a~e . busmess without providing any
separate entity and will be inJ£ nsibihty to creditors is an abuse of the
lll corporate debts. It is comin t ectual to ~xempt the shareholders from
;e shareholders should i gd 0 ~e recognized as the policy of law that
r- unencumbered capital n goo 1ai th put at the risk of the business
n If capital is illusory or ~~~onably adequat _e for its p~ospective liabilities.
t th · k f h' . ng compared with the busmess to be done and
e rls s O 1oss, t 18 1s a ground for denying the separate entity
privilege ."
[... ]
. The defen~ant Carlton claims that, because the minimum amount of
msurance required by ~he statute was obtained, the corporate veil cannot
and should not be pierced despite the fact that the assets of the
cor~oration · which owned the cab were "trifling compared with the
busmess 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 i~ and ~f itself be suffici~n: to
recompense "innocent victims of moto,~ vehicle accidents .. .. for the inJury
and financial loss inflicted upon them ·
_!1~3!4
_____ ~
JL~I~M!_!I!TA~T!_l~O~N~S~O~N~L~I~M~IT.!.:E~~o:::....::
_____ L==I::;....A_B_IL_I_T_Y
CH. 3
[. .. ] . . t' h h
1 h Id is that a partic1pa mg s are older of
Wh~t I would me~e y o ublic interest, organized with capita decid
than
~orpora~10n vested 1~itiiti:s ~hich are certain to arise in the ordina:l
msuffic1ent to meet 1~ , business may be held personally responsib{
course of _th~~~rpo~:~: corporate' income is not sufficient to cover th: intei
for such habihties. . b the statutory minimum or wh ente
cost of insurance premmms a ove f . _ere Rus:
. . . t fi ances dwindle under the pressure o competition defa
m1tial~y adequa et in d1'nary and unexpected liability, obviously th~
bad times or ex raor aga
shareholder will not be held liable. and
Th deft
1 t es of corporate enterprises that will be discouraged as a
efondy .Y? allowing the individual shareholder to be sued will be the
resu 1t o a ec1s10n . . b h am
t h ose sue h as the One in question , designed
. solely to a use t e corporate
wh
privilege at the expense of the public mterest. est
NOTES AND QUESTIONS
Ch
'
1. Let's start with a· side issue, one not exactly centered on piercing the of
veil. In Baatz, the plaintiffs based their complaint on dram-shop liability
provisions, and in particular on the rule stating that bartenders can be held
liable for the damages caused by an intoxicated client, if they served him
a:
liquor when he was already clearly intoxicated. In lots of countries there are
p
no similar provisions, and it might in fact be extremely difficult, if not
s
impossible, to hold a bartender liable under similar circumstances. It can be
interesting, especially when discussing this in a culturally diverse group, to
a
J
consider the pros and cons of dram-shop liability.
2. In Baatz, the Court strongly disagrees with the way in which the
plaintiff considers the personal guarantees given by individual shareholders
for the benefit of the corporation. For the plaintiffs, it confirms that the
corporation and the shareholders are acting as one single entity, but for the
. -i
J Court it proves the opposite. Who do you think is right?
\
'
3. Did you find Judge Keating's dissenting opinion in Walkovszky
convincing? Do you think that the conclusion of the majority would allow
private parties to make a mockery of justice, and use the corporate structure
·;
,,
'· to avoid liability in a way that is clearly contrary to the spirit of the law?
'
4. What are the possible economic consequences of easy piercing?
Could it adversely affect business activity, and therefore hinder economic
growth? Is there any possible inequitable consequence of piercing? Consider,
for example, the position of "innocent" creditors of the shareholders that
might be adversely affected as a consequence of piercing.
***
. The doctrine of piercing the corporate veil also exists in the United
Kingdom. Notwithstanding the fact that the two previous U.S. cases were
156 LIMITATION S ON LIMITED LIABILITY ~
Th e new Ar t'icl e 20 Of the Chinese Company Act states that: "Any of

the ind ependent legal
the shareholders of a company w~o ?b~s~fability of the shar eholdeerson
status of the company and the hmite . d . rs to
Comp any's debts, thus serious 1y amaging the
eva de th e paymen t o f the · · t r bT ·
interests of the company's creditorS, shall bear JOi£n ia i itie~ for the
,, The provision seems there ore to require three
d eb ts of t h e company· · the
· t en t t o avoid
f the corporate structure, t h e in
b · not easy to
e1ements: an a use do ignificant preJudice . · to ere d"t i ors. It is
payment O f deb ts, an a S · t d d }" d b
redict how these elements will be interpre e an. app ~e , . ut it
~ fi · 1 that most of the usual elements considered in piercing
e ihmtey adppears_t li"zation commingling of funds, and lack of corporat~
sue as un ercapi a ' . ·· 1·
. · · ht be relevant in the analysis (for addit10na information
.
1
£orma 1t1es, m1g . ·
y Wang Company Law in China: egu atwn o usiness
R z · f B ·
J
see iang u in a Socialist' d d El P b· ·
Organizations Market Economy, E war gar u hshing,
2014, 81 f.).
SOME FINAL CONSIDERATIONS ON VEIL

PIERCING: EMPIRICAL EVIDENCE
AND CONFLICT OF LAWS
Let's go back, for a moment, to the United States. How common is it
to successfully pierce the corporate veil and under which circumstances
do courts tend to pierce?
In a 1991 article, Professor Robert B. Thompson conducted an
empirical analysis of about 1,600 cases on veil piercing (Robert B.
Thompson, Piercing the Corporate Veil: An Empirical Study, 76 CORNELL
L. REV. 1036 (1991)). Although subsequent studies, including an update of
this first work by Thompson himself, have clarified additional details
(and in some cases questioned some of the empirical results), the 1991
study still offers the occasion to discuss some important elements of veil
piercing. We indicate hereinafter some elaborations based on the data
presented by Professor Thompson that offer material for a classroom
discussion.
In a total of over almost 1,600 cases litigated through 1985, courts
found for the plaintiffs and pierced the corporate veil in roughly 40% of
the situations. This data indicates that the possibility of shareholders'
liability is far from negligible in the U.S. Courts are slightly more inclined
to pierce when the shareholder is an individual (43% of the cases), rather
than when it is another corporation (37% of the cases). This is not
surprising because commingling of funds and lack of corporate formalities
are much more common when the shareholder is an individual.
Interestingly enough, the lower the number of shareholders the more
~ourts. are inclined to pierce: the veil was pierced in 50% of the cases
involving a corporation with one single shareholder, 46% of the cases
Ttn : I Nco 1w o . .
cu. s L l i\ll TA T10Ns lt A I IO N Pnoc1-:
ss ANn
ON LI M ITED LIABILITY 157
when tlu, r e wer two or t
th im_t h r·ee sllRre holders were
our sharehO Id rs, 35% of the cases when more
pubhcly held corporation C . pre ent, and never in situat ions involvinrr a
· fi ·
in ormation make sense') C · an you comment on these data? Does this "'
presen t , th ey can contr·ol . an you argu th h
e at w en more shareholders are
commingling of fund s is l each 0ther, and therefore abuse such as
presence of a multi tude ofessh common?h C
· an you argue, therefore, that th e
surprising to you that the s -r e alders indirectly protects creditors? Is it
f h . vei is never pierced in listed corporations?
0 ne o t e most mterestin . .
between veil piercing and th g ~iece~ of evidence concerns a correlation
Thompson , courts are m e _unl'erlymg substantive claim. According to
creditor based on a contr:rt mchmed to pierce when the plaintiff is a
As observed by Thomp c 'h~at er th8 ? ~hen he is the victim of a tort.
could be argued that c sJ.~ 1~self , th1s is quite surprising because it
information on the corpre 1trs m contract have the opportunity to collect
. ora 10 n, and therefore decide whether to rely only
on th e fimanc1a 1 resources of the . .
not "voluntary" er d't . ~orporatlon, while creditor s in tort are
. . h Id 1
e ors. Prmc1ples of fairness might suggest that
pi~rc::J s ou_ be easier for the victims of a tort . Can you elaborate on
this ormation? What might be the reasons why contractual creditors
are , on average , m~re_ successful in piercing? Could the reason be that
they are often sophisticate~ creditors (for example, banks or providers),
and also tend to be sophisticated (and wealthy) plaintiffs, with good
lawyers?
Especially in an international setting, piercing the veil raises the
question of which law should be applied . This question should be framed
in the context of our discussion, in Chapter 2, of the applicable corporate
law. Generally speaking piercing the veil deals with shareholders'
liability, and should be considered part of the internal affairs of a
corporation. As a consequence, the laws applicable to the corporation
should also govern the issue of veil piercing. For example, in the U .S., a
system based on the incorporation theory, the decision on whether to
pierce the veil of a California corporation should be resolved in the light of
California law. This, however , is not always the case. Some courts ,
especially in tort cases, apply the substantive law of the jurisdic t ion
where the tort occurred . In other words, veil piercing is not considered
part of the internal affairs of a corporation. What do you think about this
question? What do you think are the pros and cons of the two different
. ?
approaches, from a policy perspective.
In an international context you should also always keep in mind
problems concerning the possible e~fo~ce~e~ t o~ a ju~gment. A de~isio_n
in favor of piercing, obtained in a Jurisdict10n i~ which t~e doct rme is
well-established, might be difficult to enforce agamst ~ f?reign def~ndant
who has assets in a country in which the co~porate veil is rarely pierced.
·1 · · · ~act in some systems might be regarded as such a
Ve1 piercmg, 1n 11 ,
______
_1_5_8
_____
L_IM_I_TA_T_I_O_N_S_O_N_L_I_M_IT_E_D_L ~ca.
_IAB_I_L_I_TY a
departure from the principle of limited liability that it would be
considered against public policy.
This
structur1
instrum1
its busir
(securiti
number
instrum
in te rme
,_r provide
also l:
subord i
NE
that s1
losing
· isinf
right 1
have 1
appoi 1
inter£
prote ,
blurr
.. ~
corpc
,, ~
princ
pay
corp ,
(
I'
, · ....
s1m1
suer
po s1
rigb
I som
Ade
pro ·
t adc
. ' .., adc
r. ,''
•. ;1
a
......
CHAPTER4
FINANCING THE CORPORATION
•••
INTRODUCTION
This chapter discusses selected issues concerning the financial
structure of the corporation. There are of course almost
endless
instruments to provide the corporation with' the funds i{ needs to carry
on
its business: equity (shares), debt in the form of bonds and deben
tures
(securities representing a loan, generally issued and distributed to
a large
number of investors; for the sake of brevity we will refer to
these
instruments as ''bonds"), financial loans obtained from banks and
other
intermediaries and third parties, commercial loans obtained from
providers, and so on. We will focus our attention on shares and bonds
, but
also briefly discuss one important issue concernmg equita
ble
subordination of shareholders' loans.
Needless to say, the basic distinction between shares .and bonds
is
that shareholders are residual claimants of the corporation, and they
risk
losing their investment and not obtaining any dividend if the corpo
ration
· is in financial distress, while bondholders generally have a contra
ctual
right to receive interest and the principal. For this reason, shareh
olders
have more significant administrative rights, in particular voting
rights to
appoint and remove directors, while bondholders have limited power
s to
interfere with corporate decisions, and their rights are
primarily
protected contractually. Financial innovation has, however,
somehow
blurred the distinctions between these securities . For examp
le, a
corporation can issue subordinated bonds, for which the repayment
of the
principal is conditioned on the prior payment of other creditors,
or that
pay a variable interest rate based on the economic performance
of the
corporation. In terms of financial risk, these instruments can
be more
similar to shares. Conversely, shares with enhanced economic
rights,
such as a minimum dividend, can be issued, making the shareh
olders'
position potentially more secure: Si~il~rly, in terms. of a~min
istrati:e
rights, there might be shares ~1th hm_1ted or no voti_ng r1g~ts
, a~d 1n
some legal systems it is possible to issue bonds w1~h voting
rights.
Additionally, bond indentu:es (the cont:acts regulating bor_ids) often
provide covenants that significantly re~tric_t th_e fre~d?m of direct
ors_ to
adopt certain decisions, for example d1stributing d1v1dends
0
or seeking
additional credit.
159
_!
1_!!6
!!_
0 _____ _ I N~
1~\N~C~IN~G~T~H~E:....:C~O.:..:H:.:..P..:::.O
_.EF_!.: ..:.
R=-A;;..:T'-I'-O_N
_____ --.:~
De awHre, however, that different legal rights are relevant o~ly when
tlwre is a chunce of enforcement . For example, the contr~ctual right of a
bondholder to the repayment of the princi~al ~as_very httle meaning or
consequence, economically, if the corporat10n is insolvent and does not
have the funds to make any payment.
In 1958 Franco Modigliani and Merton Miller, two finance scholars
published a' groundbreaking paper on the financial structure of th~
corporation, introducing the "Capital Structure Ir~elev~nce Principle"
(the article, entitled "The Cost of Capital, Corporation Finance and the
Theory of Investment" was published in 48 AMERICAN ECONOMIC REVIEW
261 (1958)) . They both won the Nobel Prize for this contribution. In short
the Modigliani-Miller theorem posits that in an efficient market, in th~
absence of asymmetric information, agency costs, taxes, and bankruptcy
costs, the value of a firm is unaffected by how it _isfinanced (for example,
the balance between shares and bonds), and its dividend policy. Of course
in the real world the limit of the theorem is that the hypotheses on which
it is based are totally unrealistic: taxes, bankruptcy, agency costs, and
information asymmetries exist, and market efficiency is highly debatable.
Consequently, the reality is that financial decisions have a profound
impact on the value and profitability of the corporation.
The chapter is organized as follows. First, we will discuss classes of
shares, focusing on the flexibility existing in different jurisdictions for
creating categories of shares with different economic and administrative
rights. We will also consider some important protections for shareholders,
and specifically pre-emptive rights in case of issuing of new shares, and
class voting. Second, we will concentrate on selected problems concerning
bonds: different legal strategies used to protect bondholders, statutory
limits to the issuance of bonds (when present), and interpretation of the
bond indenture. Finally, we will illustrate the problem . of equitable
subordination of shareholders' loans.
THE RIGHTS OF SHAREHOLDERS

AND CLASSES OF SHARES
Common shares, also sometimes called ordinary shares, are the
"plain vanilla" type of securities representing an equity interest in a
corporation. These shares generally grant full administrative and
economic rights to the holders.
, More specifically, even if there are differences among different
jurisdictions, common shareholders can vote in the geiieral shareholders'
meeting on the election and removal of board members and also on the
ap_pointment and removal of the board of supervisors, in systems where
this corporate body is present. They also vote on amendments to the
governing documents of the corporation, and in particular on financial
CH.4 FINANCING THE CORPORATION 161
transac~ions such as mergers and issuing of new, non-authorized shares.

Depe nd mg on th e legal system considered the shareholders' meeting can
have ~roader 0 ~ na~r?wer competences. A~ a rough rule-of-thumb, it can
be said th at in civil_ law countries, often characterized by a more
concentrated ownership structure and strong controlling shareholders,
~ha_reholders have more powers, while in common law systems, especially
i~ h st ed cor~orations with a widespread ownership structure, the board of
directors enJoys more extensive powers (remember what we mentioned in
the last paragraph of Chapters 1). For example, the power to amend the
bylaws can als? be given to directors, and in some jurisdictions a lawsuit
of the corporation against the directors for breach of their fiduciary duties
must be approved by the shareholders even if often shareholders can also
bring a derivative lawsuit on behalf ~f the corporation (we will discuss
this in Chapter 7). Of course, the actual power of a shareholder also
depends on rules concerning the quorum and majority rules applicable to
the resolutions of the shareholders' meeting.
The most important economic rights are the right to obtain
dividends, if declared by the corporation and subject to limitations
intended to protect creditors; in addition shareholders are "residual
claimants" of the corporation, in the sense that they are entitled to
receive what is left (if anything) after the creditors have been paid in full
in case of voluntary liquidation or insolvency. Common shareholders (but
also other shareholders) can also enjoy a pre-emptive right in case of
issuance of new shares: the shares must be first offered to old
shareholders, and only if they do not buy them, the shares can be sold to
third parties. In some systems pre-emptive ~rights are mandatory
(generally in the U.K. and in the European Union, also due to a E.U.
directive), and can only be excluded under limited circumstances; while in
other systems (generally in the U.S.) they are not available as a default
rule, unless the governing documents grant pre-emptive rights to
shareholders.
The quite broad administrative rights of common stockholders are
justified, from an economic standpoint, exactly by the fact that they are
residual claimants, and that they bear the risk of not receiving dividends
and/or losing their investment.
In order to- raise capital at better conditions, however, corporations
are also allowed to create different classes or categories of shares with
different economic and administrative rights. The corporation can for
instance create shares with limited voting rights (for example, voting only
on amendments to the governing documents) or no voting rights, but with
stronger economic rights (a mini_mum dividend)._Or, in some jurisdictions,
multiple-voting shares can be issued. A peculiar type of shares worth
mentioning are "tracking stock": as the name suggests, these are shares
that "track" a particular division of the corporation, and pay dividends
I
_!1~6~2
______ __!F'._!l~N~A~N~C~I~N~G~T~H~E~C~O~R~P~O~R:.:A:.=-=-T::..:IO::..:N:..;._
_____ -!:~
based on the economic results only of that divisior_i,not of t~ie corporation

as a whole. This might be, in theory, an interesting te_chmque to :unlock
hidden value, because if there are investors ~nly mter~sted m one
particular business of the corporation, wit~ certair_i . financial
characteristics in terms of risk and return, they might be willmg to Pay
relatively more for shares whose value only ~epends ?n the su<:cessof
that business. A similar result could be obtamed by mcorporatmg the
division as a separate corporation issuing shares, but tracking stock
avoids the administrative and organizational costs of setting up a
separate corporation. Even if they have been used by some large multi.
divisional corporations, such as Coca Cola, tracking share~ have not been
particularly successful because they raise delicate accountmg problems in
precisely identifying the result of the tracked division (think, for example,
to the allocation of common fixed costs), and because they might raise
conflicts of interests (directors and controlling shareholders might want
to favor one division over another one).
The creation of different classes of shares raises issues because it can
alter the proportionality between investment and administrative and
economic rights, and in terms of equal treatment and protections of the
holders of the different shares. The following are the relevant statutory
provisions regulating the creation of different classes of shares under
New York and Italian law. Compare and contrast them.
New · York Business Corporation Law § 501-Authorized
Shares
(a) Every corporation shall have power to create and issue the
number of shares stated _in its certificate of incorporation. Such
shares may be all of one class or may be divided into two or more
classes. Each class shall consist of either shares with par value
or shares without par value, having such designation and such
relative voting, dividend, liquidation and other rights,
preferences and limitations, consistent with this chapter, as
shall be stated in the certificate of incorporation. The certificate
of incorporation may deny, limit or otherwise define the voting
rights and may limit or otherwise define the dividend or
liquidation rights of shares of any class, but no such denial,
limitation or definition of voting rights shall be effective unless
at the time one or more classes of outstanding shares or bonds
singly or in the aggregate, are entitled to full voting rights, and
no such limitat_ion or definition of dividend or liquidation rights
shall be effective unless at the time one or more classes of
·, out~t~nding_ s_hares, singly or in the aggregate, are entitled to .
'.··-: :f
1 ·i~.· unlimited dividend and liquidation rights. (b) If the shares are
;,
;!
J ,j
:i
di~ded into two or more classes, the shares of each class shall be
f+.,
/ ! designated to distinguish them from the shares of all other
. l
·' . i
,;, iI
l_ i
"•t
l -~
\
CH.4
FINANCIN 163
G THE CORPORATION
classes. . Shares wh· h
. t ri .bution
dis of d" ·d ic are entit. 1ed to preference in the
common shares. IVI Sh ends or. asse t s sh all not be designated as
.
th e d"1str1bution ares.d which a re not entit. 1ed to preference in
of d"
even if identified b iv\ end s or assets shall be common shares
designated as pre£eya cdahssor other designation, and shall not b;
rre s ares
Italian Civil Code Ar . .
ticle 2351-Voting Rights
1. Each shar e grants the right to vote
2. With the exception of . . :
bylaws can allow th . provisrnns m separate statutes, the
with voting rights r e_:ssuance 0 ! shar~s. without voting rights,
conditioned u on s1m1_e?-to specific dec1s10ns,with voting rights
will of a pariy Ti:c:fic events ~ot. merely depending on the
exceed half of th. . mlount of hm1ted voting shares cannot
e capita.
3. · The
· bylaws
h . .
can provid e £or 1·1m1tat10ns to the voting rights of
a sindg1e s ar~holder independently from the amount of shares
owne ' or scaling voting rights.
;h ~n th e absence of special provisions, the bylaws can allow
e _1ssuan~e. of multiple-voting shares also with respect to
specific_ decis10ns or_conditioned upon specific events not merely
dep~nd1ng on t~e will of a party. Each multiple-voting share can
attribute a maximum of three votes.
NOTES AND QUESTIONS

1. A cursory review of these provisions suggests that the New York
provision (quite representative of similar rules in other states) is more
flexible in allowing the creation of different classes of shares than its Italian
corresponding rule. In the U.S., however, additional limitations are provided,
for example, by stock exchange rules for listed corporations, as we will
discuss below.
2. Let's focus on the somehow more restrictive Italian provision. The
law provides that limited voting shares cannot exceed half of the capital.
Similar restrictions are present in other states: in France nonvoting shares
cannot exceed 25% of the capital in public limited liability companies, in
Japan 50%. What do you think is the rationale ?f these rules? Hint: does it
depends on the risk of entrenchment of controllmg shareholders? And/or on
the desirability of a certain proportion~lity between finan?ia~ investment and
administrative powers? In order to discuss where the hm1t should be set,
consider the example of Brazil. In Brazil, until 2001, publicly held
corporations could issue non-voting shares up to 2/3 of the capital. In 2001 a
'mited the threshold to 1/2 (even if with some exceptions for
new s t a t u t e l 1 t'ons) What is interesting · ·
· h at emp1r1cal
. to note, h owever, 1st
· t'
ex1s 1ng corpora 1 · . · h ·
studies show that also under the more liberal regime, t e average corporatrnn
_!1~6!4
______ ~~
_:F£_!!1N~A~N~C~I~N~G~T!.cH~E~C::.=O~R~P~O::::R::.A:.=T=--l=-=O:..:N-'-
_____
Id have 53 % of its capital composed by voting shares, and_only 47% by C H.4

1
: : ~-voting shares (see E. Gorga, Direito Societar io Atua~, ~lsevier'. 2013, 146
f.). This seems to indicate that even w~en le?ally perr~nssible, to issue rnore Sha re
than half of the shares without voting rights is ~ot de~i~able. ~an you offer a Work
possible explanation for this? Do you think this e~pirical evidenc~ tells us
something cynical about the adoption, by the legislature, of a 50 1/ocap to and
concl
limited voting shares? th e ,
3. Why do you think a shareholder ~ould be intere~ted. in ~uying t he'
limited voting shares? Note that under Itahan law, when issmng hrnited and
voting shares, no additional economic right is mandated by la~ , ~ut it is hen,
possible that the corporation can ~ttac~ au_gmented econo1:1ic rights to con.1
limited voting shares. Can you 1magme . mvesto~s not m~erested in dan
participating in the governance of the corporati~n , but mterested _m enhanced abn
economic protections? In a listed corporation, m case of a hostile takeover, C01
would limited voting shares appreciate as full voting shares? Why? gra
U.l
4. Can you imagine a situation in which it could be interesting to issue COl
shares that vote only if certain conditions are met, for example if the 01
economic and financial situation of the corporation deteriorates? Which ar
investors might be interested in a similar financial instrument? er
p,
5. Paragraph 3 of Article 2351 of the Italian Civil Code contains a
peculiar provision. Voting caps might work as follows: independently from b:
01
the number of shares you own, the maximum number of voting rights that c,
each shareholder can exercise are capped at 10% of the outstanding shares . 0
This provision would include an element of "democracy" in the shareholders' 1
meeting, in the sense that the voting power of each shareholder is not
entirely proportional to her investment. Scaling voting rights means that, for
example, up to 20% of the shares each shareholder has one vote per share,
from 20% to 40% only one vote per two shares, and over 40% only one vote
per three shares. What is the goal of these provisions?
6. An interesting provision is Paragraph 4 of Article 2351 of the Italian
Civil Code, regulating multiple-voting shares. Until 2014, multiple-voting
shares were prohibited under Italian law. The principle has however been
called into question, also in order to create an incentive for going public. After
the 2014 amendments, somehow simplifying, closely held corporations can
issue multiple-voting shares (up to three votes per shares). Listed
corporations, pursuant to Articles 127-quinquies and 127-sexies of the
Consolidated Law on Financial Markets, cannot issue multiple-voting shares.
They can, however, issue "loyalty shares" similar to the ones available in
France: these are shares whose owner obtains double voting rights if they are
held continuously for a two-year period by the same shareholder. The goal,
clearly, is to favor long-term investors. On the other hand, somehow similarly
to th_e U.S., corporations that have issued multiple-voting shares before going
publ~c. C!in k~ep them also after they are listed. Can you explain why these
pro_vis1ons might push more corporations to go public? (For more on multiple-
votmg shares, see M. Ventoruzzo, The Disappearing Taboo of Multiple Voting
'
'
CH. 4
FINANCING THE CORPORATION
165
Shares: Regulatory Res es to _the Migration of Chrysler-Fiat, ECGI Law

Working Paper No 288fons
· 2 0l5, available on www.ssrn.com).
. . . ty of multiple . .
7. Empirical evidenc e on th e d es1r ab1h -voting shares,
and mor e and not entirely
. leneral 11Y dual-class structures, is mixed
1 st
cthoncu sive. f tehvera udies seem to suggest that dual-class structures reduce
1 ·
e va 1ue o e corp
. orat ion , re duce poss1'ble returns for shareho ld ers (a so m
th 1 t ) of interests
~ ;:g- ~~; , 1~crease the cost of capital, and foster conflicts act private
s to extr
an e a 1 ity O controlling shareholders and manager ever appear to
r cont ribu tion s how
benefits_ from the corporation. Othe · s from one- ' share, one- ' vote are
contradi. ct the . argume n t th at d'ivers10n
, for example, found positive
damaging for investors. Some scholars have
adopted dual-class structures.
abnorma~ retu~ns for corporations that have
certain features seem to
Corporatwns in certain industries and with
ing shares, especially in the
gravitate more toward the use of multiple-vot
ia corporations, high-tech
U.S., th_an others. Those are news and med
are two possible explanations.
corporations, and fashion corporations. There
s, for self-evident reasons,
One is that often corporations in these industrie
ip of charismatic and skilled
are founded and develop under the leadersh
ey Brin for Google, which went
entrepreneurs (think of Larry Paige and Serg
do not want to lose control
public in 2004 with multiple-voting shares), who
ing shares. Investors, on the
by going public, and therefore use multiple-vot
that the founders remain in
other hand, might want, or at least accept,
or managerial abilities. The
control in the light of their technical, creative
ing shares in these industries
other possible reason for the use of multiple-vot
of control" that controlling
is that in these sectors the "private benefits
icularly significant, and here
shareholders want to exploit might be part
s and media corporations.
consider the political and social influence of new
***
U.S.-listed corporations
Since the beginning of the twentieth-century,
shares that allowed some
issued limited voting shares or nonvoting rol of the
shareholders, holding full voting shares, to retain cont
dits and public opinion were
corporation even with a minority stake. Pun
most U.S. stock exchanges
strongly against this practice, but at first
k Stock Exchange (NYSE)
allowed it. In 1926, however, the New Yor
Fo~ Theaters ~orporation .. In
refused to list nonvoting shares issued by
tion to the climate following
the following decades, possibly also as a reac d and
ress ion the New York Stoc k Exchange confirme . I Oh
th e Grea t. Dep , " h ,, .
are, one vote ;pr1 ncip e. t er
expanded its policy in favor of the one s
· I mar k e t s competing with the NYS E to attract issu.ers, such as
.
fi1nancia however ' a more hberal appr oach with respect to
had .
N as d aq or A mexh res , and dual class stock, and 1n the 1980s the . NYSE
. · d t· . .
11m1te vo 1ng s 'da r ·ts policy. The NYSE was, 1n particular, worried that
1 IM otors ) wou ld d e1·1st from
started to recons1 e ·ons (for example, Genera
some large corpora
t1
on a d11e
! exch ange. I n 1986,
·r'Jrent
their shar es
the NYSE an d t ra de
_!11_7~0
______ _lF];IN~A~N~C!lIN~G~T1:HQE~C~O~R~P~O~R~A~T~I_:::O~N~-~-~-~
. h ? What might be the rationale for
you think of these d1fferen~ appr~ac es. d scholarly books?
avoiding citations to law review articles an . .
h C d" . wor th mentioning, also mdhght
erience 1s · of the
4. T e ana ian exp Dual-class structures are use m Canada.
ties that link the U.S. and Canada. roximately 6.5% of the roughly 1,450
According to a 2006 paper, app St k Exchange; the leverage allowed by
corporations listed on the Toronto oc ·es is also quite significant: the
. · h 1·n these compam .
sup~r1or-votmg . s ares r has 4 _83 more votes th~n the _equity owned
median controllmg shareholde ith lO% of the capital it 1s possible to control
(in other words, for example,; Id be noted that in 1987 the Toronto Stock
almost 50% of ~he votes). It; ouOf£ s aimed at acquiring control should be
th
Exchange provided at tde?.er 1:: to shares with inferior voting rights, a
d d t the same con itwns a d t th ·
exten e a . . ·on (coattail provisions, generally, man a ~ at In ~ase
sort of coattail provisif . t d oting shares can convert their shares into
ft k holders o restr1c e -v h . h .
o a e?ver O f th onsequences of this approac IS t at superior-
full-votmg ones). ne dod etc fairly limited premium over inferior-voting
ting shares are tra e a a r~ k t ·
vo
ones Can you exp am 1 · the rationale of this rule, its e 11ects on
b mar te dprices,
h
· · if
and discuss I IS es1r ·t · d · able? . Should a similar rule a ways . e enac
d b e 1· w en
h ·th di·sproportionate voting rights can be ISsue Y 1sted
s ares w1 · · · · th· ?
corporat10ns. · ? Wh a t are the pros and cons of coattail prov1s1ons . m. d1s area.
(For further information on the Canadian case, and some mterestmg ata, see
Yvan Allaire, Dual-Class Shares in Canada: Some _Modest Proposals (2006),
available on www.ssrn.com).
5. Based on the arguments used in Business Roundtab~e v. ~~C,
above, do you think the S.E.C. in the U.S. could mandate a coattail proVIs\on
similar to the one required in 1987 by the Toronto Stock Exchange (see pomt
4 above)? Why yes or why not?
6. Some argue that multiple voting shares should be allowed at the
IPO stage, when investors are fully informed about the voting structure of
the corporation and can freely decide whether to invest, but should not be
permitted after the corporation has been listed. It has also been suggested
that there should be a mandatory "sunset" provision, meaning a rule that
eliminates superior-voting rights after a certain period, for example three
years from the listing. What do you think of a similar proposal? If you were
the legislature of a country, or the head of the regulatory agency in charge of
financial markets, would you consider adopting a similar rule (assuming you
have the power to do so)?
***
We have seen above that the Italian legislature provides for several
limitations to the issuing of different classes of shares, even if it has
recently abolished the pre-existing absolute prohibition of multiple -voting
shares. But what is the situation in Europe and other systems more
generally with respect to listed corporations? In several countries
multiple-voting shares, with some limitations, are allowed, in others they
are not. Also with respect to nonvoting shares the situation varies from
CH. 4 171
FINAN(.;INU Tim COHPOJlATION
jurisdiction to jurisdiction. 1,he following tahle and graphH, taken fron:1 a

Repor~ .0 n the Proportionality Principle in the Europca~ U~ion
commuu:noned by the European Commit-u;ion to Sherman & Srer1rng, 18S,
and ECGI published in 2007, 1 i11ustratc the situation. (Nore: with rw~pcct
to Italy, the table has been updated because as mentioned above, in 201 4
multiple-voting shares have been made avaiiable.)
Availability of different classes of shares
country multiple-voting shares nonvotinr.! shares
Bell!ium NO NO
Germanv NO NO
Denmark YES NO
Finland YES YES
France YES YES
Greece NO NO
Ireland YES YES
Italy YES YES
Luxembourg NO NO
The Netherlands YES NO
Poland NO NO
Sweden YES NO
Spain NO NO
United Kingdom YES YES
Australia NO YES
Japan YES YES
USA YES YES
emal_market/company/docs/shareholders/study/final_
------------:--=u/intat
t Available http://ec.europa.e
report_en.pdf
172 FINANCING THE CORPORATION
Percentage of listed corporations using

multiple voting shares
9()% ~-- -- - - - ------ - - --~ 8~QO%
___ !fo _
~
~
70% L- ------ - -- - ------- -1 i{-,';--- - -
60% -l-- ----- - .O_.---
S$M,L - -- --- - -1:t -':,..._
----
' -----:-::-:--
S{)4K ;- ~'1- ---- ..;p\Ll!2'7D :------ ~ :::-::--- -
t-"
t:.:
,T ·-· -
40% ,,,,
40% -1--------.-- --t;_
··,~,,
: ----
'- .,,.t----
-Im,:;.:
~ ~ p_
'--;(
":lt ----
;i:'~', ,,. :.,;;' " '
l. ' ~-'··t'- ---- ~ ·i))· ---.:--::::-:- - ~ t _'1_
~ -2--S¾-.- ~-ft - - \:;~-----
\. ----
-1 -~t::~::,. 20
t- ---. 1ffl%.-- 11 ~ ----
~ - ~~~~ 0
-J ~iJ~~---- ~ij-- !~ -- ~-- $~
10% >-- 0% ~ii ~ -
0% L ~ L-r--Fltinl,ii
and(_,--Fliiiran -,--Ire-l_an_d-,-~Th'.""e.___~Po':"l~an'"-:-
ilicLe ·~ed:en~--d--,--:Sw
:U-;:_m
.te::d- : :
Denmarlc Netherlands Kingdom
Percentage of listed corporations using

nonvoting shares
6%------------------------
5% 5%
~-~ /t\
4% -I--IJ 'ii'?·,1
; -------------~ ~,!
'-'iii--------
1%
0% 0% 0%
0%
Denmark Finland France Ireland UnitedKingdom
Multiple-voting shares, or more precisely ''loyalty shares," are

particularly common among French listed corporations (Art. L. 225-123
and L. 225-124 of the French Commercial code). The French case is
indeed quite peculiar and interesting.
Until 1930, multiple-voting shares were allowed in all public limited
companies, listed or non-listed, without limitation on the number of votes
per share. This led to grave abuses and a 1930 law prohibited issuing new
multiple-voting shares, but the previously issued ones were not
suppressed. In 1933, as a compromise, another law allowed only double·
voting shares and all previously . issued multiple-voting shares were
CH. 4
FINANCING 173
. THE CORPORATION
cancelled. This regim .
default rule in 2004 ro:~:: dshghtly~odified in 1966 and turned into the
e companies
The French situation is . . .
. Ie-votmg
mu It1p · shares u d mtere st mg · because of the peculiar type of
are entrusted only to a se ' _call~d''loyalty shares ." Double-voting rights
Y pa1"d and held £o
nominative . the shares have been
. . sh ar eh older 1f
fu 11 · d of two years . For listed
m1n1mu~ pen~
companies,· the securitiesr are· 1
than four years . There£o dguator is hostileh to vesting periods longer
· rig
re, ouble -vot mg · ts are not attached to the
shares themselves but rath
transferred, or converted ~\ to th e shareholder. Any share that is sold,
O
rights . However, a trans£ m a bea:er share loses its double-voting
jointly owned by spous er on successrnn or on the partition of property ·
·
·
entitled .
to inherit the des, or, a gift int er vivos to a spouse or a relative
onor s estate ·
sh a11nei·th er cause t h e right to be
lost, nor interrupt the holdin .
merges or splits th d blg period._If the shareholder is a company and
e vote 1s. kept un Iess th ere 1s · a contrary
provision in the a' t · 1e ou.
h . h hr ic es of mcorporation of the issuing corporation If the
c?mpany w ic as issued the shares merges or is split double~voting
rights ~re also pres~rved unless the charter provides differently. The
reason is th at t~ere 1s no substantial change, but only a formal one, and
another .reason 1s not to h1"nder val ue-maxim1z · · mg ·
· an d des1rable ·
business
transactions for the fear of losing votes.
The rationale for loyalty shares , clearly enough , is to enhance the
power of long-term shareholders and a stable control.
Since 2014 , with the so-called Loi Florange, the French legislature
has made ''loyalty shares" the default rule for listed companies. Listed
companies that do not want to have double-voting shares, or wish a
different vesting period, will have to introduce this in the governing
documents with a two-thirds majority in the extraordinary shareholders'
meeting. In practice, most listed French companies already had double-
voting shares in their articles of association so that the 2014 legislative
amendment was mostly symbolic . This reform is designed to reward long-
term shareholders and, allegedly, to allow listed companies to focus on a
long-term perspective by reducing the influence of investors (often Anglo-
American ones) accused of being subject to short termism . Double-voting
shares can also interfere with a takeover, but here the ''breakthrough"
rule contained in the Takeovers directive should be considered, as we will
discuss in the chapter on takeovers . The Loi Florange, more generally,
was a controversial statute (some provisions have also been challenged in
court) quite explicitly aimed at protecti~g French listed corporations from
hostile acquisitions, especially from foreign buyers.
, In non-listed corporations or in corporations whose shares are not
listed on a regulated market, doub!e-voting shares may be established_by
the bylaws with the vote of two-thirds of the shareholders. Double-voting
,
_!11_7!4
______ jF~IgN~AN~C:'..-!I:.£N~G~T~H~E~C~O~R~P~O:::.:R:::A:..:.T.=..:I=-=O=-=N-
shares are, h owever, less common in non-listed corporations

l . because in
.
these corpora t ions a fami·ly has often absolute. contro
. , sometimes
- through
11
a shareholders' agreement, and therefore similar contro mg enhancing
devices are less desirable.
***
In Japan, multiple-voting shares are not ~xplicitly _pe_rmittedby the
Companies · Act , but it is possible to achieve . a similar
" h result· ,, by
differentiating the number of shares representing o~e s. are umt for
different class of shares. As a default rule, each share is assigned one vote
under Japanese law (Japanese Companies Act Art . 308(1)). By a charter
provision, however, corporations can designate a number of shares
necessary to constitute a "share unit" for eac? cl~ss o~ shar_es (Japanese
Companies Act Art. 188). In this case, one voting right is assigned to each
share unit, and shares that are not sufficient to constitute one share unit
are not entitled to vote (Japanese Companies Act Art. 308(1)). In practice,
however such an arrangement has been rarely used, at least until now.
' .
The first IPO using this device, by a high-tech venture corporat10n, took
place in March 2014 . .
***
In Germany, on the other hand, listed corporations were originally
allowed to issue multiple-voting shares. However, already in the reform of
the stock corporation law of 1937 the legislature took a more , restrictive
position towards multiple-voting rights by generally prohibiting them
except in case a special permission was given by the responsible
government authority (obviously, in that period of German history, the
government tried to control the economy quite strictly). As a rationale,
the legislature gave the following official reasoning:
Official Statement on the Law on Stock Corporations
(Gesetz uber Aktiengesellschaften und Kommanditgesellschaften
au/ Aktien) of January 30, 1937
Deutscher Reichsanzeiger und PreuBischer -
Staatsanzeiger 1937, No. 28 of February 2, 1937
§ 12 subs. 2 generally forbids the issuance of multiple voting rights.
This prohi?ition is based on the concept that every share can grant only
t~e same rights to every shareholder and that every voting privilege for a
l
single shareholder or a group of shareholders has to be considered as
,,!
·, economically unjustified and dangerous. However, practical experience
.
,',S
·~
sh?wed that multiple vo~ing shares can be necessary. As a consequence
\
this _dr~ft allows t?~issuance of multiple-voting shares with the
p ermission °~
~he _M1~1stry of Economic Affairs, the Ministry of Justice
and oth:r m1n1stries 1f the issuance is in the best interest of the stock
corporat10n or of general economic development (§ 12 subs. 2 sent. 2). By
~------~F~IN~A~N~C~I~N~G~T!._H~E~C:::,:O~R~P
.!178 ~O~R~A:..=T~IO~N~==-~=--..:::.~
MARCO VENTORUZZO, ISSUING NEW SHARES
AND
PREEMPTIVE RIGHTS: A COMPARATIVE ANA
LYSJS3
12Richmond J. Global L. & Bus. 517(2013)
Introduction
[ ] One fundamental area in which [Eur?pe~n and U.S.
· d.: corporate
laws] 1verge concerns how they regulate the 1ssu mg of new shares, in
particular preemptive rights-a problem rarely a ddresse db ·
Y comparative
corporate law scholars. [. · .] -
The issuing of new shares by a corporation is often
. · t·10n. I !'act when new shares are issued and not a reci~e for
11tiga n .1
1
, offered oto existing
sh are h lders shareholders may suffer two types of damages ._ n the one
h d ohareh,olders' voting power within the corporat1·
t::oth:r hand, the value of their investment can be reduced
price is lower than the actual value of the shares.
·
0n 1s d.l d
1 ute . On
if the selling
Consider the following scenario. Corporation XYZ, wort

h four million
dollars has 1 000 shares outstanding. Shareholder A
owns 25% of the
shares' (250 shares). A controls one-fourth of the votin
g power, and the
value of her investment is one million dollars. If the
corporation issues
1 000 new shares and sells them to a third party,
A's voting power is
r~duced to 12.5% (250 shares over 2,000 outstanding).
Depending on the
price at which the new shares are offered, the value
of A's investment
could also be jeopardized. If XYZ sells the new shares at
$4,000 each (the
value before the new issue), no damage is caused. In fact,
A will still own
12.5% of a corporation worth eight million dollars,
which equals one
million dollars. If, however, XYZ sells the shares
at a "discount," the
value of A's investment will be proportionally reduced.
If, for example, the
new 1,000 shares are sold for $3,000 each, the value
of A's stake in the
corporation will decrease to $875,000 (12.5% x $7,000,000
).
Of course the law could dramatically curb this risk by prov
iding that
all existing shareholders always have a mandatory
preemptive right to
buy newly issued shares. Similar protections, howe
ver, would be
detrimental to . the corporation. It is essential that
directors retain a
certain degree of flexibility in designing the financial
structure of the
corporation. Granting preemptive rights to share
holders is time-
consuming because the shares must be first
offered to existing
-· '. stoc}0olders and ~ight hinder the ability of the corp
'' oration to quickly
obtam fresh financial resources when market cond
! '
itions are favorable.
' .,. T~e ~aw must therefore strike a delicate balance betw
'
een the protection of
existing s~areho_lders, on the one hand, and the abili
ty of the corporation
to pursue its optimal financial structure, on the other
.
3
Footnotes omitted.
CH. 4 FINANCING THE CORPORATION 179
Th ere are three basic sets of rules that contribute to strike such a
balance: rul es conc: rning the allocation of powers between directors and
shareholders to decide on the issuing of new shares, preemptive rights in
case new shares are sold, and fiduciary duties of directors engaging in the
sale of new shar~s. Th~ purpose of this essay is to consider how different
legal _syst .ems st ~ike this balance in regulating the issuance of new shares,
focusing 1n particular on preemptive rights. The comparison is not only
~mpo~tant for the relevance of the problem, but also because it
illuminates some of the fundamental differences in the corporate
governance philosophies underlying different legal systems.
[. · .] Focusing on these systems is particularly apt because the two
models follow nearly opposite approaches. In the U.S., directors enjoy
broad po~ers in th~ issuing of new shares, and there is greater freedom of
contract in regulating preemptive rights in the corporate charter. Under
this system, shareholders are mainly protected through directors'
fiduciary duties. In Europe, shareholders are protected through statutory
rules that mandate preemptive rights. Shareholders have the power to
waive preemptive rights, but only in limited circumstances.
One might argue that European systems still follow the approach
adopted in the U .S. until roughly the 1960s, and a possible explanation is
that Europe did not experience the same separation between ownership
and control that occurred in the U.S. The comparison will allow
exploration of a more general difference between shareholder protection
in the U.S. and in the civil law systems of continental Europe, namely,
the fact that the former jurisdiction relies more on ex-post litigation, and
the latter on ex-ante mandatory rules.
[... ]
Part I: U.S. Law
Competence to Issue New Shares
In the U.S., the power to issue new shares is primarily entrusted to
the board of directors. Directors enjoy a great degree of freedom in issuing
new shares; however one important limitation is that they can only issue
the number of shares authorized by the articles of incorporation.
Generally, corporations have outstanding s~ares, which are. shares
already sold to shareholders tha~ form the ~~pital of the ~orporat1on '. but
the articles of incorporation provide for add1t10nal auth?r1zed shares that
directors can issue and sell . For example, a corporat10n can have 100
. g shares held by two shareholders, but the articles of
0 t t d · · f
u s an intion can authorize the issuing o a it10na dd' · 1 200 h
inco s are s. If
. rtpora
d1rec ors wan . to
t to 1·ssue more than .the additional 200 shares, they ne ed
obtain shareholders' approval to increase the number of the authorized
shares.
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.!180 4
--
. .
This rule gives sh ar eholders some control over th e financial structur
. h t d"l t
.
of the corporatwn. a S les of shares th at m1g 1 u e sh are holderse '
h. f the corporation above the thres h old se t bY th e au th orized
owners ip o b t d by sharehold ers as an amendment to the articles of
shares must e voe .
. t·
mcorpora wn.
The practice however, 1s to prov1·de £or a num b er of
'
authorized shares significantly larger t h an th e nu mber of out t d.
. s an 1~g
th
sh ares, so a 1t ·f new financ ial resour ces are neede d, direct ors can easily
issue new shares. In contrast to European law, iss~:g · · h ·
news tres i~ .the
U.S. is substantially and practically in the ~ands o irec~ors. n addition,
minority shareholders in corporations with a c_on~rolhng shareholder
derive little protection from this rule be~ause maJor1ty shareholders can
consent to increase the number of authorized shares.
One exception to this allocation ~f powers i~ e~tablished by M.~.C.A.
§ 6 21(£) which requires shareholders approval 1f (1)the shares are issued
for ·consideration other than cash, and (ii) the voting po~er of shares that
are issued comprises more than 20 perce~t of the voting power of the
outstanding shares. Also in listed corporations,_ shareholde~s' appro~al _is
necessary when the issuing of new shares might determine a shift m
control. Rules enacted by the NYSE, the NASD, and the American Stock
Exchange require a vote at the shareholders' meeting when a listed
corporation issues an amount of new common shares exceeding 20% of the
outstanding ones, if the issuance is not made through a public offer for
cash.
Preemptive Rights
Another way to protect shareholders in the event new shares are
issued is to grant them a preemptive right to purchase these shares. In
this case, shareholders who want to avoid the dilution of their
participation can acquire pro-rata the new shares paying the required
consideration. Of course, this protection is effective only to the extent that
shareholders have the financial means and the willingness to buy the new
shares but if they do, no dilution will occur.
The traditional approach in the U.S. was that shareholders enjoyed
preemptive rights .... More modern corporate statutes [have however
abandoned] this approach and generally deny preemptive rights unless
the governing documents of the corporation opt for them. The default rule
is t~at shareholders do not have a preemptive right in case of issuance
of
new shares, unless the articles of incorporation (or sometimes, the
bylaws) expressly provide so. In Massachusetts this rule was adopted
in
1964, under chapter 156B, section 20 of the general corporation statute
.
The M.B.C.A. and Delaware law also provide for similar rules.
Notably, there are some differences in how preemptive rights are
s~ructured . ~ome statutes allow shareholders to opt-in to preemptive
rights, both in the charter and in the bylaws of the corporation. The effec
t
-
CH. 4
FINANCING THE CORPORATION 181
is obviously different bee .
approval is necessar; t ause if _the rule is in the charter, shareholders'
could be able to amendo i:m~ nd it, while if it is in the bylaws, directors
shareholders' right with0 ut shareholders' consent. It follows that
forth in the articles s fa:e more P~otected if the preemptive rights are set
0 mcorporation.
Alternatively, a different . .
corporate statut . approach followed by a mmority of
Under this _es provides an opt-out mechanism for some corporations.
ule but the re~-~e, sfh~reholders enjoy preemptive rights as a default
r ' ar ices O Incorporation can waive them.
[... ]
Directors' Fiduciary Duties and Other Limitations to the Sale of New
Shares
A delicate issue that might arise is whether directors are allowed to
freely sell shares only to some shareholders therefore altering the
balance _of P?wer within the corporation. In g~neral terms [... ] when
preemptive rights do not apply, directors can sell new shares (or treasury
shares) as they see fit. This freedom is, however, not unlimited. Consider,
for example, a situation where the charter of the corporation provides for
a supermajority of two-thirds of the votes to approve certain
extraordinary transactions, such as a merger. One shareholder owns 60%
of the outstanding shares, and another one owns 40%. Can the directors
sell shares only to the first shareholder, thus bringing his participation
above the 66.6% threshold and giving him absolute control over those
transactions? In this case, the solution should not be found in preemptive
rights, but rather in directors' fiduciary duties and in the principle of
equal treatment of shareholders.
Part II: European Law
The European Framework: The Second Company Law Directive
The Second Company Law Directive, enacted in 1977 and amended
several times sets forth a harmonized regulation of the formation of
corporations focusing in particular on legal capital and its maintenance
and alterati~n. Its breadth spans from the minimum amount of capital to
eligible contributions and from purchasing of. owned shares to
distributions to shareholders. For ~he purposes o~ this essay the_ relevant
· · a re contained in Articles 25 1 applicable to
provis10ns . publicly ·.held
. Two key principles need .to be emphasized here. First,
corpora t ions. · · · 1 b
. l p graph 1 provides that any increase
Art IC e 25 ' ara in capita must e
'd d ' Id ers ' meeting.
. . 1e 29
Secon d , Ar tic
d ec1 e upon b Y the general shareho . . · d d th h
establishes that when the capita 1 1s increase an e ne~ s are~ are
'd · h th shares must be offered on a preemptive basis to
pa1 1n cas
shareholders in e · l t db
proportion to the capita represen e Y th err · h
s ares.
.::.::.=------------------------Ca. 4
These two provisions establish a minimum level of harmoniz t'
that is very different from, and arguably opposite of, the Amear·ion
h . 1can
regulatory model. The European approac gives more powers to th
shareholders' meeting in deciding the issuing of new shares ~
mandates preemptive rights as a general rule when shares are iss;eda;
. cas h .
. 1n
a cons1'd erat1on or
To get a clearer sense of how the general provisions of the Second
Company Law Directive have been implemented in some Member State8
it is helpful to examine some specific European jurisdictions. '
Italian Law: Regulation of Issuing of New Shares for a Consideration

The Italian system offers an excellent example of the way in which
the regulation of issuing new shares adopted in continental Europe
compares with U.S . law. In fact, as we will discuss, the Italian Civil Code
(I.C.C.) follows an approach that is considered opposite to the American
one, characterized by mandatory regulation that leaves little room for
freedom of contract and directors' discretion. Under Italian law, the
interests of existing shareholders receive a stronger protection vis-a-vis
the interest of the corporation to maintain a flexible financial structure so
as not to be diluted through a capital increase.
In addition, in light of the partially harmonized regulation at the
European level, the Italian system has important similarities with the
systems of other major continental European jurisdictions, therefore
presenting a good illustration of the European regulatory model.
[. .. ]
A first crucial difference between the Italian and American
regulation and practice of issuing new shares concerns the competence to
decide the increase of capital. Under Italian law, pursuant to the Second
Company Law Directive, the power is primarily in the hands of the
shareholders. The issuing of new shares for a consideration, in fact,
represents an amendment to the corporate charter that can only be
approved by the so-called "extraordinary'' shareholders' meeting with a
supermajority. The matter can be delegated to directors by the
shareholders' meeting, pursuant to Article 2443 of the I.C.C. In this case,
the situation is similar to the one in which a U.S. corporation has
authorized but unissued shares. The delegation to directors, however , can
only be given for a maximum period of five years, therefore limiting
directors' freedom to issue new shares.
Probably the most crucial difference concerns preemptive rights. In
contrast to the U.S.--or, more precisely, in contrast to current U.S. rules,
but similar to the traditional U.S. approach-the statutory and
mandatory rule generally applicable is that, in any issuing of new shares
for a consideration, all shareholders have a preemptive right to purchase
I
l
Q!!!-~4~-----F~IN~AN~C]l' ING THE C
h ORPORATI
the news ares proportio 11 ON 183
difference with U.S. la;a. Y to their stake int .
shareholders that exerc· is ~hat, in a cl 1he corporation. Another
right to buy the new i~e their preemptive o~e{-held corporation, the
additional preemptive r~ ~;es pro rata, but r: t do not only ha~e the
not bought. Hence if g on the shares th t ey can also exercise an
. ' a corporatio h a other shareholders have
them exercises her preem t . _n as two sharehold
percentage of shares that ~hive right, she has the rig~:
t f h e other sh h
:n
d 1
Ion Ybonehof
o a so uy t e
perce~ age_ o t e corporation's c . are older refused, increasing her
ex~rcise t~is additional right of r apital. Only if shareholders do not
third parties. p eference can directors sell the shares to
. similarly
The law. is not
it. comes t o ISsuing
1 . resp t t
different c 1ear with ec o preemptive . rights when
. h . a specific rule for
c asses of share s. Th ere is
non-vot ing s ares issued b r d
Consolidated Law on Financey T~~te corpo~ations: Article 145 of the
different option in the corpo~at is ~ule provides that, in the absence of a
have a preemptive right on sh e cf arter, holders of non-voting shares
are not issued holders of th aresho the same class. If non-voting shares
' ese s ares have a t' · h
classes of shares that are iss d M preemp ive rig t on the
view that this rule is th ue .. ost commentators have expressed the
e express10n of a more general pr. . 1 h
preemptive rights include the right to su b scri'b e sh.aresincip e,_w ere
of different
· ·f . .
categories ~ the capital increase does not respect the proportion between
the categories of shares already outstanding.
Statutory Limitations to Preemptive Rights
Pree!11ptive rights c~n be_limited or excluded only in four specific and
narrow circumstances, hsted 1n Article 2441 I.C.C . The first circumstance
applies when the resolution approving the capital increase provides that
the consideration for the new shares must be a contribution in kind. The
rationale is the same as that adopted by U.S . courts to limit contractual
preemptive rights included in the corporate charter in the absence of a
specific provision: the interest of the corporation to receive exactly the
property it seeks to acquire trumps the interest of shareholders not to be
diluted. The law suggests, however, that, even in this case, it is not
sufficient that the resolution indicates a contribution in kind, but also
that a specific business purpose for the contribution in kind be shown in '""
order to not elude the right of shareholders to maintain their stake in the
corporation.
The second case in which preemptive rights do n~~ app_lyis, pursuant
to Article 2441, Paragraph 5 of the I:C.C., ~~er~ the interest of the
. · ·t" The scope of this prov1s1on 1s clearly broader and
Corpora t 10n requires 1 . . .
more blurred, but a few examples ca~ be derived from co:p?rate practice.
· t' · goi·ng public 1t needs to have a m1n1mum number
'.
When a corpora .ion 1sd r to be admitted · · ·
to a stoc k exc h ange. The 1n1tial
Ofsh are h old ers 1n or e
-- -·-- -- - --
~1~8~4
______ -=-F~I~N~A~N~C~IN:....:..::;.;G~T~H_E
______ ~ca.4
_C_O_R_P_O_R_A_T_I_O _N
public offer must, therefore, be_made to a broad range of investors, and
preemptive rights woul~ be an msurmounta~le obstacle to_the creation of
a widespread ownership structure. In this case, the mterest of th
corporation to be listed arguably requires that preemptive rights be
limited. This may occur, for example, when a corporation wants to attrac~
a new shareholder in order to become part of a corporate group, or to
exploit the business relationships and expertise of the new shareholder.
[A] third possible exclusion of preemptive rights can be based on an
intention to compensate employees with shares of the corporation.
Pursuant to Article 2441, Paragraph 8 of the I.C.C., when new shares are
offered to employees, a maximum of one-fourth of the new shares can be
sold without granting existing shareholders a preemptive right. It should
be noted, however, that the limitation on preemptive rights can only
affect 25% of the newly issued shares in order to curb the possible
dilution of existing shareholders.
The fourth and last situation in which preemptive rights can be
limited applies only to listed corporations. This is a relatively recent
innovation introduced in 2003 and inspired by German law. Article 2441,
Paragraph 4 of the I.C .C. provides that the charter of a listed corporation
can opt for the possibility of increasing the amount of outstanding shares
up to 10% of their number without granting preemptive rights . The
rationale · of this rule is to give more flexibility to listed corporations in
designing their financial structure by allowing the issuing and selling of
new shares without the time -consuming offer to existing shareholders
required by preemptive rights. In a listed corporation, when shares are
traded on a liquid regulated market, the risk of shareholders' dilution is
more limited: existing shareholders that want to maintain their position
in the corporation can, in fact, easily buy additional shares on the market.
As mentioned above, these four exceptions to mandatory preemptive
rights are the only ones allowed: contribution in kind, interest of the
corporation, shares offered to employees, and 10% of the outstanding
shares in listed corporations. Only in these cases can the stake of a
shareholder in the corporation be diluted if the shareholders' meeting so
decides. The law, however, provides for specific rules concerning the
issuing price of the new shares in case of limitation or exclusion of
preemptive rights, in order to avoid an economic damage to investors. The
selling price of the shares cannot, in these cases, be lower than a fair
price determined through specific procedures.
More precisely, in the -first three cases listed above, the directors
must present the shareholders with a proposal indicating the issuing
price calculated on the basis of the actual value of the corporation, taking
into account, in the case of listed shares, their market price in the last six
months.
CH. 4
FINANCIN
G THE CORPORATION 195
meeting is necessary for an .
Act, Art. 199(2), Art. 20 2 ( f(i~suance of _ne:v shares (Japanese Companies
3
charter provision or by a spe . f'
unles_s it 1s delegated to the board by a
is effe~tive for only one year. c~::esolution of the_sharehold~r's ~~eti1:g that
it similar to the rule ado t d . you see the rationale of this d1stmction? Is
Civil Code, discussed in pp f,e m paragraph 4 of Article 2441 of the Italian
ro essor Ventoruzzo's article above?
***
A very delicate issue co b' . ·
the £allowing . Consi'd er a legal m ming class voting and pre-emptive right is
t .
andatory p _ t· . sys em in wh'ich shareholders do have
: ) I re hemp ive rights (or pre-emptive rights are granted by the
1
Yaws · n sue a system, if different classes of shares are outstanding it
can happen that a shareh ld
o er 1oses control · of ·
the corporat10n as '
consequence of a capital increase . Would the shareholder be entitled to aa
separate vote on th~ issuing of new shares? The "Mondadori litigation" in
!taly addresse~ !his problem. The case is intriguing also because it
involved ~r. Sil:71? Berlusconi, the well-known Italian media mogul and
former Prime Minister. A little bit of additional background is, however,
necessary. As we mentioned before, under Italian law (Article 2376 of the
Civil Code), when different classes of shares are outstanding, a
shareholders' meeting resolution that adversely affects the rights of a
class of shareholders must be approved also by a separate vote of only the
holders of the shares of the affected class. Now, imagine the following
scenario. A corporation XYZ has issued 100 common shares (voting on the
election of the , board) and 100 limited-voting shares voting only on
amendments of the governing documents and the issuance of new shares.
All shareholders enjoy mandatory pre-emptive rights, and if only shares
of one class are issued, holders of all classes can subscribe them
proportionally. Shareholder A o~ns 60 common ~hares and controls the
corporation because he can appmnt the board of directors. Shareholder B,
however owns all the 100 limited-voting shares, and 40 common s~ares.
Consequ~ntly, B controls the majority of the votes that can be cast in the
general shareholders' meeting of all the share~olders competent to
·
au th orize th ·
e issu ance of new shares (200 shares), since he controls 100 +
40 votes, versus on ly 60 controlled by A. The general shareholders ,
. .
· d h £ B can decide to issue 100 new commons h ares. If
meeting an t ere ore ' ·
rights, A wi·111ose contro I of t h e
' · their pre-emptive ·
both A and B exercise ·
. B ·nb come the new controlling h h Id
s are o er, owning ·
a
corporation and wi e h I fact A will be entitled to subscri be
. . f th common s ares. n '
maJority o e h s (SOshares) while B will be able to subscribe
60/200 of the 100 new s arhe (l 4 0/200) As a consequence after the
on s ares ·
70 of the new :omm common shares (his original 60 plus ' 30), and B
transaction, A will own 9 0 . umstances is A entitled to a separate vote
110 (40 + 70). Un de r these circ '
h res to approve the issuanc .
e of new shares,
only by holders ~f co~mo~f ~icl~ 2376 of the Civil Code?
arguing the apphcabihty · . .
Ca. 4
~
E
A CORPORATE LAW SAGA: THE MONDADORI CAS
n involved) is
The "Mondadori case" (from the name of the corporatio
de a translation
extremely long and complex and it is not possible to inclu
ide an account of
of the major judicial decisions here. Instead we will prov
ons written by
the facts and legal issues, and an excerpt of legal opini
originated in 1989
famous jurists consulting the parties. The litigation
that also tells you
and some parts of it dragged on until 2013 (a fact
The case concerns
something about the duration of litigation in Italy . .. ).
and a listed
control over Mondadori, a leading Italian publisher
fight between two
corporation, and saw a bitter financial and judicial
Berlusconi and his
major Italian entrepreneurs: on the one hand, Silvio
Benedetti and his
Fininvest corporation, and on the other hand Carlo De
CIR corporation. They are pictured below.
Silvio Berlusconi
--. .,
.t
7
.. ~-
Carlo De Benedetti
-
CH,4 FINANCINGT
The story is known as th "b

RE CORPORATION 197
Milan where Mondadori has itseh ~tle of Segrate," from the town near
in the 1980s Berlusconi and F·1e~ quarters. To make a long story short,
:Mondadori. At the end of the
shareholders: Berlusconi and his
n;~~~st acquired ~ significant stake in
s, ~ondadori had three relevant
through CIR (roughly 16%) a d ~ up (with roughly 8%), De Benedetti
O
founder Arnoldo Mondadori 'an~ ro! e Forment~n family, relatives of the

with Leonardo Mondadori ( 1.ttl mer controllmg shareholders, together
executed a contract to trans£ a t~ _e more than 50%). The Formentons
P
ursuant to the agreement Der B eir sha!es to De Benedetti before 1991;
· d t 1 f
.
the corporation. In 1989 h e enedett1 would h ave acquire con ro o
heart and sold its share~ tooi:~er, th~ Formenton family had a change of
Mondadori . De Benedetti r uscom, who became _the new Chairman of
. challenged the transaction- pursuant to the
contract, disputes had to be arbitrated · Th e ar b"t ' pane 1, compose d
1 ra t·10n
£
of two 1aw p~o esso~s and a judge of the Italian Supreme Court, found for
De Benedetti, holding that the Formentons breached their contract with
him. De Benedetti regained control of Mondadori. The arbitration award
was how~ver challenged in court, and the Court of Appeal of Rome, in
1991, decided that the agreement between the Formenton family and De
Benedetti was at least partially void. The shares returned to Berlusconi.
Politicians stepped in: the control of some of the most important Italian
newspapers and magazines was at stake. Apparently Giulio Andreotti,
then Prime Minister, contributed to broker an agreement according to
which some newspapers, such as La Repubblica, one of the major Italian
newspapers, would be transferred to CIR and the De Benedetti group;
while other assets and businesses would go to Berlusconi and Mondadori.
Many years later, in 2007, the Italian Supreme Court has concluded that
a judge was corrupted in order to obtain an outcome favorable to the
Fininvest group in the 1991 decision of the Court of Appeals of Rome, and
in 2013 Fininvest was ordered to pay over 540 million euro in damages to
CIR.
This is however only the background of our problem. In the years in
which the battle of Segrate was going on, between 1989 and 1991, the
issuance of new shares that would give control to one party was .,)
considered, and this is the question we should focus on.
· h d · ued common shares with full voting rights; 11 d
Mon d a d ori a iss ·
· · d t· hares that would only vote 1n the so-ca e
preferred hm1te -vo ing s · f h .
.' h lders' meeting also on the issuance o new s ares,
extraordinary share O A . previous example and somehow
t· hares s in our '
an d some non-vo ing ~ f · story Berlusconi and his group had the
O
simplifying, at one pmnt our b t ot of the limited-voting shares; and
. . f th mon shares u n .
maJority o e com_ had the majority of the limited-voting shares.
De Benedetti and his group t approve the issuance of new common
De Benedetti had enou.gh v?t:: f:r all shareholders, independently of the
shares with a pre-emptive rig
class of shares they owned; Berlusconi did not own enough common
shares to block this resolution. Pursuant to the appellate rules, in fact, in
case new shares of only one class were issued, they had to be offered to all
shareholders. In the light of the ownership structure, if the capital
increase would have been accomplished, De Benedetti, so far holding the
majority of the limited-voting shares, would have obtained also a majority
of the common shares, and acquired control of the corporation and the
right to appoint the board of directors. The question was if, in this
scenario, holders of common shares had to separately approve the capital
increase because it damaged their position (since the controlling
shareholder would lose control). If the answer would have been
affirmative, Berlusconi could have vetoed the issuance of new shares and
kept control.
Pursuant to Article 2376 of the Italian Civil Code, a separate class
vote is necessary whenever the general shareholders' meeting approves a
resolution that "adversely affects" the "rights" of a class of shareholders.
Does the fact that one shareholder loses control due to the issuance of
new shares adversely affects the rights of a class of shareholders
)
(
pursuant to this rule? Due to the conflict among the parties, and the legal
uncertainties, the capital increase was not pursued, but several law
professors and lawyers issued legal opinions on this matter, and these
opinions have been published in law journals.
According to the opinions of some scholars, Article 2376 of the Italian
Civil Code does not apply in this scenario:
"The shareholders' meeting resolution does not envisage the
issuance of a new class of shares with preferred rights nor does it
determine any change of the current balance between common
~
shares and preferred shares: on the contrary, it increases the
. number of common shares, which results in a dilution of
.
I preferred shares. In this way, it strengthens the position of the
common shares with respect both to the voting rights and to the
cash-flow rights. Therefore, it cannot be said that the rights
attached to the common shares are adversely affected. The
opposite is true" (R. COSTI, in Giur. comm., 1990, p. 571).
"The shareholders' meeting resolution affects only one kind of
interest, i.e., the interest attached to the common shares to
maintain the same voting power. Such interest shall be protected
only by the pre-emption right. Therefore, in this case, Art. 2376
I.C.C. does not apply since there isn't any prejudice to a legal
entitlement deemed as 'a right' nor, above all, to 'a right of a ,
class of shares"' (P. FERRO LUZZI-B. LIBONATI, in Riv. dir.
comm., 1991, I, p. 708).
CH. 4 FINANCING
THE CORPORATION 199
Other scholars exp ressed a dif!' . .
"When th . . i.erent opinion:
e capital is raised th .
not deemed to be f£ ' e rights of the different classes are
distribution of new ha ected when theh planned issuance and
. s ares togeth er wit . the exercise of the pre-
emptive right have th f; · · the shareholders in
· t aming
' e e i.ect of m am
th e same position th h 1
terms of voting powe:y de d before t~e capital increase (both in
the pre-emptive rights~oil~sh-flow rights). When th~ exercise of
between classes of h not prevent the alterat10n of power
shares, it would be ns ares caused by the distribution of new
ecessary to call a se~ara t e meeting . f h
h old ers of the affected stock o t e
the exercise of the : In t~e case discussed hereby, since
shares is not suffici::t~:ptive right _by ~he holders of common
before a separat . order to maintain the same position as
appro;e the tra e mt~eti,?g of holders of common shares must
nsac wn (F · D'ALESSANDRO , 1n . G·
1990, pp. 587-58 8). iur. comm.,
"In the. case described , th e extraordin. ary general meeting's

hresoIdIu t 10n must be appr oved a 1so b Y the separate meeting of
0 ers_ of com~or_i shares: in fact, the capital increase
determines a shift 1n the balance of power between different
classes of shares and, as a consequence, a change in the voting
power
. of the outstanding common shares" (GB . . PORTALE '1n .
· R w.
d ir. comm., 1991, I, p. 732).
NOTES AND QUESTIONS
~-. First of all, consider the relevance of opinions by legal scholars and
pract;,t10ners _(so-c~lled ''pro~v~ritate" opini~ns, froi_nLatin "in the interest of
truth ), especially 1n some civil law countries. ObVIously these opinions have
no binding force, but they are often respected by courts and administrative
agencies, and can be important also to avoid the risk of liability .
2. We agree with the first two opinions, Article 2376 of the Italian
Civil Code does not apply to this case. As hinted in the excerpts reprinted, the
key issue is that the "rights" of a class of shares have not been altered here:
this would be the case, for example, if a preference in the payment of
dividends would be reduced, or limitations to voting rights would be
introduced. In our case, there is only a factual change in the position not of an
entire class, but only of one shareholder who happens to have the majority of
the common shares. Obviously this is not desirable for the shareholder losing
control but technically it is not an adverse modification of the rights of one
class. A substantive reason also supports this conclusion. Since under Italian
(and European) law shareholders have pre-emptive r~ght~, a shareholder
having the majority of the common shares and a minority of preferred,
limited-voting shares has probably decided or accepted this ownership
structure. There must have been a point in time when the shareholder, for
CHAPTER 5
CORPORATE GOVERNANCE
•••
INTRODUCTION
"Corporate Governanc " · . .·
th e is an ambiguous term. Narrowly defined it
concerns
. . e powers ' rights d d · f · '.
(m particu 1ar, shareholders' , meeting
an uties o the different corporate bodies
and directors and when it exists as
a. separate body. , the
. board of supervisors
· · ' · the
or auditors), and deals with
mternal orgamzat10nal structure of the corporation and its functioning.
!n a broader sense, however, it also includes other legal and economic
mstruments that affect the conduct of directors and shareholders: in this
broader sense, for example, the market for corporate control and
takeovers regulation is also a governance mechanism in the sense that
the possibility of a takeover can "police" the conduct' of directors. More
generally . one might argue that, directly or indirectly, corporate
governance can include all rules that have an effect on the governing
bodies of the corporation including, for example, rules concerning the
financial structure of the corporation, or shareholders' agreements.
In this chapter, we will focus on corporate governance in a fairly
narrow perspective. We will first consider the different corporate
governance models that can be found around the world, discuss the
composition of the board, and finally focus on one of the fundamental
relationships defining the governance of the corporation, the one between
the shareholders' meeting and the board of directors. In particular we will
discuss the often blurred line that divides the powers and competences of
the shareholders from the ones of the directors. Needless to say, as in
other parts of this book, it is i~possible to c?ver everything: we selected a
few topics to make the discuss10n more specific, concrete, and relevant.
CORPORATE GOVERNANCE MODELS

If e wants to focus on all the details of existing governance models,
·t lodn robably be necessary to conclude that each country has its own
1 wou p . . d 1 .
system. It is possible, however, to grou~dexisdtm~ m~ es m t h r~e. b as1cf .
families: most legal systems can be cons1 ere a optmg one variation o
these three basic models.
Th e fiirs t o Ile can be defined the "one-tier,"
£
"Anglo-Saxon" model,
· th u
£o11owe d 1n e . ., K the U.S., and most B . .h 1 .
ormer r1tis co omes, m . h. h
w 1c
219
220 CORPORATEGOVERNANCE ~
the ~hareholders' meeting appoints a board of directors. Within the board

of d1r~ctors, especially in larger and more complex organizations, several
committees are usually established, either because the law mandates
them, or because it is a best practice voluntarily followed by most
corporations. A particularly important committee is the audit committee
which has a controlling function on the activity of the board and
sometimes on accounting and financial issues. A second model is the "two.
tier" or "German model," in which the shareholders' meeting appoints a
board of supervisors (in German, Aufsichtsrat), and the board of
supervisors, in turn, appoints (and might revoke) a managing board (in
German, Vorstand). The first body, as the name suggests, has primarily
controlling functions, and sometimes is responsible for approving
strategic plans and the financial statements of the corporation; the
managing board has the responsibility to carry on the day-to-day business
of the corporation (more precisely: to coordinate with and oversee
managers and executives concerning the day-to-day activities). A third
model could be defined the "traditional Latin model," and has originally
developed in France, Italy, Spain, and countries that trace their legal
origins to these systems. Japan, China and Taiwan, usually classified as
German-law based countries for corporate law, also adopt this model,
confirming the diversity determined by legal transplants today. In this
case, the shareholders appoint both a board of directors and a separate
body entrusted with controlling functions: the · "commissaires aux
comptes" in France, the "collegio sindacale" in Italy, the "auditores" in
Spain, the "Kausayaku-Kai" in Japan and the ''jian-shi-hui" in China. In
Taiwan, the members of this body are called ''jian-cha-ren," but there is
no special name for the body because their office, and the way they act, is
individual, not collective, in order to ensure greater independence (this is
an interesting concept: can the existence of a body somehow affect
independence? What about efficacy?)
The following diagrams illustrate the three models.
' '
CH. 5 CORPORATE GOVERNANCE 221
e l
Mode
[On~tier Anglo..SuonGo1"ernanc I
[ board of directors(includesaudit and othercommittees) I

'~
J!
.5
0
"'
~
I shareholders'meeting I
·ITwo..tiel'GermanModelI
Imging board [forst.andj I

'
J!
.5 .
8.
~
Iboard of supervisors[A¢"ichtsrat]I
'
fshareholdersmeetin
, g[HauptversammlunIg]
,.
'
/ TraditionalLatin Model/
board of directors[con.selld 'admistration, boardof supervisors

con.s,jode.admini.stratores , consiglio [commisail'es
aux comptes,
auditores, collegio sin&rale]
d 'amministrazione]
• ' .
J! J!
.s .s
0
p. &
~ ~
/ shareholders'
meeting[assemb1ee,junta, assemble-a]J
In all three models, there is often also an external a1:1dinde~endent

auditor, usually mandatory in listed corpor~tions, w~ich audits !he
financial statements and performs other functions especially concermng
I evaluations and financial issues (e.g., confirming the fair price of newly
issued shares when required). One variation of the Latin model worth
mentioning can be found in Brazil, where listed corporations can, as a
controlling body, either have a permanent or a temporary "fiscal board"
(conselho fiscal). For further information on this model, and ~mpirical
data on its use, see B. S. Black-A. Gledson de Carvalho-E. Gorga ,
Corporate Governance in Brazil (2009), available on www.ssrn.com, and
also, if you read Portuguese (which you should), E. Gorga, Direito
Societario Atual, Elsevier, 2013, 263 ff.
In Germany, during the National Socialist dictatorship, a general
corporation statute was enacted in 1937 (substituted with a new statute
in 1965). In terms of governance, one distinctive feature of the 1937
German Corporation Law was the so-called Fiihrerprinzip , or "rule of the
lead~r," according to which-in line with the dom inating i deology-the
President of the Vorstand could adopt decisions also without the consent
of the other members of the board and, in addition , the Vorstand had to
manage the corporation not only in the interest of the shareholders but
also of the people and of_the State (§ 70 AktG 1937: "wie der allge~eine
Nutzen von Volk und Reich es forden") We will come b k t th" ·
later. · ac o Is Issue
CH. 5
_:::.:;:.;...;;'-------~~
Co
R~PPORATE G
. OVERNANCE
One mteresting ch 223
~
. 11y 1ollowed aracteri f
partia also . s ic of the Germ
("Mitbestimmung') T in other t ~n governance model,
. · he expr . sys em, is "co-determination"
representation of emplo . ession refers t O th d
t' Th' Yees in the b e man atory
corpora ions. . is ~o-called worker , oard ?f ~upervisors of larger
today was mamly introduced b t~ co-d~termmat10n as it is structured
because the German coal d Y e Alhed Forces after World War II
st ~~l conglomerates had supported th~
Third Reich and the Geri:n
an military · Ar guablY, some large mining
.
en t_e~prises, an d their controllin
facilitated the Nazi rearma g shareholders or directors had
. . ment, and one Of th e ideas. '
determmahon was that a more "democratic" underpinning co-
. h wor k ers • representative · · of the board,
composition
wit
. di ctatorships and s,
. ht -wmg
rig · dwould. preve n t ns. k Y an·iances between
future. Consequently, the sum u~trial potentates to occur again in the
corporations in the coal and sI'ers~ry boards of several newly formed
t
of the workers. After this rest ee t m. US ry had to include representatives
set into place by the West ruclliurn:i,gof th e coal and steel industry was
ern a es m the Weste t fG
this structure became legally b' di £ rn s~c ors o ermany,
industry in 1951 pursuant to the;:;. ~g CorDthe e~tire_ coal and steel
11K· b · . mmg o- etermmation Act (Montan-
.
. with
t 1 an d coa1 compames
estimmungsgeset
.1.t,1.itth 1 000 z) • which required a 11see
more an , emp 1oye~s to have a supervisory board consisting of
eleven members, five of which were appointed by th e emp1oyees, an d five
bY t.h e shareholders. The eleventh board member had (and has) to be
appomted by both groups.
In 1976, workers' co-determination was expanded to all corporations
by th~ Workers Co-Determination Act (Mitbestimmungsgesetz). According
to this statute, all corporations with more than 2,000 employees must
have a supervisory board in which half of the members are appointed by
the shareholders and half by the employees. The chairman ·of the
supervisory board, appointed by a two-thirds majority of the members of
the board, has a casting vote. If the supervisory board does not reach a
two-thirds majority to appoint the chairman, the representatives of the
shareholders appoint him or her, and the representatives of the
employees appoint the deputy chairman. Moreover, all corporations with
more than 500 employees must have a supervisory board in which one-
third of board members are appointed by the employees ("One-third
Workers Co-Determination Act" or "Drittelmitbestimmungsgesetz").
Although generally all German corpora~ion~ fall under the scope of the
workers co-determination, co-determination does not apply to
corporations with a political, confessional, charita~le, s~ientific, _arti_stic,
or journalistic purpose since this would be considered an un1usti_fied
vi l t' f th fundamental rights of the owners of the corporations
press, e t c. Th e
. . German
o a 10n
. o f ed of speech religion,
. .
r egar d mg ree om t upheld , the Workers Co-Determmat10n Act
·t · al C .
ons t 1 ution
Ciu:· our . .
b · t ,\ of 1976 by argmng that, for corporations with a
( 1.r1it estimmungsgese z1
224 CORPORATE GOVERNANCE Ctr
~
different purpose than the ones mentioned above, shareh?lder~' Propert
rights are sufficiently protected by granting a double votmg right to thy
chairman of the supervisory board appointed by the shareholders in th:
absence of an agreement between shareholders and employees (see
Constitutional Court as of 1/3/1979-1 BvR 532, 533/77, 41 9177, 419/78, 1
BvL 21/78, BVerfGE 50, 290). Although some members of the super~isory
board are appointed by shareholders, and some by employees, there 1snot
a distinction concerning the legal duties of board m~mbers. Con~equently,
all members of the supervisory board have to a~t m the best interest of
the corporation and all members of the supervisory board can_be held
liable for a violation of this duty. Nevertheless one has to consider that
German corporate law follows a rather broad definition of the best
interest of the corporation taking into account the interest of the workers,
the creditors and the shareholders as a whole.
Interestingly enough, several other European legal systems provide
for some form of co-determination, of course with notable local variations:
Austria, Denmark, Finland, France, Luxembourg, the Netherlands,
Poland, and Sweden (in France, for example, the number of
representatives of the workers on corporations' boards is lower than in
Germany). A proposal for co-determination was even considered in the
United Kingdom, just before the "winter of discontent" (the winter of
widespread strikes in 1977-1978 that lead to Thatcherism), in the so-
called "Bullock Report." The effect of workers' representations in the
Anglo-Saxon model would have been even more profound than in
Germany because in this latter case the workers only appoint members of
the supervisory board, not of the managing board; in the British proposal,
on the other hand, the representatives of the workers would have been
seated in a board with managing functions. The idea was however
abandoned. The European Union also has entertained the idea of
harmonized legislation on this issue, but no proposal has ever reached a
sufficient level of consensus. .
.., I
, .· ·
What could be the causes and consequences of co-determination for
~xampl~ wi_th_respect to labor law? The following excerpt offers s~me
:f 1nterestmg ms1ghts .
..
,,'
I
!
" '
I .
'j !
j
i I
·-... ..
, '
'") .-
CH.5
CORPORATE GOVERNANCE 225
JENS DAMMANN T
REDEFINING'~E MANDATORY LAW PUZZLE:
IN CoERRICANEXCEPTIONALISM
PORATELAW
65HAS TINGS L. J . 441 (2014)1
[... ]
7, . One of these reasons relates t O . . ..
,f disclosure mechanism A H the function of codetermmation as a
i work on corporate ow~er ~-1 enry Hansmann has shown in his seminal
t it can lower the corporat; P•a centr~l benefit of codetermination is that
~
asymmetries between fi1on s contractmg costs by reducing informational
nd
negotiate. If labor union ~m~ a . th~ labor ~nions with whom they
partners' economic s·t s t~c credible mformat10n about their bargaining1
1 ua ion then both si'd es m1g . ht resort to cost y
measures such as st ·k '
this problem Thr r~ :~ or lockouts. Codetermination helps toteovercom e
th . h oug_ e employ ee represe ntatives on corpora boards
e umons ave re~iable information about the economic situation of
firms, greatly reducmg the likelihood of strikes and other distributive
measures.
~he di~closure. function of codetermination is now widely recognized.
C_rucially, 1~ has important implications for explaining transnational
differences m codetermination laws. Obviously, the disclosure function
can only acquire relevance where firms (or associations of firms) are
confronted with labor unions, and where wages are in fact determined by
collective bargaining agreements. It is in this context that a further
difference between the United States and Europe gains importance.
Compared to the United States, European countries rely much more
strongly on collective bargaining agreements to set wages.
As of 2011-the most recent year for which data is available-only
about 13% of U.S. employees were covered by collective bargaining
agreements. This number contrasts rather sharply with the
corresponding percentages in European countries: 99% of employees are
,
covered in Austria, 92% in France, 92% in Slovenia, 91 % in Sweden
89.5% in Finland, 62% in Germany, 40% in Slovakia, and 28.9% in
Poland .
It follows that one of the central benefits of codetermination-:--namely
its potential to reduce bargaining costs betweer:i labor umons and
employers-simply has much more relAevanc~ mh m~nyd Eu~opeahn
· h Germany France, or ustria, t an 1t oes m t e
countries, sue as ' d · · · ffi ·
United States. This does not per se imply th~t c~ eterm16nat10Hn1s e 1ciehnt
· th its costs might outweigh its bene its. owever , t e
m Europe ere, codetermination
; · even· that . · ·k 1 b 1 t· 1
. is h e Y to e re a ive y more
crucial pomt is . U ·t d States
th · .
efficient in Europe than m e m e
•
226
~~-----~~~~~~~:.::..:,::..::..:.;~------
CORPORATE GOVERNANCE ~ CLJt
[... ]
There is also another reason why codeterminatio_n might be rnore
efficient in Europe than the United States. In ~ractice, th e employee
representatives tend to use their role in the supervisory board to voice the
concerns of employees and ensure, as they view it, that the latter are
treated fairly. The additional protection thus accorde~ to employees
might be the answer to an efficiency problem that arises _due to the
particular structure of European employment law. In the Umted ~tates,
employees can generally be fired at will. In most Europea? countri_es,by
contrast, the basic rule is that employees cannot be termmated without
cause. One can question whether this typ~ of strong ~mployment
protection is efficient, but that is beside the pomt. As a prac~ical ~atter,
for most European countries, far-reaching steps toward the hberahzation
of employment markets are simply not politically feasible. _
One major drawback of the for-cause requirement is that it creates
an obvious incentive for harassment and, more generally, bad faith
treatment. Seeking to rid themselves of below-average employees,
employers have an incentive to make the relevant employees' work
environment unpleasant in order to persuade them to quit "voluntarily."
This is an issue of great practical importance. Empirical studies in
various , European countries suggest that workplace bullying is a
widespread and serious problem affecting between two and twenty-two
percent of employees and that it has significant negative consequences for
the health of employees .
. ~
:I Admittedly, one can make a theoretical case that workplace bullying
and other bad faith treatment aimed at persuading employees to leave is
not necessarily inefficient. After all, if one strongly believes in the
efficiency of termination at will, then measures that weaken Europe's for-
cause requirements might seem prima facie desirable. However, in light
of the significant negative impact that bullying has on the affected
employees' health-costs that are not usually reflected in the employer's
cost-benefit analysis-such a line of reasoning seems rather implausible.
If, on the _ot~e_rhan~, one assumes that bullying aimed at persuading l
workers t_oquit i~ mefficient, then one of codetermination's benefits might
be that it _proVIdes some ?rotection against such bullying; employee
representatives can use their clout in the supervisory board to persuade
corporatio~s to respect the rights of the employees. If one further assumes
that American ~mploy~rs who can fire their employees at will do not need
to rely ?n bul_lymgto rid themselves of unwanted employees, the relevant
·'
.'
I
protect10n might be more sorely needed in Europe than · th
States. in e m
u· ted
.-: In sum, the fact that some European countries prote~t em lo ees
i
} I through corporate governance, while the United States does not, pea~ be
: ·i
I .,
l ·,
I ,-
; '
a certa. in t . ·
explained · to · h t sim I bex ent by efficiency consi. derations.
' det ermina t·ion mig · ce
ier relian
Co . b . . PY ea response to Europe's heav
11 t argai ning agre t . . .
on co ec ive emen s and less flexible termination rules.
***
f
It . is .interesting also t o consi·der the possi·ble effects o co-
ets o · ht £or examp Ie, that
determination h on. securities mark · ne mig argue, oyee s might be
a b?ar d t at in cludes representatives of the empl
g that the
particul~rly a~verse to a hostile acquisition or merger, fearin
respect the
transactwns will lead (as is often the case) to layoffs. In this
mung in
Ger~an governance. structure, and the use of Mitbestim
entators,
particular, can contribute to explain, according to some comm
to the U.K. or
the lower level of takeover activity in Germany as opposed
the U.S.
and linked
· We ha':e menti~ned the three basic governance models,
that in the
them to their countries of origin. It should be noted , however,
different
last few decades several countries have made available
in its bylaws,
governance models to their corporations: a corporation can,
in a "menu"
opt for one of two or sometimes even three models available
France it is
offered by the legislatures. Since 1966, for example, in
e, and a two-
possible to opt between the traditional model discussed abov
similar to the
tier model with a conseil de surveillance and a directoire
adopted this
German system. Some large French corporations have
choose from,
option. Several other European systems offer two models to
reform; and
and some even three: this is the case of Italy , after a 2003
blic allow to
Portugal, after 2006. Also recent reforms in the Czech Repu
d model in
choose between different models. Japan introduced a secon
of the one-tier
2002, and a third one in 2014. The second one, a variation
the Board of
Anglo-Saxon system , mandates three committees within
a majority of
Directors (audit, compensation and nomination) with
on the German
outside directors. The third model, however, is not based
only the audit
tradition, but is rather a simplifi ed one-tier model with
committee.
to add this
The theoretical reasons why a legislature might want
all: since all
level of flexibility are quite obvious--0ne size doesn't fit
to define the
models have pros and cons , and it is probably impossible
sh arehold ers or
most desirable model under all circumstanc es, to let the
for minority
the managers decide, providing ad~quate pr~t ections
what could be
shareholders and third parties, seem s hke a good id ea. But
one particular
the practical reasons why a corporation might pr efer
and try to li st
model? Before continuing reading , pause for a second
of th e three
possible reasons that you can imagine for adopting one
models.
~AN~C~E
___
~R~N
___ ~Ctt.5
_______
_2_2_8 C~O~R~PO~RA~T~E~G~O~VE ~
ts.
first reason might be related to cos
D_one?OK, let's see. Of course a mi ght
held corporation, some models
Especially for a small, closely erning bodies and theref ore less
e few er me mb ers of the gov
requir e Anglo.
ed organizational structure. Th
expenses and a more streamlin bil l: it can be structured in a way
r mo del see ms to fit the
Saxon one-tie
rd members .
that minimizes the number of boa ss
the oth er han d, the two -tier system could ease busine
On ecdotal
case of a friendly merger. An
combinations, especially in the has been adopted by some Italian
exa mp le, sho ws tha t it
evidence, for ego
tha t me rge d. Th e rea son is sim ple, and has to do with human
banks g a
underestimated when negotiatin
(something that should not be tem has two boards (even if with
bin atio n): the two -tie r sys
business com "Presidents" or "Chairpersons": one
ent fun ctio ns) , and the ref ore two
differ is might
one for the managing board. Th
for the board of supervisors, and ire s of the bosses of the merging
ier to acc om mo dat e the des
make it eas e. In
atio ns, gra nti ng to eac h of the m a satisfactory position and titl
corpor is apt
that the German two-tier system
this perspective it is also possible the helm of a family business: the
gen era tio nal tra nsi tio n at
to manage a sit on the supervisory board,
and
nde rs of the cor por atio n can
old fou but not
remove the managing directors,
retain the power to appoint and the new
rations of the business; while
interfere with the day-to-day ope
ing board.
generation can serve on the manag
·./ als o be des ira ble for the subsidiary of a foreign parent
It might similar
atio n to ado pt a gov ern anc e structure that mirrors, or is as
corpor iary of
sib le, to the one of the par ent . For example, a French subsid
I•
as pos ages of
pt the two-tier model: the advant
/, a German corporation might ado parent
re, already familiar to the
a similar governance structu
corporation, are self-evident.
tile
models might also make hos
Arguably, some governance German two-tier model, if
dif fic ult . Fo r exa mp le, wit h the
takeovers more stake in a corporation, even in
old er obt ain s a con tro llin g
a new shareh l
e of a co- det erm ina tio n me cha nism, before being able to contro
the absenc first
nag em ent of the cor por atio n, the new shareholder must
the ma ones;
the me mb ers of the sup erv isory board and appoint new
remove of the
, the new sup erv iso ry boa rd must change the composition
second ces and
ing boa rd. Th ese ste ps might take time and resour
manag least, more
trib _ut e to ma ke a hos tile acquisition less likely or, at
con
expensive.
,
lig ht of the se pos sib le rea son s to adopt ·a particular model
Even in
for get tha t leg al sys tem s hav e a certain degree of inertia
one should not
pre fer s to say , pat h-d epe nde ncy. Also in countries that
or, as someone lly the
~ . ma d:, mu ,~t ipl e gov ern anc e models available, statistica
hav
mo del ten ds to be by far the most widely adopted, even
trad1t10nal local
_9:!·5 CORPORATE GOVERNANCE 229
years after the introduction of d'f£ .
·n
1
Italy only six listed corpo t' i erent options (as of 2013, for example,
f little less than 300 h d d ra 10ns--eve ·f f 1
n i air y 1arge ones-over a t ot a 1
·
~012, only 2.2% of the c~r ~r o~ted t~e German model). In Japan, as of
dopted the second mod ~ ations hsted on the Tokyo Stock Exchange
athe reasons for the 1
introde introduced
t" in. 2002 . Can you now
un ders t an d
uc ion of the third model in Japan in 2014?
COMPOSITION OF THE BOARD OF DIRECTORS

A. central
. issue in exami nmg · governance structures · ·
as mdicated by
the discuss10n about co-determination · th · · ' f th b d
. t
d~rec ors.
Th dif , is e composition o e oar of
ere are ferent "categories" of directors that perform
different roles. The r~les concerning the composition of the board can be
mandatory a nd p~ovi~ed by statute or by stock exchange listing rules,
adopted volunt,~rily in the governing documents of the corporation,
sugges~ed by a code of best practices" enacted by different organizations
(sometimes pursuant to a "comply or explain" rule originated in the
1990s in the U.K.), or simply followed as a matter of f;ct.
It would be impossible to list all the different approaches existing
even just in the major jurisdictions, but it is useful to discuss the different
"categories" of directors. First of all, we should mention the role of the
Chairperson or President of the board. She is generally entrusted with
the power and responsibility of running the meetings: calling them (even
if in most jurisdictions each member of the board, or at least a qualified
minority, can call a meeting), setting the agenda, conducting the
discussion and the voting procedures, etc. Sometimes the Chairperson is
also the Chief Executive Officer, even if this practice has been criticized
by scholars and policy makers because of the concentration of power in
the hands of a single individual, especially considering that the
Chairperson has also the task of ensuring procedural fairness and
circulation of information among board members. Several corporate
governance codes require or strongly suggest separating the role of the
Chairperson and of the C.E.O. A first important distinction is the one
between executive and non-executive (or outside) directors. The first ones,
obviously, are also executives of the corporation-which generally means
employees with top managerial tasks; while outside directors only sit on
the board (and are committee members) but do not have other roles
within the organization especially as managers. Non-executive or outside
directors are considered more "independent" from the corporation since,
as opposed to executive directors, the~ are not inv~lve~ in the day-to-day
activity of the going concern, and their _compensation is generally no~ or
less strongly correlated with the economic performance of the corpora~ion.
· At least in some countries and pu~suant. to some corporate
governance codes, however, non-executive directors s~ould be
distinguished from "independent" directors. In order to quahfy as an
(' I•
CortPOIUTf•; Gov1mNANCE Ca.5

induponuunt director, bourd members must not have (or have had in the
t·ocont puHt) any significant personal, financial, or professional
rolutionHhip with the corporation in addition, obviously, to their
directorship. While generally independent directors mu~t be non.
executive directors (and they might lose th eir status. as 1~dependent
directors if they become executives), not all non-executive directors are
al1-10indepondent: consider, for example, a lawyer of the corporation
becoming a non-executive, but also non-independent director.
In<lcpendunt directors are particularly important, for example, in
order to approve (or reject) resolutions in which other board members
might have a conflict of interest, or transactions with related parties, as
we will discuss more extensively in Chapter 6 on directors' duties.
To make our discussion more concrete, consider the following two
provisions from Italy. The Italian statute regulating listed corporations
(so-called "Testo Unico della Finanza" or "TUF'', which means
"Consolidated Law on Finance") requires that if the board of a listed
corporation has more than four members-which is virtually always the
'.: case-at least one of them must have the independence requirements set
I~. \
~... forth by Article 148, Par. 3 of the same statute, pursuant to which , in
relevant part, independent directors cannot be:
"b) spouses or relatives up to the fourth degree of kinship of the
directors of the company, spouses or relatives up to the fourth
degree of kinship of the directors of the companies it controls, the
companies it is controlled by and those subject to common
., control;
c) persons who are linked to the company, the companies it
J controls, the companies it is controlled by and those subject to

common control or to directors of the company or persons
referred to in paragraph b) by self-employment or employment
relationships or by other relationships of an economic or
professional nature that might compromise their independence."
This provision raises interesting questions, demonstrating how
difficult it is to write a bright-line rule concerning the concept of
independence. For example, in your opinion, based on the above
definition, could a non-controlling but important shareholder of a listed
corporation, owning 5% of the shares, be considered "independent"?
Interestingly enough, however, one should also consider the
Corporate Governance Code sponsored by Borsa Italiana 1 the Italian
Stock Exchange. The Code is n9t mandatory, in the sens e that listed
corporatio~s are free to adopt it entirely or in part, but they are required
by law to ~1sclose to the m~r~et ':h~t parts, if any, of the Code they follow
': ' ; (s~-called comply or explam prmc1ple), and might be sanctioned if they
'
',
II :· ~
..
I
I misrepresent information in this respect . The Code provides for more
- t !
;: f H
iI ' I). '·• 1·'
; r 11 !; •
I ; ,
i ,~ ' t
.... ·! l
:_
f_H, 5 CORPORAT G
E OVERNANCE 231
rigorous rules concerning ind
t h a t an "a dequa t e" number ofependent
d" dire ct ors. F.Irst of all, 1t
. requires
.
it contains a definition of inde Ir:ctors sho~ld be independent; secondly,
more rigorous than the statut pen ence that Is more detailed and possibly
other words, indicates best pror~_one.The Corporate Governance Code, in
one established by the legislate Ices th at set a higher threshold than the
ure.
The consequence is that, in Ii ht . .
corporations that adopt the C;d 0 ~ the very high number of Italian
important role or at least e, mdependent directors have an
different questio~ would beaipear f:equently on the boards of directors (a
ample in 2013 th o c?nsider how truly effective they are). For
~x ' . ' e average size of the board of directors of an Italian
hsted · corporat10n
1 · · . was approximately 10 d"irec t ors (s1·igh t 1y more 1n ·
financia. 1nstitut10ns,
. 14) , and on avera ge th e boar d of d.irec t ors h a d 3
executive ~irecto~s, 3 non-executive directors, and 4 independent (and
non-executiv~) direc_tors (see Assonime-Emittenti Titoli. La corporate
gov:rnance in Italia: autodisciplina e remunerazioni (Anno 2013),
available at http:/ lwww.assonime .it).
In the last few years, if not decades, the number and relevance of
independent (and/or outside) directors have risen in virtually all
developed nations. Is this desirable? Does this create the risk of a less
cohesive board? Do independent directors without executive roles really
have access to all the information, generally guarded by the managers,
necessary to oversee the business and ensure the legality of corporate
activities? Or should the supervising function of independent directors be
welcome? And what are the possible causes of this evolution? In the
following excerpt, Professor Gordon offers some possible explanations:
even if focusing on the U.S . market, its reasoning is interesting also to
consider the phenomenon in other systems.
JEFFREY N. GORDON, THE RISE OF INDEPENDENT

DIRECTORS IN THE UNITED STATES, 1950-2005: OF
SHAREHOLDER VALUE AND STOCK MARKET PRICES
· 59 Stan. L. Rev. 1465 (2007)2 ·
·· Th ere 1s
· a power ful trend in favor of.independent
. . directors for public
firms in the United States, yet the emp1nc~l eVIdence addhucedh~hus fadr
· · · explanation. The Article suggests t at t 1s tr en
gives us no conv1nc1ng s r· 1 F.
reflects two interrelated developments in t~e U .. po iticat ecob~omt _y .. itrhst
. . h holder value as the primary corpora e o Jee IVe, e
1s the shift to s are . t· of stock market prices. The
d . h ter informa 1veness
secon 1s t e grea ·t · th firm to a shareholder wealth-
·d· f'!'
overr1 1ng e .1ec IS
t . to comm1 e
d by stock price performance. Stock
. . . t t gy as best measure
max1m1z1ng s ra e f most things. In this environment ,
prices are taken as the measure 0
_0l·5 CORPORATE GOVERNANCE
233
consideration. For example ·
1
concentrated ownership s~r~nt egal syst ems characterized by a more
. c ure such .
indepen d en t directors could be c .d' . as m continental Europe,
. on executive. directors e onsi ered imp ort an t to perform a controllmg.
funct10n
xpressed by th e contro 11mg
. shareholder.
Ar
2. e we sure, however th t .
"independent" and have ' ff:~. indep~ndent directors are really more
understan d mg of the business t O hicient mfo
. su . rma t'10n, k nowIe dge, an d
11
Consider, for a moment the ca cf a enge, if necessary, executive directors?
0
no relationships with the cor se t.a perfectly independent director, that has
· a mem b er of t h e
Pora ion at all . be si'd es b emg
board, but imagine that this is her
she can be removed or not . only or ~rimary source of income, and that
appomted agam by th cont ro 11· h h Id
Are we sure that she would hav . . ~ mg s are ~ er.
decision that seems in th b t . e the right mcentives to oppose a busmess
. ·t h h Id ?e eS mterest of the controlling shareholder ' but not
of minori y s are o ers.
3 .. Japan is a_noutlier among the developed countries with its low rate
of appomtment of. mdependent/outside di.rectors. F or examp 1e, some maJor ·
Japanese corpor~trnns such as Toyota, Canon and Nippon Steel & Sumitomo
Metal had appointed no outside (or non-executive) directors until 2013 or
201~. Al~hough. t~e rati~ of listed corporations that appoint at least one
outside director is 1ncreasmg and reached 74.2% among those listed in the 1st
section of Tokyo Stock Exchange as of June 2014, 39.9% of those corporations
appoint only one outside director. When it comes to independent directors
.
61.0% appoints at least one, and 21. 7% appoints two or more. What would be
'
the reasons of Japanese corporations' reluctance to appoint
independent/outside directors? On the other hand, the Japanese government
is currently encouraging listed corporations to appoint more of them, through
the 2014 reform of the Companies Act and the Corporate Governance Code,
which had been discussed under the auspices of the Financial Services
Agency and will be adopted by the Tokyo Stock Exchange in 2015. What
c~mld be the motives of the government for such a move? See, Japan's
Corporate Governance Code [Final Proposal] (March 5, 2015), available
at http://www.fsa.go.jp/en/refer/councils/corporategovernance/20150306-
l/Ol. pdf.
***
There is in fact a fourth category of directors that needs to be
considered t~gether 'with executive? n~n-executive, and inde~ende~t
directors: directors appointed by minority shareho:ders. Espec1~1ly ~n
leg I t · hich the ownership structure of hsted corporations is
a sys ems in w . · · 1 t · h
· whi'ch applying a strict maJority ru e o app01nt t e
m ore concen t ra t e d , in
board would give to the controlling group _complete control over the
· · o f th e man agi·ng body , mandating . a system to represent
composition .
· · h ld the board might effectively protect the interests
minority share o ers on
. . t·
. · h us d h
1 ·nvestors Similarly, in t e .. an t e . .,
uK
f
o small and 1nstitu 10na i · h · · k h
· , · 'd d ownership structure, t ere is a ris t at
vis-a-VIs a more w1 esprea · h b bl lf
· . · ·th the managers mig t e a e to se -
d1rectors with strong ties wi
_2_3_4
_______ ______ ~Ctt.5
~C~O~l~?I~>O~R~A~T!._E~G~0:!._V~E~•'R~N~A~N ~C~E
----.::.
p_erpetuate themselves, and minority-appoint ed director s can mitigate the
mcestuous" relationship between manag ers and board members .
The following article discusses directors' elections in the U.S
explaining why often, at least until recently , shareholders had littl~
control on the nomination of the directors, and advancing a proposal for a
system that might ensure the representation of minority shareholders on
the board.
MARCO VENTORUZZO, EMPOWERING SHAREHOLDERS IN

DIRECTORS' ELECTIONS: A REVOLUTION IN THE MAKING
3
7 EUROPEAN COMP. FIN . L. REV. 105 (2010)
A specter is haunting Corporate America-the specter of Directors'

Dictatorship . [... ] During the Ancien Regime, absolute European
monarchs were said to be entitled to the throne solely by the grace of God.
More moderate sovereigns, or sovereigns aspiring (or forced) to appeal to
democratic tendencies, expanded their style to include a reference to their
subjects. Oliver Cromwell, for example , was "Lord Protector" by the Grace
of God, and the Republic. The king of Italy, after the reunification of the
country in 1861, was such by the Grace of God, and the Will of the Nation.
And today Elizabeth the Second is Queen not only by the Grace of God,
but also "of the United Kingdom of Great Britain and Northern Ireland
and of Her other Realms and Territories." Do American directors reign
over their corporate empires by the will of the shareholders? Can their
tenure really be challenged by disgruntled equity investors? Does their
legitimization come from the shareholders' meeting, or from a quasi-
divine investiture granted by the board itself?
There are several reasons why sitting directors can easily coagulate
enough consensuses to obtain the election of either themselves or their
favourite candidates over candidates advanced by shareholders. In fact,
under the traditional U.S. regulatory framework, the ability of
shareholders to propose nominees to the board is severely constrained.
A first factual explanation might be found in the widespread
ownership structure of listed corporations in the U.S. It is qui te difficult
for a multitude of minority shareholders, who are unrelated and hold
relatively small participation, to identify specific candidates and
coordinate to concentrate their votes on those candidates. Collective
action problems, information asymmetries and transactional costs
discourage even institutional investors from following this strategy. In
case of disagreement with the way in which the corporation is managed ,
stockholders can more easily sell their shares and thus "vote with their
feet."
3 Footnotes omitted .
.--.
i 5
_9!:--~
:-::--:::-~C~O~R~P~O!!R~A~T~E
OV~Q!
ERN ANC
~~~ ~~--E---_J~
In this respect how
evol·ution· of th e 235
1 · the 'ownerev s he:,
ip str last
t decades have seen
Institutiona investors have ac . uc ure of a pecu 1·iar
Ame rican corp orations
some of the m os t impo · quiredh a more central position
rtant equ't
it is not always possible wi' th i y ol_ders.For and become·
· kl ~ 1·iqm· d a t e its an insti tutio nal investor
qu1c · inve
· stment outA facm m g pot entia · l sign
· ificant losses, to'
large hsted corporation fore · utual fund holding four percent of a
causing a little earthq~ake ;at~P_1e, can hard
ly dump its shares without
market price of the shares ;h m th e val~
e of its portfolio and in the
coupled with even stronger. c
replicate a particular market 0:~::m~s.
e:e ~conomic limitations are sometimes
For ex~mp~e, index funds that
holding the shares of the iss th with a passive mvestment strategy,
alter their portfolio For ;ers .at compose the index, simply cannot
articipate in the life. of th ese 11:1veS t ors in parti
e corp orati on and ha cular, to actively
P
direc tors is often th . . th 1 . f
. . e on 1Y viable course ofve actio a say m e se ectio no
n to protect their
investment agam , . st board's decisions th a t are perceive
· d as contrary to
share h oId ers · inter
I ests . The legal system ha s not , owever,
to h armonious Y respond to the change in the h deve1oped as
ownership structure.
Even ignoring the specific needs of large insti
tutional investors the
rules currently applicable to most listed corp
orations raise serious d~ubts
on directors' accountability to shareholders.
Several legal hurdles stand
in the way of shareholders seeking to influ
ence the composition of the
board.
The first of these hurdles concerns the majo
rity required to appoint a
director. Under Delaware law, as well as in
most other states, directors
are voted one-by-one, and not bundled together.
Each individual nominee
does not need to receive the positive vote
of the majority of the shares
represented at the shareholders' meeting to
be appointed. Like in political
elections to be elected a plurality of the vote
s cast is usually sufficient;
votes agai'nst a specific candidate are not poss . ns
ible and abstent10 are not
relevan t. Simply, the nominees that receive the
positive votes are elected. For example, if 300 high~st number of
,000 voting share_s are
represented at the meeting, nominee John Doe
_
mig ht b~ elected
·ttl
1 e as
60 t if no other individual receives a higher numwith as
l ·t· vo es, . . d' ber of
t U d thi·s rule it is easy for sittm g irect t bt . th
ors o o am e
pos1 1ve vo es. n er . cand. .
. h' h t mbe r of vote s for their idate
re 1a t 1ve 1g es nu s. .
. under the pressure · ·
of institutional investors,
In recent years, 1arge ly . votm
hift toward majority · g. I n a ma3· on·t
there has b~en a s Y vo t·mg
receive the majority of the votes represented
system, nominees need ~o at
b 1 cted and therefore "no" votes or
, ting to e e e
t e shareho
hb ld ers mee f the ,election. . According to a recent
.
a stent10ns can a £feet the outcomehlyo % of S & P 500 companies . had
study, as of February 2ooy,~:ug ting52in
their charter or bylaws. The
adopted some form of maJOrl Y vto ates
that the specific provisions
demons r
same study, however,
______
~2~36~------~C~O~RE.:PO~R~A~T~E:::._:G~O_:_VE~R~N~AN:..::..:..:C::.:E::..- C:::..:._!!:J
implemented in the governing documents of th~ c~rporat~ons _oftenwater

down significantly the intended effects of ma3or_ityvotmg in ~er~s of
shareholders' empowerment. The reason is that m i:nost cas~s _it is not
provided that directors are appointed only if they receive a maJority of the
votes, but it is simply required that candidates to the boa:~ pr_epare,
before their election, a resignation letter renouncing to the position if they
are elected but do not obtain the absolute majority of the votes cast. The
resignation, however, is subject to approval ~y ~he ol~ .board.
Consequently, the board enjoys a great deal of dis_cre~10n in overri~i~g the
shareholders' meeting outcome by simply re3ecting the anticipated
resignation.
The traditional regulation of proxy voting provides for another legal
basis for the extensive control that current directors hold on the elections
of the board. Directors send out proxies using corporate resources and
information. Shareholders cannot easily piggy-back on the proxy
solicitation conducted by the corporation because, pursuant to Federal
law, directors can exclude shareholders' proposals concerning the election
of directors from the corporate proxies. Adding nominees to the slot of
candidates advanced by the board of directors is considered a matter
regarding directors' election, .and therefore shareholders can be denied
access to corporate proxies in this regard. On the other hand,
shareholders could independently solicit their own proxies, but this is
unlikely to happen because proxy solicitation can be extremely expensive
(also in terms of potential liability for misstatements in the proxy
documents). In addition, the corporation is not mandated to reimburse
proxy expenses, even in case of complete or partial victory of the
dissenting shareholders. On top of that, shareholders might face other
procedural obstacles in their proxy fight, such as obtaining an updated
lodger of shareholders of record in a timely manner.
[Recent regulatory changes in the area of proxy voting, however, both
I in Delaware and under Federal law, have now made it easier for
shareholders holding a minimum percentage of shares to add their
nominees to the corporate proxy statement.]
For these reasons, [until the recent past, in the U.S.] directors'
elections [have often been] uncontested, which means that the number of
nominees is not greater than the number of available slots on the board,
and the only nominees are the ones selected by the existing board. But
ther~ is more. Until a recent amendment of NYSE regulation, effective for
meetings held on or after January 1, 2010, in uncontested directors
elections brokers could vote uninstructed shares. Uncontested elections,
more precisely, were considered "routine" matters, and brokers had the
discretion to vote the shares in the absence of specific instructions from
the beneficial holders of the securities. In these instances brokers would
usually cast their votes according to managers' proposals. [... ]
-
As mentioned ' however '. NYS ER

Acc ordi ng to the . . ule 452 has been amended in 2009.
tions will no longer be
considered "routine~e; provision, directors' elec ted. Consequently, from
J nuary 20l0 b k at~!rs, even when unco
ntes
a . . 't rot_ ers wi 1 no long er be perm itted to vote in the abse1nce·
f spec151c ins rue t kh 1
ions. from th e s oc o ders. The scope of the ru e 1s
bo d b ·t
red brokers , independently
f roa th ecaus: ~ apph~s to all NYSE-registe the election is listed.
rom e mar e on which the corporation holding
ehow more difficult for
. This innovation will clearly make it som
ality or a majority voting
directors to_at~rac~ v~tes u~der either a plur
ns against board nominees
syst e~. While institutional investors' campaig
the concrete effect of new
are hkely to have more chances of success
cially when plurality vote
NYSE R~le 452 is not completely clear, es~e
still applies.
majority vote adopted
In sum, plurality vote or the "weak" forms of
proxy access, the cost of an
by some states or companies, limitations to
discretionary vote in
independent proxy solicitation, and brokers'
e it very difficult, for
uncontested elections have traditionally mad
voice in the appointment
shareholders, to have a strong and independent
usions of successful hostile
of directors. In most situations, with the excl
or through the acquisition of
takeovers waged either through proxy fights
facto selected by the existing
a controlling block of shares, directors are de
shareholders' meeting.
board and simply "ratified" by a rather passive
a virtually uncontestable
. A system in which existing directors have
d and are insulated from
power to select their successors on the boar
the fiduciary relationship
shareholders' judgment may deadly wound
peculiar trait of American
between shareholders and managers. This
by several scholars and
corporate governance has been denounced
directors' accountability to
interest groups as the cause of lack of
ocracy has been advocated
shareholders, and stronger shareholders' dem
on both efficiency and political grounds.
[... ]
esentation of minority
[An interesting idea would be to mandate repr
a minority representation on
shareholders on the board. But] how should
first technical instrument
the board [... ] be regulated? In the U.S., the
ng. Cumulative voting is,
that comes to mind is cumulative voti
mino~ity shareholders the
historically, the system used to give qualifi~d
1t was, 1n fact, propose~ as a
possibility to appoint part of the board, ~nd
by Jeffrey Gordon 1n an
voting mechanism in listed corp?rat10ns
the path dependency of le?al
important article of 1994. In the hght of
strong advantage of fitting
systems, cumulative votin~ _has the clear and
in the American legal tradition and culture.
potentially
. [Cumulative voting is, however, very complex and
sands of small shareholders
ineffective in listed corporations, where thou
,
vote. A pos~ible alternat ive regime, partially im;pired by comparative

experiences [and in parti cular by Itali an law, is] "list voting".
[. .. ]
[W]ith list voting, [... ] instead of voting on single directors,
shareholders would [... ] vote for alternative lists of directors [submitt ed
by fellow shareholders reaching a minimum percentage of share or by the
directors themselves]. A predetermined number of seats on the board
(depending on the size of the body) would be reserved for the first
candidates of the list that receives the second largest number of votes.
For example, if [one] list [receives] 42% of the votes, and [another one,]
supported by minority shareholders would rank second receiving 11% of
votes, the first nominee(s) from the latter list would also enter the board.
To discuss the technical details of this approach would be beyond the
scope of this article. The goal here is to illustrate the overall rationale of
the proposed system . It is however necessary to address two important
issues. First, a minimum threshold of votes that needs to be reached in
order to actually elect the minority director(s) to the board could be
·f imposed either mandatorily by regulation, or on a more flexible basis in
the bylaws of the corporation . This would guarantee that minority
. '!
.,. directors represent a qualified minority. Bylaws or statutory provisions
. ' could hypothetically require that the second ranked candidates receive at
least one fifth of the votes obtained by the first list, or a fixed threshold,
for example 5% of the votes cast.
Second, when it comes to the fine tuning of this proposal, it would
need to be ensured that minority directors really represent minority
shareholders. There is a risk that a shareholder affiliated with the
controlling group might try to "disguise" themselves as an independent
investor, with the result that the alleged "minority" director(s) would, in
truth, be expressed by the controlling group "en travesti". To avoid this
risk is not easy, but a combination of disclosure obligations imposed on
the proposing shareholder and her nominees, with a requirement that
minority directors are proposed by shareholders independent from the
management of the other shareholders that support the managers, could
achieve this goal.
NOTES AND QUESTIONS

1. What do you think are the pros and cons of Professor Ventoruzzo's
proposal? Do you think it could ever be accepted, also politically , in the
United States? Is it really necessary, or at least as useful, in a system with
widespread ownership of shares?
2. Is a representation of minority shareholders on the board less
..·4 I
"disruptive" than a representation of workers as in the co-determination
systems? Is there a risk that a competitor of the corporation would acquire a
i
' j
;I
.i
·f
'!
CH. 5
minority stake just to be abl t .
strategic or marketing infor;a~i:romt one director and acquire confidential
3. As indicated in the f ".
experience . In 1998 the It l" a\ ic~e, hst ~oting" is inspired by the Italian
the board of auditors w;~anh eg~slature introduced this system to appoint
entirely determine th; i t .e_idea that the same majority should not
controlling body. More r;~:~~siti~ n of both the board of directors and the
of directors Article 147 t O ith
th
is approach has been extended to the board
e TUF, mentioned above, in relevant part
provides th~t- "The B 1- er
should be ele~ted on t~ a:s _provi~e that members of the Board of Directors
participation requir d ;, ~sis of hSt s of_candidates and defines the minimum
he presentatio~ of a list , not exceeding 2.5% of the
apital or the d'f£1 e torpercentage established by Consob taking into account
c ·t . t· fl er~n ·
cap1 a 11za B10n, oatmg shares a d h'
[ ] Th . n owners 1p structures of listed compames.
··· e Yaws1 can proVIde that no director is elected from a list that has
not reached · · ·n
a percentage of v ot es a t 1east equal to half of the participatio
.
t· 1
·d thfor the
reqmred " presentation of the list" · Add't·1 1ona11y, th e same ar 1c e
provi es at at least one member of the Board of Directors must be elected
from the minority lis~ that obtained the largest number of votes [after th~
first one] and that 1s not linked in any way, even indirectly , with the
shareholders who presented or voted the list which resulted first." Do you
understand the rationale of these rules? Why do you think it is important to
distinguish lists "linked" to the first one, and exclude the nominees included
in these lists? Do you think that one director voted by the minority, for
example in a board of nine members, is sufficient? One is, in fact, the
minimum mandated by law; the bylaws are free to increase the number of
minority directors.
4. What do you think is the difference between an independent
director and a minority-appointed director? Is a minority-appointed director
necessarily independent pursuant to the legal definitions of independence
discussed above?
5. How do you think the "independent" state of mind of a director can
be guaranteed? What arrangements (financial or otherwise) would help
achieve this "independence of mind"?
***
'
Talking about the composition of the board, we have discussed the
representation of workers and of minority shareholders, differ~3:1possiblet
"stakeholders" of the corporation. What about the composition of the
board in terms of gender or ethnic minorities?
s e al countries have adopted a mandatory requirement to ensure
ev tr t· n of both genders on the board, which basically means a
represen a 10 ffi · · in· favor of t h e
~or women a sort of a irmative act10n
man da t ory quota 1 1 , •
an extremely
"Ias t -represen t ed" gender · The following . excerpt from
· t · t· 1 by Professor Branson discusses the reasons to regulate
1n eresting ar 1c e . ·i1 · ·
th e existing
on boards of directors, i ustrates
th e presence of women
240 CORPORATE GOVERNAN CE Ctt
- --- ---- ~~~~~~~~~ ~-----~ .5
-----..;;.
regulatory situation in different juri sdictions, and offers sorne

explanntions about why mandatory provisions in the U.S. have not been
enacted.
DOUGLAS M. BRANSON, INITIATIVES TO PLACE WOMEN ON

CORPORATE BOARD OF DIRECTORS-A GLOBAL SNAPSHOT
37 J . Corp. L. 793 (2012) 4
[... ]
Arguments abound for an increase of diversity in every profession or
calling-law practice, medicine, academe, law enforcement, firefighting,
and more. One drumbeat, persistent since the 1990s, has been for an
increase in diversity candidates for publicly held corporations' boards of
directors-most particularly, women on boards. "[I]f Lehman Brothers
were actually Lehman Sisters, the company never would have gone
under," is a statement that captures the sentiment. Women are thought
to be more sensitive and adverse to the sorts of risk that led to the global
financial meltdown of 2008. A greater presence of women on boards of
directors may have helped avert many of the debacles which occurred.
There are several benefits to corporations from an increase in women
directors. First, this increase would provide a positive role model for other
women in the middle and lower ranks of corporate organizations. In mid-
2011, over 50% of the middle managers in corporate America were women
while only 2.6% of CEOs of Fortune 500 companies were female.
Second, boardroom diversity aids in avoidance of "groupthink," the
complacency that led to monumental governance failures at Enron and
other corporations. The presence of women aids proliferation of the array
of perspectives and viewpoints on corporate boards, leading to better
assessments of risk and less rubberstamping of CE Os' decisions .
Third, "market reciprocity" means that companies that sell goods and
services to the public send positive signals to consumers who might
purchase their products. Women account for well over 70% of the
purchasing power in our economy. The presence of women in a
corporation's senior management would filter out to and sway potential
purchasers.
Fourth, corporations will increasingly function in a diverse world.
Their governance and the makeup of their boards should reflect this,
including more women and persons of color as directors.
I- . ~t
Fifth, authoritative international laws and conventions state that
i "men and women have the same right to employment opportunities,"
"promotion," and "equal treatment in respect of work for equal value."
The latter are sound bites from Article 11 of the United Nations
241
f.H·5 CORPORATE GOVERNAN CE
Convention on Elimination of A1
Women (CEDAW). Especially in k
Forms of Discrimination Agai~st
, f~alty to CEDAW and its
commands have been influ enti al in cour~pe ion of quota laws and other
mea sures to increase the b nsid erat
rd
seats. num er of women occupying corporate boa
Women bring broader pe .

interpersonal skills to prom ot rspe ctiv es. to board service, better use
managers and help ex d t e collaboration among board members and
t ~e context of board discussi ons. Still other
cholars have written pan ut wh d' ·t · 1 d' th e
s resence of increased ex bensively abo Y iversi y, inc u mg
Only a
~ . . dnum ers of women directors, is necessary.
~ew ~~e~ an inc~eh~seAP~esence in corpcase orate governance through more
~s rticle takes the for women on boards as a
J~Un ice e~es.
the progress and programs
given_, t~rning quickly to a review of
d around the world.
contributing to the progress that has occurre
[... ]
of women on corporate
The statist~cs indicating the representation
Norway, which passed its
boards va~y widely thr?ughout the world.
dated that 40% of a public
controve~sia! quota law in 2003, in effect man
goal that Norway achieved. In
c?mpany s directors be women by 2008-a
% female directors on publicly
eight years, Norway went from 6.8% to 40.3
t, Inc., in the United States,
held corporation boards. According to Catalys
e publicly held companies
the proportion of women on boards of larg
stagnant from 2004 onward.
stands at 16.1 %, but with the proportion
orate boards of publicly held
Portugal has the fewest females on corp
corporations, accounting for just 0.6%.
11.7% but, again, the
Overall, the 2010 European average was
five highest averages were:
numbers varied widely. After Norway, the
ands (7%), Denmark (12 .5%),
Sweden (21.9%), Finland (16.8%), Netherl
Portugal, the laggards included
and the United Kingdom (12.2%). Besides
Italy (2.1 %) and Germany (7.8%).
change-to between 13%
The past two years have seen significant
early in 2011, is thought to
and 14%. France, which adopted a quota law
increase with the percentage of
be responsible for half or more of the EU
in 14 months.
women directors increasing from 12% to 24%
ng the countries with
On the Pacific Rim, Australia leads amo with
available statistics with 13.8%, and New Zealand follows
inch~,deHong Kong (8.9%) and
approximately 10%. Others in the queue
oose is Japan (0.4%).
People's Republic of China (7.2%). The cab
[... ]
of directors are ~omen, but
Germany reports that approximately 7%
German l~w requires a two-
that is the number on supervisory boards.
large supervisory board and a
tiered board structure with a relatively
242 CORPORATE GOVERNANCE
relatively small managing board, as corporate laws also prov~de in several

-
CH. 5
countries with very large populations (e.g., China, Indonesia) and some
smaller nations as well (e.g., Slovenia, Netherlands).
Mark Twain wrote that "there are three kinds of lies: lies, damned
lies, and statistics." At best, the German statistic is a half-truth. On
managing boards (Vorstand), the more exclusive circle in t~ie German
system (where "the rubber meets the road") less than 2% of directors are
women. Standing alone, without background disclosur<:, the 7%figure for
directors on supervisory boards (Aufsichstrat) seems m1slead1ng.
[... ]
Parliaments in Italy, the Netherlands, and Belgium have enacted
gender-based director laws. Norway, the first nation to act, adopted its
quota statute in 2003, ordering full compliance by 2008 and setting the
level at 40%. Spain, the second to act, ordered achievement of the 40%
level by 2016, a significant jump from the 5% level which prevailed in
Spain at the time of the adoption of the law. The Spanish statute, though,
is largely aspirational, while the Norwegian law has severe penalties.
Norwegian companies that do not comply are not only subject to delisting
on the stock exchange but to outright dissolution.
France, the third nation to act, adopted a 40% quota law early in
2011. Looking northward to Norway, a deputy of the Assemblee Nationale
(Marie-Jo Zimmerman) introduced a 20% quota bill in 2006. Thereafter,
the notion of gender parity, at least in French corporate governanc~, had
to negotiate a twisting route.
The Conseil Constitutionnel, a court that renders "advisory'' opinions
on pending measures, declared the proposed 2006 French legislation
unconstitutional. The court found that the 1999 amendments to the
French Constitution only permitted enactment of laws aimed at achieving
~e;11?erparity in elections for political office. The proponents subsequently
1n1t1ated a movement further to amend the French Constitution which
was achieved in 2008. The amendment provides that French la;s shall
promote equal access to "positions of professional and social
responsibility," as well as to elected offices.
In 2009, adding to the momentum for adoption of a quota statute the
quota measure's supporters found that only 8% of directors in Fra~ce's
largest 100 corporations were women. Further, they bemoaned that in
that year, French public companies added only six new women directors
to corporate boards.
Th~ ~ecently enacted French quota mandate is staged. Public
companies boards must have 20% women directors within three years of
enactment and 40% within six years, by 2017. Thus far, large French
.. '.
.,.
CH.5
CORPORAT G
. E OVERNANCE 243
corporat10ns are out in f. t
.
women d 1rectors on boardsion of the
in 2012 _
2014 b '
o Jective, having passed 24%
Sweden, Finland, Germ·
out in opposition to quota la:~· a nd t~e Unit ed Kingdom have all come
Finland (26%) already have fo_r various reasons. Sweden (28.2 %) and
boards . On the other handm~mngful representation of women on their
middling to poor and med 1' ' ermany and the United Kingdom have
countries have long tr ~?te record s, respectively, on the issue. Both
recalcitrant when told wha~ t~ ~~~ of bucking trends and becoming
1
French reactions to a quot .

citizens favor the quota law Ca 1aw vary. Acco~dmg to a poll, 71 % of
"Improvement without a 1 · ~O Laurence Pansot favors such a law :
nothing" Cathe . Ch aw is so slow that we cannot stay doing
· rme ouard, President 0 f th F h E 1
Opportunities a d Ant·1 D' . . . e renc qua
n · iscrimmation Commissions joins in: "It is an
, . to change
excellent. way . ment a 1·t· · be 'first step to a 'new
i ies. Th e 1aw will
way of life m companies ."
Quota laws also hav~ unintended and adverse consequences. In the
rush to name females to directorships, for instance, Norwegian companies
named one-no doubt very capable-woman to eleven corporate boards.
No one, not even Superwoman, can serve adequately on more than three
or p_erhaps fou_r boards, especially in these post-Sarbanes-Oxley years,
versions of which many countries have adopted. Quota laws produce a
surfeit of women trophy directors, which may help produce unqualified,
figurehead (token) female directors .
Quota laws also may result in a surfeit of celebrity as well as trophy
directors, who easily may be regarded as token or figurehead directors .
This has allegedly happened in France where board seats have gone to
former first lady Bernadette Chirac (from luxury goods retailer LVMH);
Nicole Dassault, wife of the controlling shareholder (from Dassault
Aviation); Florence Woerth, spouse of the former Minister for Labor (from
Hermes); Brigitte Longuet, wife of the former Minister of Defense
(broadcaster Canal Plus); and Amelie Oudea-Castera, former tennis
professional and wife of Societe Generale CEO (from the media group
Lagard ere).
Other consequences thought d:1e to the ena~tment of a quota law
include companies downsizing their boards of directors to reduce the
n um ber of Women candidates necessary . and thus search costs. An
· · d
·s that some companies may go private in or er to
ex t reme conseq Uence l
evade a quota law's requirements altogether .
·t· t actment of a quota law is strong in nations such as
0 ppos1 10n o en in
.
which women make up 591/o 0
of the work force
New Zea Ian d' a tlcoun tryerned by a female prime . . .
mm1ster, yet many
an d was recen ·Y gov ose mandatory or other gm·d e1· mes.
Th N
e ew
corporate executives opp
244 CORPORATE GOVERNANCE
Zealand Stock Exchange has publicly stated that it will not even follow its
-
CH.5
Australian counterpart, the ASX, which has a requirement for companies

to set and meet voluntary quotas for increasing the number of women at
the top. In the United Kingdom, a recent government report urges a
voluntary quota of 25% by 2015, but it pointedly stops short of any
recommendation that the United Kingdom adopt a compulsory quota, as
France, Spain, Belgium, the Netherlands, Norway, and other states have
done.
By contrast, the Malaysian government has imposed a _quota_that
publicly held companies have 30% women directors by 2016. D1scuss10n of
proposed or enacted quota laws takes place around the world, is frequent,
is at times quite heated, and contains widely divergent, often
diametrically opposed, opinions and arguments.
[... ]
In the United States, as compared to many other developed countries
around the world, the ardor for diversity has cooled. Because the fire has
not been re-kindled, the fire's embers merely glow. A countertrend to this
stall in the United States has been the SEC's new diversity disclosure
requirement, which seems to have sprung from the glowing embers.
When most U.S. corporations comply with them, the regulations and the
disclosures may produce-scofflaws just discussed aside-a significant
increase in diversity on corporate boards, re-kindling the fire . .
By contrast, a strong countertrend elsewhere-adoption of quota
laws imposing quotas for numbers of women on corporate boards-would
seem to have little promise for adoption in the United States. Although
some Americans are liberal Democrats , and others are conservative
Republicans, and still others are in-between those extremes, in my.
opinion all are libertarians, of sorts, or have a libertarian streak running
up their back. My surmise is that most Americans would regard a law
dictating how many of each sex must be on a corporation's board of
directors as excessively intrusive, far beyond any legitimate role the
government could have in regulation of corporations.
***
The issue of women on the board has been discussed and debated
extensively in the U.K. during the last few years. One notable recent
r~port, nam~ly Women on Boards: Voluntary Code for Executive Search
Firms-Taking the Next Step (March 2014) highlights recent
developments and pro~ess achieved in this area in the U.K. The full
report can be found on line.
What follows are excerpts from the Report:
[... ]
.. ·.
-, ..

The Voluntary Code of C d
launched in July 2011 a d' on uct. for Executive Search Firms was
on Boards The code w s a irect result of Lord Davies's review of Women
· searc h fiirms
. . by a num ber of executive
·
covering relevant sea ash created
board level appointm re t criteria
A and processes re atmg to FTSE 350
1 ·
earch firms coveri enth s. h s at the31st Decemb er 2013 ' 68 execu t'ive
:0 the code ~ledg' n~ O ~ w ole of the FTSE 350, had become signatories
t ' mg a here to the nine provisions of best practice this
sets ou .
[. . .]
In January 2014 women accounted for 20.4% of corporate board
members of FT~E. 100 companies. This continued the positive trend and
was up from 191/om 2013, 12.4% in 2010 and 9.4% in 2004. Although the
pace of change has increased, and current trends suggest the target of
25% by 2015 set out by Lord Davies in his 2011 report will be achieved we
cannot be complacent and assume further progress will be made without
further considered focus.
The FTSE 250 has also seen a positive increase in the number of
women taking board positions. In January 2014 15.1% of corporate board
positions were held by women compared to only 7.8% in 2010 .
As at January 2014, 511 further board positions would be required to
be taken by women to achieve the target of 25% for FTSE 100 companies,
this is assuming that no current female board members step down during
that time . For the FTSE 250 to achieve the target, a minimum of 197
board positions would have to be secured by women between now and
2015.
During the 12 months covering January 2013 to January 2014 there
were 147 Non-Executive appointments in the FTSE 100, 42 (28.6%) taken
by women. Of the FTSE 250, there were 244 Non-Executive appointments
of which 74 (30.3 %) taken by women. Although these statistics are
encouraging, we cannot be complacent about reaching the 25% targ et.
NOTES AND QUESTIONS

1. Do you think that diversity on the board of dir ectors, especi~lly
gend er-wise, is important? Why should the number of female ex~c~tives
matter? If so, do you find it sens ible to mandate by statute that a mmimum
number of directors are women (or, more generally, belong to the less
represented gend er)?
2. What about other groups potentially und er-re presented? Shoul_d
~· t' ctions to incre ase the numb er of members of ethm c
th ere b e a f1irma ive a . · · ?p 1 · h d'f -c
· · · t board s?· Religious mmonh es . eop e wit i 1erent
mmonties on corpora e . .
sexual orientations (LGBTs)? On the other hand, hdo byoudthmk ba private
. ·d · its bylaw s for examp le, t at oar mem ers must
1 · d ·
corporation can provi e, m
· I 1·crion? Think' ' for examp e, to a corporation omg
b elong to a particu ar re io~ ·
246 CORPORATE GOVERNANCE Ctt. 5
business primarily or exclusively with the Catholic Church. The answer

gener~lly varies in different legal systems, depending on how they strike the
balance between the freedom of the corporation to choose its own leadership,
and other values such as equality and prohibiting discrimination also by
private parties. In a class with participants from different systems and
cultures, this question might lead to an interesting debate.
3. Are you surprised by some of the data presented by Professor
Branson concerning different countries? Or not? Do you think that they
confirm or contradict stereotypes about different cultures?
4. Do you think diversity of nationalities, experiences, and background
is more or less important in this respect? Consider, for example, the
following: "According to research by ITAP International, as far as the largest
50 companies in the Fortune 500 are concerned, only around 5% of board
members are not American. Moreover, roughly half of US public companies
have no non-Americans on their boards at all-despite the fact that fully
three-quarters derive some of their revenues from abroad . In contrast, a
quarter of board members in Europe's largest company boardrooms, on
average, are from cultures other than the company's home country (on an
'average' board of 12 members, two will be European non-nationals and one
non-European) . This average hides some wide variations, however, with
almost three out of ten European boards (28%) having no foreign directors at
all, a figure that rises to almost six out of ten in Italy. The most diverse
companies are in Switzerland, where half of directors are non-nationals. In
the U.K., the figure is 40% whereas in Germany and Spain it is just 10%-the
latter perhaps reflecting the fact that language is a major barrier to
international diversity in these countries." (Dona Roche -Tarry, A global
board?, in Governance August 2012 Issue 218, p. 8). So is the above an
argument for quotas around international diversity? In our globalized world,
is having directors from different countri es and cultures, with different
language skills, an advantage or a disadvantage? Does it matter? Does the
U.S. appear chauvinistic in this respect?
5. Speaking about a different type of diversity, concerning educational
and professional backgrounds, do you think it is useful, for example, for
corporations like Google, Bayer, or Yamaha to have one or more practicing
lawyers on the board? Are lawyers on the board a blessing or a curse?
POWERS OF DIRECTORS VS. SHAREHOLDERS

One general question that is often litigated concerns the extension of
directors' powers, also vis-a-vis shareholders. First of all, it should be
considered that the power to manage the corporation is vested in the
board of directors, which often delegates it, at least in part to some
executiv~ directors, and to the managers (not board membe~s) of the
corporat10n. The sh~reholders' meeting has, however, also some
compete?ces conc~rn1ng, broadly speaking, the managing of the
corporat10n, especially when extraordinary transactions (such as a
5 ~N~C~E
::-------.:::::C~O~R:.!..P~O~R~A.!_TE~G~O~V~E~R~N~A______
£_!!ff.:..:· _12~4~7
· ,s assets) are concerned. Genera 11Y
merger or a sale of all the corporat10n
the sharehold. ers have the power t o amend the governing . documents of
the corporatwn, but here some distinctions are necessary. In the U.S., for
example, th ~ approva~ of the shareholders is necessary to amend the
articles of incorporation, but the amendment needs to be proposed
("initiated") by directors. On the other hand both shareholders and
director~ have a concurr~ng power to amend th~ bylaws, even if in some
states directors have t~is power as a default rule (and the governing
documents can exclude it), while in other states directors do not have this
power as a default rule, unless the governing documents give it to them
("opt-in"). In other jurisdictions, especially in continental Europe and
Japan, shareholders have a more extensive and exclusive power on all
amendments to the charter and bylaws, both in the sense that they (or at
least a qualified minority) can propose an amendment, and that virtually
all amendments of the charter and the bylaws require shareholders '
approval. This is particularly true in civil law systems with concentrated
ownership structures. In these cases, however, the shareholders' meeting
can delegate at least some of its powers to the directors (consider, for
example, issuing new shares in some systems as discussed in Chapter 4).
It should also be mentioned that in some countries, for example in
the U.S., directors have the power to decide the distribution of dividends,
while in others, for example in the French civil-law tradition, directors
can only make a proposal to the shareholders concerning the destination
of earnings, but the shareholders' meeting ultimately decides on the
distribution of dividends. Do you see a correlation between ownership
structures and the balance of powers between shareholders and
managers? For more, see the aptly entitled articles by Sofie Cools, The
Real Difference in Corporate Law Between the United States and
Continental Europe: Distribution of Powers, 30 DEL. J. Corp. L. 697
(2005); and Gen Goto, Legally "Strong" Shareholders of Japan, 3
MICHIGAN J. PRIVATE EQ.AND VENT. CAP.L. 125 (2014).
Notwithstanding these apparently clear-cut rules, there is a gray
area in which it is uncertain if the board of directors or the shareholders'
meeting can exercise powers that, at least as a matter of fact, infringe on
the competences of each other, as we will see below. · ·
In theory, a general limitation to directors' powers is represented by
the corporate purpose as stated in the charter and bylaws. This is,
however often an illusory limitation, for a number of reasons. First of all,
in lots ~f legal systems-typically in common law jurisdictions-the
corporate purpose can be defin~d in extremel~ broad ,~erms. The co~porate
purpose is often simply something along the hnes ~f The Corporation can
engage in any legal business" (see the example 1n Chapter 3). In other
systems, the corporate purpose 1?ust be defi~ed someh?w more precis~ly,
for example: ''The Corporation 1s engaged 1n the business of producing
_2_4_8
_______ ~C~H.5
~C~O~R~P~O~R~A~T~E~G~O~V~E~R~N~AN~C~E:,__
_____
-
and selling furniture," but the provision also often explicitly encompasses
"All other activities directly or indirectly related or necessary to carry on
the corporate purpose, including, but not limited to, financial
transactions ... " It is very difficult to decide if a particular act falls
outside the purpose: for example, is purchasing an expensive painting by
a famous artist included? One might argue that it is necessary to
embellish the corporate headquarters, also in order to convey a
prestigious and sophisticated image of the corporation to clients,
providers, financial partners, etc. In addition, even if the corporate
purpose is clearly defined, and the directors exceed it (act "ultra_ vires,"
Latin for "out of powers"), they might be liable toward the corporation, but
specific legal provisions, aimed at ensuring legal certainty, make these
contracts binding toward third parties, at least if they did not
intentionally take advantage of the ultra vires act being aware of the
irregularity.
A more subtle question is what interests the directors need to pursue.
More precisely, do they only have to pursue the interests of the
shareholders, or can--or must-they take into account also other
stakeholders, such as creditors, employees, and the community in
general? This question can have important implications: for example, in
deciding whether to take into account environmental issues, obviously in
the absence of a regulation mandating certain conducts, directors should
only aim at maximizing profits, even if this implies a less
environmentally friendly business, or can they also consider the impact of
corporate activities on the environment? Similarly, in case of a hostile
takeover, in deciding whether to accept an offer or to adopt defensive
measures, directors should only consider the interests of shareholders, or
also, for example, of workers that might lose their jobs if the acquisition is
successful?
It's an old question that does not have an easy answer. In some
systems and historical periods, emphasizing "shareholders' wealth" as the
sole goal of directors has had more traction; in other places and times
other stakeholders' interests are also considered relevant. The debate has
sometimes been framed in Europe as the juxtaposition of a "contractual"
view of the corporation, in which the creation of value for shareholders is
the primary obligation of directors, to an "institutional" view, advocating
that the interest of the corporation that directors must pursue is not
limited only to shareholders' interests. This discussion is famously and
nicely captured by an historical anecdote: Walther Rathenau (1867-
.
,'
1922), a German industrialist, politician, and writer, was confronting a
group of angry shareholders complaining about low dividends payments
by the Norddeutscher Lloyd, a corporation he was involved with. He
replied that the purpose of the corporation was not to pay dividends to
shareholders, but rather to make boats navigate on the !iver Rhine. At
,.·.
,,
CH,5 C
.:::,.::;~------~O~R!!JP~CORATE G
- --.:::..~O~VE~R~N~AN~C~E~
______ _!24~9
the extreme opposite of th
, ·
primac_!, one might refer toe the spectru
f m, as an example of shareholders'
2~~ Mich. 459 (1919), in which ~mous U.S. case Dodge v. Ford Motor,
d1V1dendsrather than reta· . e court directed Henry Ford to pay
.
an outl ier an d 1s
. often imng the P fit
misinter r ro 1 s. This
.
case, in reality, is quite
courts are extremely reluct t P ~ted: the reality is that also in the U.S.
. t ors concermng
d1rec . divide an to mter£ere wit · h the business decisions of
n ds.
In any case, the debate
Germany, during the Na · d. goes on. We mentioned before that in
. 'tl Y m
. d'1cated that thez1b ictatorship
exp11c1 dh , th e 19 37 Corporate Statute
in the interest of shareholde oa~ ad to manage the corporation not only
State. References to stakehof ~· u!. also of the German people and of the
directors' duties are however e~~h ifferent fr?m shareholders in defining
the past. An interesting m. d~~ e prerogative of totalitarian regimes of
shareholder value') can be £
1
J. course (also known as the 'enlightened
2006, which provides that: oun m section 172 of the U.K. Companies Act
~:.y
~:!· :~ promote the_success of the company .-(!)
A director
would hepmo~t ~~:~ act m the way he considers, in good faith,
th b fit f . y to promote the success of the company for
e ene 1 o its members as a whole, and in doing so have
regard (amongst other matters) to-
. (a) the likely consequences of any decision in the long term,
(b) the interests of the company's employees,
(c) t~e need to foster the company's business relationships with
suppliers, customers, and others,
(d) the impact of the company's operations on the community
and the environment,
(e) the desirability of the company maintaining a reputation for
high standards of business conduct, and
(f) the need to act fairly as between members of the company.
This discussion is both interesting and relevant, but sometimes it
might be quite theoretical, and it does not always have a significant
practical impact on the life of the corporation. For example, let's assume
that it could be established that the goal of the corporation is to maximize
shareholders' wealth. First of all it should be discussed if we mean wealth
maximization in the short or in the long term. The difference can
obviously be substantial. In any case, it is fairly easy to argue that also a
decision that apparently is primarily motivated by the interests of other
stakeholders has an effect, at least indirectly, on the economic situation of
the corporation. Consider, for exa~ple,_ the decision to _make a ~onation to
a charitable or educational institut10n, or to av01d experiments on
250 CORPORATE GOVERNANCE Ca.5
animals m the cosmetics industry, and adopt different and
more
expensive techniques to ensure safety. One might argue that
these
decisions negatively affect the bottom line of the corporation, at least
in
the short term, but it is quite easy to respond that they might have
a
positive impact on public relations, attract more customers, create
a
better work environment, and ultimately be beneficial also in terms
of
value for the shareholders. Similarly, if one argues that directors
can or
should take into account different stakeholders , it is not difficult to
argue
that (legal) profit-maximizing strategies can _also benefit constituenci
es
different from shareholders. For example, cutting some jobs today
in
order to maintain a higher level of profitability can be necessary to
save,
in the medium term, a larger number of jobs. This is an area in which
it is
easy to fall into empty rhetoric .
A probably more concrete question concerns the boundary that
divides directors' and shareholders' powers. The following two
famous
I •
U.S. cases illustrate the issue.
BLASIUS INDUSTRIES, INC. V. ATLAS CORP.

Court of Chancery of Delaware
564 A.2d 651 (1988)
Blasius is a new stockholder of Atlas. It began to accumulate Atlas

shares for the first time in July, 1987. On October 29, it filed a Sched
.. ,
,ti/ ule
13D with the Securities Exchange Commission disclosing that,
-71 with
,,
.,
) affiliates, it then owed 9.1% of Atlas' common stock.
[... ]
Immediately after filing its 13D on October 29, Blasiu
s'
representatives sought a meeting with the Atlas management .
[... ] At
that meeting, [Blasius] suggested that Atlas engage in a levera
ged
restructuring and distribute cash to shareholders. In such a transa
ction,
which is by this date a commonplace form of transaction, a corpo
ration
typically raises cash by sale of assets and significant borrowings
and
makes a large one-time cash distribution to shareholders. The
shareholders are typically left with cash and an equity intere
st in a
smaller, more highly leveraged enterprise. [... ]
Immediately following the meeting, the Atlas representativ
es
expressed among themselves an initial reaction that the propo
sal was
infeasible. [... ]
On ~ecember 30, 1987, B~asius caused Cede & Co. (the registe
r ed
owner of its Atlas stock) to dehver to Atlas a signed written conse
nt (1)
~dopting a precatory res?lution recommending that the board develo
p and
implement a restructurmg proposal, (2) amending the Atlas
bylaws to,
among other things, expand the size of the board from seven
to fifte en
fH. 5 CORPORAT
E GOVERNANCE 251
members the maximum n b
eight named persons to fill t~m er u1;1derAtlas' charter, and (3) electing
. e new directorships. [... ]
The reaction was imm d'
~ d wit. h Mr. Masinte e iate
conierre th· Mr · Weaver [the CEO of Atlas]
director, who viewed the conr, t e Company's outside counsel and a
Company. They decided to cal~en as an attempt to take control of the
though a regularly scheduled an ~mergency meeting of the board, even
on January 6, 1988. The poin~~~t~~! was to occur onl~ one week hence,
their conclusion (or to seek t h emergency meetmg was to act on
"that we should add at
1 ° th
ave e board act on their conclusion)
board ... ". A quorum of di::c~~r~n~ and probably two directors to the
telephone meeting that da A i owever, co_uld not be arranged for a
At that meeting the ho dy. ~e ephone meetmg was held the next day.
of the board fr~m
J w·
sev:: t:otE~ to amend t~e bylaws to increase the size
mne and appomted John M. Devaney and
Har~y · inters, Jr. _to fill those newly created positions. Atlas'
Certificate ofh · Incorporation creates stagge re d t erms £or d'irectors; t h e
ter~s _to w ich Messrs. Devaney and Winters were appointed would
expire in 1988 and 1990, respectively.
In incr~3:sing the size of Atlas' board by two and filling the newly
created positrnn _s, the members of the board realized that they were
thereby p_recluding_t~e holders of a majority of the Company's shares
from plac1n~ _a ~aJority of new directors on the board through Blasius'
consent sohc1tation, should they want to do so. Indeed the evidence
establishes that that was the principal motivation in so acting.[ ... ]
. There is testimony in the record to support the proposition that, in
acting on December 31, the board was principally motivated simply to
implement a plan to expand the Atlas board that preexisted the
September, 1987 emergence of Blasius as an active shareholder. I have no
doubt that the addition of Mr. Winters, ·an expert in mining economics,
and Mr. Devaney, a financial expert employed by the Company,
strengthened the Atlas board and, should anyone ever have reason to
review the wisdom of those choices , they would be found to be sensible
and prudent. [... ]
One of the principal thrusts of plaintiffs' argument is that, in acting
to appoint two additional persons of their own selection, including an
officer of the Company, to the board, defendants were motivated not by
any view that Atlas' interest (or those of its shareholders) required that
action but rather they were motivated improperly, by selfish concern to
maint;in their collective control over the Company. That is, plaintiffs say
that the evidence shows there was no policy dispute or issue that really
motivated this action but that asserted policy differences were pretexts
for entrenchment for' selfish reasons. If this were found to be factually
.I
_2_5_2
_______ ___:::C~O'..!R~P~O~R~A~T~E~G~O~VE~R~N::AN~C~E~-----~CR.5
---.:::.
true, one would not need to inquire further. The action taken would
constitute a breach of duty. [... ]
While I am satisfied that the evidence is powerful, indeed compelling
that the board was chiefly motivated on December 31 to forestall ;
0
preclude the possibility that a majority of shareholders might place on the
Atlas board eight new members sympathetic to the Blasius proposal, it is
less clear with respect to the more subtle motivational question: whether
the existing members of the board did so because they held a good faith
belief that such shareholder action would be self-injurious and
shareholders needed to be protected from their own judgment.
On balance, I cannot conclude that the board was acting out of a self.
interested motive in any important respect on December 31. I conclude
rather that the board saw the "threat" of the Blasius recapitalization
proposal as posing vital policy differences between itself and Blasius. It
acted, I conclude, in a good faith effort to protect its incumbency, not
selfishly, but in order to thwart implementation of the recapitalization
that it feared, reasonably, would cause great injury to the Company.
The real question the case presents, to my mind, is whether, in these
circumstances, the board, even if it is acting with subjective good faith
(which will typically, if not always, be a contestable or debatable judicial
conclusion), may validly act for the principal purpose of preventing the
shareholders from electing a majority of new directors. The question thus
posed is not one of intentional wrong (or even negligence), but one of
-<1 authority as between the fiduciary and the beneficiary (not simply legal
. lj
j authority, i.e., as between the fiduciary and the world at large). [... ]
The shareholder franchise is the ideological underpinning upon
I'
·1
which the legitimacy of directorial power rests. Generally, shareholders
have only two protections against perceived inadequate business
performance. They may sell their stock (which, if done in sufficient
numbers, may so affect security prices as to create an incentive for
altered managerial performance), or they may vote to replace incumbent
board members.
It has, for a long time, been conventional to dismiss the stockholder
vote as a vestige or ritual of little practical importance. It may be that we
are now witnessing the emergence of new institutional voices and
arrangements that will make the stockholder vote a less predictable affair
than it has been. Be that as it may, however, whether the vote is seen
functionally as an unimportant formalism, or as an important tool of
discipline, it is clear that it is critical to the theory that legitimates the
exercise of power by some (directors and officers) over vast aggregations
of property that they do not own. Thus, when viewed from a broad,
institutional perspective~ it can be seen that matters involving the
integrity of the shareholder voting process involve consideration not
CH. 5
present in any other context . h'
(... ] . m w ich directors exercise delegated power.
The board was not faced with . .
shareholder against the interests a coe~ci~e action taken by a powerful
(such as a public minority) It of a distinct ~hareholder constituency
by a 9% shareholder More· w:s presented with a consent solicitation
had time) to inform· the s~verh l~re it had time (and understood that it
O
Proposal subject to stockh oladre ers of its views on the merits of the
er vote · The 1 . t'fi . h .
such a situation, be offered for th . on Y J~s i icat10n t at can, m
better than do the shareholder e ac~10:° taken is that the board knows
While that premise is no d s what ism the corporation 's best inte~es_t.
. . oubt true for any number of matters , it is
rrrele;ant (except ms.ofar as the shareholders wish to be ided b the
boards recommendation) · is
wh en th e question · who shouldgucomprise·Y
the
.
board
. of directors. The theory f ·
o our corporat10n law confers power upon
directors as the agents of the shareholders; it does not create Platonic
maste~s .. It may be that the Blasius restructuring proposal was or is
unrealistic ai:id would lead to injury to the corporation and its
shareholders if pursued. Having heard the evidence I am inclined to
think it w~s not a so~nd proposal. The board certainl y ~ewed it that way,
and that view, held m good faith, entitled the board to take cert ain steps
to evade the risk it perceived . It could , for example, expend corpor ate
funds to inform shareholders and seek to bring them to a similar point of
view. [. . .] But there is a vast difference between expending corpora te
funds to inform the electorate and exercising power for the primar y
purpose of foreclosing effective shareholder action. A majorit y of the
shareholders, who were not dominated in any respect, could view the
matter differently than did the board. If they do, or did, they are entitled
to employ the mechanisms provided by the corporation law and the Atlas
certificate of incorporation to advance that view . They are also entitled , in
my opinion, to restrain their agents, the board, from acting for the
principal purpose of thwarting that action.
I therefore conclude that, even finding the action taken was taken in
good faith it constituted an unintended violation of the duty of loyalty
that the b~ard owed to the shareholders. I note parenthetically that the
concept of an unintended breach of the duty of loyalty is unusual but not
novel.
NOTES AND QUESTIONS

· Wh Id the appointment of two new directors by the board
r
1
p ec_ude
1. Y_
Blasms r
wot
om obtaining a majority of the board? Could not
.
t?e
tot al
. dicated in the charter (articles of
maximum number of directors m .
incorporation) be increased?
· th t the directors did not breach any duty, or
2 · The Court opmes . d a "unintended breac h of t h e du t y of 1oya lt y."
better that they comm1tte an
This is a som eho
---OR
~-RP
254-------=~~~~~~~~CO
---
w
-~-5
stra nge con
ATE GOVERNANCE
cep t, eve n if
Ca
-
the Court says it is not "novel." In
in
t, _th e dir ect ors hav e not bre ach ed any specific rule, and have acted,
fa: an
actions are nonetheless considered
prmc1ple, within their powers. Their olders' franchise. Why?Do you agree
reh
unacceptable infringement on the sha
with the Court?
Wh at alte rna tiv e cou rse of act ion would you have suggested to the
3.
proposal?
dir ors in order to oppose Blasius'
ect
We sho uld wa rn the rea der s that this decision, a classical case
4.
dynamics of corporate governance and
important to understand in theory the m a practical perspective has been
fro
the boundaries of directors' actions, n, Merceir v. lntertel, it has been
isio
rarely applied, and in a 2007 dec
partially revised.
***
OOD OF TEAMSTERS
INTERNATIONAL BROTHERH
COMPANIES, INC.
GENERAL FUND V. FLEMING
Supreme Court of Oklahoma
975 P.2d 907 (1999)
SIMMS,J.
Sta tes Co urt of Ap pea ls, Te nth Circuit, John C. Porfilio,
The United
Jud ge, pur sua nt to 20 O.S .1991, § 1601, certified to the
Presiding
ing question of law:
,.4 Oklahoma Supreme Court the follow
. 1 t the authority to create and
Does Oklahoma law [A] restric ,
' exclusively to the board of directors
implement shareholder rights plans er
resolutions requiring that sharehold
or [BJ may shareholders propose ding
shareholders for vote at the succee
rights plans be submitted to the
annual meeting?
ans we r the firs t par t of the question in the negative and the
We
par t aff irm ativ ely . We hol d under Oklahoma law there is no
second
aut hor ity gra nte d boa rds of dir ectors to create and implement
exclusive
old er rig hts pla ns, wh ere sha reholder objection is brought and
shareh
thr oug h off icia l cha nne ls of corporate governance. We find no
passed
a law wh ich giv es exc lus ive aut hority to a corporation's board of
Oklahom
the for mu lati on of sha reh old er rights plans and no authority
I directors for ing resolutions or bylaw
sha reh old ers fro m pro pos
i which preclu des
reh old er rig hts plans. We hold shareholders
amendments reg ard ing sha
older
t board implementation of shareh
f may propose bylaws which restric vide
I
cate of incorporation does not pro
rights plans, assuming the certifi
otherwise.
of the Teamsters General Fund
The International Brotherhood ing
of Fleming Companies, Inc. [Flem
[Teamsters] owns sixty-five shares er's
the com pan y] sto ck. In 198 6, Fleming implemented a sharehold
or
,..
CH- 5 CORPORAT
- . E GOVERNANCE 255
rights plan with the term of th
implemented by Fleming is an e t~1an to expire in 1996. The rights plan
boards of d.1rectors authorit ant Oi-takeov er mech amsm . . Such plans give
shareholder rights upon the ocy adopt and execute discriminatory
when a cer t am . percentage ofcurrence
h of some t nggermg
. . event usually
shareholder. A board can place" s atr~s. has been amassed by 'a single
· of' shareholdres rictions
trans :fier or receipt . or. cond't·
1 ions on the exercise,
·
shareholding power of one seek· er rights which can severely dilute the
plans usually result in entren~~1ncontr?l ?fa company. The defensive
takeover without the approval f . g ex1stmg management, making a
These rights plans can make 1·tofmcumbent management more difficult.
Because the rights plans mak thar more expens1ve · t o efl!1ect a ta k eover.
the suitor and assist incumb t e e merger of com
. pames · more pam · fu l 1or
I!
lans are often called "poi en·11m_anagementm maintaining control , the

P son Pl rights plans" or "poison pills."
. [Teamsters made a proxy
. . proposa 1 to amend the bylaws eliminating
rights plans and proVIdmg that the introduct 1·0 n of s1m1 · ·1ar poison
· p1·11s
d b
s~oul e approv~d by the shareholders, and not left to the board. The
directors of Flemmg refused to include this proxy proposa 1, an d th·1s
Iawsm·t fio11owe d] .
This is a case of first impression in Oklahoma and there is little
~i~ance from o~her states. Oklahoma and Delaware have substantially
s1m1lar corporat10n acts, especially with regard to Title 18 §§ 1013 &
1038which are of primary concern here. [.. .] '
In the scheme of corporate governance the role of shareholders has
been purposefully indirect. Shareholders' direct authority is limited. [... )
This is true for obvious reasons. Large corporations with perhaps
thousands of stockholders could not function if the daily running of the
corporation was subject to the approval of so many relatively attenuated
people. However, the authority given a board of directors under the
Oklahoma General Corporation Act , 18 O.S.1991 § 1027, is not without
shareholder oversight, 18 0.8 .1991 § 1013(B).
Fleming's argument relies on this passage, 18 O.S.1991 § 1038
(emphasis added):
"Subject to any pro~isions in the ~ertificate ~f incorporat_ion,
every corporation may create and issue . . . rights or opti~ns
entitling the holders thereof to purchase from the corpor~tion
a ny s h ares Ofits capital stock of any class
.
or classes, such rights
h · t t
or options to be evidenced by or m s~c f ;~s rum~~ or
instruments as shall be approved by the boar o irectors.
· t Fleming asserts that the word "corporation"
In ma ki ng its argumen , · d · 18 § 1038
. . h ''b d Of directors" as the term 1s use m .
1s synonymous wit oar • t d ·
T . · "every corporation may crea e an issue
herefore, according to F1eming, b d to say "[every corporation's
· .. rights and options[.]", can actua 11 Y e rea
--------~
256 ~~~-----~::'.!.·
~~~~~~CORPORATE GOVERNANCE
board of directors] may create and issue ... rights and options[.]''
--
CH 5
However, in light of the fact that both terms, "corporation" and "board of
directors", are used distinctly throughout the General Corporation Act
and within the text of 18 § 1038 itself , this assertion is flawed. Further ,
the Former Business Corporation Act, 18 § 1.2(1) and (23), defines
"corporation" and "director" differently. The statutes indicate our
legislature has an understanding of the distinct definitions it assigns to
these terms, and we find it unlikely the legislature would interchange
them as Fleming contends .
While this Court would agree with Fleming that a corporation may
create and issue rights and options within the grant of authority given it
in 18 § 1038, it does not automatically translate that the board of
directors of that corporation has in itself the same breadth of authority .
[...]
We find nothing in the Oklahoma General Corporation Act, 18
O.S.1991 § 1001 et seq., or existing case law which indicates the
shareholder rights plan is somehow exempt from shareholder adopted
bylaws. Fleming argues that only the certificate of incorporation can limit
the board's authority to implement such a plan, relying on § 1038. While
this Court might agree that a certificate of incorporation, which somehow
precludes bylaw amendments directed at shareholder rights plans, could
preclude the Teamsters from seeking the bylaw changes which are
proposed in this case, neither party has indicated Fleming's certificate
speaks in any way to the board's authority or shareholder constraints
regarding shareholder rights plans. We find no authority to support the
contention that a certificate of incorporation which is silent with regard to
shareholder rights plans precludes shareholder enacted bylaws regarding
the implementation of rights plans.
A number of states have taken affirmative steps to ensure their
domestic corporations, and in many instances the board of directors itself,
are able to implement shareholder rights plans to protect the company
from takeover . The legislation is typically called a shareholders rights
plan endorsement statute. However, the Oklahoma legislature has not
passed such legislation. There are at least twenty-four states with these
share rights plan endorsement statutes.
[... ]
This Court understands much of the reasoning behind the enactment
of rights plan endorsement statutes and why so many state legislatures
are inclined to facilitate this takeover protection for their domestic
corporations. In addition, we understand Fleming's desire to have a rights
plan available for quick, and more effective, implementation. However , if,
as in this case, the certificate of incorporation does not offer directors th is
broad authority to protect against mergers and takeover, corporations
,,, .
f_H. 5 CORPORATE GOVERNANCE

257
must look to Oklahoma's 1 . 1
properly vested with the mea egistOature , not this Court, which 1s more
·
ns offer boards sueh aut h ority.
In answering th· ..
. is certified ·
shareholder rights plans are . question, we do not suggest all
ratification or review ; this is :~i::ed to s_ubmit to shareholder approval,
find shareholders may, throu h question presented to us . Instead, we
governance, restrict the b
shareholder rights plans .
l th ~ proper channels of corporate
oar of directors authority to implement
NOTES AND QUESTIONS

1. What is a "certified t' f
litigated, and why is it neces ques wn °
law"? Where is this case being
·a th' · ?
dec1 e is issue .
sary for the Supreme Court of Oklahoma to
2. . What · ht s Pan
is a "Shareholder r ig 1 "?. We will .
: discuss . more
1t
.
extensively
· m the
th t · 1 d chapter on takeovers , but b as1ca y 1 1s an anti- ak eover
· 11 ·t · · t
device a me u es ~h:ee elements: (a) a triggering event generally
repr~sented by an ~n~ohcited acquisition of a certain percentage of shares by
a third party_ that IS hkely aiming at obtaining control of the corporation; (b)
a cata_stroph1c consequence that would make the takeover very difficult or
financially costly for the acquirer, typically the issuance of shares at a
discounted price to existing shareholders; (c) the possibility for the existing
board to redeem the plan at a nominal cost. These three features combined
create an obstacle for hostile acquisitions, protecting incumbent managers.
Shareholders, however, like Teamsters in this case, often do not like these
types of poison pills. Can you explain why?,
3. In Blasius v. Atlas, reprinted before, the Court limited the ability of
the directors to interfere with the shareholders' franchise. In Teamsters v.
Fleming the Court recognizes the power of shareholders to amend the bylaws
and restrict the board's discretion with respect to shareholder rights plans.
What are the legal grounds to reach this conclusion? Do you think it is always
in the best interest of shareholders that directors cannot effectively adopt
defensive measures in case of a hostile bid?
4. The Court underlines the reasons why shareholders' direct
authority should be limited, but it ultimately ~ecides that _ in this ca~e
shareholders can limit directors' powers . Followmg the rationale of this
decision do you think it would be admissible, under U.S. law, a bylaws
· · ' requ1r· 1·ng the assent of shareholders for every transaction with a
prov1s1on
value of $50,000 or more?
***
·es grapple with the issue of the proper boundary,
Also ot h er coun t r1 board of directors and of the shar eholders
between t h e powers of the interesting example. Two dec1s10ns · ·
are
· · n
meeting. Germany · d by th e F edera 1 Cour t of
is Ra lzmiiller case decide
. . l· th
particularly cruc1a . e o
..
258
--------~~~~~~~~~~-----~ CORPORATE GOVERNANCE Ca .5
---.:c.
Justice in 1982 and, more recently, the Gelatine cases of 2004. As a
general rule, under German law only the Vorstand, the managing board
has the responsibility to run the corporation. The powers of th~
shareholders to interfere with the management of the corporation are
quite limited: they cannot give binding instructions to directors, and the
shareholders' meeting can take business decisions only if required by the
Vorstand. This is also in line with the fact that directors can be liable for
damaging decisions (see Chapter 6), while shareholders, at least in
practice, rarely are responsible for lack of care. This principle is explained
with the adage "Keine Herrschaft ohne Ha/tung' ("No power without
responsibility"). In Holzmuller, however, a peculiar situation concerning
corporations within a group was considered. The Vorstand of the
corporation decided to spin off the most important assets of the
corporation, a harbor-operating business, to an entirely owned subsidiary.
The value of the assets transferred was approximately 80% of the total
assets of the corporation. The consequence would have been that the
directors of the parent corporation would have had extensive control on
the assets transferred to the subsidiary, because they exercise the voting
rights for the shares of the subsidiary owned by the parent. The Court
therefore held that certain key decisions that could be normally taken by
l~0
.:
E
. the shareholders' meeting of the subsidiary (which, in practice, means by
•
•,,,_.,,_
_.
_J(
'
•
. the directors of the parent) require the vote of the shareholders' of the
. . parent, for example in case of issuing of new shares by the subsidiary
(which, as we have seen, in civil law systems is generally a competence of
"1
the shareholders' meeting-see Chapter 4). This is to avoid the result of
depriving the shareholders of any control on relevant assets through the
\ ·: :'/ use of a corporate group. It's a leading decision because it recognizes, for
' I
"
the first time, non-statutory competences of the shareholders' meeting in
a matter traditionally reserved to managing directors. In a way,
Holzmiiller could be considered the German correspondent of Blasius v.
Atlas: notwithstanding the profound differences of the facts, applicable
rules, and holdings, both decisions introduce a limitation to the power of
directors to disenfranchise shareholders. This important and somehow
revolutionary decision, however, created significant legal uncertainty in
terms of its precise meaning and implications, partially addressed in the
Gelatine case.
In the next few pages, we take a closer look at these decisions.
HOLZMULLER
German Federal Court of Justice, 1982
25 February 1982
Facts
The plaintiff was a shareholder holding about 8% of the shares of the
defendant which was a corporation in the lumber industry. According to
f_fl.5 CORPORATE GOVERNANCE 259
the charter of the defenda t
· ·t·ies In
act1v1 · business purposes were
· th e 1umber indun t corporat·ion, its
. . . and acquisition
s ry as well as th e founding
of oth er corporat10ns 1n this area
defendant could allocate parts of itsMoreover the charter stated that the
the board of the defendant £ assets to these corporations In 1972
d ·
assets of a 1um ber harbor run b h th e HKiG
ouu ed - aA and transferred all
contribution in kind in excha It e defendant to this corporation as a
assets of the lumber harbor nge or all th e shares of this corporation. The
the defendant. The plaintiff ~~p.rese~ed around 80% of all the assets of
lumber harbor was void since ~~~s t at the tra?sfer .of all assets of the
transfer and that the transfer gen~ral meeting did not approve this
charter . The Regional Court L;onSb~uted a de facto change of the
(Oberlandesgericht) dismissed the ~:s~~richt) and the Court of Appeals
Grounds
The co1:1rtgrants the appeal but dismisses the case.
[... ]
The transfer is not void under German corporate law.
[... ]
The argument of the plaintiff that the transfer of all the assets of the
lumber harbor to the H-KGaA constituted a de facto change of the charter
does not lead to invalidate the transfer. The court of appeals already
stated correctly that the transfer of all the assets of the lumber harbor to
the H-KGaA did not violate any provision of the charter since the charter
explicitly allowed the transfer of assets to other corporations. Moreover,
the provisions in the charter did not limit these transfers to certain assets
or a certain amount of assets. Consequently the provisions of the charter
cannot be interpreted as prohibiting the transfer of the major assets of
the corporation.
However, this only means that a formal amendment of the charter of
the defendant was not necessary. This does not imply that the transfer of
all the assets of the lumber harbor to the H-KGaA did not require an
approval of the shareholders' meeting. If the competences ~f . the
shareholders' meeting are governed by mandatory statutory provis10ns,
this only means that the charter cannot attribute this power to the
managing board or another corporate body. [... ] ~though it is in the
discretion of the managing board whether to obtain a1: approval_ of the
, t· ·n cases where such an approval. 1s not required by
s h are h oId ers mee 1ng 1
the statute (Sec. 119 subs. 2 German ~tock C0Jo;:-t10~ Law), ther£e ar~
fundamental decisions of the managing boar t atb avde a dpro_ohun_
· h f h eholders and that cannot e a opte wit out
Ihmpact on the rig ts ohs arh lders In these cases the members of the
t e approval of the s are O •
______
~2~6~0 _____
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N~C~E:.__
managing board violate their duty of care if they do not refer the decision
to the shareholders' meeting.
The transfer of all the assets of the lumber harbor to the H-KG011
was such a decision and it required the approval of the shareholders'
meeting. This decision had an impact on the core business activity of the
defendant, involved the most valuable asset of the defendant and changed
its structure completely. Therefore this transfer exceede~ the regular
scope of business activity of the defendant and had a severe impact on the
shareholders of the defendant. Consequently the managing board was not
allowed to transfer all the assets of the lumber harbor to the H-KGaA
without a prior approval of the shareholder meeting of the defendant.
Nevertheless the violation of this duty does not affect the validity of
the transfer. According to Sec. 82 German Stock Corporation Law, the
power of the managing board to act on behalf of the corporation can only
be limited by the bylaws. Although under German law there are two
exceptions (abuse of the agent and execution of a contract with a wholly
owned subsidiary) of this principle, these exemptions cannot affect the
I
validity of the transfer since the transfer was made as a contribution in
kind and therefore does not concern only the internal affairs of the
defendant but the affairs of the subsidiary as a separate legal person. In
fact a cancellation of the transfer would require a decrease of the legal
capital or to dissolve the H-KGaA.
[... ]
The issuance of new shares by a subsidiary corporation paid by
transferring the major assets of the parent corporation threatens severely
the interest of the shareholder of the parent corporation since it could
lead to a decrease of the value of the shares of the parent corporation and
to an exclusion of the pre-emptive rights of its shareholders.
Consequently, a participation of the shareholders of the parent
corporation in future decisions of the subsidiary is essential in order to
protect their interest. This also applies in the case that the increase of
capital w~u~dnot be combined with an exclusion of the pre-emptive rights
of su?scripti~n of the parent corporation (dissenting Timm, AG 1980, 183
f.; Timm, Die AG als Konzernspitze, p. 174 f.; Lutter, in: Festschrift
Wester~ann, p. 365 f.). Even in this case the shareholders of the parent
c~rporat10n cannot subsc~ibe newly issued shares of the subsidiary
directly and make further investments in their business. Every issuance
of new shares of the subsidiary increases the probability that it will have
new (external) shareholders.
There~ore,_the general meeting of the parent corporation must be
able to decide _ifthe_capital of the H-KGaA should be raised and whether
th to the
e pre-emptive rights should be excluded or be granted
· ·
shareholder of the parent corporation · In th'1s d ec1s10n, h 1
t e genera
CH.5 CORPORA
. TE GOVERNANCE 261
meetmg of the parent corpo t·10
· the same maJ·ority as
· d a t th e general me t·ra n has t 0 vot e with
reqmre e mg of the sub si·d·iary corporation.
***
The Holzmuller deci'si·on caused · 'fi
the Federal Court of Justice d'd sigm icant legal uncertainty since
of the managing board that c~nn~t clearly defin~ fundamental decisions
shareholders, and therefore . ave a severe impact on the rights of
The Court focused on the · require specific protections of shareholders.
what about other transac~~suanc~ of m~wshares by the subsidiary, but
consequence, the precise blOnsd t ~t might have similar effects? As a
debated. Over 20 years aftero~ 1thanes 0 ~ the Holzmiiller doctrine were
Justice tried to clarif ' Gelatine, the German Federal Court of
generally limiting th ifi
~om: l aspects . of th~ Holzmiiller principle by
had been expanded 1 e lozbmuller doctrme to its original version after it
arge Y Y ower courts.
GELATINE
German Federal Court of Justice , 2004
26 April 2004
Facts
!he plaintif~s were four shareholders of the defendant corporation,
holding about 291/oof the shares of the defendant which was a corporation
in the gelatine industry . The defendant held 100% of the shares of a
Swedish and a British corporation. While the British corporation had
almost no economic impact for the defendant, the Swedish corporation
contributed around 30% of the revenues of the defendant. In 1998, the
managing board of the defendant transferred all shares of these two
corporations to a newly formed corporation in a contribution in kind in
exchange for 100% of the shares of this new corporation. At the
shareholders' meeting in 2000 the managing board asked the
shareholders to approve this transfer and a resolution was passed with a
69% majority. The plaintiffs then challenged the shareholders' meeting
resolution claiming that the transfer constituted a violation of the so
called Holzmiiller principles which-according to the plaintiffs-would
require an approval of the transfer with a three-fourths majority. The
district court (Landgericht) and the court of appeals (Oberlaudesgericht)
dismissed the case.
Grounds
The court rejects the appeal.
[... ]
. f the plaintiffs is not well founded. The shareholders'
Th e ac t 10n o h £ h · · Th e
. 1 t· di"d not require a t ree- ourt s maJor1ty.
m ee t 1ng reso u 10n . h.
Holzmiiller principle does not apply in t is case.
. .·.
CHAPTER 6
DIRECTORS' LIABILITY AND

FIDUCIARY DUTIES
•••
INTRODUCTION
Directors are the agent Of th .
A h th _s • e corporation and of the shareholders.
s sue , ey ?we to their prmcipals fiduciary duties. Although the
concept
. of fiduciary
. duties Is
· t yp1ca
· 1 of common law systems, directors' ·
duties
. .also
. mother systems , even if defined dif'i!e
1 ren tl y, su b st an t·1ve1y are
1
qmte similar to common law-style fiduciary duties.

This chapt~r exa~i~es directors' duties and possible consequences of
a ~reach of_t~e1r _duties m terms of liability. Following a traditional and
u~~versal ~1stmct10n, we will focus on the duty of care, i.e., the duty to act
diligently m the best interest of the corporation; and the duty of loyalty,
which includes different aspects: the duty not to act in conflict of interest,
transactions with related parties, and the business opportunity doctrine,
holding that a director must offer business opportunities that she became
aware of to the corporation before taking advantage of them personally.
Some scholars and courts also identify as a separate and specific duty of
directors the duty of "good faith," which-somehow simplifying-could be
considered a middle ground between the duty of care and of loyalty. Even
if, especially more recently, courts in the U.S. have been willing to expand
the notion of good faith and use it as a basis to affirm directors' liability,
we think that for our purposes it is not necessary to treat this aspect as a
separate and independent duty.
Generally speaking, especially in com~on law syst~ms, directors do
not have fiduciary duties toward creditors. Creditors only have
contractual rights toward the corporation. This is however not always the
case On the one hand, even in common law systems, when the
• t·
Corpora 10n 1
·s nearing insolvency (it is in the so-called "zone of
· d d. will
· 1 y'') and therefore an almost certam amage to ere 1tors
mso venc , . d · d d' b h
occur, directors can also have fiduciary uties J~;ar c:e _1t~:s,_ ut ~ e
case law is not well settled and varies amon~ ere~t Juris 1ctions. n
· several civil law countries specific statutory rules
th e ot h er h an d , 1n d d' · · 1
· h 1· b·1·ty of directors towar ere 1tors exist, sometimes a so
concermng t e 1a 1 1
· d d 1 f
· (
the insolvency of the corporation even 1 t ey are
·r h
m epen ent Yd romt 'de of bankruptcy). We will address this problem in
rarely enforce ou s1
267
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_2_6_8___ _;::D~l:!:R~E~C
the final part of this chapter. Of course there are also specific remedies in
case of bankruptcy, but they are outside the scope of this book.
Specific procedural issues concerning the possibility to sue directors,
especially derivatively, will be treated in the following chapter. Here we
will consider the substantive definitions of directors' duties and liabilities.
One general observation that we can anticipate is that even if in this area
comparative differences among the different jurisdictions considered exist
and are relevant, some of the basic ideas such as the definition of the duty
of care and the business judgment rule, but also the contents of the duty
of loyalty, are fairly similar. This is not surprising as the underlying
economic issues, and the need to strike a balance between directors'
liability and allowing them sufficient latitude to carry on the business
and take reasonable risks are similar in all legal systems .
DUTY OF CARE
Basically, as mentioned above, the duty of care is the duty of
directors to manage the corporation diligently. In order to understand the
content of the duty of care it can be helpful to start from a distinction
used in civil law systems, not always familiar to the common law lawyer.
In several civil law systems, there is a difference between what might be
called, with a somehow loose translation, "obligations of means" and
"obligations of result." The former are obligations that are performed
simply by being diligent, even if a specific result expected or hoped for by
a party is not reached. The latter are, on the other hand, obligations that
are performed only if a specific result is achieved: diligence or the absence
of negligence do not excuse non-performance and the party is considered
to have breached the contract if the promised result is not obtained.
In this perspective, it is essential to understand that directors do not
have an obligation of result, but only an obligation of means. They must
manage the corporation in compliance with the law and the governing
documents of the corporation, and act diligently, but the fact that the
corporation does not achieve good economic results, or even that it
becomes insolvent or bankrupt, is not automatically a source of liability.
The care required by directors, in addition, is primarily a "procedural"
. care, in the sense that directors that act on an informed basis, devote
sufficient time to their decisions, acquire-when necessary-opinions
V
f
'
.
from independent experts on a business decision, and so on, are generally
not liable for an honest error of judgment. The emphasis is, in other
words, more on the "way" in which a decision has been reached ' rather
than on the merits of the decision itself. This is so also because ' in case of
a lawsuit, judges, who are not business experts, are reluctant to
substitute their judgment for the one of the directors; in addition, it might
be difficult and somehow unfair to second-guess directors' decisions in
' ·. ,..
"i
sin CH. 6 DIRECTORS' LIABILITY

light of additional el AND FIDUCIARY DUTIES · 269
d . . ements that m· h
):ts, the ecision was taken (so-called h' idg_t have not been foreseeable when
We .
Th 1s b m sight bias)
.
o servation re quires how ·
es. genera II Y true that the £oc '. ever, a qualification. While it is
·ea . t us 1s on p d
circums ances when, based on all r_oceural due care, in egregious
ist decision was completely irrational th e information collected, the actual
tty found. ' a breach of the duty of care could be
:ty
What is the standard of d1T .
ng on principles of agency law 1·t . ig~ce to which directors are held? Based
rs'
ss
"prudent person-better di~ t t ~ v~gu_e bu~ universal standard of the
say, this does not req~ir ecdi?r-m similar circumstances ." Needless to
managing. a corporation e . rectors. to .be par r1cu1ar 1y conservative:
·
reqmres
risks are properly eval t d nd taking risks·, ere ore as ong as th e
th £ 1
of higher returns direc~~r: ha ~al~nced by the reasonable expectation
t d d ' b . ave significant leeway. Of course this vague
)f ~ an. ar . can on 1Y e given a more precise meaning by case law and the
e mqmry _is_ah~ays ve~y-fa~t:intensive. Several courts, as we will also see
below, limit directors hab1hty to cases of gross negligence.
n
A con~ecte~ a~d perhaps more complex question is if the diligence
e stan~ard 1s obJecti:e or subjective; more concretely: if a director has
:l spec~c knowledge m a certain field, based on her education and past
l expenence, would she be held to a higher standard than the fictional
"average director"? For example, let's imagine that the board of a
corporation approves both the project to build a bridge, and a complex
transaction to finance the project through derivative contracts, and let's
imagine that both an engineer and a corporate finance expert sit on the
board. If the bridge collapses or the financial transaction turns out to be
ruinous, would they be held to different standards based on their
professional profiles (so to speak, is the engineer "more liable" for the
damages connected to the failure of the bridge, and the financial expert
for the loss on derivatives?). In some legal systems, for example under
Italian law (Article 2392 of the Italian Civil Code), the corporate _s~atute
specifically provides that all directors are held to the standard of diligence
of the "average director," but that speci~c a~di_tio~al c?mpetences. ~re
t a k en 1n· t ount In other systems this distmct10n 1s not so rigid,
o ace · . h "d d·1· ,, d f ·
t £ le to what happens with t e ue 11gence e ense m
con r~~y or exa~p the U 8 based on section 11 or 12 of the 1933
securities cases m · · . Fs
· · A t ( Escott v BarChris Const. Corp ., 283 . upp. 643
·
Secun ties c see
(S.D.N.Y 1968)).
. . d f damental concept, especially in common law
One add1t10nal an_ un also in other jurisdictions, is the so-called
~yst:ms b~t-as
11
we Wl le ~~~e business judgment rule is basi_cally a
'busmess JUdgmen~ ru · ·n out their duties, directors acted m good
presumption that, m car_ryi gd . the best interest of the corporation. In
faith, on an informed basis, an m
f!.2.!..7~0
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case of dispute, it is up to the plaintiff to overcome t~is presumption and

prove with a preponderance of the evidence that this w_as not t~e case.
The business judgment rule is a quite powerful prote~tw~ f?r ?ire~tors
against liability suits, and from an economic standp~int it is J~stified,
among other reasons, by the need to be able to recruit and_ r~tai? ~~ll-
qualified professionals as directors. Can you see why a rigid liability
system might cause adverse selection?
There are, however, several circumstances in which the business
judgment rule does not apply or, more precisely, c8:n be rebutted. These
include situations in which the director breached his duty of loyalty, for
example acting in conflict of interest; situations in which the ~rector was
completely passive and failed to inform himself on the busmess of the
corporation; or cases of a knowing violation of criminal law. In addition,
as mentioned before, the corporations or shareholders suing derivatively
can overcome the business judgment rule by demonstrating that a
reasonable investigation was missing, or-even if it might be harder-
that the decision was (completely) irrational and wasteful.
While most systems recognize that directors are not liable if they
exercised good business judgment, and do not hold directors liable for an
honest error in judgment, not all systems provide for an explicit
presumption that the plaintiff must overcome to prove the lack of care of
directors. In many systems this regulatory approach follows from general
principles, according to which it is the plaintiff that must prove the basis
of her cause of action. Of course, as also the following judicial opinions
will illustrate, there is occasionally room for ambiguities. This is the case
in China, because the new Company Law of 2005 does not explicitly
address the business judgment rule. Commentators have argued that
some courts might not apply it, but even some judges seem to embrace the
general approach briefly discussed. For example, two Chinese judges have
recently written in an article: ''The people's courts should not substitute
judicial power for the company's ordinary business judgment, but should
instead respect the ordinary business judgment" (see Jiang Yu Wang,
Company Law in China: Regulation of Business Organizations in a
Socialist Market Economy, Edward Elgar Publishing, 2014, 214 f.).
Very rarely, in some systems, there is no presumption that directors
acted diligently, and if they are sued, they have the burden of proving due
care. This seems to be the case in the Czech Republic: see Bohumil Havel,
Czech Corporate Law on its Way, 12 ECFR 1, 11 (2015).
Needless to say, directors and officers can be liable both for
misfeasance, when an improper decision was taken (better: a damaging
decision was taken in an improper way), and for nonfeasance when they
failed to supervise or monitor. It is important to point out that most
developed legal systems also recognize, as part of the duty of care, a
.
DIRECTORS' LIABI LITY AN 271
CH. 6 D FIDUCIARY DUTIES
ectors to put m · I .
specific duty of dir l control systems
t ·r t d amages. For example, in the rna
P ace ade qua te mte
U.S., see the famous
to preven or mi iga e Litigation, 698 A.2d 959
case In re Ca rema7:k International Inc. Derivative
. 1996 ); in Italy see Article 2381 , p ar. 3 , It a 1·ian c·1v1·1 Code ,
(Del.· Chth t d ·
a irec tor s mu st eva lua te, based on the information received,
stating
ade qua cy of the org ani zat ion al, administrative, and accounting
the
This duty might be interpreted as
syste~s adopted by the corporation.
the internal control system of the
includin? the one .of overseeing often requires more serious
n, eve n if ove rsig ht liab ilit y
corporatio
violations.
start our comparative analysis.
With this framework in mind, we can
dis cus sed bef ore , this is an are a in which, in our opinion, there are not
As
among countries. Most jurisdictions
profound substantive differences
se we have illustrated, and most
limit directors' liability in the sen
ons kno w, in one for m or ano the r, some version of the business
jurisdicti
gm ent rul e, put ting the bur den of proving negligence on the plaintiff.
jud be
areas, is in the details. There might
The devil, here more than in other s
rts interpret and apply the protection
differences in the way in which cou ht
ors in judgment": some courts mig
for what we have called ''honest err
a ma tter of fac t, mo re or les s deferential to directors' business
be, as .,
gm ent . Let 's tak e a loo k at three leading cases from the U.S
jud
is the famous 1985 Smith v. Van
Germany, and Italy. The first one
urt of Delaware : This is one of the few
Gorkom decision of the Supreme Co
nd directors liable for a breach of the
cases in which a Delaware court fou
car e, and as we wil l see in the No tes and Questions following the
duty of
erp t of the dec isio n, it trig ger ed a legislative response from the
exc
Delaware legislature.
W. VAN GORKOM
ALDEN SMITH V. JEROME
Supreme Court of Delaware
488 A.2d 858 (1985)
HORSEY,JUSTICE(for the majority):

class action ·
. I f om the Court of Chancery involves· a c tion
Th 1s appea r ant Tra ns Un 10n orp ora
lders of the, def. end . k. · · f h
broug h t by s h are h o '), ori gin ally see 1ng res c1s s10 n o a cas -
(''Trans Un ion " or "th e Co mp any
out merger of Trans Union [. · .]
d judgment for the
· · I the former Chancellor grante g] that the
Followi~g tria' Judgment was based [on a findin be entitled to
· .] in . · £ ed manner so as to
defendant .direct ors. [. act ed an in orm
Boar d of D 1rect ors
had
. . d t rule in approving the cash-out
en
protection of the business JU gm ·
me rge r[ ... ] t both rul s ing
· ·t of the Court we conclude thawe reverse and
Speaking for the maJO rI ~!early errone~us. Therefore,
of the Court of Chancery are
272 DIRECTORS' LIABILITY AN D FIDUCIARY DUTIES CH. 6 ca.6
~
direct that judgment be entered in favor of the plaintiffs and against the lever:
defendant directors for the fair value of the plaintiffs' stockholdings in confli
Trans Union[ . . .] accot:
II
its C
We hold [. . .] that the Board's decision, reached September 20, 1980, Boar
to approve the proposed cash-out merger was not the product of an appr
informed business judgment[ . . .]
Beginning in the late 1960's, and continuing through the 1970's,
Trans Union pursued a program of acquiring small companies in order to
increase available taxable income [against which it could use the cori:
investment tax credit (ITC) and depreciation deductions its rail car tha1
leasing business generated] . Tra
oft
On August 27, 1980, [Chairperson and Chief Executive Officer salE
Jerome] Van Gorkom met with Senior Management of Trans Union. Van me :
Gorkom reported on his lobbying efforts in Washington and his desire to Crn
find a solution to the tax credit problem more permanent than a kni
continued program of acquisitions. Various alternatives were suggested dir
and discussed preliminarily, including the sale of Trans Union to a asi
company with a large amount of taxable income. m:
Donald Romans, Chief Financial Officer of Trans Union, stated that re,
his department had done a "very brief bit of work on the possibility of a sb
leveraged buy-out." This work had been prompted by a media article
which Romans had seen regarding a leveraged buy-out by management. a
The work consisted of a "preliminary study " of the cash which could be Il'
j . generated by the Company if it participated in a leveraged buy-out. As $
Romans stated, this analysis "was very first and rough cut at seeing a
whether a cash flow would support what might be considered a high price t:
for this type of transaction." t
On September 5, at another Senior Management meeting which Van 1
Gorkom attended, Romans again brought up the idea of a leveraged buy- ]
out as a "possible strategic alternative" to the Company's acquisition
program . Romans and Bruce S. Chelberg, President and Chief Operating
Officer of Trans Union, had been working on the matter in preparation
for the meeting. According to Romans: They did not "come up" with a
price for the Company. They merely "ran the numbers" at $50 a share and
at $60 a share with the "rough form" of their cash figures at the time.
Their "figures indicated that $50 would be very easy to do but $60 would
be very difficult to do under those figures." This work did not purport to
establish a fair price for either the Company or 100% of the stock. It was
intended to determine the cash flow needed to service the debt that would
"probably" be incurred in a leveraged buy-out, based on "rough
calculations" [... ]
· At this meeting, Van Gorkom stated that he would be willing to take
$55 per share for his own 75,000 shares. He vetoed the suggestion of a
CH. 6 DIRECTORS' LIABILITY AND FIDUCIARY DUTIES 273
lever_aged b_uy-out by Management, however, as involving a potential

conflict of intere st for Management. Van Gorkom, a certified public
accou~tant a nd ~awyer, had been an officer of Trans Union for 24 years,
its Chief Executive O~ficer for more than 17 years, and Chairman of its
Board fo~ 2 years. It is noteworthy in this connection that he was then
approaching 65 years of age and mandatory retirement.
[... ]
Van Gorkom decided to meet with Jay A. Pritzker, a well-known
corporate take?ver s~ecialist and a social acquaintance. However, rather
than approaching Pritzker simply to determine his interest in acquiring
Trans Union, Van Gorkom assembled a proposed per share price for sale
of the Company and a financing structure by which to accomplish the
sale. Van Gorkom did so without consulting either his Board or any
members of Senior Management except one: Carl Peterson, Trans Union's
Controller. Telling Peterson that he wanted no other person on his staff to
know what he was doing, but without telling him why, Van Gorkom
directed Peterson to calculate the feasibility of a leveraged buy-out at an
assumed price per share of $55. Apart from the Company's historic stock
market price, and Van Gorkom's long association with Trans Union, the
record is devoid of any competent evidence that $55 represented the per
share intrinsic value of the Company .
Having thus chosen the $55 figure, based solely on the availability of
a leveraged buy-out, Van Gorkom multiplied the price per share by the
number of shares outstanding to reach a total value of the Company of
$690 million. Van Gorkom told Peterson to use this $690 million figure
and to assume a $200 million equity contribution by the buyer. Based on
these assumptions, Van Gorkom directed Peterson to determine whether
the debt portion of the purchase price could be paid off in five years or
less if financed by Trans Union's cash flow as projected in the Five Year
Forecast, and by the sale of certain weaker divisions identified in a study
done for Trans Union by the Boston Consulting Group ("BCG study'').
Peterson reported that, of the purchase price, approximately $50-80
million would remain outstanding after five years. Van Gorkom was
disappointed, but decided to meet with Pritzker nevertheless.
Van Gorkom arranged a meeting with Pritzker at the latter's home
on Saturday, September 13, 1980. Van Gorkom prefaced his presentation
by stating to Pritzker: "Now as far as you are concerned, I can, I think,
show how you can pay a substantial premium over the present stock price
and pay off most of the loan in the ~rst ~ve yea:s. [: .. ] If you could pay
$55 for this Company, here is a way in which I think it can be financed."
Van Gorkom then reviewed with Pritzker his calculations based upon
his proposed price of $55 per share. ~though Pritzk~r mentioned $50 as a
more attractive figure, no other price was mentioned. However, Van
LIABILITY AND FIDUCIARY DUTIES 6
DIRE
2i4 =-=-==:..:::
----- CTOR
..:..~ ~~~~~~~~~~~~~-_:C~a.
S' ----..;.
the best price obtainabl

Gorkom stated that to be sure that $55 was
offer. Pritzker demurre~'
Tran s Union should be free to accept any better
a "stalking horse" for a~
stat~g tha t his organization would serve as
permi_t Prit~ker to buy
"au~uon contest " onl y if Tra~s Union would
et price which Pritzker
I , 7.>0,000 shares of Trans Umon stock at mark
er discussion on this
could then sell to an y higher bidder . After furth
give him a more definite
point , Pritzker told Van Gorkom that he would
reaction soon.
Van Gorkom that he
On :Monday , September 15, Pritzker advised
osal and requested more
was interested in the $55 cash-out merger prop
information on Trans Union [.. .]
again with Pritzker.
On Thursday, September 18, Van Gorkom met
intended to make a cash-
At that time, Van Gorkom knew that Pritzker
$55 per share . Pritzker
out merger offer at Van Gorkom's proposed
n specialist , to begin
instructed his attorney, a merger and acquisitio
er discussion of the $55
drafting merger documents. There was no furth
Union 's treasury stock to
price. However, the number of shares of Trans
million shares ; the price
be offered to Pritzker was negotiated down to one
price at the close of the
was set at $38--75 cents above the per share
insisted that the Trans
market on September 19. At this point, Pritzker
the next three days.
Union Board act on his merger proposal within
[... ]
a special meeting of
On Friday, September 19, Van Gorkom called
day. He also called a
the Trans Union Board for noon the following
to convene at 11:00 a.m.,
meeting of the Company's Senior Management
pt Chelberg and Peterson,
prior to the meeting of the Board. No one, exce
om did not invite Trans
was told the purpose of the meetings. Van Gork
or its Chicago-based
Union's investment banker, Salomon Brothers
partner, to attend.
ember 20 [... ] Van
[A]t the Senior Management meeting on Sept
s, but he furnished no
Gorkom disclosed the offer and described its term
ans announced that his
copies of the proposed Merger Agreement. Rom
ed that, for a leveraged
department had done a second study which show
was between $55 and $65
buy-out, the price range for Trans Union stock
nor asked Romans to make
per share. Van Gorkom neither saw the study
it available for the Board meeting.
reaction to the Pritzker proposal was
Senior Management's
ent, except Chelberg and
completely negative. No member of Managem
cted to the price as being
Peterson, supported the proposal. Romans obje
ested that consideration
too low; he was critical of the timing and sugg
of an all-cash deal for
should be given to the adverse tax consequences
ion that the agreement to
low-basis shareholders; and he took the posit
s at market price would
sell Pritzker one million newly-issued share
·-.-.
l -
-ca .6
. · ·
DIRECTORS' LIAB
ILITYANDF
IDUCIARYDU
TIES
1nh1~1t?th~r o~fer~, as would 275
furn1shm the r
g ms1de mformation t p ;hib. . .
Pritzker proposal was a "lo 0 itions against soliciting bids and
c~ ~ :;r bidders. Romans argued
proceeded to the Board meet · that the
P [. · -1 Ne
Ten directors serv d mg as sched 1 d ·vertheless ' Van Gorkom
u e without further delay.
(defendants Bonser, O'Boyle on the T U .
five outside (defendants e B W rans mon Board,
?wder, Chelberg, and Van Gofive inside
Reneker). All directors were: 1 18 rkom) and
was ill. Of the outside direc: ' Johnso th
n, Lanterman, Morgan and
officers and one was the £ esen~ at e meeting , except O'Boyle who
ors, iur were corporate chief
Business School None w orm executive
~r ean of the
analyst. All memb· ers of theasBan mvestment b k Universit y of Chicago
t · d J.':.
and its operations as a go· d . an er or ram •
oar were well mformed about e 1manc1al
mg concern [... 1 the Company
. Van Gorkom beg~n the Spe
cial Meeting of the Board with
mmute oral presentation. Co a twen t -
pie s
delivered too late for study bef of the proposed M A
ore or dur1·ngthe meeet~ t Y
Compan y' s ITC and depreciati mg
ger
. Hgeree
rev~en
iewedwt ehr ee
on problems and the efforts
~ade t~ so~ve ~hem. He discus theretofore
sed his initial meeting with Pri
his mot1vat1on m arranging tha tzker and
t meeting . Van Gorkom did not
the Board, however, the me disclose to
thodology by which he alone
the $55 figure , or the fact had arrived at
that he first proposed the $55
negotiations with Pritzker. price in his
·.
(F]or a period of 90 days, Tra
ns Union could rec eive, but cou
actively solicit, competing off ld not
ers; the offer h ad to be acted
evening, Sunday, September on by the ne xt
21 [.. .] Trans Union was requir
Pritzker one million newly-issu ed to sell to
ed shares of Trans Union at $38
per share.
Van Gorkom took the positio
n that putting Trans Union
auction" through a 90-day ma "up for
rket test would validate a dec
Board that $55 was a fair pri ision by the
ce. He told the Board that the
will have an opportunity to judge wheth "free market
Gorkom framed the decision bef er $55 is a fair price." Van
ore the Board not as whether
share was the highest price tha $55
t could be obtained, but as wheth per
er the
$55 price was a fair price [...
Attorney Brennan advised] the
members ofhthe Bofa!d that t~e
be sued if they failed to acc ~ might
ept the offer and t at a a1rnes
s opm1on was
not required as a matter oflaw
. . in his opinio
at n , $55 was "in the r ange of
Romans to ld t h e B oar d th
a fair price," but "at the beginn '
ing th of
,,
e range .
·
~-J . f Se tember. 20 last ed about two hou rs . B ase d
. The Board meeting ,0
solely upon Van Gorkom s ora
i
resentation [... ] Romans' ora
l statement ,
P
I .
...
276 DIRECTORS' LIABILITY AND FIDUCIARY DUTIES CH.6
Brennan's legal advice, and their knowledge of the market history of the
Company's stock, the directors approved the proposed Merger Agreement.
[... ]
[On] October 9, Trans Union issued a press release announcing: (1)
that Pritzker had obtained "the financing commitments necessary to
consummate" the merger with Trans Union; (2) that Pritzker had
acquired one million shares of Trans Union common stock at $38 per
share; (3) that Trans Union was now permitted to actively seek other
offers and had retained Salomon Brothers for that purpose; and (4) that if
a more favorable offer were not received before February 1, 1981, Trans
Union's shareholders would thereafter meet to vote on the Pritzker
proposal.
., Salomon Brothers' efforts over a three-month period from October 21
,,
l.
to January 21 produced only one serious suitor for Trans Union-General
Electric Credit Corporation ("GE Credit"), a subsidiary of the General
Electric Company. However, GE Credit was unwilling to make an offer
for Trans Union unless Trans Union first rescinded its Merger Agreement
with Pritzker . When Pritzker refused, GE Credit terminated further
discussions with Trans Union in early January.
In the meantime, in early December, the investment firm of
'
'
' .
,
!
' Kohlberg, Kravis, Roberts & Co. ("KKR"), the only other concern to make
a firm offer for Trans Union, withdrew its offer under circumstances
hereinafter detailed.
On December 19, this litigation was commenced and [... ] On
January 26, Trans Union's Board met and, after a lengthy meeting, voted
to proceed with the Pritzker merger. The Board also approved for mailing,
"on or about January 27," a Supplement to its Proxy Statement[ ... ]
On February 10, the stockholders of Trans Union approved the
Pritzker merger proposal. Of the outstanding shares, 69.9% were voted in
favor of the merger; 7.25% were voted against the merger; and 22.85%
were not voted.
IL
We turn to the issue of the application of the business judgment rule
to the September 20 meeting of the Board.
The Court of Chancery concluded from the evidence that the Board of
Directors' approval of the Pritzker merger proposal fell within the
protection of the business judgment rule. The Court found that the Board
had given sufficient time and attention to the transaction, since the
directors had considered the Pritzker proposal on three different
occasions, on September 20, and on October 8, 1980 and finally on
January 26, 1981.
j2:J
JAN~D~F~I ~D~ 77 ~IA~R~
.J_U~C Y[jD~
~B~I~L~IT~Y:___
__.- D_I_R_E_CT_O~R::..:.;:S=-'..:::L:.::IA
f!!~·:...:6:.
[... ]
. . ,s
The Court of Cha. ncery . mad e bu t one fi1nd1ng;1.e., that the Board
Septe mber 20 th roug h J anuary 26 ,
conduct over the entire per . 10d from
informed.
1981 was not rec kl ess or improvident, but
[... ]
te finding that the Board's
[W]e conclu~e that the. Court's ultima
is contrary to the record and not
conduct was not r~ckless or imprudent"
soning process.
the product of a logical and deductive rea
Chancery erred as a matter
The plaintiffs cor:itend that the Court of
directors under the business
of law by exonerating the defendant
g whether the rule's threshold
judgment rule without first determinin
satisfied [... ]
condition of "due care and prudence" was
ent rule is the offspring of
Under Delaware law, the business judgm
fun dam ent al prin cip le, cod ifie d in 8 Del .C. § 141(a), that the business
the
managed by or under its board
and affairs of a Delaware corporation are
480 A.2d 619, 624 (1984);
of directors. Pogostin v. Rice, Del.Supr.,
, 811 (1984) [... ] In carrying
Aronson v. Lewis, Del.Supr., 473 A.2d 805
charged with an unyielding
out their managerial roles, directors are
shareholders. Loft, Inc. v. Guth,
fiduciary duty to the corporation and its
.Supr., 5 A.2d 503 (1939). The
Del.Ch., 2 A.2d 225 (1938), aff'd, Del
and promote the full and free
business judgment rule exists to protect
d to Delaware directors. Zapata
exercise of the managerial power grante
v. Ma ldo nad o, sup ra at 782 . The rule itself "is a presumption that
Cor p.
rs of a corporation acted on an
in making a business decision, the directo
honest belief that the action
informed basis, in good faith and in the
pany." Aronson, supra at 812.
taken was in the best interests of the com
n as uninformed must rebut the
Thus, the party attacking a board decisio
an informed one.
presumption that its business judgment was
ss judgment is an informed
The determination of whether a busine
e informed themselves "prior to
one turns on whether the directors hav
terial information reasonably
making a business decision, of all ma
available to them."
is no protection for directors
Under the business judgment rule there
o hav e ma de "an uni nte llig ent or una dvised judgment." Mitchell v.
wh
hla nd- We ster n Gla ss, Del .Ch ., 167 A. 831, 833 (1933). A director's
Hig
y to info rm him self in pre par atio n for a de?ision d~rives from the
dut
corporat10n and its stockholders.
fiduciary capacity in which he serves the
. _SeeWei~berger v. UG_P,Inc.,
Lutz v. Boas, Del.Ch., 171 A.2d 381 (1961)
d1re~tor 1s vested w1~h the
supra; Guth v. Loft, supra. Since a
_affairs of the corporat10n, he
responsibility for the management of th~
1t10n that he acts on behalf of
must execute that duty with the recogn
faithlessness or self-dealing. But
others. Such obligation does not tolerate
• , f
..
278 DIRECTORS' LIABILITY AND FIDUCIARY DUTIES CH. 6 ~

fulfillment of the fiduciary function requires more than the mere absence None'
of bad faith or fraud. Representation of the financial interests of others prior 1
imposes on a director an affirmative duty to protect those interests and to 0 ut m
proceed with a critical eye in assessing information of the type and under preser
the circumstances present here . hado1
[... ] V
The standard of care applicable to a director's duty of care has also trans
been recently restated by this Court. In Aronson, supra, we stated: Van 1
surnr
While the Delaware cases use a variety of terms to describe the giver
I applicable standard of care, our analysis satisfies us that under

the business judgment rule director liability is predicated upon
concepts of gross negligence .
sale
Gor~
agre
We again confirm that view . We think the concept of gross negligence the:
is also the proper standard for determining whether a business judgment
reached by a board of directors was an informed one .
In the specific context of a proposed merger of domestic corporations, Cot
a director has a duty under 8 Del.C . § 251(b), along with his fellow ma
directors, to act in an informed and deliberate manner in determining pni
whether to approve an agreement of merger before submitting the am
proposal to the stockholders . Certainly in the merger context, a director thE
may not abdicate that duty by leaving to the shareholders alone the w,
decision to approve or disapprove the agreement.
It is against those standards that the conduct of the directors of
' , ,1 Trans Union must be tested, as a matter of law and as a matter of fact,
m
regarding their exercise of an informed business judgment in voting to
oi
approve the Pritzker merger proposal.
a:
[... ]
' On the record before us, we must conclude that the Board of
Directors did not reach an informed business judgment on September 20,
.
1980 in voting to "sell" the Company for $55 per share pursuant to the
f,,,
.,,f'r' Pritzker cash-out merger proposal. Our reasons, in summary, are as
follows:
The directors (1) did not adequately inform themselves as to Van
Gorkom's role in forcing the "sale" of the Company and in establishing the
per share purchase price; (2) were uninformed as to the intrinsic value of
the Company; and (3) given these circumstances, at a minimum, were
grossly negligent in approving the "sale" of the Company upon two hours'
consideration, without prior notice, and without the exigency of a crisis or
emergency.
As has been noted, the Board based its September 20 decision to
approve the cash-out merger primarily on Van Gorkom's representations.
~
-ca. 6 DIRECTORS' LIABILITY
absence AND FIDUCIARY
: others None of the direct DUTIES
prior know or s,
ledge that the heot r than Va 279
: and to ut merger of Tran purpose of t~ Gor
ko_mand Ch berg
I under present, other than s Union N
0
e meetmg was to el , had any
had only learned of Ch el be r~ ; mem pr op os e a cash-
the propo~ dom an bers of Senior Management were
e sa 1e an s and Peterson; an
Without any do hour earlier d the latter two
ts also transaction, the m cuments be£
th
Van Gorkom's 20 embers of the B ore em co_nce· rn ··
-minute oral oa ing the
su. mmary d of th e t
rd w e_
r
presentatione reof quired to rely entirproposed
.e erm. s of the mer ge the proposal. Noelw y upon
r given no c
th oc umentation to supp r w as pr esented; the di.rect ritten
sa1e of , e ompa d h or t the ors were
'.l ny; an t _eBoard adequ acy of $ 55 pric . e per sh ar c
Gorkom s sta!emen ha e 1o
t of his unders d before it nothing more than Vanr
agreement which tanding of the
he admittedly had su
~ence the Board had ever never read , nor whi bstance of an
seen. ch any member of
nent
[... ]
The defendants
ons, Court's finding th rely on the follo
at the Board's de wing factors to sustain the Trial
llow magnitude of the cisio
premium or spread n was an informed one: (1) the
ung price and Trans
Union's current m between the $55 Pritzker offering
the amendment of th arket price of $38
e Agreement as per share; (2) the
!tor the Board to acce submitt ed on Sept
pt any better offe em ber 20 to permit
the We discuss each of r during the "marke
these grounds seria t test" period . (... ]
tim:
[... ]
of A substantial pr
ct, emium may prov
merger, but in th ide one reason to
e absence of othe recommend a
to of a premium alon r so und valuation info
e does not provid _rmation, th~ fact
assess the fairness e an adequate ba
sis upon which to
of an offering pric
e.
[. . .]
Jf B] their own ad
[ y mission they coul
), f alue Yet also d not rely on the _st~
accurate measure by their own ad ck price as
e members assumed o v · ' m1ss1on, the Boaran
that Trans Union d
serve as a basis
upon which to as 's m ar
~ess the adequacy
ke t pr
·
ic ef ~~s d t
a eq~a e £ o t
purposes of the Se o e premium or
ptember 20 meetm
g.
[... ]
Despite the forego
. f t and circum
stances, t h ere was
the Board, either
mg a~ s or thereafter, for no ca11b Y
on Septem e~ 20 any valuation stu
or documentation r share as a measu dy
of the $55 price p~ re of the fair valu
of the Company t It is undisputed e
in a cas~-out c~ th at th e m ajor
asset of Trans U nflex ·Yet at no tim
nion was its ~as e did the Board ca
ow~nt that highly ll
for a valuation stu significant elemen
dy taking mto ac t
of the Company's co
assets.
280 DIRECTORS' LIABILITY AND FIDUCIARY DUTIES
We do not imply that an outside valuation study is essential to

support an informed business judgment; nor do we state that fairness
opinions by independent investment bankers are required as a matter of
law. Often insiders familiar with the business of a going concern are in a
better position than are outsiders to gather relevant information; and
under appropriate circumstances, such directors may be fully protected in
relying in good faith upon the valuation reports of their management.
Here the record establishes that the Board did not request its Chief
Financial' Officer, Romans, to make any valuation study or review of the
proposal to determine the adequacy of $55 per share for sale of the
Company. On the record before us: The Board rested on Romans' elicited
response that the $55 figure was within a ."fair price range " within the
context of a leveraged buy-out . No director sought any further
information from Romans . No director asked him why he put $55 at the
bottom of his range. No director asked Romans for any details as to his
study, the reason why it had been undertaken or its depth. No director
asked to see the study; and no director asked Romans whether Trans
Union's finance department could ·do a fairness study within the
remaining 36-hour period available under the Pritzker offer.
[... ]
The record also establishes that the Board accepted without scrutiny
.1
Van Gorkom's representation as to the fairness of the $55 price per share
for sale of the Company-a subject that the Board had never previously
considered. The Board thereby failed to discover that Van Gorkom had
suggested the $55 price to Pritzker and, most crucially, that Van Gorkom
had arrived at the $55 figure based on calculations designed solely to
determine the feasibility of a leveraged buy-out[ ... ]
We do not say that the Board of Directors was not entitled to give
some credence to Van Gorkom's representation that $55 was an adequate
or fair price. Under§ 141(e), the directors were entitled to rely upon their
chairman's opinion of value and adequacy, provided that such opinion
I·
was reached on a sound basis. Here, the issue is whether the directors
t .
informed themselves as to all information that was reasonably available
to them. Had they done so, they would have learned of the source and
derivation of the $55 price and could not reasonably have relied
thereupon in good faith.
None of the directors, Management or outside, were investment
bankers or financial analysts. Yet the Board did not consider recessing
the meeting until a later hour that day (or requesting an extension of
Pritzker's Sunday evening deadline) to give it time to elicit more
information as to the sufficiency of the offer, either from inside
Management (in particular Romans) or from Trans Union's own
investment banker, Salomon Broth ers, whose Chicago specialist in
..
-.
~
al to :6~::D:I:R
_9!..:·: IL:E
IT:C
YtT:O~R~S'~L
. ... ANDF
rness
;e_of
r
merge
U
· n r's an
mo a ffdair
·acs.quisitions wa s k nown
to
IDUCIARY DUTIES
th e B oard and familia

281
r with Trans
~
1n a Th us , the rec ord comp 1 h
and Board lacked valua tion i:£ s t e _conclusio
. ess JU
busin . dgmen n that on September 20
~din Company . t as to th ormf ati
. on ad equate to reach the
e airness of $55 per sh an inf ormed
are for sale of the
'hief
the (2)
the the Th is brings us to the po
defen dants ultimately re;t -8
September 20 decision :ptember 20 "market tes
ited to ac t" upon which
the directors present a cep~ t~ ;~firm the rea
so na ble
the
test" of Pritzker's $55
two- t e ntzker proposal. In ness of their
her per phar ar~ment : (a) this connection,
decision to accept his s are ouer that by making a "mark
the . . of£ a cond't
1' · et
his
.
unpuls1vely or man un er, t h ey ca nn ion of
ot be fou d t the ir Se pte mb er 20
tor the adeq 1'n£orme d
. uacy of .the $ l pre ma nner on Sept bn 20o h ave t d
7 mi.um for sale of d (b)ache
cone em the
er Co ; an
mpany twaats
ms us1vely·destablished . ov
. 1bl er
he . 11ar di
re e evi ence available--ththe following 90 t o 120 days b y t h e most
imp 1e Y contend tha e marketplace .
t the "market test " eli Th us, th e de £en dants
Board to perform any mi
other form of fairness tes nated the need for the
or thereafter. t either on September 20
'
1y '
[.. .]
re The defendants
ly attempt to downplay
prohibition against Tr the significance of the
.d ans Union's actively so
arguing that the dir licitin
n ectors "understood tha g competing offers by
community would kn t the entire financia
ow that Trans Union l
0 announcement of the Pr was for sale upon the
itzker offer, and anyone
offer was free to do so desiring to make a bette
." Yet, the press release r
with the authorization issued on September 22
of the Board, stated tha ,
into "definitive agreeme t Trans Union had enter
nts" with the Pritzkers ed
not even disclose Tran ; and the press release
s Union 's limited right did
offers. Accompanying to receive and accept highe
this press release r
announcement that Pr was a further publi
itzke c
any time one million sh r had been granted an option to purchase at
ares of Trans Union's ca
pital stock at 75 cents
above the then-current
price per share.
Thus notwithstanding what severa
claimed t~ have "though l of the outside directo
t'' occurred at the meetin rs later
cone! · th t Trans Un g, the re~ord compels the
Se t usibon a ion 's Board had no ratio
·n the na
days immediately follow l basis to conclude on
P em er ing, that the Board's
20 or·t 1k r's offer wa . .
a ccep t ance of Pr1 z e
d [
s cond1t1one on ... 1a "mar k et t est ,, f
o
the offer [. . .]
[. . .] .
We conclude that Trans Union's Board was grossly negligent in that

-
CH,6
it failed to act with informed reasonable deliberation in agreeing to the

Pritzker merger proposal on September 20; and we further conclude that
the Trial Court erred as a matter of law in failing to address that
question before determining whether the directors' later conduct was
sufficient to cure its initial error.
[... ]
On remand, the Court of Chancery shall conduct an evidentiary
hearing to determine the fair value of the shares rel?resented by the
plaintiffs' class, based on the intrinsic value of Trans Un10n on September
20, 1980 ... Thereafter, an award of damages may be entered to the
extent that the fair value of Trans Union exceeds $55 per share.
REVERSED and REMANDED for proceedings consistent herewith.
NOTES AND QUESTIONS

1. What is a leveraged buy-out and why can it be considered a risky
technique to acquire a corporation?
2. Smith v. Van Gorkom offers almost a laundry list of what a board
should not do in approving an important corporate transaction. It should be
noted that the scrutiny of the court might have been particularly rigorous
( also because the proposed merger could have been the ''last chance" for Trans
Union shareholders to cash-in the value of their shares. The board spent too
little time on the decision, relied almost exclusively on a brief oral
presentation, and did not acquire an independent appraisal of the value of
the corporation. The fact that a premium over the market price was paid was
not considered sufficient to conclude that the price was fair. In addition, the
so-called "market test," the possibility of other offers to be entertained, was
not considered sufficient in light of the additional agreements concerning the
solicitation of offers (no-shop provision) and the options given to Pritzker,
which in the opinion of the court limited the likelihood of more competitive
offers. But there is more. On the one hand, even if the court does not discuss
this issue explicitly or at length, it is not irrelevant that Van Gorkom desired
(.
to sell his shares. One aspect that you should notice is that Van Gorkom and
the board seem more focused on identifying a price that would make a
leveraged buy-out possible and convenient, rather than on obtaining the best
possible price for the shareholders. In this perspective, ·do you think it is
relevant that the merger might be the ''last chance" of existing shareholders
to obtain the fair value of their investment?
3. You should note that the price included a premium over market
prices, but the court considered this not sufficient to conclude that the price
was fair. Why? Does this mean that the court does not believe that market
prices are efficient, i.e. correctly assess the value of listed corporations and
reflect relevant information available in market prices?
:6-;:~D:IR
£:.:.fl::.:..• :E:
~L~IA. C:T
B~IfL ~~~~~~O
~~~~§ __--~S~'
:R~ ~
ITY AND FIDUCIARY DUTIES 283
4. Do you thmk that th .
· h h d · · e court 1s mo · · of the procedure through
. re critical
wh1c t e eciswn has been take n, or of its sub t .
5. This decision s t . s ant1ve outcome?
en a shiver thro h
Delaware court had shown n O d ~ ug U.S. corporate circles. A
·
d · t ;si an d 1n· fact some corporat ·
e to 'dth ed bus_mess
eJ.erencco Judgment of
1rec ions
from e aware. 1n many ways th . . nsi ere reincorporating away
unexpected . The Delaware legisl' t e decision was somehow unusual and
This is ~n interesting example of~h:rd ~:or~ly after the decision, stepped in.
and legislatures. To avoid a los . Dy1aware's mies that can occur between judges
s m ) ef t' ·
legislature a d opted section l0 2(b)( 7 O compe 1t1veadvantage, the
Law. This provision states in th ~he Delaware General Corporation
incorporation of a corporation' can inc~ud:e evant part, that the articles of
"[a] provision eliminating or limitin th . ..
director to the corporat' . g e personal hab1hty of a
for breach of fiduciar10ndor its stockh?lders for mo~etary damages
· · . ~ uty as a director, provided that such
prov1s10 n hshall not ehmmate or limit the rIab 1Tt1 Y of a d'1rector (1)
. for
b f th d ·
any reac O •• e irector's duty of loyalty to the corporation or its
~tockhol?ers, ~n) for ~cts or omissions not in good faith or which
mvolve int~nt10nal misc~ndu~t or a knowing violation of law, (iii)
un~er sect10_n 174 of this Title, or (iv) for any transaction from
whic~ . the direct~r ~erived an improper personal benefit. No such
provis10n ~h~Il ehmma!e or limit the liability of a director for any
act or om1ss10n occurring -prior to the date when such provision
becomes effective."
A few notes on this rule. First, as you have read, the provision does not cover
all violations, in particular when there is a breach of the duty of loyalty or an
act in bad faith. Second, the limitation of liability does not apply to
executives. Third, it only concerns monetary damages; it is still possible to
obtain injunctive relief or other remedies such as rescission. Fourth, it only
applies to liability toward the corporation and shareholders, not third parties.
Finally, the burden of demonstrating that a director is entitled to this
protection is on the defendant. Can you articulate and discuss the rationale
for these limitations? Why do you think that the provision should be included
in the articles of incorporation, and not in the bylaws?
6. Consider a legal system in which there is no provision similar to
section 102(b)(7) previously discussed . Do you think that a clause limiting or
excluding directors' liability toward the corporation in the_cha~ter or byl~ws
might be valid and enforceable? Some arguments to consider 1n addressing
this question: who are the subjects protected (directly or in~irectly! by the
possibility of the corporation .or of the shareholders to sue ne_g~1ge~tdirectors?
Are er d·t d other third parties included? In .caseI .of htigat10 n, can the
e I ors an . h ? If h ?A d
corpo t· th hareholders settle or waive t eir c aims. so, ow. n
· ·
ra 10n or · e s h w does this affect the possi'b'l' i ity of renouncing sumg
if th e answer IS yes,d o rally with a provis10 . . . .
·r t n In the governing documents?
dl ec ors ex ante an gene ,
C
284
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~~~ ECT
~~~ ORS
~~~ ' ::~~
:!!!. BILITY
LIA~-~: AND FIDUCIARY DUTIES
!H,6
7. In addition to Section 102(b)(7) DGCL,

---
directors can also be
er which the corporation
protected with indemnification agreements, und
enses that directors might
?ays, under certain conditions, for litigation exp
ugh directors' and officers'
~ncur as a consequence of their job, and thro
s not cover intentional
insurance. Insurance, however, generally doe
this might affect litigation?
violations, but only negligence. How do you think
***
to be reluctant to
As mentioned above, in most systems courts tend
n taken by directors and
second-guess the merits of a business decisio
r in judgment. With the
managers, especially when it is an honest erro
rts tend to focus more on
exclusion of blatantly irrational decisions, cou
n (procedural due care
the way in which a decision has been take abse nce of'
time ded icat ed to the dec isio n,
including information and
rence to the business
conflicts of interests, etc.). The degree of defe
different systems. The
judgment of the directors varies however in
n to discuss the "German
following leading German case offers the occasio
version" of the U.S. business judgment rule.
ARAG-GARMENBECK
German Federal Court of Justice, 1997
21 April 1997
Facts
sory board of the
The plaintiffs were members of the supervi
on insurance business.
defendant, a stock corporation in the legal protecti
and several subsidiary
Between 1984 and 1989 the defendant
business relations with a
corporations were engaged in some dubious
victed person who was
foreign corporation headed by a previously con
by borrowing money
actually running some kind of Ponzi scheme
s with very low interest
promising very high returns and granting loan
collapsed causing a loss
rates. In the beginning of 1990 this Ponzi scheme
since the defendant also
for the defendant of more than 80 Million DM
mainly guaranteed the
granted some loans to this foreign corporation but
to other lenders. The
repayment of loans of this foreign corporation
agement board of the
plaintiffs claimed that the head of the man
be held liable . At the
defendant violated his duty of care and should
was decided, without the
meeting of the supervisory board in June 1992 it
for damages against the
votes of the plaintiffs, not to pursue any claims
nt. The plaintiffs claimed
head of the management board of the defenda
court to declare it void.
that this resolution was unlawful and asked the
the claim. The Court of
The Regional Court (Landgericht) granted
.
Appeals (Oberlaudesgericht) dismissed the case
±_2~8~8'..
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directors liable for an honest error in judgment. Consider,
for example, the
holding of this recent decision of the Italian Supreme Court
:
''With respect to directors' liability , it is necessary to dist~n
guish
between directors' duties that have a specific content determ
ined by
statutory law or by the charter of the ~orpor_ation-for exam
p~e-the
procedural rules concerning the way m which corporat_e.
dec1s1ons
must be approved-and duties defined with general provis
ions, such
as the duty to manage the corporation diligently and
without
conflicts of interest. With respect to the second group
of duties,
directors' liability requires a violation of the general duty
of care,
therefore the exercise of due care is sufficient to exclude any
breach,
independently from the effects of directors' decisions. With
respect
to specific duties, on the other hand, their violation leads to
liability
unless the directors can demonstrate that the violation
could not
have been avoided exercising due care." (Trustee in Bankr
uptcy of
Giza Corporation v. Campari, Corte di Cassazione, Section
I, March
23, 2004, n. 5718).
In your opinion, is the distinction between duties with
a "specific content"
"determined by statutory law or by the charter," and duties
"defined with
general provisions" sufficiently clear and practical?
Using a different
terminology, it evokes the distinction between "rules"
and "standards": for
example, not exceeding the 50 mph is a "rule," not drivin
g recklessly is a
"standard." What are the effects of these different regula
tory strategies in
terms of enforcement?
DUTY OF LOYALTY
A director breaches his or her duty of loyalty when he or she
acts in
conflict of interest with the corporation . The classical notion of
conflict of
interest concerns situations in which there is a "zero-sum game
" between
the director and the corporation, i.e., when a gain of the director
implies a
loss or a lower gain for the corporation. An easy example is a
contract for
the sale of real estate between the corporation (buyer) and the
director
(seller). A more subtle situation occurs when the interest of the
directors
is not in overt conflict with the one of the corporation, but it
might still
taint his or her ability to exercise independent judgment
in the best
interest of the corporation. Consider the following simple
example: a
corporation involved in the business of building and opera
ting golf
courses is considering different lots on which to build a new
facility; one
of the lots is close to the house of the director, the other one is
far away. If
the corporation builds the golf course near the house of the
director, the
value of real estate in the proximity of the course will go up .
The director
might have a bias toward this first option, even if strictly speak
ing both
he and the corporation might gain from the decision (it is not
a zero-sum
game). The more modern approach is to also take into acco
unt these
situations. Often, but not always, also indirect interests
might be
89 ~C~IA~R~Y~D~U
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a close family member of
relevant, for exa!'11plewhen the conflict is with
th aged by the director.
the director or wi a corporation owned or man
in theory, to address
~here a-:e basically ~hree regulatory strategies,
flicted transactions might
conflicts of inte:e~t of directors. First, all con
ht however deprive the
simply ~e prohibited. A ~imilar approach mig
It is easy to imagine
corpo~atio~ of _good b~s1ness opportunities.
of reasons is willing to pay
situat10ns in which the director, for a number
she has :Uore information
the fair price for corporate assets, also because
t. The negotiation and
than a third party on the value of the asse
other hand, conflicted
transaction costs might be lower. On the
e is no need to spend time
transactions might not be regulated at all: ther
this approach. The usual
to explain why no developed economy takes
ire that the decision is
regulatory strategy is a middle ground: to requ
as to delegate the decision
taken with some procedural protections, such
s fully informed on the
to independent and non-conflicted director
is entirely fair to the
situation, or require that the transaction
corporation.
General Corporation
In this respect, Section 144 of the Delaware
Law provides as follows:
§ 144 DGCL--Interested directors; quorum.
orati~n and 1 or
"(a) No contract or transaction between a corp
orat10n and any
more of its directors or officers, or between a corp
other or~anization
other corporation, partnership, association, or
, a~e d1rect?rs or
in which 1 or more of its directors or officers
v01d or v01dab~e
officers, or have a financial interest, shall be
director or officer 1s
. solely for this reason, or solely because th~
of t~e board or
present at or participates in the meeting
sact10n, or solely
committee which authorizes the contract or tran
or officer's votes are counted for such
b ecause any su Ch dl·rector's
purpose, if:
or offic:r's
1 The material facts as to the director's transaction
( ) h. . t est and as to the contract or
ctors or the
relati?nsl ipdor in eerknown to the board· of dire · d ~ 'th
are disc ose ord arthe board or committee 1n goo 1a1
. affirmative
committee , thean t ct or transaction by the ·
authorizes con ra
. .t f the disinterested directors, even
votes of a d~~
though the 1s1n
:St:d
Jtor1
er
directors be less than a quorum; or
. 1 facts as to the director's or officer's
(2) The mate~ia t d as to the contract or transaction
s entitled to
relationship or intere~ an to the stockholder
is specifically
are disclosed orndare e ~i;~act or transaction
vote thereon, a t~h b ote of the stockholders; or
approved in good fait Yv
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(3) The contract or transaction is fair as to the_corporati
on
as of the time it is authorized, approved or ratified, by
the
board of directors, a committee or the stockholders.
(b) Common or interested directors may ?e
determining the presence of a quorum at a ~eeting of the
counted in
board
of directors or of a committee which authorizes the cont
ract or
transaction."
As you can see the law requires procedural protection
s in case a
director has a conflidt of interest: the transaction is "cure
d" if the decision
has been taken by fully informed uninterested directors
or shareholders .
In case these procedural protections have not . been
followed, the
transaction is still safe if it is "fair" to the corporat10n
when taken. The
concept of fairness is not easy _to defi?e in the ~bst~act
, but clearly it
might include an element of fair dealmg and fair ~rice
. ?ne as_pect.to
keep in mind is that the mere fact that the _corporat10n
paid a fair p~ice
might not be sufficient to cure the transaction: for exa_
mple, purchasmg
goods at a totally fair market price, when the corporat1
0n ~as, howeve~,
no need for those goods, it is not fair for the purposes of
Sect10n 144. This
is an obvious but sometimes overlooked element.
It should be observed that a violation of the above-me
ntioned rules
can also be the basis for a liability suit against a direc
tor who breached
i her duty of loyalty, if the corporation suffered damages.
•J
' It is interesting to compare and contrast the Dela
ware rule with
corresponding rules in other systems. Most syste
ms provide for
procedural protections, such as the approval of
a transaction by
independent and informed directors, as a way to insul
ate a conflict of
interest. If those procedural protections are followed,
the transaction
usually cannot be challenged and no liability can result.
In most systems,
at the same time, even if procedural protections are not
followed, there
should be no liability if the transaction was fair to the
corporation, also
because this generally means that there were no
damages for the
corporation (but, in these situations, disgorgement of direc
tors' gains can
sometimes be obtained). It is less clear if the trans
action can be
challenged and declared void or voidable, also because
the interest of a
third party, which might be in good faith, should be
considered. The
relevance of the fairness of the transaction as an elem
ent to "save" a
conflicted transaction is, for example, debated under Chin
ese law. See, on
this_ ~ssue, Jia~g ~u ~ang, Company Law in Chin
a: Regulation of
Busi~es~ Organizations in a Socialist Market Economy
, Edward Elgar
Publishing, 2014, 207 f., pointing out that a court
could invalidate a
t~ansaction in conflict of interest not approved by infor
med independent
director_s or shareholder~, even if it is fair to the corp
oration; but also
suggesting that courts might adopt a more flexible appr
oach to this issue,
_91.6 DIRE CTORS' LIAilILITYAN
and accept "entir e fairn ess'' n F1ouc1Any DUTIES 291
a breach of the duty of 1oyalty ~
as a Possible de1ense ag · t
Let's take a quick .· amS a claim based on
1
Civil Code below : ook, m this respect , t o Ar t1cle
. 2391 Of
Article 2391 f the Italian
o the Italian c· ·1
"1. A~y d irector
' must not. f hivi Cod e- I nterests of Directors
supervisors of an · i Y t e other dir
which he has . y interest, on his behalf ectors and the board of
the terms the i~ .a .corporate transaction ~rd~n b.ehalf of others,
' rigin and th 1 ' m icatmg the nat
with .delegated powers to ac~ ~: evance of the interest; direc~;:~
refrain from entering into th t behalf of the corporation must
of the decision, in case of e r~nsaction, and invest the board
shareholders at the first sh ah single director he must notify
are olders' meeting
2. In the situations described . .
the board must adequate! m ~aragraph 1 the resolution of
advantages that the corpora/ ~oti:7ate the reasons and the
3 If P ion erives from the transaction
. aragraphs 1 or 2 are not co r d . .
resolution approved with th mp ie with, or in case of a
· e outcome-deter · t·
interested
. director ' if the r eso1u t·ion can damage
mmath1ve vote of .an
it can be challenged and voided b th d' e corporation
~:::~:or;h:/t~!;r:~e~a~~
challen~e it. In any case the rights acquired by third parties in
goo~. faith based on the resolution are not affected by th
dec1s10n. e
4. Directors are liable for the damages caused to the
corporation by their action or omission."
It should be added that also shareholders can challeng ~ the decision
of the board, if it affects their rights . As you can see the approach is not
radically different from the one adopted in Delaware, even if there are
some distinctions. First, under Italian law the director has an affirmative
duty to disclose any interest, and the entire board must take the decision ,
even if nothing prevents the possibility to delegate it to some (non -
conflicted) directors. In addition, there is not a general duty of _abstention
of the interested director. The resolution can only be challenged if: (a.l)
the director did not disclose the interest or the board did not motivate; or
(a.2) the majority has been reached wit~ ~he vote of the interested
director(s); in addition, in both cases, It IS necessa_ry ~hat (b) the
resolution can damage the corporation. If you _compare 1t w1~h Delaware
law th · · 1· htl different way to say that 1fthe transaction has been
, 1S 1S a S 1g Y d' · t' 1 f ·
approved by uninterested fully informed ,rectors, or IS en ire y air to
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CH,6
the corporation, it shall not be void or voidable; similarly directors are not
liable if there is no damage(= the transaction is fair).
It might, however, be argued that the Delawa~e provi_sionis less
broad not including explicitly interests on behalf of third parties and only
limiting its scope to contracts between the corporation and the directors
or an affiliated party; although a similar result can probably be reached
applying the provision. Do you think that, according to a narrow textual
interpretation, the above-mentioned hypothetical concerning the golf
course, might escape § 144 DGCL, but not Article 2391 of the Italian Civil
Code?
The following case offers a classical illustration of a breach of the
duty of loyalty, focusing in particular on the issue of the burden of
proving entire fairness.
LEWIS V. S.L. & E.

United States Court of Appeals, Second Circuit
629 F.2d 764 (1980)
KEARSE, CIRCUIT JUDGE:

This case arises out of an intra-family dispute over the management
~-)_.c. of two closely-held affiliated corporations. Plaintiff Donald E. Lewis
.i
, ("Donald"), a shareholder of S.L. & E., Inc. ("SLE"), appeals from
,'
judgments entered against him in the United States District Court for the
Western District of New York, Harold P. Burke, Judge, after a bench trial
of his derivative claim against directors of SLE, and of a claim asserted
' against him by the other corporation, Lewis General Tires, Inc. ("LGT"),
which intervened in the suit. The defendants Alan E. Lewis ("Alan"),
Leon E. Lewis, Jr. ("Leon, Jr."), and Richard E. Lewis (''Richard"), are the
brothers of Donald; they were, at pertinent times herein, directors of SLE
and officers, directors and shareholders of LGT. Donald charged that his
brothers had wasted the assets of SLE by causing SLE to lease business
premises to LGT from 1966 to 1972 at an unreasonably low rental. LGT
was permitted to intervene in the action, and filed a complaint seeking
specific performance of an agreement by Donald to sell his SLE stock to
LGT in 1972. The district court held that Donald had failed to prove
waste by the defendant directors, and entered judgment in their favor.
The court also awarded attorney~' fees to the defendant directors and to
SLE, and granted LGT specific performance of Donald's agreement to sell
his SLE stock. ·
On appeal, Donald argues that the district court improperly allocated
to him the burden of proving his claims of waste, and that since
defendants failed to prove that the transactions in question were fair and
reasonable, he _was entitled to judgment. Donald also argues that the
CH, 6 DIRECTORS' LIAB
ILITY AND Fiou
awards of attorneys' £e CIARY DUTIES 293
· es were ·
content10ns, and therefore rev erseimproper. We
and rem an d. agree with each of th ese
I
For many years Le L .
defendant directors was tohn ~wi~, Sr., the father of Donald d th
· ' e prmcip 1 h an e
formedd m
. 1933, operated a t·ire dealea sh.areholder
. of SLE and LGT. LGT'
forme 1~ 1943, owned the land a rs ip m Rochester, New York. SLE,
Avenue m Rochester. This nd complex of buildings at 260 East
Prior to. 1956 LGT occupied si~rerty ~as S~E's only significant asset.
rent paid was initially $200 s premises without benefit of a lease· the
per month and h d . ,
to $800 per month by 195 6 whe ' . . a mcreased over the years
February 28, 1956, SLE gr~nted ~additional parcels were added. On
expanded property ("the Property") ~T a lO-year lease on the newly
$14,400 per year Under the te 'for a rent of $1200 per month, or
payment of real· estate taxe rmst~ t;e lease, SLE was responsible for
expenses were to be borne b sthont e roperty, while all other current
. Y e enant, LGT.
In 1962, Leon Lewis Sr tr £ d h.
to his six children (def;nd;ntt;i:{re d AlisSLE sdtock,90 shares i~ a~l,
Id d t d ar , an an Leon, Jr., pla1nt1ff
D ona , an . , Margaret and caro 1), givmg
wo . aughters · · 15 sh ares to
each . At t h at .time Richard , Alan and Leon, J r., were already
· h oIders,
shh are · officers and directors of LGT· cont emporaneous 1y wit ·h
! err receipt, of SLE s~,oc~, all six of the children entered into a
. shareholders agreement with LGT, under which each child who was not
a shareholder of LGT on June 1, 1972 would be required to sell his or her
SLE shares to LGT, within 30 days of that date, at a price equal to the
book value of the SLE stock as of June 1, 1972.
LGT's lease on th ~ SLE property expired on February 28, 1966. At
that time the directors of SLE were Richard, Alan, Leon, Jr., Leon, Sr.,
and Henry Etsberger; these five were also the directors of LGT. In 1966
Alan owned 44% of LGT, Richard owned 30%, Leon, Jr., owned 19%, and
Leon, Sr ., owned 7%. From 1967 to 1972 Richard owned 61 % of LGT and
Leon, Jr., owned the remaining 39%. When the lease expired in 1966, no
new lease was entered into. LGT nonetheless continued to occupy the
property and to pay SLE at the old rate, $14,400 per year. According to
the defendants' testimony at trial, there was never any thought or
discussion among the SLE directors of entering into a new lease or of
increasing the rent. Richard testified: "We never gave consideration to a
new lease." From all that appears, the defendant directors viewed SLE as
existing purely for the benefit of LGT. Richard_ testified, fo~ example, that
although real estate taxes · rose sharply during the per10d 1966-1971,
from approximately $7,800 to more th~~ $11,000, to be paid by SLE ?ut of
its constant $14,400 rental income, ra1s1ng the rent was neve~ mentioned.
He testified that SLE was "only a shell to protect the operating company
294 DIRECT ORS' LIABILI
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AND FIDUCIA
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(LGT)." When this suit was commenced there had not been a formal
meeting of either the shareholders or the directors of SLE since 1962
Ri?hard, Alan and Leon, Jr., had largely ignored SLE's separate corporat~
existence and disregarded the fact that SLE had shareholders who were
not shareholders of LGT and who therefore could not profit from actions
that used SLE solely for the benefit of LGT.
Neither Donald nor his sisters ever owned LGT stock. As the June
1972 date approached for the required sale of their SLE stock to LGT
Donald apparently came to believe that SLE's book value was lower tha~
it should have been. He sought SLE financial information from Richard,
who had been president of SLE since 1967. Richard refused to provide
information. Donald therefore refused to sell his SLE shares in 1972, and
commenced this shareholders' derivative action in the district court in
August 1973, basing jurisdiction on diversity of citizenship. The sole
claim raised in the complaint was that the defendant directors had
wasted the assets of SLE by "grossly undercharging" LGT for the latter's
occupancy and use of the Property. Although the complaint charged such
mismanagement for the period 1962 to 1973, plaintiff subsequently
limited this claim to the period between February 28, 1966, the date on
which the lease expired, and June 1, 1972, the date contractually set for
.~ valuation of the SLE shares which plaintiff had agreed to sell to LGT.
i/ LGT intervened and demanded specific performance of Donald's
r agreement to sell his SLE stock. Donald did not contest his ultimate
' obligation to sell, but took the position that since the book value of the
shares would be increased if he prevailed on his derivative claim, specific
performance should be granted only after adjudication of that claim.
There ensued an eight-day bench trial, at which plaintiff sought to
prove, by the testimony of several expert witnesses, that the fair rental
value of the Property was greater than the $14,400 per year that SLE had
been paid by LGT. Defendants sought to show that the rental paid was
reasonable, by offering evidence concerning the financial straits of LGT,
the cost to LGT of operating the Property, the general economic decline of
the East Avenue neighborhood, and rentals paid on two other properties
.,
I'
in that neighborhood. LGT presented expert testimony that the value of
'i' .,
plaintiffs stock as of June 1972, assuming a successful defense of the
derivative claims, was $15,650.
The district court subsequently filed lengthy and detailed findings of
fact and conclusions of law. Many of the court's findings went to the
)
validity and probative value of the testimony given by plaintiffs expert
. '
I
witnesses, and the court ultimately declined to credit that testimony. On
j
'j this basis, the court held that Donald had failed to establish the rental
.:J
value of the Property during the period at issue, and that defendants
l
'i were therefore entitled to judgment on the derivative claims. Implicit in
.i
the district court's ruling, granting judgment for defendants upon
1
i
I
••
Q!!:_ 6 DIRECTORS' LIABILIT

y AND FIDUCIAR D
plaintiffs failure to prove Y UTIES 295
the burden of proof on th::~te, was a determination th t 1 . t"ff b
· 1d t ·fi issue Th a p am 1 ore
ent1t e o spec1 ic performance of D e co~rt also ruled that LGT was
stock, and that Donald was not . onald s agreement to sell his SLE
SLE, but that SLE and the · e;ti~led to recover attorneys' fees from
attorneys' fees from Donald Th" m ividual defendants were entitled to
. is appeal followed.
II
Turning first to the quest·
· court erred in placing ion f b
district u o urde . ~ 0 f proo,f we conclude that the
1
Because the directors of SL~on p amtiff the burden of proving waste.
shareholders of LGT the bu d were also officers, directors and/or
demonstrate that the' transactfo:: b:ts on the defendant direct~rs to
reasonable. New York Busine C ween ~LE and LGT were fair and
(McKinney Supp.1979) (eff Sss orporation Law ("BCL") s 713(b)
(McKinney 1963) (repealed a~ f ?tember l, 1971); BCL s 713(a)(3)
596 F.2d 733, 739-40 (7th Ci~ eptember 1, 1?71); see Cohen v. Ayers,
R ·11 d B . k C R . 1979) (construmg current BCL s 713)·
emi ar ric o. v. e~illard-Dandini Co., 109 Cal.App.2d 405, 241
P.2_d66, 75 ~1952) (construmg California Corporations Codes 820 upon
which the prior BCL s 713 was patterned). '
U~der .normal cir~umstanc~s th~ directors of a corporation may
determn~e, In :he exerc;1se of their busmess judgment, what contracts the
cor~oration will ent_er mto and what consideration is adequate, without
review of the merits of their decisions by the courts. The business
judgment rule places a heavy burden on shareholders who would attack
corporate transactions. Galef v. Alexander, 615 F.2d 51, 57-58 (2d Cir.
1980); Auerbach v. Bennett, 4 7 N.Y.2d 619, 629, 419 N.Y.S.2d 920, 926,
393 N.E.2d 994, 1000 (1979); 3A Fletcher, Cyclopedia of the Law of
Private Corporations s 1039 (perm. ed. 1975). But the business judgment
rule presupposes that the directors have no conflict of interest. When a
shareholder attacks a transaction in which the directors have an interest
other than as directors of the corporation, the directors may not escape
review of the merits of the transaction. At common law such a transaction
was voidable unless shown by its proponent to be fair, and reasonable to
the corporation. BCL s 713, in both its current and its prior versions,
carries forward this common law principle, and provides special rules for
scrutiny of a transaction between the corporation and an en~ity in whi~h
its directors are directors or officers or have a substantial financial
interest.
The current version of s 713, which becam~ effective on September 1,
1971, and governs at least so much of the ~ealmg between SLE and LGT
as occurred after that date, expressly p~ov1des that _a contract between a
·c · d t·t ·n which its directors are interested may be set
orporat10n
'd an an en 1 Y 1t of the contract "shall estab 1· · Iy
1sh a ffi1rmative
as1 e unless the proponen . . ..
,,
that the contract or transaction was fair and reasonable as to

-
ca.s
the
Thus
corporation at the time it was approved by the board.··." s 713(b).
tive action agains t the
when the transaction is challenged in a deriva
ction
interested directors, they have the burden of proving that the transa
was fair and reasonable to the corporation. Cohen v. Ayers, supra.
The same was true under the predecessor to s 713(b), former 8
n
713(a)(3), which was in effect prior to September ~· 1971. Sectio
that
713(a)(3) was not explicit as to the burden of proof, but simply stated
be voidab le "If the
a transaction with interested directors would not
at the
contract or transaction is fair and reasonable as to the corporation
the
time it is approved by the board .... "The consensus among
rule,
commentators was that s 713(a)(3) carried forward the common law
ors.
which placed the burden of proof as to fairness on the interested direct
[.. .]
During the entire period 1966-1972, Richard, Alan and Leon, Jr.,
who
were directors of both SLE and LGT; there were no SLE directors
all
were not also directors of LGT. Richard, Alan and Leon, Jr., were
, shareholders of LGT in 1966, and from 1967 to 1972 Richard and

Jr., were the sole shareholders of LGT. Under BCL s 713, theref
Richard, Alan and Leon, Jr., had the burden of provin g that
a fair and reasonable annual rent for the SLE property for the
February 28, 1966 through June 1, 1972.
$14,4 00
Leon,
ore,
was
period
Our review of the record convinces us that defendants failed to carry

would
their burden. At trial, there was no direct testimony as to what
and
have been a fair rental during the relevant period, i.e., 1966 to 1972,
ishing that
the evidence that was introduced fell far short of establ
$14,400 was a fair annual rental value for those years .
to
) Quite clearly Richard, Alan and Leon, Jr., had made no effort
determine contemporaneously what rental would be fair during the
1966-1972. Their view was that the rent should simply cover
years
expenses
no
and that SLE existed for the benefit of LGT. During this period
rent the
appraisals were made; no attempts were made to sell or
a fair
Property; no thought whatever was given to whether $14,400 was
consume
and reasonable rent even when real estate taxes had risen to
nearly all of that amount.
ss
(The Court discusses at length the evidence concerning the fair~e
of the rental price.] -
the
We conclude, therefore, that defendants failed to prove that
fair and
rental paid by LGT to SLE for the years 1966-1972 was
to LGT
reasonable. Thus, Donald is not required to sell his SLE shares
of SLE
without such upward adjustment in the June 1, 1972, book value
value
as may be necessary to reflect the amount by which the fair rental
of the Property exceeded $14,400 in any of the years 1966-1972
.
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D--==I:.::..:R:.::E:...::C~T~O~R~S~'
AND FIDUCIARY DUTIES 301
***
A problem closely related t 0 .
· ·
opportumties. Th ·
e situation oc conflict ·
s Of mterests concerns business
f b . curswhenad·
aware o a usmess opportunit th irector (or an officer) becomes
rather than offering it to they at c~uld benefit the corporation, but
scenario is different from a confl~o:p~r~twn, takes advantage of it. The
not have a formal decision infl ic O ~nterest because in this case we do
rather a loss of opportunity u:nce. and tainted by an interest, but
directors clearly have not acteda: ~ams for ~he corporation; however,
and the shareholders and th· b a oyal fashwn toward the corporation
statutory rules we have is reach
' just exa . does n.0 t fa 11s~uare 1y wit · h'11:1 th e
mmed concernmg conflicted transactions.
In common law systems th ''b ·
. , e usmess opportunity doctrine" was
dl th b ·
developed· tod address· this problem · If appli'ed t oo broa y, e us1ness
opportumty octrine. could . . virtually any act·1v1
. block ·t yo f a d'irec t or. As a
paradox, consider the situation m which a director is informed of a good
deal on a lux~ry car th~t could be easily purchased and resold for a profit.
Shoul~ s~e disclose this opportunity to the corporation? In theory, the
orgamzation could take advantage of this possibility. A rule of reason
should apply here: minor transactions not included in the core business of
the corporation should not be relevant. To be more precise , however, two
basic problems come up in business opportunity cases, and they have
been addressed by judges balancing the need to ensure loyalty and the
,. .., ·,
need to leave some latitude to directors. The first is if any information . ·..
acquired by a director, also when she is not acting in her capacity as
director ; should be relevant. For example, what if the director learns
about an opportunity at a social gathering completely unrelated to her
job? Different systems and different courts might take more or less
rigorous approaches, but we think that distinguishing between activities
carried out "as director" and "personal" ones is very difficult and
uncertain. It seems preferable to conclude that when someone is se~ving
as director of a corporation, she must offer all relev ant busmes s
opportunities that she encounters to the corporation, a_ndtake ~h~m ~nly
l'f th e corpora t·10n (;"·e., the board) declines them, without . distmctions
based on how the director learned about the opportumty. .
Th e secon d ' an d pro bably more delicate issue, is what constitutes a

·
bus1ness ·t c 0 urts have elaborate
d t e so-ca11
h e d "l'me-o f-
opportun1 y. . h 1 h b ·
·
busmess-test ,, h" h · es that to be subJect tot e rue , t e us1ness
w 1c requir . · h · ·
. ' f 11 'th" the activities m which t e corporation 1s
opportunity should a WI in . ll · t ested in Of course this is a
. d di · potentia Y 1n er ·
actually involve an or is . 1 rely on the purpose of the
. hl
h 1g 1 1 . and to s1mp y
y factua ana ysis , h t ( ven when it is defined somehow
. d . the c ar er e
corporation as state in . t b ufficient. Narrower tests have also
precisely, which is rare) might n~e L~;arde test.
been used such as for example t
'
AND FIDU CIA RY DUT ES --
I .; CH,6
-Y
302 ::..:..:..:
-----= ~!.:.:RS'
~ CTO
DIRE LIAB
:::.... ...=:. :: Y
:ILIT
.:.::::
::..::: :..=..
...:.... :...:..::.. ..:::.. ..:.::: ~...:.:
~___ ....::.
_:.-~ ------..::.
es con sidered is th
A relat ed factor that courts have sometim
ortunit y. For exnmple, i~
financial ability of the corporation to tak e the opp
it would not be fina ncially
a corporation is in distress , and it is clear th at
ecto~ should be free to step
~apab~e ~f taking advantage of th e deal , the dir
wmg reason: at least in
1n. This 1s, however, a slippery slope, for the follo
ect has a sufficient positive
theory, from a financial point of view, if a proj
ng funds or issuing shares.
net present value, it could be financed borrowi
even a corporation in
The argument could therefore be made that
e of the transaction . or
financial distress might be able to take advantag
that can hardly be resolved
course this is also a complex question of fact
in general terms.
should a director who
Another problem worth mentioning is what
all potentially interested in
serves on the boards of different corporations,
re of it? The best answer
a business opportunity, do when he becomes awa
nity simultaneously or as
is probably that he should disclose the opportu
with . In the decisions on
soon as possible to all corporations he is involved
considered having a conflict
whether to take the opportunity he should be
affiliated with.
of interest on behalf of the other entities he is
opportunity disputes
Empirical analysis suggests that business
orations, and that the
generally involve primarily closely held corp
with the activity of the
business opportunity is often in direct competition
Interests in the Corporate
J corporation (see Pat K. Chew, Competing
9)).
I Opportunity Doctrine, 67 N. C. L. REV. 436 (198
d through case law in
The business opportunity doctrine, develope
sometimes with specific
common law systems, has also been adopted,
, e.g., the last paragraph
statutory provisions, in other legal systems (see
of Article 2391 of the Italian Civil Code).
***
listed corporations, a
Some countries have adopted, especially for
with related parties. These
specific regulation applicable to transactions
not necessarily one or more
rules deal with situations in which there are
e are transactions among
directors with a conflict of interest, but ther
in which a corporation could
affiliated entities, especially within a group,
1.·, •
' of another one and its
be unfairly advantaged to the detriment
interested directors, rules
shareholders . Even if not strictly related to
raise issues of fiduciary
concerning transactions with related parties
ht favor another one with
duties because the board of a corporation mig
which there is a relationship.
sactions with related
One interesting example of regulation of tran
provision of the Italian Civil
parties can be found in Italy . Based on a
nsob) has enacted, in 2010, a
Code (Article 2391·bis), the Italian SEC (Co
regulation is very long and
regulation dealing with this problem. The
related parties, and mandates
.i
'
complex, but in short it basically identifies
·;
.!
!
-
CH,6
. .
DIRECTORS' LIAB
specific disclosure and proc d 1
ILITY AND FIDUCIARY DUTIES 303
possi·ble d et rimental
· effectse of
urath and sub st antive rules to mitigate the
subject is related to another -t~e transactions . More specifically a
controlled by the same entity·ontehi
0
it co~trols it, is controlled by it 0 ; is
for examp e, executives are c .d relatio nsh'1ps are also considered-so
1 ' er '
work for, and family member:n~\~red related to the corporation the;
related parties. The regulation t~ ~dab~ve-m~ntioned subjects are also
of "major relevance" based en i£entifies, m particular, transactions
· 1 ·
particu ar economic importanc £a ormula , meamng
on · .
transactions of
exceeds 5% of the equity or t~' or example transactions whose value
approve these transactions e ass.~s of the corporation. In order to
protections must be adopted . ' speci ic procedural and substantive
b In d particular,
f d. t to
( simplify ' th ese t ransactions
. must be approved by the
. o;r o d i:e~_or\ cannot be delegated to one director). A committee of
m epen ~n. irec ors not related to the corporation must be involved in
the
· 11negotiat10n
d of ·the transaction
. ' obtain adequat e in
· £ormation
· on it, · an d
is a dowe to require further mformation and give · adV1ce
· . In a dd.ition,
· th e
boar can ap~rove the transaction only after having obtained an opinion
by the ~ommittee ~n th~ interest of the corporation to enter into the
transaction, an~ o?its fairn~ss. Alternative procedures can be adopted as
Ion? ~s the ~aJority o~ the mdependent and not related directors have a
decisive role in approving the transaction. Finally, the board can decide to
carr~ ~n the tran~~ction also against the advice of the committee, but only
obtammg a positive vote of the shareholders (for a more detailed
discussion of these rules, including an empirical analysis of the
application, see M. Bianchi and others, Regulation and Self-Regulation of
Related Parties Transactions in Italy, Quaderni di Finanza Consob, 2014,
available at www.consob.it).
This regulation is partially inspired by the U.S. approach, in the
sense that in the presence of a potential conflict it requires the adoption
of procedural safeguards to ensure the fairness of the transaction . One
problem worth discussing, however, is whether the regulatory approach,
or at least the way in which it is enforced, mixes up procedural and
substantive protections. As we have discussed, under U.S. law, if a
director has a conflict of interest but the transaction is approved by fully
informed independent directors or shareholders, the transaction cannot
be challenged. When the procedural protections are no~ foll~wed, the
transaction can be saved only if the defendants prove entire fairness. In
other words, the substance of the deal (its fai_rness)is o~ly examined if
there was a procedural failure. In the Italian re_gulation_on related
arti'e , t t' s on the other hand, the committee of independent
P s ransac 10n , · b ·
directors does not simply approve the transaction, ut _must_issue an
·n· ·t " · I thi's opinion protected by the business Judgment
Opi 10n on i s 1airness. s . .
rule? Or can courts and enforcement agencies second-guess the merits of
the determination of the independent committee? To what extent can

independent directors face liability or sanctions if their decision was not
fully informed? This is a very delicate problem that is not clearly resolved
by the applicable rules . In our opinion, both the decision of the committee
and of the board should be protected by the business judgment rule if
effective procedural safeguards have been strictly followed.
***
Comparing breaches of the duty of care and of the duty of loyalty, it
is interesting to briefly discuss remedies. An insightful observation is
offered by Professors Eisenberg and Cox in their casebook on corporations
(Corporations and Other Business Organi zations, Foundation Press , 2011,
726 ff.). They point out how the traditional remedies for violations of the
duty of loyalty are ·restitutionary: rescission of the unfair contract,
accounting , or constructive trust in the corporation 's favor in case of
violation of the business opportunity doctrine. On the other hand
remedies for a breach of the duty of care are generally monetary damages.'
They observe that as a consequence a director who violated his duty of
loyalty might end up not worse off than before the violation, while a
director who violated the duty of care could. This might create an
incentive to breach the duty of loyalty, if the possibility of not being
caught is taken into account. It should be considered , however, that if
restitutionary remedies cannot be obtained, the unfaithful director might
have to pay damages. In addition he could be terminated for cau se, with
the obvious reputational consequences. Moreover, occasionally courts
have included other remedies, for example mandating the director to
repay salary earned and disgorgement of ill-gotten gains; and in some
cases punitive damages have been awarded .
Is this a potential problem also in other jurisdictions, especially when
courts have more limited flexibility in shaping the proper remedy , as is
often the case in civil law countries, where for example punitive damages
are generally not admissible? In this analysis it should also be tak en into
account, however, that often intentional violations especially of the duty .
of loyalty can also be subject to criminal sanctions.
DIRECTORS' FIDUCIARY DUTIES

TOWARD CREDITORS
Generally speaking, in common law systems, directors do not own
fiduciary duties to creditors. Creditors can only rely on contractual right s,
or on specific anti-fraud provisions (for example, fraudulent convey ances).
The situation might change, however, when the corporation approache s
insolvency, when it is in the so-called "zone of insolvency." In this
situation, · which is difficult and fuzzy to define precisely, in several (not
all) jurisdictions directors are deemed to have a duty of care and of loyalty
-
-
,6
in
le
1e
n CHAPTER 7
:t
3
1 SHAREHOLDERS' LITIGATION
1
)
•••
INTRODUCTION
As we have seen in the prev10us
. itself .
towar d th e corporation t d . chapt er, d"1rectors can be hable
.
and toward corporate creditoowa~mgle sha~eholders or third parties,
fiduciary duties, damage the rs. e~ever directors, breaching their
shareholders. Clearly enough 1.f th corporat10n th · d"
' ey m 1rectly damage also
valuable or the business is 1 ' fieassets of the corporation are less
.
negligence or abuse also ess th
pro 1table as a co
nsequence of d.1rectors,
shareholders is gene;all 1 th
e. va ue of e shares owned by the
· k f th · 't d Y, ~egatively affected; or at least the return and
r1s o e 1nves ment eter10rate.
When th e damage c~used affects both the corporation and its
shareholders,
l one problem
. 1s who is entitled t o sue. Th e corporation
· 1s· a
separate egal entity fro1? the shareholders, and it h~s the right to sue
and be sued. Generally, if the corporation has a cause of action against
someone, it can sue. The decision to sue, if and how to continue litigation,
and the management of the dispute, is normally a business decision
rese~ved to directors (sometimes delegated, at least in part, to high-
rankmg corporate employees). When, however, the potential defendant is
one or more current directors, it is unlikely that the top management
acting on behalf of the corporation, drags to court one of their own.
Of course there could be situations in which the corporation (i.e., the
board of directors) will decide to sue a member of the board, for example
in case of an egregious violation of a single director alienating fellow
directors, or-more often-when new directors are appointed, possibly
after an acquisition, and they realize that the previous board has harmed
the corporation. Even this scenario , however, is not very common: there
can be a certain degree of reciprocal back-scratching among directors that
makes these lawsuits fairly rare. ·
Shareholders however, need to be protected . For this reason most
modern legal syst~ms have introduced "~erivative actions." Even _if, as we
will see, the role of these procedural devices and the rules governmg them
differ in different jurisdictions, they share some common f~atures. In .a
derivative action, shareholders are allowed-meeting cer~ain
· t t corporate directors on behalf of the corporation.
re qmremen s- o sue
317
318 SHAREHOLDERS' LITIGATION CH.7
They can, in other words, step in the shoes of the corporation
and assert a
claim that belongs to the legal entity, in order to overcome the
reluctance,
when not the conflict of interest, which prevents directors from
suing. In
case of victory, monetary damages would be awarded to the
corporat~on
(with very few exceptions, as we will see), not to the share
holders suing
derivatively; and only under certain conditions winning
shar~holders
might be entitled to recover their legal expenses from the corpo
ration.
Based on these elements you might wonder why shareholde
rs bring
derivative lawsuits at all. What incentives do they have?
On the one
hand, even if compensation goes to the corporation, shareholde
rs might
indirectly benefit from it: if the assets of the corporation are
restored to
their original value, this increased value should be reflected
in the value
and the market price of the shares. Secondly, shareholders migh
t sue also
to stop an ongoing abuse (obtaining an injunction), or as part
of a strategy
aimed at ousting incompetent or unfaithful directors. Final
ly, derivative
litigation can be attorney-driven, especially if lawyers can
take the case
on a contingency fee basis.
It is important to understand that shareholders can sue deriv
atively
only when the corporation is damaged. There might be
situations,
however, in which directors, breaching their duties, cause
a damage
directly to the shareholders, a damage that is not the cons
equence of a
damage suffered by the corporation. Consider the following
example:
directors intentionally publish false financial statements
or a false
prospectus that fools existing shareholders into believing
that the
economic situation of the corporation is much better than
it actually is.
Relying on this information, existing shareholders subscribe
newly issued
shares at a price significantly superior to the fair value of
the securities.
When the truth is discovered, the price of the shares drop
s, causing a
significant loss to the shareholders. In this situation, you
might argue
that the breach of the directors has damaged directly
(only) the
shareholders, not the corporation . You might even go as far
as arguing
that the corporation not only has suffered no damage, but
it has had an
advantage because it was able to receive more financial resou
rces for its
shares. In this case shareholders have a direct cause of
action against
directors (and a class action or other form of collective redre
ss might be
available), but there is no derivative lawsuit, since the corpo
ration has not
been hurt. As we will see, to distinguish between direct
and derivative
claims is not always as easy as it might seem.
Keep in mind that, in several jurisdictions, at least in
theory,
shareholders can sue derivatively on behalf of the corporatio
n also a third
party who is not a director and damaged the corporation.
This type of
suits is however rare, and in any case in this book we
only consider
derivative actions against directors.
CH. 7
SHAREHOLDER ,L
S ITIGATION 319
This chapter discusses sharehold , . .
common law systems and in f ~rs derivative actions, starting with
their regulation in other syst par 1; ar :U
derivative claim, and the pro::·
·~
· law, and then considering
e will investigate how to identif~ a
derivatively have to jum th ~al loopholes that shar eholders suing
their corporation. On the ~the:o~g to suc
~es
( nd its directors) can f£ t· 1 and _wewill sfull!' sue the directors_of
a_ . . consider how a corporat10n
will focu e ec ive Y avo id or resi st derivative lawsuits . We
. . s, 1n particular, on some basi·c di'st inc
· t 10n
· s b et wee
and
. civil law systems., and the different role of n common 1aw
. th e sh are h old ers '
m thes~ legal _families also vis-a-vis dire meet 1ng
'
ctors' liabilities toward the
corpo~~tion, a diffe~ence that might partially
prevruling ownership structures (see Chapter be explained in light of the
1).
DERIVATIVE SUITS IN COMMON LA

W
SYSTEMS: THE U.S. AND THE U.K.
One of the first issues that should be address
ed is if the claim of the
shareholders is direct (in which case a deri
vative action is not possible),
or if it is derivative , allowing the shareho
lders to sue the directors on
behalf of the corporation. The following
leading case examines this
question in the U.S.
PATRICK TOOLEY AND KEVIN LEW

IS V. DONALDSON,
LUFKIN, & JENRETTE, INC., AND OT
HERS
845 A.2d 1031 (2004)
[. . .]
VEASEY, CHIEF JUSTICE:
[...]
. Facts
. L wis are former minority stockholders
Patrick Tooley and Kevin e of
D ld L fk. (DLJ) a Delaware corporation
ona son, u 1n & Jenrett e, 1nc.
ki ,
uired by Credit. 8 u1s.
engaged in investmen~ ban
Group (Credit Suisse) in .th e
;;ll
DLJ was acq
of 2000 . Before that acquisition , AXA
d o/c of DLJ stock, controlled DLJ.
se
Financial, Inc.(AXA), which owne 71 t b:tween AXA and Credit Suisse,

Pursuant to a stockholder -~f~e::; Suisse its DLJ stockholdings !or a
AXAagreed to exchange Wl .d ation received by AXAconsisted
mix of stock an d cas h · The consioneer-third of
rim the pure h ase pric
· C d.1t
e. r_e
P aril y of stoc k . Cash made up · ·ng minority interests of publicly-
Suisse intended to acquire . the remaini
tender offer, followed by a merger 0 f DLJ
held DLl stock through~ ~ash
into a Credit Suisse subsidiary . .
.. ·
328 SHAREHOLDERS' LITIGATION Cu. 7
9. Keep in mind that shar ehold ers ar e entitl ed to brin g derivativ e
actions, but directors and creditors are generally not. Court s ar e divided with
respect to convertible bondholders: hold ers of bonds convertibl e into shar es
before the conversion, are in fact creditors; however they are peculia;
creditors because they might become sharehold ers. If you were a judg e or a
legislature, would you allow convertible bondhold ers to file a derivative suit
against the directors?
10. We mentioned that a distinctive feature of derivative lawsuits is
that any recovery goes to the corporation, not to the shareholders acting on
its behalf. There is an important possible exception to this principle, a
situation in which shareholders suing derivatively can obtain the damages
awarded directly. Can you imagine when this occurs? It is not easy to identify
if you are not familiar with the issue, but once it is mentioned it is very
obvious. The situation is when some other shareholders, possibly controlling
the corporation, are also wrongdoers together with the directors . Consider,
for example, a situation in which the controlling shareholder (holding 55% of
the voting shares) has pushed the directors to breach their duty of loyalty
toward the corporation and all shareholders, participating in the breach, in
order to obtain a personal benefit to the detriment of the corporation and
other minority shareholders. Now imagine that minority shareholders have
successfully managed to bring a derivative suit. If the damages awarded, e.g.,
$200,000, would be paid by the director to the corporation, the controlling
shareholder who participated in the wrongdoing would indirectly benefit
proportionally from the increase in the value of the corporation's assets,
clearly an illogical and unfair result. In this scenario, therefore, courts can
order the damages to be paid directly to minority shareholders.
11. Derivative actions are equitable in nature; the question has been
discussed, therefore, if there is a right to a jury trial in derivative actions
·, . r
l (since in equity there is no jury). The distinction and the question are not so
relevant in Delaware where the Court of Chancery-as the name suggests-
is a court of equity and no jury is present. Also the distinction between
remedies at law (monetary damages) and in equity (injunctions, specific
performance, modification of contract .. .) is today not so relevant, as courts of
general jurisdiction can grant both remedies. The question has, however,
been addressed in an interesting 1970 Supreme Court case, Ross v. Bernhard
(396 U.S. 351), which based on the Seventh Amendment of the U.S.
Constitution (right to jury trial) has concluded that, at least in federal courts,
if the underlying issue could be brought as an action at law by the
corporation, the shareholders suing derivatively have a right to a jury trial.
We have not included this case, which deals primarily with a procedural law
question, but if you are curious to know more check it out!
***
Shareholders suing derivatively act on behalf of the corporation. The
claim in truth, belongs to the corporation. To allow shareholders to sue.
'
derivatively without giving to the corporation-and therefore to its
---=S:...::.H=-AR~E~H~O~L~D~E~RS~_____ :!TI!!~9
'__!L~IT~I~G~A_l!32 O~N~
...:.7
_0!~~_____
e. At
directors-a~y ch~nce ~o control the litigation would seem too extrem
ion. The
the same time, it might prompt excessive and futile litigat
to sue
proced~ral tool used to balance the possibility of shareholders
derivatively
,, a nd corporate control over litigation is the "demand on the
boar d .
tive
. The rule requires that shareholders , before bringing a deriva
Basically
action, must make ~ proper demand on the board of directors.
want
shareholders must give to directors the opportunity to decide if they
on to
to sue or not. On the one hand, directors might be in the best positi
st of the
properly_eval~ate t~e pros and cons of the litigation in the intere
es of a
corpo~at1on, . includi~g. for example the reputational consequenc
often
lawsuit against existing or former directors. Needless to say,
and even
directors prefer not to bring a lawsuit against fellow directors,
might be
more so if the very directors that must decide whether to sue
a conflict
implicated in the litigation. Directors, in other words, can have
rs.
of interest in deciding whether to sue as required by the shareholde
ing
. Shareholders can challenge the decision of the board, follow
by the
demand, not to litigate, but the board decision can be protected
decision,
business judgment rule (see Chapter 6). To set aside the
decision
shareholders would have to overcome the presumption that the
the best
has been taken in good faith, on an informed basis, and in
h of the
interest of the corporation, for example demonstrating a breac
duty of loyalty . As we know, it might be difficult to prevail.
nd
On the other hand, there are some situations when the dema
nd on
requirement, i.e., the rule requiring shareholders to make a dema
excused:
the board before bringing a derivative lawsuit, can be
. This is
shareholders can go directly to court with their derivative claim
n of
the case when shareholders can prove-and they have the burde
proving it-that the demand would be futile, because it is almost certain
of a
that the board would decide not to litigate, for example in the light
conflict of interest.
the
To decide when demand should be excused is not easy, as
s have
following case illustrates. Also for this reason some jurisdiction
is never
preferred to adopt a so-called universal demand rule: demand
holders
excused. In Delaware , however, demand can be excused, and share
e~tly. to
often try to have the demand requirement byp~ssed and. go dir
dismiss
court (on the other hand, the directors _woul_df~le a motion to
ore, to
based on failure to make a demand). It is quite important , theref
are
understand when courts would excuse dema~d. A 1984 Delaw
used but
Supreme Court case, Aronson u. Lewis, has estabhs_hed a broadly
mere fact
not crystal-clear standard holding among other things that the
ient to
that the directors are na~ed as possible defendants is not suffic
demand.
consider them in conflict of interest and therefore to excuse the
330 SHAREHOLDERS' LITIGATION CH. 7
If that was the case it would be too easy for the shareholders-plaintiffs to
always avoid dema~d, simply by naming the exist~ng directors as possi?le
defendants. The court said that in order to consider the den:iand futile,
something more is necessary. More precisely,. the court in Aronson
determined that demand can be excused if shareholders plead
particularized facts raising a reasonable doubt that a majority of direct?rs
are interested and/or not independent; or that the challenged transaction
was not the product of a valid exercise of the board's business judgment.
A more recent case decided in 2000 by the Delaware Supreme Court,
Brehm v. Eisner, illustrates the standard adopted to decide if demand can
be excused. The case concerns the epic litigation over the compensat ion
and termination payout of Michael S. Ovitz as President of the Walt
Disney Corporation. In short, Ovitz was hired in 1995, but was
terminated without fault just over 14 months after, receiving a severance
package worth approximately 140 million dollars. Shareholders were not
happy, and some of them tried to sue derivatively the directors arguing
that demand should be excused . (On the recent corporate story of Disney,
we recommend a page-turner: "Disney War" by Pulitzer Prize winner
James B. Stewart)
Before reading the case, however, it is important to understand and
keep in mind one issue of litigation strategy: from the perspective of
shareholders, to make a demand on the board is risky, because the board
can refuse to sue, and this decision would be difficult to challenge . On the
other hand, if shareholders go straight to court and argue that demand
would be futile, they also are in a difficult position: they must satisfy the
somehow exacting standard of Aronson without having , generally, access
to full discovery. In a way, shareholders are caught between the rock of
"demand on the board " and the hard place of demonstrating the "futility''
of the demand with limited evidence. Notwithstanding this, · most
plaintiffs prefer to try to argue that demand should be excused . This can
cau_se ~xcess_ive litigation (and keep in mind, in this respect, that
derivative suits are often attorney-driven) . For this reason, the American
Law Institute before, and the Model Business Corporation Act after (and
~ev~ral states foll~wing .the MBCA), ha~e suggested or opted for a
universal demand requirement, mandating that shareholders, in any
case, must make a demand on the board.
And, with this, let's take a look at Brehm v. Eisner.
CH. 7
SHAREHOLDERS' L
ITIGATION
331
BREHM V. EISNER 0
s ' VITz, AND OTHERS
upreme Court of DeIaware
746 A.2d 244 (2000)
[... ]
VEASEY, CHIEF JUSTICE:
In this appeal from the C t f
oft h e Court of Chancery thatour th o Chaneery, we agree with · the holding
subject to dismissal for failure to es::~ckholder ~eriv~tive Complaint was
reasonable doubt that the d" orth particularized facts creating a
independent or that the· irectdor defend ants were disinterested and
judgment rule. Our affirmaIr con h uct was . .prot ect ed bY t h e busmess
.
nee, owever Is in pa t b d h
different analysis than th t Of ' r ase on a somew at
·
Accordingly · the inte
In t aOf . .the Court below or th e par t·ies.
. . ' res s Justice, we reverse only to the extent of
proVIding th at one aspect of the dismissal shall be without prejudice, and
we rema~d to the Court of Chancery to provide plaintiffs a reasonable
op?o_rtunity to file a further amended complaint consistent with this
opm10n.
The claims before us are that: (a) the board of directors of The Walt
Disney Company ("Disney") as it was constituted in 1995 (the "Old
Board") breached its fiduciary duty in approving an extravagant and
wasteful Employment Agreement of Michael S. Ovitz as president of
Disney; (b) the Disney board of directors as it was constituted in 1996 (the
"New Board") breached its fiduciary duty in agreeing to a "non-fault"
termination of the Ovitz Employment Agreement, a decision that was
extravagant and wasteful; and (c) the directors were not disinterested and
independent.
The Complaint, consisting of 88 pages and 285 paragraphs, is a
pastiche of prolix invective. It is permeated with conclusory allegations of
the pleader and quotations from the media, mostly of an editorial natu:e
(even including a cartoon). A pleader may rely on factual statements 1n
the media as some of the "tools at hand" from which t~e pleader intends
to derive the particularized facts necessary to comply with ~hancery Rule
ll(b)(3) and Chancery Rule 23.1. But ma~y _of;he quotat10ns fro~ the
media in the Complaint simply echo plaintiffs concl~sory allegat10ns.
. 1 h no purpose other than to complicate the work of
Accor d 1ng y, t ey serve
reviewing courts. .
. . · · 11 a very troubling case on the merits. On the one
This 1s potentia Y · t that· (a) the compensation and
hand it appears from the Comp 1ain · · ·r ·
: . O itz were exceedingly lucrative, 1 not 1uxur1ous,
term1nat10n payout for v h C pany· and (b) the processes of the
d O ·t ' alue to t e om '
compare to Vl Z _v .n with the approval and termination of the
boards of directors 1n deah g casual if not sloppy and perfunctory .
Ovitz Employment Agreement ~~r~ is so ~nartfully drafted that it was
On the other hand, the Comp ain
}
I
CH. 7
properly dismissed under our pleading standards for dehrivative suitsf.

. d fi · t pleading ' t e. processes o
From what we can ferret out of t h 1s e icien O
f
the Old Board and the New Board were hardly ~aradigms good
· M of the
th e sheer size fi payout to
corporate governance practices. oreover, th b ·
Ovitz, as alleged, pushes the envelope of ju~cial r~s?ect ~ efi usi~es~
judgment of directors in making compensation decisions.
ds and the waste test,
e:e
this
_ore, ot
1s a close
as to t h e processes of th e t wo Boar
case.
But our concerns about lavish executive compensation and . our
ins · t·10ns that boards of directors of Delaware corporations
· t·t1 u t·10na1 asprra .
live up to the highest standards of good corporate practic~s do . not
translate into a holding that these plaintiffs have set forth particulari~ed
facts excusing a pre-suit demand under our law and our pleadmg
requirements.
This appeal presents several important issues, inclu~g: ~1) the
scope of review that this Court applies to an appeal from the d1sm1ss~ of
a derivative suit; (2) the extent to which the pleading standards required
by Chancery Rule 23.1 exceed those required by Rule 8 of that Court; and
(3) the scope of the business judgment rule as it interacts with the
relevant pleading requirements. To some extent, the principles
enunciated in this opinion restate and clarify our prior jurisprudence.
Facts
This statement of facts is taken from the Complaint. We have
attempted to summarize here the essence of Plaintiffs' factual allegations
on the key issues before us, disregarding the many conclusions that are
not supported by factual allegations.
A. The 1995 Ovitz Employment Agreement
By an agreement dated October 1, 1995, Disney hired Ovitz as its
president. He was a long-time friend of Disney Chairman and CEO
Michael Eisner. At the time, Ovitz was an important talent broker in
Hollywood. Although he lacked experience managing a diversified public
company, other companies with entertainment operations had · been
interested in hiring him for high-level executive positions. The
Employment Agreement was unilaterally negotiated by Eisner and
approved by the Old Board. Their judgment was that Ovitz was a
valuable person to hire as president of Disney, and they agreed ultimately
with Eisner's recommendation in awarding him an extraordinarily
lucrative contract.
?vitz' Empl~y~ent Agre_ement ?ad an initial term of five years and
reqwred t~at _Ovitz de~ote his full time and best efforts exclusively to the
Company, with except10ns for volunteer work, service on the board of
another company, and managing his passive investments. In return,
CH. 7 SHAREHOLD '
ERS LITIGATION 333
Disney agreed to give Ovitz b
discretionary bonus, and two s ~ ase salary of $1 million per year a
st °Ck options (the "A" options and the
"B'' options) that collectively e s olfd
.
shares of D 1sney common stock.wou enable Ov1·t z to purchase 5 million
The "A" options were sched 1 d .
1 million shares each, beginnin u e ; 0
veSt m three annual increments of
the third full year of employm!:t aeptemb~r 3?,1998 (i.e., at the end of
years (through September 2000 )) T~d contmumg for t~e following _two
that the "A" options would t : e _agreement specifically provided
non-fault termination of th veEs imlmediately if Disney granted Ovitz a
· · e mp oyment Agree t Th "B" t·
consisting of 2 million shares . . me:r:1· e op ions,
Although scheduled to vest ' differe~ 1~ two important respects .
year after the last "A" an:r:1-ually starting m September 2001 (i.e., the
.. d . option would vest), the ''B" options were
cond1t10ne on Ovitz and Disney first havm·g agree d t o ext en d h"1s
emp 1oyment b eyond. the five-year term of the E mp1oymen t Agreemen.t
Furt h O vitz would forfeit the right to qualif £ th "B" t·
· · ermore,
· · 1 1 Y or e op ions if
his irutia e~p oyment term of five years ended prematurely for any
reason, even if from a non-fault termination.
The Empl~yment Agreement provided for three ways by which Ovitz'
employment might end. He might serve his five years and Disney might
decide against offering him a new contract. If so, Disney would owe Ovitz
a $10 million termination payment. Before the end of the initial term,
Disney could terminate Ovitz for "good cause" only if Ovitz committed
gross negligence or malfeasance, or if Ovitz resigned voluntarily. Disney
would owe Ovitz no additional compensation if it terminated him for
"good cause." Termination without cause (non-fault termination) would
entitle Ovitz to the present value of his remaining salary payments
through September 30, 2000, a $10 million severance payment, an
additional $7.5 million for each fiscal year remaining under the
agreement, and the immediate vesting of the first 3 million stock options
(the "A" Options).
Plaintiffs allege that the Old Board knew that Disney needed a
strong second-in-command. Disney had. rec~ntly made seve~al
· ·t· d questions lingered about Eisner s health due to maJor
a cquisi 10ns, an
heart surgery. The Compla~nt furthr 1e_ges ~h a~ · "E.1s~:~ h a d
_a~
demonstrated little or no capacity to wor w~t- 1mpor an or we - nown
. t· who wanted to position themselves to succeed
su bor d 1nate execu 1ves . ~
. " · · h d t res of Disney executives Jef:i.rey Katzenberg,
h 1m citing t e epar u 1 Th h B d
Richard Frank and Stephen Bollenbach as examp es. ~tsh,tdet otakr
k : the chance for long-term success, 1 a o a e
new that~ to n1;cre~se d ·sion to hire Disney's new president.
extra care 1n reviewing a eci
., . . , . . that Disney should hire Ovitz as its president
· But Eisner s decision . d When Eisner told three memb ers of the
was not entirely well-receive ·
f
/I

Old Board in mid-August 1995 that he had decided to hire Ovitz, all
th.ree
"denounced the decision." Although not entirely clear from the Comp
laint,
the vote of the Old Board approving the Ovitz Employment Agree
ment
two months later appears to have been unanimous. Aside
from a
conclusory attack that the Old Board followed Eisner's biddi:
1g, the
Complaint fails to allege any particularized facts that the three direc~
ors
changed their initial reactions through anything other than the
typical
process of further discussion and individual contemplation.
The Complaint then alleges that the Old Board failed properly
to
inform itself about the total costs and incentives of the Ovitz Employme
nt
Agreement, especially the severance package. This is the key allega
tion
related to this issue on appeal. Specifically, plaintiffs allege that
the
Board failed to realize that the contract gave Ovitz an incentive to
find a
way to exit the Company via a non-fault termination as soon as possib
le
because doing so would permit him to earn more than he could
by
fulfilling his contract. The Complaint alleges, however, that the
Old
Board had been advised by a corporate compensation expert,
Graef
Crystal, in connection with its decision to approve the Ovitz Empl
oyment
Agreement. Two public statements by . Crystal form the basis
of the
allegation that the Old Board failed to consider the incentives
and the
total cost of the severance provisions, but these statements by
Crystal
were not made until after Ovitz left Disney in December
1996,
approximately 14 ½ months after being hired.
The first statement, published in a December 23, 1996 article in
the
web-based magazine Slate, quoted Crystal as saying, in part, "Of
course,
the overall costs of the package would go up sharply in the
event of
Ovitz's termination (and I wish now that I'd made a spreadsheet
showing
just what the deal would total if Ovitz had been fired at any time)
." The
I
second published statement appeared in an article about three
weeks
later in the January 13, 1997 edition of California Law Business.
The
article appears first to paraphrase Crystal: ''With no one expec
ting
failure, the sleeper clauses in Ovitz's contract seemed innocuous
Crystal
says, explaining that no one added up the total cost of the s~ver
ance
package." The article then quotes Crystal as saying that the amou
nt of
Ovitz' severance was "shocking'' and that "[n]obody quantified this
and I
wish we had ." One of the charging paragraphs of the Comp
concludes: laint
57. A~ has been concede~ by Graef Crystal, the execu

tive
co1:1pensat10n consultant who advised the Old Board with respe
ct to the
Ovitz Employment Agreement, the Old Board never considered
the costs
that would be incurred by Disney in the event Ovitz was terminated
from
the Comp~ny for a reason other than cause prior to the natural expira
of the Ovtiz Employment Agreement. tion
I'
_9!· 7 SHAREHOLDERS' LITIGATION 335

Although repeated in va .
adm1ss1. .
ons b Y Crystal constitut nous £orms . th
th m e Complaint these quoted
allegation that the Old Board ; . ~ extent of the factual ~upport for the
elements of the agreement Th"ai1Ce properly to consider the severance
. .
al1ega t 10ns wit h the legal presu . is ourt how
t· ' .
ever, must Juxtapos e these
th
a proper exercise of business j~p ion at the Old Board's conduct was
statutory protection for a board ~:~nt. !ha~ presump~ion includes the
advising the Board. We m t d r_ehes m good faith on an expert
allegations, if proven, would rebust th ecide whe~her plaintiffs' factual
u at presumption.
B. The NewT Board' s At· . Approving
c 10ns m
th e Non-Fault Termination
_Soon after Ovi:z began work, problems surfaced and the situation
continued h"to 11 deteriora
· te during the first year of h"1s emp 1oymen.t T o
~upport t 1s a ~gation, the plaintiffs cite various media reports detailing
internal complaints and providing external examples of alleged business
mistakes. The Complaint uses these reports to suggest that the New
Board had reason to believe that Ovitz' performance and lack of
commitment met the gross negligence or malfeasance standards of the
termination-for-cause provisions of the contract.
' The deteriorating situation, according to the Complaint, led Ovitz to
begin seeking alternative employment and to send Eisner a letter in
September 1996 that the Complaint paraphrases as stating his
dissatisfaction with his role and expressing his desire to leave the
Company. The Complaint also admits that Ovitz would not actually
resign before negotiating a non-fault severance agreement because he did
not want to jeopardize his rights to a lucrative severance in the form of a
"non-fault termination" under the terms of the 1995 Employment
Agreement.
.996 Eisner and Ovitz agreed to arrange for Ovitz
11 ' 1
0 n D ecem . b er the ' non-fault basis prov1·ae d £or m . t h e 1995
o
t 1eave D 1sney on " ,, h N B
isner then caused t e ew oar d "t o ru bb er-
mp
E 1 · oyment greemen t E
A· · (b , · t al consent')." This. dec1s10n · • was imp · 1emen t e d
stamp his dec1s10n Y1996 mu uletter to Ovitz . from d e1en~ d an t S an £or d M .
by a December 27, . . ne That letter stated: .
Litvack an officer and director of Dis y.
' f your agreement with the Company ·as
This will confirm the terms 0
follows: ment under your ex1stmg · · E mp 1oymen t
1
1. The Term of your em~ oy Company will end at the close of
Agreement with The Walt Disney ignature confirms the end of your
business today. Consequently, Y0 ':1r s tion as a director, of the Company
service as an officer, and your resigna
and its affiliates.
CH. 7
SHAREHOLDERS' LITIGATION
336
2. This letter will for all purposes of the Employm~nt Agreem~n\~e
treated as a "Non-Fault Termination." By our mutua agtreAemen' e
d your Employmen greement,
total amount payable to you un er . . the event of a "Non.
including the amount payable under Sect10n ll(c) m . .
. t· ,, . $38 888 230 77 net of withholding reqmred by law
F au lt Term1na ion, is ' ' . ' . 1 tt acknowled
or authorized by you. By your signature on this e er, you ge
· t f 11b t $1 000 000 of such amount. Pursuant to our mutual
receip O a u ' ' $1 000 000 balance h
agreement this will confirm that payment of the , , as
been defe;red until February 5, 1997, pending final settlement of
accounts ..
3. This letter will further confirm that the option to purchase
3,000,000 shares of the Company's Common Stock granted ~o you
pursuant to Option A described in your Employment Agreement will vest
as of today and will expire in accordance with its terms on September 30,
2002.
Although the non-fault termination left Ovitz with what essentially
was a very lucrative severance agreement, it is important to note t:iat
Ovitz and Disney had negotiated for that severance payment at the time
they initially contracted in 1995, and in the end the payout to Ovitz did
not exceed the 1995 contractual benefits. Consequently, Ovitz received
the $10 million termination payment, $7.5 million for part of the fiscal
year remaining under the agreement and the immediate vesting of the 3
million stock options (the "A" options). As a result of his termination
Ovitz would not receive the 2 million "B" options that he would have been
entitled to if he had completed the full term of the Employment
Agreement and if his contract were renewed.
The Complaint charges the New Board with waste, computing the
value of the severance package agreed to by the Board at over $140
million, consisting of cash payments of about $39 million and the value of
the immediately vesting "A" options of over $101 million. The Complaint
quotes Crystal, the Old Board's expert, · as saying in January 1997 that
Ovitz' severance package was a "shocking amount of severance."
The allegation of waste is based on the inference most favorable to
plaintiffs that Disney owed Ovitz nothing, either because he had resigned
(de facto) or because he was unarguably subject to firing for cause. These
allegations must be juxtaposed with the presumption that the New Board
~x~rcised_its business judgme~t in deciding how to resolve the potentially
htigable issues of whether Ovitz had actually resigned or had definitely
breach~d h~s contract. We must decide whether plaintiffs' factual
allegat10ns, if proven, would rebut that presumption.
Scope of Review
Certain dicta in our jurisprudence suggest that this Court will review
under a deferential abuse of discretion standard a decision of the Court of
-ca.7 SHAREHOLD ,
ERS LITIGATION
Chancery on a Rule
s at emen t s, apparently 23b ·1 motio .
the
t Court of Ch . n t 0 d. . 337
eg . 1sm1
. ancery's decision · ind.1984. Ass a den·vatw· e suit.
inn mg . Th
the alle~ations of the co ~n ronson v. Lewis, state ese
mp lai nt isc that
demand 1s excused. ret ionary in determining wh
, support the contention eth er
that pre-suit
Our vie . wt heis that i n determmm
ancery in proper ex . .. g d
Ch er .
un
th e particularized fact ll of its d . eman. d futility the Court of
. erc ise
d
1) th e di. rector iscretwn
(transac
s are disintereste s ad egaed ' .a r easo bl must decide whether
tion was otherwise th nd na e doubt is create '
judgment. mdependent [or] (2) the ch d that:
e product of a valid exerc all en ge d
ise of business
is deBy implication, therefore th
ferentia l, limited to a' d ~se d.
Chancery abused its discre :eta would ' suggest that ou
r review
that our review is for abus tion e/~~ation of whether the Court of
e of d: n t~e ' all parties
1scre 10n. to this appeal agree
The· viewf dwe . ex. press tod
ay ' h owever, is . desig . ned to make clear tha
ou
norvorev aniew
d pleonaryec.[1s10 ns
... ] of the
. Co urt of Ch 1
t ·
.
ancery app ymg Rule 23.1
is de
Therefor~, our scope of
review must be de novo
Aro~son ~nd its progeny_ . To the extent
contain dicta expressing
of discret10n scope of rev or suggesting an abuse
iew, that language is overr
uled.[ ... ]
Pleading Requirements in
Derivative Suits
. Pleadings in derivati
ve suits are governed by
Just as pleadings alleging Chancery Rule 23.1,
fraud are governed by
Those pleadings must Chancery Rule 9(b).
comply with stringent
particularity that differ substantially req uir ements of factual
pleadings governed so fro m the permissive notic
lely by Chancery Rule e
satisfied by conclusory 8(a). Rule 23.1 is not
statements or mere notic
hand, the pleader is no e pleading. On the other
t required to plead evide
must set forth are particu nce. What the pleader
larized factual statemen
the claim. Such facts ts that are essential to
are sometimes referred
"principal facts" or "elem to as ''ultimate facts,"
ental facts." Nevertheless,
factual statements that the particularized
are required to comply
pleading rules must also with the Rule 23.1
comply wi'.h th~ mand~te
that they be "simple, co of Ch"?-cery Rule B_(e)
ncise and drr~ct. A prom
conclusory language, like < complamt larded with
the Complamt here, does
not comply with these
fundamental pleading ma
Chancery Rule 23.1 nd ates.
requires, in part, that the
with particularity facts plaintiff must allege
rai sin g a rea so na ble
act· b · t· d was properly the produdoubt that the _corporate
10n eing ques 10ne ct of business Judgment.
The rationale of Rule 23
· ·rr .1 is two-f . 0~ thifeonheh d · ld n
d ·th di covery old an d tri
la~ t'_iftf
wou 1·a oV: ha
al t e p ain i comp ies wit
Pla1nti to procee wi s
this rule and can articulate a reasonable basis to

be entrusted with a
-
Ctt. 7
claim that belongs to the corporation. On the other

hand, the rule does
not permit a stockholder to cause the corporation, to
e~pe~d mone?" and
resources in discovery and trial in the stockholders
qu_1xoticpu_rs_u1oft a
purported corporate claim based solely on conclus10
ns, op1n10ns or
speculation. As we stated in Grimes v. Donald:
The demand requirement serves a salutary purp
ose. First, by
requiring exhaustion of intra-corporate remedies, the demand
requirement invokes a species of alternative dispute
resolution procedure
which might avoid litigation altogether. Second, if litiga
tion is beneficial,
the corporation can control the proceedings. Third, if
demand is excused
or wrongfully refused, the stockholder will norm
ally control the
proceedings.
The jurisprudence of Aronson and its progeny is desig
ned to create a
· balanced environment which will: (1) on the one
hand, deter costly,
baseless suits by creating a screening mechanism
to eliminate claims
where there is only a suspicion expressed solely in conc
lusory terms; and
(2) on the other hand, permit suit by a stockhold
er who is able to
articulate particularized facts showing that there is
a reasonable doubt
either that (a) a majority of the board is independe
,. nt for purposes of
responding to the demand, or (b) the underlying trans
action is protected
( by the business judgment rule.
[... ]
Independence of the Disney Board
The test of demand futility is a two-fold test under
Aronson and its
progeny. The first prong of the futility rubric is "whe
ther, under the
particularized facts alleged, a reasonable doubt is
created that ... the
directors are disinterested and independent." The
second prong is
whether the pleading creates a reasonable doubt that
"the challenged
transaction was otherwise the product of a valid
exercise of business
) judgment." These prongs are in the disjunctive. Ther

is satisfied, demand is excused.
In this case, the issues of disinterestedness
efore, if either prong
and independence
involved in the first prong of Aronson are whether a
majority of the New
Board, which presumably was in office when plaintiffs
filed this action,
was disinterested and independent. That is, were they
incapable, due to
personal interest or domination and control, of objec
tively evaluating a
demand, if made, that the Board assert the corporati
on's claims that are
raised by plaintiffs or otherwise remedy the alleged
injury? This rule is
premised on the principle that a claim of the corp
oration should be
evaluated by the board of directors to determine if pursu
it of the claim is
in the corporation's best interests. That is the analy
sis the Court of
,r'
Cu. 7
SHAREHOLDERS' LITIGATION . -
338 . t O be entrusted with a
· I
this rule and can articu e a
8 t reasonable
. basis h d the rule does
On the other an '
claim that belongs to the corporat10n. or oration to expe1:d mone?7 and
not permit a stockholder to ~au~e the ~to~kholder's quixotic pu_rs_mtof a
resources in discovery and trial I~ the 1 1 on conclusions, opmions or
purport ed corporate claim b~se soDeyald·
t d in Grimes v. on .
speculation. As we st a e t y purpose . First, by
The demand requirement serves a sa 1u ar medies the demand
.
requiring exhaust10n of m · tra-corporate re ' .
. d" pute resolution proce dure
· of alternative is
'
requirement invokes a sp~cies S d if litigation 1s· b ene fi1c1a
· 1,
th
which might avoid litigation altoge er._ eco;h .rd if demand is excused
the corporation can control the procee~;gs. - ~ ~ormally control the
or wrongfully refused , the stockho er w11
proceedings . .
d 1·t rogeny is designed to create a
The jurisprudence of Aronson an sp h hand deter costly
. balanced environment which will: (1) on the _one to eli~inate claim~
· b f g a screening mec amsm
baseless smts Y cream . .
where there is only a susp1c10~exp~essed solety 1 in conclusory terms; and
kh lder who is able to
(2) on the other hand, permit suit by a s oc ?
articulate particularized facts showing that there is a reasonable doubt
either that (a) a majority of the board is independent ~or ~urposes of
responding to the demand, or (b) the underlying transaction 1s protected
by the business judgment rule .
[...]
Independence of the Disney Board
The test of demand futility is a two-fold test under Aronson and its
progeny. The first prong of the futility rubric i~ "whether, under the
particularized facts alleged, a reasonable doubt 1s created that . . . the
directors are disinterested and independent." The second prong is
whether the pleading creates a reasonable doubt that "the challenged
transaction was otherwise the product of a valid exercise of business
judgment." These prongs are in the disjunctive. Therefore, if either prong
is satisfied, demand is excused.
In this case, the issues of disinterestedness and independence
involved in the first prong of Aronson are whether a majority of the New
Board, which presumably was in office when plaintiffs filed this action,
was disinterested and independent . That is, were they incapable, due to
personal interest or domination and control, of objectively evaluating a
demand, if made, that the Board assert the corporation's claims th at are
raised by plaintiffs or otherwise remedy the alleged injury? This rule is
premised on the principle that a claim of the corporation should be
evaluated by the board of directors to determine if pursuit of the claim is
in the corporation's best interests. That is the analysis the Court of
:-:;::~~~S~H~A~R
7
f!!--:·
__~_E_~_H
_ ~O~L~D
~
Chancery brought to bear
examine to the extent nece~snat h
ERS LITIGATIO
ry ;1or maaptterr, and

N
. it is that anal ys1· s we now

339 ~
The facts supporting . . P opnate appellate review
. .mt eres t e d
d1s . ependentp 1amtiffs' c1a· h .
or md t im t
·
maJori·t Y of t h e Board was b h urn on pl · ·ff ' at the New Board was not
ld amti s central allegation that a
were beholden to Ovitz. Pla~
to"ffe;1to Eisner. It is not alleged
Ov·itz , m · t erests . arily bm i s the
prim ory is· th at Eis · ner was
that they
.
redoun to 1sner's benefit siecause a la · h adv .
ancing
d E
to have his own compensationn E" vis con trac t for Ov
. h ~e isner would thereby gain in tiz would
be mt e nature of the mc rea sed lavishl Th" th his quest
in the end, this theoryoldismaxim th , . ~- 1s eory appears to
t at a 'high tide floats all boats."
conclusory allegations Moreono But,
allegations were illoo-i~al and ver ~~p p~rted by well-pleaded facts,
, e_ 0 1:r~of Chancery found tha only
b~ countermtuiti ve: t these
.
Plaintiffs' allegation that E"1sner · was mte · rested in maximizing his
compensati bl onb at· the expense of Di·
reason~ Y e mf~rred from sne y an d 1·t s sh are h old ers cannot
the facts alleged in Plaintiffs'
com·11pla· mt. At · all times material to this litigation amended
nn 10n options to purchase Dis , E. 1sn er ow d
ney stock. Therefore it wouldne sever al
Eis~~r's econ~mic interest to not be in
cause the Company to issue
add1t10nal opt10ns unnecessarily millions of
and at considerable cost. Such a
would not, as Plaintiffs sugges gesture
t, "maximize" Eisner's own com
package. Rather, it would pensation
dilute the value of Eisner's
substantial holdings. Even if own very
the impact on Eisner's option
relatively small, such a large value were
compensation package would, and
largely negative attention did, draw
to Eisner's own performance
compensation. Accordingly, no and
reasonable doubt can exist as
disinterest in the approval of to Eisner's
the Employment Agreement, as
law. Similarly, the Plaintiffs a matter of
have not demonstrated a reason
that Eisner was disinterested abl e doubt
in granting Ovitz a Non-Fault
thus allowing Ovitz to receiv Termination,
e substantial severance benefit
terms of the Employment Agreement. Nothing alleged by
generates a reasonable inference Plaintiffs
s under the
1
that Eisner would benefit person 1
from allowing Ovitz ally
to leave Disney without good cau
se.
The Court of Chancery held that "no
. , d" · reasonable doubt can exist as to
t · the approval of the Emplo
1Sn er s 1sinteres in yment Agreement, as a
E tter
e~~ ~
ma of law » and similarly that pla . . ,
reasonable do~bt that Eisner
mtiffs 'h_avenot. d t t d
ra a
wa s
. . ,, Plaintiffs chadis interes~ed m grla1:tmgb vtitz a
llenge this cone usion, u we on-
Fault Termination. agree
with the Court of Chancery a nd ffi that holding.
we
d toa irm . s associ. .
detail the variou
The Complaint then proce::d ations that
had with Eisner. In an alte
each member of the New rnative
Bo eeded meticulously to analyze
h?lding, the Court ?f Ch
director's
0
ancery PJ~hey could have each
exercised business
ties to Eisner to see
judgment independent of Eisner. Because we hold that the Complaint

fails to create a reasonable doubt that Eisner was disinterested in the
Ovitz Employment Agreement, we need not reach or comment on the
analysis of the Court of Chancery on the independence of the other
directors for this purpose.
In this case, therefore, that part of plaintiffs' Complaint raising the
first prong of Aronson, even though not pressed by plaintiffs in this Court,
has been dismissed with prejudice . Our affirmance of that dismissal is
final and dispositive of the first prong of Aronson . We now turn to the
primary issues in this case that implicate the second prong of Aronson:
whether the Complaint sets forth particularized facts creating a
reasonable doubt that the decisions of the Old Board and the New Board
were protected by the business judgment rule.
Analytical Framework for the Informational
Component of Directorial Decision-making
Plaintiffs claim that the Court of Chancery erred when it concluded
that a board of directors is "not required to be informed of every fact, but
rather is required to be reasonably informed." Applying that conclusion,
) the Court of Chancery held that the Complaint did not create a
reasonable doubt that the Old Board had satisfied the requisite
informational component when it approved the Ovitz contract in 1995. In
effect, Plaintiffs argue that being "reasonably informed" is too lax a
standard to satisfy Delaware's legal test for the informational component
of board decisions. They contend that the Disney directors on the Old
Board did not avail themselves of all material information reasonably
available in approving Ovitz' 1995 contract, and thereby violated their
fiduciary duty of care.
The "reasonably informed" language used by the Court of Chancery
here may have been a short-hand attempt to paraphrase the Delaware
jurisprudence that, in making business decisions, directors must consider
all material information reasonably available, and that the directors'
process is actionable only if grossly negligent. The question is whether the
trial court's formulation is consistent with our objective test of
reasonableness, the test of materiality and concepts of gross negligence.
We agree with the Court of Chancery that the standard for judging the
informational component of the directors' decision-making does not mean
that the Board must be informed of every fact. The Board is responsible
for considering only material facts that are reasonably available, not
those that are immaterial or out of the Board's reasonable reach.
We conclude that the formulation of the due care test by the Court of
Chancery in this case, while not necess arily inconsistent with our
traditional formulation, was too cryptically stated to be a helpful
precedent for future cases. Pre-suit demand will be excused in a
8 J3~4!1
_0!~7------ _____~'.!:LfIT!:!IQGA ~T~I[_QO~N~
~:-.:-= :...:::.H::.A~R::!:::E~H~O~L!!_DE~R~S
. .
derivative suit only if the Court of Ch instan ce, and this
C0 urt in its de novo revie ancery 1n the first
1ude that the particularized facts in the
plaint create a reaso wblco~c
th
~~: directors' decision-mU:ki~ oubt at the informationa l component of
of gross
z· ence included co .d g_ process, measured by concepts
nsi eration of all material inform ation reaso nably
neg~gbl ' Th
ava .a e. . us, we now apply this analytical framework to the
t· f
part1cular1zed facts pleaded juxtaposed w1·th th e presump ion o
regularity of the Board's proce~s.
in
[0~ th ese bases, the_ court examines the conduct of the directors
of
approVIng the compensatwn package and dealing with the termination
that the
Ovitz, ~nd finds that there is no reasonable ground to believe
].
board VIolated procedural or substantive due care, or committed waste
Conclusion
with
One can understand why Disney stockholders would be upset
lucrative compensation agreement and
such . a~ extraordinarily
only a
termination payout awarded a company president who served for
d. That
little over a year and who underperformed to the extent allege
not insurmountable-burden on
said, there is a very large-though
tive
stockholders who believe they should pursue the remedy of a deriva
these
suit instead of selling their stock or seeking to reform or oust
directors from office.
Delaware has pleading rules and an extensive judicial gloss on those
tive
rules that must be met in order for a stockholder to pursue the deriva
. This
remedy. Sound policy supports these rules, as we have noted
does
Complaint, which is a blunderbuss of a mostly conclusory pleading,
not meet that burden, and it was properly dismissed.
[... ]
NOTES AND QUESTIONS
1. Before considering the specific issues concerning the demand

ssion
requirement, it should be noted that this case offers an interesting discu
in case of
of the possible structure of a compensation agreement, in particular
advisable
termination, probably a structure that it would not be particularly
ts of
to adopt after this litigation. We focus here on the pro~edural as?ec
1der~he
derivative litigation, it is interesting ~owever al~o to briefl! co_ns
duties
substance of the above decision, which 1s very tellmg about fiduciary
. In an
and the reluctance of Delaware courts to hold directors liable
Disney
interesting recent article, Professor Gevurtz has .c?mp~red the
1on. m the . so-called
litigat 1·on above w1·th an important Germ. an h f dec1s
1 1
Mannesmann case. We report parts of his ins1g t u ana ys1s:
"De1aware cour t s exonerated directors of The Walt Disney Comp
. any
.
.
from liability for damages-despite t~e direct ors havm g paid
Michael Ovitz around $130 million 1n exchange for a year
Cf
CH. 7 --
of
b t executive at Disney. At frc
accomplishing li~tle as the num er wo reme Court held that pl:
about the same time, the German Federal Sup AG breached their o\l
directors of the German company, Mannesm~nn of a roximately th
duty to the company when they awarded a onus PP
$17 million to the outgoing CEO-whose actions appare n tly played ot
w
gammg over $ 50 bi·iron for the Mannesmann
. . .
an important role m i . d d
shareholders. As a result, the Mannesmann direct?rs en e du~ tl
paying a multi-million euros settlement for ~avmg_ r~~ar e li
success while their counterparts at Disney avoided habiht! for b:
paying 'eight times as much to reward failure. [... ]. ~ evident e:
divergence between Delaware law, as illustrated by Disney, a nd tl
German law, as illustrated by Mannesmann, lies in the de~ee of 3
deference . that the Delaware and the German courts. giv~ to t
directors under the business judgment rule. The factual situatrnns f
in the two cases are, of course, distinguishable. Neverthele~s, the (
skepticism with which the German court in Mannesmann dissects
the question of whether paying the challenged bonus could p_roduce
any offsetting advantage for the company seems at odds with th,e
deferential way in which the Delaware courts accept the boards ·
actions in Disney. Both Disney and Mannesmann pay homage to the
so-called business judgment rule-the idea that courts should be
reticent to second guess the business decisions of disinterested
directors. [... ] Despite its recognition of the business judgment rule,
however the court in Mannesmann held that the directors breached
their duty ' to the corporation
in approving the bonus. The court
based this holding on the assertion that the bonus could yield no
advantage for the company. Essentially, this is the same as a waste
claim in the United States." (Franklin A. Gevurtz, Disney in a
Comparative Light, 55 AM. J. COMP. L. 453 (2007))
This case is a perfect illustration of what we explained in Chapter 6
concerning the substantive scope of fiduciary duty and the business judgment
rule in different countries: the idea is there and it is fairly similar in the
abstract; the way in which courts interpret the degree of deference due to
directors' decisions varies.
2. The Delaware Supreme Court has quite clearly identified the
standard that courts need to apply to decide demand futility: a court must
"decide whether, under the particularized facts alleged, a reasonable doubt is
created that: (1) the directors are disinterested and independent [or] (2) the
challenged transaction was otherwise the product of a valid exercise of
business judgment." First of all, notice that the complaint needs to allege
"particularized facts": this is also a somehow flexible standard, but it means
that the allegations must be sufficiently precise, detailed, and specific. In this
case, the court was quite unhappy with the complaint, considering it prolix
and vague: the decision contains a quite strong "scolding'' of the lawyers.
3. The first prong of the test concerns the fact that demand can be
excused if directors are not disinterested. We suggest considering two aspects
SHAREHOLDE , 343
CH, 7 RS LITIGATION
- .
of this element: on the one h an d ' dire .
ctors 8 h Id h ave been disinterested
11
from th e a ege
d b reach of fidu · y duti.es Th ou the
· tiff m
plain
· o':r case is that ciar the CEO · . e core of the argument of
(~isner) had an inte rest in an
outrageously high compensation£ 0 th ght
President (Ovitz), because he thou
that this would help also him to 0 ~t .e
a higher compensation· and that the
other directors were beholden t th am ment is ~onsidered too
weak, speculative, and in any coase enot CEO. This dargu ·
t ·
sus_ame by well-pleaded facts. On
the other hand, directors can also be
non-i?dep~ndent because they would
likely be defendants in the laws ·t d
possibly hable . In this respect, as we
briefly mentioned above, court~\ a~
to_ exclude that merely naming the
existing directors as possible de£ ~n icient to make
them non-independent and excuseendema ants m the lawsuit·t is suff
nd (oth . wis~ 1 wou b e too easy £or
er . Id
.
a plaintiff to avoid demand) Th ch
the likelihood of liability is· ~re -~ight be situations, however, in whi
t, and alleged ~ith particulariz~d
facts, that it is clear that di::c:igm ican ~erenely decide on the lawsmt.
Observe how in this ers t ?rs cannot een the
. . . P pee ive there 1s a connection h betw ·
conduct challenged an d th e abT f
substantive dec1s1on or whe ther to sue. ' I ity o t e directors to
independently dec ide
us that demand ~an be excused if
4._ The second prong of the test tells
saction was the product of business
there IS a doubt that the challenged tran
derivatively and to have demand
judgment._ Shareholders wishing to sue
ehow anticipate the merits of their
excuse~, 1n othe~ words, must som
there is a reasonable possibility that
compla!nt to c~nv1nce the court that
will prev ail. The con cep t, not prof oundly different from the one used to
they
ered by the Romans with a cool Latin
obtain temporary injunctions, was rend
of good law", meaning the likelihood
expression: "fumus boni iuris," or "smoke
as we have seen, Delaware's judges
of a grouded claim. In the case above,
e to business decisions, concluding
show the usual (and desirable) deferenc
the com pen sati on pac kag e gran ted to Ovitz, while very high and
that
to a violation of directors' fiduciary
probably not advisable, did not amount
and we want to stress, that in case
duties. We have already mentioned,
rd, and the board decides not to sue,
shareholders make a demand on the boa
in court, but it is protected by the
this decision itself can be challenged
in our opinion, that in this situation
business judgment rule. This means,
ision not to litigate upheld in court)
directors can prevail (a~d see their dec
appears a valid exercise of business
not only when the challenged transaction
sible reasons, they reasonably decide
judgment, but also when, for other pos
helpful: imagine a situation in which
not to sue. One example might be
that appears a breach of the duty of
shareholders challenge a transaction
ted by expert litigators) to prevail and
care, and there is a 70% chance (estima
obtain an award of damages for $20
0,000; a 30% change to lose and have to
s
suit would determine ~ddi~ional cost
pay $60,000, and in any case the law
impact_ on the cor?oration 1n terms of
estimated at $100,000 and a negative that would cost
reputat· d 'ble consequent decline 1n sharfe h'prices, - · · · £ h
10n an a poss1 ·mately $70 000 The value o t 1s 11tigat10n_ 1s, or t e
the corpora t·10n approx1 , ·
o t· t· $14 0 000 $18 000 - $100,000 - $70,000 - -$48,000.
corp , - '
ra 10n, nega 1ve:
,. ,'
r
SHAREHOLDERS' LITIGATION
CH.7 -C
C
344 vail it would make perfect
. d. the likelihood to pre '
In this case, notwiths~an _mgthe directors) not to sue.
sense for the corporation(i.e., . t t this case and especially
. ective con . of t h e German
ras decision
5 · From a comparative
persp . ' h 1997
· · t 4 with t e · 6 A
what we explained above m pom , enbeck examined m Chapter_ . . _nd
Federal Court of Justice ARAG/Garm . on the Mannesmann litigation
, bservations
keep in mind Professor Gevurt_zs O Wh t are the differences, 1 any,
·r
in Germany reported abov~ in Notewi.th 1 a
respect ·
to directors ' d'iscre t·ion in
between German and American La_w ?
decidingto sue directors and executives.
***
na e to initiate the derivative
Let's imagine that the shareholfdelrlsmthaat1emand would have been
success u. tYthat directors can do 1f
example a rguing
• I! .
smt, 1or . h' they come
futile. Is there something, at ~ . ~om 18
18
: otentially very disruptive and
to the conclusion that th_e htigat~on p d the possible benefits?
damaging for the corporation, and its costs excee .
al device envisioned by corporate law attorneys is th~ so-
calle~~':p~c1al litigation committee" (or "SLC"). Direct?rs can appomt a
special committee, composed of individuals completely mde~e_nde~t from
the litigation (sometimes elected to the board af~er the htiga~i?n ~as
commenced specifically for the purpose of servmg ~n the ~1ti~at10n
committee) to decide on the opportunity to file a motion. to d~sm~ss or
·i otherwise settle the litigation . The decision to voluntar~~ d1sm1ss or
settle a derivative action, under both Federal Rules of Civil Procedure
and Delaware Chancery Rules, must be approved by the court. If the
committee is truly independent and in good faith and its conclusions are
well supported, the court should exercise its own independent business
judgment in determining whether the motion should be granted. More
precisely, the decision to dismiss or settle of the SLC is upheld by the
courts if two conditions are met: (1) the corporation proves that the
members of the SLC were independent, in good faith, and conducted a
reasonable investigation; and (2) the court determines, exercising its own
independent judgment, that the motion to discontinue the litigation
should be granted in the light of the best interest of the corporation. In
l '
many ways, this is a kind of "watered down" version of the business
!' judgment rule, one in which it is the corporation that has the burden of
'
'I .
.,j
proving the independence and care of the SLC, and still the court can
second-guess the merits of the decision. In this respect it can be argued
that the court is allowed more latitude in reviewing the decision of the
,.
.1 dir~ctors (to_ ~ismiss the action) than generally with respect to other
:I busmess dec1s10ns, presumably for two reasons: the delicacy of the matter
and the specter of a conflict of interest of directors or at least of some
recip:ocal back-s_cratching with the fellow director~ sued; and the fact
I
.I
t~at ~udges are ~1kely to be more well-equipped to evaluate a decision to
d1sm1ss a lawsmt, rather than other business decisions. Two interesting
I
.f!!·7 . .
SHAREHOLD ,
ERS LITIGATION 345
cases discu ssing the special 1·t·Igati.on c .
. I rea d"I~gs, are ZapaI ta M ommittee, which can be suggested
as optiona
Thompson v. Scientific Atlanta, ~75 aldonado, 430 A.2d 779
(1981), and
example of how the special Iitigat·Ion comm Ga.App. 680 (2005). They offer an
ittee sh Id k
To sum up what we have d" ou wor .
. Iscus sed he ' d'
' _res a Iagram that represents
the diffieren t a It ernatives that · h t occu r ma derivative action:
mig
board decides to sue
demand on board
I board declines to sue ~ shareholders

can challenge
but b.j.r.
f shareholders / ~
.
I
I
if shareholders are
suing derivatively,
~~~t.~.
) demand excused ~- - - - _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ :d::e~:~
to decide motion
to dismiss
***
picture
~en_ we shif~ our focus on derivative actions in the U.K., the
these actions
emerging IS very different than the one in the U.S. Although
on law, they
were recognized as early as the nineteenth century at comm
ght, rarely
were hardly ever used, and even when they were brou
current U .K.
supported by the court. The following extract discusses the
the reasons
rules (which since October 2007 are governed by statute), and
in mind a
why these actions are so rare. But before that we should keep
, which have
couple of fundamental differences between the U.S. and U.K.
fees and the
a bearing on derivative actions. These relate to attorney's
U.K. loser pays principle (discussed in more detail below
), which means
ative claim
that a shareholder in the U.K. who decides to bring a deriv
be obtained
must not only fund the action (unless third party funding can
r against
or the court orders the company to indemnify the shareholde
ed t?~ay the
liability for those costs), but also bears the risk of ~e~1;gorder
obta1n1ng an
defendant directors' costs (subject to the poss1b1hty of
~osition in the
indemnity from the company). This is ~issimilar to the
ct to
U.S., where parties usually bear their own costs. With respe
in t~e ~ederal
attorney's fees, whereas these are specifically p~ov~dedfor
continuing an
Rules of Civil Procedure and state laws for ~ru~g1ng and
as are the
action, in the U.K. the Companies Act 2006 1s silent on these
,
s' LITIGATION Cu, 7
SHAREHOLDER
350 QUESTIONS
NOTES AND d the two-stage permission
. . un er
extensive criteria. illustrate wel 1 h ov: .proce.duraUy
1. The abov_e derivative claim d to provide d1smcentives to
application to continue/ h law has develo~e hareholder who genuine
ly
and sub~tantiv~ly. E:g I~agine a bona fi ero:gh this (non-ex~a~stive, it
prospective plain_tiff · action and reads thh UK Law Comm1ss1on itself
contemp la t es taking an
d) r t It is no surprise ·
,
as t e · ·
h "list may appear to be a set
should be stresse . isP~per para 16.43), th at t edwhich would deter them.
d ·ts (Consultation ' It
a mi h' h pplicants have to overcome .
an . .
f ot favoring derivative actions .
of hurdle~lwbic se:n as maintaining a policy o hnto shareholders which would
could easi Y e
. 1 of an over-res t ric · tive approac
· the averages h are h old er will
and as a signa " d with these complex1·t ies,
over-deter them . Fae~ d t this early stage.
often give up in despair alrea ya y produce as did the case law
2 The exacting criteria . . 1·sted1 . above maautious ' . 1 d ..
. d . fve action judic1a ec1s10ns (the
1 over-c h
on the common law eriva
. . ·t'
. . 'th applica tion no less t an fiive times
.
1 st' d1sm1s s e .
court is remmded that mu nstrainmg the flex1'bl e exercise .
of
in sections 261-264). It could be_se~n as acsoanxious to encourage, in that
the
discretion which the Law Co~m~ssionf \her criteria may suggest that
. .on of th ese these
an d the om1ss1on o .
0
mclus1 rtant
are the only relevant ones or the most impo . . .
. ractical difficulties, do you thmk the_re is any
3. Given the above P . t' claim procedure under English law at
value in having a statu~ofryh_deriva~v:re was not available to shareholders?
all? What would be lost i t is proce
Do you th m . k u K J·udges should follow U.S. judges and be more
4 · · · t ff · ? If
· · · 11 d ·
willmg to a ow er1vat·1ve a ctions and hence intervene m corpora ea airs.
h?
so, what do you think would be the price of such an approac .
***
DERIVATIVE SUITS IN CIVIL LAW
EUROPEAN SYSTEMS
/ As mentioned in the Introduction, several continental European
systems belonging to the civil law tradition have adopted, more or less
recently, rules that might be considered the equivalent of the common-
law-style derivative suits. Even if with meaningful differences, these
,,
rules share with common-law derivative suits the goal of allowing
},
shareholders "to take matters into their own hands," and sue directors on
behalf of the corporation.
Italian law offers, in this perspective, an illustrative example. You
might remember that in Chapter 5, discussing corporate governance, but
also in other parts of this book, we have observed how in civil law
countries, where the ownership structure also of listed corporations is
more concentrated or at least there are "stronger" owners and "weaker"
managers, the shareholders' meeting often has more powers vis-a-visthe
_0!J SHAREHOL · GATION
DERS' LITI
board of directors when
di·r'1e
Crence ca 1 c
.d . Jt n a so be se ompared to
cons1 ermg a )"ian law en in th e are co0 fmd" mon law system Th'
b
351
,As a general rule, un as a represent a. S.
irectors' liability, spec 1S ast·C
der Italian ative example of these ifically
entrusted to the shareh 1 ju ris di cti ons .
lawsuit would be). Thisolders' !1w, th e decision to su
appro ~etmg, not to e di rectors
resolve the conflict of the directors (as any ot is
interest~~ :i:kes a lo her
themselves or their fe t of se ns e, be ca us e it sh
llow dire ta irectors
wi.th 1a:ge s h areholde can have if they have toould
rs c or s. Bu t
often holdi ' th ere is . ab sue
corporation, the real ~t ... In a sy
minority shareholders. conflict f . ng t a_ controllmg stake in stethm
themselves, or in any Contr ~- mtereS ts be e
ca se
tween controlling and
block holders appoin diroec~~;s~hareholders
t an d are ~£ten directors
compensation and of ave a_strong allegian ce to them:
ten o-i remove directors, de
this means th' at the t:, ~v em or e or 1 ter m ine their
. contr Ir ess s t ne· t d'irecti·ons. In
·11
dire· ctodrs Wl · rare £1y su
° m g s
h
ar eh olders who have appo practice,
inted the
was amaging e . th em . ' especiall Y if th e a11eged
shareholders. or mmonty sharehol di. rectors' breach
ders but n 0 t f
or contro11m· g
To balance ~his po~s
ible agency problem,
allo_wsalso a q~ahfied the Italian Civil Code
minority to sue derivati
vely. Consider the follo
Article 2393-bis: wing
"1. Shareholders representing
outstanding shares or at least one-fifth
the different percentag of the
bylaws, not to exce e established in the
ed one-third, can su
damages caused to th e the directors for
e corporation.
2. In publicly held
corporations, sharehol
least 2.5% of the ou ders representing at
tstanding shares, or
established in the by the lower threshold
laws, can exercise th
e action regulated by
the previous paragrap
h.
3. The corporation
must be served of pr
party in the lawsuit. Th ocess and can be a
e corn.plaint rnust be no
president of the supe
tified also to the
rvisory board.
4. The shareholde
rs intending to sue rn
ust appoint, through a
· majority vote, one or
more lead plaintiffs.
. victory of the shareh
n case Of olders, the corporati
5 I
reimburses the plaintiff on
s for the expenses of t h 1. . . h
the judge has not orde 1t1gation t ~t e
red the losing defendan
ts to pay or that 1S
not possible to recupe
rate from th em.
6 The shareholders
that have
d: . h d' ute· any copr omoted th; lithigadt~on.
rn pensat1on ,or t e 1srn1Scanl
1sm1ss or sett 1et. e sa
isp ' ld b aid to the corp
or settling of the dispute shou oration."
eP
352 SHAREHOLDERS'LITIGATION CH.7
It should be noted that the corporation can dismiss or settle the

litigation; however, the decision must be taken by the shareholders'
meeting. Needless to say, if the controlling shareholder, holding the
majority of the votes, would be able to dismiss or settle the dispute
notwithstanding the opposition of the minority that brought the
derivative suit, the entire provision allowing the minority to bring a
derivative suit would be nugatory. Article 2393 of the Italian Civil Code
therefore provides that the shareholders' meeting resolution approving
the dismissal or settlement of the lawsuit is only valid if the proposal does
not receive a percentage of "no" votes equal to the percentage required to
bring the derivative lawsuit (20% of the capital in closely held
corporations and 2.5% in listed ones, unless the bylaws provide for a
different threshold within the limits set by the statute). This means that
if the minority shareholder(s) who brought the lawsuit, for example
holding 6% in a listed corporation, oppose dismissal or settlement, the
controlling shareholder (or the directors) will not be able to overrule them
and block the litigation.
NOTES AND QUESTIONS

1. Based on this brief information about the Italian system, compare it
to the American one considered above. Which system do you find more
effective? Which system do you think achieves the best balance between the
need to protect minority shareholders against negligent or unfaithful
directors and avoiding excessive and frivolous litigation? Or would you rather
say that each system is better suited to the business scenario of the different
countries, especially with respect to different ownership structures?
2. As we mentioned, there is no demand requirement in the Italian
system and, for that matter, generally in civil law systems . The power to
bring a derivative lawsuit is given to qualified minorities. What do you think
are the advantages and disadvantages of this approach? Is it preferable to
allow only qualified minorities to bring a derivative lawsuit, as in the Italian
system, or is it preferable to allow each shareholder, independently from the
percentage of shares owned , to sue?
3. The absence of a formal demand requirement, however, does not
prevent shareholders from informally "suggesting" the lawsuit to directors.
This suggestion can be particularly persuasive if made by institutional
investors or other qualified minorities holding enough shares to sue
derivatively. Do you think that directors should take this possibility into
account when deciding whether to sue or not?
4. Comparing the US and the Italian approach (but, as we will see,
other jurisdictions follow the Italian system), two models for derivative
litigation emerge: in the first one, normally directors have the power to
decide to sue directors, but shareholders can sue derivatively subject to
demand on the board or if demand can be excused because it would be futile .
'I
7
f! !_
latter
:·:~:~:S_!!H~A~R~E~HQ01LERS
~=: LITIGATION
DQ_~~ '_1!~~~~-----~~
cannot vote. In add. .
. nge
t1e
the appoin set z, 10 oYoshareh ldition ' also pur 357
Ak tment f spe
o cia
~rs can obt ain suant t s .
l re w·t1 h t hoe appect 10n
dev elo pm ent the enf
0 rov 147
al of the of
couthe
rt
. t · t d. . orc eme n t of iab
. pre sen tati ves Be sid
irt
irec ors is ra itionally not th e d1omain 1 . · es th·
1s recent'
d i Yof
c aimh s ofh the corporat 10n· agains · t
This, however does not
as a . governance ' tool in Ge mermananthat sh s hare olders.
perceived abuses by challengin th ar_e olders' litigation is not used
Y· Typically, shareholders
the_ following excerpt illustr!tes react
e ;hareholders' meeting resolutions, to
claims, more or less legitimatel as
managers to settle the claim. Y, ·to ometimes shareholders use these
pressure the corporation and/or the
More generally, considering th E
article , Professor Gelter ide f fi e uro .
pe~n situ ation, in the following
explanations why derivative s:i: 188
in doing so he also challenges some interesting and com ling
s are not very often used in Europpel e, and
offers a good overview of d.;;
regimes. ime commonly held beliefs. The arti
1 erent Europ
ean-style derivative sui cle
ts
MARTIN GELTER, WHY Do

SHAREHOLDER DERIVATIVE
SUITS REMAIN RARE IN CONT
INENTAL EUROPE?2
37 Brook. J. Int'l L. 843 (2012)
[... ]
INTRODUCTION
. Th~ objective of this symposium
piece is to explore why shareholder
derivative suits are rare in Co
ntinental Europe. I mainly focus
Germany, France, and Italy, and on
further provide less extensive refere
regarding derivative suits in Au nces
stria, Belgium, the Netherlands,
and Switzerland. In doing so, Spain,
I compare the Continental Europ
situation with the one in the Un ean
ited States and Japan, where der
suits are important mechanisms ivative
of corporate governance enforcem
is sometimes thought that sha ent. It
reholder litigation and litigiousn
general are cultural ess in
features of U.S. society. In
shareholder derivative suits hav Jap an- wh ere
e also become common since the
1990s-cultural theories gave way to theories early
incentives that were more stro em pha siz ing eco nom ic
ngly supported by the evidence,
discernible cultural shift occurr as no
ed when suits became widesprea
emphasize economic incentives d. I als o
set by the legal framework to exp
scarcity of derivative suits in lain _the
Continental ~urope. Tins explan
similar to the explanation provid ation,
ed for_Japan, is_also ~nly cultural
as legal and structural constraints as far
setting these incentives are part
of the
respective culture. [... ]
rs omitted.
2 Footnotes and paragrap h s n Umbe
s and Steel,
In his Pulitzer Prize-winning book Guns, Germ ,
the "Anna Karenina
geographer and biologist Jared Diamond popularized
ic novel. Tolstoy
Principle" based on the first line of Leo Tolstoy's class
characteristics that
suggested that happy families share a number of core
ond varies the idea
must all be present to ensure happy family life. Diam
of criteria, including
to explain that an animal species needs to meet a list
be susceptible to
diet, social behavior, and breeding habits, to
ber of domesticable
domestication by humans. The relatively small num
if even one criterion
species can thus be explained by the observation that
ous to employ for
on the list is not met, the species would be too oner
and Japan seem to
human purposes. Likewise, only the United States
to make derivative
"get it right" with respect to all necessary criteria
contrast, no single
litigation a successful model for shareholders. By
ative litigation in
factor suffices to account for the scarcity of deriv
y the available and
Continental Europe--or even a single country. I surve
criteria have to be
some additional explanations, and suggest that several
met to make derivative suits attractive.
[... ]
entators that
The European evidence is fragmentary, but comm
number of suits is
discuss individual countries uniformly confirm that the
by Armour et al.,
very low. In the United Kingdom, an investigation
twenty-six suits in
spanning 2004 through 2006, brought to light only
not aware of any
which directors were named as the defendants. I am
and Black report
systematic evidence for Continental Europe. Cheffins
bers before 1997 in
only two suits against German supervisory board mem
only two published
which damages were awarded at trial. Ulmer reports
of a submission by
German cases awarding damages on the basis
between 1965 and 1999. Pierre-Henri Conac, Luca
shareholders
published French,
Enriques, and I began to compile a database of
2007 where self-
German, and Italian cases decided between 2000 and
this can provide us
dealing by controlling shareholders is alleged. While
subset of derivative
only with a limited (and maybe not even the main)
found only two such
suits, it is still interesting to note that we have so far
GmbH, roughly the
suits in Germany (one of which related to a
[... ]
equivalent of an LLC), two in Italy, and one in France.
[... ]
ONS
THE ANNA KARENINA PRINCIPLE: EXPLANATI
FOR THE ABSENCE OF SUITS
litigation in
I focus on four issues to explain the scarcity of derivative
the Anna Karenina
spite of its availability in principle. In analogy to
four dimensions to
principle, countries need to "get it right" in at least
nsions are as follows:
allow shareholder suits to proliferate. The four dime
do not include a
there must . be favorable standing requirements that
_91.7 SHAREHOLDER '
- S LITIGATION 359
minimum ownership threshold (S .
allocated favorably to overcome e?tio~ 2.1) ; the litigation risk must be
(Section . 2.2); ~~tential plainti~tority shareholders ' ~ational apathy
informa_t10n to litigate (Section )· must have sufficient access to
make it possible for shareh 2ld3 ' and the enforcement model must
wrongdoers , which not only . 0 ers to derivatively sue potential
. 2.4) .
sharehol d ers (Section inc1udes dire ct ors, but a 1so contro 11·mg
Minimum Share Ownership Re ·
quirements
A number of Continental E · .
shareholders (or grou s of sh uropean Jurisdict~ons require that
h , h p areholders) hold a qualified percentage of
t ~ copmpanys s a~es_or a specified amount of capital to bring a derivative
smt. ercentage hmits can be rationali·zed ·
· b · . as a screening mech anism ·
agamst a usi~e lawsuits on the grounds that the incentive for a
shareholder with a small amount of shares to bring a legitimate suit is
very likely small . Given that any shareholder 's benefits from the results
of a successful suit consist only of a proportionate share in the rise of the
value of the corporation, it seems hard to imagine why a shareholder with
only a few shares would sue for a legitimate reason. For a small investor,
a suit would seem to be rational only when the investor can somehow
coerce management into an abusive settlement that constitutes an
effective bribe to make the investor go away , i.e., the litigation equivalent
of greenmail. Theory cannot explain what particular percentage should
provide the cutoff, which could be set at 1%, 5%, 10%, or any other
number with almost equal justification . A plaintiffs motives are
presumably legitimate when the benefits of the lawsu~t: m~ltipli~d by ~he
probability of its success, exceed the costs of htigat10n , . mcludmg
nonmonetary cost . Any percentage limit is, t? some extent, _arbitrary_and
can preclude some legitimate suits. T~e ~eqmreI?ent to retam a relatively
large number of shares while the smt is pendmg may act as a further
deterrent. ·
Grechenig and Sekyra suggest that percenta~e limits are to blame f~r
· ati've· suits in Contmental Europe. Their
t h e a b sence of d eriv . · · d ·d
. 1 d 1 tures a simple intmt10n: m or er to av01 a
mathematica mo e cap ly need to deal with those
lawsuit, potential defendant_ mbalnatghers hoonldIn order to ''bribe" these
b th apphca e res .
shareholders a ove e ld have to offer these shareholders an
large shareholders, manage~s wou f om managerial wrongdoing. Large
advantage that exceeds th eir 1os~es :nitor management, but become
shareholders, therefore, do nof m exploiting investors whose share is
accomplices of management in ac wns _
below the threshold. · h e reduced minimum
· and 1ta 1Y av
In recent years, Germa~;.
10 1 German enforcement mechanism
ownership thresholds. The tra 1 o/cna DM 2 000 000 until 1998, when it
required a qualified minori ty of 10 o or
. . ' '
CH. 7
360 SH AREHOLDERS' LITIGATION
where shareholders could
was lowered to 5% or € 500,000 for ca~es 1·olations of the law or the
. . d' t· d' honesty or serious v . only
establish facts m 1ca mg is· t' . . d d ·n 2005 requires .
smt mtro uce the1 German legislature
corporate charter. Th e eriva ive . r . t'1
d
1% or €100,000 . To _prev _ent_ ~bus 1,;:w~t~f: :mission procedure," or
1 f which plaintiffs must
introduced a special Judicial· g the course o
..{,h dur~n b . the suit. Shareholders have
Klagezulas-sungsver,a ren,
show that they demanded that directors rmg. vi·olations of the law or
. . d. t· dis · h Onesty or serious
d t ·ne whether litigation
to establish facts m ica mg d th court must b e£ ermi
the corporate charter, an e e allowing it to proceed
would be in the interest of_the company e or
beyond this stage .
· · · · t duced Italian law started
In 1998, when derivative suits were 1~ ro ' r used the 2003
out with a 5% threshold. Since the mechamsm was nev~ d ' t d d ·t
reform eliminated the six month ownership requireme1: an t~ en ~t ~
.,.. to unlisted stock corporations. In unlisted corporatwns , e sui is
restricted to shareholders owning at least 20%, unless the corpor.ate
charter provides an even higher threshold of up to 33}~· For pubhc~y
traded firms the threshold was reduced from 5% to 2.51/oin 2006, agam
because deri~ative suits failed to emerge in practice.
Whereas Belgian law also only requires 1% or a nominal_ capit~l
share of£ 1,250,000 for a derivative suit, the thresholds are higher 1n
Spain (5%) and Austria (10%). [... ]
The percentage limit theory cannot explain the cases of F~an~~ and
Switzerland, where-as in the United States and Japan-1nd1vidual
shareholders can enforce liability claims against directors without
, I holding a minimum stake. These laws also do not have the additional
. I procedural hurdles of German law, such as the demand requirement and
admission procedure . The German situation is not well explained by the
./ theory, since there is a special derivative mechanism available to every
j shareholder in the law of corporate groups, but the mechanism has also
l failed to produce litigation . [... ]
. -1
Costs and the Allocation of Litigation Risk
II Law Firm Driven Litigation in the United States

[...]
j
The high frequency of derivative (and other shareholder) litig~tion is
typically credited to the entrepreneurial and specialized plaintiff bar.
This bar actually has quite a strong incentive to bring derivative suits
I given that contingency fees resulting from an award or settlement could
be as high as one third of the amount. Even when the settlement does not
l contain a monetary award, and only requires changing the firm's
corporate governance practices (e.g., more independent directors) the law
I
,
f
firm can receive a considerable award under the "substantial benefits"
SHAREHOLD , 361
CH.7 ERS LITIGATION
-
th
doctrine. Specialized · law firm h ~refore only need to find a suitable
lf
plaintiff and sometimes actua to sue
he ar ab ou t a po ssi ble ~a i: d a ~to:k P~rtfolio to be able
once the y
ee n law fi · ~h is sit ua t10 n may result in a "race
to the courthouse" be tw firm to
rol e of lea d irm s s~ nc e, tra ditionally, the first.
file is assigned the cotunthe sel m the case an d th us receives most
ce ab ou
of the fiee. H owever, sin t ye ar 20 _00,Delaware courts have
va rie ty of fa
begun to rely on a dto de term~ne lead counsel, including
pla int iff s sta k c ors
the size of the th e. quaht! of the pleadings filed.
ma rgi O: all y d' e .a~ h
While this may . SU its or mduce plaintiffs to take
are thi s £ I~ nis
cases out of Delaw 1 St rates that the incentive to sue
wi th the ~:w ;:~ ~U
rests almost entirely
The "Loser Pays" Principle
generally 1~ wh at In . is
European countries lis h R "· ap p the United States
urs e the
ng
often called the "E. . . u1e · the losmg party has to reimb
. . ce the outcome of a lawsm·t 1s · rare ly
for liti ga tio n co sts Sin
wmmn ·t rty
· g pa · f
su gg est ed tha
·
t the most 1·mport an t 1a i' ·
ct or det erring
certa 1s
. m,. 1 . . o ten
is tha t sh are ho lde rs wi ll no t be willing to take the risk of
deri_vativesuits s. Th e argument appears persuasive
for the de fen da nts fee
havmg to pay co mp lexity of the case, which is
Fe ~s of_ ten de pe nd on the
a~ fir~t _gl~nce. iss ues. Moreover, to the extent
that
lve s 1n tr1 ca te bu sin ess
high 1f It Invo co urt fees will also be very high in
on _ th' : am ou nt ~n dis pu te,
fees ~epe_nd lue at stake in such suits.
ve su it giv en the hig h va
a derivati
[... ]
the
er, Eu rop ea n rei mb urs em en t systems are often closer to
Moreov ing
Ru le in pra cti ce tha n in the ory. In several countries, includ
American is limited to court fees plus expe
nses
an d Ita ly, rei mb urs em en t
Germany ici al tariff promulgated by the
bar
rs, ac co rdi ng to the off
for lawye er is even more limited in Fran
ce;
. Re im bu rse me nt by the los
association ed, lawyers' fees normally are
not.
urt fee s are us ua lly rei mb urs
while co losing party only when retentio
n of
au tom ati ca lly bo rne by the
These are generally not the case in comm
ercial
ey is ma nd ato ry, wh ich is
an attorn grant
ere co rpo rat e ca ses are litigated. French judges can
courts, wh but, if
fee s to the wi nn ing pa rty under equitable considerations,
lawyers' er than
gra nte d in pra cti ce , the amount tends to be much low
fees are
.
what lawyers actually charged
ion s ha ve sp ec ial . rul es_ reg ar~ing litigation c~s.tsfor
Several jurisdict sli gh tly improve the position of
ve su its , all of wh ich
shareholder derivati iple.
int iff sh are ho lde rs co mp are d to the basic ''loser pays" princ
pla
No Contingency Fees
t could
sid es the "E ng lis h Ru le, " the oth~r classic di~ference tha
Be ce of
the rar ity of de riv ati ve suits_ 1n Europe 1s .the absen s are
explain ncy fee
nt· fi I tra st to the United States, contmge
co mgency ees. n con
CH.7
-
C
. C tin enc fees have traditionally been

f:
u~common and often ille~~~u ~~ to ~istirt the incentives of lawyers to l:
re3ected bec~use ;~ey are Al~hough the cultural aversion to a more ]
represent clients mtere st s. · th" h t
entrepreneuria· l view
· of the legal profession. may
. be receding, blis tas no
th
yet resulted in the emergence of a plamtiff bar compara e O e
American one. .
[... ]By itself, however, the contingenc~ ~ee~rohib~tion does n~t seem
to explain the absence of derivative htigat10n eith;.r. Hertig and
McCahery suggest that contingency fees already ar~ a common but
concealed practice throughout Europe." The new I~ahan law seems to
allow at least conditional fees, and derivative suits still have not e~er~ed
as a prominent factor. This is illustrated by the _emerge~ce_of derivative
suits in Japan in the early 1990s. Two-part ta~1ffs co?s1stmg of a fixed
retainer and a fee conditional on success-either m the form of a
judgment or a settlement-were seemingly enou~h to encourage
derivative litigation. For Japanese firms representmg shareholders,
retainers tend to be low and success fees high .
[. . .]
Access to Information
[... ] [I]n the United States, plaintiffs with a thin basis of evidence
can avail themselves of pretrial discovery, in the course of which the
defendant is required to disclose pertinent information to the plaintiff.
Once the suit passes the demand requirement on the basis of relatively
limited notice pleading, plaintiffs may rely on information gathered in
discovery to coerce the defendant to settle or go to trial. In Europe, a
party to a civil suit must generally identify specific documents and ask
the court to order the other party to produce them; furthermore, it must
explain why these documents are necessary and where they are located.
The absence of a wide-ranging discovery procedure is often thought to
make derivative suits, particularly strike suits, more difficult in Europe.
Fishing expeditions are typically not permitted, while "the opponent's
obligations to cooperate are usually strict and quite restrictive."
Is there a Continental European functional equivalent that makes up
for this "information gap"? While there is no obvious or complete one, a
mechanism that is sometimes brought up by Continental European
observers is the appointment of a "special auditor" by a court upon
application _by minorit~ shareholders. The auditor, who will typically be
an. ac~ountmg profess10nal or other certified expert, is tasked with
reviewmg problematic or suspicious management activities and
~ubsequ~ntly su~mits a report at the shareholder meeting. The
mformat10n compiled by the auditor can-at least in theory-form the
basis for a lawsuit.
[.. .]
_01.7 SHAREHOLDERS' LITIGATION 363
As a true functional equivale t t .
0
fail by and large. The instrument~ di~covery, special audits seem to
because the minority right can b is re~atively popular in France, partly
Furthermore, under the gene e ~x;rcised b~ ~ shareholder association .
shareholders can also ask the ra aw of civil procedure, individual
trl.al to establish facts · El sewhcourt to appoint an expert even before a
ere spe 1 d"
frequently, although appointments h cia au .1tors are not appointed
nd Italy requirements t h ..app_enocc~swnally. Both in Germany
a
b rden of, proof on th o s ow ser10us"
t'1f . irregu 1an·t·ies put a h eavy
u ] e pe ioner, which rules out fishing expeditions.
[.. .
Limitations Regarding Potential Defendants
[... ]
. 11:a~l of the countries surveyed here, the legal basis for derivative
suits I~, m ~11case,s,. fm.~~din a_section of the respective corporate law
g~vernmg_d1r~ctors _hab1hty. This fact has two important consequences .
First, derivative suits are only available for claims to damages. The
French courts, for example, found that derivative actions are not
available for injunctions. The potential of derivative litigation to prevent
harmful corporate behavior ex ante and to put pressure on those actually
in control of the corporation is therefore low. [.. .]
Second, possible defendants in Continental European derivative suits
are limited to directors (including supervisory board members), and in
some cases corporate officers, auditors, or the founders of the corporation.
The opportunity to engage with controlling shareholders is therefore
limited. True, sometimes controlling shareholders may be sued because
they are also directors, and in rare cases a director can be successfully
sued for failing to prevent illicit self-dealing by controlling shareholders;
the lim itation may still, however, prevent litigation that would otherwise
be brought.
[... ]
NOTES AND QUESTIONS

1. Professor Gelt er offers several reason s that might explain the mo~e
. ·t
l1m1ed use of deriva · t 1ve
· sui·ts 1·n Europe , when compared to the U.S. What 1s
· l l l bl · th's1 analysis is that he does not rely on general and
part1cu ar y va ua e m · h · 11 1 d
· "
sometimes vague cu It ura l" differenc es ' but on specific dtee mca , ega , an
· 1 1
· · Th' · t to say that cultural an socia e emen t s are
economic differences. IS IS no . d·f'!!
. l . . comparative I ierenc es ' but it is very important to
not relevant 1n exp a1mng . . t th t might account for compar ative
identify precise legal rules a nd mSbthu es sai.bleelements that can influence
d1'f'i!
1erences. Can you m .0
th· k f any ot er pos
le is the fact that corporations rely
th f d . t· I wsmts? For examp '
e use o er1va 1ve . a · d therefore on shareholders, to finance
more or less on equity mark ets, an
CHAPTERS
SHAREHOLDERS' A GREEMENTS
•••
INTRODUCTION
Shareholders' agreement
all) shareholders regulating :h a:e cof t~acts ~mong some (or sometimes
rights; in some cases the elr re _atwnsh 1ps or the exercise of their
agreement. The best way to c~~po;atlon itself is also a party to the
1
consider two of the most co us rate a shareholders' agreement is to
extensively below· lim 1·tat · mmtonhtypesof pacts that we will discuss more
voting agreements. wh'1 wns h o t e free tra ns £era b'l't
11 Yof t h es h ares; and
, c govern the way i h'1 h th h h ld
exercise their voting r 1g
· ht s. n w c e s are o ers
It is important to .under!'
. me th a t sh are h olders , agreements constitute
a s~parate ?0 ntract, ~1stmct from the corporate contract embodied in the
article~ of mcorporat10n and the bylaws, and a contract that generally
onl?7 bmds the specific shareholders that have executed it (while the
art1c_le_sand bylaws generally bind all shareholders). The substantive
provis10ns of a shareholders' agreement can often also be included in the
articles or byl~ws, r~prese~ting in this case a clause of the governing
documents. This opt10n might have some advantages: for instance in
France, in a simplified public limited liability company (societe 'par
actions simplifiee) transferring the shares in violation of a charter
provision would be invalid (Article L. 227-15 of the French commercial
code); on the contrary a bre_ach of a separate shareholders' agreement
would only lead to the payment of damages (the transfer would be valid).
Italian law is similar in this respect. There are, however , very good
reasons why shareholders might prefer, when they have an option, to
enter into a separate contract . For example, shareholders might want to
be bound only with some other shareholders, not with all, and/or they
might want to keep the agreement confidential: in some systems
shareholders' agreements, especially in ~ lis~ed corporation, must be
disclosed but often they can be kept confidential and unknown to other
shareholders especially in a closely held corporation. As we will see,
there might ~lso be other and more technical reasons why shareholders
prefer to include, for example, a pre-emptive r~ght in case of a sale of
shares in a separate contract, rather ~~an m the b~laws; reaso_ns
co · h the agreement can be modified, or the available remedies
ncermng ow · h h.b. · 1 d. ·
in case of breach. In addition, the law m1g t pro 1 1t me u 1ng certam
375
CH.8
SHAREHOLDERS' AGREEMENTS
376
. . th' se a separate agreement to is
r or bylaw s. m is ~a ·ght be tax reaso ns
provisions in the charte the shares
the only option. Finally, in some systems , t ere t:tnsferring donation or
becausde r exclu de lir
execute a shareholders' agreement,
among members of the agree men
t might reb uce . orrtant especially in a VE
inheritance taxes, something that might e impo s1
family-owned business. tock transfer agree ments a:
. . t· t f~ t·
In this chapter we will examme restric ive s lly agreemen s a iec mg s·
first, and voting agreements (and more gener~ d contrasting rules f'
~o~parmg/:m also discuss the
the governance ~f ~he ~orp~ration) ?-e~t, iction s. W . th
and practices ex1stmg m differ ent Jurisd e
, £ ·ng in particu 1ar on s of a
rs agre~ ~ent~ , ~cus~ he differ ent effect
legal effects of shareholde .
consequences in case of breach, d1stmgmshmg or m the bylaws.
clause included in a separ ate share holde rs' agree ment,
· th e u .S . and U ·K ., shareholde rs' agree ments are
As we w1·11 see, 1n of clo_sely held
generally discussed almost exclusively in the conte~t
m publicly held
corporations, and are not particularly common
ook or ma~ual, !he
corporations . If you look at a U.S. corporate law caseb
often be in the. part d~scuss11:g
chapter on shareholders' agreement will
s, howe ver-m ~articular m
closely held corporations. In other system
share holde rs agreemen~s
continental European systems, but not only-
corpo ration s . We will
are broadly used also in publicly held and listed
/ 1 explore possible reasons for this difference .
)I are extremely
, ••. I
One final point is that shareholders' agreements
used in international
'_/;11 common in corporate practice, and are often
ventu re in a foreign
-~
.$. I transactions, for example when establishing a joint
te a shareholders'
country. The ability to negotiate, understand, and litiga
cing nationally or
agreement is an important tool for any lawyer practi
internationally.
LIMITATIONS ON THE FREE TRANSFERABILITY

OF THE SHARES
I
default rule, it is
To become a voting member of a partnership, as a
partners. This is only
generally necessary to have the consent of the other
sever al liability for the
natural, because partners normally have joint and
, and because the
1. '' . 1 obligation of the partnership (with some exceptions)
of partners in the
governing rules envision an active involvement
,j expression sometimes
management of the business enterprise. The Latin
cteristics of the
used to express the fact that the individual chara
is "intuitu personae"
contracting parties are essential in partnerships
:J (literally, ''because of the person"). On the other hand,
free transferability
indeed, as we noted in
of the shares is the general rule in corporations;
-
I .
I•
:I Chapter 3, free transferability of the shares is one
of the defining features
of corporations. Limited liability . and the governance
structure of the
;' i.
I
,,
f._H.8 SHAREHOLDERS' A .
. GREEMENTS 377
corporation make less rel evant for £ 11
other st a k eh O1ders who the sh are h older e ow share holders ' creditors and
T
s are. his, . at least, is how the
theory goes.
In practice, however th.
limited liability, especially' i ningsl are quite different. Notwithstanding
. t a c osely held corporation, it is obviously
very 1mpor ant for sharehold fellow
shareholders. Just imagine a si·t uatio ers_ to_ know and trust . their .
. 1vency, needs fresh fi n m which a corporation, 1n. order to
avoi'd mso .
inanc1al resour ces m . t erms of eqmty : to be
sure t h at your fellow sharehold g to provide new
funds can be essential. Similarler~~re ca~able and willin ns why you
~;h ere might be sever al reaso
are willing to be in busines trust to her
w_ithone person, from mutu al
skills and experience ' but n ostw1 others.
Restrictive stock transfer
or reduce the risk th t
. . . a
;1f eements represent one way to eliminate
e ow shareholders will transferd 1their
lcom ed new investors · Bu t th ey can b e use a so to
· ipatio
partic hn to unwe · · g the ex1st
· tamm · ·mg ''balance
achieve ot,, er connected goals , s uch as mam
holders against
of powe~ among sha _re~olde~s, protect minority share so on.
changes m the economic situation of the corporation , and
of the shares
T~e adv~ntages o~ lin:iitations to the free transferability
first of all, they might
are quite obv10us. Their risks should also be clear:
rs de la societe'
make some shareholders, as the French put it, ''prisonnie
table obstacles to
("prisoners of the corporation "), by creating insurmoun
r and inefficient.
the alienation of the shares, something that can be unfai
next paragraph)
On the other hand, especially when (as we will see in the
can entrench some
combined with a voting agreement, these pacts
them to control the
shareholders in a position of strength, allowing
contribute , in other
corporation even with a limited investment. They can
that causes agency
words, to separate ownership and control in a way
from the corporation.
costs and facilitate the extraction of private benefits
balance between
Statutes and courts must therefore find the right
results, especially
freedom of contract and the need to avoid undesirable
in order to protect small investors.
ments limiting the
· There are different types of shareholders' agree
of
free transferability of the shares . The following "families" capture _som~
of course keep m ~md
the most common ones that you might encounter;
labels we use are Just
that the following list is not carved in stone: ~he As always, to
. d som eti·mes different name s migh t be used..
conven t 10ns, an . .
1s more important than to
d t h e su b s t a nee Of the provis10ns
un d erstan
commit their names to heart. .
. f fl t f"-'r provisions: these clauses provide that at
1rs o 1.e h th' d t mus
Right o t' a transfer of s ares to a 1r par . y,Unde r
s' agreement
shareholder, before execu mg bers of th e s hareholder
o.£'.£'th e s h ares t o ie" How .mem . b . 11 shareholders who are parties to
uer
a right of first offer provision, asica y,
-
CH. 8
SHAREHOLDERS'AGREEMENTS
378 . b ) on the shares that another
l l op 10
t" n (rig ht to uy provisions can be genera 11y
ffer
the agreement hav e a ca f fi t
irs t t which the shares might be
O 0
shareholder intends to sell. Right ° consideration calculated on
divided into right of first option, pursu~n a d1"tions that the third party
acquired by the offeree-shareh older paying .
1 der the samel con ursu ant to whi ch the price at
un .
the basis of a formu a, _or
is willing to pay; and right of (irs~ :ef~sa
df n the contract. Keep in mind,
this terminology in a different
which the option can be exercise . I~t ixe
rces mdifig use ·ght of first offer as. simply an
however, that different soueop ri
le e ine abefore others, and a right of first
1 P t
way: for examp e, ~ome .th iYd ditions Again do not sweat
obligation to negotia te wi one pa:f . '
con
refusal as a call option under speci ie
these semantic distinctions.
colorful 1:ame refe~s. to
"Russian roulette" provisions: this
·d· th a t if sha reholder X finds a potential buyer wilhling
agreements provi mg shareholders sh~ m~s! pure ase
to buy the shares, upon request of other
that the bu~er i~ willing. to pay
their shares under the same conditions ers are dissatisfied with the h
h er. The i·dea is · that if fellow sharehold .
1
. ·
t e
the cor por atio ~ a iena ting
possible new shareholders, they can exit
e offered by a third party.
shares at the same (and possibly fair) pric
clauses provide that, before
Consent restraint provisions: these
alienating shareholder must
transferring shares to a third party, the
shareholders or corporate bodies,
secure the consent or approval of other
tract can be more or !e.ss narrow
typically the board of directors. The con
consent, and the decis10n can be
in terms of possible reasons to withhold
any duty to justify the denial of
entirely discretionary and not subject to
vision might cause a shareholder
the consent. Needless to say, a broad pro
n, for example if the board of
to become a prisoner of the corporatio
I
,I
,I
directors systematically and for no good
sell the shares. For this reason,
discretionary restraint provisions are
statutory protections are mandated (e.g
reasons denies its permission to
in several systems completely
disliked by courts, or . specific
., appraisal rights in case of
prohibition to sell).
'/ ers: in this case a provision
Limitations to certain possible buy
reholders to transfer the shares
might limit the freedom of existing sha
:Ii only to individuals that meet certain req
and ~xperience, for example only to inv
uirements in terms of education
estors holding a college degree in
managing a lab. The existence of
,I chemistry for a closely held corporation
to be evaluated by a body of the
the desi~ed requirement might have
directors, and in this case the
,
.J
·l
corporatio~, fo_r ~xample the board of
proVIs10n 1s s1mil~r to a consent rest
dependent · on h'
f
ques 10n, 1n t 1s respect, 1s whether lim mple what b t
people are lawful and enforceable · For
raint in which the consent is
certain more . or less objective requiremen
exa
,
ts O · t
. ne 1n eres 1ng
itations to certain categories of
a ou a prov1s10n
t·
· ·
11 ·
ng t
h
e tran sfer of sha res onl y to "Ca ucasian males younger than 45
a owi
' 379
SHAREHOLDER
S AGREEMENTS
_9!·8
hinese citi of Chinese descent"
or to
years old," or to "C et h z~ ~s an ~ pe op le
ican M O 1st going
members of the "Afr t Ep is ~o pa l Church"? We ar.e not
to answer this question bu you can d1scu 't m . c1ass. Hmts for the
' . ' . ss 1
. . Ar d 1minating 1uses ma P . a t e agreement, v0.1dper
discussion: e 1scr ca ' riv
? To th e extent that the g not discriminate, wou
ld
se. ov ;rn m en t co ul d.
inations such
prohibitions of discrim t. a so ap pl y to pr ivate organizations, ns?
ld a cour e similar provisio
as corporations? Wou m your country enforc
Absolute prohibth itions to t ~e r th e shares: as the na
me
e cl ra ns tion of
suggests, in this case c: ~: ~ w ou l~ si m pl y prohibit any aliena
for a lled '1ock-up
the shares, at least pe rw d Cth ese are also ca ' , to
etim m t·ion goes pu blic
rovisions" and som e us ed w he n a
. corpor a
P ' controlling hes ar h ld itted to the investmen
t
ensu re th at er s re m am co m m tle
) sCare o s have lit
for a period of tim e · ourts and corporate law system 'bil't t 11
un re as on ab le re st ra int t o th e poss1 I Y o se
e, however, for s
toleranc ar es .
th e sh
· ht assures
d ta g- al on g pr ov · ·1ons:a tag-a1ong rig
1s
g an ,
D. rag-alon
m aj or ity sh ar eh ol der) sells his shares
i!
th_at a party (gen
erally the
have th e rig ht to jo in th e sale and sell their stak
e
mmonty shareholders m e co nd iti on s. M or e precisely, since the
der the sa agreement, the major
ity
to. the third party_ un no t bo un d by th e
generally es
third-party buyer 1s th at th e bu ye r w ill also purchase the shar
assure party
seller has the duty to is th e op po si te : it is the obligation of a
ag-along the
of the minority. A dr ar eh ol de r) to se ll he r shares together with
(generally the minor
ity sh e same
or ity sh ar eh ol de r) to a buyer under th
maj ong right
seller (generally the ns se rv e di ff er ent purposes: a tag-al
prov is io becoming fellow
conditions. The two fr om th e ris k of
shareholders a presumably fair
protects non-selling t lik e, of fe rin g th em
ne they do no ve called a ''Russian
shareholders of someo r to w ha t w e ha
ehow simila e case of the Russian
way out. It is som ce be in g th at in th
the differen ird party must buy
the
roulette" provision, th e sh ar es to a th
seller of ong,
roulette clause the of th e ag re em en t; in the case of a tag-al
embers ince the third-party bu
yer
shares of the other m re em en t m us t co nv
the ag embers
the selling member of s sh ar es , al so th e ones of the other m
n to hi litate
to purchase, in additio lo ng pr ov is io n, on th e other hand, can faci
drag-a buyer is
of the agreement. A e co nt ro lli ng sh areholder), in case a
(o f th ud:s
the sale of the shares la rg e st ak e in th e corporat~ont~at i~cl
quiring a m this
only interested in ac es of th e ag re em ent. Keep m mmd,
e pa rti e in a co_rporat~on
the shares of all th a c~ nt r~ l~ in ~ st ak
purchaser of der to avoid haVIng
perspective, that the th e m m on t1 es m or
le to buy out
often wants to be ab
to deal with them. ned i~
e- m en tio ne d pr ov isions can be combi
ov
Of course all the ab is far from uncommon to1 have a shareh oldehrs
d I .
t th fi e i't . fi a , an a tag-a ong. t .e
d1·f~ re us
1.eren ways; · er1e dor both a nght of first 1s
re em en t t h at m e u es
ei 'th er bu y th e sh ar es that someone else
ag h · ht t o
· h
parties ave t e rig
I
380 SHAREHOLDERS'AGREEMENTS CH.8
considering selling, or have their shares bought from the third pa~ty
(from a financial point of view, it is like a collar, or call-put option
trigger ed by the intention to sell the shares).
The bottom line here is that contractual freedom, in this area, is
quite broad; and the fantasy of the parties can envision all so~ts of
different rules applicable in case of a transfer of shares. As mentioned
before a critical limitation to contractual freedom, often expressed in
mand~tory statutory provisions or judicial precedents, derives from the
need to avoid freezing the market for the shares and reducing
shareholders to prisoners of the corporation. The magic expression here is
"unreasonable restraint to the free transferability of the shares." In most
legal systems, therefore, absolute restrictions or restrictions that make it
almost impossible to disinvest from the corporation are unlawful or at
least unenforceable. For example, either based on general principles or on
specific statutory provisions, most courts would not uphold absolute
prohibitions to alienate the shares that are not limited to a reasonable
period (e.g., three years). As we will see, some statutes prescribe the
maximum duration of shareholders' agreements limiting the free
transferability of the shares (and also other shareholders' agreements), or
provide that they are not binding when certain events occur, for example
when a tender offer is launched.
One question that sometimes people unfamiliar with these provisions
ask is why a shareholder would accept these limitations to her freedom.
Of course when the provision is enforced, there might always be a
shareholder who would prefer not to encounter any limitation. The
reason, obviously, is that ex ante the agreement might have been
desirable or, at least, necessary to secure an investment. For example ,
imagine that shareholder A is interested in investing in XYZ Inc. with B,
a controlling shareholder, but is afraid that in the future B might decide
to sell the shares to someone else. It might make sense for A to accept to
(
1)
invest only if she and B enter into a tag-along provision, so that she is
sure that if B sells to a third party, A can also sell the shares at the same
conditions. At the same time, if for B it is important to have A as a
shareholder (he might need the funds that A is able to provide) , B might
accept to sign the agreement. It can happen, however, that after a couple
of years A decides to sell the shares, and the tag-along provision would
'
I apply to her sale too. She might not be happy about that, but still to
execute the agreement might have been the best option ex ante .
THE JIMINY CORPORATIONHYPOTHETICAL

Rather than a more extensive general and abstract discussion on
restrictive stock t_ransfer agre~ments, and before considering some cases ,
we propose a brief hypothetical, which we believe might help you to
CH.8 SHAREHOLDERS' A . 381
_. GREEMENTS
become more familiar with the ine the following

scenario. You are a lawyer sittin s~ agreements. Imag
fine day, a new
client walks in seeking your adJ m ;our ?ffice an~, one
Pinocchio tells you that he has b een ce. e will call him Mr. Pinocchio. FMr.
. acted by Mr. Cat an d Ms. ox,
t" cont .
who have ma d e h 1m an int
become a minority sharehold:;e~o;~fn busi~ ess proposition. He would
2
g ~1/o of the common shares of
JiminY Corporation; Mr. Cat and M ly, 55% and
5%. Mr. Pino cchio is inter e t d . s.h~ox will holdt , respective
2 0 s e Hint 1s opportun·1 Y, envis1om· ng th e new
· ·
terpr ise as a profi table · fi b eing ·
en one. e also tells you th t h e is me a
·nority investor and th t th e ownershi.p structure ais not negotiable. He
mi t 8 Mr Cat ' d Ma F
trus •· • an s. ox, considering them honest and capable
or both of them
p~rtners, but his real conce~n is that after a while one · par t·1cul ar
party that he does not t rus t , m
migh . t sell· theh share. s to a third · ht acquire · th e
he 1s afrai· d p· t at eithe r
, Mr. Stromboli or Mr · Lampw·1ck m1g
h" does not respect.
s~ares: . in inocc 10 s own words, two "goons" he
sign a right of first
Pmocch10tells you that Cat and Fox have accepted to
. Your task as
refusal agreement, and that they have prepared a draft
t out all possible
Pinocchio's lawye: is to read the proposed draft and poin
problems and pitfalls, suggesting-if necessary-how to rewrite the
mind that the goal
agreement in order to improve it. In doing so, keep in
ership structure of
of your client is to avoid the possibility that the own
without having
the corporation might change in a way he does not like,
possible investors.
the opportunity to purchase the shares before other
g as possible, and
Your task, therefore, is to make the agreement as stron
you that in this
avoid any possible circumvention. Pinocchio also tells
pt most proposed
negotiation phase Cat and Fox are very likely to acce
they desperately
changes, as long as they are reasonable and fair, because
need his five gold pieces to start the business.
s you. Read
The following is the draft agreement that Pinocchio show
g how to change
it carefully, and try to identify its shortcomings, suggestin
es and Questions"
it. ATTENTION, the answer is below, in the "Not
_ s~re not to look
section: if you want the exercise to be meanin~ul, ~ake
ng 1t 1n class.
at it before reasoning on this provision and/or d1scuss1
any portion
"No stockholder shall sell to third parties his stock or
e of such
thereof without first having given written notic
er.
intention to this Corporation and to each other stockhold
each other
During the fifteen days succeeding the announcement
such ~t?ck,
stockholder shall have the right . to purchase
. 11 t h"s stake in the capital, at the same conditions
propor t10na y o 1
:
offered by third parties."
2_3~8~2
______ ..£:S~H~A~R~E~H~O~L~D~E~R~S~'.=.:A~G --=-C..::.:E::
______ ::.::R=:E:::E:::::M:::.: .~
NOTES AND QUESTIONS
1. Needless to say, the draft provision above is oversimplified and
there might be several valid improvements that you could sugges_t. We want
to focus, however, on three potential problems. The first one. is that the
provision refers only to "sales" of shares and appears to be trigger~d only
when a shareholder "sells" his shares . There are however many different
ways to transfer ownership in the shares, and a sale is only one of them. The
shares can be exchanged (bartered), contributed to another corporation,
gifted, inherited, and so on. In this respect, therefore, if Pinocchio wants to
enjoy a pre-emptive right anytime fellow shareholders intend to transfer the
shares, the provision should be broader. Of course the problem is how to
apply a call option when the consideration that the seller might obtain from a
third party is not fungible cash, but a specific asset; or there is no
consideration at all. If, for example, Cat wants to exchange his shares with
an apartment owned by Stromboli, Pinocchio cannot-obviously-offer the
same apartment. The shareholders' agreement must, therefore, provide for a
mechanism to allow Pinocchio to exercise his option with a payment in cash:
for example, in this situation, an independent expert must be appointed in
order to determine the market value of the apartment, and Pinocchio will be
allowed to purchase the shares paying a price equal to that value. The
question might be even more difficult when the shares are donated or
inherited. In some legal systems it might be questionable to allow Pinocchio
to prevail and obtain the shares, paying a sum of money, because this might
be considered an unacceptable limitation to the freedom to gift specific
property to specific people or to dispose of personal property after death.
2. A second problem is that the proposed text provides that the right of
first refusal only applies when the shares are sold to "third parties." The
.(
·'' reference to "third parties" is ambiguous: on the one hand, it might be
interpreted as limited to transfers to buyers that are not shareholders and/or
not members of the shareholders' agreement; on the other hand, it could be
interpreted in a broader sense, as referring to any transfer to a buyer
different from the seller. If the first-and quite likely-interpretation is
followed, however, there is something that needs to be clarified with
Pinocchio: if he wants the option to also apply if a fellow shareholder sells to
another fellow shareholder, for example if Cat sells to Fox. The question is
very important because it might be different, for Pinocchio (and any minority
shareholder) to participate in a corporation with two other shareholders
holding, respectively, 55% and 25% of the shares, or only with another
controlling shareholder holding 80% of the shares. A minority shareholder
might want to avoid a situation in which one single large shareholder owns
almost all the shares and is able to take unilateral decisions without
substantively being challenged by the minority. If this is the case, you might
want to suggest to Pinocchio to clarify in the agreement that the option right
is triggered in any case of transfer of the shares, both to shareholders and to
third parties (non-shareholders).
-
CH. 8
•
SHAR EHOLDJ?RS' A
3. Finally, there is a probl

- GREEMENTS
4
.
383
th th e fact that the option right can be

exercised und er the "same cond't~m ~i
'd . i ions offered bY a t h'1rd party. Imagine that,
give or t a k e, consi ermg the rel
participati~n . of Fox is $100,00;~~~ ele~ ents, the fair value of the 25%
investor willmg to pay an exorbit t ~t if Cat finds a completely nai:ve
would be between a rock and a~ p;ice, for example $200,000? Pinocchio
accepts a new and possibly

demonstrated not to be busin
u:~:~i
excessive price to prevent the a 1 ar place: he either accepts to pay an
or ren~unces _exercisingthe option but
rable (if nothing else, because he has
roblem is to provide that ~:s/avvy) n~w shareholder. The solution to this
price, the parties can initi;te ase of d_isagreementon the fairness ?f the
P . an evaluation procedure pursuant to which an
independent expert will determine the f · · f h h d h
· ·11b 11 . air pnce o t e s ares , an t e
Parties wi ea owed to exercise the opti·onund th d't· d t · d
h t A £ er e con i ions e ermme
by ~ e_expe_r ·. ew suggestions on how to write a similar provision: first,
avoid identifymg the expert ex ante in the contract. The reason should be
obvious: im~gine you ind_icateas an expert a famous professor of finance from
the best business school m your country, which appears to be independent . At
the time of the appraisal, the expert might be dead, might have married the
selling shareholder thus losing her independence due to a clear conflict of
interest, might have become incapacitated . . . . You should instead provide for
a neutral appointment mechanism writing, for example, that the expert will
be selected by the president of the court sitting where the corporation has its
seat, or by dean of a renowned business school, among experts presenting
certain requirements in terms of independence and competences. No system
is perfect, and also in this case there is the possibility that the appointi~g
person might lack independence, but in this way you should be able to avoid
major problems.
4. Based on these three suggestions, here 's an improved version of the
agreement:
"No stockholder shall sell or otherwise transf~r his st?ck or any
. thereof without first having given written h'notice of such
por t ion
to t is
corpora
t·
ion
intention and of the conditions of the transfer
and to each other stockholder.
Durin the fifteen days succeeding _such notice each stockh?lder
the Dean of XYZ Busmessd
might grequire t h e Corpora ti'on to notify
. . t an independent appraiser among tenure
School, who will appom . der to determine the fair value
professors of corporate finance m or
of the shares . . . ·· .
. . · th a raiser has indicated the fair value of
Withm ten days after e k1;,;ld r shall have the right to purchase
st
the shares, each ot~er oc ~s :take in the capital, at the price set
such stock, propor~wnally ,~0 .
forth by the appraiser . . . . ht want to discuss with your client
5. An additional issue th at _you mig ore than one person exercise the
. .ded m case m . d t
is how shares would b e dlVl . h holder owning 10 shares mten s o
. ple ' if a s are
option. In the previous exam
, I
i
384 SHAREHOLDERS' AGREEMENTS CH. 8
sdl. and two shareholders each owning 15% decide to buy, each of them will
be e ntitl ed to rec eive 5 shares. If only one of them exercises the option, he
will be allowed (but also will have) to buy all the 10 shares. This seems fair
because it might be difficult, for the seller, to find another buyer interested in
only 5 shares. The structure of the provision in this respect is, however,
negotiable also subject to the bargaining power of the parties . It is possible to
give more or less flexibility to the shareholders intending to exercise the
option with respect to the percentage of shares that they can/must buy. Try to
imagine situations in which deviations from this approach might be desirable
for one party, and explain them.
***
Hopefully the previous exercise contributed to make you understand
more clearly the possible content of a right of first refusal and other
similar limitations to the free transferability of the shares, including
strategic considerations about how to negotiate and draft them. The
exercise does not however entail, in itself, comparative considerations. We
) dare to say, in fact, that in terms of drafting limitations to the free

transferability of the shares, there are comparative differences, but they
are not particularly profound. Or, more precisely, we think that what you
have discussed and learned in the Jiminy Corporation Hypothetical could
be useful in different jurisdictions. From a comparative perspective, you
will probably find more differences, in this area, concerning contract
interpretation techniques, specific rules governing the disclosure and
1''
duration of this type of agreements, available remedies in case of breach,
and whether they bear against third parties .
.
,
' In this perspective, let's start with one case combining the problem of
unreasonable restraints to the transfer of shares and contract
interpretation. It is a famous U.S . case, which offers the occasion to
compare U.S. law with other systems.
IN RE ESTATE OF GILBERT MATHER

Supreme Court of Pennsylvania
' 410 Pa. 361 (1963)
~ 'j
I
'''
o'
i'
'
BELL, CHIEF JUSTICE.
;
_, ~
j
The Executors of the Estate of Gilbert Mather took this appeal from a
•. i decree which entered judgment on the pleadings and ordered specific
'·.~
performance of a written stock option agreement. The Executors claim the
agreement was invalid as an unreasonable restraint on alienation,
because the optional purchase price was fixed at $1.00 per share, which
was only a small fraction of the stock's actual value.
In order to decide this question a review of the relevant facts 1s
necessary.
-
:. 8
c~~s::;-:~~=~S:H~AR~=~
~
.
intent of its drafter: object' .
. F
interpre t a t ion. or a conive inte
OLDERS'A
GREEMENTS
b trpret a t·ion seems preferable to s b' 391

contract interpretation rulecise s an dutech t"
. exc
n'ellent . discussion of d'ff u Jec
!e, system. s ·z
see
L Cat h erme Valcke, Contractiques m civil law and
1 ere nces i~e
m
b.e an wi z I 1
C aw: An Exe rcis e in c ua com mo n aw
)n COd NT RACTLAW, J. Neyers e~m~rative nterpretation at Common Law
1e www.ssrn.com). L~gal Rhetoric, in EXPLORING
' ., art Pubhsher, 2008 (als o available on
ct
~d 4. If you are not from th U
distinction between contractual i et S
1g · ., also based on the above-mentio
law systems, ow do you think th n erpreta tion st 1 · ned
Ld
,, your system? h A partially simil e M th Y es m commonlaw and civil
a er case could
intereste d , try to find it (this couarld case was decid d hav e
· J been reso
If
lved in
find cases; of course if you are fa . 1 b e m apan.
~ so . e a research project to learnyou are
very easy), and compare it withmi 1iar wit h the J apa t · how to
February 17 2009 2038 Ha · J'h the M th nese sys ems 1t would be
, , nre1 1 o 144a. er case: Supreme Court of Japan,
g
e ***
(l Let's briefly talk about remedies
in case of breach. Shareholders'
r agreem. ents are con. tracts among
parties , and 1'n case of b reac h , genera y
speaking, the typical remedy wo
., uld be damages. If a share tran ll
I limitation is breached, and the sfer
shares sold to a non-member of
l agreement, therefore, it is imposs the
ible to get back the shares from
buyer, at least in the absence the
of bad faith. Russia is a good exa
Article 32.1 of the Federal Corpor mple:
ate Law provides that "Shareholder
agreements are only binding for s'
the parties. A contract executed by
the parties in violation of the agr one of
eement can be voided by the judge,
the request of an interested party, upon
only if it is proved that the other par
knew or should have known the ty
limitations provided by the agreem
ent."
Going back to our Pinocchio hyp
othetical, therefore, imagine that
breaches the agreement and sell Fox
s the shares to Lampwick . What
Pinocchio do? Of course he can can
sue Fox for breach of contract, but
problem is the calculation of dam one
ages. What is the damage suffere
Pinocchio because a new shareh d by
older has entered the corporation
because he was not allowed to and/or
exercise his option? Clearly; it mig
very difficult to tell, and this cou ht be
ld lead to _extensive htigatb1on. Oh
·t· t th' bl m and to create a d1smcentive ne1de1ad
t o m1 1ga e
· 1d 1s pro e , to a rea c , wou
1· ·d ted damages clause m . the agreem
e to
b · inc u e a 1quf1 da mages that would disc ent , pos s1'bl y
sett . our age the ·
parties from
. mg. a measure o t a most . s, courts en1~ orce r ' d t d
v10latmg the contrac · 1n jurisdic. tion 1qm a e
. .
lty provisions 1 ·r th are not ine qui tab ly high.
damages an d/ or pena ver dissatisfaceytory remedy: the
Damages could however be a. real goal of
k Y t f the corporation. It might
Pinocchio is to keep Lam~wic also be
. . h" ou t? stipulate in the agreement
important, 1n t 1s resp ect , if. the par ies that a
. . . .
breach would determine an ir_r
ble harm; in several Jur 1sd 1ct 10ns t h'1s
e_para d r or other injunctive reli
might help to obtain a re 5t raining ef against
or e
392 SHAREHOLDERS'AGREEMENTS C1-1. 8
Fox; but if the shares have already been transferred to a third party, it
might be very difficult-indeed, often impossible-to claim the right to
own the shares. The third-party buyer is not part of the shareholders'
agreement, and the agreement is not enforceable against him.
We want to underline one important comparative distinction in this
respect. A stock transfer restriction can be included in a separate
shareholders' agreement, or can be included in the bylaws of the
corporation. In the first case, what we have mentioned above in terms of
unenforceability toward third parties is true in most legal systems; but if
the provision is included in the governing documents, in some systems
(especially in civil law systems, for example in France, Italy, Spain) it also
bears against third parties. The rationale is that the bylaws, in these
systems, are a public document, and a third party, before buying the
shares, can obtain a copy: therefore there is a sort of constructive
knowledge of the agreement by the third party. In this case, the third
party might be forced to relinquish ownership of the shares and our
friend Pinocchio might be able to claim them; alternatively the transfer in
violation of the bylaws provision might be considered void. A good
example is German law. The German Corporation Law offers two ways to
limit the transferability of the shares. First, the charter of the corporation
,/ can state that the transfer of the share requires the approval of the
corporation (Sec. 68 German Stock Corporation Act). In this case a
contract transferring the shares without the approval of the corporation
would be void. However, this limitation, called Vinkulierung (from Latin
vinculum, meaning "chain"), can only be used for registered shares
(Namensaktien). For bearer shares (lnhaberaktien) such a limitation can
only be established in a shareholder agreement on a contractual basis,
and in case of violation only damages would be available. A provision
limiting the transferability of bearer shares in the charter would be
considered void.
In the U.S., the inclusion of stock transfer limitations in the bylaws·
does not make them automatically binding on third parties. Limitations
to the free transferability of the shares might be binding on third parties
if they are noted conspicuously on the share certificates, but inclusion in
the bylaws (which are often not a public document) does not suffice by
itself, to bind third parties. . '
Base_don this additional piece of information, let's go back to our
hypothetical. Put yourself once again in the shoes of Pinocchio's
counselor, and imagine that you are in a civil law system that follows the
above-mentioned approach (for example, Italy). Your client tells you:
"Hey, Fox and Cat have told me that for them it's the same to include the
right of first refusal in a separate shareholders' agreement, or in the
bylaws. What do you suggest to do to make the provision as strong and
effective as possible?"
~ CH,8
AG
SHAREHOLDERS'
trty, it Think about it for a REEMENTS 393
ght to consider th e percentage of shares
>lders'
held by the _three shareho:ome)nt ers . (hint:
You might be tempted t 0
After dall, if this makes it b"in d~uggeS t including the 1 . h e bylaws
n this ing o th' cause mt
iarate the a ":a~tage that Pinocchio willnb ir~ parties, the bylaws option ha~
Lampw1c or any undesired new e a le to recover the shares from
f the that you cai:i th~nk about. Even if :hareholder. There is however a twist
ms of
we are considermg, there is a que?ti~n\~:: nothing about the jurisdiction
but if you should ask yourself.
The question is· wh t
:tems ' . a are the r u 1es to amend a separate
~ also
sh are h oId ers agreement and t
norm all Y can only be amended
' . h th e bY1aws? A separate contract
o amend
:hese
parties; the default rule to a ~it h th e unanimous agreement of all
~ the
majority vote. In our case remmeenbt e bylaws, on the other hand, is a
ctive - • m er that p· h'
shares, while Cat has 55% and Fox 25 o/c _mocc 10 onl! has 20% of the
;hird 0
It is true that, ma way, a stock
transfer restriction in the bylaw . "strong "£ h
our s 1s
reasons; however Pinocchio sh ld b er or t e above-mentioned
8r in · ' ou e aware th t , oth er t h mgs' b ·
equal, if the clause is part of th b 1 a emg
good Cat alone) could change the b 1e yaws, ~a~ and Fox (and possibly even
rs to Yaws and ehmmate or modify the rule in a
way t h at would
. allow
. them to sell the sh ares. Th e 1.d ea, h ere 1s . that to
tion · amen' d ments of
answer t h IS quest10n you must know the rul es governmg
the · 1ar contract
e a
contracts
· h generally (usually ' unanimity) • and of th a par t Icu
t
that IS t e bylaws of a corporation (usually, majority).
tion
1tin It is however possible to have the best of both worlds. If the other
Lres ~hareholders (or _en_oug~shareholders to reach a majority) agree, you can
can mcl~de the restnc_t10_n m the bylaws, but also provide for a supermajority
SIS,
requirement to ehmmate or amend the restriction. For example , in our
10n
case, if a supermajority of 85% is necessary to amend the right of first
refusal, Pinocchio will have a veto power to prevent any undesired
be
modification. Also, you should make sure that in the jurisdiction you are
operating a supermajority requirement like this one is lawful and
ws enforceable (in some systems very high supermajority requirements, or
·llS unanimity requirements in corporate bylaws, are not acceptable for fear
'.eS of a deadlock). But once you have established this, you might help your
in client. Be also aware that in some countries the corporate statute itself,
by for some business organizations, might attribute a veto power on
amendments of the governing documen_ts t_o ~inority sharehold~:s; For
example, in a French simplified pubhc hmited c_ompa1:1y(societe par
.ir
actions simplifiee), provisions like the one ~e are d1scussmg can 01:ly be
,'s
introduced in and removed from the governm_g documents by unammous
1e
vote (Article L. 227-19 of the French commercial code).
1:
, gesti·on in any case, would be-if possible-to
Le A smart Iawyer s sug , . . .
shareholders' agreement and a provision m
:e ac t ua Ily have bot h : a separa te t . t'
d the bylaws containing a stock transfer res ric wn. -
(
CH. 8
-
394 SHAREHOLDER S' AGREEMENTS
One final insight. Also if your only option is a sepa~at~ contract with
other shareholders, and you cannot include the restramt .m the bylaws,
there might be other techniques to make a breach less likely ..18We have
already mentioned the liquidated damages provision, ai:id that fo~ sure
useful. Something else you might consider is to req~nre the parties to
deposit the shares with a trusted independent third party, ~.g., an
attorney or a bank, who will undertake the obligation not to deliver ~he
shares to a third-party buyer unless it is established that the pre-emptive
right has been offered to and refused by other shareholders. In
jurisdictions in which it is possible to establish a trust, a trust can also be
used to achieve this goal.
***
VOTING AGREEMENTS
Voting agreements are another common type of contract among
shareholders. Shareholders participating in a voting agreement basically
agree to vote at the shareholders' meeting of the corporation in a certain
way and following certain rules. In this respect, we can distinguish three
basic types of voting agreements. Ranking them from the less intrusive on
the shareholders' franchise to the more intrusive, they are: consultation
agreements, unanimity agreements, and majority agreements.
Pursuant to the first type, the only obligation that shareholders
undertake is to get together and consult among themselves before any
occasion in which they have to vote, either at a convened meeting, or by
written consent. The purpose of this "weak" type of agreement is simply
, _I
to facilitate the adoption of a shared voting strategy, but no specific
,;, I;;
obligation concerning how to vote is envisioned.
In a unanimity agreement, shareholders are bound to vote in the
shar eholders' meeting according to the outcome of a "pre-vote," but only if
they all agreed on how to vote at the upcoming meeting. Consider for
example a closely held corporation with five shareholders. Three of them,
A, B, and C, holding respectively 30, 20 and 5% of the shares, execute a
unanimity voting agreement. Pursuant to the agreement, before the date
of a shareholders ' meeting called, for example , to approve a merger, the
parties will get together or otherwise communicate according to what has
been established in the agreement. If the three of them agree that they
should vote in favor of the merger, this "pre-meeting" decision becomes
binding, and A, B, and C will have to participate either in person or by
.-!: .. proxy to the meeting, and vote accordingly (in favor of the merger). If they
.r'
do not, they have breached the agreement and might be liable for
damages. On the .other hand , if even just one of them, for example C with
o?ly_a 5% s~a_ke,1s contrary to the merger, without unanimity there is no
bmdmg dec1s1on, and each shar eholder is free to vote as he or she sees fit
.fJI· S SH
:.;:;;c..------~~A~R~E!HHOLDERs' AG
With in the following meeting I REEMENTS 395
aw 8 , · h ·
has t h e rig t to veto a sh dn other words, each b
1ave goal is to foster the b"l· are and binding d -~em er of the agreement
sure a 1 1ty of a gro ecision. Also in this case the
strategy, and the . effects of th e agreem
up of shareholders
t to ~10 11ow a common
s to a mere consu lt ation agreeme t h en are stronger than. th f
an if all the contracting partie n ; owever, there is a bind· idn . ~ case ol
the s see the issu mg ec1s10non y
F" 11 · e eye-to-eye
tive 1na Y,fm a majority voting pact th d . . .
In memb ers o the agreeme t b ' e ec1s1onof the majority of the
shareholders: based on th n ecomes binding also on dissenting
> be e contract all 0 f th
t hemse 1ves to the will of th . ; . e members must align
· u ·
meetmg. smg again the exam e rnaJority
f m t·
vo mg at the shareholders'
agreement the three of the p1e ? A, B, and C, pursuant to a majority
shareholders' meeting that mu~ w~11 have to get together before the
favor of the merger, and B s dvoC e ~11:a merger_.If A, holding 30% is in
majority (of the participants ·a~h ' Jointly ownmg 25% oppose it, the
,ng therefore all three sharehold~~s e agreeme?-t) supports the merger, and
Hy have breached the agreement. muSt vote m favor. If they do not, they
nn
·ee · N~edleless to say,. majority voting agreements are often the most
on attractive
. for the parties
. ' but .also the most cont roversia
· 1. Th ey are a
on typ1~a-1 co_ntrol enhancmg device: in the previous example A, with a
part1c1pat10n,of only 30:° thanks to the agreement controls, in fact, 55% of
the_ votes. As control 1s not absolute, in the sense that B or C might
rs dec1d~ to_breach the agreement, but there might be legal strategies, such
1y as a hqmdated damages provision or others that we will consider below
>y to make breach unlikely, if not impossible. The consequence is a possibl;
ly alteration of the proportionality between economic interest and voting
LC power. For this reason, some authors have even suggested the
unlawfulness of voting agreements, but as interesting as this position
e
might be from a policy perspective, it has rarely gained significant
traction in most modern corporate law systems. Two Italian scholars, for
tf
example, have in the past considered with skepticism these agreements:
r
Tullio Ascarelli at least since the 1950s, and more recently Guido Rossi,
.,
possibly also in ' light of the widespread use (and one might say abuse) of
i
this device in their own national system. Statutes have however recently
expressly regulated shareholders' agreements, . providing for. rules
concerning their duration and dis~lo~ur_e,_as w~ ~111_ see be~o:w,with the
consequence that today, in most 1urisd1ct10ns, 1t 1s 1mp_oss1b:l~_to ar_gue
the unlawfulness of shareholders' agreeI?ents per se, while cr1tic1sms ma
reform perspective is naturally still possible. ·
· ht · gain wonder why a minority shareholder, for
You m1g once a d · · · ·t ·
exam le C in the previous example, woul ~om a maJon y votm~
p . . · is voting freedom. There might be several reasons.
agreement hm1tmg h h h ld s to establish a formal way to
£ ·1 .
am1 y ties sugges m~
f to some s are o er
. Alternatively C might have been
coordinate their votmg strategies. '
-
396 SHAREHOLDERS'AGREEMENTS CH. 8
allowed to purchase shares in the corporation only under the condition

that he would sign the voting agreement. Again, there might be a mutual
benefit because, for example, C is the majority shareholder in another
corporation participated by A and B with minority stakes. Entering into
shareholders' agreements for both corporations, C makes A's position
stronger in the first one, and A makes C's position stronger in the second
one.
A couple of additional observations concerning voting agreements are
in order. Differently from stock transfer restrictions, which might be
included in a separate agreement only among shareholders and in the
bylaws of the corporation, voting agreements are rarely included in the
bylaws. One of the reasons, at least in some systems, is simply that voting
agreements are valid and enforceable as a separate contract, not binding
for the corporation, but are not valid and enforceable in the bylaws
because they might violate mandatory corporate governance rules. In
addition, as you can imagine, while a stock transfer restriction might
make sense also without a voting agreement, a voting agreement is
hardly effective if it is not accompanied by a limitation to the free
transferability of the shares. In fact, if shareholders A and B are bound by
a voting agreement, but one of them can sell the shares to a third party
that is obviously not bound by the voting agreement, the whole purpose of
the voting agreement would be frustrated. It is therefore fairly rare to
have a voting agreement not coupled with a limitation to the
transferability of the shares. This can however happen in situations in
which the shareholders with the right to vote are already clearly
identified, and the parties want to bind themselves only for the upcoming
A simple "vote pooling agreement" binds the parties, and the party
breaching the agreement might be required to pay damages. As we will
· consider below, since damages are difficult to determine in these
situations, a liquidated damages provision might be very important.
Additionally, as we also see below, sometimes courts might order specific
performance of the agreement. Damages are however clearly an
inadequate remedy: the parties want to ensure that the shares are voted
according to the agreement. Some legal techniques to reinforce voting
agreements, therefore, include depositing the shares with a trusted third
party, granting him an irrevocable proxy (to the extent that this is
possible) to vote the shares pursuant to the contract. Alternatively, in
systems that recognize the trust, one possibility is to transfer the shares
to a trust, and instruct the trustee to vote them according to the
agreement. The trust creates a separation between ownership and voting
rights because the trustee has exclusive power to vote the shares, and
therefore voting trusts are subject to certain limitations. For example, in
the U.S., under the Model Business Corporation Act, the voting trust
8
. :.-------..!:S~H~A
.£_;.:;.;.H• ARE HOLDERS' A
GREEMEN'
agreement must be £o d . " · , rs 397
. rin e w1th
corporation, and-most i certain for ..
extended (we will come b ~ortantly-is only m~~~ties, delivered to the
. ac to duration of . va 1 for ten years unless
A very important and d l' . votmg agreements below)
if shareholders can bind h e icate issue concern· . ·
in the shareholders' me t_ emselves not only to mg v_otmgagreements is
directors. A typical sc et1~g,_but also to vote vote':' a certain manner
only want to bind then:'!~::.: !~e f?llowing:~~a::~~~d:r~e~!~t;\:~
vote, as. members of the board ofo~~t each other as director, but also to
rectors, .to appoint A CEO of th e
. com
corporation, or to approve a certain
an ey d O t h at? Would th pensation package for execut'
C th
first part of the agreement
problem, but it is more unce~
(h:areement be valid and enforceable?!~-
? as shareholders)
v?fte is generally. not :
directors. As we know fro aC1hn 1 they can also bind themselves as
· t h at directors m
poss1'b'l11't y 1s h apter
h 6, an argument against this
interest of the corporation anda;~ t ~ duty to act diligently in the best
a risk of liability. In order to ca e s are~olders, a duty that also implies
0 th
to decide the best course of ac;.ry ; eir duties, directors should be free
circumstances, and cannot be ~on ~s~d on all the existing and variable
freedom. Courts appear someti::: to Yta; agreeme~t . that limits their
uphold these agreements, subject to cert ~ e andl~~s rigid approach, and
cases one from the u s d f ain co itions. The following two
' · ., an one rom an Ital' b' ·
framework to discuss this issue. You can find ;~n ~r itration, pro~ide the
both decisions after the second one. e otes and Questions for
CLARKV. DODGE ET AL.

Court of Appeals of New York
269 N.Y. 410 (1936)
CROUCH, JUDGE.
[The facts], briefly stated, are as follows: The two corporate
defendants are New Jersey corporations manufacturing medicinal
preparations by secret formulae. The main office, factory, and assets of
both corporations are located in the state of New York. In 1921, and at all
times since, Clark owned 25 per cent and Dodge 75 per cent of the stock of
each corporation. Dodge took no active part in the business, although he
was a director, and through ownership of their qualifying shares,
controlled the other directors of both corporations. He was the president
of Bell & Co., Inc., and nominally general manager of Hollings-Smith
Company, Inc. The plaintiff, Clark, was a director and held the offices of
treasurer and general manager of Bell & ~o., Inc.,.and also had charge of
the major portion of the business of Holhngs-Sm1th Company, Inc. The
formulae and methods of manufacture of the medicinal preparations were
known to him alone. Under date of February 15, 1921, Dodge and Clark,
the sole owners of the stock of both corporations, entered into a written
______
~31!9§.8 1S~H~A~R!_!E~H~O~L~D~E~R~S['~A~G!!:R~E~E~M~E~N~T~S::-..-----..::C
. fter reciting the stock ownership of both
agreement under seal, which a k h Id continue in the efficient
parties, the desire of Dodge that ~lar sfoBu11& Co Inc. so long ash
of the business o e t t so ·'manage ' and cont e1
managemen t an d cont roI . O
should 'remain faithful, efficient and ~ompete~l k hould not be the 0 rf
the said business'; and his further desire t~:t h ar :-1s knowledge th/ ~
custodian of a specified formula, but s~ou s are0 f Dodge provided re?
and of the method of manufacture with a ~on_ ' . , in
t> 11 . Th t Dodge during his lifetime and, after his death,
su bs t ance, as 10 ows. a t h' t k and
a trustee to be appointed by his will, would so vo e is s oc_ so vote
as a director that the plaintiff (a) should continue to be a director of Bell
& Co., Inc.; and (b) should continue as its general managers~ long_as ~e
should be 'faithful, efficient and competent'; (c) s~ould _during his hfe
receive one-fourth of the net income of the corporat10ns ~ither by way of
salary or dividends; and (d) that no unreasonable ?r incommensurate
salaries should be paid to other officers or agents which would so ~educe
the net income as materially to affect Clark's profits. Clark on his part
agreed to disclose the specified formula to the son and to instruct him in
the details and methods of manufacture; and, further, at the end of his
life to bequeath his stock-if no issue survived him-to the wife and
children of Dodge.
It was further provided that the provisions in regard to the division
of net profits and the regulation of salaries should also apply to the
Hollings-Smith Company.
The complaint alleges due performance of the contract by Clark and
breach thereof by Dodge in that he has failed to use his stock control to
continue Clark as a director and as general manager, and has prevented
Clark from receiving his proportion of the income, while taking his own,
by causing the employment of incompetent persons at excessive salaries,
and otherwise.
The relief sought is reinstatement as director and general manager
and an accounting by Dodge and by the corporations for waste and for the
proportion of net income due plaintiff, with an injunction against further
violations.
The only question which need be discussed is whether the contract is
illegal as against public policy within the decision in McQuade v.
Stoneh~m, 263 ~-Y: 323, 189 N.E. 234, upon the authority of which the
complaint was d1sm1ssed by the Appellate Division.
'The business of a corporation shall be managed by its board of
directors.' General Corporation Law (Consol.Laws, c. 23) § 27. That is the
statutory norm. Are we committed by the McQuade Case to the doctrine
that there may be no variation, however slight or innocuous from that
norm, where salaries or policies or the retention of individu~ls in office
are concerned? There is ample authority supporting that doctrine. E. g.,
' '
8
0!_:~-:.
· ~==~~S~HA~R~EH~O~LD~E~R~st'l:A~G
REE~~~
MENTS
~-----_j!fil! 399
West v. Camden, 135 Us
507 • l0 S.Ct 838
Hooper, 76 NJ· ·E q. 592, .75. A. 5 L· , 34 L.Ed. 254 ; Jackson v.
"-I:Sal~mon ~ Co., [1897] A.C. 68,' 27 a .R.A
since 1t furnishes a simple if 22 b'44' nd . (N. S) 658. But cf. Salomon
a m1..rust ra t'1ve convenience ' th ar itrary te somethmg may be said for it
' t A t from
d
mor~ or 1ess ne bulous. Pub' lic e polreasons up s · h'par h . its practical,
ic . .
detnment to the corporation ar hy, th ~n w i_c 1t 1s said to rest are
little. Possible harm to bona' fid: p r~e e mtention of the Legislature,
s which in this connection mean
stock.holding minorities have m pur~
ase
in many instances If the ·en£ ore su st rs of stock or to creditors or to
ance; but such harms are absent
nobody-not even· in any orce~ent
of a particular contract damages
reason for holdin~ it illegaiercep ibh
le de~e:, the public--0ne sees no
broad provision of section ,2 eve[n t ] ough it impin r htl th
7· · · · Where the dire ~esctos ig
rs Y upo
are then sole
e
stockh old
h ers, t h ere £
seems to. be no obJecti. on t o en1~ orc·mg an agreement
among t em to vote or certam people
as officers.[ .. .]
Except for the broad dicta in the Mc
Quade opinion, we think there
can be no ~oubt that the agreement
here in question was legal and that
the complaint states a cause of action.
There was no attempt to sterilize
the board of directors, as in the Manso
n and McQuade Cases. The only
restrictions on Dodge were (a) that
as a stockholder he should vote for
Clark as a director-a perfectly legal contract ; (b) that as dire
should continue Clark as general ma ctor he
nager , so long as he proved faithful ,
efficient, and competent-an agreement which could harm nobody
that Clark should always receive as ; (c)
salary or dividends one-fourth of the
'net income.' For the purposes of this
motion, it is only just to construe
that phrase as meaning whatever
was left for distribution after the
directors had in good faith set aside
whatever they deemed wise; (d) that
no salaries to other officers should
be paid, unreasonable in amount or
incommensurate with services render
ed-a beneficial and not a harmful
agreement.
If there was any invasion of the pow_ersof
the direct~rate under. th at
agreement, it is so slight as to be neg
ligible; and certainly there 1s no
damage suffered by or threatened to
anybody.[.·.]
MR.Av.XYZ
Arbitral Tribunal, 2011 .
November 2011 '
. ·· B c· llone (President), G. Rossi,
Arbitrators: . ava G. De Nova
[... ]
Facts .
. t d on the stock exchange managed by
Borsa
XYZis a corporation 118 e
Italian s.p.a. since March 2007.
SHAREHOLDERS'AGREEMENTS C.!:!.:_!
412 . . ht h
. . . f the exercise of votmg rig s s all not
° ·r1 e owes a duty not to exercise its
It follows that an mJu~ctwn
be ordered as a rule, ev~n if e0
voting rights under Article
th
17
r:: f e
~;eement
ly when
in this case. Injunctive
(i) all shareholders are
relief may be gra~ted as an excep t)
i~n the Agreeme nt clearly requires
certain manner.
parties to the votmg agr~emehn~, an tingnrights in a
shareholders not to exercise t eir vo
NOTES AND QUESTIONS
. d b the restrictions of the availability of injunctive
entdi~~ema :sv~he court denied that Art. 17(1) of the Ccontract
. fl. Asbi:nt
re 1ie are o i er ic u ' t· . question
executed by the shareholders covered the transac wn m . . · ompare
the approach to contractual interpretation of the Nagoya Di~trict Court to the
th mk are the most
one followed in In re Estate of Mather: what do you
remarkable differences, if any?
'r 2. Do the restrictions on availability of injunctive relief imposed by the

Nagoya District Court make sense? Why yes, or why ~ot? ~ot~ that Japan, as
a civil law jurisdiction, permits specific performance m prmc1ple as a matter
of general contract law (Art. 414, Japanese Civil Code).
3. Even if specific performance of voting agreement in form of
injunction to vote in violation of the agreement is available, the validity (or
invalidity) of a vote in violation of shareholders ' agreement vis-a-vis the
corporation is a different problem. This is because shareholders' agreements
are only governed by the law of contracts and only have effects among the
parties of the agreement (the issue might be more complex if the corporation
is also a party to the agreement) . As mentioned, this is generally, and
somehow simplifying, also the case in countries such as France, Spain, and
Italy . · .
. 4. Does the position ~f the Nagoya District Court offer any argument
with respect to the question of the validity of a vote in violation of
shareholders' agreement vis-a-vis the corporation?
DISCLOSURE AND DURATION OF

SHAREHOLDERS' AGREEMENTS-
I INTERNATIONAL LAW ASPECTS
I · 11Y stock transfer restrictions and
lders' agreements.' especia
! t · Shareho .
i vo mg agreements, have an impact on the ip structure of the
!
I
corporation As we h ave d"1scussed a sh hownersh
· Old
f I
:l
·1 devices to control a number of votes' si . are e~ can use these legal
I
. gnfificantly higher than the ones .he
I
would be entitled to on th b as1s

I
> J h
l e o the h e owns. Votmg
~ J agreements in other words , can separate O s ares h" k
' '
j
J transfer restrictions, on the other h nd wners 1p and control. Sta~
•j"
i structure of the corporation d . a • can freeze the ownership
'f•
;
l
j ' an impede or make difficult third-party
-~
1
·1
,,,
. t
1l
\
'
~ .9!=--8 SHAREHOLDERS'A
~
_____ _!!!
. · · --~~G~R~E~E~M~E~N~T~S 413
nsof control. Es e . .
11not 8 cqu1s1t10
3
problem. t·
p cially in listed corpora ions, this can be a
ise its
nctive Most legislatures ' ho wever rath
rs are · · sh are h o1ders' agree er than prohib"t"1 mg or narrowly
Iirn1.etmg d ment's (a ri ·d
iuires ion that might be difficult
to eniorce an contrast with contractuaf1 solut opted for allowing
these contr~cts, but regulatin freedom), have
shareholders agreements and f.
~~em mandating
g their maxi .
disclo
mum
sure of
durat i·on
Disclosure. andb duration provi·s1·ons imitm
are co .dered to achie .
nsi ve a desirable
1ctive compromise etween contractu 1 f
need to protect
1tract shareholders and third parties. a reedom and the
1pare
Disclosure. obligations are generally provid d £ 1·
o the
he ld corporat10ns, not for closel h ld e or 1sted or publicly
most
transparency of the ownership s~ et ones, for the obvious reason that
nd bution of power
is particularly important when t{uc ;:re a of the distri
investors can acquire them. At a e ~ ~res are. traded
7 the on the market and
1, as much stricter for listed than £or cmlose ini mum, disclosure requirements are 1
1y-held corporal" F
under Italian law, most stock transfe r ·t .
· ion~. or examp e,
1tter
in listed corporations are null and vr. 01~~~
.
:!wns and voti~g agreements
1 . ey are not disclosed to the
1 of Italian Securities and E xch ange Comm1ss1on (Cons0b) ·th· fi d
publi shed · · WI m days ays
ive after
· (or after .execu tion , . ma national newspaper withi n ten
f
the execution,
· Ifandh filed ·
with a public reo-is 4
i:. i in fift
ter w'th· i een d ays rom
·
mts
· h tion.
execu t bese disclo.sure obligations are not comp1·ie d w1'th , voting
the rig ts cann~t e _exercised, and if they are the resolution of the
ob (Article 122 of
ion shareho~ders meet~ng can be challenged also by Cons
In addition in
md the Italian Consolidated Law on Financial Markets).
md publicly · held corporations shareholders' agreements must also' be
of shareholders'
deposited with the corporation, and the existence
of any shareholders'
mt agreements must be disclosed at the beginning
In France, any clause
of meeting (Article 2341-ter of the Italian Civil Code).
terms and conditions
in a shareholders' agreement allowing preferential
h are admitted to
to be applied to the sale and purchase of shares whic
at least 0.5% of the
trading on a regulated market and that amount to
Financial Markets
capital or voting rights must be submitted to the
AMF). Failing such
Authority (Autorite des marches financiers, or
, and the parties are
submission the effects of that clause are suspended
d released from ' their undertakings while any public offer of sale is in
AMF. Note that only
e progress. These provisions are made public ~y the
to the AMF and the
tl the relevant provisions have to be commumcated
e public, not the entire shareholders' agreement.
rs' a~eements
rT
:, Again under Italian law , the duration. of shareholde
t d th e years in listed corporat10ns,l"dand dfive years m closely
cannot L F' · 1
excee re n ?o.ns o ate aw on mancia
)
held ones (Articles 123 of the Italia 1
). Agreements can be
r Markets and 234l-bis of the Italian C1~l. Code
.red for an add1t10na three or five years, but
l
r enewe d a fter t h ey h ave ex Pl
I
I
CH. 8
SHAREHOLDERS' AGREBIE?\TS
414
sharchnlders have an opportunity to decide if they want to continu~ to be

bound, thu s avoiding the risk of becoming prisoners o~the corporation . I~
France there is not such a short limit to the duration of shareholders
ngree mcnts in listed corporations but, as mentioned before , case law
indicat es that agreements with excessive duration are not upheld ,
typically over ten years.
As previously stated, also in the United States t~ere are statuto~
limitations to the duration of some shareholders agreement.s , m
particular for those agreements that take the form of a voting trust.
Pursuant to Section 7.30 of the Model Business Corporation Act , for
example, a voting trust "is valid for not more than 10 years after .its
effective date unless extended" with the written consent of the parties. sb
Occasionally courts have concluded that a pooling agreement combined lil
with the deposit of the shares and an irrevocable proxy should be treated st
as a voting trust with respect to maximum duration (see Abercrombie v. sl
Davies, 130 A.2d 338 (Del. 1957)). Cf
It is probably clear that the rationale underlying the maximum il

duration provisions relates also to the desire to foster a market for J
corporate control, since it prevents entrenchment of some shareholders.
One interesting rule at the European level, in this respect, is the
breakthrough provision set forth by Article 11 of Directive 2004/25 on
takeovers. We will discuss takeovers and tender offers in Chapter 10, but
it might be interesting to anticipate something about this rule. Clearly
enough, shareholders' agreements can hinder the possible success of a
tender offer. To the extent that an efficient market for corporate control is
desirable, therefore, the European regulation of tender offers limits the
effects of stock transfer restrictions (both in the bylaws and in a separate
agreement) and of voting agreements when a public offer is launched.
Consider this rule:
Article 11, Paragraphs 2 and 3, Directive 2004/25/CE
"2. Any restrictions on the transfer of securities provided for in
the articles of association of the offeree company shall not apply
vis-a-vis the offeror during the time allowed for acceptance of the
bid laid down in Article 7(1).
Any restrictions on the transfer of securities provided for in
contractual agreements between the offeree company and
holders of its securities, or in contractual agreements between
holders of the offeree company's securities entered into after the
adoption of this Directive, shaU not apply vis-a-vis the offeror
during the time allowed for acceptance of the bid laid down in
Article 7(1).
3. Restrictions on voting rights provided for in the articles of
association of the offeree company shall not have effect at the
CH. 8 Sa .
~ ~:..;..-----~~":\REHOLDERS' A
GREEllEXTS 415
be general mee ting of sh
·m accordan arehold
. ers which d ·d
In measures
ce "'1th Article 9 ec1 es on any defensive
:rs' . t·
Res t nc ions on vot - . ·
l\.V ing n°h t provid ed fo .
agreements between th o s
d, securities , or in contractue aloffer ee company a:_d~olcdontr act~al
ers of its
~ agree Id
oueree company's securit· ments bet ween h
~y this Directive shall n t ~es entered into after tho :rs ?f th e
shareholders 'which doec1_dave optt~on off
effect at the gener:i amee
n . es on .mg o
·
t. accor d ance with Article 9 .,, an y defens ive measur es m
,:r
s NOTES AND QUEsno Ns
l. How differe nt are th ruI · the duration of
l h Id ' es regardin g extending
e Itali
h a:e ? ers agreements
s_ under
1inutat10ns of duration of shareh Id :,inlaw and under the MBCA
( ? Also
statutes but by case law. For ex:mer~ agreements could be provid ed.not b;
held that
shareholders should not be bound bp ' one_Japanese lower court
after "a period of
considerable length" has passed (lO Y a vo~g thagreement
consid ering the
intent of the parties . (Tokyo ff i;e~s m e case), also
. _durt, May 30, 2000 , 1750 Hanrei
Jiho169) . It is preferable to ad optiga ngi statutory ru1e, or a more fle:n"bl e
standard that courts can apply in this area?
2. Comm ent on the breakthrough proVIS1·0· n above WI"th respect to

" · t· t h ies " What does 1·t mean, an d h ow b roa d
.restnc 10ns . . o t e transfer of securit -
1s the provisr nn? h For examp le, a covenant that would req"~ ...e one sh are h oIder
f llin u.u.
g price of her shares to other shareholders if she
0 ,,
to pay 5 , o O t e se
Wha t is
decide~ to sell them, is a "restriction" pursuant to Article 11 above?
the ratrnnale of the rule?
under
3. What about voting agreements? As we will see in Chapter 10,
of a tender offer, defined as any
European law defensive measures in case
(e.g., purcha sing own
measure that might frustrate the success of the bid
ed by the
shares, issuing new shares, selling assets, etc.), must be approv
they want to
shareholders' meeting . This is to allow shareholders to decide if
, if they prefer to
tender their shares or, if the offer is not value-maximizing
ents are
resist it. In this scenario, the Directive provides that voting agreem
meetin g called _ to vote on
not binding with respect to the shareholders'
ture has
defensive measures . Can you explain why the European legisla
adopted this rule?
o Article 12 of Directive 2004/2 5, the rules reprinted ·
4 . P ursuan t t . 1 · h D·
tory but optiona l. In ~P e~entm g t e irective ,
above are not manda r 10, had the
discuss more extensively m Chapte d · hi
Mem ber S tates, as we willkthrough provision or to. opt
f· (
out o 1t an m t s case
. d h b 1 ) Th e vast
opt 10n to a opt ·t e reauld decide to introduce 1t m their by aws .
- ·
· I . dated the breakthrough rule.
smg e corporations co
. . f E untnes has not man rough rule : Estonia, Latvia,
maJonty o uropean co the breakth
Only three States have man~ated t financial markets of the Union. The
and Lithuania-not the most 1mportan
416 SHAREHOLDERS' AGREEMENTS CH. 8
consequence is that most shar eholders ' agreements would remain binding
also in the case of a tender offer. Can you think of pos sible reasons why
Member States have decided to avoid the breakthrough rule?
***
A shareholders' agreement is, as we now know very well, a separate
contract, distinct from the charter and bylaws of the corporation. In
principle it can include a choice of law provision pursuant to which
parties can subject the agreement to the laws of a system different from
the one that governs the internal affairs of the corporation (at least if the
provision does not indirectly affect the structure of the corporation) .
Similarly, the parties can give jurisdiction over disputes arising out of the
shareholders' agreement to courts of a different country or to an
arbitration panel.
As for choice of law, in the absence of an explicit provision most
courts would apply the laws that govern the corporation. As you will
remember from Chapter 2, this means the laws of the state of
incorporation but, in some systems, it might mean the laws of the country
where the corporation has its "real seat." In the U.S., when a choice oflaw
clause has not been included, sometimes parties have tried to argue that
the shareholders' agreement was subject to the laws of the state where
the agreement was executed, or where it had to be performed, if different
from the state where the corporation was incorporated. Courts have
however generally declined to follow this approach, and applied the laws
applicable to the internal affairs of the corporation (for a brief discussion
of this principle, see again Ringling v. Ringling Bros. (29 Del.Ch. 318
(1946)).
Choice of forum or arbitration clauses are generally admissible, if
they do not undermine the public policies of the country in which the
decision will have to be enforced. The previous Mr. Av. XYZ arbitration is
a fitting example.
FOCUS ON SHAREHOLDERS' AGREEMENTS

IN LISTED CORPORATIONS
In Cha~ter ~· disc~ss~ng ~ultiple voting shares, we cited a study on
the Proportionality P~1n~1ple1n the European Union, commissioned by
the European Comm1ss10n to Sherman & Sterling, ISS and ECGI
published in 2007. 1 The same study presents interesting data on the use
of shareholders' agreements in listed European corporations. The data in
fact, take only into account the largest listed corporations, therefore they
do not tell the whole story, but are still significant:
1
Available at http://ec.europa .eu/internal _market/company/docs/shareholders/stud /final
report_en.pdf. Y -
.0J· 8 SH
::,:;:c.~------2.!YAREHoLnERs' AG
--=:..:cR~E,.c.EMENTS
ling ---- _____
---..:::.::::_ ~4!]1~7
vhy Percentage of "I
argest" EU
sharehold • corporations with
35% r3111%% -- ..!.-.._______ ers agreements
3.te
In
ch
25%
30%
20%
==
====
--======= ==
==
>rn 15%
he 10%
1).
5% +--l~----
1.e 0%
0% t--"--.--- --,-- ~_J
Ln
;t
11
>f As mentioned, the data offer an . t .
y example no shareholders' agreem t m eI~st mg, but partial picture. For
V which they are used also in liste~n s are tted for Germany, a country in
t considered the largest 20-DAX corcorpo~a ion, beca~se the research only
as -Henkel Metro and Po h
' '
0
i;-
hrahtions,excluding corporations such
rsc e, w ic ave shareholders' agreements In
· Ecase, the data
any · reported clearly
. ·
indicate that sha reh olders , agreements
m uropea_n hst~d corporations are quite widespread, especially in civil
law countries with a more concentrated ownership structure (Belgium
France,_Italy, Spain), and less in the U.K., a common law system with~
more widespread ownership structure. In the U.S., as mentioned before
most manuals, casebooks, and treatises only discuss shareholder;,
agreements in the context of closely held corporations, or at least consider
~hem a typical feature of this type of organizations. Japan might again lie
m the middle. In this country, discussions regarding shareholders'
agreements center on closely held corporations, as in the U.S.; but voting
agreements in public corporations have been reported. In addition, as
noted in Chapter 1, cross-shareholdings are fairly common in Japan; for
example, a public corporation often has many shareholders, each holding
less than 5% of shares, who have business relationships with the
corporation. The corporation, in return, also holds the shares of these
shareholders. Although there is no formal shareholders' agreement
among these shareholders, it could ~e argued that they act. under ~n
implicit understanding to support the mcumbent management 1f a hostile
shareholder appears. ·
The limited diffusion of shareholders' agreemen~s as a control
· d · · th UK and in the U.S., as well as mother common
en hanc1ng ev1ce
· 1nfi e d · lso . ·
· by recent empirical · H . M asullo,
analysis.
1aw systems ' 1s con 1rme · A comparison
t · a Publicly Traded Companies: ·
Shareholder Agreemen in
I Cl
CH.8
--
418 SHAREHOLDERS'AGREEMENTS
Betwe en the U.S . and Brazil (2015), available on u:z.:;w.ssrn .~om, notes
that in the period between 2010 and 2012, 54 Brazilian publicly-traded
corporations had signed 64 shareholders agreements, and 6? U .S. ones
signed 69 ones. Considering that as of 2012 there were appr~ximately 353
listed corporations in Brazil and 4,102 in the U.S ., .it is clea.r how c
relatively uncommon these agreements are in t~e U.S. ~n comparison to
other (civil law) systems . This poses an mterestmg conundrum .
']
~
Shareholders agreements might be very desirable for some shareho~ders,

to limit the risk of hostile takeovers , reinforce control, or also simply
coordinate with fellow shareholders . Why are they therefore not used (or
not so commonly used) in the U.S.?
One explanation is for sure based on ownership structures.
Shareholders agreements tend to be less common where ownership
structures are more widespread, if nothing else because it is less
important-and more difficult-to gather a minimum number of
shareholders with enough shares to render the execution of a
shareholders' agreement an effective control enhancing device. In
addition, shareholders' agreements tend to be more used in systems in
which a relative small number of shareholders own significant cross-
holdings in different corporations. For obvious reasons it is easier, in
these systems , that two or more parties enjoy a reciprocal advantage by
entering into several shareholders' agreements, and it is easier to
coordinate a small group of influential shareholders.
In addition, at least in the U .S., some state statutes prohibit certain
types of voting agreements in public companies. Section 7.32 of the Model
Business Corporation Act lists several voting agreements that "cease to
be effective when the corporation becomes a public corporation" : for
example, agreements restricting the discretion or powers of the board of
directors (like the one in Clark v. Dodge), allowing distribu tions to
shareholders not proportional to the shares owned ; requiring dissolution
of the corporation at the request of one or more shareholders or upon the
occurrence of a specified contingency , and so on. Also the Florida
Business Corporation Act, just to give another example, provides that
some shareholders agreements cease to be binding if the corporation is
listed.
Widespread ownership structure and rules akin to 7.32 of the MBCA
do not, however, seem completely satisfying explanations for the limited
use of shareholders' agreements in the U.S. In the following excerpt from
an essay, Professor, Ventoruzzo offers some possible specific legal reasons
why shareholders agreements · are not widespread am r
t d
corporations in the U.S. ong is e
ca.8 SHAREHOLDERS' AGR EEMENTS 419
.;;--
HYS
MARCO VENTORUZZOINW LHAREHOLDERS' AGREEMENTS
us
ARE NOT USED
ED CORPORATIONS: A
CONUNDRUM IN SEARc:T ANATION
N OF AN EXPL
Penn State Law Research Pa per o 42-2013 (avai·1abl eon www.ssrn .com)
·
explore oth .
It is [interesting] to ion erh,slp ficrules thatt mi ght create a
u . d
disincen tiv e to the dif fus of h
s led
eci
are O ders' greemen s m t h e nite
a r·
ow
States]. This exercise, to my knthoug~;. has not been attempted before, so
I will try to offer some food for
First of all, entering into ea diffe;:n~
poison pill. A poiso n
pe
pil l
it
can
rov
tak
id
ro::
sha h ld
a~eem en
_s, ut gene
t can
.
trig ~er_ a
~ally and in the
trig ge red by
its
more common . sha
. . . P es a catastrophic evenht ld f h F
n, wi tho ut bo ard
. 's ap pro val , of a set th res o o s ares. t' or
acquis itio . . · th e corpora ion
uisition of a 150;ro/ st a k e in
exampIe, in a typical pill, acq . excepti'on of th e ones t rig · gerin · g th e
11 a 11 s h are ho lde rs ' wi th the
wo Id
. u a ow . . .
on co mm on sto ck at a p ric · e b e1ow th e ·
ns rig hts
pill, to ex.ercise P .opt10 . the acquisition of the set
k ce. 01 s?n pil!s are often triggered by of
ma r et pri
ne si~ gle inv est or, bu t can also be triggered by a "group"
~hreshold by o_ reholders'
act ing in co nc ert . Since the parties of a sha a
mvest ors
be co nsi de red me mb ers of a group, the stipulation of
agreements can r a poison pill and have very nega
tive
' ag ree me nt can trig ge
shareholders ment.
:ce s ~n the co rpo rat ion an d on the members of the agree has
conseque1 n pills
shi p be tw een sha reh olders' agreements and poiso
The rel ati on
ve ry mu ch , bu t I po sit tha t the fear of triggering a pill
not been studied to the stipulation of shareh
olders'
a po we rfu l dis inc en tiv e
might be
agreements. or
pu rsu an t to the W illi am s Act, beneficial owners of 5%
Second ly, icating also
co mm on sto ck mu st dis close their participations, ind
more of
acq uis itio n, an d dis clo sin g any 1% or more increase
the purpose of their Th e members of a shareholders'
the ir pa rtic ipa tio n.
or decrease of red a "group" for disclosure purpo
ses,
ll ge ne ral ly be co nsi de
agreement wi ly with the disclosure provis
ions if
ore be req uir ed to co mp
and theref create a
ly the y cro ss the 5% threshold. This can also
collecti ve
int o a sha reh old ers ' ag ree ment, especially because
disincentive to enter rpo ses of the beneficial owner. Both
dis clo sur e of the pu
U.S. law requires urs might be very reluctant to
est ors an d en tre pre ne
institutional inv context. Hence another po
ssible
ir str ate gie s in thi s
disclose the ·
inc en tiv e to sha reh old ers ' agreements.
dis the limite d used of
al an d ov erl oo ke d ex pla nationd for. Id b fi .
On a dd't' . 1c es co u e ou n 1n
e I ion control-enhancing . ev.d d. . .
shareh oId ers , agree ments as gin a m~~
1 er tra 1n g pro VI s~on
Ex ch an ge Ac t, the ~ri
section 16(b) of the -sw ing profits. In a nutshell, sect10
n
at are cal led "sh ort
that regulates wh liz e a profit on a purchase and sal. .
e, or
th t 'f "' 'de rs" rea
16(b) proVI'd es a 1 1ns1 n
ase , of be ne fic ial ly ow ne d stock of the company w1th1
a sale and purch
420 SHAREHOLDERS'AGREEMENTS CH. 8
any six-month period, the profit is recoverable by the company. F~r
example, if the CEO of a corporation buys one share at $5 and sells it
three months later at $7, she will have to disgorge any profit ($2) back to
the corporation. Basically, there is a presumption that the pr~fit was
obtained using inside information. For the purposes of this rule,
"insiders" include directors, officers, and beneficial owners of more than
10% of the common stock. One crucial question is if members of a
shareholders' agreement could be considered as a single beneficial owner
of shares for the application of this rule. If the answer is affirmative, any
shareholder owning less than 10% will be reluctant to enter into a
shareholders' agreement that aggregates more than 10% of the shares,
because her ability to profit from trading on the shares would be
significantly limited.
Also corporate law statutes, at the state level, can deter the
stipulation of shareholders' agreements. In this case, obviously, Delaware
law is particularly relevant. Space constraints force me to oversimplify
the issue, but to give an example section 203 of the DGCL provides, in
relevant part, that stockholders who acquire beneficial ownership of more
than 15% of the stock of the corporation without prior board approval
become "interested stockholders ." Such interested stockholders cannot
enter into business combinations such as mergers, consolidations, but
also other transactions with the corporation for a period of 3 years
without supermajority approvals. The act of entering into an agreement,
arrangement or understanding with other stockholders could cause the
stockholders to be attributed ownership of the other shares subject to the
agreement, which would limit the possibility to do business with the
corporation.
NOTES AND QUESTIONS

1. What do you think of these possible explanations for the limited role
of shareholders' agreements in U.S. financial markets?
2. Based on our discussion, do you think that shareholders'
agreements should be prohibited in listed corporations? What are the pros
and cons of shareholders' agreements, also considering the broader interest to
have well-functioning financial markets? A suggested exercise is the
following: imagine the class is the parliament of a country of your choice, and
divide the students into two groups. One group has to support a bill
prohibiting shareholders' agreements in listed corporations, the other one
should oppose the bill, and suggest instead that shareholders' agreements
should be allowed but, possibly, regulated with respect to duration and
disclosure. What would be the most compelling arguments? Is it relevant
if
the bill is discussed in a country with concentrated or widespread ownership
structures?
CHAPTER 9
MERGERS AND ACQUISITIONS

•••
INTRODUCTION
This chapter addresses extraordinary financial transactions in
particular mergers and ac~uisitions (M&As). Acquisitions of a controiling
stake in a listed corporat10n through a public offer and other takeover
issues will be discussed in the next chapter.
The regulation of M&As in the jurisdictions we will be considering
presents profound comparative differences, but also important
similarities. In Europe, for example, several aspects of the rules
concerning mergers (and spin-offs) have been harmonized with Directive
78/855(and Directive 82/891). The topic we are tackling here is extremely
broad, and it is not possible to treat it in a comprehensive way in the
space we have. As in other chapters, therefore, we have selected some
specific issues that we ·consider particularly interesting or relevant for
this course, both practically and theoretically. The chapter is organized as
follows. First, by way of general introduction, we will take a look at
mergers and acquisitions from an economic perspective. This introductory
part will not discuss specific comparative differences, but rather
concentrate on three issues: what distinguishes different acquisition
techniques (sale of shares, sale of assets, ·contributions in kind , mergers,
and spin-offs), but also what they have in common; the basic economic
structure of a merger and the meaning and calculation of the exchange
ratio; and some empirical evidence concerning M&As. Second, we will
discuss sales of all or substantively all the assets, focusing in particular
on the so-called de facto merger doctrine. Third, we will talk about
leveraged buyouts, a particular type of acquisition technique involving
debt and mergers. Finally, we will concentrate on cash-out mergers and
freeze-out transactions, illustrating some interesting differences between
U.S., European and Japanese law.
AN OVERVIEW OF MERGERS AND ACQUISITIONS

· A merger · is a transaction in which the assets and liabilities of a
corporation (A) are transferr ed to another one (B). A is extinguished as a
consequence of the merger, and B issues new shares to the former
shareholders of A. A variation is a consolidation, in which the assets and
421
~
1 / . ·.,
~4~2~2
------~M!!E~R~G~E~R~S~AN~D~A~C~Q~U-!.!.I~SI~T~IO~N~S:::..------~~
liabilities of two corporations (for example, A and B) are tr~nsfe_rred to a

third newly incorporated entity (C), A and B are extinguished by
operation of law, and C issues new shares for the former sha~eholders of
A and B. Consolidations are much rarer than mergers,_ ess_entially for tax
and practical reasons (in most systems, consolidation~ are less
advantageous than mergers) and for practical reasons. We will therefore
focus on mergers.
In a merger, B, the surviving corporation, acquire_s A, ~he corporation
merged with and into B; or, more precisely, acquires its assets and
liabilities. The consideration paid to the shareholders of the acquired
corporation is generally newly issued shares of B, with the consequence
that the ownership structure of B after the merger will change, and its
shareholders will include both the old shareholders of B, and the new
ones who owned shares of A. As we will see, however, at least in some
systems, the shareholders of the corporation extinguished as a
consequence of the merger might also be liquidated in cash (cash-out
merger). In addition, sometimes a wholly owned subsidiary of a
corporation is merged with and into the parent. In this case, no new
shares are issued and the transaction is generally simplified.
A first basic concept that should be understood is that a merger is
one way to acquire the business of another corporation, and in this
perspective it can be compared and contrasted with other similar
transactions. Consider the following example. Corporation A has two
shareholders, X and Y, and corporation B has only one shareholder, Z.
I
Now imagine that Band its shareholder Z want to acquire the business of
A, meaning its assets and liabilities.
One possibility, obviously, is for Z to acquire the shares of A from X
and Y. In this case the transaction will result in Z being the sole
shareholder of the two corporations. Alternatively, the shares of A could
1 be purchased by B, with the consequence of creating a group of
corporations in which Z controls B, and B controls A. Another option
would be for A to transfer its assets and liabilities to B. The assets and
liabilities can be sold to B for cash, with the consequence that A will only
own cash and B the business that used to be managed through A (at
which point A might invest the proceeds of the sale in a new business, or
dissolve and distribute the sums received to X and Y) . A could, however,
also transfer its assets and liabilities to B with a spin-off and a
contribution in kind to B (see Chapter 3): in this case, B will issue new
shares to A. Note the similarities and differences with other scenarios:
here, once again, B will own the business of A, but A (and indirectly its
owners X and Y), becomes a new shareholder of B, together with Z.
Finally, in a merger, the assets and liabilities of A are transferred to B, A
is extinguished, and B issues shares directly to the former shareholders of
_9!J.-- MERGERS AND ACQUISITIONS 423
X and Y. In this case, the ownership structure of B after the merger

!hiincludeX, y, and Z.
Needless to say, t~ese different transactions have profoundly
differentlegal, tax, financial, econ_omic,and organizational consequences.
Otherimp?rtant consequen~es might be determined by antitrust issues
( ntitrust 1s often relev~nt 1n large acquisitions), or labor and industrial
;lationships. One particular road might be preferable for a broad range
r reasons. In a way, however, they also all have something in common:
~heyallow the combina!i~~ of the businesses of A and B, and often (not
always)imply the acqu1s1t10~or the control of the business of A by the
groupcontro~ed b! Z tha~ mcludes B. As a lawyer, your obligation is
frequentlyto identify creatively the way to acquire a business that better
servesthe interests of your client, also keeping in mind the interests of
the other parties and stakeholders. Just consider, for example, the
possible differen~ consequences in terms of liability toward corporate
creditorsof the different alternative transactions briefly described above.
Thecomplexity of the variables that you must consider is magnified when
the acquisition has an international dimension, typically because the
corporationsinvolved are located in different jurisdictions and are subject
to different corporate laws. Like in a game of three-dimensional chess,
youneed to be able to figure out the best strategy based on the different
movingpieces, and carry it on effectively.
Zeroing in on mergers, we need to underline that a merger is a
process,a procedure, and that to successfully complete a merger several
steps are necessary, and also---as a general rule-the approval of
differentcorporate bodies of the corporations involved (boards of directors
and shareholders' meetings) must be obtained. Roughly speaking, in most
jurisdictions the merger procedure requires three steps. First, the boards
of directors of both corporations must approve the merger according to a
documentsometimes referred to as the merger project or plan. The plan
endorsed by the boards must then be approved by the shareholders'
meetings of the two corporations, sometimes with supermajority
requirements. Finally a formal deed of merger must be prepared and filed
with the secretary of state or similar public register, in order for the legal
effectsof the merger to occur. · ·
There are two important observations on this procedure. First, this is
the default rule. A "simplified" procedure (sometimes also called "short-
form merger") might be available, for example when the surviving
corporation owns a significant stake of the merged one (often 90% or
more), in which case the approval of the shareholders is not always
necessary, as we will discuss more analytically below. Second, in the real
Worldthe negotiations preceding the formal approval of the merger by the
boards, often conducted by the CEOs and other top executives, are
extremely important. In this phase of the process some crucial and
~4~2!_
___4__ ~M~E~RQG~ER~S~AN~D~A~C~QU~I~S
_____~IT ~~
~I~O~N;::...S
· ate
d ehc agreements are often reac h ed amo ng the directors and officer f
. .
t h e corporations . so
For example, confidi en t·ia 1i·ty agre.ements .are signed to
ensure that business secrets and other imp
ortan~ information. that need
to be exchanged during a negotiation will not
be disc~osed to th ird parties
or used to the detriment of the party mak
ing the disc!os_u:es. Often the
parties will also execute no-shop provisions
, aimed ~t limiting the ability
of one party to seek or receive other offers from
po~sible buyers or sellers:
the rationale here is to prevent a party from
being ~sed as a stalking
horse (do you remember that in Smith v. Van
Gorko_min Chapter 6, there
was a no-shop provision?). Sometimes
"material adverse change"
agreements are entered into, to protect
in particula_r the buyer from
possible unpleasant surprises down the road
concerning the conditions
and value of the target. Finally, the parties
might provide for penalties in
case the deal is not consummated or
for other interruptions of
negotiations. These provisions are delicate
because, as you can imagine,
they somehow limit the freedom of the
board of directors or of the
shareholders to reject a proposed transact
ion, and therefore might be
considered an infringement on the franchis
e of these bodies (see Chapter
5).
In order to understand the nuts and bolt
s of a merger, and its
economic and legal consequences, one crucial
issue is to understand what
the exchange ratio is and how it is determi
ned. As we mentioned, with
the exclusion of cash-out mergers, the conside
ration paid to shareholders
of a corporation merged with and into
another one, and therefore
extinguished, are shares of the surviving corp
oration. The exchange ratio
indicates how many shares of the surviving
corporation the shareholders
of the merged corporation should obtain,
for each share of the merged
corporation that they owned. If A is merged
into B, and the exchange
ratio is 2, for example, for each share of A its
shareholders will obtain two
shares of B. If it is ½, they will obtain one sha
re of B for every two shares
of A. The exchange ratio can be considered
the "price" of the merger, and
determines the relative economic and adm
inistrative powers that the
shareholders of the merged corporation will
have in the new venture.
Obviously, it must be calculated based on
the relative values of the two
corporations. It is extremely important to
clearly understand how the
exchange ratio is determined. We know that
(most) law students freak
out when they see some numbers, but we still
want to offer you a numeric
example to explain this concept. We promis
e that if you understand the
following example, understanding merger
negotiations and litigation will
be enormously easier. If you went through
fifth grade, you know enough
math to follow us.
Consider two corporations, X and Y, with
balance sheets and ownership structures: the following simplified
425
_0!;9-------------'---'--"-==---=~~~~~~----_j~
Xlnc Y Inc
800 Liabilities As sets 400 300 Liabilities

~ 1000
A(50%)
200 100 Capital
B (50%)
!
C (100%)
tanding
The shareh~lders of X are A and B, holding 50% of the outs
C. Imagine that the
shares each, while all the shares of Y are owned by
with and into
directorsand the shareholders of X and Y agree to merge y
operation of
X:the assets and liabilities of Y will be transferred to X by
d shares of X.
Jaw,Y will be extinguished, and C will receive newly issue
he owns in Y?
Howmany shares of X should C receive for each share that
In other words, what is the exchange ratio?
on. First ,
To answer this question, we need some additional informati
corporations.
weneed to know the number of outstanding shares of both
a par value or
Let's assume that X has 200 shares outstanding with
tanding, also
accountingvalue of $1 each, and that Y has 100 shares outs
ssed the concept
witha par or accounting value of $1. (We have not discu
rtant for our
of par or accounting value, which is not particularly impo
consider this as
purposesand that would require a long explanation. Just
ever different
a conventional value attributed to each share, which is how
shares.)
from,and generally lower of, the price or actual value of the
is the "fair
The other important information that we need to have
es of the two
value"of X and Y. From an accounting perspective, the valu
unting value of
corporations, simply determined by subtracting the acco
respectively 200
the liabilities from the accounting value of the assets, are
not represent the
forX and 100 for Y. The accounting values, however, do
, in fact, often
"fair" values of . these businesses. Accounting principles
accounting rules
underestimate the real value of a corporation, because
registered in the
are conservative. For example, several assets might be
price that the
financial statements at their historical cost, i.e., the
ion. Their actual
corporationpaid to acquire them, reduced with depreciat
r, for ~xample, a
value, however, might be significantly higher. Conside_
res 1n research
Patent: its historical cost might include only the expenditu
patent, plus some
and development occurred by a business to secure the
register it . A few
additional legal and administrative fees necessary to
426 MERGERSAND ACQUISITIONS CH.9
yea rs after the pat ent has been reg1·s tered h 0 wever its commercial value
might increase dra matically due to a new , '. d
technological eve1op~ent t?at
makes the patent extremely precio · It actual value at this pomt
might be ten tim es its historic al cosus. s . '
ts, but the financial st atements wil,l
still indicate the historical cost. In add
ition, the ?ialanc_e,~heet gen~rally
does not take into account the "goodw
ill" or the badwill of a busmess,
i.e., tha t part of its value derived from
its ability to gener3:te a flow of
earnings or a cash flow, or a loss, in the
future . If you take into ac~ount
these phenomena, it should be clear tha
t the actual value of a busm~ss
might be significantly higher-or,
more rarely, lower-than its
accounting value .
How can you therefore determine the "fai
r value" of X and Y? There
are several criteria that can be adopted
, depending also on the industry
and type of business, to determine the
value of a business . Some criteria
are simply based on the evaluation of
the single assets and liabilities,
independently from their accounting
value. Other criteria take into
account the goodwill (or badwill) by calc
ulating the value of the firm as
the value of any investment, by determ
ining the net present value of the
flow of future earnings or future cash flow
s that the business is expected
to generate. If the corporation is listed
and there is an active market for
the shares , market prices can (and sho
uld) also be considered. In most
cases financial experts must be hired to
find the appropriate formula and
determine the fair value, often a very com
plex calculation that inevitably
depends on several assumptions on which
reasonable minds can disagree .
It is therefore accurate to say that there
is not such a thing as a single
and precise "fair" value, but rather
a range of values that could be
considered acceptable. In addition, also
keep in mind that even if based
on the opinions of the experts, the parties
will negotiate. In our example,
C will try to convince X and its sha
reholders that the value of his
corporation, Y, is as high as possible; and
vice versa A and B will argue
that the value of X is as high as possible.
In any case, for our purposes, we can tak
e the fair values of X and Y
as ~ven. Let'~ imagine, therefore, tha
t after obtaining opinions from
quahfie~ a~d mdependent experts, and
negotiating the transaction , all
~he parties.mvolved agree that the fair
value of Xis $300 ($100 more than
its ac~ountmg v~lue), and that the fair
than its accountmg value) . value of Y is also $300 ($200 more
Now we ar~ ready to calculate the exc

should be used is the following: hange ratio. The formula that
427
fair value of merged corporation (Y)

corporation (Y)
number of outstanding shares of merged
nl:>"e ratio = fair value of surviving corporation (X)
e:CCha
g corporation (X)
number of outstanding shares of survivin
Substituting the numbers, we have:

300
100 2
exchange ratio = =3 x - =2
300 3
200
exc han ge rati o is 2, me ani ng tha t C will obtain 2 shares of X for

The
not rocket science. Consider the
eachshare of Y. Does it make sense? It's
fair value of one share of Y with
formulaabove: it basically compares the
re of X is worth half of the value
thefair value of one share of X. If one sha
for each share of Y, the former
of one share of Y, it follows that,
of X.
shareholdersof Y must receive two shares
the acquiring corporation, will
Is this enough to determine what X,
like afte r the me rge r? No , we also need to determine the capital
loo k
se tha t X mu st rea lize to com ple te the merger. Basically this
increa
shares that must be issued and
requires determining the number of new
formula can be used:
factorin their dollar value. The following
capitalincrease for merger

rged corporation (y)
= exchange ratio x number of shares of me
x accounting or par value of one sha
re of surviving corporation (x)
Based on our numbers we have :

x $1 = $200
capital increase for merger= 2 x 100
shares of Y will be cancelled
Once again, the idea is very simple: 100
uen ce of the me rge r (Y wil l dis app ear), for each one of those
as a conseq
must receive 2 shares of X, and the
shares the (former) shareholders of Y
of X (attention, not its fair value) is
accountingor par value of one share
nse que ntly , X mu st issu e 200 sha res with an accounting or par
$1. Co
this is what X will look like:
valueequal to $200. After the merger,
428 MERGERS AND ACQUISITIONS Ca.9
X Inc (post merger)
Assets 1400 1100 Liabilities
~ A(25%)
Delta 100 400
Capital \ B (2S%)
C (50%)
As you can see, the assets and liabilities of Y have been transferred
to X and, in X's balance sheet, the value of the assets and liabilities is the
sum of the value of the assets and liabilities of the two merged
corporations: assets = 1000 (assets of X) + 400 (assets of Y) = 1400;
liabilities = 800 (liabilities of X) + 300 (liabilities of Y) = 1100. The new
capital is $400, determined as the old capital of X ($200), plus the $200
that we have just determined as capital increase based on the exchange
ratio. The 200 newly issued shares have been given to C, the former
shareholder of Y, who now owns half of the outstanding shares of X.
Pause here for a second to consider this: does it make sense from a
substantive economic standpoint? Of course yes: if you look at the new
joint venture, you can argue that C ''brought" with him "something'' (the
business of Y) that was worth $300. Also what A and B brought together
to the common enterprise, corporation Y, was worth $300. It is therefore
correct and fair that the former shareholder of Y will control half of the
new business of X, and that the other half is divided among the old
shareholders of X.
But wait a minute. What is that "Delta" of $100 indicated in the
balance sheet of X after the merger, above? Simplifying complex
accounting rules, that number can be considered an expression of the
difference between the fair values of the two corporations and their
accounting values, a sort of goodwill that the merger allows and requires
to recognize and indicate in the financial statements.
This simplified explanation has hopefully made you more aware of
what a merger is and how it works. As simple as this is, if you keep in
mind these basic concepts it will be much easier to understand any
merger transaction that you will encounter (as an exercise, try to
calculate the exchange ratio and the capital increase of a merger of Y
with and into X in the previous example, assuming however that X has
issued 50 shares with an accounting value of $4 each, Y has issued 200
shares with an accounting value of $0.5 each, that the fair value of Xis
MERGERS AND ACQUISITIONS 429
~that the
.
fair
.
value of Y 1s $150). The answers which you should
d · · d d · '
$600an t only after h aving trie to eterm1ne the values yourself ' are in the
100k a t
footnot.e . .
A merger 1s often a re~eipt for litigation. Shareholders might
lain that the exchange ratrn or the cash consideration received is not
t · db Y conflict of interest, and so forth.
. that the transac t·rnn was ainte
colllP
fair, · k ed by shareholders in case of
· r_emed'ies th a t can b e 1nvo
W}latare maJor
llegedlyunfair merger or, more generally ' frequently litigated issues
ana t?
inthe merger contex .
First of all, dis sen ting shareholders can challenge the transaction
}leginga breach of the fiduciary duties of the directors, or-to the extent
:hat it might be relevan~f other shareholders, or other substantive or
roceduralviolations. Based on these allegations, shareholders can seek
~onetarydamages, to set aside the merger (but in most jurisdictions, to
protectthird partie~ ~nd ~egal certainty, this is not possible after the
mergerdeed), or an 1nJunct10n to prevent the completion of the merger. In
civillaw countries, as we discussed previously, shareholders challenge the
validityof the shareholders' meeting resolution approving the merger, a
remedynot so often invoked in common law systems. Especially when the
corporationsinvolved are listed, shareholders can also sue for violations
of the securities laws, for example omissions or misstatements in the
proxysolicited for approving the merger. One of the more distinctive
remediesis, however, the appraisal right, which in different forms exists
in mostjurisdictions. To understand this remedy, we need to take a step
backin history.
Until the end of the XIX century or the beginning of the XX century,
in several legal systems, fundamental transactions such as mergers,
which have a profound and lasting impact on the structure of the
corporations involved, traditionally required unanimity of the
shareholders. Unanimity is, however, a problem: even a single small
shareholder can veto an efficient and otherwise desirable transaction.
Mostlegislatures therefore, in the last century, abandoned unanimity
fundamental transactions,
7equirements and provided that most
including mergers, could be approved with the majority of the votes
(sometimesa supermajority). In order to compensate minority dissenting
shareholders, the appraisal right was created. Dissenting shareholders
canask the court to "appraise" their shares, to determine their fair value,
and the corporation (or sometimes other shareholders) will have to
Purchasethe shares of the dissenting minority at the price determined by
the court or by an expert appointed in other ways.
exchan.g, ratio=-· 1 capital lncrease = $50

16'
430 l\11mmmsANI>ArtH!Y"'.!!"'N~ (,
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• ,, 141ill in nn i11h 1
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rl ft I ,joril)• U11 A
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\ • • I
c ' 14 t 1\l'I H'll 1•11·1y t' 11t <: ·
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t'~Pt'l'inllyintlw U,..::,.,i no P •
• • l r<'nll'dy i1-1not 11v11il11hlt in
cxnmpk: in ~t>lll l' juri~d~dion:-1~ht nlppt1·111l:-1 _ •lwld1• 11 r1-1
c;llll t•1H-lilHt•ll y lho
. .d
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co1·pm·nt1ons (tl , 1tt,n ht'll\g t 111 1-11111 l
1c t • • l l ,,·~ mu1-1 t jump tht·oul- {h
,} .,, . tl·1 , . ·k ,t) in 11dd1t.wns 1llll'L'\O1 < < ~
~ HH1...:on s c mni t • .- l t (fot·
•
exump l, notify
•
sev<.'rnlprcx•1...,dural
•
loopholt'Sto e xt'l' Ct~ o t 1ll' 1 ig 1 tho
' I I l ' , . .t,'
~orporntion of tlwir int<'ntinn to dis~t,nt beful' O th0 8 1llH't' 10 1 <.t'r~nwte 111s
culled to npprove the llll'l'gL'l\ nn · d t }ly di~~l'l1t Ol' H1lH l\lll I\ l 110
nc un ·· . . .
· g). v n1un t'
meetm 10n cr1·t,e 1, 1·,,·1 \l~ed
• by experts
· mi~ht ·not f mnx1m 1 1io tho
va Iue o f tl1e sh 111 .es,
and the nfJprni snl proc<'r lm·
o 1s o ton ong nnrl
.
expensive, and its costs often fnll on dh,~enting shnrc 110 lders.
.
In terms of remedies, one interesting co1_npnrntive .d~stinction

concerns the role of shnreholders' actions chnllcngmg th~ ~nhdtty of the
shareholders' meeting resolution approving a merger. In _c1v1l ~nw systems
often sharehold ers bring an action for the nulhficntion of the
shareholders' resolution approving the merger, arguing for example thnt
procedural rules have been breached, that the resolution passed thanks to
the votes of a conflicted shareholder, or that the exchange ratio wns
unfair. In this perspective, it is particularly important to underline that
under the harmonized European rules set forth by Directive 78/855 an
external independent expert has to examine the merger project drafted by
the directors and take a position on the fairness of the exchange ratio.
The report of the expert must be deposited with the corporation before the
shareholders' vote on the merger, to allow shareholders to consider it.
Article 10 of the Directive provides, in fact, that:
"1. One or more experts, acting on behalf of each of the merging
companies but independent of them, appointed or approved by a
judicial or administrative authority, shall examine the draft
terms of merger and draw up a written report to the
shareholder~. However, the laws of a Member State may provide
for the a~pomtment ~f on~ or more independent experts for all
~he_ ~ergmg c?~pam~s, if such appointment is made by a
Judicial _oradm1mstrat1ve authority at the joint request of those
compames. Such experts may, depending on the laws of each
Member State, be natural or legal persons or companies or firms.
2. In the report menti?ned i_npa~·agraph 1 the experts must in
~ny ~ase state whether 1n their opmion the share exchange ratio
is fair and reasonable. Their statement must at least:
(a) indicate _the method or methods used to arrive at the share
exchange ratio proposed;
f!!J--- MERGERS AND ACQUISITIONS 431
(b) state whether such method or meth d .

case in question~ indicate the values arr~v:d are ad_equate in the
method and give an opinion on the ~t t~sin~ each such
attributed to such methods in arriving at th re al ived i?1portance
e va ue ecided on.
The report shall also describe any special val . . . .
which have arisen. uation difficulties
3. Each ·
expert shall be entitled to obta· f
11 1 ·
h .
in rom t e merging
companies a re evant information and docu t d
out all necessary investigations." men s an to carry
It is interesting
1 · to1 point out that even i·n syste ms in
· wh.ich it· is
· not
mandatedby th e. egis atur~ (such as in several common law systems), the
Opinion of a qualified. and . independent expert on the £airness
· of a maJor
·
corporate , transact10n
d 1s, often.b obtained.
. . . . The reason h as t o do wi·th
directors. a~ managers possi le habihties: an independent opinion is
oftenan indispensable tool to reduce the risk of being accused of a breach
of the duty of care or of loyalty (once again, do you remember Smith v
VanGorkom on this specific issue?). ·
Challengi~g the shareholders' meeting resolution is possible but not
veryfrequent in common laws systems, where the most utilized remedies
are monetary damages or appraisal rights. You should be aware
however, of the fact that even in systems in which challenging the'
validity of the shareholders' meeting is more common, such as in
continental Europe, .the legislature generally only allows this before the
mergerdeed is filed with the public register or the secretary of state (this
generally means only within a few weeks after the shareholders' vote).
After that moment, only monetary damages are available. The rationale
is legal certainty and protection of third parties that might rely on the
validity of the merger, and also the high costs-and sometimes
impossibility--0f untangling a business combination. In these systems,
alsothe creditors of the corporation involved in the merger can enjoin the
transaction in the period preceding the publication of the merger deed, if
they can demonstrate that they will suffer a prejudice as a consequence of
the merger, but after that moment they are only entitled to damages.
Mergers and acquisitions tend to come in waves. This is partially
natural, as changing economic and legal conditions influence the
convenience of business combinations. For example, in a period of low
interest rates in which obtaining fresh financial resources to acquire
other corporations might be easier, M&As can peak; similarly if market
Price are down, and corporations are (perceived to be) underval':1ed,
acquisitions might become more common. Also legal developments mi~ht
hinder or foster mergers, for example more li?eral rules 01:1 defensive
measures or more rigorous enforcing of the. antitrust la~s m1g~t reduce
the numb er · of acqu1s1
· ·t·10ns, not to mention tax considerations. . The
_!4~32L_
_____ ]M~E~R~G~E~R~S~AN~D~
A~C~Q~U':.!:.l~Sl~T~IO~N
..:..:S:.,___~~~-C
. . nl referring to mergers involv
followmg graph en if O ! ing U.K,
corporations, co,nfiev
rms the exist ence 0 f "merger waves" (source: U.K.
Office for National Statistics, 20
14).
Numberof M&AsinvolvingUK
companies
2500 ------------
---------
- - -- -
2000 +----
..
ii
-:l 1500 ..-- - -
0
~
eti
:I
1000 -1- --------- - -- -- '- -----
z ,
0#~~~~~~~~~~~~~#~##
Year
~~#,~~~~
In this section we have conside
red mergers as one particular
business combination, and type of
compared them with other
transactions. We have then alternative
explained a typical merger
focusing in particular on the procedure,
different steps necessary to
transactions. Next we wanted complete the
to clarify the economics of a me
particular the determination rger, and in
of the exchange ratio, someth
have done with some basic acc ing that we
ounting and numbers, hopeful
traumatizing the readers. We ha ly without
ve finally mentioned possible
case of an alleged unfair merge rem
r, and made a reference to "merg edies in
The framework that we laid do er waves."
wn in this chapter is, more or
for most modern jurisdiction less, valid
s, even if of course there are
differences. We believe, howe important
ver, that this common backgro
helpful-in fact, essential-for und will be
the following comparative analy
sis.
SALES OF ALL OR SUBSTA
NTIVELY
ALL THE ASSETS
As we have mentioned, in the
United States as well as in ma
jurisdictions , several "extraord ny other
inary financial transactions
mergers, generally require the " including
approval of both the direct~rs
shareholders of the corporat and the
ions involved. The idea is
transactions are funda~e.ntal that these
amendments to the articles of
and/or have effects s1m1lar to incorporation
the winding up of a corporat
therefore cannot be approved ion and
without the consent of the sha
rehold~rs . A
AND ACQUISITIONS
¢!-- . . MERGERS 433
<1ermight significantly alter the risk/return of the investment of
:e::eholders, and th ey m~ st have a voice in these decisions. Selling some
;,rtheassets of a corporatwn, on the other hand, is generally considered a
iness decision th at falls ~ithin the competences of the board of
~tors- In the absence of a different provision in the charter or bylaws
(iireCtorsare. gene~a~lyfree to sell specific assets, and of course potentiall;
Jjablefor their dec1s1on.
This general rule, howev~r, ~as exceptions or, more precisely, raises
a particular proble?1. What if director~ sell all or substantively all the
ore materially modifying the purpose of the
assets of a . , theref .
corpodratwn
corporation an its econ_omic ~er_spectives? Is a shareholders' vote
ecessary?Are the protections existing for minority shareholders in case
:frnerger also available in this case?
We touched o? a rela~ed problem in Chapter 5, discussing corporate
governance and in . particular the relative powers of directors and
shareholders.You might remember (or go back and review) the German
caseHolzmiiller we discussed there. The question raised by that case was
whether directors, spinning off assets to a different controlled
corporation,infringed the shareholders' franchise because, after the spin-
off, directors would be able to manage the assets that had been
transferred without shareholders' supervision. We now examine a
partiallysimilar issue with respect to sales of assets and mergers.
The problem is particularly evident when the sale of assets has
economiceffects very similar to a merger. Consider the following example:
the directors of corporation X sell all the assets of X to Y, an independent
corporation,for cash. With the proceeds of the sale, X buys shares of Y
fromone of its shareholders. At this point, X is dissolved, creditors are
paid, and the shares of Y owned by X are distributed among X's
shareholders. As you can see, the practical consequences are almost
identicalto the ones of a merger of X with and into Y: X will disappear, its
assets will be transferred to Y, and the former shareholders of X will
a
becomeshareholders of Y. Formally, however, the transaction is not
merger.Should it be treated as a de facto merger for some purposes? For
example,should dissenting shareholders of X be entitled to exercise their
appraisal rights, if appraisal rights are not explicitly provided by the
applicable statute in case of sale of assets? From a broader perspective,
this is a typical problem that lawyers and judges encounter all the time:
s
shouldthe substance of the transaction (the fact that the economic effect
is
are similar to a merger) prevail over its form (the transaction
in
:echnically not a merger), and shareholders be treated and protected as
ase of merger?
Thefollowing case illustrates the Delaware approach to this probl em.
_0!J---
, te objective, this possibility of introducing shareholder control will
ora · £ and old ones are liquidated .. . . FSA
carP. . h as new compames are ormed h ' h .
·J111n1s . . 1 t .
d1ow FCA] hstmg r~ es con am ig ly detailed regulations specifying
[n tions that reqmre shareholder approval based on the percentage of
transacssets, pro r·
·
its, th e capi·t a 1 t h ey entail or the consideration paid ' and
lfl'OSS a . 1 d .
e;·-htransactions me u e maJor asset sal~s .... ".
S ue
***
In other legal ~ystems, the pro~lem raised by the sale of all assets is
roached from different perspectives. One interesting example, which
~ppalsoconnected to another comparative distinction that we have
15
:n entionedin Chapter 3, c~ncerns the "purpose" of the corporation. As you

remember, the govern~ng doc1:~ents of the corporation must indicate
the business pu~pose. _This provis10n can be extremely broad in some
. risdictions, typically in common law systems, where a corporation can
b~ established to "engage in any lawful act and activity." Some countries
however require a more precisely defined purpose, for example "the
productionand sale of medical equipment, and all related activities." Also
these provisions tend to be quite broad, especially because they include
activitiesrelated and instrumental to the core business, such as financial
activities. There are therefore few acts that might be deemed outside the
business purpose, and in any case directors and top executives are
generallyconsidered to have at least apparent authority to act on behalf
ofthe corporation. If, however, directors sell all (or substantively all) the
assets without the consent of the shareholders, possibly to use the
proceedsfor different goals, the transaction might be considered a de
factoamendment of the corporate purpose. Since an amendment of the
corporate purpose requires shareholders' approval (and often triggers
appraisal or withdrawal rights of dissenting shareholders), a de facto
amendment decided only by the directors might be unlawful. One
application of this general principle is Article 2361 of the Italian Civil
Code:this rule provides that even if the bylaws include in the corporate
purposethe acquisition of participations in other business organizations,
it is forbidden to acquire participations that substantially modify the
corporatepurpose indicated in the bylaws.
Differently from Italy, French courts do not generally follow the
doctrineof de facto amendments of the corporate purpose. For example, in
a 1994 case, the board of directors of a close corporation sold real ·estate
ownedby the corporation ..A minority shareholder sued arguing that the
sale made impossible pursuing the corporation's business purpose and
could only be approved with a vote of the shareholders' meeting. The
French Supreme Court rejected the request holding that the sale of real
estate did not represent a modification of the purpose of the corporation
(Cour de cassation, February ler 1994, Francis Carricaburu c/ SCGC,
Revue des societes 1994 p. 697, note Y. Chaput.). In this decision the
_!4_!-lOQ
______ ~M~E~R~G~E~R:§SlA
~Q~U
~N~D
!:?..
Sl~'l'
~l~A~c
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Fren ch Supreme Court took a quite formali St ic aphp
· · the roac!\ ha sical]y
1gno rmo- . actua 1 f" t f the sale on t e act1v1ty carri
substantive '-•d
e 1ec s o "
b o t· ' d
on y th e corpora 10n. 1n or e r to bette r prote ct inve stors, one scholar has
.
suggested that at least for listed corporations, th e Fren h 1 ·
c egislature
should provid~ that a sale of all or substantively
a~l th e assets is
equivalent to an amendment of the articles of incorpora
tion and requires
a vote of the shareholders. The rule could apply, for e~am
ple, w~en over
80% of the assets in terms of book value are sold
(se~ Pierr~-Henn Conac,
Cession de l'essentiel des actifs d'une societe cotee:
plaidoyer pour la
competence de l'assemblee generale extraordinaire (AGE
), REVUE DES
SOCIETES 598 (2014)).
Under German law the sale of all or substantively all
the assets
requires a shareholder resolution with ¾ majority at
the shareholder
meeting in order to protect minority shareholders (Sec
. 179a German
Stock Corporation Law). A contract executed without the
approval of the
shareholders is void and the corporation can claim back
the assets.
Wrapping up, selling all or substantively all the
assets (and
liabilities) of a corporation is a risky transaction for share
holders, because
it allows directors to profoundly alter the investment of
the shareholders.
Different regulatory techniques or arguments might be
used to protect
shareholders. One possibility is to say that if the sale has
effects similar
to a different transaction that offers better protections
for shareholders
(for example, resembles a merger that requires a vote of
the shareholders
and in which shareholders could invoke appraisal right
s), the same
protections existing for the latter should be extended to
the sale with a
legal analogy. This approach, which is the de facto merg
er theory, hinders
however legal certainty, applying the regime set forth
for one type of
transaction to other transactions not precisely defined.
Courts, at least in
Delaware, are reluctant to do that. Another option, follo
wed in Germany,
is to specifically attribute the competence to approve
a sale of all the
assets to the shareholders, either by statute or with a
provision in the
bylaws, and possibly provide for additional protections,
such as appraisal
rights for dissenters. When a similar provision does not
exist, it might be
possi:i,le to argue t_hatdirectors infringed in the sharehold
ers' franchise by
altenng substantially the purpose of the corporation
something that
would normally require a positive vote of the sharehold
ers to modify the
charter.
Do you think protections for shareholders are necessary
in case of a
sale of all the assets? If so, which one of the above men
tioned regulatory
strategies do_you ~nd preferabl _e? Is it necessary to also
the need to give directors sufficient flexibility? take into account
LEVERAGED BUYOUTS
Do you reme~ber Sm~ v. Van Gorkom, the case on directors'
th duty
that we discussed in Chapter 6? If you do (and if you do not we
· ·) ·11
0f caret you review it, you wi remember that the underlying facts
suggesneda leveraged buyout, and in fact one· of the criticism of the
t · th t th ey d'd · the sale price of the
. · nr of the d'irec ors is a
cance i not maximize
ged
decisi~but rather accepted a price that would have made the levera
sharet' possible for the buyer.
buyou
ts
It is now time _to discus~ a little more extensively leveraged buyou
an
d their regulat10n. Basically, a leveraged buyout ("LBO") is
anuisitionin which the buyin g corporation obtains a loan or other credit
h f' · 1 the
. orderto have t e inancia resources necessary to obtain control of
acq
::rget. Often the acquiring. corporation is an empty shell incorp orated
ial
specificallyfor the transaction, and before the acquisition its financ
ed
statementswill only show the debt as liability and the proceeds obtain
the
fromthe creditors as assets. Once control of the target is acquired,
. The
targetis merged with and into the vehicle that the buyer is using
, but
resultis generally a corporation that looks very similar to the target
hasa much higher leverage (more debt).
to
Consider the following example. A, a listed corporation, wants
might
acquireB, another listed corporation. For a number of reasons, A
ple, A
decidethat it needs credit to complete the transaction: for exam
make
mightnot have the required financial resources , or a loan might
ly, A
sense to take · advantage of low interest rates. Consequent
lete
incorporatesa riew corporation , X, essentially a vehicle used to comp
try to
the acquisition. X generally has little capital. At this point A will
launch
convincea bank or other investors to lend it the money needed to
launch
a tender offer on B. If the loan is secured, with the proceeds X will
X.
a tender offer on B. Once control is acquired, B will be merged into
The transaction can be illustrated with the following example:
' I
442 MERGERS AND ACQUISITIONS Cu.9
-
~
X \'IC
,.._ 1000
10
10 210 ~
Tnc
100 ..-
In our example, X incorporates V, the "vehicle" for the LBO, with an

initial capital of 10, entirely owned by X. X and V obtain a significant loan
that will be used to finance the acquisition of the "target" T, equal to 290.
As you can see, V is a highly indebted corporation. At this point the cash
of V is used to launch a tender offer on T. Imagine the bid is successful
and, for sake of simplicity, imagine that V obtains all the shares of T. At
this point Tis merged into V. With some simplification, after the merger,
which represents the second step of the acquisition, V will have the
following financial structure:
Vine
Assets 300 390 Liabilities
Delta 100
10 Capital
The surviving corporation has the assets of th t

1ia. b·1· ·
1 ities are represented by the old li'ab·1·t·
e arge t T , an d 1·ts
. . . 1 1 1es of T p 1us t h e Ioan
originally granted to V 1n order to finance the a ·
to be repaid.
· Af cqu1s1·t·10n,' wh"1ch stl·11need
ter the LBO, the resulting c
Ieverage d corporat10n,. . orpora t·10n 1s·
a 1so a h"ighly
with a fairly low cap·t 1 · , . Th. · a
i a Vls-a-v1s debt. 1s is
_0!JL-- MERGERS AND ACQUISITIONS
443
.
.cal consequence" of an LBO, and, if you th·in k ab out it -
tYP the generic
1 · ·
, you might argue
guarantee' that was ofi- d
t V
tha nded the loan to was represented by th 1ere to the d.
t ere itors that
e~eget T. In other words, the business p:o ass~t~ and business of the
n that v (a~d its .
tar ' . ng sh are h old er X) ma de to the creditorspositio
was:" .
ontrolh
~ can use to buy the target; once I will be the new contr~t: me credit that
willmanage the target so well that I will be able to hng shareholder,
1andstill make a profit." pay back the debt,
Clearly enough, the LBO is a highly risky transact" If th

· · t d f£ · ion. e target
corporat~o~isl ndodm~nthagde be Tectiv~ly, it can easily becom e insolve nt
e t. he situatio n is even m d .
because.it is oa e wi ore e1icate when
the creditors are not represented by sophisticated counterparties such as
ban~s, but rather bondh?lders. To fin_ance acquisitions in this way,
issuing bonds, bec~me fairly common in the 1980s, especially in the
United States, dunng a takeover". frenzy. These bonds, even if pr · d
. ld b k k omise
high yie s, ecame nown as Jun bonds" due to their highly risk
nature (in the 1980s, one of the "kings" of junk bonds was financ· y
Michael Milken, who ended up spending time in prison for insi~::
trading). LBOs are, however, certainly older, as demonstrated by the
wo~derful,Shake~peari_an movie "_Highand Low( a 1963 crime drama by
AlnraKurosawa, in which the main character Kingo Gonda is a Japanese
managerplanning a leveraged buyout.
Some legislatures do not see it as their job to limit or regulate LBOs.
They might require full disclosure on the transaction in order to inform
investors purchasing junk bonds of the highly speculative nature of the
transaction, but these rules are generally confined in the area of V
securities regulation. Substantive corporate law provisions limiting or

regulating the acquisition are not enacted. In other systems, the
legislature has introduced specific rules designed to give to shareholders
and creditors a deeper understanding of the transaction, and more control
on the decision. For example, pursuant to Article 2501-bis of the Italian
Civil Code, in case of a merger in which one corporation has obtained
credit to acquire control of the merged one (basically, the definition of an
LBO),the directors must present to the shareholders (and also make
available for creditors) a detailed plan indicating how the debt will be
repaid. Not only that, but an external independent expert must ?repare
an opinion on the reasonableness of the plan proposed by the directors.
What do you think of a similar rule? Is it useful or pointl~ss? ls it
excessively patronizing? Is it easy to define precisely when it should
apply?
\
444 MERGERS AND ACQUISITIONS CH.9
FREEZE-OUTS, CASH-OUT MERGERS, AND

GOING PRIVATE TRANSACTIONS
The United States and Europe have a radically different approach to
the regulation of "cash-out" mergers. This difference is as important as is
poorly understood. As the name suggests, a cash-out merger is a merger
in which some or all the shareholders receive, instead of shares of the
surviving corporation as in a regular merger, cash or other consideration.
These transactions are very delicate because shareholders, and minority
shareholders in particular, are "expropriated" of their shares, and only
receive the value of their investment. The fairness of a cash-out merger
is, therefore, extremely important: for many investors, it represents the
last chance to receive the value of their investment. Cash-out mergers are
so controversial that, as we will see, several jurisdictions prohibit or
significantly restrict them, and ·also where they are allowed, they often
cause litigation and are governed by extensive statutory and judge-made
rules designed to protect minorities.
The complexity of this area of the law makes it difficult to gain a
comprehensive understanding by only considering a few cases. For this
reason, we have decided to tackle this issue with a somehow longer
excerpt of an article comparing cash-out mergers, and more generally
"freeze-out transactions" (transactions in which minority shareholders
are bought out) in listed corporations, in the U.S. and in Europe. The
excerpt also examines some of the most important decisions in this area.
MARCO VENTORUZZO, FREEZE-OUTS: TRANSCONTINENTAL

ANALYSIS AND REFORM PROPOSALS 2
50 Va. J. Int'l L. 841
One of the most crucial, but systematically neglected, comparative

differences between corporate law systems in Europe and the United
States concerns regulation governing freeze -out transactions in listed
corporations. [... ] [F]reeze-outs can be defined as transactions in which
the controlling shareholder exercises a legal right to buy out the shares of
the minority, consequently delisting the corporation and bringing it
private. Beyond this essential definition, the systems diverge profoundly.
Few studies have undertaken to examine the differences between the
European and U.S. approaches to minority freeze-outs, despite the fact
that they are among the most debated issues in corporate law, the public
media, a vast body of scholarly work, and case law in the United States
l and Europe. In light of the relevance of the subject and the extensive and
? growing number of transatlantic
I mergers in which the acquiring
I
'i
!
corporations and target corporations are subject to different legal
(
z Footnotes omitted.
\
I
•j
:1
.l
•
NS
MERGERS AND ACQUISITIO 445
9 ---
!:-
f.! ch focused on comparin g th e European and
the dearth
. 1es of resear
. . f ze-outs is startling.
reQ 'ln ' h t
A;erican approac es o minority ree
[... ]
of transactions that allow
There are numerous combin~tions equity interests f . .
trolling sharehholders to appropriate the . o mmoried ty
co n I U ·t dS the dif fer ent tec hni que s are dis till
shareholders.. n t e n~ e tates, out)
sales, reverse stock splits, (cash-
into four maJor categories: asset
e ~wo more common techniques are
mergers, and tender offers. [... ] Th t
erg ers and tender off ers . More . specifically, under Delaware la W, WO
b . ula r: the "long-form merge ' (or
r,,
Ill
shav e eco me 1nc rea s1n gly pop
opproache
eze -ou t") an d th e "ten der -offer/short-form merger" (or "t _
"one-step fre
rger, controlling sharehold::s
C,
eze -ou t"). In the _ lon g:f orm me

step fre
app rov e a me rge r 1n wh ich the consideration offered to minority
simply of
reh old ers is cas h or oth er non equ ity securities, rather than shares
sha
sur viv ing ent ity . Th e ten der off er/short-form merger, a more recent
the
a voluntary tender offer on all the
development,consists of two steps:
parent corporation, generally aimed
outstanding shares launched by the rt-
standing shares, followed by a sho
at acquiring at least 90% of the out
form,cash-out merger.
[...]
ori ty sha reh old ers oft en cha llen ge a merger on the basis of some
[M]in
par ticu lar for bre ach of dir ectors' fiduciary duties or
illegality, in
e vio lati ons of fed era l sec uri ties laws . The bulk of cases that
disclosur
law of goi ng- pri vat e tra nsa ctio ns in the United States deal with
shapethe
these types of allegations.
(...]
are cou rts fre que ntl y adj udi cat e minority shareholders' claims
Delaw
of fid uci ary dut ies , or oth er ille galities, in connection with cash-
ofbreach
ctio ns. In dec idi ng the se dis putes, Delaware courts have
out transa
ted to bal anc e the pow er of the directors and the majority
attemp
ers on one han d wit h the pro tec tion of minority shareholders on
sharehold
er. To o mu ch of the latt er pre vents efficient, value-ma ximizing
the oth
ns, wh ere as too mu ch of the former leads to injustice. Courts
transactio
ntl y rel uct ant to gra ppl e wit h elusive standard ·s of substantive
are freque
par ticu lar ly bec aus e the leg isla ture has already attempt ed to
fairness,
bal anc e thr oug h pro ced ura l pro tections. Notwithstanding the
strike the
y of the iss ue, cou rts hav e we igh ed in, and the resulting legal
complexit
rk [ca n be] illu stra ted thr oug h .sev en leading cases, each of which
framewo
sai c of reg ula tio n gov ern ing going-privat e transa~tions.
adds to the mo
are : We inb erg er v. UO P, Inc ., Rosenblatt v. Getty Oil Co.,
These cases
Systems , Inc., Solomon ~-. P~the
Kahn v. Lynch Communication ,
iconix Inc. Sharehold ers L1tigatwn
Communications Corp., In re Sil .,
rp., and In re Pur e Resources, Inc
Glassman v; Unocal Exploration Co
-
Sharehold ers Litigation. The first t h r ee cases dealt with long-form
mergers· the last four addressed short-form mergers.
' to Long-Form Cash-Out
Delaware Case Law on Challenges .
Mergers from Weinberger to Getty Oil . .
. bsidiary of Signal Companies (Signal,
In Wemberger, UOP, a s_u .
. 50.5o/c
h oIdmg o o
f th e out st dmg votmg sh ares )' was merged .into th e
an sh-out merger. Dissentin
p~ren~ corporation through a long-form~ ca tion and brought a clas;
mmor1ty shareholders refused cash considera t d. ectors of the t
action suit against the subsidiary and th e parBen'h rr h
companies, and the investment bank Lehman rot l~rfs, c \tng 11 1. t:o
fairness of the transaction and seeking injunctive re ie or, a erna~~ 1 e
ive Y,
monetary damages .
The key factual issues leading to approval_ of the merger are ~o:th
recounting . In the early 1980s, Signal sought invest~ent opport~mti
es.
After considering different alternatives, the company s _board of direct
~rs
concluded that the best option was to acquire the totah~y of ,shares
of ~ts
subsidiary, UOP, through a cash-out merger .. Signals execu
tive
committee informed James V. Crawford, UOP's president, CEO, and
long-
time Signal group executive, of this intention and quoted a price
per
share between $20 and $21. Evidence at trial showed that, during
the
discussion, Crawford agreed that the price was fair but concentrate
d his
attention on the consequences of the acquisition for personnel. Follow
ing
this conversation , Signal's board of directors approved a merger propo
sal
offering $21 per share to minority shareholders, a figure signif
icantly
above market price, which fluctuated around $15. The proposal provid
ed
that the merger would be completed only if it satisfied a double condi
tion:
the totality of the votes cast in favor of the merger would be greate
r than
or equal to two-thirds of the entire voting capital, and a majority
of the
minority shareholders (constituting 49.5% of all shares) would
vote in
favor.
The UOP board approved these terms and recommended the merge
r.
In_ making . it_s d~cision, the board relied upon, among other things
, a
fairness opinion issued by Lehman Brothers, which, at trial, the
court
determined to have been hastily prepared . The trial also revea
led that
t~o UOP directors (who were also e~ployees of the acquiring corpo
ration
~ignal) , ha1 prepa~ed a repo~t q~oting a price of up to $24 as
a "good
investment for Signal. This higher price would have had minor
consequences on the financial structure of the deal for Signal b
t ould
have created substa~tial additional benefit for UOP's sharehol:er:
The
report was never disclosed to UOP's outside direct
s h are d w1·th s· ors an was on1y
d
1gna1,s b oar d .
Notwithstanding the revelation of the $2 4 per share
recommendation, the Chancery Court consi'dered h
t e merger fair an d
-----·-
ft l, tt,...---
9"".,,, h I dt1ft•ntlunt
Mt:tua :H~ Nl> AC(tUISITION~
----
447
--------:...:;...:.
s. On nppl 1nl, how •v •r, th o Supr emo Court of
n,tfurt 1:,\r ·t•d th I low •r court' s ruling nnu took th o o Tnsion to
~ 1L1
I'
r~d
pt•l:lwrtl'tl partially r \solv '. sl'v \ml difC•rent iss ues, including share
•u:1::1,
t\ . ' I
~t:ll . . \ ttl(_'hl\lQlll ~-
h.1t\t10l
lYl'r held that
,w~ \' .inber.., under Dclnwnre lnw, as in oth er U.S.
\ .~ . freeze -out transactions conducted by controlling
f d 1· 'I'hus, f reeze-out transactions are
. t t ·rsns,amount to sel · ca mg.
. d1ct1o
ju.r~
:;h:l:''ho l l •cntire fairness" review. Th e decisio n explor ed the concept of
,ct to · · h · encompa si,,es both
iU bj."- ! . nr1ssin the merger context, a rguing t at 1t
1
en~ired~rn( and "fair price." The former is a procedural element ,
iair t:~l with the way in which the acquisition is negotiated; the latter
eonrtrnb·tantive element, taking into account the economic rational e
is a SUS
behindthe deal.
Th most relevant part of the decision for the current analysis,
. , er is dicta buried in a footnote, where the Suprem e Court of
howe~
Del are e' proscribed the means b y wh'1ch t e entire a1rness reqmr· ement
h · f ·
, ~; be met: the corporation considering a cash-out merger should
•ou ·nt 8 special committee of independent hdirectors, entrusted with the
appo1 . . ' 1
taskof negot1atmgthe merger at arms engt .
The court's laconic observation stirred a theoretical debate.
Supporters of outside directors' ability to ensure truly independent
decisionsin the best interest of all shareholders clashed with critics that
doubtedthe efficacy of a special committee with veto powers . At a more
practical level, however, many corporations soon followed the path
pointed out by Weinberger, and litigation erupted on the precise
consequencesof the committee's approval.
Twoanswers were possible, and the judges of the Delaware Chancery
Courtsplit. Byone approach, the committee's decision would be measured
by the "business judgment rule." In other words, the resolution of the
independent directors would be presumed to have been made on an
informedbasis, in good faith, and in the honest belief that the action was
in the best interest of the corporation. Alternatively, the special
committee'sdecision would simply shift the burden to the plaintiff to
provethe absence of entire fairness. This school of thought was more
fa~ou~able to plaintiffs because to prove that a transaction is not entirely
fair,either for lack of fair dealing or fair price, is less cumbersome than
overcomingthe highly deferential business judgment rule .
W . The Delaware Supreme Court addressed the issue left open in
L emberger in two pivotal cases: Rosenblatt v. Getty Oil and Kahn v.
e~ch. In both decisions, and under different circumstances, the court
P~ r~ced the view that if merging companies complied with specific
ace ural safeguards intended to protect minority shareholders, review
MERGERS AND ACQUISITIONS CH. 9
448
would be limited to the entire fairness test, with th e bu rd en of proof
transferred from the defendant to the plaintiff.
Getty Oil settled the question concerning the effect of a majority ?f
the minority shareholders' approval of a merger. In the 196 0s, Gett~ ~11,
an oil behemoth created by Jean Paul Getty, became ~ m~Jor1ty
stockholder of Skelly, another big player in the in~u~try, owning direc~ly
7.42% of the outstanding voting shares, and 1nd1rectly, through its
controlled subsidiary Mission, an additional 72.6%. Jea~ Paul _Ge:ty
opposed any further integration between the two companies'. behevn~g
that a certain degree of competition between them was beneficial to their
own strength and profitable for the shareholders. Soon after his death,
however, Getty Oil's executive vice-president, Ha:o~d E. Berg, ~ontacted
Skelly President James H. Hara to discuss comb1n1ng Getty 011, Skelly,
and Mission.
The directors of Skelly and Getty Oil engaged in an extensive hard-
bargaining process to determine the proper exchange ratio for
outstanding stock. Skelly's representatives were very determined to
obtain the best possible conditions for their shareholders, focusing
extensively on the application of the Delaware Block Method. Eventually,
the boards agreed on an exchange ratio of 0.5875 Getty Oil shares for
every Skelly share. With the boards' unanimous approval, the deal was
submitted to the shareholders of the corporations involved and
conditioned on the approval of the majority of the minority stockholders.
Almost 90% of the minority shares present at the meeting, representing
58% of all the outstanding minority shares, voted in favour of integration,
which was subsequently completed. The merger was, however, challenged
by disgruntled Skelly shareholders, who brought a class action suit
claiming the exchange ratio was unfair. After a lengthy and complicated
trial, the Chancery Court found the deal entirely fair and entered
judgment for the defendants. On appeal, the Delaware Supreme Court
affirmed.
Applying Weinberger, the Delaware Supreme Court evaluated issues
of both fair dealing and fair price. Its decision offers an insightful
discussion of the Delaware Block Method and proper disclosure of all
material facts in a proxy statement. For current purposes, however it
resolved what significance should be attributed to the mino;ity
shareholders' vote:
Clearly, Getty, as majority shareholder of Skelly, stood on both sides
of_this transaction and bore the initial burden of establishing its entire
fairness. However, approval of a merger, as here, by an informed vote of a
m~jority of the minorit~ shareholde~s, while not a legal prerequisite,
shifts the burden of proving the unfairness of the merger entirely to the
plaintiffs. ·
I

449
~ ..
. . . ng this procedural protect10n simply shifted the burden of
'{Jtl1lZ1
. the fairness of t he t ransac t'ion. l t did
. not alter
the standard of
pro~ngtO the business judgment rule, with its more deferential treatment
review gers an d i·t s 1ess favoura bl e d'isposit1 · ·0n towards minority
of mana
shareholders. . . .
In Kahn v. Lynch, decided nine years after Getty Oil, the Delaware
e Court reached a consistent conclusion where the procedural
Supremt·on afforded minority shareholders was approval of the merger by
Protec1·ttee of indepen dent d'irectors.
a comml
In Kahn, Alcatel, holding almost 44% of Lynch, pursued a freeze-out
er with Lynch, whose board of directors instituted a special
mergmittee to negotiat· e th e t erms of th e acquisit
· · ion
· . Alcatel proposed a
co~ price for minorities of $14 per share; Lynch representatives
casntered at $17. Finally, the board endorsed a price of $15.50 per share,
cou
b t only after Alcate 1 executiv . es in
. £orme d h
t e commit. tee that they were
c:nsidering a hostile tender offer directly to minority shareholders at a
lowerprice.
The Chancery Court ruled that the negotiation between the acquiring
corporationand the special committee was, in fact, conducted at arm's
length, and that the burden of proving unfairness of the $15.50 price
thereforeshifted to the plaintiffs. Moreover, the court concluded that the
plaintiffs had not satisfied their burden. On appeal, the Delaware
SupremeCourt reversed but, in doing so, endorsed the general rule that
approval by an independent committee shifted the onus of proving
unfairness to the plaintiff. Having subscribed to this view, the court
nonethelessconsidered what effect the threat of a hostile tender offer had
on the directors' ability to negotiate independently and determined that
the plaintiffs had made a prima facie showing of unfairness. Simply put,
the directors' capitulation in the face of a possible hostile tender offer
beliedtheir ability to operate independently and to adequately protect the
interests of minority shareholders. The case was therefore remanded to
the lower court, with the burden of proving entire fairness shifted back to
the defendant. ·
Thus, by the mid-nineties, Delaware case law on long-form, freeze-
out mergers was well settled. As in any non-arm's-length transaction,
cou~ts would review a merger conducted by controlling shareholders
aga_msthe t two-pronged entire fairness test (Weinberger). Under normal
e~tire fairness review, the defendants shoulder the burden of proving
fairness. However, in the context of a freeze-out where certain procedural
Protections are afforded to minority shareholders-for example, when
th
ere is approval by a truly independent special committee (Lynch), or
af Prov~lby the majority of the minority stockholders (Getty) - the burden
0
Provingunfairness shifts to the plaintiff.
450 MERGERS AND ACQUISITIONS
C~
b applied extensively and
This doctrinal framework has dee~· ons
consistently, even if more recent eJis have added further
i
specifications and in some cases, suggeste pos sibl e reforms.
p
Tender Offers ~ollowed by Short-Form
Mergers from athe to
Pure
.
The second techmque used to achieve a a freeze-out of minority
shareholders, the tender-offer followed . by short-form merger, was
K h Lynch to launch
anticipated by Alcatel's alleged threat in
tender offer directly to the shareholders, byp a _n vth board of direct a
assin~ e h ·t t· or~.
Th e essentia· l questio
·
n for a court t O consider 1n sue a s1 ua
straightforward: When a majority shareholder h bl· b10n
·d 1s
1
purchase the outstanding minority shares of launc es a pu ic . ~o
a controlled corporation, 1s
the offer subject to the entire fairness standard
?
In 1996, the Delaware Supreme Court ans
wered in the negati~e.
Solomon v. Pathe Communications Corp.
involved a complex financial
transaction with global ramifications. Path
e financed its acquisition ~f
the movie company MGM/UA with loans
from the Dutch bank Credit
Lyonnaise Banque Nederland N.V. (CLBN
). The loans were guaranteed
by security interests in 89% of Pathe's sha
res and 98% of MGM/UA
shares. CLBN also obtained control over 89.5
% of Pathe's shares through
voting trusts. Not long after the acquisition
, CLBN voted to remove four
Pathe directors, among them CEO Gianca
rlo Parretti. An Italian court
found Parretti's removal improper, and
while the legal grounds and
possible consequences of the ruling in the
United States were unclear,
CLBT nonetheless decided to foreclose its
security. Pathe and CLBN
reached an agreement pursuant to which the
former would not delay the
foreclosure, and the latter would extend an
offer to buy the publicly held
shares of Pathe for $1.50 per share. A com
mittee of independent directors
approved the merger, supported by financia
l and legal advisors.
The likely motivation for Pathe's directors
to launch a tender offer on
all the shares was to reduce potential liab
ilities toward shareholders.
Nonetheless, Solomon, representing the clas
s of Pathe's shareholders that
tendered the shares, brought suit alleging
that the directors breached
their duty of care in failing to resist the
foreclosure and not negotiating
effectively the price of the tender offer. Thi
s second failure, according to
the plaintiff, also represented a breach
of the directors' duty of fair
dealing. . , ..
. ~he D~la~are Supr~m~ Court confirm
ed the Chancery Court's
decision, reJecting the plaintiffs the~ry:
In the case of totally voluntary
tender offers, as here, courts do not impose
any right of the shareholders
to receive a particular price. Delaware law
recognizes that as to allegedly
volunt~ry . tender offers (in c~ntras~
to cash-out 'mergers), the
determinative factor as to voluntariness
1s whether coercion is present, or
~ .. " .
d'
451
ther there is [sic] materially false or misleading isc1osures made to
whe holders in connection with the offer."
share
as a surprise to the legal commum.ty. p rior .
The decision came . r of'l! h
to
on the comm on un d erstan d mg was that a tende
So1omtrolhn
' . h h ld . ier 1aunc ed by
g s are o er prese nted a confl ict of inter t d
n . h . f . es an was
a co airness requi rement . This po·m t of view . '
rore subJect to1 t ef entire h b .
therei1 , .
hasized the roe of t e b' oard. of directors of the sub si'd'iary m
eillP .
Otiatmg the terms o the id with. the parent corporation . Th e cour t
neg
soned, however, that .the h two parties of the deal are the bidder On th e
rea h . h ld unrelated
onehand, an~ t e mmority s are o .ers on th~ other. They are
ions, single
parties and, m the absence of coercion and disclosure violat
investorsare free to accept or refuse the proposed price.
ctional
Notwithstanding the very specific facts of Solomon, transa
a less
lawyers and their clients started to consider tender offers
traditional
treacherous pathway for the elimination of minorities than the
nated by the
long-formcash-out merger. Any remaining doubts were elimi
Shareholders
Delaware Supreme Court's holdings in In re Siliconix Inc.
decided in
Litigation and Glassman v. Unocal Exploration Corp., both
2001.
tarily
In Siliconix, the vice-chancellor· determined that a bidder volun
not obliged to
launching a tender offer followed by a short-form merger is
tors industry
offera fair price. Siliconix Inc. was active in the semiconduc
York Stock
and listed on the NASDAQ. Vishay, listed on the New
interest.
Exchange,was its controlling shareholder, with an 80.4% equity
to significant
In 2000, the market price of Siliconix's shares was subject
ls were
volatility, hitting a low in December. The company's fundamenta
ing rate.
alsolooking grim: sales and profits were decreasing at an alarm
Siliconix
In February 2001, Vishay proposed a cash tender offer on
ium over the
for $28.82 per share. The quoted price included a 10% prem
controlling
market price. Vishay also announced that if it reached a 90%
· subsidiaries
stake, it would proceed to merge Siliconix into one of its
$28.82 price.
through a short-form, cash-out merger at the same
to evaluate
Siliconix'sboard appointed a two-member special committee
endence of
the offer. Although questions were raised on the actual indep
with the
the committee's members because of their relationships
offered was
~ontrollingstockholder, the committee found that the price
2.
inadequate. By then, Silicon1x's shares had risen above $28.8
y started
When the committee rejected the initial offer, Visha
which was
considering a less financially burdensome stock-for-stock offer
the speci~l
;nnou_nced in May 2001, with no opportunity provided for
nge ratio
ommittee to evaluate the fairness of the transaction. The excha
Vishay shares
Wascalculated simply by dividing the price of Siliconix and
.:!.4~5~
______
2 ~M~E~R~G~ER~S~A:.,:N~D~A~C::..::Q !:.:U::.::l.:::.SI:-:::...::
______ C~
.:T~IO..:;_N_S
on February 22, 2001, and was fixed at 1.5 yishay sha~es for each
Siliconix share. No premium above the market price was considered .
In the public disclosure documents conc~rning the. ~cquisition,
Vishay included a majority of the minority nonwaivable condit10n, stating
that the offer would be finalized only if a majority of the nonaffiliated
investors tendered their securities. In addition, Vishay informed the
public that, following the offer, it might proceed to a cash-out short-form.
merger for the same consideration offered in the bid, but specified that it
would follow through only if certain conditions were met. Siliconix, on the
other hand, stated in its Schedule 14D-9 form that the special committee
was neutral with respect to the offer, not having issued a
recommendation. It also declared that no fairness opinion had been
provided by an outside financial advisor.
Raymond L. Fitzgerald, a qualified minority shareholder holding 6%
of Siliconix's outstanding shares, sued asserting individual claims both on
his own behalf and on behalf of a class of Siliconix's minority
shareholders. He also filed a derivative action on behalf of the corporation
seeking, in particular, to enjoin the transaction.
Relying on Solomon, the court denied Fitzgerald's petitions. For [our
purposes] it is sufficient to note that the court distinguished mergers
(where corporate boards are the primary negotiators, with extensive
power to structure and bring forward the deal) from tender offers (where
the counterpart to the bidder consists of minority shareholders with
power to decline the proposal if inadequate). In other words, the tender
offer does not entail the conflicts of interest that arise when directors and
officers elected by the controlling acquiring corporation promulgate a
merger. On this basis, the court determined that a tender offer is not
subject to entire fairness review.
Siliconix focused on the front-end of the new freeze-out technique, the
tender offer. In contrast, Glassman v. Unocal Exploration Corp.
addressed the back-end, the subsequent short -form, cash-out merger. In
fact, no tender offer ever took place in Glassman. When Unocal initiated
the short-form merger of its subsidiary UXC, it already owned 96% of
UXC's outstanding shares and proceeded directly to the short -form
merger pursuant to Section 253 of the Delaware General Corporation
Law (DGCL). Dissenting minority shareholders brought a class action
suit alleging an unfair exchange ratio.
Crucially, the court considered the statutory procedure for a short-
form merger set forth by Section 253 inherently incompatible with
equitable relief based on entire fairness review . In a short-form merger,
the board of directors and the shareholders of the merged subsidiary have
no voice, are not involved in the decision, and do not even receive advance
notice of the transaction. This exceptionally truncated process, which
MERGERS AND ACQUISI'rIONS 453
~the parent
' . .
company s board of directors to unilaterally determine
allows saction, is based on a clear policy rationale: the relatively small
·
· interests
the tran·on of minority · ·ry a 1engthy and more costly
fai·1s to Justi
d'rnens1 .
.1 edure, such as that req~ire
d .
in_a 1ong-£or_mmer~er. In the court's own
proCds:"The equitable claim plainly conflicts with t~e statute. If _a
wor te fiduciary follows the truncated process authorized by § 253, it
c~~ror~be able to establish the fair dealing prong of entire fairness. If,
1
~ t n d the corporate fiduciary sets up negotiating committees, hires
~n~ eae~dent financial and legal experts, etc., then it will have lost the
in epbenefit provided by the statute-a simple, fast and inexpensive
vetYessfor accomplishing a merger. We resolve this conflict by giving
p~~t the intent of the General Assembly. In order to serve its purpose,
§ 2
~3 must be construed to obviate the requirement to establish entire
.
fairness. "
Applying its own precedents, the court reasoned that, in the specific
context of a short-form merger, minorities are sufficiently protected by
the appraisal remedy available to "dissenting'' shareholders even if
technicallythey do not vote and, therefore, cannot "dissent" in the general
sense. Equitable relief through an entire fairness claim is therefore not
available in the context of short-form mergers.
Siliconix and Glassman combined to clear the way for going-private
transactions through a tender offer followed by a short- form merger:
neither of the two components of the transaction would be subject to the
demanding standard of entire fairness.
The resulting doctrinal picture was subject to criticism, particularly
by academics. Two types of transactions aimed at the same substantive
result of eliminating minority shareholders-the long-form merger and
the tender-offer followed by a short-form merger-were held to radically
different standards of review. One-step mergers (i.e., long-form mergers)
were subject to the entire fairness standard, more protective of minority
investors. Two-step mergers (i.e., tender ·offers/short-form mergers),
however, were subject to the pro-manager business judgment rule absent
proof of coercion and disclosure violations.
In 2002, with In re Pure Resources, the Chancery Court attempted to
reconcile these differences by establishing further protections for minority
shareholders in two-step mergers. In Pure, Unocal, the controlling
shareholder of the corporation that gives its name to the case, launched a
stock-for-stock tender offer on the common stock of its subsidiary. The
exchange offer, as in Siliconix, was conditioned on the majority of the
minority nonaffiliated shareholders tendering their shares and was also
subject to the waivable condition that Unocal secure at least 90% of all
Pure shares before it initiated a short-form merger pursuant to DGCL
Section 253. Unocal also stated that it would proceed with the merger as
i4~54£______ __JM~E~R~G~E~R~S:.!_A~N~D~A~C_sQ~U~IS~I~T::..:10::.:N:...;..S=-------C.c....
soon as possible after completion of the tender offer, at th e same exchange

ratio as the front-end offer.
The special committee instituted by Pure to eval_uate th e tran~acti?n
prepared a 14D-9 communication recommendu~g th at minor~ty
shareholders not tender their shares. A class actwn follow~d, with
dissenting minority shareholders seeking to enjoin the transaction. The
plaintiffs proffered the usual argument: The offer did _not_meet th~ entire
fairness standard because it was coercive and material 1nformat10n was
not properly disclosed.
The court ruled in favor of the plaintiffs, enjoining the offer. [... ]
[T]he court, for the first time, distinguished clearly between the one-step
merger (subject to the entire fairness standard) and the two-step merger
(subject to the business judgment rule in light of the greater freedom of
minority shareholders to accept the front-end offer). The court was not,
however, oblivious to the risk that a two-step merger might sometimes
confront minority investors with a prisoner's dilemma, forcing them to
accept less-than-optimal consideration for their shares. Coercion of the
minority would be more subtle in a two-step merger than in a one-step
merger, but still present. Therefore, to level the playing field, Pure
established three conditions that must be met in order to exclude the
transaction from entire fairness review: (1) the offer must be subject to a
nonwaivable condition of approval (expressed through tendering) by the
majority of the minority; (2) the bidder must guarantee to promptly
consummate a short-form merger at the same conditions of the tender
offer in terms of price and/or exchange ratio; and (3) the bidder can make
no retributive threats in dealing with the target's directors.
[... ]
To sum up the discussion thus far, Delaware law provides two
primary modes by which controlling shareholders can freeze-out
minorities. The first is the one-step, long -term, cash-out merger, subject
to the entire fairness standard of review. Absent certain procedures to
protect minority shareholders, the burden to prove fairness is on the
defendants. The burden is shifted to the plaintiffs, however, if a truly
independent special committee of the controlled corporation is instituted
to negotiate the deal, or if a majority of the minority unaffiliated
shareholders of the acquired corporation approve the merger.
Alternatively, controlling shareholde!s can employ a two-step tender offer
follo~ed by a short-form -~erger, where entire fairness review applies
only if the three Pure condit10ns are not satisfied.
_(Itshould be added that more recent case law, in Delaware, further
clarified ~he p~oper test under which a going private transaction should
be ex~mined _in case it is conditioned ab initio upon approval of a
committee _of independent directors and of a majority of the minority of
g0L--
hareholders, fully informed. In Kahn v. M&F Worldwide Corp. (Del.
the s C t Of "The F irst ' State" (Delaware's official
Ol4) the Supreme our
2. kn~me)concluded that the standard .should be the protective ''business
. t eres f1ng app r1cation of this precedent can be found
. d rnent rule." An 1n
nic
~u g very recent decision of the Chanchery Court, In re Books-A-Million
1
n a Stockholders Litigation (Del. Ch. Oct. 10, 2016).] '
1nc.
[...]
Unavailability of Cash-Out Mergers in Europe
Cash-out mergers are generally not permitted in Europe. Articles 3
nd 4 of the Third Council Directive Concerning Mergers of Public
tirnited Liability Companies (Third Directive) provide that in a "merger
by acquisition" and in a "merger by the formation of a new company,"
shareholders of the constituent corporations must receive shares of the
survivingcorporation according to an exchange ratio agreed upon by the
boards of directors and approved by the shareholders. They can also
receivea cash payment, but "not exceeding 10% of the nominal value of
the shares ... issued or, where they have no nominal value, of their
accountingpar value."
Thus, shareholders of the corporation extinguished by the merger are
entitled to receive at least some shares of the surviving company and
cannot simply be cashed out. In other words, under European law, a
merger with an entirely cash consideration for some shareholders is
unacceptable. This rule is the expression of a more general principle, still
reflectedin the national laws of most Member States, that a shareholder's
participation right cannot be taken away without her consent.
To be sure, the exchange ratio could theoretically be set so high that
minority shareholders of the acquired corporation will not, as a matter of
fact, obtain shares of the acquiring corporation, similar to what can
happen in a reverse stock split, or share consolidation. Consider, for
instance, a situation where the controlling shareholder owns 51,000
shares, and no other shareholder matches this equity interest. If the
exchange ratio is set at one share of the surviving corporation for every
51,000shares of the merged corporation, only the majority shareholder is
able to obtain equity of the surviving entity.
The exchange ratio cannot be set arbitrarily but must express a fair
relationship between the value of the two constituent corporations and
their shares. According to the Third Directive, in all Member States,
?efore the draft terms of a merger are presented to the shareholders, a
Judicially-appointed independent expert must examine the exchange ratio
and issue an opinion on its intrinsic fairness. This provision embodies in
~any respects one of the fundamental differences between European, and
in particular civil law based systems, and U.S. law. The former rely more
on ex ante procedural protections regulated by the legislature; the latter
CH. 9
456 ME RGERS AND ACQUISITIONS
d. tors enjoy greater freedom in
is a litigation-based system whe~~ ;r:c potentially extensive review
structuring the deal. but are s~ J~C inothe United States, the outcome
through ex post lawsmts. Intere st mg[' ess suggesting procedural
of litigation often backfires on t e _pdrocre'duce the risk of a class
. . . th a t can avo1 or
protections for mmorit1es
action. . · II
1. t d corporation w1l1 vrrtua y never
According to European rule~, a is e h ge ratio so high as to freeze
er with an exc an
be a owed to pursue a mer g .
II . th t ome small investors may
out minority shareholders. It is ~oss1ble 8: sI share of the resulting
have insufficient shares to obtam even a singe . b
. d . th'
corporation, an 1n 1s cas , e the constituent corporations offer to uy· the
Id
h
s ares Th t .
e vas maJori Y ·t of m1·nority shareholders, however,
· ·
are
·
ent1t eh
·· · t he1r
to ma1nta1n · st a t us 1n
· the new corporation . The hm1tat10n on cas
consideration ensures this result.
Consider, for example a merger in which the par value of the shares
of both corporations is €1, the real value for one share of P (the
parent/acquiring corporation) is €2, and the real_value of one share of S
(the subsidiary/target) is €1.10. The exchange ~atio ~ould be 0.55 (1.10/2),
meaning that for each share of S, an investor 1s en~1tled t~ 0.55 shares of
P. This will result in many shareholders of S being entitled only to a
fraction of P's shares, with obvious complications for the merger process.
European law allows reducing the exchange ratio by offering
consideration partially in cash. The cash consideration cannot, however,
exceed 10% of the par value of P's shares. In this example, it would be
possible to provide that for each S share, an investor is entitled to €0.10
cash (10% of the €1 par value) on top of the exchange ratio, consequently
setting the exchange ratio at 0.5 (2/1), a more manageable figure.
These adjustments, however, are very limited and, as a practical
matter, are simply used to round up the exchange ratio, not to cash out
minorities. In this respect, the European approach resembles the one
prevalent in the United States before the mid-1930s, when corporate
statutes were just beginning to allow cash-out mergers . .
Statutory Freeze-Out in Europe: Takeover Directive, Article 15
The fact that cash-out mergers are not the principal method by which
to conduct going-private transactions in Europe does not mean that
freeze-outs are impossible. A freeze-out can, in fact, be accomplished
through a different legal technique, explicitly regulated by Article 15 of
the Thirteenth Directive on Takeovers (Takeover Directive).
~n.short, Article 15, under c~rtain conditions, grants any shareholder
O
acquiring at least 90_1/o
of the voting shares of a listed corporation through
a tender offer the right to cash out minorities at a fair price. In these
general terms, the overall structure of the provision recalls a U.S.-style ,
short-form merger. Upon closer analysis, however, important and
-
f!!:!---
rofound
- .
differences eme~ge. First, pur~uant to Article 15, minorities are
p shedout without merging t~e target into the parent corporation. After
ca aJ·orityshareholder exercises the freeze-out right, the delisted target
the Ill'ther maintain
· · ·t
i s corpora t e i· dentity
· as a wholly-owned subsidiar
y or
canbeie completely merged into the parent.
~n .
[...]
Afternative Ways _to _Fr~eze Out Minority Shareholders in Some
European J ur1sd1ctions
Before providing a critical comparison of the different systems, a few
ore words are necessary on freeze-outs in European countries. In some
~isdictions, freeze-out rights based on Takeover Directive Article 15 are
~ot the exclusive means by which controlling shareholders can
unilaterally cash out minorities. Two examples of additional procedures
are the United Kingdom's "scheme of arrangement," and Germany's
Aktiengesetz(AktG) Articles 327a ff. Each is briefly considered.
Pursuant to British law: "A "scheme of arrangement" or a
"reconstruction" under [Companies Act] 2006, Part 26 and Part 27
(additional requirements for public companies) enables a company to
effect mergers and amalgamations, and also to alter the rights of its
members or its creditors, with the sanction of the court. The provisions
are sufficiently wide to accommodate schemes having a considerable
diversity of objectives and range of complexity, which may involve more
than one company .... Unless the court orders otherwise, the members or
creditors who dissent are nevertheless bound to accept the terms of the
scheme."
Thus, a "scheme of arrangement" is a flexible procedure used to reach
a broad variety of outcomes with the approval of a court. Theoretically,
this technique can be employed to cash out minorities. Existing case law
is limited on the subject, however, and doubts remain as to whether the
procedure is as streamlined as a short-form merger in the United States.
An example of a case where the scheme of arrangement was employed is
In re Hellenic & General Trust Ltd., where Hambros intended to buy all
of the outstanding shares of Hellenic. The transaction was approved at
the general shareholders' meeting by a large majority of the votes. It was
opposed, however, by minority shareholders, in particular, the National
Greek Bank, which held 14% of the ' shares. The court did not sanction
this scheme. Rather, it required a positive vote of the majority of the
(nonaffiliated) minority as a "different class." The case is illustrative of a
certain reluctance to allow a scheme of arrangement for freeze-out
Purposes when shareholders could otherwise be cashed out pursuant to
Article 974ff of the Companies Act of 2006, implemented pursuant to
~keover Directive Article 15. The British scheme of arrangement
erefore does not appear equivalent to the U.S. cash-out merger and can
458 MERGERS AND ACQUISITIONS CH. 9
be considered a much more uncertain, lengthy, and potentially expensive
cash-out technique, if it is one at all.
Sections 327a through 327f of the German AktG also provide a
means by which to freeze out minorities outside the scope of Takeover
Directive Article 15, while . at the same time granting meaningful
protections for minority shareholders. This procedure is available when a
shareholder holds 95% of the shares. In short, the controlling shareholder
convenes a meeting of all shareholders to approve the cash-out procedure .
Because the squeeze-out is not preceded by any tender offer, the fairness
of the cash-out price cannot be determined based on presumptions
regarding the price of the triggering offer. Rather, a court-appointed
expert evaluates the fairness of the proposed price. The expert's positive
opinion limits the possibility of challenging the transaction in court.
While this particular procedure clearly broadens the possibility to
squeeze out minorities and is quite flexible, it is still significantly stricter
than the American short-form merger. The controlling shareholder, in
fact, must own a very high percentage of shares, close to 100%, in order to
exercise her freeze-out right.
In conclusion, Article 15 of the Takeover Directive is not the
exclusive freeze-out provision in all European jurisdictions. But, to the
extent that other rules exist in Member States, they are significantly less
liberal than in the United States. This follows naturally from the bedrock
European principle that minority shareholders enjoy a quasi-absolute
right to remain members of the corporation in which they have invested.
Because these additional freeze-out provisions are generally ineffectual,
exist in only a handful of Member States, and lack harmonization, they do
not undermine the reform proposals advanced in the final Part of this
Article.
[... ]
Causes and Consequences of the Diverging Approaches
Different overlapping elements explain the origins of different
approaches to freeze-outs in the United States and in Europe . [... ] Four
explanations for the comparative differences can be identified: (1) the
federal structure of the American corporate law system and the related
chartering competition among states, (2) the risks and costs of litigation
associated with the status of listed corporations, (3) the potential role of
freeze-out rules or the absence thereof as a springboard for hostile
corporate acquisitions or a protection for entrenched shareholders, and (4)
a path-dependency phenomenon linked to how the legal system and local
culture have traditionally envisioned the property rights of shareholders.
The first reason that explains the existence of a more flexible freeze-
out regime in the United States can be found in regulatory competition
-
~tates and the existence of a market for corporate charters The
arn°0 glsy debate has largely expla ined the different dynami~s of
· · · th U ·t d S tates and Europe, to the extent
scholar
Iatory compet1t~o_n1n . e . n1 e
regtl porate .mob1 hty .exists . 1n Europe. There . is little doubt that a
b
hat cor facili.tates gmng private can e appealing for decision-makers
t . that
reguneelecting the jurisdiction ofbincorporat ion. This conclusion holds
when s use freeze-out ru Ies can ~ a? 1~~o · · r for regulatory
oth beca rtant drive
b tition and because corporate Jurisdictio ns generally characterized
cornPmoree · · e approac h are 1·k
permissiv i eIy to of'l!1er more flexible rules
by a rning freeze-outs. The limited role of the mark et for corporate
conce . II . h . rations or
charters in Euro?e, _especi? y wit. resp~ct to pubhc corpo be more
orations considering gmng pubhc, which could poten tially
· priva · te in h
· th e fu t ure, supports t e conclusio · n that
corp
. terested in gmng
these
lin
egi
·siatures and . policy makers have few incentives to facilitate
typesof transactions. .
tion.
The second, and related, explanation concerns the risk of litiga
shareholder
To the extent that a system relies on litigation to enforce
controlling
rights, going private will be an attractive option to
buying out
shareholders. In the United States more than in Europe,
suits and
minority shareholders eliminates the risk of future derivative
tial costs
class actions, and its value is directly correlated with the poten
controlling
associated with these events for the corporation, its
private itself
shareholders, directors, and managers. It is true that going
ers might
is often a catalyst for litigation. Nonetheless, corporate insid
transaction;
prefer to face a "controlled" risk of litigation for one specific
established
minimizing the risk by complying with the now well-
tial lawsuits
Delaware case law, rather than remaining exposed to poten
as a listed corporation.
iated with
Vis-a-vis the higher potential relevance of litigation assoc
e-out rules
publicly-held status, it is therefore not surprising that freez
r and more
emerged as a pivotal issue in the United States earlie
s it became
forcefullythan in Europe. For American legislatures and judge
g states, to
crucial, especially in light of regulatory competition amon
value of the
~acilitate going-private transactions while protecting the
investment of minority shareholders.
e-out rules
This last motivation for the different development of freez
remark from
opens the door to a more general, and probably more cynical,
law systems
a public choice perspective. The idea that in most civil
d States is
Private benefits of control are higher than in the Unite
pressure from
coherent with the observation that legislatures face less
facilitate going- .
co?trolling shareholders, managers, and their lobbies to
reduces the
P_rivatetransactions. A lower level of minority protection
ration.
fsks and costs associated with the status of a publicly held corpo
shareholders
n other words, and more bluntly: In Europe, controlling
and directors might be less eager to buy out minority shareholders

because the likelihood of litigation (and losing this litigation) is low while
the possibility of exploiting the private benefits of control are more
significant than in the United States.
But there is even more. Barriers to going-private transactions might
have a protective effect for incumbent controlling shareholders against
hostile acquisitions. It can be a sort of implied antitakeover measure,
which has not really been examined by scholars and policy makers. It is
intuitive that many hostile acquisitions in the form of leveraged buyouts
and management buyouts can be sustained financially only by bringing
the corporation private and cashing out minorities. This might be the case
for different reasons, perhaps because of the tax benefits of substituting
equity with debt, or because the debt incurred to take over the
corporation can be serviced only by cutting compliance expenses, or
because the corporation needs an organizational turnaround that cannot
be effectively and efficiently accomplished in the presence of minority
shareholders.
When potential buyers know that achieving a position in which they
can unilaterally cash out minorities is difficult, especially with the
opposition of the existing controlling shareholder, the risk of not being
able to obtain 100% of the outstanding shares might discourage hostile
acquisitions. It can therefore be argued that, in states with concentrated
ownership structures that do not favor the proliferation of hostile
acquisitions, stricter rules concerning freeze-outs might also serve as an
indirect, but relatively effective, deterrent to some takeovers, to the
advantage of existing controlling shareholders. ·
A fourth and final explanation for the different approaches to freeze-
outs in the United States and Europe can be found in a cultural relic
concerning the legal qualification of the interests of minority shareholders
in the corporation . Most continental European systems emphasize the
property rights of the single shareholder over the shares she owns and
consider most forced acquisitions an infringement of the right to own
property. In some Member States, freeze-out statutory rights have even
raised constitutional law challenges on the grounds that they might be
considered unconstitutional takings based on private, rather than public,
interests.
Allowing controlling shareholders to unilaterally buy out minorities
is at odds with this view. In Europe, it is still the dominant view that
cashing-out minorities should be possible only in extreme circumstances.
This_ ap~roach a~sumes that the best protection of minority shareholders
consists 1n allowing them to hold on to their shares.
In ~he ~nited States, o:q.the other hand, the prevailing perspective is
that minority shareholders are primarily investors with a financial
ISITIONS
MERGERS AND ACQU 461
¢------ . .
in th e co rp or ati on . Accordingly the form ~f
t to ~a ra nt e:~Pf~pria~e
ar eh ol de rs is
intere~·on for minority sh fo r co nt ro lli ng eir
sahirvhauldeon than
nal fle xi bi lit y are o er s d
protec1ent. Additio . . th fi . of th .
. vestlll e inancial structure e corporat10n~
1n ers in defsignitng ·t th ·t co m pa tible with th
Jilanag ex i e eq ui ~ m ~r k~ t, is
·ncludingthe op i?n .o as m in or ity .int~res ts are liquidated at
, so Io n~
~nterestso~ the min~rity vi ro nm en t. Th is view assumes th at wi't
h
0n -fr ee en
. value in a. coerc1 . d . .
eh ol de rs can find alternative
fair , ~1 no rit y sh ar
the considerat10n receive ient market.
. vestments in a robust, effic
111
S
NOTES AND QUESTION
ica n ju ris pr ud en ce on ca sh-out mergers and
1. Do you find the Amer of Professor Ventoruzzo's
work
se d in th e fir st pa rt
freeze-out discus example,
he re nt ? Ca n yo u id en tif y possible criticisms? For
reasonableand co th e sh o.r~-form merger does not
require
fe r fo llo ~e d by
whythe tender ot
th e th re e co nd 1t 10 ns es tab lished in In re Pure?
entirefairness review only if t
n, is th e U. S. or th e Eu ropean approach to cash -ou
2. In your opinio hy ? Is there a reason to facilitate
the
ts pr ef er ab le? W
mergersand freeze-ou nt ro lli ng sh areholder, also against the
will
es by th e co
acquisitionof all shar
ofthe minority shareholders?
zo of fe rs so m e po ss ib le explanations for the
3. Professor Ventoruz tw o sid es of the Atlantic . Do you find
we d on th e
differentapproaches follo e th er e ot he r possible reasons for this
lli ng ? Ar
these explanations compe t? Ar e an y of the explanat ions offered
d su gg es
divergencethat you coul
larly strong?
particularlyweak, or particu sh-out
le ab ov e di sc us se s th e general framework of ca
4. The artic lities ,
ou t tra ns ac tio ns . W hi le it delves into some technica
mergersand freez e- in ed . If you are from one
tails th at co ul d be ex am
ofcoursethere are other de th er e an y ad di tio na l issue that you would
ed , is
of the jurisdictions consider e fro m a di ffe re nt jurisdiction, how are
yo u ar
suggest to consider? And if ns ac tio ns re gu lat ed in your system if they
ou t tra
cash-out mergers and freeze- ed ? W he re th e line between manager ial
th ey all ow
are regulated at all? Are shareholders should be draw
n?
d pr ot ec tio n of m in or ity
flexibilityan
***
to
fre ez e- ou t tra ns ac tio ns is an interesting addition
Japanese law o'n of
pa ne se ap pr oa ch in th is area presents elements
our discussion. The Ja e U. S. ap pr oach, but has also its ow
n
oa ch an d th
both the European appr fa ct, fre ez e-out transactions were
re 20 05 , in
specific features. Befo es Ac t of 20 05 opened the door to
e Co m pa ni
generally unavailable. Th in g ca sh -o ut m ergers (Art. 749(1)(iii)
these transactions, first by all ow
-fo rm m er ge rs in wh ich a supermajority vote
ng
CompaniesAct) both as lo (A rt . 78 3( 1) an d Art. 309(2j(~ii)
requ ire d
of the shareh~lders is m m er ge rs in wh ich the surVIvmg
shor t-f or
Companies Act), and as
CHAPTER 10
TAKEOVERSAND TENDEROFFERS
HOSTILEACQUISITIONS,AND '
DEFENSIVEMEASURES
•••
:
TAKEOVERSTHE ECONOMIC
AND LEGALBASICIDEAS
Takeovers, and the dramatic battles for corporate control that the
entail, are one o~ the few corporate law topics entertaining enough t~
makeit into movies. Hollywood blockbusters depicting takeovers include
WallStreet (1987), Other People's Money (1990), and Pretty Woman
(1990),portraying more-or-less unforgettable corporate raiders such as
GordonGekko ~ich~el Douglas), Larry The Liquidator (Danny DeVito),
andEdward Lewis (Richard Gere). OK, maybe they are not all considered
masterpiecesby movie buffs, but if you haven't yet, we suggest you watch
themas part of your cultural background on takeovers.
When a corporation is listed (and in this chapter we only focus on
listedcorporations), someone interested in obtaining control must, first of
all, decide if a friendly acquisition is possible, or if it is possible-and
necessary-a hostile acquisition. By "friendly'' acquisition we refer to a
transaction in which control is transferred with the consent of the
existing controlling shareholder and/or management of the target
corporation;by contrast, and obviously enough, a ''hostile" acquisition
occurswhen the existing controlling shareholder and/or management of
the corporation opposes the takeover: in this situation the incumbents
andthe buyer engage in a legal and financial duel. This distinction is not
always as clear-cut as it might appear. For example, a "friendly''
acquisitionmight be conducted under the more-or-less overt threat that a
hostile one could be successfully launched . In addition, in a "friendly''
acquisitionother stakeholders, different from major shareholders and top
m~nagement, might oppose the plans of the acquirer: employees and
unions,creditors sometimes even the government. Generally, however,
we distinguish between hostile and friendly acquisitions based on
whetherthe incumbent is willing to transfer control or not.
· ·t 0 f the
If a controlling shareholder owning an absolute maJor~Y
shares exist, it is generally very difficult to obtain control without her
469
TAKEOVERS AND TENDER OFFERS, HOSTILE
470 ACQUISITIONS, AND DEFENSIVE MEASURES CH.10
consent. A 60% shareholder, for example, can pre vent a .takeove

th'
r simply
·t .
by not selling her shares. In reality, to obtain contr? 1 infi is s1 u~tion
might be very difficult, but not entirely impossible._Thmk, ~r e~~mp e, to
the battle for controlling Mondadori, which we discussed 1~ apter 4,
talking about different classes of shares (do you remem?er · It was the
case involving former Italian Prime Minister Berlus~oni). In .th at case
shareholders holding limited voting shares could p~ssibly obtain control
notwithstanding the opposition of the then controlling sharehol~er: But
those are fairly unique situations, and if someone owns. th e maJority of
the outstanding shares the only way to obtain control is, generally, to
convince her to sell you some or all her shares.
There might, however, be a shareholder able to control the
corporation without holding an absolute majority of the shares. For
example, imagine a situation in which the largest shareholder ~wns 33%
of the common stock, the next largest shareholder after him is an
institutional investor with 5% then three other smaller shareholders
with 2% each, and then the rest ' . read among
of the shares are widesp
investors holding tiny participations (not more than 0.3% each). In this
case, because of the "rational apathy'' of minority shareholders, who
generally do not actively participate in the governance of the corporation
due to information asymmetries, transaction costs, and so on (see Chapter
5), our 33% shareholder is likely able to appoint the majority of the
directors, influence the management of the corporation, and unilaterally
adopt most shareholders' meeting resolutions.
The position of the controlling shareholder, in this situation, is
however vulnerable. A third party might try to acquire control with his
consent, persuading him to sell his shares, but could also try a hostile
acquisition. In fact, if a third party manages, for example, to buy 45% of
the voting shares from the minority shareholders, the third party might
become the new controlling shareholder. Of course the same is true in a
corporation with a very widespread ownership structure with no strong
controlling shareholder, a real "public corporation" controlled, as a matter
of fact, by its managers and directors.
Now, what are the possible techniques to acquire control? First, the
acquirer can buy in private transactions, not on the stock exchange, large
participations from the existing controlling shareholder or from qualified
minorities. This technique obviously requires the existence and
w~llin~ess to sell of relati~ely large shareholders. Second, the acquirer
m1~ht simply start purchasmg shares on the market, trying to obtain the
desired threshold, for example 51% of the voting shares (with or without
the consent of the incumbents). Open market purchases however can be
problematic for the acquirer. ' '
,.
TAKEOVERS ANO TENDER OFFERS, HOSTILE

O A CQUISITIONS, AND DEFEN SIVE MEASURES 471
£!!=1-- -
To understand why,~~ i:ieed to ta~e a step back _andbriefly illustrate
tionale of the acqms1tion. Imagine a corporat10n whose shares in
the ;a st two months, have had a relatively stable market pric~ of
the ~mately $3. The buyer is generally motivated to obtain control
apPro·se basically, he thinks that the corporation is undervalued or more
beC8Ually ' that he can ma k e a profi1t. For example, he might think ' that if
gene~tains control, by managing the corporation more effectively and
:~;ently, the value of the corpora~ion will increase and the market price
.11reflect that, for example reaching the $7 level. At that point, he could
willthe shares and reap a large gain. Alternatively, the buyer might
she .nk that by merging the target with other business activities he is
. olved with an d exp1··
tl 01ting economies . of sea1e, or by breaking up the
~~;getand sellin_gthe differei:it parts, he ~an make a pr?fit. The bottom
line, however,. 1s,,that _ as 1n any_ busmess transaction there is a
"reservationprice, a pric_eabove which for the buyer, based on his plans
and projections,the deal 1s no longer profitable. In our previous example,
if the acquirer hopes to be able to push the prices to $7, he might still be
willingto buy shares for $6.5, even if at this point his marginal profit will
be lower,but not for $7.5.
With this in mind, let's go back to the idea of obtaining control
through open market purchases. Acquisitions of control by buying shares
on the market, without making a public offer, are sometimes also called
"creepingacquisitions." Especially if the buyer needs to acquire a large
number of shares, his activity will put a significant pressure on market
prices:the demand for the shares might be very relevant. In addition, as
wewill see, most legal systems impose specific disclosure requirements on
whoever acquires certain thresholds of listed corporations, in order to
ensure that investors are informed on the ownership structure. Under
these conditions, the market price might skyrocket, also irrationally:
other investors, realizing that someone is trying to obtain control, might
also start buying shares, and since they do not know the reservation price
of the buyer, the price could easily exceed the $7 limit in our previous
example. For this reason, acquiring control through open market
purchases might be difficult, expensive, lengthy , and in short not feasible.
Another option available for the acquirer, therefore, is to launch a
public tender offer. With a tender offer the buyer invites all existing
shareholders to tender their shares, offering the same conditions to
everyone. Of course, to be successful, he must offer a price above the
market price, but the advantage is that he can "cap" the price and plan
accordingly. Going back once again to the numbers of the previous
example, our acquirer might launch a tender offer paying $4.5 per share,
a_q~ite significant premium over current market prices of $3, but still
significantly lower than the $7 value that he attaches to the shares. The
terms of the tender offer might vary, for example it might be an offer for
TAKEOVER S AND TENDER OFFERS, HOSTILE
4 72 A CQUISITIONS, AND DEFEN S
IVE MEASURES CH. 10
. . . d to a certain percentage of
all the outstanding shares, or Just hm~te t threshold (typically a
shares; it might be conditioned t? re~chmg a se £ a longer or shorter
controlling participation) , or not; it might be ~pe_n ~r res regulate quite
period, and so on. As we will see, most egis1af; . nt information i
precisely these aspects, especially to ensure th at _su_ icie . offe s (£ s
J
disclosed to investors by the offeror, and to hmdit 0 e:civ~ t r tt" or
example, offers only opened for a very short perio , fr esigne ~ ~u mg
undue pressure to tender on the offerees, or partial O 1 ers on a irs -come,
first-served basis). l
You can find here one of the most important _ a nd st riking
comparative differences with respect to the ~e~lat~o~ of control
l
1
acquisitions. In some countries, under certain cond1t10~s,it is mandatory
to launch a tender offer on all (or part of) the outstanding sh~res , at a_set
minimum price, in order to obtain control, or ~fter having acquired
control. This is the case in the European Un10n, pursuant to the
Thirteenth Directive modelled after the U.K. approach, but also-of
course with significant variations-in countries as dive~se as Japan ,
China, and Brazil. Other systems, and specifically the Unite~ States, at
I
least at the federal level, do not provide any such mandatory bid rule, and
allow much more freedom on how to conduct an acqu isition . What is the
rationale of the mandatory tender offer? How is it regulated? What are its
effects, also based on the prevailing ownership structures? These are
some of the questions that this chapter will address.
In addition to negotiated, over-the -counter purchases from large
shareholders, market transactions, and tender offers, there are also other
possible ways to acquire control or, more precisely , to substitute the
members of the board. One example is proxy fights, in systems that allow
them. With a proxy fight , someone simply tries to convince-with a
solicitation of proxies-a majority of the voting shareholders to vote for
certain candidates to the board and oust the existing board, or to vote on
certain corporate transactions in a way different from what is suggested
by the existing incumbents. Even if proxy fights might be a way to oppose
controlling shareholders or managers, they do not involve the acquisition
of shares (actually, they can be a preliminary step to a future acquisition
of shares), and therefore we will not consider them here, even if you
should keep them in mind as a possible alternative to other takeover
techniques.
We have so far considered the "weapons" that can be used by
someone aiming at obtaining control. Let's now consider the perspective
of the target corporation in case of a threatened or launched hostile
acquisition. An existing controlling shareholder, or the directors and
managers of a target corporation, might vehemently oppose a non-
negotiated acquisition . Generally the new controlling shareholder will
remove the existing directors and substitute them with directors she
TAKEOVERS AND TEND E R O FFFRR H
ACQUISITIONS, AND DEFENs , ' ' ' o~n.·,
LF,
,M1,:Asu10:s . iv1-
473
and the new board will prob ably rep1ace th
trusts , · h put in e _top executivcH. 'l'hc
former control_h~g s areholder might be . a corner, .and loHe h', 1::1
·VI·legedpos1t10 n. After all, .very often th e Pnm a .motivation for
pr1 ver is . h th way in which the co . ry
keo to c ang e e rpor ati on 18 r a
ta un a nd turn it
around.
What are the legal tools that the incumb URe to reHiHt a n
solicited, and unwelcome, acquisition? Wh t ent c~n in oth
a are er worcJR' the
un ible "weapons" of t h'1s b attle? Before read·ing furth '
e t
POss · f r, ry to come up
with a list of possible corporate actions that can rustrate the goals of a
corporate raider.
th
The list is long, but even limiting ourselves t 0st common ones
coo e ~
..,e should mention the following. .Having the rporat10n purch ase own
" in th h
shares could be a way to put serious obstacles
mark ~ P3:t of a hostile
bidder. On the one hand, this strategy pushes
tandi: pnc;s ~p; on th_e
other hand, there would be fewer shares outs t er~fore it
might be harder to acquire ·a maj ority stake. A somgh,an opp osite' but
t·1ve a It ernative 1s · for the corporation to · e ow
· l lye f't'
Poten.tla.
1ec
h h ld issue new sharh'es
at a carefully dete rmi ned price Al
to existing s are ok ers, h d £ • tso t £18
.ion can ma e 1't ar er or the bidder to acquire cooro ,~1
transact · d he mi ht d
to reach the necessa ry thre sho ld
example becauseh 1n or er b f h . g nee
· t0
. h.
to acquire a 1g er num er. o s . ares . Merging a subsidiary with and In
h consequences, since-as
the target-parent corporat10n m1g t have similar
the issuance of new shares
we have seen in Chapter 9-a merger requires
according to the exchange ratio.
ite knight," a friendly
The target can also be rescued by a "wh
er offer at more attractive
corporation that might launch a competing tend
conditions, with the understanding that in case of success it will not
lace whoever controls the
substitute the management, or otherwise disp
t either match the second
corporation. The original hostile bidder mus
with a colorful name is called
offer, or retreat. Another defensive measure
is that directors might sell
"selling the jewels of the crown": the idea here
nt by the hostile bidder, for
some crucial assets, considered very importa
nts, therefore mak ing the
example a trademark or a portfolio of pate
valuable. Of course in this
target corporation much less attractive and 5t
risk is to dam age the targ et corp orat ion by giving away its mo
case the
requires selling the assets to
precious assets, and generally the technique for th e
sell them bac k whe n-ho pefu lly,
a friendly third party that will
target-the danger is gone. d
. . n. of this. tee h n1q · · ht 1·nvolve the so-calle t
A particular vanatio ue mig 8
trus t in whi ch som e asse or
Dutch "stichtin"'' a sort of foundation or h t d ith a take ove r , a
8hares can be placed
5 ,
In practice ' when t rea ene w 1 ble
£ t O it its moreti'ty va ua
. . s er d t whose
corporation can create a stichting · and· tran · · depen en en
an in
ssets, e.g. a business unit. The stichting is
a
CH. IO
474 ACQUISITIONS, AND DEFENSIVE MEASURES
fi d term and cannot be
directors are appointed by. the target for a . ixe_ tructions concerning
removed or changed. The directors have specific ins d
11. th to anyone an on1y
the assets, such as for example not. se mg em he risk of hostile
transfer them back to the target if and when t b d in oth
acquisition is over. The instrument can however also e usfeth t etr
I! • • •
ways, 1or example grantmg it an option o pur t chase shares o e arge
. ,
. .
engineered m a way that would make t e acquisi h · ·tion too expensive
. .or
impossible for the bidder (with effects somehow similar to a poison p~ll,
see below). As "trustees", the directors of the stichting must ~ompl~ w~th
the instructions given by the target and the purpose written ~n its
governing · · canno t b e "~ ndone". , even if the
· document, and the stichting
bidder obtains control of the target, at least for a period of time. The leg~l
status of the stichting is still debated, but it has been used as a defense in
some notorious battles for control, e.g. the (eventually successful)
acquisition of steel giant Arcelor by the Indian Mittal group, or more
recently in the Teva-Mylan deal.
Again, a corporation might adopt the so-called "Pac-Man" ~efense,
from the name of the famous arcade game of the 1980s. Like the
character of the game, Pac-Man could turn around and eat the enemies
that were chasing him after touching a power-pellet, this defense consists
of a counter tender offer or purchase of shares of the hostile bidder by the
target: the prey turns around and attacks the predator. This defense,
however, only works if the bidder or its controlling corporation are listed
and vulnerable to hostile acquisitions; in addition lots of legal systems
put limitations on cross-holdings of shares: since the bidder often already
has a participation in the target before launching a tender offer, in some
jurisdictions the law limits the ability of the target to acquire voting
shares of the bidder.
Another type of defense is represented by the introduction of very
large compensations for directors and managers in case of a non-
negotiated change of control, so called "golden parachutes." The inhibiting
effect of golden parachutes is due to the potentially huge payments to
former executives. In addition, even if generally the bidder wants to
change part of the management, he often does not want to find
replacements for all the managers, something that might be difficult to do
in a short period of time . Other "shark repellents" (the expression clearly
betrays a negative view of hostile acquisitions, which is not necessarily
justified) include staggered boards provisions, under which a new
c?ntrolling shareholder_ m~ght nee_d more time to obtain a majority of the
directors, and supermaJor1ty requirements that might make the approval
of mergers or other extraordinary transactions difficult.
One last defense that we should mentioned, particularly common in
the U.S., is the a~tl~ named "poison pill," aka "shareholders' rights plan."
We encountered 1t 1n Chapter 5. The poison pill, in fact, is a family of
TAKEOVERS
CH. 10 Ac U AND TENDER OFFERS, HOSTILE
,Q ISITIONS, AND DEFENSIVE MEASURES 475
defenses that share certain features but also present some d1stmc . . .
essence the " ill" . tions. In
'nts of Pthe 1s a set .of rues ·
1 generally mclude · ·
docume d m the governing
characterized b th corporatwn and adopted by the board of director~,
(from the . ( f r~e elements: (a) a triggering event; (b) a catastrophic
possibil"t 1 p;in b O view of the hostile bidder) consequence; and (c) the
. . Y O
e . redeemed at nominal costs by the directo rs. The
t riggermg event 1s often represente d by the acqms1 ·
· · tion f ·
th h Id Of h o a certam
. ;es fo s ares by a shareholder, for example 20%, signaling a likely
in en wn to acquire control (disclosure is mandated by the securities
· · g event occurs, shareholders can exercise some
laws)
k" d · fOnce . th e t riggerm
°
~n right that makes the acquisition much more difficult for the
bidd:r. For. ~xample, in a "flip-in" pill shareholders of the target can
~cqu~r~ addit~?n~ shares from the corporation at discounted price; while
in a flip-over pill shareholders of the target can have the right to obtain
shares of the bidder if, after the acquisition, it wants to merge with the
target. The bottom line is that the pill is calibrated to grant to existing
shareholders advantages that frustrates the goals of the bidder.
The pill-which, as we have seen, is basically a right granted to
shareholders-----can however be redeemed by the directors at a very low
price, for example they can "cancel" the rights for one cent per share. If
you consider the effects of these three elements, the result is that an
acquirer can only hope to obtain control with the agreement of the
existing board, which must redeem the pill (interestingly enough, bylaws
provisions only allow continuing directors to redeem the pill, in order to
avoid that new directors appointed through a proxy fight could get rid of
this defense, even if the permissibility of these "dead-hand" pills 1s
excluded in several jurisdictions, including Delaware).
As you can clearly see, defensive measures comprise a gamut of
different and heterogeneous techniques, ranging from purchase of own
shares to seeking a white knight. Some of them can be adopted after a
hostile takeover has been launched; others work better if introduced
before any declaration of war. From a legal point of view, in different
legal systems, these measures might be within the competence of the
shareholders' meeting or of the directors, and they basically have only one
thing in common: they are designed to frustrate a hostile offer.
'
'
The key issue is that the adoption of defensive measures, in

particular by directors, presents an inherent conflict of interest. Directors
might be adopting a defense not because it is in the best interest of the
corporation or the shareholders, but simply to save their own ... seat.
Fearing that a new controlling shareholder might fire them, directors
could frustrate an offer that would actually be fair and desirable for the
shareholders, and economically efficient, simply to entrench themselves.
What is even more delicate is that, in deploying their defenses, directors
use-and might destroy-corporate resources. Let's go back to the
'
CH. 10
476 ACQUI SITIONS, AND DEFENSIVE MEASURES
. . . that
example of the tender offer for $4.5 on t h e sh ar es of a corporation £
floats at around $3. The offer might be val':1e-maxii:i~:~g for
shareholders who might be happy to accept it; the bidder mig d in act
have a chan~e to manage the corporation more effectively, :3-n see the
market price go up to $7, but only after having re~oved the incompetent
existing directors . Everyone would be happier with the offer (Pareto-
efficiency), but the directors . They have the power to bloc~ the offer, f~r
example selling the jewels of the crown. By doing so they might succeed in
discouraging the bidder, and keep their job for a few more years, bu~ they
would also have impoverished the corporation. It would be_ as if the
defenders of a citadel under siege, in order to repel the barbarians at the
gates, would set fire to the riches of their community .
If this is the case, why don't corporate law systems si~ply prohibit
directors from adopting defensive measures? The answer is that there
are, in fact, situations in which defensive measures are desirable from the
point of view of shareholders and other stakeholders, and the proposed
tender offer is not value maximizing . Consider again our previous
example. You might imagine a situation in which the market price of the
shares is unreasonably low, for example it is depressed in a period of
extraordinary high interest rates that cause lots of investors to sell equity
and buy bonds. Under these circumstances , the directors of the target
might genuinely and correctly believe that the actual value of the shares
is at least $6, not $3 (the current market price), but not even $4.5 (the
price offered by the bidder). They might believe that if the shareholders
hold on to their shares, wait a few months and let them carry on their
strategy, the market will adjust and prices will go up. Shareholders,
obviously , would not be better off tendering the shares now for $4.5; if the
offer is successful they might not have the opportunity to enjoy the full
possible capital gain. In addition , the bidder might be using techniques
designed to . create a pressure to tender, to the extent that the legal
system allows them, such as giving a very short timeframe to accept the
offer. In this scenario, you might argue that it is not only legitimate and
in the best interest of shareholders that existing directors adopt defensive
measures, but that directors have a duty to protect the corporate bastion.
Using again a military metaphor, when the attackers threaten to sack the
city, the captain of the guards must throw some arrows and boiling oil at
them. If nothing else, a defensive measure might force the bidder to
improve the terms of the offer.
As you can see, the regulation of defensive measures must strike a
complex balance between two opposing goals: preventing the incumbents
from adopting frustrating measures not in the best interest of the
corporation and the shareholders, but at the same time do not tie their
hands so tightly that they cannot adopt defenses necessary to react to
inadequate, damaging and coercive offers.
TAKEOVER S AND T
cu.10 A C· UISITIONS
. ENDER OFFER S HOSTILE
AN D '
D EFEN SIVE MEASURES 477
Legal system s around th
equilibrium but once . he world struggle to find the optimal
divide . Some' countries (inagam . ere w fi d ·
e m an mterestmg · ·
comparative
UK approach ad 0 f 1
c udm~ all the E.U. Member States) follow the
The· idea her~ · fh i~g some kmd of "passivity'' or "no-frustration" rule.
' t·l t' iks a to address the conflict of interest of directors in
f h os
case o i e a eover the b t t· · · · concerrun
· g
deJ.enses away from them es op ion is to take any decision
r
h d 1 t h · ·
, an e s areholders decide since they are the
ones. ~ at can be primarily benefitted or harmed by the offer. The
1
1
passivity rul~, ther .efore, simply says that when an offer is pending the
shareh~lders meeting, and not the directors , must approve any action
that might frustrate the goals of the bidder. We will discuss how and
under whic.h conditio.ns this simple and ingenious solution can work well,
and when it can be ineffective, or even counterproductive. On the other
end of the spectrum, in the U.S., the way in which this problem is
addresse.d is primarily through directors' fiduciary duties. In the takeover
context, 1n other words, a modified duty of care and duty of loyalty dictate
what directors can and cannot do in terms of defensive measures. This
difference is interesting because it shows, once again, a defining feature
of American corporate law, its reliance on litigation and ex post measures
to regulate corporate governance. One note of caution is however
important : focusing on Delaware case law and taking an historical
perspective, it is fair to say that the standards adopted starting in the
1980s to regulate takeovers have been partially relaxed more recently,
according to some commentators as a reaction to the development of other
monitoring mechanisms such as a more significant role of institutional
investors, and the corporate governance movement that has introduced
stricter rules on the composition and incentives of the board of directors
(see S. Davidoff Solomon, R . S. Thomas, The Rise and Fall of Delaware's
Takeover Sandards, ECG! Law Research Paper No. 329/2016, Vanderbilt
Law and Economics Research Paper, 16-24, available on www.ssrn.com) .
., .
To sum up this unusually long but necessary introduction, looking at
different strategies to regulate takeovers you can come up with a matrix
in which you can have fun trying to fit different systems:
'l
,
'
TAKEOVERSANDTENDER OFFE · RS HOSTILE

' SURES CH.10
478 ACQUISITIONS,AND DEFENSIVEMEA
boardneutralityrule
yes no
Cl
UnitedStates
s;:
·C'-
'13
,Cl
~
~ EuropeanUnion
~
E Japan
""
~
(but oftenboard
neutral\tyis optional)
Needless to say, this matrix oversimplifies

the reality. As we w~ll
partially see later, for example, the passivi
ty rule has been adopted_m
different ways, more or less rigorously, in
different European countries,
and also in the United States there might be
some rules at the state level,
or in the governing documents of the corpor
ation, which have effects not
dissimilar from the ones of a mandatory tend
statutes"). As with all simplified models, how
basic alternative regulatory approaches.
er offer (so-called "cash-out
ever, it captures nicely some I
To explore further the regulation of takeove
as follows. First, we will take a closer loo
rs, the chapter proceeds
k at the regulation of tender
l
offers, and particularly mandatory tender offe
rs, and defensive measures, ~
l
in different countries. In this perspective,
we will consider the effects of
the adoption of the U.K. approach, based
on mandatory tender offer and
passivity rule, in systems with a very differen
t ownership structure, such
as_Italy or France: It is an interesting exa
mple of legal transplant and
possible unintended consequences. Second
, we will focus on the European
situation, to consider if the Thirteenth Dir
ective on Tender Offers has
really harmonized takeover rules, or if the
differences among European l
States are still profound. Third, we will mo
discuss another interesting effect of regulat
ve back to the U.S., to briefly
ory competition among states
I
(remember Chapter 2?): anti-takeover stat \
utes . Finally, we will consider
the Japanese experience, particularly interest
a sort of hybrid approach between the Europe
ing because Japan followed l
an and American ones.
l
i
TENDER OFFERS AND DEFENSIVE 1
MEASURES: l
j
UNINTENDED CONSEQUENCES?
l
. Tender offers, ?oth voluntary and mandato 1
ry, are subject to rules
designed to pr?tect mvestors. These rules l
focus on disclosure, mandating
!hat wh~ever mtends to launch a tender
offer must provide certain key
mformation to the market and the offe
rees (and sometimes other
1l
!
l
TAKEOVERS AND TE
H:!-.
_Q__ ___
- ~1o::.- D N~S~AN~~N~D~E!R~O~F
A_C_Q=U=IS::.::I-=:.Tl~O~
' EFENSIVE MEASURES
F~E~RJS~,~H~o~sQ_T~I~L
4 79 ~E----!l!!
stakeholders, e.g., workers), concer · th ..

Jans for the corporation in a f£ n~ng e conditions of the offer and his
p mpetent financial ma;ket n otheri~g document generally filed with the
co s au ority · Additio 1 1 t ·
ubstantive aspects of the offer £ . ~a . ru es govern cer a1n
s en for more than a certain , . o~ example its timing (the offer must be
op . . minimum number of days and less than a
certain,, maxi,mum), ~n~ equal treatment of offerees ("pro-rata " "all-
holders
. · !
and 'best-price rules) ' and so on · The goa1 of th ese prov1s10ns ·
1s,
10 many
·d · , connected to and instrumental 1n
ways · to
· d'isc1osure, an d 1s
avo1 .excessive
. pressure to tender on the of'l' · d t 11
ierees, 1n or er o a ow em th
to .obJectively
. evaluate the offer and take a ra t·iona 1 an d un b"1ased
dec1s10n.
I~ . the United States, most of these rules are included in the
Securiti_esand Exchange Act, and more precisely in the part introduced in
1968 with. the so-ca_lled Williams Act (section 14). In Europe they are
regulated in the Thirteenth Directive, and further specified in national
statutes an~ re~lations enacted by the Member States. In Japan,
relevant legislat10n are Articles 27-2 to 27-22-4 of the Financial
Instruments and Exchange Act and related secondary rules .
One important provision to understand the mechanics of takeovers is
the requirement that whoever acquires a qualified participation in a
listed corporation must disclose her acquisition. For example, in the U.S .,
under section 13(d) of the Williams Act, anyone who becomes the
beneficial owner of 5% of any class of equity securities must file with the
SEC a Form 13D within 10 days of the acquisition, indicating in
particular the source of the funds used for the purchase, and her
intentions with respect to the corporation, and specifically, if she aims at
obtaining control. Similar provisions exist in most developed financial
markets, even if the triggering threshold might vary (for example, in
some European countries it is 2% and the scope of disclosure is not
identical) .
This provision is very interesting because it demonstrates quite well
the double-edged nature of most takeover rules: on the one hand, they can
protect minority shareholders and investors, but on the other hand they
can protect the incumbent managers or controlling shareholder.
Mandating to disclose the acquisition of a participation allows, obviously,
the market and therefore investors to have a more complete picture of the
ownership structure of the corporation, and informs them on possible
impending takeovers that might drive the market price of the shar es up.
The disclosure however also represents a wake-up call for managers and
large shareholders on the possibility of a hostile at~empt to acquire ~he
corporation, giving them the time to react and 1mplemen! def ensive
measures. In this perspective, for example, the 10-day_ ~~ndow that
section 13(d) of the Williams Act allows betw~en the acqu1s1tion and the
TAKEOVERSAND TENDEROFFERS, HOSTILE
~4 ~SO~----...:A~ CQ~U~I~S!:!IT~I
~AN~
O~N~
D~D~
S~,E~FE~N~S~IV~E~l\i~E
__~A~SC-=...
U.::..R:.:.;H
:.:.:E~
.~.!!
S:...--
fil . r
1 mg o Form 13D can be preci·
ous for t h e buyer to accumulate shares in
excess of 5% unbeknownst to the incumbents.
In any case, in the United States, with the exception of some possib!e
anti-takeover provisions at the state or corporate level, no ma nd atory
bid
is required. Let's consider, however, the opposite approach, ~nd read
the
provision of the Thirteenth Directive (2004/25/EC) mandating a tende
r
offer:
Article 5-Protection of minority shareholders, the mandatory
bid and the equitable price
1. Where a natural or legal person, as a result of his/her own
acquisition or the acquisition by persons acting in concert with
him/her, holds securities of a company [regulated by the laws of
a Member State and whose securities are listed in a Member
State] which, added to any existing holdings of those securities of .
his/hers and the holdings of those securities of persons acting in
concert with him/her, directly or indirectly give him/her a
specified percentage of voting rights in that company, giving
him/her control of that company, Member States shall ensure
that such a person is required to make a bid as a means of
protecting the minority shareholders of that company. Such a bid
shall be addressed at the earliest opportunity to all the holders
of those securities for all their holdings at the equitable price as
defined in paragraph 4.
[... ]
3. The percentage of voting rights which confers control for the
purposes of paragraph 1 and the method of its calculation shall
be determined by the rules of the Member State in which the
company has its registered office.
4. The highest price paid for the same securities by the offeror,
or by persons acting in concert with him/her, over a period, to be
determined by Member States, of not less than six months and
not more than 12 before the bid referred to in paragraph 1 shall
be regarded as the equitable price. If, after the bid has been
made public and before the offer closes for acceptance, the offeror
or any person acting in concert with him/her purchases securities
at a price higher than the offer price, the offeror shall increase
his/her offer so that it is not less than the highest price paid for
the securities so acquired.
NOTES AND QUESTIONS

1. The rationale of the mandatory tender offer is twofold: to spread at
least partially, the "control premium" among all shareholders, and to
grant to
T/\AIU:OVEll~ AND 'l'1•:N1>t,;1t
01, •1,•1,
·1cu I If> , .
Ct1.10 C UISITIONS • .,, HIii.i ~
~ :..;:..;;.--- --i.;;..;~.:...:.:.:.!.:! '2!.!.A~N~I~) .!_
ll~lit
•:l•')i~ M 1-:AHlJ ICl-:!;_____
~ '.:_ ,1HH
Comparing th e Japnn cHo und th o I•'

. k t hcir
you tlun . r at ional
. es ur·o? , l lr()J> ('iln f'Ul pu · t 1' 1I 11l 11,v
,., 1'"' o, w .,1111,
,I"
* • .,,
Shifting now our atte ntion to c.l f .
takeovers, we hav e already m<mtion ~ e~Hivu ~ ouHuro1-1 _in CHH(l uf' hw-1tilo
th
the basic conflict of interest th,1 t th ~<l m ~ f irHl Aocl1on of' thi1-1chupl ur
The U.K., since the 1960s ~ -~Jr nc.loptiondet urmin cH for dirnclorH.
·on" rule , a opted th e so-cul hi<l up111-1Hivity'' or "no-
frus t r atl , pursuant to which c1· ·t . .
measures if not specifically authorized hy1rtch•c <litu,c1opt'~.)efp~l~h1vo
o <s>rhs1rc11hnnl
· h ·' 1 c o c.ors mu<!1., lng. . ey
must, in ot er. word s,. stay on the side-lines nnd toRR tho bull to th o
shareholders, · 11directly
) interested in
· the t"n<l"r f"
~ · ~ o ,er.
'l'h IF!
· npprouc
. h h us
bee~ (partia _Y embraced by the European Takeover Directive whmm
Article 9 provides that: '
Article 9-0bligations of the board of the offeree co,',,,pany
[... ]
2. During the period referred to in the second subparagraph,
the b~ard_ of the offeree company shall obtain the prior
authorisation of the general meeting of shareholders given for
this pu:pose_ befor~ taking any action, other than socking
alternative bids, which may result in the frustration of the bid
and in particular before issuing any shares which may result in
a lasting impediment to the offeror's acquiring control of the
offeree company.
Such authorization shall be mandatory at least from the time the
board of the offeree company receives the information [... ]
concerning the bid and until the result of the bid is made public
or the bid lapses. Member States may require that such
authorisation be obtained at an earlier stage, for example as
soon as the board of the offeree company becomes aware that the
bid is imminent.
3. As regards decisions taken before the beginning of the
period referred to in the second subparagraph of paragraph 2
and not yet partly or fully implem ented, the general meeting of
shareholders shall approve or confirm any decision which does
not form part of the normal course of the company's business and
the implementation of which may result in the frustration of the
bid.
[...]
This provision is not mandatory: Me1!1ber States, pursuan_t to Article
12 of the Directive can in fact opt out of 1t and leave corporations free to
adopt board neutr~lity or not in their bylaws. 'fhis optional regime was
490 ACQUISITIONS, AND DEFENSIVE MEASURES CH. 10
the Directive (it's the so-called
necessary as a compromise to approve M b States strenuou sl
"Portugu ese
comprorm· se"), s_m
· ce some
d em
h t er·t could make nationalY
opposed _the passivity rule, bemg concerne . tnara~ders not subject to the
corporations vulnerable to attacks from foreig f£ t f this rule and of ·t
san_ierestrictions. We will consider _late~th ee e~i~:ale of Paragraph \~
optional nature. For now, can you pmpomt the ra 3
Article 9 above?
. d · th u s the issue of directors adopting
A s we men t 10ne , 1n e · · . t dd d h ·ft'
defensive measures vis-a-vis a hostile takeover is no a resse s 1 mg
decision-making authority to shareholders, but through that malleable
and powerful, but sometimes confusir:ig,. legal tool represented by
fiduciary duties. Recognizing the peculiarity of the takeover conte_xt,
courts-and in particular Delaware courts-have .develop_ed specific
fiduciary duties of directors. This difference is also interesting, f~om a
comparative perspective, because it says a lot about the preference, 1n the
U.S., to regulate through ex post case law,_rather than through _e; ante
regulatory provisions ("we will cross that bridge when we come to it).
The following two cases, Unocal v. Mesa and Revlon v. MacAndrews
& Forbes, are two of the leading decisions that define what directors can
and cannot do to defend the corporate citadel under Delaware law. To be
sure, as we will briefly illustrate, these cases only show one side of the
issue, and some of their conclusion have been refined or even modified
with successive decisions or statutory and regulatory provisions. They
still offer, however, a general sense of the U.S . approach to defensive
measures. The cases are so famous that you might already be familiar
with them, but a quick review cannot hurt .
UNOCAL CORP. V. MESA PETROLEUM Co.

Supreme Court of Dela ware
493 A.2d 946
MOORE, JUSTICE.
We confront an issue of first impression in Delaware-the validity of

a corporation's self-tender for its own shares which excludes from
participation a stockholder making a hostile t ender offer for the
company's stock.
The Court of Chancery granted ·a preliminary injunction to the
plaintiffs, Mesa Petroleum Co., Mesa Asset Co., Mesa Partn ers II and
Mesa Eastern, Inc. (collectively. ''Mesa"), enjoining an exchange offer of
the defendant , Unocal Corporat10n (Unocal) for its own stock. The trial
court c~nclud e~ t?at a selective exchange offer, excluding Mesa, was
legally 1mp~rmiss1ble. W~ cannot agree with such a blanket rul e. The
factua~ findings of th~ Vice Chancellor, fully supported by the reco r d,
establi sh that Unocal s board, consisting of a majority of independent
TAAKEOVERS AND TEND ER O FFE RS lf C) S'fJL ll'
CH. 10 CQUI S ITIONS ·' · r,
- 'AND DEFEN SIVE MEAS URES 4!; J
directors , acted in good faith and f

that Mesa 's tender offer was' ho h ~ ter reasonable invc~tigation found
·rcumstances the board h db ~ mad equat e and coercive. Uncfor the
c~rceived to be harmful to~ ot the power and duty to oppoHea hid it
p tisfied that the devic U e cfrporate e~terpri se. On thi s r~cord we arc
;~reat posed, and that ethen~ca adopted _is reasonable in rel_at ion to th e
. . d t W . oard acted 1n the proper exercu;e of sound
?fu::es~ J~e;,me; ·. . e will not substitute our views for those of th e hoard
1 . e ! . s _ecisi?n can be "attributed to any rational business
purpose. Sin~lair Oil Corp. v. Levien, Del.Supr., 280 A.2d 717, 720
(1971). Accor~n~ly, w~ ~everse the decision of the Court of Chancery and
order the prehm1nary 1n1unction vacated.
I.
The factual background of this matter bears a significant
relationship to its ultimate outcome.
On April 8, 1985, Mesa, the owner of approximately 13% of Unocal's
stock, commenced a two-tier "front loaded" cash tender offer for 64 million
shares, or approximately 37%, of Unocal's outstanding stock at a price of
$54 ?er share. The ''back-end" was designed to eliminate the remaining
publicly held shares by an exchange of securities purportedly worth $54
per share. However, pursuant to an order entered by the United States
District Court for the Central District of California on April 26, 1985,
Mesa issued a supplemental proxy statement to Unocal's stockholders
disclosing that the securities offered in the second-step merger would be
highly subordinated, and that Unocal's capitalization would differ
significantly from its present structure. Unocal has rather aptly termed
such securities "junk bonds".
Unocal's board consists of eight independent outside directors and six
insiders. It met on April 13, 1985, to consider the Mesa tender offer.
Thirteen directors were present, and the meeting lasted nine and one-half
hours. The directors were given no agenda or written materials prior to
the session. However, detailed presentations were made by legal counsel
regarding the board's obligations under both Delaware corporate law and
the federal securities laws. The board then received a presentation from
Peter Sachs on behalf of Goldman Sachs & Co. (Goldman Sachs) and
Dillon, Read & Co. (Dillon Read) discussing the bases for their opinions
that the Mesa proposal was wholly inadequate. Mr. Sachs opined that the
minimum cash value that could be expected from a sale or orderly
liquidation for 100% of Unocal's stock was in excess of $60 per share. In
making his presentation, Mr. Sachs showed slides outlining the valuation
techniques used by the financial advisors, and others, depicting recent
business combinations in the oil and gas industry. The Court of Chancery
found that the Sachs presentation was designed to apprise the directors of
the scope of the analyses performed rather than the facts and numbers
492 ACQUISITIONS, AND DEFENSI VE MEASURES CH. 10
used in reaching the conclusion that Mesa ,s tender offer price was
inadequate. .
d £
Mr. Sachs also presented various e ensi d·ve strateg ies availa ble to the
ffer was inadequate
board if it concluded that Mesa's two-~tep te~i::d was a self-tender by
O
and should be opposed. One of the devices ou~

Unocal for its own stock with a reasonable price range of $70 to t$75. per
share. The cost of such a proposal would cause the co~pany O incur
$ 6 . 1-6 5 b·11· f dd'ti
. i ion o a i Onal debt, and a presentatw~ was made
dl ·t Th direct
to han e i · ~ b t ors were
• •
informing the board of Unocal's ability
told that the primary effect of this obligation wou1 e O re d.uce
exploratory drilling, but that the company would nonetheless remain a
viable entity.
The eight outside directors, comprising a c~ear majo~ity of t~e
thirteen members present, then met separate!! with Unocal s financ:al
advisors and attorneys. Thereafter, they unanimou~ly agreed to advise
the board that it should reject Mesa's tender offer as inadequate, and. that
Unocal should pursue a self-tender to provide the stockholders with a
fairly priced alternative to the Mesa proposal. The board then :econvened
and unanimously adopted a resolution rejecting as grossly inadequate
Mesa's tender offer. Despite the nine and one.,half hour length of the
meeting, no formal decision was made on the proposed defensive self.
tender.
On April 15, the board met again with four of the directors present by
telephone and one member still absent. This session lasted two hours.
Unocal's Vice President of Finance and its Assistant General Counsel
made a detailed presentation of the proposed terms of the exchange offer.
A price range between $70 and $80 per share was considered, and
ultimately the directors agreed upon $72. The board was also advised
about the debt securities that would be issued, and the necessity of
placing restrictive covenants upon certain corporate activities until the
obligations were paid. The board's decisions were made in reliance on the
advice of its investment bankers, including the terms and conditions upon
which the securities were to be issued. Based upon this advice, and the
board's own deliberations, the directors unanimously approved the
exchange offer. Their resolution provided that if Mesa acquired 64 millio
n
shares of Unocal stock through its own offer (the Mesa Purchase
Condition), Unocal would buy the remaining 49% outstanding for
an
exchange of debt securities having an aggregate par value of $72 per
share. The board resolution also stated that the offer would be subject
to
oth_er conditions that had been described to the board at the meeting,
or
which were deemed necessary by Unocal's officers, including the exclusion
of Mesa from t~e proposal (the Mesa exclusion). Any such conditions were
required to be 1n accordance with the "purport and intent" of the offer.
TAKEOVERS AND TE
Ctl• 10 ACQUISITIONS AND ~ER OFFERS, HOSTILE
EFENSIVE MEASURES 493
~ '
Unocal's excha nge offer was comm
romptly chall enged it by filing this su 1.~1;ce! onCA pril17, 1985, and Mesa
P in e ourt of Chancery. [.. .]
II.
The issues we address involve th f d
Unocal board have the power and d:~e ~n amental questions : Did the
reasonably perceived to be harmful to t{e corpo o oppose a takeo:7er thre~t it
. · h ·1 rate enterp. rise and 1f 80
entit ed to the prote ction of th b · d ' '
is its act10n ere e usiness JU gment rule?
Mesa conte nds that1 the discri minatory exch ange of'i! ·
· d · u . 1er vio1ates the
Mesa
fiduci~ry uties r:oca o~es it. Mesa argues that because of the th
exclusion the dbusin ess Judgment rule is inapplicable , b ecause e
· b t · th · e a finan cial benef it that
directors ! en ering err own shares will deriv
Unocal · stockholders · Thus , i't i·s M esa ,s u lt'1mate
is not availa
· hble to all fair to
contention t at Unocal cannot establish that the exchange offer is
all sha~eholders, and argues that the Court of Chancery was
correct in
concludmg that Unocal was unable to meet this burden.
Unocal answers that it does not owe a duty of "fairness" to Mesa
of
given the facts here . Specifically, Unocal contends that its board
two-tier
directors reasonably and in good faith concluded that Mesa's $54
ive
tender offer was coercive and inadequate, and that Mesa sought select
board 's
treatment for itself. Furthermore, Unocal argues that the
ed
approval of the exchange offer was made in good faith, on an inform
Unocal
basis, and in the exercise of due care. Under these circumstances,
ct the
contends that its directors properly employed this device to prote
company and its stockholders from Mesa's harmful tactics.
III.
of a
We begin with the basic issue of the power of a board of directors
Absent
Delaware corporation to adopt a defensive measure of this type.
fairness
such authority, all other questions are moot. Neither issues of
ng of a
nor business judgment are pertinent without the basic underpinni
board's legal power to act.
Its
The board has a large reservoir of authority upon which to draw.
rred by
duties and responsibilities proceed from the inherent powers confe
''business
8 Del.C. § 141(a), respecting management of the corporation's
and affairs". [... ]
duty
Finally, the board's power to act derives from its fundamental
includes
and obligation to protect the corporate enterprise, which
its source.
stockholders, from harm reasonably perceived, irrespective of
[... ]
w~ich
Given the foregoing principles, we turn to the standards by
rule 1s a
director action is to be measured. [... ] The business judgment
ors of a
"presumption that in making a business decision the direct
OF
TAKEOVERSANDTENDER FER S HOSTILE
E MEASURES
494 ACQUISITIONS,ANDDEFENSIV CH. 10
corporation acted on an informed _basis, . · ood faith and in the honest

in ~ . terests of the company."
belief that the action taken was in th e
Aronson v. Lewis, Del.Supr., 473 A.2d 805 1
be; ;(l 984) (citations omitted)
, · that a court will not
A hallmark of the business judgment 1
r~
substitute its judgment for that of th e boa ~f:: latter's decision can be
"attributed to any rational business purposr } 8 . el ·r Oil Corp. v. Levien
e. inc ai ,
Del.Supr., 280 A.2d 717, 720 (1971).
When a board addresses a pending takeov
er bid it ~at~an obliga~~on
to determine whether the offer is in the
best intere st ~ 0 d~f~orpo:~ion
and its shareholders. In that respect a
board's d~~y is n~ ~de;en ~om
any other responsibility it shoulders, and
entitled to the respect they otherwise wo its decisrnns ~ ?u h e n~ ess
uld be accorde in t e rea m of
business judgment. See also Johnson v.
Trueblood, 629 F.2d 287, 29~-293
(3d Cir.1980). There are, however, certain
caveats to a proper exercise of
this function. Because of the omnipres
ent specter that a board may _be
acting primarily in its own interests, rath
er than tho~e of the corp?ra~i?n
and its shareholders there is an enhanc
ed duty which calls for Judicial
examination at the' threshold before
the protections of the business
judgment rule may be conferred.
IV.
In the board's exercise of corporate pow
er to forestall a takeover bid
our analysis begins with the basic princip
le that corporate directors have
a fiduciary duty to act in the bes
t interests of the corporation 's
stockholders. Guth v. Loft, Inc., Del.Supr.,
5 A.2d 503, 510 (1939). As we
have noted, their duty of care extends
to protecting the corporation and
its owners from perceived harm wheth
er a threat originates from third
parties or other shareholders. But suc
h powers are not absolute . A
corporation does not have unbr\dled dis
cretion to defeat any perceived
threat by any Draconian means availab
le.
The restriction placed upon a selective
stock repurchase is that the
directors may not have acted solely
or primarily out of a desire to
perpetuate themselves in office.
A further aspect is the element of balanc
e. If a defensive measure is
to come within the ambit of the bus
iness judgment rule, it must be
reasonable in relation to the threat pos
ed. This entails an analysis by the
director_sof the nature of the takeover
bid and its effect on the corporate
en~erpr1se. Examples of s~ch_concerns
may include: inadequacy of the
~rice offered:, natu~e an~ t~~1ng of the
offer, questions of illegality, the
impact on constituencies other tha
n shareholders (i.e., creditors ,
c~stomers, employees, _and perhaps eve
~ the community generally), the
risk of nonconsummation, and the qua
the exchange. lity of securities being offered in
TAKEOVERS AND TENDE
0
~S~ ~~Q
ANAS ~R ~H~O~S~T~IL~E~---~~
~~FF~E~R~S~,495
U.. .::. ;IS =-= I=- =-T ~IO ~N
SIV E ME UR ES
Q_ ~~~A_C~Q:....:. ' D EFEN
- •...=l:.;;.O
H!!
Specifically, the Unocal direct or h d of
sta nti all y ab ov e the $~ a cohucludedtha~ the valuethe
Unocal was sub 4 per s are offered 1n cash at . .
d . F ur th ermore, t h ey determined th t th b d·
front en sa' s a d a e su or 1nated securities
t be exch an ge d in Me squeeze ou t of the remaining
. . th ''b nn ou nc e k b d ,,
o h ld merger we "'
share o ers 1n e ack-end" ed that su:~ t~f~rs :rn s wlor~h far l~ss
than $54. It is now twellt recogdniz ea c ass1c coercive
e designed . 0 . s _ampe e shareholders into tendering at the first
measur .
ina de qu ate ou t of fea r of wh t th 8 ·n ·
pri ce 1s
Wholly beyond th eacoerc!ivewiasprec
tier, even 1f the eivfe at
ba ck en d of the tra nsa cti on ect o an
the . · s po sed b t
ier ten de r off er, the thr eat wa y a co rpo ra e
inadequate tw ' o-t 1 . .
· ·h t n as a "greenma ile r"
raider wit a na 10na reputat10
~ the sel ect ive ex ch an ge off er, the board stated that its
. I~ adoptin quate Mesa offer or, should the
s eit he r to d~ fea t the ina de
obJectiv~ wa of its stockholders who would
cee d, pro vid e the 49 %
offer still suc nd s", with $72 worth ~f senior debt.
for ced to acc ep t "ju nk bo
otherwise be valid.
We find that both purposes are
sa's
e-: -7e suc
r,_ h eff ort s wo uld have been thwarted by Me
!1_ow res,
at1 0n 1n the ex ch an ge off er. First, if Mesa could tender its sha
partic1p to
wo uld eff ect ive ly be sub sid izi ng the farmer's continuing effort
Unocal n,
al sto ck at $5 4 pe r sha re. Se cond, Mesa could not, by definitio
buy Unoc ive
the cla ss of sha reh old ers be ing protected from its own coerc
fit within
and inadequate tender offer.
ably
us, we are sat isf ied tha t the selective exchange offer is reason
Th
.. ]
related to the threats posed. [.
V.
tha t it is un law ful , an d the trial court agreed, for a
Mesa contends er . It
rat ion to dis cri mi na te in thi s fashion against one sharehold
corpo des
rre ctl y tha t no cas e ha s ev er sanctioned a device that preclu
argues co rs.
m sha rin g in · a be ne fit av ailable to all other stockholde
a raider fro principle of selective stock
ha ve no ted ear lie r, the
However, as we ion is neither unknown nor
De law are co rpo rat
repurchases by a
unauthorized. [... ] . the
le the ex ch an ge off er is a for m of selective treatment, given
[W]hi r
thr eat po sed he re the res ponse is neither unlawful no
nature of the int erested, has acted in good
bo ard of dir ect ors is dis
unreasonable. If the use of
d wi th du e car e, its de cis ion in the absence of an ab
faith an ise of business judgment.
ll up he ld as a pro pe r ex erc
discretion wi be
sa res po nd s tha t the bo ard is not disinterested, because
To this Me ten der of their own shares,
eiv ing a be ne fit fro m the
the directors are rec do es no t devolve upo? a_ll
Me sa ex clu sio n,
which because of the 1s
eq ua lly . [ ... ] Th e an sw er of course is that the exclus10n
stockholders
ERS HOSTILE
TAKFOVERSAND TENDER 0 FF ' ES CH.10
" VEMEASUR
496 ACqUISITIONS, AND DEFENSI "
. . . . he exchange offer does not rise
valid, and the directors' part1c1pat10n1n t
to the level of a disqualifying interest. [. · .] .
"' d" director transaction merely
Nor does this become an mtere st e ockholders. As this Court has
beca~se certain board members are large st ate a disqualifying "personal
previously noted, that fact alone does n?t er~ h b iness judgment rule.
pecuniary interest" to defeat the operation o t e us
~-J .
· permi·t s the. directors to
Mesa also argues that the exclusion Thabdicate
b d
· · h ·t H
the fiduciary duties t ey owe 1 · owev ' er that 1s not B t · th oar
so. e .£'
· d · f d
continues to owe Mesa the uties o ue car e and loyalty.. u 1n e 1ace
of the destructive threat Mesa's tender offer was perceived to_pose, ~he
board had a supervening duty to protect the corporate enterprise, which
includes the other shareholders, from threatened harm.
[... ]
VI.
In conclusion there was directorial power to oppose the Mesa tender
offer, and to unde~take a selective stock exchange made in good faith and
upon a reasonable investigation pursuant to a clear duty to protect the
. corporate enterprise . Further, the selective stock repurchase plan ~hosen
by Unocal is reasonable in relation to the threat that the board rationally
and reasonably believed was posed by Mesa's inadequate and coercive
two-tier tender offer. Under those circumstances the board's action is
entitled to be measured by the standards of the business judgment rule.
[... ]
The decision of the Court of Chancery is therefore REVERSED, and
the preliminary injunction is VACATED.
NOTES AND QUESTIONS

1. This decision set forth one important principle. Somehow
simplifying, the actions of the board of directors in a hostile takeover scenario
are protected by the business judgment rule (therefore, as you will remember
from Chapter 6, they can hardly be attacked) if two conditions are met: (1)
directors had a reasonable ground to believe that the takeover would not be
in the best interest of the corporation and its shareholders; and (2) the
defensive measure is reasonable in relation to the threat posed, in other
words it does not unnecessarily waste corporate resources. The court applies
a sort of modified business judgment rule, if you will. Why a modified
business judgment rule is necessary? Of course this principle is fairly easy to
state, but can be difficult to apply. It sets a somehow vague standard that
requires a very factually intense, case-by-case analysis. What is interesting to
observe, from a comparative perspective, is both the broad freedom granted to
TAKEOVERS AND TEND
CH. 10 ACQUISITIONS AND DER OFFERS, HOSTILE
- ' EFENSIVE MEASURES
497
directors under Delaware law a d th
fiduciary duties. ' n e regulatory technique used, i.e.,
2. In. Unocal v. Mesa, the court u hol .
P lan excludmg the hostile bidder Th" p . ds a selective stock repurchase
treatment of shareholders but· this raises a quest"ion m ·
terms of equal
"responsible" for having la~nched e cou_rt considers that Mesa was
.
entitled to equal treatment in this pa coercive. offer• an d th ere£ore 1s .
not
erspective A differ t 1 f
the court, would basically have resulted . U · . e?- so u 10n, argued
offer that it was trying to de£eat Shintl nocfalfmancmg the very unfair
·
introduced, however, the so-called "all-hold or Y,, a ter th e decision,
· · _th e SEC
1
offers cannot discriminate against a sharehe:l~ ru ~,_purs~ant to ~hich public
1
of federal intervention to correct state law a der. is _afnidnteres~mgexa~ple
bTt f t · n ' even 1 to ay this rule limits
the a i i y o a arget corporation to use a selective f£ d £
holding of the decision, based on the natureo oefrtahsa theenste,thdecore
. rt f h e rea an the
proportiona i Y o t e response above mentioned, is still valid.
3.. In the U.S., the adoption. of unreasonabl e or d"isproportionate ·
defensive measures can. lead to directors' liability . Let's go b ack £or a moment
to the board neutrality rule embodied in Article 9 of the European Th" t th
. · · d b ir een
D1rectlve, repnnte a ove. If a defensive measure is approved b f 11
informed shareholders, and directors implement the defensive· trans:ct:n:
that rec~ived the gre_en light, but it turns out to cause damage to the
corporat10n, could directors still be liable? Do you think that the
shareholders' meeting's resolution exculpates them? Under Italian law
apparently, directors can be liable also if they implement a shareholders~
approved defense if it is clearly damaging. Article 104 of the Italian
Consolidated Law on Financial Markets, in fact, provides that
notwithstanding a shareholders' resolution authorizing a defensive measure,
"Directors are responsible for their acts and transactions." The idea is that
directors must, in a sense, "oversee" shareholders' decisions, and refrain from
carrying them out if they are detrimental to the corporation. What do you
think of this provision and its effects? As a side note, however, it should be
observed that notwithstanding this provision, from a practical perspective,
most _judges will not consider totally irrelevant, in evaluating possible
directors' breaches, that they acted on the basis of a shareholders' meeting
resolution, especially if the shareholders' decision was fully informed. Can
you argue, based on this last observation, that also in systems that provide
for board neutrality, directors' duties and potential liability are still
important to regulate takeovers?
4. We mentioned in the introduction that the judicial standards
elaborated by Delaware courts in the 1980s, such as the ones set forth in
Unocal v. Mesa, have been relaxed more recently also as a r~action of the
introduction of other monitorin mechanisms that protect investors ~nd
shareholders specifically. An interesting contribution dis~uss~ng _the question
whether this case and the standards it adopted are still b1nd1ng, that we
encourage students to read to discuss the matter, is R. B. Thompson, G.D.
S HOSTILE
TAKEOVERS AND TENDER 0 FF ER '
498 ACQUISITIONS, AND DEFENSI VE
MEASURES CH. IO
Smith, Toward a New Theory of the Shareholder R O le: 'Sacred Space" in

Corporate Takeovers, 80 TEXASL. REV. 261 (200l).
***
REVLON, INC. v. MAC.ANDREWS & FORBES HOLDINGS, INC.
506 A.2d 173
MOORE, JUSTICE:
In this battle for corporate control of Revlon, Inc. (Revlon), the Court
of Chancery enjoined certain transactions designed to thwart the efforts
of Pantry Pride, Inc. (Pantry Pride) to acquire Revlon. The defendants are
Revlon its board of directors and Forstmann Little & Co. and the latter's
affiliat~d limited partnership (collectively, Forstmann). The injunction
barred consummation of an option granted Forstmann to purchase
certain Revlon assets (the lock-up option), a promise by Revlon to deal
exclusively with Forstmann in the face of a takeover (the no-shop
provision), and the payment of a $25 million cancellation fee to
Forstmann if the transaction was aborted. The Court of Chancery found
that the Revlon directors had breached their duty of care by entering into
the foregoing transactions and effectively ending an active auction for the
company. The trial court ruled that such arrangements are not illegal per
se under Delaware law, but that their use under the circumstances here
was impermissible. We agree. See MacAndrews & Forbes Holdings, Inc. v.
Revlon, Inc., Del.Ch., 501 A.2d 1239 (1985). Thus, we granted this
expedited interlocutory appeal to consider for the first time the validity of
such defensive measures in the face of an active bidding contest for
corporate control. Additionally, we address for the first time the extent to
which a corporation may consider the impact of a takeover threat on
constituencies other than shareholders. See Unocal Corp. v. Mesa
Petroleum Co., Del.Supr., 493 A.2d 946, 955 (1985).
In our view, lock-ups and related agreements are permitted under
Delaware law where their adoption is untainted by director interest or
other breaches of fiduciary duty. The actions taken by the Revlon
directors, however, did not meet this standard. Moreover, while concern
for various corporate constituencies is proper when addressing a takeover
threat, that principle is limited by the requirement that there be some
rationally related benefit accruing to the stockholders. We find no such
benefit here.
Thus, under all the circumstances we must agree with the Court of
Chancery that the enjoined Revlon defensive measures were inconsistent
with the directors' duties to the stockholders. Accordingly, we affirm.
TAKEOVERSANDTENDE O .. ,
ACQUISITIONS ~ . Fl-ER8, HOSTILE
ca.10
- 'AND DEF E!'.SJVE MEA'-;URP.S
I.
499
The somewhat complex manoe uvres of the ·

rt'ms. necessitate a
rather detail ed exami nation of th f. pa
began in June 1985 whe R ledO acts. The prelude to this contro versy
'officern of ona Perelman , ch · f th e boar d
and chief executive p · . . air~an o
antry Pnde, met with his counterpart at
h 1 C
Mi e . Bergerac, to discuss a friendl Y acquis · 1·t·10n of Re v1on by
t n, p ·cd p 1
Revlo
Pan ry n e. ere ~an suggested a price in the range of $40-50 per
with Bergerac d.1sm1s · those figures as
· sing
. but the meeting ended
share,
considerably below Revlon's intrinsic value. All subsequent Pantry Pride
overtures were rebuffed, perhaps in part based on Mr. Bergerac ' s st rong
personal antipathy to Mr. Perelman.
!hus, on Au~st 14, Pantry Pride's board authorized Perelman to
acquire Revlon, _either th~ough negotiation in the $42-$43 per share
range, or by making a hostile tender offer at $45. Perelman then met with
Berg:rac and outlined Pantry Pride's alternate approaches. Bergerac
remained_ ada~antly opposed to such schemes and conditioned any
further discuss10ns of the matter on Pantry Pride executing a standstill • ' >
agreement prohibiting it from acquiring Revlon without the latter's prior

approval.
On August 19, the Revlon board met specially to consider the
impending threat of a hostile bid by Pantry Pride. At the meeting, Lazard
Freres, Revlon's investment banker, advised the directors that $45 per
share was a grossly inadequate price for the company. Felix Rohatyn and
William Loomis of Lazard Freres explained to the board that Pantry
Pride's financial strategy for acquiring Revlon would be through "junk
bond" financing followed by a break-up of Revlon and the disposition of its
assets. With proper timing, according to the experts, such transactions
could produce a return to Pantry Pride of $60 to $70 per share, while a
sale of the company as a whole would be in the "mid 50" dollar range.
Martin Lipton, special counsel for Revlon, recommended two defensive
measures: first, that the company repurchase up to 5 million of its nearly
30 million outstanding shares; and second, that it adopt a Note Purchase
Rights Plan. Under this plan, each Revlon shareholder would receive as a
dividend one Note Purchase Right (the Rights) for each share of common
stock, with the Rights entitling the holder to exchange one common share
for a $65 principal Revlon note at 12% interest with a one-year maturity.
The Rights would become effective whenever anyone acquired beneficial
ownership of 20% or more of Revlon's shares, unless the purchaser
acquired all the company's stock for cash at $65 or more per share. In
addition, the Rights would not be available to the acquirer, ~nd prior to
the 20% triggering event the Revlon board could redeem the nghts for 10
cents each. Both proposals were unanimously adopted.
TAKEOVERSAND TENDER OFFERS, HOS'l'l~E
500 ACQUISI1'I0NS, AND DEFENsl
i, ... vf
i' MEASURhS CH. 10
~ -'
Pantry Prid e made its first hostile · n Augu st 23 with a cash

move O
tender offer for any and all shares of ~ev 1on a t $4 7 50 per comm on s h are
Pa~tr Pri de's obta inin
and $26 .67 per preferred share, sub1ect to (l) .
financing for the purchase, and (2) the Rights being r eyd med re scinde~
ee - '
or voided.
Th e R ev1on b oar d met agam. on August 26 The directors advised the
· · l
stockholders to reJec t the offer. F urt h er de1rensive mea sures a so were
planned.
[At this point, Pantry Pride and Revlon engage in a battl
e in which
Pantry Pride responds to different defensive measure~
adopted by Revlo~
substantially improving the conditions of the offer in
order to make it
more attractive for Revlon's shareholders. Eventually,
Revlon finds an
alternative offeror that the directors prefer , Forstman
n, and Revlon's
directors approve certain conditions of a proposed offer
by Forstmann.]
[.. .] On October 12, Forstmann made a new $57.25 per
share offer,
based on several conditions. The principal demand was
a lock-up option to
purchase Revlon's Vision Care and National Heal
th Laboratories
divisions for $525 million, some $100-$175 million
below the value
ascribed to them by Lazard Freres, if another acqu
iror got 40% of
Revlon's shares. Revlon also was required to accept a
no-shop provision.
The Rights and Notes covenants had to be removed as
in the October 3
agreement. There would be a $25 million cancellation
fee to be placed in
escrow, and released to Forstmann if the new agreement
terminated or if
another acquiror got more than 19.9% of Revlon's stock
. Finally, there
would be no participation by Revlon management
in the merger. In
return, Forstmann agreed to support the par value of
the Notes, which
had faltered in the market, by an exchange of new notes
. Forstmann also
demanded immediate acceptance of its offer, or it woul
d be withdrawn.
The board unanimously approved Forstmann's proposal
because: (1) it
was for a higher price than the Pantry Pride bid, (2)
it protected the
noteholders , and (3) Forstmann's financing was firmly
in place. The board
further agreed to redeem the rights and waive the
covenants on the
preferred stock in .response .to any offer above $57 cash
per shar .e. The
covenants were waived, contmgent upon receip t of an inves
tment banking
opinion that the Notes would trade near par value
once the offer was
consummated. .
. Pantry Pride, which had initially sought injunctive
relief from the
Rights ~lan on August 22, filed an amended complaint
on October 14
chall
. enging the lock-up, the cancellation £ee, and th
e exercise · of th e
Rights . and
. the Note s cove nants . Pant ry Pri'd e also s ht t
restraimng order to prevent Revlon from placing an oug a emporary
.
transferring them to Forstmann . Moreover on Oct Y asse t s in
· escrow or
b 22 p p
, antry ri·de
· · d · b'd · h ' o er
again raise its i , wit a cash offer of $58 per sh are
con d'it10n
· e d upon
CH.10
nullification of the Rights, waiver of th , . . .

the Forstmann lock-up. e covenant s, and an rnJunct1on of
On October 15, the Court of Cha . .
of assets and eight d n~e.ry prohibited the further tran sfer
.' ays 1ater enJ01ned the 1 k h d
cancellat10n fee provisions of th , oc _-up, no-s op, an
that the Revlon directors h d b e aghreeme~t. 'I he trial court concluded
a reac ed their duty of loyalt b k'
concessions to Forstmann out of £ h . . ~. Y ma mg
noteholders, rather than m~ximizing t~encerln ~r tfe1hr hab1hty to the
h Id , b fi sa e price o t e company for the
stock o ers ene 1t. MacAndrews & Fo b uOld · 1
Inc., 501 A.2d at 1249-50. r es ings, nc. v. Revlon,
II.
To obtain a preli~inary injunction, a plaintiff must demonstrate both
a reason~ble ~robabihty of success on the merits and some irreparable
harm which will occur absent the injunction. [... ]
We turn first to Pantry Pride's probability of success on the merits
[... ] . .
[W]hen Pantry Pride increased its offer to $50 per share and then to
~53,_it became apparent to all that the break-up of the c~mpany was
1nevit_able. The Revlon board's authorization permitting management to
negotiate a merger or buyout with a third party was a recognition that
the company was for sale. The duty of the board had thus 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. This
significantly altered the board's responsibilities under the Unocal
standards. It no longer faced threats to corporate policy and effectiveness,
or to the stockholders' interests, from a grossly inadequate bid. The whole
question of defensive measures became moot. 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.
III.
This brings us to the lock-up with Forstmann [... ]
A lock-up is not per se illegal under Delaware law [... ]. Such options
can entice other bidders to enter a contest for control of the corporation,
creating an auction for the company and maximizing shareholder profit.
Current economic conditions in the takeover market are such that a
"white knight" like Forstmann might only enter . the bidding for t~e target
company if it receives some form of compensation to cover the risks and
costs involved. [... ]
Forstmann had already been drawn into the contest on a preferred
basis, so the result of the lock-up was not t? foster bidding, ~ut to destroy
it. The board's stated reasons for approving the transactions were: (1)
bette r fina ncing (2) not eholder protection, and (3) higher price. As the
Court of Chanc~ry found, and we agree, any distinctio~s between the
rival bidd ers' methods of financing the proposal were nominal at best, and
such a consideration has little or no significance in a cash offer for any
and all shares. The principal object, contrary to the board's duty of care,
appears to have been protection of the noteholders over the shareholders'
interests.
While Forstmann's $57.25 offer was objectively higher than Pantry
Pride's $56.25 bid, the margin of superiority is less when the Forstmann
price is adjusted for the time value of money. In reality, the Revlon board
ended the auction in return for very little actual improvement in the final
bid. The principal benefit went to the directors, who avoided personal
liability to a class of creditors to whom the board owed no further duty
under the circumstances. Thus, when a board ends an intense bidding
contest on an insubstantial basis, and where a significant by-product of
that action is to protect the directors against a perceived threat of
personal liability for consequences stemming from the adoption of
previous defensive measures , the action cannot withstand the enhanced
scrutiny which Unocal requires of director conduct. [... ]
In addition to the lock-up option, the Court of Chancery enjoined the
no-shop provision as part of the attempt to foreclose further bidding by
Pantry Pride. [... ] The no-shop provision, like the lock-up option, while
n_ot per se illegal, is impermissible under the Unocal standards when a
board's primary duty becomes that of an auctioneer responsible for selling
the company to the highest bidder. The agreement to negotiate only with
Forstmann ended rather than intensified the board's involvement in the
bidding contest.
[... ]
The court below similarly enjoined the payment of the cancellation
fee, pending a resolution of the merits, because the fee was part of the
overall plan to thwart Pantry Pride's efforts. We find no abuse of
discretion in that ruling.
IV.
Having concluded that Pantry Pride has shown a reasonable
probability of success on the merits, we address the issue of irreparable
harm. The Court of Chancery ruled that unless the lock-up and other
aspects of the agreement were enjoined, Pantry Pride's opportunity to bid
for Revlon was lost . The court also held that the need for both bidders to
compete in t~e marketplace outweighed any injury to Forstmann. Given
the complexity of the proposed transaction between Revlon and
Forstmann, ~he obstacles to Pant!y Pride obtaining a meaningful legal
remedy are immense. We are satisfied that the plaintiff has shown the
TAKEOVERS AND TE i ,,
ACQUISITIONS AND ~ER Ol•F ERS, HOS'l'ILE

CH.10 503
"'' EFENSIVE MEASURES
need for an injunction to protect .t f
.
nd i t rom irrep arable harm, which need
outweighs any harm to the defe ans.
V.
.
In conclusion, the Revlon board with a situation not
confronted
uncommon in the current wave Of was
determined bidder sought the com corporat: takeovers. A hostile and
was inadequate. [... ] However ' in .Pany at ~ price the board was 1convinced
grantmg an11as se t _opt'wn ock-up to
F?rstmann, we must conclude that under
directors allowed considerations other th:n the c1rcu~s~anc_es the
th e max1m1zat10n of
shareholder profit to affect th · . d nd
,_ at foltl?wed a cours~ that
ended the auction for Revlon, :~s~~t ~:~t m erven wn, to the ultimate
. .
t f its h
s areholders. No such d e1.e ~ ·
d etrim en o
h . nsive meadsure can be
· d the d'irec t ors , fun amental duty
susta1ne w en . it represents a breach of
S S r., 488 A.2d 858, 874 (1985). In
of care. ee mith v. ~an G~rk~m, Del.Suptled to the d ~ d d·
that context. the . boards act10n is not enti e1.erence accor e 1t
s were properly enjoined. The
by ~h~ business Judgment rule. The measure AFFIRMED.
e, is
decis10n of the Court of Chancery, therefor
NOTES AND QUESTIONS

on, no-shop provision, and
1. _Accordi~g to the court, lock-up opti
ped an auction that could have
cancellat10n fee 1n favor of Forstmann stop
cutting out Pantry Pride. The
further benefitted Revlon's shareholders,
red illegitimate. It is essential,
defensive measure is, therefore, conside
at a time when the corporation
however, that the decision had been taken
a new controlling shareholder
was "for sale" and it had become clear that
ous "Revlon moment," in which
would have acquired control. This is the fam
think the Revlon moment can be
directors become auctioneers. How do you
theoretically clear standard that
precisely identified? Is this yet another
becomes blurry and determines
however, when applied to actual facts,
uncertainties?
the court is that directors are
2. Another important principle stated by
s of other stakeholders besides
not allowed to take into account the interest
n deciding defensive measures. In
shareholders (in this case, noteholders) whe
that a successful takeover would
other words, even if you could demonstrate
than the benefits to shareholders,
cause damages to the employees greater
ply on this basis. This evokes a
directors cannot oppose the takeover sim
responsibility: to what extent can-
broader issue concerning corporate social of stakeholders
or must-directors and managers also consider the position
nt is profit and value maximization
different from shareholders? To what exte
te purpose of corporate directors?
("shareholders' primacy'') the only legitima
because a skilled lawyer, in this
This discussion is often slippery, also
situations, argue everything a~d _its
respect, can fairly easily, at least in most
directors must only_~ax1m1ze
opposite. For example, even assuming that
matically that the dec1s1onto be
shareholders' value, it does not follow auto
TAKEOVERS AND TENDER OFFEltS, HOS'l'll:E
504 A CQUIS ITIONS, AND DEFENSIVE MEASUIU,H C11.10
· m entally responsible,
environ · also 1·r no t man dnted by lnw, and to tuke into
. . .
account the int erest of oth er stakeholders, contr adi~ts va 1ue muximizution.
You could for example argue t h at re spec,t 1or.
" the environ
. .m.ent. .pro<luc
, oRgood
·11 ·th t
w1 w1 cus on1ers an d th e communi·ty , av01ds ri sks of bhnb1lity should
applicable rules change, and so on, therefore ultimat ely emg_ · h t the
·
c~>?rcn wi~h
shareholders' wealth maximization in the medium term, even if it 18 COf::itm ly
the short term. Going back to takeovers, in any case, it is inter esting to point
out that several U.S. States (approximately 30) have enact ed so-~alled "other
constituencies' statutes" that explicitly allow directors to take mto account
the interests of different stakeholders besides shareholders in taking cert ain
decisions. As we have seen this approach has been adopted also in the U.K.
with the 2006 Companies Act (in section 172 of the Act), but ~n this country it
is less relevant in the takeover context since, as we mentioned, the board
neutrality rule applies . "Other constituencies' statutes" appear, in this
respect, to reject Revlon. What do you think: can, or must, directors consider
the impact of an acquisition on workers, customers, creditors, and on the
community generally? What about other legal systems you are familiar with?
3. To decide which one is the better offer among several offers might
not be always easy . As the court says in Revlon, price is not the only element.
One important variable could be the type of consideration offered. Do you
think that a cash offer is always superior to an exchange offer in which other
securities are used as a consideration for the shares of the target? Imagine, in
other words, two bids, one offering $3 per share, the other offering for each
share a fixed interest rate bond traded on a regulated market and whose
price, in the last two weeks, has been $4, with very minor variations. Which
offer is superior? Does it depend? If so, on which variables does it depend?
Can the answer be different for different offerees? In such a situation, how
can directors make sure that they are not facilitating an inadequate offer, or
preventing a value-maximizing one?
4. The undeniable ambiguity of the Revlon standard has been
somehow mitigated, if not eliminated, in an important but somehow less
famous 2009 decision, Lyondell Chemical v. Ryan. The Delaware Supreme
Court basically clarified that as long as the board was in "good faith" and
"reasonable", its decisions cannot be challenged. While these paramters are
also difficult to pinpoint, this is a clear shift toward more deference to
directors' judgment. If you want to go deeper, check out this decision.
***
Japan started regulating defensive measures quite late. In 2004,
some takeover battles attracted the attention of regulators and in 2005
~~e Min~stry of Econ~my?Tr_adeand Industry and the Mini~try of Justice
Jointly issued the Guidelines Regarding Takeover Defense for the
Purposes of Protection and Enhancement of Corporate Value and
Shareholders' Common Interests (May 27, 2005)", also called "METI-MOJ
Guidelines." The Guid~lines, _w~ichdo ~ot have any formal binging force,
are based on the following principles. First, the adoption, implementation,
CH.10
ACQUISITIONS, AND DEFENSIVE MEASURES
509
Guidelines look for additional d · · · ·
' group.
in your study sources, an
. discuss this question m class or
***
You hopefu~ly now have a good understanding of the basic differences
among alter~ative approaches to takeovers, and more precisely of the
rules governing mandatory tender offers and defensive measures in the
U.S., the European Union, and Japan. It's time for two even more
fascinating questions. Keeping in mind that what we have called the
"European" approach has been largely inspired by U.K. law, a first
question is why the U.S. and the U.K., two legal systems that share
several features (common law tradition, existence of a fairly large number
of listed corporations with a widespread ownership structure, advanced
and competitive financial markets) have developed so radically diverse
rules? And, secondly, what are the effects of having extended the U.K.
approach to continental European systems, with a much more
concentrated ownership structure? The first question is tackled in an
interesting article by John Armour and David Skeel (Who Writes the
Rules for Hostile Takeovers, and Why?-The Peculiar Divergence of U.S.
and U.K. Takeover Regulation, 95 GEO. L. J. 1727 (2007)), and the second
in another article by Marco Ventoruzzo. Since the latter also refers to the
former, consider the following excerpt.
MARCO VENTORUZZO, TAKEOVER REGULATION AS A WOLF

IN SHEEP'S CLOTHING: TAKING U.K. RULES TO
CONTINENTAL EUROPE 1
11 U. Pa. J. Bus. & Emp. L. 135 (2008)
- [... ]
In [an] insightful work, John Armour and D~vid Skeel address ~he
wh takeovers in the U.K. and in the United States of ~merica
reasons re y re ulated so differently. More specifically, their ~?rk
(U.S.) a ; h · torical events and the economic, legal, and political
d~monstrates. ow 11sthe role of lobbying groups-in the U.S. and the
.chmate-pafr;1culdarbyth the content of substantive takeover rules, and the
U K have a 1ecte O · d £ d
. .
processes throug h wh.ich they are created an en orce . . .
- . .t. of a set threshold of the voting shares
[I]n the U.K., ~cqu1sh1iobn er to launch a mandatory tender offer on
. , t) requires t e uy h N
(th irty percen . at the highest price paid for those s ares. o
all the outstanding shar~s t rovi·ded under U.S. law at the federal
1 · Of this sor are P
laws or regu at10ns •d £ r "best-price rules" whose effects are
level, even if some states provib.edroule Similarly the British "City Code"
similar to the UK · · ma ndatory, it· s that· might ' frustrate a hosti·1e b'd
i
imposes a ban on d ir . ectors ac ion
,, ·n Ol"l•'l•'RR HOSTILE
'f AK..:ov..:ns AND 1 l•,NIH, ' MrA su iu .:s CH. 10
510 A C.:qUISITIONS , AND 1)1,:Fl•:NSJVI~ ,, ,
. . m,ts star kly with the relative
wjthout share holder 1:1pprovHl, whach ~ontrh t"le acquisit ion.
a os 1
freedom that U.S. directors have to rc1:111,t .
. d.1re\ •nccs by pointing to the fact
Armour and Skoel explain these · ere h' structure that both
th at, notwith i;tanding ih e widm{pr~nd _owi:i e~: l :~vestors in the U.K. as
syste ms have in common the role of mstitutw . . k .
' . . d . fluencing the po1icy ma ers, 1s
sharcho]d ers and as an organize group in_ · . tment by small and
ahsent in the U.S. Instead, in the U.S., direct inves d Sk
· · n Armour an ee1 1
d1i;organized shar eholders 1s more commo · , the contexta so of
examine why corporate directors and managers, 1hn th . B ·t· h
American federalism, have a more effective role t an eir ri 18
counterparts in shaping takeover rules.
· · l par t of their contribution underlines
Th e most ong1na . . h b t t'the
importance of the rule-making process in determining_ t e su s a~ ~ve
regulatory outcome. In this respect, Armour and Skeel Juxtapose British
"coerced self-regulation, made under a clear gove~nn:iental threat . of
intervention" favored also by the geographical prox1m1ty of the ma~or
actors in the City, with the U.S. legislative and case-law processes, V:h~ch
are largely derived from litigation and judge-made rules. Comb1n1ng
these and other elements, they conclude that, in the U .K., coordina t ed
and influential institutional investors were able to promote a private
takeover regime particularly favorable to minority investors. The pillars
of this regime are the mandatory bid and the non-frustration rule . In the
U.S., by contrast, incumbent directors and managers were able to obtain
more leeway to resist takeovers thanks to a number of factors ranging
from U.S. federalism that (borrowing the image used by Armour and
Skeel) amplifies the voice of corporate managers to the lesser impact of
institutional investors' lobbying efforts on the development of case-law.
The story told by Armour and Skeel is not only well grounded and
convincing from an historical perspective, it is also consistent with
modern public-choice models that analyze the role of lobbying groups in
determining the level of investors' protection in different jurisdictions
[... ] .
But, therein ~ays_th~ rub .. If it is tr_ue that the U.K. ·approach to ·
takeovers ~avors institut10n_al investors 1n systems with a significant
degree of dispersed ownership structure, why would the essential pillars
of this approach be spontaneously adopted, well before the Thirteenth
Directive, in several continental European countries that have
concentrated ownership structures? In these systems entrenched
controlling sharehol~ers an~ the associations representing their interests
are among the most influential pressure groups in the political a and
·1nstitut10na
· · 1 inves
· t 1
ors p ay, a comparatively rena,
. less relevant roe.1 I n th'1s
A
context, rmour an d Sk 1
ee s analysis leads to additi'onal
. ques t·ions: Who
are the lobbying groups that promoted this legislation? Or, is it possible
TAKEOVERS AND TEND
CH. 10 ACQUISITIONS AND DER OFFERS, HOSTILE
~:~~h~l:.::1:~:~~,~~~EIFE~N~S~1yv~E~M~E~A~S~U~R:iEis ___ ~51_!11
.
that t e egis atures were me re 1Y particula
t' f · · · to the need of
r! Y att entive
protec 10n o minority investor s? Wh
Ita~y among the first, dating b;ck t~ ;ere countries such as France and
regime when they have otherw· b he 1990_s,to embrace the British
minority investors? ise een slower m legislative protection of
[... ]
Mandatory bid the be t .
breakthrough provisio ns whic~ price rule, board neutrality, and
th
considered to be effectiv~ takeov::p::seft . e e~tire panoply of what is
effects when applied in systems with~ ation, might have v~r~ different
dispersed ownership. This h th . ncentrated ownership mstead of
especially in the public debate ypo t ~:~st has.
nd
been largely overlooked,
intuitive. ' no wi a ing the fact that it is quite
Consider ~andatory. bids. In very broad terms, this rule provides

bidder acquires a set threshold of vot ing ·
· sh ares of a hsted
that when. a (1 ,
corporati?n et s say 30 perc:nt), it must launch an offer on all the
outstanding shares
. , at an equitabl
. ·
. . Now imagine
e price · h ow t h'is ru 1e
wo~ld apply in a system with a very dispersed ownership structure in
which, for example, the average participation necessary to have de facto
control o~ a corpo~ation is_t~~ percent. In that context, a raider can easily
succeed m a hostil~ acquisition without triggering the mandatory bid. If
~he ~urrent contr?lhng shareholder holds ten percent of the voting shares,
it might be sufficient to acquire, for example, eighteen percent to be in the
driver's seat. And this can be done with a partial tender offer, by buying
shares on the market, or by negotiating blocks of shares outside the
market with qualified minority shareholders. In any case, by not
exceeding the thirty percent threshold, no mandatory bid is required on
all the shares.
The important implication is that, in a system with widespread
ownership, the real goal of the mandatory bid is not so much the one of
protecting minority investors from any change in control, but rather from
a change in control when the resulting ownership structure of the
corporation is characterized by the presence of a large block-holder. The
importance of this protection is that a new large block-holder weakens the
potential disciplining role of the market. In other words, mandatory bids
provide a fair exit to shareholders when a change of control takes place
that is not easy to reverse.
Compare the same rule in a system in which !he ownership structure
is concentrated and the largest shareholders typically hold a percentage
higher than th; thr eshold triggering the mandat?ry bid. In ~h~t context ,
the practical effect of the rule is that whoever aims at obta1n1ng control
must be ready to buy all the out standing shares. Needless to say ,
rendering the acquisition more expensive might help th e controlling

shareholder to fend off an undesired suitor.
In a similar vein the board neutrality rule can also lead to
dramatically different' consequences depending on th e ownership
structure of the corporation. This rule provides th8:t when a ten~~r _offer1s
launched, the directors of the target corporat10n cannot initi~te or
continue any action that might frustrate the success of the offe~ without
obtaining the approval of the shareholders' meeting. Once again, whe_n
the ownership structure is widespread, and the real ag~ncy pr~blem 1s
between directors and managers as against relatively dispersed
shareholders, required approval by shareholders' meeting empowers the
investors. This is especially true if-as Armour and Ske~l show to be the
case in the U.K.-organized and competent institutional investors, able to
make informed decisions, are present and actively participate in the
Conversely, when the ownership structure is concentrated and there
are strong controlling shareholders, the real agency problem is not
between directors and managers, on the one hand, and dispersed equity
investors, on the other, but rather between majority and minority
shareholders. A resolution of the shareholders' meeting in that context
does not really address the crucial issue. More simply, when there is a
controlling shareholder holding more than forty percent of the voting
shares, a defensive measure against a hostile bid voted by the
shareholders' meeting is unlikely to resolve the inherent conflict of
interest between incumbent, entrenched controllers able to extract
private benefits from the corporation and minority investors that might
welcome a value-maximizing bid.
[... ]
[T]he mandatory bid might appear favorable to minority
shareholders in the case of a friendly acquisition where the existing
controlling shareholder sells its participation, or a significant part
thereof, to an acquirer. In such a scenario, the same price per share
recognized by the seller must be offered to all of the shareholders.
However, the parties will take this element into account in their
negotiations, thus raising as a preliminary issue whether the new rule
might also deter friendly takeovers.
[... ]
Together with the mandatory bid mechanism, the non-frustration
prohibition-also called ''board neutrality'' or the "passivity rule"-is the
landmark difference between U.S. and U.K. approaches to takeovers. The
degree_ of freedom enjoy_ed by American directors in structuring and
deploying ~re- an~ post-bid_ defe_nses, with the only substantive limitation
being their fiduciary duties, is unknown in the U.K. and in those
TAKEOVERS AND TENDER O
___
CH!!.•.::.1..::.0 ' ~N~S~AN~D H~O~ST:!!I~L~E---~~ 513
2D~~~F~F~E~R~S~,
A~C~Q~U_I~S~IT.::..:I~O EFENSIVE MEASURES
-- -
European countries that have adopted th U
frustration prohibition of the General Princf le·:· approach. The non-
Takeover Code prevents directors from ·tt dof ~ule 21 of the U.K.
ei _er a optmg or setting into
motion most post-bid defenses . It also requires a r.
general shareholders' meeting. Extensive d b t n .exp 1c1t vote by the
leeway in resisting a takeover-as is the a e ex~sts whether greater
ld H . e case in the U.S.-fa vo~s
shareho ers . owever, with a caveat that will be dis
cannot be denied that board neutrality and shareh Id hc~ss~d later, it
. d d . o er c mce in the U K
were perceive an fintroduced as protections · t di , · ·
' n· .
o interest
agams rectors and
.
in a takeover cont est . Th.is purpose is
managers . con
d th icts
1 . 1 . .
confi1rme in e egis ative history of the provision.
~ recent. and insightful analysis, however, questions whether this
rule 1s truly important or merely · 1y
illusory · David Kersh aw persuasive
· h ·
argues t h at in t e very Jurisdiction where the non-frustration rule
developed_, most takeover ~efenses would also require shareholder
approval 1n the absei:c_eof this rule. General company law principles, he
argu~~' end up requirmg the same. More precisely, Kershaw concludes
that ~n the _absence of the non-frustration prohibition not only would
post-bid, directors-controlled [takeover defenses] require pre-bid
shareholders consent but when made available there is limited scope to
use them for entrenchment purposes" .
To the extent that this theory is well-grounded in the U.K., even
without a detailed analysis of corporate law in civil law systems, it is fair
to say that in countries such as Italy, a similar conclusion would be even
more justified. In these systems, the extent and relevance of the
competences of the shareholders' meeting versus the directors are even
broader than in common law systems. [... ] The issuing of option rights to
subscribe or acquire the target's shares at a discount, as well as most
business combinations (e.g., mergers, spin-offs, contributions in kind), are
used to increase the corporation's capital. These [actions, in most
European continental systems] are [generally] subject to shareholders'
approval independent of the passivity rule. [. .. ]
Independent of the scope of the non-frustration rule, the crucial point
is that determining at shareholders' meetings whether defenses in
systems where the most important agency problem is between controlling
shareholders holding a majority of the shares and minority investors may
not be in the best interest of the minority shareholders.
Needless to say such a rule is better than nothing. The fact that a
defense must be ap;roved (or re-approved) ~y t~~ shar_eholders' meeting
implies several important advantages for minorities. First and fo:emost,
it has the advantage of increasing the transparency of t~ie adoption of a
frustrating action . In fact, even if a defer:ise a~opted unilat~ral~y by_t~e
directors would also be subject to specific disclosure obligations if i~
involved price-sensitive information, pas sage through the shareholders
1'AKE0VEltS AND TENDl•:R O1-'Ft<:HS,J(OS'l'll,'E
C11. 1o
514 AC'qUISITIONS , AND Dl ',' 1·L'L'NSIV"'
1·, ,
1 MFASUIU.S
·, ' '
mect ·m 01 allows orn-·m1z

y
· ed mmor1t1cs
· · · to d'1H . · th e mcai;ur c a .nd to obtain
cu1,s
I <l<l't'on th e cx1Htcncc of a
furth er information from th e directors. n al , 1t 1t h'e po t c.m1.Ja
0 '
•
, · . l f'ur 1cg·11
shar eholders' meeting resolution crcateH at caH h . .'
· · I t' It may create t .c pot cntia 1 for
action, such as challenging th e reso u wn. . h'b't' th d t·. ·
· · a pre1·1mmary
obtammg · · ·
mJunc t'10n from
. the court m 1 1 mg . e a op 10n
· · h
of the defense. The resolut10n m1g t c c a e . 'b h 11 nged for . 1m;tanc e ' on th.e
grounds that the majority shareholder has a confhc_tof int ~r~i;t or ~hat it
· exercising
1s · · its
· power man
· abusive· manner. Even .1f sustaining claims . of
this type would be very difficult, it is at least less improbabl e than if th e
decision were taken only by the directors.
NOTES AND QUESTIONS

1. Do you find that the explanation offered ?Y
~rofessors Armo~r and
Skeel for the differences between takeover regulation m the U.S. and m the
U.K. is convincing? Have you ever thought how geog~aphical _proximity or
dispersion of legislatures, regulators, judges and lobbies can mfluence the
rule-making process? Discuss.
2. Professor Ventoruzzo argues, basically, that the mandatory bid can
be a defensive tool en travesti: when the controlling shareholder owns more
than the triggering threshold , the mandatory bid can help entrench the
incumbents. Similarly, he argues that in a system with concentrated
ownership, letting the shareholders' meeting-which basically means the
controlling shareholder-decide on defensive measures might be like asking
the fox to guard the henhouse. Do you agree? To be fair, he also indicates
some possible positive effects for minority shareholders of the mandatory bid
and the board neutrality rule: can you identify them?
3. The empirical evidence seems to confirm, or at least not to disprove,
Professor Ventoruzzo's claims. Consider, for example, the low number of
hostile tender offers launched in Italy from the 1990s through today: this
data ~ight be interpreted as a sign of the fact that, under the European
rules, incumbents can entrench themselves and scare away any hostile
bidder.
4. Based on what you know of the Japanese law on takeovers do you
think that. the considerations of Armour, Skeel, and Ventoruzzo mi~ht also
apply to this system?
5. To conclude our analysis of ?efensive measures, before moving to
othe: sys~ems, w~ want to mention one additional idea worth of
consideration.
. As 1t should be clear , there are 80 me d e £enses t h at a
corporation can. adopt before going public , such as th e p01son
· p1·11an d ot h er
measures des1gned 'd to entrench control (e·g · multi'pl e vo t·1ng sh ares ) . 0 ne
h 1 h
e enses a t t h e IPO stage
fsc o ar as cons1
k ered the. adoption of takeover d £
rom a mar et perspective: Sharon Hannes Th ~ ,r k
Defenses 101 Nw
'
uL REV 125 (
· · · ·
7) ? e 1.Y1ar
200 . In this fascinat'
et for Takeover
t d · h
Professor Hannes argues that h . ing s u Y, 1n s or t ,
without defenses ("shielded" 0 ;"ue: ~. c~~pdo~at~on decides to go public with or
8
ie e ), it does not (or should not) take
TAKEOVERS AND TENDER 0
ACQUISITIONS AND D FFERS, HOSTILE
CH. 10 E MEASURES 515
. . . ' EFE NSIV
this dec1s1on m· a vacu um but also m · 1· h of the p T
Iiste d corporat10ns
' ect. If
·m this resp tig t . reva1 mg structure of
o~ations are shielded, bidders
will be willing to pay a higher pricemos d corp unshielded
ones, other things being equal · At 1eas an t ~remhmm for the few f
m t d e abse nee O a controlling
' ld
shareholder, therefore, when not many uns h ie e corporati ons are present,
. h b bl 1. .
there m1g t e a stronger incentive to go out~r with weaker-
tu . c w~h
defenses. More specifically, investors purc
;1~g :. ~res m the I~O will ~e
willing to pay a higher price for unshielded O 1
~l~b~) ta~gets. This dynamic
might result in oscillations around a market eqm 1 rmm m terms of shield d
. Id d 1· This insi htful th . . .. e
versus uns h 1e e 1sted corporations. by empi _g 1 'd eore (tica l mtm t10n
seems to be at least partially confirmed rica evi ence see Kose John
. K d h anova, Does Board Classi 'ic t · JI K 1.
& D a l1sa a yrz
{ S ·zz ,, a ion i.v.1 .atte r
,or Industry
. l '2 E .d cts in the Mar ket for Cor or C
R wa s. u~ ence o ,pi over Effe P ate ontrol,
2009, workmg paper on file with Authors).
TION,
TAKEOVER REGULATION, HARMONIZA
GAL
REGULATORY COMPETITION, AND LE
TRANSPLANTS: EUROPE, U.S., CHINA,
INDIA, AND BRAZIL
and harmonization
What is the effect of regulatory competition
t with European law. So
efforts on the regulation of takeovers? Let's star
Takeover Directive, which
far we have referred primarily to the 2004
ry approach in this area;
offers a good sense of the European regulato
have to make with respect
there are, however, some important caveats we
lemented in the different
to the way in which the Directive has been imp
ed in political controversy
Member States. The Directive had been embroil
cerns of some governments
for almost twenty years, especially due to con
champions vulnerable to
that the new rules could make national
of the Directive was only
takeovers by foreign firms . In fact, approval
of making the most
possible thanks to compromise, in the form
optional. The Directive, in
contentious rules not mandatory, but simply
rk, but leaves to Member
other words, sets forth a common legal framewo
ent the different rules. It
States lots of freedom on if and how to implem
l of harmonization and in
provides, in other words, a quite minimal leve
n at all; while others even
fact, according to some, no real harmonizatio
does a two-track regulatory
argue that the Article 12 option, creating as it
ctive pointless . Whatever
environment for takeovers, has made the Dire
ect-for example-to the
the case may be, there is flexibility with resp
datory offer on all the
definition of "control" that triggers the man
the minimum price of the
outstanding shares, on the calculation of
nsions of the obligation to
mandatory offer, on the exemptions and exte
launch an offer, and-particularly important for our purposes-even on
of the "pillars" of the U.K.
the adoption of the board neutrality rule, one
addition, also another rule
approach which inspired the Directive. In
516 ACQUISITIONS, AND DEFENSIVE MEASURES CH. IO
designed to facilitate efficient hostile takeovers, the "b_reakthrough rule"

set forth in Article 11 of the Thirteenth Directive, is opt10nal.
We have not previously explained the breakthro1:1gh rule , so let's
open a parenthesis here and spend a few moments on this rul~. The boa:d
neutrality rules deals with defenses decided and adopted durin _g a hostile
offer; a corporation or its controlling shareholders can howe~er implement
many other legal devices before any hostile takeover is attempted,
designed to entrench control or at least make a non-negotiated acquisition
very difficult. Some of these devices can be effective without any need for
specific action when a hostile takeover is launched. We have seen
examples of these "control enhancing devices" throughout this book:
shareholders' agreements limiting the free transferability of the shares,
dual-class share structures with multiple voting shares , supermajority
requirements to -approve transactions often necessary to complete an
acquisition, such as a merger, and so on. The very existence of similar
provisions can deter potential suitors.
The breakthrough rule aims at curbing the paralyzing effect of these
devices on the market for corporate control, limiting the powers of the
incumbents. The rule was also intended to level the playing field across
Europe, since the corporate law systems of different countries allow
different control enhancing devices. In order to achieve these goals,
Article 11 of the Thirteenth Directive provides two things. First, when an
offer is made public, restrictions on the transfer of shares and voting
agreements, either provided in the bylaws of the target corporation or in
shareholders' agreements, are not enforceable until the end of the offer.
In other words, for example, a shareholder normally bound by a right of
first refusal would be free to tender the shares to the bidder without
incurring any negative legal consequence. Second, if the offer has been
particularly successful (i.e., more than 75% of the outstanding voting
shares have been tendered), most restrictions designed to undermine the
position of the successful bidder are suspended: voting caps, multiple
voting rights, supermajority requirements, and the like, are neutralized,
therefore sterilizing defenses that could hinder the reorganizational goals
of the new controlling shareholder.
That's all interesting in theory, however, as you can imagine, also the
breakthrough rule (as the board neutrality one) prompted significant
opposition from some legislatures. The consequence? In this case as well,
the rule has been made optional, and Member States are not required to
mandate it (again the "Portuguese compromise").
Th~refore, both the board neutrality rules and the breakthrough rule
are optional, and Member States can decide not to mandate them: in this
cas?, however, they !11ust al~ow corporations to adopt these provisions in
their bylaws (the idea being that if the market appreciates them,
rrAl<EOVl<:RSANI>TENDER OFFERS, HOSTILE
cn.10 AC< UISl'l'IONS ANO DRFENSlVE MEASURES 517
n,f\nngcrs and sharehold ers might be inclined to opt-in those provisions).
In addition, if th o national legislature mandates either board neutrality
or breakthrough rul e, it con make them applicable only if reciprocity is
respected, moaning only if the bidder is subject to similar restrictions
limiting its ability to resist hostile acquisitions (Article 12 of the
Directive). The result is that very, very few European companies are
subject to the breakthrough rule.
Going back to our panoramic view, the bottom line here is that most
provisions of the Directive are, in fact, optional, or at least Member States
have significant flexibility in implementing them. Let's take a general
look, with the help of the following table, at how some of the major
provisions of Directive 2004/25 have been implemented in different
Member States (please note that the table requires some inevitable
simplification, and some more nuanced details of the different systems
are not indicated; the overall picture is, however, accurate).
C
France Germany Italy Spain United

Kingdom
purchase of purchase of purchase of purchase of purchase of
30%of 30%of 30%of 30%of 30% of
voting voting voting rights voting voting rights
rights rights or 25% of rights or
voting rights appointment
on the of more than
appointment half the
of or removal directors in
of directors 24 months
event
triggering
mandatory small and
tender offer medium
corporations
can opt in
their bylaws
for a
different
threshold,
between 25
and 40%
highest price highest highest
highest highest price paid
price paid paid by the price paid
price paid by the by the
by the bidder for
by the the shares in bidder for bidder for
minimum bidder for bidder for the shares
the last 12 the shares
price the shares the shares in the last
months in the last
in the last in the last 6 12 months
12 months
12 months months
1I
~
518
CH. 10
i
ACQUISITIONS, AND DEFENSIVE MEASURES 1
I
1
mandated mandated J
not not provided by
mandated mandated law as a by law, but by law, not
by law, by law, default rule, subject to subject to
issuers can issuers can and subject reciprocity reciprocity
adopt it in adopt it in to
the bylaws, the bylaws, reciprocity,
and in this and in this but issuers
board case can case it is can opt out
neutrality decide if it subject to in their
rule is subject to reciprocity bylaws
reciprocity
or not
(before
2014
mandated
by law, but
subject to
reciprocity)
not not not not not
mandated mandated mandated by mandated mandated
by law, bylaw, law, issuers bylaw, bylaw
issuers can issuers can can adopt it issuers can
adopt it in adopt it in in the adopt it in
the bylaws, the bylaws, bylaws, and the bylaws,
and in this and in this in this case and in this
breakthrough case it is case it is it is subject case it is
rule subject to subject to to reciprocity subject to
reciprocity reciprocity (but in case reciprocity
of tender
offer
shareholders'
agreements
are not
enforceable)
As even this partial sketch makes clear, the degree of harmonization

achieved by the directive is limited, and local departures from the default
rules of the directive can be interpreted as a form of regulatory
competition: Member States have adopted rules that they consider
protective of national interests, in particular designed at fencing out a
foreign hostile bidder that might take over local corporations and possibly
adversely affect employment.
A particularly interesting example of how Member States can use the
flexibility embedded in the Directive is the recent (August 2014) Italian
reform of the mandatory bid rules. Before these new rules, under Italian
law whoever acquired 30% of the voting shares of a listed corporation had
to launch a tender offer on all the voting shares. This rule is still
applicable, but one additional threshold triggering the bid had been
added: 25%, when no other shareholder owns more. More relevant for us
here, the new rules allow the bylaws of small and medium listed
corporations (defined based on gross sales and market capitalization) to
provide for a different threshold triggering the mandatory bid, in between
20 and 40% of the voting shares. By lowering the triggering threshold,
mandatory bids are made more likely and hostile acquisitions more
.£_'.!!ff~.
=-1
O.::..-
___ A_C
_Q-"--U_IS_I_T_IO_N_S
..:.2,
:...:.A.::.N.:-=.D~D~E~F~E~N~S~IVE~!!M~E~A~S~U
___ J5~1~9
!_!R~E~S~
expensi:e . The new provisions can be interpreted as a protection of

controlling shareholders against unwelcomed suitors, and allow
shareholders ~o control th e corporation with a smaller investment. In fact,
as we _have discussed ab~ve, the mandatory bid can represent a sort of
defensive mea~~re, ~speci~lly when the existing controlling shareholder
owns. ~ par_ticipation higher than the triggering threshold (not
surprisingly, in some U.S. States, provisions that have effects similar to
the mandato~y tende~ offer rule are regarded as defensive measures). In
this perspective ,. consider the case of a listed corporation controlled by a
sh~reholder ow~ing ~3% of the voting shares . Under the previous regime,
which set the tr1gger1ng threshold at 30%, in theory a hostile acquisition
could have been successful without triggering the mandatory tender offer,
if the buyer would have obtained, for example, 28% of the voting rights.
Under the new approach, on the other hand, the controlling shareholder
could set the triggering threshold at 20% and therefore be protected from
hostile acquisitions by the mandatory bid mechanism. It will be
interesting to test empirically, in the next few years , if Italian small and
medium corporations-or , better, their shareholders-will take advantage
of this new option.
The recent Italian reform is also interesting because it allows bylaws ,
and therefore a private contract, to define the triggering threshold of the
offer. This raises two questions: one of compatibility with European law,
and a more general theoretical question on the role of private ordering in
this area . With respect to the former, Article 5 of the Takeover Directive
states, "The percentage of voting rights which confers control for the
purposes of [mandating the tender offer on all the voting shares] and the
method of its calculation shall be determined by the rules of the Member
State in which the company has its registered office." Someone has
therefore objected that the legislature, and not the governing documents
of the corporation, should determine the triggering threshold. This
interpretation seems, however, too narrow and one might reply that the
Directive simply requires the Member State to set the rules to calculate
"control": it does not seem to prevent a Member State from doing so by
"delegating'' the definition of control to corporate bylaws.
The second, more theoretical question, is to what extent it is
desirable that the statutory regulation of takeovers does not include
mandatory provisions, but only default ones, therefore leaving the matter
to contractual freedom. Should the takeover regime be determined at the
level of the single corporation? The answer, of course, depends on your
faith in the efficiency of the "market for corpor~te bylaws." It depen~s, in
other words on whether you think that investors can effectively
appreciate takeovers rules articulated in the bylaws of single
corporations, effectively "price" them, and therefore effectively c~use
incumbents to internalize their preferences and opt for Pareto-efficient
520 ACQUISITIONS, AND DEFENSIVE MEASURES CH.10
rules. Some authors believe in this ability of the market, and therefore
suggest the adoption of almost entirely optional rules (see, ~or example, L.
Enriqu es, R. J. Gilson, and A. Pacces, The Case for an Unbiased Takeover
Law (With an Application to the European Union), 4 J:fARVARD B~s. L.
REV. 85 (2014)). We are more skeptical about the VIrtues _of pnv~te
ordering in this area, but the issue offers the occasion f~r an interesting
discussion. For example, if takeover rules should be flexible, do you ?nd
preferable to have a default rule in favor of incumbents, and corporat10ns
can opt-in a rule more protective of investors, or the other way arou?d? If
the level of protections against hostile takeovers is se~ ~y a res~l';ltio~ of
the shareholders' meeting, what is the role of supermaJority proV1s10ns.
· France has also used the flexibility of the Directive to enact rules
designed to protect incumbents against takeovers. To begin with, it
reduced the threshold for a mandatory bid from 33% to 30% in 2010: as
we have seen, a- lower triggering participation might mean more
expensive hostile takeovers. In 2014, the board neutrality rule was
abandoned and the right of information of the employees' council
strengthened. Also the fact that "loyalty shares" (discussed in Chapter 4)
have become the default rule in 2014 can be considered an anti-takeover
device: when the shareholders' meeting votes on a defensive measure,
long-term shareholders will have proportionately more influence than
more recent ones, including the bidder . The breakthrough rule (Article 11
of the Takeover Directive) could curb the effect of loyalty shares, but as
seen in the above table, the rules is not mandatory in France.
As French loyalty shares suggest, the barriers to takeovers do not
only depend on takeover rules, but also on other corporate law rules.
There are countless examples. Consider, for instance, corporate
governance rules that we have studied in Chapter 5. As we mentioned in
that part of the book, many commentators have argued that the two-tier
German system of governance represents, in itself, a possible protection
against takeovers, because a new shareholder, before being able to control
the management of the corporation, not only has to change the
composition of the supervisory board, but must also wait for the new
members of the supervisory board to change the members of the
managing board. According to some, this apparently minor glitch could
contribute to raising the cost of a takeover. In addition, and probably
more substantively, German Mitbestimmung, the mandatory
representation of employees in the supervisory board, can also make
German boards particularly averse to hostile takeovers. Employees '
representatives, quite clearly, will not be particularly pleased with
acquisition plans aiming at "greater efficiency," if this means layoffs.
We discussed that optional rules and differences in the corporate
laws of the Member States have significantly limited the harmonizing
effects of the Takeover Directive. Should it, however, be considered a total
TAK EOVERS AND T ENDER O
CH.10 ACQUI SITIONS AND D FFER S , HO STILE
' E FENSIVE MEA SURES 52 1
-
failure for the purposes of creating a I 11d .
similar evaluation would be too har sh e;~ e
"' playin g field? We believe a
features of the Directive that have h ·1 ;r e ar~ other less controversial
level playing field for takeovers in E:r pe ~; will _helpto bring about a
th
no ing else, the Directive
bas contributed to the development . oEpe. of a "common Ia~~uage"
' m urope
mak~ r .
on takeov er amon g busine sspeo ple, polic
and legal and economic scholars · It h as con y t 'b s, Judges, practit10ne·rs,1
ri uted to identifyi
aspec ts of takeov er regula tion, and to more easil cl ·r . ng cruc_ia
takeover regimes and rules as more or less in . y f assi yfinghalte~native
k h Id Th . h avor o t e different
st~ e ho ters.b 1·at m_1gt_be ~onsidered a not partic ularly rich consolation
prize, u we e ieve 1t 1s not irrelevant.
It should be noted, on the other hand, that also in the U.S. states
ha~e competed to a~tract corporations through the enactment of rules
e takeovers . we re £er, of
. bents against- hostil
designed to protect " incum
course, t o so-ca11ed anti-takeover statutes." Some of the earlier versions
of these statutes, based ?n~erit review of hostile offers by st~te bodies,
have been held unconstitutional because they were in violation of the
commerce clause and pre-empted by the Williams Act (see Edgar v. Mite
Corp., 457 U.S. 624 (1982)); subsequent generations of anti-takeover
statutes, based on corporate governance rules, have however been upheld
in court (see CTS Corp . v. Dynamics Corp. of Am., 481 U.S. 69, 94 (1987)),
and they offer a broad variety of techniques to protect incumbents. We
find "control share acquisition" statutes, providing limitations to the
voting rights of whoever acquires a certain threshold of shares, unless the
other shareholders approve the acquisition; "fair price" statutes, pursuant
to which business combinations with relevant shareholders (for example,
holding more than 15% of the shares) must be approved by a
supermajority vote unless they offer a minimum price to existing
shareholders; "cash-out" statutes, according to which if a person obtains
control, she must offer to purchase the remaining shares at the highest
price paid (as you can see, the economic effects of these provisions are
similar to the ones of the mandatory tender offer); and ''business
combination" statutes, which limit the ability of large shareholders to
carry on mergers and other transactions fo~ a few years after_ the
acquisition of the shares unless those transactions are approved with a
supermajority vote .
But what about other legal systems, and in. particular "~RIC"
countries? Have the regulatory approaches adopted in Europe or in !he
U.S. been successfully exported to those jurisdictio~s? T_he _follo~ing
,
excerpt very effectively, even if briefly, illustrates the situation 1n China
India, and Brazil.

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SUMMARY OF CONTENTS

............. ....................... ......... ......... ..........

I METHODOWGICAL LvrRODUCTIO N (DO NO'rSKIP THIS)

Chapter 3. The Incorporation Process and Limitations on

d 'Agreements ....................... .. ..... . ······ ················ 375 3

Chapter 9. Mergers an d Acqu1s1

Chapter 10. Takeovers and Tender Offers, Hostile Acquisition s,

COMPARATIVE CORPORATE LAW:

A Japanese case, for example, mig

Some scholars have in fact ar d th · .

I I exercise is often at least a comparison of the ways different states deal to

I~troducing a_ comparative perspective could shed light on such

very old because ever . f ntries and states. The persons

Loo~ng across the Border in Company Law: Leo-isl t

Governance. Anal!':'1s and Recommendations of 1992 (2 vols ., 1994) and

i j the Federal Secunties Code of 1978 (2 vols., 1980). ,

Contracts and the Principles of . les of

I to consider foreign law . I reference to foreign sources by

In Europe, the discussion about the desirability of c~oss-citations

I is less politically contentious. A possible explanation could be

citing cited court

Austria - 0 I 4 447 0 3 0 0 21 476

The most cited courts appear to be the ones of Germany, followed by

Total number of citationsof foreign courts

Of course, as the authors mention, these data are sometimes difficult

Foreigncitationsof the AustrianSupremeCourt

elements of both common la d . . xed Jurisdictions that present

decides without a jury. In addition, in many commercial contracts jury

So what is the different applicable rule?

l systems. This is not due to an "America-centric" bias, but because we

I it to say that directives_are enact\ Y t :es with a statute

. One article of these authors is particularly interesting in this respect:

Data on Shareholders Rights from LLSV ( 1998)

0.00 0.20 0.40 0.60 0.80 1.00

• preemptiveright new shares. .

Based on these and other data, LLSV concluded that "countries

CHOICE OF APPLICABLE CORPORATE

"d t"f appli"c"'blecorporate lnw ruloA.'.l'ho fir1-1t,

CENTROS LTD. V. ERHVERVS- OG SELSKABSSTYRELSEN

I Judgment of the Court of 9 March 1999

I The Board submits that its refusal to grant registration is not

In those circumstances, the Hojesteret has decided to stay

I entitled to carry on their business in another Member State through an

paragraph 18, Case C-330/91 Commerzbank [1993] ECR l-4017, CH.2

establishment. The right to form a c9mpany in accordance with the law of

I first ~~ate from a~optin_g any ~ppropriate measure for preventing or

justify a practice of refusing to register a branch of a company, which has

mode~mzm~ ~ules regardmg the protection of creditors, in particular (C

has yet to experience a one state domination of the "incorporation

GERMAN FEDERAL COURT OF JUSTICE, 13 MARCH 2003

RACE TO THE TOP OR TO THE BOTTOM? A MORE

WILLIAM L. CARY, FEDERALISM AND CORPORATE LAW:

Delaware is both the sponsor and the victim of a system contributing

. ~ few illustrations of the legislative approach reveal the Delaware

Nevertheless, it concluded that "[t]hose decisions are, however, in our CH.2

has .r~ceiv~d _a benefit to the exclusion and at the expense of the

per~pect_ive,arguing that freedom of incorporation leads to a more flexible

MARK J. ROE, DELAWARE'S POLITICS 5

Look at what we have done here. We've reversed the conventiona l

limited protection of investors. For example, lots of corporations located in