117 comparative company law 117 company...117 comparative company law 117 day 5 – monday, july 26...

117 COMPARATIVE COMPANY LAW 117

Day 5 – Monday, July 26 III. CORPORATE GOVERNANCE

Welcome back from your relaxing weekend and to our scintillating course on comparative company law. This week we look at how power is allocated within the corporation. As you remember, last week we looked at how corporations are regulated in the United States and Europe – starting with the contract/institution debate, then looking at the basics of corporate law, next focusing on the protections given non-shareholder creditors, and finally considering the source of corporate/company law.

Now it’s time to look at the essence of corporate law – the ways in which power is

allocated between shareholders (capital) and management (labor). We first look at how business profits are allocated in the US corporation and the Italian company – who makes the decision and what judicial oversight is there of the internal process? We then turn to the question of the purpose of the corporation/company and the responsibility of managers to non-shareholder constituents – comparing the US approach and the European approach.

After this look at corporate governance, we turn our sights to shareholder protection. We

first consider the ways in which shareholders and stock markets are protected from those who seek to exploit unfair informational advantages – looking at the similarities and differences in the regulation of “insider trading” in the United States and Europe. We then wrap up this whirlwind course looking at how financial fraud in US corporations has differed from fraud in European companies – comparing the Enron scandal with the Parmalat scandal.

Then we will each get on an airplane, train or vaporetto, and return to our regular lives,

forever enriched by this comparative experience – especially with each other. A. Power Over Business Earnings One of the main attributes of any business organization is how business profits are

allocated. Do they go entirely to the shareholders or do managers also share in them? This is an age-old question. Remember in medieval Venice, profits in colleganze were divided between capital contributors and labor contributors (with capital contributors getting the lion’s share, reflecting that capital may be scarcer and thus more highly valued than labor). But then after a few centuries, capital contributors kept all the profits and just paid labor a fixed salary.

In the modern corporation/company, shareholders have a right to profits – though there is

a question of timing. Must the profits be distributed when earned, or can they be accumulated within the business to make even more profits and then distributed later? That is the question that we first take up. Is the decision to retain profits one for the managers (the corporate board of directors) or for the shareholders? And if shareholders are unhappy with how profits are distributed, can they go to court and compel the board to act in a particular way? Interesting questions – let’s find out.

1. Locus of corporate power in the United States We start in the United States by looking at the Delaware corporate statute, a typical one

in this regard. Who has power under Delaware law to decide the business affairs of the

118 COMPARATIVE COMPANY LAW 118 corporation, including the distribution of profits? Are there any protections for shareholders who are unhappy with the allocation of power? We read a famous Delaware case that lays out the nature of judicial review of corporate dividend policy in public corporations. We then read another Delaware case that deals with the same issue in a closely-held corporations. What’s your guess – different kinds of review for different kinds of businesses?

DELAWARE GENERAL CORPORATION LAW Subchapter IV. Directors and Officers

§ 141. Board of Directors; Powers

(a) The business and affairs of every corporation organized under this chapter shall be managed by of under the direction of the board of directors, . . . .

* * * § 170. Dividends; Payment (a) The directors of every corporation, subject to any restrictions contained in its certificate of incorporation, may declare and pay dividends upon the shares of its capital stock …. either (1) out of its surplus, as defined in and computed in accordance with ‘’ 154 and 244 of this title, or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year.

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Sinclair Oil Corp. v. Levien Supreme Court of Delaware

280 A.2d 717 (1971)

This is an appeal by the defendant, Sinclair Oil Corporation (hereafter Sinclair), from an order of the Court of Chancery in a derivative action [brought by minority shareholders of a subsidiary corporation on behalf of the subsidiary] requiring Sinclair to account for damages sustained by its subsidiary, Sinclair Venezuelan Oil Company (hereafter Sinven), organized by Sinclair for the purpose of operating in Venezuela, as a result of dividends paid by Sinven, the denial to Sinven of industrial development, and a breach of contract between Sinclair's wholly-owned subsidiary, Sinclair International Oil Company, and Sinven. THE FACTS

Sinclair, operating primarily as a holding company, is in the business of exploring for oil and of producing and marketing crude oil and oil products. At all times relevant to this litigation, it owned about 97% of Sinven's stock. The plaintiff owns about 3000 of 120,000 publicly held shares of Sinven. Sinven, incorporated in 1922, has been engaged in petroleum operations primarily in Venezuela and since 1959 has operated exclusively in Venezuela.

Sinclair nominates all members of Sinven's board of directors. The Chancellor found as a fact that the directors were not independent of Sinclair. Almost without exception, they were officers, directors, or employees of corporations in the Sinclair complex. By reason of Sinclair's domination, it is clear that Sinclair owed Sinven a fiduciary duty. [cites omitted] Sinclair concedes this.

119 COMPARATIVE COMPANY LAW 119 STANDARD OF REVIEW

The Chancellor held that because of Sinclair's fiduciary duty and its control over Sinven, its relationship with Sinven must meet the test of intrinsic fairness. The standard of intrinsic fairness involves both a high degree of fairness and a shift in the burden of proof. Under this standard the burden is on Sinclair to prove, subject to careful judicial scrutiny, that its transactions with Sinven were objectively fair.

Sinclair argues that the transactions between it and Sinven should be tested, not by the test of intrinsic fairness with the accompanying shift of the burden of proof, but by the business judgment rule under which a court will not interfere with the judgment of a board of directors unless there is a showing of gross and palpable overreaching. A board of directors enjoys a presumption of sound business judgment, and its decisions will not be disturbed if they can be attributed to any rational business purpose. A court under such circumstances will not substitute its own notions of what is or is not sound business judgment.

We think, however, that Sinclair's argument in this respect is misconceived. When the situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing the terms, the test of intrinsic fairness, with its resulting shifting of the burden of proof, is applied. The basic situation for the application of the rule is the one in which the parent has received a benefit to the exclusion and at the expense of the subsidiary.

A parent does indeed owe a fiduciary duty to its subsidiary when there are parent-subsidiary dealings. However, this alone will not evoke the intrinsic fairness standard. This standard will be applied only when the fiduciary duty is accompanied by self-dealing -- the situation when a parent is on both sides of a transaction with its subsidiary. Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary. CLAIM THAT SUBSIDIARY PAID EXCESSIVE DIVIDENDS

We turn now to the facts. The plaintiff argues that, from 1960 through 1966, Sinclair caused Sinven to pay out such excessive dividends that the industrial development of Sinven was effectively prevented, and it became in reality a corporation in dissolution.

From 1960 through 1966, Sinven paid out $108,000,000 in dividends ($38,000,000 in excess of Sinven's earnings during the same period). The Chancellor held that Sinclair caused these dividends to be paid during a period when it had a need for large amounts of cash. Although the dividends paid exceeded earnings, the plaintiff concedes that the payments were made in compliance with 8 Del.C. § 170, authorizing payment of dividends out of surplus or net profits. However, the plaintiff attacks these dividends on the ground that they resulted from an improper motive -- Sinclair's need for cash. The Chancellor, applying the intrinsic fairness standard, held that Sinclair did not sustain its burden of proving that its transactions were intrinsically fair to the minority stockholders of Sinven.

Since it is admitted that the dividends were paid in strict compliance with 8 Del.C. § 170 [distributions limited to payments from surplus and current earnings], the alleged excessiveness

120 COMPARATIVE COMPANY LAW 120 of the payments alone would not state a cause of action. Nevertheless, compliance with the applicable statute may not, under all circumstances, justify all dividend payments. If a plaintiff can meet his burden of proving that a dividend cannot be grounded on any reasonable business objective, then the courts can and will interfere with the board's decision to pay the dividend.

We do not accept the argument that the intrinsic fairness test can never be applied to a dividend declaration by a dominated board, although a dividend declaration by a dominated board will not inevitably demand the application of the intrinsic fairness standard. If such a dividend is in essence self-dealing by the parent, then the intrinsic fairness standard is the proper standard. For example, suppose a parent dominates a subsidiary and its board of directors. The subsidiary has outstanding two classes of stock, X and Y. Class X is owned by the parent and Class Y is owned by minority stockholders of the subsidiary. If the subsidiary, at the direction of the parent, declares a dividend on its Class X stock only, this might well be self-dealing by the parent. It would be receiving something from the subsidiary to the exclusion of and detrimental to its minority stockholders. This self-dealing, coupled with the parents' fiduciary duty, would make intrinsic fairness the proper standard by which to evaluate the dividend payments.

Consequently it must be determined whether the dividend payments by Sinven were, in essence, self-dealing by Sinclair. The dividends resulted in great sums of money being transferred from Sinven to Sinclair. However, a proportionate share of this money was received by the minority shareholders of Sinven. Sinclair received nothing from Sinven to the exclusion of its minority stockholders. As such, these dividends were not self-dealing. We hold therefore that the Chancellor erred in applying the intrinsic fairness test as to these dividend payments. The business judgment standard should have been applied.

We conclude that the facts demonstrate that the dividend payments complied with the business judgment standard and with 8 Del.C. § 170. The motives for causing the declaration of dividends are immaterial unless the plaintiff can show that the dividend payments resulted from improper motives and amounted to waste. The plaintiff contends only that the dividend payments drained Sinven of cash to such an extent that it was prevented from expanding.

[The court then decided that the parent had not usurped corporate opportunities of the subsidiary.]

Next, Sinclair argues that the Chancellor committed error when he held it liable to Sinven for breach of contract. In 1961 Sinclair created Sinclair International Oil Company (hereafter International), a wholly owned subsidiary used for the purpose of coordinating all of Sinclair’s foreign operations. All crude purchases by Sinclair were made thereafter through International. On September 28, 1961, Sinclair caused Sinven to contract with International whereby Sinven agreed to sell all of its crude oil and refined products to International at specified prices. The contract provided for minimum and maximum quantities and prices. The plaintiff contends that Sinclair caused this contract to be breached in two respects. Although the contract called for payment on receipt, International’s payments lagged as much as 30 days after receipt. Also, the contract required International to purchase at least a fixed minimum amount of crude and refined products from Sinven. International did not comply with this requirement. Clearly, Sinclair’s act of contracting with its dominated subsidiary was self- dealing. Under the contract Sinclair received the products produced by Sinven, and of course the minority shareholders of Sinven were not able to share in the receipt of these products. If the contract was

121 COMPARATIVE COMPANY LAW 121 breached, then Sinclair received these products to the detriment of Sinven’s minority shareholders. We agree with the Chancellor’s finding that the contract was breached by Sinclair, both as to the time of payments and the amounts purchased. Although a parent need not bind itself by a contract with its dominated subsidiary, Sinclair chose to operate in this manner. As Sinclair has received the benefits of this contract, so must it comply with the contractual duties. Under the intrinsic fairness standard, Sinclair must prove that its causing Sinven not to enforce the contract was intrinsically fair to the minority shareholders of Sinven. Sinclair has failed to meet this burden. Late payments were clearly breaches for which Sinven should have sought and received adequate damages. As to the quantities purchased, Sinclair argues that it purchased all the products produced by Sinven. This, however, does not satisfy the standard of intrinsic fairness. Sinclair has failed to prove that Sinven could not possibly have produced or someway have obtained the contract minimums. As such, Sinclair must account on this claim.

Delaware Supreme Court (2005) _______________________________________ NOTES 1. The notion that the “affairs of the corporation are managed by, or under the direction of,

the board of directors” is not an American invention. Instead, the corporate board – a discrete group of central decision-makers – arose out of European medieval political ideas that favored collegial decision-making. See Franklin A. Gervurtz, The European Origins and the Spread of the Corporate Board of Directors, 33 Stetson L. Rev. 925 (2004). While other trading companies, such as the merchant houses of imperial Japan, gave authority to a single family member, trading companies in Europe developed a system of centralized collegial management.

The boards of European trading companies (the forerunners of U.S. corporations)

originated in the structure of medieval guilds, where the guild charter established a board to resolve inter-member disputes and regulate members’ conduct. Borne of the medieval political practice (for example, in Florence) of representative assemblies, the boards of


guilds and municipalities reflected a new preference for collegial decision-making. (It is worth remembering that this was also the period when the 12-person jury arose in northern Europe.)

The use of councils in Europe has even deeper roots in the Christian church,

whose councils famously decided such matters as the content of orthodox religious texts and the resolution of church schisms. By contrast, the family-oriented hierarchical structure of Japanese trading houses is consistent with Confucian values of obedience in human relations. Of the five Confucian relationships among people (ruler-subject, father-son, husband-wife, elder brother-younger brother, and friend-friend), four of the relationships are vertical and demand unquestioning obedience.

2. Notice that Sinclair Oil involved a derivative suit, in which a single shareholder sought to enforce corporate rights. Should a single minority shareholder be able to challenge a board’s dividend policy, applicable to all shareholders? a. What is a derivative suit? It is a representative suit in which a shareholder sues

on behalf of the corporation to vindicate corporate (generalized) rights, such the right that corporate fiduciaries act with due care and utmost loyalty. In effect, the shareholder seeks to become the voice for the corporation.

b. Who may bring a derivative suit in Delaware? Any shareholder may sue, regardless of the shareholder’s amount of ownership. Most corporate statutes, including Delaware’s, require that the plaintiff-shareholder have been a contemporaneous owner when the challenged wrong occurred.

c. What must the plaintiff allege? The shareholder-plaintiff must allege some harm to the corporation. Any recovery will be to the corporation, not to individual shareholders.

3. Consider the rule of U.S. corporate law that decisions about payments to shareholders is

made by the board of directors. a. Why should the shareholders who invested equity capital in the business not be

able to withdraw cash as they seem fit – after all, aren’t they the owners? b. What is the holding of the Delaware court in Sinclair Oil - when can a minority

shareholder challenge a dividend decision of the board? Why is dividend policy a matter for the board to decide? Isn’t a return on investment an assumption of any shareholder’s investment?

c. One answer may be that shareholders can always change dividend policy by electing a new board. But what if the dividend policy, as in Sinclair Oil, is made by a board controlled by a majority shareholder. What protections do minority shareholders have against abuse of management discretion – besides suing the board in a lawsuit that will likely be futile?

4. Notice that the court held Sinclair to be liable for self-dealing with its subsidiary. What is self-dealing? Why is it wrong? a. Consider how the minority shareholders of the subsidiary must feel when they

discovered that Sinclair was taking profits from Sinven that it was not sharing with Sinven shareholders. This is the essence of “tunneling.”

b. What is the remedy for this self-dealing? Sinclair must return to Sinven any amounts above the fair market value of the purchases it made, plus any purchases it might have made if Sinven had been allowed to produce at full capacity.


c. One interesting final point: the court held that Sinclair could not “setoff” the value to Sinven of being part of a corporate group – shared accounting, tax breaks, etc. Instead, the assumption was that Sinclair had to deal with Sinven like any other third party supplier! (We will soon see that Italian law is different in this regard and permits a “setoff” – effectively negating challenges to inter-group dealings.)

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Litle v. Waters Court of Chancery of Delaware, New Castle

1992 Del. Ch. LEXIS 25 (1992)

Plaintiff, Thomas J. Litle, instituted this lawsuit against defendants alleging that they had committed, and continue to commit, various breaches of fiduciary duties.

As alleged in the complaint, in 1979 Litle and Waters formed Direct Order Sales Corporation ("DOSCO"), a Delaware corporation which engaged in the catalog sales and merchandise fulfillment business. At the beginning, DOSCO was unprofitable and Waters infused it with capital by lending it money. In 1983, Litle and Waters formed Direct Marketing Guaranty Trust Corporation ("old DMGT"), a New Hampshire corporation which engaged in the credit card processing business for catalog sales transactions. Waters owned 2/3 of the stock of both companies and Litle owned 1/3.

The two men agreed that Waters would provide the capital and Litle the management for the two entities. Although the two elected to treat the corporations as S corporations, with flow-through tax status, they never formally agreed that the corporations would actually pay dividends.

In September 1985, Waters fired Litle as president and CEO of both companies. Waters then merged the two companies into DMGT Corp. ("new DMGT"). Waters became the new corporation’s CEO and board chair, and then used the combined entities' profits to begin repaying the debt that DOSCO had owed him.

Since the merger, new DMGT has done very well:

Year Reported earnings 1987 $ 739,000 1988 $ 909,000 1989 $ 3.8 million 1990 $ 3.6 million

These earnings have resulted in a tax liability of $ 560,000 for Litle, who retained a 33% interest in new DMGT, even though new DMGT has not distributed any dividends to its shareholders. According to Litle, Waters is having new DMGT not pay dividends to make Litle's shares worthless so that Waters can buy Litle out "on the cheap." In fact, Waters’s tried to have his accountants justify this hoarding of cash, but the accountants could not state a need for not paying dividends.

In the complaint, plaintiff alleges that "the Director Defendants breached their fiduciary duties to the stockholders in that the course of action embarked upon was designed to and did

124 COMPARATIVE COMPANY LAW 124 favor one group of stockholders to the detriment of another." Defendants argue that "the declaration and payment of a dividend rests in the discretion of the corporation's board of directors in the exercise of its business judgment; that, before the courts will interfere with the judgment of the board of directors in such matter, fraud or gross abuse of discretion must be shown." Gabelli & Co., Inc. v. Liggett Group, Inc., Del. Supr., 479 A.2d 276, 280 (1984). Further, defendants argue, the mere existence of funds from which the entity could pay dividends does not prove fraud or abuse of discretion by a board in its determination not to declare dividends. See Baron v. Allied Artists Pictures Corp., Del. Ch., 337 A.2d 653, 659 (1975), appeal dismissed, Del. Supr., 365 A.2d 136 (1976). Defendants argue that the Board's decision to not to declare dividends is protected, unless the plaintiff can show Aoppressive or fraudulent abuse of discretion." Eshleman v. Keenan, Del. Ch., 22 Del. Ch. 82, 194 A. 40, 43 (1937).

In making their respective arguments, the parties overlook an important issue. That is, what is the proper standard of judicial review or the Board's actions? Plaintiff merely states in a footnote that an entire fairness standard applies. Defendants, by relying on Eshleman imply that the business judgment standard applies.

An interested director is one that stands on both sides of a transaction or expects to derive personal financial benefit from the transaction in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally. See Aronson v. Lewis, Del. Supr., 473 A.2d 805, 812 (1984). The decision as to whether a director is disinterested depends on whether the director . . . involved had [a] material financial or other interest in the transaction different from the shareholders generally. "Material" in this setting refers to a financial interest that in the circumstances created a reasonable probability that the independence of the judgment of a reasonable person in such circumstances could be affected to the detriment of the shareholders generally. Cinerama, Inc. v. Technicolor, Inc., Del. Ch., C.A. No. 8358, 1991 Del. Ch. LEXIS 105, *37 (Allen, C. June 24, 1991).

Waters served his own personal financial interests in making his decision to have DMGT not declare dividends. By not making dividends, he was able to ensure that he would receive a greater share of the cash available for corporate distributions via loan repayments. Further, the decision enabled him to put pressure on Litle to sell his shares to him at a discount since the shares are and were only a liability to Litle who receives no corporate distributions, yet owes taxes on the company's income. Indeed, the loan repayments continue to enable Waters to keep the pressure on Litle to sell the shares at a discount since the loan repayments provide cash that he can use to pay his tax liability, while Litle has to find sources of cash to pay his tax liability. Therefore, I must consider Waters to be an interested director with respect to the Board's decision to not declare dividends.

Since plaintiff's complaint sufficiently alleges facts which justifies the applicability of the entire fairness standard and defendant has not adequately rebutted its applicability by showing the other new DMGT directors are independent, the burden shifts to defendants to demonstrate that the decision to not declare dividends and to repay the company's debt to Waters was intrinsically fair.

Counts I of plaintiff's complaint state claims for which I can grant relief. Defendants' motion to dismiss Counts is DENIED. _________________________________


NOTES

1. Consider when a derivative suit can be brought to challenge a majority-controlled board’s dividend policy. Would the result in Litle v. Waters have been different if – a. the defendant had suggested a good business reason for not paying dividends --

such as to expand DMGT’s credit card processing business to the Internet? b. the DMGT board had been composed of a majority of non-employee directors

who did not have any business or personal relationship with Waters? c. Waters had offered to pay Litle a fair price for his shares, but Litle had refused

hoping to get a better price later if the company went public? 2. How is the approach in Sinclair Oil different from that of Litle v. Waters?

a. Does it make any difference whether the minority shareholders are seeking to have dividends paid rather to have them invalidated?

b. Does it make any difference that the minority shareholder in Sinclair had purchased publicly-traded shares in a holding company structure, while Litle invested in a closely-held business?

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2. Locus of corporate power – Europe (and Italy) Now that you’ve got a basic understanding of US corporate law on the question of how profits are allocated within the firm or corporate group, let’s look at Europe. What happens if company insiders (such as in a family-controlled business) decide to take out money from the business for themselves and at the expense of minority shareholders? What are the protections for minority shareholders in such cases?

It turns out that this question – sometimes called “tunneling” – is fundamental to how corporate law systems are evaluated. Systems that protect minority investors get high marks; those that do not are viewed as anti-capitalist pariahs. A 2006 research project involving a collaboration of Lex Mundi (a worldwide association of independent law firms) and the World Bank sought to investigate how well different countries protect corporate investors against self-dealing by corporate insiders. Doing Business: Protecting Investors, The World Bank (2006).

The project asked participating law firms to analyze a standard case in which a dominant board member of a public company (who owns 60% of the company’s stock) proposes that the company will purchase supplies from a private company in which he owns 90% -- at a price higher than fair market value. The researchers sought information from each country on questions such as who approves the transaction, what information must be disclosed, how easy is it for shareholders to bring suit, and what do minority shareholders have to prove to stop the transaction or receive compensation.

Using answers from 90 Lex Mundi law firms with a practice in 154 countries, the project researchers constructed an index of “investor protection.” The project found that the countries that have the best protection have several things in common: (1) they require immediate disclosure of the transaction and the board members conflict of interest, (2) they require prior approval of the transaction by other shareholders, (3) they enable shareholders to hold the company’s directors liable and to have the transaction voided if its terms are unfair, and (4) they permit shareholders who take the company directors to court to access all relevant documents.

http://www.doingbusiness.org/documents/Protecting_investors.pdf�


Where are investors protected—and where not? Most protected Least protected New Zealand Singapore Canada Hong Kong, China Malaysia Israel United States South Africa United Kingdom Mauritius

Costa Rica Croatia Albania Ethiopia Iran Ukraine Venezuela Vietnam Tanzania Afghanistan

In assessing the difficulties in protecting investors, the corporate lawyers participating in

the survey identified the following major obstacles (the percentage of countries in which obstacle was identified is shown in parenthesis):

• Lack of information on related-party transactions (53%) • Investors must prove their case to the level of certainty in criminal cases (39%) • Directors keep profits from self-dealing even after being convicted of breach of duty

(37%) • Liability for directors only if they act fraudulently or in bad faith (13%) • No access to company’s or defendant’s documents (8%)

Several developing countries protect investors well, but in general poor countries regulate

self-dealing less often than rich countries. This is especially true in requiring disclosure, and some poorer countries try to compensate for the lack of shareholder access to information and courts by relying on government inspectors. The study identified a correlation between investor protection and equity investment, with lower protection being strongly associated with lower levels of investment. This is consistent with other studies, including a recent study of private equity transactions that found countries with a higher risk of expropriation experience half the investment (as a share of GDP) compared with countries with good investor protections. Consider the ratings of the following countries. (The first three entries indicate, in order, the extent of disclosure, the extent of director liability, and the ease of shareholder suit – the last entry, an average of the three, provides a composite “strength of investor protection.”)

Disclosure D liability Sh suit Composite Italy 7 2 5 4.7 France 10 1 5 5.3 Germany 5 5 6 5.3 Poland 7 4 8 6.3 Russia 7 3 5 5.0 United Kingdom 10 7 7 8.0 United States 7 9 9 8.3


With respect to the United States, the study noted that the country protects investors through broad court review of directors’ actions. During trial all relevant company documents are open for inspection. In court, plaintiffs can directly question all witnesses, including the defendant, without prior judicial review of the questions posed. Directors must show the transaction was fair to the company—both in price and in dealing. This, the study concluded, “makes the United States one of the easiest places to bring shareholder suits.”

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INTRODUCTORY NOTES

1. Consider how a minority shareholder in an Italian company might challenge a board’s refusal to recommend dividends. a. Can the shareholder convince the other shareholders to declare a dividend, even

though the board has failed to do so? b. Can the shareholder compel the company’s auditors to force the board to declare

a dividend or to initiate a judicial investigation of the board? c. Can the shareholder bring a court action to have a judge compel the declaration

of dividends. Does Italian company law contemplate derivative suits? 2. Consider the related situation where a controlling shareholder causes the company to deal

with one of the shareholder’s companies, rather than with outside companies at market rates. For example, suppose that Silvio Berlusconi had his company Telinvest, a country-wide network of TV stations, buy all of the TV cameras used by the stations through his own company. a. If you were a minority shareholder in Telinvest, how would you feel about this?

How is your investment affected by the Berlusconi self-dealing? b. What rights would you have under Italian company law to claim that the

purchases of TV cameras were unfair to Telinvest?

3. So control has its privileges! Would you rather be a controlling shareholder in Italy or the United States? In a study by a Harvard economist of controlling shareholders in 661 firms in 18 countries, the value of control (which can be used to extract value at the expense of other shareholders) was found to range from 0% (Denmark) to 50% (Mexico) of the firm’s overall market value. That is, in Mexico the value of controlling a firm worth $1,000 is $500 -- that is, a 50% shareholder with control would value his ownership at $750, while the same shareholder without control would value his interest at $250! What determines the value of control? The study measured the general strictness of the legal environment (courts), the regulation of takeovers, power-concentrating provisions in company charters, and the likelihood of control contests. It found that the legal environment explains 75% of the cross-country variation in the value of control. Tatiana Nenova, The Value of Corporate Costs and Control Benefits: A Cross-Country Analysis, SSRN Paper 237809 (July 2000).

4. Here’s a somewhat discouraged assessment by Professor Enriques of the current status of

Italian company law, even after the recent reforms:

US and Italian corporate laws couldn't be more different one from the other. In the US, corporate law is enabling; in Italy mandatory terms in corporate law provisions are still pervasive; in the US, corporate law concentrates on

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=237809�


relationships between shareholders and managers and between minority and majority shareholders; in Italy, many corporate law rules are in place also to protect creditors. In the US, (Delaware) courts play a central role in policing proper corporate behavior by enforcing open-ended standards (e.g. fairness); Italian courts seldom are involved in corporate governance issues and tend to defer to insiders' decisions.

Luca Enriques, US and Italian Corporate Law: Faraway, so Close (Diritto societario statunitense e diritto societario italiano: In weiter Ferne, so nah). Giurisprudenza Commerciale, Part I, pp. 274-287, SSRN paper 1014824 (2007).

5. We next turn to a famous law review article by an Italian commercial law professor who reviews how corporate governance works in listed companies in Italy. As you’ll notice, Italian company law (like much of Continental Europe) proceeds on the assumption that power in the company resides with the shareholders and happens during the shareholders’ meeting – or assembly. How does this compare with the United States?

You’ll also notice that the Italian company law system introduces another body in the company governance system – namely, the board of auditors. Selected by shareholders, the board of auditors is supposed to serve as a watchdog to protect shareholders from wayward managers. In the United States, a similar function is provided by outside accounting firms that audit the financial information of the corporation. Although not formally part of the US corporate structure, these auditing firms can be liable to shareholders if their audits fail to uncover internal corruption or financial fraud.

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Corporate Governance in Italy: Strong Owners, Faithful Managers: An Assessment and a Proposal for Reform

6 IND. INT'L & COMP. L. REV. 91 (1995) Lorenzo Stanghellini1

E. The Protagonists of the Governance of the Societa per Azioni.

Power in the societa per azioni is allocated among three organs: the shareholders; the board of directors; and the board of auditors. Broadly speaking, shareholders have the power to decide who will manage the company, who will supervise the managers, and they have a voice in

1 Assistant Professor of Law, University of Florence, Italy. J.D., University of Florence (1987);

LL.M. Columbia University (1995).

http://ssrn.com/abstract=1014824�

129 COMPARATIVE COMPANY LAW 129 certain fundamental decisions. Directors manage the company, and auditors, who are part of the corporate structure, supervise directors in the interests of shareholders and creditors.

1. The Shareholders.

Shareholders in the societa per azioni do not have direct power to manage the company. Their fundamental powers consist in electing and removing directors and auditors, in determining their compensation, in voting on amendments to the charter and by-laws (which include matters such as the issuance of new stock and convertible bonds, mergers, dissolution of the company), in voting on the issuance of bonds, C.c. art. 2364, 2365 (Italy), and ... the system is a special power of shareholders over directors' and auditors' liability.2

This feature will be specially examined throughout this paper: directors and auditors may be held liable only if a majority of the voting shareholders decide to institute action against them. C.c. art. 2393(1) (Italy). [This was the state of affairs as of 1995, before the 2003 reforms permitted derivative suits.]

Shareholders act generally as a group, following a call for a meeting. Each shareholder, however, or in certain cases shareholders representing a certain fraction of the capital, have some special rights. These rights include authority to provoke inspections by the auditors and by the court and to request and obtain a call of a shareholders' meeting. Each shareholder, moreover, has the right to question in court the validity of any shareholders' resolution and to obtain its voidance if it is proven to be against the law or the charter.

Shareholders normally are not allowed to give orders to the directors. Even so, the amount of power shareholders of Italian companies have, when compared with their American counterparts, can be considered very high. Shareholders have the final say on fundamental matters like dividend policy and capital structure. They decide what part of the earnings must be paid out to them and what part may be reinvested. * * *

2. The Board of Directors.

All members of the board of directors are elected by the shareholders; any contrary provision is void. A partial exception to this principle is midstream vacancies owing to resignation or other causes, which can be temporarily filled by the board itself. While a different rule is permitted, the default rule is that all the members of the board are elected by the majority. No representation on the board is thus granted to the minorities only by operation of the law, and charters rarely provide otherwise.

The corporation is governed by a one-level board. [Again, this was the state of the law as

of 1995; after the 2003 reforms, Italian joint stock companies can choose among three structures: a board/statutory auditor, a monistic board, and a dualistic board.] The board of directors has all the powers necessary to manage the company, while the supervision of the management is committed to the board of auditors that is independent from the board of directors and lacks any managerial power. The Italian system is, therefore, "monistic," as opposed to "dualistic" systems like Germany's, in which day-to-day operations, on the one hand, and major corporate policy

2 One of the most emphasized powers of shareholders is the power to approve the financial statements of the company. The shareholders’ role with respect to this matter, however, is ambiguous at best. Financial statements are obviously prepared by the board of directors (C.c. art. 2423(1) (Italy)), which has the relevant information and can make the necessary evaluations. Whether shareholders can only approve or reject financial statements or they can also modify them is a matter of debate.

130 COMPARATIVE COMPANY LAW 130 decisions and supervisory activity, on the other, are mandatorily apportioned at two different levels of the same administrative structure.

The principal duty of directors is to manage the company in the interests of the shareholders. Specific obligations to the creditors, imposed by the general civil law and by some specific provisions, do not create a general duty to act in the creditors' interest. Moreover, even if a certain amount of charitable contribution is commonly admitted, a general duty to act in the interest of constituencies other than the shareholders or of the community at large does not exist.

3. The Board of Auditors.

The board of auditors, probably the most peculiar aspect of the Italian corporate

governance system, is composed of independent professionals entrusted by the shareholders with the supervision of the directors. The manner in which auditors are elected is identical to that of directors: the shareholders elect all the members of the board, and, unless the charter so provides, no representation is granted to the minority.

The board of auditors is composed of either three or five members, plus two substitutes for possible vacancies. A recent reform enacted in compliance with the Eighth European directive on company law has tightened requirements for serving on the board, providing that all members be chosen from the roll of the "revisori contabili" [auditors]. The roll is kept under public supervision and lists persons with a significant curriculum of studies in law, business organization and/or accounting, who have proven experience in practice, and who have passed a special examination. Typically, auditors are practicing professionals who serve on the board of more than one company.

The central idea behind the legal structure of the board of auditors is independence. Relatives of the directors and persons who are employees or who are otherwise compensated on a regular basis by the company or by its subsidiaries cannot be elected as auditors. Auditors serve for a period of three years, and unlike directors, they can be removed exclusively for cause; the shareholders' removal, moreover, takes effect only if approved by the court. Auditors have fixed compensation and variable risks; their compensation is fixed for the entire period of service and does not depend on the company's performance.

The auditors' duties are basically monitoring directors and acting in the place of the latter if they refuse to follow the rules of corporate governance, or to accomplish specific and legally mandated acts. It is not the auditors' responsibility to assess the appropriateness of business decisions made by the board of directors. In other words, the auditors' task is to assure compliance with the rules set forth in the law and the charter, not to review the conduct of the board on its merits.3

3 A recent case sent shockwaves through the corporate community. Judgment of May 7, 1993, No.

5263, Cass. Civ., 1994 FORO ITALIANO I, 130, found auditors liable for lack of intervention against a series of negligent decisions causing the company to spend a substantial amount of money in partly unauthorized real estate purchases, saying explicitly that it is the auditors' duty to review managerial decisions. The case, however, concerned an easily detectable case of gross negligence, and it is arguable that the duty to review managerial decisions constitutes only dictum.


In particular, auditors must (a) meet as a board at least each quarter, and attend the meetings of the shareholders and board of directors; (b) check regularly the company's books and internal accounting system; and (c) prepare a report accompanying the annual financial statements, which goes to the shareholders and then, together with the financial statements, is made publicly available. (The auditors' report must take a position on the fairness of the financial statements with respect to the accounting system and to the financial situation of the company.) Moreover, auditors have a general power to make investigations and a duty to report to the shareholders irregularities discovered in the management of the business.4

They are not, however, mere agents for the shareholders, as they may challenge in court the validity of shareholders' resolutions.

Auditors are jointly and severally liable with the directors for the directors' acts or omissions that cause losses to the company or its creditors, if they could have avoided the losses through diligent behavior and monitoring. While the first kind of responsibility does not create any particular difficulty, the second can be problematic because it involves a judgment on when an omission has taken place. Therefore, deciding when auditors can be held responsible for directors' conduct may not be simple.

Auditors can ask the court to void the board's resolutions approved with the vote of interested directors.5

The auditors can report acts of mismanagement to the shareholders, and they can report criminal activities (embezzlement, frauds perpetrated on creditors, etc.) to criminal prosecutors, who have the means to stop directors. If the directors do not, auditors must report the company's losses to the shareholders and, in certain cases, can ask the court to appoint a liquidator. In most cases, the auditors' normal monitoring activity and the threat of their intervention will suffice to instill diligence in the directors.

In deciding on auditors' liability, the courts tend to follow a rule of reason. They normally charge collusive or simply idle auditors with responsibility for directors' egregious violations that easily could have been detected or for a delay in reporting to shareholders a financial crisis that required their prompt intervention. In other words, courts charge auditors with having ignored serious, and often multiple, "red flags." The fact that the majority of, or all of, the shareholders were aware of the "red flags" is not deemed a valid defense.

There is a risk, however, that the auditors can become scapegoats for the losses of insolvent companies. Most liability suits against directors and auditors are instituted by bankruptcy trustees who want to enrich the estate by trying to involve auditors, often professionals with deep pockets or insurance. It is up to the courts to discourage this type of action. Courts seem to strike an appropriate balance when they dismiss charges against auditors that diligently fulfilled their duties or were unable to detect skillfully concealed directors' acts of mismanagement or misappropriation.

4 Auditors have the duty to make investigations when requested by shareholders holding at least

five percent of the capital. See C.c. art. 2408(2) (Italy). 5 It is my opinion that when requested by a shareholder, a court can issue an injunction under art.

700 Code of Civil Procedure (Italy) to prevent the board from implementing a transaction approved by interested directors. (I argue this because of the criminal sanction imposed on directors acting in conflict of interest, C.c. art. 2631 (Italy)). However, such a remedy would apply only ex ante, and could do nothing once the transaction has been implemented.

132 COMPARATIVE COMPANY LAW 132 F. Summary Based on the legal system, the following conclusions concerning the respective roles of shareholders, board of directors and board of auditors can be inferred.

A. Shareholders.

A.1. Shareholders possess powerful tools of corporate governance. Essentially they possess the right to vote on capital structure, on dividend policy and on fundamental changes such as mergers. Normally, however, shareholders' powers consist of the right to veto the board's actions rather than the right to impose such actions.

A.2. Shareholders' powers are primarily in the hands of the majority. In other words,

majority rule normally governs the way in which shareholders express their voice, while single shareholders have very limited powers. The directors' liability rules, which we will examine next, confirm this conclusion.

B. Board of directors.

B.1. The board of directors has all the powers not expressly reserved to the shareholders. No formal separation between managerial and supervisory activity exists at the board level.

B.2. The board of directors, however, has a flexible structure that allows a delegation of

day-to-day operations and substantial decisional authority to a part of its members. Non-delegated members still retain authority to intervene in every decision. A separation between directors in charge of day-to-day operations and directors in charge of supervision exists in every medium-large company.

C. Board of auditors.

C.1. The board of auditors is formally charged with supervision over the administration of the company. Aside from the case of directors' conflict of interest, the board of auditors has no direct intervention or veto power over directors' decisions. However, it has an effective, even if indirect, means of preventing directors from committing unlawful acts. The board of auditors is not charged with the duty to review directors' business decisions on their merits.

C.2. The board of auditors is normally elected by the majority of shareholders, i.e., by the

same group that elects directors. Yet auditors, once elected, are relatively independent of shareholders and can challenge their resolutions, if invalid, in court. Whether the board of auditors is an effective institution is an open question.

______________________________

NOTES 1. The 2003 reform to Italian company law makes it easier for minority shareholders to

challenge actions of majority shareholders and company boards that interfere with their rights. Below are the company law provisions on payment of dividends in joint stock


companies (SpA) and shareholder challenges to actions taken at the shareholders’ meeting or by the board of directors. a. How are the current Italian company law provisions different from pre-reform

law? Are the new provisions more or less flexible in permitting the payment of dividends? More or less protective of minority shareholder interests?

b. Do you see any similarities in the new provisions to US law? For example, how do the provisions of Article 2393-bis compare to US law?

2. Under Italian company law, what is the procedure by which the board and shareholders

decide whether (or not) to declare dividends? As you will notice, the shareholders’ meeting is the locus of power in the Italian joint stock company – the shareholders approve the financial accounts as presented by the board and then declare dividends. a. What are the rights of shareholders – to profits, to voting? Consider Article

2350, 2351. b. How do shareholders act? See Articles 2364, 2365. How often are shareholders’

meetings held? What are the rights of minority shareholders in calling a shareholders’ meeting. See Article 2367.

c. How are dividends determined? What must the directors do at the end of the financial year? See Article 2423-2432. What happens at the annual shareholders’ meeting? See Article 2433.

d. What is the effect of a shareholders’ resolution? See Article 2377. Can minority shareholders challenge a shareholders’ resolution? See Articles 2378-2379.)

3. How is this process for the distribution of profits different from the approach in the

United States? a. Can shareholders declare dividends on their own, or can they only approve or

disapprove of the board’s recommendation? b. What possibilities are there for a minority shareholder unhappy with the board’s

dividend policy? Can there be a challenge for board “bad faith”? c. Assume that the facts of Sinclair Oil v. Levien arose in Italy. Could a minority

shareholder challenge the decision to declare dividends at a level that allegedly depleted the company’s growth potential? Outline an argument under the new provisions added by the Italian company law reforms.

d. Again assume the Sinclair Oil facts with respect to the self-dealing claim that the parent had preferred a wholly-owned subsidiary over partially-owned Sinven. Must the plaintiff show not only that Sinven was damages in its oil contracts with wholly-owned International, but that this damages outweighed any benefit the subsidiary enjoyed by being a member of the Sinclair group? According to Italian Civil Code Article 2497, 1° paragraph, introduced by the 2003 reforms, a parent corporation is not liable for damages to the shareholders of a partially-owned subsidiary “when the damage are lacking according to the global result of the activity of management and coordination or integrally eliminated as a result of operations directed to this purpose.” Court and lawyers have read this to mean that if the subsidiary is benefited by being a part of the group, the plaintiff must show that any self-dealing harm exceeds group benefits – a nearly impossible burden. See Jones Day, “Groups of Companies under the New Italian Law” (March 2004). A similar result is provided for director liability under Article 2634, which exonerates directors in a corporate group if harm to the subsidiary

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“is compensated by advantages achieved or reasonably expectable… from … belonging to the group.”

e. Assume now that the facts of Litle v. Waters had arisen in Italy. Could Litle challenge the actions of Waters in refusing to declare dividends? Outline an argument under the new provisions added by the Italian company law reforms.

Italian Company Law Civil Code, Book V (Arts. 2325-2548) Joint Stock Companies Section V The shares Article 2350 Right to earnings and a share on liquidation - Every share includes the right to a proportional part of the net profits and the net assets resulting from liquidation, except for special rights established for [workers’ shares]. The company may issue shares with economic rights related to the results of the activity in a specific sector. The by-laws set forth the criteria [of such shares].

Italian Company Law (pre-2003) Civil Code, Book V (Arts. 2325-2548) Joint Stock Companies Section V The shares Article 2350 Right to earnings and a share on liquidation - Every share includes the right to a proportional part of the net profits and the net assets resulting from liquidation, except for special rights established for [workers’ shares].

Article 2351 Right to vote - Every share includes the right to vote. [The] bylaws may provide for the creation of shares without the voting right, with voting right limited to specific matters, with voting right subordinated to the happening of certain conditions.... The value of such shares cannot be higher in aggregate than one half of the capital. Supervoting shares cannot be issued. [Venture capital shares] may have voting rights on specific matters and in particular they may have the right to appoint ... an independent member of the board of directors or the supervisory board or of an auditor.

Article 2351 Right to vote - Every share includes the right to vote. The articles of association can establish that privileged shares ... have rights to vote only under the conditions of Article 2365. Shares with limited voting cannot exceed half of the company’s capital. Supervoting shares cannot be issued.

Section VI - Company bodies Paragraph I - Shareholders Article 2364 Regular meetings in companies without a supervisory board - In a company without a supervisory board, the regular meeting (1) approves the financial statements, (2)

Section VI - Company bodies Paragraph I - Shareholders Article 2364 Regular shareholders’ meeting - Shareholders at a regular meeting (1) approve the financial statements, (2) nominate the managers, the auditors and

135 COMPARATIVE COMPANY LAW 135 appoints and revokes the directors, appoints the auditors and the chair of the board of auditors .... (3) determine the compensation of the managers and the auditors, unless set out in the by-laws (4) resolves on the liability of directors and auditors .... The regular shareholders’ meeting shall be convened at least once every year, within the date fixed in the by-laws or in any case not later than 120 days from the closing of the fiscal year.

chair of the auditor board, (3) determine the compensation of the managers and the auditors, if not established in the articles of association (4) resolve on the liability of directors and auditors ... The regular shareholder’s meeting shall be convened at least once every year, within four month after the closing of the fiscal year.

Article 2367 Request by members for calling of meeting - The directors or the management board shall call a shareholders’ meeting without delay, when a demand is made by shareholders representing at least one-tenth of the company’s capital or the lower percentage provided in the by-laws and the demand indicates the matters for the meeting. ...

Article 2367 Request by minority for calling of meeting - The managers shall call a shareholders’ meeting without delay, when a demand is made by shareholders representing at least one-fifth of the company’s capital and the demand indicates the matters for the meeting. ...

Article 2373 Conflict of interest - The resolution approved with the determining vote of members having a direct conflict of interest or on behalf of third persons with that of the company may be challenged in accordance with Article 2377 if the company may be prejudiced.

Article 2373 Conflict of interest - The right to vote shall not be exercised by a shareholder in any matter in which he has, himself or on account of a third party, an interest conflicting with that of the company. ... The managers shall not vote in matters relating to their liability. ...

Article 2377 Nullity of resolutions - The resolutions of the shareholders' meeting passed in compliance with the law and by-laws are binding for all the members, even if not in attendance or in disagreement. The resolutions which are not passed in compliance with the law or the by-laws may be challenged by the members not present, by the dissenting ones or those who did not express a vote, by the directors, by the supervisory board, or the board of statutory auditors. The challenge may be filed by the members [when they own voting shares at least 0.1% of listed company and 5% of the others]; the by-laws may exclude such a requirement.

Article 2377 Nullity of resolutions - The resolutions of the shareholders' meeting passed in compliance with the law and the deed of incorporation are binding for all the members even if not in attendance or in disagreement. The resolutions which are not passed in compliance with the law and the deed of incorporation may be challenged by the directors, by the statutory auditors and by the absent or dissenting members, and those of the ordinary shareholders' meeting also by the members with limited voting right, within three months from the date of the resolution or, if this is subject to registration in the register of enterprises, within three months from the registration. ...

136 COMPARATIVE COMPANY LAW 136 The challenge ... must be filed within 90 das from the date of resolution or, if registered in the registry of enterprises, within 3 months from the date of registration .... Article 2378. Procedure for the challenge - The challenge is submitted to the tribunal where the company has its registered office. The challenging member must show to be the owner at the time of challenge [or the shares provided in Article 2377]. [The challenging party] may request suspension of the execution of the resolution. ... [The] judge may also rule at any time that the members acting as plaintiffs offer adequate guarantee for the restoration of damages, if any. All the challenges related to the same resolution must be dealt with at the same time, and they are decided in only one judgement. ....

Article 2378. Procedure for the challenge - The challenge is submitted to the tribunal where the company has its registered office. The challenging member must deposit at least one share with the chancery. The president of the tribunal may order that the challenging member deposit a proper guarantee for the possible compensation of expenses. All the challenges related to the same resolution must be dealt with at the same time, and they are decided in only one judgement. ....

Section VI-bis Management and Control Paragraph I. General Provisions Article 2380 Systems of management and control. If the by-laws do not provide differently, the management and the control of the company are regulated by the following paragraphs 2, 3 4. ..... Paragraph II. The directors Article 2380-bis Management of the Company -The management of the company exclusively belongs to the directors, who act as necessary for the reaching of the corporate object. The management may also be entrusted also to non members. When the management is entrusted to several persons, they constitute the board of directors. If the by-laws do not establish the number of the directors, but indicates only the maximum and minimum number, the determination belongs to the shareholders. The board of directors elects among its

Section VI-bis Management and Control Paragraph II. The directors Article 2380 Management of the Company -The management of the company exclusively belongs to the directors, who act as necessary for the reaching of the corporate object. The management of the company may be entrusted also to non members. When the management is entrusted to several persons, they constitute the board of directors. If the articles of association do not establish the number of the directors, but indicates only the maximum and minimum number, the determination belongs to the shareholders. The board of directors elects among its members' the chair, if not appointed by the shareholders.

137 COMPARATIVE COMPANY LAW 137 members' the chair, if not appointed by the shareholders. Article 2392 Liability towards the company -The directors must fulfil the duties imposed on them by the law and by the by-laws with the diligence required by the nature of their appointment and by their specific competences. They are liable jointly towards the company for the damages arising from the non-compliance with such duties, unless it involves a matter delegated solely to the executive committee or one or more directors. In any event the directors are jointly liable ... if, being aware of prejudicial acts, they do not do what they could to stop the performance or to eliminate or diminish the damaging consequences of such acts. The liability for acts and omissions of the directors does not extend to the one among them who, being without fault, had his disagreement noted without delay in the minutes and the resolutions of the board, by giving immediate notice in writing to the chair of statutory auditors.

Article 2392 Liability towards the company -The directors must fulfil the duties imposed on them by the law and by the articles of association with the diligence of a trustee, and they are jointly liable towards the company for the damages arising from the non-compliance with such duties, unless it involves a matter delegated solely to the executive committee or one or more directors. In any event the directors are jointly liable if they have not supervised the general workings of management or if, being aware of prejudicial acts, they do not do what they could to stop the performance or to eliminate or diminish the damaging consequences of such acts. The liability for acts and omissions of the directors does not extend to the one among them who, being without fault, had his disagreement noted without delay in the minutes and the resolutions of the board, by giving immediate notice in writing to the chair of statutory auditors.

Article 2393 Company’s action for liability - The company’s action against the directors is instituted following a resolution of the shareholders’ meeting, even if the company is in liquidation. The resolution regarding the ability of the directors can be passed on occasion of the discussion on the balance sheet, even if it is not indicated in the meeting agenda. The action may be started with 5 years from the termination of the director from his appointment. The resolution on the liability action entails the revocation from office of the directors against whom it is proposed, provided it is passed with a favorable vote of at least one fifth of the company's capital. ...

[same]

Article 2393-bis Company action for liability by members.

138 COMPARATIVE COMPANY LAW 138 The company action for liability may be exercised by members representing at least one fifth of the capital or such different percentage indicated in the by-laws which in any case cannot be greater than one third. For [listed] companies the action may be exercised by the members representing 1/20 of the company’s capital or such lower amount contemplated in the by-laws. The company must be convened in court and the deed of summons may be served on it also in the person of the chair of the board of auditors. The members who intend to promote the action appoint, by majority of the capital owned, one or more representatives for the exercise of the action and for the fulfillment of the related acts. If the request is accepted, the company pays the plaintiffs the judicial expenditures and those incurred for the ascertainment of the facts .... The members who have initiated the action may abandon it or settle; any compensation for the waiver or settlement must be for the benefit of the company. [Any settlement must be approved at a shareholders’ meeting, subject to a veto by 20% of shares, or 5% if a listed company.]

[not in pre-reform law]

Article 2394 Liability to the company's creditors - The directors are answerable to the company's creditors for non-observance of their duties regarding the preservation of the company's assets. The action can be brought by the creditors when the company's assets are insufficient for the satisfaction of their credits. The waiver of the action by the company does not stop the exercise of the action by the company's creditors. The settlement can be challenged by the company's creditors only through the action for revocation when there are the causes of action.

Article 2394 Liability to the company's creditors - The directors are answerable to the company's creditors for non-observance of their duties regarding the preservation of the company's assets. The action can be brought by the creditors when the company's assets are insufficient for the satisfaction of their credits. In the event of bankruptcy or of administrative compulsory liquidation of the company, the action may be brought by the bankruptcy receiver or the commissionaire liquidator. The waiver of the action by the company does not stop the exercise of the action by the company's creditors. The settlement can be challenged by the company's creditors only through the action for revocation when


there are the causes of action. Article 2395 Individual action of the member and of the third party - The provisions of the preceding articles does not affect the right to the compensation of damages pertaining to the individual member or to third parties who have been directly damaged by negligent or fraudulent actions of the directors.

[same]

Section IX. The financial statements Article 2423 Drafting preparation of the balance sheet - The directors must prepare the financial statements for the fiscal year, comprising the balance sheet, a profit and loss statement and explanatory notes. The financial statements must be clearly presented and they must represent truthfully and correctly the assets and financial situation of the company and the economic results of the fiscal year. ....

[same]

Article 2430 Legal reserve - A sum corresponding to at least one twentieth of the net annual profits must be deducted from such profits to establish a reserve, until this reaches one-fifth of the company's capital. ....

[same]

Article 2431 Share premium - The sums received by the company for the issue of shares at a price higher than their nominal value cannot be distributed until the legal reserve has reached the limit established by article 2430.

[same]

Article 2432 Profit sharing - The sharing in profits by promoters, founding members and directors is computed on the basis of the net profits resulting from the financial statements, after the deduction for the legal reserve.

[same]

Article 2433 Distribution of profits to the members - The decision on the distribution of profits is approved by the members’ meeting which approves the financial accounts ... Dividends on the shares cannot be paid,

Article 2433 Distribution of profits to the members - The shareholders meeting that approves the financial statements shall resolve the distribution of the profits to the shareholders.

140 COMPARATIVE COMPANY LAW 140 except out of profits actually obtained and resulting from the regularly approved financial statements. If a loss of the company’s capital occurs, the distribution of profits cannot be made until the capital is replenished or reduced in a corresponding amount. The dividends paid in violation of the provisions of this article cannot be claimed back, if the members collected them in good faith on the basis of a regularly approved financial statements, from which corresponding net profits result.

Dividends on the shares cannot be paid, except out of profits actually obtained and resulting from the regularly approved financial statements. If a loss of the company’s capital occurs, the distribution of profits cannot be made until the capital is replenished or reduced in a corresponding amount. The dividends paid in violation of the provisions of this article cannot be claimed back, if the members collected them in good faith on the basis of a regularly approved financial statements, from which corresponding net profits result.

2433-bis Accounts on dividends. Payments on account of dividends are permissible in companies whose balance sheet is subject by law to the certification by a [listed accounting firm]. .... The amount of payment on account of dividends cannot exceed the amount of the profits accrued since the close of the previous fiscal year, reduced by the proportions which shall be set aside as a reserve pursuant to the law or the by-laws and that of the available reserves, which is lower.

[not in pre-reform law]

Italian Parliament __________________


NOTES 1. Notice that when we studied US corporate law on power within the corporation, we

looked at two court decisions. Now, when we study Italian company law on the same question, we look at a scholarly article and legislation (along with recent reforms). Do you like finding law in cases or in legislation? Or does it depend on what you’ve become used to?

2. Looking at Italian law before the 2003 reforms, Professor Enriques described the protections of minority shareholders as follows:

Although generally speaking there are few statutory rules protecting

minority shareholders, the holders of 10% of the capital can petition the local court to get it to investigate the affairs of the company where irregularities are suspected. A group of 20% of shareholders can call an emergency general meeting. Until recently, no formal rules existed to provide for derivative actions. The courts are, however, protective of minorities by using general concepts such as good faith and fairness. Thus, the Court of Cassation has allowed shareholders to bring actions to annul resolutions that violate their rights where principles of good faith and fair play have not been observed.

Centre for Law & Business, Faculty of Law, University of Manchester, Company Law in

Europe: Recent Developments - Italy at 40-41 (Feb. 1999). 3. How well does shareholder protection work in Italian courts? Looking at all of the

company law decisions by the Milan Tribunal during a recent 10-year period, Professor Enriques analyzed those decisions dealing with questions of majority oppression, self-dealing transactions and non-payment of dividends. His findings were discouraging:

If corporate law matters to corporate governance and finance, then in

order to assess its quality in any given country, one must look at corporate law "off the books," i.e., corporate law as applied by judges and other relevant public officials. This paper provides an assessment of Italian corporate law off the books based on analysis of a sample of 106 decisions by the Milan Tribunal, Italy's most specialized court in corporate law. The judges' quality is evaluated by looking at: (1) how deferential they are to corporate insiders; (2) how keen they are to understand, and possibly take into account, the real rights and wrongs underlying the case before them; (3) how antiformalistic their legal reasoning is; (4) how concerned they are about the effects their decisions may have on the generality of corporate actors.

The analysis casts a negative light on Milanese (and by extension,

Italian) corporate law judges. It highlights egregious cases of deference to corporate insiders, especially with regard to parent-subsidiary relationships. Furthermore, only recently, and in any case still sporadically, have at least a few court's opinions been so drafted as to let the reader understand what the real dispute was and which party had really acted opportunistically. In any case, it appears to be rare for the court to take the substantive reasons for the dispute into any account. Cases are described, in which the court has adduced very casuistic


arguments. And finally, there is no sign that the judges care what signals they send to corporate actors. Apparently, they are quite unconcerned about whether their decisions provide the right incentives for directors and shareholders.

Luca Enriques (Universita' di Bologna; European Corporate Governance Institute), Off the Books, but on the Record: Evidence from Italy on the Relevance of Judges to the Quality of Corporate Law, Forthcoming in GLOBAL MARKETS, DOMESTIC INSTITUTIONS: CORPORATE LAW AND GOVERNANCE IN A NEW ERA OF CROSS-BORDER DEALS (Curtis J. Milhaupt ed., New York: Columbia University Press) SSRN Paper 300573 (October 2002).

4. But these assessments of Italian company law came before the reforms of 2003 and 2005,

reflected in the legislative texts above. The Italian reforms are consistent with the winds of change blowing across corporate Europe over the past decade. In 2002, the EU Commission, foreseeing these changes, charged a group of so-called “wise men” to recommend company law reforms. Their report represents a fundamental rethinking of European company law. Here’s what they said on corporate governance:

_____________________________

Report of the High Level Group of Company Law Experts on a Modern Regulatory Framework for Company Law in Europe

Brussels, 4 November 2002 CHAPTER III – “Corporate Governance”

The original mandate of the Group included a review of whether and, if so, how the EU should actively co-ordinate and strengthen the efforts undertaken by and within Member States to improve corporate governance in Europe. We stress that corporate governance is a system, having its foundations partly in company law and partly in wider laws and practices and market structures.

Being the residual claimholders, shareholders are ideally placed to act as a watchdog. This is particularly important in listed companies, where minority’s apathy may have harmful effects. Shareholders’ influence will highly depend on the costs and difficulties faced. Shareholders’ influence was traditionally exercised through the general meeting, which is no longer physically attended by many. Modern technology can be very helpful here, if it is introduced in a balanced way.

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Pre-meeting communication is frequently a one-way process. The biggest difficulties and costs arise with bearer shares, but registered shares also present some problems. Modern technology may offer a solution to many problems. Putting meeting materials and proxy forms on the company’s website is efficient for both the company and its shareholders. Many responses to the consultation supported the enabling approach, but the Group believes that we should anticipate future normal practice.

The rights to ask questions and table resolutions are often difficult to exercise, but responses to the consultation did not call for mandatory provisions at EU level in this area. In practice, the exercise of these important rights may be facilitated by modern technology, but companies should be able to take measures to keep the whole process manageable. The necessary flexibility for companies should be provided for at national level, but annual disclosure of how these rights can be exercised should be required at EU level.

In view of the difficulties to attend meetings, shareholders should be able to vote in absentia. The necessary facilities should be offered, but not imposed, to shareholders. Some companies offer participation to general meeting via electronic means, which increase shareholders’ influence in an efficient way. Use of electronic means in meetings should be possible for companies, but not yet mandatory.

Institutional shareholders have large shareholdings with voting rights, and tend to use them more frequently than before. Responses to the consultation were mixed about a possible formalisation of the institutional investors’ role. The Group believes that good governance of institutional investors requires disclosure to their beneficiaries of their investment and voting policies, and a right of their beneficiaries to the voting records showing how voting rights have been exercised in a particular case. Responses to the consultation did not support an obligation to vote, and the Group agrees that there are no convincing reasons for imposing such an obligation.

In many cases, shareholders are inclined not to vote, due to a lack of influence and/or a lack of information. The special investigation procedure offered in several Member States is an important deterrent. A EU rule on special investigation right was supported by responses to the consultation. It should be open to the general meeting or a significant minority, and any authorisation by the court or administrative body should be based on serious suspicion of improper behaviour.

Many difficulties prevent dispersed shareholders from directly monitoring management, which calls for an active role of non-executive or supervisory directors. No particular form of board structure (one-tier/two-tier) is intrinsically superior : each may be the most efficient in particular circumstances.

The presence of (a group of) controlling shareholder(s) is likely to result in closer monitoring of management, but non-executive or supervisory directors then have an important role on behalf of the minority. Their general oversight role is of particular significance in three areas, where conflicts of interests may arise: nomination of directors, remuneration of directors, and audit of the accounting for the company’s performance. The need for more independent monitoring is highlighted by the US regulatory response to recent scandals. The Group does not express views on the composition of the full (supervisory) board, but intends to promote the role of non-executive / supervisory directors. Nomination, remuneration and audit committees could be set up, and composed of a majority of independent directors. To qualify as independent, a

144 COMPARATIVE COMPANY LAW 144 non-executive or supervisory director, apart from his directorship, must have no further relationship, with the company, from which he derives material value. Certain other relationships with the company, its executive directors or controlling shareholders may also impair independence. Related parties and family relationships should also been taken into account. With respect to the competence expected from non-executive or supervisory directors, existing rules are generally abstract. Competence must be assessed together with the role a director has on the board. Basic financial understanding is always required, but other skills may be of relevance.

Remuneration of directors is one of key area of conflict of interests. In order to align the interests of executive directors with the interests of the shareholders, remuneration is often linked to the share price, but this potentially has a series of negative effects. The Group considers that there is no need for a prohibition of remuneration in shares and share options, but that appropriate rules should be in place.

Recent corporate scandals and responses highlight the key importance of trust in financial statements. At national level, the board traditionally has a collective responsibility for the probity of financial statements, which avoids undue excessive individual influence. Collective responsibility must cover all statements on the company’s financial position, except for ad hoc disclosure (where proper delegation must be organised), and also all statements on key non-financial data.

The introduction of a framework rule on wrongful trading was opposed by some respondents who argued that this is a matter of insolvency law. The Group rejects this view: the responsibility of directors when the company becomes insolvent has its most important effect prior to insolvency and is a key element of an appropriate corporate governance system. Various existing national rules make directors liable for not reacting when they ought to foresee the company’s insolvency. The details of these national rules vary considerably, but they generally apply to group companies and do not interfere with on-going business decisions. The majority of responses to the consultation supported the introduction of a EU rule on wrongful trading. Without overly restricting management’s decisions, such a rule would enhance creditors’ confidence and introduce an equivalent level of protection across the EU.

Misleading disclosure by directors should be properly sanctioned, and applicable sanctions should be defined by Member States. Criminal and civil sanctions present some weaknesses, and the disqualification of a person from serving as a director of companies across the EU is an alternative sanction which may be easier to effectuate and has a powerful deterrent and longer disabling effect.

A proper audit is fundamental to good corporate governance. Some initiatives have already been taken by the Commission, among which the Recommendation on Auditor Independence. A new Communication on Audit is expected soon. In the present Report, the Group has focused on the internal aspects of auditing practices. As explained above, the Group believes that there is a key role to play for non-executive or supervisory directors who are in the majority independent. The main missions of the audit committee, which in practice is often set up for these purposes, are summarised in the present Report with respect to both the relationship between the executive managers and the external auditor, and the internal aspects of the audit function.


In the Consultative Document, the Group expressed reservations about the establishment of a EU corporate governance code: the adoption of such a code would not achieve full information for investors, and it would not contribute significantly to the improvement of corporate governance in Europe. A clear majority of responses to the Consultative Document rejected the creation of a European corporate governance code. _________________________________

NOTES 1. One of the members of the High Level Group commented:

Enron is not just an American balance sheet scandal, but should teach Europe a lesson on how to act in a timely manner. One of the key concerns of European company and capital market law reform should be improving European corporate governance. For company law, the focus is clearly on the board. Shareholder decision-making on the principles and limits of board, full disclosure (also of the individual remuneration), and mandatory accounting of stock options under revised international accounting standards might be useful European rules. Disclosure is a powerful tool for improving corporate governance in Europe. It interferes least with freedom and competition of enterprises in the market and also avoids the well-known petrifying effect of European substantive law. Non-disclosure and, even more, false disclosure must have consequences for the directors that are felt.

Klaus J. Hopt (Professor, Max Planck Institute for Private Law), Abstract: Modern Company and Capital Market Problems: Improving European Corporate Governance after Enron, SSRN Paper 356102 (November 2002, revised December 2009).

2. In response to the High Level Group Report the EU Commission urged reliance on

voluntary codes of corporate governance that companies must adopt (and comply with) or explain their reasons for non-adoption.

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