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Corporate governance in publicly-held companies: lessons for China’s companies limited by shares Liu, Jingrong 1997

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CORPORATE GOVERNANCE IN PUBLICLY-HELD COMPANIES LESSONS FOR CHINA'S COMPANIES LIMITED BY SHARES by JINRONGLIU L L . B , Jilin University, 1992 LL.M., Jilin University, 1995 A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF LAWS in THE FACULTY OF GRADUATE STUDIES (Faculty of Law) We accept this thesis as conforming to^hejrequired standard^  THE UNIVERSITY OF BRITISH COLUMBIA August 1997 ©JINRONGLIU, 1997 In. presenting this thesis in partial fulfilment of the requirements for an advanced degree at'-the University of British Columbia, I agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive., copying of this thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department of LAIA/ The University of British Columbia Vancouver, Canada Date >6\ / 9 f ' DE-6 (2788) 11 ABSTRACT The thesis purports to address the current corporate governance in companies limited by shares in China, starting from a review of the theoretical debate between the contractual and legal regulatory theories in American corporate law scholarship. An optimal corporate governance should consists of a mix of mandatory corporate rules, markets and morality. The author argues that central to the debate is the balance between efficiency and fairness in reducing agency costs, which is contingent upon actual social circumstances. A review of Canadian corporate law and its literature is conducted from the perspective of corporate governance. Corporate statutes, securities acts and stock exchange polices are the foci in this study. The article concludes that the balance between directors' discretion in managing the company and accountability to shareholders should be presented in an optimal corporate governance. China's corporate laws and securities regulations have provided a governance frame, but left some looseends to be refined. The author argues that China is following the North American experience which relies on the stock market and institutional investors in designing corporate governance, but suggests that cautions should be taken while addressing corporate governance in China with such a perspective. The state of stock markets and institutional investors in China does not justify too much optimism as to their significance in corporate governance. The intervention of the administrative organ authorised to oversee the stock market into corporate governance is necessary in light that laws and markets can not provide sufficient protection to shareholders. i i i IV TABLE OF CONTENTS Abstract ; Table of Contents iv Acknowledgement vi Dedication vii INTRODUCTION 1 Chapter I Theoretical Review of Corporate Governance 5 Background 5 Contractual Theory 7 Legal Regulatory Theory 14 Enabling V. Mandatory: Efficiency V. Fairness 22 Compelling but Incomplete 26 Opposite but overlapping 29 Chapter II Review of the Legal Aspects of Corporate Governance in Canada.... 33 Division of Power between the Board of Directors and Shareholders 33 Shareholders' Voting Rights 38 Proxy System 43 Problems with Voting System 50 Directors' Duties 51 Duty of Care, Diligence and Skill 54 Duty to Act Honestly and in Good Faith and in the Best Interests of the Company 58 Disclosure of Interests in Transactions and Offices 60 Proper Purpose Rule? 63 Accountability to Corporation for Profits Made from Corporate Opportunities ...64 Shareholder Access to Corporate Information 67 Disclosure of Corporate Information and. Corporate governance 67 Access to Corporate Records and Shareholder List 70 Continuous Disclosure of Financial and Material Information 71 Disclosure of Corporate Governance 75 Investigation of Company by Inspector 77 V Liability Strategy in Corporate Governance 77 Liability Rules Necessary in Corporate governance 77 Derivative Suit .80 Personal Suit 84 Application for Compliance, Restraining and Corrective Orders 88 Shiftable Liability: Indemnity and Insurance 89 Summary 93 Chapter III Review of Legal Aspects of Corporate Governance of Companies Limited by Shares in China. 95 Introduction of the Stockholding System in China 95 Power-Sharing Governance Structure 100 Shareholders' General Meeting 101 Shareholders' Voting Rights 106 The Board of Directors 109 The Supervisory Board 109 Directors'Duties 114 Relationship between Directors and Company 114 Directors'Duties 116 Shareholders' Access to Corporate Information 124 Shareholders' Access to Corporate Records 124 Company's Duty to Disclose Information 125 Liability Strategy in Corporate Governance 129 Critique of the Enforcement of Company Law 132 Summary 133 Chapter IV Reflections on Non-Legal Aspects of Corporate Governance in China 135 German and Japanese Model? 135 German and Japanese Model 136 China's Choice 138 Stock Markets and Corporate Governance 141 Institutional Shareholders and Corporate Governance .145 The State as the Shareholder 145 Investment Funds and Corporate Governance 146 Administrative Regulation and Corporate Governance 148 Chapter V Conclusions 150 Bibliography.: 153 ACKNOWLEDGEMENT My greatest source of inspiration has been my primary supervisor, Dr. Pitman Potter, who has helped me broaden my academic vision, and provided comments and advice which are always insightful and thought provoking, and have generated many ideas for future research. My special thanks should go to my second reader, Professor Brian ChefFins, for faithfully checking the earlier drafts of this thesis, and bringing a fresh and revealing perspective and brilliant critical appraisal to my work as it approached completion. People at the Law Faculty at UBC have been more than helpful. Dr. W.Wesley Pue has shown great dedication and boundless patience to the graduate program. I also want to express my appreciation to Lillian Ong and Deanna Clark for their help throughout the study. The transit to Vancouver and embarking on graduate studies would not have been possible without the support of many people on the other side of the Pacific Ocean. First and foremost are my parents, my lifetime teachers, on whose love and support I always depend. The fact that they have an ungrateful son should not deprive them all the recognition they deserve for their so many years financial support of my education. Words can not express my gratitude to my wife and best friend, Kunchi Wang, for her love, encouragement and patience towards my long-time absence. Her. letters and phone calls have been of priceless value to me. The graduate study at UBC, which has been enjoyable and also challenging, is going to its end, but my debt of gratitude to anyone who has contributed to its completion in his/her own way will carry over with me into future life. Vll DEDICATION TO MY PARENTS, MY WIFE and MY BROTHERS 1 1 INTRODUCTION Corporate law scholarship holds that company law is primarily concerned with structuring of economic power relative to its institutions and processes, with a particular focus on the structure and governance of business that has been incorporated.1 In the traditional model of corporations, shareholders are owners of the corporation and entitled to control it, determine its fundamental policies, and decide whether to make fundamental shifts in corporate policy and practice; put it short, owners manage the corporation and managers own it.2 This is the so-called traditional shareholders primacy model.3 As the corporation grows and the capital market expands, the ownership and control in a corporation are separated, and shareholders have to rely on management to operate the business in their best interests.4 With such a separation comes the likelihood that management would diverge from the interest of shareholders in exercising the power to operate the company, either lacking incentives to maximising shareholder profitability, or pursuing their own self-interests. Therefore, the traditional shareholder primacy model is modified to such a form as that managing powers are rested with management, and 1 See E.W. Orts, "The Complexity and Legitimacy of Corporate Law" (1993) 50 Wash. & Lee L. Rev. 1565 at 1577. 2 J.H. Matheson & B.A. Olson, " Corporate Law and the Longterm Shareholder Model of Corporate Governance" (1992) 76 Minn. L. Rev. 1313 at 1327 [hereinafter "Longterm Model"]. 3 Ibid. 4 In this article, the management is used in its broad meaning, referring to both directors and managers, unless indicated otherwise. 2 shareholders rely on monitoring mechanism to restrain its discretion, in a hope to conform its actions to the interest of shareholders. Corporate law starts with the notion that a business corporation is primarily for the best interest of shareholders. Although corporate law acknowledges the powers of directors to manage the corporation, "[t]he discretion of directors is to be exercised in the choice of means to attain that end [the best interest of shareholders], and does not extend to a change in the end itself...[I]t is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others..."5 Nowadays how to prevent directors from abusing their powers has become a challenge to both corporate law and its scholarship. China's shareholding system (gufenzhi) has undergone a rapid development, and companies limited by shares have mushroomed nationally. The purpose of this thesis is to examine the corporate governance China has so far established, and by which shareholders' interests are safeguarded and directors are committed to the best interests of shareholders. Through such examination, this thesis is purported to address problems China is confronting in dealing with the challenge arising from the separation of ownership from control in companies limited by shares. 5 Dodge V. Ford Motor Co. 170 N. W. 668 at 684 (Mich. S.C. 1919) 3 It is the assumption of this thesis that a review of general theories of corporate governance and related laws in common law jurisdictions will offer some insights into addressing China's counterparts. Therefore, Chapter I reviews the debate between the contractual and legal regulatory theories, the heart of which is measures to minimise agency costs. In the US, there has been vigorous debate on this issue. This chapter argues that the balance between the efficiency in resources allocation and the protection of shareholders as thorough as possible (fairness) is a major consideration in designing corporate governance. In this chapter, the approach of economic analysis is heavily relied upon. The contribution of economics to corporate law scholarship has become profound in the US. Therefore, this chapter focuses on American corporate law literature. In Chapter II, Canadian legal framework concerning corporate governance is examined, and it is revealed that the balance between directories' accountability and flexibility in managing the corporation is another factor to be taken into account in designing corporate governance.6 Chapter III, based on the insights gained in the preceding parts, reviews the legal aspects of corporate governance in China through examining China's company and securities laws and regulations, and Chapter IV is to review the performance of the non-legal aspects, such as stock markets, institutional investors, and their bearing upon corporate governance. This thesis ventures to argue that China has established some key 6 This chapter will focus on the Canada Business Corporations Act R.S.C. 1985, c.44 [hereinafter CBCA], and British Columbia Company Act R.S.B.C. 1979, c. 59 [hereinafter BCCA]. 4 institutions that have proved to be playing a significant role with respect to corporate governance in the North-America, nonetheless China's short history and lack of experience in these developments, suggests that cautions should be taken where reliance on these institutions are made in addressing corporate governance. Despite that the effectiveness of these institutions relating corporate governance isn't comparable with that of the North-America, China seems to be committed to following its model, rather than the German and Japanese model which heavily relies on banks and their interaction with corporations. The administrative monitoring over listed companies carried out by the administrative agency authorised to oversee stock markets, which is a measure China has already taken, although may not be efficient, has to be accepted in the short run. 5 CHAPTER I: THEORETICAL REVIEW OF CORPORATE GOVERNANCE 1.10 Background Corporate law has gone a long way to provide an effective and coherent set of rules to regulate the relationship between management and shareholders, which became complex since the appearance of separation of ownership and control of corporate property in publicly-held corporations, and is characterised as one of power and dependence.7 In such a connection, shareholders rely on management who voluntarily undertake the responsibility to take care of dependants' (shareholders') investment, with powers granted • • • 8 by dependants and exercised in the way that grantors deem to be in their best' interests. Corporate governance is a widely used term to denominate the legal and non-legal systems regulating the said power-and-dependence relationship. It means the system for decision-making, including process and structure, used to direct and manage the business and affairs of the corporation with an objective of enhancing the long-term interests of shareholders; a good corporate governance consists of such processes and structure as that on one hand, allocate decision-making powers between shareholders and management whose discretion is proportionate to their responsibility to manage corporate affairs and 7 L.E. Mitchell, "The Death of Fiduciary Duty in Close Corporations" (1990) 138 U. Pen. L. Rev. 1675 at 1675. 8 Ibid at 1676. 6 business; on the other hand, ensure that persons in charge are accountable to shareholders.9 The study of corporate governance is necessitated by the likelihood of conflicts of interest between shareholders and management.10 Such conflicts of interest have long been the central problem that corporate law has been coping with. As Dean Clark stresses: "the overwhelming majority of particular rules, doctrines and cases in corporate law are simply an explication of the duty of loyalty or of the procedural rules and institutional arrangements involved in implementing it."11 There are two schools of prominent theories of corporate governance dealing with how to control the divergence of interests between shareholders and management. One is the legal regulatory theory which proposes to use legal rules, some of which must be mandatory, to direct and govern the way in which directors use their discretion. The other one is the contractual theory which challenges the necessity of legal rules, especially mandatory rules, for their inefficiency, and advocates that markets together with non-9 Toronto Stock Exchange Committee on Corporate Governance in Canada, Where Were the Directors: Guidelines for Improved Corporate Governance in Canada (Toronto: Toronto Stock Exchange Committee on Corporate Governance, 1994) at 7. 1 0 Corporate law and corporations are characterised as dialectical in nature, which requires to give management the discretion to utilise their expertise responding to changing circumstances, but at the same time ensure management's accountability. Corporate governance is designed, among other things, with a purpose to transcend such dialectical nature. See J.H. Matheson & B.A. Olson, "Corporate Co-operation Relationship Management, and the Trialogical Imperative for Corporate Law" (1994) 78 Minn. L. Rev. 1441 at 1449-52. 1 1 R.C. Clark, Corporate law (Boston: Little Brown, 1986) at 34 [hereinafter Corporate Law]. 7 market mechanisms should be eligible to displace mandatory rules in corporate governance. Studies conducted on both sides require an interdisciplinary exploring in organisation theory, psychology and economics.12 A review of these scholarship, not only offers two theoretical perspectives to the study of corporate governance, but also gives some enlightenment to the basic theory of corporate law. 1.20 Contractual Theory The separation of ownership and control brings together in one corporation investors who possess capital but may need investment and managerial skills and directors who lack capital but have the comparative advantage in managerial expertise desirable to investors. "[I]n order to be efficient, our society must rely on the specialised production of goods and services and on an extensive system of exchange to make such goods and services available to those who need them".13 This general principle of production also applies to the internal organisation of corporations. However, in the case of a publicly-held company, such separation renders shareholders vulnerable to the possibility of abuse of powers by directors due to conflicts of interest.14 1 2 V. Brudney, "Corporate Governance, Agency Costs and the Rhetoric of Contract" (1985) 85 Colum. L. Rev. 1403 at 1444. 1 3 A.G. Anderson, "Conflicts of Interest: Efficiency, Fairness and Corporate Structure" (1978) 25 UCLA. L. Rev. 738 at 739. 1 4 The interests of shareholders and directors may diverge. Professor Eisenberg characterises the divergence into three categories. Directors have a potential interests in working at a slack pace and investing less efforts than they are expected of. This is the problem of shirking. Directors are inclined to divert the shareholders' assets to their own advantage through self-dealing. This is the problem of traditional conflicts of interest. Directors also tend to maintain and enhance their positions even at the shareholders' expense. This type of divergence of interest is referred to as positional conflicts of interest. See M.A. Eisenberg, "The Structure of Corporate Law" (1989) 89 Colum. L. Rev. 1461 at 1471-72. 8 The contractual theory15 argues that a corporation is a "nexus of contracts"16 and it is the centre around which there are a series of contracts, both express and implied, entered into by directors, shareholders, creditors, employees and customers, etc.. Shareholders and directors should be free in drafting the corporate contract (articles of incorporation and. by-laws, which define the structure and process in corporate governance), because agency costs can be reduced by the external market and non-market mechanisms.17 Since the optimal contract for a specific corporation in designing structure and procedure of [hereinafter "Structure of Corporate Law"] In another article, Professor Eisenberg concludes that divergence is more likely to arise from structural decisions than business ones, where self-interest is more discernible. In structural decisions, self-interests are motivated by both financial and non-financial considerations. Financial motives include appropriating corporate property, looting corporate opportunities, while non-financial motives include the desire for personal power and the desire for prestige when expansion is proposed even if shareholders' interests will not be served by such changes. See also M.A. Eisenberg, "The Legal Roles of Shareholders and Management in Modern Corporate Decisionmaking" (1969) 57 Cal. L. Rev. 1 at 27-33. 1 5 This school of scholarship includes too extensive literature to list, but the following literature are several major contributions, including: R.A. Posner, Economic Analysis of Law, 3d ed. (Boston, Little Brown, 1986); H.N. Butler, "The Contractual Theory of the Corporation" (1989) 11 Geo. Mason L. Rev. 99; D.R. Fischel, "The Corporate Governance Movement" (1982) 35 Vand. L. Rev. 1259; F.H. Easterbrook & D.R. Fischel, "The Corporate Contract" (1989) 89 Colum. L. Rev. 1416 [hereinafter "Corporate Contract"]; R.K. Winter, "The "Race for the Top" Revisited: A Comment of Eisenberg" (1989) 89 Colum. L. Rev. 1530; R. Romano, "Answering the Wrong Question: The Tenuous Case for Mandatory Corporate Laws" (1989) 89 Colum. L. Rev. 1599; E.F. Fama & M.C. Jensen, "Separation of Ownership and Control" (1983) 26 J.L. & Eco. 301; K.E. Scott, "Corporation Law and the American Law Institute Corporate Law Governance Project" (1983) 35 Stan. L. Rev. 927; N. Wolfson, "A Critique of Corporate Law" (1980) 34 U. Miami L. Rev. 959; H.N. Butler & L.E. Ribstein, "Opting out of Fiduciary Duties: A Response to the Anti-Contractarians" (1990) 65 Wash. L. Rev. 1; D.R. Fischel & M. Bradley. "The Role of Liability Rules and the Derivative Suit in Corporate Law: A Theoretical and Empirical Analysis" (1986) 71 Cornell L. Rev. 261; F.H. Easterbrook & D.R. Fischel, " Corporate Control Transactions" (1982) 91 Yale L. J. 698; F.H. Easterbrook, "Managers' Discretion and Investors' Welfare: Theory and Evidence" (1984) 9 Del. J. Corp. L. 540. 1 6 M.C. Jensen & W.H. Meckling, "Theory of the Firm: Managerial Behaviour, Agency Costs, and Ownership Structure" (1976) 3 J. Fin. Econ. 305 at 310-11. 1 7 Agency costs arise in principal-agent like relationships where one person undertakes to act on behalf of others, including the costs of principals to oversee and enforce the agent to live up to the undertaking, the costs of agents to try to guarantee performance or reassure the principal, and the residual costs arising from the unpoliced imperfect performance of agents. See R.C. Clark, "Contracts, Ellites, and Traditions in the Making of Corporate Law" (1989) 89 Colum. L. Rev. 1703 at 1719 [hereinafter "Making of Corporate Law"]. 9 corporate governance varies from one to another, there shouldn't be a uniform, mandatory contract for all corporations. Some proponents argues that markets and other dynamics will align the interests of directors and shareholders and create an incentive for the party with powers to act in such a way as to minimise agency costs in that "market mechanisms will cause corporate management to bear the costs of failing to minimise agency costs by making the costs of finance and risk of take-over higher for such managers."18 The contractual theory approaches its arguments by availing itself of the economic analysis of law and the rationale of natural choice in market place where the company with the best corporate governance survives in the long run. It assumes that the parties to a corporate contract know best their interests in the contract, accordingly a contract, with each party having equal access to information, equal freedom to make choices, can best serve the welfare of parties. Corporate law, which should be enabling in nature, allows corporations to set their own corporate contract that incorporators think is value-increasing. The more contractual freedom parties have, the more value-increasing the contract would be. The efficient capital market hypothesis, an important theoretical premise upon which the contractual theory is constructed, is worth mentioning. This hypothesis proclaims that "securities prices are efficient in that they accurately reflect all publicly available 1 8 F.H. Buckley, M. Gillen & R. Yalden, Corporations: Principles and Policies 3d ed, (Toronto: Emond Montgomey, 1995) at 516 [hereinafter Corporations]. 10 information about the security. Prices of actively traded stocks quickly reflect at least all pubic information about a company."19 Hence market prices constitute the most reliable prediction of a stock's future returns. The publicly available information in or outside of the stock market can continually change investors' expectations about future returns of a specific share and the prices they decide to pay when buying securities.20 Terms in a specific corporate contract form a part of the market information and is available to every market participant to evaluate the desirability of investments. Therefore, the corporate contract is priced and tested in a sense that those contracts which harm investor's interest will be recognised and punished by stock price reduction in the market,21 and will fail in competition for capital with other firms.22 Such pricing and testing mechanisms in an efficient market are the key devices of the stock market.23 Corporations that perform poorly in the stock market are likely to be the targets of take-overs from others. Once a take-over is successful, the directors of the target corporation are usually displaced by a new team nominated by the new controlling shareholder(s). In addition, corporate performance in the stock market could be the evidence of directors' expertise of and commitment to managing corporate business and 19 Ibid, at 106. 20 Ibid, at 106. 2 1 "The Contractual Theory of the Corporation", supra note 15 at 106. 2 2 "Corporate Contract", supra note 15 at 1430. 23 Ibid, at 1430. 11 affairs, and affects their marketability in the market of managerial service. The change of stock price is a trigger of the functions of markets of capital, corporate control and managers. The professional investors on the stock market are crucial players in this process. They can seek out information about different firms and buy and sell their stocks, accordingly contributes to an efficient stock market, and this in turn ensures that the market for capital and corporate control as well as the market for managerial services will function smoothly.24 In addition to markets discussed above, competition in the product market, executive compensation and corporate ownership structure, as well as the prospect of promotion are also important and effective mechanisms in aligning directors' interests, therefore reducing agency costs. Any act of directors that favours themselves may make it more difficult and costly for the firm to obtain the necessary capital for production, while extra costs in the capital market result in higher prices of company's products which may cause the company to be ousted of the market by competitors. Therefore,. the possibility of bankruptcy will force management to refrain themselves from deviating from shareholders' interests.25 The executive compensation in the forms of salary, bonus, and inside stock ownership is also effective to create incentives for management to increase the corporate value, because the better the firm performs in markets, the more management can be compensated. 2 4 "The Corporate Governance Movement", supra note 15 at 1278. 2 5 "The Contractual Theory of the Corporation", supra note 15 at 99. See also "The Corporate Governance Movement", supra note 15 at 1264. 12 Furthermore, even if it is true that shareholders with small interests in a firm are usually rationally apathetic of the operation of their firms, those institutional investors, such as banks, trust companies, pension funds, insurance companies and mutual funds, with a large block of interests in a firm, may have so much of their wealth at stake that they can't afford to be ignorant of directors' performance; so their direct monitoring over directors is conducive to reduce agency costs. Recent experience in the North-America shows that institutional investors' activism in corporate governance is increasing with their growth in the size of shareholding in portfolio companies, and this trend is likely to continue.26 Institutional investors are "often in a position to alter management's intended course of action by privately or publicly expressing their dissatisfaction with management (often in conjunction with other institutional investors), voting against management, threatening to exercise their dissent rights, suing to enjoin the transaction, or, in rare cases, by mounting or participating in a proxy battle against management."27 Empirical evidence suggests that concentrated shareholding is likely to enhance firm value, and also results in better alignment of managerial decision making with shareholder interests.28 Finally, the temptation of being promoted along the corporate bureaucratic ladder will induce management to compete with each other in increasing the value of the company, in the final analysis, of shareholders. 2 6 J.G. Macintosh, "Role of Institutional and Retail Investors in Canadian Capital Markets" (1993) 31 Osgood Hall L. Rev. 370 at 381. For American experience with respect to institutional investors, see B.S. Black, "The Value of Institutional Investor Monitoring: The Empirical Evidence" (1992) 39 UCLA L. Rev. 895 at 925-27. Regarding institutional investors' incentive to participate in corporate governance, legal regulatory theorists hold a different view, which will be discussed below. 2 7 Macintosh, supra note 26 at 377-78. 28 Ibid, at 378-79. 13 The contractual theory does not deny that although the dynamics of a variety of external mechanisms having been discussed are strong, agency costs can't be reduced to zero.29 However, these forces combine to reduce agency costs so that "the gains from the division of labour inherent in the corporate form of firm organisation outweigh the resulting loss to investors."30 That is to say that market forces can reduce the divergence of interest to a point where the marginal benefit of the reduction equal to the marginal costs incurred in such reduction, accordingly any further attempt to reduce the remaining agency costs will not be justified by additional and unnecessary costs. Then, the question following this assertion is whether corporate law should be necessary, i.e. whether there should be corporate law. According to contractual theorists, corporate law also serves the efficiency purpose, but in a different way. Since it is impossible for the parties to specify in a corporate charter every issue that might arise in future, and the costs of an exhaustive contract are prohibitive, corporate law, in particular the fiduciary principle enforced by courts, fills in the blanks and oversights with the terms that people would have bargained for had they anticipated the problems and been able to transact costlessly in advance.31 Therefore, corporate law is another instrument to promote efficiency, by virtue of saving parties the costs of exhaustive contracting. F.S. McChesney, "Economics, Law, and Science in the Corporate Field: A Critique of Eisenberg" (1989) 89 Colum. L. Rev. 1530 at 1538-40; and see also "Corporate Governance Movement", supra note 15 at 1265. 3 0 "Corporate Governance Movement", supra note 15 at 1265. 3 1 "The Corporate Contract", supra note 15 at 1444-45. 14 Consequently, corporate statutes, which should be enabling as opposed to mandatory, are only supplementary to actual bargains. Notwithstanding the existence of corporate law, the parties still have the complete contractual freedom. To summarise the contractual theory, a corporation is the centre of a complicated nexus of contractual relationships; it isn't different from markets in organising production.32 The external monitoring mechanisms are efficient to reduce agency costs. The desirable role for corporate law is to offer a set of standard contractual terms that parties would have chosen had they negotiated costlessly and with full information. Parties should have the complete freedom to choose the terms of corporate contracts and opt out provisions in corporate law. There should be virtually no mandatory roles for corporate law. Just as Dean Clark summarises, the contractual theory can be condensed to one sentence: "[everything is negotiable."33 1.30 Legal Regulatory Theory Proponents of the legal regulatory theory dispute the assumptions, arguments and conclusions of the contractual theory and hold that it is more convincing theoretically than it practically is.34 This theory argues that, with the basic assumptions held by the 32 "Making of Corporate Law", supra note 17 at 1705. 33 Ibid. 3 4 The scholarship in this regard comprises some significant literature, including: V. Brudney, "Corporate Governance, Agency Costs, and the Rhetoric Contract" (1985) 85 Colum. L. Rev. 1403; R.C. Clark, "Agency Costs Versus Fiduciary Duties" in J. Pratt & R. Zeckhauser, eds., Principals and Agents: The Structure of Business (Boston: Harvard Business School Press, 1985) 55; L.A. Gordon, "The Mandatory 15 contractual theory inconsistent with reality, conclusions of the contractual theory are consequently flawed, even misleading. Contract is the instrument by which separate and conflicting interests of the parties can be reconciled and brought to a common goal.35 The basic function of a contract is its optimality in increasing both parties' value.36 Such optimality are derived from that "the rights and duties between the two parties are specified and fixed by their own voluntary and actual agreement",37 and consequently the symmetry of information, equal freedom of choice and equal access to alternative choices between parties are likely to be the prerequisites of the value-increasing function. In reality, being rationally apathetic, shareholders have less information than management who controls and operates the company. While such asymmetry of information discounts the optimality of contract to investors, as a corollary, transactions entered into between investors and management may not necessarily be optimal to investors. The legal regulatory theory also challenges the effectiveness of market and non-market forces in aligning the interest of management and shareholders and causing management to adopt value-increasing contracts. Structure of Corporation Law" (1989) 89 Colum. L. Rev. 1549; J.C. Coffee, "The Mandatory/Enabling Balance in Corporate Law: An Essay on the Judicial Role" (1989) 89 Colum. L. Rev. 1618; L.A. Kornhauser, "The Nexus of Contracts Approach to Corporations: A Comment on Easterbrook and Fischel" (1989) 89 Colum. L. Rev. 1395; M.A. Eisenberg, "The Structure of Corporation Law" (1989) 89 Colum. L. Rev. 1461; A.G. Anderson, "Conflicts of Interest: Efficiency, Fairness and Corporate Structure" (1978) 25 UCLA. L. Rev., 738; R.C. Clark, "Contracts, Elites, and Traditions in Making of Corporate law" (1989) 89 Colum. L. Rev. 1703. 3 5 A.G. Guest, Anson's Law of Contract, 26 ed., (Oxford: Clarendon, 1984) at 3. 3 6 A.T. Kronman & R.A. Posner, The Economics of Contract Law (Boston: Little, Brown, 1979) at 1-2. 3 7 Clark, "Agency Costs Versus Fiduciary Duties", supra note 34 at 60. 16 Prices in a perfectly efficient stock market can effectively reflect the publicly available information about a stock. Stock prices are affected by the systematic risk that affects all market assets, and therefore does not reflect only firm-specific risk.38 Moreover, stock prices are not reliable yardstick to measure the performance of management, because there are many factors, including the quality of management, industry involved, the accidents of timing, and those internal matters in the enterprise for which the present management can't be said to be responsible, combined to determine corporation's success and failure, moreover, any component can't be assessed separately in terms of its weight in the decision of selling or buying stocks.39 Supposing there is a pricing efficiency in the stock market, it doesn't of its own force management to be more responsible; and what it makes possible is to trigger the functions of the take-over market.40 However, the premiums that are paid to the target shareholders in take-overs, plus the very large fees paid to investment bankers, lawyers, and other professionals, are so high above the market price that may prohibit the bidders form proceeding the proposed take-overs.41 Poison pills, which are pervasive among large "Corporate Governance, Agency Costs and the Rhetoric of Contract", supra note 12 at 1423. 39 Ibid, at 1424. 40 Ibid, at 1425. 4 1 The premium for all take-overs runs between thirty and fifty percent over market price. The premium is high partly because all existing shareholders value their shares higher than the market value, and partly because the target's directors can create some obstacles to a bidder, like poison pills, that can be overcome only by a substantial premium over the market price. See "Structure of Corporate Law", supra note 14 at 1498. 17 public corporations, make take-over attempts prohibitively costly and almost futile. Therefore, an optimal deterrence policy is unlikely to arise solely through the market for corporate control. Take-overs are more often directed to taking over well-managed corporations than to poorly managed corporations,42 even in some cases the target is better managed than the bidder.43 Take-overs deal with the overall performance of management, instead of specific directors' behaviours. In addition, it usually takes a long period of time for the value-decreasing nature of inefficient or dishonest management to be so visible that a take-over is justified to step in. Thus, without mandatory corporate law, and before a take-over is initiated, directors are left unpoliced. As a result, it is obvious that the market of corporate control is not so effective as it is theoretically expected to be. However, fiduciary duties enforced by the court, can punish every specific errant action immediately after its occurrence, without waiting for the take-over to come, so that prevent the aggregate losses from being too high. 42 Ibid, at 1499. 4 3 E.S. Herman, "The Limits of the Markets as a Discipline in Corporate Governance" (1984) 9 Del. J. Corp. L. 530 at 536-37. The rampancy of take-overs in US in 80s has shown some fundamentally unhealthy side effects of take-overs, including promoting a short-term bias of both management and shareholders, creating an environment of confrontation and distrust between management and shareholders and undermining manager-shareholder communication. See S.A. Rosenblum, "Proxy Reform, Takeovers, and Corporate Control: The Need for a New Orientation" (1991) 17 J. Corp. L. 185 at 202. 18 The legal regulatory theory also argues that there is a very weak link between management's performance in corporations and in the market for corporate managers, because this kind of market is of no relevance to chief executive officers, top executives or outside directors.44 Moreover, the optimal compensation package contemplated by the contractual theory whereby directors would absorb all variations of profits, and in effect become the holders of a portion of the firm's residual value, so that could be expected to live up to the proper level of care and to adopt investment policies which maximise firm value, is not feasible in most corporations.45 In the product market which is characterised as imperfect, management's self-dealing or abuse of powers will not necessarily drive the company into bankruptcy. If the market is primarily oligopolistic, some corporations can generate profits in excess of those that are obtainable in perfectly competitive markets, and have sufficient resources to internalise the losses resulted from the inefficiency of corporate management.46 Institutional investors are considered as effective monitors over management, but they are not free of problems which arouse suspicion about their efficacy. As investors, their primary obligation lies to their own investors, instead of to their fellow shareholders in firms; their first reaction to the flaws in corporate governance is to switch out as quickly 4 4 "Structure of Corporate Law", supra note 14 at 1495. Empirical inquiries demonstrated no relationship between management's compensation and corporate performance evidenced by stock market prices. See "Corporate Governance, Agency Costs and the Rhetoric of Contract", supra note 12 at 1422. 45 Corporations, Supra note 18 at 582. 46 "Structure of Corporate Law", supra note 14 at 1489. 19 as possible rather than stay in and correct the flaws.47 Some institutional investors are perplexed with conflicts of interest in that some portfolio companies are sometimes the clients of their institutional shareholders; and it is very likely for the managers of those institutional investors to be unwilling to jeopardise the ability to retain business by challenging the proposals of the board of directors in the portfolio companies.48 Institutional investors are also criticised as short-termist. Because their performance is assessed on a quarterly basis by their own investors, and under the pressure of competition attracting funds, managers are likely to press companies to declare dividends regardless of the overall profitability of companies.49 Hence, given that the long-term interest is the objective of corporate governance, institutional investors' eligibility of responsible and effective monitors from whom other shareholders can obtain a free ride could not be overstated. Legal regulatory theorists are of the view that full and correct information is essential to shareholders' welfare, however the informational asymmetry is likely to make investors, especially those uninformed and unsophisticated, vulnerable to management-chosen, one-4 7 "The Legal Roles of Shareholders and Management in Modern Corporate Decisionmaking" supra note 14 at 49. As a matter of fact, this view should be modified with the change of institutional investors. Rather than selling their investments when dissatisfied with management (the "Bay Street Rule"), institutions are increasingly retaining their investments and attempting to influence management's course of action. Although not active in day-today management, they are actively involved in important issues, such as dual class recapitalisation, take-over defences, related party transactions and corporate restructuring, as well as executive compensation. See Macintosh, supra note 26 at 380-81. 4 8 E.J. Boros, Minority Shareholders' Remedies (Oxford: Clarendon Press, 1995 ) at 32. w Ibid, at 33. 20 sided contract terms. Such likelihood opens the way for their argument that binding legal rules are necessary because of the informational superiority of legislators and regulators, at least in some contexts. They believe that legislators may be more efficient information collectors and processors because of their acquired abilities or because they are specialists who have the time and substantial expertise about technical matters, thus reaping economic scale in information utilisation. The contractual theory states, using the so-called economic theory of regulation, that the biggest drawback of legislators is their imperfect incentives to care as much about the real effect of rules on the welfare of the subjects of rules as subjects themselves do; thus the legislature is not reliable to do what is best for the subjects at large.50 However, the legal regulatory theory takes the view that there is still no priori reason to preclude the possibility that the informational advantages of legislators may outweigh the costs of the defects in their incentives, therefore abandoning contractual autonomy and subordinating to legal rules may have net benefits for investors, at least in such contexts as those which need substantial expertise and knowledge of technical matters.51 It is necessary for corporations to have the discretion to alter the corporate contract in response to changing circumstances. Amendments are usually proposed by directors who will argue that the amendment will be profit-maximising to shareholders. This gives "Economic, Law, and Science in the Corporate Field: A Critique of Eisenberg", supra note 29 at 1544. "Making of Corporate Law", supra note 17 at 1720. 21 d i r e c t o r s a n o p p o r t u n i t y t o inser t i n t o t h e c o n t r a c t c l a u s e s tha t m a y t r a n s f e r p r o p e r t y f r o m s h a r e h o l d e r s t o t h e m s e l v e s . A l t h o u g h s h a r e h o l d e r s c a n u s e s u p e r m a j o r i t y v o t i n g n e e d e d t o a p p r o v e t h e a m e n d m e n t s as a m e a n s t o p r o t e c t t h e m s e l v e s , r a t i o n a l s h a r e h o l d e r a p a t h y a n d t h e v o t i n g b y i n t e r e s t e d s h a r e h o l d e r s ( s h a r e h o l d e r s w h o at t he s a m e t i m e a re d i r e c t o r s ) m a y r e n d e r s h a r e h o l d e r s ' v o t i n g no t so m e a n i n g f u l as it a p p e a r s t o be . U n d e r t he c u r r e n t l a w a n d p r a c t i c e , s h a r e h o l d e r s ' c o n s e n t s t o t he a m e n d m e n t s s p o n s o r e d b y m a n a g e m e n t , p a r t i c u l a r l y i n p u b l i c l y h e l d c o r p o r a t i o n s , m i g h t n o t s h o w the i r a c t u a l a w a r e n e s s o f the, p o t e n t i a l r i s k s o f t he a m e n d m e n t s , b e c a u s e t h e c o n s e n t s m i g h t b e e i t he r n o m i n a l , t a i n t e d b y a c o n f l i c t o f in te res t , c o e r c e d o r i m p o v e r i s h e d . 5 2 T h e l e g a l r e g u l a t o r y t h e o r y , i n s t e a d o f c o m p l e t e l y n e g a t i n g t h e e f f i c a c y o f m a r k e t a n d o t h e r n o n - m a r k e t m e c h a n i s m s , s t resses the i n a d e q u a c y o f t h e i r f u n c t i o n s i n r e d u c i n g a g e n c y c o s t s a n d p r o t e c t i n g s h a r e h o l d e r s . It p r o c l a i m s tha t n e i t h e r d i r e c t o r s n o t s h a r e h o l d e r s s h o u l d h a v e u n l i m i t e d d i s c r e t i o n i n t a i l o r i n g c o r p o r a t e g o v e r n a n c e , a n d s o m e c o r p o r a t e r u l e s , at leas t t h o s e g o v e r n i n g f i d u c i a r y du t i es , f u n d a m e n t a l c o r p o r a t e c o n t r a c t a m e n d m e n t s , a n d p r o x i e s , as w e l l as d i s c l o s u r e o b l i g a t i o n s t o s h a r e h o l d e r s , e t c . , s h o u l d b e m a n d a t o r y , b e c a u s e i n t h e s e r e s p e c t s subs tan t i a l d i v e r g e n c e o f i n te res ts is l i k e l y t o a r i se . M a r k e t s , m o r a l s a n d l a w t o g e t h e r be t t e r se r ve the o b j e c t i v e o f a l i g n i n g i n te res t s o f s h a r e h o l d e r s a n d m a n a g e m e n t . 5 3 T h e r e f o r e , su f f i ce it t o say tha t th i s t h e o r y i s a k i n d o f r e v i s i o n a n d c r i t i c a l t h e o r y of , r a the r t h a n a t o t a l d e n i a l o f t he c o n t r a c t u a l t h e o r y . "Structure of Corporate law", supra note 14 at 1474-80. Ibid, at 1525. 22 1.40 Enabling V. Mandatory: Efficiency V. Fairness This theoretical debate between the contractual and legal regulatory theories gives rise to some of the fundamental questions of corporate law theory. The focus of this debate concerns whether or not the parties of corporate contracts should be free in contracting, and whether corporate law should be enabling. It is the argument of this article that the underlying social values on each side are respectively: efficiency and fairness. Efficiency, considered as a neutral term, exists when resources are allocated to their most highly valued use. In the context of this paper, markets and contractual mechanisms are regarded as efficient in terms of their use of social resources in reducing agency costs. However the legislation of enabling rules still could serve the efficiency purpose in the sense that such rules can serve a set of standard contractual terms which can be opted in or out, saving incorporators from the exhaustive negotiation. Contractarians are of the view that the mechanisms used to reduce agency costs unaddressed by markets and other contractual mechanisms are not efficiency-justified. The meaning of fairness is elusive, and it is difficult to give a definition that is generally applicable. Fairness "cannot be assessed in a vacuum or simply from one member's point of view. It will often depend on weighing conflicting interests of different groups within the company. It is a matter of balancing all the interests involved in terms of the policies underlying the company legislation in general..."54 5 4 [1984] 1 NZLR 686 at 694-95, quoted in D.A. Wishart, "Fairness in Company Law (1990) 4 Canterbury L. Rev. 284. An obvious illustration of the principle of fairness is the oppression remedy for oppression or unfairly prejudicial activities of the company or majority shareholders, or directors' powers 23 This article observes that it is unfair for management to favour themselves at the expense of shareholders by abusing their managing powers granted by shareholders. Mandatory legal rules, in particular those of fiduciary duties embody and encourage such dynamics as fairness, honesty and business ethics, all of which are socially desirable moral properties within the boundaries of the corporate form of business.5 5 If management can "internalise" a sense of immorality of and refrain from deviating actions, it is socially efficient in the long run, since such "internalisation" could reduce agency costs at no costs. For legal regulatory theorists, directors driven by the conflicts o f interest, are provided with an opportunity to benefit themselves from manipulating corporate affairs, at the expense of shareholders. Although markets can reduce agency costs, they are inadequate for the purpose of protecting shareholders' interests. The remaining agency costs are not what shareholders would have anticipated, expressly or implicitly, when they ceded their assets to management to take care in exchange for increased returns; otherwise, they would not have chosen to entered into such transactions. Thus, it is proposed by the legal regulatory theorists that the use of mandatory rules is necessary to further reduce agency costs, in order to fulfil the reasonable expressions of shareholders, even i f so doing may sacrifice efficiency when efficiency and fairness are not complimentary. It can be inferred that are exercised in an oppressive or unfairly prejudicial way. See BCCA S. 224 and CBCA S. 241. The oppression remedy will be discussed in details in P82-84. 55 "The Death of Fiduciary Duty in Close Corporations", supra note 7 at 1695-96. 24 that legal regulatory theorists believe that fairness should prevail over efficiency if they are in conflict and promotion of either one needs to sacrifice the other. Moreover, according to the theory of contract law, when a fraud has been committed by one party to the other, but the victim can't prove it, then enforcing such agreements is inefficient.56 By the same token, enforcing corporate contracts which may raise the possibility of abusing power by management is inefficient. To the society as a whole, the inefficiency of further reducing agency costs may be more desirable compared with the greater inefficiency of enforcing too many contracts by which the management can cheat shareholders for their own interests.57 Over-emphasising either one between efficiency and fairness may be detrimental to the whole economy and ultimately the interest of investors. Without enough fairness, investors may be deterred form entering into capital markets which are the source of corporate capital. Without sufficient efficiency, it is hard to imagine any social and economic development. If such argument holds true, then the problem of corporate governance becomes the trade-off between efficiency and fairness, which is a matter of moral choice.58 A . T . Kronam, "Paternalism and the Law of Contracts" (1983) 92 Yale. L . J. 763 at 768. Ibid.atl6&. J.L. Howard, "Fiduciary Relations in Corporate Law" (1991) 19 Can. Bus. L.J. 1 at 5. 25 The balance of being enabling and mandatory is influenced by some factors. The more efficient markets are, the more effective they are in reducing agency costs; the more effective markets are, the less needs there are for mandatory rules. The extent to which corporate law is mandatory should be proportionate to the level of conflicts of interest, the degree to which such conflicts fundamentally affect shareholders' interest, and the strength of markets. The balance between being enabling and mandatory is also determined by the preference between efficiency and fairness of the dominant social value. The less perfect markets are, the wider areas mandatory rules should cover. Therefore, the designing of corporate law is a market-specific project, primarily the stock market.59 The legal regulatory theory suggests that corporate law should be a balanced mix of enabling and mandatory rules, depending on the circumstances and the type of legal rules in question.60 Usually mandatory legal rules should govern those core fiduciary and structural areas in which the interests of shareholders and top managers may materially diverge.61 The content of such rules falls into the following categories: the fiduciary duties of management, disclosure of corporate information to shareholders and institutional A stock market is efficient if traders in the market can't make abnormal returns through formulating and executing trading strategies relying on a particular set of information. There are three kinds of market efficiency: (1) weak-form efficiency: traders can't realise abnormal returns by analysing and relying on historical price movement; (2) semi-strong for efficiency: traders can't make any abnormal returns by using any publicly available information; (3) strong-form efficiency: even insiders can't regularly make abnormal profits from using insider information, because the market prices have already reflected such non-public information. See RJ. Daniels & J.G. Macintosh, "Toward a Distinctive Canadian Corporate Law Regime' (1991) 3 Osgood Hall L.J. At 872-873. 6 0 "The Complexity and Ligitimacy of Corporate Law', supra note 1 at 1580. 6 1 "Structure of Corporate Law", supra note 14 at 1480. 26 mechanisms to ensure the reliability of such disclosure, and the safeguard of integrity of shareholder voting, as well as requirements of shareholder consent to fundamental corporate changes. 1.50 Compelling but Incomplete Although theorists on both sides have tried hard on their own to strengthen and defend their arguments, no one on either side can claim that his theory is without problems. Contractual theorists consider stock prices, the fluctuations of which trigger a series of reaction in the market of corporate control and managerial services, as the barometer of corporate governance, particularly the performance of management. Being judged by such standard, directors will distract their attention from the long-term interests of the company as a whole, to the reaction of the stock market. What contractual theory ignores is the fact that some management decisions may drive up stock prices, but may damage the corporation's earning power and production capability in the long run. A hostile take-over may prompt up stock prices, but the American experience in the 70s and 80s proves that a hostile take-over may not produce long-term productivity.62 In the current society, the corporate form of business is so important to the economy and social welfare that its long-term efficient and fair operation is of great social Rosenblum, supra note 43 at 201-06. 27 significance.63 Therefore the ultimate goal of corporate governance can't be other than the creation of social utility through a competitive corporate structure and process that can lead to long-lasting success in competition. A long-term governance structure should improve incorporators' (both shareholders and directors) incentives to maximise corporate value, management accountability to shareholders, directors' discretion in managing the corporation, and shareholders' communications among themselves.64 The economic analysis is based on some assumptions, like that economic actors are considered as rational wealth maximisers, that stock markets are efficient and that stock prices can effectively reflect all publicly available information, but the reality is that they are not always held true in real world.65 Thus, contractual proponents need to use some caution in drawing theoretical pictures by using these assumptions, keeping in mind that some of their significant assumptions and hypotheses might be at odds with reality. Because of the possibilities of such disparity and inconsistency, the persuasiveness of the theory is greatly discounted. The process contemplated in the economic analysis, in which the markets perform their functions, starting from a non-optimal corporate governance structure to low prices for M. Lipton & S.A. Rosenblum, "A New System of Corporate Governance: The Quinquennial Election of Directors" (1991) 58 U. Chi. L. Rev. 187 at 216 [hereinafter "A New System"]. 6 4 "Longterm Model", supra note 2 at 1365 footnote 187. 6 5 B.R. Cheffins, "An Economic Analysis of the Oppression Remedy: Working Towards a More Coherent Picture of Corporate Law" (1990) 40 U.T.L.J. 775 at 788. 28 stocks, and finally to the new managers through take-overs needs to take a long time to show its effects, even several years.66 The "invisible hand" of market dynamics operates in so long a term that it might be very late to protect shareholders when the process finishes and the flaws in corporate governance are cured. Given such problems, the contractual theory is not warmly received by some corporate lawyers. Such attitude is implied in Victor Brudney's comment: " [notwithstanding the efforts of the academic free marketers and their associates in the business community, there has not yet been demonstration or acceptance of the proposition that the markets alone provide an adequate mechanism for narrowing managerial discretion so as to press management to improve its efficiency, much less to press management to perform optimally for the stockholders of their corporation."67 The legal regulatory theory presents a picture of corporate governance illustrating that the mix of markets, morals and law would be superior than any single one. However, it has failed to tell how to balance mandatory and enabling rules and where the line should be drawn. Although Eisenberg proposes that the core fiduciary and structural rules, where the interest of shareholders and directors may materially diverge68, should be mandatory, this standard, on a second guess, doesnot disclose too much about how the balancing can be struck due to the fact that materiality hasnot been defined in any literature. Dean Clark "Managers' Discretion and Investors' Welfare: Theory and Evidence", supra note 15 at 556. 6 7 V. Brudney, "The role of the Board of Directors: the ALI and Its Critics" (1983) 37 U. Maimi L. Rev. 223 at 235. 6 8 "Structure of Corporate Law", supra note 14 at 1473. 29 even argues that an ideal system should rely on all three sources, to varying degrees in different contexts, but it is impossible to specify with any precision what the optimal mix of sources is and where the optimal line should be drawn.69 Obviously, legal regulatory theorists concern more about the existence of remaining agency costs than about the costs to reduce them, but the precise meaning of adequacy is unattainable, as a result it is difficult to know to what extent corporate law should be mandatory. The unkownability of the optimal balance and the uncertainties surrounding the elusive terminology prevent this theory from being thorough or completely illuminating. 1.60 Opposite but Overlapping These two theories share some common grounds which may reveal some features of corporate governance and how agency costs can be reduced. Markets and legal rules are not mutually exclusive; they co-exist and play different and specialised functions. First of all, both theories deal with the divergence of interests and try to develop monitoring mechanisms to minimise agency costs by limiting management's discretion. These two theories based on the same or similar premise that management has seized control because of its position in the relationship of dependence with shareholders, while without any external protection, shareholder are helpless facing such dominance by directors. 'Making of Corporate Law", supra note 17 at 1743. 30 Secondly, their respective solutions, although different, are to align the interest of management with those of shareholders through inducing or forcing the former to subordinate their interest to the latter where there are conflicts of interest. By constraining management's discretion, it is assumed that due to the inherent conflicts of interest, management is inclined to pursue self-regarding activities at the expense of shareholders. By subordinating management's interests, it postulates that shareholders are owners of the corporation, and have intrinsic rights to decide how to run the corporation and get its profits.70 Thirdly, neither markets nor legal rules alone can achieve the objective that an optimal balance of the mixture of forces can do. No one society can afford to overly favour efficiency while ignoring fairness, and vice versa. Without fair operation of the corporation by its management, social economy will be injured in the long run in that investors withhold their investment until they are assured that management will live up to their expectations. In addition, in order to secure the operation of the market of corporate control, mandatory fiduciary duties, like those enunciated in Unocal Corporation V. Mosa petroleum71 and Revlon Inc. V. MacAndrews & Forbes Holdings, Inc.72 deter and prevent management from adopting unreasonable defence to drive up the premium so high that it is impossible for a take-over bidder to proceed the proposed transaction. Under the 7 0 "Making of Corporate Law", supra note 17 at 1787. 7 1 493 A.2d 946 (Del. S.C. 1985). 7 2 5 06 A. 2d 173 (Del. S.C. 1986). 31 auspices of fiduciary duties, the market of corporate control can better discipline inefficient management. The rules governing enforced disclosure, constraints on insider trading and proxy process will prevent management from taking measures that may abuse inefficient stock markets. Therefore, mandatory rules, to some extent, act to cure the market failures and as a result to protect the smooth operation of the markets. Moreover, without the deterrence of fiduciary duty and liability rules, the contractual promise of faithful discharging of obligations would be worth less and more unreliable. A mixture of considerations of efficiency and fairness permits a corporation, on one hand, to be highly flexible in structuring its organisation, and makes corporate governance adaptive to the actual circumstances by incorporators; on the other hand, management accountability to shareholders is ensured. Meanwhile, such mixture should only take the long-term interest of the corporation as its goal. Although some investors are rationally apathetic, those who have a long-term interest in the investment and those who have a large stake in the corporation and cannot exit the market quickly will find it is worthwhile to monitor management. Therefore, corporate governance should have channels to import shareholders input and ensure their voices would be heard by management. The problem of agency costs has been one of the controversy of corporate law scholarship. This alluded debate over the contractual freedom in corporate law brought into light one critical question—What are the dynamics of corporate governance? Contractualism emphasises the effectiveness of markets and other non-market measures as 32 monitoring devices or "sweeteners" to align the interest of management and shareholders, and there should be no need of mandatory corporate law. While the legal regulatory theory contends that there should be mandatory rules at least in some contexts, because of the informational advantage of those legislators and regulators on general technical matters which are too sophisticated for shareholders to understand the impact on their future interests. An optimal mix of markets, morals and law should be the sources of corporate governance. This debate also comes up with two fundamental factors in addressing corporate governance: efficiency and fairness. On one hand, considerations should be given to the requirement that social resources should be utilised efficiently, on the other hand, regards that social welfare should be justly distributed among participants of corporate operation are equally essential. The elusive balance of efficiency and fairness is a significant theme cutting across all aspects of relationships between shareholders and directors, and changes in different social contexts. Therefore corporate governance should be sensitive and adaptive to variations of social reality. 33 CHAPTER II: REVIEW OF THE LEGAL ASPECTS OF CORPORATE GOVERNANCE IN CANADA 2.10 Division of Power between the Board of Directors and shareholders Shareholders and the board of directors are two polars within the corporate structure. Within such bi-polar system, each one, with different financial interests, granted different powers and assuming respective liabilities, controls one another in appropriate situations. To examine the division of power between the board of directors and shareholders, it is necessary at the outset to review briefly the nature of the relationship between them. The leading English case Automatic Self-Cleansing Filter Syndicate Co., Ltd. V. Cunninghame74 laid a foundation for the common law principle in this regard. It is firmly established that, given that directors are acting within the ambit of the powers authorised by the articles, shareholders even 100 percent of shareholders, can't interfere with such powers, except first altering the articles through special resolutions following specific procedures in general meetings.75 This doctrine has been well accepted in Canada, 7 3 Bruce Welling, Corporate Law in Canada: The Governing Principles, 2d. ed. (Toronto: Butterworths, 1991) at 300. [hereinafter Corporate Law in Canada] 7 4 [1906] 2 Ch. 34 (C.A.). 7 5 B.V. Slutsky, "The Division of Power Between the Board of Directors and the General Meeting" in J. S. Ziegel, ed., Studies in Canadian Company Law: Corporation and Securities Law in the Seventies (Toronto: Butterworths, 1973) 166 at 169. 34 evidenced by directors' sweeping power to manage or supervise corporate operation under BCCA and CBCA.76 BCCA allows the articles of a company to shift managing powers from directors to shareholders.77 Under CBCA, shareholders can restrict, in whole or in part by a shareholder agreement, directors' managerial powers.78 In BCCA, where the articles of association is deemed to be a contract binding upon the company,79 a framework with respect to the power allocation has been structured, but shareholders may override the statute in some respect through the articles of association.80 In CBCA, there is no contractual concept associated with the articles, and it is the incorporating laws that are 76 BCCA S. 141(1) and CBCA S. 102(1). Under BCCA, directors can either manage or supervise the corporate business and affairs, whereas under CBCA, directors only have one function that is to manage the corporate business and affairs. 77 BCCA S. 141(1) provides that "[t]he directors shall, subject to this Act and the articles of the company, manage or supervise the management of the affairs and business of the company." So, it would be lawful if the articles provides that all or a part of the rights of directors are held by the shareholders. 78 CBCA S. 146(2)-(5). 7 9 BCCA S. 13. 80 BCCA Table A Articles 10.1 provides that: "The directors may exercise all such powers and do all such acts and things as the company may exercise and do, and which are not by these articles or by statute or otherwise lawfully directed or required to be exercised or done by the company in general meeting, but subject, nevertheless, to the provisions of all laws affecting the company and of these articles and to any rules, not being inconsistent with these articles, which are made from time to time by the company in general meeting; but no rule, made by the company in general meeting, shall invalidate any prior act of the directors that would have been valid if hat rule had not been made." 35 responsible for the allocation. Consequently, whether a specific transaction is within the authority of directors depends on the interpretation of statutory provisions.81 Directors are empowered collectively, instead of individually. As a group, the board of directors make decisions in the form of resolutions at board meetings. Subject to certain restrictions,82 the board of directors can delegate part of its rights to various committees composed of its members so appointed.83 In theory, directors are supposed to make business strategies and policies, and supervise officers in their day-to-day operation. However, in practice, directors of large public companies do not fulfil either function because they leave most of the decisions to officers who play the role of real controllers.84 CBCA acknowledges the validity of a unanimous shareholder agreement in allocating powers between shareholders and the board of directors. From the reading of S. 102(1) which provides that "[s]ubject to any unanimous shareholder agreement, the directors shall manage the business and affairs of a corporation. it can be argued that to the extent of agreement's legitimacy, shareholders can retain the managing power to themselves through a unanimous shareholder agreement. BCCA doesn't have the corresponding provision. It is certain that a unanimous shareholder agreement is binding on all shareholders, but whether it is also binding on directors respecting their powers remains unclear. 8 2 See CBCA S. 115(2) provides that: "[i]f the directors of a corporation, other than a corporation referred to in subsection 105(4), appoint a committee of directors, a majority of the members of the committee must be resident Canadian. S. 115(3) provides that: "[notwithstanding subsection (1), no managing director and no committee of directors has authority to (a) submit to the shareholders any question or matter requiring the approval of the shareholders; (b) fill a vacancy among the directors or in the office of auditor, (c) issue securities except in the manner and on the terms authorised by the directors; (d) declare dividends; (e) purchase, redeem or otherwise acquire shares issued by the corporation; (f) pay a commission referred to in section 41; (g) approve a management proxy circular referred to in Part XIII; (h) approve a take-over bid circular or directors' circular referred to in Part XVII; (I) approve any financial statements referred to in section 155; or (j) adopt, amend or repeal by-laws." 8 3 See CBCA S. 115(1). BCCA has no provisions about the delegation of rights by the board of directors. 8 4 See generally M.L. Mace, Directors: Myth and Reality (Cambridge, Mass.: Harvard Graduate School of Business Administration, 1971). 36 Notwithstanding directors' powers under statutes and the loss of the status of proprietors of corporate assets as the result of personifying corporate entity,85 shareholders are given by the articles and corporate statues, the major, in theory, final say, indirectly about how the corporation is managed; and such final authority is exercised collectively, in the form of general meeting resolutions which are relative to the appointment or removal of directors, approval or denial of specific transactions, and the demise of corporations. General meetings, annual or special, provide shareholders with a forum where they can discuss corporate matters, and review directors' management. Voting right is one of the means by which shareholders' final say is expressed.86 Shareholder groups retain the power to elect directors to and remove them from the board of directors. Although managing powers are rested with directors, the right to decide the composition of the board of directors, which is tantamount to a power to choose corporate strategies and policies in the long run, is held by shareholders. To vote intelligently, shareholders are entitled to thorough and reliable information about corporate business and affairs. The board of directors is the corporate organ responsible for informing shareholders. 85 See Salomon V. A. Salomon & Co., [1897] A.C. 22. 8 6 Shareholders' right to sell shares is another important right to express themselves. See infra note 147-148. 37 To sum up, directors act collectively to serve as the driving force of corporate business and affairs.87 Shareholders, as a whole, are the final decision-maker to the extent that they choose directors and determine the destiny of corporate entity. Supported by the right to be informed and the right to communicate with other shareholders, voting right is the most meaningful and powerful means for shareholders as decisionmakers. Shareholders may have the power to do what the directors are unable to do in case of a deadlock in the board of directors. In Barron V. Potter,n it was held that the board meeting was invalid due to the lack of quorum .The corporation's articles stated that its two directors were the quorum of every board meeting. However, those two directors disagree with each other so that one director did not want to attend the board meeting convened by the other. In the decision of the court, an extraordinary general meeting called upon by one director to elect new directors and remove the other director was upheld. In this case, given the disagreement between directors, for the practical purposes, the board of directors was paralysed because of the wanting of quorum, but to avoid the "Affairs" means the internal relationships among directors, officers, and shareholders of the corporation, whereas "business" means the relationships between corporate entity and outsiders. See Beatty V. First Exploration Fund 1987 and Co. (1988), 25 B.C.L.R. (2d) 377 (B.C.S.C.) at 387-88. CBCA S. 2 defines the affairs as: "the relationships among a corporation, its affiliates and the shareholders, directors and officers of such bodies corporate but does not include the business carried on by such bodies corporate". [1914] 1 Ch. 895. 38 corporation being disfunctioning, shareholders were granted the power to manage the corporation when there was no functioning board of directors.89 2.20 Shareholders' Voting Rights As discussed in the preceding part, voting right is the most important power for shareholders to participate in corporate governance. Subject to the articles or unanimous shareholder agreements, shareholders are entitled to vote in general meetings.90 Shareholders have the right to choose people sitting in the board by an ordinary resolution,91 to remove the incumbent directors from the board.92 Shareholders are given the right of approval in respect of certain changes concerning corporate business and affairs that are so fundamental that they will affect the expectations held by shareholders when they first join the corporation. CBCA permits shareholders to alter corporate name, to change any restriction on the business that the corporation may carry on, and to create In this case, the company is an English-model registration one in which directors derive their powers by delegation from shareholder, whereas in Canada, the original power of the board is derived directly through the statute from the legislature. Therefore, it isn't likely a good law in Canada, except in Nova Scotia. Corporate Law in Canada, at 507. 90 CBCA S. 140(1) provides that "unless the articles otherwise provide, each share of corporation entitles the holder thereof to one vote at a meeting of shareholders." 91 CBCA S. 106(3) and S. 109(2) acknowledges the validity of an exclusive right to elect one or more directors by shareholders of a specific class or series. 92 CBCA S. 109(1) authorises shareholders to remove any director(s) from office by ordinary resolution at a special meeting. See CBCA S. 2 for the definition of ordinary resolution. BCCA S. 154(3) entitles shareholders to remove a director from office before the expire of his term of office by special resolution. See BCCA S. 1 for the definition of special resolution. 39 new class of shares, as well as to increase the maximum or minimum number of directors by a special resolution through amending the articles.93 BCCA also allows amendments of memorandum for the purpose of altering restrictions on the business that the company may carry on,94 changing the corporate name,95 and increasing the authorised capital,96 subdividing or consolidating outstanding shares as well.97 Besides alterations of articles or memorandum, there are other types of changes that are within the ambit of shareholders' special resolutions. These are amalgamation of the corporation with another corporation,98 a sale, lease or otherwise disposition of all or substantially all of the corporation's assets,99 or continuance of the corporation in another jurisdiction.100 Shareholders can choose to voluntarily liquidate and dissolute the corporation by a special resolution.101 CBCA S. 173(1). See CBCA S. 2 for the definition of the special resolution. BCCA S. 245. BCCA S. 247(1). BCCA S. 254. BCCA S. 255. BCCA S. 272(4), CBCA S. 183(5). BCCA S. 150, CBCA S. 189(3). BCCA S. 37(1), CBCA S. 188. CBCA S. 211(3), BCCA S. 291. 40 As to voting rights of shareholders respecting fundamental changes, there is a notable difference between CBCA and BCCA. It is that under CBCA, shareholders are generally entitled to vote disregarding whether or not they otherwise have the right to vote,102 whereas BCCA hasnot such express provisions. To directors, shareholders' voting rights have special values. Although shareholders cannot relieve retroactively directors from liability for breach of duties, like being interested in corporate contracts, and looting corporate opportunities, directors can be resolved from liabilities that would otherwise be applicable to them by virtue of law if they make full disclosure of their interests therein, and get the shareholder approval, given the transaction being reasonable and fair to the corporation.103 To those public corporations listed on stock exchanges, the stock exchange's by-laws, policy statements or listing agreements are another source relating power allocation between shareholders and directors. Any failure of compliance with these requirements or commitments may lead to trading halt, even delisting. For an instance, S. 606 of the General By-Law of the Toronto Stock Exchange requires shareholder approval as a precondition of acceptance of a notice required by S. 19.06, if the Exchange is of the view that the proposed transaction may materially affect control of the company, or has not 102 CBCA S. 183(3), 188 (4), S.189 (6), S. 211(3). 103 BCCA S. 145-146. CBCA S. 120(7). This issue will be discussed in more details in the part of directors' duties. 41 been negotiated at arm's length; or is of such a nature as to render shareholders' approval being for the public interest. This section grants shareholders some additional control over the corporate business, by shifting to shareholders the final right to determine the issuance of shares or options, which is traditionally within the province of directors.104 The apparent value of voting rights is that it guarantees that shareholders have a say over matters that may affect their interests, such as take-over defences, charter amendments, and the sale of all or substantially all of the corporate understandings. The voting right also facilitates take-overs and proxy fights. Offerors of take-over bids can appeal directly to shareholders and persuade them to tender their shares, then possessing a majority of votes, and proceed to vote in new directors.105 Similar rational applies to proxy fights. Insurgent shareholders can solicit proxies from fellow shareholders, after obtaining a majority of vote, not only control the corporate management, but guarantee the right to determine the composition of the board of directors. The threat of displacement serves both as a monitoring force on the incumbent board of directors and as 0 4 BCCA S. 41(5) states that: "[u]nless there is provision to the contrary in its memorandum or articles, a reporting company may allot and issue its shares at the times, in the manner and to the persons, or class of persons, the directors determine." CBCA S.25 provides that: "[S]ubject to the articles, the by-laws and any unanimous shareholder agreement and to S.28, shares may be issued at such times and to such persons and for such consideration as the directors may determine." 1 0 5 Corporate Law, supra note 11 at 95. 42 a disciplinary mechanism by which suboptimal directors can be corrected. Empirical study shows that voting process enables corporations to operate more efficiently; and firms in which holders of voting shares are inactive in corporate governance do poorly compared with those where shareholders are active.107 Another value of voting rights to shareholders is that voting rights can decrease the risks shareholders bear.108- Residual owners' gains from their investments are closely related to the corporate well-being, and the experience of institutional investors reveals that they have more incentives to concern about what is best for the company than those with fixed claims in the firm, like creditors and bondholders.109 Easterbrook and Fischel point out that: "[y]et all of the actors, except the shareholders, lack the appropriate incentive. Those with fixed claims on the income stream may receive only a tiny benefit (in increased security) from the undertaking of a new project. The shareholders receive most of the marginal gains and incur most of the marginal costs. They therefore have the right incentives to exercise discretion."110 The assumption of these arguments is that voting makes the check over directors' discretion possible and, possibly increases the incentives of residual owners to oversee 1 0 7 F.H. Easterbrook & D.R. Fischel, "Voting in Corporate Law" (1983) 2 J. L. & Econ. 395 at 408 108 Ibid, at 403. 1 0 9 See supra note 26. 110 Supra note 107 at 403. 43 management, and more incentives produce better corporate management. Certainly, the better the corporation performs, the less risky the investment is. 2.21 Proxy System Shareholders in publicly-held corporations are usually widely dispersed. On the one hand, it is impossible for every shareholders to attend general meetings in person, on the other hand, general meetings have quorum requirements. Without general meeting, voting rights become meaningless. Thus, proxy system seems to be important in terms that it may affect how virtually all shareholder votes in these corporations are conducted.111 A growing body of evidence shows that shareholders' opposition to certain management proposals, particularly proposals to adopt take-over defences, has been on the rise, and shareholders are now inclined to criticise management.112 The existence of increasingly aware and active shareholders, particularly institutional investors, highlights the significance of proxy solicitation in opening another way for shareholders to participate in corporate governance. Proxy solicitation makes it possible for dissatisfied shareholders to defeat management proposals, even remove them from office. The right to appoint proxy(ies) is an extension of voting rights, while the right of proxy solicitation is a step taken to make full use of voting rights to improve corporate governance. 1 1 1 C. Goforth, "Proxy Reform as A Means of Increasing Shareholder Participation in Corporate Governance: Too Little, but not Too Late" (1993) 43 Am. U. L. Rev. 379 at 387. 112 Ibid, at 409. 44 Under both CBCA and BCCA, directors of publicly-held corporations are obliged to solicit proxies from each shareholder entitled to receive the notice of shareholders' meetings.113 The mandatory solicitation of proxies gives an opportunity to inform every shareholder of the information as to the matters to be voted on at the meeting because directors must accompany the proxy form with an information circular setting forth sufficient information in a specified form.114 The underlying assumption of such disclosure requirement is that shareholder demand more information about corporate matters than directors provide voluntarily and desire to be involved in setting corporate policy, and they are easily misled and vote contrary to their interests unless the type and accuracy of information provided to them is carefully regulated.115 To make the voting process a "fair corporate suffrage",116 law requires that any solicitor of proxies should disclose material information about the transactions to be voted on to shareholders from whom proxies are solicited. CBCA S. 135(6) requires that the nature of transactions be disclosed in sufficient details so that shareholders can make a reasoned 113 CBCA S. 149(1). BCCA S. 177. CBCA requires that the solicitation must be made concurrently with the notice of meetings, while BCCA requires that the proxy must be mailed to shareholders concurrently or before the sending of notice of meetings. 114 BCCA S. 178(1) (a), S. 181 and Form 24. CBCA S. 150(l)(a) and Canadian Business Corporation Regulations, SOR/94-419, S. 35. [hereinafter CBCA Reg.] 115 Supra note 107 at 449. 1 1 6 J.E. Fisch, "From Legitimacy to Logic: Reconstructing Proxy Regulation" (1993) 46 Van. L. Rev. 1129 at 1195. Fisch defines the terms as "a voting process in which shareholders are able to voice their concerns and objectives, communicate them to fellow shareholders, and implement them in corporate decisions." 45 judgement concerning the proposed matters.117 BCCA has the similar standard.118 Courts also sought to ensure that adequate information is provided to shareholders and have formulated the common law interpretation of the "materiality" of information that should be disclosed. In TSC Industries Inc. V. Northway Inc.119 the United States Supreme Court held that if there was a substantial likelihood that a reasonable shareholder would consider the omitted information important in deciding how to vote, the omitted information was material and should be disclosed.120 The propensity to affect the voting process is found to be the essence of this standard, which narrows the criterion in Mills V. Electric Auto-Line Co.121 in that the sufficient likelihood that the disclosure of the omitted information would have caused reasonable shareholders to change his vote is no longer necessary. What TSC standard really implies is: "a showing of a substantial likelihood that, under all the circumstance, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder. Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investors as having significantly altered the "total mix" of information made available."122 The Canadian case Harris V. Universal Explorations Ltd. concurred with this theme.123 1 1 7 See also CBCA Reg. S. 35(jj). 1 1 8 See BCCA Form 24, Item 11. 1 1 9 426 U.S. 438 (1976). 120 Ibid, at 449. 1 2 1 396 U.S. 375 (1970). 122 Supra note 116 at 449. 1 2 3 (1982) 17 B.L.R. 135 (Alta. C.A.). 46 To enhance communication among shareholders as to their common concerns about corporate governance is another object of proxy rules. Under CBCA S. 137, shareholders entitled to vote at the annual meeting of shareholders have the right to submit to the corporation a proposal stating any matter that they want to discuss at the meeting, and directors are obligated to include such proposal in directors' proxy soliciting materials, and disseminate them at the expense of the corporation. Shareholders may also request that a supporting statement not more than two hundred words for the purpose of elaborating the proposals be included and distributed.124 Shareholders holding in aggregate not less than five percent of all the voting shares or of voting shares in one class of the corporation are entitled to nominate directors to be elected at the meeting.125 The major policy argument supporting the shareholder proposal rule is the shareholder consultation rationale, which posits that shareholder proposal process allows the presentation of different views to shareholders, especially those views that may be disfavoured by directors, and through this process, shareholders can achieve consensus and place the board of directors on notice of their expectations. 1 2 6 Such access to directors' proxy circulars is especially useful for shareholders who cannot afford to launch a proxy fight, but disagree with management on its certain policies. Shareholders in the US 124 CBCA S. 137(1)(2)(3). 125 CBCA S. 137(4). 1 2 6 E.A. Welter, "The Shareholder Proposal Rule: A Change to Certainty" (1992) 60 Geo. Wash. L. Rev. 1980 at 1994. 47 have shown more interests in making proposals than the counterparts in Canada. A study of shareholder proposals in the US in recent years reveals that the number of shareholder proposals is growing, especially those relating to corporate governance; and shareholders proposals are receiving a greater share of the vote, even over management opposition.127 The increasing use of shareholder proposals in the US is suggestive of its utility for shareholders in terms of corporate governance, and may receive some attention from Canadian shareholders. To have proposals included in directors' proxy circulars, shareholders have to follow certain procedural and substantive requirements posed by law. Proposals can be denied by the directors for the reason that their primary purpose is to enforce a personal claim to redress a personal grievance against the corporation or its directors, officers or security holders, or to promote general economic, political, racial, religious, social or similar causes or to secure publicity.128 There are other forums existing for the expression of these concerns.129 Proposals may also be rejected if they are substantially the same ones submitted and defeated within two years preceding the receipt of the inclusion request,130 127 Supra note 111 at 410. 128 CBCA S. 137(5)(b)-(c). The leading case regarding the exclusion of proposals whose primary purpose is to promote general economic, political, racial, religious, social or similar courses is Medial Committee for Human Rights V. Securities & Exchange Commission 432 F.2d 659 (1970), 404 U.S. 403 (1972); and Varity Corp. V. Jesuit Fathers of Upper Canada (1987), 59 O.R. (2d) 459. After the Medical Committee case, this exclusion was eliminated. For a detailed discussion of the development of shareholder proposal rules in the U.S., see supra note 126 at 1989. 129 Medical Committee for Human Rights V. Securities & Exchange Commission, 432 F.2d 659 at 677. CBCA S. 137(5)(d). 48 not submitted at least ninety days before the anniversary date of the previous meeting,131 or shareholders failed to present, in person or by proxy at the meeting, proposals included in the directors' proxy material within the previous two years.132 When disputes concerning the inclusion or exclusion of proposals arise, both directors and shareholders can apply to court for an order to exclude or include the proposal in directors' proxy circular.133 It is incumbent on the applicant to prove that the proposal is or is not permitted to be included by law.134 Cost allocation rules of proxy contest play a significant role in potential dissidents' decision to wage a contest and consequently have a substantial impact on the frequency with which the proxy campaigns are waged and how vigorously they are conducted.135 Both BCCA and CBCA are unclear about the allocation of the costs of proxy campaign incurred by directors and shareholders. 131 CBCA S. 137(5)(a). 132 CBCA S. 137(5)(c). 133 CBCA S. 137(8)-(9). 134 Supra note 129 at 680. 1 3 5 L.A. Bebchuk & M. Kahan, "A Framework for Analysing Legal Policy Toward Proxy Contests" (1990) 78 Cal. L. Rev. 1073 at 1075. 49 Vaughan Williams L.J. stated in Peel V. London and Northwestern Ry. Co. that it is directors' positive duty to take care that shareholders get a sufficient statement of the facts which will be considered important, and such informing and advising expenses, being incidental to and consequential on directors' execution of their managing duty, should be borne by the corporation.137 Buckley L. J. added more details to the foregoing standard. He held in his judgement that: "the point here decided is that directors bona fide acting in the interests of the corporation, and not to serve their own interests, are entitled and bound to inform and guide the corporations in matters affecting the corporate interests, and any expenses reasonably incurred in so doing may be borne out of the funds of the company."138 The tenet in this case was assented to by the American case Rosenfeld V. FairchUd Engine and Airplane Corp..139 According to these cases, the costs of proxy solicitation by directors are normally paid by the corporation. However it may be difficult to discern proxy solicitation by directors [1907] 1 Ch. 5 (C.A.). Ibid at 13-14. Ibid, at 21. 128 N.E. 2d 291 (N.Y. Ct.App. 1955). The rule adopted in this case is that: "in a contest over policy, as compared to a purely personal power contest, corporate directors have the right to make reasonable and proper expenditures, subject to the scrutiny of the courts when duly challenged, from the corporate treasury for the purpose of persuading the stockholders of the correctness of their position and soliciting their support for policies which the directors believe, in all good faith, are in the best interests of the corporation.?" at 293. 50 solely for the purpose of entrenching themselves from those motivated by the best interests of the company. To dissidents, the rule is different. Also in Rosenfeld, the court adjudicated that shareholders had the right to reimburse successful dissidents for the reasonable and bona fide expenses, subject to court scrutiny.140 That is to say that only dissidents can decide to reimburse themselves only after they have obtained the control of the corporation. It is unclear whether shareholders will be reimbursed if they win the proxy fight for corporate affairs, like charter amendments, but the incumbent control is unchanged. However, it is apparent that success-contingent rules of cost allocation has a chilling effect on potential dissidents' incentive to participate into the proxy contest. 2.22 Problems with Voting System The current voting system is not free of problems. It chills shareholders' incentive to actively involve in the proxy process, especially the proxy contest. First of all, every dissident solicitor of proxy must make sufficient disclosure of material facts to other shareholders, which is expensive to most shareholders. Secondly, the meaning of solicitation is unclear,141 which may dissuade shareholders from communicating with 140 Ibid, at 293. 1 4 1 The boundaries of solicitation are far from clear. According to CBCA S. 147, "the sending of a form of proxy or other communication to a shareholder under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy" can be an activity of solicitation. The definition in BCCA has the same wording. According to such a definition, most shareholder communication activities can be easily interpreted as solicitation by the court. 51 others in the fear of being caught to be soliciting proxy then having to make the expensive disclosure. Thirdly, the rule of success-contingent cost reimbursement to dissidents discourages proxy fights. Finally, directors usually control the proxy agenda. Directors control what shareholders get to vote on, when they get to vote, what order proposals are offered in, and when shareholders learn what's on the agenda; in sum, directors have superior information about the vote.142 After the proxy card come in, directors have a range of options, including increased campaign efforts, targeted lobbying of shareholder who have voted against them, and strategic withdrawal of a proposal.143 A combination of the above factors put shareholders in a disadvantageous position compared with directors in voting, in particular, proxy process. Such impact is obviously contrary to the original intention of the drafters of voting rules. The rational apathy of shareholders, the inherent problem with shareholders' voting first pointed out by Berly and Means in their landmark work,144 has attracted much attention from academics. The economic reason of the rational apathy is that the aggregate costs to shareholders of informing themselves of potential corporate actions, assessing the wisdom of such actions and casting their votes greatly exceed the expected benefits generated from 1 4 2 B.S. Black, "Shareholder Passivity Re-examined" (1990), 89 Mich. L. Rev. 520 at 591-95. 143 Ibid. 1 4 4 See generally A.A. Berle & G.S. Means, The Modem Corporation and Private Property, rev. ed. (New York: Harcourt, Brace & World, 1968). 52 the informed voting. Being rational apathetic, shareholders, especially with small stake in the corporation, expect fellow shareholders to inform themselves and launch proxy campaigns, and free ride on their efforts. This is another drawback of the voting system, which is called free ride problem, and goes hand in hand with the rational apathy problem.146 Given these problems, some corporate lawyers argue that investors do not buy stock in publicly held companies with any serious expectation of participating in corporate governance, and the Wall Street Rule is the only practical choice to reasonable investors.147 The Wall Street Rule holds that shareholders who are dissatisfied with corporate performance can "vote with their feet" by selling their shares and investing in other corporations.148 Critics of this theme of arguments assert that the Wall Street Rule accelerates the turnover of stock ownership and increases volatility in capital markets, in 145 Corporate Law, supra note 11 at 390-91. There are three kinds of informational costs incurred by shareholders in a voting. The first is the cost involved in actually securing specific bits of information in the form of reliable statements about material aspect of the. transactions and the dissidents. The second kind of cost is incurred to gain financial sophistication, that is the ability to read and understand the information provided. The third kind of cost comes from the time and effort necessary to absorb the available information and reach the appropriate decision. The first kind of cost can be reduced by the mandatory disclosure requirement on directors and dissidents. The other two can't be reduced by legal regulations. See H.G. Manne, "Some Theoretical Aspect of Share Voting" (1964) 64 Colum. L. Rev. 1427 at 1440. 146 Corporate Law, supra note 11 at 392-93. 147 Supra note 126 at 2001. 1 4 8 Louis Lowenstein, "Beating the Wall Street Rule with a Stick and Carrot" (1988) Annual Rev. BankingL. 251 at251,citedinsupranote 111 at407. 53 which case would depress the market, and result in a lower return on investments than the market would normally provide.149 They are optimistic about shareholders' participating in corporate governance, because of the growth of institutional investors' stock ownership. Due to their large size of ownership, institutional investors cannot exit the companies in which they invest as easily as the Wall Street Rule depicts. Moreover, these institutions have the resources and financial incentives to undertake a more active role in corporate governance.150 Since they own shares in a wide range of companies and some structural and procedural problems cut across a number of companies, they can achieve economics of scale in informing themselves of the facts of companies and face a lower informational 2.30 Directors' Duties It has long been a principle of common law that directors are fiduciaries of the company and owe their duties only to the company.152 Prior to the statutory codification of directors' duties, the court had taken an eclectic approach to formulate workable system 14s' Supra note 111 at 407. 1 5 0 Ibid, at 405-07. 151 Supra note 142 at 575-80. Notwithstanding the economics of scale and more incentives, institutional investors have other drawbacks as an active monitor of corporate governance. See supra note 47-49 and accompanying text. 1 5 2 See Percival V. Wright, [1902] 2 Ch. 421. 54 of rules applicable to directors, by looking into the law of trusts and agency.153 From the current statutory provision, it can be seen that these common law rules have substantial influence in shaping the statutory provisions regarding directors' duties. Before proceeding further, one point merits note. While the managing power is granted to the board of directors as a collective, the duties are imposed by statutes on directors individually; in other words, every individual director carries the same duties as others and each director is supposed to honour duties when he participates into collective activities. 2.31 Duty of Care, Diligence and Skill The modern statutory requirement of care, diligence and skill is derived from the common law principle, mainly the rules articulated in Re City Equitable Fire Insurance Company Ltd..™ In this case, a director was required of a degree of skill that may reasonably be expected from a person of his knowledge and experience, namely the director's own qualification and experience is the criterion of his conduct. As long as honesty and good faith are shown, stupidity of a director doesnot matter. Also, a director 1 5 3 In determining what duties were imposed on the directors and to whom these obligations were owned, the normal approach the court took were to compare directors' position with that of trustees, but the court was aware that a trustee was the legal owner of the trust res, while title to corporate property was not vested in the directors but in the corporate entity. Therefore, the court sought alternate designation, and the most popular variation was that of agent. There was inaccuracy with agent. A normal agent is one who is subject to others' control, however, a corporation does not control its directors, rather the directors control it. Moreover, directors are not subject to the direct will of the shareholders; the shareholders' control was through elections. Therefore, the court dipped into both the law of trusts and agency to formulate duties of directors at common law. E.E. Palmer, "Directors' Powers and Duties" in J.S. Ziegel, ed., Studies in Canadian Company Law, Vol. 2 (Toronto: Butterworths, 1967) 365 at 366-67. [1925] 1 Ch. 407. 55 is not bound to give continuous attention to affairs of the corporation. In the absence of grounds of suspicion he is fully justified in trusting corporation officials to be honest.155 With some variations, these rules served as the background for statutory stipulation of the duty of care, diligence and skill. Under CBCA and BCCA, directors shall exercise the care, diligence and skill of a reasonably prudent person in comparable situations.156 Although this criterion retains the subjective nature of the common law test,157 it is evident that the current standard is more exacting. The present requirement can be broken down to three kind of obligations: duty of care, duty of diligence and duty of skill. The duty of care requires a director, based on common sense, "must act deliberately and cautiously and try to foresee the probable consequences of a proposed course of action".158 Directors should also make inquires which a person of reasonable prudence in the like position would make.159 This is the duty of diligence. It is an evident change to the duty of skill that directors should have the skill of a reasonably prudent person in comparable situations. The statutory reference to a "reasonably prudent person" requires a directors to rise to the level of a reasonably 1 5 5 Alberta Institute of Law Research and Reform, Corporate Directors' Liability (Edmonton: Institute of Law Research and Reform, 1989) at 8-10. 156 BCCA S. 142(l)(b). CBCA S. 122(l)(b). 157 Corporate Law in Canada at 332. 1 5 8 The Continuing Legal Education Society of British Columbia, Company Law (Vancouver: Continuing Legal Education Society of British Columbia, 1987) at 4.1.06. 159 Ibid, at 4.1.06. 56 prudent person if his skills happen to be below that level. It is arguable what this standard does to those directors with some special skills and knowledge, such as lawyers who sit on the board. A broad reading of the statutory provisions, in conjunction of the purpose of the legislation, needs such directors to exhibit skills of a reasonably prudent person with that special skill and knowledge ,160 In addition to duties alluded above, in order to demand more diligence, directors are encouraged to attend board or committee meetings. Both CBCA and BCCA impose liability on absent directors for their constructive consents to board resolutions that are in violation of laws. CBCA S. 123(3) provides that a director who was not present at a meeting at which a resolution was passed or action taken is deemed to have consented thereto unless within seven days after he becomes aware of such resolution or action he notifies his dissent to the company. BCCA S. 151(6) is in the same vein except that it only applies to some types of transactions specified in S. 151(1). In modern corporations, given the volume and complexity of transactions to be executed, directors are entitled to rely on the officers of the company, subject to being cautious and diligent in monitoring officers. CBCA S. 123(4) permits a director to rely in good faith on: Ibid, at 4.1.07. 57 "(a) financial statements of the corporation represented to him by an officer of the corporation or in a report of the auditor of the corporation fairly to reflect the financial condition of the corporation; or (b) a report of a lawyer, accountant, engineer, appraiser or other person whose profession lends credibility to a statement made by him." BCCA S. 151(9) is more restrictive in this respect in that it is silent on directors' reliance on statements or reports of persons whose profession could lend credibility to a statement. The U. S. law contains a judicially created doctrine dealing with directors' duty of care, diligence and skill, which is called "business judgement rule". The rule is.a "presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company."161 Directors are shielded from liability unless it is shown that their decisions are primarily based on perpetuating themselves in office, or some other breach of fiduciary duties, such as lack of good faith, fraud, or being uninformed.162 To be protected by this rule, a director has to show good faith and conduct reasonable investigation, which involves having all material information reasonably available to them, prior to making decisions.163 Aronson V. Lewis, 413 A.2d 805 (Del. Supr. 1984) at 812. Supra note 77 at 953-55. Zapata Corp. V. Maldonado, 430 A.3d (Del. Supr. 1984) 779 at 782. 58 Absent from fraud, overreaching and mala fide, directors are found liable only for those decisions made on the basis of gross negligence.164 The business judgement rule is consistent with the statutory principle that the business and affairs of a company are managed by its board of directors. This rule exists to protect and promote the full and free exercise of the managerial power of directors. This rule stands for the objective of the modern economy to preserve and enhance the competitiveness of enterprises in that it gives much freedom to directors to move quickly and to take big risks.165 Unfortunately, this rule has not been well adopted by Canadian 2.32 Duty to Act Honestly and in Good Faith and in the Best Interests of the Company Under CBCA and BCCA, directors have the duty to act honestly and in good faith and in the best interests of the company.167 This duty is usually called the duty of loyalty or the 164 Supra note 161 at 812. This is a civilian term. "[T]he qualifying adjective suggests a particularly lax duty, not a boorish tortfeasor." See Corporations, supra note 18 at 593. It is the want of ordinary diligence and care which usually prudent man takes of his own property. See H.C. Black, Black Law Dictionary, 4th ed. (St. Paul, Minn.: West Publishing, 1968) at 1185. 1 6 5 R.B. Perkins, "The ALI Corporate Governance Project in Midstream" (1986) 41 Bus. Lawyer 1195 at 1197. 1 6 6 However, this rule has had an impact on the approach of Canadian courts in analysing fiduciary law and the oppression remedy. See Corporations, supra note 18 at 603. 167 CBCA S. 122(l)(a). BCCA S. 142(l)(a). 59 fiduciary duty.168 The duty of honesty requires being open with fellow directors and always telling them the truth, in particular, refraining from secret profits or conflicts of interest.169 The duty to act in good faith and in the best interests of the company requires directors to exercise powers in the best interests of the company as a whole and not for any improper or collateral purpose.170 Chief Justice Alaskan in Canadian Are Service Ltd. V. O 'Malley interprets the fiduciary duty as loyalty, good faith and avoidance of a conflict of duty and self interest.171 The concept of good faith is not clearly defined in the statute. The definition in Black's Law Dictionary is an honest intention to abstain from taking any unconscientious advantage of another, even through technicalities of law.172 Put in the context of a director, this interpretation reads as importing refraining from self-interesting actions. If this reasoning is appropriate, what the duty of good faith adds to the duty of honesty and the duty to act in the best interests of the company is questionable. 1 6 8 The concept of fiduciary duty was developed by the court of equity over centuries. Such duty exists in fiduciary relationships, which is diverse, including trustee-beneficiary, agent-principal, and solicitor-client relationships. These relationships have the same characters: (a) The fiduciary has scope for the exercise of some discretion or power. (b) The fiduciary can unilaterally exercise that power or discretion so as to affect the beneficiary's legal or practical interests. (c) The beneficiary is peculiarly vulnerable to or at the mercy of the fiduciary holding the discretion or power. Director-corporation relationship fits the description. See Corporate Law in Canada at 378-81. 169 Supra note 158 at 4.1.05. 170 Ibid, at 4.1.05. 1 7 1 [1974] S.C.R. 592 at 620. 172 Black Law Dictionary, Supra note 164 at 822. 60 Directors' fiduciary duty generally arises in three situations where: ( 1 ) a director personally contracts with or competes with his company or is a director of two companies that contract with each other; (2 ) a director is motivated other than by the best interest of the company; ( 3 ) a director profits from business opportunity that comes to him in the course of his execution of managerial duties. 2.33 Disclosure of Interests in Transactions and Offices In Aberdeen Ry. Co. V. Blaikie Brothers, Lord Cranworth L.C. held that: "[i]t is a rule of universal application that no one having such duties to discharge shall be allowed to enter into engagements in which he has or can have a personal interest conflicting or which possibly may conflict with the interests of those whom he is bound to protect. So strictly is this principle adhered to that no question is allowed to be raised as to the fairness or unfairness of a contract so entered into."173 Such a rule of rigidity, on one hand, can prevent a director from transferring wealth from the company to himself through a self-interesting contract, on the other hand, will impose costs on corporations in certain situations. A company, in financial difficulties, is unlikely to get outside financing, but if directors are willing to save the company by granting it loans, there is no reason to invalidate such transaction even though it is not negotiated at an arm's length. Fortunately, such rigidity hasnot been accepted by the modern statute. [1843-60] All E. R. Rep. 249 cited in Corporations, supra note 18 at 643. 61 Under BCCA and CBCA, an interested director should disclose the nature and extent of his interest to the board of directors or shareholders' general meetings.174 However, the criteria of being "interested" in these two statutes are unclear, nor identical. A broad reading of BCCA S. 144 (l)-(3) may justify an argument that if a director is a "member, director or officer of a specified corporation," or if he is a "partner in, or owner of, a specific firm,"175 he is interested under BCCA. A director who is a party to a material contract or is a "director or an officer of or has a material interest in any person who is a party to a material contract or proposed material contract with the corporation." is deemed to be interested under CBCA.116 The "materiality" of contracts and interest in the provisions of CBCA is also left to be judicially defined.177 The rigidity of the rule in Arberdeen is relaxed in the statute. If a director is interested, he doesnot have to account to company for any profit that he makes therefrom, provided that certain requirements are satisfied. Under CBCA, an interested director, in order to make the transaction unavoidable by shareholders, has to disclose the nature and extent of his interest to other directors or to shareholders and the transaction has to be fair, 174 BCCA S. 144. CBCA S. 120-21. 175 BCCA S. 144.(3). 176 CBCA S. 120(1). 1 7 7 Professor Welling argues that the purpose of the legislation is to ensure that the bargain is negotiated effectively by the director on behalf of the corporation, therefore any personal relationship or monetary interests that might be thought to be inhibiting a director from so doing is a material interest. But he doesn't touch on the "materiality" of a contract. See Corporate Law in Canada at 452. 62 reasonable and approved by directors or shareholders.178 BCCA is similar on this matter, except that the reasonableness and fairness requirement is necessary only for the approval by shareholders, unnecessary for the approval by the board of directors.179 For interested directors whose corporations are in the jurisdiction of the Ontario Securities Commission, the O.S.C. Policy 9.1 requires other procedures to be followed to consummate the related party transactions. Where the value of the asset or treasury security or the principal amount of the liability subject to the related party transaction exceeds 25% of the corporation's market capitalisation, such transaction should be approved by the majority of the minority shareholders of each class of affected securities. This is the so-called "minority approval rule".180 If a director holds an office whereby a duty or interest in conflict with his duty or interest as a director of the company might arise therefrom, BCCA requires him to disclose the nature and extent of the conflict.181 Accordingly, a director, who is also a director or officer of other companies that compete with the corporation, is bound to disclose to this CBCA S. 120(7). BCCA S. 145. See O.S.C. Policy 9.1 Part V & VIII. BCCA S. 147. There is no corresponding provision in CBCA. 63 effect to the board of directors. But on this matter, the statute is far from complete in that BCCA remains silent on the question of the effect of disclosure and the consequences of non-disclosure. 2.34 Proper Purpose Rule? In the English case Hogg V. Cramphorn Ltd., it was held that directors' power to issue shares was only to raise money on behalf of the corporation, and could not be used to influence and alter the control of the company.182 This is the so-called "proper purpose rule". In Canada this doctrine was declined by Teck Corp. Ltd. V. Millar,1*3 which held that directors could do such acts and things as authorised by law, and its memorandum and articles, and the only obvious limitation upon the exercise of rights, including the right to issue shares, is the obligation to serve what directors perceive to be the best interests of the corporation.184 This principle is concurred upon by Richard J. in Exco Corp. V. Nova Scotia & Loan Co., which held that the fiduciary nature of the directors' duty require that directors must be able to show that the consideration upon which the decision to issue share was based are consistent with only with the best interests of the company and inconsistent with any other interests, and directors should bear the onus of proof.185 See Hogg V . Cramphorn, [1967] 1 Ch. 254 at 267-69. [1973] 2 W.W.R. 385, (1972), 33 D.L.R. (3d) 288 (B.C.S.C.). [1973] 2 W.W.R. 385 at 404. (1987), 35 B.J.R. 149 at 261, 78 N.S.R. (2d) 91, 93 A.P.R. 91 (T.D.) 64 Certain take-over defensive tactics were approved in Olympia & York Enterprises Ltd. V. Hiram Walker Resources Ltd., on the ground that they were believed to be taken bona fide for the purpose of maximising the value of the shares for all shareholders. Another case 347883 Alberta Ltd. V. Producers Pipelines Inc. reiterated the principles articulated in the above cases, and summarised them as: "the directors must exercise their powers in accordance with their overriding duty to act bona fide and in the best interests of the corporation even though they may find themselves, through no fault of their own, in a conflict of interest situation. If after investigation they determine that action is necessary to advance the best interest of the company, they may act, but the onus will be on them to show that their acts were reasonable in relation to the threat posed and were directed to the benefit of the corporation and its shareholders as a whole, and not for an improper purpose such entrenchment of the directors."186 Therefore, Professor Welling concludes that there is no "proper purpose" doctrine in Canada, and the exercise of any power depends on the interpretation of the wording of the grant of power, and in the absence of specific restrictions in the memorandum and articles, the only requirement is to act for the best interests of the corporation.187 2.35 Accountability to Corporation for Profits Made from Corporate Opportunities Some corporate lawyers argue that the accountability principle that fiduciaries should be accountable to the company for profits made from corporate opportunities is [1991] 4 W.W.R. 577 at 595. Corporate Law in Canada at 355. 65 prophylactic in nature and is designed "not to prescribe unjust enrichment (which itself is not a test of liability but a conclusion) but to stifle the siren call of temptation."188 It is consequently proposed that the liability net should be cast wide, to make accountable any fiduciary who profited by virtue of his position, with the connection with the fiduciary position being the only issue, and any possible conflict of interest would be the target, it not being open to fiduciaries to show that the conflict is only potential, not real.189 In Regal (Hastings) Ltd. V. Gulliver, Lord Russell was of the opinion that the defendants standing in a fiduciary relationship to the Regal, having obtained profits by reason and only by reason of the fact that they were directors of Regal and in the course of the execution of their office, should be accountable to Regal for the profits made therefrom.190 The ratio in this case, whether a director is liable for accounting profits he makes depends on the degree to which the opportunity to make such profits is associated with his position as a director and the process in which he carries out managerial duties, was strictly followed in the Canadian case Peso Silver Mines Ltd. V. Cropper.191 The degree of connection required in this case, however, was found to be zero. Another Canadian case Canadian Are Service Ltd. V. O'Malley192 could also be narrowly 188 D D P r e n t i c e ; " T h e Corporate Opportunity Doctrine" (1974) 37 Mod. L. Rev. 464 at 468. 189 Corporate Law in Canada at 396. 190 Regal (Hastings) Ltd. V. Gulliver, [1942] 1 All E.R. 378 at 389. 1 9 1 [1966] S.C.R. 673, 56 W.W.R. 641, 58 D.L.R. (2d) 1. 1 9 2 [1974] S.C.R. 592, (1974), 40 D.L.R. (3d) 371. 66 interpreted as recognising the tenet of the foregoing two cases. But this case did not stop at this point. Mr. Justice Alaskan suggested that "it is a mistake, in my opinion, to seek to encase the principle stated and applied in Peso by adoption from Regal (Hastings) Ltd. V. Gulliver, in the strait-jacket of special knowledge acquired while acting as directors or senior officers, let alone limiting it to benefits acquired by reasons of and during the holding of those offices. As in other cases in this developing branch of the law, the particular facts may determine the shape of the principle of decision without setting fixed limits to it."194 He further held that "[t]he general standards of loyalty, good faith and avoidance of a conflict of duty and self-interest to which the conduct of a director or senior officer must conform, must be tested in each case by many factors which it would be reckless to attempt to enumerate exhaustively."195 This general standard is similar with the open-ended fairness standard adopted by American courts, in eschewing the exclusive touchstones applied in Regal and Peso in favour of a review of all the facts surrounding the corporate opportunity.196 Although it is Corporate Law in Canada at 398. [1974] S.C.R. 592 at 620. Ibid. This general principle "disqualifies a director or senior officer from usurping for himself or diverting to another person or company with whom or with which he is associated a maturing business opportunity which his company is actively pursuing; he is also precluded from so acting even after his resignation where the resignation may fairly be said to have been prompted or influenced by a wish to acquire for himself the opportunity sought by the company, or where it was his position with the company rather than a fresh initiative that led him to the opportunity which he later acquired." Ibid, at 607. In Canaero, it is suggested that the following factors should be taken into account: "the position or office held, the nature of the corporate opportunity, its ripeness, its specificness and the director's or managerial officer's relation to it, the amount of knowledge possessed, the circumstances in which it was obtained and whether it was special or, indeed, even private, the factor of time in the continuation of fiduciary duty 67 arguable whether the prophylactic rules in Regal or Peso survive the Canaero,191 one point is clear that the principle in Canaero requires one to look beyond the capacity and relationship issue, to focus on the specific circumstances and the general standard of loyalty, good faith and avoidance of a conflict of duty and self-interest. 2.40 Shareholder Access to Corporate Information 2.41 Disclosure of Corporate Information and Corporate Governance Shareholder access to corporate information is the fundamental principle underlying the corporate and securities laws in both the United States and Canada.198 In 1995, the where the alleged breach occurs after termination of the relationship with the company, and the circumstances under which the relationship was terminated, that is whether by retirement or resignation or discharge." Ibid, at 620. 1 9 7 The proponents of the prophylactic rules may focus on Mr. Laskin's statement to the effect that "there may be situations where a profit must be disgorged although not gained at the expense of the company on the ground that a director must not be allowed to use his position as such to make profit even if it was not open to the company...to participate in the transaction." Those who disfavour the prophylactic rules may emphasise Mr. Laskin's emphasis on factual circumstances and his remarks about Regal. See Corporations at 694. Professor Welling seems to stand firm in favour of the prophylactic rules. He expresses such view in his six propositions about the management accountability. See Corporate Law in .Canada at 408-13. F.H. Buckley argues that Regal and Peso were not overruled, because the difference between Canaero and these two cases is attitudinal, and his approach in Canaero is methodological and not ethical. F.H. Buckley, "Ratification and the Derivative Action under the Ontario Business Corporations Act" (1976) 22 McGill L.J. 165 at 201-02. 1 9 8 E.C. Harries, "Access to Corporate Information" in J.S. Ziegal ed. Studies of Canadian Corporate law 476 at 476. 68 Toronto Stock Exchange amended its listing requirements through the addition of disclosure of corporate governance, to implement recommendations in the 1994 report by the TSE's Committee on Corporate Governance.199 By obliging corporations to divulge specific information to shareholders, the objective of the disclosure regime is to "provide investors with what they need to know to help them to decide whether to buy , retain and sell corporate securities."200 A good information supply regulation can also be an effective, timely, and cheap corporate governance tool.201 By providing shareholders the information necessary to intelligent exercise of voting rights, the access of shareholders to corporate information adds substance to their voting rights. The effectively formulated obligations to supply shareholders with corporate information on directors is the efficient mechanism to reduce agency costs. Corporations are required to disclose details of the information about directors' compensation and significant transactions with companies, and such disclosure is apparently designed to help the shareholders monitor directors' self-interesting behaviours. Mandatory disclosure can save shareholders the private costs in obtaining 1 9 9 The report is Where were the Directors: Guidelines for Improved Corporate Governance in Canada, supra note 9. The 1995 corporate governance reforms made to the TSE listing rules will be discussed below. 2 0 0 B.R. Cheffins, "Corporate Governance in the United Kingdom: Lessons for Canada' (1997) 28 Can. Bus. L.J. 69 at 105. 2 0 1 L.Lowenstein, "Financial Transparency and Corporate Governance: You Manage What You Measure" (1996) 96 Colum. L. Rev. at 1336. 69 information about directors' breach of duties, thus reducing monitoring costs, ultimately agency costs.202 By the same token, mandatory disclosure at corporation's expense is a tool worth considerations in solving the problem of shareholder apathy and free ride through reducing the informational costs. The impact of mandatory disclosure on corporate governance could be appreciated through Professor Louis Loss' excellent analogy: "[p]eople who are forced to undress in public will presumably pay some attention to their figures".203Additionally, disclosure obviates substantially the need for substantive regulation and oversights upon directors, as the words of Louis D. Brandeis, "[s]unlight is said to be he best of disinfectants; electric light the most efficient policeman".204 Shareholders collect corporate information mainly through two approaches. The first one is shareholders' access to corporate records and shareholder list as a matter of right. The second is company's obligation to disclose financial data and material information on a continuing basis. The continuous disclosure requirements generally derive from one or a combination of the following four sources: (a) federal and provincial corporate acts, (b) 2 0 2 P.G. Maponey, "Mandatory Disclosure as A Solution to Agency Problems" (1995) 62 U. Chi. L. Rev. 1047 at 1050. 2 0 3 Loui Loss, Fundamentals of Securities Regulation, 2d. ed. (Boston: Little, Brown & Co., 1988) at 33. 204 Supra note 201 at 1334. 70 provincial securities regulations, (c) policy statements of securities regulatory agencies, and (d) the rules and requirements of stock exchanges in Canada. 2.42 Access to Corporate Records and Shareholder List First of all, corporations must maintain adequate accounting records and other records required by law, including: (a) articles, memorandum and amendments thereto, (b) minutes of meetings and resolutions of board and general meetings, (c) a register of shareholder, debentureholders and directors, etc.205 These records should be kept at the registered office of the corporation or another place within Canada chosen by the directors.206 Shareholders, their agents and legal representatives have the right to examine the articles, memorandum, by-laws, unanimous shareholder agreement, minutes of shareholder meetings, notices of directors, and other records allowed by law, except the minutes of directors meetings and directors resolutions, during the usual business hours of the corporation, and may take extracts therefrom, free of charge.207 Every company or its agent shall furnish to every shareholder a shareholder list setting out the names of the shareholders of the corporation, the number of shares owned by each shareholder and the CBCA S. 20(1). BCCA S. 187(1). CBCA S. 20(1) (4). BCCA S. 39, 40, 187. CBCA S. 20(4), 21 (1). BCCA S. 188. 71 address of each shareholder as shown on the records of the corporation.208 However, the shareholder list must be used for the permitted purposes.209 2.43 Continuous Disclosure of Financial and Material Information The US Securities Exchange Act of 1934 is deemed to have laid the basis for the modern continuous disclosure system in corporate and securities laws, for its requirements of annual and interim reports as well as proxies and accompanying information circulars.210 Continuous disclosure requirements can be divided into two categories, periodic disclosure and timely disclosure. While the first category involves the regular reporting to shareholders through financial statements, sometimes together with proxy materials, the disclosure of information when such information becomes material constitutes the second category.211 208 CBCA S. 21(3). BCCA S. 191(a)-(c). 2 0 9 Under CBCA S. 21(9), the shareholder list can only be used in connection with: (a) an effort to influence the voting of shareholders of the corporation; (b) an offer to acquire shares of the corporations; or (c) any other matter relating to the affairs of the corporation. CBCA S.21(9). Under BCCA, the shareholder list can only be used for the corporate purpose which means any effort to influence the voting of members of a corporation at any meeting, or to effect an amalgamation or reorganisation of the corporation. See BCCA S. 191(d), S.l. 2 1 0 J.A. Read, "Continuous Disclosure" in Complying With Public Disclosure Requirements (Toronto: Insight Press, 1994) 19, at 23. 211 Ibid, at 29. 72 An annual comparative financial statement, including an income statement, a statement of surplus, a statement of changes in financial position and a balance sheet, prepared in accordance with generally accepted accounting principles, must be filed by a reporting issuer within 140 days after the end of the latest financial year.212 This statement should also be coupled with a management discussion and analysis ("MD&A"). With a "focus on information about the financial condition of an issuer as well as its operations with particular emphasis on liquidity and capital resources",213 The MD&A requires directors to discuss the dynamics of the business and to analyse the financial statements. Shareholders can enhance the understanding of the nature of an issuer, its operations and known prospects for the future, with the help of the supplemental analysis and background material contained in the MD&A, consequently, MD&A has become an important mandatory disclosure document.214 A reporting issuer other than a mutual fund, has to file with the relevant institutions and send to shareholders, cumulative quarterly financial statements, including a statement of changes in financial position and an income statement, on a comparative basis, within 60 212 BCCA S. 196; British Columbia Company Act Regulations, 402/81 O.C. 204/81, S. 1. [hereinafter B.C. Reg.] British Columbia Securities Regulation, 479/95, S. 145(1).[hereinafter BCSA Reg.] CBCA S. 155(1), CBCA Reg. S. 44. Under BCCA and CBCA, the financial report should be accompanied by a report of the auditor. 2 1 3 National Policy Statement No.47, Sch. 2, Appendix A (1) (2). See also NIN #94/2 "Filing Requirements for Annual Information Forms". 214 Supra note 210, at 33. 73 days of the date to which they are made up.215 Regarding the interim financial disclosure, there are two points merit notes. The first one is that S. 197 of BCCA only requires semi-annual interim financial statements, and such statements do not need to be audited. The second is that CBCA itself doesnot mandate the interim financial disclosure, and reporting issuers need to file with or send to a public authority or a stock exchange or to send to shareholders the interim financial statements only when so required by other regulations and laws.216 The other part of requirements of continuous disclosure is the event-driven disclosure, timely disclosure of material information. In the context of corporate governance, such disclosure can keep shareholders update of the development about the corporate affairs that have significant impact on their shareholdings. Such disclosure, being closely tied to the occurrence of a material change in the affairs of a reporting issuer, is an effective tool enabling shareholders to oversee the progress directors are making and "blowing the whistle" timely if directors are going astray in corporate management. British Columbia Securities Act (BCSA) S. 67 requires a reporting issuer to file a press release as soon as practical where there is a material change, to disclose the nature and substance of the change. Such change should have two features: (1) it is a change in relation to the 2 1 5 See BCSA. Reg. S. 144; NIN #91/20 "Comparative Interim Financial Statements"; BOR #89/2 "Requirement to Send Interim Financial Statement to Shareholders of a Reporting Issuer" and NIN #89/5 "Introduction of Revised Quarterly Report". 216 CBCA S. 160(4). -74 business, operation, assets or ownership of the issuer; (2) it would reasonably be expected to have a substantial effect on the market price or value of any of the securities of the issuer.217 Also reportable is the decision to implement the proposed changes made by the directors of the issuer or senior management of the issuer who believe that confirmation of the decision by the board of directors is probable.218 These statutory provisions should be read in conjunction with the National Policy Statement 40 (NP 40), which expends directors' reporting obligation from material changes in BCSA to material information. Under NP 40, material information is "any information relating to the business and affairs of an issuer that results in or would reasonably be expected to result in a significant change in the market price or value of any of the issuer's securities"219 Apparently, this definition is so broad that it comprises material changes and material facts relating to the business and affairs of an issuer. To further expand the reportable subjects, NP 40 urges directors, where "an external development will have or has had a direct effect on the business and affairs of an issuer that is both material...and uncharacteristic of the effect generally experienced by other issuers engaged in the same business or industry",220 217 BCSA S. 1. 218 Ibid. 2 1 9 National Policy Statement 40 at para. D. 75 to explain the particular impact on them. Directors are the corporate agency that is responsible for determining what information is material and the timing of disclosure in the context of the issuer's own affairs. 2.44 Disclosure of Corporate Governance In 1993, The Toronto Stock Exchange Committee on Corporate Governance was established to conduct a comprehensive study of corporate governance in Canada, and to make recommendations to improve the manner in which Canadian corporations are governed.221 The report prepared by the Committee recommended a disclosure requirement with respect to corporate governance applicable to all listed companies incorporated in Canada, which was subsequently adopted by the TSE. 2 2 2 Every listed companies must disclose a "Statement of Corporate Governance Practices" in its annual report or information circular, describing the company's system of corporate governance with reference to the guidelines set out in the report of the Committee, and where the company's practice is different from the guidelines, explanations of the differences must be furnished 2 2 3 The disclosure must cover the following points: (1) the Toronto Stock Exchange Company Manual S. 472. 222 Ibid. 2 2 3 Toronto Stock Exchange General By-Law, S. 19.17 and Toronto Stock Exchange Company Manual, S. 473. The guidelines are also set forth in Company Manual S. 474. Topics dealt with in the guidelines 76 mandate and composition of the board of directors; (2) description of the mandate of the board committees, structures and processes to ensure the independence of the board from management, and the process and measures to enhance the board performance; (3) measures improving communications between shareholders and the board, and the board's expectations of management.224 For reporting issuers under Ontario Securities Act, the executive compensation became an important subject to disclose by virtue of the amendments concerning the filing and distribution of information circular in 1993.225 In accordance with the changes, a corporation must disclose by way of summary compensation table details with respect to salary, bonus, the value of share options and other compensation payable to the CEO and each of the four most highly compensated officers.226 Details are also needed on the composition of the compensation committee and its policies and factors it takes into account in determining the executive payment.227 include: responsibilities of the board of directors, the selection of non-executive directors, the composition of the board and committees, the role outside directors should play on behalf of the corporations, and the internal financial control. 2 2 4 TSE General By-Law S. 19.17 and Company Manual S. 475. Both TSE General By-Law and Company Manual are set out in V.P. Alboni, Securities Law and Practice, 2d ed., Vol. 9 (Scarborough, Ont.: Carswell, 1984^). 225 Supra note 200 at 102. The amendments were set out in Ontario Securities Act, R.S.O. 1990, CS. 5(as amended), S. 81, 86 and R.R.O. 1990, Reg. 1015, S. 5, Form 28 and Form 40. 2 2 6 Form 40, supra note 226 Item II. Ibid. Item VIII. 77 2.45 Investigation of Company by Inspector Both CBCA and BCCA set forth procedures by which, subject to certain restrictions, inspectors may be appointed by the court order or the special resolution of general meetings, to investigate the affairs and the operation of the company and any of its affiliates and to report in the manner to the persons designated by the order or resolution by which the inspector is appointed.228 To the extent that the inspector has a sweeping power of access to corporate records and a large range of information related to the corporate business and affairs, and that details of the investigation are recorded in the inspection report, shareholders' power to have inspectors appointed is a cheap, efficient and reliable furtherance of their access to corporate information, consequently the investigation regime is an important supplement to the disclosure requirements. 2.50 Liability Strategy in Corporate Governance 2.51 Liability Rules Necessary in Corporate Governance? 2 2 8 Pursuant to BCCA, only shareholder(s) holding not less than 1/5 of the issued shares of any class of the company can apply to the court for the appointment of an inspector, and shareholders can appoint an inspector by a special resolution, whereas according to CBCA, an inspector can be only be appointed by the court on the application from any shareholder, and only on the ground that (a) the business or affairs are carried on fraudulently, oppressively or unfairly prejudicially; (b) the corporation or any of its affiliates is formed or dissolved for a fraudulent or unlawful purpose; or (c) persons concerned with the formation, business or affairs of the corporation or any of its affiliates act fraudulently or dishonestly. See BCCA S. 233, 234; CBCA S. 229. 78 D i r e c t o r s a s s u m e a w i d e r a n g e o f d u t i e s , i n c l u d i n g d u t y o f c a r e , d i l i g e n c e a n d s k i l l , a n d d u t y o f l o y a l t y , a n d are sub jec t t o v a r i o u s l i ab i l i t i es f o r t he i r b r e a c h e s o f du t i es . L i a b i l i t y r u l e s i n c o r p o r a t e l a w are e n f o r c e d b y s h a r e h o l d e r s , c o r p o r a t i o n a n d o t h e r c o m p l a i n a n t s h a v i n g t h e s t a n d i n g t o b r i n g su i ts aga ins t e r ran t d i r e c t o r s . T h e n e c e s s i t y a n d a d v i s a b i l i t y o f r e t a i n i n g l i ab i l i t y r u l e s as a a c c o u n t a b i l i t y m e c h a n i s m , h o w e v e r , is c o n t r o v e r s i a l i n c o r p o r a t e l i t e ra tu re . B e f o r e p r o c e e d i n g the ana l ys i s o f t he c u r r e n t l i ab i l i t y s y s t e m , t h e c l o s e c o n n e c t i o n o f t h e d e b a t e c e n t r i n g the e f f ec t i veness o f l i ab i l i t y s t r a tegy as a c o r p o r a t e g o v e r n a n c e m e c h a n i s m w i t h t h e thes i s o f th i s a r t i c l e w a r r a n t s a b r i e f c o m m e n t o n t h i s d e b a t e . T h o s e c o r p o r a t e l a w y e r s w i t h e c o n o m i c ben t , p r o p o n e n t s o f t h e c o n t r a c t u a l t h e o r y , h o l d tha t l i ab i l i t y r u l e s o n l y p l a y a m i n o r r o l e i n a s s u r i n g d i r e c t o r s ' p e r f o r m a n c e i n p u b l i c l y - h e l d c o r p o r a t i o n s . 2 2 9 T h e i r a r g u m e n t s a re that t he m a r k e t a n d o t h e r a l t e r n a t i v e m e t h o d s o f a s s u r i n g c o n t r a c t u a l p e r f o r m a n c e h a v e e f f e c t i v e l y a l i g n e d t o g e t h e r t h e i n te res t o f d i r e c t o r s a n d s h a r e h o l d e r s , r e d u c i n g a g e n c y c o s t t o t he m i n i m u m l e v e l , a n d l i ab i l i t y r u l e s s i m p l y a d d u n n e c e s s a r y c o s t s d u e t o t he h i g h c o s t s o f l i t i g a t i o n t o e n f o r c e t h e m . A c c o r d i n g l y t hese r u l e s a re m e a n i n g f u l o n l y t o t h o s e d i v e r g e n c e o f i n te res t lef t u n p o l i c e d b y t h e m a r k e t a n d c o n t r a c t u a l m e c h a n i s m s , bu t t he c o s t s t h e r e o f m a y e x c e e d t h e e x p e c t e d b e n e f i t s . 2 3 0 L e g a l r e g u l a t o r y t h e o r i s t s asser t that o n o n e h a n d , l i ab i l i t y r u l e s h a v e l o n g b e e n 2 2 9 D.R. Fischel & Michael Bradley, "The Role of Liability Rules and the Derivative Suit in Corporate Law: A Theoretical and Empirical Analysis" (1986) 71 Cornell L. Rev. 261 at 263. 2 3 0 Ibid, at 264-76. 79 regarded as the heart of the accountability devices, for they profoundly affect the conduct of directors, at least in some aspects, by aligning the interests of directors and shareholders, and creating directors' incentives to engage in socially desirable conducts; on the other hand, market function sanctioning the errant directors for self-interesting transactions or looting corporate opportunities still remains.231 Liability rules are not cost free. Any error in courts' judgements may cause social costs. In addition a rigid liability system may deter directors from taking creative actions necessary in the competitive business environment, which in turn undermine the firm value. Such costs are called reverse incentive costs. Litigation to enforce liabilities usually consume a large amount of money and time, the so-called enforcement costs. But in the meantime, rigid liability rules may provide shareholders with deterrence benefits, dissuading directors from self-regarding actions, and urging them to perform functions better. The alluded costs and benefits should be given weight in determining whether the liability rules are socially efficient. However, they are not quantifiable with accuracy. In the absence of precise quantitative measurement, it is premature to assert that liability rules are counterproductive or inefficient. Given the fact that there is a mix of factors, such as markets, and legal regulations, shaping directorial performance incentives, it is difficult to tell the effect of any one element in isolation, and it is the same difficult to 2 3 1 See generally K.E. Scott, "The Role of Preconceptions in Policy Analysis in Law" (1986) 71 Cornell L. Rev. 299; D.E. Schwartz, "In Praise of Derivative Suits" (1986) 71 Cornell L. Rev. 322. 80 assert that liability rules play a minor role in corporate governance. These said factors are not mutually exclusive; they co-exist and play somewhat different and specialised functions. Consequently, the significance of liability strategy as a corporate governance mechanism should not be slighted. 2.52 Derivative Suit When the wronged is a corporation, the corporate personality principle will allow only the corporation and no one else to decide whether to sue.232 But this civil procedure has been overridden by the statutory derivative action. Derivative actions were developed in equity, and is designed to enable shareholders to sue in the name of the corporation when those in control of the company refuse to assert a claim belonging to it.233 According to Professor Welling, this kind of civil action is originated in America.234 Notwithstanding the corporate personality principle, "American judges have cut through this technical difficulty (by what authority is unclear) and looked at the economic reality of the situation. They noted that the shareholder is effectively prejudiced, in that any corporate loss is likely to be reflected in lower share prices or lower dividends. Consequently, they were able to identify a second-level right in Corporate Law in Canada at 525. 2 3 3 A.G.T. Moore II, "Shareholders Rights Still Alive and Well in Delaware: the Derivative Suit: A Death Greatly Exaggerated" (1994) 38 St. Louis U. J.L. 947 at 954. 234 Corporate Law in Canada at 544. 81 the shareholder, "derived" through the corporate entity, to sue the wrongdoer".235 Therefore the nature of the derivative suit is two-fold. First of all, it is the equivalent of a suit by shareholders to compel the corporation to sue because of its failure to assert its rights; secondly, it is a suit by the corporation, commenced by shareholders on its behalf, against those wrongdoers.236 The derivative suit is the sword of shareholder policing directors, with simplicity as its beauty.237 Under CBCA and BCCA, only "complainants" can have the standing to bring derivative suits, and shareholders including the beneficiary owners of shares, are indeed the entitled complainants.238 The initial procedure to start a derivative suit is a hearing by way of motion or other summary application, purported to determine whether the complainant has met the prerequisites to commence the suit and whether the leave to proceed the suit 235 Ibid, at 544. 236 Supra note 233 at 954. 2 3 7 In Foss V. Harbottle (1843), 2 Hare 461; 9 Digest (Repl.) 36; 67 E.R. 189, it was decided that a suit to redress a wrong done to a corporation, on behalf of the corporation, may not be brought by a shareholder thereof, and can be brought only by the corporation itself through resolution by the majority in general meetings, with exceptions of ultra vires acts, fraud on the minority, personal rights and special majorities, the statutes has substituted for the exceptions some more flexible prerequisites, such as the good faith of the shareholders and the interests of corporation. (These prerequisites will be discussed below). The statute makes it easier to commence a derivative suit in circumstances of other than exceptions, but makes it more difficult where exceptions would have been invoked because leave of a court to litigate is required. See, Corporations at 654. For a detailed discussion of Foss V. Harbottle, see S.M. Beck, "An Analysis of Foss V. Harbottle" in J.S. Ziegel, ed., Studies in Canadian Company Law (Toronto: Butterworths, 1967) 545. 238 CBCA S. 238. BCCA S. 225(1). But it should be noted that the scope of complaints in BCCA, mostly including shareholders and directors, is narrower than the equivalent in CBCA, whereas including shareholders, security holders, directors, administrative officer called the Director. 82 should be granted. The first prerequisite of a derivative suit is the notice from shareholders to the company to the effect that directors should commence or diligently prosecute or defend an action to assert corporation's claims, and a suit will be brought to the court if directors fail to do so.239 The most obvious purpose of this demand requirement is to give the company an opportunity to sue on its own behalf. But the court is divided in interpreting the "reasonable efforts" a complainant should make in notifying the company.240 Another prerequisite is that the action should appear to be in the interest of the company if it is brought and defended, which can be satisfied if the action is prima facie in corporation's interests.241 Since the initial hearing is to decide nothing more than whether an action should be commenced, suffice it to prove that the complainant has adduced sufficient evidence testifying that the action, so far as can be judged from the first disclosure, is in the interest of the company.242 The third condition precedent is the good faith of complainants.243 It is 239 BCCA S. 225(3)(a). CBCA S. 239(2)(a). 240 In Re Daon Development Corp. (1984), 54 B.C.L.R. 235 (B.C.S.C.) at 240, a reasonable notice to the directors of the request together with details of the nature of the claim is the minimum requirement. In Re Northwest Forest Products Ltd,. [1975] 4 W.W.R. 724 (B.C.S.C.) at 734, no more is required than what is sufficient to found an endorsement on a generally endorsed writ of summons. In Re Bellman and Western Approaches Ltd. (1981), 130 D.L.R. (3d) 193 (B.C.C.A.) at 200-01, only a letter to the board of directors or their lawyers will suffice, and a failure to specify each and every cause of action in a notice doesn't invalidate the notice as a whole. 241 BCCA S. 225(3)(c). CBCA S. 239(2)(c). 2 4 2 See generally Re Northwest Forest Products Ltd., [1975] 4 W.W.R. 724 (B.C.S.C). 243 BCCA s. 225(3)(b). CBCA S. 239(2)(b). 83 unclear what this requirement adds to the best interest prerequisite. It is hard to imagine a scenario where a complainant, motivated by a mala fides, commences a suit which is in the interest of the company. Provided that the conditions precedent are met, the leave to proceed the suit can be granted. At common law, majority shareholders can affirm of adopt rule-violating directorial conducts, "provided that such affirmance or adoption is not brought about by unfair or improper means, and is not illegal or fraudulent or oppressive towards those shareholders who oppose it."244 This principle hasnot survived statutory derivative actions. Under both CBCA and BCCA, the approval or the anticipated approval by shareholders cannot cause the action to be stayed or dismissed, and such approval is only of evidential value as to the fairness of the transaction in making an order by the court.245 2 4 4 North-West Transportation Co. V. Beatty (1887), 12 App. Cas. 589 (Ont., J.C.P.C.) cited in Corporations, supra note 18 at 645. 2 4 5 BCCA S. 225(7). CBCA S. 242. Professor Welling argues that the elimination of the decisive role of majority ratification in dismissing a suit by shareholders on behalf of the corporation isn't originated by the statute, rather the majority shareholder ratification died in 1897 with the conclusive Salomon decision that the corporation is a legal entity separate from both its management and its shareholders. Ratification means confirming or making valid acts, compacts, or promises, by consenting or approving what has been done by someone else. A ratifier can only retify the wrongs done to himself. Similarly a majority shareholder retification can only prevent the majority from subsequently suing and by no means cures any breach of duty that was owed to the corporate person, and prevents the corporation from suing. See Corporate Law in Canada at 428-38. 84 It is a common practice in America to appoint a committee of the board by directors (called a "special litigation committee") to review shareholders' demand to commence a suit and report whether the action is in the interest of the company. The underlying premise of this practice is that whether or not to sue is within the ambit of directors' managerial powers, therefore, the business judgement rule should apply. American judges have developed two lines of attitude in reviewing special litigation committee's reports. The first is articulated in Auerbach V . Bennett: the court may inquire the adequacy and appropriateness of the committee's investigative procedures and methodologies, but there should be no judicial scrutiny of the decision itself which is within the domain of business judgement. 2 4 6 The second which is subtly different is taken in Zapata Corporation V . Maldonado: the court should not only inquire into the independence and good faith of the committee and the bases supporting its conclusions, but also should make its own independent business judgement in order to strike the balance between legitimate corporate claims contained in complainants' demand and the interest of the company expressed by the committee, and determine whether the leave should be granted. 2 4 7 2.53 Personal Suit 393 N.E.2d 994 (N.Y.C.A 1979.) at 996. Supra note 163 at 779. 85 In corporate law, a wrong may cause injury to the corporation and at the same time to one or more shareholders and a shareholder may bring a personal suit to redress the wrongs to himself.248 Unlike in a derivative suit, a shareholder needs no judicial permission to commence a personal suit. A derivative suit seeks to recover for the benefit of the corporation and its whole body of shareholders, with benefits of the judgement going directly to the corporation, while shareholders indirectly benefit from the increase in corporate share value 2 4 9 A personal suit, directed at enforcing a claim belonging to shareholders, permits benefits of the judgement to go directly to the plaintiff. The most typical personal suit is the one for remedies for oppression conducted by directors or majority shareholders. Following the English steps, nearly every Canadian corporate statute provides shareholders with the access to protection against directorial oppression.250 Although the oppression remedy is widely deemed to be applicable primarily to close corporations, the court is willing to apply it to public ones.251 The most common type of remedy application Corporate Law in Canada at 538. 2 4 9 In a derivative suit, a judge may adjudicate the benefit directly to the complaint in certain circumstances where the justice requires. For an instance, when the defendant director is also the controlling shareholder of the corporation, it is the director, not the minority complaint that gets most of the benefit of the judgement in favour of the corporation; therefore, the judgement should order the director or the corporation to buy out the complaint shareholder at the fair value of his shares. 250 Corporate Law in Canada at 555. 2 5 1 Neither BCCA nor CBCA has express limitations of types of company the oppression remedy may apply. In some cases the applications of oppression remedy in corporations with publicly traded shares have been successful. For examples Palmer V. Carling O'Keefe Ltd. (1989), 67 O.R. 161 (Ont. Div. Ct.) 86 alleges that directors have diverted corporate profits to their own uses, have used corporate money or assets for their personal advantage, or have inappropriately looted corporate opportunities.252 Such breach of obligations is also the grounds for derivative suits by shareholders, therefore, these two types of common suits overlap in grounds for 253 actions. A shareholder may apply to a court for a remedial order if: (a) the business or affairs of the corporation or any of its affiliates are or have been carried on or conducted; Or (b) the power of the directors of the corporation or any of its affiliates are or have been exercised, in a manner that is oppressive or unfairly prejudicial to or that unfairly disregards the interest of the security holders.254 Canadian courts interpret the "oppression", by adopting and Sparling V. Southam Inc. (1988), 41 B.L.R. 22 (Ont. H.C.) For a detailed discussion, see B.R. Cheffins, "The Oppression Remedy in Corporate Law: Recent Developments" (1990) 48 Advocate 361. 2 5 2 B.R. Cheffins, "The Oppression Remedy in Corporate Law: The Canadian Experience" (1988) 10 U. Pan. J. IntT Bus. L. 305 at 322. 2 5 3 For a detailed discussion of the relationship between derivative and oppression suits, see J.G. Macintosh, "The Oppression Remedy: Personal or Derivative?" (1991) 70 Can. Bar Rev. 29. 2 5 4 CBCA S. 241(1)(2). BCCA S. 224(1) has the similar wording, but the scope of oppression is narrower than CBCA, because it excludes the unfairly disregarding of the interest of security holders from the actionable grounds. 87 the words of the English case Scottish Co-operative Wholesale Society Ltd V. Meyer,255 as conduct which is "burdensome, harsh and wrongful or which lacks of probity and fair dealing to the prejudice of some portion of its shareholders."256 The court is of the view that the statutes regarding unfairly prejudicial actions, emphasise the manner in which the acts have been carried out.257 In this vein, a shareholder is not unfairly prejudiced even if he is adversely affected unless the conduct of the corporation or directors is damaging in an unjust or inequitable manner.258 While the most obvious problem with the current statutory oppression system is the lack of a conceptual framework for analysing oppressive and unfairly prejudicial conduct, the court hasnot attempted to do so either.259 Canadian court are also divided in the attitude toward the role that bad faith of the director as the defendant in the constitution of oppression.260 Canadian judges are left with the power to determine what oppression and unfair prejudice mean, and their dominant viewpoint is that the interpretation of these terms should be based on the fairness of conducts of directors and majority [1959] A.C. 324. Supra note 252 at 320. Brant Investment V. KeepRite Inc. (1991), 3 O.R. (3d) 289 (Ont. CA.) at 305. Supra note 252 at 321. "The Oppression Remedy in Corporate Law: Recent Developments" Supra note 251 at 365. Ibid at 366. 88 shareholders.261 The broad wording of oppression and unfair prejudice, and judge's discretion in interpreting their meaning based on the fairness concept in specific situations make the connotation of oppression remedy open-ended. The very open-endedness of the oppression remedy makes it, beyond question, the broadest and most comprehensive shareholder remedy in the common law world,262 and the most important and the most enduring of the corporate reforms of the 1970s and 1980s.263 2.54 Application for Compliance, Restraining and Corrective Orders When there is the default, defect, or irregularity of directorial compliance with corporate statutes, regulations, articles, by-laws, resolutions of any general, class or series meeting, resolutions of the board of directors, or a unanimous shareholder agreement, shareholders can apply to the court for an order directing directors to comply with or restraining such persons from violating any provisions thereof, and the court can make any further order it thinks fit.264 BCCA has gone further than CBCA in rectifying and restraining directors' deviation from obligations by allowing the court to make the order it thinks fit on its own motion.265 In the circumstance of an interested contract of directors Supra note 252 at 314. Ibid, at 305. Corporate Law in Canada at 525. CBCA S. 247. BCCA S. 230(1). BCCA S. 230(l)(d). 89 with the company, undisclosed to the board of directors or shareholders or unapproved thereby, a shareholder can apply to the court to set aside the transaction, or enjoin the company from entering thereto, or any other orders the court thinks appropriate.266 Such actions for compliance, restraining or corrective orders, in nature, are neither derivative nor personal. On one hand, they are different from derivative suit in that shareholders need no judicial leave before commencing them, on the other hand, they do not share causes of action with personal suit, because grounds concerning the wrong done to the corporation itself, like the appropriation of corporate assets by directors through self-interesting transactions with the company can apparently enable shareholders to apply for an order. The access to such suits give shareholders the standing to quickly invoke judicial discretion to review directors' alleged violation of obligations, whereas the oppression remedy is always invoked only when the applicant has all the equities while all the strict legalities favour the other side.267 2.55 Shiftable Liability: Indemnity and Insurance In corporate governance, the deterrence of a strict liability system is as significant as the continued service of competent and experienced people in the board of directors and the BCCA S.146. CBCA S.120 (8). Corporate Law in Canada at 554. 90 assurance that they will be able to exercise their business judgement without fear of personal liabilities, as long as they honour the basic duty of honesty, care and the duty to act in the best interest of the company.268 In corporate law, the indemnification and insurance for directors is the mechanism to "accommodate the tension between society's interest in corporate accountability to the public and society's concomitant interest in attracting entrepreneurial, aggressive directors."269 Under CBCA, there are mandatory and permissible indemnity to directors. A director is to be indemnified as a matter of right in respect of all costs, charges and expenses reasonably incurred by him in connection with the defence of any civil, criminal or administrative action or proceeding to which he is made a party by reason of being or having been a director of the company, if he is substantially successful on the merits in his defence of the action or proceeding.270 Judicial approval is not required for such indemnification. But the meaning of the term "substantially successful" remains far from clear. Is the director successful if the action is dismissed for the failure of observance of the due procedure? Is the director successful if the action is discontinued by the plaintiff without any form of adjudication? What is the extent to which the director's success is substantial? These questions are left open. 2 6 8 Paula Walter, "Statutory Indemnification and Insurance Provisions for Corporate Directors: To What End?" (1989) 38 Drake L. Rev. 241 at 242. 269 Ibid. 2 7 0 CBCA S. 124(3). 91 E v e n i f a d i r e c t o r c a n n o t b e i n d e m n i f i e d as a m a t t e r o f r i gh t , t h e f i r m m a y s t i l l i n d e m n i f y h i m p u r s u a n t t o CBCA S . 1 2 4 ( l ) - ( 2 ) . B u t t he s t a n d a r d f o r i n d e m n i f i c a t i o n i n d e r i v a t i v e a c t i o n set f o r t h i n S . 1 2 4 ( 2 ) is h i g h e r t h a n tha t f o r n o n - d e r i v a t i v e a c t i o n p r o v i d e d i n S . 1 2 4 ( 1 ) . F o r a d e r i v a t i v e a c t i o n , c o u r t a p p r o v a l is r e q u i r e d f o r i n d e m n i f i c a t i o n , w h i l e u n n e c e s s a r y f o r n o n - d e r i v a t i v e a c t i o n s . T h e c o m m o n p r e r e q u i s i t e s f o r i n d e m n i f i c a t i o n i n b o t h S . 1 2 4 (1 ) a n d (2 ) a re tha t a d i r e c t o r s e e k i n g i n d e m n i f i c a t i o n , (a) ac t s h o n e s t l y a n d i n g o o d f a i t h w i t h a v i e w t o the bes t in te res t o f t he c o r p o r a t i o n ; a n d (b) h a s r e a s o n a b l e g r o u n d s f o r b e l i e v i n g tha t h is c o n d u c t is l a w f u l i n t h e c a s e o f a c r i m i n a l o r a d m i n i s t r a t i v e a c t i o n o r p r o c e e d i n g tha t is e n f o r c e d b y a m o n e t a r y p e n a l t y . 2 7 1 A l i t e ra l r e a d i n g o f t he s t a t u t o r y w o r d i n g c a n te l l tha t t he s c o p e o f i n d e m n i f i c a t i o n , m a n d a t o r y o r p e r m i s s i b l e , is r e s t r i c t e d t o b r e a c h e s o f d u t y o f d i l i g e n c e , c a r e a n d s k i l l , w h e r e a s t h e b r e a c h o f f i d u c i a r y d u t y is a p p a r e n t l y e x c l u d e d f r o m b e i n g i n d e m n i f i e d . T h e o n l y d i f f e r e n c e BCCA has f r o m CBCA is tha t BCCA has n o d i v i s i o n b e t w e e n m a n d a t o r y a n d p e r m i s s i b l e , n o r b e t w e e n d e r i v a t i v e a n d n o n - d e r i v a t i v e ; b e c a u s e a n y i n d e m n i f i c a t i o n n e e d s c o u r t ' s a p p r o v a l . CBCA p e r m i t s c o m p a n i e s t o p u r c h a s e i n s u r a n c e f o r a d i r e c t o r aga ins t a n y l i ab i l i t y i n c u r r e d b y h i m i n t h e c a p a c i t y as a d i r e c t o r e x c e p t t h o s e r e l a t e d t o h i s f a i l u r e t o ac t 1 CBCA S. 124(1). 92 honestly and in good faith with a view to the best interests of the corporation.272 Like the matter of indemnification, liability insurance is also limited to those for breaches of duty of diligence, care and skill. Under BCCA S. 152(4), a company is allowed to purchase insurance for directors against any liability incurred in the capacity as directors. Whether S. 152(4) is contradictory to S. 143 is another question to be answered.273 Indemnity and insurance have two sides as other things do. While an abling director is persuaded to sit in the board of directors, and is assured of the discretion in business judgement, the existence of indemnity and insurance may sap his incentive to take care of the corporate business and affairs because he can pass on the burden of liability to the company or other insurance buyers, undermining the efficiency motives in imposing liability.274 Additionally, shareholders' incentive to litigate to enforce the directorial liability for breaches of duty of diligence, care and skill is likewise weakened. 272 CBCA S. 124(4). 273 BCCA S. 143 provides that: "[t]he provisions of a contract, the memorandum or the articles, or the circumstances of his appointment shall not relieve a director from the duty to act in accordance with this Act and the regulations, or from any liability that by virtue of any rule of law would otherwise attach to him in respect of any negligence, default, breach of duty or breach of trust of which he may be guilty in relation to the company." It is arguable whether the liability insurance is tantamount to a kind of relief of a director from the liability against which he is insured. Corporations, Supra note 18 at 639. 93 2.60 Summary Corporate law, securities acts, and securities commission policies as well as stock exchange requirements intertwine and form the web of corporate governance. With the focus of this article on the interaction between shareholders and directors, this chapter reviews the governance mechanisms available to shareholders to enforce the accountability of directors who have the power to manage and supervise the business and affairs of the company. Directors have the managerial power granted by statutes, articles and unanimous shareholder agreements, independent from shareholders' interference within clearly delimited ambit. Shareholders retain the ultimate control of the company through exercising voting rights to appoint and remove directors, to approve fundamental changes in corporate affairs, or to terminate the life of the company. As the furtherance and supplement of voting rights, proxy system becomes increasingly important in public companies. By virtue of proxy, shareholders can not only exercise and enjoy the benefit of voting rights without going to the shareholder meeting, but also communicate with fellow shareholders, propose business initiatives to influence the board of directors, and wrest the control of the company. The substantive and procedural unclarity and obstacles within the current proxy system should be eliminated in order to let shareholders access to communication and proxy machinery more easily. 94 Disclosure is playing an increasingly important role in corporate governance, especially after the reform of the TSE listing rules. On one hand, disclosure helps investors decide whether to buy or sell stocks; on the other hand, equips shareholders with information necessary for intelligent exercise of voting rights. With corporate statutes, securities acts, and securities commissions policies as well as stock exchange requirements as the sources of disclosure obligations, the disclosure regime for public companies is the most complex governance mechanism. An obvious challenge in this system is to decide the volume of information required for shareholders to make an informed decision in light of the necessary costs for the company and the rational apathy of shareholders. Directors are required to exhibit the diligence, care and skill of a reasonably prudent person in similar situations, and to act honestly, in good faith with a view of the best interests of the company. These duties are crafted so that, on the one hand, the accountability is assured; on the other hand, directors are given discretion to exercise the business judgement corresponding to the actual competitive surroundings. To back up and enforce directorial duties, liability strategy is the final front where shareholders can have directors live up to the duties. Statutory grounds for derivative and personal actions, application for restraining, compliance and corrective orders as well, are open-ended to give grieved shareholders opportunities to be redressed. To strike the balance between the management accountability and social desirability of aggressive entrepreneurs and business judgements, indemnification and insurance are allowed to be provided to directors. 95 CHAPTER III: REVIEW OF LEGAL ASPECTS OF CORPORATE GOVERNANCE OF COMPANIES LIMITED BY SHARES IN CHINA. 3.10 Introduction of the Stockholding System in China China's economy has been growing with a rapid speed, thanks to the strong driving force of reform and opening policy initiated by Deng Xiaoping, the late paramount architect of reform. The momentum of economic development has injected fuel to the taking off of the stock market in China. The two national stock exchanges opened respectively in Shenzhen and Shanghai in the early of 1990s, have tremendously uplifted the evolving capital market. Over about seven years, the stockholding system in China has fulfilled its original purpose to raise capital to speed up modernisation.275. The promulgation of the Company Law of the People's Republic of China was an important step in the evolution of the stockholding system.276 With an emphasis on establishing a modern enterprise system, through converting state-owned enterprises into independent and commercially viable market participants,277 the PRC Company Law provides a solid basic legal work for companies carrying out business activities in China.278 In addition, the 2 7 5 For a general discussion of the development of stock markets in China, see Andrew X. Qian, "Riding Two Horses: Corporatisation Enterprises and the Emerging Securities Regulatory Regime in China" (1993) 12 UCLA Pac. Basin L.J. 62. 276 Zhonghua renming gongheguo gongsifa (The Company Law of the People's Republic of China) in China Current Laws 1994 Vol. 4 Issue 3 [hereinafter PRC Company Law]. 277 PRC Company law Art. 1. 2 7 8 David Ho, "China's New Company Law: Something Concrete to Go By" (1994) 16 East Asian Executive Reports 9 at 14. 96 PRC Company Law depicts a legal framework for entities selling shares in capital markets, attracting active and passive capital from both domestic and overseas.279 Under the PRC Company Law, there are two kinds of companies: limited liability company and company limited by shares. The limited liability company is a legal person whose shareholders shall be liable to the company within the limits of their respective capital contributions and that shall be liable for its debts to the extent of all its assets.280 A company limited by shares, also a legal person, is an entity whose total capital shall be divided into equal shares to be listed and traded on a stock exchange upon approval by the State Council or a department authorised by the State Council for the administration of securities, whose shareholders shall be liable to the company within the limits of their respective shareholdings and that shall be liable for its debts to the extent of all its 2 8 1 assets. Shares issued by Chinese companies limited by shares are generally divided into domestic investment shares and foreign investment shares, in accordance with the identity of shareholders. In the case of the first category (named A share) which is listed on domestic stock exchanges, shareholders are Chinese natural and legal persons, and other 2 7 9 P.M. Torbert, "China's New Company Law: Foreign Investment Issues" (1994) 16:7 East Asian Executive Reports 8. 2 8 0 PRC Company Law Art. 3 Para. 2. 281 PRC Company Law Art. 3 Para. 3 and Art. 151. This paper only focuses on the company limited by shares. 97 economic organisations, while the second category is listed domestically or overseas, and traded by foreign natural and legal persons and Chinese residing overseas.282 Domestic investment shares have three subdivisions: (1 ) state shares iguojia gu) which are held by the state, and not listed and traded on stock exchanges; (2 ) legal person shares (faren gu) which are held by domestic legal persons and listed and traded in the Securities Trading Admitted Quotations System (STAQS) and the National Electronic Trading System (NETS), the liquidity of which is limited; (3 ) individual shares (geren gu) owned by natural individuals and listed and traded on stock exchanges. Foreign investment shares, pursuant to the place of listing, are divided into the following types: ( 1 ) B shares , the RMB denominated shares, subscribed for in a foreign currency, listed and traded on China's stock exchanges;283 (2 ) H shares, listed and traded on the Hong Kong stock exchange; and ( 3 ) N shares, traded in the form of American Depository Receipts (ADRs) in the New York Stock Exchange.284 The classification of domestic investment shares in accordance with the status of holders is presumably to meet the ideological requirement of maintaining the leading role 2 8 2 This group of shareholders include natural and legal persons and other kind of economic organisations in Hong Kong, Taiwan and Macao. 2 8 3 For details of the listing and trading of B shares, see gufen youxian gongsi jingnei shangshi wuaizigu guiding de shishi xize {Listing of Foreign Investment Shares Inside China by a Company Limited by Shares Provisions Implementing Rules) (1996) 10 China Law & Practice at 10 26-34. [hereinafter B Shares Regulations] B shares are refereed to in regulations as foreign investment shares listed in PRC. 2 8 4 For regulations governing the H and N shares, see Guowuyuan guangyu gufen youxian gongsi muji gufeng ji shangshi de tebie guiding {Special Regulations of the State Council Concerning Floating and Listing of Shares Overseas by Companies Limited by Shares in China Laws for Foreign Business: Business Regulation, Vol. 2 (CCH Australia Ltd.) 13-551. H and N shares are refereed to in regulations as foreign investment shares listed outside the PRC. 98 of public economy by having state and public organisations hold the majority of shares. But regarding the state shares, the designers of such classification erred in holding the assumption that it is necessary to make the state shares non-tradable in order to maintain control of the state assets of the enterprises and consequently the leading role of public ownership. It is believed that this classification is, in nature, temporary and was developed more or less by default. The artificial division of shares according to the identity of holders should disappear as the reform progresses and the shareholding system evolves. China's stockholding system, up to now, has proved to be successful, although leaving some problems to be improved, in that it has led some state-owned enterprises into the operation of an independent company, and more important, it has injected into the economy enormous amount of poorly-needed capital. By the end of 1997 March, China has had a total of 570 companies listed on the Shanghai Stock Exchange and Shenzhen Stock Exchange, with the total issue of 110.007 billion A shares, of which 28.708 billion shares being listed with a total market value of RMB 1,327.931 billion and a total circulating market value of RMB 363.078 billion.285 In the meantime, 87 Chinese companies have had issued a total of 8.985 billion B shares, of which 7.94 billion shares with a total market value of RMB 45.566 billion and a total circulating market value of Dong Jian, "China Has 570 Listed Companies" (1997) 18:20 China Economic News 4. 99 RMB 36.87 billion have been listed.286 Additionally, 29 companies have been listed overseas, which have raised a total of US $5.9 billion.287 Notwithstanding the exciting achievements, protection offered to investors in the stock market and corporate governance has been the concern hovering over investors, both domestic and international. Although management of Chinese listed companies is, with time, becoming more responsive to the demand of investors, some important concepts for a market economy such as the responsibility to investors and the management of enterprises in accordance with company law and related regulations have not been established in the country yet.288 At the policy level, the Chinese government is accused of using capital markets only as a means of raising money, uninterested in any benefits which private shareholding could be expected to confer.289 This chapter will examine the corporate governance in listed companies with a focus on shareholders' powers, directors' duties and shareholders' remedy in case of breaches of duties by directors. 2 8 7 Of these 29 companies, 22 were listed in Hong Kong, 2 in New York, 4 in both Hong Kong and New York and 1 in both Hong Kong and London. Moreover, a Chinese company would soon be the first to be listed on a stock exchange in Australia. Ibid. According to China News in Brief, the China Securities Supervision Commission (CSRC, the supervision and control organ over the specific activities in connection with the issue and trading of securities) and Japan's Ministry of Finance in Tokyo signed a memorandum of Understanding on 18 March 1997 regarding co-operation in the supervision of the securities and futures market, and the signing of the Memorandum paved the way for Chinese companies to list on the Japanese securities market. "CSRC and Japan's Ministry of Finance Signed Memorandum of Understanding" China News in Brief (March/April 1997) 4. 2 8 8 See "Eight Loopholes of China's Listed Companies" (1997) 18:9 China Economic News 6 [hereinafter "Eight Loopholes"]. 2 8 9 Sophie Roell, "What Does the Future Hold for B and H Shares?" (1996) 10:7 China Law & Practice 17 at 18. 100 3.20 Power-Sharing Governance Structure As capital contributors, all shareholders of a company shall enjoy such rights proportional to their shareholdings, as benefiting from capital contribution, making major decisions and selecting the management.290 The principle that shareholders control and supervise corporate operation through the shareholders' general meeting is the thread holding together the basic structure of China's company law.291 Responsible to and under the supervision of the shareholders' general meeting, the board of directors is in charge of operation and investment planing.292 Departing from BCCA and CBCA which use the outside directors as monitors of inside directors' managerial activities,293 the PRC Company Law separates the supervisory function from management. The supervisory board, composed of nominees of shareholders and representatives of employees, is established as the monitor over the board of directors, managers and other senior officers, with an aim to ensure that the interests of shareholders are protected and the company is 290 PRC Company Law Art. 4. 2 9 1 Zhou Jianlong, "Lun gufeng youxian gongsi jingying de neibu jiandu jizhi: zhongguo gongsifa fazhan zi qianzhan" (On the Internal Supervision Mechanism over the Operation of Companies Limited by Shares: Foresight of the Development of China's Company Law) (1995) 5 Review of Legal Science 11 at 12. 292 PRC Company Law Art. 112Para.(2). 293 CBCA S. 102(2) provides that any company issuing shares to the public which remain outstanding and are owned by more than one person, shall have not fewer than three directors, at least two of whom are not officers or employees of the corporation or its affiliates. For a discussion of the outside directors as a corporate governance mechanism, see Laura Lin, "The Effectiveness of Outside Directors as a Corporate Governance Mechanism: Theories and Evidence" (1996) 90 Northwestern U. L. Rev. 898-976; P.H. Zalecki, "The Corporate Governance Roles of the Inside and Outside Directors" (1993) 24 U. Toledo L. Rev. 831-858; D.E. Pease, "Outside Directors: Their Importance to the Corporation and Protection from Liability" (1987) 12 Del. J. Corp. L.25-106. 101 operated in a way allowed by laws, regulations and the articles of association.294 Both directors and supervisors are subject to fiduciary duties,295 and are liable for breaches of duties.296 Therefore, in addition to the shareholders' general meeting, shareholders have the supervisory board overseeing directors.297 3.21 Shareholders' General Meeting The shareholders' general meeting is the corporate organ through which shareholders exercise their voting rights. As the organ of power of the company,298 shareholders' general meetings are granted the functions and powers to: (1) elect and remove directors and supervisors nominated by shareholders and decide on matters relating to their remuneration; (2) make business policies and investment strategies of the company; (3) examine, discuss and approve reports of the board of directors and supervisory board, annual budget and final accounts plans, and profit distribution and loss-making-up plans; (4) make resolutions on the increase or reduction of the registered capital, and the issue of company bonds;(5) make resolutions on matters of mergers, division, dissolution or liquidation of the company and amend the articles of association of the company.299 294 PRC Company Law Art. 126. 2 9 5 The fiduciary duties in China's company law will be discussed below in page 108-116. 296 PRC Company Law Art. 63, 128. 2 9 7 The role of supervisors as monitors and their effectiveness in reducing agency costs are not free from questions. Whether there are other agency costs arising from trusting the supervisory board, in addition to those with the board of directors will be discussed below. 298 PRC Company Law Art. 102. 299 PRC Company Law Art. 103. 102 Resolutions specified in (5) must be adopted by more than two-thirds of the voting rights of shareholders who attend the meeting.300 Read in conjunction with the rights of the board of directors,301 the powers listed above imply shareholders' supremacy in investment and operational plans, and the role of the board to implement these plans by setting specific implementing measures. Compared with shareholders' general meetings in the jurisdiction of BCCA and CBCA, the Chinese equivalent is more powerful. Besides the right to formulate business plans and investment strategies, most notable is that shareholders have the right to decide on matters relating to distributing profits, making up losses and issuing dividends, the right absolutely within the province of directors under CBCA and BCCA.302 Assigning broad powers to shareholders' general meeting is supposedly to be consistent with the government's approach managing state-owned enterprises, and the primary purpose of the PRC Company Law to maintain the state control over enterprises and promote state interests, the hallmark of China's corporate law.303 In the current stock 300 PRC Company Law Art. 106 Para. 2 and Art. 107. 301 PRC Company Law Art. 112. Directors' powers will be discussed below. 302 CBCA S. 102(1) and BCCA S. 141(1). 3 0 3 Peter Little, "A Common Lawyer's View of China's Company Law" (1994) 3 Asia Pacific L. Rev. 62 at 63-64. See also R.C. Art & Minkang Gu, "China Incorporated: The First Corporation Law of the People's Republic of China" (1995) 20 Yale J. Int'l L. 273 at 297; M.D. Bersani, "Privatisation and the Creation of Stock Companies in China" (1993) 1993 Colum. Bus.. L. Rev. 301 at 305. 103 market, state shares have accounted for a 51-80% of the total shares issued by companies listed on stock exchanges.304 Although the Chinese government has been trying to relieve itself from the daily management of enterprises, extraordinary powers of shareholders' general meeting and the dominating shareholding position allows it to maintain the ultimate control over corporations and to decide their operation and investments as state interests command. Such position might mean a toll for the state to implement the macro-economic policies of the government at the central and local levels, through influencing the internal management and investment policies. To reduce the current unemployment pressure, the state can cause the company to acquire enterprises which have been close to bankruptcy and whose employees have been actually unemployed, even if such acquisition is proved to be counter-productive to the profitability of the company at the outset of the transaction. Consequently, the relationship between majority and minority shareholders and restraints upon majority shareholders from abusing its position while ignoring the interests of minority shareholders seem to be necessary to maintain investors' confidence. Nonetheless, the PRC Company Law is devoid of any assurance to investors, because it doesnot touch on the question of minority shareholder protection, let alone the oppression remedy provided for in BCCA and CBCA. 3 0 5 The Articles of Association of Companies 3 0 4 Ren Kan, "The State of the State's Shares" Bus. Weekly, China Daily (3 May 1993) 3. Unfortunately more update statistics is unavailable. 3 0 5 For oppression remedy in Canada, see BCCA S. 224 and CBCA S. 241. 104 seeking a Listing Outside the PRC Prerequisite Clauses (Prerequisite Clauses) is the only regulation that deals with controlling shareholders' duties, but its application is limited to companies seeking a listing overseas.306 The role of public ownership in the reform of corporate system has been one of the key concerns of both the proponents and opponents of the reform. The essence of this problem is the political ramifications of the stock market experiment, i.e. whether the public ownership is still the controlling component, the question determining whether the reform is in the socialist direction. According to an insider of the reform, to compromise with the conservative forces, "it has become almost a habit for policy makers, especially more liberal officials, to justify their policies by citing political correct concepts, rather than addressing the substantive issues."307 The so-called maintaining the controlling position of public ownership in stockholding system is a strategic and tactical compromise between advocates of the reform and conservative forces, in order to implement the true reform measures, and such approach is reflective of the assumption that the means justify the ends.308 3 0 6 See Dao jingwai shangshi gongsi zhangcheng bibei tiaokuan (The Articles of Association of Companies Seeking a Listing Outside the PRC Prerequisite Clauses) (1995) 9:4 China Law & Practice at 19-59 [hereinafter Prerequisite Clauses]. Art. 47 provides that the controlling shareholder may not make decisions prejudicial to the interests of all or part of the shareholders in exercising the voting rights. But the connotation of "Prejudicial" needs further explanations. Since the focus of this paper is on the relationship between shareholders and directors, the minority shareholder protection is dealt with in brief, but it doesn't mean its insignificance, to the contrary, to enhance the confidence of investors in the stock market, especially international investors, a thorough corporate law system including the minority shareholder protection, in light of China's unique shareholding situation, is necessary 3 0 7 Gao Xiqing, "The Perceived Unreasonable Man-A Response to Fang Liufang" (1995) 5 Duke J. Comp. & Int'l L. 271 at 275. 308 Ibid. 105 Shareholders have the right to make suggestions for or enquiries about the operation of the company. 3 0 9 However, in reality, this right is tantamount to only a general principle or slogan, for the PRC Company Law doesnot set forth any details on procedural matters. To make this right applicable, questions such as: to whom suggestions and enquiries should be made, shareholders' general meeting or board of directors; whether there are restrictions on the scope of suggestions and enquiries; and how directors should respond, shall be answered in the statute. Under the Prerequisite Clauses, shareholders holding 5% or more of the total voting shares are entitled to propose new motions in writing to the company, and the company must include matters in the motion that fit into the powers of shareholders' general meetings set forth in Art. 50 into the agenda of annual general meetings. 3 1 0 There are three restrictions on this right of motion. First of all, motions can only be raised to the annual shareholders' general meeting, instead of the special general meeting; secondly, only those shareholders owning voting rights more than the threshold requirement can make motions; and finally, the subject of motions must be within the powers of the meeting; otherwise directors have the right to reject such motions. 3 1 1 309 PRC Company Law Art. 110. 310 Prerequisite Clauses Art. 54. The powers of the shareholders' general meeting in the Prerequisite Clauses are practically identical to the content of Article 103 of the PRC Company Law. 3 1 1 Since the board of directors is responsible for convening general meetings, the motion, by reference from the wording of Art. 54, should be made to directors, before or during the meeting. 106 Under the PRC Company Law shareholders holding 10% or more of the shares issued by the company have the right to request a special general meeting be convened. 3 1 2 Competent shareholders do not need to specify any reasons for the meeting in the request. With respect to this, the Prerequisite Clause is more restrictive, but more concrete. Shareholders with 10% or more of the total voting rights of the company may request in writing the board of directors to convene a special general meeting. 3 1 3 Shareholders can convene the meeting requested i f the board of directors fails to do so within 30 days after it has received the request, and reasonable expenses of the meeting incurred by shareholders are to be borne by responsible directors through deducting the costs from the sum owed by the company to the negligent directors. 3 1 4 3.22 Shareholders' Voting Rights With the ultimate control over corporate affairs and business, shareholders have the right to vote on the plans, resolutions, and reports listed in the PRC Company Law. Art. 103. Shareholders are the corporate constituency to elect directors and supervisors nominated by shareholders.3 1 5 Unlike BCCA or CBCA which allow shareholders to 312 PRC Company Law Art. 104(3). 313 Prerequisite Clauses Art. 72 (1). However, in accordance with this article, shareholders holding 10% or more of shares issued by the company may not be qualified for such right, if their voting rights don't account for 10% or more of the total voting rights. It is an interesting question whether this restriction is contrary to the PRC Company Law Art. 104. The Prerequisite Clauses is formulated in accordance with the PRC Company Law. 314 Prerequisite Clauses Art. 72 (2). 315 PRC Company Law Art. 103(2)(3). 107 remove directors before the term of office expires with a supermajority or simplemajority vote,316 the PRC Company Law forbids shareholders from dismissing a director before the expiration of his term of office without reason.317 This provision intends to ensure the continuing service of management, preventing corporate operation from being interrupted by the change of personnel, but invites the unanswered question: under what circumstances a director can be removed from office before the term of office expires? This paper suggests that corporations may specify such reasons in their articles. But by any means, a simplemajority resolution of the general meeting is likely to be necessary for such removal. Breach of duties or poor corporate performance attributable to directors' low qualifications or commitment to the corporate business are apparently reasons for removal. Any shareholder with voting shares can authorise a proxy or proxies to attend a shareholder's meeting on his behalf and exercise voting rights as authorised in proxy forms, after the proxyholder provides the company with the evidence attesting to the duly executed authorisation.318 Proxies in companies seeking a listing overseas must place the proxy form at the domicile of the company or other places as specified in the notice of the meeting within 24 hours prior to the specified time for the meeting.319 316 BCCA S. 154(3) and CBCA S. 109. 317 PRC Company Law Art. 115 Para. 2. 318 PRC Company Law Art. 108; Prerequisite Clauses Art. 60 and B Shares Regulations Art. 21. 319 Prerequisite Clauses Art. 61. 108 The PRC Company Law has no regulations governing the solicitation of proxies or consents,320 and there are no duties of disclosure upon solicitors. Thus, the validity of solicitation of proxies by any insurgent shareholders is quite unclear under it. The Administration of the Issuing and Trading of Shares Tentative Regulations321 (Tentative Regulations) Art. 65 authorises shareholders to entrust one or more proxies to exercise their voting rights, but it also provides that once any shareholder has solicited 25 or more authorisations, he must disclose to that effect in accordance with the regulations of the Securities Supervision Commission with respect to the disclosure of information and making of reports.322 Such disclosure may "blow the whistle" for controlling shareholders and the board of directors who have no obligation of mandatory proxy solicitation, and warn them that some dissent shareholders might appear.323 It may make the solicitation harder for shareholders if such disclosure prompts directors to solicit proxies and initiates a proxy fight within the company. Solicitors are not required to send information circulars to disclose their positions regarding matters to be voted on and other related information. 3 2 0 For the discussion of Canadian regulations relating to proxy solicitation, see Chapter Two 2.21. Resolutions in Chinese companies can only be passed by vote at a shareholders' general meeting. There is no mentioning of consents in writing, in lieu of a general meeting, to a resolution by every shareholder who would have been entitled to vote in person or by proxy at a general meeting, accordingly their validity is unclear. 321 Gupiao faxing yu jiaoyi guanli zhanxing tiaoli {Administration of the Issuing and Trading of Shares Tentative Regulations) (1993) 6 China Law & Practice 23-44.[hereinafter Tentative Regulations] 322 Tentative Regulations Art. 65. Information disclosure requirements in the company law and securities regulations will be discussed below. 3 2 3 It is even unclear whether the board of directors can solicit proxies. 109 3.23 The Board of Directors The board of directors should hold itself responsible to shareholders' general meetings, and is granted such powers as to: (1) convene, report to the shareholders' general meeting, and implement its resolutions; (2) decide on business and investment plans, draft the annual financial budget and final accounts, and work out plans for distributing profits and making up losses; (3) draft plans for the merger, division or dissolution, formulate the basic management system; and (4) engage or dismiss the manager, deputy managers and person-in-charge of financial affairs and their remuneration. Under the Prerequisite Clauses, when the board of directors disposes of fixed assets, and if the sum of the expected value of the consideration for the proposed disposal together with the value of the consideration for fixed assets disposed within the immediately prior four months exceeds 33% of the fixed assets value shown in the balance sheet placed before the last shareholders' general meeting, such disposal must be approved by a simple majority vote at shareholders' general meetings.324 The disposal of fixed assets only refers to the assignment of a certain interest in assets other than by way of security.325 3.24 The Supervisory Board Prerequisite Clauses Art. 89. 325 Prerequisite Clauses Art. 89 Para. 2. From a liberal interpretation of this article, it can be inferred that this article should cover the disposal of fixed assets by way of lease. Shareholders can't set aside the transaction even if directors fail to get the required shareholder approval, and there is no requirement of good faith on the part of the assignee regarding the transaction. Prerequisite Clauses Art. 89 Para. 3. For a comparison with directors' power to dispose corporate assets under BCCA, see BCCA S. 150. 110 The separation of the supervisory board from the board of directors can be dated back to the East Indian Company of Holland, and was developed into the modern model by the German company law.326 Besides Germany, the supervisory board has been accepted in Japan, Holland, and Austria.327 As a necessary organ within companies limited by shares, the supervisory board has the rights to: (1) examine the financial affairs of the company; (2) monitor directors and managers to see if they fail to honour their duties, and require them to correct their acts which are harmful to the interests of the company; (3) propose to convene the special shareholders' general meeting and attend meetings of the board of directors as non-voting attendees.328 It can verify financial information and data submitted by the board of directors to the shareholders' general meeting, and if in doubt, retain a registered accountant or auditor to help in reviewing such information, at the expense of the company.329 In the case of directors' breach of duties, the supervisory board is entitled to initiate legal proceedings against such directors.330 Supervisors could be more effective monitors over directors than shareholders, because of their right of more ready access to corporate information. Their supervision is 3 2 6 In Germany, directors are responsible for corporate operation, and supervisors have the right not only to monitor directors' managerial activities but also to appoint and dismiss directors. See Deguo Gufen gongsfa (Law of Stock Companies of Germany) S. 84 in Dongdong, eds., Gongsifa quanshu (Comprehensive Book of Corporate Law) (Beijing: Chinese Workers' Publisher, 1993) 1369 at 1742 [hereinafter Comprehensive Book] 327 Ibid. 328 PRC Company Law Art. 126. 329 Prerequisite Clauses Art. 108(4). 330 Prerequisite Clauses Art. 108(6). I l l performed on a daily basis, and they can retain accountants and lawyers for consultancy at the expense of the corporation. Therefore, they are more likely to detect and correct errant actions of directors timely than shareholders. A regular flow of information between the two boards may give directors the access to the knowledge and expertise of supervisors, in which case supervisors could serve as the advisory resources for the directors in deliberation of corporate policies. Supervisors are subject to the same obligations in exercising monitoring functions as directors do in managing the company.331 The effectiveness of monitoring depends on the independence of supervisors from directors,332 the incentives to perform supervising functions, and the capacity to "acquire and assimilate accurate and timely information and to constructively act upon such assessments."333 It is an important question to ask, at least in theory, whether the delegation of monitoring power to the board of supervisors gives i rise to agency costs. There are no provisions governing the nomination process of supervisors in company law. If the articles of association of a^  company specify that supervisors are to be 331 PRC Company Law Art. 128. 3 3 2 To ensure the independence of supervisors, following the suit of the system of outside directors in Canada and US, the Japanese commercial law established the outside supervisors. It provides that a large, public company should have at least one outside supervisor, who was never a director, manager or other employee of the company or its subsidiary within 5 years immediately preceding the taking of office as a supervisor. See Zentaro Kitagawa, ed., Doing Business in Japan, Vol. 4 (New York: Matthew Bender, 1996) Part 7 Business Organisation Chapter 1 at VII 1-55. 3 3 3 "A Common Lawyer's View of China's Company Law" Supra note 303 at 66. 112 nominated by directors, then their independence can be in doubt, and their effectiveness as monitors is seriously undermined.334 The diligence which supervisors exhibit as monitors is another factor bearing upon their roles in corporate governance. The incentives of supervisors to engage in supervision could be affected by whether they are sufficiently compensated for the efforts and time invested therein, which should be tested on the case-by-case basis. The vaguely drafted duty and liability rules in the PRC Company Law are about to do little in enhancing supervisors' incentives. As discussed below, there is no requirement of diligence, care and skill for supervisors in the PRC Company Law. Moreover, even though supervisors have the right to attend meetings of the board of directors, directors may still be in a more advantageous position than supervisors, as a result of their more ready access to and manipulation of corporate information.335 Consequently, it can be concluded that the likelihood of dependence on directors, limited incentive and sanction and limited access to information might restrict supervisors' ability to monitor directors' integrity and efficiency. Therefore employing "agents" (supervisors) to watch for "agents" (directors) 3 3 4 The independence problem of supervisors is similar to that of outside directors whose independence is usually compromised in some ways. The selection of outside directors is controlled by the management of the company, which like to name people who are friendly to them; most outside directors share similar social and professional backgrounds with their inside colleagues; and friendship between the outside and inside directors may grow during their terms of office. G.W. Dent, "The Power of Directors to Terminate Shareholder Litigation: The Death of the Derivative Suit" (1980) 75 Nw. U. L. Rev. 96 at 111-13. See also R.J. Gilson & R.Kraakman, "Reinventig the Outside Director: An Agenda for Institutional Investors (1991) 43 Stan. L. Rev. 863 at 872-76, V. Brudney, "Independent Director—Heavenly City or Potemkin Village?" (1982) 95 Harv. L. Rev. 597. 335 Supra note 303 at 69. 113 may cause agency costs. However, whether such agency costs exceed the benefits from such employment is difficult to generalise. Rather, the answer differs from one firm to another. Notwithstanding that the power-sharing governance structure has provided a frame within which corporate powers are divided among shareholders, directors and supervisors, the PRC Company Law leaves some vacuum and gaps to be filled and bridged by the articles of association of the company. Consequently, a thoroughly and skilfully drafted articles of association is a work of significance for the corporate machinery to operate smoothly. The skeleton power-allocation frame is, on one hand, consistent with the progress of corporatisation reform which was at the experimental stage when the law was enacted, with some details to be specified as the experiment evolves; on the other hand, compatible with the legislative tradition of China. A law which is drafted and approved by the National People's Congress is usually skeleton, in terms that it only stipulates some general rules and principles. At the same time, it always provides that the State Council or one of its departments might formulate implementing measures in accordance with the law or it might affirm a certain ministry or commission as the department in charge of implementing the law. In the case of the PRC Company Law, the State Council Securities Commission, State Planning Commission, and the State Administration for Industry and Commerce have drafted separately or in collaboration, implementing regulations regarding 114 internal management, securities regulation or other related areas, such as the B Share Regulation, Prerequisite Clauses and Tentative Regulations. 3.30 Directors' Duties 3.31 Relationship between Directors and Company In China's legal theory, rights and obligations are the subject of certain legal relationship. Once a legal relationship is established, rights and obligations of participants thereof are subsequently defined. Directors' duties are basically contingent upon the nature of the relationship between directors and the company, which may be determined by company law, articles of association, even resolutions of shareholders' general meetings.336 In civil law jurisdiction, it is the consensus of corporate law and literature that directors of companies are in a mandate relationship (weiren guanxi) with the company.337 In such a 3 3 6 Wang baoshu, "Gufen youxian gongsi di dongshi he dongshihui" (The Directors and Board of Directors of Companies Limited by Shares) (1994) 1 Foreign Law Review 1 at 3. 337 Japanese Commercial Code Art. 254(1), which provides that regulations of mandate relationship shall apply to the relationship between directors and the company. See Reben shangfadian (Japanese Commercial Code) in Comprehensive Book at 1632. Taiwan Company Law has the same provision. See Taiwan gongsifa (Taiwan Company Law) in Comprehensive Book 1314 at 1378. Within a mandate relationship, the contractual relationship based on the mutual trust between participants, one party is entrusted to execute matters for the other party. See supra note 319 at 4. The mandate relationship is different from the agency relationship. The former is refereed to the relationship between the mandatory and mandator, while the latter refers to the relationship among the principle, agent and the third person with whom the agent deals. Only when the mandatory is granted such authority as dealing with the third person on behalf of the mandator, the mandate relationship co-exists with the agency relationship. For a discussion of the mandate relationship, see Shi shangkuan, Zhaifa gelun (shang ce) (On Law of Obligation), Vol. 1 (Taibei: Shi Shangkuan, 1960) at 305-310. 115 legal relationship, a director, as the mandatory, is entrusted to manage the corporate business and affairs by the company, the mandator. A director should assume duties of loyalty, diligence and care of a bona fide manager (shanliang guanlireri)33* While the PRC Company Law is silent on the nature of such relationship, Chinese corporate lawyers suggest that China should follow the suit of civil law theory with respect to the director-company relationship.339 This article argues that the problem with such an adoption is that there hasnot the concept of a mandate relationship in China's civil law, not to mention the relevant legal regulations.340 Nonetheless, China has decided to import the concept of fiduciary, by drafting the Trust Law of the PRC, and the draft law has been submitted to the National People's Congress, the national legislature, for discussion and approval.341 In addition, there has had a wide range of literature studying the theory of trust law in China, which has laid the theoretical background for the introduction of trust law.342 In light of 3 3 8 The meaning of bona fide manager, is seldom interpreted in civil law code and literature. A bona fide manager is also called a good father {shanliang jiafu) in China. In a traditional Chinese family, the father is the controller of all of the affairs of the whole family, including personal matters of members. Therefore, such a father is supposed to have a high standard of care. By analogy, a director is required to have the care of the same standard as such a father. Thus, in practice, the understanding of directors' duty of care depends upon the interpretation of the good father. 339 Supra note 337 at 4. 3 4 0 In China's legal system, the civil and commercial relationships are governed by the General Principle of Civil Law (minfa tongze). But in the current General Principle of Civil Law, there is no regulations of mandate relationships. According to the information the author have collected, it is unlikely for China to add into the General Principle of Civil Law the regulations in this respect. 3 4 1 The draft law is said to be based on internationally recognised principles of trust law, and hopefully will be passed in the near future. See "Editorial" China News in Brief (March/April 1997) 1. 3 4 2 For an academic discussion of trust law, see generally Zhongguo nianjian bianjibu, (The Editorial Department of the Law Yearbook of China), "Xintuo lifa" (Legislation of Trust Law) in Zhongguo falu nianjian {Law Yearbook of China) (Beijing, Press of Law Yearbook of China, 1996) at 844; Jiang Ping & Zhou Xiaoming, "Lun zhongguo de xintuo lifa" (On China's Legislation of Trust Law) (1994) China Legal Science 53-59; Zhou Yingying, "Shilun xintuo lifa" (On Trust Legislation) (1995) 3 Ningbo U. Rev.: Humanitarian Series Edition 103-07. 116 such situation, it is the time for China to add the concept of fiduciary relationship into the PRC Company Law, thus making the director-company relationship definite and clear, at least in theory. 3.32 Directors' Du ties Under the PRC Company Law, the general and primary duty of a director is to observe the articles of association, faithfully perform their duties and protect the interests of the company, as well as not to take advantage of their positions and powers in the company to seek personal gains.343 In essence, directors' duties are that directors should not seek personal interests, or engage in activities which are harmful to the interests of their company. A director is prohibited from: (1) accepting bribes or other illegal income for the reason of their functions and powers, or seizing corporate property for themselves;344 (2) misappropriating company funds or lending them to others, depositing corporate assets in an account of his or other individual's or using the corporate assets for security for the debt of shareholders or other individuals;345 (3) disclosing secrets of the company unless required by laws or approved by shareholders' general meetings;346 and (4) engaging in the same line of business as his company's, either for his own account or for others', or having PRC Company Law Art. 123 Para. 1. PRC Company Law Art. 59 Para. 2. PRC Company Law Art. 60. PRC Company Law Art. 62. 117 any kinds of transactions unless the articles of association so provides or shareholders' i • 3 4 7 general meetings so approve. Compared with BCCA and CBCA, the PRC Company Law has two discrepancies. The first is that it emphases the "passive obligation" refraining from any activities harmful to corporate interests, while fiduciary duties in BCCA and CBCA require not only the good faith and honesty in directors' activities, but also the commitment to further the best interests of the company.348 The second, which is more notable, is that there is no requirement of the duty of diligence, skill and care. The "passive obligation" is reflective of some actual practices of management in companies, like accepting briberies and misappropriating company funds. The stipulation shows the commitment of the government to rectifying these sub-standard performance. However, this article disagrees with the legislators on specifying these activities in company law. These practices have already been expressly prohibited by accounting, criminal and other laws. Additionally, this article is of the view that these "passive obligations" can be included in the fiduciary duty stipulated in BCCA and CBCA. As the PRC Company Law evolves, these obligations should be replaced by the principles of fiduciary duty. 347 PRC Company Law Art. 61. 3 4 8 D.A. DeMott, "Beyond Metaphor: An Analysis of Fiduciary Obligation" (1988) 1988 Duke L. Rev. 879 at 882. 118 It may well be that prima facie, the duties of directors in China are less onerous than in BCCA or CBCA. But if the social dimension of China's company law is fully appreciated, it seems that the duties of directors are more onerous than in common law counties.349 The PRC Company Law mandates that the company must observe the professional ethics, strengthen the establishment of a social spiritual civilisation and be subject to the supervision of the government and the public.350 Companies are required to strengthen labour production so as to ensure the safety in production, and strengthen professional education and vocational training in order to improve the quality of their staff and workers.351 When the company makes decisions on matters relating to the personal interests of staff and workers, such as wages and welfare benefits, or production and operation of the company, the company should be responsive to the opinions and suggestions of the labour union and the staff and workers.352 These obligations of the company exert great amount of pressure on directors in that they obligate directors to persistently make the balance of interests between shareholders and other stakeholders. The fact that these interests are not necessarily consistent makes the onus on directors heavier. "A Common Lawyer's View of China's Company Law", Supra note 303 at 69. PRC Company Law Art. 14 Para 1. PRC Company Law Art. 15. PRC Company Law Art. 121-122. 119 Imposing the above-mentioned obligations upon the company regarding labour protection is reflective of the transitional nature of the current economy and society. In light of the fact that social security system is still lacking, enterprises, as they did in the planning economy, still have to shoulder some social responsibilities, like professional education and vocational training, that should be assumed by the society. The emphasis that the voice of workers as to the management and operation of the company should be heard mirrors the socialist ideology of democratic internal management, and the goal of the reform which is to establish a market economy with Chinese characteristics. Therefore, it is the firm belief of this author that it is inappropriate to understand the written laws without associating them to the political and economic background. Regarding directors' duties, the Prerequisite Clauses has made a great progress of the PRC Company Law353 It imposes on directors the duty to act honestly in the best interests of the company,354 the duty not to deprive the company of any opportunities that are favourable to the company,355 and the duty to perform the due activities with care, diligence and skill as a reasonably prudent person should exhibit under similar The Prerequisite Clauses is similar to the Table A of the Hong Kong Companies Ordinance, which is of common law tradition, thus it incorporates some principles generally accepted in the common law countries. See Cheuk-Yan Leung & Douglas So, "Editorial Notes on the Articles of Association of Companies Seeking a Listing Outside the PRC Prerequisite Clauses" (1995) 9:4 China Law & Practice 60. But it apparently departs from the common law principle on one point that directors assume duties to every shareholder, not the company. See Prerequisite Clauses Art. 114. 354 Prerequisite Clauses Art. 114(2). 355 Prerequisite Clauses Art. 114(3). 120 circumstances.356 A director should not cause the company to act beyond the scope of business specified in its business license.357 The standard to judge a corporate opportunity under the Prerequisite Clauses is whether such opportunity is favourable to the company. The most important development in the Prerequisite Clauses is that it puts forward the principle of honesty and creditability that directors must abide by while fulfilling their duties.358 The principle of honesty and creditability is a unique, generally utilised legal mechanism in civil law system.359 It is even considered as the only basic principle governing the civil activities.360 This principle, purported to maintain an order through balancing interests of parties in certain legal relationships, is characterised as uncertainty in its connotation, but the very uncertainty can remedy the limitations of the concrete statute law.361 This principle acknowledges the judge's creative adjudication, and allows the judge to make judgements in the absence of express legal provisions, making use of judicial Prerequisite Clauses Art. 115. The B Shares Regulations requires a director to show to the company good faith and diligence in exercise the powers, but there are no further explanations as to the good faith and diligence. See B Shares Regulations Art. 6. 357 Prerequisite Clauses Art. 114(1). 358 Prerequisite Clauses Art. 116. 3 5 9 Xu Guodong, Mingfa jiben yuanze jieshi: Chengwenfa juxianxing zhi kefu (Interpretation of the Basic Principles of Civil Law: Overcoming the Limitations of the Statute Law) (Beijing, The University of Politics and Law Publisher, 1992) at 73. Ibid, at 77. 121 discretion in accordance with the equity principle.362 Thus, this principle is deemed to be the equity law on judges' hands.363 The fiduciary duty, as a legal principle, shares some similarities with the principle of honesty and creditability. First of all, the fiduciary duty is originated in equity.364 The equity principle imposes fiduciary relationships to situations even falling short of "trust"; for an instance, a company's directors are deemed to be in a fiduciary relationship with the company, thus, assume fiduciary duties to the company. Secondly, the fiduciary duty is a means to balance the interests of parties in one fiduciary relationship. Thirdly, the hallmarks of the fiduciary duty, the situation-specificity and flexibility, make it the readily applied legal remedy, especially for the limited applicability of common law.365 This article suggests that these two principles share the same origin and function, and it might be feasible to include the contents of fiduciary duties into the principle of honesty and creditability. In this respect, the Prerequisite Clauses has made a precedent for China's attempt to incorporate internationally accepted principles into its own legal system, and paved the way for the internationalisation of company law, which becomes necessary if the 3 6 3 Shi Shangkuan, "Zhaifa zonglun" (General Theory of the Law of Obligation) (Taibei: Rongtai Publisher, 1978) at 319. 364 Supra note 348 at 880. 365 Ibid, at 881. 122 government continues to raise international investments.366 The next step for China to take seems to be adding the fiduciary duty and duty of care, diligence and skill into the PRC Company Law, and making them applicable to all companies, rather than only those seeking a listing overseas. Under the principle of honesty and creditability a director is supposed not to place himself in a position where there is likely a conflict between his personal interests and duties.367 Besides all the duties discussed in the preceding paragraphs, to comply with the principle of honesty and creditability, a director should also (but not limited to): (1) exercise powers within the scope of their powers delimited in the articles of association, company law or legal regulations;368 (2) personally exercise his lawfully granted discretion, maintain the independence from any manipulation of other persons, and not delegate the discretion to another person without the permission of laws and administrative regulations or the informed consent of the shareholders' general meeting.369 Nearly identical with the principle set forth in Canadian Are Service Ltd. V. O'Malley,370 the principle of honesty and creditability requires that the duties imposed on directors subsist even after the 3 6 6 At this stage, the stocks of Chinese companies are floated mostly on stock markets of common law countries. See supra note 287 and accompanying text. Consequently, it seems urgent to standardise the company law in accordance with the corporate law principles in those jurisdictions where the shares are listed. 367 Prerequisite Clauses Art. 116. 368 Prerequisite Clauses Art. 116(2). 369 Prerequisite Clauses Art. 116(3). 3 7 0 It is held that fiduciary duties of directors and officers may continue even after their resignation from office. Supra note 171 at 593. 123 termination of tenure for such a period of time as fairness determines, taking into consideration the time lapse between the termination of tenure and the matter concerned and the circumstances and conditions under which the relationship with the company terminates; in particular, the duty of confidentiality in relation to the company's trade secrets may continue forever.371 Circumventing laws or the articles of association by a director through causing his spouse, minor children, trustee, partner or an organisation controlled by him to do what he is not allowed to do is strictly prohibited.372 However, the Prerequisite Clauses is obviously contradictory with the PRC Company Law concerning the competition of a director with the company, because it legalises such competition if it is approved by an informed shareholders' general meeting, while any kind of competition is unconditionally disallowed by the PRC Company Law. In summary, there is no concept of fiduciary duty and duty of diligence, care and skill in the PRC Company Law. Without any general principles or rules, directors' duties are presented in the form of specific forbidden activities. Such activity-specificity, on one hand, makes provisions easy to follow, on the other hand, may leaves some loopholes due to the limited scope the rules can cover . The Prerequisite Clauses has made an obvious Prerequisite Clauses Art. 118. Prerequisite Clauses Art. 117. 124 development of the PRC Company Law in these two areas, but its limited scope of applicability discounts its effectiveness in regulating directors' activities. 3.40 Shareholders' Access to Corporate Information 3.41 Shareholders' Access to Corporate Records A company is required to record in writing minutes of the decisions on matters under discussion at the shareholders' general meeting,373 maintain financial records in accordance with laws, administrative regulations and provisions of the State Council's department in charge of finance,374 and keep at its office the company's articles of association, register of shareholders, minutes of shareholders' general meeting and financial and accounting reports.375 Except the register of shareholders, shareholders are expressly allowed to examine the documents and records mentioned above.376 Shareholders of companies seeking a listing overseas have the right to examine and make a copy, after payment of reasonable charges, of: (1) the register of shareholders, and the personal information on the directors, supervisors, manager and other senior management staff of the company; (2) PRC Company Law Art. 109. PRC Company Law Art. 174. PRC Company Law Art. 101. PRC Company Law Art. 110. The article is silent whether shareholders can examine the register of shareholders. In addition, shareholders can only examine the records and documents, but no other methods are provided for. There is no conditions attached to the examination. 125 reports of the buy-back by the company of its shares since the last fiscal year, and the 3 7 7 status of the company's share capital as well as the minutes of shareholders' meetings. 3.42 Company's Duty to Disclose Information Like Canadian disclosure regime, disclosure requirements in China are divided into two categories, the periodical disclosure, which is augmented by the timely disclosure of material information. A company limited by shares should work out the annual financial and accounting reports, including (1) balance sheet, (2) profit and loss statements, (3) statement of changes in financial state, (4) explanatory statement on financial conditions, and (5)profits distribution statement.378 These reports should be prepared and audited by a registered accountant within 120 days after the end of each fiscal year.379 In compliance with the Tentative Regulations, the annual report requires the extensive information, from the industry the company is in, the share structure of the company, and personnel changes, to operations of the company.380 377 Prerequisite Clauses Art. 45(5).Compared with the PRC Company Law, the Prerequisite Clauses lists more documents that shareholders have access to, but a reasonable payment is charged for examining and copying these documents. 378 PRC Company Law Art. 175. 379 Tentative Regulations Art. 57(2). 380 Tentative Regulations Art. 59. In this article, the listed items include: (1) a summary of the company's circumstances, the main products or main services, and a summary of the industry the company is in; (2) a summary of the important assets owned by the company, details of fluctuations in the value of the outstanding bonds, and details of the outstanding shares; (3) the number of shareholders, a brief description of the directors, supervisors and senior management personnel and their shareholding, and a description of affiliates of the company; (4) an abstract of financial information for the last three years or for the period since its establishment, and the management discussion and analysis of the financial position and operating results (MD&A); (5) major litigation involving the company, and comparative consolidated financial report for the last two years for the listed holding companies. 126 An interim financial and accounting report should also be worked out within 60 days after the end of the first 6 months of each fiscal year.381 The interim report doesnot need to be comparative or audited by a registered accountant, but it must include (1) a financial report, and details of fluctuations of the value of the outstanding shares; (2) management discussion and analysis of the financial position and operating results, important matters submitted to shareholders with voting rights for consideration, and major litigation involving the company.382 A company limited by shares shall disclose the required financial reports by publishing them in national newspapers and periodicals designated by the CSRC, and may simultaneously publish relevant information in local publications designated by the stock exchange where shares are listed.383 The CSRC makes all the information filed with it by companies, subject to some exceptions, available for the public to inspect.384 Companies listed in Hong Kong have to provide each holder of foreign investment shares listed outside the PRC with the annual and interim reports by prepaid mail.385 The reports should 381 PRC Company Law Art. 156; Tentative Regulations Art. 57(1). 382 Tentative Regulations Art. 58. 383 Tentative Regulations Art. 63. From the wording of this article, the meaning of relevant information is unclear. It may refers to the additional information the stock exchange where the shares are listed requires to be published. 384 Tentative Regulations Art. 64. The information on file with the CSRC will not be open to the public if it is non-public in nature obtained in the course of investigation by the CSRC of illegal activities, or is permitted by laws and regulations not to be disclosed. What information is non-public in nature seems to dependent on the interpretation of the CSRC. Prerequisite Clauses Art. 133(2). 127 be prepared according to China's accounting standards, laws and regulations.386 In case of companies issuing foreign investment shares, either listed within or outside the PRC, the international accounting standards and those of the listing place or the place where the major offering takes place should also be followed; moreover, any differences in the reports made respectively in accordance with different sets of accounting standards should be disclosed 3 8 7 The requirement of disclosure of financial information is augmented by the timely disclosure of major events whose occurrence is reasonably expected to have a significant impact on the market value of shares of the company, and which have not been disclosed to investors.388 In the presence of such events, a company should immediately submit a report explaining the events to the securities exchange and CSRC, in the meantime disclose the essence of these events to the public.389 Compared with the material changes in British Columbia Securities Act, the scope of reportable events in the Tentative Regulations is broader, from changes not only to the business, operation, assets or ownership of the company, but to outside business conditions, internal organisation, to major litigation in which the company is implicated.390 To make the disclosure obligation 386 PRC Company Law Art. 174. 387 B Shares Regulations Art. 36, Tentative Regulations Art. 134-135. 388 Tentative Regulations Art. 60. 389 Ibid. 3 9 0 The Tentative Regulations lists the events that necessitate the timely disclosure as follows: (1) a contract is concluded that may have a marked impact on one or several of the following: the company's assets, liability, interests and rights, and business income; (2) the business policy or the scope of business 128 more onerous, a company limited by shares is responsible for publicly clarifying any news appearing in the public media that may have a misleading effect on the market value of shares of the company, once it becomes aware of such news.391 The standardisation of disclosure of corporate information has long been the focus of the CSRC in regulating the stock market.392 Having established a workable disclosure system, the next step for China to take is to upgrade the accuracy, completeness and impartiality of the information disclosed and develop the civilian financial sector with a commitment to strengthening the dissemination of information disclosed by companies, so that investors can better digest what is made public to them. The goal of developments relating to disseminating information should be that the published reports should not only be repackaged and interpreted by securities analysts and financial advisory services, but have a major change; (3) an major investment or a purchase of large-sum durable assets are conducted; (4) the company incurs a significant debt; (5) the company defaults when the debt falls due; (6) a major business or non-business loss is suffered by the company; (7) a major loss occurs in the company's assets; (8) the business environment changes significantly; (9) a law, regulation, policy and rule is promulgated which may markedly affect the business of the company; (10) the chairman of the board of directors, 30% of the directors or the general manager is changed; (11) an increase of decrease of 2% occurs in the shareholding of shareholders who have already held 5% or more of the outstanding shares; (12) major litigation the company get involved into; (13) the process of liquidation or bankruptcy is initiated. 391 Tentative Regulations Art. 61. Under BCSA, a listed company is not obligated to clear up misleading news on its own initiative. 3 9 2 Up to date, the CSRC has issued the following regulation in an effort to standardise the disclosure of information by the listed companies: News Disclosure by Companies Issuing Shares to the Public Implementing Rules; Disclosure of Information by Companies Issuing Shares to the Public Implementing Rules (Trial Implementation); Contents and Formats for Public Share Issuing Companies Information Disclosure Guidelines No.2: Contents and Formats of Annual Reports (Trial Implementation); No.3: Contents and Formats of Interim Reports; No.4: Contents and Formats of Rights Issue Prospectuses; No.5: Contents and Formats of Reports on Changes in Respect of Company Shares; No.6 Part One: Explanation of Contents and Formats of Legal Opinions and Lawyers' Work Reports; Part Two: Explanation and Sample of Contents and Formats of Legal Opinions on Rights Issues by Listed Companies. The above-listed regulations are obtained in China Law & Practice. 129 also be disseminated by the financial press, in the form of expert analysis, and interviews with analysts even with management of the company that publishes the reports. The CSRC seems to have become aware of the significance of press media in disseminating financial information. In 1996 August, it issued a directive to control the media reports of securities markets. The CSRC found that some reports covering the securities markets did not conform with the facts and had consequently created chaos in the markets and caused discontent among investors. The directive, which was directed to prohibit the false reports or fabricated news, said that the media coverage of securities market should be "factual, accurate, impartial and complete, and that reports were to reflect at least two different views on events to prevent misleading the market."393 3.50 Liability Strategy in Corporate Governance As a principle, a director shall be liable for losses and damage incurred by the company, as a result of his actions that are in violation of laws, administrative regulations or the articles of association of the company in the course of performing managing duties.394 Therefore a director, who takes part in making a rule-violating resolution of the board of directors and causes significant damage to the company, unless his dissent is recorded in the minutes of the board meetings, shall assume responsibilities therefor.395 Although 3 9 3 "New Directive to Control Media Coverage of Securities and Future Markets" China News in Brief (1996 August) 3. 394 PRC Company Law Art. 63. 395 PRC Company Law Art. 118 Para. 3. 130 shareholders are not entitled to sue a director for the wrong done to the company derivatively on behalf of the company, under the Prerequisite Clauses the supervisory board has the right to institute a derivative suit against the errant directors.396 A shareholder is entitled by the PRC Company Law to bring an action to the court for an injunction if the resolution of the board of directors is against laws, and infringes his lawful rights or interests.397 Nevertheless, it should be noted that, for one thing, what shareholders can apply for is only an injunction on the board of directors to cease the harmful action, and damages are excluded from the application; for another, a resolution in violation of the articles of association is not actionable. The Prerequisite Clauses has, once again, made a breakthrough compared with the PRC Company Law at this point by allowing shareholders to sue directors for resolutions that go against the articles of association.398 Even more noticeable and momentous development in the Prerequisite Clauses is the availability of arbitration for resolution of disputes between shareholders and directors.399 Equally dramatic, for companies to be listed in Hong Kong, arbitration is a means, and the only means for settling such disputes; moreover, the award of an 396 Supra note 328. The chairman of the board of directors is the person represents the company. But in the mean time, the PRC Company Law recognises the right of the supervisory board granted by the articles of association of the company. The Prerequisite Clauses delegates to the supervisory board the capacity to represent the company in a suit against directors. It can be argued that the supervisory board's such capacity is derived from the company. The only difference of such a derivative suit from the counterpart in BCCA and CBCA is that the capacity to launch a suit is vested in the supervisory board, not the shareholders. 397 PRC Company Law Art. 111. 398 Prerequisite Clauses Art. 7 Para. (2). 399 Prerequisite Clauses Art. 7 Para. (3). 131 arbitration should bind on all shareholders who have a cause of action due to the same facts as those that give rise to the arbitration.400 On the whole, by comparing civil liabilities that a director may assume with administrative and criminal liabilities, as well as the liabilities in labour law provided for in the PRC Company Law Chapter X (Legal Responsibilities) and enforced respectively by administrative agencies, judicial departments and the company itself, it seems to show that China relies more on administrative institutions than shareholders to detect directors' rule violation and enforce their corresponding liabilities. The administrative liability, in the forms of fine, confiscation of illegal income, and return of assets to the company, may be imposed in cases where directors deposit the corporate assets in an account opened in his or other individual's name,401 disclose false financial and accounting reports or such reports as concealing major facts to shareholders and the public,402 or abuses his powers to accept bribes or other illegal income or to seize unlawfully corporate assets.403 The company shall impose sanctions on directors in accordance with its internal management system made under the guidance of labour law, when they embezzle company funds or 400 Prerequisite Clauses Art. 63 Para. 2(1). The arbitration organisation is either the China International Economic and Trade Arbitration Commission, or the Hong Kong International Arbitration Centre. The award of the arbitration shall be final and binding upon each party. Prerequisite Clauses Art. 163 Para. 2 (4). 401 PRC Company Law Art. 211 Para. 2. 402 PRC Company Law Art. 212. PRC Company Law Art. 214. 132 lend them to others, provide security with company assets for shareholders or other persons,405 or engage in the same line of business as the company.406 3.60 Critique of the Enforcement of Company Law The enactment of the PRC Company Law is an important step to transform the state-owned enterprises into independent market player as the economic reform expects. However, given the inclination of instrumentalist and formalist approach to law,407 to establish a modern enterprise system, the second task for China is to focus on how effectively law is enforced. An official of the CSRC admits that the enforcement of company law is far from satisfaction.408 Loopholes in the listed companies are expressed as: (1) lacking of proper restriction of powers of the chairman of the boards who can actually put matters pending discussion into real effect and some of whom even scramble 404 PRC Company Law Art. 214 Para. 2. 405 PRC Company Law Art. 214 Para. 3. 406 PRC Company Law Art. 215. 4 0 7 The instrumentalist approach means that laws and regulations are intended to be instruments of policy enforcement. See P.B. Potter, Foreign Business Law in China: Past Progress and Future Challenges (San Francisco: The 1990 Institute, 1995) at 5. In the context of this article, the company law is the instrument of to enforce the policy of establishing a modern enterprise system by which state-owned enterprises are transformed into legal persons relatively independent from the government. Formalistic approach is relative to the assessment of the effects of law. Formalism means that "the content of law is assumed to represent reality, with little if any inquiry permitted into gaps between the content and operation of law. Law is seen not only as a tool by which desired social, economic, and political goals can be attained, but also is presumed to be an effective tool. Where a policy is agreed upon and then expressed through law or regulation, the law or regulation serve as a conclusive indication that the policy is being enforced." Ibid, at 7. Supra note 288. 133 for power with the general managers; (2) failure of some directors of the boards to assume their responsibility; (3) lacking of restriction by shareholders whose rights and interests stipulated in the company law have become merely words; (4) no enough information disposal; (5) lacking of social security against the burden from retired employees and non-performance assets that impede the economic efficiency of the companies.409 3.70 Summary China's corporate governance structure is distinct from those in common law jurisdictions. Directors are empowered with managing the company, subject to the monitoring of both shareholders and supervisors, and liabilities for breaches of duties. The shareholders' general meeting is the corporate organ of authority to which the supervisory board is responsible. Shareholders retain the ultimate control of the corporate business and affairs by exercising voting rights, which is made intelligent by the company's obligation to disclose information. The most obvious problem with corporate governance as a whole is the discrepancy in protection afforded to holders of foreign investment shares and holders of domestic investment shares. The holders of foreign investment shares are more favourably protected in such areas as supervisory board's powers (the power to wage derivative suit against directors), directors' onerous duties, company's duty to serve information, and the Ibid. See also supra note 288 and infra note 437-439 and accompanying text. 134 flexibility of shareholders' remedies (arbitration). To take serving corporate information as an example, the company is obligated to send the international shareholders the notice of general meetings by mail, while to domestic shareholders, a notice in the designated national newspaper is enough. This means that domestic shareholders, to be informed of the convening of general meetings, must subscribe for the said newspapers on their own expenses, and read them every day, regardless whether or not they really need to; otherwise they may miss the meeting. There seems to be no reason that can justify such onus on domestic shareholders. The advantageous treatment to international investors, on one hand, reflects China's desire to attract foreign capital it needs for modernisation and its willingness to upgrade its shareholder protection to an internationally accepted level; on the other hand, such desire doesnot justify the ignorance of domestic investors. Therefore, this article suggests that the PRC Company Law should be extended to accommodate the breakthroughs in the Prerequisite Clauses for the sake of improving and unifying the current corporate governance system. 135 CHAPTER IV: REFLECTIONS ON NON-LEGAL ASPECTS OF CORPORATE GOVERNANCE IN CHINA As discussed in Chapter I, additional to legally binding regulations, the securities market and institutional shareholders play a role in corporate governance. In the words of contractarians, the monitoring of the stock markets, by virtue of its pricing efficiency in evaluating corporate contracts, and institutional investors is cost-effective and therefore efficient in disciplining directorial actions, and reducing agency costs. This chapter explores the state of China's stock market and institutional shareholders, their future developments and the impact upon their roles in corporate governance. Prior to proceeding further, it is worthwhile to discuss different corporate governance models available for China to consider and follow, and which one China is following or tends to follow. 4.10 German and Japanese Model? Some Japanese economists suggested that in view of the fact that China's securities market is at the stage of standardisation and development, and ordinary Chinese do not understand the risks of stock markets, China should follow the Japanese model, keeping its firms dependent on bank loans rather than securities markets, so making banks the 136 effective monitor of firms' operation.410 Japanese are of the view that a strong stock market undermines the economic control by the government which Japan found useful in its development stage of the national economy, while in the case of banking loan, the government can control the direction and timing of capital flow.411 4.11 German & Japanese Model Japanese firms centres around the Keiretsu, a voluntary grouping of firms and financial institutions with cross-shareholdings and business relationships.412 In the Keiretsu, a main bank owns 5% of the stock of industrial firms, which in turn own some stocks in the main bank, and usually, "four other banks and insures own blocks of stock in the industrial firms, roughly equal to 5% of the outstanding shares, thus creating a latent five-holder coalition with 20% of the outstanding stock."413 In the past twenty-five years, empirical studies of Japanese firm ownership has shown a persistent pattern of banks' concentrated ownership, in both small or mid-sized firms, and largest ones.414 4 1 0 The suggestion was made by Japanese Finance Minister to top Chinese economic officials in a seminar in Beijing in 1995. See D.A. EU, "Financial Reforms and Corporate Governance in China" (1996) 34 Colum. J. TransnatT L. 469 at 472 footnote 17. 4 1 2 "A New System", Supra note 63 at 219. 4 1 3 M.J. Roe, "Some Differences in Corporate structure in Germany, Japan and the United States" (1993)' 102 Yale L.J. 1927 at 1939. 4 1 4 The ownership in fourteen largest Japanese firms by five largest financial institutions yearly average is as the following: 19.60 in. 1967, 19.51 in 1972, 19.60 in 1977, 18.51 in 1982, 18.94 in 1987, 19.16 in 1988, 18.76 in 1989, 18.31 in 1990, 18.94 in 1991, 18.69 in 1992, and the historical average in 19.11. Ibid, at 1940 Table III 137 While different from the Japanese model, the German mechanism leads to the same result: banks control the listed firms. German banks not only deploy their capital in stock ownership in big blocks, but more important, control the voting machinery in firms.415 Since individual investors deposit the stocks they own with their bank and voluntary delegation of voting rights to banks is the norm,416 German bankers' voting power comes not only from direct ownership of stocks, ownership of stocks by investment companies controlled by banks, but also proxies of banks' brokerage customers.417 Usually, German banks hold over 90% of voting rights of the listed firms.418 The power of control the credit capital historically exercised by banks augments German and Japanese banks' power that comes from the large-block, even controlling, shareholding or voting rights. In short, the German and Japanese model is characteristic of the banks' combination of the powers generally vested in controlling shareholders and controllers of project funding that firms want. Such a model "should improve the flow of information from inside the firm to large shareholders, thus helping to deter the short term propensities often seen in the stock market."419 A regular, private flow of information between management and shareholders should enhance the accuracy of shareholders' 4 1 5 In the one hundred largest German industrial firms, large banks own twenty-two blocks of at least 5% of the outstanding stock. Sec Ibid, at 1938, and Table VIII in the Appendix at 1998. 4 , 6 " A New System", Supra note 63 at 220, 4 1 7 Supra note 410 at 1938. 4 1 8 "A New System", Supra note 63 at 220. 419 Supra note 413 at 1987. 138 evaluations of management's performance. While bankers tend to be concerned with the firms' ability to repay the loans, not the maximisation of firms' value, their large-block shareholding may mitigate their risk-averseness of creditors. The balanced propensities of banks consolidate their effectiveness as monitors. The German and Japan model is different from that of the North America, which stresses the role of securities market where shares are diversely owned and liquidity is relatively high. Here, it seems to be necessary to make it clear that by introducing the German and Japanese model, this paper does not intend to prove, nor indicate that one model is superior than the other. Rather it is of the view that there is more than one model in constructing corporate governance. As some academics point out the political preference, history, cultures and paths of economic development combine to shape the model and structure of corporate governance,420 China should take into account its social conditions, economic reality and policy preference in designing its own corporate governance model. In light of the complexity involved in the discussion of structuring corporate governance and the paucity of information on China's social and economic realities, the following discussion focuses on whether or not China will model on German and Japanese experience. 4.12 China's Choice Ibid, at 1929. 139 In general, Chinese banks are not capable of performing functions German and Japanese counterparts do. First of all, the influence of banks as creditors and controllers of credit capital cannot be counted on as an effective monitoring mechanism. Chinese state-owned and specialised banks, which account for a majority of the banking system in terms of the assets they have and the capital they handle, are still organs of governmental planning at the beck and call of political and social demands. As a general rule, companies financially doing poorly should be denied to any capital resources from commercial banks and for those insolvent and hopeless firms, bankruptcy is the usual choice. The threat of bankruptcy should extend influence on management. But bankruptcy is still an alien to Chinese government and enterprises.421 Banks' money has been siphoned off by the government to subsidise firms having long mired in insolvency, making banks a money-losing sector. Whether a firm should go bankrupt is determined by the government, not banks, even though they are the largest creditors. Up to now, the bankruptcy mechanism has posed little threat by banks to management. The paramount consideration in the reluctance of enforcing bankruptcy law is the likely impact of bankruptcy on social stability. The most thorny and sensitive problem the 4 2 1 As a matter of fact, China promulgated the Enterprises Bankruptcy Law back in 1986, and altogether over 1,000 firms had been declared bankrupt by the end of 1994. But by no means this is to show the actual state of the economy. On the contrary, more than 39% of enterprises were running in the red, by the end of 1994. The Enterprises Bankruptcy Law is remained as paper work, and the actual bankruptcy is quite a different matter. Those insolvent firms "[s]ee bankruptcy as a fierce tiger and turn pale at the mere mention of the word. They rather cling to the strings of the government and live on bank loans. "Wretched living is better than dying in honour." That is their motto. The employees treasure their "iron rice bowls" and are afraid of landing in destitution." See "Enterprise Bankruptcy Haunts the SOE Reform" 16:15 China Economic News 1. 140 government facing is the settlement of the employees of the enterprises closed down. Given the large number of employees to be out of employment due to bankruptcy,422 a well-developed back-up system, including social insurance system and reemployment project, is indispensable to maintain the social stability. However, such system hasnot been established yet. Thus the fear of social instability resulting from any miss of hand in handling the actual bankruptcy matters deters the government from proceeding bankruptcy process in a giant stride.423 Without the autonomy to cut off the capital flow and apply for bankruptcy of insolvent enterprises, it is unimaginable for Chinese banks to be effective monitors over firms. Secondly, China's banks are consistently denied the status of shareholders of enterprises. Considering the enormous amount of capital under the control of banks, and the possible damage that might follow any manipulation by banks on the stock market, it has long been an unswerving policy that banks should be kept out of the stock market, and prohibited from owning any shares in enterprises.424 It appears that the government stands According to an official estimation, there will be a total of 6 million workers to be out of jobs by 2000. Ibid, at 2. 4 2 3 China is committed to adopting wide-ranging economic reforms, but only at a pact that will allow it to maintain employment level and protect key industries. In the view of the government any reform can't justify the loss of workers' livelihood. See "China Cautious about Economic Reforms" China News in Brief (1995 May) 4. 4 2 4 See Guowuyuan guanyu jinrong tizhi gaige de jueding {State Council Resolution on Financial System Reform) in Shichang jinji geifan yanju ketizu (Group of Market Economy Regulations Project), ed., Shichang jinji falu daquan (Collection of Laws on Market Economy), 1995 ed., (Xiamen: Xiamen University Publisher, 1995) 803 at 805. In this resolution it is decided that state-owned commercial banks should not invest in non-financial enterprises. See also, Zhongguo renmin yinhang guanyu zhuanyie yinhang bude zhijie chong shi zhengquan jiaoyi de han (China People's Bank Circular on Prohibition of Specialised Banks from Directly Engaging into Stock Business) Renmin ribao (People Daily) (11 August 1990) 3. In this circular, specialised banks are ordered not to carry on stock business. 141 fast on this point and this policy will carry on. In 1996, China's four state-owned banks withdrew from the trust and investment business, by spinning off the trust and investment companies they controlled. The exit of the four banks from the trust and investment business is purported to prevent bank funds from flowing into the risky investment, including stocks.425 On June 5, 1997, China People's Bank issued a notice reiterating the policy that the bank funds should be separated from the stock market.426 It is the view of this article that the weak influence of banks as creditors on enterprises and the incapacity of being shareholders preclude China following the German and Japanese model. China may place its focus of corporate governance construction on the stock market, institutional investors and state as controlling shareholders, where the blueprint may come. 4.20 Stock Markets and Corporate Governance In Chapter I, it is discussed that the pricing efficiency in, and only in an efficient stock market, by which stock prices reflect all the information publicly available in the market, certainly including those concerning the corporate contract and management performance, may provide pressure on management of companies which desire to raise capital through 4 2 5 See '"Big Four' Retreat from Trust Business" China News in Brief (1997 February) 2. 426 Guanyu jinzhi yinhang zijin jinru weigui liouru gupiao shichang de tongzhi (Notice Prohibiting Bank Funds from Unlawfully Flowing into Stock Market) Shenyang ribao (Shenyang Daily) (5 June 1997) at 2. This notice reiterated the policy that any commercial bank and its subsidiaries should not carry out the trust and stock business. 142 the stock market. The stock market's function of monitoring over companies by virtue of the pricing efficiency and competition in the capital market is deemed to be more cost-effective and efficient, compared with legal regulations. China's stock markets are expanding rapidly,427 but still at the stage of standardisation and development. Therefore the ability of stock markets to act as monitors of companies as the contractual theory advocates is a big question mark. The reputation for volatility and the opportunity provided for officials, companies and individuals to speculate and incur losses have been accompanying the expansion of the stock market.428 The wanton manipulations and large-scale illicit over-speculation perpetrated by institutional investors, state-owned enterprises and listed companies on the stock market have come to a quite serious dimension.429 These market players "use bank credit funds or capital funds raised from stock floating to wantonly buy in stocks for raking in a big profit within a very short time through the speculation. Some listed companies taking advantage of their strong position in monopoly of information have gone so far as to collude 4 2 7 The State Planning Commission and the Securities Committee of the State Council have set the limit for stock issues in 1997 as RMB billion, two times of the quota of 1996 and 6 times of the 1995 issue. The distribution of the increase will favour the 1,000 key state-owned enterprises, 120 enterprise groups and 100 enterprises experimenting with the modern enterprise system, as well as enterprises in agriculture, energy, transport, telecommunications, major raw materials and high technology. See Shi Lieu, "China to Float RMB 30 Billion Stocks" China Economic News (6 June 1997) 3. The stock market in China has catered to 18 million investors, both international and domestic. "China Securities Regulatory Commission (CSRC) Vowed to Tighten Stock Rules" China News in Brief (1996 December) 2. 428 Supra note 289 at 19. 4 2 9 The speculation-aggravated risks in the stock market led to a package of corrective measures by the government, including an increase of the quota of share issue, increase of stamp taxes on stock deals and prohibition of bank funds flowing into the stock market. See "Overheated China Stock Market Under Macro Policy Correction" 18:21 China Economic News (9 June 1997) 1; see also Gang Jin, "China Strictly Forbids State-owned Enterprises and Listed Companies to Engage in Stocks Speculation" 18:21 China Economic News 3. 143 with the stock operators to manipulate stock trading of their own shares at the expense of the medium-sized and small investors by fabrication false information and through the speculation also plunged their own production capital into high-risks market manoeuvrings."430 According to the official statistics, in 1996, 84.21% of a certain listed company's profits was derived from the stock market, and many companies gained their profits even merely from securities investment.431 The CSRC, the regulator of the stock market in China, has been vowing to make tough regulation on the stock market, and has put a set of rules into effect, but China still lacks a national securities law, which is necessary for a uniform and productive market regulation. Even more problematic is China's ability to enforce the existing rules and regulations. With only 14 branch offices all over the country, and limited number of staffs and experience, the CSRC is hardly in a position to monitor the markets as closely as it is expected to. Besides a national securities law, China still needs both a well-trained legal profession specialised in securities law who can advise companies on stock transactions, and a number of judges with expertise'in securities laws. The courts in China are not anticipated to enforce the securities rules effectively. The inclusion of arbitration as a measure of disputes resolution in the articles of association of companies seeking a listing overseas, Ibid, at 1-2. Ibid, at 2. 144 on one hand, shows a development of the company law in providing flexibility in protecting shareholders, on the other hand, reflects the lack of confidence of investors, even of the government, in the ability of the judicial system to hear cases involving securities rules. Equally problematic for both international and domestic investors is that China is unwilling to give up the controlling stake in the listed companies, making it almost impossible for other shareholders to exert control over management.432 Perhaps the largest obstacle blocking the stock market from developing is, as a commentator points out, that the government is committed to keep tight control over the market, but is uncertain of how it should develop.433 Given the rampant speculation and manipulation, China's stock market is hardly to show any pricing efficiency in reflecting the information in the market. Considering the 4 3 2 Supra note 289 at 18. 4 3 3 Ibid. The stock market in socialist market economy is quite a new and unprecedented thing, and the Chinese government wants to control the speed of its evolution, for fear of any serious problems that might follow too fast changes over which it loses control. For better understanding China's approach over economic development and its attitude of the stock market, it is helpful to quote a western practitioner's relevant comments: the leader of China, Deng Xiaoping, "used to like managing the Chinese economy to crossing a turbulent river: if you move too quickly and plunge straight in, you will be swept off your feet and drowned. The only approach that can lead to success is to study the river; identify the best place to cross; enter it slowly, moving one foot at a time, and finding a solid rock before moving the other foot; never be afraid to move backwards if an unstable rock is encountered, but never lose sight of the ultimate objective." Ian Lancaster, "The Chinese Approach to Business and Law" 18:1 East Asian Executive Reports 10. 145 complexity involved in improving and regulating the stock market, and China's ability to do so, it will be a long time for the stock market to rise to the level where it meets the expectations of contractarians. 4.30 Institutional Shareholders and Corporate Governance 4.31 The State as the Shareholder Corporate governance theory acknowledges the incentives of institutional investors, who have staked almost all of their interests in the portfolio companies, to have a say in and monitor the operation of these companies. Institutional investors are expected to perform the functions of monitors for the sake of corporate governance.434 In China, the state is in the controlling position in the stock market, and generally the paramount shareholders in listed companies.435 Nevertheless, its performance as a shareholder suggests nothing but the refusal to entrust it monitoring functions. The most conspicuous and serious problem is the lack of a system of managing the state-owned investments,436 without which it is always difficult to know who should really represent the 4 3 4 For a discussion of the institutional investors and corporate governance, see K.E. Montgomery, "Market Shift-the Role of Institutional Investors in Corporate Governance" (1996) 26 Canadian Bus. L.J. 189; J. E. Zanglein, "Who's Minding Your Business? Preliminary Observations on Data and Anecdotes Collected on the Role of Institutional Investors in Corporate Governance"(1992) 10 Hofstra Labour L.J. 23; J.W. Barnard, "Institutional Investors and the New Corporate Governance" (1991) 69 N.C. L. Rev. 1135. 4 3 5 See supra note 304 and accompanying text. 4 3 6 China has decided to establish a new system for managing state-owned capital assets, and four principles have been chosen to govern the system. The first is the establishment of system based on a clear separation of rights and duties with respect to the administration of state-owned investments. The second 146 state-owned investments in certain companies. In the absence of such a representative, the rights and interests stipulated in laws for shareholders are merely words. Even worse is that "in some cases representatives appointed by the state do not have the true right empowered and some even sometimes run counter to the interests of shareholders."437 Moreover, state administrative departments, sometimes appointed as the representatives of the state, "are still regarding listed companies as enterprises under their jurisdiction, and then should operate under their command",438 they even often designate the chairman of boards of directors.439 Such interference with the internal management has definitely gone too far from the power of shareholders, and the experience of the planned economy suggests that such state interference results in nothing but counter-productivity. In view of these problems, the state's monitoring capability is arguable. 4.32 Investment Funds and Corporate Governance is the establishment of scientific objectives for the most effective management and value-maximisation of state-owned investments. The third is the establishment of a system for the transfer of property rights consistent with economic and market demands. The fourth is the establishment of a system that operates in accordance with law in the management of state-owned investments. "New System of Management of State-Owned Capital Assets" China News in Brief (1995 September/October) 3. The State Administration has been drafting the law on state assets since 1995, but no law is coming out yet. See "Committee Drafts Law on Assets" China News in Brief (1995 May) 9. The current problem is that these general principles provide little guidance for state departments and companies in dealing with the state-owned investments. 4 3 7 "Eight Loopholes", Supra note 288. 147 In 1987, the first investment fund was developed by the Bank of China and China International Trust and Investment Corp. (CITIC).440 Since then to 1995, more than 70 investment funds, with assets ranging from tens of million Renminbi to RMB 600 million have been established.441 Notwithstanding the ten-year development, investment funds in China are still in the birth bed, and there hasnot a piece of legislative work so far.442 The government has been cautious in unleashing their development, for there are some restrictive macro factors to be solved. Problems with respect to sponsorship, documentation, issuance, trusteeship, listing and information provision are pervasive in the existing funds.443 In addition, the hardship of selection of a fine portfolio and making the strategy of diversification of risks because of the volatile and risky stock market, compounded by the lack of experienced management professionals make the rapid expansion of funds difficult.444 Due to the fear of the impact of uncontrolled fast development of investment funds on the stock market under the condition of imperfect laws and regulations, and limited 4 4 0 "Investment Funds to See a Better Development in China" 16:4 China Economic News 5. 441 Ibid. 4 4 2 According to China Economic News, China will publish a set of regulations in 1997 on the administration of securities investment funds. But by the time of writing this paper, to the best of the author's information, such regulations haven't been promulgated. See "Investment Funds-A New Source of Foreign Capital Inflow" 18:15 China Economic News 1. 4 4 3 Investment funds are considered as a convenient tool for raising money, but the sponsors are seldom aware of the risk involved in the operation, and their responsibility to investors. As disclosed, some funds put the same persons or organs concurrently as issuers, managers and trustees. See supra note 439 at 6. 4 4 4 Ibid. 148 expertise in regulating investment funds, the cautious attitude of the government towards the investment funds could be expected to continue. The reluctance of the state to sell the controlling stake on the stock market to the private sector would possibly stifle the development of investment funds on a large scale. Consequently, it is premature to envision their prospect to garner a position in the stock market where they can perform meaningful and effective monitoring functions. 4.40 Administrative Regulation and Corporate Governance Under the circumstances of incomplete laws and regulations, immature stock market and institutional shareholders, the appropriate administrative supervision over corporate governance seems to be the only resort for China to standardise the operation of companies limited by shares and safeguard the interests of investors. In 1996 February, the CSRC issued the Procedures for Checking of Listed Companies (Checking Procedures) which specifies the procedures by which the CSRC organises the checking unite, composed of securities administrators, accountants, lawyers • engaging into the securities business, to check the internal management of listed companies.445 The companies to be checked shall be decided by the CSRC on a sampling basis,446 and any company chosen shall provide full co-operation by providing information and reporting the situation accurately and completely.447 The checks will cover: (1) the accuracy, completeness and 445 Procedures for Checking of Listed Companies China Economic News (17 February 1997) 7. [hereinafter Checking Procedures] 446 Checking Procedures Art. 11. 447 Checking Procedures Art. 6. 149 timeliness in disclosing information; (2) the compliance of the use of share capital with the original prospectus; (3) the lawfulness of the articles of association and its enforcement; (4) the composition of shareholders' general meeting and the board of directors, and their operation; (5) the exercise of the functions and powers of the supervisory board; and (6) other internal organisation matters that the CSRC designates.448 Should there be any unlawfulness, the CSRC is empowered to take corrective actions and enforce punishment to the company and personnel concerned.449 Checks enforced by the CSRC can supplement shareholders' access to corporate information, and correct any deflection of internal management from laws, regulations and the articles of association. Although such administrative checks do not empower shareholders, they may safeguard their rights from being infringed. The problem with such,, checks is that they may not be carried out timely nor effectively, given the limited personnel and experience of the CSRC. And relevant to this is the lack of shareholders' right to organise an investigation by a resolution of the shareholders' general meeting or have an investigation arranged by the court. Checking Procedure Art. 4. 449 Checking Procedures Art. 13. Between June 30, 1996 and October 31, 1996, the CSRC carried out a check on the listed companies. Nationally, 3897 companies are checked in accordance with the Checking Procedures. See "Examination of Companies in China" China News in Brief (1996 May) 6. 150 C H A P T E R V : C O N C L U S I O N This thesis has discussed the problem of agency costs and two models proposed by academics dealing with it. Contractarians believe that a combination of markets, institutional investors, and other contractual measures can minimise agency costs, by conforming the interest of management to what shareholders' interests demand. Company law serves only as a formal articles of association, clauses of which are free to be opted out by companies corresponding to their actual circumstances. The major contribution of this theory is its incorporation of economics into corporate law, and the emphasis on the functions of markets and other contractual mechanisms. The regulatory theory argues that the expectations and functions attached to the markets, in particular, the stock market, can be realised only when the markets are efficient. However the ideal efficiency is, in reality, difficult to achieve. With markets and other contractual measures functioning, company law should be mandatory in some areas where the divergence of interests between management and shareholders are likely to arise. The debate with respect to corporate governance brought to attention the balance of two focal considerations in reducing agency costs: efficiency in utilising social resources and completeness of protection of shareholders. This article holds that such balance requires a union of the tenets of both contractual and legal regulatory theories. In addition, company law should be mandatory in areas where the markets and contractual measures are likely to fail. Determining the extent to which and where company law should be 151 mandatory is circumstantial, depending upon the extent to which the markets are efficient and institutional investors are mature.450 Canadian company and securities laws constitute a well-knitted web of corporate governance, in which shareholders exercise the ultimate control over corporate business and affairs by virtue of voting rights, including the right to entrust and solicit proxies, augmented by the right to corporate information. Directors are commissioned the sweeping right to manage and supervise the corporate business and affairs, subject to mandatorily imposed duties and liabilities. Such a structure ensures the management accountability and efficient business operation, the balance between which is the second one to be struck in agency costs reduction. China's company and securities laws provide a legal framework for companies limited by shares to go by. The power-sharing system clearly grants the ultimate control over the company to shareholders. The clarity in the division of power among shareholders, directors and supervisors, makes it easy for them to exercise respective functions and fulfil obligations; however, enumerating of directors' rights in the PRC Company Law undermines the flexibility directors need in managing corporate business in competitive markets. 4 5 0 By being mature, on one hand institutional investors are well-developed in their internal operation, on the other hand are concerned about the long-term well-being of the company, and active in monitoring and co-operative with the management; in short they are both intelligent investors and effective monitors over the management. 152 The PRC Company Law is far from complete and thorough in terms of the power-sharing structure and the process by which the powers are exercised. The Prerequisite Clauses represents a substantial development, but its limited application area weakens the significance of those breakthroughs to the construction of corporate governance. This thesis proposes that the PRC Company Law should be extended and enriched, taking the Prerequisite Clauses as a model. Nonetheless, this author suggests that given the instrumentalist and formalist approach of China to law, attention should be paid to whether the corporate governance stipulated in company law has promoted management efficiency and shareholder protection, and how effective it is in this regard. Stock market are still at the stage of development, and institutional investors especially the state as the paramount investors and controlling shareholders in listed companies, are immature in their own development. 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