the securities as commodities in which corporations deal. The Delaware ... also covers the Securities Regulations in the two jurisdictions, wherever appropriate.
Capital Stock, Its Shares & Their Holders – A Comparison of India and Delaware
Paper accepted for the World Wide Junior Corporate Scholar Forum Conference Columbia Law School, New York March 2-3, 2007
Submitted by P.M. Vasudev Ph.D Candidate, Osgoode Hall Law School, York University, Toronto
Capital Stock, Its Shares & Their Holders – A Comparison of India and Delaware Abstract This paper explores the origin of “shareholder supremacy” in Anglo-American corporate law and the present legal position of corporate capital stock, its shares and their holders. The study is comparative, and the statutes of India and Delaware are selected for comparison. The paper argues that Indian company law, which is based on English law, adopts the “business model” of corporations that gives at least as much importance to the business of companies as it does to their finances. But American corporate law, as it has evolved over the last two hundred years and exemplified by the Delaware statute, creates a “financial model” in which corporations are treated mostly as issuers of securities, and the statute treats the securities as commodities in which corporations deal. The Delaware statute has a bias in favour of the stock market and adopts the policy of encouraging trade in the securities. The paper traces the process of development of corporate law in the two jurisdictions, and attempts to explain the divergence in their philosophies in the context of the respective developmental processes. The implications of the two philosophies for corporate behavior and governance are also examined. The comparison also illustrates how Indian company law is converging towards the American financial model, since the government of India adopted the policy of economic liberalization and globalization in the 1990s. Keywords Corporations, shareholder supremacy, corporate law, stock market, corporate governance ******
Capital Stock, Its Shares & Their Holders – A Comparison of Indian Companies with Delaware Corporations A business corporation is organized and carried on primarily for the profit of the stockholders. 1 Corporate law has traditionally treated the capital stock as the core of corporations and endowed the contributors of capital stock with ultimate powers over the business and affairs of corporations. Stockholders have the power to elect and regulate corporate managements, and they are imputed with the “ownership” of companies, which entitles them to the residue that remains in companies after their external liabilities are met. This preeminent position of stockholders can be termed the central plank of Anglo-American corporate law, and is often referred to as the philosophy of “shareholder supremacy.” This is also true of Indian company law, which for historical reasons has traditionally followed the English model. 2 When we dissect the corporate statute of Delaware 3 and the Indian Companies Act, 1956, 4 for the purpose of understanding the position and rights of shareholders, the results are significant. Although “shareholder supremacy” can be broadly described as the common principle in both the jurisdictions, the description is rather facile and conceals more than it reveals. The paper argues that there are substantial differences in the philosophy of the two traditions. Indian company law, which is based on English law, adopts the “business model” of corporations that gives at least as much importance to the business of companies as it does to their finances. But American corporate law, as it has evolved over the last two hundred years and exemplified by the Delaware statute, creates a “financial model” in which corporations are treated mostly as issuers of securities, and the statute treats the securities as commodities in which corporations deal. The Delaware statute has a bias in favour of the stock market and adopts the policy of encouraging trade in the securities. The paper is divided into three parts of which the first part explores the origin of “shareholder supremacy” in Anglo-American corporate law and examines the general attributes and characteristics of capital stock. The vast increase in the size and importance of corporations, and the experience with them has given rise to the corporate governance debate in which the principle of shareholder supremacy is vigourously questioned. The first part also briefly discusses the issues with respect to shareholder supremacy that are now articulated in the discourse on corporate governance. The second part traces the development of corporate law in the United States on the one hand, and England and India on the other, and offers the respective process of development as the explanation for the divergence that occurred in their philosophy. The final part of the paper makes a comparative study of capital stock and stockholders under the Delaware statute and the Indian Companies Act, and the discussion also covers the Securities Regulations in the two jurisdictions, wherever appropriate. A. Joint-Stock Companies & Their Capital Stock – An Overview i. Origins
Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668 (1919) This link is due to the fact that India was a British colony for about two hundred years, from mid-eighteenth century to mid-twentieth century. The current Indian corporate statute, Companies Act, 1956, is based on the English Companies Act, 1948. 3 Delaware Code, Title 8, Chapter 1 4 Central Act 1 of 1956 2
The origin of joint-stock companies in the English-speaking world 5 can be traced to sixteenth and seventeenth century England. From the beginning, there were two types of companies, incorporated and unincorporated. Incorporated companies had charters from the crown or parliament, and Merchant Adventurers, incorporated in 1505, appears to have been the earliest. 6 Companies that had charters were subject to the terms of their charters, which usually granted some special privilege or right to such companies. 7 For instance, the East India Company, which was granted a charter in 1600, had exclusive rights under its charter for trade with the East Indies. Companies without any charter were the other variety. 8 Here, a group of businessmen pooled their stock of merchandise and formed “companies” for jointly carrying on trade. The name “joint-stock company” is quite descriptive, as it captures the essential elements of such an entity. The joining of the stock-in-trade of more than one individual resulted in the formation of a “company.” The word “stock” used in the name originally referred to the stock of merchandise contributed by the businessmen to the company. 9 It represented the company’s capital, and since it was in the form of stock, it was known as “capital stock.” Pooling of capital was a major function of such companies, whether chartered or not. From here, the emergence of “shares” of capital stock and their transferability were natural developments, which Gower explained in the following words. Many joint stock companies were originally formed as partnerships by agreement under seal, providing for the division of the undertaking into shares which were transferable by the original partners with greater or less freedom according to the terms of partnership agreement. 10 Joint-stock companies were, therefore, a product of the agglomerating tendencies in the society, and they came into existence long before any laws were enacted for their formation or regulation. 11 The development of joint-stock companies was in the true spirit of the common law tradition in which the practices of the society are gradually recognized as its law. Basically, people are free to organize their affairs as they desire, and their customary practices form the law of the society. In other words, the common law is endogenous to the society. Companies formed by businessmen, therefore, had the legal character that was customarily imputed or attributed to them.
As a result of British rule (see Note 3, above), India has imbibed most of the traditions of the English legal system, and shares most features of the common law system. Therefore, for the purpose of this paper, I will treat India as a part of the English-speaking world. 6 Ted Nace, Gangs of America: The Rise of Corporate Power and the Disabling of Democracy, (San Francisco, CA: Berret Koehler Publishers, Inc., 2003). Available online: http://www.gangsofamerica.com/gangsofamerica.pdf, 33 7 These privileges were the incentive for the incorporators to procure charters from the parliament or crown, which was an expensive and arduous process. As the following discussion shows, companies without charters were quite common, and in the absence of any special rights, there would be no incentive for the promoters to go through the effort and incur the expense of procuring charters. 8 It would appear that formation of companies by a group of individuals without any charter from the crown or parliament was quite lawful under the common law, and charters were not mandatory. This view is supported by the widespread formation of such companies during seventeenth and early eighteenth century, and the fact that it was only in 1720 that the Bubble Act prohibited companies without charters. But even the Bubble Act saved existing companies. Blackstone, however, expressed the view that companies with transferable shares of their capital stock always required some kind of government license. Commentaries, I, 472. In the factual background, this view appears to be incorrect. 9 L.C.B. Gower, The Principles of Modern Company Law, (London: Stevens & Sons, 3rd Edition, 1969), 25 10 Ibid. 11 For the early history of companies, see W.R. Scott, Joint Stock Companies to 1720, (Cambridge: Cambridge University Press, 1909)
The common law as it developed with respect to joint-stock companies, or corporations, 12 was described by Adolf A. Berle and Gardiner C. Means in the following words. Corporations were originally groups of investors pooling their individual contributions of risk capital to organize and carry on an enterprise. Since they had saved their earnings or gains and had risked them in the undertaking, they were assimilated to the owner of land, who had cleared and cultivated it, and sold its products. As the economics of the time went, this was justifiable. They had sacrificed, risked and to some extent worked at the development of the product. Presumably they had done something useful for the community, since it was prepared to pay for the product. 13 Applying these standards, there developed the tendency to treat corporations as the alter ego of their stockholders. 14 The statutes expressly endorsed this position, and treat companies as aggregations of their stockholders. 15 It follows from this that the stockholders who contribute the capital of companies would have the power to constitute and regulate their management, and would also be entitled to the residue in the corporations after the corporations had discharged their liabilities to others. The common law, therefore, understood companies as existing for the benefit of their shareholders, and the decision in Dodge v. Ford Motor Co. 16 can be appreciated from this perspective. This traditional position of shareholders in corporate law has continued almost undisturbed despite other important developments. 17 ii. Capital Stock & Its Position in Companies Capital stock, as we have noted earlier, is traditionally regarded as the core of companies and it is fully exposed to business risks. There is no statutory protection for the capital stock, except that the directors and officers who control the capital are under fiduciary duties 18 and a standard of care rule 19 under the common law. Not only is there no legal protection for the capital stock, the stockholders are also prohibited from drawing the corporate resources, whether by way of dividend or in any other manner, except out of the profits of a company or when it is solvent. That is to say, its assets are adequate for the payment of its liabilities to creditors. A company must either have profits or be solvent before it can pay any remuneration on the capital stock by way of dividends or repay the capital to the stockholders. Although a company can issue special classes of stock, such as preferred stock that carry a fixed dividend and are also repayable, the liability for payment of dividend and repayment of 12
It is a common practice to use the expressions “company” and “corporation” interchangeably, and the practice is followed here. But it is possible to describe a company as an agglomeration of its stockholders or members, and a corporation as a legal entity created by statute, quite distinct from its stockholders. 13 Adolf A. Berle and Gardiner C. Means, Preface to The Modern Corporation and Private Property, (New York: Harcourt, Brace & World, Inc., Rev. Ed., 1968) 14 See generally John H. Farrar, “Frankenstein Incorporated or Fools’ Parliament: Revisiting the Concept of the Corporation in Corporate Governance,” (1988) 10 Bond LR 142 15 The stockholders of a company are termed its “members,” and, on incorporation, the members “shall be a body corporate.” Companies Act, (India), § 34(2) 16 Note 1, above 17 See generally Margaret Blair, Ownership and Control: Rethinking Corporate Governance for the 21st Century, (Washington, DC: Brookings Institution, 1995) 18 An individual under fiduciary duties must always act in the interests of the person to whom he or she owes such duties. Therefore, the directors and officers of a company must always act in the best interests of the company. 19 The standard of care rule requires that an individual must exercise reasonable care in the performance of his or her duties.
capital are both contingent on solvency or availability of profits. This restriction is meant to protect the interests of the creditors of companies, who generally have no right to participate in the management. As companies are under no legal obligation either to repay the capital stock or to pay any remuneration on it, they would be under no legal pressure to earn profits, and even if they do, they are under no obligation to distribute the profit among the stockholders. This scheme of law enables companies to employ their capital stock for business without any anxiety either about repayment of capital or payment of any remuneration on it. This position of the capital stock, which is also known as “equity,” is quite unlike the case with borrowed capital, which would be the other component of a company’s capital. The loans that a company borrows and the goods and services it purchases on credit represent the capital provided by its creditors. In the case of loans, they have to be serviced regularly through payment of interest and also repaid according to the terms of the contracts under which they are borrowed. Similarly, the company must make payments for goods and services purchased on credit, within the agreed credit period. These obligations are regardless of the financial position of the borrowing company; neither its ability to pay, nor its willingness would be material considerations. The creditors of a company can also make efforts to protect their capital through contractual safeguards, such as security rights over assets, personal guarantees of the directors and the like. The law offers additional legal protection to them by prohibiting the stockholders, who have the ultimate power over corporate resources, from drawing the resources in any manner unless the company is in a position to meet its liabilities to the creditors. The obligations that come with credit capital place companies under financial stress. But the capital stock contributed by the stockholders is, in theory, stress-free, as companies are under no obligation either to pay remuneration by way of dividends or repay the capital. The present difficulties of General Motors are illustrative of the consequences of excessive reliance on borrowings. 20 iii. Stockholders & Corporate Management While the capital stock of companies is thus exposed to business risks and the stockholders are also prohibited from tapping the corporate resources unless a company is in a position to fully meet its liabilities, corporate law at the same time empowers the stockholders to control the companies. They have the power to elect or remove the directors who are responsible for the management of companies and they can also get themselves elected as directors. Stockholders can also regulate the directors and officers in their managerial function. 21 Thus, stockholders who contribute the risk capital of a company are empowered to control the management of the company. The deficiencies of this regime in which exclusive powers are given to the stockholders to elect and regulate corporate management are increasingly realized. Among the major criticisms of the stockholder regime is the disempowerment of all other constituencies, such as the creditors, vendors, employees and consumers, not to mention the community at large. 20
See e.g. “Why GM’s Plan Won’t Work?” Businessweek, 9 May 2005 The Indian Companies Act has a provision that directly enables the shareholders to regulate the directors (§ 291), but the Delaware statute adopts a more complicated method, which is consistent with its generally promanagement philosophy. The powers of the directors would be governed by the Certificate of Incorporation (§ 141) and it would be necessary for the stockholders to amend the Certificate of Incorporation under § 242 if they wish to regulate the powers of the directors. 21
The privileged position of stockholders in the matter of voting rights encourages companies to adopt shareholder-centric policies that are often prejudicial to other constituencies. 22 Another criticism is that although the stockholders hold the legal power to elect and regulate the management, they do not effectively exercise the power. In effect, the full-time managers are in de facto control of companies, and to a lesser extent, the directors who oversee the management. 23 Such a situation is hardly contemplated in corporate law. 24 Even among the stockholders, the application of the majority rule in decision-making often leads to oppression of minority stockholders and acts of mismanagement by the majority. Often, the controlling group indulges in acts that are designed to promote the interests of the group in control, but harmful to the company as a whole and the minority groups that are not in control. The limited general remedy that corporate law has developed until now to deal with such situations is to empower the minorities to resort to legal action and question the acts of the majority. But corporate law is yet to attempt systemic reform that promotes good corporate governance by the majority group in control in the interests of all the constituencies. iv. Voting Rights or the Empowerment of Share Capital The law on companies or corporations was, as we have seen, formulated on the salutary principle that the capital contributed by the shareholders would be exposed to business risks, and in turn, the shareholders would be empowered to manage the company, either by electing themselves or others as directors and to regulate the directors. Voting rights were the instruments that empowered the shareholders to elect the directors and regulate them. The principle behind the voting rights attached to shares is that the capital stock of a company represents its “ownership,” which means that it must carry the right to vote on the corporate affairs. A majority rule regime, similar to that in the political democracy, was established for corporations. In corporations, which are essentially vehicles for pooling capital, each share of its capital stock had a vote, similar to every citizen having a vote in the political democracy. 25 In the formative years of corporate law, all shares of capital stock had compulsory and equal voting rights, and companies had no freedom either to take away or whittle down the voting rights. But the principle of compulsory and equal voting rights for all shares was abandoned in America during the movement for liberalization of corporate law. 26 Companies could issue shares that had no voting rights and they were also free to formulate different varieties of voting rights for different classes of shares. These devices were meant to enable businessmen to retain corporate control even after public issue of the capital stock of their companies. Although Securities Laws also do not make any efforts to regulate the rights attached to shares issued by listed companies, the stock market has been wary of nonvoting shares or shares with disproportionate voting rights. The New York Stock Exchange earlier prohibited
See Margaret Blair, Ownership and Control, Note 17, above. The reality was accurately summed up by Bruce Welling in his work on Canadian corporate law, whose principles are also not dissimilar. Corporate Law in Canada: The Governing Principles, (Toronto: Butterworths, 1984), 301 24 This was the basic theme of the pioneering work of Berle and Means, The Modern Corporation and Private Property, Note 13, above, published in 1932. But not much progress has been made since then, and the issues articulated by them are important even now. See William Bratton, “Berle and Means Reconsidered at the Century’s Turn,” (2001) 26 J. Corp. L 737 25 Bruce Welling, Corporate Law in Canada, Note 23, above, 443 26 Berle and Means, The Modern Corporation and Private Property, Note 13, above, 71 23
corporations listed on it from issuing shares without voting rights. But this was recently diluted when General Motors issued such shares and the Exchange did not take any action. 27 The pitched battles fought in the 1980s for corporate takeovers demonstrate the importance of voting rights for shares and the consequences of the freedom that the law allows corporations in deciding the voting rights. The “poison pills” developed by companies that were targets of hostile takeover attempts is an interesting example of what might be called market innovation. The poison-pill provisions enable the existing shareholders of a company to acquire special rights in the event of a hostile takeover of the company. These special rights enable the existing shareholders to purchase more shares in the company, post-takeover, at a low price and thus strengthen their position. They also confer a legal right on the existing shareholders to purchase shares in the acquirer-company and thus neutralize, either wholly or in part, the hostile takeover. 28 As noted earlier, the “ownership” rights imputed to the capital stock are the basis of the voting rights granted to them. But if the ownership element is undermined, and shares are treated merely as financial instruments issued by companies, then devices such as nonvoting shares and poison pills would not be inappropriate. It is argued in the discussion that follows that American corporate law has increasingly moved towards the latter position, and the proprietary position of capital stock is weakened. These later-day practices in American corporations, such as the poison pills discussed above, are proof of this trend. v. Stockholders as the Residual Claimants As we have seen earlier, corporate law imputes the stockholders with ownership of the companies, and it is, therefore, quite natural that they are entitled to the entire residue that remains in a corporation after its external liabilities are either discharged or adequate provision is made for them. This claim over the corporate residue is a critical attribute of capital stock, and has vital implications for corporate governance and the stock market. The nominal dependence of the directors on the stockholders for their election and the legal position that the entire profits that remain after meeting the external liabilities of a company belong to its stockholders combine to strengthen the profit-maximizing tendency of corporations. The profit-maximizing tendency of corporations, which is under attack in the corporate governance debate, 29 can be traced to this combination of features –namely, the dependence of managements on shareholders for election and the need to please the stockholders with ever-increasing profits. The directors are very enthusiastic about profits because that would please the stockholders who elect the directors. 30 The residual claimant position of stockholders also plays a key role in the determination of security prices in the stock market. The question of residual claim would be of little relevance for a company that has a running business, as there is little likelihood that it will close its business, liquidate the assets, pay off its liabilities and distribute the residue among 27
A.C. Pritchard, “Markets as Monitors: A Proposal to Replace Class Actions with Exchanges as Securities Fraud Enforcers,” (1999) 85 Virginia Law Review 927, 1013 28 For a brief but informative discussion on poison pills, see http://www.professorbainbridge.com/2004/02/whats_a_poison_.html#more 29 See e.g. Lawrence E. Mitchell, Corporate Irresponsibility: America’s Newest Export, (New Haven, Connecticut: Yale University Press, 2001) 30 This criticism is based on the theoretical model of corporate law, but it has been known for some time that the actual model of control in the large, publicly held corporations is quite far-removed from theory. In reality, the full-time managers, most of whom are not even directors control the companies, and the position of directors and shareholders is considerably weakened. See generally Berle and Means, Modern Corporation and Private Property, Note 13, above. Also see Bruce Welling, Corporate Law in Canada, Note 23, above.
the eligible shareholders. It is, however, of crucial importance for the pricing practices in the stock market. Under the residual claim principle, the entire value of a company, net of its liabilities to persons other than stockholders belongs to the stockholders and this is an important premise in the pricing of shares in the stock market. The market is supposed to determine share prices as representing the residual value available to the shareholders. The pricing of equity or common shares is done in the stock market on the principle that their aggregate market price, which is referred to as market capitalization, represents the value of the company. An important criticism of the “residual claimant” position of the stockholders is the tendency it encourages among corporate managements to focus exclusively on “shareholder value,” which is a term applied to refer to increases in the market prices of shares. 31 When a company reports increase in earnings or improvement in business prospects, the stock market generally responds with increases in the price of the company’s shares. Such rewards offered by the stock market to the stockholders through increase in prices can be termed “external,” as the wealth of the stockholders increases without any direct outflow of resources from the companies. It is quite different from the wealth that stockholders would derive from the distribution of a company’s profit through dividends, which would be “internal.” The fact that the stock market rewards the progress or success of companies leads to a shift in corporate policy from “shareholder-centricity,” to which we have earlier referred, to “stockmarket centricity.” Corporate decisions are made increasingly with the object of achieving increases in share prices in the stock market, and other consequences of the decisions are sidelined. Enron and General Electric, which we discuss a little later, are pointers to this tendency among corporations. vi. Limited Liability Limitation of liability is another important attribute of shares. Corporations can limit the liability of their shareholders to the amount that they have either contributed or agreed to contribute towards capital and no more. In other words, the stockholders of a company would not be personally liable for the debts of the company, if its assets are not adequate for discharging its debts. But the capital contributed by the stockholders, as well as any profits retained in the company would be applied to meet the liabilities. The protection of limited liability for the shareholders of companies is in recognition of two factors. One is the inherent risk that business ventures carry and the possibility of huge losses in excess of the capital invested in the business. Secondly, it recognizes a degree of separation that exists between the shareholders who contribute the capital and the directors and managers who control the corporate business. The theory is that the fortunes of a company are dependent on the actions of the managers and it would not be fair to make the shareholders personally liable for the consequences of managerial action. 32 The protection of limited liability to shareholders was provided in English company law as an after-thought, but it appears to have been generally available in American corporate law right from its formative years. The limited liability rule has attracted a charge that it encourages irresponsible corporate behavior, as the stockholders are protected by the rule. 33 But this criticism is open to question as it can be easily demonstrated that the protection of limited 31
See e.g. Edward Chancellor, “Sold Out,” The Guardian, London, 27 July 2002 For an account of the development of the limited liability rule in England, see L.C.B. Gower, The Principles of Modern Company Law, Note 9 above, 44-50. 33 Lawrence E. Mitchell, Corporate Irresponsibility, Note 29, above, 53 32
liability was not a major consideration for companies that have exhibited a consistent tendency for less-than-responsible behavior. For instance, General Electric has been repeatedly charged with legal violations, but it has found it more profitable to break the law and pay the financial cost for doing so, rather than to obey the law. 34 During the years when General Electric indulging in such actions, its profits were rising and it was rich enough to violate the law. There was hardly any likelihood of its stockholders being compelled to invoke the limited liability rule to ward off the consequences of violation. The features of corporate law described above and the broad position of capital stock in corporations has remained fairly stable, despite mounting criticisms in the corporate governance debate. The next section narrates the origin and development of corporate law and examines the process of development in England and the United States. B. Development of Corporate Law & Its Political History i. Origin & Development of Corporate Law As we have seen earlier, the concept of joint-stock companies, their capital stock and the division of capital stock into transferable shares had its origin in England in the sixteenth and seventeenth century, and from there, it spread to what is now the United States in the eighteenth century and to India in the nineteenth century. Therefore, to understand the origin and development of corporate law in the United States and India, it is, a fortiori, necessary to refer to events in England. The origin of corporate law was, as noted earlier, in the common law, and the position of companies under the common law during the seventeenth and eighteenth century can be summarized as follows. The holders of capital stock were treated as the “members” of the companies. For companies that had no charters, the documents by which their promoters entered into agreements among themselves for the purpose of forming companies were treated as contracts that bound the members. 35 The common law governed the contractual relationship among the members of a company as well as the relationship between the company and third persons. For chartered companies, their charters were also an important legal instrument that defined their character, rights and obligations. But they were equally subject to the common law, which was paramount. The shares of the capital stock of companies were transferable in terms of the constituent documents and trade in the shares was common. The trading prices of shares were compiled and published in England as early as 1692, 36 and there existed an established profession of stockbrokers, then known as “stockjobbers.” A stock market, consisting of a loose network of investors and stockbrokers, had come into existence in London by the end of the seventeenth century. Brisk trade in company shares, active financial speculation and the prospect of gain encouraged the formation of a large number of companies, and not many of the promoters 34
See Joel Bakan, The Corporation: The Pathological Pursuit of Profit and Power, (New York: Free Press, 2004), 75-79 35 This position was later formalized under the English corporate statue, which provided that the constituent documents of companies –namely, the Memorandum of Association and the Articles of Association constitute a contract among the members. Companies Act, 1956 (India), § 36. 36 John Houghton, A Collection for Improvement of Husbandry and Trade (London: Randall Taylor, 16921703), No. 1, March 30, 1692
took the trouble to obtain any charters for their companies. 37 The Bubble Act, 38 enacted in 1720, was a response to the large-scale formation of companies without any charters and it outlawed the formation of such companies. 39 But existing companies that had no charters were expressly saved by the statute. 40 In result, after 1720, special charters from parliament or crown were required for the formation of new companies in England, a position that continued through the seventeenth century, into early eighteenth century. The Bubble Act can be viewed as marking a transition to the principle that incorporation was a privilege, and no longer a right. The society, represented by its governing agency, had to grant incorporation, and it was not a natural right of citizens to form corporations. It is also possible to read into this principle that terms could be imposed for incorporation, and citizens who wished to form corporations could not insist on absolute freedom with respect to the business and affairs of the corporations. These principles, as we will see a little later, had important implications for the development of corporate law and corporate governance. United States There were very few companies in the American colonies during early eighteenth century, and the Bubble Act was extended to the colonies in 1741. 41 The statute that extended the Bubble Act to the American colonies was wider in scope, and it also mandated the winding up of existing companies that had no charters. Therefore, for all practical purposes, the position in America has historically been that companies could be formed only by the grant of legislative charters, and the concept of companies without charters was almost unknown. The ban on companies without charters was not disturbed by the American Revolution (177684) and it continued, with the result that after the Revolution also, it was generally understood that formation of companies required legislative charters. The American Constitution, adopted in 1787, had no explicit provision on the jurisdiction over corporations and did not vest it either with the states or with the federal Congress, an ambiguity that continues to the present. 42 Given this ambiguity, both the states and the federal Congress were in the practice of granting charters, though federal charters were very few. An active market for trade in securities developed in the United States in the 1790s, when Alexander Hamilton introduced his financial plan, 43 and this development also provided an impetus to incorporation activity in the United States. 44
For an account of the company formation activity in this period, see Edward Chancellor, Devil Take the Hindmost: A History of Financial Speculation, (New York: Farrar, Straus and Giroux, 1999), 34-39. 38 6 Geo. 1, c. 18 39 The Bubble Act is often understood as the regulatory response to the South Sea Bubble, caused by runaway increases in the price of the shares of the South Sea Company. But this appears to be incorrect, since the preparation of the legislation began in February 1720 and it was enacted in June 1720. But it was only in August 1720 that the fall in the price of South Sea shares commenced and triggered a complete collapse in the stock market. Stuart Banner, Anglo-American Securities Regulations: Cultural and Political Roots, 1690-1860, (Cambridge, England: Cambridge University Press, 1998), 75-79. 40 L.C.B. Gower, The Principles of Modern Company Law, Note 9, above, 29. 41 1 Geo. II, c. 37 (1741) 42 The discussions in the Constitutional Convention on the question of jurisdiction over corporations, see Ted Nace, Gangs of America, Note 6, above, 60-61. 43 Richard Sylla, “Origin of the New York Stock Exchange,” Paper presented at the Conference on the History of Financial Innovation, International Center for Finance, Yale School of Management, New Haven, Connecticut, March 6-7, 2003, Available from http://icf.yale.edu/pdf/hist_conference/Richard_Sylla.pdf, April 2006. 44 For a detailed account on the incorporation of companies in the United States after the American Revolution, see Stuart Banner, Anglo-American Securities Regulations, Note 39, above, 190-191.
A suspicion of the corporate form of organization and a sense of hostility towards it were present in the new republic, 45 and American corporate law, as it developed in the early stages, reflected this spirit. During late seventeenth and early eighteenth century, there were no general corporate statutes that provided for automatic incorporation on complying with the prescribed procedure, and each corporation had to procure its own legislative charter. Individual charters had to be negotiated by the incorporators with the state legislatures, and this acted as a check on corporate power. Efforts were made to restrict corporate powers and minimize the conflict between corporations and the public interest. Adolf A. Berle observed: To be valid, therefore, the arrangements between the associates (incorporators) themselves, and the powers granted to the corporate managements had to be thrashed over with the state authorities. During this period, the arrangement may be described as a “State controlled” agreement; since the various legislatures [sic] were required approve every item in the transaction and in fact they used their power to regulate severely the arrangements entered into. 46 The charters that were granted to corporations usually had a stable structure, and they restricted the powers of corporations in a number of ways. The following were among the important restrictions. 47 •
The activity for which a corporation was chartered was clearly defined, and corporations were prohibited from engaging in other businesses or activities.
There were limitations on the right of corporations to own property.
The capital structure of corporations was clearly defined in the charters, as was the division of capital into a specific number of shares.
The geographical area in which corporations could operate was demarcated. This was particularly important as it defined the locale of corporations and confined their activities.
Corporations were also generally prohibited from owning stocks in other corporations.
Incorporation became easier when New York enacted a statute in 1811, which was the first statute in the English-speaking world to facilitate incorporation by filing the prescribed documents with the government. It dispensed with the need for individual legislative charters, but incorporation continued to be subject to a number of restrictions, which were mainly the following. •
Corporations would have a limited life of twenty years.
Corporations could be formed only for specified businesses –namely, manufacturing, textiles, glass, metals, and paint. 48
The importance that was traditionally attached to the business activity of corporations continued under the New York statute. This was the defining principle of corporate law as it 45
See e.g. John Taylor, An Enquiry into the Principles and Tendency of Certain Public Measures, (Philadelphia: T. Dobson, 1794), cited by Stuart Banner, Anglo-American Securities Regulations, Note 39, above, 210-212 46 Berle and Means, The Modern Corporation and Private Property, Note 13, above, 122 47 Ted Nace, Gangs of America, Note 6, above, 68-69 48 Ibid. 89-90
originated in the United States.49 In its original form, a corporation was understood primarily as a business mechanism for carrying out a predefined activity, and not as a finance mechanism, as it came to be engineered later. New York relaxed the position further in 1846, when it enacted a general corporation statute under which incorporation was possible for any activity. Other states followed suit and, by 1902, almost all the states had general incorporation statutes in place. 50 By this transition, it became possible to attain incorporation by filing the prescribed documents with the relevant agency of the government. These documents would be prepared by the incorporators, who usually planned to (a) raise capital from the public, and (b) retain corporate control. The transition to the new regime of incorporation by filing documents was favorable to the incorporators, and it had important consequences for corporate culture. Berle and Means pointed out: The proponents of the charter – a promoting group or the like – were required to justify every clause of it to outsiders; they were thus checked at every point and the resulting document had some semblance of having been examined with a view to protecting all of the interests involved. This automatic check vanished with the general incorporation act. … in substance the general incorporation law today permits the originating group to write their own contract on the very broadest of terms. The progressive easing of the process of incorporation encouraged the formation of companies, and there was a steady rise in incorporation right from early nineteenth century. Although the process of incorporation became easier, the corporate statutes mostly retained the restrictions that were traditionally placed on companies in the charter regime. But over a period of time, the restrictions were gradually whittled down, and in the process, American corporations made a transition from their primary character as business vehicles to a new avatar as finance mechanisms. In 1888-89, New Jersey provided the lead in the removal of the restrictions that were placed on corporations, and the first step taken by it was to permit corporations to own the stocks of other corporations. Ted Nace traces the origin of this legislative amendment in New Jersey to the influence of Tom Scott, one of the railway barons of nineteenth century America. 51 Nace refers to extensive lobbying by business interests and its impact on the public policy and legislative process. The New Jersey amendment introduced the concept of “holding companies,” which was an important development that permitted a corporation to hold the stocks of another corporation, and control the other company. The holding company mechanism facilitated the consolidation of corporate control through layers of intervening corporations. Adolf Berle termed the practice “pyramiding,” and demonstrated how it was used to concentrate corporate control. 52 Introduction of the concept of holding companies represented an important step in the evolution of corporations; from their origin as business vehicles, pure and simple, they were also now instruments for exercise of business control. 53 Geographical limitations on the operations of corporations formed in a jurisdiction were gradually withdrawn, and this gave the option to corporations to select their jurisdiction. 49
In this respect, American corporate law was the forerunner of English law, as we will see a little later. Ted Nace, Gangs of America, Note 6, above, 89 51 Ted Nace, Gangs of America, Note 6, above, 81-83. 52 Berle and Means, The Modern Corporation and Private Property, Note 13, above, 69-71 53 Trusts were another instrument tried in the United States around this period for consolidation of businesses and concentration of control. See Thomas R. Navin and Marian V. Sears, “The Rise of a Market for Industrial Securities,” Business History Review 29 (1955): 105, 112-116 50
These developments, in turn, led to a competition among the states to attract incorporation to their jurisdiction. New Jersey initiated the “race to laxity” 54 among corporate jurisdictions by dropping many of the safeguards that earlier existed in corporate law. Among the legal amendments, the following were significant. •
The requirement that companies must clearly define their business enterprise was discarded. The freeing of capital in this manner promoted the concept that corporations were vehicles for financial capital, rather than devices for predefined business enterprises.
The stability of corporate capital structure was diluted by permitting companies to purchase their own stock and determine the consideration payable for issue of their stock. The earlier sanctity of the par value of stock and prohibition on companies dealing in their own stocks were discarded. In addition to promoting the financial model of corporations, this also compromised the interests of the creditors, as it more readily permitted companies to apply their resources for the purchase of their own stocks.
The rule that dividends could be paid only out of the profits earned by companies was diluted by the introduction of a loosely defined solvency test, which enabled managements to pay dividends even in the absence of profits.
The rule that a minimum subscription of capital had to be in place before a company could commence business was discarded. The minimum subscription rule ensured that companies had a minimum amount of capital before commencing business and it was an example of the concern of corporate law for the financial viability of companies.
Some jurisdictions earlier made efforts to regulate borrowing by companies, which would promote their financial stability. 55 These were given up.
The rigid rule that major policy decisions, such as amendments to the constituent documents or changes in the capital structure, could be made only by the shareholders was diluted. The process of decision-making was made easier and managements were empowered to make many of the decisions.
The pre-emptive right of the existing shareholders of companies to subscribe to new issues of shares was discontinued, and managements were given freedom in the matter. This was the breeding ground of the practice of “watering,” a practice that proved very useful for stock market manipulation. 56 Persons in control of companies could issue shares to themselves, and this power was crucial for their manipulative practices in the stock market.
Companies were permitted to issue shares without voting rights, which was not possible earlier. Nonvoting shares were purely financial instruments without any legal right for participation in the corporations, and they discarded the element of ownership that was inherent in corporate stocks. The general principle was one vote
This phrase was used by Justice Brandeis to describe the process of development of corporate law in America in his dissenting judgment in Louis K. Liggett Co. et al. v. Lee, Comptroller et al, 288 US 517 (1933). 55 Gerald D. Nash, “Government and Business: A Case Study of State Regulation of Corporate Securities, 18501933” Business History Review 38 (1964): 144, 146-147 56 For an illustration of “watering” and its consequences, see Edward Chancellor, Devil Take the Hindmost, Note 37, above, 171-172
per share, but interestingly, the Oregon statute provided for one vote per shareholder. 57 New Jersey, which was the pioneer in the race to laxity, was handsomely rewarded by businesses for its generosity. It became the popular choice among corporate jurisdictions, and according to corporate lawyer Charles Bostwick, [S]o many Trusts and big corporations were paying tribute to the State of New Jersey that the authorities had become greatly perplexed as to what should be done with [its ] surplus revenue... .” 58 Alfred Conard refers to the admission in the Report of the Law Reform Commission of New Jersey that any efforts to provide greater safeguards to investors, creditors, employees, customers and the general public will only drive corporations out of the state to more hospitable jurisdictions. 59 The success of New Jersey led to a competition among the states to derive revenue from incorporation services through wholesale dilution of their corporate statutes and the whittling down of the safeguards that had been earlier developed. Conard observed: The performance might better be called a “chase” than a “race,” since it is characterized by one or two states starting off in the lead, and the others striving only to stay within hailing distance. 60 Delaware has emerged as the clear winner in the race,61 and it earns handsome rewards for its hospitality to corporations. Listed, publicly-held corporations from all parts of the United States flock to Delaware, and no less than twenty-seven percent of the revenues of the state were earned from the incorporation services provided by it. 62 These facts raise serious questions about the process of lawmaking in modern, democratic societies and the considerations that go into the making of law. Theodore Roosevelt, who was the President of the United States during early twentieth century made efforts to get a federal incorporation statute enacted by the Congress, but was unsuccessful. By then the race to laxity among the state jurisdictions was almost complete and the corporate statutes of the states did little to promote corporate responsibility. The apparent object of the federal statute mooted by Theodore Roosevelt was to inculcate a greater sense of corporate responsibility, but it was not to be. 63 The race to laxity among the states resulted in a transformation in the character of corporations, which were no longer legal entities created for carrying on a predefined activity, subject to legal restrictions. They were now engineered as finance mechanisms used for agglomeration of financial capital. The role of corporations as issuers of securities was given primacy and the statutes treated the securities as commodities in which the corporations dealt. In the transition of corporate character from that of a business vehicle to a finance
Gerald Nash, “Government and Business,” Note 54, above, 147 Cited by Ted Nace, Gangs of America, Note 6, above, 83 59 Alfred Conard, Corporations in Perspective, (Mineola, New York: The Foundation Press, 1976), 12 60 Ibid. 61 See generally William Cary, “Federalism and Corporate Law: Reflections Upon Delaware,” (1974) 83 Yale Law Journal 663 62 Joel Bakan, The Corporation, Note 34, above, 156 63 Ernie Englander and Allen Kaufman, “The Politics of Executive CEO Compensation and Managerial Accountability,” Paper presented at the inaugural conference, Institute for International Corporate Governance and Accountability, The George Washington University Law School, June 1-2, 2001, Washington, D.C. 58
mechanism, the rising influence of the stock market from late nineteenth century and the eagerness of businessmen to participate in the market were instrumental. The rise of the stock market as a major institution in nineteenth century America can be traced to the issue of stock by railroad companies that raised substantial capital from the market. 64 During the last decades of the century, industrial businesses, which had until then mostly operated in the non-corporate form, also increasingly switched over to the corporate form, and this promoted the “corporatization” of the American economy. 65 The important incentives for businessmen to elect for incorporation were the prospect of raising capital or offloading equity in the stock market, and liquidity for the securities in the market. While businessmen were keen to take advantage of the stock market by adopting the corporate form, they were at the same time particular that corporate law was not too stifling, and they retain the freedom that they had enjoyed before incorporation. The objectives of businessmen were thus two-fold; one, to be able to participate in the stock market by using the corporate form, and two, not to lose their freedoms by opting for incorporation. This meant that corporate law had to lose much of its rigidity and the fetters it placed on corporate managements had to be relaxed. 66 To the stock market, corporations are just issuers of securities, and the securities themselves, merely “commodities” traded in the market. Corporate business and other “fundamentals,” such as earnings or future prospects, are relevant to the stock market only to the extent that they influence the prices of stocks. If participation in the stock market is accepted as a major function of companies, then it is imperative that the financial theme, rather than the business theme becomes powerful in the law under which corporations are organized. As a corollary, if corporate jurisdictions were to be “attractive” to corporations eyeing the stock market, then they had to give primacy to the financial character of corporations. This offers a useful perspective of the transition of American corporate law from the business model to the financial model in the nineteenth century. India The development of companies and company law in India can be traced to British rule, which lasted about two hundred years from mid-eighteenth century to mid-twentieth century. The corporate form of organization with its capital stock divided into shares, the transferability of such shares and a market for trade in the shares were not indigenous to India, and their entry into India was a product of British rule. The first corporate statute was introduced in India in 1850, and there was no question of any Indian company being formed or existing prior to that. A market for trade in securities had developed in India a little earlier, in the early part of eighteenth century, and trade was mostly in the debt instruments (bonds) of the East India Company and the shares of British banks. 67 In England, the first corporate statute, the Joint Stock Companies Act, 1844, was enacted in 1844, and it facilitated the formation of companies by filing the prescribed document – 64
Edward Chancellor, Devil Take the Hindmost, Note 37, above, 183, estimates that railroad companies invested nearly one-and-half billion dollars in the period 1865-1873, and the money was mostly raised in the stock market. 65 See Navin and Sears, “The Rise of a Market for Industrial Securities,” Note 52, above. 66 In the unshackling of the corporation in America, the ruling of the Supreme Court in Santa Clara County v. Southern Pacific Railroad Company, 118 US 394 (1886), appears to have played a role. In this decision, the Supreme Court equated corporations with natural persons, which appears to be erroneous given the legal history of corporations in America, both before and after the Revolution. 67 For the history of the stock market in India, see Bal Krishan & S.S. Narta, Security Markets in India, (New Delhi: Kanishka Publishers, 1997), 259-274
namely, a deed of settlement with the designated government official. Following that, a similar statute was also enacted in India in 1850. Needless to add, the Indian statute was largely modeled on the English statute, and this was the beginning of the trend for company law in India to adopt the English model. This trend continued even after India attained political independence in 1947, 68 and the present Indian corporate statute, Companies Act, 1956, is based on the English Companies Act, 1948. The Joint Stock Companies Act, 1844 (“the 1844 Act”) was the first English statute that provided for automatic incorporation in the place of the existing requirement of charters for incorporation. 69 The 1844 Act created companies as mechanisms that agglomerated financial capital. B.C. Hunt observed: The Act of 1844 marks an epoch in the history of English company law. In giving a statutable (sic) position to the joint-stock enterprise, it recognized a powerful instrument for organization and application of capital. 70 The Act of 1844 was not overly concerned with the business activities of the companies, and it was generally understood that the rights of companies to engage in business or activity was on par with those of the individuals who comprised them. 71 In other words, corporate capacity was similar to the capacity of the “members” of the companies, as the contributors of its capital stock were termed. This was quite different from the position in America, where corporations were legal entities created by law for specific, predefined objects. 72 The Act of 1844 did not limit the liability of the shareholders, and their liability for the debts of companies was unlimited. The protection of limited liability was given more than ten years later, under the Limited Liability Act, 1855. 73 The move of English company law towards the business model can be said to have begun with the introduction of limited liability and subsequent developments. With the introduction of limited liability for the shareholders, they had personal immunity, and in consequence, the position of the creditors was considered more vulnerable. This called for regulation of the powers of companies to deal with capital. In 1856, the procedure for incorporation was amended by another statute, Joint Stock Companies Act, 1856, 74 and a Memorandum of Association and Articles of Association were prescribed as the documents to be submitted by the incorporators, in the place of the deed of settlement under the Act of 1844. The Memorandum of Association had to state the objects 68
India, like the United States, is also a federation of states. The Constitution of India, adopted after the departure of the British, largely retained the administrative scheme that had been introduced under the Government of India Act, 1935, a statute passed by the British Parliament shortly before independence. The Government of India Act, 1935, centralized most of the powers in the federal or the central government, and the jurisdiction over corporations was also with the central government. This has continued in independent India, and the corporate statute is a central enactment. 69 The Bubble Act of 1720, which made parliamentary charters mandatory, was repealed in 1825. Therefore, technically, it was possible to form companies without charters after the repeal. 70 B.C. Hunt, The Development of the Business Corporation in England, (Cambridge, Mass. 1936), 94-95 71 This was the position since the ruling in Sutton’s Hospital, (1612) 10 Co. Rep. 1a, 23a. See L.C.B. Gower, The Principles of Modern Company Law, Note 9, above, 83 72 This arose from the fact that in America, incorporation was always under legislative charters, and the concept of unincorporated companies was hardly present in America. The legislative charters were invariably granted for specific activities to be carried on by the corporations, and this led to a habit of thought that corporations were meant for predefined activities. In England also, the position that companies that were incorporated by acts of parliament for special purposes could not divert their funds for other purposes was recognized. Eastern Counties Rly. V. Hawkes, (1855) 5 H.L.C. 331 73 18 & 19 Vict. c. 133 74 19 & 20 Vict. c. 47
of companies, and with this development, English company law moved towards defining the business objects of companies. The new regime was put to test in Ashbury Carriage Co. v. Riche, 75 which was decided in 1875. Here, the question was whether a company could lawfully engage in any activity not covered by its business objects as stated in the Memorandum of Association. The House of Lords ruled that it could not, and enunciated the Rule of Ultra Vires, which means “beyond the powers.” Any activity or transaction not covered in the business objects of a company were treated as ultra vires, and the company cannot take up such activity or transaction. The Rule of Ultra Vires emphasized the business aspect of companies. 76 The process of development of company law over the next seventy-odd years ensured that the lessons learnt in the experience with companies and the stock market were applied, and various statutory safeguards were developed. L.C.B. Gower explained the pattern of development of company law in England: By the end of the nineteenth century, the Board of Trade had established the practice of securing the appointment of an expert committee to review company law at intervals of about twenty years and of implementing its recommendations by a statute which was immediately repealed and incorporated in a consolidating Act. 77 The report of the Loreburn Committee (1906) was implemented in the Companies (Consolidation) Act, 1908, and the reports of the Wrenbury Committee (1918) and the Greene Committee (1926) were implemented in the Companies Act, 1929. The Companies Act, 1948, was based on the recommendations of the Cohen Committee (1945). In this method of legal development that occurred in England, experts studied the subject, took into account the experience and made their recommendations. Statutory law was enacted on the basis of such recommendations. This method is in striking contrast to the developments in America, where the freewheeling political process pushed the law along very different lines. The process of transition of English company law to the business model continued through late nineteenth century and early twentieth century. As we have noted earlier, companies had to define their business objects, and the Rule of Ultra Vires emphasized the business character of corporations. 78 Simultaneously, various other measures were taken to subordinate the financial element in companies. These were mostly based on the lessons of the past and were intended to discourage excessive involvement of corporate managements with the stock market and share prices. The following were among the important legal changes made for the purpose. •
The consideration for payment of shares was strictly monitored, and efforts were made to ensure that shares were not freely distributed by the managements.
(1875) L.R. 7 H.L. 653 The course of development of English and American law on this subject is quite interesting. English company law commenced with the position that companies had all the powers of natural persons, but American corporate law had maintained that corporations had only limited powers to carry on the activity specified in their charters. But gradually English law moved towards a more restrictive position, while American law moved towards openness.76 English law appears to have completed a full circle with the Companies Act, 1985, recognizing “general commercial companies.” It is no longer obligatory for companies to have specific business objects. 77 L.C.B. Gower, The Principles of Modern Company Law, Note 9, above, 54 78 The practical effectiveness of these measures is, however, quite another matter. It is a regular practice for companies to make efforts to enlarge their business freedom to the maximum extent by including all possible and conceivable businesses in the objects clause. This substantially defeats the efforts to regulate the powers of managements in the matter of application of capital. 76
Nonvoting shares, which are pure financial instruments without any legal right for participation in a company, were prohibited. This underscored the character of equity shares as representing the “ownership” of companies.
Companies were prohibited from providing financial assistance to others for acquiring their shares. 79
Similarly, companies were prohibited from purchasing their own shares. 80
The statute spelt out the types of shares that companies could issue and defined their characteristics. Managements did not have unrestricted freedom to devise new varieties of shares.
The shares issued by companies had to have a par value, and any consideration for the shares received by a company in excess of the par value was designated as “premium,” which could be applied only for permitted purposes.
These measures were designed to discourage companies from focusing on the stock market and share prices, and from dealing in their shares on a regular basis with the object of influencing market prices. In contrast, the Delaware statute expressly permits such practices, as we will see in the discussion in Section (C), below. The present Indian statute, the Companies Act, 1956, is based on the English Act of 1948, and by adopting the English model, India benefited from the experience and the expertise that had been gained in England over a couple of centuries. However, since the 1990s when the government of India adopted the policy of economic liberalization, there has been a rise in American influence on Indian policy, and the tendency now is to accord greater importance to the financial aspect of corporations, rather than their business, as we will see in Section (C), below. ii. Political History of the Development of Corporate Law The political milieu played an important role in shaping corporate law in all the jurisdictions –namely, United States, England and India. England, with its relatively long history, partybased parliamentary system and an old, well-entrenched, permanent bureaucracy that dates back to pre-electoral democracy days, adopted what could be termed a more professional approach. The practice of setting up expert committees periodically to study the subject and make recommendations is a pointer. Such committees obviously had subject or domain expertise, and were not very vulnerable to pressures from special interest groups. The process of lawmaking in England appears to have been relatively self-contained, and free from power politics. It was apparently quite possible in England to enact laws without being overly swayed by special interest groups. However, hypocrisy, which was a prominent feature of Victorian England, played a part in the development of corporate law. Gower refers to the “more than a slight whiff of Victorian humbug” in the argument in the Report of Select Committee on Investments for the Savings of the Middle and Working Classes (1850) that the protection of limited liability would enable the middle and working classes to invest in companies. 81
The practice of companies funding the purchase of their shares by investors goes back to the South Sea Bubble of 1720. See generally Edward Chancellor, Devil Take the Hindmost, Note 37, above, 73 80 The principle behind the prohibition was explained in Trevor v. Whitworth, (1887) 12 A.C. 409 (H.L.) 81 L.C.B. Gower, The Principles of Modern Company Law, Note 9, above, 45
The picture in the United States was quite different, as the political process was more open and freewheeling. The United States commenced its existence with the idea of representative government and electoral democracy, and legislators have always maintained a close relationship with their constituencies. There was also the question of multiplicity of jurisdictions, as each state could have its own corporate law. In this environment, it is quite inevitable that the legislative process is more exposed to external pressures, and the kind of professionalism with which corporate law was handled in England would be difficult to achieve in the United States. In a political system such as that of the United States, it was quite natural that the more vocal and resourceful sections were able to dominate the legislative process, and the passive groups were sidelined, irrespective of their size and the legitimacy of the interests they represented. When lawmaking is subject to pressure from special interest groups, the content and philosophy of law are more likely to reflect special interests, rather than the common public interest. Direct material on the influence of special interest groups, to wit, business interests, on the legislative process for corporate law is scanty, but there are numerous references to their influence on corporate law and securities regulations, which are closely related subjects. We have earlier referred to Ted Nace’s account of the influence of Tom Scott in inspiring the dilution of corporate law in New Jersey. 82 Earlier, Berle and Means made a reference to the corruption that was prevalent in the charter regime when incorporators had to negotiate individual charters for their corporations. 83 Jonathan Macey and Geoffrey Miller have extensively described the efforts of bankers in promoting Securities regulations by the states during early twentieth century, the so-called “blue-sky laws.” 84 More recently, Larry Neal and Lance Davis have referred to corruption in the framing of Securities Regulations in New York in the nineteenth century. 85 Stuart Banner is another writer who has written about the effectiveness of lobbying by the New York Stock Exchange. 86 Quite apart from these materials that indicate the influence of business interests over the legislative process, the trend of legal amendments is itself quite unmistakable; successive amendments diluted the corporate law, and it can be hardly disputed that the amendments benefited businessmen who were in control of companies. More precisely, the amendments facilitated the participation of business corporations in the stock market, and businessmen benefited from the process. Corporations had to be aligned with the stock market, and their business theme had to be subordinated to the financial theme. If this outcome is applied as the test, then we can safely conclude that business interests and revenue considerations played a vital role in shaping the corporate legislation of states, given the relatively freewheeling political process in America. The larger public interest became a secondary consideration. In India, till she gained independence in 1947, politics played little role in the development of corporate law, which mostly consisted of borrowing the English model. Immediately after independence, the government of India adopted a policy of socialism, and in line with this, a policy of containing corporate managements was adopted. This was done mostly through
See Note 50, above. Berle and Means, The Modern Corporation and Private Property, Note 13, above, 127 84 Jonathan R. Macey & Geoffrey P. Miller, “Origin of the Blue Sky Laws, Texas Law Review 70 (1991): 347, 354 85 Lance E. Davis and Larry Neal, “The Changing Roles of Regional Stock Exchanges: An International Comparison,” Paper presented at the Social Science History Association Conference, Chicago, IL, 19 November 1998 86 Stuart Banner, Anglo-American Securities Regulations, Note 39, above, 267-270 83
typical bureaucratic mechanisms. 87 In the 1960s, 1970s and 1980s, quite a few committees were constituted study company law and make recommendations on reform. Based on their recommendations, some important measures were attempted, and these were mostly dictated by the dominant political ideology of the time. An important measure tried in India during this period was the introduction of the concept of “deemed public companies.” 88 The English statute of 1948 made a distinction between private and public companies and subjected the latter to a more rigorous regulatory regime. 89 The broad idea was that private or closely held companies were little more than partnerships, and did not warrant extensive regulation or oversight. This regime also obtained under the Indian statute. In 1960, a new variety of companies –namely, deemed public company was introduced in India, and large, private companies that had substantial capital or business volumes were brought under the definition of deemed public companies. They were treated on par with public companies and subjected to the regulations applicable to them. The reasons were politically appropriate for the time, as evident from the report of the Committee that recommended the measure: It is, however, well known that there are many private companies with large capital doing extensive business and controlling a number of public companies. This is made possible because funds of other companies, public and private, are invested in such private companies. As public money is invested in such companies, there is no reason for treating such companies as private companies. … private companies, which employ public money directly or indirectly to a considerable extent, should be subject to the same restrictions and limitations as to disclosure and [sic] otherwise as apply to public companies. 90 With the onset of liberalization in the 1990s, many of the measures introduced earlier, including deemed public companies, were dropped, 91 and increasingly, Delaware-style provisions have been adopted, as the discussion in Section (C), below, shows. The liberalization process has, at least for now, finished the limited efforts that were made in India to develop an indigenous tradition of corporate law. C. Delaware & India – A Comparison In Section (A), above, we have discussed the features of capital stock that are mostly common to both the jurisdictions. Although the broad principles are similar, yet there are important, specific differences between the Delaware statute and Indian company law, which define the philosophy of the corporate entity in the two jurisdictions. This section analyzes these differences and examines their implications for corporate governance. i. Issue of Capital Stock & Raising Capital Pooling of capital is an important function of companies, and this is done through public issue of capital stock. In what circumstances can companies raise capital by issuing their shares to the public? For what purposes can companies raise capital? We attempt to answer these questions by referring to the regulatory regime. Positing that raising capital for 87
These were mostly of the New Deal variety of regulations that conferred vast powers on the bureaucracy, which later came in for strident criticism from the Milton Friedman School. 88 Introduced by the Companies (Amendment) Act, 1960 (India) 89 For instance, the managerial remuneration in public companies is regulated (Companies Act, 1956 (India), § 310 and Schedule XIII), there can be no restrictions on the right to transfer shares in public companies (§ 182). 90 Report of the Companies Act Amendment Committee, Paragraph 23. Extracted in A. Ramaiah, Guide to the Companies Act, (Nagpur, India: Wadhwa, 15th Edition, 2001), Vol. 1, 446 91 Companies (Amendment) Act, 2000 (India)
business would be a legitimate object for the issue of capital stock by companies, we examine the position under the Delaware statute and in India. Delaware The Delaware statute makes little effort to regulate the issue of capital stock by corporations, which are free to make issues as they deem fit. The only restrictions are those that a corporation might choose by inclusion in the Certificate of Incorporation. 92 We can, therefore, conclude that the Delaware statute is not concerned with the objects for which corporations issue securities, and this is quite consistent with its minimalist approach. But the corporate statute is not the final word, as federal Securities Laws are also applicable to public issues of securities. All issuers of securities, including corporations, must file a registration statement with the Securities and Exchange Commission (SEC), established under the Securities Exchange Act of 1934 93 before they can “sell” their shares or other securities. 94 Use of the word “sell” in the statute is significant, as it indicates the tendency in the United States to treat corporate shares as commodities that are regularly traded, rather than instruments that represent the capital and ownership of corporations. Originally, the registration statement had to “state the principal purposes for which the net proceeds …. are intended to be used and the approximate amount intended to be used for each such purpose.” 95 This recognized the principle that public issues of securities would be for specific purposes and promoted a degree of accountability in the handling of the proceeds. But this has been discarded, and now, it is not compulsory that a company must have specific purposes for the issue of its securities. When a company has “no current specific plan for the proceeds,” it is adequate if the “principal reasons” for the issue are stated and discussed. 96 A company with no current need for capital can issue its shares as long as it discloses the factual position that it has no such need. The Securities Regulations also permit “blank check” companies that have no “specific business plan or purpose” to issue securities to the public. 97 The SEC is empowered to make special disclosure rules for issue of securities by blank check companies and regulate the application of the proceeds. 98 Rule 419 of Regulation C framed by the Securities and Exchange Commission provides for the deposit of the proceeds from the issue of securities by blank check companies in an escrow account or in specified securities. In result, the position in the United States is that the presence of serious or genuine business purpose is not a prerequisite for public issue of shares by companies. India Two distinctive legal phases can be identified in India with respect to public issue of capital stock by companies, one until the 1990s before the Securities and Exchange Board of India Act, 1992 99 was enacted, and the other, after the said statute was enacted and the Securities and Exchange Board of India (SEBI) was established as the super-regulator of the Indian
Delaware General Corporation Law, § 151(a) 15 USC § 78a et seq., 94 Securities Act of 1933, 15 USC § 77a et seq., § 5 95 Regulation S-K (17 CFR Part 229), Item 504 96 Ibid. 97 Securities Act, § 3(b)(3) 98 Ibid. § 3(b)(1) 99 Act No. 15 of 1992 93
capital market. 100 SEBI is the Indian counterpart of the SEC and it has the specific mandate of “promote the development” of the stock market “by such measures as it thinks fit.” 101 This provides a clue in understanding the bias of SEBI regulation. SEBI is charged not merely with regulating the stock market, but also with “promoting” the market, and it holds a virtual carte blanche for the purpose. Until the 1990s, an Indian company of the English business model had to file a prospectus with the incorporating authority before it could raise capital from the public by the issue of shares of its capital stock. 102 The corporate statute had a set of comprehensive provisions on the disclosures to be made in prospectuses, and it was obligatory for a company to declare in the prospectus the objects of the proposed issue, the project cost and the means of financing, including contribution by the promoters. 103 This would indicate that for a company to raise capital from the public by the issue of its shares, it must have a serious and concrete business purpose. The entry of SEBI has made a difference to this position. As noted above, SEBI has wide, almost blanket, powers to regulate the stock market and it has framed the SEBI (Disclosure & Investor Protection) Guidelines, 2000, which contain elaborate provisions on prospectuses and the raising of share capital by companies. The earlier provisions in the corporate statute also continue, which means that there are now in India two sets of regulations governing the raising of capital by companies. The regulations introduced by SEBI are summarized below. •
For new companies to enter the capital market with public issues, eligibility is judged with reference to their business record and net worth. 104
But new companies without any track record or financial standing can also make a public issue, if the size of the issue is at least 100 million rupees and a sizable part of the issue is taken up by banks or other “qualified institutional buyers,” which are mostly professional investment or financial agencies.105 The apparent regulatory intention is that if the issue is of a minimum size and has the support of expert investors that is proof of the bona fides of the issue. In such case, the track record and the net worth of a company are not important.
Companies that are already listed on the stock exchanges can make further issues of shares, subject to restrictions on the volume of resources to be raised. The total amount of a new public issue by a listed company cannot exceed five times its net worth prior to the public issue. This rule is again subject to the exception that if a sizable part of the issue is taken up by banks or institutional investors, the ceiling would not apply. 106
The importance earlier given (in the corporate statute) to the “project” of a company as the object of the issue of shares is now diluted and companies are permitted greater flexibility. They are encouraged to approach the market, which is best reflected in the recognition given to raising funds for the purpose of “rotation such as working capital.” 107 This new standard, evolved by SEBI recently in 2000, is less rigorous
Securities and Exchange Board of India Act, 1992, § 3 SEBI Act, § 11(1) 102 Companies Act (India), S. 60 103 Ibid. Schedule II, Part I, Item IV 104 Ibid. Chapter II, Clause 2.2 105 Ibid. 106 Ibid. Clause 2.3 107 Ibid. Clause 220.127.116.11 101
than the earlier regime under the corporate statute in which the “project” for which the public issue was proposed was given importance. This indicates the regulatory bias to promote in the stock market, which is consistent with the statutory mandate of SEBI. •
But the SEBI Regulations promote accountability in the matter of application of proceeds of public issues. They provide for greater transparency by requiring the deposit of the proceeds in a separate bank account and disclosure of the details of utilization. The status of the unutilized amount must be disclosed regularly in the balance sheets under appropriate heads. 108 These provisions are meant to enable the tracking of the proceeds of public issues.
Although the Indian regime on public issues has moved towards greater flexibility, there can be little doubt that it still considerably retains the regulatory theme. But the departure from the earlier position that public issues had to be only for corporate projects dilutes the business theme and promotes the financial theme of corporate and securities laws in India, and this represents convergence with the American model. ii. Application of Share Capital Having raised capital from public issues, the next question is with respect to application of the capital by corporations. Here again, there are significant differences between Delaware and India. Delaware If we understand corporations as vehicles created for carrying on specific, predefined activities, then defining their business objects becomes important. It would automatically follow that the resources of a corporation represented by its capital can be applied only for those purposes. But the Delaware statute, with its financial theme, pays scarce attention to business objects and it is adequate if the incorporation document states that, “the purpose of the corporation is to engage in any lawful act or activity for which corporations may be organized.” 109 The statute does not obligate corporations to specify their proposed business, nor does it make any efforts to ensure that they engage only in such businesses. On the contrary, corporations are given full freedom with respect to their activities, which means that they can apply their capital for any purpose, subject to the fiduciary duties and the standard of care rule applicable to managements under the common law. The freedom of corporate managements to pursue any business activity is valuable from the perspective of corporate governance and accountability, and the practical consequences of the Delaware regime can be explained with the cases of Enron and General Electric. Enron Corp. (Enron), an energy company founded in 1930, was apparently overpowered by the Net frenzy of the 1990s and ventured into the broadband business. In 1999, it incurred capital expenditure of 1,216 million dollars under the head “wholesale energy operations and services,” and it is stated that the expenditures were “due primarily to construction of domestic and international power plants and the Enron Broadband Services fiber optic network.” 110 Information on the precise amount spent on the fibre optic network is not available. But the fact that the Enron management could be swept by the Net tide of the 108
Ibid. Clause 18.104.22.168 Delaware General Corporation Law, § 102(a)(3). This is, of course, subject to limited exceptions relating to banking business and education. 110 Enron Corp. Form 10-K for the year ended December 31, 1999, available from http://www.sec.gov/Archives/edgar/data/1024401/0001024401-00-000002.txt 109
1990s and commit a large amount of money for the construction of a broadband network is significant. Enron management did not have to even make any declarations for such new business projects, much less obtain any approvals. In the Delaware regime, there are no systemic safeguards against such adventures by corporate managements, and this undermines their responsibility. General Electric Co. (GE) presents what might be called the other facet. It is a company of longstanding and hoary lineage, founded in 1890 by no less a personality than Thomas Alva Edison. The classification of GE with the SEC is “Electronic & Other Electrical Equipment (No Computer Equip).” For most part of its existence, GE was indeed a company that manufactured electronic and other electrical equipment. But the recent decades have seen a transformation of its business, which is evident from its financial results. During this period, GE closed many of its manufacturing plants in the United States and shed thousands of employees. 111 It has gradually transformed itself from a manufacturing company into a conglomerate with a large part of its revenue and profits coming from financial services and media businesses. In the five years between 2000 and 2004, the contribution of financial services and media businesses to the revenues of GE has ranged between 42 and 47 percent and their contribution to its profits was between 30 and 47 percent. 112 Under the corporate law, the managements of Enron and GE both had the freedom to mould or shape the business of the companies completely as they desired. They were not required to seek any approvals for their business plans, nor even make disclosures or declarations on the considerations for embarking on the new activities. One of them, GE, has earned large profits and the market price of its shares appreciated manifold, but the other company, Enron, collapsed and filed for bankruptcy. From a business perspective, therefore, it is possible to argue both for and against the freedom in law that allows corporate managements to take up any business activity. But such freedom also has other dimensions –namely corporate governance and accountability. The unchecked authority allowed by the law for managements to venture into any business undermines their accountability, and experience shows that speculative ventures can lead to instability. India The position in Indian company law of the English variety is quite different. Although the statute does not explicitly restrict the freedom of companies in dealing with their capital, the Doctrine of Ultra Vires, recognized by the Courts in1875, effectively checks their freedom. 113 The principle is that persons who have contributed capital to a company, whether share capital or credit capital, have done so on the basis that it would be applied for the business objects spelt out in its Memorandum of Association, and the company must not divert its capital to any other purpose. The importance of business objects was also affirmed by the process of amendments to the business objects of companies. Until recently, amendment of the business objects of a company required shareholder approval as well as regulatory approval. Public notices were a part of the regulatory approval procedure and these were intended to enable any persons, in 111
See generally Thomas F. O’Boyle, At any Cost: Jack Welch, General Electric and The Pursuit of Profit, (New York: Alfred A. Knopf, 1998) 112 Available from http://www.ge.com/en/company/investor/ar/mda_segop_summary.htm, October 2005 113 It is an interesting fact that on the question of freedom to deal with corporate capital, English law started on a freer note and moved towards rigidity, whereas the American law moved from a position of rigidity to laxity.
particular, the creditors, to voice their objections, if any, to the proposed amendments. But under the liberalization agenda adopted in the 1990s, the requirement for regulatory approval was abolished, and it is sufficient if the shareholders approve amendments to the business objects of companies. 114 This, again, removes a check on the freedom of companies to deal with their capital and promotes convergence with the American financial model. iii. Types of Shares The freedom that the statute grants companies to devise varieties of securities provides another clue in understanding its characterization of corporations and their securities. Here again, the Delaware statute is quite liberal but the Indian statute is more restrictive, as the following discussion shows. Delaware The Delaware statute, as noted earlier, treats capital stock and the shares of stock virtually as commodities in which a company trades. Consequently, it adopts an enabling rather than regulatory approach and makes little effort to regulate the right of companies to devise and issue any variety of shares. Companies have complete freedom in devising and issuing securities and determining their rights and obligations. The statute endorses the right of companies to issue securities with such “voting powers, full or limited, or no voting powers, and such designations, preferences and relative, participating, optional or other special rights, and qualifications, limitations or restrictions” as are stated in the Certificate of Incorporation or in the resolutions passed by the directors, if the directors are authorized by the Certificate of Incorporation for the purpose. 115 The only restrictions are those that a company might choose by inclusion in its Certificate of Incorporation. 116 These provisions in the Delaware statute indicate that it treats dealing in securities itself as corporate business, and the idea that shares represent corporate capital raised for carrying on business activity is not dominant. Easterbrook and Fischel accurately sum up the prevailing American view of corporations and their securities. The corporation and its securities are products in financial markets to as great an extent as the sewing machines or other things the firm makes. Just as the founders of a firm have incentives to make the kind of sewing machines people want to buy, they have incentives to create the kind of firm, governance structure, and securities the customers in capital markets want. 117 Easterbrook and Fischel go on to observe: The founders of the capital markets will find it profitable to establish the governance structure that is most beneficial to investors, net of the cost of investments. People who seek resources to control will have to deliver more returns to investors. Those who promise the highest returns –and make the promises binding, hence believable – will obtain the largest investments.
Companies Act (India), § 17(2), as amended by the Companies (Amendment) Act, 1996, with effect from March 1, 1997 115 Delaware General Corporation Law, § 151(a) 116 Ibid. 117 Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law, (Cambridge, Massachusetts: Harvard University Press, Reprint, 1998), 4-5
These comments made in late 20th century highlight the recent understanding of corporations predominantly as issuers of securities traded in the stock market, and they make a sharp contrast with the earlier conception of corporations described by Berle and Means. 118 The two descriptions bring out the transition that has occurred. Business corporations are no longer groups of businessmen doing business jointly, but finance mechanisms used for raising capital from the public by the promise of high returns. The returns need not be only from dividends paid out of business profits, but equally from rise in the market prices of shares. It is quite a natural development that the incentive of returns from trading in the shares has emerged as a more important consideration than the business profits of companies. India Consistent with the English philosophy that companies are business vehicles that raise capital for their business, the statute regulates the varieties of shares that they can issue, and Indian companies lack the freedom that Delaware corporations have in devising and issuing any variety of shares. In the pre-liberalization era, Indian companies could only issue two varieties of shares –namely, preference shares and equity shares, 119 but now a third variety – nonvoting shares has been added. All the three types are subject to regulation, as the following discussion shows. Preference shares are subject to compulsory redemption, and companies must repay the preference share capital in not more than ten years. 120 Repayment can be made only from three sources. 121 They are, respectively, the accumulated profits, the proceeds of a fresh issue and the balance in its share premium account. 122 Preference shares carry no voting rights, except when the dividend payable on them remains unpaid. The equity shares regime has undergone changes after the adoption of the liberalization agenda in the early 1990s. Earlier, all equity shares were equal in all respects and each share carried one vote. 123 Disproportionate voting rights were expressly prohibited. 124 Companies were also prohibited from restricting the voting rights of shareholders except on the ground of nonpayment of subscription money. 125 These provisions clearly defined the “ownership” position of share capital in companies and prohibited companies from diluting the rights attached to equity shares. By implication, this scheme clarified that capital is meant for enabling the corporate business and not an end by itself. The clarity of the regime outlined above is somewhat diluted by a recent amendment, which enables companies to issue equity shares “with differential rights as to dividend, voting or otherwise.” 126 This is part of the move of the Indian company law towards the American financial model, but there is a rider that the differential rights must conform to the conditions prescribed in subordinate legislation. The Companies (Issue of Share Capital with Differential Voting Rights) Rules, 2001, have been framed for the purpose and they permit only profitable companies with a clean record to issue shares with differential voting rights. The component of differential voting shares cannot be more than twenty-five percent of the total share capital and differential rights are permitted only with respect to voting. Companies cannot make any distinctions for other matters such as dividend or participation 118
Berle and Means, The Modern Corporation and Private Property, Note 13, above Companies Act, 1956 (India), § 85 120 Ibid. § 80A 121 Ibid. § 80(1)(a) 122 For a discussion on premium, see (v), below. 123 Companies Ac, (India), § 87 124 Ibid. § 88 and 89 125 Ibid. § 181 and 182 126 Ibid. § 86(a), as amended by the Companies (Amendment) Act, 2000, with effect from December 13, 2000 119
rights. Also, existing shares with equal voting rights cannot be converted to differential voting shares. Despite the amendments, therefore, Indian law retains its regulatory theme. iv. Consideration for Shares, Par Value and Premium Shares, whether treated as the source of capital for corporate business activity or as commodities in themselves, are undoubtedly valuable instruments. For one, the voting rights attached to shares determine corporate control. Secondly, they offer liquidity for their holders because of their tradability in the stock market. There can be little dispute that shares are valuable and, therefore, the question of consideration payable to companies for issuing shares is important. Delaware Delaware corporations can issue shares of their capital stock for “consideration consisting of cash, any tangible or intangible property or any benefit to the corporation, or any combination thereof.” 127 Significantly, it does not refer to “adequate” or “appropriate” consideration. This provision, although quite loose, recognizes the principle that shares are valuable and cannot be distributed as largesse. The general rule is that the directors can determine the consideration, unless the Certificate of Incorporation vests authority in the shareholders. 128 While the statute provides no guidance on the standards to be applied in determining the consideration payable for shares, it is keen to protect the directors by stipulating that, “in the absence of actual fraud in the transaction, the judgment of the directors as to the value of such consideration shall be conclusive.” 129 This is intended to protect the directors against any charge with respect to the adequacy of the consideration payable for shares and dilutes the principle that shares are valuable instruments that can be issued only for consideration. Companies are also free to make “determination of amount of capital.” 130 They can determine any portion of the consideration received by them towards the issue of their shares to be “capital,” subject to the condition that in the case of shares with par value, the amount of capital cannot be less than the par value. For shares without par value, there are no restrictions and companies can determine any part of the consideration to be capital. This freedom is important for the payment of corporate resources to the shareholders, as it enables companies to decide the net assets for the purpose of payment of dividends and repayment of capital, which are discussed a little later. The statute also empowers the directors of a company to allocate the surplus, defined as the excess of the net assets over the amount of capital,131 to any class or classes of shares. This provision deals essentially with the participation rights of shares, and in effect, permits companies to issue shares with no participation rights. But the wording is curious, as it permits the directors to apply the surplus selectively to certain class or classes of shares, which would benefit their holders. The directors are apparently empowered to choose among the different classes of shares that a company might have issued and allocate any part of the surplus to the selected classes. But this would be subject to the terms of issue of the different classes, and it would not be possible for the directors to make post facto selections. But the scheme of the provision is significant for its illustration of the permissive philosophy of the Delaware statute. 127
Delaware General Corporation Law, § 152 Ibid. § 153 129 Ibid. § 152 130 Ibid. § 154 131 Ibid. 128
India The Indian Companies Act, 1956, considers shares as valuable and the statute is more regulatory. Efforts are made to ensure that shares are issued only for adequate consideration. Although the amendments made in the recent liberalization era have considerably relaxed the rigor of the earlier regime, the regulatory theme continues, as evident from the following. •
Shares must have a par value, which is subject to regulation and cannot be less than one Indian rupee in any case. It can be below ten rupees only if the issue price is five hundred rupees or more per share. 132
The consideration payable to companies for the issue of their shares cannot be less than the par value. Issue of shares at less than par value requires regulatory approval and the discount cannot be more than ten percent unless there are exceptional circumstances. 133
Companies can issue shares for consideration higher than the par value and the excess is termed “share premium.”
The amount of premium that companies could collect on their shares was earlier subject to regulation under the Capital Issues (Control) Act, 1947, a wartime measure introduced by the colonial British Government. It was retained in independent India until the early 1990s, when the SEBI was set up. In the earlier regime, new companies making their initial public offering could not charge any premium, and only listed companies making further offerings could do so. The amount of premium was subject to prescribed ceilings computed with reference to their net worth and the average earnings per share in the three preceding years. The scheme also had an element of flexibility if the market price of the shares was higher than the maximum premium computed with reference to the net worth and average earnings, by twenty percent or more. 134 This framework promoted the ideal that the consideration received by a company for its shares must have a rational nexus to its intrinsic value, but it is no longer so in the present SEBI regime.
Now, there are no ceilings on the premium that a company can collect on its shares. SEBI permitted the practice of “book-building” in 1995, which enables companies to approach the market without a firm issue price. Book building is a process similar to auction and the price of shares offered by companies is supposed to be discovered by the market. There would be no clarity or certainty on the amount that a company would raise from the public issue of its shares and it is quite removed from the earlier concept that companies would approach the market for an ascertained sum of capital required for their business. In the present arrangement, the earlier ideal that the offer price for the shares of a company must have some relation to its intrinsic value also has no place.
Only companies that do not opt for book building are required to justify the issue price of their shares, by presenting financial data and explaining the price with
SEBI (Disclosure & Investor Protection) Guidelines, 2000 (India), Clause 3.7.1 Companies Act, 1956 (India), § 79 134 These guidelines were issued under the Capital Issues (Control) Act, 1947, a war-time measure introduced by the colonial British government. It continued until the establishment of SEBI in the early 1990s. K.V. Shanbogue and K. Ganesan, Guide to Capital Issues and Listing, (Nagpur, India: Wadhwa, 1987) 124-125 133
reference to asset value and earnings. 135 Merchant bankers are prohibited from involvement in the public issue of such shares if the issue price cannot be justified by the data. •
For companies that adopt book building, it is adequate if the prospectus states that the price has been determined on the basis of demand from investors. 136 The scheme is, quite obviously, designed to encourage companies to opt for book building, rather than to approach the market with firm prices for their shares.
There has always been a rule that when a company issues shares for consideration other than cash, it must have a written contract that shows the consideration for the issue and a copy of the contract has to be filed with the incorporating authority. 137 This is designed to check the issue of shares except for valuable consideration, and to promote transparency with respect to shares issued for non-monetary consideration. There are instances where the consideration was held to be insufficient and the holders of shares were held liable to make good the shortfall.138 The clarity of this regime is now diluted by the introduction of “sweat-equity,” discussed a little later.
The Indian regime outlined above, although generally business-oriented, is definitely moving towards greater laxity and financial-centricity of the American variety. Among the changes made since 1991, the permission for the issue of “sweat-equity shares” is important. Sweatequity shares issued to directors and employees for non-monetary consideration are at the root of the stock options issue, discussed below. vi. Stock Options The stock options granted to employees and directors enable them to acquire the shares of companies and play an important role in corporate governance and in the stock market. The grant of shares to managers appears to have been originally devised as a measure to reward managerial performance and to encourage them to have a proprietary stake in companies. This is the theoretical justification for the grant of stock options to employees and directors, and to this extent, few can dispute its reasonable and beneficial character. But the experience with stock options to employees and directors has thrown up a number of negatives, and these can be traced to the state of corporate law to significant extent. Delaware The Delaware statute, as we have seen, enables the issue of shares for any consideration and the judgment of directors on the adequacy of consideration is final, in the absence of fraud. It has an equally open set of provisions governing the grant of “rights and options respecting stock,” 139 and companies have complete freedom to issue rights and options as well as determine the terms of issue. The only condition is that if the shares to be issued towards the rights or options have a par value, the consideration payable for them must not be less than the par value. This is of little practical consequence, as companies generally tend to fix very low values if at all they decide to have par values for their shares.140
SEBI (Disclosure & Investor Protection) Guidelines, 2000 (India), Clause 6.13 Ibid. 137 Companies Act (India), § 75(1)(b) 138 See e.g. Alote Estate v. R.B. Seth Hiralal Kalyanmal Kasliwal, (1970) 40 Com. Cases 1116; AIR 1971 SC 920 139 Delaware General Corporation Law, § 157 140 For instance, the shares of Sycamore Networks (NasdaqNM: SCMR) have a par value of $ 0.001. 136
The statute again clarifies that “in the absence of actual fraud in the transaction, the judgment of the directors as to the consideration for the issuance of such rights or options and the sufficiency thereof shall be conclusive.” 141 It explicitly recognizes the grant of rights and options to employees and directors, 142 but makes little effort to regulate them. In consequence, corporations have complete freedom to issue shares towards stock options, and the statute makes little effort to promote responsible exercise of authority by corporate managements in issuing stock options. These set of provisions are also in negation of the principle that shares are instruments that represent corporate capital raised for business purposes. Quite surprisingly, the public discourse on stock options largely ignores the loose legal regime that permits many of the known negatives and treats stock options as a purely economic phenomenon. Lack of attention to the permissiveness of the legal regime makes the debate both incomplete and inaccurate. India As noted earlier, the longstanding position in India is that shares must have a par value and the consideration for their issue cannot be less than par value. Shares can be issued for nonmonetary consideration, but it has to be recorded in a written contract, a copy of which is to be filed with the incorporating authority. Yet another check on the freedom of companies to issue shares is the condition that any new issue has to be offered to the existing shareholders in proportion to their holding. 143 There are, thus, some systemic safeguards to ensure that company managements handle shares with care and circumspection. In this regime, it would be difficult for companies to either freely issue shares or grant rights and options. The clarity of the position outlined above is diluted by a recent legislative amendment that permits the issue of “sweat-equity” shares, defined as equity shares issued to “employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called.” 144 The new sweat-equity regime is a part of the move towards the American financial model, initiated in the 1990s. It encourages the creation of more shares and promotes trading activity in the stock market. The permission for the issue of sweat-equity represents a climb-down from the earlier regime that strictly monitored the consideration receivable by companies for the issue of their shares. However, the principle that consideration is a must for the issue of shares is retained in the new regime, as evident from the reference to intellectual property rights and value additions. The corporate statute lays down just one condition for a company to issue sweat-equity shares – namely, that it must have been in business for at least one year, and leaves it to subordinate legislation to develop a more elaborate regulatory framework. Two sets of rules have been developed for sweat-equity, one by SEBI for listed companies145 and the other, by the government of India for unlisted companies.146 They both, however, share a common approach.
Delaware General Corporation Law, § 157 Ibid. 143 Companies Act (India), § 81(1A) 144 Ibid. § 79A introduced by the Companies (Amendment) Act, 1999, with effect from October 31, 1998 145 SEBI (Issue of Sweat Equity) Regulations, 2002 (India) 146 Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003 (India) 142
The price for the issue of sweat-equity by listed companies is linked to the market price of their shares, which promotes reasonable correlation between the issue price of sweat-equity and the market price.
For unlisted companies, the criterion is “fair price” calculated by an independent professional.
The intellectual property contributed in consideration of the sweat-equity shares must be evaluated by professionals, and this would enable comparison of the value of the intellectual property with the value of the sweat-equity shares issued towards such property.
Shareholder approval is necessary for the issue of sweat-equity and systemic provisions are made for transparency of the consideration for which they are issued.
Sweat-equity shares are subject to a lock-in period of three years from the date of issue.
If the intellectual property acquired by the issuing company represents an asset, it must be recorded in the balance sheet of the company, but if they do not represent any asset, then the consideration is to be expensed according to applicable accounting standards.
In addition to sweat-equity, the Employee Stock Options and Employee Stock Purchase Scheme Guidelines, 1999, framed by SEBI also enable companies to issue options and shares to employees at less-than-market prices. Although they stipulate a minimum lock-in period, the object is clearly to increase the number of shares in the stock market and to confer a benefit on company employees by making available shares at less-than-market prices. This appears to be another leaf from the American model of corporate management and stock market culture. vii. Dividends Dividends are the periodic reward paid to the shareholders for the capital contributed by them to companies. As we have seen earlier, companies are under no obligation to pay any dividend on shares. On the contrary, corporate law, with the object of protecting creditors, restricts payments by companies to their shareholders. These general principles are common to both the Delaware corporate law and English company law, yet there are some distinctions. Delaware Directors of companies have the authority to pay dividends 147 and they have considerable freedom in the matter. Payment of dividends must be either out of the surplus or the net profits. “Surplus” is defined to be the excess of net assets of a company over the amount of its capital, and “net assets” means the excess of total assets over the total liabilities of a company. 148 We have already seen that the directors have the authority to determine that any portion of the consideration received for the issue of shares would be the capital. This freedom of directors allows them to determine the surplus for the purpose of dividend. Another condition is that the assets must be “sufficient to pay any debts of the corporation for which payment has not been otherwise provided.” 149 A corporation must, therefore, be 147
Delaware General Corporation Law, § 170(a) Ibid. § 154 149 Ibid. § 244(b) 148
solvent before it can pay dividends, but the statute provides no guidance on the valuation of assets, which means that the directors are free to form a reasonable opinion on the value. The net profits of a company are the other source for distribution of dividends to shareholders. The Delaware statute has no provisions on the financial reporting systems that companies must follow and provides no guidance on determination of net profits. But the capital of a company must be in tact before it can pay dividends to shareholders. If the capital is impaired either by depreciation in the value of assets or by losses, the general rule is that they must be made good before the company can pay dividends. This is more rigid than the position in India, explained below. India Indian company law permits the payment of dividend for any year only from the profits earned in that year, and after providing minimum depreciation on assets at the prescribed rates. 150 Dividends can be paid only out of current year profits, and not from the retained profits of earlier years. The Indian statute, however, pays no attention to accumulated losses, unlike its Delaware counterpart. Therefore, a company can pay dividends for any year if it earned profits in that year even if its capital is impaired by losses suffered in earlier years. However, companies cannot distribute their entire profits as dividends and must transfer between two-and-a-half and ten percent of the profits to reserves, with the percentage of transfer depending on the quantum of dividend they propose to distribute. 151 Indian company law also recognizes payment of interest on share capital raised for meeting the “expenses of the construction of any work or building, or the provision of any plant, which cannot be made profitable for a lengthy period.” 152 Payment of interest is also subject to regulatory approval, and is an almost non-existent practice. viii. Stock Dividends or Bonus Shares Dividends are generally paid in cash. Although cash payment is the general practice, the corporate statutes also permit the issue of shares towards dividend. This is done by converting a portion of the profits or retained earnings into capital stock. Here, payment of dividend is by issue of shares instead of payment in cash, and the conditions that apply to cash dividend –namely, availability of profits or surplus would apply equally to stock dividends. The Delaware statute uses the term “stock dividend” 153 to refer to dividends paid by issue of shares and in the Indian statute they are called bonus shares. 154 Payment of stock dividends is attractive for companies for two reasons. Firstly, it saves cash outflow for the company, and secondly, it enables shareholders to take advantage of the market price of the shares, as the following discussion shows. Delaware The law on the amount of profit to be designated as capital or “capitalized” towards the issue of stock dividends is similar to the law on the consideration for the issue of shares. Such amount cannot be less than the par value of the shares if the shares have par value, but if they have no par value, the directors are free to determine any amount. 150
Companies Act, 1956 (India), § 205 and Schedule XIV Companies (Transfer of Profits to Reserves) Rules, 1975 (India) 152 Companies Act, 1956 (India), § 208(1) 153 Delaware General Corporation Law, § 173 154 The Indian statute does not explicitly authorize the issue of bonus shares, but there are references in the statute to bonus shares, e.g. Companies Act, 1956 (India), § 75(1) and § 80(5). 151
Stock dividends enable shareholders to take advantage of the market price of the shares of a company. Let us take the case of shares with a par value of one dollar and a market price of two dollars. If the company wishes to issue a hundred thousand shares towards stock dividend, it must capitalize a hundred thousand dollars of its retained earnings or profits, which would cover the par value of the proposed stock dividend. By capitalizing one dollar of its profits and issuing shares at this par value, the company puts assets of a much higher market value, represented by the market price of the shares, in the hands of its shareholders. The capitalization of a hundred thousand dollars of profits translates into two hundred thousand dollars for the shareholders, in terms of market value of the shares. Achieving similar results for shares without par value would be even simpler, as companies are free to determine the amount of profits or retained earnings, which they must apply for the issue of a given number of shares towards stock dividend. Theoretically, this can enable even greater disproportion between the amount of profits to be capitalized and the market value of the resulting shares. 155 By a stroke of the pen, a company can convert a particular amount of its profits or retained earnings carried in its financial statements into liquid assets for its shareholders in the form of shares with a higher market value. The fact that the increased market value in the hands of shareholders is without proportionate economic substance raises questions on the ethical aspect of the arrangement permitted in law. India In India, as we have seen, shares must have par value. Therefore, companies that issue bonus shares must capitalize an appropriate part of their accumulated profits, equivalent to the par value of the bonus shares. In the pre-SEBI era, there were curbs on the issue of bonus shares by listed companies, which could not issue more than one bonus share for each outstanding share. The frequency of issue was also subject to regulation, 156 but these checks have been generally discarded in the present rules, 157 which are quite sketchy. Companies can now freely issue bonus shares out of their accumulated profits, except that bonus shares cannot be issued in lieu of dividend payment. The present regime is meant to encourage, rather than regulate bonus issues, which is quite in line with the increasing stock market-centricity of corporate arrangements in India. 158 This is part of the move of company law in India towards the American financial model in which the constant endeavour is to increase the number of shares that circulate in the stock market and promote their trade. ix. Repayment of Capital Repayment of capital is similar to payment of dividends on shares as it involves the payment of corporate resources to the shareholders. Corporate statutes are, accordingly, cautious in 155
We must also address the question, what happens if the market value of shares is low? In that case, companies are unlikely to resort to stock dividends, as there is no incentive for them to do so. Continuing with the example of shares with a par value of one dollar, if they trade in the market at less than a dollar, there would be no charm for the company to pay stock dividends. 156 These controls were implemented under the Capital Issues (Control) Act, 1947. See Shanbogue and Ganesan, Note 132, above. 157 SEBI (Disclosure & Investor Protection) Guidelines, 2000 (India), Chapter XV 158 Infosys Technologies Limited (NYSE: INFY) is a prominent user of the technique of bonus shares. It made its initial and only public issue of about 1.4 million shares in 1993, and has since issued more than 228 million bonus shares in the next ten years until fiscal year 2004-05. It plans yet another bonus issue in 2005-06, which would again double the number of its shares.
permitting the repayment of capital stock. The incentive for companies to repay capital and buyback their shares is that it generally produces a positive impact on the market prices of the shares, for two reasons. First, the prospect of shareholders receiving cash from the company, and second, the expectation that earnings per share would increase in the future years on account of the reduced number of shares that would be outstanding after the buyback. The positions in the Delaware and Indian statutes on repayment of capital by companies to their shareholders are summarized below. Delaware Quite typically, the statute authorizes corporations to “purchase, redeem, receive, take or otherwise acquire, own and hold, sell, lend, exchange, transfer or otherwise dispose of, pledge, use and otherwise deal in and with its own shares.” 159 This provision enables corporations to virtually trade in their shares and supports the view that the Delaware statute treats the shares as stock-in-trade. Corporations can, as a matter of course, purchase their shares and pay consideration to the holders of such shares. However, such dealing in shares involves repayment of capital, and it is subject to conditions. The capital of a company buying its shares back must neither be impaired at the time of purchase of shares, nor likely to be impaired as a consequence of purchase or redemption of shares. Purchase or redemption is also subject to the solvency test, as it is clarified that reduction of capital is not permissible “unless the assets of the corporation remaining after such reduction shall be sufficient to pay any debts of the corporation for which payment has not been otherwise provided.” 160 These safeguards represent some continuity with the traditional principle that capital stock is the core of corporations and provision must be made for other liabilities before corporations can apply their resources for payment to the stockholders. But these minimal provisions do not prevent companies from unhealthy practices such as borrowing for the purpose of making purchase or redemption of shares. 161 India Until recently, the Indian statute was rigid in preserving the sanctity of capital stock, and the application of corporate resources for the purchase of shares issued by companies was subject to stringent regulations. Public companies were prohibited from either purchasing their own equity shares or lending money to other persons for the purpose. 162 Reduction of share capital for any purpose whether for the deletion of capital eroded by losses or for the repayment of capital to the shareholders needed regulatory approval and the process afforded the creditors an opportunity to oppose the reduction, if they wished to do so. While these general rules continue, the liberalization process initiated in the 1990s has led to relaxation of the regime on purchase of shares by companies. Now, companies can purchase their shares, subject to specified conditions.163 The new regime permits buyback of shares from (a) accumulated profits, (b) balance in the share premium account or (c) the proceeds of a new issue. Buyback in any year is subject to a ceiling of twenty-five percent of the paid-up capital and another important condition is that the debts of a company proposing buyback of its shares must not exceed twice its net worth. This is intended to discourage companies from incurring debt for the purpose of financing buybacks. 159
Delaware General Corporation Law, § 160(a) Ibid. § 244(b) 161 See e.g. Edward Chancellor, “Sold Out,” Note 31, above. 162 Companies Act, 1956 (India), § 77 163 Ibid. § 77A, introduced by the Companies (Amendment) Act, 1999, with effect from October 31, 1998 160
Therefore, the regulatory theme continues substantially in India despite the permission for companies to buyback their shares. In addition to the conditions specified in the statute, SEBI has framed the SEBI (Buy-Back of Securities) Regulations, 1998, which govern the procedure to be followed by listed companies for the repurchase of their shares. Yet another set of regulations, the Private Limited Company and Unlisted Public Company (Buy-Back of Securities) Rules, 1999, framed by the government of India deal with the procedure to be followed by unlisted companies. These regulations promote transparency, but they are representative of “regulatory overkill,” which is common in India. The tendency for regulatory overkill appears to even stronger for stock market regulation, judging from the volume of regulation now in existence and still being churned out by SEBI. x. Corporate Capital Structure & Its Stability Corporate law has traditionally accorded a stable place to share capital and restricted the freedom of the companies to deal with it. This principle has been progressively undermined with the rise of the financial model of the corporation in which importance is given to the freedom of corporations to freely deal with their “securities,” and shares of capital stock are increasingly treated as just another variety of securities issued by corporations. The element of “ownership” that was essential to capital stock is steadily weakened, although the other traditional features –namely, voting and participation rights continue. All securities issued by companies, including shares of capital stock, are treated as their stock-in-trade, and the regulatory policy is to encourage trade in the securities, except that trade in shares is subject to a loosely defined test of solvency. A natural consequence of these developments is that the capital stock no longer has a stable and fixed place in the structure of a company, and its position is almost as fluid as that of the stock-in-trade of the company. Conclusion An object of this paper to is to explain the changes that have occurred in the position of capital stock, its shares and their holders, which undermine the basic tenets of corporate law and the theoretical model on which it is constructed. In particular, the voting and participation rights of shareholders, which are at the root of corporate governance were based on the premise that the shareholders play an active role, at least by constituting and regulating corporate managements, if not managing the corporation by themselves. If this premise is no longer valid, does it call for a review of the traditional position? The answer to this question is of vital importance for corporate governance as well as the stock market. ******