Extreme Times, Extreme Measures: Pandemic-Resistant Corporate Law

These are exceptional times, and policymakers are taking exceptional measures in public health, public finance, monetary policy, and public law. Among the latter, of great relevance to corporate governance are the rules broadening governments’ powers to authorize large share block purchases (e.g., in Germany and Italy). Even stronger proposals are being aired, and in some cases adopted, to inject public funds into companies in exchange for equity (Germany), if not to nationalize businesses altogether (France).

But some incursions into private law have also been made. This is especially true with regard to insolvency (or bankruptcy) law, as documented by Aurelio Gurrea Martinez. Some of the bankruptcy law-related measures change rules that ordinarily apply in the vicinity of insolvency and are therefore at the boundary between insolvency and corporate law. For instance, a number of countries are discussing whether to review directors’ duties in the proximity of insolvency (e.g., the UK and New Zealand: see Licht) or have already done so (e.g., Australia, Spain and Germany).

Similarly, some of the jurisdictions still providing for the “recapitalize or liquidate” rule (which requires directors to promote a recapitalization of the company, convert it into an unlimited liability partnership, or liquidate it if net assets fall below a given threshold), such as Spain, Italy, and Ecuador have chosen to suspend it during the crisis. Finally, in Italy rules on the subordination of shareholders loans have also been suspended.

Should company law rules not specifically dealing with companies in the twilight zone also be tweaked to face the emergency? One obvious focus are rules dealing with how general meetings must be held (see e.g., the UK and Italy). Such rules may be at odds with social distancing provisions wherever they don’t allow for virtual meetings or forms of collective representation of the shareholders. But one can think more broadly about how corporate law should be amended in order to avoid economic rather than viral contagion and keep companies afloat in these exceptional times. Below are some general considerations to guide policymakers in this area, followed by examples of temporary corporate law interventions for the emergency. This post concludes with some thoughts about how to prepare for a similar emergency in the future.

Tackling the current crisis: a framework for tweaking corporate law

What kind of interventions should be made in the area of corporate law? First, the case can be made for adopting, wherever feasible, the simplest form of intervention: the suspension of existing rules or the temporary application of existing lax rules to situations currently covered by strict ones.

The alternative would be to craft new, special temporary rules. While in some cases that may be necessary (as some of the examples below will illustrate), caution is warranted: Experimenting with new (corporate law) rules in exceptional times carries the risk that the new rules will not have been properly pondered, let alone gone through a consultation process or a cost-benefit analysis (as Iris Chiu and her co-authors point out with reference to financial regulation). In addition, in exceptional times such as these, it is likelier that excessive state interventionism and “stealth protectionism” (Pargendler) will be the outcome. Finally, novel off-the-cuff measures could be taken as a response to the political pressure to “do something” for the sake of it rather than because something needs to be done (Romano). While lawmakers and governments may have plenty else to do to show that they are facing the crisis, securities regulators may find themselves in the more awkward position of being seen as on the side lines and therefore strongly tempted to come up with something (as I argued here with specific regard to the 2008 short-selling bans). For this reason, granting regulators new emergency powers rather than allowing them to relax or suspend existing rules should be resisted.

All such measures should have a clear and reasonably short end date, so that the need to extend them will be duly pondered and the risk that they will last too long is reduced.

Needless to say, they should also be proportionate, which means that deviations from the corporate law that applies in normal conditions should be as narrow as possible. One way for the intervention to be proportionate is to suspend normal-times rules in the way that is most deferential to individual companies’ autonomy. In a time of extreme uncertainty, it is safer to let individual companies decide on whether to move away from normal-times corporate law rules – unless, that is, a clear case can be made that individual companies would make choices contrary to the interests of society.

Deference to companies’ choices can take many forms, which policymakers should consider when assessing rules for proportionality. First, rather than themselves suspending rules, policymakers may allow companies to deviate from them (subject to overarching public interests). They may do so by leaving the opt-in decision to the shareholder meeting or the board. Second, and more effectively but also more intrusively, lawmakers may introduce new “majoritarian defaults” (Easterbrook and Fischel, p. 15), based on the notion that, at the time of starting a company or going public, shareholders did not focus on a pandemic such as the current one[1] and that, had they done so, they probably would have chosen a leaner decision-making process. Hence, instead of suspending a given mandatory rule, policymakers may provide for a new, more lenient rule that companies would remain free to opt out of.

Finally, what sort of rules should policymakers tamper with? Normal-times corporate law rules exist to make sure that, throughout their life, companies are managed in the interests of their shareholders and other stakeholders, so long as contractual protections are insufficient to protect the latter. Lawmakers enact those rules because they believe their benefits for investors, other stakeholders, and society more generally are greater than the costs. Things can change dramatically in extreme times. With economies worldwide so disrupted, most companies are in survival mode, and corporate law constraints, justified as they are in normal times, may simply prove fatal to them. Hence, the main focus should be on those rules that may affect a company’s very survival.

In addition, lawmakers write rules based on the assumption that uncertainty may, of course, vary across time but, arguably, not to the point that we presently observe. This raises the question of whether any corporate law rules may become ineffective, if not counterproductive, once the level of uncertainty becomes unprecedented.

Extreme uncertainty also hits share prices. Again, share prices may plummet to the point when rules implicitly relying on prices as estimates of future cash flows may no longer rest on secure ground. Of course, there is no way to tell whether the market has overreacted in recent weeks. At the same time, the market currently discounts a level of uncertainty that will soon disappear as more is known about the health and economic consequences of the pandemic.

Tackling the current crisis: what tweaks?

Every jurisdiction is, of course, different and may require different interventions, but here are some areas that policymakers may consider, with a special focus on EU countries. The suggestions are made having publicly traded companies in mind, although most of them would be appropriate also for closely held companies.

1. Survival: how to facilitate equity and debt capital injections. To ensure that companies survive, attention should be given to rules that hamper quick decisions on vital matters.

While most policymakers are focused on whether companies can borrow to ensure their survival, it is already clear that quickly raising equity could be a lifeline for many companies. Governments in many countries are not helping by tightening public law rules on foreign investments. But they could also help by making equity capital raising easier.

Wherever the law grants shareholders a pre-emption right on newly issued shares, they could relax (if not outright suspend) that requirement, and hence considerably shorten the time it takes to execute a capital increase resolution (within the EU, by at least 14 days: article 72(3), Directive (EU) 2017/1132). That should make it easier to find one or more investors willing to prop up the company via an equity capital injection.[2]

Because timing can be existentially important in securing new funding, another requirement that may be suspended or narrowed is that shareholders approve new issues of shares or delegate that power to the directors within the boundaries set, for EU countries, by article 68, Directive (EU) 2017/1132.[3]

Granted, measures such as these will increase the risk that existing shareholders lose out to buyers of newly issued shares at a bargain. But any self-dealing or other abuse can be dealt with by ex post review, including liability suits for breach of directors’ duty of loyalty, and this seems preferable to chilling all transactions ex ante.

One way for a company to find new equity may be by having the incumbent controlling shareholder cede control to a new one. A mandatory bid, under normal circumstances, would follow, which may, at the margin, rule out not only inefficient control transfers but also efficient ones (see e.g., Bebchuk). Many European jurisdictions allow for exemptions in special situations such as financial distress (see Clerc et al). Others provide for a general exemption power in the hands of the regulator, as in the UK (id). Where the latter does not exist, the current situation may justify a (temporary and default) exemption from the mandatory bid rule. For countries that provide for a general exemption power such as the UK, a general policy could spell out conditions, if any, under which the regulator will still require mandatory bids in case of control transfers during the emergency.

With regard to debt financing, a dominant shareholder even of a listed company may be able to provide cheap debt to an ailing company. In times when the need for cash may be urgent and the avoidance of bankruptcies is in the public interest, restrictions on such cash infusions may have to be eased even at the cost of, again, increasing the risk of abuse. The suspension or relaxation of rules on related party transactions, especially when they considerably lengthen the decision-making process, should be considered. That, incidentally, should also be the case for new shares issues reserved to related parties.[4]

All these measures should be merely default ones: well capitalized companies may want to signal their good shape by opting back to normal-times rules; thereby, they can also reassure their institutional shareholder base that the risk of abuse will not increase.

2. Dealing with extreme uncertainty. Two areas where rules can be tweaked to deal with extreme uncertainty are director liability and control transactions.

2a. Director liability. Companies do not have to be close to insolvency for their managers to get things terribly wrong. Liability for directors’ violations of the duty of care may be too harsh in a business environment of extreme uncertainty (see generally Hill and Pacces). For instance, Germany’s version of the business judgement rule requires the defendant director to prove that they complied with their duty to make informed decisions.

Uncertainty will eventually recede, and we (and judges and regulators in at least some jurisdictions) may be too quick to conclude that harmful choices made during the crisis could and should have been avoided if directors had given due weight to warnings.

Hence, more lenient standards could be temporarily introduced. Reputation concerns and the risk of losing their jobs should be incentives enough for diligent decision-making. Hence, inhibiting risk-taking in an extremely uncertain business environment may be a greater threat than potentially bad decisions by directors.

Any change in this area should take the form of a default rule, granting companies the power to opt back into the ordinary regime whenever they wish.

2b. Hostile acquisitions. Extreme uncertainty also implies low share prices that may attract hostile bids. In the U.S., poison pills are experiencing a revival of sorts. Where, as in the EU (other than in the Netherlands), poison pill-style defenses are unavailable, companies may have to rely on governments to fend off hostile bids. That gives them an incomplete and potentially costly defense: Yet the target may not hold “strategic assets” that trigger government vetting powers. In addition, the bidder may be better connected than the incumbent with the government: Geopolitics may even lead the government to acquiesce to a hostile bid from a foreign company to maintain good relations with a foreign government. In addition, political capital may have to be spent in order to secure the government’s veto, which may then come with formal or informal strings attached.

With low valuations reflecting current uncertainty, shareholders themselves may prefer managers to focus on their business rather than mounting a defense to a low-ball hostile bid.[5] Hence, there may be a need for more contractual freedom in defending against potential hostile acquisitions until the crisis is over.

One possibility is a temporary default rule granting boards the right to approve purchases of share blocks above a given threshold. Another is a temporary default rule requiring a supermajority for the removal of directors if a bid is on the table. Finally, temporary tenured-voting shares could be facilitated through a default rule that doubles the voting rights of shares held for a certain time, but only until a pre-set date or the date when the government declares the emergency over. Again, the stickiness of the default could vary, and opting-back could be made more or less difficult. But there would seem to be no reason to require anything more than a simple majority of the shareholders (or a board resolution) to opt-back to one-share-one-vote before tenured voting becomes effective.

Being prepared for future crises

The current crisis will teach us many lessons. One is to have in place regulatory governance mechanisms that facilitate adaptation of corporate law to emergencies. That would have two main advantages. First, if a new crisis hits, adaptation would be faster and, hopefully, better thought-through. Second, we could reduce the risk that solutions disproportionate for normal times would be adopted under the guise of preparing for a future crisis.

Corporate law legislation should thus include delegations of powers to the government (executive branch) so that a pre-determined set of rules can be suspended (or replaced by leaner one) in an emergency. To identify which rules should be tweaked, the experience of deviating from normal law in the current crisis will help.

ENDNOTES

[1] Arguably, the pandemic was a known unknown, in the sense that it was highly likely to strike at some point but no one could know exactly when. But given that very few people have memory of previous pandemics and governments reactions to pandemics themselves change over time, it is almost impossible to anticipate how best to deal with an exceptional event such as one of this kind. In addition, human beings, both individually and collectively, may be biased against planning for such an event, as Tim Harford explains here.

[2] In the UK, self-regulatory constraints on share issues, which practically limited issuances of shares without granting existing shareholders a pre-emption rights to five percent of the company’s capital have been relaxed: the limit is now 20 percent.

[3] In the US, where it is stock exchange rules that vest shareholders with voting rights on new issues of shares, the New York Stock Exchange has relaxed, through June 30, 2020, certain requirements of its shareholder approval rules.

[4] The UK Financial Conduct Authority has done that for recapitalization transactions with related parties requiring majority of minority approval (until further notice).

[5] Consistent with this intuition, ISS and Glass Lewis have recently revised their guidance on poison pills, adopting a more open stance with regard to those laid out specifically to address threat situations such as the current Covid-19 crisis.

This post comes to us from Luca Enriques, Professor of Corporate Law at the University of Oxford. A version appears here on the Oxford Business Law Blog.