Tilting the Balance Between Capital and Labor? The Effects of Regulatory Arbitrage in European Corporate Law on Employees

Fordham International Law Journal, Dec 2009

This Article examines an issue of regulatory competition that seems to be of greater interest for the corporate governance of large, publicly traded firms: the position of the employees. The Article proceeds in three parts. Part I sets out the basic premise of the analysis by describing why employees may be relevant to the corporate governance structure. This Part will briefly draw on economic theory to explain why, at least under certain circumstances, it can be beneficial to create an institutional structure that facilitates long-term commitment between firms and their employees. Part II identifies aspects of European corporate law that are relevant to labor and corporate law arbitrage opportunities. After delineating the scope of regulatory arbitrage, this Part describes the three main issues that surround regulatory arbitrage. The most important of these are employee participation systems, which give employee representatives a say in corporate governance. The second issue relates to the controversial issue of directors

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Tilting the Balance Between Capital and Labor? The Effects of Regulatory Arbitrage in European Corporate Law on Employees

FORDHAM INTERNATIONAL LAW JOURNAL Fordham International Law Journal Martin Gelter - 2009 Article 3 Copyright c 2009 by the authors. Fordham International Law Journal is produced by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/ilj Martin Gelter This Article examines an issue of regulatory competition that seems to be of greater interest for the corporate governance of large, publicly traded firms: the position of the employees. The Article proceeds in three parts. Part I sets out the basic premise of the analysis by describing why employees may be relevant to the corporate governance structure. This Part will briefly draw on economic theory to explain why, at least under certain circumstances, it can be beneficial to create an institutional structure that facilitates long-term commitment between firms and their employees. Part II identifies aspects of European corporate law that are relevant to labor and corporate law arbitrage opportunities. After delineating the scope of regulatory arbitrage, this Part describes the three main issues that surround regulatory arbitrage. The most important of these are employee participation systems, which give employee representatives a say in corporate governance. The second issue relates to the controversial issue of directors’ duties, with special attention to the extent that directors may defend against hostile takeovers. A third and often overlooked issue is the degree to which directors are independent from shareholder intervention. Finally, Part III presents the core of the analysis by describing the economic consequences of ex ante and ex post regulatory choice. Regulatory arbitrage provides the advantages of increased flexibility and possibilities to avoid some obviously inefficient regulation. On the other hand, mechanisms that may help to foster long-term commitment of firm employees are undermined by ex post arbitrage opportunities because of shareholders inability to permanently commit to a particular system. This Article argues that employee participation systems are at risk, in spite of the arbitrage limitations set by secondary EU law. TILTING THE BALANCE BETWEEN CAPITAL AND LABOR? THE EFFECTS OF REGULATORY ARBITRAGE IN EUROPEAN CORPORATE LAW ON EMPLOYEES Martin Gelter* INTRODUCTION Ten years after the European Court of Justice’s (“ECJ”) seminal Centros decision,1 which ushered in a series of cases that now allow firms to choose their country of registration regardless of the location of their business activities, regulatory competition in European corporate law has still not come of age. True, Centros, Überseering,2 and Inspire Art3 have collectively transformed European corporate law into a transnational field of research and triggered a debate about regulatory competition. Some scholars have optimistically argued that the ECJ has ushered in an era of a race to the top in the European Union (“EU”), meaning that the forces of competition will coerce member states to optimize their laws.4 Others have, justifiably, expressed doubt as to whether there will be much, if any, regulatory competition.5 Some have 2010] taken mixed or skeptical positions.6 At the very least, the notion that any member state could establish itself as a fully fledged “European Delaware” is probably deemed unlikely by the majority of scholars.7 So far, the academic literature has focused mostly on the long-term consequences within the triangle between investors, large shareholders, and managers. In practice, legal issues relating to corporate creditors have been the main driver of regulatory arbitrage.8 The incorporation of thousands of newlyfounded firms in a particular jurisdiction, typically England, that intend to be active primarily in another one, in many cases Germany,9 is said to undermine the capital maintenance and creditor protection systems in countries that import the corporate law of a more liberal corporate law.10 Some recent reforms to legal capital and other policies intended to protect creditors have been identified as a form of “defensive” regulatory competition—measures attempting to prevent economic entities from incorporating elsewhere that are intended to do business in the member state where these legislative measures are taken.11 However, these creditor protection mechanisms are usually an impediment only to the formation of new firms, which is why “defensive” regulatory competition primarily affects just these new businesses.12 This Article examines an issue of regulatory competition that seems to be of greater interest for the corporate governance of large, publicly traded firms: the position of employees. EU member states offer a wide spectrum of different systems of mandatory “employee participation,” under which a firm’s employees enjoy representation on a corporation’s board of directors. The two recent innovations of secondary EU law that permit the formation of the European Company—Societas Europaea (“SE”)—and the cross-border merger at first seem to von Missbräuchen [Act to Modernize the GmbH Laws and Combat Abuse], Oct. 23, 2008, BGBl. I at 2026, takes various measures to facilitate the formation process for the limited liability company, or Gesellschaft mit beschränkter Haftung (“GmbH”), and introduces the entrepreneur corporation, or Unternehmergesellschaft, which is not subject to the minimum capital requirement, but does require a business entitys taking this form to use the designation “Unternehmergesellschaft (haftungsbeschränkt)” or simply “UG (haftungsbeschränkt)” in its name. See id., § 5(a). For a detailed description of the German reform, which does not take the final version into account, see William W. Bratton et al., How Does Corporate Mobility Affect Lawmaking? A Comparative Analysis, 57 AM. J. COMP. L. 347, 381–82 (2009). The protocols of the parliamentary debate clearly show, as do previous proposals for the law, that the motivation for the enactment of this reform was competition among jurisdictions and the influx of firms incorporated in England, notwithstanding their high rates of failure. See Erklärung von Sabine Zimmermann [Statement of Sabine Zimmermann], Deutscher Bundestag Drucksache [BTDrucks] 16/172, at 18196 (quoting Doctor Jürgen Gehb as stating that “we are standing in European competition, not only regarding the production of goods and services, but also with respect to legal systems and legal forms. We accept this competition. We want to and have to win it.”); Entwurf eines Gesetzes zur Modernisierung des GmbH-Rechts und zur Bekämpfung von Missbräuchen (MoMiG) [Draft Act to Modernize the GmbH Laws and Combat Abuse (MoMiG)], BTDrucks 16/6140, at 56 (the original government draft explicitly stating that the “GmbH should remain internationally competitive”). Similarly spirited Dutch and Austrian projects are looming on the horizon. See, e.g., Bratton et al., supra, at 31, 34–36 (discussing the planned Dutch reform); REPUBLIK ÖSTERREICH [REPUBLIC OF AUSTRIA], REGIERUNGSPROGRAMM [GOVERNMENT PROGRAM] 2008–2013, at 138–3 9 (2008 ), at http://www.austria.gv.at/DocView.axd?CobId=32965 (declaration by the Austrian government announcing, among many other things, that minimum capital will be reduced during the current legislative period). 12. The fact that new businesses have made use of the freedom of incorporation in some countries far more than in others also seems to be influenced by administrative burdens or even blatant ignorance of the European Court of Justice (“ECJ”) case law that the authorities in some states impose on setting up a branch office. See Marco Becht et al., Centros and the Cost of Branching, 9 J. CORP. L. STUD. 171 (2009) (reporting on branching costs of several thousand Euros in Italy and a complete disregard of the Centros decision in Greece). 2010] limit the ability for corporate law arbitrage relating to this group by requiring the merging firms to negotiate with employees about their representation rights as a precondition to the merger. However, this Article emphasizes that this protection is incomplete, and that the structure imposed by these directives subverts the basic premises, and potential economic functionality, of employee participation systems. Specifically, the regulatory arbitrage13 driven by controlling shareholders can have negative effects for employees going beyond employee participation systems in firms that have operated for decades.14 The economic function of employee participation systems, to foster long-term commitment, is undermined by the inability of shareholders to commit to a particular regime. An analysis of the position of employees would not be complete if it were restricted to participation systems. This Article therefore also addresses other potentially relevant mechanisms affected by regulatory arbitrage opportunities, particularly the degree to which management is directly or indirectly influenced by shareholders. The Article suggests that controlling shareholders, whose presence characterizes corporate governance structures in much of Europe, are in a good position to exploit arbitrage opportunities to the disadvantage not only of minority investors, but also of employees. The Article proceeds in three parts. Part I sets out the basic premise of the analysis by describing why employees may be relevant to the corporate governance structure. This Part will briefly draw on economic theory to explain why, at least under 13. This Article prefers the terms regulatory choice and regulatory arbitrage over regulatory competition. This is because, as previously noted, the evidence for actual regulatory competition of member states actively seeking re-incorporation remains scarce. The most interesting national reaction to regulatory arbitrage so far is a recent proposal by a group of German law professors to allow German companies to negotiate with employees about the introduction of a flexible employee participation system comparable based on the same negotiation mechanism that is required for the formation of a European Company (Societas Europaea (“SE”)) or a cross-border merger. See Arbeitskreis “Unternehmerische Mitbestimmung,” Entwurf einer Regelung zur Mitbestimmungsvereinbarung sowie zur Größe des mitbestimmten Aufsichtsrats [Draft Rules on Codetermination Agreement and the Size of the Supervisory Board Codetermination], 2009 ZEITSCHRIFT FÜR WIRTSCHAFTSRECHT [ZIP] 885 (F.R.G.). For purposes of this Article, regulatory arbitrage will mean that the involved parties make deliberated choices about the law. 14. See Daniel Komo & Charlotte Villiers, Are Trends in European Company Law Threatening Industrial Democracy?, 34 EUR. L. REV. 175, 192–93 (2009) (discussing the effects of incorporation choice of small firms on employee involvement). certain circumstances, it can be beneficial to create an institutional structure that facilitates long-term commitment between firms and their employees. Part II identifies aspects of European corporate law that are relevant to labor and corporate law arbitrage opportunities. After delineating the scope of regulatory arbitrage, this Part describes the three main issues that surround regulatory arbitrage. The most important of these are employee participation systems, which give employee representatives a say in corporate governance. The second issue relates to the controversial issue of directors’ duties, with special attention to the extent that directors may defend against hostile takeovers. A third and often overlooked issue is the degree to which directors are independent from shareholder intervention. Finally, Part III presents the core of the analysis by describing the economic consequences of ex ante and ex post regulatory choice. Regulatory arbitrage provides the advantages of increased flexibility and possibilities to avoid some obviously inefficient regulation. On the other hand, mechanisms that may help to foster long-term commitment of firm employees are undermined by ex post arbitrage opportunities because of shareholders inability to permanently commit to a particular system. This Article argues that employee participation systems are at risk, in spite of the arbitrage limitations set by secondary EU law. I. WHY BOTHER ABOUT EMPLOYEES IN CORPORATE LAW? It is tempting to argue that employees play an insignificant role in corporate law arbitrage. After all, the contractarian approach, which predominates in academic analysis of corporate law, presumes that nonshareholder constituencies of the firm have their rights specified by contract, which is why they are said to not bear a risk comparable to that of shareholders.15 However, 15. See FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 11 (1991) (describing shareholders as the bearers of the greatest risk); Lyman Johnson, Corporate Law Professors as Gatekeepers, 6 U. ST. THOMAS L.J. 447, 44 9 (2009 ) (identifying shareholder wealth maximization as the goal of corporate law according to the majority of scholars). Creditors are sometimes considered an exception to this theory, even by those that endorse the shareholder primacy view. See, e.g., Henry Hansmann & Reinier Kraakman, The End of History for Corporate Law, 89 GEO. L.J. 439, 443 (2001). The rationale behind this exception is that creditors suffer the downside risk when the company approaches insolvency. See Stewart C. Myers, Determinants of Corporate Borrowing, 5 J. FIN. ECON. 147, 164–70 (1977). Both U.K. and U.S. law has 2010] much of the literature on the theory of the firm now considers the assumption of complete contracts to be an oversimplification that carries with it analytical limitations;16 other firm constituencies may also be exposed to risk because of firmspecific investment by these groups. Most important to this Article, workers often make such an investment by acquiring skills that are only useful within their current employment relationship.17 This type of investment may initially be costly to acquire, but it allows employees to gain quasi rents in the course of the relationship with the firm. As a result, the productive process of the firm may sometimes improve, thus increasing the total corporate “pie,” either because of productivity increases or because skilled workers can be motivated to take on the job (for instance, due to moving costs).18 The traditional agency view of corporate law assumes employee investment to be fully protected by contract, which is why many describe employees as avoiding residual risk.19 However, real-life contracts are not normally “complete therefore developed doctrines suggesting that directors have duties towards creditors in the vicinity of insolvency. See, e.g., Geyer v. Ingersoll Publ’n Co., 621 A.2d 784 (Del. Ch. 1992); Credit Lyonnais Bank Neth., N.V. v. Pathe Commc’n Corp., Civ. A. No. 12150, 1991 WL 277613, at 34 n.55 (Del. Ch. Dec. 30, 1991); W. Mercia Safetywear Ltd. v. Dodd, [1988] B.C.L.C. 250 (Eng.). But see N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) (denying direct fiduciary claims against directors by creditors and limiting these duties to situations where the firm is already insolvent). 16. See, e.g., Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 VA. L. REV. 247, 249–50 (1999). 17. See, e.g., HENRY HANSMANN, THE OWNERSHIP OF ENTERPRISE 26 (1996); John Armour & Simon Deakin, Insolvency and Employment Protection: The Mixed Effects of the Acquired Rights Directive, 22 INT’L REV. L. & ECON. 443, 445–46 (2002); Larry Fauver & Michael E. Fuerst, Does Good Corporate Governance Include Employee Representation? Evidence from German Corporate Boards, 82 J. FIN. ECON. 673, 679 (2006); Gavin Kelly & John Parkinson, The Conceptual Foundations of the Company: A Pluralist Approach, in THE POLITICAL ECONOMY OF THE COMPANY 113, 123–27 (John Parkinson et al. eds., 2000); David Kershaw, No End in Sight for the History of Corporate Law: The Case of Employee Participation in Corporate Governance, 2 J. CORP. L. STUD. 34, 42–46 (2002); see also James M. Malcomson, Individual Employment Contracts, in 3B HANDBOOK OF LABOR ECONOMICS 2291, 2330–33 (Orley Aschenfelter & David Card eds., 1999) (reviewing the labor economics literature on contractual protection of specific investment). 18. See, e.g., EIRIK G. FURUBOTN & RUDOLF RICHTER, INSTITUTIONS AND ECONOMIC THEORY 232 (2d ed. 2005); see also ANNALEE SAXENIAN, REGIONAL ADVANTAGE: CULTURE AND COMPETITION IN SILICON VALLEY AND ROUTE 128, at 135 (1994) (quoting a Texas engineer as describing career mobility as the norm following the advent of Silicon Valley). 19. See, e.g., EASTERBROOK & FISCHEL, supra note 15, at 10–11. contingent” agreements.20 The transaction cost necessary to anticipate every improbable state of the world would exceed the potential welfare gains from incorporating such provisions into the contract. Being subject to bounded rationality, parties might be unable to foresee possible contingencies and to process the information they receive because of cognitive limitations.21 More specifically, economic theory suggests that it is in many cases impossible to make human capital investment a condition of an enforceable contract, because courts will often be unable to determine whether an employee has made the specified amount of relationship-specific investments.22 It follows that employees whose future gains from the continued employment relationship are not protected against opportunism from other corporate constituencies (particularly controlling shareholders, who typically hold an ex post interest to maximize stock value) will avoid making specific investment in the first place. Even in corporate finance, the “purely financial” view of corporate governance no longer dominates entirely. In the latest edition of their leading textbook, Brealey, Myers, and Allen note that “managers and employees of a firm are investors, too . . . . If you give financial capital too much power, the human capital doesn’t show up—or if it does show up, it won’t be properly motivated.”23 By going public, stockholders can commit “not to interfere if managers and employees capture private benefits when the firm is successful.”24 In other words, one economic function of the publicly traded firm may be to serve as a nexus for specific investment. 2010] It is unnecessary to address the issue of what degree of specific human capital investment is important in particular corporate governance systems. Nevertheless, the various aspects of corporate law discussed in Part II are likely to influence whether employees have incentive to invest. Moreover, the impact of regulatory arbitrage opportunities on the shareholderemployee relationship are of interest even if one does not follow the specific-asset theory of human capital because the utility derived from employees may be of interest from a distributive perspective.25 A particular corporate governance structure in any given country is likely to be an equilibrium result of bargaining on the political level and the outcome of historical path dependence. As such, it may, in any given society, gain wide acceptance as a balanced solution tolerable to the relevant interest groups.26 Regulatory arbitrage creates possibilities to modify this outcome without universal assent or at least an open debate that probably most would prefer to have about such an important issue of social and economic governance. II. CORPORATE LAW ARBITRAGE OPPORTUNITIES AFFECTING EMPLOYEES In order to analyze regulatory arbitrage opportunities, it is necessary to delineate the extent to which corporate law affects the relationship between a firm and its employees. Part II.A identifies issues that are potentially subject to regulatory arbitrage, and Part II.B will study the effects that these issues are likely to have on employees. Delineating the Scope of Employee-Related Regulatory Competition The primary fields of law governing the employee-firm relationship would seem to be employment and labor law, which 25. Cf. Luigi Zingales, Corporate Governance, in 1 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW, supra note 20, at 497, 498 (defining corporate governance “as the complex set of constraints that shape the ex-post bargaining over the quasi-rents generated by the firm”). 26. See generally Mark J. Roe, Backlash, 98 COLUM. L. REV. 217 (1998) (arguing that economically efficient policy choices may not be sustainable because of political backlash); MARK J. ROE, POLITICAL DETERMINANTS OF CORPORATE GOVERNANCE (2003) (developing a theory of comparative corporate governance focusing on the role of past political choices that may have been economically inefficient, but necessary to achieve social peace). are not objects of regulatory competition in corporate law. Under the new European regulation on the law applicable to contractual obligations, colloquially known as the Rome I Regulation, employment contracts are normally governed by the law of the jurisdiction where the employee “habitually carries out his work in performance of the contract,” even “if he is temporarily employed in another country.”27 If no such country can be identified, the contract is governed “by the law of the country where the place of business through which the employee was engaged is situated.”28 Other laws apply only when it can be shown that “the contract is more closely connected with” another country.29 While the regulation allows for choice of law,30 the latter may not deprive the employee of mandatory protection accorded to him under the otherwise applicable default law.31 Rights collectively held by employees, such as the right to establish works councils, and the specification of their rights and competences, typically depend on the location of the business establishment.32 In fact, EU law requires large transnational firms with a cross-border scope of activities to permit the establishment of a European Works Council.33 A 2002 directive further requires 2010] member states to implement information and consultation systems for employee representatives in other firms that exceed a minimum size, while leaving to national law the question regarding how employees should be represented.34 Any regulatory arbitrage regarding these rules will therefore be only an element of competition for businesses in general— employment law may influence the decision where to locate a plant, but as a factor in regulatory competition it will be strongly confounded with other aspects pertinent to its physical location, including taxation. B. Employee Participation Systems and Codetermination While at least some of the issues outlined above are no doubt important, in particular the requirement to consult with works councils and other employee representatives, these rules are not subject to corporate law regulatory arbitrage opportunities. However, some corporate law issues are of considerable importance to employees as well, which is discussed below in more detail. At present, member states that favor codetermination and other employee participation systems do not even attempt to apply their employee participation statutes to foreign firms.35 directive to the United Kingdom); see also CATHERINE BARNARD, EC EMPLOYMENT LAW 707–20 (3d ed. 2006) (providing a detailed discussion of this directive). Collective bargaining agreements are governed by the law of the country where the employment relationship is executed or the law of the employment contract. See Krebber, supra note 31, at 537. 34. Council Directive Establishing a General Framework for Informing and Consulting Employees in the European Community, No. 2002/1 4, 2002 O.J. L 80/29; see also BARNARD, supra note 33, at 732–39 (explaining the objectives of the directive). 35. On Germany, see, for example, CLEMENS JUST, DIE ENGLISCHE LIMITED IN DER PRAXIS [THE ENGLISH LIMITED LIABILITY COMPANY IN PRACTICE] 199–202 (2d ed. 2006) (F.R.G.), Marcus Kamp, Die unternehmerische Mitbestimmung nach „Überseering” und „Inspire Art” [Codetermination After „Überseering” and „Inspire Art”], 59 BETRIEBS-BERATER 1496, 1498–99 (2004) (F.R.G.), Klaus J. Müller, Die englische Limited in Deutschland—für welche Unternehmen ist sie tatsächlich geeignet? [The English Limited Liability Company in Germany— For Which Businesses Is It Useful in Practice?], 61 BETRIEBS-BERATER 837, 840 (2006) (F.R.G.), Bernd Gach, in 3 MÜNCHENER KOMMENTAR ZUM AKTIENGESETZ [MUNICH COMMENTARY ON THE STOCK CORPORATION ACT] § 1 MitbestG cmt. 6 (Bruno Kropff & Johannes Semler eds., 2d ed. 2004) (F.R.G.), Christoph Teichmann, Restructuring Companies in Europe: A German Perspective, 2004 EUR. BUS. L. REV. 1325, 1334, and Martin Veit & Joachim Wichert, Unternehmerische Mitbestimmung bei europäischen Kapitalgesellschaften mit Verwaltungssitz in Deutschland nach „Überseering” und „Inspire Art” [Codetermination in European Corporations with Headquarters in Germany After „Überseering” The Prevalence and Significance of Employee Participation Systems The system of codetermination in Germany assigns half of the seats on the supervisory board of German companies to employees36 and is one of the issues that has received the most attention in the comparative corporate governance literature.37 The system of codetermination occupies one end of the regulatory spectrum, the other being no employee participation at all.38 Codetermination in the strictest sense of the word requires the election of half of the members of the firm’s supervisory board by employees39 in firms with more than 2000 employees.40 The applicable law specifies the precise number of directors that and „Inspire Art”], 50 DIE AKTIENGESELLSCHAFT 14, 16–17 (2004) (F.R.G.). For possible future “outreach” statutes applying employee participation systems to foreign firms, see infra notes 133–37 and accompanying text. 36. See Mitbestimmungsgesetz [MitbestG] [Co-Determination Act], May 4, 1976, BGBl. I at 1153, § 7, last amended by Gesetz, July 30, 2009, BGBl. I at 2479, 2491, § 1(1) (F.R.G), translated in D. HOFFMAN, THE GERMAN CO-DETERMINATION ACT, 1976 (MITBESTIMMUNGSGESETZ 1976) (1976). The law is applicable to all companies outside of the coal, mining, and steel industries. Id. § 1(2). These industries are governed by an even stricter statute, the Montan-Mitbestimmungsgesetz [MontanMitbestG] [Montane Co-Determination Act], May 21, 1951, BGBl. I at 347, last amended by Gesetz, October 31, 2006, BGBl. I at 2407, 2434 (F.R.G.). 37. See, e.g., Luca Enriques et al., The Basic Governance Structure: Minority Shareholders and Non-Shareholder Constituencies, in THE ANATOMY OF CORPORATE LAW 90, 100–02 (Reinier Kraakman et al. eds., 2d. ed. 2009) ; Mark J. Roe, German Codetermination and German Securities Markets, 1998 COLUM. BUS. L. REV. 167. 38. Slovenia, for instance, initially adopted the German version of codetermination after gaining independence, but subsequently abandoned it after its constitutional court declared the system unconstitutional. See THOMAS RAISER, UNTERNEHMENSMITBESTIMMUNG VOR DEM HINTERGRUND EUROPARECHTLICHER ENTWICKLUNGEN, GUTACHTEN B FÜR DEN 66. DEUTSCHEN JURISTENTAG [WORKER BOARD-LEVEL PARTICIPATION AGAINST THE BACKDROP OF EUROPEAN DEVELOPMENT, REPORT B FOR THE 66TH MEETING OF THE ASSOCIATION OF GERMAN JURISTS], B 42–B 43 (2006) (F.R.G.); Rado Bohinc & Stephan M. Bainbridge, Corporate Governance in PostPrivatized Slovenia, 49 AM. J. COMP. L. 49, 58–60 (2001). 39. See MitbestG § 10. German law and the laws of various other countries in the European Union (“EU”) require stock corporations to have dual board system comprised of a management board, or Vorstand, whose members are the senior managers of the firm, and a supervisory board, or Aufsichtsrat, whose members are outside directors. See Aktiengesetz [AktG] [Stock Corporation Act], Sept. 6, 1965, BGBl. I at 1089, §§ 76–116, last amended by Gesetz, July 31, 2009, BGBl. I at 2509 (F.R.G.), translated in THE GERMAN STOCK CORPORATION ACT (Hannes Schneider & Martin Heidenhain trans., 2d ed. Kluwer Law Int’l 2000). 40. See MitbestG §1(1), ¶2. 2010] will comprise the supervisory board according to the size of the firm.41 A minority among these directors are not employees of the firm, but representatives of unions.42 In the case of a tied vote, the vote of the president of the board, a shareholder representative, is decisive, putting the representatives of capital at an advantage.43 Nevertheless, codetermination strengthens the position of labor by facilitating access to information and the possibility to grant and withhold assent to important corporate decisions, most of all regarding the composition of the management board.44 A more moderate employee participation scheme applies in firms with 500 to 2000 employees, in which employee representatives fill only one-third of the board seats.45 The German system of codetermination is far from unique in the European Union. Although Britain, perhaps the most shareholder-centric European corporate jurisdiction today, famously rejected what it touted as “industrial democracy” in the 1970s,46 employee participation systems giving one-third of the seats on the board to employees exist in countries such as Austria,47 Denmark,48 Finland,49 Luxemburg,50 and Sweden,51 as well as in post-Communist states such as the Czech Republic, Slovenia, Slovakia, and Hungary.52 Many of these states reserve one-third of the seats on the board to employees.53 Notably, Denmark, Finland, Luxemburg, and Sweden have one-tier board systems with varying proportions of seats being assigned to employees.54 Large Dutch firms are subject to the structure regime known as structuurregime,55 in which one-third of the shareholder-elected supervisory board is nominated by the works council.56 Until statutory reform in 2004, Dutch board members were appointed under a system of “controlled co-optation.”57 The overall efficiency of employee participation is contested. While some scholars have found that it depresses shareholder value (which may not necessarily mean that the system is inefficient overall),58 other studies have suggested that moderate forms have a beneficial effect on Tobin’s q59 in certain 2010] industries60 or that its introduction is correlated with gains in productivity.61 The conclusions of these studies are limited by their use of a measure of shareholder wealth as a dependent variable, while possible rents to employees—which are difficult to quantify—should in principle figure into the efficiency calculus.62 Furthermore, it is quite possible that codetermination and other employee participation systems contribute to the maintenance of social peace and good employment relations.63 Consequently, employee participation models, like the system of codetermination, may therefore have an indirect benefit for firms that are not captured by econometric studies. As noted earlier, even if the potential efficiency benefits are unconvincing, it seems clear that employee representation has important distributive consequences, as it will at least enhance the bargaining power of employees and thus entail a marginal increase in rents accruing to labor. 2. Negotiations About Employee Representation In order to subject a company to the law of a member state other than the one under which it was originally founded, shareholders in practice must avail themselves of specific instruments of EU law that impose restrictions on ex post changes to employee participation systems. The main instrument for reincorporation is the cross-border merger as contemplated by the Council Directive on Cross-Border Mergers.64 Under this (William Fellner et al. eds., 2d ed. 1977). It is frequently used to measure how much wealth a firm generates for its shareholders compared to other firms. 60. See Fauver & Fuerst, supra note 17, at 675. These results do not hold when the employee representatives do not actually work in the firm, but are sent by unions. See id. at 710. 61. See generally Felix FitzRoy & Kornelius Kraft, Co-determination, Efficiency, and Productivity, 43 BRIT. J. INDUS. REL. 233, 242–4 4 (2005 ). 62. Conceivably, there could be other consequences, such as helping society to become more egalitarian, which are even more difficult to assess from the perspective of utility-maximization. See RAISER, supra note 38, at 49–50 (criticizing econometric studies for leaving these aspects aside). 63. See MARK J. ROE, STRONG MANAGERS, WEAK OWNERS 214 (1994) (“[C]odetermination affects corporate governance in the supervisory board, impeding intermediaries from pushing for rapid organizational change that would disrupt employment.”). 64. Council Directive on Cross-Border Mergers of Limited Liability Companies, No. 2005/5 6, 2005 O.J. L 310/1. instrument, a shell subsidiary is set up in the target member state, followed by a merger between the original and the new entity. Another potential path to a different member state’s law is the creation of an SE through a merger under the SE Statute.65 While the SE is a corporation governed by EU law, the SE Statute provides a rather shallow regulatory framework;66 gaps are filled by special national legislation governing SEs with their registered office in the respective member state, and failing that, by national provisions applicable to public limited liability companies.67 As a result, there are a number of British, Czech, French, Swedish, and other SEs that are all to a large extent governed by the respective national law.68 Since article 8 of the SE Statute explicitly allows the transfer of the SE’s registered office without initiating a winding up of the firm,69 national obstacles to reincorporations can be overcome with relative ease.70 However, for a previously existing purely national firm, the route to a foreign type of SE is, again, to create a shell company in the target member state and then merge with it, in this case under the SE Statute. The Directive on the Involvement of Employees in the SE71 sets up a negotiating procedure that must be followed before the SE can be registered.72 Employees from both companies merging into the new SE must elect or appoint a “special negotiating body” (“SNB”) to settle employee representation rights in the future SE with the competent bodies of the merging 32. 2010] companies.73 Negotiations should normally be concluded within six months, but the parties may agree to extend this period to a year.74 National legislatures are required to establish standard rules in the event that negotiations break down.75 In the case of an SE created by a cross-border merger, this provision applies by operation of law when at least twenty-five percent of the employees of the merging firms participated in some type of employee representation system.76 However, they also apply when a smaller number of employees were subject to such a system, and when the SNB passes a resolution to that effect.77 The standard rules must conform to a “highest level” principle, meaning that the proportion of employees on the board must correspond to the “most advanced” system before the merger.78 Even employees previously not covered by an employee participation system at all must have this level of participation rights after the conclusion of the merger.79 While the applicable law is that of the state in which the SE is registered, all member states (including those without mandatory employee representation rules for purely national companies) are required to develop a default employee participation system for SEs.80 These rules must stipulate that the highest proportion of employee participation of any of the participating firms applies to the SE resulting from the merger.81 Slightly modified rules apply under the Directive on CrossBorder Mergers. As a general principle, the law applicable at the registered office of the entity resulting from the merger governs employee participation.82 However, there are three exceptions: first, negotiations are mandatory when one of the merging companies has an employee participation system and more than 500 employees; second, when national law applicable after the merger does not provide the same level of employee representation to employees that were previously subject to such a regime; and third, when the postmerger law discriminates against employees employed in another member state by not granting equivalent representation rights.83 Regarding cases of mandatory negotiations, the CrossBorder Mergers Directive refers to the respective provisions of the SE Regulation and SE Employees Directive.84 However, the threshold for automatic application of the “standard rules” in this case is thirty-three and one-third percent.85 Furthermore, employee representation in a one-tier board may be limited to one third of the positions, even if the merged firm previously applied parity codetermination on the supervisory board.86 absence of an agreement with the SNB if the member state refused to adopt the default provisions in the formation of an SE through merger. See Paul Davies, Employee Involvement in the European Company, in THE EUROPEAN COMPANY: DEVELOPING A COMMUNITY LAW OF CORPORATIONS 67, 67 n.2 (Jonathan Rickford ed., 2003); Jonathan Rickford, Inaugural Lecture—The European Company, in THE EUROPEAN COMPANY, supra, 13, 28 n.56; Ger van der Sangen, The European Company and the Involvement of Employees, in THE EUROPEAN COMPANY: CORPORATE GOVERNANCE AND CROSS-BORDER REORGANISATIONS FROM A LEGAL AND TAX PERSPECTIVE 169, 199 (S.H.M.A. Dumoulin et al. eds., 2005). The United Kingdom did not elect to use this option, but instead provides that the standard rules apply in the case of a merger. See European Public Limited-Liability Company Regulations, 200 4, S.I. 2004 /2326, c. 6, § 33(3) (U.K.). 82. See Council Directive on Cross-Border Mergers of Limited Liability Companies, No. 2005/56, art. 16(1), 2005 O.J. L 310/1, at 7. 83. See id. art. 16(2); see also Arianna Ugliano, The New Cross-Border Merger Directive: Harmonisation of European Company Law and Free Movement, 2007 EUR. BUS. L. REV. 585, 609. 2010] The European Union has debated the introduction of a directive on the cross-border transfer of a firm’s registered office (the “14th Directive”) for many years, but the project has been shelved since late 2007, at least for the time being.87 The ECJ determined in the recently decided Cartesio case that a member state may prohibit companies governed by its law from relocating the firm’s real seat to another member state while retaining its character as a company under the laws of the origin state. However, a member state may not prevent a company from converting into a company governed by the law of another state as long as the latter will accept the firm.88 Without a directive, however, a change of the national law applicable to the firm is wrought with great difficulty.89 It is usually thought that if the 14th Directive is ever passed, it will include comparable provisions regarding employee representation.90 Since a transfer of seat involves only a single company, the codetermination GESAMTE HANDELS- UND WIRTSCHAFTSRECHT 613, 626 (2007) (F.R.G.); Olaf Kisker, Unternehmerische Mitbestimmung in der Europäischen Gesellschaft, der Europäischen Genossenschaft und bei grenzüberschreitender Verschmelzung im Vergleich [Codetermination in the European Company, the European Cooperative, and after Cross-Border Mergers in Comparison]‚ 59 RECHT DER ARBEIT 206, 2 10 (2006 ) (F.R.G.). 87. See Stephan Rammeloo, The 14th EC Company Law Directive on the Cross-Border Transfer of the Registered Office of Limited Liability Companies—Now or Never?, 15 MAASTRICHT J. EUR. & COMP. L. 359, 372–73 (2008). 88. Cartesio Oktató és Szolgáltató bt, Case C-210/06, [2008] ECR I-9641, ¶¶ 110– 13; see also Gert-Jan Vossestein, Cross-Border Transfer of Seat and Conversion of Companies under the EC Treaty Provisions on Freedom of Establishment, 6 EUR. COMPANY L. 115, 120 (2009). In other words, member states may voluntarily take their own laws out of the market for corporations, but must not inhibit competitive actions by other states. See Rammeloo, supra note 87, at 368–71. 89. It is very plausible that provisions of the SE Regulation on the transfer of seat would apply by analogy, which might require negotiations about employee participation. See Georg Eckert, Sitzverlegung von Gesellschaften nach der Cartesio-Entscheidung des EuGH [Transfer of a Company’s Real Seat Under the Cartesio Decision of the ECJ], 2009 DER GESELLSCHAFTER 139, 149–53 (Austria). 90. See, e.g., Maureen Johnson, Does Europe Still Need a Fourteenth Company Law Directive, 3 HERTFORDSHIRE L.J. 18, 38 (2005) (noting that a new company law directive, if adopted, will provide for employee participation); see also Federico M. Mucciarelli, Corporate ‘Emigration’ and EC Freedom of Establishment: Daily Mail Revisited, 9 EUR. BUS. ORG. L. REV. 267, 300 (2008) (suggesting that a “corporate mobility” directive should have similar safeguards as the cross-border mergers directive); Marco Ventoruzzo, “CostBased” and “Rules-Based” Regulatory Competition: Markets for Corporate Charters in the U.S. and the E.U., 3 N.Y.U. J.L. & BUS. 91, 149 (2006) (same); Eddy Wymeersch, Is a Directive on Corporate Mobility Needed?, 8 EUR. BUS. ORG. L. REV. 161, 16 8 (2007 ) (same);. management214 The prevailing Nazi ideology of the Führerprinzip certainly dictated strong leadership,215 but the policy of insulation was at least in part the consequence of a longstanding debate in German economic and legal theory during the previous decades, in which a left-wing current in the literature sought to restrain the influence of capital and, arguably, to protect firms from changing majorities and coalitions in the shareholder meeting.216 The German model affected other countries as well, such as Austria and France. In Austria, the German model was clearly followed when the Aktiengesetz was introduced in 1938.217 In France, the position of the Président Directeur-General (“PDG”), which combined the functions of the president of the board and the CEO, was introduced in the hastily enacted reforms of 1940218 and 1943 219 and remained mandatory until 2001 .220 214. Id. § 119(2). The law of course requires shareholder votes for structural changes such as mergers, which go beyond mere management decisions, and the courts have additionally required shareholder votes in the case of certain other transactions of high significance. BGH, Feb. 25, 1982, 174 BGHZ 80 (requiring a vote on the contribution of 80% of the firm’s assets to a wholly-owned subsidiary in a case popularly known as Holzmüller). But see BGH April 26, 2004, 155 BGHZ 02 (clarifying that Holzmüller duties only apply in exceptional cases). For a description of the development of the case law see, Marc Löbbe, Corporate Groups: Competences of the Shareholders’ Meeting and Minority Protection—The German Federal Court of Justice’ Recent Gelatine and Macotron Cases Redefine the Holzmüller Doctrine, 5 GERMAN L.J. 1057 (2004). 215. See Jan von Hein, Vom Vorstandvorsitzenden zum CEO? [From Chief Executive Officer to CEO?], 166 ZEITSCHRIFT FÜR DAS GESAMTE HANDELS- UND WIRTSCHAFTSRECHT 464, 475 (2002). 216. Important writers include: WALTHER RATHENAU, VOM AKTIENWESEN: EINE GESCHÄFTLICHE BETRACHTUNG (1917); and Oskar Netter, Zur aktienrechtlichen Theorie des „Unternehmens an sich”, in FESTSCHRIFT HERRN RECHTSANWALT UND NOTAR JUSTIZRAT DR.JUR.H.C. ALBERT PINNER ZU SEINEM 75 GEBURTSTAG 507 (Deutscher Anwaltsverein et al., eds., 1932). But see FRITZ HAUSSMANN, VOM AKTIENWESEN UND VOM AKTIENRECHT (1928) (criticizing Rathenau’s theory of the institutional interest of the corporation). 217. The 1938 promulgation of Aktiengesetz was introduced for newly founded corporations on April 11, 1938 by Erste Verordnung zur Einführung handelsrechtlicher Vorschriften im Lande Österreich [First Regulation to Introduce Commercial Law Provisions in the Land of Austria], RGBl No. 385/1938, and for existing firms as of January 1, 1939, by Zweite Verordnung zur Einführung handelsrechtlicher Vorschriften im Lande Österreich [Second Regulation to Introduce Commercial Law Provisions in the Land of Austria] RGBl No. 982/1938. 218. Law of Nov. 16, 1940, Journal Officiel de la République Française [J.O.] [Official Gazette of France], Nov. 16, 1940, p. 5828. This law replaced the prior Law of September 18, 1940, before it could come into force. See Paul Cordonnier, Loi du 16 novembre 1940, in 1941 DALLOZ RECUEIL CRITIQUE 1, 1–2 (1941). 2010] Contemporary writers sometimes attributed this development to a “transposition of the German theory of the Führerprinzip” in France (although the issue is, unsurprisingly, controversial).221 French law, however, always retained the rule that directors could be removed by a shareholder resolution at any time, which counteracted the independence of the PDG.222 Even the United Kingdom, which is usually thought of as the most proshareholder European jurisdiction, once had a statute requiring directors to have regard to the interests of employees.2 23 The Companies Act of 2006 has, however, changed the law to the effect of requiring a concern to “enlightened shareholder value.”224 Concentrated ownership structures persisted in spite of these rules, and large shareholders usually remain able to impose their will on corporations, even in Germany.225 However, the extent to which directors and managers are able to assert their independence from large shareholders depends on a complex set of factors, including personal authority and corporate culture. But in the case of any individual firm, the applicable law is still a major determinant of shareholder influence of major and minor business decisions. This factor could therefore be the subject of regulatory arbitrage. III. CONSEQUENCES OF REGULATORY ARBITRAGE IN THE NEXUS BETWEEN SHAREHOLDERS AND EMPLOYEES Having identified legal mechanisms that could potentially serve as targets for regulatory arbitrage, this Part will now analyze possible consequences of ex ante and ex post corporate law choices in corporate law. As a result of the ECJ’s Centros and Überseering cases, codetermination and other aspects of corporate law relevant to employees are no longer mandatory at the formation stage of the firm, at least in those member states that do not counteract EC law by setting up further hurdles for setting up a branch office.226 The only limitation is the necessity to select the entire bundle of a particular law. A. Ex Ante Choice of Law At the formation stage, the incorporation decision is often taken by a group of founders who will typically take on the role of shareholders and managers concurrently; minority investors, employees, and other stakeholders only enter the picture later. In other cases, employee participation systems may already be important at the beginning, for example when a joint subsidiary comprising some existing business is set up by two firms from different countries. Obviously, regulatory arbitrage can have a beneficial impact: founders will be able to choose the bundle most appropriate in light of the firm’s business environment. This applies also to the firm’s relationship with its employees:227 If the mechanisms described in the previous section indeed protect employees’ specific investment, firms operating in an industry where specific investment is a competitive advantage will 226. See Überseering BV v. Nordic Constr. Co. Baumanagement GmbH (NCC), Case C-208/00, [2002] E.C.R. I-9919; Centros Ltd. v. Erhvervs-og Selskabsstyrelsen, Case C-212/97, [1999] E.C.R. I-1459. But see Becht et al., supra note 12 (describing differences in costs among member states and even citing blatant disregard of ECJ case law in some). 227. Cf. Stefano Lombardo, Conflict of Law Rules in Company Law after Überseering: An Economic and Comparative Analysis of the Allocation of Policy Competence in the European Union, 4 EUR. BUS. ORG. L. REV. 301, 322–30 (2003) (making a similar argument regarding creditors). 2010] be able to choose the preferable legal system by committing to a beneficial legal framework in the formation stage. Firms choosing a suboptimal regime would—in the long run—be eliminated by competition in product markets. The result would be, more or less, efficient choice.228 In practice, however, pro-employee laws, particularly employee participation systems, appear not to be selected voluntarily on a regular basis. To the contrary, it currently seems that some firms are trying to escape or mitigate German codetermination through regulatory arbitrage.229 Of course, one reason could be that these are simply inefficient and therefore not chosen by firms.230 However, there are other possibilities. The primary corporate law issue driving regulatory arbitrage at the formation stage seems to be minimum capital and related creditor protection doctrines, which have also been the only issue addressed by legislative reactions to corporate law arbitrage. At the founding stage, employee participation systems are hardly any concern, since it is not known whether they will ever grow big enough to support a substantial workforce. With employee participation systems typically “bundled” with minimum capital in one regulatory package, they simply are not important enough to influence the incorporation decision. Even a choice influenced by long-term prospects of the firm may not be uniformly efficient. The most frequently cited arguments in the literature regarding why such regimes are not chosen voluntarily appears to be adverse selection: laws increasing the bargaining position may reduce the wage differential between senior management and workers, which is why the best managers might avoid these firms; furthermore, since the least able workers are likely to have the strongest preference for job security, firms committing to consider employee interests may also attract the least effective workers.231 Furthermore, for individual employees it may be irrational to bargain for job protection as it may signal the absence of a commitment to work hard.232 The analysis so far has assumed that employees are able to look after their own interests by penalizing an unfavorable corporate law regime with a discount, in a similar way as creditors may impose higher interest rates, or simply by avoiding specific investment and always expecting the looming possibility of a job change in the near future. In reality, this assumption may not always hold, with some employees being unable to adjust their firm-specific investment to a level commensurate with the risk. This mirrors the debate about corporate creditors, which distinguishes between “adjusting creditors” on one side, and “non-adjusting” or only “partially adjusting” creditors on the other.233 Only adjusting creditors react to risk by requiring higher interest rates, by stipulating that the entire loan will fall due in the case of events that increase risk, or simply by not trading at all. Analogously, non-adjusting workers might put too much trust in their relationship with the firm and therefore overinvest compared to what would be optimal from their individual perspective. While it is hard to assess whether a substantial group of such workers exists, regulatory arbitrage would then become largely a fairness issue. If workers always specifically invest, the legal arrangement is irrelevant for purposes of a firm’s competitiveness. Still, the issue can be relevant for distributive policy reasons. In order to maximize social welfare234 one would then need to have context-specific information about the marginal utility of wealth of workers and stockholders. Even when workers adjust, one likely problem for the voluntary provision of pro-employee rules is that crucial aspects Sunstein, Human Behavior and the Law of Work, 87 VA. L. REV. 205, 225–26 (2001). But see J. Hoult Verkerke, An Empirical Perspective on Indefinite Term Employment Contracts: Resolving the Just Cause Debate, 1995 WIS. L. REV. 837, 902–05 (describing the adverse selection argument and possible objections). 232. See, e.g., Sunstein, supra note 231, at 225–26; Verkerke, supra note 231, at 903. 233. See, e.g., John Armour, Legal Capital: An Outdated Concept?, 7 EUR. BUS. ORG. L. REV. 5, 10–11 (2006); Lucian Arye Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 YALE L.J. 857, 864–65 (1996). 234. See generally LOUIS KAPLOW & STEVEN SHAVELL, FAIRNESS VERSUS WELFARE (2002) (discussing total social welfare as the maxim and of economic and legal analysis). 2010] of corporate law favoring employees, such as codetermination, pertain to the entire firm. Such mechanisms could then not develop as the result of bargaining within the individual employment relationship. In fact, one of the major mechanisms protecting workers is collective bargaining, where either unions or elected representatives act as the agents of workers.235 B. Ex Post Opportunism: The Clash Between Shareholder, Manager, and Employee Interests in Corporate Law Arbitrage 1. Benefits and Risks of Flexibility Ex post choice, like ex ante choice, has important advantages, the most obvious being flexibility. Employee participation systems could be designed to operate efficiently and adapted to the changing needs of the firm, for instance those regarding the size of the supervisory board or the degree of employee involvement, which of course might depend on the industry and market of the firm. The downside of employee participation systems is often their inflexibility. German codetermination law rigidly stipulates a mandatory size of the board depending on the size of the firm236 and has thus long been criticized for making the supervisory board cumbersome and ineffective.237 Comparable provisions neither exist in some other member states with codetermination systems, nor for SEs or firms that undergo a cross-border merger.238 Firms might therefore avail themselves of a less intrusive system where these disadvantages are less serious. The downside of flexibility is always the risk of not meeting someone’s expectations. In this case, employees might form expectations about the stability of the work environment. If a 235. Cf. Armour & Deakin, supra note 17, at 445 (suggesting that specific collective rights of employees may protect firm-specific human capital). 236. See supra note 41 and accompanying text. 237. See, e.g., ROE, supra note 26, at 73; Katharina Pistor, Codetermination: A Sociopolitical Model with Governance Externalities, in EMPLOYEES AND CORPORATE GOVERNANCE 163, 178–79 (Margaret M. Blair & Mark J. Roe eds., 1999). 238. For analysis of these rules, see Habersack, supra note 86, at 632–34. It is disputed whether the total number of members must be agreed upon during negotiations or whether it can be set in the corporate charter (meaning that the result of negotiations would have to be the share of seats on the board allocated to employees). reincorporation coupled with a reduction in participation rights is possible, these expectations might not be fulfilled because employees’ formal or informal power has been reduced. As a result, the possibility of reincorporation could therefore marginally influence the incidence of specific investment. 2. Reasons for Mandatory Corporate Law and the Importance of Ownership Structure Ex post opportunism is often brought as a rationale why corporate law should be mandatory. In the United States, Lucian Bebchuk argues that management is able to accomplish charter amendments that are detrimental to shareholders and advantageous to management, given the powerful position of the board in U.S. firms and collective action problems of shareholders.239 Correspondingly, amendments that are beneficial to shareholders, but detrimental to managers, will not happen. Mandatory constraints might therefore be beneficial.240 As a first step, it is necessary to ask who decides about reincorporations in practice, since this power ultimately determines the ability to use arbitrage opportunities. Employees as a driving force can be ruled out, given that they cannot induce firms to reincorporate.241 While it is clear that the initial incorporation decision is taken by the founders of the firm, the question becomes more complicated when the company is up and running, and when different interest groups and coalitions have formed. If regulatory arbitrage is driven by shareholder interest, employees may suffer from shareholder opportunism. However, the situation is more complicated because managers may also play a role. Given the triangle of possible coalitions, regulatory competition might lead to different results depending on which coalition’s form is able to prevail. As previously noted, a variable that fundamentally alters the equation in the theory of regulatory competition is the presence of controlling shareholders in continental Europe and the 2010] tendency to see dispersed ownership in U.S. firms.242 In the U.S. context, Lucian Bebchuk has pointed out that it is necessary to have both the board of directors and the majority of shareholders agree to a reincorporation.243 Thus, reincorporations typically will not purely favor either managers or shareholders, but there must be something in it for both groups for a firm to subject itself to the law of a new state. In spite of possible pressures from the capital markets to incorporate in a state with “optimal” corporate law, agency problems will never be fully resolved because of the board veto.244 At the same time, regulatory competition will also not be fully pro-managerial because of the necessity of a shareholder vote.245 In the United States, the requirement to submit a reincorporation proposal to a shareholder vote provides at least some degree of a check on managerial opportunism in deciding on reincorporations according to Bebchuk’s modern “race to the bottom” school of thought.246 However, concentrated ownership implies that the relevant agency problem is not the one between managers and shareholders, but between majority and minority shareholders. Majority shareholders will typically decide on the issue of reincorporation alone, which may allow them to capture the regulatory competition process, or at least to use regulatory arbitrage possibilities.247 As described in another article, large shareholders effectively control reincorporation in continental Europe.248 Unlike managers in the United States, who need a shareholder vote for a reincorporation that increases agency cost, managers in continental Europe do not need to seek the approval of the minority for their actions. This argument applies analogously with regard to non-shareholder constituencies. It has already been suggested that creditors of European firms might find themselves in a similar situation with their expectations 242. See supra note 209 and accompanying text. 243. See Lucian A. Bebchuk, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 105 HARV. L. REV. 1437, 1460–61 (1992). 244. See id. at 1470. 245. See id. 246. See id. at 1471–75. In fact, Bebchuk’s view can be classified as intermediate because he seeks to identify criteria for which a race to the top or bottom is likely. 247. See Gelter, supra note 7, at 269–75. For a similar analysis see also Birkmose, supra note 7, at 47–54. 248. See Gelter, supra note 7, at 269–75. being negatively affected, because shareholders, particularly large blockholders, control the incorporation process.249 Equivalently, if reincorporation is ex post beneficial to shareholders, but harmful to employees, it is very likely that such a redistributive reincorporation will take place when shareholder benefits exceed the (possibly substantial) costs of reincorporation. In the case of a true shareholder-stakeholder conflict, large blockholders will even be able to typically obtain the support of minority shareholders. Thus, ownership structure plays an important role. However, in individual cases it will depend on what coalitions are formed. For example, in a dispersed ownership company, employees and shareholders might share an interest in strong enforcement of the directors’ duty of loyalty, while they would probably share managers’ interests regarding hostile takeovers and the prospect of confrontation with the board. In other words, with respect to issues where managers and employees share similar objectives, employees might gain by free-riding on managerial opportunism because managers succeed in committing the firm to a legal system not hospitable to takeovers and resisting shareholders’ attempts to change the applicable regime. In a concentrated ownership environment, however, managers are immediately subject to the wishes of the controlling shareholder and will be unable to resist their advances. True, ex ante there may be an incentive to commit to a corporate law system favorable to employees in order to ensure their goodwill and long-term cooperation. However, an ex ante decision is only helpful if it is coupled with a previous commitment. Shareholders may sometimes benefit from an ex post change of the applicable regime to the detriment of employees, in which case there will be little incentive for shareholders or managers to take the interests of nonshareholder constituencies into account in ex post reincorporation decisions.250 If a reincorporation is easy, any ex ante choice is simply preliminary, which is why it cannot have any desirable incentive effects. 249. Enriques & Gelter, supra note 8, at 617–18. 250. Cf. Bebchuk, supra note 243, at 1485. 2010] 3. Dispersed Ownership and Employees Next, consider firms with dispersed ownership, which predominate in Europe only among listed firms in the United Kingdom. As suggested by the U.S. discussion, the objective sought by self-interested managers seems to be increased independence from shareholders.251 All three of the issues identified earlier as relevant for employees252 may play a role here—reducing direct possibilities by shareholders to influence managerial conduct may widen the possibilities for managers to obtain rents and classical private benefits of control. In other words, it may affect agency cost. By contrast, team production advocates emphasize that shielding managers from shareholders allows insulated managers to avoid the exploitation of the quasirents of nonshareholder constituencies.253 Part III.D of this Article describes the potential conflicts of interest where managers and employees will be on one side, and shareholders on the other. While I have argued elsewhere that the influence of dispersed shareholders on managerial decisionmaking is greater in the United Kingdom than in the United States (among other things, because of a higher incidence of hostile takeovers),254 it does not seem likely that managers might use it as an opportunity to secure independence from shareholders. To be sure, the issues identified above might serve this purpose. In a dispersed ownership firm, employees on the board might be faithful allies of management against “intrusion” by shareholder activists or outside board members seeking to maximize shareholder wealth. Directors’ duties using a pluralist objective may sometimes help directors to justify their actions when seeking re-election, as they could say that a new management team would not be in the position to do anything else. And, of course, it might help them to construct a shield against the occasional liability suit. Likewise, a reduced risk of hostile takeovers may increase managers’ freedom to act. Here, it 251. See Bebchuk, supra note 243, at 1462–68 (describing the value-decreasing rules that managers may seek when determining whether to reincorporate). 252. See supra Part II.B–D. 253. See Blair & Stout, supra note 16; see also Coffee, supra note 202, at 70–71, 73–81 (discussing breaches of implicit agreements as a result of hostile takeovers); Shleifer & Summers, supra note 153, at 42 (same). 254. Gelter, supra note 195, at 186–93. is the duties of managers (or their freedom to defend against takeovers) that may be important also for employees. The U.S. experience provides a good example: firms all but threatened to migrate out of Delaware when it was suggested that managers would be forced to let hostile takeovers go through.255 Among these three options, it is probably safe to say that employee participation systems are likely to be the least popular among managers. Even as potential allies, employee board representatives are difficult to keep under control and will typically seek to promote their own agenda.256 It is sometimes argued that German codetermination undermines the functioning of the supervisory board because employee representatives cannot sometimes be trusted with confidential information.257 While this argument is usually made before the backdrop of German concentrated ownership, it applies irrespective of ownership structure: employee participation may help managers when employee and managerial interests coincide, but it may hurt them greatly when they do not.258 In dispersed-ownership firms, managers will therefore rather seek a coalition with shareholders against employees with regard to codetermination. Although the European legal framework puts 255. The notorious “Wachtell Lipton Memo” was disseminated by one of the leading U.S. corporate law firms after the Delaware Chancery Court’s decision in City Capital Assoc. v. Interco Inc., 551 A.2d. 787 (Del. Ch. 1988), which would have greatly reduced managers ability to defend against hostile bids. See Jeffrey N. Gordon, Corporations, Markets, and Courts, 91 COLUM. L. REV. 1931, 1959 n.95 (1991) (quoting Memorandum from Wachtell, Lipton, Rosen, & Katz to clients, The Interco Case (Nov. 3, 1988)). The decision was subsequently rejected by the Delaware Supreme Court. See Paramount Communications, Inc. v. Time, Inc., 571 A.2d. 1140 (Del. 1990). 256. See, e.g., Klaus J. Hopt, The German Two-Tier Board: Experience, Theories, Reforms, in COMPARATIVE CORPORATE GOVERNANCE: THE STATE OF THE ART AND EMERGING RESEARCH 227, 247 (Klaus J. Hopt et al. eds., 1998) (describing how labor interests predominate the discussion on German boards). 257. See, e.g., Jean J. Du Plessis & Otto Sandrock, The Rise and Fall of Supervisory Board Codetermination in Germany, 16 INT’L COMPANY & COM. L. REV. 67, 74–75 (2005); FitzRoy & Kraft, supra note 61, at 236 (citing studies revealing a deliberate restriction of information in some firms); Roe, supra note 37, at 171–75. 258. See supra notes 198–203 (contrasting when employee and manager interests coincide and when they do not). An example would be managerial private benefits of control or self-dealing, which is typically not in line with employee interests. However, it may sometimes be possible to bribe employee representatives on the board, which is not a novel practice. The most prominent case is the Volkswagen corruption affair. See Mark Landler, Sentences in Volkswagen Scandal, N.Y. TIMES, Feb. 23, 2008, at C3. From the perspective of a potential managerial self-dealer it will be preferable if there is no employee representative they would have to bribe. 2010] some breaks on the erosion of employee participation systems, codetermination arbitrage may be a factor to reckon with even in continental dispersed-ownership firms, whose number has increased during the past decade.259 Reduced exposure to takeovers and attenuated influence of shareholders on the firm may be of broader interest for both employees and managers. One might, for example, expect managers to seek opportunistic movements away from member states that implement the neutrality rule. In fact, regulatory competition is usually considered to be the reason for the promanager slant in U.S. takeover law.260 However, as a general matter, it seems relatively unlikely that shareholders in European firms that already have dispersed ownership would agree to a reincorporation into a less takeover-friendly jurisdiction, particularly if such a move was motivated by pro-employee concerns. Most of all, a shareholder vote would seem to be a particularly strong obstacle for British companies. True, U.S. shareholders have often approved staggered boards in the past, which is one of the elements that makes a company takeoverproof, but this has stopped since about 1990.261 Institutional investors in Britain are also known to be more proactive than their U.S. counterparts; while normally acting cautiously, they are known to take action in situations where the alarm bells in a particular firm ring.262 A reincorporation into another member state from Britain, and the (partial) attempt to escape from the financial culture of the City of London would seem to be a more significant event than a mere reincorporation from one U.S. state to another. Arguably, the recent EU Shareholder Rights Directive263 will strengthen the position of institutional investors—often based in the United States or the United Kingdom—also in other member states.264 Thus, the argument would seem to apply by analogy also in continental dispersed ownership firms. 4. Concentrated Ownership and Employees The more pressing issue seems to be whether firms with concentrated ownership might avail themselves of corporate law arbitrage opportunities that are relevant to employees. Here, the triangular relationship between shareholders, managers, and employees is transformed into one involving large shareholders, small investors, and employees. This changes the situation dramatically, since powerful managers are essentially eliminated from the picture as another independent force framing issues of corporate policy. Large blockholders, either acting singlehandedly or in coalition, can easily initiate a reincorporation if they can garner the required supermajority.265 Large shareholders are also in a position to exploit holdup possibilities with respect to employees by means of their continued control over management; if, for some reason, they are unwilling or unable to do so, they may voluntarily sell control to someone else who will, and thus share part of the profits arising from opportunistic behavior towards employees. In the issues identified above as potential shareholder-stakeholder conflicts, minority and large shareholders share an ex post interest in large financial gains. While I have elsewhere argued that large shareholders are in a position to exploit the minority by means of regulatory arbitrage,266 they are equally well-positioned to exploit holdup possibilities to the detriment of employees. This argument is in line with U.S. varieties of stakeholder theories of corporate law, particularly the team production 2010] theory,267 which emphasizes that stakeholders will benefit from the insulation of the board from shareholders. In the comparative corporate governance debate, some authors seem to share this position.268 Others have suggested that employees could rely on the long-term position of large shareholders within the firm, who might have a greater stake in securing the longterm cooperation of stakeholders.269 The second view would seem to rule out opportunistic reincorporations to the detriment of labor and rather indicate that controlling shareholders might seek alliances with labor against small investors. The literature seems not yet to have made much progress towards a synthesis of these two opposing views, which would require a closer investigation of what factors determine the stance towards stakeholders taken by either managers or controlling shareholders.270 For purposes of regulatory arbitrage, it is important to emphasize that the effects on employees may largely depend on the identity of the controlling shareholder, as that person may refrain from opportunism for idiosyncratic reasons. Employees can be protected from takeovers because of nonpecuniary benefits received by the controller of a firm.271 267. See, e.g., Blair & Stout, supra note 195, at 418–22. 268. See, e.g., Gérard Charreaux & Philippe Desbrières, Corporate Governance: Stakeholder Value versus Shareholder Value, 5 J. MGMT. & GOVERNANCE 107, 116 (2001); Andrei Shleifer & Robert W. Vishny, A Survey of Corporate Governance, 52 J. FIN. 737, 758 (1997); see also Michel A. Habib, Monitoring, Implicit Contracting, and the Lack of Permanence of Leveraged Buyouts, 1 EUR. FIN. REV. 139 (1997) (mathematical model in the LBO context); Pagano & Volpin, supra note 203, at 841 (providing a model in which managers have an incentive to provide employees with strong protection to make the firm unattractive as a target of takeovers; however, this incentive rests on managers having only a small stake in equity). 269. See William W. Bratton & Joseph A. McCahery, Comparative Corporate Governance and Barriers to Global Cross Reference, in CORPORATE GOVERNANCE REGIMES: CONVERGENCE AND DIVERSITY 23, supra note 176, at 27; Julian Franks & Colin Mayer, Ownership and Control in Europe, in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW, supra note 20, at 722, 728–29; Ruth V. Aguilera & Gregory Jackson, The Cross-National Diversity of Corporate Governance: Dimensions and Determinants, 28 ACAD. MGMT. REV. 447, 451 (2003). 270. For an attempt to provide a formal model addressing the issue see Giulio Ecchia, Martin Gelter & Piero Pasotti, Corporate Governance, Corporate and Employment Law, and the Costs of Expropriation (European Corporate Governance Institute Law Working Paper No. 128/200 9, 2009 ), available at http//ssrn.com/abstract=1430623. 271. See Gilson, supra note 209, at 1663–64 (defining nonpecuniary benefits as “forms of psychic and other benefits that, without more, involve no transfer of real company resources and do not disproportionately dilute the company’s stock to a diversified investor”). This could be, for example, the personal satisfaction that a member of an entrepreneurial family may derive from his or her privileged position as a controlling shareholder,272 or political benefits if the controlling shareholder is a government entity. Those controlling shareholders that are in a position to initiate reincorporations therefore have a shared interest with employees and are unlikely to reincorporate in an environment where their position is less secure. However, regulatory arbitrage could be a possible road to go down once the nonpecuniary benefit has subsided—such as when a family firm is passed on by the founding generation. As far as aspects of corporate law actually help to foster long-term commitment, regulatory arbitrage gains can easily obtained by the controlling shareholder once such a change occurs. Assuming constant ownership structures, are any of the relevant corporate law issues likely to trigger anti-employee arbitrage, or sufficiently significant to help support a decision to reincorporate? Board-centric takeover defenses are largely irrelevant for firms with concentrated ownership; blockholders’ cooperation is often needed for a change of control over the firm. The neutrality rule is irrelevant. The breakthrough rule may be significant, given that it removes some entrenchment possibilities of large shareholders.273 For employees, its relevance is limited to those where the incumbent controller (such as an entrepreneurial family) takes a friendly attitude towards them to foster long-term investment, whereas the challenger (such as a hedge fund), takes a different position. In some cases, the reciprocity rule of the Takeover Directive may create incentives to opt into board neutrality and the breakthrough rule. Since other firms normally applying these rules may opt out of them vis-à-vis firms that do not apply them, the reciprocity rule facilitates taking over firms. Firms (through their controlling shareholders) expecting to be bidders and not targets might avail themselves of this possibility, but potential 272. See Mike Burkart et al., Family Firms, 58 J. FIN. 2167, 2168 (2003) (“A founder may derive pleasure from having his child run the company that bears the family name.”); cf. Gilson, supra note 209, at 1666 (describing social and political benefits that accompany being a member of the fifteen wealthiest families in Sweden). 273. See Joseph A. McCahery et al., The Economics of the Proposed European Takeover Directive, in REFORMING COMPANY AND TAKEOVER LAW IN EUROPE 575, 623–36 (Guido Ferrarini et al. eds., 2004). 2010] targets will not. Firms are more likely to be targets if there are either inefficiencies, potential private benefits of control for the bidder,274 or rents that can be expropriated from employees.275 Opting out of the neutrality or breakthrough rule in order to avoid being an open target may be a potential corporate law arbitrage strategy, and typically one that employees will appreciate. By contrast, opting into either of these rules will not work in their favor. However, an opt-in does not necessarily require corporate law arbitrage because member states must permit firms to do so in their charter.276 Thus, the one major employee-relevant issue where one might expect significant corporate law arbitrage is employee participation. Controlling shareholders are not likely to be in favor of it, in substance for the same reason as powerful managers in a Berle-Means firm. While employee directors might sometimes turn out to be useful allies for managers,277 their propensity to develop their own agenda, and the frequent suspicion that they cannot be trusted with certain sensitive information relevant for their constituencies,278 will most likely be a deterrent against codetermination. As a result of an increased involvement of international institutional investors precipitated by developments such as the Shareholder Rights Directive,279 even relatively employee-friendly controlling shareholders might feel compelled to put greater weight on the concerns of small shareholders with issues that are as visible as employee participation.280 It seems safe to conjecture that corporate law arbitrage would in most cases disfavor employee participation. 274. See generally Lucian A. Bebchuk, Efficient and Inefficient Sales of Corporate Control, 109 Q.J. ECON. 957 (1994) (providing an analysis how various factors, including private benefits of control of controlling shareholders, determine what kind of takeover law is best suited for a particular corporate governance system). 275. Shleifer & Summers, supra note 153, at 34. 276. See supra note 178 and accompanying text. 277. See supra note 203 and accompanying text. 278. See supra notes 256–57 and accompanying text. 279. Council Directive on the Exercise of Certain Rights of Shareholders in Listed Companies, No. 2007/36, 2007 O.J. L 184/17. 280. Cf. Pinto, supra 264, at 621 (postulating that the Shareholder Rights Directive might reconfigure the power balance between various players in the corporate structure). Some scholars have suggested that regulatory competition could precipitate changes in corporate governance structures. Most of all, the U.K. takeover regime might draw continental firms seeking a stock exchange listing, ultimately aiming for dispersed ownership.281 In addition to the other benefits, this could entail an increase due to gains from employees if the firm becomes more contestable.282 However, making use of transnational regulatory possibilities may not even be necessary. Although member states are not required to implement the neutrality and breakthrough rules as mandatory law, they are required to allow firms to apply them voluntarily.283 Unless the British Takeover Panel possesses significant institutional advantages over its counterparts in other EU member states, a choice within one legal system (and simply making the respective choice in the charter) will suffice. Firms can still seek an exchange listing in the United Kingdom, in which case they will be subject to those aspects of U.K. takeover law that hinge on the exchange listing. Most other issues of takeover law, besides board duties, are not dependent on where the firm has its registered office.284 5. Erosion of Codetermination? The rather theoretical reflections of the preceding sections aside, the one practical issue where we already seem to be seeing regulatory arbitrage is employee participation. Ex post changes of the applicable codetermination regime could be used for opportunistic purposes by controlling shareholders, as the assent of employees is not required. At first glance, the negotiation mechanism regarding employee participation applicable to crossborder mergers and the creation of an SE would seem to greatly mitigate the effects of such a move. Even when using the less “employee-friendly” rules of the Directive on Cross-Border Mergers, the highest level of employee participation prevails when a third of the merged firm’s employees were previously subject to any participation system; and even where a single 281. See Armour, supra note 4, at 390–91; Armour & Skeel, supra note 163, at 1789– 90. 282. See supra Part II.C.3. 283. See supra note 178 and accompanying text. 284. See Enriques & Tröger, supra note 184, at 531–32. 2010] employee was previously subject to such a mechanism, the SNB may decide which participation system applies. One might therefore conclude that the SNB has a strong bargaining position, as the default rule awards the entire prize to their constituency.285 Some commentators have concluded that codetermination effectively insulates employee participation systems from regulatory competition.286 If the analysis stopped here, the only situation where the expectations of employees in one member state with regard to a particular level of participation would be disappointed might be one where shareholders and managers succeed in pitting employee groups from different states against each other.287 Significantly, the default rules do not apply in newly merged entities where previously fewer than twenty-five percent (SE Directive) or thirtythree percent (Cross-Border Merger Directive) of employers were subject to an employee participation system.288 The rationale for this threshold is apparently to avoid forcing boardroom participation on reluctant employees.289 However, the impression that codetermination is completely protected is deceptive. An SE can indeed be used to escape codetermination by converting into a legal form of national law.290 A conversion into a corporation governed by national law is permitted two years after the registration of the SE, and after that period, it will not normally be considered “misuse.”291 As already pointed out, a merger with a legal form of national law may even be possible before the end of the two-year period.292 Whether an employee participation system must be “transferred” to the acquiring firm is essentially up to the member state. 285. Furthermore, it can delay the registration of an SE by six months, which is the default maximum duration of negotiations. See supra note 74 and accompanying text. This creates additional bargaining power for the employee side. See Rickford, supra note 81, at 27 n.50. 286. See, e.g., Johnston, supra note 91, at 109. 287. See discussion supra note Part II.B.3. 288. See supra notes 76, 85 and accompanying text. 289. See Rickford, supra note 81, at 28 n.56. For example, British unions were historically skeptical about employee participation. See, e.g., KNUDSEN, supra note 46, at 52. 290. See supra notes 117–22 and accompanying text. 291. Supra notes 117–18 and accompanying text; see also Kisker, surpa note 86, at 208 (suggesting that a transformation after more than two years will not be a “misuse”). 292. See supra note 119 and accompanying text. Likewise, after a period of least three years (unless member state law prescribes a longer period), a firm formed by a cross-border merger can be merged with a “clean slate” firm that is not subject to a negotiated employee participation agreement.293 In both cases, it is largely left to the member state where the firm is incorporated to decide how the negotiated employee participation system is dealt with in such cases. True, some companies may be deterred from setting up an SE or merging by the lengthy negotiation process.294 However, companies may elect to submit to the applicable default participation rules voluntarily in a cross-border merger and thus avoid lengthy negotiations.295 Whether “outreach statutes” applying national employee participation systems to “pseudo-foreign” firms incorporated in other member states will be politically feasible and legally possible under EU law remains to be seen.296 While transformations into the SE form have so far not yet become a mass phenomenon, they are growing in popularity. In June 2008, there were 213 SEs in Europe.297 So far there is no systematic data on the exact motivation to transform a firm into an SE, but anecdotal evidence indicates that board structure plays an important role. While some observers point out that the legally mandated size of the German supervisory board is often considered detrimental by firms,298 at least in some cases, SEs appear to have been used to avoid the future possibility of codetermination or of a stronger form of it once the firm exceeds the required size threshold.299 Some observers predict that a large proportion of large publicly traded German firms may become SEs in the future.300 Given that only a handful of the 293. See supra note 124. 294. See Joseph McCahery & Erik Vermeulen, Does the European Company Prevent the ‘Delaware Effect’?, 11 EUR. L.J. 785, 799 (2005); Rock et al., supra note 124, at 218. 295. See supra notes 82–83. 296. See supra notes 133–37 and accompanying text. 297. Eidenmüller et al., supra note 68, at 20. 298. See id. at 25 (reporting that several German publicly traded firms reduced the number of board members). 299. See Ingrid Herden & Reinhard Kowalewsky, Das neue Drohpotenzial: Europa-AG [The New Potential Threat: Europe-AG], CAPITAL, Mar. 1 9, 2008 , at 192 (citing a representative of Klöckner SE saying that there will never be board codetermination after the firm has been transformed); see also supra note 108 (describing how the creation of an SE reduced the size of the Allianz supervisory board). 300. See Herden & Kowalewsky, supra note 299, at 192 (quoting German corporate governance experts and politicians that a large number of firms will transform into SEs). 2010] existing SEs are truly large firms, this assessment may be premature.301 Furthermore, the evidence compiled by Eidenmüller et al. suggests that SEs are more popular in countries with employee participation systems, such as Austria, the Czech Republic, Germany, or the Netherlands, than in others such as France, Italy Spain, or the United Kingdom, where SEs are rare relative to population size, or do not exist at all thus far.302 Ultimately, whatever bargaining victory the SNB achieves, it may be a pyrrhic one since shareholders are unable to commit to retaining the results after a subsequent merger. It seems also unlikely that a court would consider a subsequent merger abusive in the case of a time lag of several years. The assessment that European corporate law legislation could result in an “erosion” of German codetermination303 may therefore well turn out right. CONCLUSION The possibilities of regulatory arbitrage put employees at a disadvantage compared to the traditional “protected” national systems of corporate law. Previous articles have pointed out that differences in ownership structure between Europe and the United States are likely to result in stronger risks in the European context due to the relatively unchecked power of controlling shareholders on the European continent. Due to differences in ownership structure, the results of regulatory arbitrage opportunities are likely to be very different from the United States, where regulatory competition seems to have largely reinforced the pre-eminence of managers over shareholder power. U.S. shareholders have traditionally been prevented by political forces (that have influenced securities law and financial regulation) from gaining an intrusive influence on firms.304 True, 301. See Eidenmüller et al., supra note 68, at 22–23 (reporting on the conversion of only four firms with more than 10,000 employees, those being Allianz, Porsche, Strabag, and Elcoteq). 302. See id. at 20 (reporting numbers of SEs by population). This is my own interpretation of their evidence. In fact there are many reasons why the SE form may be chosen, including tax advantages. 303. See, e.g., Habersack, supra note 86, at 643; Teichmann, supra note 137, at 1787; see also MILHAUPT & PISTOR, supra note 108, at 85 (“[T]he mandatory codetermination regime can be softened considerably.”). 304. See generally ROE, supra note 26. FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 33:792 no state in the United States has implemented an employee participation system. Still, employees have often figured prominently in the debate on hostile takeovers, in which managers asserted their independence and insulation. U.S. managers’ assertion of their independence has probably shielded employees from takeovers to some extent—where employee and managerial interests overlap, it has most likely done so even without employees having a formal influence on decisions whether or not to reincorporate. In continental Europe, by contrast, blockholders dominate corporate governance. Controlling shareholders are not only in a position to use their influence to the detriment of other stakeholders, but they are also the likely beneficiaries. Their position has been strengthened further by the regulatory arbitrage opportunities created by EU law that can undermine pro-employee institutions of national corporate governance systems. Employee participation systems are the main issue that could become a target of regulatory arbitrage. While EU law sets certain limits to arbitrage by requiring negotiations, there are techniques that can allow patient shareholders to erode codetermination. The negotiation mechanism implemented by the SE Employees Directive and the Directive on Cross-Border Mergers does not provide complete protection, and even allows controlling shareholders to escape employee participation systems. Possible incentives in long-term commitment and firmspecific investment are mitigated or eliminated because controlling shareholders can renege on a prior commitment to a particular law. Free choice of the corporate law regime regarding employees implies that shareholders cannot permanently commit. The reason why such mechanisms may sometimes be beneficial for firm-specific investment is precisely because they are likely to foster long-term commitment and trust. Regulatory arbitrage rules out a permanent commitment to codetermination or similar systems. Decisions on reincorporations are taken exclusively by shareholders, who cannot stipulate against mergers or the creation of an SE. The limits of “codetermination arbitrage” under European law remain tentative. Thus, even if an efficient ex ante choice is possible, specific investment by employees may not occur or be adjusted in anticipation of 1. Centros Ltd . v. Erhvervs-og Selskabsstyrelsen , Case C- 212 /97, [1999] E.C.R. I1459 . 2. Überseering BV v. Nordic Constr. Co. Baumanagement GmbH (NCC) , Case C208/00 , [2002] E.C.R. I- 9919 . 3. Kamer van Koophandel en Fabrieken voor Amsterdam v. Inspire Art Ltd., Case C - 167 /01, [2003] E.C.R. I- 10155 . 4. See, e.g., STEFANO LOMBARDO , REGULATORY COMPETITION IN COMPANY LAW IN THE EUROPEAN COMMUNITY: PREREQUESITES AND LIMITS ( 2002 ) ; John Armour, Who Should Make Corporate Law? EU Legislation Versus Regulatory Competition, 58 CURRENT LEGAL PROBS . 369 ( 2005 ) ; Jens C. Dammann, Freedom of Choice in European Corporate Law, 29 YALE J . INT'L L . 477 ( 2004 ). 5. See, e.g., Luca Enriques, EC Company Law and the Fears of a European Delaware , 15 EUR. BUS. L. REV. 1259 ( 2004 ). 6. See, e.g., Martin Gelter , The Structure of Regulatory Competition in European Corporate Law , 5 J. CORP . L. STUD. 247 ( 2005 ) ; Tobias H . Tröger, Choice of Jurisdiction in European Corporate Law: Perspectives of European Corporate Governance, 6 EUR. BUS. ORG. L. REV. 3 , 6 ( 2005 ). 7. See, e.g., Enriques, supra note 5; see also, e.g., Gelter, supra note 6 , at 253-64; Tröger, supra note 6, at 5-6. 8. See, e.g., Luca Enriques & Martin Gelter, How the Old World Encountered the New One: Regulatory Competition and Cooperation in European Corporate and Bankruptcy Law , 81 TUL. L. REV. 577 , 612 - 13 ( 2007 ). 9. See Udo Kornblum , Bundesweite Rechtstatsachen zum Unternehmens- und Gesellschaftsrecht , Stand 1.1.2008 [Nationwide Facts on Business and Corporate Law, as of 1.1.2008], 100 GMBH-RUNDSCHAU [GMBHR] 25 , 31 (2009) (F.R .G.) (estimating roughly 15,000 limited liability companies in Germany as of year-end 2007 ). See generally Marco Becht et al ., Where Do Firms Incorporate? Deregulation and the Cost of Entry , 14 J. CORP . FIN. 241 ( 2008 ) (providing empirical data on the basis of the residence of directors). 10. Centros and its progeny have triggered an intense academic debate about creditor protection rules, which are thought to be more important in Europe than in the United States . See generally LEGAL CAPITAL IN EUROPE . ECFR SPECIAL NO. 1 (Marcus Lutter ed ., 2006 ); THE LAW AND ECONOMICS OF CREDITOR PROTECTION: A TRANSATLANTIC PERSPECTIVE (Horst Eidenmüller & Wolfgang Schön eds., 2008 ) (analyzing the merits of legal capital from various perspectives); Luca Enriques & Jonathan R. Macey , Creditors Versus Capital Formation: The Case Against the European Legal Capital Rules , 86 CORNELL L. REV. 1165 ( 2001 ) (criticizing legal capital as inefficient); Peter O. Mülbert & Max Birke, Legal Capital-Is There a Case Against the European Legal Capital Rules?, 3 EUR . BUS. ORG. L. REV. 695 ( 2002 ) (same). 11. A recent German reform can be clearly identified as motivated by regulatory competition. The Gesetz zur Modernisierung des GmbH-Rechts und zur Bekämpfung 20. A complete contingent contract would require stipulations for payoffs to all parties under every single possible state of the world, however unlikely . See, e.g., Alan Schwartz , Incomplete Contracts, in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 277, 277 (Peter K. Newman ed., 1999 ). 21. The idea of “bounded rationality” is attributed to Herbert Simon. See Herbert Simon, A Behavioral Model of Rational Choice, 69 Q .J. ECON. 99 , 104 ( 1955 ) ; see also OLIVER HART, FIRMS, CONTRACTS AND FINANCIAL STRUCTURE 81 ( 1995 ); OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM 45-46 ( 1985 ); Christine Jolls, Cass R. Sunstein & Richard Thaler , A Behavioral Approach to Law and Economics, 50 STAN. L. REV. 1471 , 1477 ( 1998 ). 22. Cf . FURUBOTN & RICHTER, supra note 18, at 233 (defining the terms “verifiable” and “observable”); HART , supra note 21, at 37-38 n. 15 ( same ). 23. RICHARD A. BREALEY, STEWART C. MYERS & FRANKLIN ALLEN , PRINCIPLES OF CORPORATE FINANCE 949 (8th ed. 2006 ). 24. Id . at 949 n.36. 27. Council Regulation on the Law Applicable to Contractual Obligations (Rome I) , No. 593/ 2008 , art. 8 ( 2 ), 2008 O.J. L 177/6. 28. Id . art. 8 ( 3 ). 29. Id . art. 8 ( 4 ). 30. See id. art. 3. 31. See id. art. 8 ( 1 ). For a more detailed discussion of the equivalent predecessor provisions of these rules in the former Rome I convention, see SIR PETER NORTH & J.J. FAWCETT , CHESHIRE AND NORTH'S PRIVATE INTERNATIONAL LAW 208- 10 (13th ed. 2004 ). See also Sebastian Krebber, Conflict of Laws in Employment in Europe, 21 COMP . LAB. L. & POL'Y J . 501 , 522 - 29 ( 2000 ). 32. See Krebber, supra note 31 , at 538- 39 . For a German perspective, see Rolf Birk, in 1 MÜNCHENER HANDBUCH ZUM ARBEITSRECHT [MUNICH HANDBOOK ON EMPLOYMENT AND LABOR LAW] § 22 , cmts. 5- 6 ( Reinhard Richardi & Otfried Wlotzke eds., 2d ed. 2000 ) (F.R .G.) (explaining the principle of territoriality), and Dieter Martiny, in 10 MÜNCHENER KOMMENTAR ZUM BÜRGERLICHEN GESETZBUCH [MUNICH COMMENTARY ON THE CIVIL CODE] EBGBG art . 30 , cmts. 129 - 36 (Kurt Rebmann et al. eds., 4th ed. 2006 ) (F.R .G.) (same). For a French perspective, see PIERRE MAYER & VINCENT HEUZÉ, DROIT INTERNATIONAL PRIVÉ [PRIVATE INTERNATIONAL LAW] 553 - 54 (9th ed. 2007 ) (Fr.) (pointing out that collective rights of employees necessarily depend on territoriality and mentioning a case where an international firm had to permit a works council in its French operations ). 33. Council Directive on the Establishment of a European Works Council or a Procedure in Community-Scale Undertakings and Community-Scale Group Undertakings for the Purposes of Informing and Consulting Employees , No. 94 /45, art. 1 ( 2 ), 1994 O.J. L 254/64, amended by 1998 O.J. L 10 / 22 (extending the original 41. See id. § 7 ( 1 ). 42. See id. § 7 ( 2 ). 43. See id. § 29 . 44. Enriques et al., surpa note 37 , at 101. 45. See Drittelbeteiligungsgesetz [ One-Third Employee Representation Act], May 18 , 2004 , BGBl. I at 974, last amended by Gesetz, July 30 , 2009 , BGBl. I. at 2479, § 1 ( F.R.G.). 46. A codetermination system comparable to the German one was recommended in the “ Bullock Report.” REPORT OF THE COMMITTEE OF INQUIRY ON INDUSTRIAL DEMOCRACY , 1977 , Cmnd. 6706 ( U.K. ). For the reasons on why it was rejected, see, for example , HERMAN KNUDSEN, EMPLOYEE PARTICIPATION IN EUROPE 53 ( 1995 ), and David Marsh & Gareth Locksley, Capital in Britain: Its Structural Power and Influence over Policy, 6 WEST EUR . POL . 36 , 49 - 50 ( 1983 ). 47. See Arbeitsverfassungsgesetz [ArbVG] [Labor Constitution Act], Bundesgesetzblatt Teil I [BGB1 I] No. 22/ 1974 , § 110 (Austria). 48. RAISER, supra note 38, at B 43-B 44. Regarding the Danish system , see KNUDSEN, supra note 46 , at 81-95, and Jesper Lau Hansen, The Danish Green Paper on Company Law Reform-Modernising Company Law in the 21st Century, 10 EUR. BUS. ORG. L. REV . 73 , 89 - 90 ( 2009 ). 49. See Laki yhteistoiminnasta yrityksissä [Act on Cooperation with Undertakings] ( 1978 : 725) (Fin.). A unofficial translation by the Finnish government is electronically available at http://www.finlex.fi/pdf/saadkaan/E9780725.pdf. 50. See Law of May 6, 1974 , Mémorial du Grand-Duché de Luxembourg [Official Gazette of Luxembourg], A -No. 35 , May 10 , 1974 , at 620 (Lux.). 51. See 32 § Lag om Medbestämmande i arbetslivet [Act on Codetermination in the Workplace] (Svensk författningssamling [SFS] 1976 : 580) (Swed.), translated in FOLKE SCHMIDT, LAW AND INDUSTRIAL RELATIONS IN SWEDEN ( 1977 ). 52. See RAISER , supra note 38, at B 42. The idea likely spread to these postcommunist countries because their legal tradition has historically been influenced by Germany. See Holger Spamann, Contemporary Legal Transplants-Legal Families and the Diffusion of (Corporate) Law, 2009 B.Y.U. L. REV . 1813 , 1867 . 53. See RAISER , supra note 38, at B 42. 54. See id. at B 43-B 44. 55. See Abe de Jong & Alisa Roëll, Financing and Control in the Netherlands: A Historical Perspective, in A HISTORY OF CORPORATE GOVERNANCE AROUND THE WORLD 467, 473 (Randall K. Morck ed., 2005 ) (discussing the aim of structurregime and its drawbacks) . See generally STEVEN R. SCHUIT ET AL., CORPORATE LAW AND PRACTICE OF THE NETHERLANDS 111-14 (2d ed. 2002 ) (describing the corporate structure of “large” Dutch corporations); Edo Groenewald, Corporate Governance in the Netherlands: From the Verdam Report of 1964 to the Tabaksblat Code of 2003, 6 EUR . BUS. ORG. L. REV. 291 , 294 ( 2005 ) (providing a breakdown of the statutory two-tier regime) . To qualify as a “large” company, a firm must meet three criteria: (1) an equity capital of at least € 13 , 000 ,000; (2) the corporation or a dependent company must have established a Works Council (as required by law); and (3) a regular workforce of 100 or more persons in the Netherlands (together with dependent companies) . See Burgerlijk Wetboek [BW2] [Civil Code] bk. 2 , tit . 5, arts. 153 ( 2 ), 263 ( 2 ) (Neth.). There are several exemptions to this definition. For example, a dependent firm with a parent company that fulfills the requirements is exempt . See SCHUIT ET AL., supra, at 115-17. 56. See BW2 [Civil Code] bk. 2, tit . 5, art. 158 ( 6 ). A rejection of the nominees of the works council is only possible for a limited number of reasons . See Groenewald, supra note 55 , at 295 (describing the grounds for the shareholders to object to a nominee of the works council ). 57. Groenewald , supra note 55, at 297. 58. See , e.g., Gary Gorton & Frank A. Schmid, Capital, Labor and the Firm: A Study of German Codetermination, 2 J . EUR. ECON. ASS'N 863 , 885 - 86 ( 2004 ). 59. Tobin 's q, as it is referred, is the ratio between the firm's market value and the replacement value of its assets . See, e.g., James Tobin & William C. Brainard , Asset Markets and the Cost of Capital, in ECONOMIC PROGRESS , PRIVATE VALUES , AND PUBLIC POLICY 235 65. Council Regulation on the Statute for a European Company , No. 2157/ 2001 , arts. 17 - 31 , 2001 O.J. L 294/1, at 7- 10 . See generally Luca Enriques, Silence is Golden: The European Company as a Catalyst for Company Law Arbitrage, 4 J. CORP . L. STUD. 77 ( 2004 ) (discussing how the Societas Europaea (“SE”) can be used for company law arbitrage). 66. See Enriques, supra note 65 , at 77 ( noting that the statute is limited in scope). 67. Council Regulation on the Statute for a European Company , No. 2157/ 2001 , art. 9, 2001 O.J. L 294/1, at 6. 68. A recent study found a total of 213 of these companies . See Horst Eidenmüller et al., Incorporating Under European Law: The Societas Europaea as a Vehicle for Legal Arbitrage, 10 EUR . BUS. ORG. L. REV. 1 , 20 ( 2009 ). 69. Council Regulation on the Statute for a European Company , No. 2157/ 2001 , art. 8, 2001 O.J. L 294/1, at 5-6. 70. See Enriques, supra note 65 , at 81-82. 71. Council Directive Supplementing the Statute for a European Company with Regard to the Involvement of Employees , No. 2001 /86, 2001 O.J. L 294/22. 72. For a detailed description of this directive , see BARNARD, supra note 33 , at 723- 73. See Council Directive Supplementing the Statute for a European Company with Regard to the Involvement of Employees , No. 2001 /86, arts. 3- 4 , 2001 O.J. L 294/22, at 24- 26 . Article 4(2) sets out the issues the agreement must cover, such as the allocation of seats and the powers of the representative body . Id. art. 4 ( 2 ). 74. See id, art. 5 , 2001 O.J. L 294/22, at 27. 75. See id. annex (setting out the fundamental principles of these rules). 76. See id. annex, pt. 3(b); see also BARNARD , supra note 33 , at 730; Paul L. Davies, Workers on the Board of the European Company? 32 INDUS . L.J. 75 , 85 - 87 ( 2003 ) (explaining the “highest level” requirement). 77. See Council Directive Supplementing the Statute for a European Company with Regard to the Involvement of Employees , No. 2001 /86, art. 7 ( 2 )(b), 2001 O.J. L 294 /22, at 27. 78. See id. art. 7. 79. BARNARD, supra note 33, at 730. 80. See Council Directive Supplementing the Statute for a European Company with Regard to the Involvement of Employees , No. 2001 /86, pmbl. ¶¶ 3 - 4 , 2001 O.J. L 294/22, at 22. 81. See id. annex, pt. 3(b) . According to article 7(3), member states may provide that the default provisions do not apply if the SE is formed by merger . Id. art. 7 ( 3 ). This provision was introduced in order to secure Spain's approval of the directive . According to the predominant interpretation of the provision, an SE cannot be formed in the 84. See Council Directive on Cross-Border Mergers of Limited Liability Companies , No. 2005 /56, art. 16 ( 3 ), 2005 O.J. L 310/1, at 8. 85. See id. art. 16 ( 3 )(e). 86. See id. art. 16 ( 4 ) (c). The rationale seems to be that employee influence on a one-tier board is thought to be more significant than on a supervisory board, which is less directly involved in the firm's decision-making processes . See Mathias Habersack , Grundsatzfragen der Mitbestimmung in SE und SCE sowie bei grenzüberschreitender Verschmelzung [Fundamental Issues of Codetermination in the European Company and the European Cooperative, as well as After a Cross-border Merger], 171 ZEITSCHRIFT FÜR DAS 219. Law of Mar. 4 , 1943 , J.O. , Mar. 6 , 1943 , p. 642 ( Fr .) ; see also MICHEL GERMAIN & LOUIS VOGEL, 1:2 TRAITÉ DE DROIT COMMERCIAL 400 , 442 - 45 (G. Ripert & R. Roblot eds., 18th ed. 2001 ). 220. Law No. 2001 -420 of Mar. 15 , 2001 , J.O. , May 16 , 2001 , p. 7776 ( Fr .). 221. See , e.g., JEAN PAILLUSSEAU , LA SOCIETE ANONYME , TECHNIQUE D'ORGANISATION DE L'ENTREPRISE 154- 55 ( 1967 ) (Fr.) (providing various references). 222. See GERMAIN & VOGEL, supra note 219, at 453; Claude Ducouloux-Favard, Les déviances de la gestion dans nos grandes entreprises [The Deviations of Management in Our Largest Businesses], 1996 RECUEIL DALLOZ SIREY , chronique 190 , 191 (describing the possibility of removal at nutum as being at odds with the prevailing institutional theory of the firm); Enriques et al ., supra note 36 , at 61 (noting the nonwaivable right in French law to remove directors midterm). 223. See supra notes 142- 43 . 224. See supra note 141. 225. Supervisory board members, who decide about the removal of management board members, are typically close confidants of large shareholders, and the requirement of a 75% supermajority is not insurmountable . See, e.g., Peter Doralt , Die Unabhängigkeit des Vorstands nach österreichischem und deutschen Aktienrecht-Schein und Wirklichkeit [The Independence of the Board Under Austrian and German Company LawAppearance and Reality], in DIE GESTALTUNG DER ORGANISATIONSDYNAMIK . FESTSCHRIFT FÜR OSKAR GRÜN 31 , 47 - 48 (Werner H. Hoffmann ed., 2003 ); see also Reinhard H. Schmidt, Corporate Governance in Germany: An Economic Perspective, in THE GERMAN FINANCIAL SYSTEM 386, 393 (Jan Pieter Krahnen & Reinhard H . Schmidt eds., 2004 ) (reporting that blockholders and banks are represented on the supervisory board besides employees). 228. See , e.g., Michael C. Jensen & William H. Meckling , Rights and Production Functions : An Application to Labor-Managed Firms and Codetermination, 52 J. BUS. 469 , 472 - 75 ( 1979 ) (arguing that the burden of proof lies with the proponents of codetermination). 229. See supra notes 108-09 and accompanying text. 230. See Jensen & Meckling, supra note 228, at 472-75. 231. See Fauver & Fuerst, supra note 17, at 679. For similar arguments regarding the voluntary introduction of provisions equivalent to employment protection laws , see Armour & Deakin, supra note 17 , at 447-48; David I. Levine , Just-Cause Employment Policies in the Presence of Worker Adverse Selection, 9 J. LAB . ECON. 293 ( 1991 ) ; and Cass R. 239. See Lucian A. Bebchuk , Limiting Contractual Freedom in Corporate Law: The Desirable Limits of Constraints on Charter Amendments , 102 HARV. L. REV. 1820 , 1835 - 47 ( 1989 ). 240. See Jeffrey N. Gordon , The Mandatory Structure of Corporate Law , 89 COLUM. L. REV. 1549 , 1573 - 85 ( 1989 ). 241. See Dammann, supra note 4 , 515 - 16 . 259. See generally Julian Franks et al., The Life Cycle of Family Ownership: A Comparative Study of France, Germany, Italy and the U.K. ( Oct. 1 , 2009 ) (unpublished manuscript) , available at http://ssrn.com/abstract=1102475. 260. See e.g., Bebchuk & Ferrell, supra note 154. 261. Bebchuk et al., supra note 159 , at 900 ( describing how staggered boards were frequently approved before 1990, but not afterwards ). 262. See , e.g., G. P. STAPLEDON , INSTITUTIONAL SHAREHOLDERS AND CORPORATE GOVERNANCE 122-29 ( 1996 ); John Armour et al., Corporate Ownership Structure and the Evolution of Bankruptcy Law: Lessons from the United Kingdom , 55 VAND. L. REV. 1699 , 1751 - 54 , 1752 ( 2002 ) ; Bernard S. Black & John C. Coffee , Jr., Hail Britannia?: Institutional Investor Behavior Under Limited Regulation , 92 MICH. L. REV. 1997 , 2036 - 37 , 2053 ( 1994 ). 263. Council Directive on the Exercise of Certain Rights of Shareholders in Listed Companies , No. 2007 /36, 2007 O.J. L 184/17. 264. See Arthur R. Pinto , The European Union's Shareholder Voting Rights Directive from an American Perspective: Some Comparisons and Observations, 32 FORDHAM INT'L L.J . 587 , 617 - 19 ( 2009 ). 265. Amendments to a firm's charter in European states, including the United Kingdom, typically require a supermajority . See, e.g., AktG, Sept. 6 , 1965 , BGBl. I at 1089, § 179 ( 2 ), last amended by Gesetz, July 31 , 2009 , BGBl. I at 2509 ( F.R.G. ) (requiring a majority vote of three-quarters for reincorporation); C. TRAV . art. L. 225 - 96 (Fr.) (requiring two-thirds) ; Companies Act 2006 , 2006 , c. 46 , §§ 21 ( 1 ), 283 ( 1 ) (U.K. ) (requiring three-quarters) . 266. Gelter , supra note 7, at 269-75.


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Martin Gelter. Tilting the Balance Between Capital and Labor? The Effects of Regulatory Arbitrage in European Corporate Law on Employees, Fordham International Law Journal, 2009,