The Conflicts of Interests Within the Objectives of Minimum Capital Maintenance - Research Paper Example

A on the Conflicts of Interests within the Objectives of Minimum Capital Maintenance According to the European Corporate Law 0 Introduction: It has been proved form time and again that any well managed company with exceptionally strong corporate governance history and outstanding social and environmental performance would always outperform the competitors in the market and would accelerate its global growth at a rapid pace. Reaching such a position would obviously strengthen the rights of the shareholders and protect the interest of both internal and external stakeholders. However during the journey to reach the level of optimal performance, the corporate entities have to face and resolve a number of conflicts that may arise among various interest groups. And the conflicts may also relate to several organizational issues, including the maintenance of the minimum capital according to the corporate legislations prevalent in the European Continent. This note presents a review of the possible conflicts, reasons for the occurrence of them together with an evaluation thereof. 2.0 A Review of the Conflict: It has often been contended that the provisions of the various European Company Law legislations that deal with the share capital of the companies have been formed solely with the object of protecting the rights of one class of the external stakeholders namely the ‘creditors’. The need to protect the creditors from the improper use of the ‘doctrine of limited liability’ by the shareholders had been felt for quite a long time even since the time of Salmon v Salmon case that is being quoted quite often in connection with the ‘corporate veil’ of the companies. “A common rationalization of the share capital provisions is that they protect corporate creditors from the abuse of the limited liability by shareholders” (John Armour 2000) The room for such conflicts between the rights of the shareholders and the protection of the interests of the creditors had always been there in the development of corporate culture over the periods In spite of the presence of various of various company and insolvency law regulations, such conflicts endure over time and it had also necessitated a periodic review of the various company law provisions governing the shareholders’ rights. 3.0 Possible Causes for Such Conflicts: An article by Asian Development Bank (ADB) Institute opines that “the typical corporate governance framework views shareholders as the principal, and the objective of the management of a corporation is to maximize the interests of the shareholders.” The law and practices pertaining to the shareholders’ rights do not vary much between countries as they have the common interest of maximizing the interest of the shareholders and at the same time they have a responsibility to provide for the protection of the rights of the creditors who have also stakes in the companies, be it is financial institutions or individuals. Hence any variation in the shareholders’ rights will naturally be looked into suspiciously by the creditors as to the effect of such changes in their claims against the assets of the company. Hence any variation in the shareholders’ rights would be a possible cause of conflict between the two interest groups. For example introduction of dual class voting rights for the shareholders may not be viewed favourbly by the creditors. The actions of the shareholders which result in any diversion of assets of the company would obviously be viewed as detrimental to their interest by the creditors. Because of their control over the management of the affairs of the company they may encourage the declaration of unreasonable dividend payments or enter in to contracts for the provision of commissions for transactions with firms in which they are interested. These cash outflows from the company would reduce the financial strength of the company, on the basis of which credits were extended to the company. According to Macey Jonathan (2001) “shareholders can engage in claim dilution.” By dilution it is implied that shareholders may create additional liabilities on the company by contracting with new creditors with the same or different terms. This would have the effect of diluting the existing creditors’ rights on the company’s assets in case the company becomes insolvent. Another possible cause for such conflicts of interests would lie in the shareholders’ because of their position, possibly winding up any projects of the company that ensures a positive net present value and in which the creditors’ interests are predominant. The shareholders by engaging in ‘Off Balance Sheet Financing’ can attempt to pursue the capital expenditure projects which are otherwise riskier. This way the shareholders can try to enhance the value of their shareholding at the risk of the creditors of the company. On the other hand the creditors may also create the grounds for possible conflicts between themselves and the shareholders in such ways. “Creditors can also benefit themselves at the expense of the shareholders by engaging in similar behavior” (Frank H. Easterbrook (1984) By forcing the company for the earlier repayment of the loans or by virtue of their controlling interests may prevent the company from declaring dividends. By pressuring the company to issue additional shares to make a cushion for their exposure, the existing shareholders’ interest may be diluted By forcing the companies to invest in less risky projects the creditors can strengthen their position at the risk of the company not making additional profits out of these less risky projects. By preventing the companies to undertake high risk projects where the present value is high and beneficial to the shareholders provided the creditors have better control over the company than the shareholders. However it cannot be said that such kind of conflicts would be continuously present in an organization which is having a sound operation. But if the company is at the verge of insolvency, may be the situation is different. “The risk of opportunistic behavior by corporate debtors looms large primarily during some sort of end period, such as when a company is near insolvency.” Posner (1976) Moreover only the financial creditors who are able to influence the functioning of the company are in a position to exert these kinds of pressures on the shareholders. “Other creditors, including some trade creditors, employees, and especially involuntary creditors such as tort victims and the state as tax collector, are not able to contract for themselves” Phillip I. Blumberg, (1986) 4.0 Ways of Mitigating the Conflicts: In order that any corporate entity functions normally and flourishes in a short time would depend on good corporate governance encompassing a perfect harmony among all the varied interest groups connected with the organization both externally and internally. Several attempts have been made by the governments of the nations from legislative angles by introducing series of amendments and changes to existing laws for a proper resolution of these kinds of conflicts. Especially “in Europe, fixed claimants (creditors) play an integral role in corporate governance, and European legal capital rules exist to protect fixed claimants from opportunistic behavior by residual claimants (shareholders)”. Macey Jonathan (2001) In quite contrast, the situation in the USA is different in that it is for the creditors to take care of their interests. In the United States, creditors who wish to protect themselves from shareholders behaving opportunistically must do so by contract” Easterbrook and Fischel (1991) The changes contemplated in the European corporate laws provide for some of the ways in which these conflicts may find a resolution. The European Union has adopted Second Directive through legal capital doctrine to provide for remedies like minimum capital requirements, restriction on dividend payments and repurchase of shares, requirements to recapitalization or liquidation of the organization in case of exorbitant losses. The second directive also proposes to put restrictions on the increase or decrease in the share capital by publicly traded companies. The Minimum Capital Rules require the companies to have a minimum capital of at least Euro 25,000 before any company can start their business and at least 25 percent of the subscribed capital should have been paid up at the time of commencement of the business. There is an additional requirement to transfer the shares issued for consideration other than cash within a period of five years. The proposed law prescribes a test on the balance sheet of a company to decide on the declaration of dividends. The acquisition by a company of its own share are allowed only up to a certain limit and also subject to several other restrictions imposed. The Second directive also has specifically prohibited the companies from providing financial assistance to anyone who want to acquire the shares of the company. Several criticisms have been raised against the “Legal Capital Doctrine’ The first criticism is that “the Second Directives minimum initial capital requirement provides no meaningful protection for creditors” Dan D. Prentice (1996) According to Macey Jonathan (2001) the doctrine has created costs for the creditors, shareholders and the companies alike. She also opines that creditors will find their own means of protecting their interests before they risk the funds with any company and such a financial shrewdness has made the usage of this doctrine obsolete. 5.0 Accounting Implications of the Conflicts between Creditors and Shareholders’ Interests: The presence of such kinds of conflicts does pose some complexities in the preparation and presentation of the financial statements of the companies. While the financial statements are expected to present a true and fair view of the financial affairs of the company because of the underlying intentions of the shareholders expressed through the Board of Directors and managers of the companies often put the accountants and the auditors of a company in a rather embarrassing situation with respect to the preparation and certification of the financial statements. The examples of such situations arise when the companies adopt the policies of ‘Earnings Management’ or ‘Off Balance Sheet Financing’ either to defraud the creditors or to genuinely arrange for additional financing for capital projects having a positive present value that is truly advantageous to the company. “They are characterized by excessive complication and the use of novel ways of characterizing income, assets or liabilities.” (Wikipedia) Under such situations the accountants are either forced or cajoled in any way to make suitable alterations in the accounting and other statements so that the objectives of the shareholders are achieved. Though not intended specifically against the creditors of the company, the accounting fraud that saw the end of the company ‘Enron’ is a classic example of such pressures on accountants and auditors when there are no valid intentions of any interest groups. Another issue that is being usually encountered by the creditors is the valuation of assets of the company before the distribution of dividends by the company. In order that the value of their shareholding goes up in the market, the shareholders tend to revalue the assets and liabilities of the company and present a financial statement that shows a fairly strong position of the company in the eyes of the investors. This often creates complexity in the accounting as well as the preparation of the balance sheet of the company for any particular period. 6.0 Conclusion: The perpetuity is an important element of the joint stock company form of an organization. May be in theory it is possible that the shareholders take advantage of the vulnerable position of the creditors to the enhancement of their interests. Similarly the creditors provided they have a sound controlling interest in the affairs of the company may potentially try to do some harm to the interests of the shareholders. But lending and borrowing are some continuous processes in any ongoing business and as such it may not be possible for the shareholders to infringe in to the rights of the creditors a more than once as, the company has to continue to run its operations. If the shareholders schematically are going to defraud the present creditors then the future creditors would not be in favour of extending any credits to the company. Hence the changes in the legal provisions should be more extensive and explicit in such a way no interest group has an opportunity to intrude into other’s rights or claims. Irrespective of the legal and other measures to mitigate the conflicts between these major interest groups, the fact remains that the existence of a perfect harmony among the various internal and external stakeholders alone can make the organization grow in a concerted way to achieve its goals without causing harm to anyone who is connected and concerned with the organizational performance. Word Count: 2080 References: 1. ADB Institute Evaluation of Shareholders Rights and Effectiveness of Board of Directors http://www.adbi.org/book/2005/02/02/884.corporate.governance.asia/evaluation.of.shareholders.rights.and.effectiveness.of.boards.of.directors/ 2. Dan D. Prentice (1996)Veil Piercing and Successor Liability in the United Kingdom, Journal of International Laws Vol. 10 No. 7 pp 469, 470 (1996) 3. Easterbrook H Frank & Fischel K Daniel. The Economic Structure of Corporate Law 17-35 (1991). 4. Frank H. Easterbrook (1984) Two Agency-Cost Explanations of Dividends, AM. Economic Review Journal vol. 74 pp 653-655 (1984) 5. John Armour (2000) Share Capital and Creditor Protection: Efficient Rules for a Modern Company Law The Modern Law Review Vol. 63 No. 3 pp 355-378 (quoted from Company Law Review Steering Group Company Formation and Capital Maintenance London: DTI 1999) 6. Macey, Jonathan R (2001) Creditors versus capital formation: the case against the European legal capital rules. Cornell Law Review September 1, 2001 7. Phillip I. Blumberg, (1986) Limited Liability and Corporate Groups, Journal of Corporate laws Vol. 11 pp 573 (1986) 8. Posner .A (1976) The Rights of Creditors of Affiliated Corporations, 43 U. CHI. L. REV. 499, 504 n.14 (1976) 9. Wikipedia Creative Accounting http://en.wikipedia.org/wiki/Creative_accounting Read More