Transfer Pricing In Nigeria

VOLUME 34 NUMBER 9

THE COMPANY LAWYER

COMMENT263

ANALYSIS265

The unsecured creditors’ raw deal272

The failure of the entity maximisation and sustainability model

NEWS DIGEST281

FINANCIAL REGULATORY UPDATE285

INTERNATIONAL287

Nigeria’s new transfer-pricing regime290

Let them be liable—bear the equivalent responsibility for auditors’ return

*557861*

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General Editor PROF BARRY A. K. RIDER—Professorial Fellow, Centre for Development Studies, University of Cambridge, Professor of Comparative Law, Renmin University and former Director of the Institute of Advanced Legal Studies, University of London

Editors PROFESSOR MADS ANDENAS—Professor of European Law, University of Leicester and former Director of The British Institute of International and Comparative Law

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LORD GOODHART Q.C.

THE HON MR JUSTICE LIGHTMAN—Former Justice of The Chancery Division

MR MICHAEL BLAIR Q.C.—Former General Counsel, Financial Services Authority

PROFESSOR JOHN BIRDS—Professor of Commercial Law, University of Sheffield

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PROFESSOR GARETH JONES—Former Downing Professor of the Laws of England, University of Cambridge and Fellow of Trinity College, Cambridge

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PROFESSOR HARRY RAJAK—Former Professor of Law and Director of the Centre for Legal Studies, University of Sussex

PROFESSOR EILÍS FERRAN—Director of the Centre for Corporate and Commercial Law, University of Cambridge and Fellow of St Catharine’s College, Cambridge

MR RICHARD NOLAN—Professor of Law, University of York

MS JENNIFER PAYNE—Professor of Corporate Law, University of Oxford, Fellow of Merton College, Oxford and Solicitor

PROFESSOR DAN PRENTICE—Former Allen and Overy Professor of Corporate Law, University of Oxford and Fellow of Pembroke College, Oxford

PROFESSOR JOHN MAHER—Professor of Law and for-mer Dean, Dickinson Law School, Penn State University, USA

PROFESSOR EVA LOMNICKA—Professor of Law, King’s College, University of London

HER HON JUDGE DIANA FABER—Circuit Judge and former Law Commissioner

PROFESSOR G. McCORMACK—Professor of International Business Law, University of Leeds

PROFESSOR JOHN FARRAR—Emeritus Professor of Law, Bond University, Australia and Professor of Corporate Governance, University of Auckland Business School, New Zealand and Honorary Professor of Law, University of Waikato, New Zealand

PROFESSOR DAVID SUGARMAN—Professor of Law, University of Lancaster

THE HON MR JUSTICE DAVID HAYTON—The Caribbean Court of Justice

MR SAUL FROOMKIN QC—Senior Counsel, ISIS Law, Bermuda and former Attorney General of Bermuda and Director of Criminal Law, Federal Government of Canada

PROFESSOR JANET DINE—Former Director of the Centre for Commercial Law Studies, Queen Mary College, University of London

PROFESSOR P. TRIDIMAS—Professor of European Law, Queen Mary College, University of LondonMR SAUL FROOMKIN Q.C.—Senior Litigation Partner, Mello, Hollis, Jones & Martin, Bermuda and former Attorney General of Bermuda and Director of Criminal Law, Federal Government of Canada

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MR MICHAEL CRYSTAL Q.C.—3/4 South Square, Gray’s Inn

PROFESSOR PAUL LATIMER—Professor of Law and Deputy Head of the Department of Business Law and Taxation, Monash University, Australia

PROFESSOR TOM HURST—Professor of Corporate Law, University of Florida

PROFESSOR MICHAEL LEVI—Professor of Criminology, University of Cardiff

PROFESSOR ALISTAIR ALCOCK—Professor of Law, University of Buckingham

PROFESSOR ROSS GRANTHAM—Professor of Law, University of Queensland

MR TIM HERRINGTON—Chairman of the Regulatory Decisions Commitee, FSA

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PROFESSOR GUIDO FERRARINI—Professor of Law, University of Genoa

PROFESSOR GEOFFREY MORSE—Herbert Smith Professor of Company Law, University of Birmingham

PROFESSOR PAUL DAVIES—Allen and Overy Professor of Corporate Law, University of Oxford and Fellow of Pembroke College, Oxford

MR MICHAEL ASHE Q.C. SC—One of HM Recorders

MS LISA LINKLATER—Barrister, Chancery House Chambers, Leeds

MS CHARLOTTE VILLIERS—Reader in Law, University of Bristol

PROFESSOR RIFAAT KARIM—Secretary General, The Islamic Financial Services Board

PROFESSOR LOUIS DE KOKER—Professor, School of Law, Deakin University, Australia

DR KERN ALEXANDER—Professor of Law, University of Zurich

MR KHEWAR QURESHI Q.C.—Serle Court, Lincoln’s Inn, London

PROFESSOR SARAH WORTHINGTON—Downing Professor of the Laws of England, University of Cambridge

SIR KENNETH WARREN—Former Chairman of the House of Commons Select Committee on Trade and Industry

PROFESSOR SALLY WHEELER—School of Law, Queen’s University Belfast

PROFESSOR JOHN LOWRY—University College, London

DR YE FENG—Director General, Supreme Peoples Procuratorate, Peoples Republic of China

PROFESSOR G.R. SULLIVAN—Professor of Law, University College London

DR CHIZU NAKAJIMA—Director of The Centre for Financial Regulation, Cass Business School, City University and Professor of Financial and Corporate Law, BPP University College

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General Editor: Barry A.K. Rider. Publisher: Andrew Moroney. House Editor: Scott McHugh.

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COMMENT

Exposing the modestyof companies!Professor Barry Rider

Attribution; Corporate liability; Corporate personality;Criminal investigations; Developing countries;International co-operation; Investigations; Knowledge;Money laundering; Tax evasion

There have always been critics of the doctrine of corporatepersonality and indeed, it is not every legal system thathas espoused the principle in Salomon v Salomon. Forexample, in Islamic law there are many scholars who areuncomfortable with the notion. On the other hand thelogical consequences that stem from the notion that onincorporation companies have a separate personality inlaw and in particular the allocation of the enterprise’sproperty to corporate body has allowed development oflimited liability and on the whole served business well.It is the case, however, that the logical application of theseprinciples on occasion results in what might well be seenas unfairness. However, the advantages of certainty andpredictability have generally been almost insurmountablehurdles in front of those who would for whatever reasonseek to disregard or penetrate the so-called corporate veil.Of course, if one had the privilege of starting anew thenmany of the advantages that stem from inviolablecorporate personality could be designed in other ways asindeed, is largely the case under Shar’iah. While therehas always been great debate in the academy as to thecircumstances when the law should and can look throughthe corporate veil and fix liability or a constituent ofliability such as knowledge or malice on a real individual(or for that matter another corporation) it is the case thatthere are precious few cases where the courts have beenprepared to do this.In these circumstances it is not surprising that crooks

and conmen have delighted in the facility that corporatepersonality affords them. The ability to operate behindthe person of a company and thereby obscure ownership,responsibility and complicity while long a tool of the

fraudster, has in more recent years become a vital devicefor the money launderer and tax evader. The freedomwith which some jurisdictions are prepared to grant theprivilege of incorporation has been noted and criticisedfor many years by those concerned about such issues.Indeed, Commonwealth Law Ministers meeting inBarbados in 1979 called for action as did theMetropolitanPolice in its report to the HomeAffairs Select Committeein 1994 on Organised Crime in the UK. Issues such asthis, however, take a while to grab the attention of thosewith real political power and it is really only since concernfocussed on the extent of tax evasion (or to quote oneofficial—culpable avoidance!) that anything tangible isbeing done. The British government, for a variety ofworthy reasons, has been in the vanguard albeit in thewider context of tax havens in persuading generally smalljurisdictions to co-operate. Of course, the problem is thatmany of those jurisdictions which historically have beenprepared to prostitute their sovereignty “belong” to eitherthe UK or USA! It is also the case that the real problemshave not been so much ease of incorporation, but variousadditional “advantages” such as confidentiality, secrecyand even blocking laws together with corrupt,incompetent or more usually under-resourcedadministration. Indeed, as the police pointed out in 1994,the UK is probably one of the easiest and cheapest placesto incorporate and we all know how good the City is atlaundering.Over the last couple of years, the media has been

particularly vocal about the misuse and abuse ofincorporation. For example, Panorama has run twoprogrammes and even Private Eye has published severalspecial (and surprisingly well researched) reports. Sadlythe point is often missed that it is not so much the abilityto incorporate that is the problem but the iniquity of thosewho stand behind it or who facilitate the process. It isalso the case that some of the most serious problems forthose seeking to get behind the corporate façade arecreated by the use of non-incorporated structures andtrusts. It also needs to be emphasised that for thoseactually conducting inquiries, the law is generally not aproblem—at least in obtaining intelligence. Of course,converting that intelligence into evidence admissible ina relevant proceeding may be a different matter—but italmost always is when dealing with serious and complexcases. Traditionally the problem has always been theinability, or perhaps in some cases unwillingness, of localpolice and other agencies to provide mutual assistance.Indeed, we are inclined to forget, for example, howreluctant before 9/11 that, for example, US and UKagencies were to provide meaningful assistanceparticularly to developing countries pursuing the ill-gottengains of corrupt officials or trying to enforce their fiscallaws. Indeed, several major cases of corruption inquiriesin China have recently been dropped because inquiriescame to a dead end here and in Italy.

Comment 263

(2013) 34 The Company Lawyer, Issue 9 © 2013 Thomson Reuters (Professional) UK Limited and Contributors

In the recent case of Prest v Petrodel Resources Ltd,1the Supreme Court seized a rare opportunity, at this level,to “sort out” the law on lifting the veil of incorporation.Most of their Lordships considered that there were twosituations thrown up by the cases. Firstly wherecompanies were used to conceal what had gone on andthe second where companies were used to evade existingobligations. Where companies are used to hide identity,then really there is no need to pierce the veil ofincorporation as the courts can simply look through thelegal form to those who it has attempted to obscure. It isreally only where the company is being utilised as anengine of fraud to evade a pre-existing legal obligationthat according to

“a limited principle of English law…the courtmay…piece the corporate veil for the purpose, andonly for the purpose, of depriving the company orits controller of the advantage that they wouldotherwise have obtained by the company’s separatelegal personality”. (Lord Sumpton).

While this exposition of the law is to be welcome, itprobably does not add to our jurisprudence. In practicethe courts have always been keen where they smell fraudor abuse to get to the wrongdoers—one way or another.This is probably the reason why no one has bothered totake such an issue so far up the legal ladder. LordDenning, for example, had no problem in seeing DrWallersteiner as the “puppet master” for his companiesand the South African courts, for example, in 1965

thought that putting mere puppets on a board amountedto a fraud in itself.2 Of course, equity has also generallybeen up to the task—although not always absent somereal skulduggery. Indeed, as Professor Len Sealy soperceptively pointed out in an early edition of his casebook on company law when discussing the seemingdifference in certain cases relating to personal or in remliability, that in all probability to the dichotomy was notone of law, but simply a result of the way arguments havebeen put before the courts with a particular remedy inmind.That the attribution of knowledge to corporate bodies

and also within them is an equally vexed issue it wouldseem to many in the academy. On the other hand thejudges have again in practice been rather more robust.For example, the government and the opposition haveboth been considering how to make it easier, in thecontext of criminal and administrative proceedings, toattribute responsibility on to the larger corporate wallet.The usual suspects have been sent off to look at US lawand seemingly have returned none the wiser. However,there is good precedent in our law, which holds that thingsdone by an employee as an employee albeit outside theirauthority and against the express instructions of theiremployer, may none the less be done in reality as theemployer. 3 It remains to be seen whether an ever cautiousSFO with ever diminishing resources will actually tryand utilise such law, although commendably the SFO istoday formore likely to pursue corporate wrongdoing—solet’s see!

1 (2013) UKSC 34.2 S v Shaban 1965 (4) SA 646 (W).3 See, for example, Re Supply of Ready Mixed Concrete (No2) (1995) 1 AC 456.

264 The Company Lawyer


ANALYSIS

The unsecuredcreditors’ raw dealRichard D. Tarling*

Corporate insolvency; Distribution; United States;Unsecured creditors

Introduction“It is obvious that someone must bear the loss …when a company collapses owing more than itsassets. It is similarly obvious that limited liabilityshifts the burden of that loss onto the creditors ….”1

Accordingly, a key function of the insolvency process isto determine the basis on which different categories ofcreditor will bear the overall deficiency. There isultimately no happy ending to this story. If creditor Peteris to obtain more, creditor Paul “must be robbed” to payfor it.Cork stated that one of “the aims of good modern

insolvency law”2 is “to distribute the proceeds of therealisations amongst the creditors in a fair and equitablemanner …”.3 However, it is in determining the criteriafor assessing what is “fair and equitable” that theproblems arise. “Fair and equitable” to one party appearsas “unfair and inequitable” to another. A further issue iswhether it should be the principles governing the

distribution which should be fair, or whether fairnessshould be determined by the outcome, e.g. the relativedistributions that each creditor group actually obtains.This article contends that it is the latter objective whichis the more appropriate.

Insolvency distributionsMokal, in his review of the pari passu principle in 2001,highlighted how,4 “In an overwhelmingmajority of formalinsolvency proceedings, nothing is distributed to thegeneral unsecured creditors …”.5

With regard to returns in the new administrationprocedure,6 Frisby reported in 20107 that the percentageof cases in which nothing was returned to unsecuredcreditors was 77 per cent.8 An equally poor outturn forthe unsecured creditor was reported by the Office of FairTrading Study in 2010, in relation to actual recoveriesobtained in administration and which found9 that“preferential creditors had the highest average recoveryrate (83 per cent) followed by secured creditors (36 percent) and unsecured creditors (4 per cent)”.10

The courts have played a key role in determining thispoor outcome for the unsecured creditor by endorsing therights to grant security. Such rights have often beensimilarly supported by academic writing. It is these rightswhich are examined and questioned in this article.

Salomon v Salomon & Co

In factThe facts in Salomon11 were briefly as follows. MrSalomon was a boot and shoe manufacturer. He had builta thriving business. He had a wife, five sons (four ofwhom worked in the business) and a daughter. The sonswere not partners “but servants”,12 who pressed MrSalomon to turn his business into a private company, sothat they could have a share in the business. He agreed.“All the usual formalities were gone through; all therequirements of the Companies Act 1862 were dulyobserved.”13 In addition to the shares, Mr Salomon alsoreceived from the sale of his business to the new company£10,000 in loan debentures secured against the assets ofthe company.

*Richard D. Tarling LLB, LLM, ACIS Non-Practising Barrister. This article is based upon work undertaken for my LLM dissertation at Kingston University. Dr John Tribewas my supervisor and I wish to thank him for his keen support and guidance. All views expressed in this article and any errors or omissions are, of course, my own. Duringmy career I have been Company Secretary of Trade Indemnity Plc /Head of Internal Audit at Euler Hermes UK Plc.1Ben Pettet, “Limited Liability: A Principle for the 21st Century? (Part II)” (1995) 48 Current Legal Problems 125, 146.2 Insolvency Law and Practice, Report of the Review Committee (1982), Cmnd 8558 (Cork Report), para.198.3Cork Report (1982), para.198 (f).4R.J. Mokal, “Priority as Pathology: The Pari Passu Myth” (2001) 60 Cambridge L.J. 581.5Mokal, “Priority as Pathology: The Pari Passu Myth” (2001) 60 Cambridge L.J. 581, 588.6 Post Enterprise Act 2002.7 S. Frisby, “The Pre-Pack Promise: Signs of Fulfilment?” (Spring 2010) Recovery 30.8 Frisby, “The Pre-Pack Promise” (Spring 2010) Recovery 30. This figure was the same for both pre-pack and non-pre-pack (business) sales.9 From a sample review of 500 companies in administration.10Office of Fair Trading, “The market for corporate insolvency practitioners” (June 2010), in particular pp.15 and 16.11 Salomon v Salomon [1897] A.C. 22 HL at 47 and 48 (in particular).12 Salomon v Salomon [1897] A.C. 22 at 48.13 Salomon v Salomon [1897] A.C. 22 at 48.

Analysis 265


However, “The company had a brief career: it fell uponevil days.”14 Mr Salomon tried to help by cancelling hisexisting debenture and replacing it with a new debentureto a Mr Broderip, which secured a fresh loan of £5,000toMr Salomon and which he, in turn, lent to the company.When interest was unpaid, Mr Broderip appointed a

receiver. Liquidation followed and the assets were sold.Enough was realised to payMr Broderip (his £5,000) butthere were no funds to repay the debentures in full (i.e.the £5,000 due to Mr Solomon) or the unsecuredcreditors.15

The liquidator claimed that the formation of thecompany was a fraud on the creditors and that thedebentures should be cancelled. The litigation began.

In courtAt first instance, Vaughan Williams J. considered thatMr Salomon’s intention was “to take the profits withoutrunning the risk of the debts”,16 and that:

“[T]o allow a man who carries on business underanother name,17 to set up a debenture in priority tothe claims of the creditors of the company wouldhave the effect of defeating and delaying hiscreditors. There must be an implied agreement by[Mr Salomon] to indemnify the company … thisbusiness was Mr Salomon’s business and no oneelse’s … he chose to employ as agent a limitedcompany … he is bound to indemnify that agent,the company; and … the company, has a lien on theassets which overrides his claims.”18

Round one to the unsecured creditor. Mr Salomon waspersonally liable for the corporate debts and could notclaim the debenture assets as his security.In the Court of Appeal, Lord Lindley disagreed with

Vaughan Williams that the company was Mr Salomon’sagent. In his opinion the company was a trustee for MrSalomon.19Mr Salomon’s liability rested “on the purposefor which he formed the company, on the way he formedit, and on the use which he made of it”.20 Lindley L.J.concluded that some companies were:

“[M]ere devices to enable a man to sweep of thecompany’s assets by means of debentures which hehas caused to be issued to himself in order to defeatthe claims of those who have been incautious enoughto trade with the company without perceiving thetrap which he has laid for them.”21

Further:

“If the legislature thinks it right to extend theprinciple of limited liability to sole traders it will nodoubt do so … But until the law is changed suchattempts as these ought to be defeated whenever theyare brought to light. They do infinite mischief …cheating honest creditors.”22

Honest unsecured creditors would be protected by thecourts. Parliament could not have intendedotherwise—and statute law would be interpretedaccordingly. By a different route, the court had effectivelyarrived at the same outcome as the court below.

InterredThis extra-statutory protection granted to unsecuredcreditors was to be short lived. As Lord Halsburyobserved:

“I have no right to add to the requirements of thestatute, nor take from them the requirements thusenacted. The sole guide must be the statute itself.”23

Little empathy for the unsecured creditor in the House ofLords.24

The principles of agency and of trusts applied in thelower courts were dis-applied. The company was neitherMr Salomon’s agent nor his trustee.In Lord Watson’s view:

“Whatever may be the moral duty of a limitedcompany and its share-holders, when the trade ofthe company is not thriving, the law does not layany obligation upon them to warn those membersof the public who deal with them on credit that theyrun the risk of not being paid.”25

And with regard to examining the register of charges, “acreditor who will not take the trouble to use the meanswhich statute provides…must bear the consequences ofhis own negligence”.26 The unsecured creditor had lostthe day.

InformedWhat if the unsecured creditor had, however, known ofthe registered charge, how much benefit would this havebeen to him? It would not have told him whether thecompany had funds to comply with the debenture terms,the extent of the debts secured by the charge, or that MrSalomon’s company might continue to rely on its good

14 Salomon v Salomon [1897] A.C. 22 at 4915 Salomon v Salomon [1897] A.C. 22 at 50.16Reported in Broderip v Salomon [1895] 2 Ch. 323 CA at 329.17 i.e. the company.18Broderip v Salomon [1895] 2 Ch. 323 at 331.19The two other Lords Justice Lopes and Kay in the Court of Appeal reached the same conclusion.20Broderip v Salomon [1895] 2 Ch. 323 at 338.21Broderip v Salomon [1895] 2 Ch. 323 at 339.22Broderip v Salomon [1895] 2 Ch. 323 at 340.23 Salomon v Salomon [1897] A.C. 22 at 29.24Although see the judgment of Lord Macnaghten in Salomon v Salomon [1897] A.C. 22 at 53.25 Salomon v Salomon [1897] A.C. 22 at 40 (emphasis added).26 Salomon v Salomon [1897] A.C. 22 at 40.



name to buy goods on credit, when its business wasfailing. Nor that there was now a clear divide betweenmoral obligations of a company and its duties at law.Lord Macnaghten at least acknowledged the threat of

the floating charge, however:

“I have long thought … that the ordinary tradecreditors of a trading company ought to have apreferential claim on the assets in liquidation inrespect of debts incurred within a certain limitedtime before the winding-up. But that is not the lawat present. Everybody knows that when there is awinding-up debenture-holders generally step in andsweep off everything; and a great scandal it is.”27

Cold comfort for the unsecured creditor. UnlessParliament changed the law, that position would remain.Limited protection was introduced for outstanding wagesdue to employees by granting them preferred status andrules were introduced to invalidate floating charges incertain circumstances.28 LordMacnaghten’s warning was,however, substantially left unheeded.

The theoretical justification forsecurity—bargain, value and noticeAcademic writers have sought to justify the securedcreditors’ position. Goode did ask, however, whether thelaw was too favourable to the secured creditor29:“Common lawyers have become so accustomed tosecurity rights that they no longer realize how stronglythe present law favours the secured creditor.”30 Heobserved that the priority for the secured creditor hastraditionally rested on three principles,31 assuming thedebtor to be solvent at the time of the charge. Brieflythose principles were:

1. “Bargain”.

The creditor bargained for the preference:it was the basis upon which he granted thecredit.32 Other parties have notice of suchsecurity interest and so are not misled.That a “bargain” of a loan for interest isstruck is indeed true and the securityregistered, although whether it should beseen as a justifying principle is anothermatter. It assumes that the parties makingthe bargain had the legitimate right to doso, despite the damaging effect on therecoveries of others, i.e. the unsecured

creditors. Arguably, this principle alsoassumes that the unsecured creditor has anequal opportunity to obtain security. It issuggested that any such assumption ispurely theoretical as most unsecuredcreditors are, practically, unable to obtainsecurity.33 In the case of many smallerunsecured creditors it is arguablyuneconomic to do so.34 Why should,however, a debtor company and a lenderbe assumed to have the right to effectivelybargain away the rights of unsecuredcreditors, without the unsecured creditors’agreement?

2. “Value”.

“Where the debtor is not insolvent at thetime it gives security, the grant of thesecurity is generally considered fair, evenif for past value, unless made with intentto defraud creditors.”35Goode also observedthat: “Where the creditor takes security forcontemporaneous or subsequent value thequestion of unfair preference cannotnormally arise”,36even if the security is ofgreater value than the debt as “the quantumof security can never exceed the debtor’sindebtedness”.37

In response, it is contended that value isalso provided by the unsecured creditor,each time he supplies goods on credit,without obtaining any priority. Further,applying “unfair preference” as a broadterm, it is suggested that that the securedcreditor does obtain such a preference. Thepreference is that his claim has priority andis not admitted with the claims of all theunsecured creditors should insolvency arise,despite the fact that they also have provided“value”. It is contended that the fact that“In taking and enforcing his security the[secured] creditor is not withdrawing fromthe estate a single penny more than he paidin”38 still leaves him with his priority overthe unsecured creditor, who similarly is notseeking to withdraw any more than thevalue of goods he has supplied.

27 Salomon v Salomon [1897] A.C. 22 at 53.28D. Milman, “Priority Rights on Corporate Insolvency” in A. Clarke (ed.), Current Issues in Insolvency Law (London: Stevens & Sons,1991), p.57 at p.63.29R.M. Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53. The heading was the title of an article written by Goode in 1982 justafter the Cork Committee released its report.30Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 53 and 54.31Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 57.32Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 57.33 See section “Democratic creditors” below.34 See Office of Fair Trading, “The market for corporate insolvency practitioners” (2010), OFT 1245, p.44, para.4.5635Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 59.36Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 60.37Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 60.38Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 60.

Analysis 267


“A much more serious problem”39 referredto by Goode was that of “after acquiredproperty”. New assets acquired by thedebtor “are deemed to have attached asfrom the date of the security agreement”40

and this “retrospective attachment greatlyexpands the concept of new value”.41 “Soa creditor lending £1 on the security of thedebtor’s after-acquired property can, aseach asset is acquired by the debtor, stackup more and more security withoutinjecting any fresh value.”42

Goode observed:

“It is now becoming recognised thatto give such all pervading force to theafter acquired property clause mayhave undesirable consequences. Inparticular, unsecured creditors arelargely squeezed out of the liquidationprocess, in addition … [such] clausemay encourage the secured creditor tocontinue financial support for thedebtor when the latter is plainlyinsolvent, so that the debtor continuesto trade and obtains further suppliesfrom the unsecured creditors withoutpaying for them.”43

As Finch has observed, “managers may…expend assets in a desperate gamble to tradeout of trouble and save their jobs …”.44 Allat the expense of the unsecured creditor.

3. “Notice”.

The unsecured creditor has notice of thecharge and therefore he contracts,accordingly. However, it might be said thatthe notice required to be publicly registeredis limited and is only of partial value to theunsecured creditor.45

Goode, in referring to the subsidiarypurposes of security, observes:

“Where the debtor company is tryingto organise a moratorium in order totrade out of its difficulties, an all

assets debenture is wonderfullyeffective in restraining a trigger-happyunsecured creditor from trying to steala march on his less aggressivebrethren.”46

In response, it is noted that “the bargainelement” might be said to involve thesecured creditor “stealing a march” over allunsecured creditors.As Goode himself observed: “I can wellunderstand that unsecured creditors as aclass feel badly treated; indeed they arebadly treated.”47

Democratic creditorsThe justification for security has also been addressed byJackson and Kronman,48 who asked:

“Why does the law [in the United States] permitsecured financing in the first place? Put differently,why does the law allow a debtor to prefer somecreditors over others by securing their claims?”49

And “what explains the widespread use of securedfinancing and why do some classes of creditors typicallyfinance on a secured basis and others on an unsecuredone?”50

Jackson and Kronman observed: “The idea that allcreditors should be treated equally … has played animportant role in the evolution of the federal bankruptcysystem.” However, the authors commented:

“Despite this apparent appeal … the principle ofequal treatment has never succeeded in supplanting… a basic recognition of a debtor’s contractualpower to prefer one creditor over another. When adebtor grants a security interest to one of hiscreditors, he increases the riskiness of othercreditors’ claims by reducing their expected valuein bankruptcy.”51

Regrettably, this is clearly the case.Milman,52 also observing how pari passu had its origins

in equity, commented: “Nevertheless it would have beenpossible to opt for a regime that ranked debts forrepayment according to the date of accrual or according

39Having previously discussed the application of the rule in Clayton’s Case.40Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus L.J. 53, 61 (after referring to Holroyd v Marshall 11 E.R. 999; (1862) 10 H.L. Cas.191).41Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus L.J. 53, 62.42Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 62.43Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 62.44V. Finch, Corporate Insolvency Law Perspectives and Principles, 2nd edn (Cambridge: Cambridge University Press, 2009), p.742.45 See section “Informed” above.46Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 56.47Goode, “Is the law too favourable to secured creditors?” (1983–4) 8 Canadian Bus. L.J. 53, 73.48T.H. Jackson and A.T. Kronman, “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143.This article explores and extracts just a part of their more detailed overall analysis.49 Jackson and Kronman, “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143, 1146.50 Jackson and Kronman, “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143 1146.51 Jackson and Kronman, “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143, 1147.52Milman, “Priority Rights on Corporate Insolvency” in Current Issues in Insolvency Law (1991), p.57 at p.59.



to the needs of the individual creditor.”53 There is nomandatory requirement for security to be the determiningfactor for preference at law.Jackson and Kronman subsequently asserted that:

“It is a fair assumption, however, that these other[unsecured] creditors will be aware of the risk andwill insist on a premium for lending on an unsecuredbasis,54 will demand collateral (or some other formof protection) to secure their own claims or willsearch for another borrower whose enterprise is lessrisky.”55

This article disputes, however, that this “is a fairassumption” as claimed. To citeMilman: “Many creditorshad neither the economic power, nor indeed sufficientlegal knowledge, to require that security be given.”56.With regard to finding “less risky” buyers, less risky doesnot mean no risk and unsecured creditors will rarely havesufficient and current detailed information to fullyappreciate the risk involved in their credit sales.Jackson and Kronman observe how “The price a

creditor charges for extending credit … varies directlywith the riskiness of the loan itself”,57 and refer to “thethreat of “debtor misbehaviour”,58which the creditor willtake into account in agreeing the loan and for which hemay increase the interest rate. Alternatively, he mayreduce the risk of misbehaviour bymonitoring the debtorsconduct after the loan.59

It was further contended by the authors that, owing todifferent levels of monitoring costs for each creditor, itwas advantageous for creditors to agree among themselveswhich creditors should obtain priority. Accordingly:

“The rule permitting debtors to encumber their assetsby private agreement is therefore justifiable as acost-saving device making it easier and cheaper forthe debtor’s creditors to do what they would doanyway.”60

While it is accepted that debtor misbehaviour andmonitoring costs may be important factors for banks inpricing loans, it is suggested that the issue of debt defaultoften arises from activities quite unrelated to debtormisbehaviour, that is from the actions of third parties andwhich cannot be resolved by simply monitoring the

debtor. More significantly, it is disputed that the outcomeof security and interest rates is not what creditors “woulddo anyway”, as practically the alternative option ofsecurity is simply not available to most unsecured tradecreditors. They have no choice in the matter and,accordingly, there is no democratic consent by them totheir unsecured position.As Jackson and Kronman correctly acknowledge

subsequently, “secured financing does involve fixed startup costs… This may explain, at least in part, why certainsmall creditors, notably trade creditors, typically do notfinance on a secured basis”.61

It is contended that Jackson and Kronman’scomparative analysis is more applicable to bank lending:contrasting secured and unsecured loans, rather thansecured loans with loans by trade creditors. Further, theidea that trade creditors can or do adjust their pricessystematically according to some perceived likelihood ofnon-payment by their trade purchasers is doubted.62Moreprobable is the case that if the purchase price is likely tobe paid or there is little evidence to suggest default, thegoods will be supplied; if payment is unlikely they willnot. The company does not knowwhich buyers it supplieswill default, but allows for default in a general bad debtprovision.

The abuse of corporate identityIt was Kahn-Freund who took a quite different view ofthe trade creditors’ position and highlighted “the abuseof corporate identity”.63 While he observed how “theprivileges of incorporation and of limited liability wereoriginally granted in order to enable … capitalists toembark upon risky adventures without shouldering theburden of personal liability”,64 he observed “the rigiditywith which courts applied the corporate concept eversince the calamitous decision in Salomon v Salomon”.65Traders were “almost tempted” to form a company,

“even where no particular business risk is involved, andwhere no outside capital is required”. The partnershiphad been largely displaced by the private company. Hehighlighted how “the courts have failed to give thatprotection to the business creditors which should be thecorollary of the privilege of limited liability”.66And whilethe courts had adapted the law of “fiduciary relationships”

53Milman, “Priority Rights on Corporate Insolvency” in Current Issues in Insolvency Law (19910, p.57 at p.59.54 See also R.A. Posner, “The Rights of Creditors of Affiliated Corporations” (1976) 43 U. Chi L. Rev. 499, 505, who referred to the fact that “the creditors’ estimation ofrisk of default will determine the amount of credit extended, the length of time for which it is extended, and the interest rate (which, of course, need not be stated separatelyfrom the sale price or wage rate)”.55 Jackson and Kronman “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143, 1147 and 1148.56Milman, “Priority Rights on Corporate Insolvency” in Current Issues in Insolvency Law (1991), p.58.57 Jackson and Kronman, “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143, 1149.58 Jackson and Kronman, “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143, 1150.59 Jackson and Kronman, “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143, 1150.60 Jackson and Kronman, “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143, 1157 (emphasis added).61 Jackson and Kronman “Secured Financing and Priorities Among Creditors” (1979) 88 Y.L.J. 1143, 1158.62By way of a simple illustration of the problems involved, imagine a pizza trader supplying food on credit to different companies and wishing to price in default probability.Assuming three sizes of pizza, 10 differently priced toppings and a scale of 1 to 10 for payment default probability, the pizza manager would have to calculate and store upto 300 different price variations—special offer adjustments might double or triple that number. Quite possibly by the time he had gathered all the necessary data on hisbuyers to complete his default calculations and pricing, his competitors would now be supplying his clients. If not now bankrupt he would, however, be well placed to starta bank or become a credit insurer.63O. Kahn-Freund, “Some Reflections on Company Law Reform” (1944) 7 M.L.R. 54.64Kahn-Freund, “Some Reflections on Company Law Reform” (1944) 7 M.L.R. 54, 54.65Kahn-Freund, “Some Reflections on Company Law Reform” (1944) 7 M.L.R. 54, 5466Kahn-Freund, “Some Reflections on Company Law Reform” (1944) 7 M.L.R. 54, 55.

Analysis 269


to directors in order to protect shareholders, they had notbeen prepared to extend the law of agency to protect “thelegitimate interests of creditors…The company has oftenbecome a means of evading liabilities …”.Kahn-Freund was concerned that “the metaphysical

separation between a man in his individual capacity andhis capacity as a one-man-company can be used to defraudhis creditors”.67 Possible solutions were to deem thecompany to be an agent for its owners, who would beheld liable: effectively endorsing Vaughan Williams inSalomon.68 Alternatively, both could “be treated as onefor all legal purposes”.69

Whether Kahn-Freund was right in his conclusion,effectively that a parent company should be responsiblefor its subsidiaries’ debts, it is nevertheless contendedthat his analysis provides support for questioning theprivileges enjoyed by floating charge creditors.

The Cork ReportIn 1982 the Cork Committee produced “a comprehensivereview of the law of insolvency”.70 Cork observed how“Credit is the lifeblood of the modern industrialisedeconomy”71 and “fundamental to trade, commerce andindustry”.72 Secured loans had grown significantly sincethe 19th century73; relaxing security “would have seriousrepercussions for the British economy as a whole”.74Corkreferred to the contractual rights of creditors to obtainpriority above other creditors by seeking security.75 It wasagainst this backdrop that the position of unsecured tradecreditor would be viewed.

Jekyll and HydeCork, having identified the great advantages provided bythe security of the floating charge,76 then observed,however, that it “has serious disadvantages, and is capableof working great injustice …”,77 including “the commonpractice of giving a floating charge over the entireundertaking”.78

Sir Kenneth Cork was later to write:

“Banks which had floating charges, and that was allof them, tended to go on lending much longer thanthey should. More often than not, by the time areceiver was appointed there was no money left forthe unsecured creditors.”79

Cork cited80 Buckley J. in Re London Pressed Hinge CoLtd81:

“It is an injustice arising from the nature as definedby the authorities of a floating security. The mischiefarises from the fact that the law allows a charge uponall future property.”

So, whatever its advantages, Cork also highlighted cleardisadvantages in the operation of the floating charge:disadvantages to the unsecured trade creditor. Corknonetheless considered82 “that the floating charge hasbecome so fundamental a part of the financial structure… that its abolition can no longer be contemplated”. Thechallenge was to provide:

“[L]egitimate safeguards to those who … provide… finance to commerce and industry, with justiceto the ordinary unsecured trade creditor who is aninvoluntary supplier of goods, materials or serviceson credit.”83

Cork’s solution was that unsecured creditors should, “toa limited extent” share in “the proceeds of assetscomprised in the charge”.84 This would increase “thedividends payable … to ordinary unsecured creditors,including trade suppliers”.85

However, Cork did not in reality penalise the floatingcharge creditor in order to correct the imbalance. Rather,he proposed the abolition of the preferred status for mostgovernment taxes—a Crown preference “of greatantiquity”.86 As this would result in higher returns for thefloating charge creditor, it was “neither inappropriate norunfair to insist upon some concession in return for thegeneral body of creditors …”.87 The concession was theTen Percent Fund,88 i.e. 10 per cent of the net realisationsof floating charge assets would be available solely forunsecured debts89 now to include unpaid tax, formally a

67Kahn-Freund, “Some Reflections on Company Law Reform” (1944) 7 M.L.R. 54, 5568 See above.69Kahn-Freund “Some Reflections on Company Law Reform2 (1944) 7 M.L.R. 54, 57.70Cork Report (1982), para.1.71Cork Report (1982), para.10.72Cork Report (1982), para.10.73Cork Report (1982), paras 17 and 1473.74Cork Report (1982), para.19.75Cork Report (1982), para.1481.76Cork Report (1982), para.104.77Cork Report (1982), para.105.78Cork Report (1982), para.105.79K. Cork, Cork on Cork (London: Macmillan, 1988), p.198.80Cork Report (1982), para.106.81Re London Pressed Hinge Co Ltd (1905) 1 Ch. 576 at 581, 583.82Cork Report (1982), para.110.83Cork Report (1982), para.110.84Cork Report (1982), para.1532, Introduction.85Cork Report (1982), para.1532(b).86Cork Report (1982), para.1409.87Cork Report (1982), para.1531.88Cork Report (1982), para.1538.89Cork Report (1982), para.1538.



preferential debt. Cork did not envisage that the fundwould “result in any significant change in the availabilityof credit for the corporate sector.”90 In his autobiography,Sir Kenneth Cork later explained:

“We reckoned by cutting out all preferential claimssome 14% of the realisations would be saved onaverage for the debenture holder. In that case wethought banks would not take too unkindly to havingto hand over 10% of them to the liquidator … .”91

The banks would not lose out financially as a result ofthe change.However, Mokal, writing in relation to this proposed

fund, considered, on the basis of a broad brushcalculation, that the dividend for unsecured creditorsmight increase from 7p to 7.4p in the pound92:

“It should be obvious then, that even if thesecalculations are wide of the mark … the averagerecovery rates for unsecured creditors in anoverwhelming majority of formal insolvencyproceedings are unlikely to go up to the extent thatsuch creditors would be appreciably better off.”93

When Parliament substantially implemented this Corkrecommendation called the “prescribed part”, the levywas fixed at 50 per cent of the floating charge assets upto £10,000 and 20 per cent thereafter, up to a capped limitof £600,000.94 While the actual levy implemented was ata higher percentage than that which Cork recommended,it was to be subject to an overall cap.95 Nevertheless,despite the benefit of the prescribed part levy, theresulting financial improvement for the unsecured creditoroverall remains unclear.

ConclusionMany insolvency law changes have been introducedfollowing Cork,96 but the unsecured creditor still obtainsvery little from the insolvency process.Amendments to the law to provide a more fair and

equitable distribution of the insolvent company’s assets,in favour of the unsecured trade creditor are, it iscontended, still required.

90Cork Report (1982), para.1537.91Cork, Cork on Cork (1988), p.199.92Mokal, “Priority as Pathology” (2001) 60 Cambridge L.J. 581, 618.93Mokal, “Priority as Pathology” (2001) 60 Cambridge L.J. 581, 618.94The Insolvency Act 1986 (Prescribed Part) Order (2003/2097).95 In Cork there was no overall cap except that the unsecured creditor was not to obtain a greater share. of its debts than the percentage share received by the debenture-holder(see Cork para. 1539).96Cork Report (1982).

Analysis 271


The failure of the entitymaximisation andsustainability modelMin Yan*

Company law; Corporate governance; Jurisprudence;Shareholders; Stakeholders

IntroductionWith the view that neither the shareholder primacyapproach nor the stakeholder theory is perfect, ProfessorAndrewKeay has recently proffered a new approach—theentity maximisation and sustainability (EMS)model. TheEMS is based on the idea that the company is a distinctentity and independent from all its investors,1 whichfollows from the viewpoint of Professors Blair and Stoutthat a company “can lead a life of its own”.2 It is true thatthrough the development of company law, theindependent legal personality of the company has becomeone fundamental rule.3 A series of cases after Salomon vSalomon & Co Ltd,4 such as Macaura v NorthernAssurance Co5 and Lee v Lee’s Air Farming Ltd6 hadalready been well elaborated. Meanwhile, the case lawalso indicates that directors owe their fiduciary duty tothe company rather than shareholders. Separate legalpersonality has become the fundamental conceptualstructure of modern company law, not merelytheoretically important.7

Accordingly, a company could make contracts, ownproperty in its own capacity, sue or be sued, and only thecompany is eligible for being regarded as a victim inderivative actions. But EMS goes much further and statesthat the company could also have its ownobjective—namely, maximising the values of the entityper se on one hand and ensuring its sustainability on theother.8 That is to say that neither shareholders nor otherstakeholders are the end. None of the corporateconstituencies would be preferred under EMS. Nor wouldconstituencies as a whole be seriously considered. In

addition, issues other than economic ones would not onlybe taken into account, but account for a material position.Keay argues that the EMS model could bring moreefficiency and fairness.9

However, the shareholder primacy approach is not asproblematic as those opponents contend.10 Is it necessarythen to create a new model? In other words, is it possibleto contend that merely modifying the existing models atthe present time is enough? The so-called advantages interms of EMS seem to be overstated. As will be discussedin this article, the EMSmodel is neither efficient nor fair.Rather, there are many inherent vaguenesses and defectsin this new model. This article proposes to explore andexamine the issue of necessity and the failure of EMS indetail. Specifically, the second section will, from thefoundation and distinction of the EMS, discuss whethersuch a new model is needed. After that, the main defectsof this model will be thoroughly analysed andre-examined in the third section. Finally, the article willconclude that there is no need to create a new model,although some ideas from EMS are worth learning as agood direction for solving problems under the shareholderprimacy approach.

Is a new model needed?As the underlying supporting point of EMS, the separatelegal personality of the company could be respected bythe shareholder primacy approach as well. Aftershareholders no longer having direct equitable rights oncorporate assets as well as the shares being recast intothe interests of the company profits,11 it has been alreadygenerally accepted that the corporate assets are ownedand only owned by the company and shareholders haveno rights upon them. Such personality under EMS seemsto be magnified to the extent which an objective couldbe engendered by such legal personality. As will bediscussed in the next section, nothing instructs companiesto behave on their own. In consequence, it seems thereis no need to emphasise this aspect too much.Secondly, maximisation of the value of the company

is not dissimilar to what the shareholder primacy approachpursues. Under the shareholder primacy approach, to

* School of Law King’s College London, University of London, United Kingdom. LLB (Hons); LLM (Distinctions); PhD candidate in Law.1A. Keay, “Ascertaining the Corporate Objective: An Entity Maximisation and Sustainability Model” (2008) 71 Modern Law Review 663, 679.2Keay, “Ascertaining the Corporate Objective” (2008) 71Modern Law Review 663, 680, refers to M. Blair and L. Stout, “Director Accountability and the Mediating Roleof the Corporate Board” (2001) 79 Washington University Law Quarterly 277.3RKraakman et al., The Anatomy of Corporate Law: A Comparative and Functional Approach (Oxford: Oxford University Press, 2009), p.9; H. Hansmann and R. Kraakman,“The End of History for Corporate Law” (2001) 89 Georgetown Law Journal 439, 439.4 Salomon v Salomon & Co Ltd [1897] A.C. 22 HL.5Macaura v Northern Assurance Co [1925] A.C. 619 HL.6 Lee v Lee’s Air Farming Ltd [1961] A.C. 12 PC (New Zealand).7 P. Ireland, I. Grigg-Spall and D. Kelly, “The Conceptual Foundations of Modern Company Law” (1987) 14 Journal of Law and Society 149, 149.8A. Keay, The Corporate Objective (Cheltenham: Edward Elgar, 2011), p.175.9 For example, see Keay, The Corporate Objective (2011), p.176.10 It is far beyond the scope of this article to justify the shareholder primacy approach, which is better to leave to another article to discuss. Nevertheless, two brief pointsare worth mentioning here, as follows: first, there are two ways to maximise shareholders’ wealth. The essence of the shareholder primacy approach is through maximisingthe wealth of the whole company to achieve the objective of shareholder wealth maximisation. In addition to this method, admittedly, there is another way to maximiseshareholders wealth, i.e. externalising. It is indisputably manifest that the second way is what most opponents of the shareholder primacy approach oppose. However, thereal shareholder primacy approach should be the first one rather than the approach through profit distribution, extracting wealth from other stakeholders or externalisingcosts to third parties. Secondly, the adverse externality as the principal valid criticism left against the shareholder primacy is possibly internalised through regulating byeffective mandatory rules. Suffice it to say, we should not rush too much to deny this approach.11 P. Ireland, “Company Law and the Myth of Shareholder Ownership” (1999) 62 Modern Law Review 32, 41; P. Ireland, “Capitalism without the Capitalist: The JointStock Company Share and the Emergence of the Modern Doctrine of Separate Corporate Personality” (1996) 17 Journal of Legal History 41, 50–53; Ireland, Grigg-Spalland Kelly, “The Conceptual Foundations of Modern Company Law” (1987) 14 Journal of Law and Society 149, 152–153.



maximise company wealth is normally the premise byvirtue of the residual nature of the shareholders.12 Thedifference is that maximisation in EMS is an end whereasmaximisation in the shareholder primacy approach furtherindicates increasing residual cash flow to shareholders.Besides, in the mind of Keay, maximisation ofshareholder wealth is restrained to profit maximisationwhile his entity maximisation encompasses things suchas reputation augmentation.13 Such a narrow understandingof shareholder wealth maximisation seems to be biasedand limited, just in the very situations of solely pursingshort-term profit may ignore things like reputation andR & D. Not only does the stakeholder theory inherentlyoriginate from, and focus on, those issues advocated byKeay, but the shareholder primacy approach does notnecessarily exclude them, particularly from a long-termperspective where all the above—which could be seen asthe interests of non-shareholding stakeholders—aregenerally accepted as meaningful and helpful means forshareholder wealth maximisation.In this regard, the function of the EMS model is not

much different from long-term shareholder wealthmaximisation. Disregarding the interests of employees,creditors, communities and suppliers among others isundoubtedly not the right way to realise the shareholderwealthmaximisation implied by the shareholder primacyapproach. Ensuring safety and stability for employees,timely payments and non-excessively risky ventures forcreditors, goods with quality and a fair price for customersand the like are also required by the shareholder primacyapproach in order to achieve effective relationships withstakeholders on grounds of their indispensable role forfacilitating the corporate success. The example of Nike’sbrand reputation damage is exactly in line with the pointof balance between long-term value and short-term value.In addition, preventing “acquir[ing] unprofitable assets”or “undertak[ing] investment projects with negative netpresent value”14 are certainly not unique to EMS.Thirdly, with the defects of shareholder primacy in

mind as well as the theoretical and practical difficultiesof the stakeholder theory, it seems that Keay tries to usethe entity model to substitute for the shareholder primacyapproach while avoiding the disadvantages of thestakeholder theory at the same time. For example, animportant reason for him to raise the EMS model is itssuperiority in avoiding problems such as balancing.15

Pursuant to Keay, the difficulty of defining the conceptand scope of the stakeholder and the issue of enforcement

are, inter alia, two main defects of the stakeholdertheory.16 Consequently, EMS is intentionally describedas having a clear goal to overcome problems such asdefining the stakeholder groups and the never-ending taskof balancing and/or integrating multiple interests byfocusing solely on the entity wealth.With a simplificationof the entity as an end, Keay holds the view that thefundamental defects of stakeholder theory are resolvedwhile the superiority is retained compared withshareholder primacy. However, the downside of theshareholder primacy approach is by no meansinsurmountable, and indeed is overestimated by theopponents.17 It is in fact better and more viable than thestakeholder theory. The shareholder primacy approachas such has a much clearer aim, i.e. to maximise theinterests of a real group compared with that of an artificialentity which cannot be utilised as a guideline, as will bediscussed in the next section. The so-called benefits ofEMS appear to be a facade. The mere advantage of beingsuperior to the stakeholder approach cannot become apersuasive reason for applying a new model.Fourthly, the fact of the separation of control from

ownership, or, say, less effective control of the directorsby shareholders, does not lead to the corollary that thecompany is able to run automatically on its own.Shareholders as a whole are treated as an organ under allcorporate governance models; their right as a class shouldnot be disregarded simply by the fact of dispersedshareholding.18 In the same way, in talking aboutemployees’ rights, it would be worthless to just focus onan individual worker since different workers in diversepositions may have varying preferences or priorities19;instead, the entire group should be utilised as a base. Evenin practice, most public companies do have very dispersedshareholders, which may in turn signify that shareholdersare not able to exert an effective influence on internalcorporate governance. Nevertheless, as long as theargument that shareholder wealth maximisation is a betterway to improve social wealth has any merit, it remainswrong to conclude that the company should runautomatically.20 Rather, under such situations the focusshould be on how to improve shareholder control or howto make directors more accountable to the shareholders.On top of that, the strong rejoinder to the so-called

distinctions of the EMS model is as follows: first, EMSalso involves value transfer, namely extracting wealthfrom any of its constituencies in the name of entityenhancement. Under EMS, making employees redundant

12 In accordance with the gain allocation rule which empowers shareholders to catch whatever is left from the income stream, it directly ties the benefits of shareholders tothe performance of the company. As a result, the wealth of the shareholders as the residual claimants could be maximised in the event that the wealth of the company ismaximised.13Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 685.14Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 686.15Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 687.16Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 675–678.17 See fn.10.18As Professor Daniel Greenwood has pointed out: “in the eyes of the law and corporate management, shareholders are all the same. As a result, managers are given relativelyclear direction without need to pierce the cacophony of inconsistent demands from conflicted and conflicting individuals.” D. Greenwood, “Fictional Shareholders: ForWhom are Corporate Managers Trustees, Revisited” (1996) 69 Southern California Law Review 1021, 1026.19 For example, some may focus on more free time, some focus on better working conditions, and others focus on higher wages. Apparently, different ways should beadopted in order to meet the interests of workers with different preferences.20 In the next section, the article will continue to argue that a company in effect cannot run automatically even it wants to.

Analysis 273


could be justified by the consideration of the entity andits wealth maximisation. Secondly, EMS disregards thecostly redistribution which has already been opined bymany legal and economic scholars to be a transactioncost.21 Deliberately ignoring the issue of reconcilingdiverse and competing interests of various constituenciesin the company by claiming that they would be better offif the position of the whole company were enhanced isonly viable in theory. For example, A and B are bothstakeholders of a company; one decision would make Abetter off by an increase of £10 whereas B would lose£9. Apparently, such a decision would increase £1 of theentire company wealth and would be thereby adopted inorder to achieve the maximisation of the entity, accordingto the entity theory. Professor Keay would probably arguethat B would be better off ex post in virtue of the overallenhancement of the company. As discussed, such viewsare untenable on grounds of the failure to take transactioncosts in redistribution into account.Concerning the concept of sustainability, as the other

side of EMS, there is nothing innovative in effect. Onlyshort-termism may pursue profits without consideringexcessive risks among others which may affectcompanies’ sustainability. Meanwhile, so-called riskmanagement was gaining increasingly more popularsupport far prior to the EMS model being formulated.Sustainability is simply a bottom line.Thus far, it may be straightforward enough for readers

to consider whether this newmodel is needed in the sensethat the advantages and distinction EMS brings are limitedwhile the embedded defects of, and in, it areunderestimated, which will be exhibited below.

Defects of the EMS model“Unfair”, “not clear”, “imprecise” and “unworkable” arethe reasons given by Professor Keay to justify the EMSmodel as a substitution for the current shareholderprimacy approach and stakeholder approach.22 However,after a thorough review of EMS, it is hard to identifyEMS as not suffering any of these problems, amongothers. The concept is inherently problematic.Before discussing the specific defects, it may be

essential to point out that “those people and groups whohave interests in the company will be referred to asinvestors” in EMS.23 This in effect equates to the conceptof stakeholder under the stakeholder theory. The changeof the name should be always borne in mind in order toprevent confusion because of the use of “investor” inKeay’s later arguments. The “investor” under the EMSis different from the usage in other voluminous treatises

which generally refer to it as the group of shareholders.Keay utilises a great number of references to expoundhis model, but the concept of investor is not alwaysidentical compared with the original meaning of thereferences.24 Without an available and practicablemechanism, simply terming the stakeholder as an investorcannot solve the problems.25

Artificial natureGreat effort has been undertaken by Keay to explicatethe entity theory since the corporate personality is thestarting point and the foundation of the EMS model.Whatever the company is,26 its separate legal nature hasbeen already generally accepted and is incontestable.What remains doubtful is whether the concept of entitycan lead to an inference of the company having its ownand separate mind, i.e. is corporate activity an end initself? The company as an artificial entity could obtainseparate legal personality, which makes it possible tohave the legal authority to own assets, take legal actionsand so forth. But that the company has a mind of its ownis not a foregone conclusion. It remains difficult toimagine that a companywould have feelings like a naturalhuman being.Companies per se have no will. If a company does

something wrong, no one can deny that this stems fromthose people who control the conduct of that company.This is not necessarily based on the perspective of seeingthe company as an aggregation of individuals as in the18th and early 19th centuries, or adopting the nexus ofcontracts theory of the late 20th century. While the natureof the company as an independent entity is fully respectedhere, nothing prevents the corollary that a corporatepurpose without considering any of its members or otherconstituencies is unconvincing. As insightfully observedby Professor Donna Wood:

“[Institutions] do not exist to serve their ownpurposes, but rather to serve the needs of societiesand their people. Business, like all other societalinstitutions (including the family, religion, education,government, etc.), serves vital functions but is nevercompletely free to act as an independent entity.”27

Corporate personality never confers on the company aseparate mind, and in effect cannot do so even if this isdesired, just as a robot is hardly capable of beingcompletely independent from its designer/operator andbehaving automatically. Even assuming that in the futurea robot might behave entirely automatically after beingdesigned, one still has to point out that the premise is that

21 For example, see Keay, The Corporate Objective (2011), pp.228–230.22A. Keay, “The Ultimate Objective of the Company and the Enforcement of the Entity Maximisation and Sustainability Model” (2010) 10 Journal of Corporate LawStudies 35, 38.23Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 679.24 For example, see Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 679 fn.128.25 It is similar to the discussion of defects of the stakeholder theory such as uncertainty and vagueness of its scope and definition.26The nature of the company remains in debate, and even Keay himself admits this.27D. Wood, “Corporate Responsibility and Stakeholder Theory: Challenging the Neoclassical Paradigm” in B. Agle and et al., “Dialogue: Toward Superior StakeholderTheory” (2008) 18 Business Ethics Quarterly 153, 160. Although in the view of Professor Wood, the purposes should be served for a broad stakeholder groups, which thisarticle does not agree with, she clearly exhibits the nature of the business.



an appropriate program has been written and input intothe robot. By the same token, how could companiesautomatically generate an objective without referring toany of their constituencies? Even if we admit that thecompany could function like a natural person, thepremised step of a triggering and enabling procedure isessentially required.28Namely, without a first order beinggiven, how can it start? The first order in this situation isthe instructions that inform the company of what it shoulddo. While the company is able to be independent fromshareholders, in some places Keay himself acknowledgesthat it remains dependent on them.29 The contradictionobviously shows that the problem of the entity conceptis not whether the company can obtain a separatepersonality or have independent interests, but rather theproblem of whether such a type of entity is able toengender an objective of its own.What may be salient so far is that companies are not

able to set a goal just by themselves. Even though in therunning of companies the board of directors as an organmay choose the way companies develop, at least the firstor, say, triggering order and instruction should be given,for example, by the shareholders’ memorandum or thecompany’s constitution. Insisting that companies couldhave their own goals is erroneously equating the separatelegal personality with the natural personality. Unlike thestatement that “the duties of directors are owned to thecompany is absolute because it indicates that only thosewho can claim to act as or on behalf of the company canenforce the duties”, it is almost meaningless to place toomuch emphasis on the interest of the company, as pointedout by Professor Paul Davies, “because the company isan artificial legal person and it is impossible to assigninterests to it unless one goes further and identifies withthe company the interests of one or more groups of humanpersons”.30 Moreover, the company can only functionthrough its organs.31 While a company can be perpetualfrom certain aspects, one cannot deny it would collapseas soon as its human organs left. The company is artificialin nature, similar to the function of Parliament, whichdepends on its members to make decisions. And there isno conflict between this artificial nature and separatepersonality on the grounds that the legal personality couldbe artificial without any ability of generating anindependent mind.Taking one step back, let us assume that a given

company X is an entity with an entirely automatic andself-generating will, and see what will happen. In termsof EMS, X should be the exclusive beneficiary.Nevertheless, when the directors operate the business of

X, the inevitable indeterminacy would be generated asthere needs to be someone to bear all the residual risksincluding the loss and failure of the business. Becausethe shareholders are no longer the beneficiary under EMS,it would be not difficult to infer that they should not, andwould not like to, become the residual risk bearers anylonger. The only available alternative approach is enablingX as such to undertake all the risks. Consequently, at leasttwo points can be safely drawn.32 First, the shareholdersshould get a fixed and guaranteed payment as a returnsimilar to that of the creditors and other stakeholders. Aslong as they do not bear any residual risk, there shouldbe no uncertainty about their expected payoff. Thevariable and flexible return as under the current companystructure in accordance with the shareholder primacyapproach is no longer viable.Secondly, and also more importantly, any small loss

suffered by X would give rise to unsustainability. This isbecause X has to utilise its own assets to cover any lossit faces after becoming the residual risk bearer instead ofthe shareholders who originally played this role. Then allstakeholders of X including shareholders, creditors,employees, etc. have an explicitly fixed claim against Xat the same time, which implies that any minor reductionof the entity’s property would possibly mean that Xcannot satisfy all these stakeholders’ claims. In otherwords, if X as the residual risk bearer has to undertakeany loss with regard to its property, while itsconstituencies all attach a specific claim against it withregard to the property contributed by them, anydiminution might immediately result in the incapabilityof mandatory payment to those fixed claimants. If acompany only has debt capital without any equity capital,any slight loss would lead to insolvency since thiscompany cannot find money from other sources to repaythe entire debts in due time without a windfall. Under theshareholder primacy approach, for example, a companycan resist corporate loss by arranging for the shareholdergroup to suffer any slight or moderate loss. In thishypnosis, however, X is not able to swallow such a loss.Therefore such an entity model does not seem to beworkable in practice.Moreover, the origin of the company should not be

forgotten. While the argument that “companies are nowmerely cash-flow machines”33 might not be morallyaccepted, the company is indisputably established by theincorporators’ will for the purpose of creating wealth forthem.34 Although shareholders gradually relinquish thecontrol rights in order to run themodern public companiesmore efficiently, what they expect to get (i.e. profits) is

28One simple example is that the company could only be created by the shareholders and run by directors and managers as well others they employed.29Keay, The Corporate Objective (2011), p.183.30 P. Davies, Principles of Modern Company Law, 8th edn (London: Sweet & Maxwell, 2008), p.507.31As Lord Cranworth opined more than a century ago: “[a] corporate body can only act by agents.” See Aberdeen Railway Co v Blaikie Brothers (1854) 1 Macq. 461 at471.32As discussed above, the residual claimants, contrary to the fixed ones, can catch most of the marginal gains and incur most of the marginal costs. Therefore no residualclaimants except X as such would have an incentive to monitor.33M. Albert, Capitalism against Capitalism (London: Whurr Publishers, 1993), p.75.34Though companies are argued to have served the public interest in early times—for example see J. Farrar, Corporate Governance: Theories, Principles and Practice, 3rdedn (Oxford: Oxford University Press, 2008), p.24—it seems not unconvincing to retain such a standpoint with regard to modern commercial companies.

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never changed. Nonetheless, the focus is on the entityinstead of its investors under EMS.35 The maximisationand enhancement of the entity are further argued to haveno direct relationship with the welfare of the shareholdersor stakeholders in order to avoid the problematic andnever-ending balancing under the stakeholder theory.Obviously, it is not tenable that one creates somethingsolely for the benefit of such an artificial entity ratherthan one’s own welfare. To be more critical,shareholders—as residual claimants undertaking theresidual risks, and embracing the uncertainty of theirfuture return—might no longer want to put their wealthinto companies with the EMSmodel since they only takerisks but their interests cannot be emphasised. This meansthat the cost of raising capital would substantiallyincrease. Also noteworthy is how takeovers oracquisitions could happen if a company has its ownmind.Nomatter how attractive the premium is, an entity wouldnot agree to sell itself. By the same token, it is difficultto justify that a company can generate its own mind tomaximise its ownwealth when takeover and restructuring,which signify the doomsday of the company if theyhappen, are not infrequent.Professor Keay too may be aware of the problem; as

a result in some places in his articles he admits that EMSaims to increase the interests of all stakeholders.36 Heattempts to declare that the advantage of EMS is to benefitall constituencies (or, say, stakeholders).37However, whenhe turns to the question of how to realise it or how to dealwith the internal conflicting relationships, the answer thensuddenly changes to state that the focus of EMS is solelyon the entity as such and there is no requirement forengaging in considering the benefit or harms of itsconstituencies. Along with this contradiction, this wouldalso give rise to the problem of value transfer. Thecompany can easily retain profits instead of distributingthem with a simple excuse, i.e. for EMS, such excessiveuncertainty could be inexorably conducive to directors’unaccountability.

Concept of maximisationBeyond the artificial nature of EMS, the concept of entitymaximisation as the first limb of EMS is problematic aswell. It has to first clarify that maximising companywealth is in line with that of the shareholder primacyapproach. Meanwhile the so-called corporate reputationor employees’ loyalty pursued under EMS, which isutilised to distinguish it from financial profitmaximisation, could be also categorised into the elementsunder the shareholder primacy approach for promoting

the success of the company. Therefore the problem is notmaximising company wealth as such; it instead turns towhat the end of maximisation is.In addition to the overlap, the concept of maximisation

under EMS suffers from uncertainty and vagueness. Tobegin with, what is the companywealth in terms of EMS:does it mean the aggregation of the wealth of the entireconstituencies including shareholders and all otherstakeholders? Or, alternatively, is it different orindependent from that of its constituencies? If the formerinterpretation is adopted, then all criticisms discussedunder the defects of the stakeholder theory could beapplied here. Professor Keay apparently followsSuojanen’s argument that the entity is separate from thosewho invest in it.38 The internal logic is that as long as thecompany can own assets, it would be meaningful to talkabout maximising its wealth. However, this seems farfrom the end of the story, as will be further revealed inthe next section.The second following doubt is whether the

maximisation remains relevant if not applied from thefinancial aspects, especially when the subject discussedin question has no similar feeling and perception like ahuman being. As aforementioned, it seems to be hard tojustify the value of the artificial nature of the companyapart from the financial perspective. After all, almost allother values in the context of the business world arepossibly to be interpreted as comparable economic values,or at least they have corresponding positions in theeconomic domain. Brand reputation, for example, whichis deemed as of intangible value, is also financiallyrelevant. In spite of the fact that increasing reputationwould be positive for EMS indirectly, it could at the sametime be directly seen as intangible assets. Brandsthemselves own financial values in practice, such asCoca-Cola, IBM and the like, which are all valuable,where reputation is the key determinant. Equally, thoughthemorale of employees has no directly comparable price,higher worker morale undoubtedly implies higherproducing efficiency or even more working hours which,in turn, can be calculated from the financial aspects.Indeed, there is a self-contradiction in Keay’s argument

as to the explanation of maximisation. Pursuant to Keay:

“[E]ntity maximisation does not just mean a focuson profit maximisation, for it encompasses suchthings as augmenting reputation, which have alonger-term impact on the financial standing of thecompany.”39

Apparently, Keay contends that EMS does not, and shouldnot, only focus on profit. But the requirement ofencompassing other things besides financial profits suchas reputation remains to be directed at the purpose of

35Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 685.36Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 686.37At this juncture, it seems to return to the point of the stakeholder theory. This also could be deemed as another possible aspect of evaluating necessity of the EMS.38Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 685.39Keay, The Corporate Objective (2011), p.273.



economic wealth, albeit in a long-term perspective.40 Onthe other hand, however, decisions or investment projectsthat might lead companies to perform financially worsethan in previous periods could still be justified on accountof the possible prosperity in the future under EMS.41 Thusthe concept of maximisation is not well defined underEMS and it fails to play a constructive and efficaciousrole in providing guidance.There are two further questions concerning the issue

of maximisation, namely who decides what maximisationis and how to measure it. Owing to the fact that acompany is not able to generate a mind and can onlyfunction through its organs, it seems that directorsessentially determine the first question; and the secondquestion of measuring maximisation is accordinglyimpossible to achieve. The unfettered discretionary powerwould not find it difficult to establish an excuse in thename of entity welfare by attaching the phrase “in thelong-term”. As a result, for one thing the concept ofmaximisation is ambiguous and the instructive functionof the EMS is problematic, and for the other it is hard toensure or control the accountability of directors. Aboveall, transaction costs are high and would not be easilyreduced by the so-called trust. As expressed elsewherein this section, there are no guarantees or safeguardsregarding the interests of companies’ constituencies;agency costs including opportunism andmonitoring costscan be prohibitively high as well. Secondly, the assertionthat efficiency may be achieved by all investors underthe EMS contributingmore—on the grounds of no priorityof a single group—is too optimistic. It is again a triteargument under stakeholder theory and nothinginnovative. In a nutshell, all of these problems imply thepotential inefficiency of the EMS.

Profit allocationAnother big weakness of the EMS, which relates to theproblem of treating companies as natural persons, is thefailure of dealing with economic profits. It should benoticed that Professor Keay uses a full but short chapterin his latest book to discuss this problem.42Unfortunately,however, the fundamental issue of allocation remainsuntouched. While any surplus and profits indeed shoulddirectly go into the company’s account instead of theshareholders’ pockets in the first place, maximisation ofthe entity’s wealth is far from the end of the story. Eventhough the company has a capacity to own and retain its

profits, it can never consume or enjoy such profits. Thisis in line with the argument of Professor John Parkinsonthat companies with an artificial nature are not able to“experience well-being” and to demand that a companybenefits itself is irrational.43 Without taking the humanbeings behind the corporate form into account, it wouldbe senseless to talk about the interest of the company.44

Keay holds the view that this is for the second limb ofthe EMS, namely sustainability.45 But the reason thatpeople invest financial or human capital to establish andthen run a company is for getting benefits, not just forkeeping it surviving. Given that the members and otherconstituencies of the company are not able to explicitlyobtain benefits under this model, sustainability meansnothing at all. Sustainability is just a bottom line forrunning companies. Even for society, apart from the tax,the company under this model may create less socialwealth in view of the fact that most of the economicwealth is retained by an artificial entity.46 It might beargued that enhancing the entity’s benefits wouldultimately improve all so-called investors’ interests. Ifso, then what is the difference between EMS and theshareholder primacy approach? It seems that there is nonecessity to formulate this new entity model in terms ofsuch an interpretation. Indeed, one contradiction lies atthe heart of Keay’s EMS model. When describing thedistinction and advantages of EMS, he declares that themodel focuses on the entity as such; for example directorsunder EMS aremerely requested tomake decisions whichare best for the company and not required to beaccountable to any constituencies of the company.47 Thenhe argues that entity wealth would also benefit all of itsconstituencies in other places. Similarly, EMS iscontended to focus on entity wealth enhancement and thesubsequent benefits to the so-called investors in one sense,and the interests of the corporate constituencies areexplicitly claimed to have no assurance in another. Putsimply, Keay endeavours to separate the benefits ofshareholders together with other stakeholders from thesuccess of the company and contends that EMS wouldnot consider the interests of these so-called investors, butcould finally benefit them indirectly.Considering that the ultimate goal is to maximise entity

wealth, then what is the purpose of paying high bonusesto employees or the like? Is that still in order to achievethe goal of entity maximisation?48 As Keay argues,allocation of profits to benefit shareholders or otherstakeholders should be done “in a way as to produce entity

40Keay, The Corporate Objective (2011), pp.273–274; A. Keay, “The Ultimate Objective of the Company and the Enforcement of the EntityMaximisation and SustainabilityModel” (2010) 10 Journal of Corporate Law Studies 35, 70.41Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 685.42Keay, The Corporate Objective (2011), pp.320–330.43 J. Parkinson, Corporate Power and Responsibility: Issues in the Theory of Company Law (Oxford: Clarendon Press, 1993), pp.76–77.44 Just as Professor Paul Davies correctly noted two decades ago that: “[the] notion of the corporation having an independent interest serves to obscure the potential conflictsamong the various groups of persons affected by the way the company is run, or worse, to disguise a policy of promoting the interests of one of those groups at the expenseof others.” P. Davies, “Institutional Investors in the United Kingdom” in D. Prentice and P. Holland (eds),Contemporary Issues in Corporate Governance (Oxford: ClarendonPress, 1993), p.75.45Keay, The Corporate Objective (2011), p.328.46Moreover, because the company can only be run by the human organ, i.e. directors of the board and the delegated managers, there are great risks of increasing agencycosts, as mentioned above, and the social wealth would be thereby reduced accordingly.47 For example, see Keay, The Corporate Objective (2011), pp.188, 208.48Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 695.

Analysis 277


enhancement”49 and must be determined “on the basis ofmaximising the entity’s wealth”.50 Once more, theargument falls into an endless circularity. Maximisingentity wealth is for the ultimate benefit of all itsconstituencies, but when facing the distribution of theprofits after its wealth has been increased or maximised,the guideline returns to maximising entity wealth again.The value of certainty has been demolished altogether.Besides, this would inexorably involve a judgment ofwhich group or groups can most promote the success ofcompany for deciding distribution as rewards. But theEMS model fails to deal with this point.Moreover, maximisation is unintelligible or even

senseless from a going concern perspective. It would belogically impossible to declare that one thing has arrivedits highest point while it is still going on—as long as thecompany can earn one more penny the next minute. Lackof a clear policy in profit allocation signifies no guaranteeor protection for the constituencies of the company.Directors could have an endless excuse to sacrifice theinterest of shareholders and/or other stakeholders sinceentity maximisation can never be achieved. Theaccumulated profits could be reinvested forempire-building among other things, which implies thatshareholders or other stakeholders may not eventuallyget anything except a picture of a promising futuredepicted by the directors. Keay’s argument of achievingEMS statutorily by deleting “for the benefit of thememberas a whole” after the words “the success of the company”51 in s.172(1) of the Companies Act 2006 does in factfurther generate obscurity and vagueness. In addition topursuing endless entity maximisation, directors arerequired to allocate benefits under EMS,52 and therebythe unfettered discretionary power would result in greaterpotential of agency costs.Corporate constituencies cannot be guaranteed for the

profit they contribute.53 Even shareholders who have nofixed claim against the company and agree to be the lastin the line to receive payouts cannot be assured to pickup anything when a company runs profitably either. Itseems unjustifiable to refuse those who bear all theuncertainty and residual risks to take precedence in thefirst place, and at the same time unattractive tostakeholder theorists as stakeholders could still besubordinated in the name of EMS. Persuading investorsto sacrifice their interests with a view that they will getbenefits some day in the future54 is pointless and inane tosome extent, particularly when future interests cannot be

guaranteed either. It is completely unfair and destructive.Secondly, how can one ensure fairness when someoneloses while others benefit at times? No balancingmechanism is involved under the EMS; in effect suchmechanisms are intentionally derided and thereby omitted.Take an unprofitable plant of a company for example:closing it down would benefit creditors among others byreducing the bad assets in one sense, and keeping itrunning, in another, could be regarded as transferringwealth from creditors to employees.55 Consequently,making decisions without taking the issues of interestbalance into account is impossible in practice. Unlikewhat Keay has declared, fairness cannot be found underthe EMS model without any balancing mechanism andexplicit priority.56 Companies are not run for shareholderinterests, which means their interests would not beconsidered in the decision-making process. Nor are theyrun for other constituencies’ interests. Siphoning wealthfrom any group to another could probably happen in thename of enhancing the entity wealth. As the previousargument runs, the EMS model solely focuses on theentity which requires everything starting from this point,and thereby transfer of wealth is not only unavoidablebut also immune from being blamed.Accordingly, EMS suffers the same shortcoming as

under both the shareholder primacy and stakeholderapproaches. That is, “the company has every incentiveto externalize costs onto those whose interests are notincluded in the firm’s financial calculus”.57 Under EMS,individual interests are able to be sacrificed andsubordinated in the name of the entity. Decisions may bemade to the benefit of the company at the expense ofothers. The adverse third-party effect and negativeexternalities would not be eliminated automatically withadopting the EMS.

Enforcement issuesAs is known, a right without remedy is futile. This leadsto another problem under EMS, i.e. what can be done andby whom in the event that the interests of companies aredisregarded or damaged? Similar to the problem underthe stakeholder theory, enforceability remains a difficultsector, if not an insurmountable problem.First, EMS is not, or at least is not directly, intended

to protect the interests of all stakeholders.58As repeatedlyreiterated, it seems easy to justify any decision on thebasis of entity maximisation. Secondly, in terms of theartificial nature of the entity, this implies that the company

49Keay, The Corporate Objective (2011), p.326.50Keay, The Corporate Objective (2011), p.207.51Keay, The Corporate Objective (2011), p.226.52Keay, The Corporate Objective (2011), p.330.53 For example, see Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 690.54Keay, “Ascertaining the Corporate Objective” (2008) 71 Modern Law Review 663, 690.55The interests of shareholders as well as other stakeholders maybe also involved in this situation, as analysed in the previous sections, but here these two groups are justmentioned as a simple example.56Under the stakeholder approach, though no clear priority exists as discussed, there is at least an emphasis on balancing which more or less could relieve problems suchas uncertainty. However, under EMS, even such a process of weighing up has been omitted. As a result, the situation is no better than that of the stakeholder approach withthe abstract nature of the entity.57K. Greenfield, “Saving the World With Corporate Law” (2007) 57 Emory Law Journal 947, 959.58Keay, “The Ultimate Objective of the Company and the Enforcement of the Entity Maximisation and Sustainability Model” (2010) 10 Journal of Corporate Law Studies35, 46.



is only able to run through its organ since it cannotgenerate its own mind, as examined above. In addition,the foregoing discussions reveal that no direct relationshipexists between the wealth of the entity and theconstituencies. All of these points suggest that even theinterest of the company has been damaged; apart fromformidable obstacles with regard to legal proceduresneither shareholders nor other stakeholders have enoughincentive to initiate an action, which largely stems fromthe fact that no residual risk bearer exists other than theentity, as in the example of the hypothetical company Xdiscussed above.Keay brings forward eight enforcement options:

1. exit;2. voice;3. pressure;4. board representation;5. administration/liquation;6. government intervention;7. oppression/unfair prejudice provision; and8. derivative claim.

Because most of these are ineffective and unintelligibleboth theoretically and practically,59Keay’s main argumentrelies on the last option, i.e. modifying the currentderivative action system. In his mind, the refinedderivative action should grant all the so-called investorsa right to initiate a suit. They can bring derivative actionswhen the board of a company does not comply with EMS:

“All that the proposed action does is to extend therange of possible applicants for permission to takeforward a derivative action and to permit derivativeactions not only where the directors have donesomething that has harmed the company, but wherewhat they done or intend to do would fail to ensurethe company’s maximization and sustainability.”60

However, on the ground that the concept of maximisationis not well defined and maximisation may conveydifferent implications to different people, as alreadyanalysed, it is not by any means worth envisaging theeffectiveness of the refined derivative actionoptimistically. Worse still, the purpose is to maximisethe entity’s wealth without referring any of theconstituencies’ interests in accordance to EMS. How topersuade someone without a stake to take action inanother’s interest?

Further, increasing the chance of protecting company’sinterests by suits61 would bring uncertainties and leavemuch room for potentially inappropriate actions.Unmeritorious or vexatious claims can be hardly avoided.Even if a given corporate decision or investment projectis in line with EMS, at a certain point someone may bebetter off, whereas others may be worse off, and thosewhose interests are being harmed would certainly havean incentive to bring an action. In spite of conceding thatKeay’s argument that no avalanche of litigation wouldhappen and that permissions to continue an action wouldbe effectively controlled is not without evidence,62 nobodycould guarantee that the company’s competitor orsomeone with bad faith would never utilise their right tobring a claim against the company for defamation, forexample. Inter alia, the cost would be much lessened thanthat of the original derivative action which requests thatthese people become shareholders in the first place. Moredamagingly, by virtue of the vagueness andunpredictability under EMS, there is no assurance foreliminating loopholes allowing those with bad faith tobring a successful claim.Keay contends that to “enable other investors to appear

at the permission hearing” may be a way to avoid thederivative proceedings “out of hand”.63 Nevertheless,though EMS is not obeyed and thereby the companywealth has not been maximised, at least some so-calledinvestors could obtain part of the benefits due to theoutcome of the conflict of interests, and as a result theywill certainly not agree with initiating a derivative claimagainst the company. Assuming that closing an oldmanufacturing plant of a company does not follow EMS,but some constituencies such as shareholders and creditorsmight fairly welcome this decision since their interestswould be enhanced under that decision, these groupswould certainly stand with the board of the company atthe time of a permission hearing.What should also be noticed is that so-called investor’s

personal interest being prejudiced is not grounds forderivative action unless EMS has not been complied withat the same time. This means, apart from the severefree-riding problem, that the refined derivative actionconfronts the problem of lack of incentive for theinvestors to initiate a claim. The situation is distinct fromwhat the shareholders face in terms of the currentderivative claim system. Admittedly, shareholders cannotretain any direct benefits if the suit succeeds, but they arenevertheless the residual claimants who can retain all thebenefits from the income stream after all fixed claimants

59Keay himself also concedes the first seven options are problematic: Keay, The Corporate Objective (2011), pp.241–254; Keay, “The Ultimate Objective of the Companyand the Enforcement of the Entity Maximisation and Sustainability Model” (2010) 10 Journal of Corporate Law Studies 35, 46–55.60Keay, “The Ultimate Objective of the Company and the Enforcement of the Entity Maximisation and Sustainability Model” (2010) 10 Journal of Corporate Law Studies35, 60.61Keay, “The Ultimate Objective of the Company and the Enforcement of the Entity Maximisation and Sustainability Model” (2010) 10 Journal of Corporate Law Studies35, 57.62Keay, “The Ultimate Objective of the Company and the Enforcement of the Entity Maximisation and Sustainability Model” (2010) 10 Journal of Corporate Law Studies35, 60–61.63Keay, “The Ultimate Objective of the Company and the Enforcement of the Entity Maximisation and Sustainability Model” (2010) 10 Journal of Corporate Law Studies35, 62.

Analysis 279


are satisfied. In consequence, unlike Keay’s standpoint,64

the incentive of both shareholders and stakeholders ismuch less likely to be stimulated with regard to theallocation of the benefit and cost.A further underestimated problem under EMS is the

court review. The question is how the court can knowwhether EMS is complied with when the concept ofmaximisation is not yet evident. This is not to requestthat judges become commercial experts, or competentenough for weighing up commercial decisions. Rather,it is just a question of which criteria judges could rely on.The EMS model, as Keay claims, includes more thanfinancial profits; how is a judge as an outsider to discoverwhat is the real maximisation for a specific company?There might be never an objective criterion.

Director unaccountabilityRelated to the problem of enforcement and the vaguenessof maximisation, the accountability of directors isproblematic as well. The effect of the mixture of “board,contractual, regulatory, market and fiduciary constraints”65

on directors continues to be debatable. Conspicuously,Keay is aware that no effective mechanism exists toensure or facilitate the directors’ accountability under theEMS model; he therefore tries to go around it by listing10 methods and mechanisms.66 He attempts to use amixture of plural mechanisms to overcome theunaccountabilitywhile eachmechanism has flaws.67Thesemechanisms have been already attempted by stakeholdertheorists, however. Except for intentionally disregardingthe issue of balancing, it is difficult to identify anydistinction compared with the stakeholder theory. If notunworkable, why does the stakeholder theory still suffersevere attacks because of this weakness?Previous discussions explicitly show that the

discretionary power of directors under EMS is muchgreater than that of the shareholder primacy and

stakeholder theory. Here we will just mention the threemost evident points: first, directors under EMS are onlyaccountable to the company rather than shareholders orany other stakeholders, and they solely focus on theentity’s wealth; secondly, directors can determine whatmaximisation and sustainability of the company mean,and their decisions are difficult to be impugned; thirdly,directors can allocate profits as long as they contend thatthis could benefit for the company. In short, the inherentdefects such as overestimating the artificial nature of theentity, an ill-designed maximisation concept and profitallocation mechanism, and the lack of workability wouldfinally give rise to the unaccountability of directors bygranting them almost unfettered powers. Those almostunfettered discretionary powers would undeniably resultin substantial unaccountability which, in turn, would causesevere agency costs and lower the aggregate companywealth.

ConclusionIn conclusion, although the entity maximisation andsustainability model represents a meaningful endeavourto solve the problems existing in identifying the corporateobjective, this article respectfully disagrees with theviability of this model. The inherent defects such asoverestimating the artificial nature of the entity,ill-designed maximisation and profit allocation, and lackof workability would finally give rise to theunaccountability of directors by granting them almostunfettered power. Meanwhile, this article also notes thatthe distinction claimed by Professor Keay for EMS is notthat evident. At least at the current stage, it seems thatthis entity model cannot without further development bejustified to be a substitutional approach for theshareholder primacy approach and stakeholder approach.

64As argued by Keay, shareholders also face the problem of a lack of incentive in derivative actions under the shareholder model, so he thinks it is not a big problem underhis modified model: Keay, “The Ultimate Objective of the Company and the Enforcement of the Entity Maximisation and Sustainability Model” (2010) 10 Journal ofCorporate Law Studies 35, 63.65Keay, The Corporate Objective (2011), p.304.66Keay, The Corporate Objective (2011), pp.305–318.67Keay, The Corporate Objective (2011), p.318.



NEWS DIGEST

Plan released to combat tax evasionand money laundering

Company incorporation; International co-operation;Money laundering; Tax evasion; Transparency

A UK action plan based on common principles agreed atthis year’s G8 summit to counter tax evasion and moneylaundering has been released by the Prime Minister’sOffice.The 2013 summit took place at Lough Erne, Northern

Ireland, in June under the UK presidency and endorsedcommon core principles to prevent the misuse ofcompanies and legal arrangements. These principles areregarded as essential to secure the integrity of beneficialownership and basic company information, the timelyaccess to such information by law enforcement forinvestigative purposes and, where appropriate, thelegitimate interests of the private sector.Participants undertook to publish national action plans

setting out the actions to be taken. The core principlesare consistent with the Financial Action Task Force(FATF) revised standards, and G8 members will reportpublicly to the FATF on progress made in implementingtheir action plans.The UK action plan is as follows:

1. conduct, and share the findings of, anational assessment of money launderingand terrorist financing risks by 2014,co-ordinating action by the public andprivate sector to assess risks, applyresources and mitigate those risks;

2. ensure the Companies Act 2006 and UKMoney Laundering Regulations obligecompanies to knowwho owns and controlsthem, by requiring that companies obtainand hold adequate, accurate and currentinformation on their beneficial ownership;

3. amend the Companies Act 2006 to requirethat this information is accurate and readilyavailable to the authorities through a centralregistry of information on companies’beneficial ownership, maintained by

Companies House. Consult on whetherinformation in the registry should bepublicly accessible;

4. ensure that trustees of express trusts areobliged to obtain and hold adequate,accurate and current information onbeneficial ownership regarding the trust;

5. put in place mechanisms to ensure that therelevant competent authorities have accessto information on trusts and ensure effectivemechanisms to share this information withother jurisdictions, in line with bilateral andmultilateral agreements;

6. improve the supervision and enforcementof those who facilitate company formationin the United Kingdom. This will start witha review of supervision and enforcementof trust and company service providers. Thereview will include consideration ofadditional measures to ensure companyformation agents conduct effective duediligence including the identification andverification of beneficial owners;

7. review of corporate transparency, includingbearer shares and nominee directors, by theDepartment for Business, Innovation andSkills. This will start with the publicationof a pre-consultation paper beforeSeptember 2013;

8. support the Overseas Territories and CrownDependencies to publish Action Planssetting out the concrete steps, whereneeded, to fully implement the FinancialAction Task Force Standards;

9. improve international cooperation includingthe timely and effective exchange of basicand beneficial ownership information;

10. implementation of the measures will bethrough, and at the same time as,transposition of the Fourth MoneyLaundering Directive and UK MoneyLaundering Regulations, changes to theCompanies Act 2006, as well as throughother relevant bilateral and multilateralagreements.

Key company reporting reforms comeinto force

Directors’ powers and duties; Directors’ reports;Environmental reports; Strategic planning

Reformswhich aim to simplify and strengthen companies’non-financial reports are due to come into force onOctober 1, 2013.

News Digest 281


The changes, which affect all reports produced inrelation to financial years ending on or after September30, are being introduced by the Companies Act 2006(Strategic Report and Directors’ Report) Regulations2013 which were laid before Parliament on June 13. Keyreforms being introduced include a duty on a company’sdirectors to prepare a strategic report, the purpose ofwhich is to help members assess how the directors haveperformed their duty to promote the success of thecompany.Rules relating to the preparation and content of

strategic reports have been inserted by reg.3 of theRegulations in a new Ch.4A in Pt 15 of the CompaniesAct 2006. Businesses entitled to the small companies’exemption will not be required to produce a strategicreport, which replaces the requirement for a businessreview to be prepared as part of the directors’ report.The strategic report must contain a fair review of the

company’s business, and a description of the principalrisks and uncertainties facing it. For quoted companies,a new s.414B of the Companies Act 2006 stipulates thata breakdown of the number of men and women on theboard must be included.Strategic reports of quoted companiesmust also contain

information on environmental matters (including theimpact of the company’s business on the environment)and social, community and human rights issues.The Large and Medium-sized Companies and Groups

(Accounts and Reports) Regulations 2008 (SI 2008/410)and the Small Companies and Groups (Accounts andDirectors’ Report) Regulations 2008 (SI 2008/409) areamended by the new regulations.The need to provide information on a company’s

purchase of its own shares to public companies is limited,and some items of information from the directors’ reportare removed. Quoted companies are required to makedisclosures on greenhouse gas emissions in the directors’report by an amendment to SI 2008/410.

BIS publishes call for views oncorporate responsibility

Corporate social responsibility; Department forBusiness Innovation and Skills

The Government is intending to produce a frameworkfor action on corporate responsibility by the end of thisyear based on feedback from business and otherstakeholders from a consultation exercise.A document,Corporate responsibility: A call for views,

was published by the Business Minister, Jo Swinson, inJune and seeks responses by September 27, 2013 on theGovernment’s plans to promote ethical, environmentaland social practices.Key questions included in the document include:

• How can government encourage morebusinesses to adopt internationallyrecognised guidelines?

• How can companies manage their supplychains responsibly?

• How can best practices be adopted bySMEswhen this is normally associatedwithbig business?

• What are the main barriers to businesscontributing to social initiatives?

• What more can government and businessdo to improve the information available toconsumers who want to take ethicalconsiderations into account whenpurchasing goods or services?

Examples of corporate responsibility include:

• big business supporting small business (e.g.Santander’s UK breakthrough programmewhich helps to provide finance for SMEs);

• helping to promote fair trade (e.g.Sainsbury’s Fair Development Fund, whichseeks to improve the livelihoods of farmersand workers in the developing world);

• supporting disadvantaged groups (e.g.Deloitte’s Parasport resource launched in2007 aimed at helping disabled peoplebecoming more active through sport);

• serving communities (e.g. EDF Energy’smove to work with its suppliers to ensurethey meet the 10 principles of the UNGlobal Compact).

Guernsey Financial ServicesCommission proposes reforms tosupervisory legislation

Financial regulation; Financial services; Guernsey

The Guernsey Financial Services Commission has issueda consultation paper on consolidating and revising theregulatory and supervisory legislation for which it isresponsible.At present, financial services businesses in Guernsey

are supervised by the Commission in accordance withseveral distinct laws which have been separatelydeveloped and enacted over 25 years. The proposedreforms are contained in the FSC’s Consultation paperon consolidating and revising the supervisory legislation,which was published on June 12, 2013 and seeksresponses from stakeholders.While each law has been effective in its own terms,

the differences between the laws in relation to supervisorypractices and procedures have resulted in inconsistenciesof approach between the different types of regulated



activity. The current situation is considered to beunhelpful to licensees and also makes the efficientdischarge of the Commission’s functions more difficult.Development of a law which consolidates much of the

existing supervisory legislation would address theseinconsistencies and provide the opportunity for theCommission to create a single streamlined, overarchingset of policies, procedures and controls for supervisionof the finance sector. A clearer, simpler and single lawwill also be of benefit to the sector.The consultation paper suggests improvements as well

as consolidation in a number of areas, and proposes thatthe Prescribed Businesses (Bailiwick of Guernsey) Law2008 should be repealed and replaced by new legislation.The Prescribed Businesses Law provides the Commissionwith powers to administer the anti-money launderingframework for firms of lawyers, accountants and estateagents.Following his retirement, the current FSC

director-general, Nik van Leuven, will be retained asspecial adviser for the project to consolidate and revisethe regulatory laws. The Commission has also decidedto change its internal structure to bring supervision andpolicy functions together, and increase its effectiveness.A new Innovation Unit will be formed to perform cost

benefit analysis of proposals for new businesses, productsand services. Its function will be to help the Commissionreach balanced decisions on the risks and rewards for theBailiwick of authorising new innovative businesses, andthe unit will also liaise with the states to ensure thatGuernsey complies with International Monetary Fund(IMF) recommendations on financial stability.A Conduct Unit will be established to take a

Commission-wide lead on conduct supervision and policy,particularly the implementation of Guernsey FinancialAdvice Standards (GFAS). A specialist Risk Unit is alsoto be set up in order to help the Commission deliver andembed risk-based supervision.

Parliamentary banking commissionrecommends jailing reckless bankers

Bankers; Banking regulation; Bonuses; Criminalliability; International banking standards; Professionalconduct; Recklessness; Remuneration

A series of reforms to improve banking industrystandards—including the creation of a new criminaloffence of recklessmisconduct for senior bankers carryinga prison sentence—have been put forward by theParliamentary Commission on Banking Standards in itsfinal report.Changing banking for good, published on June 19,

2013, makes proposals based on five themes designed torestore trust in banking:

• making individual responsibility in bankinga reality, especially at the most seniorlevels;

• reforming governance within banks toreinforce each bank’s responsibility for itsown safety and soundness and for themaintenance of standards;

• creating better functioning andmore diversebanking markets in order to empowerconsumers and provide greater disciplineon banks to raise standards;

• reinforcing the responsibilities of regulatorsin the exercise of judgment in deployingtheir current and proposed new powers;

• specifying the responsibilities of theGovernment and future governments andparliaments.

In addition to the suggested creation of a criminal offenceof reckless misconduct, the Commissionmakes a numberof other recommendations, including:

• a new senior persons regime, replacing theapproved persons regime, to ensure that themost important responsibilities withinbanks are assigned to specific, seniorindividuals so that they can be held fullyaccountable for their decisions and thestandards of their banks in these areas;

• a new licensing regime underpinned byBanking Standards Rules to ensure thatthose who can do serious harm are subjectto the full range of enforcement powers;

• a new remuneration code better to alignrisks taken and rewards received inremuneration, with the power to deferbonuses for up to 10 years;

• a new power for the regulator to cancel alloutstanding deferred remuneration, alongwith unvested pension rights and loss ofoffice or change of control payments, forsenior bank employees in the event of theirbanks needing taxpayer support, creating amajor new incentive on bankers to avoidsuch risks.

Company ownership: transparencyand trust discussion paper published

Access to information; Beneficial ownership;Companies; Department for Business Innovation andSkills; Directors’ powers and duties; Ownership;Transparency

News Digest 283


A range of proposals aimed at enhancing the transparencyof UK company ownership and increasing trust in UKbusiness have been published in a discussion paperproduced by the Department for Business, Innovationand Skills.Views on the following propositions relating to the

ownership and control of UK companies have beeninvited by the paper:

• implementing a central registry ofinformation on the beneficial owners of allUK companies, but with companies alreadysubject to stringent disclosure rules possiblybeing exempt;

• giving companies statutory tools to identifytheir beneficial ownership, perhaps withadditional requirements to help themachieve this;

• what information should be provided to theregistry, how frequently it should beupdated and how to ensure that it asaccurate as possible;

• whether information in the registry shouldbe made public, noting the strong case foropenness but recognising possible concerns;

• prohibiting the creation of new bearershares, with existing bearer sharesconverted to ordinary registered shares;

• considering options to enhancetransparency concerning nominee directors,and whether corporate directors should bebanned.

Transparency and trust: Enhancing the transparencyof UK company ownership and increasing trust in UKbusiness (July 2013) also contains proposals to strengthenthe business regime through tackling the activities ofrogue directors by:

• amending directors’ statutory duties in keysectors such as banking, and debatingwhether to allow sectoral regulators todisqualify directors in their sector;

• considering what additional factors thecourt may take into account in directordisqualification proceedings (e.g. the natureand number of previous company failuresand director has been involved in);

• looking at options to help creditors receivecompensation when they have sufferedfrom a director’s fraudulent or recklessbehaviour;

• proposing that the time-limit for bringingdisqualification proceedings in insolventcompany cases should be extended fromtwo to five years;

• offering disqualified directors education ortraining to help equip them with the skillsto go on to run successful companies;

• considering whether individuals subject toforeign restrictions should be preventedfrom becoming a director of a UKcompany, and whether directors convictedof a criminal offence in relation to themanagement of an overseas companyshould be able to be disqualified in theUnited Kingdom.

The United Kingdom committed at the G8 summit inJune to introducing new rules on a range of issuesincluding identification of company ownership; a registerof beneficial ownership information; and the use of bearershares and nominee directors.



FINANCIALREGULATORY

UPDATE

TheEMIRof Strasbourg:changing the financiallandscape of the EEADr Graeme BaberBPPUniversity College of Professional Studies,London

Central counterparties; Derivatives; EU law; EuropeanEconomic Area; Financial reporting; Over-the-countermarket

“All standardized OTC derivative contracts shouldbe traded on exchanges or electronic tradingplatforms, where appropriate, and cleared throughcentral counterparties by end-2012 at the latest. OTCderivative contracts should be reported to traderepositories. Non-centrally cleared contracts shouldbe subject to higher capital requirements. We askthe FSB and its relevant members to assess regularly

implementation and whether it is sufficient toimprove transparency in the derivatives markets,mitigate systemic risk, and protect against marketabuse.”1

While these G-20 commitments have not materialisedwithin the timescale above, most of the 19 memberjurisdictions of the FSB have made steady progresstowards bringing them into effect.2 In April 2013, five ofthese states had implemented the requirement to reportOTC derivative contracts to trade repositories, while 11further countries had (at least) adopted the legislativeframework.3 At this time, only one jurisdiction hadimplemented the commitment to clear standardised OTCderivatives through central counterparties, while 13further states had enacted the framework rules.4

Countries remain slow to impose the G-20 requirementfor all standardised OTC derivative contracts to be tradedon exchanges or electronic trading platforms.5 None ofthe member jurisdictions of the FSB had put thiscommitment into effect in April 2013, while 11 of thesecountries had adopted the legislative framework.6

The European Economic Area (EEA)’s primary andimplementing legislation is in force.7 Nonetheless, thereare gaps, due to the prolonged nature of the legislativeprocess within the European Union (EU).8

The EMIR distinguishes between a “financialcounterparty” and a “non-financial counterparty”.9 Thisdistinction is important, because the obligations for theformer under the Directive are more onerous than thelatter. For instance, an OTC derivative contract that hasbeen concluded between two financial counterpartiesmust be cleared through a CCP (central counterparty).10

A non-financial counterparty is only required to clear allof its OTC derivative contracts through a CCP, if its

1University of Toronto:G20 Information Centre, G20 Leaders’ Statement: The Pittsburgh Summit (2009), para.13, http://www.g20.utoronto.ca/2009/2009communique0925.html [Accessed July 17, 2013]. Please see G.S. Baber “The EMIR of Strasbourg: a three-year journey ‘from Pittsburgh’” (2013) 34Company Lawyer 117, for the definitionsof “OTC” (over-the counter), “derivative”, and “FSB” (Financial Stability Board), and for commentary.2The 19 member jurisdictions of the FSB are Argentina, Australia, Brazil, Canada, China, the European Union (EU), Hong Kong, India, Indonesia, Japan, Mexico, theRepublic of Korea, the Russian Federation, Saudia Arabia, Singapore, South Africa, Switzerland, Turkey and the United States.3Financial Stability Board,OTCDerivativesMarket Reforms: Fifth Progress Report on Implementation 15 April 2013 (2013), Figure 1, p.2, http://www.financialstabilityboard.org/list/fsb_publications/index.htm [Accessed July 17, 2013].4Financial Stability Board,OTCDerivativesMarket Reforms Figure 1, p.2, http://www.financialstabilityboard.org/list/fsb_publications/index.htm [Accessed July 17, 2013].5 I noted this fact in Baber, “The EMIR of Strasbourg” (2013) 34 Company Lawyer 117.6 Financial Stability Board, OTC Derivatives Market Reforms (2013), Figure 1, p.2, http://www.financialstabilityboard.org/list/fsb_publications/index.htm [Accessed July17, 2013].7The primary legislation is Regulation 648/2012 on OTC derivatives, central counterparties and trade repositories, which entered into force on August 16, 2012. ThisRegulation is known as the Efficient Markets Infrastructure Regulation (EMIR). The implementing legislation comprises three Commission Implementing Regulations(1247/2012, 1248/2012, and 1249/2012), which entered into force on January 10, 2013, and six Commission Delegated Regulations (148/2013, 149/2013, 150/2013,151/2013, 152/2013, and 152/2013), which came into force on March 15, 2013. Articles 13, 14 and 15 of Commission Delegated Regulation 149/2013 supplementing theEMIR with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financialcounterparties, and risk mitigation techniques for OTC derivative contracts not cleared by a CCP, apply from September 15, 2013. As all of these Regulations are labelled“Text with EEA relevance”, they apply to the Iceland, Liechtenstein and Norway in addition to the 28 Member States of the European Union.8The rules on exchange/electronic trading platforms, and on transparency and trading, are in the Second Markets in Financial Instruments Directive (MiFID II) and theMarkets in Financial Instruments Regulation (MiFIR), both of which are (at the time of writing) under discussion at the Economic and Financial Affairs Committee of theCouncil (http://ec.europa.eu/prelex/detail_dossier_real.cfm?CL=en&DosId=200940 (MiFID II)) and http://ec.europa.eu/prelex/detail_dossier_real.cfm?CL=en&DosId=200938 (MIFIR). The rules on capital requirements are in the Capital Requirements Regulation (CRR), which (at the time of writing) is waiting for Council approval inits First Reading (http://ec.europa.eu/prelex/detail_dossier_real.cfm?CL=en&DosId=200720#120961 [All accessed July 17, 2013]). The ordinary legislative procedure inart.294 of the Treaty of the Functioning of the European Union applies to this legislation.9A “financial counterparty” is an investment firm, a credit institution, an insurance undertaking, a life assurance company, a reinsurance undertaking, a UCITS (Undertakingfor Collective Investment in Transferable Securities), a UCITS management company, an institution for occupational retirement provision, and an alternative investmentfund, that has been authorised to provide services in the EEA in accordance with the relevant Directive (art.2(8), Regulation 648/2012). A “non-financial” counterparty isan undertaking that is established in the EEA other than a “financial counterparty” and a “CCP” (art.2(9), Regulation 648/2012). A CCP (central counterparty) is a legalentity that is placed between the counterparties to contracts that are traded on a financial market (art.2(1), Regulation 648/2012).10Regulation 648/2012 art.4(1). This is called “the clearing obligation”.

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rolling average position over 30 working days in aparticular class of OTC derivative contracts exceeds theclearing threshold for this class.11

All counterparties and CCPs are required to report thedetails of any derivative contracts, or of any modificationor termination to a derivative contract, to a registeredtrade repository.12 This is a responsibility for allcompanies that enter into derivative contracts in order tomitigate the fluctuations in value that arise during theordinary course of their business.13

As the counterparty or the CCP may delegate thereporting of any derivative contract,14 a financialcounterparty may take responsibility for reporting thosecontracts that it enters into with non-financial

counterparties. However, such latter counterparties willbe required to report derivative contracts made with other(non-financial) entities within the relevant corporategroup, given that the reporting of these contracts mustnot duplicated.15

Although many institutions within the EEA carefullyrecord their financial trades as a matter of good corporatepractice, the legal requirement to do this formalisesprocedure and provides a comprehensive audittrail—which is indispensable if something goes awry.These requirements of the EMIR are changing thefinancial landscape for companies—andwill do so furtheras its implementation takes effect.

11Regulation 648/2012 art.10(1)(b). This excludes OTC derivative contracts with a non-financial counterparty that is not subject to the clearing obligation (art.4(1)(a),Regulation 648/2012). The clearing thresholds are €1,000,000,000 in gross notional value for OTC credit derivative contracts and OTC equity derivative contracts (art.11(a)and 11(b), Regulation 149/2013). The thresholds are €5,000,000,000 in gross notional value for OTC interest rate derivative contracts, OTC foreign exchange derivativecontracts, and other OTC derivative contracts (art.11(c)–11(e), Regulation 149/2013). In calculating the rolling average position, the non-financial counterparty is to includeall the OTC derivative contracts by non-financial counterparties within its corporate group that do not reduce risks that relate to the commercial or treasury financing activityof this group (art.10(3), Regulation 648/2012). Thus, hedging transactions are excluded from the calculation—as specified in art.10(1) of Regulation 149/2013.12Regulation 648/2012 art.9(1). This article refers to “derivative contracts” rather than to “OTC derivative contracts”. It therefore includes exchange-traded derivativecontracts, such as futures contracts. A “trade repository” is a legal entity that collects and maintains the records of derivatives (art.2(2), Regulation 648/2012).13The reporting obligations are precise and onerous. Table 1 of the Annex to Regulation 148/2013 requires the completion of up to 26 data fields with information for thecounterparties to the derivative contract. Data include, for instance, the date and time of reporting to the trade repository (field 1), a unique code that identifies the reportingcounterparty (field 2), a unique code that identifies the other counterparty (field 3), the mark to market (or mark to model) value of the derivative contract (field 17), thevaluation date (field 18), and the valuation time (field 19). Table 2 of the Annex to Regulation 648/2012 of at least 33 data fields with information concerning the detailsof the derivative contract. Data include for instance product identifiers (fields 1 to 3), an identifier for the underlying asset (field 4), the currency of the contract’s notionalamount (fields 5 to 6), the currency to be delivered (field 7), the price per derivative (field 12), the number of derivatives that are represented by one contract (field 15), andthe number of contracts that are included in the report (field 16).14Regulation 648/2012 art.9(1).15Regulation 648/2012 art.9(1).



INTERNATIONAL

Nigeria’s new transferpricing regimeDr Derek ObadinaAssociate Professor, Lagos State University

Advance pricing agreements; Dispute resolution;Double taxation; Nigeria; Penalties; Transfer pricing

IntroductionIt is becoming increasingly evident that transfer pricingis being used by multinationals operating in Africa as ameans of tax avoidance through the mispricing of transfertransactions.1 This has prompted a growing number ofAfrican countries to legislate on the matter. Nigeria is themost recent example. In 2012 the Federal Inland RevenueService (FIRS), the body responsible for administeringtax laws in Nigeria relating to companies, released theIncome Tax (Transfer Pricing) Regulations No.1 (theRegulations),2 the first piece of legislation in the countrydealing specifically with transferring pricing.The stated objectives of the Regulations are, among

others, to ensure that Nigeria is able to tax businesses“appropriately” based on their economic activities in thecountry3 and to equip Nigerian tax authorities with thetools to fight tax avoidance “through mispricing oftransactions between associated persons”.4

The Regulations, which require the FIRS to test transferprice transactions by reference to the “arm’s lengthprinciple” and enable it to adjust non-complianttransactions, are to be applied in a manner consistent withart.9 of the UN and OECDModel Tax Conventions5 andthe OECD’s Transfer PricingGuidelines forMultinationalEnterprises and Tax Administrations.6

Scope of the RegulationsThe Regulations apply to “controlled transactions”between “connected taxable persons”.7 A controlledtransaction means a commercial or financial transactionbetween connected taxable persons.8 Such transactionsinclude those relating to sale or purchase of goods andservices; sales, purchase or lease of tangible assets;transfer, purchase, licence or use of intangible assets;provision of services; lending or borrowing of money;and manufacturing arrangements.9

The phrase “connected taxable persons” coversindividuals, entities (both corporate and non-corporate),joint ventures and trusts, and includes “associatedenterprises” within the meaning of art.9 of the OECDModel Tax Convention.10 For the purposes of theRegulations, permanent establishments are to be treatedas separate entities and any transaction between apermanent establishment and its head office or otherconnected taxable persons is a controlled transaction.11

Duty to comply with arm’s length principleThe “arm’s length principle” means:

“[T]he principle that the conditions of a controlledtransaction should not differ from the conditions thatwould have been applied between independentpersons in comparable transactions carried out undercomparable circumstances”12

Where a connected taxable person has entered into aregulated transaction or a series of regulated transactions,that person is under a duty to ensure that “the taxableprofit resulting from the transaction or transactions is ina manner that is consistent with the arms lengthprinciple”.13

1 See for instance, D. Kar and D. Cartwright-Smith, “Illicit Financial Flows from Africa: Hidden Resource for Development” (Report, Global Financial Integrity, March2010).2Federal Republic of Nigeria Official Gazette No.77 Vol.99 (September 21, 2012). The FIRS made the Regulations in the exercise of powers conferred on it by s.61 of theFederal Inland Revenue Services (Establishment) Act No.13 of 2007.3Regulations reg.2(a).4Regulations reg.2(b).5Regulations reg.11(a).6Regulations reg.11(b).7Regulations reg.3(1).8Regulations reg.19(i).9Regulations reg.3(1).10Regulations reg.10.11Regulations reg.3(2).12Regulations reg.19(b).13Regulations reg.4(1).

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Methodologies and comparability factorsThe Regulations contain a list of the alternativemethodologies that parties to a controlled transactionmayuse in determining whether the pricing of the transactionis consistent with the arm’s length principle. These arethe same are as those prescribed by the OECD and UNmodels.14 The “most appropriate method” must be usedtaking into account a number of enumerated factors,15

including the availability of reliable information neededto apply a particular transfer pricing method.16 A transferpricing method not listed may be used if the taxpayer canestablish that none of the listedmethods can be reasonablybe applied to determinewhether the pricing of a controlledtransaction is consistent with the arm’s length principle17

and that the alternative method produces a result that isconsistent with that principle.18

In determining whether the conditions of a controlledtransaction are consistent with the arm’s length principle,the taxpayer must, in the first instance, ensure that thetransaction is comparable with a similar or identicaltransaction between two independent persons carried outunder sufficiently comparable conditions having regardto a number of specified factors.19 For these purposes, anuncontrolled transaction is comparable to a controlledtransaction when there are no significant differencesbetween the two under comparable circumstances thatcould materially affect the conditions being examinedunder the appropriate transfer pricing method.20 Whendifferences exist, reasonably accurate adjustments mustbe made in order to eliminate or reduce the effects ofthose differences.21

Advance pricing agreementsIf a connected taxable person wants to have certaintyregarding the acceptability of the transfer pricingmethodused, it may request the FIRS to enter into a time-relatedadvance pricing agreement (APA) to establish “anappropriate set of criteria for determining whether aperson has complied with the arms length principle [withrespect] to future controlled transactions undertaken bythe person over a fixed period of time”.22

The FIRS may enter into an APA with the requestingtaxable person either alone or “with the competentauthority of countries of the connected taxable person”.23

Thus an APA can be used to address double taxationissues in a situation where the transfer pricing transactionis between a company resident in Nigeria and anassociated company resident in another jurisdiction.Any request for an APA must be accompanied by a

description of the transactions to be addressed by theagreement; a proposal for determining the transfer pricesfor those transactions; a list of any countries wishing toparticipate in the APA; and the cumulative amountresulting from the controlled transaction concerned inevery year of assessment.24

The FIRSmay accept, modify or reject a request madefor an APA after taking into account the “expectedbenefits” from the agreement.25 In any case where theFIRS accepts or modifies a proposal for an APA, it may,by means of a term in the APA, provide confirmation thatno transfer pricing adjustment will be made to thecontrolled transaction covered by the APA if thetransaction is consistent with that APA.26 However, theFIRS may, by notice, cancel an APA if there has been: abreach of a “fundamental term” or an underlying criticalassumption; a material change in the relevant tax law; orwhere the APA was induced by misrepresentation ormistake.27 A connected taxable person is also entitled tocancel an APA in specified circumstances.28

Transfer pricing documentation anddisclosureA connected taxable person must record in writing orelectronic medium sufficient information and analysis toverify that the pricing of a controlled transaction isconsistent with the arm’s length principle.29 Thisdocumentation must be in place prior to the due date forthe filing of the income tax return for the year in whichthe documented transaction occurred.30 If the FIRS sorequests, the taxable personmust make the documentationavailable within 21 days after the filling of the company’sannual tax returns. Additionally, at the time of filing theannual tax return the company must file a transfer pricingdisclosure.31 Here the connected taxable person must

14Regulations reg.5(1); i.e. the comparable uncontrolled price method, the resale price minus method, the cost-plus method, transactional profit split method, and thetransactional net profit method.15Regulations reg.5(2)(a)–(d).16Regulations reg.5(2) Other relevant factors are the respective strengths and weaknesses of the transfer pricing method used in the circumstances of the case; the natureof the controlled transaction having regard to the functions to be performed, asset employed and risks assumed by the parties; and the degree of comparability betweencontrolled and uncontrolled transactions.17Regulations reg.4(a).18Regulations reg.4(b).19Regulations reg.9(4).20Regulations reg.9(3)(a).21Regulations reg.9(3)(b).22Regulations reg.7(1).23Regulations reg.7(5).24Regulations reg.7(2).25Regulations reg.7(3).26Regulations reg.7(6).27Regulations reg.7(8).28Regulations reg.7(9).29Regulations reg.6(1).30Regulations reg.6(5).31Regulations reg.6(6).



disclose all regulated transactions undertaken, indicatewhether the prescribed transfer pricing documentation isin place and state whether the Regulations have beencomplied with.

Assessment and adjustment of transferpricingIt is for the FIRS to determine whether the taxable profitresulting from a controlled transaction complies with thearm’s length principle. In examining that question, theFIRS must base its review on the transfer pricing methodused by the taxable person “if such method is appropriateto the circumstances”.32Where the FIRS consider that theconditions imposed by a connected taxable person in acontrolled transaction are not in accordance or consistentwith the arm’s length principle, reg.4(2) requires the FIRSto make “adjustments necessary”.33 The Regulations donot elaborate on what this will entail but, having regardto reg.14, which provides for review of such adjustments,it is clear that the Regulations contemplate that in such asituation the FIRS will adjust the transfer price to reflectto the open market price and then issue a draft taxassessment reflecting the adjustment.

Dispute resolutionThe Regulations require the FIRS to establish an internal“Decision Review Panel” (the Panel) for the purpose ofresolving “any dispute or controversy arising from theapplication of the Regulations”,34 comprising the head ofthe FIR’s Transfer Pricing Department and two otheremployees of the department of at least deputy directorrank. 35

A taxable person may, within 30 days of receipt of adraft assessment, refer the assessment to the Panel forreview.36 The Panel must issue a decision in the form ofa formal assessment within three months, taking intoaccount the basis on which the draft assessment wasissued, the taxable person’s objections and the evidence

presented “by the parties”.37 In the event that a connectedtaxable person does not refer a draft assessment to thePanel within the prescribed period, the Panel must proceedto issue an assessment giving effect to the draftadjustment.38

The decision of the Panel on any assessment before itis “final and conclusive”, but the taxpayer is entitled torefer the matter to a court of competent jurisdiction.39

Double taxation—corresponding adjustmentsWhere a competent authority of a country with whichNigeria has a double taxation treaty makes an adjustmentto the taxation of a controlled transaction that results intaxation in that other country of income or profits thatare also taxable in Nigeria, the FIRS may upon requestby the connected taxable person subject to tax in Nigeria,determine whether the adjustment is consistent with thearm’s length principle. If so, the FIRS may make acorresponding adjustment to the amount of tax chargedin Nigeria on the income so as to avoid double taxation.40

Offences and penaltiesA taxable person who contravenes any of the provisionsof the Regulations is liable to “a penalty as prescribed inthe relevant provision of the applicable tax law”. By virtueof the Companies Income Tax Act, an applicable law forthese purposes, failure to have in place the prescribedtransfer documentation or to file a transfer pricingdeclaration is potentially an offence attracting a fine onconviction.41 Also, where the FIRS has made anadjustment to a transfer price, failure to pay the additionaltax required within the prescribed period would attract apenalty of 10 per cent of the unpaid or underpaid tax.42

Ultimately, the directors and officers of the companyconcerned could incur criminal liability unless they wereable to show that the default took place without theirknowledge, consent or connivance.43

32Regulations reg.5(3).33Regulations reg.4(2).34Regulations reg.14(1).35Regulations reg.14(2).36Regulations reg.14(3).37Regulations reg.14(4).38Regulations reg.14(5).39Regulations reg.14(6).40Regulations reg.8.41Regulations reg.13 read with the Companies Income Tax Act s.92(1).42 Federal Inland Revenue Service (Establishment) Act (Cap. F.36) s.32.43 Federal Inland Revenue Service (Establishment) Act s.49.

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Let thembe liable—bearthe equivalentresponsibility forauditors’ returnTsui Tat Chee*

Auditors; Auditors’ powers and duties; Comparativelaw; Criminal liability; Duty of care; Financial reporting;Hong Kong; Professional liability; Shareholders

A proposal for reform of the CompanyOrdinance in HongKong, the largest market of initial public offering (IPO)of the world,1 has provoked strong objections fromprofessional accountants and, at the same time, offers anopportunity to review auditors’ liabilities, in particularthose towards individual shareholders in common lawjurisdictions after recent financial scandals.

The new auditors’ liability section in HongKongClause 398, “Auditor’s opinion on other matters”,introduced by the Hong Kong Government, states that:

“A company’s auditor must state the auditor’sopinion in the auditor’s report if the auditor is of theopinion that … the financial statements are not inagreement with the accounting records in anymaterial respect.”2

Clause 398(3) adds:

“If a company’s auditor fails to obtain all theinformation or explanations that, to the best of theauditor’s knowledge and belief, are necessary andmaterial for the purpose of the audit, the auditor muststate that fact in the auditor’s report.”3

Clause 399, “Offences relating to contents of auditor’sreport”, proposes that:

“If a statement required to be contained in anauditor’s report under section 398(2)(b) or (3) isomitted from the report an offence is committed byeach individual who … knowingly or recklesslycauses the statement to be omitted.”4

In short, auditors may be liable for a mistake which causesnecessary and material misleading if they knowingly orrecklessly commit such a mistake.The Hong Kong Institute of Certified Public

Accountants (HKICPA), the only statutory professionalbody in the territory, has argued that such legislation isnot necessary. It further suggests that even if theGovernment insists on imposing criminal liabilities onmistakes auditors commit, mere knowledge orrecklessness should not be sufficient. An act of dishonestymust be proven in order to constitute a criminal charge.The Financial Services and the Treasury Bureau did

not concur with the HKICPA’s view, with the followingreply:

“[T]he person who ‘knowingly or recklessly’ causesthe required statement to be omitted would be liable.In this regard, mere negligence would not constituterecklessness. To fall within ‘recklessness’, a personshould be suspicious of certain matters butdeliberately avoids finding out the truth. Hence,‘knowingly or recklessly’ is already a high thresholdwhich, while seeking to enable users of financialstatements to be better informed, avoids theprovision being too onerous for auditors.”5

Comparing this with the criminal obligation, it is moreurgent to consider the civil liabilities of auditors toindividual shareholders, not only because they require alower level of proof than criminal charges, but also inview of the fact that the general public lost their savingin a series of financial scandals in the early 21st century.

Civil liabilities of auditors’ opinions

BackgroundIt seems that auditors’ duties, in particular the civilliability towards individual shareholders, are minimalcompared with their income in some common lawjurisdictions.The principle of auditors’ liability in the British courts

stems from Denning L.J.’s view in Candler v Crane,Christmas & Co,6 which is widely applied in commonlaw countries such as England,7 Australia8 and HongKong.9

The major concern as to why individual investorsshould be excluded from auditors’ liabilities in negligenceis that:

*BBA (CUHK), JD (CityUHK), LLM (UC Berkeley), LLM (Hamburg), LLM (Bologna), MA (Vienna), PhD Candidate (TCD), is a consultant of the Standard Law Firm,Shenzhen.1Pricewaterhouse Cooper Hong Kong, “Hong Kong tops leading IPO destination for three consecutive years” (January 4, 2012), http://www.pwchk.com/home/eng/pr_040112.html [Accessed June 28, 2012].2Companies Bill, C7 (2012) cl.398(2) (HK), http://www.legco.gov.hk/yr10-11/english/bills/b201101141.pdf [Accessed July 17, 2013].3Companies Bill cl.398(3).4Revised Companies Bill cl.399(1), http://www.legco.gov.hk/yr10-11/english/bc/bc03/papers/bc030526cb1-1979-2-e.pdf [Accessed July 17, 2013].5 Financial Services and the Treasury Bureau, Bills Committee on Companies Bill Administration’s Response to Deputations’ Views on Clause 399 (Revised)CB(1)1979/11-12(02), http://www.legco.gov.hk/yr10-11/english/bc/bc03/papers/bc030526cb1-1979-2-e.pdf [Accessed July 17, 2013].6Candler v Crane, Christmas & Co [1951] 2 K.B. 164 CA.7 See Caparo Industries Plc v Dickman [1990] 2 A.C. 605.8 See Esanda Finance Corp Ltd v Peat Marwick Hungerfords (1997) 71 A.L.J.R. 448 (Australia).9 See Leung Alfred Cheuk Wah v Ernst & Young LLP, China/ Hong Kong (2005) 390 (Hong Kong).



“These considerations amply justify the conclusionthat auditors of a public company’s accounts oweno duty of care to members of the public at largewho rely upon the accounts in deciding to buy sharesin the company. If a duty of care were owed sowidely, it is difficult to see any reason why it shouldnot equally extend to all who rely on the accountsin relation to other dealings with a company aslenders or merchants extending credit to thecompany.”10

The circumstances in the United States are morecomplicated: the first milestone case addressing auditors’liability is Ultramares Corp v Touche,11 where auditors’liability only covered third parties who were actuallyknown and identified beneficiaries of the audit, a situationwhich was quite similar to that in Candler.The New Jersey Supreme Court expanded the liability

in Rosenblum Inc v Adler,12 in which auditors were liablefor ordinary negligence to all third parties that they couldreasonably foresee as users of the financial statementsfor routine business purposes.Nonetheless, the California Supreme Court introduced

a contrary view in Bily v Arthur Young & Co,13 thatauditors owed no general duty of care regarding theconduct of an audit to persons other than the client. Theprinciple went back to that in Candler.

Denning’s misunderstandingsIn order to answer the conflict between Rosenblum andBily, the only solution is to examine investors’ behaviourof relying on the auditors’ report and its reasonablenessin reality.Auditors’ liabilities should not cover individual

shareholders’ interest unless the answers to Denning L.J.’sconcerns are positive. First, should auditors owe theshareholders a duty? Secondly, do individual shareholdersrely on reports that the auditors produce? And thirdly, isit affordable for them?The economist Adam Smith provides a perfect answer

to the first question:

“[I]t is not from the benevolence of the butcher, thebrewer or the baker, that we expect our dinner, butfrom their regard to their own interest. We addressourselves, not to their humanity but to their self-love,and never talk to them of our own necessities but oftheir advantages.”14

No liability comes from a vacuum. It is not harsh toimpose such a liability on auditors, when the potentialcost of such responsibility comes only as a part of theirremuneration every year.Auditors’ remuneration, in substance, is paid from

companies’ profit that is the interest of the companies’owner. Therefore it is difficult to justify that there is norelationship of proximity between auditors andshareholders.The answer to the second question is that information

is easily available to individual shareholders ineducational materials from most of the securitiesauthorities. Contrary to the view of Denning L.J. that itis not certain whether investors rely on the auditors’reports when making a decision, securities authorities,including those in the United States15 and Hong Kong,16

encourage investors to “do their homework” before theyinvest. As an essential component of the annual report ofa company,17 it is difficult to justify investors not relyingon the auditors’ report especially when the annual reportis the major material for the public, as an outsider, tounderstand the subject-matter of investments inaccordance with the advice of the securities authorities.As for the third question, of course it is impossible for

the auditor to identify which specified individuals relyon its audited report for making an investment decision,but there must be a group of people, namely theshareholders, who invest in the company. The auditedreport is an essential element so that such a group canconsider whether they should invest in the auditors’ client,the company.Is it too far-fetched for auditors’ liabilities to cover

such a group? It is not true to the extent that the groupdoes not cover people who intend to invest in thecompany but then decide not to purchase stock. Onlypeople who become shareholders when purchasing thestock may act. The scope of the latter is certain andlimited, as the number of shareholders is just limited topeople who really obtain the stock, and the amount is asmuch as they invest, instead of the uncertain liability thatDenning L.J. worries about.From these three issues it is clear that Denning L.J.’s

view on investors’ behaviour is not true, at least in themodern investment environment. At the same time hemay overestimate auditors’ liability towards individualshareholders when it is limited to the true investors insteadof “the whole world”.

10Caparo v Dickman [1990] 2 A.C. 605 at 623 (per Lord Bridge of Harwich).11Ultramares Corp v Touche 255 N.Y. 170, 174 N.E. 441 (1931).12Rosenblum Inc v Adler 93 N.J. 324, 461 A. 2d 138 (1983); 461 A.2d 138 (N.J. 1983).13Bily v Arthur Young & Co 3 Cal. 4th 370, 11 Cal. Rptr 2d 51, 834 P. 2d 745 (1992).14Adam Smith,Wealth of Nations (1776) Ch.2, http://www.econlib.org/library/Smith/smWN1.html#B.I%2C%20Ch.2%2C%20Of%20the%20Principle%20which%20gives%20Occasion%20to%20the%20Division%20of%20Labour%2C%20benevolence [Accessed July 17, 2013].15US Securities and Exchange Commission, “Five Questions to ask before You Invest”, http://investor.gov/investing-basics/guiding-principles/five-questions-ask-before-you-invest [Accessed July 17, 2013].16HongKong Securities and Futures Commission,DrWise’s guide to investment homework”, http://www.invested.hk/invested/en/html/section/dr_wise/2009articles/homework_apr09.html [Accessed July 17, 2012].17US Securities and Exchange Commission, Annual Report (10K), http://investor.gov/glossary/glossary_terms/annual-report-10k [Accessed July 17, 2013].

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Criminal liabilities of auditors’ opinionsFrom the case of Arthur Andersen LLP v United States,18it is not difficult to find that, because criminal chargesrequire proof beyond all reasonable doubt, auditors willnot held criminally liable simply because of their client’scollapse. The concern of HKICPA that the “auditprofession is put under a criminal penalty regime for anomission in its professional work without need to proveany dishonest intent” is exaggerated.For the charge that someone “knowingly uses

intimidation, threatens, or corruptly persuades anotherperson, or attempts to do so, or engages in misleadingconduct toward another person under Tamperinng witha Witness, Victim or an Informant”,19 the prosecutionmust provide that:

“A ‘knowingly … corrup[t] persaude[r]’ cannot besomeone who persuades others to shred documentsunder a document retention policy when he does nothave in contemplation any particular officialproceeding in which those documents might bematerial.”

In practice it is not easy to regard it as a breach of dutyfor auditors if they perform the tasks properly, which isunder an objective test that:

“Generally, an accountant must possess the skillsthat an ordinarily prudent accountant would haveand must exercise the degree of care that anordinarily prudent accountant would exercise.”20

It is much easier to explain this in a matrix format withfour quadrants. Under this principle, auditors may fit intoone of the four:

1. auditors perform properly, no materialerror;

2. auditors perform properly, material error isnot found;

3. auditors perform improperly, no materialerror;

4. auditors perform improperly, material erroris not found.

Surely an auditor is not liable under the perfect situationin (1), and luckily there is no error indeed in situation (3).The argument lies mainly in situations (2) and (4).According to the objective test, how does an accountant

satisfy the test of “exercis[ing] the degree of care that anordinarily prudent accountant would exercise”, in orderto release his/her liability in situation (2)?To give a practical example: when auditors are not

satisfied with the result of the performance of auditsampling, they should request the client to investigate,

expand the sample size or perform alternativeprocedures.21 If the auditors have performed reasonablesteps to ensure their work reaching a reasonable standardin the eyes of a reasonable accountant, there is no dutyeven though there is a material error, as in situation (2).On the contrary, if the auditors fail to perform further

procedures to find out the error when the result of auditwork done is not satisfactory, and suggest adjustment ordisclosure in order to achieve an opinion in a true andfair view, it is reasonable for the legislative authority tosuggest that auditors may be subject to criminal liabilities,as in situation (4).

ConclusionWhen it is nearly impossible to achieve the ideal Paretoefficiency, that interventions in the market cause at leastone individual to be well off and no one is harmed,Nicholas Kaldor and John Hicks suggested theKaldor-Hicks efficiency as an objective of policy: theyallowed changes in which there are both winners andlosers, but required that the gainers gain more than thelosers lose.22

It is clear that ensuring reliability of financial reportswill increase the interests of investors, as the Hong KongGovernment has emphasised.23 However, we should notimpose additional liability on auditors simply becausethe benefits of investors policy produce excessive losson the part of auditors, as lawmakers should also considerfairness and reasonableness, rather than focusing onefficiency as economists.From the analysis above, it is clearly unfair if auditors

owe no civil liability towards individual shareholders, asthe courts do not realise that audited financial statementsare a foundational material for shareholders to considerwhere they invest their money. The judges alsooverestimate the auditors’ potential liability when thenumber of people eligible to claim and the amount islimited by actual investment instead of “open to the wholeworld”.Imposing civil liability on auditors in this circumstance

does not exploit the auditors’ interest; rather, it merelyadjusts their liability to the same level as their return, asshareholders are the true payers of auditors’ remuneration.In terms of criminal liability, it is the general direction

of financial regulation in the past decade that people inthe financial market should take responsibility for theinformation they provide. After the Enron scandal,directors of companies bear personal responsibility underthe Sarbanes-Oxley Act s.404. Strangely, though auditorsacted in a key role in a series of scandals, they do not bearan equivalent liability in the reform.

18Arthur Andersen LLP v United States 544 U.S. 696 (2005).19 18 USC §1512(b)(2)(A)(B).20Clarkson Kenneth, Miller Roger and Jentz Gaylord,West’s Business Law: Text and Cases, 11th edn (Baker & Taylor Books, 2011), p.1085.21 International Federation of Accountants, International Standard on Auditing 530, Audit Sampling, http://www.ifac.org/sites/default/files/downloads/a027-2010-iaasb-handbook-isa-530.pdf [Accessed July 17, 2013].22Roger Van den Bergh and Peter Camesasca, European Competition Law and Economics: A Comparative Perspective, 2nd edn (Sweet & Maxwell, 2006), p.30.23 Financial Services and the Treasury Bureau, Bills Committee on Companies Bill Administration’s Response to Deputations’ Views on Clause 399 (Revised)CB(1)1979/11-12(02), http://www.legco.gov.hk/yr10-11/english/bc/bc03/papers/bc030526cb1-1979-2-e.pdf [Accessed July 17, 2013].



In the legislation the Hong Kong Government suggestspaving the first step in the right direction towardsenhancing market efficiency by ensuring the accuracy ofinformation. It would be even better if it consideredindividual shareholders’ loss because ofmisrepresentationfrom audited financial statements.

Such reforms should also be considered by lawmakersin other common law jurisdictions, since reform of thefinancial environment, in particular the protection ofindividual shareholders’ interest, is a major concern afterthe financial scandals in the early 2000s.24

24 Subject to minor amendment, the bill was passed and came into force at the end of 2012. The statutes and related information are available on the web-page of HongKong Companies Registry, http://www.cr.gov.hk/en/companies_ordinance/index.htm [Accessed August 4, 2013].

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Transfer Pricing In Nigeria

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