The Correlation of Contract and Corporate Law

Sukhanov Yevgeny A., Doctor of Law, Professor, Honoured Worker of Science of the Russian Federation, Juris Doctor Honoris Causa of the Cyril and Methodius University of Skopje (Macedonia), Head of Civil Law Department of the Law Faculty, Lomonosov Moscow State University, Moscow, Russia

The article considers the issues of interrelation between contract law and corporate law in light of the current changes in the Russian civil legislation. Corporate relationships are known to be a component of the object of civil-law regulation (Art. 2(1) of the RF Civil Code). The article analyses such concepts as corporation, corporate agreements, private and public companies. This is a comparative research by means of comparative analysis of the RF Civil Code and civil legislation of Europe (Austria, Germany, France), the USA and England. The author believes that the new corporate law of Russia should be based on general approaches of the European type of regulation with the account of differentiation between contract law and corporate law.

Key words: corporation, contract, corporate agreement, Civil Code, minority shareholders, public and private companies.

Corporate law was reinstated as an integral part (sub-branch) of Russian civil law in the course of reforming the Civil Code of the Russian Federation (hereinafter referred to as the Civil Code) pursuant to Order No. 1108 of the President of the Russian Federation ‘On Improvement of the Civil Code of the Russian Federation)[1] dated July 18, 2008. According to Clause 1 Article 2 of the Civil Code (as amended by Federal Law No. 302-FZ[2] dated December 30, 2012), corporate relations are now expressly named as a part of the civil law subject-matter. Federal Law No. 99-FZ[3] dated May 05, 2014, provides the division of legal entities into corporate and unitary organizations (Article 65¹ of the Civil Code), Articles 65¹ to 65³ of the Civil Code provide general provisions on corporations, Articles 66 to 68 of the Civil Code substantially expand general regulations applicable to basic commercial corporations – companies and partnerships, and Article 123¹ of the Civil Code provides general provisions applicable to non-profit corporations. Thus, the General Section of Corporate Law as an independent sub-branch of Russian civil law is actually formed.

However, the problem of correlation between corporate law and contract law has arisen, inasmuch as corporation is caused to be created by virtue of civil-law agreement entered into by and between its founders (future members) (or unilateral deed of sole founder, as applicable to single founder companies). In terms of partnerships, the aforesaid agreement determines general organization of their business, and thereby is considered as a charter. As of today, the most common types of commercial corporations – joint-stock companies and limited liability companies – widely use corporate agreements, i.e. agreements entered into by and between their respective members. At the same time, corporate relations as an independent part of civil (private) law subject-matter take a special civil-law form, not reduced to the rules of contract law, which is based on the ‘freedom of contract’ principle, while contract law, first of all, has to protect the interests of corporate minority shareholders, as well as those of third-party creditors. That is why it unavoidably needs imperative regulations extrinsic to contract law.

The aforesaid circumstances are evaluated with the use of two fundamentally different approaches. Those advocating relative corporate law independence (within the scope of civil law) usually invoke special corporate legal nature of both articles of incorporation (partnership) and corporate agreements. Indeed,  corporation is caused to exist by the implementation of a partnership contract, but it is neither a party thereto, nor, technically, bound by the terms and conditions thereof, although its will is driven by resolutions jointly adopted by the parties to (members of) such contract. That situation is caused by a special legal nature of a partnership contract long ago mentioned in the European legal doctrine. A partnership contract is a special organizational, rather than barter, type of agreement, disabling the application of a number of general rules of law of obligations to relations that have arisen out of it. It is generally accepted by the German civilistic doctrine that a partnership contract, as obligation and right agreement entered into by and between the parties mutually obliged to each other (thereby providing the application of some general rules of law of obligations thereto), may not be considered as one of those common ‘agreements of exchange’ (schuldrechtlicher, aber kein Austauschvertrag), due to which general rules of contract law may apply to substantially limited extent[4]. That is why the relations caused to exist by a partnership contract have to be considered not as common contractual (obligation binding) civil-law relations, but as special corporate ones.

Shareholder agreements have become a part of European corporate law as stemmed from U.S. law, where those are applied as articles of partnership (incorporation) and at the same time – corporate charters. The European approach is based on the premise that certain members of business entity may act as legitimate holders of shares (participatory interests), dispose of them , as well as determine the procedure for their alienation (usually – by way of providing somebody with priority right to their acquisition), and/or procedure for the realization of corporate rights vested into their respective shares (participatory interests) (such as, first of all, right to vote, i.e. to participate in the management of company’s business). However, only that circumstance does not transform the aforesaid contracts into corporate deeds (otherwise, corporate deeds could include, e.g., testaments providing the transfer of testator’s shares to his/her heirs). Those are of ‘obligation and right’ nature, and legal relations caused to exist thereby are contract-binding, but not corporate.

That rule is generally accepted by European civil law. It, inter alia, provides that corporate agreements, as one of the types of civil-law agreements, cause obligations binding upon their respective parties, but not upon corporation in general. Consequently, where such agreement is breached by a party thereto, it may incur contractual liability in the form of obligation to reimburse for damages, or pay a pre-agreed penalty. However, both voting results and resolutions adopted by corporation will remain valid and may not be subject to a dispute even if those are in conflict with terms and conditions of the corporate agreement.

Some contractual relations related to business of modern joint-stock companies are sometimes mistakenly classified as corporate relations. For example, in many developed European nomocracies, non-certificated shares are frequently issued and registered not by joint-stock companies, but by commercial banks providing services to such joint-stock companies. Correspondingly, in many instances relations between shareholders and joint-stock companies with respect to the acquisition, alienation and use of such shares are transformed into strictly obligatory (contract-based) relations between ‘investors’, i.e. buyers and sellers of such shares, and commercial banks. However, ‘paperless asset’ acquirers and alienators have actually no relations with joint-stock companies that have issued the asset. They are only formally considered as members of such companies and subjects of corporate relations. At the same time, relations between shareholders, joint-stock companies and banks are actually obligatory, but not agreed upon.

On the other hand, there are some demands to ensure the most comfortable business environment and remove unfeasible ‘administrative burden’, usually including imperative legal requirements, providing mandatory registration of corporations with state register, payment of minimum authorized capital, corporate management structure, competence of corporate management bodies, etc. A special role is assigned to the wide application of corporate agreements together with use of intra-corporate ‘internal regulations’ (similar to U.S. business judgment rules). In the aggregate, these arrangements have to replace imperative regulation of company status and make contractual (non-mandatory) regulation governing with respect to both intra-corporate relations, and relations between corporations and third parties (creditors). By using that approach, traditional corporate law will eventually be gradually replaced by contract law with its fundamental ‘freedom of contract’ principle, which will inevitably result in maximum liberalization and optionality of the content of corporate law regulation.

So, the proposed ‘replacement’ of imperative rules peculiar to corporate law with those of ‘non-mandatory’ nature raises the question of feasibility of corporate law existence. That approach was successfully described by one of modern German researchers as follows: so what, ‘Goodbye and farewell to corporate law welcome and hail to contract law? Let the magic of the markets work its wonders? Could it really be that simple? Have generations of continental geniuses of company law gone utterly wrong and in an absolutely misleading direction?"[5]. The answer to these questions largely depends on the results of analysing the legal nature of corporate agreements playing various roles in European civil and U.S. and British corporate law.

For a long period of time, the Western European doctrine classified the aforesaid agreements as one of the types of simple partnership agreements focused on the achievement of a joint objective. That is why they were often named as ‘syndicate agreements’ (Syndikatsverträge). Only during the last two decades that approach has become open to question, inasmuch as ‘agreed-voting agreements’ are entered into not to achieve a joint business objective, but to ensure mutual influence on the corporation operations[6]. That is why they are often considered as ‘voting right binding agreements’ (Stimmrechtsbindungsverträge), or ‘shareholder binding agreements’ (Aktionerbindungsverträge), i.e., agreements for the realization of shareholders’ rights, and mostly – right to vote.

For example, in French corporate law the aforesaid agreements (conventions de vote) may technically be related only to voting of shareholders and only to a specific meeting (but not for a certain period of time) (fixed-term or open-ended shareholders’ voting agreements may only apply in ‘simplified joint-stock companies’ – Société par actions simplifiée, SAS). So-called ‘preferential agreements’, restricting the transfer (alienation) of shares from one shareholder to another, have been used during the last few years, as well. However, contents of shareholder agreement in all cases must be known to corporation in general and financial market supervision authority[7].

It is generally accepted by European civil law that the aforesaid agreements may neither change the corporation structure imperatively established by the law, nor debar any person from voting, acquire any person’s vote, or otherwise misuse the granted right, or act in a manner conflicting with ‘good practices’ (gegen die guten Sitten). In addition, they usually disallow any third party, other than member of corporation, to be a party to such agreements, inasmuch as only the corporation members determine and form the corporation property, identify its business objectives, state them in the charter, and determine the fate of corporation; that is why only they may take part in the formation of the will of corporation (and third party may, by prevailing over the votes of members, have an opportunity to affect corporation resolutions, while the risk and consequences of such resolutions will be incurred by members of corporation, but not the said third party)[8]. In addition, such negative stance on the third party’s participation in corporate agreements is explained by the fact that such third party is not subject to traditional corporate obligations to act in an honest manner and to the benefit of corporation in general.

These agreements are most commonly encountered in Swiss legal practice. After a number of doubts, it has allowed an option for members of non-public joint-stock companies to enter into mutual agreements, providing not only agreed voting, but also preliminary or pre-emptive acquisition of shares, imposition of some additional duties on shareholders (abstention from mutual competition, non-disclosure of certain information), or granting of additional rights to them (right to information, or even right to participate in the adoption of certain resolutions). However, even here those are classified as obligation and right agreements for the realization of shareholders’ rights[9].

Modern German and Austrian legal practices consider the shareholder agreement provisions binding upon corporation as a whole if each and every member of corporation is a party to such agreement. That standpoint is criticized in literature, as it causes ‘multiple control’ of corporation status by its charter and corporate agreements without compliance with necessary ‘publicity directives’ (inasmuch as the contents of corporate agreement remain unknown to third parties, and especially – to corporation creditors), and also breaches the principle of ‘severance’ between personality and property of legal entity (corporation) and those of its members (participants)[10].

Basic principles of Western European corporate law include the principle of protection of creditors’ rights[11], but not the ‘freedom of contract’ principle. Continental European corporate law proceeds from the premise that the privilege of independent (agreement-based) corporation management may only have members of partnerships (associations) incurring full (unlimited) liability for their respective debts. In limited (and in point of fact – absent) liability corporations, the management structure is formed by legislator seeking protection of proprietary interests of third parties and minority shareholders. So, it is assumed that the regulation mechanism of the corporate status ‘generally cannot be subject to discretion, as its modifications based on individual autonomy and replacement of certain keystones may cause the whole legal regulation building to collapse’. Parties to corporate relations are provided by legislator with a freedom of choice only among various corporation models established by it, combining both imperative and non-mandatory regulation, which to the fullest extent corresponds to the protection of interests of all members[12].

European approach conceptually differs from the U.S.-based law approach, providing an option of freely executed corporate agreement to establish any corporate management structure and enabling the participation therein for any third party subject to any conditions, i.e. with the widest application of the freedom of contract principle in corporate law. In terms of U.S. law, a corporation itself is usually seen as a contractual arrangement among its founders (members) having contractual (agency) relations with corporate management. So, the corporate structure is determined by its agency costs, i.e. expenses incurred in connection with the supervision over the operation of its corporate management acting in the capacity of an ‘agreed agent’ of corporation members. The aforesaid costs include monitoring costs – expenses incurred by investors in connection with monitoring  the managers’ operations, as well as indirect monitoring costs, i.e. expenses incurred in connection with loyalty warranties provided by such managers and prevention of potential damages from the management of inadequate quality. The extent of those costs is determined in a voluntary manner (agreed upon), i.e. based on market premises[13].

So, any state interference with the formation of corporate relations structure (in the form of imperatively established corporate management system) certainly becomes excessive and may only result in the creation of supervisory authorities, the maintenance of which  will cost  more than possible damages. From that point of view, mandatory (imperative) corporate regulation status is unnecessary, and even harmful, inasmuch as market relations themselves cause the most efficient monitoring effect. This is the source of demands for every possible liberalization and eventual deregulation of corporate relations, as well as postulates on contractual and legal nature of corporate status, which has only been formed by non-mandatory rules (based on the freedom of contract principle), i.e. most at the discretion of the parties thereto[14].

In the U.S. and British private limited or closed corporations with small number of members, some of them often act as corporation managers at the same time. In these cases, members have to enter not only into voting agreements, but also into those restricting the freedom of corporate boards of directors to adopt their respective resolutions. U.S. corporate law is traditionally focused on regulating the status of ‘public corporation’, and for a long period of time contained almost no rules concerning closed corporations. Special regulation of their status has only occurred in the Model Statutory Close Corporation Supplement (MSCCS) to the Revised Model Business Corporation Act, 1984 (RMBCA). §22 of the MSCCS provides an option for the complete replacement of closed corporation’s internal regulations with shareholders’ agreement entered into by shareholders of that corporation. In addition, Article 17 of the Companies Act 2006 also provides an option for the modification of company’s charter by shareholders’ agreement (to restrict powers of the board of directors, grant ‘reinforced right to vote’ to certain shareholders, determine the management structure other than provided in charter, etc.), having the only restriction for the compliance of shareholders’ agreement with ‘public order’ and third parties’ interests.  

However, the aforesaid agreements entered into by corporation members and restricting the freedom of corporate boards of directors to adopt their respective resolutions are in conflict with one of the key principles of U.S. corporate law, according to which it is the board of directors (but not members of corporation) that has to administer the affairs of corporation. Furthermore, those are often executed by majority shareholders against minority shareholders. That is why the U.S. court practice for a long time had a negative stance on shareholders’ agreements. For example, see Long Park, Inc. v. Trenton-New Brunswick Theatres Co., according to which all three shareholders agreed that one of them, owning half the shares, should have full authority to manage the corporation’s business for 19 years. The court considered that to be a major violation of the principle of managing the corporation’s business by the board of directors of that corporation only and invalidated the agreement.

However, when trying Clark v. Dodge case, according to which two members of ‘closed corporation’ have agreed that one of them should be its director and general manager as long as he was ‘faithful, efficient and competent’, the Supreme Court of the State of New York considered such restrictions of the freedom of action for the corporate board of directors as ‘insignificant’, inasmuch as the aforesaid manager at any time could be withdrawn by the board of directors should he discharge his duties improperly, e.g. as a result of obvious lack of skills. The Supreme Court of the State of Illinois in its widely known ruling on Galler v. Galler case (1964) pointed out that business management agreements may be entered into in ‘closed corporations’, provided that each and every member of corporation is a party to such agreement, contents and implementation of such agreement affects neither creditors’ interests nor those of minority shareholders of corporation, and the aforesaid agreement breaches none of statutory rules[15].

So, the U.S. court practice does not unambiguously admit any corporate agreements that cancel or replace any rules of corporate law. Although, since 1991 §7.32 RMBCA allows to order the board of directors of corporation to act in a certain manner by virtue of unanimous agreement of its members, U.S. corporate law actually does not provide such wide options for the contractual (non-mandatory) regulation of intra-corporate relations, invoked by its Russian advocates.

However, in general U.S. and British corporate law shows a high level of optionality in the legal regulation of non-public company status. Its basic objectives are other than the protection of creditors’ and minority shareholders’ interests, as those are protected either by the rules of contract law (creditors by themselves have to seek for the respective remedies, thereby securing the proper performance of obligations), or by the laws on insolvency and bankruptcy (within the scope of which the interests of minority members of corporations may be protected).

Modern business practice requires the maximum free regulation of limited liability corporation’s status, formed by agreements between its members. It has raised the questions as to admissibility of third parties (e.g., banks that lend to joint-stock companies, or venture funds) and corporations themselves (bound by agreements of all, or even the most part of, their members) to those agreements. That is why the Ministry of Economic Development of the Russian Federation, continuously expressing the interests of business people, persevered for the introduction of the respective modifications and supplements to the Civil Code of the Russian Federation and Federal Law ‘On Joint-Stock Companies’, having taken shareholders’ agreements, commonly encountered in U.S. and British corporations, as a model. At the same time, it has accepted a division inherent to U.S. and British corporate law - the division of business corporations into public and private companies, considered to be different forms of one and the same type of legal entities (corporations), and discarded the historically formed fundamental distinctions in European continental law with respect to joint-stock and limited liability companies. That approach of the Ministry of Economic Development of the Russian Federation was to a considerable extent embodied in the new version of the Civil Code.

The ‘corporate agreement’ rules for the first time appeared as far back as in 2008 in the Federal Law ‘On Limited Liability Companies’ (Clause 3 Article 8), and then – in 2009 in the Federal Law ‘On Joint-Stock Companies’ (Article 32¹) where they were expressly named as ‘agreements for exercising the  company members’ rights (or those certified by stock)’, for the most part concerning the right to vote at general meeting and right to alienate the stock or participatory interests. These rules disallowed any third party to be a party to such agreements, and provided them to be only binding upon members of corporation, but not upon corporation in general. In terms of their legal nature, the aforesaid agreements were civil-law agreements for the realization of shareholders’ rights, but not ‘corporate deeds’ determining the corporate management structure. However, some tried to substantiate the ‘dual legal nature of those agreements[16]’, thereby focusing on the expansion of their contents and field of application with due regard for the U.S. and British models. Later on, some tried to supplement the updated rules of the Civil Code with those providing unrestricted participation in the aforesaid agreements for both any third party and company in general, formalizing an option for challenging company resolutions adopted in violation of corporate agreement, as well as providing secret nature of their contents and even the fact of entering into them, the structure of members, etc.

The final version of Article 67² of the amended RF Civil Code provides that information on corporate agreement contents ‘shall not be disclosed and shall be confidential’, and the parties thereto shall only ‘notify the company’ of their actual entering into them. A breach of the corporate agreement terms and conditions may cause challenging of the respective resolutions of corporate bodies should all members of corporation be the parties thereto. So, in the amended version of the Civil Code, corporate agreements in terms of its form and content greatly differ from a civil-law agreement for the exercise of the corporate members’ rights, and to the large extent became similar to a ‘corporate deed’ for the management of corporation’s business.

However, as a result of its use, the management of corporation may be completely taken out of that corporation and concentrated in hands of any third party, incurring no obligations to members of corporation and corporation in general, which completely distorts the basics of corporate law. So, through the example of corporate agreement, one can see the results of attempting to replace or ‘merge’ corporate law with contract law by way of distorting the legal nature of civil-law agreement (‘corporate agreement’). The impairment of minority shareholders’ rights introduced to the benefit of big businesses (even other than those participating in corporation) will hardly contribute to the improvement of ‘investment environment’ in the Russian Federation. Approaches of that kind must become not only the subject-matter of critical re-evaluation on the part of the Russian legal science, but also be subject to unavoidable and substantial adjustment in terms of applicable law-enforcement practices.

It should be stressed as well that the ‘freedom of contract’ principle is not a common principle of civil (private) law: it applies neither to civil-law relations among an indefinite range of third parties (governed by law of things and ‘intellectual property’ right), nor to civil-law relations with the participation of an obviously weak party (governed by corporate law and consumer protection law -Verbraucherschutzrecht- thriving recently in European continental law). That is why new Russian corporate law must keep, as its general approach, the European continental type of corporate legal regulation based on differences between corporate and contract laws. This approach perfectly well meets both historic traditions of Russian law and modern economic realities, and thereby still remains promising.

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