Legal System Strategies against Self-Dealing

It is appropriate to note that self-dealing transactions traditionally fall within the scope of insider’s fiduciary duty of loyalty (Enriques, 2000, p. 5), that is, the duty to subordinate their own interests to those of the corporation whenever a conflict arises (Henn and Alexander, 1983). Often, the rationale for the regulation of self-dealing transactions is coincident with the rationale for the imposition of the duty of loyalty which is most often tackled with a set of anti-theft provisions. This argument is constant with the nature of self-dealing transactions, as discussed in the previous chapter, which do not necessarily result in damage to the corporation when there are fair transactions. However, in the case of unfair self-dealing transactions, the corporation suffers damage equal to the difference between its outcome and the hypothetical outcome of the transaction that would have been agreed upon by an independent decision-maker (Clark, 1986, p. 149). Accordingly, “one can generally describe self-dealing regulation as an attempt to prevent unfair self-dealing transactions from taking place” (Enriques, 2000, p. 14).

Based on this understanding, legal systems can employ different approaches to tackle self-dealing transactions. First is the prophylactic approach, in which no rule covers self-dealing as such, while the response to unfair self-dealing is only the recovery of damages to the corporation (the “pure liability system”) (Enriques, 2000). Second is a system which, again, does not regulate self-dealing per se, but provides for stronger responses if unfair self-dealing occurs. These systems entitle the corporation not only to damages, but also to the disgorgement in its favour of the profits made by the director. The problem of the above two systems just described is that they do not eliminate the incentives for a director to divert assets to themselves (Enriques, 2000, p. 14). This is illustrated by the fact that a director when deciding whether to enter into an unfair self-dealing transaction will compare the expected benefits they receive from the transaction with the expected costs imposed on them by the legal system in case of legal intervention. This  probability of incurring costs will normally be small (Cooter and Freeman, 1991) as probability of judicial settling-up, is limited due to information asymmetries which may prevent the corporation and its shareholders from successfully challenging an unfair transaction before a court (Enriques, 2000, p. 15).

This explains why some legal systems provide for some form of response to self-dealing as such by subjecting it to some procedural mechanism of ex ante control (“procedural rules”).  It also accounts for why some systems rely on stronger sanctions, such as criminal punishment, to prevent unfair self-dealing. Prohibitive and procedural rules serve the function of preventing unfair self-dealing only if they are combined with some form of sanction to be applied in the case of their violation, regardless of whether the transaction is unfair (Enriques, 2000, p. 14).

Djankov et al. (2008) propose two kinds of instruments for the protection of minority shareholders: public and private. Private enforcement involves mechanisms established on standards for information ex and post disclosure, transaction approvals and the capability of minority shareholders to take actions to the court. Public mechanisms focus for the most part on seeking out fines and sanctions in court.

Similarly, Conac et al. (2007) propose in three separate categorical mechanisms: (a) legal strategies against minority shareholders’ appropriations, subsuming ex ante rules and ex post standards, (b) solutions and actions that the legal system supplies to private parties thus to respond to self-dealing transactions (c) criminal sanctions against self-dealing. What follows is a brief discussion of these mechanisms by which legal systems can regulate corporate insiders self-dealing by looking at all the possible rules, doctrines and remedies.

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