Disclosure Rules and the Concept of Beneficial Ownership . 92

As noted above, the ownership structure affects agency costs and should be of interest to investors, and thus the capital market can potentially play a significant monitoring role. Market pressure would raise the capital costs of controlling shareholder structures without adequate internal control mechanisms, and this would correspondingly factor in the equation of benefits and drawbacks of maintaining a controlling position.

An important precondition for the capital market to monitor the ownership structure of a company is the disclosure of the shareholdings of those in control and ultimate shareholders. Under Article 25 of the Securities and Exchange Law, directors, supervisors, officers and large shareholders in possession of more than ten percent of all shares of a publicly issued company must report and disclose their holdings. They must also report any change of their shares. The calculation of shares held by shareholders includes those shares held under the names of their

spouses, minor children, and those held under the name of other parties.³² In the event that the juridical shareholder or its authorized representatives are directors or supervisors under Article 27, shares of them both are calculated.

To further facilitate the identification of the ultimate shareholders, publicly issuing companies must list their ten largest shareholders and also shareholders with over five percent of total shares in the prospectus.³³ Furthermore, in the case that directors or supervisors are juridical shareholders or their representatives, the juridical shareholder in question must disclose its ownership structure.³⁴ The disclosure to the public stops at the first level, regardless of whether the primary shareholders are also juridical persons. In practice, companies also voluntarily disclose the ownership structure of all juridical shareholders.

There are two problematic issues in the above framework. First, the level of disclosure of ultimate controlling shareholders is incomplete and may halt at the level of a juridical person, which could impart little information on the ultimate controller. Second, the criteria for calculating shares possessed are too inflexible and narrow. Taiwan has not adopted the comprehensive and broad definition of the concept of beneficial ownership under American law. To take an example, the shares owned by the holding company would not be attributed to its controlling shareholder in calculating the possession of the shares by the controlling shareholder for the purposes of disclosure. This case can not be covered by the phrase

“nominee”.

2. Cross-holdings a. Overview

Generally speaking, cross-holdings are structures in which firms own blocks of each others’ stocks. In discussing cross-holdings and their effect on control however, relevant financial literature has been narrower in scope, in which cross-holdings are defined as when the firm has both an ultimate owner and owns shares in its ultimate owner or in a firm that belongs to her chain of control.³⁵ This kind of cross-holdings easily allows controlling shareholders to magnify control in relation to equity investment, which can result in large deviations between ownership and

32. Securities and Exchange Law Article 22-2III; Securities and Exchange Law Enforcement Rules Article 2.

33 . Criteria Governing Information to be Published in Public Offering and Issuance Prospectuses, Article 11.

34. Id. at Article 10(1) iv.

35. LaPorta et al., supra note 1; Yeh, supra note 19, at 92-93.

control.³⁶ Empirical studies indicate that controlling shareholders in Taiwan commonly utilize this cross-holdings mechanism to enhance their company control rights.³⁷

However, cross-holdings falling outside this narrow scope can also enhance control to a certain extent, as insiders in otherwise unrelated corporations tend to vote for the incumbents. Therefore, both the narrower and more general forms of cross-holdings are important to constructing and maintaining a controlling minority ownership structure.

Cross-holdings have various recognized beneficial and detrimental effects. However, its negative effects are exacerbated in the case of subordinate companies holding the shares of the controlling company or other companies along the chain of control. Conversely, the benefits of strategic alliances and risk dispersal seem muted in this situation. Thus the balance of benefits and drawbacks is different in the two situations, and should be regulated separately.

b. Legislative Development

Prior to the 2001 enactment of Article 167 III and IV, only Article 369-10 of the Company Law dealt with inter-corporate cross-holdings. It regulates only cases of mutual investment companies, i.e. where a company and another company have invested in each other to the extent that one third or more of the total number of the voting shares or the total amount of the capital stock of each companies are held or contributed by the other. The requirements are twofold: notification to the target company and disclosure of holdings once they reach the one-third threshold, and the limitation of voting power to one third of all votes when criteria for mutual investment companies are met. This alleviates the entrenchment of control.

However as noted, cross-holdings between companies along the chain of control, should be subject to enhanced regulatory scrutiny. The case is even more strengthened by the fact that under Article 167I, subject to limited exceptions, a company is prohibited from buying back its own shares. To be consistent, a company should at the same time to be prohibited from engaging in such conduct through the conduit of its subordinate companies. Yet only Article 369-10 regulated cross-holdings and cross-holdings between companies along the chain of control would fall outside its scope when the subordinate company does not hold that many shares of its controlling company.

36. See, e.g., Bebchuck et al., supra note 3, at 457.

37. See Yeh, supra note 19, at 93 (finding that 40.1% of companies in the sample utilized the cross-holding mechanism).

The deficiency of the above framework prompted the 2001 enactment of Article 167III and IV, which explicitly prohibit the subordinate company from purchasing or accepting as a security in pledge, shares of the controlling company and shares of companies along the chain of control. This Article was not retroactive and previous purchases by the subordinate company were still valid. This was a cause for concern because many subordinate companies had already completed purchases of the controlling company or companies along the chain of control before the amendment. This was further dealt with by the 2005 amendment of Article 179, which stripped such shares of their voting rights. Article 167III and Article 179 override Article 369-10 in the event of overlap.

Thus Taiwanese law now rightly provides for separate frameworks for regulating cross-holdings along a chain of control and otherwise. An important remaining loophole is that the concept of “control” under Article 167 and Article 179 is still determined by the formalistic criteria of majority of the total number of outstanding voting shares or of the total amount of the capital stock which allows entrenchment through companies substantively subordinate companies. This differs from the Chapter of Affiliated Enterprise which adopts a substantive concept of control. Nevertheless, these amendments have raised the difficulty of magnifying control through cross-holdings and will rein in the most flagrant abuses. Another similar concern is whether the one-third threshold for mutual investment companies is set too high as one-third of shares are normally sufficient to exercise control.

3. Incorporating the Concept of Control a. Present Framework

The concept of substantive control entailing accountability is relatively unfamiliar under Taiwanese law. Article 8 of the Company Law focuses solely on the official positions in defining the responsible persons of a company. Article 27 in providing that representatives of juridical shareholders elected as directors or supervisors in their personal capacity could be replaced on the whim of the juridical shareholder, further contributed to the disconnect between control and accountability.

Prior to the 1997 enactment of the Chapter on Affiliated Enterprises, under Article 8, official position within the company was necessary for the establishment of legal liability under Taiwanese corporate law.³⁸ While controlling shareholders could theoretically be civilly liable under tort law for injury done intentionally in a manner against the rules of

38. Taiwanese Company Law Article 8, 23.

morals, the abstract concepts of tort law were too indefinite and difficult to prove in practice.

A reason for this neglect was perhaps because Article 178 of the Company Law already prohibits the voting of interested shareholders that may impair the company’s interests. This could in theory pose a potential barrier to abuse of control by controlling shareholders, but its application in practice has proved otherwise. The first difficulty is that any shareholder resolution inherently affects the company and its shareholders, and thus the concept of “interested” shareholder needs further clarification. To date, the standard provided has been whether the shareholder in question would gain legal rights or incur legal obligations from the resolution,³⁹ but this standard is still somewhat abstract and inadequate to prevent abuse by controlling shareholders. Second, this prohibition would seem to run counter to the normal economic goals of holding shares. Third and most relevantly, this Article does not apply to the election of directors and supervisors. Thus this Article does not prevent the controlling shareholder from exerting control through the designation of directors and supervisors and thus cannot avoid the need for accountability for controlling shareholders. Article 369-4⁴⁰ under the Chapter of Affiliated Enterprises is the only article under Taiwanese law that deals specifically with the responsibility of controlling shareholders outside official capacity. The definition of control in this Chapter is quite comprehensive and covers the concept of substantive control.⁴¹ A few observations should be highlighted:

The scope of this Article is limited to the case where both the controller and subordinate are companies. While the responsible person of the controlling company may be jointly liable with the controlling company,⁴² this is still extremely easy to evade as the ultimate controller would only have to avoid this position in the controlling company. The original draft sought to regulate to some extent the control of non-corporate entities (e.g. head coordinating office) but this was deleted from the final version.

The second significant feature of Article 369-4 is that rights toward the controlling company belong to the subordinate company, not the minority shareholders or creditors; minority shareholders or creditors may only bring derivative suits on behalf of the subordinate company.

39. DaliYuan Tong Zi No. 1766.

40. Article 369-4 of the Company Law: “In case a controlling company has caused its subordinate company to conduct any business which is contrary to normal business practice or not profitable, but fails to pay an appropriate compensation upon the end of the fiscal year involved, and thus causing the subordinate company to suffer damages, the controlling company shall be liable for such damages.”

41. Taiwanese Company Law Article 369-2, 369-3.

42. Taiwanese Company Law Article 369-4 II.

Third, this Article is significant in that it attempts for the first time to delimit the duty of the controlling shareholder. As seen, the controlling company does owe a duty, albeit exclusively to the subordinate company.

The determination of the detrimental nature of business or transaction is made by reference to the standard of an independent company.⁴³ This makes clear that Taiwanese law holds inter-group arrangements to the same standard of business between unrelated companies. The only leeway granted to controlled/subordinate companies is that appropriate compensation at year end may preclude liability, and represents an acknowledgment, by Taiwanese corporate law of the existence and importance of affiliated enterprises as an economic entity, a departure from the traditional viewpoint of individual companies as the regulatory unit. The content of this duty merits the discussion set out below.

First, as noted above, actions that are carried out for the interest of the corporate group would still fall under the term “contrary to normal business practice” and the only leeway allowed is that appropriate compensation can preclude liability. This regime is extremely hard to implement in practice as demonstrated through the German experience.⁴⁴ Difficulties such as determining and quantifying detrimental transactions aside, an important difficulty concerns the artificial projection of autonomous interests of the subordinate company in the context of comprehensive corporate group strategy.⁴⁵ This gives rise to the fundamental issue of the content of the duty of controlling shareholders and permeates the entire corporate governance framework. It is worth rethinking under the integrated operation of a corporate group, whether a member company may appropriately pursue not the company’s individual benefit, but the benefit of the corporate group as a whole.⁴⁶

Second, the purpose of granting the reprieve of year-end appropriate compensation was to accommodate intra-group arrangements economically beneficial to the corporate group as a whole. Yet this Article on its face permits the utilization of this mechanism for any arrangements regardless of their purpose. It remains a question under Taiwanese law

43. Kai Lin Faung, Legal Issues on the Regulation of the Chapter of Affiliated Enterprises of Abuse of Control Part I, 63 CHENGCHI LAW REVIEW 271, 303 (2000).

44. Gerard Hertig & Hideki Kanda, Related Party Transactions, in THE ANATOMY OF CORPORATE LAW, A COMPARATIVE AND FUNCTIONAL APPROACH 102, 124-126 (Reinier H.

Kraakman et al. eds., 2004).

45 . JOSE ENGRACIA ANTUNES, LIABILITY OF CORPORATE GROUPS, AUTONOMY AND CONTROL IN PARENT-SUBSIDIARY RELATIONSHIPS IN US, GERMAN AND EU LAW: AN INTERNATIONAL AND COMPARATIVE PERSPECTIVE 350-358 (1994).

46. See Hertig & Kanda, supra note 44, at 125 (discussing the well-know French Rozenblum case which held that a French corporate parent may legitimately divert value from one of its subsidiaries if three conditions are met: the structure of the group is stable, the parent is implementing a coherent group policy, and there is an equitable intra-group distribution of costs and revenues overall.)

whether a transaction improperly arranged for the personal benefit of the controller of the controlling company is covered by this Article and could avail itself of the reprieve of year-end appropriate compensation. If so, it would run counter to the objective of facilitating economically beneficial intra-corporate groups arrangements and accord too much discretion to controlling shareholders.⁴⁷ Moreover, in that case, the Article could paradoxically lower the duty of the controlling company under tort law.⁴⁸ The Article adds failing to pay appropriate compensation at the year end as a prerequisite of liability, which is not required under tort law.

It seems that this Article should be correctly interpreted as only applying to arrangements carried out for the economic benefit of the corporate group as a whole. However this conclusion would mean that the sole Article dealing with the liability of controlling shareholder does not impose any further responsibility, but only seeks to accommodate the economic reality of corporate groups.⁴⁹ Its ultimate result is only to clarify the ambiguity concerning whether actions carried out for the benefit of the corporate group as a whole could be legitimate. It does not regulate the egregious violations such as the tunneling of resources for the controlling shareholder’s personal benefit that is currently the more pressing issue of corporate governance.

Moreover, this Article is difficult to enforce as minority shareholders or creditors still bear the burden of proving general and abstract terms.

Controlled/subordinate companies’ business may be highly interconnected and may carry out innumerable transactions amongst themselves, and to pinpoint the disadvantage of specific transactions is extremely difficult.

Coupled with the high enforcement costs and litigation risks of the derivative suit, the enforcement mechanism under Article 369-4 is extremely weak.

Third, the wording of Article 369-4 is ambiguous on the whether the company would be liable for negligence toward the subordinate company.⁵⁰ As both controlling companies and directors exert control and should be held accountable, it is arguable that their duty toward the subordinate company should be the same as directors and include, inter alia, the duty of care.

b. Future Reform

When seeking to regulate the responsibility of controlling

47. Faung, supra note 43, at 295.

48. Id.

49. Id.

50. Ming Jye Huang,Reflections upon the Shareholder Limited Liability Regime, inLEGAL FRAMEWORK FOR PUBLICLY ISSUING COMPANIES AND CORPORATE GOVERNANCE 69, 111-118.

shareholders, the guiding principle should be the overlap of control and accountability. Many countries such as the United Kingdom and Korea have sought to resolve the issue of control and accountability by introducing the concept of “shadow director” or “de facto director”. The extent of the application of the concept of substantive control can vary.

For example, under the Korean version, the de factor director does not assume the duty of directors for the purposes of applying the provisions on self-dealing.⁵¹

Article 369-4 takes another approach by providing a separate regulation of conflicted shareholder transactions. However, most aspects of a controlling shareholder’s duty remain governed solely by tort law. A more simple and comprehensive approach would be perhaps to adopt the concept of shadow director and provide that those who directly or indirectly exert control over a company’s personnel, financial or operational matters assume the same duties as the company’s directors.

This would encompass the ultimate controller regardless of its form and automatically extend the duty of directors to the company or third parties.

Nevertheless, the rights accrue to the subordinate company under this approach. Therefore, the problems of high enforcement costs and derivate suits remain. A possible resolution would be to confer direct rights on creditors and minority shareholders toward the controlling shareholder and an inversion of the burden of proof to the defendant. Another lingering issue is the precise content of the controller’s or director’s fiduciary duty in the context of the pursuit of benefit to the corporate group as a whole.

4. Related-party Transactions

Controlling shareholders expropriate resources through their control of company organs, primarily the board. Thus, besides regulating the controlling shareholder directly, this expropriation could also be limited through procedural protections and liability imposed on directors of the controlled company.

a. Present Legal Framework

As discussed earlier, potential responsibility of the controlling shareholder regardless of his lack of official position is restricted to Article 369-4. Other law on related-party transactions all hinge on the

51. Kon Sik Kim & Seung-Wook Jeong, Controlling the Controlling Shareholders: Conduct, Structure, and Market, in RECENT TRANSFORMATIONS IN KOREAN LAW AND SOCIETY 153, 164 (Dae Kyu Yoon ed., 2000).

official position of the actor.

The departure point of the Company Law is the generally applicable rule Article 206, which applying mutatis mutandis the provisions of Article 178 on interested shareholders, prohibits interested directors from voting or voting on behalf of other directors on the matter in question if the company’s interests may be impaired. This provision seems on its face quite restrictive as the concept of “interested” seems broad, and the transaction in theory must be approved by disinterested directors. This in practice has proved a very weak constraint, but the framers of the Company Law presumably considered this mechanism adequate in most conflict of interest situations. Consequently, they only provided for further protection under Article 223 in very limited circumstances.

Article 223 of the Company Law provides that in the case that a

Article 223 of the Company Law provides that in the case that a