154 5 Equity and Shareholders’ Capital
Furthermore, the existence or absence of the legal capital regime does not
change the fact that certain controlling shareholders may always have incentives
to manipulate the balance sheet and an opportunity to expropriate the company’s
assets.^111 It can therefore be difficult to design a legal capital regime or an equity-
insolvency test that would adequately protect creditors when the entity has a con-
trolling shareholder. Typically, creditors can be protected by the personal liability
of the controlling shareholder (see Volume II). A legal capital regime will never-
theless make it easier for non-controlling shareholders to invoke breach of manda-
tory provisions of company law in the event of expropriation of the company’s as-
sets.
Interests of the firm. Both a legal capital regime and a statutory equity-
insolvency test can help to protect the interests of the firm.
A legal capital regime is designed to signal a lower risk particularly to share in-
vestors and to reduce the funding costs of the firm. All parties have knowledge
about the contents of a legal capital regime as it is based on the law.
Furthermore, absolute statutory constraints on distributions to shareholders can
protect the firm against expropriation by shareholders as they can make it easier
for the board and management to resist shareholders’ claims for bigger distribu-
tions in a company with dispersed ownership. Without absolute statutory con-
straints, it would be easier for short-term financial shareholders who have obtained
control of the company to give members of the company’s board an incentive to
distribute the company’s assets to shareholders contrary to the long-term interests
of the firm. In other words, it would be easier for the board to let the controlling
shareholder “loot” the firm. In order to be effective in a company with a control-
ling shareholder and weak non-controlling shareholders, the absolute statutory
constraints should also prevent circumvention (be “watertight”), because other-
wise they would only channel actions into particular forms.^112
A further benefit is that, if effective, absolute statutory constraints on the distri-
bution of assets to shareholders can help the firm to defend itself against hostile
takeovers by making refinancing more difficult. Again, absolute statutory con-
straints cannot prevent the merger of the takeover vehicle and the target company
(section 20.4).
A legal capital regime should preferably be complemented by an equity-
insolvency test to make the regime more “watertight” and to cover general busi-
ness transactions typically not covered by a legal capital regime.
Those aspects can be contrasted with the use of mere debt covenants. (a) Debt
covenants are designed to protect particular debt investors under that particular
debt agreement. They are not designed to protect shareholders. (b) Debt investors
and equity investors generally have less information about debt covenants in other
agreements than their own. (c) Although debt covenants can be enforced against
the company itself, they cannot be enforced against members of its corporate bod-
(^111) For German law, see Hommelhoff P, Modernisiertes HGB-Bilanzrecht im Wettbewerb
der Regelungssysteme. Konzeptionelle Bemerkungen aus Anlass des RefE BilMoG,
ZGR 2008 p 253.
(^112) See Armour J, Legal Capital: an Outdated Concept? EBOLR 7 (2006) pp 5–27.