Corporate governance literature has largely focused on listed firms with dispersed ownership, but those with controlling stockholders are increasingly important in the United States and Europe. In the U.S., the likes of Google, Facebook, and other technology firms have gone public with their founders retaining a controlling stake. This has prompted interest in understanding the impact that controlling shareholders have on firm value and the problems they pose for outside investors. Moreover, in Europe, where most listed firms have controlling shareholders, the control exercised by those shareholders has been blamed for the gap in stock market development relative to the U.S. and the low percentage of firms that access stock market financing.
On the surface, it may seem that, as ownership structures on each side of the Atlantic converge, so do corporate governance problems. But closer analysis shows that the difference in the regulatory environments that controlling shareholders face in Europe and the U.S. gives rise to a situation in which shareholders are strong and outside investors weak, which in turn facilitates outside investor expropriation in European-controlled firms and perpetuates stock market under-development in Europe relative to the U.S.
We trace this problem to the distinct European approach of protecting outside investors by empowering active shareholders rather than shielding passive investors. Because of this, European shareholder protection can be considered strong and the protection of outside investors weak. Although there are strong rights for active shareholders in European jurisdictions and the law seems well designed, outside investors face huge obstacles in gaining effective protection through lawsuits, protests, or selling their shares when there is a controlling shareholder. Interestingly, this inability of outside investors to successfully oppose the policies of the controlling shareholder means that disputes are rare in these companies, and this may erroneously reinforce the positive view of many European legal scholars.
Both in Europe and in the U.S., corporate governance mechanisms are difficult to apply to controlling shareholders. The threat of exit by small investors, who may sell their shares and depress market prices, can work against firms with important financial needs. But a controlling shareholder in a firm which generates free cash-flow can choose to withhold that cash, and there are few effective tools to force its distribution through dividends. What’s more, a controlling shareholder has the power to monitor managers, but outside shareholders, whose interests may clash with those of the controlling shareholder, must rely on independent directors or activist shareholders to serve those interests. Those parties’ ability to oppose the controlling shareholders is limited, however, because controlling shareholders cannot be fired or otherwise disciplined by the board.
Lawsuits are a strong threat to managers and controlling shareholders in the U.S., but they are of limited use in Europe, in part because, unlike in the U.S., shareholder control does not trigger fiduciary duties.
Summing up, Europe treats investors as shareholders that will get protection by active management of their control rights. While this approach may work in private firms, it is clearly not well suited to the problems of controlled listed firms.
How can Europe improve protection for minority shareholders and facilitate outside financing? The most powerful tool would be to make controlling shareholders liable for decisions that harm outside investors. This requires a system where liability is triggered by effective control, as in the U.S. But, paradoxically, limiting self-dealing may reduce the number of listed European firms. A liability regime for controlling shareholders seems incompatible with the complex group business activities that are typical of listed European firms and would face huge opposition.
A less controversial alternative would be to implement majority-of-the-minority (MOM) voting rules. MOM rules apply to controlled firms and require all related party transactions to be approved ex ante by a majority of the minority shareholders, excluding the related party from voting either at the board level or at the Shareholders General Meeting. In the case of board approval, effective application of MOM requires conflicted decisions to be reviewed by a committee of independent or disinterested directors (unaffiliated with the controlling shareholder). But outside investors in listed firms are rationally passive and will not seek information or act upon it. Expecting these investors to exhibit rational inaction, effective application of MOM rules requires the participation of activist investors, independent directors, or other informed parties whose interests coincide with those of the outsiders and who have enough power to affect key decisions. It follows that a precondition for effective MOM rules is to have truly independent and well informed directors and active institutional investors. Unfortunately, few of these preconditions exist in most European jurisdictions.
In any case, the final version of Article 9c of the EU Shareholders Rights Directive, regulating related party transactions, has left out MOM rules and has maintained the power of the controlling shareholder to make decisions about transactions in which has a conflict of interest. The only additional requirement is that companies publicly disclose ex post material related-party transactions that are most likely to create risks for minority shareholders and to submit these completed transactions for approval of the Shareholders General Meeting or the board. Unfortunately, it seems that this new reform is a missed opportunity to tackle the key problems discussed above.
This post comes to us from María Gutiérrez-Urtiaga, a professor at Universidad Carlos III de Madrid’s Business Department and research associate at the European Corporate Governance Institute, and from Professor Maria Isabel Sáez-Lacave at Universidad Autónoma de Madrid, Faculty of Law. It is based on their recent paper, “Strong Shareholders, Weak Outside Investors,” available here.