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Corporate Governance Challenges in Controlled companies. USA versus EU

Corporate Governance Challenges in Controlled companies. USA versus EU

María Gutiérrez and Maribel Saéz have recently published an enlightening article on this aspect of Corporate Governance, traditionally much more connected with the European reality than with the US case. (1)


Their analysis covers the three mechanisms with which shareholders may react to underperforming companies, (exit, voice and loyalty or liability (2)), with an innovative approach; they understand their respective effectiveness depends on the type of controlling insider and on the nature of the outsider.  Controlling shareholders have been more common on Europe and other areas than in the US, although in recent times both the reduction of public firms and certain governance practices (dual-class shares…) have made them also more frequent in the US. Even if reality appears to converge, nevertheless governance practices differ as for the treatment that controlling shareholders receive, so that tunneling, self dealing and other rent-extraction methods by them against the minority shareholders or investors is still much more limited in the US than in Europe, (perhaps one of the reasons for the much more limited role of capital markets there).

The key difference between US and EU lies in the legal frameworks regarding fiduciary duties imposed on controlling shareholders. Let`s go through the three mechanisms.

  1. Exit. Discipline can be imposed on insiders by:
    1. Retail investors’ decision to sell the shares. When many of them sell the shares, pressure is channeled through the equity linked part of compensation to managers and directors, and through the capital market threat, (takeovers). Even if controlling shareholders and their appointed managers or directors face a lower risk, pressure is also transmitted through lower credit facilities granted to a company with declining or deceiving stock prices. So unless the company generates enough cash, (or can live with previously raised funds), investors can inject some pressure. This takes us to the following point.
    2. The coordinated pressure by investors to ask for greater and big dividends so as to recover funds faster, (partially exiting the investment). This will allow investors to have an exit credible threat even in cash-generating firms. The question is whether insiders and controlling shareholders decide on dividends policy or if minority investors have enough power to influence it, (empirical analysis don`t favor this hypothesis). So only other strong governance mechanisms will force controlling insiders not to use company cash flows to obtain private benefits from companies and minority investors.
  2. Voice. Voice is not very effective in controlled companies, (let`s remember also that voice by controlling shareholders constitutes the tool for efficiency in these firms, so that introducing obstacles to it could not be the best), although as Kastiel suggests reputation could give this tool some strength (see (3)). Voting mechanisms provided are not effective due to rational passive attitude by investors, (thus in the US this power is limited to elect directors and a few more items). Corporate law in the US has reacted empowering some informed third parties, in order to protect passive investors (institutional investors, (see also 4), or independent directors). In the EU the approach has been different, as emphasis is placed in voting rights by (so desired) active investors, (covering much more aspects than in the US). In controlled companies voting rights are dominated by the controlling shareholder, so these rights alone provide no big solution in Europe. European legislations have nevertheless tried to still favor minority investors voting rights: (i) super-majorities and/or quorum or suspended voting rights for controlling shareholders for certain decisions; (ii) special rights for minority investors, (appraisal rights, cumulative voting, right to call a shareholders meeting or access the proxy, etc.); (iii) legislations have reinforced the Shareholder Franchise, (SOP, etc.). In any case, only active investors are favored, (passive suffer from asymmetries, collective action problems, …), and sometimes they might have personal agendas, (additional agency costs…). Thus only accountability might have some effect, and this faces the problem that controlling shareholders are not allocated fiduciary duties by European legislations. Gutiérrez and Saéz conclude by suggesting that in order to reduce private benefits (particularly when conflicts of interest are present) the power given to the majority of the (non-controlling) minority could be a good measure in Europe.
  3. Liability. Fiduciary duties in the case of directors and managers is effective provided the Judiciary System is efficient, (the case in Delaware, for instance). But the number of derivative suits against controller shareholders is irrelevant in countries where controlled companies are abundant. First, because this litigation protects the company, (and not expropriated shareholders); second, protection is ex-post, that is only a decision by all shareholders can be opposed once it is adopted; third, self-dealing transactions often remain out of the radar as boards can pass them; fourth and most relevant, fiduciary duties owed by controller shareholders are not recognized in most of European legal systems, and the obstacles are diverse: (i) judges find it difficult to choose between one shareholder`s interest and the interest of the company, where controlling shareholders need to be counted; (ii) some private benefits are indirectly extracted with decisions protected by the BJR, in the case of business or strategic decisions; (iii) part of the literature finds it efficient to bear a certain level of private benefits (5), (cost-benefit analysis, compensation for oversight, business opportunities provided and investment concentration,…), ….to decide what the efficient level is and how to implement it; the level can be LOW, as in the US through the controlling shareholder´s fiduciary duties mechanism; or the level can be HIGH as in Europe, where the fiduciary duties mechanism does not exist and where the interest of the company is made equivalent to the interest of the majority by courts.
  1. Papeles de Economía, 2017 nº 151, March 2017. Follow link for download: http://www.funcas.es/Publicaciones/Detalle.aspx?IdArt=22906
  2. See both Hirschman`s 1970 contribution at “Exit, Voice and Loyalty: responses to declining firms, Organizations and States, Harvard University Press, and also the recent approach by Hansmam and Kraakman, at “Exit Voice and Liability”, http://papers.sioe.org/paper/131.html
  3. See my post (https://joaquinbarquero.wordpress.com/2015/07/16/is-shareholder-activism-in-controlled-firms-possible/ ) and the commented article by Kobi Kastiel (Harvard Law School) here: http://www.law.harvard.edu/programs/corp_gov/papers/Brudney2015_Kastiel.pdf
  4. https://joaquinbarquero.wordpress.com/2016/07/18/why-do-institutional-investors-exit-instead-of-raising-their-voice/
  5. Gutiérrez Urtiaga, María and Sáez Lacave, Maria Isabel, A Contractual Approach to Discipline Self-Dealing by Controlling Shareholders (May 22, 2014). European Corporate Governance Institute (ECGI) – Law Working Paper No. 138/2010. Available at SSRN: https://ssrn.com/abstract=2440663or http://dx.doi.org/10.2139/ssrn.2440663
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