Electronic copy available at: http://ssrn.com/abstract=1432672

Minority Shareholder Choices and Rights in the New Market

Environment

Themistokles Lazarides*

* Department of Applied Informatics in Administration and Economy, Technological Institute of West Macedonia, Grevena, 51100, Greece, themis@themis.gr, tlazarides@teikoz.gr, Tel.

+302462087691, Fax: +302462087692

Abstract

During the last few years minority shareholders have suffered many shocks. Their rights and options were compromised. New legal and regulatory initiatives have failed to establish stability and trust on the mechanisms and contracts that are essential for organizational and market stability. The paper cites the basic rights of minority shareholders and analyzes the feasibility of their protection and enforcement. Minority shareholders are, in essence, without any choices or the choices that they have to rely on are the will and faculty of the dominant group (managers in the case of the Anglo-Saxon countries and major shareholders in Continental Europe countries).

1. Introduction

The rights of shareholders are not the same around the world, not evenly enforced and shareholders are not evenly active or interested in using their rights. The paper focuses on shareholders’ rights as they are described in OECD’s Principles of Corporate Governance (2004). The source of shareholders’ rights protection of may be the provisions of the law, the judicial system, external mechanisms of control or voluntary adoption of corporate codes of corporate governance, ethics and internal control systems.

La Porta et al. (1998) argue that historically there is no legal isomorphism. Different legal traditions have prioritized their impact on corporate environment. Common law tradition countries “have the strongest legal protection for minority investors while French law provides the weakest protection. German law countries fall in the middle in terms of protection to shareholders” (Krishnamurti, et al., 2005). In civil law

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Electronic copy available at: http://ssrn.com/abstract=1432672

countries the disadvantage of legal protection is hedged by major shareholders’ sense of social responsibility or duty to protect minor shareholders’ interests.

There is a bidirectional effect of the legal system and the fundamentals of the corporate environment (ownership structure, inner power and control structures, market for corporate control, etc.). Legal framework and enforcement affects directly or indirectly ownership structure, remuneration, capital finance, corporate valuation (Klapper and Love, 2004; Berkowitz et al., 2003; Beck et al., 2003; La Porta et al. 1999, 2000; Claessens et al., 2000; Lombardo and Pagano, 2000). From another perspective, policy makers and legislators take into account these factors when they are planning their initiatives. What troubles many researchers is the question: Can law and regulation framework be used to create change in the corporate environment or it should be facilitate the status quo in the other dimensions of the corporate environment? This question can also be formed like this: Is the legal dimension the prevalent one in the corporate environment?

During the last two decades corporate governance (CG) initiatives have tried to mitigate any problems that were apparent and significant. A paradox is that while “firm-level corporate governance matters more in countries with weak shareholder protection and poor judicial efficiency” (Klapper and Love, 2004), these countries didn’t endorsed and fully appreciated the value and effectiveness of CG initiatives, and they didn’t perceived CG mechanisms and principles as a medium to solve problem, but rather as a burden or cost amplifier. Another way to look at things is that weak governed firms’ stakeholders need more a good and effective legal framework than the ones that have a strong and effective corporate governance framework.

Klapper and Love (2004) argue that law and regulation reforming is difficult, while improvement of firm level is easier. This point may lead to the argument that voluntary codes or firm level initiatives are better and more effective solutions to mandatory legal provisions, but the same researchers stress the importance of legal reform.

2. Corporate Governance Systems

Many researchers (i.e. Keenan and Aggestam, 2001; Weimer and Pape, 1999) have tried to categorize and rank the differences on country level in order to formulate policies, practices and to detect any fallacies in the corporate environment. These taxonomies are used in comparative, empirical studies to test hypothesis like investor protection, market efficiency, etc.

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The basic differences between corporate governance systems are in orientation, ownership concentration and time horizon of economic relationships (Shleifer and Vishny, 1997). The differences are fundamental and not superficial. Even the notion of family owned firms is different in these groups of countries. Ali, Chen and Radhakrishnan (2007) report that family firms, of the S and P 500 firms, own on average the 11% of their firms, while in Continental Europe the ownership percentage is more than 35%. Franks et el. (2008) report that in UK ownership concentration is 18%, while in Germany the percentage is 43% and in Italy 68%.

In Continental Europe system countries, like Greece, Italy, Spain, agency problem is a secondary problem whereas the main problem is the protection of minority shareholder. The fundamental difference is ownership concentration which is the source of all the other differences. Ownership dispersion in Anglo-Saxon countries specifies the corporate governance problem in Anglo-Saxon countries. In Continental Europe, on the other hand, the problem of corporate governance is different. Protection of minority shareholders’ rights is the primary problem, while agency problem is secondary. Major shareholder have motives to participate (low cost, high risk of non participation because ownership stake are high and the capital invested is not dispersed) in controlling and monitoring as well in managing the firm. They are controlling the Annual Shareholders Meeting (ASM) and the Board of Directors (BoD). Minority shareholders are vulnerable to expropriation from major shareholders. Expropriation can take the form of profit reallocation, assets misuse, transfer pricing, sell bellow market price departments or parts of the firm to other firms that major shareholders own or acquisition of other firms that major shareholders own at a premium (La Porta et al., 2000). As the same authors argue this kind of expropriation “though often legal, have largely the same effect as theft” (p.4).

The problem of CG in Continental Europe countries is the establishment of balance between major and minor shareholders’ goals and interests and not the interception of improper managerial behavior. Ethical issues are different as well. In agency theory moral hazard, adverse selection (Arnold and de Lange, 2005) and asymmetric information (Akerlof, 1970; Arrow, 1985; Rothschild and Stiglitz, 1976) are the key ethical issues, whereas in Continental Europe countries the problem is the abuse of power and control by the controlling shareholders.

In Continental Europe the majority of executive managers are members of the dominant group, with absolute ownership majority. Their actions and decisions are legitimate and cannot be questioned by minority shareholders. So, corporate governance mechanisms that are designed to control and monitor their decision are

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needless and moreover these mechanisms produce costs that are considered to be not relevant with the way the firm is governed, controlled and monitored and therefore without any value. Corporate governance is more likely a burden than an optimizing tool.

Although corporate governance systems are formed historically as a result of local economy dynamics and its fundamental characteristics, there is a trend to use the same set of principles, guidelines and practices. Since shareholders rights are not the same, the use of the same set corporate governance mechanisms, practices and principles may inflict collateral problems on shareholders rights.

The Anglo-Saxon system shareholders have better ownership rights (see the relevant principle of OECD, 2004) protection than the ones of the lenders in comparison with the Continental Europe system. The better protection comes from better legal protection, stronger structure of the internal control mechanisms and the more efficient capital markets and market for corporate control. Legal and judicial protection of shareholder ownership rights acts as a substitution of market mechanisms and creates a balance in capital structure between equity and liability capital (La Porta, et al., 1997; Cuervo, 2002).

In the Anglo-Saxon system there is a mix of market and explicit – legal protection. This mix is the main cause of trust creation to corporate environment and to markets. When the corporate scandals emerged there was a collapse of trust. Both sides of the mix were blamed and Sarbanes – Oxley Act (SOX) and Securities Exchange Committee initiatives were employed to create trust again. On the other hand, in the Continental Europe system the markets are less liquid and they do not have the same capacity to monitor and control because firms are control by a small number of shareholders (banks, families) (Baums, 1993; Kester, 1997; Cuervo, 2002).

3. Corporate Governance benchmarking

Another set of interesting stream of literature is relevant to corporate governance benchmarking. Analysts and evaluation institutions play a major role in disseminating information to shareholders. The vast majority of shareholders do not have the expertise, knowledge, time and resources to monitor and control the firm that they have invested in. Trust and reputation are prerequisites in establishing confidence and reliability on their reports. During the last decade many academics, institution and private consulting firms have tried to evaluate the risks and benefits of corporate governance.

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Benchmarking is executed at two levels: Country level and corporate level. A paradox is that two firms with the same evaluation rate, but located in two different countries (with different legal, regulative and market standards) present different levels of risk (Standard and Poor’s, 2002). In case there is a decrease of the CG’s quality level, investors and other stakeholders will try to find better protection in countries with better institutional and law enforcing frameworks (Standard and Poor’s, 2002). Usually, an investor evaluates first the country and afterwards the firm.

Minority shareholders and institutional investors do appreciate or they should appreciate risk mitigation and good protection from exploitation and rights deprival. Benchmarking is a tool to select “rationally” the country and the firm that is better suited to their risk profile and expectations. During the last two decades a series of benchmarking methodologies have been introduced, by firms specialized in corporate governance (Institutional Shareholder Services, Governance Metrics International, Standard and Poor’s, TrueCourse, Moody’s Investment Services, etc.) or by institutions that have a stake in corporate and country evaluation and finally by academics (Drobetz et al., 2004; Black et al., 2006).

However, there are flaws in the previously mentioned methodologies. The first flaw is that all these studies measure and evaluate corporate governance as it is defined in the Anglo-Saxon system. Gompers, Ishii and Metric (2003), Bebchuk, Cohen and Ferrell (2004) and other studies have been based on variables that measure problems and mechanisms like performance, incentives, board structure, asymmetric information, interest alignments, etc.

The second flaw is that this studies to not measure the effectiveness of corporate governance mechanisms, but merely their existence. An indicant of this argument is that independent members of the Board of Directors were a dominant characteristic at Enron (45%), Tyco (65%), and Disney (60%). The existence of large numbers of independent members weren’t enough to prevent any fraudulent behavior or to increase the monitoring and controlling efficiency of the Board of Directors (Tosi, Wei and Gentry, 2003).

The same is also true for the observance of rules and the preservation of shareholder’s rights. Benchmarking and system ranking just record their existence and they do not measure their effect on shareholders rights, choices and status. Shareholders rights are not equally preserved and protected around the world.

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4. Rights of Shareholders, Key Ownership Functions and Hirschman’s

options

Shareholders’ rights are described in OECD’s Principles of Corporate Governance (2004, p. 32), but the description is not in detail. OECD cites shareholders rights1 and describes the basic principles for their protection. What OECD does not provide is the mechanisms and controls to protect these rights. As OECD (2004) states as a fundamental principle “the corporate governance framework should protect and facilitate the exercise of shareholders’ rights” (p. 32)

Facilitation of rights exercise may be possible under some prerequisites: uninterruptible information flow to and from shareholders, active capital and market for corporate control, effective and transparent internal control system, effective and independent Board of Directors, reliable system of transactions, ethical use of power and authority by the dominant group (manages in the case of the Anglo-Saxon countries and dominant shareholders in the case of Continental Europe countries) within the firm, effective information systems that minimizes the cost of information dissemination and group work facilitation, well defined corporate policy regarding the exercise of vote and will expression rights, and finally an effective and efficient regulatory, legal, judicial and penalty system. Some these factors can be substituted by others or work in parallel. Institutional investors and monitoring authorities should take the role or duty to provide monitoring and control over the dominant’s group decisions.

Hirschman (1970) has given three choices that a shareholder has in any given situation (exit, loyalty, voice). The voice choice is infeasible due to the significant power of controlling shareholders or managers (triple role: shareholder, executive, member of the BoD and CEO/President). In the case of Continental Europe countries ownership concentration gives controlling shareholders the capability to neutralize minority shareholders intervention (shareholder activism movement is not as active in Europe as in Anglo-Saxon countries) to all levels of decision making and reduce their capability of monitoring and controlling them. Voice choice may have merit to

1 “Basic shareholder rights should  include the right to: 1) secure methods of ownership registration; 

2)  convey or  transfer  shares; 3) obtain  relevant  and material  information on  the  corporation on a 

timely and regular basis; 4) participate and vote in general shareholder meetings; 5) elect and remove 

members of the board; and 6) share in the profits of the corporation” (OECD, 2004, p. 32).

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shareholders in Anglo-Saxon countries and regulating framework sponsors it, but in Continental Europe countries the “voice choice” is no choice at all.

In Anglo-Saxon countries there is the hypothesis that shareholders may be heard. This hypothesis relies on their monitoring capabilities. Recent corporate scandals have shown challenge this hypothesis. Hart (1995) argues that shareholders do not comprehend that monitoring is not a public good. Transaction and monitoring – controlling costs are high; shareholders may not have the skills, knowledge and time; dominant group may inhibit any attempt of interference in the current decision making process, raise obstacles and raise the costs of obtaining information or rights exercising. Shareholders are willing to free ride. This is a reverse equilibrium. Shareholders acting orthodoxically do not practice monitor and control, although they welcome any tradeoff benefits of other shareholders’ or stakeholders’ activity.

An interesting point is that OECD (2004) provides for the creation of group dynamics between dispersed shareholders: “Shareholders, including institutional shareholders, should be allowed to consult with each other on issues concerning their basic shareholder rights as defined in the Principles, subject to exceptions to prevent abuse”. This provision is an acknowledgement that sporadic minority shareholders cannot influence, monitor and control dominant’s group decision. A necessary and adequate condition for shareholders to protect their rights themselves is to accumulate power “signing” a contract regarding their goals and scope of their intervention in the decision making process. Even if minority shareholders are willing to compromise and to act as a group the transaction costs of the agreement are high. These alliances are transitory, not explicitly formulated and based more on incomplete contracts, and trust. The hypothesis that all shareholders have the same goals and expectations (i.e. maximization of wealth) is not, in the majority of cases, valid. Furthermore, there is the element of time. Decisions are made within a time frame. Even if shareholders are willing to undertake the costs, it is probable that their decision is obsolete and will have no effect at all.

These arguments lead to the conclusion that the voice choice is not feasible or choice in the Anglo-Saxon countries as well. Enron’s minority shareholders didn’t have, in reality, the capability or opportunity to exert monitor and control over top management’s decisions and strategy.

These are the reasons why shareholders usually use their exit options if they disagree with management or if they are disappointed by the company’s performance, signaling – through share prices reduction – the necessity for managers to improve

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firm performance (Hirschman, 1970). Where capital markets are adequately liquid (Anglo-Saxon countries) the exit option may not have significant costs and hence it is feasible and attractive to shareholders. Lack of market liquidity (Continental Europe countries) creates problems in the effectiveness of shareholders exit option.

The cost of involvement with management and control for the minor stockholder is greater than the cost of exit and so they may easily choose to sell their stocks (“they vote with their feet”) if they are not content with managements’ choices. Shareholders encirclement does not necessary mean participation in corporation governing. In countries where business has traditionally been based on relationship and trust, corporate information is thought of as secret; and it is accepted practice to keep different sets of books, e.g. one for taxes, one for outside investors, and one for the majority shareholder (Fremond and Capaul, 2002, p. 18). There is a vicious cycle: managers consider secrecy as imperative so that shareholders do not vote with their feet and through it they can cover up their lack of efficiency or impotence; minority shareholders (major shareholders already have the information cause they are members of the BoD, management or the relevant cost for them is not too high) do not actively demand information because the cost of acquiring and processing it, is too high for them.

The final choice (loyalty) is traditionally the one that minority shareholders in Continental Europe are familiar with. As Aguilera and Jackson (2003) argue the Continental Europe systems is characterized by commitment by large shareholders to their investment and minority shareholders to the leadership and competence of major shareholders. External mechanisms (market for corporate control, labor market, etc.) are not as active and effective as in Anglo-Saxon countries and hence the loyalty choice is, more or less, a blind one. Major shareholders control the decision making levels and information flow (Lazarides and Drimpetas, 2008). Loyalty is not the outcome of logic but rather the outcome of faith and trust that the major shareholders are not going to exploit their dominant position to gain more benefits or to undermine the firm’s value that they have invested in heavily.

5. New Legal or voluntary initiatives and market efficiency as rights defenders

The only real choice, although a costly one, is the one of exit. Changing legal framework has not contributed significantly to the enrichment of minority shareholders’ choices and didn’t solve any off the major problems that they face. On the contrary, legal reforms gave the opportunity to major shareholders to use

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compliance as a mean to arbitrary take decisions and to “legalize” minority shareholders’ expropriation, removing the ethical advantage of minority shareholders.

Sarbanes – Oxley Act (SOX) in USA (2002) was a good step in establishing a corporate governance framework compatible with the OECD’s principles. In contrast with Cadbury Report (1992) a decade earlier, in 1992, SOX was more holistic. Provisions for responsibility (Sections 302, 307, 906), accountability (Sections 802, 805, 806, 807), ethics (Section 406), transparency (Section 401-409) and establishment or enforcement of internal control mechanisms (Section 404, 804), have brought a perspective in formulating legal corporate environment.

SOX Act was disdained to a more legalistic approach than directional one. It is no surprise that SOX, although a very detailed legal document, had no effect or failed in creating case-law. The vast majority of the literature and practitioners attention was focused on Section 404 (Management assessment of internal controls). The “vaguer” but more essential sections in protecting shareholders rights and in provisioning feasibility in all shareholders options, as they were described in OECD’s Principles, were left out of the spotlight. This may be a key factor to SOX failure to preclude corporate scandals (i.e. Lehman Brothers, Fannie Mae and Freddie Mac) that took place after its enactment.

A mimetic trend was building up from 2002 to 2008. All over the world legal initiatives used SOX as a canon to regulate domestic capital markets. Globalized institutional investors solicited for a homogeneous set of rules and regulations. Domestic capital market committees and regulating bodies anxiously accepted the need for a homogeneous set of rules, regardless the cultural, political, economical, legal, judicial and social differences. This may have a significant impact on the protection of shareholders rights in Continental Europe due to the fact that SOX’s provisions and mechanisms have been designed to work in a very different corporate environment.

So, SOX failed in USA but it may have a double effect in Continental Europe: a) Shareholders rights are still under-protected and b) legislative and regulating authorities are focusing on other remedies for the problem. As it is in medicine, providing the wrong remedy it may be lethal. The issues that troubled shareholders are not addressed by the authorities, which chase, like Don Kichotes, windmills. It is no surprise that the legal community, in either side of the Atlantic, has a legal proposition as to how the current economic crisis could be tackled.

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Some academics and practitioners advocate the idea that the market will address all issues and problems. As Holmstrom and Kaplan (2001) argue, shareholders value raise after deregulation and the emergence of new information and communication technologies. Regulation that protected the rights of shareholders was an obstacle to their “prime” goal. Markets were deregulated and remain so till now. Greed was the locomotive of shareholders “happiness”. Product markets and market for corporate control were deregulated, internal control systems were poorly designed and dominant groups prevailed. This was an incentive for abnormal returns for the firms. Dominant groups demanded equally abnormal returns for themselves and the vicious cycle of greed began. SOX and the followed initiatives failed to break the cycle. The “voice” and “loyalty” option were no more. The option of “exit” was the only one left for minority shareholders. As Figure 1 illustrates market is not as effective as the advocates of effective markets would like. It took shareholders four (4) months to take the exit option. By that time shareholders lost more than ninety percent (90%) of their previous wealth. All this time auditors, managers, CEOs and Presidents of the Board of Directors were complacent.

Firms that are willing to implement strong corporate governance systems are taking an extra functional and administrative cost. These costs reduce profitability and hence the incentive to conserve the system. Firms that can manipulate the system in order to minimize administrative and governing cost and at the same time to preserve the image of a firm fully compliant with the principles and guidelines of a complete and strict corporate governance system, have an advantage over the others firms. A legalistic approach serves that purpose.

Kirkpatrick (2009) states that the system of Corporate Governance should not be static. Dynamics in organizational, ownership, product and financing should be matched by the dynamics of the corresponding Corporate Governance system. If the system of Corporate Governance is static, market (product and capital) competition is not efficient and preconditions for problem accumulation are formed.

Figure 1. Share Prices two months before and 4 months after corporate failures

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Source: ISS (2005)

6. Conclusions

Minority shareholders during the last years have suffered major shocks. Their choices have been reduced and their status worsened. Wang and Chen (2004) report 4 governance mechanisms: explicit contracts, implicit contracts, reputation, and trust. These four mechanisms support and shape shareholders choices. All other mechanisms (i.e. legal, statutes, personal relations, etc.) are based on them. Explicit contracts in the form of legal initiatives, corporate statutes and internal control mechanisms didn’t produce the expected results. New legal regulation framework initiatives were outdated and not well focused. Market mechanisms (market for corporate control, stock price formulation) reacted insufficiently. Analysts and benchmarking agencies were blinded by their own tools, methodologies and approach to firm’s evaluation. These developments lead to collapse of trust and reputation. Anglo-Saxon corporate governance system relies mostly on explicit contracts, trust and reputation, whereas Continental Europe’s system relies more on implicit contracts and trust.

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Overall, Hirschman’s (1970) options were all compromised. Minority shareholders are, in essence, without any choices or the choices that they have to rely on are the will and faculty of the dominant group (managers in the case of the Anglo-Saxon countries and major shareholders in Continental Europe countries). Loyalty to the dominant group (managers) in Anglo-Saxon countries, due to the free rider problem, is without merit. As a congressman put it eloquently: Managers stated that the ship (firm) is doing well, provided themselves with a huge bonus, lowered rescue boat and finally they left the ship to sink. Managers can manipulate information and analysts and if this doesn’t work they have the exit option (without any real costs). To make things worse the exit option in Anglo-Saxon countries has minimum efficiency. On the other hand loyalty in Continental Europe countries may have some merit. Major shareholders’ capital investment reassures that they have the motive to manage efficiently the firm and hence to protect minority shareholders’ capital interests as well.

Minority shareholder rights are in practice restricted to the ones that do not challenge power and control status quo. Power concentration and lack of control have attributed to shareholder rights deprival. Shareholder activism (voice) seems as the only option that can make a difference. Through activism shareholders can recuperate their lost rights and influence the creation of a more suitable legal and corporate environment. Regulating authorities and dominant groups must realize that it is in the best interest of all stakeholders to protect and enforce minority shareholders rights. Without them corporate capital accumulation, stock market function and risk mitigation are feasible or at least efficient.

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