Our paper “Strong Shareholders, Weak Outside Investors” (available here), analyses the differential regulatory environment that controlling shareholders face in Europe, compared to the US.
Traditionally, corporate governance literature focuses on listed firms with dispersed ownership, but the growing importance of controlled listed firms is apparent both in the US and in Europe. In the US the likes of Google, Facebook and many technological firms have gone public with their founders retaining a controlling stake. This has produced renewed interest in understanding the impact that controlling shareholders have on firm value, and the problems of protecting outside investors when insiders have an ownership stake that allows them to control firm decisions. Moreover, in Continental Europe, where most listed firms have controlling shareholders, problems of minority expropriation arising from this ownership structure have been blamed for the gap in stock market development with respect to Anglo-Saxon markets and the low percentage of firms that access stock market financing.
A superficial view may suggest that as ownership structures on both sides of the Atlantic are converging, corporate governance problems are also converging. But a more profound analysis shows that the differential regulatory environment that controlling shareholders face in Europe, compared to the US, gives rise to a “strong shareholders-weak outside investors” situation, which facilitates outside investor expropriation in European controlled firms and perpetuates stock market under-development in Europe relative to the US.
This problem can be traced back to the distinct European approach to the protection of outside investors based on empowering active shareholders rather than shielding passive investors. In this paper we explain why in European jurisdictions shareholder protection can be considered high, while outside investors’ protection can simultaneously be considered low, ie the “strong shareholders-weak outside investors” problem. Although there are strong rights for active shareholders in European jurisdictions and the law on the books seems well designed, outside investors face huge obstacles in practice to gain effective protection by exerting liability, voice or exit in the presence of a controlling shareholder. Interestingly, this inability of the outside investors to successfully oppose the policies of the controlling shareholder means that it is very unusual to observe conflicts in these companies, and this may erroneously reinforce the positive view of many European legal scholars.
Both in Europe and in the US, corporate governance mechanisms are difficult to apply to controlling shareholders. The threat of exit exercised by small investors, who may sell their shares and depress market prices, can work for firms with important financial needs. But a controlling shareholder in a firm which generates free cash-flows can choose to retain them and expropriate the outside shareholders. And there is a lack of effective tools that can force him to distribute these free cash-flows as dividends. Voice gives ample control rights to the controlling shareholder to monitor the managers. But outside shareholders, whose interests may clash with those of the controlling shareholder, can only hope to be represented by independent directors or activist shareholders, and even these information intermediaries do not have effective tools to oppose the controlling shareholders, because controlling shareholders cannot be fired or otherwise disciplined by the board.
Liability is a strong threat both for managers and controlling shareholders in the US, but it faces deep substantive and enforcement limitations in Europe, inter alia because, unlike in the US, effective control does not trigger fiduciary duties for the controlling shareholders.
The US regulator is focused on protecting passive market investors from the people that manage their money, be it managers or controlling shareholders. But Europe treats investors as shareholders that will get protection by active management of their control rights. While this approach may work effectively in private firms, it is clearly not well suited to the problems of controlled listed firms.
This analysis leads to the question of what can be done to improve the protection of minority shareholders and facilitate outside financing for European firms. The most powerful tool to combat expropriation is to make controlling shareholders liable for their decisions when they harm outside investors. And this requires a system where liability is triggered by effective control, as in the US. But, paradoxically, limiting self-dealing may reduce the number of listed European firms. A reinforced liability regime seems incompatible with the complex group business activities that are typical of listed European firms. Therefore, European companies may find that the cost of dismantling these complex business structures exceeds the benefits of listing. The conclusion therefore is that introducing in Europe a strong and effective fiduciary duty for controlling shareholders would create a serious barrier for listing companies that operate as groups. A liability policy that induces outside investors to invest more money in the capital markets will be inefficient if small and medium firms continue choosing opaque business structures. Therefore, a prerequisite for such an important reform would be to first change the business environment that creates incentives for European companies to organise as complex groups.