The ‘one-share one-vote principle’ is one of the most fundamental rules in modern corporate law. However, in reality, controlling shareholders often obtain voting rights in excess of their economic rights through control-enhancing mechanisms, allowing them to leverage control over the firm. Empirical studies indicate that leveraged corporate control is prevalent among listed companies of various countries, yet, to date, many countries still disagree on a regulatory framework. The EU and OECD conducted studies concerning the regulatory policy over control-enhancing mechanisms several years ago. However, failing to reach a consensus, the reports only advised governments to enhance disclosure and transparency. In recent years, as entrepreneurs hope to maintain their control after public listing, they seek to utilize dual-class share structures to leverage corporate control when going public. This led to recent reviews by the Hong Kong and Singapore Stock Exchanges — the Hong Kong Stock Exchange refused to grant listing to companies with dual-class share structure, while the Singapore Stock Exchange approved the proposal to allow listing companies to have dual-class shares in order to maintain competitiveness. My paper, recently published with Columbia Business Law Review, reviews current theoretical and empirical research and re-examines relevant corporate governance issues of leveraged corporate control.
This paper first reviews the practice and regulatory framework of leveraged control in the US, Europe, and East Asia. In general, most jurisdictions allow for a certain amount of deviation from the one-share one-vote rule. Yet, there does not seem to be a consensus on how to regulate different forms of deviation devices. This paper then reviews current theories and empirical studies on leveraged control to see if there are coherent grounds either for or against leveraged control. Proponents of leveraged control argue that the deviation from one-share one-vote should be allowed because shareholders have the freedom to contract with respect to the allocation of corporate control. However, such deviation from the one-share one-vote rule may exacerbate the principal-agent problem in a controlled firm because a controlling-minority shareholder is not only entrenched, but also has the incentive to extract private benefits of control because he owns disproportionally less equity. On the other hand, a leveraged control firm still enjoys the benefits of efficient monitoring by the controlling shareholder. Therefore, it is unclear whether a leveraged control structure generates net benefits or net costs to shareholders. Even though the findings of existing empirical studies are mixed, there are more studies that suggest leveraged control correlates with lower firm value. In particular, there is evidence showing that the value discount may not come from inefficient monitoring, but rather from the extraction of private benefits by controlling-minority shareholders. This result explains the concern over increased entrenchment agency costs in a leveraged control firm.
Next, this paper critically reviews the freedom of contract argument, which supports practices that deviate from the one-share one-vote principle. Through the lens of the contractarian theory of the firm, this paper suggests that differentiating the IPO stage from the post-IPO (or ‘midstream’) stage is essential in analysing the agency problem faced by outside shareholders in a leveraged control firm. This paper argues that the contracting mechanism, which ensures the efficiency of any governance design, can be achieved, at best, only in the IPO stage where potential investors can place discounts on any pro-insider governance measure and corporate insiders directly suffer the loss of a price discount. In the midstream stage, the contracting mechanism that is present at the IPO stage is no longer present. In the midstream charter amendment, pro-insider amendments are likely to be passed because outside shareholders lose their bargaining power by giving up a majority of the votes to controlling-minority shareholders. In cases where a leveraged control firm adopts a supermajority voting requirement for charter amendments during its IPO, like in the case of Google and Alibaba, such a supermajority provision further distorts the contracting mechanism in the midstream and weakens minority shareholders’ ability to adopt value-enhancing amendments. With disproportionate voting power at hand, controlling-minority shareholders can easily block such amendment proposals. Recent recapitalization of Google and Facebook as well as going-private transactions among many US-listed Chinese firms provide vivid examples of the midstream opportunistic behaviours of controlling-minority shareholders.
In its final part, my paper discusses the ways in which policy should address the midstream pro-insider distortions in leveraged control firms. One size does not fit all. Considering how different corporations demonstrate different characteristics, this paper argues that an outright prohibition of certain types of control-enhancing mechanisms may not be optimal. Instead, we should leave these decisions in the hands of shareholders. To do so, empowering shareholders by increasing shareholder participation would be the best way to resolve the imbalance of power in a leveraged control firm. In particular, the participation of institutional investors and shareholder activists is essential to counteract the superpower of controlling-minority shareholders and to govern their midstream opportunistic behaviours.
Yu-Hsin Lin is an Associate Professor at City University of Hong Kong School of Law.