The amendment of the Shareholder Rights Directive is currently in its final stage (see Council press release of 3 April 2017) and with its upcoming regulation of related party transactions, a large portion of the economic theory of agency will find its way into EU legislation.

Since Jensen and Meckling (1976) described the separation of ownership and control in companies as a conflict between principals and agents, the economic theory of agency has become one of the most important models to examine corporate law.  Kraakman et al went even further in describing all main conflicts of interests among stakeholders in a company as agency problems.  According to them, the three main agency conflicts are between

  1. managers and shareholders;
  2. controlling and noncontrolling shareholders; and
  3. the company and its contracting parties (such as creditors, employees and customers).[1]

This post focuses on the second agency conflict and how legislators in the EU are currently trying to resolve it in the field of related party transactions.

In their seminal studies on corporate ownership around the world, La Porta et al (1998) demonstrated that the agency problem between controlling shareholders and noncontrolling shareholders is the major conflict of interest within companies in most parts of the world.  Initially, it may seem curious to classify controlling shareholders, who often bear the highest residual risks in companies, as agents of noncontrolling shareholders.  However, one must consider that they effectively have the power to lead a company’s business instead of its hired managers.  Where important business decisions are concerned, a company’s management often receives detailed instructions from controlling shareholders regarding its course of action.  In such situations, noncontrolling shareholders are clearly principals of controlling shareholders in economic terms, depending on the actions of their agents.

However, the fact that there is an agency conflict among shareholders should not erroneously lead to the assumption that there are no fundamental differences from the conflict between managers and shareholders.  In their capacity as an executive body, managers act purely as fiduciaries for the company and their shareholders.  Consequently, almost every restriction of management’s power that reduces the overall costs of running the firm is legitimate, whether it is based on close monitoring, veto rights or even the dismissal of management in reaction to poor performance.

In contrast, controlling shareholders are both agents and principals, and while in many jurisdictions, they owe some fiduciary duties to minority shareholders, these duties do not reach the full extent of the management’s duties.  Regarding their membership and high investment in the company, corporate law cannot unconditionally shape and restrict the rights of controlling shareholders.  In the second agency conflict, it is therefore far more complex to find adequate measures in order to reduce agency costs.

Nonetheless, when it comes to related party transactions, lawmakers tend to apply the same legal strategies on the second agency conflict as they do to solve the first conflict.  Until 2000, the United Kingdom was one of the few countries which enacted a strict set of common rules for related party transactions with directors of a board as well as substantial shareholders (see FCA LR 11) , but with Britain’s uniquely high level of shareholder dispersion in public companies, one may wonder if there are significant problems with the second agency conflict.

However, since the turn of the millennium, rules on related party transactions have been strengthened in numerous continental European jurisdictions with a more concentrated ownership in public companies while, in most of them, a uniform set of legal instruments for both transactions with shareholders and managers has been installed.

The most recent example of this development is the upcoming amendment of the Shareholder Rights Directive:  In its heavily criticised proposal for an amending directive, the Commission proposed that related party transactions must be approved by the majority of the disinterested shareholders (see Art. 9c, para. 2 of the proposal).  Such a provision would empower shareholders to veto any related party transaction, regardless of whether it is a transaction between the company and its directors and key personnel, or the company and a controlling shareholder.  In the first case, the approval right simply means giving back some managerial power to the principal.  However, in the latter case, the provision would give minority shareholders the ability to decide upon the execution of a transaction, making them agents of the controlling shareholder and therefore turning the agency conflict around.

While it makes sense to keep the conflicted party out of the decision-making process, minority shareholders are hardly better decision-makers.  On one hand, minority shareholders are often rationally apathetic, which means that they behave entirely passively considering their low investment in the company.  This is especially true when ownership among the minority shareholders is highly dispersed.  In such a case, minority shareholders are usually badly informed about the company’s business and only marginally incentivised to enact change, even if they are given access to all relevant information to decide upon the execution of a transaction.  The strategy therefore fails in an environment where the second agency conflict is most severe.

On the other hand, giving important decision rights to minority shareholders may provide unwanted leverage for opportunistic activist hedge funds, who may employ holdout strategies in order to pursue their individual interests.  But even in a company where such problems might not occur (for example, when its minority shareholders are mostly sophisticated institutional investors), the massive costs of informing all shareholders and executing a vote for every major related party transaction would still have a prohibitive effect on many useful transactions.  The efficiency of a minority approval right on related party transactions is therefore doubtful, whereas it is certainly a massive interference in the controlling shareholders’ voting rights and the principle of equality.

In their final compromise text for the amending directive, the European institutions have responded to this criticism.  By giving more discretion to Member States and establishing the option of a board approval instead of a majority of the minority shareholder vote, the final form of the directive is far more consistent with the legal and economic framework in continental European countries.

Nevertheless, Member States may also face difficulties with the transposition of the new directive when choosing the board approval mechanism.  The crucial point about this mechanism is that board members have to be disinterested in order to act as proper trustees.  Restricting the vote to non-executive members is certainly reasonable in order to ensure independence from executives entering into transactions with the company, but it cannot resolve the second agency conflict.  When it comes to transactions with substantial shareholders, Member States must also provide for directors’ independence from these parties.

For British and American companies, there is nothing new about the majority of their directors being independent from major shareholders.  In most continental European countries, however, boards are often filled with representatives of the controlling shareholder.  In order to transpose the new directive, it will not be necessary to fill the majority of the entire board with independent directors.  An efficient rule could give boards the option to delegate the negotiation and conduct of the transaction to a small committee which meets this criterion, similar to the special committees used by many corporate boards in the United States.  But even for such a small committee, it remains questionable how Member States can ensure its independence from a controlling shareholder who has the power to appoint and dismiss its members.

Many scholars therefore advocate the involvement of minority representatives in the decision making process (see, for example, Gutiérrez and Sáez (2012)).  In some jurisdictions, the presence of a single minority representative on the board can already positively affect governance standards for related party transactions (see, for Italy, Bianchi et al (2014)).  However, in a jurisdiction like Germany, the existing regulatory framework hardly allows for the establishment of minority representatives.  In companies under the German Co-Determination Act of 1976, even a single minority director would be in a pivotal position in every conflict between the worker and the shareholder representatives, which he could easily use as leverage.  Instead of just mitigating the existent conflict between controlling and noncontrolling shareholders, the establishment of minority representatives in the board would again partially turn around the agency problem.

When it comes to the second agency conflict, it seems like there is no one-size-fits-all approach.  Fortunately, the agreed final form of the revised Shareholder Rights Directive gives Member States much leeway in implementing it in their national laws.  It is essential that national legislators now make use of their discretion.  Finding an adequate balance between the level of minority shareholder protection and the majority shareholders’ freedom to exercise their legitimate control rights is a delicate problem, which calls for bespoke solutions.

 

[1] For more detail, see Armour, John et al, Agency Problems and Legal Strategies, in Kraakman, Reinier et al, The Anatomy of Corporate Law, 3rd ed (2017).