Corporate Governance - Shareholder's duty of care.

According to Hansmann (1996), determining which constituency should govern the firm comes down to identifying which has the lowest decision making costs and which has the greatest need of protection.

Best position to supervise?

Being the residual claimholders, shareholders are ideally placed to act as watchdog. However, dispersed shareholders, with small interests in the corporation, are unlikely to incur the large monitoring costs that are sometimes required to keep management in bay. They are more likely to make management their proxy, or to abstain. Furthermore, dispersed shareholders may just not take an active interest in the corporation.

The increasing amounts of equity investments held by institutional investors has initiated a debate as to the role of institutional investors in the corporate governance of listed companies. Institutional investors are usually characterised as investors who invest on behalf of their beneficiaries, to whom they owe fiduciary duties defined by law and the particular contractual relations between them. Where traditionally, in corporations with dispersed ownership, shareholders can produce little countervailing power against management, the rise of institutional investment may have changed this. The substantial holdings of institutional investors make the exit strategy (selling on the market / outsider-model) less attractive to them and they are increasingly inclined actively to engage in internal control within the corporation.

Therefore, a way to overcome the problems mentioned earlier is active and continuous monitoring by a large shareholder, who could be a wealthy investor or an institutional investor, such as a bank, a holding company or a pension fund. Advantages of this –insider- model are that the corporation holds a more stable shareholder base, that although the large shareholder does not control management, it does have the power to adjust managements’ policy. Furthermore, it reduces the disparity of information and the ‘free-rider’ problem.    

Duty of Care

A potential difficulty with this approach is, who monitors the monitor and the risk of collusion between management (the agent) and the delegated monitor (large shareholder). If dispersed shareholders have no incentive to supervise management and take an active interest in the management of the corporation, why should fund managers have better incentives to oversee management? Even if they are required to vote at the annual shareholders meeting, why should they spend the resources to make informed decisions when the main beneficiaries of those decisions are their own principals, the dispersed investors in the fund? Furthermore, there are concerns about the potential for conflicts of interests of those who manage the investment (on behalf of their beneficiaries), both in terms of their relationship with the corporations they invest in and in terms of their internal reward schemes. Moreover, one can argue that large shareholders disturb the level-playing field and might lessen ‘transparency’ because of their bargaining power.  

In the United States it is recognised that shareholders, like directors and officers owe duties to the corporation and to other interests within the corporation. State law generally creates these duties but the federal securities statutes also impose duties that are similar to, and partially overlap, state created duties.    

Shareholders as such have no power to manage the business and affairs of the corporation and do not perform services for the corporation in that capacity. However, they do select the directors and have power to approve or ratify certain transactions. It is a short step from the shareholder director to considering the fiduciary duties of the (large / controlling) shareholder herself. However, an additional feature complicates the matter of the controlling shareholder’s fiduciary duty to the corporation and its minority shareholders. We can think of this feature as a policy clash between two values, the dominant value is that a controlling shareholder’s power over the corporation, and resulting power to affect other shareholders, gives rise to a duty to consider their interests fairly. The subsidiary value is the entitlement of all shareholders –even controlling shareholders – to vote in their own interest (Tanzer v. International General Industries, Inc. 379 A.2d 1121, 1124 (Del. 1977).

Because of this, shareholders, particularly controlling shareholders, owe a (fiduciary) duty to their corporation and their fellow shareholders in some circumstances. It is held in a number of states that controlling shareholders in closely held corporations owe a duty to other shareholders similar to that owed by partners in a partnership to each other (see e.g. Fender v. Prescott, 476 N.Y.S.2d 128 (App. Div. 1984). Furthermore it is held that controlling shareholders owe duties to creditors, holders of senior securities and minority shareholders when they transfer control of the corporation to a third party (Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983)). Moreover, transactions between a controlling shareholder and the corporation must be “entirely fair” to the corporation and the controlling shareholder has the burden of proving entire fairness. (Kahn v. Lynch Communications Systems, 638 A.2d 1110 (Del. 1994); Lewis v. S.L. & E., Inc., 629 F.2d 764 (2d Cir. 1980)) .

Summary / Conclusion:

In countries with good shareholder protection, where expropriation of minority shareholders is limited by law, investors pay higher prices for their shares, and hence controlling shareholders are willing to reduce their stakes or even to give up control. As a consequence equity markets are both broader and more valuable in these countries (La Porta et al 1997) and ownership is less concentrated. The NBER working paper “Corporate Ownership Around the World” considers that “legal reforms [in Europe] may be considerably (…) radical in nature, and give minority shareholders explicit rights to either prevent expropriation or seek remedy when it occurs…”  

The High Level Group of Company Law Experts recommends for listed companies in Europe to be required to provide shareholders with electronic facilities to access relevant information and to vote in absentia and for institutional investors to be required to disclose their voting policies to their beneficiaries.  

Because they have the power to affect the interest of minority shareholders, U.S. corporate law generally provides that large and/or controlling shareholders owe the corporation and its minority shareholders a fiduciary duty of loyalty whenever they exercise any aspect of their control. All shareholders, however, have the right to vote their shares in their best interest. Thus there is some tension between a controlling shareholder’s exercise of voting rights, which can arguably be exercised in her own self-interest, and her exercise of “control” over the corporation. It is this exercise of control that gives rise to an obligation of fairness to other shareholders.

The Dutch corporate law structure is quite different from the systems used in the United States and in Europe in general. Particularly the Dutch ‘structural regime’ is a real difference. The ‘structural regime’ takes away the right of the shareholder to elect the board of directors, and which thus lessens the ability to influence corporate decisions. Perhaps minority shareholders in the Netherlands are already sufficiently protected against ‘unfair’ behaviour by large shareholders (under the ‘structure regime’). In any instance we believe that shareholders should gain more control in the corporation, in which case the protection of minority of shareholders should automatically become more of an issue in the Netherlands.

Bibliography

Kabinetsreactie op het rapport van de Monitoring Commissie Corporate Governance, Tweede Kamer, vergaderjaar 1998-1999, 25 732, pp 2-8. (in Corporate Governance Reader (nr 110195) 2002/2003)

Corporate Governance and Control, Becht, M, Bolton, P & Röell, A., National Bureau of Economic Research Working Paper Series, Working Paper 9371, December 2002. ()

Corporate Ownership Around the World, La Porta, R., Lopez-De-Silanes, F. & Shleifer, A., National Bureau of Economic Research Working Paper Series, Working Paper 6625, June 1998. ()

Report of the High Level Group of Company Law Experts on a Modern Regulatory Framework for Company Law in Europe, Winter et al., Brussels, 4 November 2002. ()

Corporations, Hamilton, R.W., Black Letter Series, West Publishing Co, 4th Ed. 1997.

Essays, Cases & Materials on Corporations, Allen & Kraakman, working paper NYU/Fordham, Fall 2002 (not published).

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