Majority-of-Minority Shareholder Voting Rights Can Reduce Expropriation
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In companies with concentrated control rights, a key governance challenge is how to protect minority shareholders from expropriation attempts by controlling shareholders. The controlling shareholders have the incentive to transfer public companies' resources through related party transactions (RPTs), ultimately to their own pockets. Previous studies find that expropriation through RPTs is common and costly to minority shareholders. At the same time, though, within-group transactions, such as vertical integration and internal capital markets, can serve as alternative means to overcome market shortcomings. An outright prohibition of RPTs would be too costly, and identifying mechanisms that preserve the benefits of RPTs while limiting their abuses has proven to be difficult.
My study, recently published in the Journal of Accounting Research, empirically investigates whether a mandatory majority-of-minority (MOM) shareholder vote on RPTs reduces the expropriation of minority shareholders and whether its net effect on shareholder value is positive. In principle, a mandatory and binding voting mechanism enables shareholders to block transactions perceived as detrimental to shareholder value. Furthermore, a large number of votes against an RPT resolution, even if not sufficient to outright block the RPT, can impose reputation costs on controlling shareholders or board members. In anticipation of the potential cost of shareholder dissent, controlling shareholders may be deterred from proposing transactions that would be perceived as hurting minority shareholders.
I examine the adoption of a mandatory MOM voting rule on RPTs in India. India’s corporate sector is dominated by large business groups. A single individual (ie promoter) or family usually maintains the de facto control of all group firms, making RPT abuse a major concern. In 2009, the concern escalated following the Satyam scandal, which was partly exposed by suspicious RPTs. In the subsequent revision of corporate law, known as the Companies Act, 2013, the Indian legislators included a provision mandating that listed companies seek shareholder approval for material RPTs before they take place. The Securities and Exchange Board of India (SEBI) also adopted a similar rule in the revised listing agreement. Importantly, the rule only allows “disinterested” shareholders to vote, meaning shareholders classified as connected to the related party are not eligible to vote on RPT resolutions.
My empirical analyses offer several sets of results. First, I use voting data from Institutional Shareholder Services (ISS) to provide descriptive evidence on how shareholders vote on RPT resolutions. In a sample of 348 RPT resolutions in the first two years after the regulation, I find that 9.77% of the RPT resolutions receive more than 25% ‘against’ votes of the votes cast from eligible shareholders, which is significantly higher than the corresponding frequency of non-RPT resolutions (0.56%) at the same firms. The stronger dissent on RPT resolutions is attributed to both the MOM feature and the fact that minority shareholders cast ‘against’ votes more often. Cross-sectional regressions show that shareholder dissent is positively associated with the firm’s financial RPT level and foreign institutional ownership, and negatively associated with return-on-assets.
Second, I employ a difference-in-differences (DID) design to examine the voting rule’s overall deterrence effect on the use of RPTs. I classify firms into the treated group and control group based on how likely it is for the firm to be affected by the rule. The DID estimation shows that, controlling for observable characteristics, the treated firms (ie the more likely affected firms) experience an economically significant reduction in total RPTs scaled by lagged total assets relative to the control firms.
This analysis shows that MOM votes indeed ‘bite’, but whether the deterrence effect is beneficial to shareholder value or firm performance is not yet clear. For example, managers may be reluctant to discover or propose complex RPTs with a valid business purpose if they anticipate that minority shareholders may not understand the transactions and may vote against them. To shed light on the value implication of MOM voting, I examine how stock prices react to news related to the passage of the RPT voting rule. Results from event studies show that the market reacts positively to the key legislative milestones that signal a higher likelihood of the rule’s passage, implying investors expect the voting rule to enhance shareholder value.
In addition, I use the DID design to investigate changes in the association between RPT level and firm profitability around the voting rule’s actual implementation. I find that treated firms experience an increase in the association between RPT level and return-on-assets relative to control firms, consistent with the notion that shareholder voting helps filter out expropriation from value-creating RPTs. Lastly, I also show that foreign institutional holdings increase following the rule’s implementation, suggesting a reduction in the risk of expropriation perceived by foreign investors.
To sum up, the results show that empowering minority shareholders with mandatory and binding voting rules can be effective, even in markets not traditionally characterized by shareholder activism. The findings may have implications for MOM shareholder votes in other settings or countries. To make the rule ‘bite’, the voting rights may need to be given primarily to the minority shareholders, especially in companies where control rights are concentrated.
Nan Li is an Assistant Professor of Accounting at Carlson School of Management, University of Minnesota.
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