The Case Against a Special Regime for Intragroup Transactions
Corporate groups are an important reality of the modern corporate landscape. Virtually every major firm is organised as a group, ie, as a constellation of different (and formally independent) subsidiary companies controlled by a ‘parent’ company, usually itself controlled by a controlling shareholder. In many jurisdictions, groups are often organized as minority-co-owned groups (‘MCGs’), namely groups with minority shareholders in one or more subsidiaries.
MCGs are notoriously problematic. On the one hand, they facilitate tunneling, meaning controllers’ appropriation of corporate wealth to the detriment of (non-controlling) shareholders. Tunnelling is in fact easier to perpetrate if a firm is organised as an MCG. By choosing this organisational structure controllers increase the opportunities for tunneling and make it harder to detect, since intragroup transactions—a major conduit for wealth-diversion—become routine, and also facilitate the extraction of value through more elusive non-transactional techniques.
On the other hand, MCGs can be valuable organisational tools. Consider the case of a particular subset of MCGs, namely those with publicly traded subsidiaries. Publicly traded MCGs permit a larger and more fine-tuned use of performance-based compensation, in the form of stock options or similar arrangements. Managers of a listed subsidiary will be better incentivised to perform if they are paid in the subsidiary’s stock. This may improve the performance of each listed business unit within the group. Furthermore, listing the shares of one or more subsidiaries is an effective way of providing investors with more information about the group, and of more credibly binding controllers to enhanced transparency at the business unit level. Finally, in some cases there are no alternatives to organising the firm as an MCG. In cross-border acquisitions, national governments and regulators may prevent foreign acquirers from achieving full ownership of national firms by requiring them to preserve the presence of (domestic) minority shareholders at the local subsidiary level and the acquired firm’s listing on a local stock exchange. When that is the case, MCGs are the only viable means of realising (presumptively) value-increasing cross-border mergers.
MCGs are the subject of a sharp divide across national corporate laws. Some jurisdictions leave the regulation of relationships between group members to the common rules of corporate law, thus subjecting MCGs to ordinary rules against directors’ and controlling shareholders’ self-dealing. Other jurisdictions, on the contrary, establish a special regime, usually centered on the relaxation of directors’ fiduciary duties with regard to such relationships.
In a recent paper, we analyse this special regime (‘group law’) with the goal of shedding new light on the question of whether in firms organised as groups efficiency considerations justify the relaxation of fiduciary duties.
The primary goal of group law is to grant the controller (the parent company or its ultimate controlling shareholder, if there is one) greater leeway in managing the group. The underlying justification is that freeing group controllers from constraints on their ability to manage the group as though it was a single entity reduces the costs of managing the group and enhances the parent’s ability to maximise group value, to the benefit not only of the controller but also of society as a whole and, possibly, minority shareholders themselves.
The most significant obstacle to smoother group management is usually identified in directors’ fiduciary duties and, more specifically (and whatever the label in individual jurisdictions), in the duty of loyalty. Group law proponents view standard fiduciary duties as a hindrance to efficient group management and hence to controllers’ ability to maximise group value. According to them, such duties impose excessive constraints on intragroup exchange and group members’ investment policies, thus hindering a number of value-creating actions. Fiduciary duties imply an assessment of fairness (and hence, presumptively, value creation) focused on each individual transaction, without allowing for a broader perspective that considers intragroup exchange as non-episodic and therefore capable of offsetting the harm suffered from an individual transaction with the benefits gleaned from another. According to this view, the narrow focus of ordinary corporate law fiduciary duties is bound to deliver a disproportionate number of ‘false positives’, ie, of overall fair (and value-creating) intragroup exchange that never materialises or is mistakenly judged to be unfair.
Its supporters view group law as an effective solution to these shortcomings. A common element of group law across the jurisdictions that have adopted it is that controllers are granted the licence to force the affiliate to make disadvantageous decisions for itself if this is in the broader group interest. Yet, this option is usually subject to one important condition: any harm inflicted on the subsidiary as a consequence of unfair transactions must be fully compensated. In an even more enabling formulation of this regime, what is necessary and sufficient is that, at the time the harm is inflicted, directors could reasonably assume such compensation to materialise within a reasonable time.
The option to force the affiliate into the adoption of disadvantageous decisions gives controllers flexibility in managing the group: they may in fact allocate resources and business opportunities free of fair-price constraints, ie, as though the group were a single multi-divisional firm, where no such constraints apply to inter-divisional exchange. According to its supporters, group law would also allow for a more rounded assessment of fairness in intragroup exchange, as it permits intragroup transactions to be evaluated also in light of future (or past) offsetting advantages.
In short, in the view of its supporters group law is an efficient policy that is apt to maximise the value of firms organised as groups, allowing shareholders to capture the greatest possible benefits from choosing this organisational structure.
Our analysis supports a more sceptical view. We show that, as far as MCGs are concerned, the benefits of adopting this regime are limited and the costs substantial. To reach our conclusion, we focus on the rules on groups contained in the European Model Companies Act (EMCA), a model law drafted by a group of European academics. The EMCA’s rules are centered on the standard according to which directors of a subsidiary may legitimately adopt decisions harmful for an individual group entity if (1) the decision is beneficial to the group as a whole and (2) at the time the harmful decision is taken, directors may reasonably assume that the harm will be offset by a benefit within a reasonable time.
Our critique debunks the idea that the EMCA standard brings about significant net benefits, showing that the advantages usually associated with it are more limited than its proponents contend and that the costs are larger than usually believed.
First, we show that any type of group-value-maximising action that can be implemented under the EMCA standard can in principle also be implemented under ordinary director duties. Most notably, we show that director duties, including the core duty to act in the company’s best interest, do not prevent group company directors from undertaking actions that create additional net value at the group level, at the expense of the affiliate company. Indeed, what ordinary principles require in this case is that the company receives adequate compensation (or a legally enforceable promise thereof)—a negotiating outcome that, transaction costs aside, can always be reached, given that, by hypothesis, the harmful action for which compensation is required creates overall more wealth than it destroys. Ordinary director duties thus offer much more flexibility than many scholars tend to think, which means that the EMCA standard offers much less additional flexibility than is commonly believed.
Second, while we acknowledge that the EMCA standard allows for the reduction of the transaction costs of actions increasing group value, we show that the magnitude of this cost reduction is not significant. For instance, the EMCA standard makes it more difficult for minority shareholders to challenge directors’ decisions and, therefore, by reducing the risk of litigation over intragroup transactions, it reduces the transactions costs of intragroup exchange. However, this benefit is limited wherever derivative suits are infrequent also under ordinary corporate law rules against self-dealing (as is the case of all the major European jurisdictions that have group law in place—namely Germany, France and Italy).
Third, we show that the EMCA standard is unable to provide a better assessment of fairness in intragroup exchange than the ordinary corporate law rules on self-dealing. The principle may help to reduce the number of false positives (transactions that do not divert value but are mistakenly considered to be value-diverting), but it also increases the number of false negatives (transactions that divert value but are considered as not value-diverting).
In fact, in light of its limited benefits, the EMCA standard raises significant concerns regarding minority shareholder protection against tunnelling. Minority shareholders would have a hard time persuading a court that directors are liable for breach of their fiduciary duties in the case of an intragroup transaction. Under the reasonable assumption that the challenged transactions will be a subset of those diverting value from subsidiaries because detection will be difficult and costly for minority shareholders, the EMCA standard offers controllers the opportunity to single out ex post whatever benefit an affiliate may have obtained from its participation in the group and ‘spend’ it to escape liability for those value-diverting actions minority shareholders have detected and sued over. Worse still, minority shareholders may also encounter undue difficulties in recovering damages with respect to harmful transactions for which ex post compensation is lacking, since in this case directors may still avoid liability by proving that it was nonetheless reasonable to expect compensation ex ante.
The higher the chances of escaping liability for unfair self-dealing, the more controllers may be inclined to engage in tunnelling. If minority shareholders correctly discount the negative effects of tunnelling on the share price, they may still get a fair deal. But a lax regime would also have negative effects more broadly, in the form of higher agency costs and a higher cost of capital across the board.
Overall, our analysis suggests that EMCA-style special regimes for intragroup transactions are dysfunctional as far as MCGs are concerned. They bring about some benefits (eg, lower group management costs) but these benefits appear overall modest compared to the costs (specifically a higher tunnelling risk, leading to increased agency costs and a higher cost of capital for all firms). Our policy suggestion is thus that, if a special, lenient standard for intragroup transactions and, more broadly, for decisions made in the interest of (other entities of) the group is justified, it should only operate as an opt-in regime. In addition, any midstream transition to it, if it is to be allowed at all, should be accompanied by adequate safeguards for minority shareholders.
Luca Enriques is Professor of Corporate Law at the University of Oxford.
Sergio Gilotta is Assistant Professor of Business Law at the University of Bologna.
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