Justifications for Minority-Co-Owned Groups and Their Corporate Law Implications
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Corporate groups are an important reality of the corporate landscape. Virtually every large firm is organized as a group, that is, as a network of formally independent companies under the common control of a ‘parent’ company. A significant number of corporate groups around the world are minority co-owned groups (MCOGs), namely groups with one or more listed subsidiaries.
MCOGs are well-known to entail significant risks for minority shareholders. They facilitate controllers’ tunneling, relative to more straightforward corporate structures, such as wholly owned groups (that is, groups with minority shareholders present only at the parent company level) and the multidivisional single-entity firm.
By structuring their firms as MCOGs, controllers (i) can engage in frequent intragroup transactions (IGTs)—the chief tunneling technique in groups—and obfuscate their negative effects on minority shareholders more easily, because conflicted transactions like IGTs tend to become routine business transactions; (ii) gain the option to siphon off common corporate value via elusive (and difficult-to-police) non-transactional techniques involving no exchange between group members (eg, they may induce a minority-participated subsidiary to forgo a profitable business opportunity or to invest in a loss-generating project with, respectively, negative or positive spillover effects on other group members in which they have a larger equity stake).
To be sure, so long as minority shareholders correctly discount tunneling risks in the price they pay for minority shares, controllers’ choice in favor of the MCOG structure should not be expected to have distributive consequences. Tunneling, however, has social costs. Because it is (usually) illegal also where it is ineffectively policed, it must be hidden or disguised, which generates costs (both direct and indirect) that, from society’s standpoint, are a pure deadweight loss. Furthermore, widespread tunneling may generate adverse selection in equity capital markets: honest entrepreneurs that cannot credibly signal their intention not to steal from prospective investors are unable to avoid a tunneling discount when they take their company public, with the consequence that, at the margin, some firms will forgo positive net present value projects and/or a listing on the stock exchange.
In our essay forthcoming in a special issue of Theoretical Inquiries in Law on controlling shareholders and control enhancement mechanisms, we problematize the conventional view of MCOGs as tunneling infrastructures by showing that MCOGs may also have value-enhancement justifications, ie, their existence may be explained not only by controllers’ intention to extract larger amounts of pecuniary private benefits, but also in ways consistent with the goal of creating value for all shareholders. To this end, we first recall the major efficiency reasons for organizing a firm as a group, rather than as a single entity, and show that they do not also justify the choice of an MCOG structure. We show, however, that such a structure may have five specific, non-mutually exclusive justifications: first, the MCOG structure may increase firm transparency (as a result of the subsidiary-level listing(s)), potentially decreasing the group’s cost of capital. Second, it allows subsidiary managers to receive compensation in the form of stock (or stock options) of the specific entity they are at the helm of (and therefore whose results they can influence with their effort), which may lead to reduced managerial agency costs and a lower cost of capital. Third, the MCOG structure may be used to circumvent inefficient restrictions to dual class shares or, fourth, to facilitate acquisitions by foreign firms. Fifth, the MCOG structure may find a justification in path dependency and the high costs of switching to more efficient organizational structures. Other things equal, these rationales may make MCOGs a superior organizational form relative to both the single entity firm and the wholly owned group.
The fact that MCOGs may deliver unique benefits has significant implications. To begin with, it weakens the case in favor of radical policy choices, such as a ban on pyramids. Second, it may seem to support the view that favors laxer corporate law constraints on self-dealing when it takes the form of intragroup transactions. As a matter of fact, some national corporate laws (mostly in continental Europe) already provide for a similar regime (we provide a description and an assessment of this special regime in a companion paper, summarised here). These special rules on groups relax directors’ fiduciary duties by allowing subsidiary directors (under certain conditions) to adopt decisions that are disadvantageous for the subsidiary but beneficial for the whole group, thus allowing controllers to prioritize the group interest over that of the subsidiary. The chief goal of this special regime is to ease the management of firms organized as groups, by removing the constraints that corporate law poses in this respect, such as onerous procedural requirements for IGTs. One may argue that the introduction of this special enabling regime is even more justified once it is demonstrated that MCOGs can be value-increasing organizational structures. Indeed, by decreasing group management costs the regime would maximize the benefits that the MCOG structure brings about, to the advantage of all the shareholders involved.
Our essay debunks this idea, showing that none of the five value-enhancement justifications we identify are consistent with the claim that corporate law’s constraints against unfair self-dealing should be relaxed for firms organized as groups (including MCOGs) to ease their management. Quite the opposite, those justifications reinforce the proposition that rules on IGTs should be rigorous or, at the very least, not less rigorous than those established for other conflicted transactions. Consider, for example, the MCOG-specific benefits of enhanced transparency (via subsidiary listing) and improved managerial motivation to pursue shareholder interests (via stock-based compensation). For either of those benefits to play out the listed subsidiary must be granted a significant degree of independence from the rest of the group. Were that not the case and the listed subsidiary were to be managed just like any other division of the larger group (ie, as a company engaging frequently in intragroup exchange and free from fair-price constraints), what could be gained thanks to the separate listing in terms of decreased informational asymmetry and incentive alignment would in fact be lost. The high number of IGTs, coupled with the systematic deviation from fair price constraints in those transactions, would blur the separate picture that the subsidiary’s financial reports would be meant to provide, making it much harder to gauge the financial performance of the subsidiary and hence of its management team. Accordingly, an enabling regime that were to facilitate intragroup exchange would undercut the specific functions of MCOGs as outlined above and therefore their benefits for the relevant shareholders. A similar reasoning can be extended to the other three value-enhancement rationales we identify, thus strengthening the case against any relaxation of self-dealing rules in the context of intragroup relations.
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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