Evidences of Minority Shareholders Expropriation

Minority shareholders are defined as outside or non-controlling shareholders because their holdings are small in absolute terms and relative to the corporation’s total outstanding shares. With only a small portion of the corporation’s outstanding shares, these investors have limited voting rights and accordingly have little power of control within the corporation. Sometimes their investment is only a small share of their personal portfolios in the corporation; hence they have little motivation to control the corporation (Sheifer and Vishny, 1997; LLSV, 1998; Gonenc, 2006; Kostyuk et al., 2007). This increases the likelihood of expropriation which is associated with high ownership concentration as the large shareholders policies may result in diverting the firm profits at the minority shareholders expenses. This is due to this nature of the minority shareholders that their expropriation is a major type of PBC.

Many studies offer evidence of expropriation of minority shareholders. LLSV (1999), Claessens et al. (2000), and Dyck and Zingales (2004) suggest that the main agency problem outside the U.S. and the U.K. is not the manager-shareholder conflict, but rather the risk of expropriation by the dominant or controlling shareholder at the expense of minority shareholders.  Even within the U.S., Barclay and Holderness (1989), as highlighted earlier, found evidence that large shareholders receive value from extracting private benefits at the minority shareholders expenses, in addition to the fraction of the company’s monetary returns to which they are entitled.

Wolfenzon (1999) presents a model which predicts that the minority shareholders expropriation is a prominent feature of paramedical structure (the control of a firm through a top-down chain of ownership relations) as it creates a wedge between the cash-flow and control rights for controlling shareholders. Going more global, Hanouna et al. (2001) identify a set of 9,566 acquisitions of public companies between 1986 and 2000 in the seven most industrialized nations[1]. They found that the controlling shareholders in a company based in the United States is acquired at a median premium that is 20-30 per cent higher than the premium paid for a minority position. A similar 20-30 per cent control premium is paid in other “market-oriented” countries, namely the United Kingdom and Canada. The control premiums paid in “bank-oriented” countries, namely Japan, France, Italy and Germany, are considerably lower. In Germany, Franks and Mayer (1994) find empirical evidence that large shareholders seem to act in their own interests, and that the gains from control transfers accrue solely to the holders of large blocks, which in turn indicate for expropriation of the minority shareholders.  Similarly, Gugler and Yurtoglu (2003) highlight the issue of minority shareholders expropriation by looking at the dividend policy of majority-controlled firms in Germany. They argue that controlling shareholders can extract private benefits at the expense of minority shareholders; their preference translates into lower dividends payout. They also call for better minority shareholder rights protection and increased transparency in the course of European Capital Market Reform.

Meoli et al. (2008) find that in the case of Telecom Italia-TI, and despite substantial reforms, such as Draghi’s 1998 Reform[2], the pyramid structure and the dual-class structure allocated the controlling shareholder with excessive power that increased minority expropriation. Further evidence on control contestability and payout policy is provided by Ozkan and Mancinelli (2006) who show that the dividend payout of Italian firms is negatively related to the fraction of voting rights under the control of the largest shareholders. Looking at large firms in East Asia and Western Europe, Faccio et al. (2001) report systematic expropriation of outside shareholders when examining the association between dividend rates and the separation of cash flow rights and voting rights between 1992 and 1996.

In Hong Kong, Cheung et al. (2006) use a sample of 254 filings of “connected transactions” between listed corporations and their controlling shareholders during between 1998 and 2000, to present evidence that controlling shareholders do extract gains or engage in expropriation from non-controlling shareholders. Their analysis shows that corporations acquire assets from related parties by paying a higher price compared to similar arms’ length deals. In contrast, when they sell assets to related parties, they receive a lower price than in similar arms’ length deals.

Using dataset of 2,658 large publicly-traded corporations in East Asian (Hong Kong, Indonesia, Singapore, Japan, South Korea, Malaysia, the Philippines, Taiwan and Thailand) in 1996, the year before the regional financial crisis, Claessens et al. (1999) find that the risk of expropriation is indeed the major principal-agent problem for corporations. They also find that the higher cash-flow rights are associated with higher market valuation, but higher control rights are associated with lower market valuation, especially when cash-flow rights are low and control rights are high. This suggests expropriation of minority shareholders by controlling shareholders. Johnson et al. (2000a) note that the emerging markets crisis of 1997-98 offers many instances of looting of firms by their controlling shareholders. Assets were transferred out of companies, profits syphoned off to escape creditors, and troubled firms in a group propped up using loan guarantees by other listed group members (Johnson et al., 2000b).

Different studies have found that financial institutions which own large stakes of corporate subsidiaries reap private benefits at the expense of the minority shareholders of those subsidiaries. Weinstein and Yafeh (1998) find that Japanese firms belonging to bank-controlled Keiretsus pay higher interest rates on their liabilities than unaffiliated companies. Similar behaviour was reported for Korea First Bank following the collapse of Hanbo Steel and General Construction, which had received loans at above-market rates from its creditor-owner. In 1998, the Korean Financial Supervisory Commission filed lawsuits against the presidents of five other major Korean banks on charges of illegal loans and breach of trust (Byeon, 1998). Bae et al. (2002) examine evidence from mergers from Korean business groups known as Chaebols. They argue that the owner-managers of the Chaebols have substantial discretionary power and legal protection against the expropriation of Korean minority shareholders. They report significantly negative stock returns when Chaebol-affiliated firms make acquisition for poorly performing targets within the same group, so the minority shareholders of these firms loose out while controlling shareholders gain because of the increase in value of other firms in the group.

Moreover, dilutive transactions are relatively common in emerging market (Johnson et al., 2000b). Prior to the 2002 legal changes which aim to improve minority investors’ pre-emptive rights, Bulgarian minority shareholders suffered severe dilution. When privately controlled firms issue shares, almost all are purchased by controlling shareholders, often at the minimum lawful price (the shares’ par value of one Bulgarian levy per share) and at a large discount to market value. Freeze-out offers are at an average of less than 35 per cent of market value, which was often already depressed by prior dilutive offerings and investor anticipation of future tunnelling (Atanasov et al., 2008b).

After the 1997 Asian financial crisis period, Singhai (2002) presents different examples to illustrate improper dilution of non-controlling shareholders. In Korea, he presents cases for over-payment for an Unlisted Acquisition in Hyundai Mobis, massive dilution in Hawit Bank and dilution through absence of Pre-emptive Rights in Shinsegae Department Stores. In Thailand, he illustrates an example for deep discounted rights issue in the Thai Farmers Bank, where the minority shareholders faced a Hobson’s choice of either investing more money to maintain their stake, or getting massively diluted.

In summary, different studies demonstrate that controlling shareholders may use their control power to consume corporate resources for their own interests in most cases at the expense of minority shareholders. Although, the thesis is directed towards assessing the role legal systems can play in preventing expropriation and then aiding the development of the financial markets, the following section focuses on unfair self-dealing which is a dominant form of PBC transactions.

[1] The Group of 7 nations are known as the G7, which includes: the United States, Japan, Germany, France, Italy, the United Kingdom, and Canada.

[2] The 1998 Draghi Reform required company boards to improve their monitoring and compliance; observe ‘principles of correct administration; review internal controls, administrative and accounting systems; appoint at least three auditors and ensure that at least one statutory auditor is elected by minority shareholders (Clarke, 2007).