Corporate_pp03

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Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012

International Corporate Governance

Control versus Ownership Rights

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Lecture Aims

The aim of this lecture is to review the various devices that create a wedge between control and ownership.

It is important to be aware of differences between control and ownership as they determine the types of conflicts of interests that a company and its stakeholders may be subject to.

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Learning Outcomes

By the end of this lecture, you should be able to:1. Distinguish ownership from control 2. Explain how to obtain the various combinations of

weak or strong control with dispersed or concentrated ownership

3. Define security benefits and private benefits of control

4. Assess the importance and amplitude of private benefits of control across countries.

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Introduction

While in the UK and the USA most listed corporations are widely held, in the rest of the world corporations tend to have large shareholders with significant control.

How do these large shareholders manage to stay in control?

The short answer is that they leverage control, i.e. they manage to hold a substantial percentage of voting rights while holding fewer cash flow rights.

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Introduction (Continued)

We have already seen one way of leveraging control which is ownership pyramids, but there are others.

More generally, we shall analyse the various combinations of dispersed or concentrated ownership and weak or strong control.

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Combinations of Ownership and Control

We shall distinguish between two extremes for both control and ownership– strong versus weak control– concentrated versus dispersed ownership.

Control

Weak Strong

Ownership

Dispersed

Combination A:

weak control

and dispersed

ownership

Combination B:

strong control

and dispersed

ownership

Concentrated

Combination C:

weak control

and

concentrated

ownership

Combination D:

strong control

and

concentrated

ownership

Figure 1 – Combinations of control and ownership

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Combinations of Ownership and Control

Dispersed ownership has two major advantages– increased liquidity resulting in a lower cost of

capital, and– the exposure to hostile takeovers putting pressure

on managers to perform well.

Its main disadvantage is the free-rider problem whereby each individual shareholder refuses to monitor the management as s/he will bear all the costs from doing so, but will share the benefits with all the other shareholders.

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Combinations of Ownership and Control (Continued)

Concentrated control and ownership also have a major advantage as there will be a shareholder with enough power and sufficient incentives to monitor the management.

Its main disadvantage is the danger of minority shareholder expropriation.

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A priori, we expect– combination A to apply to most Anglo-American

firms, and– combination D to most Continental European firms.

However, due to several mechanisms, combination D does not apply to most Continental European firms.

As a result, combination B prevails outside the UK and the USA.

Combinations of Ownership and Control (Continued)

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Combination A: Dispersed Ownership andWeak Control

Case of most UK and US firms. Advantages of liquidity and takeover market. Disadvantages of insufficient monitoring. Main conflict of interests is between the

management and the shareholders.

Box 1 – The 10 largest shareholders in BT Group Plc in October 2010 Investor Name % Investor Type Country INVESCO Asset Management Limited 11.02 Investment Managers United Kingdom BlackRock Investment Management (UK) Ltd. 4.89 Investment Managers United Kingdom AXA Investment Managers UK Ltd. 4.63 Investment Managers United Kingdom Legal & General Investment Management Ltd. (UK) 3.99 Investment Managers United Kingdom Norges Bank Investment Management (NBIM) 3.10 Investment Managers Norway M & G Investment Management Ltd. 2.08 Investment Managers United Kingdom Aviva Investors Global Services Limited 1.99 Investment Managers United Kingdom BlackRock Advisors (UK) Limited 1.76 Investment Managers United Kingdom State Street Global Advisors (UK) Ltd. 1.36 Investment Managers United Kingdom Standard Life Investments Ltd. 1.24 Investment Managers United Kingdom

Source: Thomson Financial

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Box 2 – The 10 largest shareholders in The Coca Cola Company in October 2010

Investor Name % Investor Type Country Berkshire Hathaway Inc. 8.66 Investment Managers United States Vanguard Group, Inc. 3.62 Investment Managers United States State Street Global Advisors (US) 3.46 Investment Managers United States BlackRock Institutional Trust Company, N.A. 3.29 Investment Managers United States Fidelity Management & Research 2.80 Investment Managers United States Capital World Investors 2.59 Investment Managers United States SunTrust Bank 2.38 Investment Managers United States Fayez Sarofim & Co. 0.85 Investment Managers United States Davis Selected Advisers, L.P. 0.84 Investment Managers United States Grantham, Mayo, Van Otterloo & Co., L.L.C. 0.83 Investment Managers United States

Source: Thomson Financial

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Combination B: Dispersed Ownership andStrong Control

This combination prevails in most corporations outside the UK and the USA.

Active market in the shares. There is a controlling shareholder with enough

power to prevent the managers from expropriating the shareholders.

However, there is also an increased risk of minority shareholder expropriation.

Box 3 – Ownership and control of BBS AG

Source: Hoppenstedt Aktienführer 2007

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Combination C: Concentrated Ownership and

Weak Control

This is a fairly rare combination. It applies to only a few firms across the world,

including German firms with voting caps. Minority shareholders are protected as no

single shareholder is able to dominate. Lack of monitoring and low liquidity.

Box 3.4 Voting cap in Nestlé SA

Nestlé SA has a provision in its articles of association specifying a voting cap which prevents any person from voting directly or indirectly for more than 5% of the equity. Under this provision, legal entities that have links via equity holdings, voting rights, common management or any other form will be considered as a single shareholder.

Source: Nestlé SA, 2010 corporate governance report

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Combination D: Concentrated Ownership and

Control

This combination creates strong monitoring incentives.

However, there is also low liquidity and a reduced takeover probability.

Volkswagen AG holds 99% of the shares of Audi AG.

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How to Achieve Dispersed Ownership andStrong Control

There are five main ways of achieving this combination – ownership pyramids,– proxy votes,– voting coalitions,– dual-class shares, and– clauses in the articles of association that confer

additional votes to long-term shareholders.

They all consist of leveraging control, i.e. having control while holding a lower ownership stake.

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Ownership Pyramids

Figure 2 – Simple ownership pyramid

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Proxy Votes

We have already discussed proxy votes held by banks.

These proxy votes originate from the shares of the banks’ customers deposited with the banks.

However, proxy votes may also be solicited by– the management, or– small shareholders seeking the support of the other

shareholders to obtain approval for a motion they intend to put forward at the shareholders’ meeting.

Box 6 – Proxy votes solicited by the managementSlide 3.22


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Voting Coalitions

A voting coalition or voting pool consists of several shareholders agreeing to vote in the same way.

In practice, voting coalitions are rare, especially those that persist in the long term.

One reason for the infrequency of voting coalitions may be the costs imposed by regulation.

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Voting Coalitions (Continued)

The UK City Code on Takeovers requires shareholders that have acquired a stake of at least 30% to make a tender offer to the remaining shareholders.

The same rule applies to voting coalitions. However, there is evidence that in the UK

voting coalitions are formed on an ad hoc basis to intervene in poorly performing companies.

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Dual-class Shares

Companies with dual-class shares have two classes of shares– a class with voting rights or superior voting rights, and– a second class with no voting rights or fewer voting

rights.

While non-voting shares have the disadvantage of no vote, in some countries these shares confer preferential dividend rights and a higher seniority (e.g. German preference shares).

Dual-class shares are issued by some Continental European firms, but also some American firms.

Box 7 – Ford Motor Company dual-class shares

Percentage of Equity Represented by Class A and Class B Stock

97.9%

2.1%

Class A stock Class B stock

Voting Rights of Class A and Class B Stock

60%

40%

Class A stock Class B stock

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Ford Motor Company has dual-class shares outstanding. The common stock represents

roughly 97% of the equity (33 / (33 + 1)) and the class B stock 3%. However, the common

stock has only 60% of the votes compared to 40% for class B.

Source: Ford Motor Company – 2009 annual report p.77 & p.150

“The Ford family holds all 71 million shares of the company's Class B stock, along with a

small number of the company's […] common shares. Under rules designed to preserve family

control and drafted when the company went public in 1956, the family holds 40 percent of

the voting power at the company as long as it continues to own at least 60.7 million shares of

the Class B stock [...]”

Source: Keith Brasher (2000), Ford Motor to Pay $10 Billion Dividend and Ensure Family

Control, New York Times, 14 April, Section C, p.1.

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Conferring Additional Votes to Long-term Shareholders

Many French companies confer additional voting rights to their long-term shareholders via a clause in their articles of association.

Frequently, such clauses are put in place at the time of the IPO and are also retrospective.

Box 8 – Double voting rights conferred to long-term shareholders of LVMH SA

Source: LVMH Reference document 2009, Bylaws, p.228; LVMH annual report 2009, p.12

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The Consequences of Dispersed Ownershipand Concentrated Control

Sanford Grossman and Oliver Hart argue that large stakes create benefits of control.

There are two types– security benefits originate from the increase in

firm value due the monitoring of the management and they are shared by all the shareholders

– private benefits are extracted from the firm by the large shareholder and are at the expense of the minority shareholders.

The latter include tunnelling, transfer pricing, nepotism and infighting.

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The Consequences of Dispersed Ownershipand Concentrated Control (Continued)The five main ways of achieving dispersed ownership with concentrated control , i.e.,–ownership pyramids,–proxy votes, –voting coalitions,–dual-class shares, and–clauses in the articles of association that confer additional votes to long-term shareholders.

all violate the rule of one-vote one-share.The main consequence of violating this rule is the increase in private benefits of control and the increased probability of minority shareholder expropriation.While private benefits are difficult to quantify, there are nevertheless empirical studies that have tried to do exactly that.

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The Consequences of Dispersed Ownershipand Concentrated Control (Continued)

The study by Michael Barclay and Clifford Holderness was one of the first such studies.

They measure the value of private benefits by the premium above the market price paid by the buyer of a block of shares.

However, Jeffrey Zwiebel argues that one also needs to take into account the size of the block changing hands.

Table 1 – Block premiums per country

Notes: The block premium is the difference between the price per share paid for the block and the stock price two days after the announcement of the transfer of the block divided by the latter price and multiplied by the proportion of cash flow rights presented by the block.Source: Dyck and Zingales (2004)

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Conclusions

The combination of ownership and control determines the main potential conflict of interests.

Combination A prevails in the UK and the USA whereas combination B prevails elsewhere.

How to achieve combination B (such as through ownership pyramids, proxy votes, dual class shares etc.) and its main consequences.

- They confer more control rights than cash flow rights to the large shareholder.

- They create a wedge between control and ownership and violate the rule of one-share-one vote.

- This has important consequences as it determines the size of the private benefits of control that the large shareholder may extract from the firm at the expense of the minority shareholders.

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