NOTE NUMBER 265 P U B L I C P O L I C Y F O R T H E privatesector 54117 AUGUST 2003 Minority Shareholders Mierta Capaul Mierta Capaul What Works to Protect Shareholder Rights? (mcapaul@worldbank.org) is a senior corporate T h e Wo r l d B a n k 's a s s e s s m e n t s o f c o r p o r at e g ove r n a n c e p r a c t i c e s i n governance specialist in 2 5 c o u n t r i e s a c ro s s f i ve c o n t i n e n t s h ave reve a l e d a g e n e r a l the World Bank Group's Investment Climate c o m m i t m e n t t o c o m p l y w i t h i n t e r n at i o n a l p r i n c i p l e s . B u t t h e T H E W O R L D B A N K G R O U P PRIVATE SECTOR AND INFRASTRUCTURE NETWORK Diagnostics Unit. She has n e c e s s a r y l eg a l c h a n g e s a re s l ow a n d s u b j e c t t o p o l i t i c a l c o m p ro m i s e . written a number of corporate governance M o re ove r, m o s t c o u n t r i e s h ave a p o o r t r a c k re c o rd i n e n f o rc i n g assessments under the ex i s t i n g l aw s a n d reg u l at i o n s . E x p ro p r i at i o n o f m i n o r i t y s h a re h o l d e r s joint World Bank­ International Monetary c o n t i n u e s t o b e a p ro bl e m a ro u n d t h e wo r l d . Fund ROSC (Reports on the Observance of Global debates about strengthening the protec- Reforms in the rules Standards and Codes) tion of shareholders have moved beyond codes The World Bank's corporate governance assess- program. Before joining to oversight and compliance. How can enforce- ments reveal growing awareness around the world the World Bank she was the regional head of a ment be strengthened? What alternatives do of the importance of corporate governance.1 large financial countries have for enforcing their corporate Almost all the countries assessed are undertaking institution, covering governance laws and regulations? Should devel- reforms to bring their legal and regulatory frame- Ecuador, Guyana, oping and transition economies rely on courts works into compliance with the Organization for Suriname, República or regulators? Economic Co-operation and Development's Bolivariana de Venezuela, A lively debate is also under way about a sec- (OECD) principles of corporate governance--a and the Caribbean. ond set of questions--whether voluntary com- set of nonbinding standards against which coun- pliance and choice can improve shareholder tries' performance can be measured. protection in a country. Can the incentive of Consider Romania, a country that undertook attracting capital compel companies to volun- mass privatization. Since the vouchers were free, tarily comply with best practice? Is using a menu the new shareholders did not see themselves as of options to create choice an effective way to owners and the privatized companies did not improve corporate governance practices? If so, treat them as investors. The result was wide- under what circumstances? And can a country spread expropriation of minority shareholders. simply replicate approaches that have suc- That started to change when shareholders ceeded elsewhere, or does the appropriate solu- became more vocal. Romania recently adopted tion depend on its level of development and regulations that significantly strengthen share- other characteristics? holder rights. M I N O R I T Y S H A R E H O L D E R S WHAT WORKS TO PROTECT SHAREHOLDER RIGHTS? Still, changing laws and regulations is a slow very market practitioners being supervised. and complex undertaking, and it requires much Moreover, professional associations usually lack negotiation and compromise. Brazil's dilemma the means to impose effective sanctions. Auditors of how to treat minority shareholders in a have sometimes given unqualified opinions, cer- change of control is a case in point. The corpo- tifying that the accounts audited provide a true rate law originally granted all owners of voting and fair picture despite the many defects noted. shares "tag along" rights (equal treatment in a The penalties for such behavior are low, and change of corporate control, ensuring that the enforcement generally lax. None of the countries control premium is equally distributed among surveyed has set the fines for such actions high 2 majority and minority shareholders). In 1997, enough to act as an effective deterrent. however, tag-along rights for minority share- Weak enforcement can also arise when the holders were abolished to maximize state rev- enforcement responsibility is divided among dif- enues from privatization. In the sale of the bank ferent institutions, allowing issuers to conduct Banespa, for example, the government received "regulatory arbitrage." For example, while the a control premium of 912 percent.2 A corporate Hong Kong Stock Exchange is the frontline reg- law reform proposed in 2001 would have ulator for listed companies, the Securities and restored tag-along rights for all voting shares, Futures Commission supervises such aspects as but powerful business interests representing takeovers, insider dealing, and disclosure of inter- controlling shareholders successfully lobbied ests in securities. Since the listing rules are not against its passage. The compromise finally statutory and carry weaker sanctions, issuers reached requires that the purchaser offer at reportedly sometimes attempt to structure trans- least 80 percent of the share price paid to the actions so that they fall under the purview of the controlling group to all voting shareholders. stock exchange rather than the Securities and Futures Commission. A recent example is the Problems in enforcement Boto case, where a takeover was structured as a It is not just the quality of the law that matters. sale of major assets governed by the listing rules. An important lesson from the corporate gover- That allowed Boto's majority shareholder to avoid nance assessments is that most developing and subjecting himself to the stringent takeover rules. transition economies fail to enforce their laws, While such transactions appear unfair to outside rules, and regulations consistently and evenly. investors, they do comply formally with the law. This failure was not anticipated by the OECD In some countries minority shareholders are principles, which implicitly assume that coun- expected to raise no questions about decisions tries have an efficient legal and regulatory by majority shareholders even if they have the framework in place and that courts and securi- right to do so in theory. When minority share- ties regulators have the means and capabilities holders did so during a takeover in Morocco in to enforce it. In reality, however, such practices 2000, it ignited a public controversy. The target as self-dealing and insider trading are wide- company's minority shareholders objected to spread. Such offenses mostly go unpunished, the valuation commissioned by the bidder and even if stiff penalties apply in theory. requested a second opinion. While this request Auditing is another area where weaknesses are is permitted by law, the press branded it outra- apparent. Most countries surveyed delegate the geous. Through the press, the oligarchs argued setting of accounting and auditing standards to that the law should not allow "just any" share- the accounting association. Compliance by holder to bring a merger or acquisition to a issuers is generally monitored by the securities standstill. Minority shareholders questioning regulator or, as in South Africa, by the stock the wisdom of management or controlling exchange, institutions that often lack the expert- shareholders was considered unacceptable. ise to fulfill this obligation. Meanwhile, the pro- fessional conduct of accountants and auditors is Alternatives for enforcement monitored by the professional accounting and If the courts and regulators fail to protect share- auditing associations--and thus generally by the holders, there will be few shareholders. Under the concentrated ownership that results, the con- and Shleifer 2001). Judges face a broad set of trolling shareholder rather than an outside insti- tradeoffs and focus less on issues of investor pro- tution takes on the enforcement of shareholder tection than do specialized regulators, who tend rights--through the board of directors. In most to be more motivated and more knowledgeable developing and transition economies, regardless about securities laws and listed firms. of their legal heritage, companies follow a parlia- There is also the question of resources. In mentarian model of board representation in South Africa, for example, courts are so over- which directors represent the constituency that burdened that they simply lack the capacity to elected them rather than all shareholders. In cope with commercial issues. For some coun- 3 many countries majority shareholders exercise tries it may be preferable to rely on regulatory significant influence over boards, directly (as agencies until the judicial system becomes more board members) or indirectly (through board efficient. But this approach works only if the reg- members who report to them). Malaysia and ulators can enforce sanctions without being sub- South Africa are among the countries trying to ject to automatic and lengthy appeal. subject such controlling shareholders to statutory In Poland strict enforcement of the securities requirements and hold them liable for their law by a highly motivated regulator was associated actions as "shadow directors."3 with a rapidly developing stock market. In the Business groups are another alternative Czech Republic hands-off regulation and reliance enforcement mechanism in countries with a on the court system had the opposite effect. weak corporate governance framework. They act as intermediaries between individual entrepre- A menu of options neurs and the imperfect market, so that transac- Legal frameworks and their enforcement are tion costs are minimized. Business groups grow rarely perfect. What else can help improve and diversify internally, constructing a web of shareholder protection? Should regulators rely companies through pyramid structures and on the companies themselves? After all, attract- cross-shareholdings that support one another. ing capital at the lowest possible cost should pro- At the apex of the group is a large enterprise con- vide a natural incentive for companies to trolled by a family (and often not listed on the voluntarily comply with good corporate gover- exchange) that plays a corporate finance func- nance practices and even exceed the minimum tion for smaller companies by financing suppli- requirements. ers and new firms and smoothing out income An interesting lesson from the corporate gov- flows. Thus business groups ensure access to ernance assessments is that giving issuers a finance in an environment where external choice of corporate governance options can finance may be impossible to obtain. This system facilitate reform. That has been the case in of internal corporate governance, while not Brazil, where Bovespa, the São Paulo stock transparent, substitutes for a weak external exchange, launched a new market segment framework by replicating the functions provided known as the Novo Mercado in 2001.4 New list- by institutions in advanced economies. ing segments have traditionally been introduced to encourage small and medium-size enterprises Solutions to become listed. The listing rules for these seg- So, how should a country strengthen enforce- ments are usually watered-down versions of those ment of shareholder rights? for the main board. Not so in Brazil. The com- panies listed on the Novo Mercado must adopt Courts or regulators? the one-share, one-vote principle, grant full tag- Should a country rely on courts or regulators for along rights to minority shareholders, abide by enforcement? In an ideal world both would play U.S. generally accepted accounting principles or a part. In the countries assessed, however, courts the International Accounting Standards, and are often underfinanced, unmotivated, unfa- have a free float of at least 25 percent.5 The com- miliar with how the law applies to economic panies also must submit to arbitration to settle issues, and even corrupt (see Glaeser, Johnson, shareholder disputes. M I N O R I T Y S H A R E H O L D E R S WHAT WORKS TO PROTECT SHAREHOLDER RIGHTS? The Novo Mercado was created to give issuers Whatever the method, codes of best practice a choice of complying with higher corporate represent a market push to institutionalize and governance standards than those legally professionalize corporate governance. They required and thus differentiating themselves in improve the image of companies that uphold the competition for capital at home and abroad. them and allow investors to sort good compa- A listing on the Novo Mercado allows companies nies from bad. viewpoint to attract quality domestic and international investors and lower their cost of capital. Conclusion is an open forum to Brazilian pension funds, for example, are The corporate governance assessments show encourage dissemination of allowed to invest a larger share of their assets in that choice can facilitate reform. Allowing dif- public policy innovations for companies listed on the Novo Mercado. The ferent models of corporate governance to coex- private sector­led and Novo Mercado has raised the bar, becoming the ist permits investors with varying risk profiles to market-based solutions for new standard that investors expect. But how suc- choose the appropriate market and company to development. The views cessful it will be remains open to question. With invest in and allows market forces to pick the win- published are those of the only a small number of companies listed on the ners. When companies have the choice of listing authors and should not be Novo Mercado, the jury is still out. their shares on a stock market segment with attributed to the World A "menu of options" approach based on dif- stricter corporate governance rules or of com- Bank or any other affiliated ferentiated market segments is most likely to be plying with a code of best practice, they can use organizations. Nor do any of effective in a country with relatively sophisti- this option to signal to investors that they are dif- the conclusions represent cated corporate and securities laws and reason- ferent. While establishing a corporate gover- official policy of the World able protection of basic shareholder rights, but nance market segment appears to be an Bank or of its Executive with weak confidence in the judicial system and attractive option only for middle-income coun- Directors or the countries a small number of investors. To be successful, tries, codes of best practice seem to be important they represent. the approach must include mechanisms allow- regardless of a country's level of development. ing established companies to "graduate" from To order additional copies the main board to the corporate governance contact Suzanne Smith, tier. Otherwise, that tier will be perceived as a managing editor, Room I9-009, small cap market with low liquidity. Countries Notes The World Bank, with more mature securities markets, a strong 1. For more on the World Bank's corporate gover- 1818 H Street, NW, rule of law, and effective judicial enforcement nance assessments, see http://www.worldbank.org/ifa/ Washington, DC 20433. should focus on measures to improve the cor- rosc_cg.html. porate governance standards of the market as a 2. Based on data from the Brazilian Securities and Telephone: whole rather than establish a separate tier. Exchange Commission (Comissão de Valores Mobiliarios). 001 202 458 7281 There are other ways to introduce choice. 3. "Shadow directors" are controlling shareholders or Fax: Many countries are working to improve corpo- shareholders who exert significant influence over the 001 202 522 3480 rate governance by developing a national code board even though they are not directors. Email: of best practice. By January 2003, 43 economies 4. The transparency tier of the Bucharest stock ssmith7@worldbank.org had adopted a corporate governance code, exchange is another example of a corporate governance including Brazil, Croatia, the Czech Republic, segment. Copyedited and produced by Hong Kong (China), India, the Republic of 5. The free float is the share of capital that is not held Communications Korea, Malaysia, the Philippines, Poland, by controlling shareholders and can be easily purchased Development Inc. Romania, the Russian Federation, and South by portfolio investors. Africa. Such codes can be tailored to each coun- Printed on recycled paper try. Some countries adopt a "comply or explain" Reference rule requiring that companies comply with the Glaeser, Edward, Simon Johnson, and Andrei Shleifer. code or explain in their annual report why they 2001. "Coase versus the Coasians." Quarterly Journal of have not done so. Thailand has taken an inter- Economics 116: 853­99. esting approach, allowing companies that adopt the code of best practice a discount on their list- ing fees. This Note is available online: http://rru.worldbank.org/Viewpoint/index.asp