One Share One Vote Controversy in EU : Hype or a Genuine Need? Dr. Arman Khachaturyan Associate Research Fellow, CEPS

1. One Share One Vote Controversy in EU : Hype or a Genuine Need? Dr. Arman Khachaturyan Associate Research Fellow, CEPS One Share One Vote: A Means for Corporate Control A CEPS Roundtable 07 December 2006

2. Presentation Outline • Part I. Introduction • Part II: History and the New Phase of Corporate Governance Reform in the EU • Part III: 1S1V Definition and Background in the EU • Part IV: Shareholder Democracy Argument • Part V: Cost of Capital and Minority Protection Argument • Part VI: Efficient Capital Market Argument • Conclusions and Policy Recommendations

3. Part I: Introduction: Corporate Frauds: What Happened? • Schemes: siphoning off corporate assets • Enron: SPE, market-to-market accounting and “third party” hedging transactions • Parmalat: simple theft through offshore accounts • Governance Dimensions • accounting: largely enforcement failure • auditing: largely enforcement failure • corporate governance: minority abuse by managers or minority abuse by a majority shareholder • Gatekeepers • collusion with the auditor despite legal prohibition to do so • phenomenal lack of due attention and due care by the market • Legal Dimensions • Legal loopholes: company law, securities law

4. Part II. EU Company Law Reform: Past and Present • In 1995, a study conducted by Ernst & Young: the EU should set framework principles for corporate governance of large companies in a directive, which could be transposed into the individual national legal systems either by law or within the framework of a national “best practice” code • Dec 1998 Commission Hearing: No regulatory EU level intervention on corporate governance is necessary nor desirable Priority items to be tackled Take-over bids and defensive actions Auditors some emphasis on 5th directive on harmonizing company structures in the EU? • November 2002, HLG-Winter II: Two level approach • general principles in a directive • more detailed rules in a self-regulatory code of conduct

5. Part II. EU Company Law Reform: Past and Present • May 21, 2003, the EC Communication : 17 legislative and 7 non-legislative measures ! “ A dynamic and flexible company law and corporate governance framework is essential for a modern, dynamic, interconnected industrial society…An effective approach will foster the global competitiveness of businesses in the EU and strengthen shareholders rights and third party protection • New policy dynamics of EU company law reform • board structures • More shareholder empowerment • more disclosure • more independent directors: nomination, remuneration and audit • stricter remuneration policies • more directorial liability for financial and non-financial information • disclosure by institutional investors • EU corporate governance forum

6. Part III: 1S1V Definition and Background in the EU • What is 1s1v? • Cash flow rights=voting rights • Rationale: • Shares entail to economic ownership (cash flow rights) and voting power (voting rights) • Shareholders have identical preferences • Shareholders equally vote to max the firm value • Stocks are valued so does price reflects governance and operations

7. Part III: 1S1V Definition and Background in the EU • Deminor (2005) examines the FTSE–Eurofirst 300 companies, highlights that: • The 1S1V rule is already applied by 65% of all companies analysed. • There is variety of exceptions to the 1S1V rule notably in in France, the Netherlands and Sweden • Multiple voting rights 44%; Priority shares 8%; Depository receipts 4%; Ownership ceilings 11%, Non-voting Stock 6%; Golden shares 4%; Non-voting shares; Voting right ceilings 23%

8. Part III: Ownership Concentration in the EU

9. Part III: Private benefits of Control Table 2: Controlling vs. Minority Shares Table 1: Control blocks in selected countries

10. Part III: Instruments of separation of ownership and control in the EU Source: Bennedsen & Nielsen (2002).

11. Part III: Instruments of separation of ownership and control in the EU Source: Faccio & Lang (2002)..

12. Arguments • Pro-market argument: deviations from one share one vote are economically efficient and so do controlling shareholder structures since, otherwise, competitive evolutionary processes would have eliminated them; or • Market failure argument: deviations from one share one vote persist because of inefficiencies in the market processes and so do inefficient controlling shareholder structures • How to deal with (in)efficient controlling shareholder structures? Mandatory 1s1v rule, more laws or market exposure?

13. Part IV: Shareholder Democracy Argument • Political vs. Corporate Democracy • Shareholder Democracy in the US: • Blasius Standard • Unocal Standard • The end goal: disciplining wayward managers through active takeover markets • Conclusion: 1s1v does not promote corporate democracy, integrity and accountability to shareholders • Shareholder Democracy in the EU: • Proportionality between non-voting (risk-bearing) capital and voting stock • Break-through rule/One-share-one-vote • The end goal: ??? • Conclusion: conceptually-empty rhetoric: procedurally- political complications and problems • Primacy of shareholder decision-making • Take-over independent BTR • Inconsistency between the BTR and MBR

14. Part V: Cost of Capital and Minority Protection Argument • Dispersed vs. Concentrated • Managers vs. Minority Shareholders (US, UK): Collective action Problem! Separation of ownership and control: PROBLEMS: • Organizational structure that makes it impossible for shareholders to monitor and discipline managers effectively • Professional managers are said to be virtually unaccountable to shareholders • Diversion of corporate resources • related-party transactions • projects targeted to their needs and ends • pursuing visionary projects • enhancing their human capital

15. Part V: The Structure of Corporate law: DOS • Three sets of rules designed to induce directors to govern in the interest of shareholders • Shareholder voting rules which allow shareholder to replace directors • Fiduciary duties and procedural rules that provide shareholders with incentives to enforce those duties • Disclosure rules that require management to disseminate information about a company’s finances and operations • Item 9 of Form S-1 with respect to the corporate governance rights of the securities being sold, • Item 11(k) of Form S-1 with respect to directors and officers, • Item 11(l) with respect to executive compensation ; • Item 16(a) with respect to the articles of incorporation, bylaws and other documents or contracts specifying the rights of security holders. • Rules governing the market for corporate control: 1S1V reinforcing shareholder primacy through monitoring and disciplining corporate boards.

16. Part V: Cost of Capital and Minority Protection Argument: Ownership Concentration • Majority vs. Minority (continental Europe): Collective action problem solved! • CG problem: Majority abuse of minority: disproportional control benefits through ownership cascades, pyramids and voting trusts • related-party transactions, • control premia; • freeze-out transactions • Misjudgement and overconfidence • Gravity of generations

17. Part V: The Structure of Corporate law in COS: law and market exposure SOLUTION: to constrain PBC and ensure equitable treatment of all shareholders Corporate Law • business judgement and intrinsic fairness rules • fair dealing and fair price rulesIAS 24: related party disclosure: resources, services and obligations Securities Law/disclosure • IAS 24: related party disclosure: resources, services and obligations • IAS 24.16: disclosure of managerial pay • IAS 1.96-97: disclosure of changes in equity • 4th Company Law directive: reporting standards on balance sheets, P&L’s and annual reports • What about mandating 1s1v??? • Ineffective as curbing majority abuse! • Can lead to pyramidal structures

18. Part VI: Efficient Capital Market Argument: the optimality debate • 1s1v maximizes the value of the firm (Grossman & Hart (1988) and Harris & Raviv (1988). • Assumptions • shareholders have the same identical preferences; • control is concentrated through a dual-class structure with a 50:50 split between the voting and non-voting shares that have equal cash flow rights; • the incumbent management does not enjoy private benefits; • there is only one party in the control contest obtaining significant private benefits; and • the bidder bids only for the voting stock, while the holders of non-voting stock incur the costs of inefficient management without benefiting from any control premium.

19. Part VI: The sub-optimality debate • deviations are necessary to extract the highest value from the bidder (Shleifer & Vishny (1986 and 1988), Hirshleifer &Thakor (1994) and Hirshleifer (1995); • deviations from the 1S1V rule can create more shareholder wealth since they allow for capturing more benefits of control from the successful bidder (Jensen & Warner (2000)) • deviations from the 1S1V rule might be desirable to mitigate post-takeover agency problems in the absence of the mandatory bid rule (Burkart, Gromb & Panuzzi (1998)) • Deviations can create more value increasing bids (At, Burkart & Lee (2006)

20. Part VI: The sub-optimality debate • The imposition of the 1s1v rule is tantamount to creating a takeover independent break-through rule (Mulbert 2006) • Inability of the BTR to achieve pyramidal structures • Mandatory bid eliminates the need for a BTR/1s1v • Deviations are necessary to avoid value destroying voting arbitrage (Martin and Partnoy 2005) • Promotes self-interested incentives, value-destroying takeovers and worse yet can become a takeover defense.

21. Part VI: 1s1v and market for corporate votes • wholesale and retail vote-trading in the market for corporate votes: • stock lending, equity swaps, direct and indirect hedges • stock lending allows for separating cash flow rights from voting power so that the borrower ends up with enough voting power while the lender retains cash flow rights in exchange for some fee: 99% of market capitalisation in the US can be lent and borrowed • Collars allow corporate insiders hedge by taking put and call positions simultaneously to limit their possible risk through fixing the downside and upside : US senior executives of listed companies use collars for 36% of their holdings, which allows them to outsource 25% of their cash flow exposure • Direct and indirect hedges allow combing pure positions with short positions • CONCLUSION: such separation can indeed be value-destroying, and worse yet, as compared with dual-class recapitalisation, does not require a shareholder vote

22. Conclusions • EC policy-makers have not submitted the burden of proof that the 1S1V rule will rebuild investor confidence, protect shareholders and third parties as well as foster business competitiveness and efficiency across the EU. • standards of subsidiarity and proportionality are not adequately justified • disregard to the diversity of the core and supporting institutions of corporate governance in the EU, such as traditionally-concentrated ownership structures, multiple classes of votes, and complex mechanisms of retaining control and balancing the liquidity of shares. • 1S1V is neither a sufficient nor a necessary condition for shareholder democracy in general or shareholder empowerment in the EU in particular. • Switch to pyramidal structures conferring high level of PBC and minority abuse • Decomposition through derivative techniques leading to further heterogeneity, incentives for value-destroying voting arbitrage and approval of value reducing transactions • worse yet, as compared with dual-class recapitalisation, decomposition does not require a formal shareholder vote

23. What is next? • First: No EU level action in light of possible perverse effects of a mandatory 1S1V rule. • Second: reinforcing the role of non-executive directors as well as transparency and disclosure rules • Third: A self-regulatory approach as well as transparency and disclosure rules