Chapter 7 Shareholders.pdf

# Shareholder litigation in practice Shareholder litigation in practice reveals a significant gap between the potential rights available to shareholders and their actual use due to various deterrents, with the United States being a notable exception due to its unique legal environment. ## 1 Shareholder litigation in practice The tradition of shareholder passivity persists even with publicly traded companies, despite the collective power shareholders wield and the individual rights available to them. This leads to a discrepancy between the law as written and the law as it functions in reality, where shareholder litigation is infrequent [13](#page=13) [14](#page=14). ### 1.1 Factors deterring shareholder litigation Several factors discourage shareholders from pursuing litigation [14](#page=14): #### 1.1.1 Doctrinal challenges While remedies like the oppression/unfair prejudice remedy exist in jurisdictions such as the U.K. and Commonwealth countries, offering flexibility and discretion courts have been reluctant to entertain cases brought by minority shareholders in publicly traded companies. For instance, U.K. courts do not permit shareholders of public companies to rely on breaches of informal undertakings or agreements, unlike their counterparts in private companies [13](#page=13) [14](#page=14). #### 1.1.2 Practical litigation deterrents Even if legal principles favor a shareholder, practical obstacles arise [14](#page=14). * **Distraction and Expense:** Preparing for trial can be a considerable distraction, and legal expenses can be substantial. Shareholder litigation is often complex, leading to significant legal bills [14](#page=14). * **"Loser Pays" Rules:** Concerns about legal fees are amplified by the common "loser pays" rule found in most countries, which requires unsuccessful litigants to cover a portion of the winning party's legal expenses. While the enforcement of this rule varies, and it may not cover all legal costs, prospective litigants fear bearing their own legal bills and those of the successful defendants [14](#page=14). #### 1.1.3 Free riding The issue of "free riding" particularly deters shareholder lawsuits in publicly traded companies, most notably in derivative litigation. In a derivative suit, where a shareholder vindicates corporate rights, any benefit to the shareholder comes only through an increase in the company's share price, which is not always likely. If the share price does rise, the litigant shareholder gains no more than other shareholders who did not participate in the legal action. This "free riding" effect creates a strong incentive for potential litigants to let others initiate lawsuits, leading to a collective action problem where meritorious lawsuits may not be filed if all investors adopt a similar mindset [14](#page=14). > **Tip:** The "free riding" problem highlights a classic collective action dilemma, where individual rational decisions (to avoid the costs and risks of litigation) can lead to a collectively suboptimal outcome (a meritorious lawsuit not being brought). ### 1.2 Exceptions to shareholder passivity Despite the general deterrents, there are instances where shareholders engage in litigation [14](#page=14). * **Japan:** Lawsuits filed by activist attorneys with political agendas, aiming to "send a message" to Japanese public companies, contribute to the frequency of derivative litigation [14](#page=14). * **Germany:** A significant number of lawsuits involve shareholder litigants challenging resolutions of publicly traded companies. This practice is driven by "professional" minority shareholders who, owning small stakes, leverage German company law's broad scope for challenging resolutions to extract side-payments by threatening lengthy court proceedings, which can be detrimental when swift implementation is crucial [14](#page=14). ### 1.3 Shareholder litigation in the United States The United States stands out as the jurisdiction with the most prevalent public company shareholder litigation. Derivative lawsuits occur, and a majority of mergers and acquisitions involving public companies are challenged by stockholders. Appraisal rights litigation is also common in mergers where minority shareholders are compelled to accept cash for their shares. This high level of litigation is attributed to a uniquely hospitable legal environment in the U.S. [15](#page=15). #### 1.3.1 The "American Rule" for legal expenses Unlike the international norm of "loser pays," the U.S. generally follows the "American rule," where litigants typically bear their own legal expenses, irrespective of the outcome. This rule is intended to facilitate access to justice and encourages even long-shot lawsuits by shareholders [15](#page=15). #### 1.3.2 Contingency fees and "no win/no fee" arrangements The U.S. legal system widely accepts contingency fees, often referred to as "no win/no fee". This arrangement, where plaintiffs' lawyers are paid a percentage of the recovery only if successful, shifts the downside risks of litigation primarily to the lawyers. Consequently, potential shareholder plaintiffs worry less about losing in court [15](#page=15). #### 1.3.3 The "common fund" doctrine A significant financial incentive for U.S. attorneys is the "common fund" doctrine. This long-standing convention allows an attorney who secures a "common fund" for other shareholders through litigation to receive a fee award from the generated benefits. In cases of successful derivative litigation or class actions, judges typically approve fee awards from the recovered proceeds, often as a percentage of the total recovery. Even in out-of-court settlements, which frequently involve no monetary compensation but rather undertakings for disclosure or governance adjustments, settlement agreements often stipulate plaintiffs' attorneys' fees. Judges generally approve these fee agreements, even in non-monetary settlements [15](#page=15). > **Example:** A shareholder lawsuit challenging a merger might settle with the company agreeing to provide more detailed information about the transaction and make certain governance changes, rather than paying monetary damages. The plaintiffs' attorneys would still receive a fee, awarded from the "benefit" conferred upon the shareholders. The "common fund" doctrine and contingency fees empower entrepreneurial attorneys to actively seek out legal violations and corporate targets, rather than waiting for clients to approach them. Publicly traded corporations are particularly vulnerable due to extensive disclosure requirements under federal securities law, making the legal profession in the U.S. a primary driver of shareholder litigation, unlike in other jurisdictions [15](#page=15). --- # The role of institutional investors Institutional investors play a significant and evolving role in corporate governance, acting as both potential catalysts for change and subject to traditional passivity [10](#page=10) [11](#page=11). ### 2.1 Evolution of shareholder engagement The historical perception of shareholders as passive in public companies, a concept notably discussed by Berle and Means in 1932, has been challenged. This shift is partly attributed to the rise of "activist shareholders," with hedge funds being prominent agents of this change since the early 2000s [10](#page=10). #### 2.1.1 Offensive shareholder activism Hedge funds employ an "offensive" activism style, acquiring substantial stakes in carefully selected public companies they believe are undervalued. Their goal is to agitate for changes to boost shareholder returns, often employing aggressive tactics like proxy contests to gain board representation. This approach contrasts with typical institutional investors who maintain highly diversified portfolios, which dilutes the impact of improved returns from a single engagement [10](#page=10). #### 2.1.2 Defensive shareholder activism Concurrently, there has been speculation about the increased prevalence of "defensive" shareholder activism aimed at protecting the value of existing shareholdings. The substantial growth in institutional investors' presence in global equity markets has led to a resurgence of the idea of shareholders as monitors [10](#page=10). ##### 2.1.2.1 The "Big Three" and index tracking funds Asset managers running index tracking funds, such as BlackRock, Vanguard, and State Street (the "Big Three"), are considered strong candidates for defensive activism. These firms dominate the index tracking industry, collectively owning a significant portion of shares in S&P 500 companies and having global reach. They have publicly committed to responsible stewardship [11](#page=11). #### 2.1.3 Limitations and scepticism regarding institutional activism Despite the theoretical potential, institutional investors have not fully lived up to expectations in terms of engagement. While commentators have noted the consolidation of stock markets in the hands of large institutional investors, the consensus is that they have failed to significantly improve corporate performance [11](#page=11). ##### 2.1.3.1 Challenges for index trackers The business model of index tracker funds tends to undermine incentives for active shareholder engagement. These funds focus on minimizing costs and tracking errors, and any gains from identifying and correcting managerial shortcomings would be shared across the market, potentially increasing fees and leading to market share loss to cheaper rivals. This often results in tiny shareholder engagement teams relative to the number of companies owned, with meetings between these firms and the companies being an exception rather than the rule. Empirical research suggests that corporate governance deteriorates when index funds replace other institutional investors, and passive funds are more likely to defer to managerial recommendations on shareholder votes [12](#page=12). ##### 2.1.3.2 Influence in different ownership systems The influence of index trackers may be less substantial in countries with insider/control-oriented ownership systems compared to those with diffuse ownership. This is because dominant shareholders can often dictate outcomes regardless of other shareholders' stances. Additionally, the "Big Three" hold smaller stakes in companies with dominant shareholders due to index construction principles that focus on "free float" rather than aggregate market capitalization [12](#page=12). ### 2.2 Reforms to foster shareholder engagement Recognizing the potential benefits of managerial accountability through shareholder engagement and the partial disruption of shareholder passivity, reforms have been introduced globally to encourage more active participation [13](#page=13). #### 2.2.1 Stewardship codes A key initiative has been the promulgation of stewardship codes, beginning with the U.K.'s Financial Reporting Council (FRC) Stewardship Code in 2010. These codes aim to incentivize asset managers and institutional shareholders to disclose their engagement approaches. The U.K. Code served as a model for similar initiatives in nearly twenty other jurisdictions. The European Union also mandated disclosure of policies regarding shareholder engagement as part of a revision to its shareholder rights directive [13](#page=13). ##### 2.2.1.1 Effectiveness of stewardship codes Despite these efforts, the effectiveness of stewardship codes has been questioned. A 2018 review of the U.K. FRC concluded that the Stewardship Code was not effective in practice. Many other codes are voluntary and lack enforcement mechanisms, leading to doubts about their ability to substantially change shareholder passivity [13](#page=13). > **Tip:** While stewardship codes aim to increase transparency and accountability, their voluntary nature and lack of enforcement in many jurisdictions limit their practical impact on shareholder engagement. > **Example:** The U.K.'s Stewardship Code, despite being a significant intervention, was found to be ineffective in practice, highlighting the challenges in translating disclosure requirements into actual shareholder engagement [13](#page=13). --- # Shareholder activism and engagement Shareholder activism and engagement explore how shareholders utilize their rights to influence corporate governance and decision-making, moving beyond passive ownership. ### 3.1 The role of shareholder rights in practice The practical application of shareholder rights, both individual and collective, is heavily influenced by a company's ownership structure. In public companies with dispersed ownership, shareholders typically direct their influence towards the board and management due to the absence of a dominant shareholder. Collective rights are less impactful in such firms due to a general shareholder tendency towards passivity. Conversely, in companies with a dominant shareholder, collective rights can be more potent, as the dominant shareholder can leverage alliances to control board and management decisions, potentially leading to a well-contained managerial agency cost problem. However, this also carries a risk of dominant shareholders extracting private benefits of control, diminishing the relevance of collective rights for minority shareholders who may then focus on individual rights against both management and dominant shareholders [5](#page=5). #### 3.1.1 Collective shareholder rights Public company shareholders acting collectively possess several key rights, including amending the corporate constitution, selecting directors, and vetoing significant corporate transactions. These collective actions primarily manifest through resolutions passed at shareholder meetings. While corporate legislation may offer alternative mechanisms, they are seldom practical for public firms [5](#page=5). **Shareholder meetings and voting:** * Publicly traded companies are statutorily required to hold annual shareholder meetings, which boards can also call as "special" or "extraordinary" meetings [6](#page=6). * Shareholders who cannot attend in person typically vote by proxy. Regulations aim to mitigate risks associated with company representatives, like the board, acting as proxies for shareholders [5](#page=5). * Voting usually follows a one-share, one-vote principle, though companies have scope to create different share classes with varying voting rights [5](#page=5). * Shareholders can request the board to include resolutions on the meeting agenda, but the board can decline [6](#page=6). **Shareholder-initiated resolutions:** * In the EU, the 2007 Shareholder Rights Directive mandates that member states grant shareholders owning at least 5 percent of a company's shares the right to propose resolutions for shareholder votes [6](#page=6). * Globally, a 5 percent ownership threshold for shareholder proposals is common, with some countries having stricter or lower requirements [6](#page=6). * In the United States, under Securities and Exchange Act Rule 14a-8, shareholders meeting modest ownership requirements (from 2,000 to 25,000 dollars depending on holding duration) can have their resolutions included in proxy materials [6](#page=6). * Rule 14a-8 has several qualifications, including precluding proposals on ordinary business operations. Framing proposals as "precatory" or "advisory" can help circumvent this restriction, meaning many resolutions passed may not be binding [6](#page=6). * Despite this, Rule 14a-8 proposals are frequent and often taken seriously by boards, leading to significant governance reforms in the U.S., such as the adoption of by-laws allowing shareholders to call special meetings. The U.S. is considered to have a particularly robust "shareholder proposal culture" [6](#page=6). **Shareholder powers: appointment and decision rights:** * Shareholders' collective powers are generally categorized as appointment rights and decision rights [6](#page=6). * **Appointment rights:** Shareholders typically have significant formal influence over the selection and removal of board members. These powers are considered the most important, as the theoretical possibility of board turnover influences directors, even though shareholders usually vote overwhelmingly for nominated candidates [6](#page=6). * **Decision rights:** Shareholders often have the right to approve or veto board proposals under specific circumstances. Approval requirements for shareholder actions appear less common in the U.S. compared to many other jurisdictions and are strictly limited to fundamental changes like mergers. For example, while many jurisdictions grant shareholders a veto right over share issuances and alterations of share capital, these matters are typically handled solely by the board in the U.S., unless the corporate constitution needs amendment to increase authorized equity capital [7](#page=7). * **Amending the corporate constitution:** Shareholders generally have full formal control over amending the corporate constitution. While the board usually sets the agenda, changes to the constitution can occur without direct board involvement. In contrast, in the U.S., shareholders have substantial control over by-laws but the board typically initiates changes to articles of incorporation, which govern core aspects like board configuration and capital structure [7](#page=7). **Managerial authority and shareholder instructions:** * Corporate legislation typically vests managerial authority in the board. As a general principle, boards can disregard shareholder resolutions that purport to instruct them [7](#page=7). * Corporate constitutions can reallocate managerial authority to shareholders, but this rarely happens [7](#page=7). * In the U.K., shareholders allocate managerial authority through the corporate constitution, usually granting it to the board. This is often qualified by a provision allowing shareholders to issue instructions to the board, though such resolutions are very rare in British public companies [7](#page=7). #### 3.1.2 Direct shareholder suits Direct suits offer protection to shareholders in various scenarios across different jurisdictions. These include challenging the wrongful deprivation of personal entitlements like receiving declared dividends or voting shares at a properly called meeting. Shareholders also have standing to seek relief on their own behalf when challenging the propriety of collective shareholder resolutions. In companies with a dominant shareholder, a minority shareholder might allege a breach of duties owed to other shareholders. Some jurisdictions, like the U.K., offer statutory measures for shareholders to seek relief if the corporation is operated oppressively or unfairly prejudicially. Additionally, some jurisdictions provide a statutory "appraisal" right, allowing shareholders to demand the company purchase their shares at fair value when they object to transformative transactions like mergers. These options often come with substantial qualifications, especially for publicly traded companies. Challenging shareholder resolutions is more common in continental Europe than in the U.K. or U.S. Derivative litigation, shareholder duties jurisprudence, and appraisal rights are more developed in the U.S. than elsewhere [9](#page=9). #### 3.1.3 Shareholder engagement in practice The concept of "law in books" versus "law in action" is crucial when examining shareholder rights and engagement. Despite significant collective shareholder powers, a prevalent issue in corporate governance has been shareholder indifference. This passivity is attributed to several factors [9](#page=9): * **Diversified portfolios:** Inability to closely monitor individual companies due to broad investment holdings [9](#page=9). * **Managerial expertise:** Awareness that managers are better qualified to run companies [9](#page=9). * **Exit option:** The ease of selling shares on the stock market [9](#page=9). * **Collective action problems:** Difficulties in coordinating action among numerous shareholders [9](#page=9). * **Fear of legal breaches:** Investors may avoid intervention if they fear violating rules like insider trading prohibitions, especially when discovering confidential, price-sensitive information [9](#page=9). * **Acting in concert:** Collaborating shareholders might be subject to disclosure rules for large shareholdings or mandatory takeover bid obligations if they acquire substantial minority stakes [10](#page=10). **The rise of shareholder activism:** * The traditional separation of ownership and control, as identified by Berle and Means in 1932, has been challenged by the rise of activist shareholders [10](#page=10). * **Hedge fund activism ("offensive" activism):** Since the early 2000s, hedge funds have become prominent in "offensive" activism, where they acquire significant stakes in companies to agitate for changes that boost shareholder returns. This contrasts with typical institutional investors' diversified approach. Activist hedge funds focus on a small number of carefully selected companies, aiming for meaningful gains if their investment strategy succeeds. They target companies perceived as undervalued and are prepared to actively press for changes, sometimes employing aggressive tactics like proxy contests for board representation [10](#page=10). **Institutional investors and "defensive" activism:** * There has been speculation about an increase in "defensive" shareholder activism aimed at protecting existing share value [10](#page=10). * The substantial growth of institutional investors, such as pension funds and mutual funds, in global equity markets has been seen as a potential catalyst for engagement. Their large holdings and the risk of significant share price impact if unwinding stakes make engagement plausible [10](#page=10). * As of the end of 2022, institutional shareholders owned 44 percent of global stock market capitalization [10](#page=10). #### 3.1.4 Passive ownership and its implications for engagement Asset managers running index-tracking funds are considered strong candidates for defensive shareholder activism due to their large scale and the nature of their business model. Index trackers aim to mimic market index performance by keeping fees low and employing a plain-vanilla investment approach. Their low fees often lead to outperformance compared to actively managed funds, attracting significant investor inflows [11](#page=11). **The "Big Three" asset managers:** * BlackRock, Vanguard, and State Street, U.S.-based firms with a large majority of assets in passive index funds, dominate this sector [11](#page=11). * Collectively, they own nearly 25 percent of the shares in companies within the S&P 500 index and have significant global reach [11](#page=11). * These firms have publicly committed to responsible stewardship in relation to their shareholdings [11](#page=11). **Caveats to passive activism:** * Despite the potential, the assumption of shareholder passivity cannot be entirely discarded [11](#page=11). * Offensive shareholder activism by hedge funds is geographically concentrated, with the U.S. being the primary hub for both campaigns and targets. Non-American targets are limited to a few countries like Japan, the U.K., and Canada [11](#page=11). * For mainstream institutional investors, engagement "remains the exception rather than the rule". Scholars note that institutional investors have not fully lived up to expectations regarding improved corporate governance [11](#page=11). * The impact of passive ownership on corporate governance is still unsettled. Skepticism exists regarding the activism of dominant index-tracking asset managers [12](#page=12). * **Incentives for index funds:** The business model of index trackers, focused on low costs and minimal tracking errors rather than active stock-picking or performance beating, disincentivizes shareholder engagement. Resources spent on identifying and correcting managerial shortcomings would be shared across the market, potentially increasing fees and losing market share to cheaper rivals [12](#page=12). * **Resource constraints:** Firms dominating the index tracking sector employ small shareholder engagement teams relative to the number of companies they invest in. Meetings with companies are rare, and a few overworked specialists handle thousands of resolutions annually [12](#page=12). * Empirical research suggests corporate governance can deteriorate when index funds replace other institutional investors, and passive funds are more likely to defer to management recommendations on votes than actively managed funds [12](#page=12). * **Insider/control-oriented systems:** The influence of index trackers is less substantial in countries with insider or control-oriented ownership systems compared to jurisdictions with diffuse ownership. The voting power of dominant shareholders often dictates outcomes regardless of other shareholders' stances [12](#page=12). * The "Big Three" hold smaller stakes in companies with dominant shareholders because stock market indices track "free float" rather than aggregate market capitalization, and dominant shareholders' shares are typically excluded from the free float [12](#page=12). --- ## 3 Shareholder activism and engagement Shareholder engagement reforms aim to encourage asset managers and institutional shareholders to actively participate in corporate governance, often by mandating disclosure of their engagement strategies [13](#page=13). ### 3.1 The global stewardship movement The movement towards increased shareholder engagement gained significant momentum with the promulgation of the U.K.'s Stewardship Code by the Financial Reporting Council (FRC) in 2010. This code is considered the genesis of what has been termed the "global stewardship movement". It was designed to address the perceived primary corporate governance issue in the U.K.: rational passivity among institutional investors in a market characterized by dispersed ownership [13](#page=13). #### 3.1.1 Proliferation of stewardship codes The U.K. Stewardship Code, including a revised version in 2012, served as a model for numerous other jurisdictions, inspiring nearly twenty similar initiatives globally over the subsequent decade. The European Union also embraced this trend, requiring Member States as part of a 2017 revision of its shareholder rights directive to enact laws obliging institutional investors and asset managers to disclose their shareholder engagement policies [13](#page=13). #### 3.1.2 Effectiveness and challenges of stewardship codes By 2019, a significant number of asset managers and institutional shareholders in the U.K. were signatories to the Stewardship Code, committing to publicly disclose their compliance with its engagement principles and provide explanations for any non-compliance. However, despite these disclosure efforts, shareholder passivity persisted in the U.K.. A government review in 2018 concluded that the Stewardship Code, despite being a well-intentioned intervention, was not effective in practice. This assessment raises concerns for stewardship codes in other regions, particularly since many of these codes are voluntary and lack enforcement mechanisms to encourage disclosure by asset managers and institutional investors. Consequently, where shareholder passivity is prevalent in publicly traded companies, stewardship codes and related disclosure initiatives appear unlikely to bring about substantial change [13](#page=13). > **Tip:** The limited effectiveness of voluntary stewardship codes highlights the challenge of overcoming ingrained shareholder passivity, even with increased disclosure requirements. The absence of strong enforcement mechanisms appears to be a significant factor [13](#page=13). --- # Shareholder rights and their rationale Shareholder rights are legal entitlements that empower those who own a portion of a company, forming a key aspect of corporate governance. ### 4.1 The privileged position of shareholders Corporate governance and law have historically tended to favor shareholders, though modern analyses also consider stakeholder perspectives. Despite this, shareholders are often regarded as "first among equals" due to various reinforcing legal aspects [1](#page=1). ### 4.2 Why empower shareholders? Several rationales have been proposed for granting shareholders a privileged position in corporate governance [2](#page=2). #### 4.2.1 Shareholders as owners One common justification is the notion that shareholders are the "owners" of the company. Historically, ownership was seen as the basis for shareholders' central role, entitling them to control management and receive the company's benefits. However, contractarian analysis challenges this by viewing shareholders as parties in a contractual matrix who do not "own" the company but rather "bargain" for specific rights. Case law also supports the idea that shareholders own their shares, not the company itself, though the perception of shareholders as owners persists outside academia [2](#page=2). #### 4.2.2 Shareholders as residual claimants A more contractarian-aligned rationale is that shareholders are "residual claimants". Unlike other constituents like creditors or employees who contract for fixed returns, shareholders' returns are based on what remains after all other obligations are met. This unique position means shareholders benefit most from corporate success, theoretically providing them with the strongest incentives to monitor management, reduce agency costs, and maximize firm value. Corporate law supports this by granting shareholders rights to hold management accountable and by offering beneficial "gap-filling" for the complex nature of their residual claim [2](#page=2) [3](#page=3). #### 4.2.3 Shareholder democracy Another potential justification for shareholder empowerment is the analogy to political democracy, where shareholders, like voters, elect representatives (directors). However, contractarians argue this is "fundamentally flawed" because voting rights are allocated contractually, not politically. The analogy is also problematic because state power, which warrants political say, differs from the voluntary investment in public companies where exit is easier than for citizens of a state [2](#page=2) [3](#page=3). #### 4.2.4 Gap-filling and social benefit Granting shareholders substantial rights can be seen as beneficial "gap-filling," hypothesizing how parties would contract under ideal conditions. Additionally, shareholder oversight can foster socially beneficial outcomes by keeping corporate "insiders" in check [2](#page=2). ### 4.3 Critiques and alternative perspectives on shareholder empowerment While contractarians acknowledge that vesting shareholders with rights can help monitor insiders, they do not necessarily advocate for shareholder activism. They anticipate shareholders will use their rights sparingly and that market dynamics, such as the ability to exit via the stock market, will provide sufficient checks and balances and drive beneficial change [3](#page=3). Conversely, many commentators, such as Lucian Bebchuk, view shareholder powers as a primary accountability mechanism rather than a last resort. This perspective, supported by initiatives like the EU's Shareholder Rights Directive, emphasizes that effective shareholder control is crucial for sound corporate governance. The case for shareholder empowerment can be broadened to include societal benefits, as shareholder oversight may contribute to efficient, honest, and fair corporate management, aligning with state interests in economic growth and constraining corporate externalities [3](#page=3) [4](#page=4). However, the case for shareholder empowerment is not without its weaknesses. Contractarian arguments about the difficulty of bargaining for rights do not fully protect other corporate constituencies. Conflicts of interest can arise between shareholders and other stakeholders, potentially leading to detrimental outcomes for the latter if shareholders exert influence. Furthermore, the effectiveness of shareholder rights depends on whether shareholders actually exercise them, and passivity can undermine accountability and the protection of broader societal interests [4](#page=4). ### 4.4 The nature of shareholder rights Shareholder rights can be broadly categorized into those exercised collectively and those exercised individually [4](#page=4). #### 4.4.1 Collective rights Collective shareholder rights often involve "decision rights" that can impact board authority or "appointment rights" related to selecting directors. The primary mechanism for exercising these rights in publicly traded companies is through resolutions passed at shareholder meetings [4](#page=4). * **Shareholder Meetings:** Public companies are mandated to hold annual shareholder meetings, and boards can also convene special meetings. Shareholders can, in most jurisdictions, call a special meeting if they collectively own a designated minimum percentage of shares (typically 5% or 10%). Resolutions are formulated for voting, and while boards usually propose them, shareholders may have statutory rights to introduce their own proposals, particularly in the EU where a 5% threshold is common. In the U.S., SEC Rule 14a-8 allows proposals if modest share ownership requirements are met, though these proposals are often advisory and may not be binding [5](#page=5) [6](#page=6). * **Appointment Rights:** Shareholders generally have significant formal influence over the selection and removal of board members. While shareholders typically vote overwhelmingly in favor of nominated candidates, the theoretical potential for board turnover is a critical aspect of director accountability [6](#page=6). * **Decision Rights:** Shareholders may have the right to approve or veto board proposals in certain circumstances, such as fundamental changes like mergers. Approval requirements for issuing shares or altering share capital are more prevalent in many jurisdictions outside the U.S., where such matters are often handled solely by the board [7](#page=7). * **Amending the Corporate Constitution:** Shareholders typically have formal control over amending the corporate constitution, which defines internal rules. While boards often influence the agenda, changes can occur without direct board say, although this varies by jurisdiction [7](#page=7). #### 4.4.2 Individual rights Individual shareholder rights typically do not directly impinge on boardroom prerogatives. Examples include receiving declared dividends and voting on collective resolutions. Another significant individual right is the ability to seek redress through litigation in response to alleged misconduct by the board or mistreatment by dominant shareholders [4](#page=4). ### 4.5 The relevance of rights based on ownership structure The practical impact of both collective and individual shareholder rights varies with the company's ownership structure [5](#page=5). * **Diffuse Share Ownership:** In public companies with widely dispersed ownership, individual rights are usually directed at the board and management, as there is no dominant shareholder. Collective rights may be less effective due to a general bias towards shareholder passivity [5](#page=5). * **Dominant Shareholders:** In companies with dominant shareholders, collective rights can be more potent if the dominant shareholder can secure necessary allies to exercise them, allowing them to influence board and management decisions. However, this can also lead to dominant shareholders extracting private benefits of control, making collective rights less useful for minority shareholders, who may then focus on individual rights and direct action against both dominant shareholders and management [5](#page=5). > **Tip:** Understanding the distinction between collective and individual rights, and how their effectiveness is mediated by ownership structure, is crucial for analyzing shareholder influence. > **Example:** In a company with many small shareholders (diffuse ownership), a minority shareholder might sue the board for mismanagement (individual right), whereas in a company dominated by a large investment fund, that fund might use its voting power to elect preferred directors (collective right). ### 4.6 Shareholder passivity Despite the rights vested in them, shareholders in publicly traded companies have traditionally exercised these rights infrequently, exhibiting significant passivity. Even with rights like voting, directors often have substantial power to ignore shareholder resolutions unless the corporate constitution allows for reallocation of authority, which is rare. While some jurisdictions allow shareholders to issue instructions to the board, such resolutions are very uncommon in practice. Efforts to foster shareholder engagement aim to address this passivity, but substantial changes in approach are not guaranteed [1](#page=1) [7](#page=7). > **Tip:** Remember that while shareholders possess numerous rights, their actual exercise of these rights is a critical area of study in corporate governance, with passivity being a recurring theme. --- # Shareholder rights and legal recourse Shareholders possess various rights and legal avenues to seek redress, though their practical exercise is often influenced by systemic factors and practical deterrents, particularly in publicly traded companies [9](#page=9). ### 5.1 Types of direct shareholder actions Shareholders can pursue legal action directly on their own behalf in specific circumstances, distinct from derivative suits which vindicate corporate rights [9](#page=9). #### 5.1.1 Personal rights infringement A direct suit is appropriate when a shareholder's personal entitlements are wrongfully deprived. Examples include [9](#page=9): * Denial of declared dividends [9](#page=9). * Improper prevention from voting shares at a properly called shareholders' meeting [9](#page=9). #### 5.1.2 Challenging shareholder resolutions Shareholders have standing to sue directly when challenging the validity of resolutions adopted by the collective body of shareholders [9](#page=9). #### 5.1.3 Dominant shareholder breaches In companies with a dominant shareholder, other shareholders may bring direct actions alleging breaches of duties owed to them by the dominant shareholder [9](#page=9). #### 5.1.4 Oppression and unfair prejudice claims Certain jurisdictions, such as the U.K., provide minority shareholders with statutory remedies in cases where the corporation is operated in an oppressive or unfairly prejudicial manner [9](#page=9). #### 5.1.5 Statutory appraisal rights In some jurisdictions, shareholders have a statutory right to demand the company purchase their shares at fair value if they object to transformative transactions like mergers [9](#page=9). > **Tip:** These direct action options are typically subject to significant qualifications and exceptions, especially concerning publicly traded companies [9](#page=9). ### 5.2 Shareholder engagement in practice The practical exercise of shareholder rights reveals a gap between "law in books" and "law in action," with a prevailing tradition of shareholder passivity [9](#page=9). #### 5.2.1 Reasons for shareholder passivity Several factors contribute to shareholders' indifference to investee companies: * **Diversified portfolios:** Inability to focus closely on individual companies due to diversified investments [9](#page=9). * **Managerial expertise:** Belief that company managers are better qualified to run the businesses [9](#page=9). * **Exit options:** The ease of selling shares on the stock market [9](#page=9). * **Collective action problems:** Difficulties in coordinating action among many shareholders [9](#page=9). * **Fear of legal breaches:** Concern about violating insider trading rules or disclosure obligations when engaging with a company [9](#page=9). * **"Acting in concert" risks:** Collaborating shareholders may trigger obligations to disclose substantial shareholdings or make takeover bids [10](#page=10). #### 5.2.2 Rise of shareholder activism Commentators suggest the tradition of shareholder passivity has been disrupted by the rise of "activist shareholders." [10](#page=10). * **Offensive activism:** Driven by hedge funds since the early 2000s, this involves building significant stakes and agitating for changes to boost shareholder returns, often targeting undervalued companies. These funds differ from traditional investors by actively pressing for changes and employing aggressive tactics like proxy contests [10](#page=10). * **Defensive activism:** Oriented towards corrective action to protect the value of existing shareholdings. The growth of institutional investors has been cited as a potential catalyst for this [10](#page=10). > **Example:** Institutional investors like pension funds and mutual funds hold substantial portions of public company shares. Their engagement could be driven by the sheer volume of their holdings, where unwinding them could depress share prices [10](#page=10). #### 5.2.3 The role of passive investors Asset managers of index tracking funds are often considered strong candidates for defensive shareholder activism due to their significant holdings and focus on low fees [11](#page=11). * **Dominance of the "Big Three":** Major U.S.-based firms like BlackRock, Vanguard, and State Street collectively own a substantial portion of the S&P 500 and have significant global reach. They have publicly committed to responsible stewardship [11](#page=11). * **Skepticism about impact:** Despite their potential, skepticism exists regarding the actual impact of these passive investors on corporate governance. Their business model prioritizes low costs and tracking errors over active engagement, as any gains from identifying managerial shortcomings would be shared with the market, potentially increasing fees and reducing market share [12](#page=12). * **Limited resources:** The "Big Three" employ small shareholder engagement teams relative to their extensive shareholdings, making direct meetings with companies rare. Empirical research suggests corporate governance may deteriorate when index funds replace active institutional investors, and passive funds are more likely to defer to management recommendations [12](#page=12). #### 5.2.4 Influence in different ownership systems The influence of activist investors may be less substantial in countries with insider/control-oriented ownership systems compared to those with diffuse ownership [12](#page=12). * **Dominant shareholders:** The voting power of dominant shareholders can override the stance of other shareholders [12](#page=12). * **Index fund holdings:** Passive funds hold smaller stakes in companies with dominant shareholders due to index configurations that prioritize "free float" (publicly traded shares excluding strategic/dominant investors) [12](#page=12). #### 5.2.5 Reforms to foster engagement Reforms have been introduced to encourage greater shareholder engagement: * **Stewardship Codes:** The U.K.'s Financial Reporting Council (FRC) promulgated a Stewardship Code in 2010, initiating a global movement. These codes incentivize asset managers and institutional shareholders to disclose their engagement policies [13](#page=13). * **EU Directive:** A 2017 revision of the EU shareholder rights directive required member states to enact laws obliging institutional investors and asset managers to disclose their shareholder engagement policies [13](#page=13). > **Note:** While many jurisdictions have adopted stewardship codes, their effectiveness is debated, particularly for codes that are voluntary and lack enforcement mechanisms [13](#page=13). ### 5.3 Shareholder litigation in practice Shareholder litigation, similar to engagement, is often an exception rather than the rule, with various factors discouraging its pursuit [13](#page=13). #### 5.3.1 Practical deterrents to litigation * **Disinclination of boards:** If the board is unwilling to pursue legal action, a shareholder may decide to exit their investment rather than litigate [14](#page=14). * **Doctrinal challenges:** While some remedies like the U.K.'s oppression/unfair prejudice claim appear broad, courts may not be receptive to cases brought by minority shareholders in publicly traded companies, particularly concerning informal undertakings [14](#page=14). * **Preparation and expense:** Litigation is complex and can incur significant legal expenses [14](#page=14). * **"Loser pays" rules:** In most countries, the losing party must cover a portion of the winning party's legal expenses, creating a fear of bearing both one's own legal bills and those of the successful defendant [14](#page=14). * **"Free riding":** In derivative litigation, where the shareholder vindicates corporate rights, any benefits (like share price increases) are shared among all shareholders, including those who did not participate in the litigation. This discourages individual shareholders from initiating such suits due to a collective action problem [14](#page=14). > **Tip:** The "free riding" problem is most pronounced in derivative litigation but can also arise in class action lawsuits seeking to vindicate personal rights [14](#page=14). #### 5.3.2 Exceptions and specific jurisdictions Despite general deterrents, shareholder litigation occurs in certain contexts: * **Japan:** Lawsuits filed by activist attorneys with political agendas to "send a message" to Japanese public companies contribute to the frequency of derivative litigation [14](#page=14). * **Germany:** A considerable number of lawsuits challenge shareholder resolutions, often driven by "professional" minority shareholders who use the threat of litigation to extract side-payments [14](#page=14). * **United States:** Litigation is most prevalent in the U.S. due to a unique environment hospitable to shareholder lawsuits [15](#page=15). #### 5.3.3 The U.S. litigation environment The U.S. legal system facilitates shareholder litigation through several key features: * **The "American rule" on legal expenses:** Unlike the international "loser pays" system, U.S. litigants typically bear their own legal expenses regardless of the outcome. This encourages even "long-shot" lawsuits by facilitating access to justice [15](#page=15). * **Contingency fees ("no win/no fee"):** Widespread acceptance of contingency fees shifts the downside risk of litigation to lawyers, reducing plaintiffs' concerns about losing in court [15](#page=15). * **"Common fund" doctrine:** This doctrine provides attorneys with a financial incentive to act as entrepreneurs by seeking out legal violations and clients. If a lawsuit creates a "common fund" for other shareholders (e.g., through a successful derivative suit or class action), the plaintiff's lawyer is entitled to a fee award from the proceeds, often as a percentage of the recovery [15](#page=15). * **Settlements:** Even in settlements, which may not involve monetary compensation but rather governance adjustments or increased disclosure, attorneys' fees are often awarded out of the settlement proceeds, with judicial approval [15](#page=15). > **Example:** In the U.S., entrepreneurial attorneys may actively seek out corporations as targets and then find a shareholder willing to serve as the plaintiff, driven by the potential for fee awards under the common fund doctrine, especially given the extensive disclosures made by publicly traded corporations [15](#page=15). --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Shareholder Litigation | Legal actions initiated by shareholders against a company or its management, typically to enforce rights or address alleged misconduct. | | Shareholder Engagement | The active participation of shareholders in the governance of a company, often involving communication with management and voting on corporate matters. | | Stewardship Code | A set of principles and guidelines designed to encourage institutional investors and asset managers to take a more active role in the stewardship of the companies in which they invest. | | Shareholder Passivity | A tendency for shareholders, particularly institutional investors, to remain inactive in corporate governance, often due to perceived costs or lack of influence. | | Oppression/Unfair Prejudice Remedy | A legal recourse available to shareholders in certain jurisdictions, allowing them to seek redress when the company's affairs are being conducted in a manner that is oppressive or unfairly prejudicial to them. | | Doctrinal Challenges | Legal obstacles or difficulties arising from the interpretation and application of existing laws and legal principles, which can deter shareholder litigation. | | Practical Litigation Deterrents | Factors that discourage shareholders from pursuing legal action, such as the significant time commitment required for trial preparation, substantial legal expenses, and the risk of adverse cost awards. | | Loser Pays Rule | A legal principle where the losing party in a lawsuit is required to pay a portion of the winning party's legal expenses, acting as a deterrent to litigation. | | Free Riding | A phenomenon where some shareholders benefit from litigation initiated by others without contributing to the costs or effort involved, which can discourage individual shareholders from bringing lawsuits. | | Derivative Litigation | A lawsuit brought by a shareholder on behalf of the corporation against a third party, typically management or directors, for harm done to the corporation. | | Shareholder Resolutions | Decisions or proposals put forth for a vote by shareholders at a company's general meeting. | | Appraisal Rights Litigation | A type of lawsuit filed by shareholders who dissent from a corporate transaction, such as a merger, seeking a judicial determination of the fair value of their shares. | | Acting in Concert | A legal concept where individuals or entities coordinate their actions regarding a company's shares, potentially triggering disclosure obligations or mandatory takeover bids if they collectively acquire a substantial stake. | | Activist Hedge Funds | Investment funds that build significant stakes in publicly traded companies with the explicit goal of agitating for changes to increase shareholder returns, often employing aggressive tactics. | | Asset Managers | Firms responsible for managing investment portfolios on behalf of clients, including institutional investors and individuals. | | Berle and Means | Refers to the seminal 1932 argument by Adolf Berle and Gardiner Means that a separation of ownership and control in large corporations led to a lack of shareholder engagement and fostered inefficiencies. | | Big Three | Refers to the three major U.S.-based asset management firms (BlackRock, Vanguard, and State Street) that dominate the index tracking industry and collectively hold a significant portion of shares in large publicly traded American companies. | | Corporate Governance | The system of rules, practices, and processes by which a company is directed and controlled, encompassing the relationships between a company's management, its board, its shareholders, and other stakeholders. | | Defensive Shareholder Activism | Shareholder activism primarily focused on corrective actions intended to protect the existing value of shares currently owned by investors. | | Derivative Action | A lawsuit brought by a shareholder on behalf of the corporation against a third party, typically management or the board of directors, for harm done to the corporation. | | Diffuse Ownership | A situation where a company's shares are held by a large number of shareholders, with no single shareholder or small group holding a controlling stake. | | Disclosure of Policies | The requirement for institutional investors and asset managers to publicly reveal their strategies and approaches concerning how they engage with the companies in which they invest. | | Dominant Shareholder | An individual or entity that holds a significant enough proportion of a company's shares to exert considerable influence over its decision-making. | | Engagement | The active participation of shareholders in the corporate governance of a company, typically involving communication with management or voting on corporate matters. | | Shareholder Activism | A strategy employed by shareholders to influence a company's management or board of directors, often by acquiring a significant stake and advocating for specific changes to improve performance or shareholder returns. | | Collective Rights | Legal entitlements that shareholders possess when acting together as a group, such as the right to amend the corporate constitution, elect directors, or veto significant corporate transactions. | | Individual Rights | Legal entitlements that a single shareholder can exercise independently, such as the right to receive declared dividends or to bring a direct suit against the company or its management for perceived wrongs. | | Diffuse Share Ownership | A company ownership structure where shares are held by a large number of individual investors, with no single shareholder possessing a dominant stake, leading to a greater reliance on the board and management. | | Managerial Agency Cost | The potential for conflicts of interest between company managers (agents) and shareholders (principals), leading to decisions that benefit managers at the expense of shareholders. | | Shareholder Meetings | Formal gatherings of a company's shareholders, typically held annually, where they can exercise their voting rights on important corporate matters, elect directors, and approve resolutions. | | Proxy | A process by which a shareholder authorizes another person, often a company representative, to vote on their behalf at a shareholder meeting, which is subject to regulation to mitigate potential conflicts of interest. | | Shareholder Proposal | A resolution put forward by a shareholder for consideration and voting at a shareholder meeting, often concerning corporate governance, social, or environmental issues. | | Precatory Resolution | A shareholder resolution that is advisory or recommendatory in nature, meaning it is not legally binding on the company's board of directors if passed. | | Appointment Rights | Shareholder powers related to the selection and removal of board members, representing a significant formal influence over the composition of the company's leadership. | | Shareholder | An individual or entity that owns shares in a company, representing a claim on the company's assets and earnings. Shareholders are often considered "owners" of the corporation, though this is debated from a contractarian perspective. | | Contractarian Analysis | A theoretical framework that views a corporation as a nexus of contracts among various parties, rather than an entity with inherent ownership. In this view, shareholders are one group among many who bargain for specific rights. | | Agency Cost Theory | A theory that explains the potential conflicts of interest between principals (e.g., shareholders) and agents (e.g., managers) in a firm. It posits that managers may act in their own self-interest rather than in the best interest of the shareholders. | | Residual Claimants | Shareholders are referred to as residual claimants because their return on investment is contingent upon the company's profits after all other obligations to creditors, employees, and other stakeholders have been satisfied. | | Shareholder Democracy | The concept that shareholders, as owners or stakeholders, should have a voice in the decision-making processes of a corporation, often exercised through voting rights analogous to citizens in a political democracy. | | Decision Rights | Shareholder rights that allow them to approve or veto certain significant corporate actions proposed by the board of directors. These rights can impact major transactions or fundamental changes to the company. | | Shareholder Meeting | A formal gathering of shareholders, either annual or special, where they can exercise their voting rights, discuss company matters, and vote on resolutions proposed by the board or by other shareholders. | | Direct Suit | A legal action initiated by a shareholder on their own behalf to address a personal grievance or a wrong that directly affects them, rather than the corporation as a whole. This can arise from the wrongful deprivation of personal shareholder entitlements, such as the right to receive declared dividends or vote at shareholder meetings. | | Derivative Suit | A legal action brought by a shareholder on behalf of the corporation to address a wrong committed against the corporation itself. The shareholder acts as a representative, seeking to vindicate corporate rights when the company's management or board of directors fails to do so. | | Oppressive or Unfairly Prejudicial Conduct | A legal standard, particularly in jurisdictions like the U.K., that allows minority shareholders to seek relief when a corporation is managed in a manner that is deemed oppressive or unfairly prejudicial to their interests. This provides a mechanism for protection against abusive corporate practices. | | Appraisal Rights | A statutory right granted to shareholders who object to certain transformative corporate transactions, such as mergers. These shareholders can demand that the company purchase their shares at a fair value, providing an exit mechanism and compensation for their dissent. | | Activist Shareholder | A shareholder who actively seeks to influence a company's management or policies, often by acquiring a significant stake and advocating for changes to improve performance, increase shareholder value, or address governance issues. This can be "offensive" (seeking to build value) or "defensive" (protecting existing value). | | Institutional Investor | A large entity that pools money to purchase securities, stocks, and other investment assets. Examples include pension funds, mutual funds, and insurance companies, which collectively own substantial portions of publicly traded companies and have the potential to influence corporate governance. | | "Law in Books" vs. "Law in Action" | A distinction used to describe the difference between legal rules as written in statutes and regulations ("law in books") and how those rules are actually applied and enforced in practice ("law in action"). This concept is relevant to understanding why shareholder rights and legal recourse may not always be effectively utilized. | | "Loser Pays" Rule | A legal principle common in many jurisdictions where the party that loses a lawsuit is required to pay a portion of the legal expenses incurred by the winning party. This can act as a deterrent to litigation, as potential litigants may fear bearing significant costs if their case is unsuccessful. | | "American Rule" (Legal Fees) | In contrast to the "loser pays" rule, this principle, prevalent in the United States, generally dictates that each party in a lawsuit pays their own legal expenses, regardless of the outcome. This can encourage more litigation, including by shareholders, by reducing the financial risk of losing. |