Chapter 7 Shareholders (1).pdf

# Shareholder rights and their rationales This section explores the justifications for empowering shareholders in corporate governance, examining various rationales and outlining the rights afforded to them by corporate law [1](#page=1). ### 7.1 Why empower shareholders? The privileged position of shareholders in corporate governance is attributed to several potential rationales [2](#page=2). #### 7.1.1 The "owner" argument One prominent rationale is the characterization of shareholders as the "owners" of the company. Historically, this was the primary explanation for their central role in corporate affairs, entitling them to control management and exclusively benefit from company activities. While influential figures like Milton Friedman used this framing, contractarian analysis within economics has largely dispensed with the notion of shareholders "owning" the corporation, viewing it instead as a contractual matrix where shareholders bargain for specific rights. Nevertheless, the perception of shareholders as owners persists widely outside academia, as businesses are seen to require owners, and shareholders are the most logical candidates [4](#page=4) [7](#page=7) [9](#page=9). #### 7.1.2 Shareholder democracy and political analogies Another potential justification is the analogy of corporate governance to political democracy, where shareholders are seen as voters electing representatives (directors). However, contractarians find this flawed, arguing that voting rights are allocated contractually, not politically. Furthermore, the analogy is problematic because states possess coercive power that individuals in a corporation, who invest voluntarily and can exit the market, do not face . #### 7.1.3 Residual claimants Contractarian scholars propose that shareholders' status as "residual claimants" provides a strong rationale for their empowerment. Unlike stakeholders like creditors and employees who contract for fixed returns, shareholders receive the unspecified upside after all fixed obligations are met. This unique benefit from corporate success gives shareholders robust incentives to monitor management, reduce agency costs, and maximize firm value. Corporate law aids this by granting shareholders significant rights to hold management accountable . #### 7.1.4 Gap-filling The concept of "gap-filling" suggests that empowering shareholders is a beneficial way to address potential problems under ideal contracting conditions. Given the open-ended nature of their residual claim, it is challenging for shareholders to explicitly bargain for all necessary safeguards. Therefore, corporate law steps in to provide them with rights that facilitate their oversight role [6](#page=6). #### 7.1.5 Fostering social benefit and checking insiders Empowering shareholders can also be justified on the basis that their oversight of company management is beneficial in societal terms. The state, like shareholders, has an interest in efficient, honest, and fair corporate management, albeit for different reasons such as constraining externalities and promoting economic growth. Shareholder intervention can thus potentially contribute to socially beneficial outcomes . > **Tip:** While various rationales exist for shareholder empowerment, it's important to note that each has its weaknesses, and the case for shareholder primacy is not universally accepted [2](#page=2) . ### 7.2 The nature of shareholder rights - an overview Shareholder rights can be broadly categorized into those exercised collectively and those exercised individually . #### 7.2.1 Collective rights Collective shareholder rights typically involve "decision rights" that can impact board authority or "appointment rights" concerning director selection. These are most commonly exercised through resolutions passed at shareholder meetings . #### 7.2.2 Individual rights Individual shareholder rights generally do not directly impinge on boardroom prerogatives. Examples include receiving dividends and the right to litigate in response to alleged misconduct by the board or mistreatment by dominant shareholders . > **Example:** A shareholder might exercise an individual right by suing the company on its behalf in relation to a breach of directors' duties, known as a derivative suit . ### 7.3 Collective rights Collective shareholder rights are potent, particularly in publicly traded companies . #### 7.3.1 Shareholder meetings and voting The primary mechanism for exercising collective rights in publicly traded companies is through resolutions at shareholder meetings. While shareholders rarely attend in person, they can vote by proxy. Voting typically follows a one-share, one-vote principle, though companies can structure classes of shares to allocate voting rights differently. Public companies are statutorily obliged to hold annual shareholder meetings, and boards can also call special meetings . > **Tip:** While boards typically set the agenda for shareholder meetings, shareholders owning a designated minimum percentage of shares (often 5% or 10%) usually have the statutory right to call a special meeting . #### 7.3.2 Shareholder proposals Shareholders can propose resolutions to be voted on at meetings. In the U.S., under Rule 14a-8, shareholders meeting modest ownership requirements can have their resolutions included in proxy materials. Many such proposals are advisory, but they have driven significant governance reforms . #### 7.3.3 Types of collective powers Collective shareholder powers generally fall into two categories: appointment rights and decision rights . * **Appointment rights:** Shareholders typically have substantial influence over the selection and removal of board members. This power is considered among the most important, even though directors are almost always elected unanimously . * **Decision rights:** Shareholders may have the right to approve or veto board proposals under certain circumstances, though these requirements are less prevalent in the U.S. than in many other jurisdictions and often limited to fundamental changes like mergers. Amending the corporate constitution is another area where shareholder control is generally stronger globally than in the U.S . > **Important Note:** Corporate legislation typically vests managerial authority in the board, meaning boards can generally disregard shareholder instructions passed by resolution. While corporate constitutions can reallocate some authority to shareholders, this rarely occurs . ### 7.4 Rights exercisable individually Shareholders also possess individual rights pertinent to corporate governance . #### 7.4.1 Derivative suits A key individual right is the ability to launch litigation on the company's behalf to address breaches of directors' duties, known as derivative suits. This mechanism addresses situations where the board, potentially conflicted, fails to sue wrongdoers. Derivative suits are subject to various filtering mechanisms, including board notification and court leave, to prevent frivolous litigation . #### 7.4.2 Direct suits When a shareholder can demonstrate an infringement of a legally protected personal right, they can bring a "direct" suit. This bypasses the procedural filters of derivative litigation as the shareholder is vindicating their own rights . > **Example:** A direct suit could arise from wrongful deprivation of entitled dividends or from challenging the propriety of shareholder resolutions . Other scenarios for direct suits include: * Challenging resolutions adopted by shareholders acting collectively . * Alleging a dominant shareholder breached duties owed to other shareholders . * Seeking relief under statutory measures for oppressive or unfairly prejudicial corporate operations (e.g., in the U.K.) . * Exercising "appraisal" rights, allowing a demand for fair value purchase of shares in response to transformative transactions like mergers . > **Note:** The availability and development of these individual rights, such as derivative litigation and appraisal rights, vary significantly across jurisdictions, with the U.S. often showing more developed mechanisms in these areas . ### 7.5 Shareholder engagement in practice Despite the substantial rights vested in shareholders, a significant gap exists between "law in books" and "law in action," often referred to as shareholder passivity . #### 7.5.1 Reasons for passivity Several factors contribute to shareholder passivity: * **Diversified portfolios:** Inability to focus on individual companies due to broad investment . * **Managerial expertise:** Awareness that managers are often better equipped to run companies . * **Ease of exit:** The quick and simple option of selling shares via the stock market . * **Collective action problems:** The difficulty of coordinating action among numerous shareholders . * **Legal risks:** Fear of breaching regulations, such as insider trading prohibitions, when engaging with companies . --- # Shareholder engagement and passivity This topic examines the gap between shareholders' legal rights and their practical engagement in corporate governance, highlighting historical passivity and the rise of shareholder activism and stewardship. ### 2.1 Shareholder rights versus practical engagement While shareholders possess significant legal rights, both individually and collectively, there is a crucial distinction between "law in books" and "law in action". This disparity is particularly evident in the context of shareholder engagement [9](#page=9). ### 2.2 The tradition of shareholder passivity A common critique in corporate governance is that shareholders have historically been indifferent to their investee companies. Several market-oriented explanations contribute to this tradition of passivity [9](#page=9): * **Diversified investment portfolios:** Shareholders are unable to focus intensely on individual companies due to managing broad investment portfolios [9](#page=9). * **Managerial expertise:** The belief that company managers are better qualified to run the businesses in which shareholders have invested [9](#page=9). * **Ease of exit:** The readily available option to sell shares on the stock market [9](#page=9). * **Collective action problems:** Difficulties in coordinating action among a large number of shareholders [9](#page=9). > **Tip:** Understanding these underlying reasons for passivity is key to appreciating why reform efforts are necessary. Furthermore, investors may refrain from intervening due to fears of breaching legal rules. Specific concerns include [9](#page=9): * **Insider trading prohibitions:** Shareholders might discover confidential, price-sensitive information and be prohibited from trading or disclosing it [9](#page=9). * **"Acting in concert" obligations:** If shareholders collaborate, they might be deemed to be "acting in concert," triggering disclosure requirements for large shareholdings and potentially an obligation to make a takeover bid [9](#page=9). ### 2.3 Disruption of shareholder passivity: The rise of activism The traditional passivity of shareholders in public companies has been significantly challenged. This shift is partly attributed to the rise of activist shareholders [10](#page=10). #### 2.3.1 Hedge fund activism Hedge funds have been prominent agents of change, particularly through "offensive" activism. This involves investors building substantial stakes in companies with the intention of agitating for changes to improve shareholder returns. Unlike typical institutional investors with diversified portfolios, activist hedge funds often concentrate their investments in a small number of carefully selected public companies. Their stakes are large enough to yield significant gains from improved investment performance. These funds target undervalued companies, seeking to profit from share price increases driven by positive stock market re-ratings. Crucially, activist hedge funds are proactive in accelerating improvements by pressing for changes. Their tactics can include aggressive strategies such as proxy contests to gain board representation [10](#page=10). #### 2.3.2 "Defensive" shareholder activism and institutional investors There is also speculation about the increased prevalence of "defensive" shareholder activism, aimed at protecting the value of existing shareholdings. The substantial growth in institutional investors, such as pension funds and mutual funds, in global equity markets is seen as a potential catalyst for engagement. Their large shareholdings represent significant financial stakes, and the size of these holdings could make them difficult to unwind without negatively impacting share prices [10](#page=10). > **Example:** A pension fund holding a substantial percentage of a company's shares may be motivated to engage with management to ensure the company's long-term performance and thus protect the value of its investment for its beneficiaries. ##### 2.3.2.1 Index-tracking funds and the "Big Three" Asset managers running index-tracking funds are considered strong candidates for defensive shareholder activism. These funds aim to match the performance of a stock market index and achieve low fees through a simple investment approach. Due to the difficulty active managers face in consistently outperforming markets, index trackers have become popular, leading to a significant increase in their ownership of public company shares. Major U.S.-based firms like BlackRock, Vanguard, and State Street, often referred to as the "Big Three," dominate this sector and collectively own a substantial portion of shares in major U.S. and international companies. These firms have publicly committed to responsible stewardship in their investee companies [11](#page=11). ### 2.4 Limitations and ongoing debate regarding engagement Despite the rise of activism, it is premature to dismiss the assumption of shareholder passivity entirely [11](#page=11). * **Geographical concentration of activism:** Offensive shareholder activism, particularly by hedge funds, is heavily concentrated geographically, predominantly in the United States. While U.S. hedge funds lead campaigns globally, non-U.S. targets are limited to a few countries like Japan, the U.K., and Canada [11](#page=11). * **Mainstream institutional investors' engagement:** While the growth of institutional shareholdings suggests a move away from the Berle and Means characterization of dispersed and passive shareholders, engagement "remains the exception rather than the rule" for prevailing institutional practices. Scholars acknowledge the potential of large institutional investors but also their failure to fully meet high expectations for improving corporate performance [11](#page=11). * **Unsettled impact of passive ownership:** The precise effect of the rise in passive ownership on corporate governance is still debated. While the "Big Three" are seen as potential game-changers, sceptics argue that the business model of index funds undermines incentives for engaged shareholdership. Index fund operators focus on low costs and minimizing tracking errors, as any gains from identifying and correcting managerial shortcomings would be shared market-wide, potentially increasing fees and losing market share to cheaper rivals [12](#page=12). * **Limited shareholder engagement teams:** Firms dominating the index tracking sector employ very small shareholder engagement teams relative to the number of companies they hold shares in, making meetings with companies exceptional. Empirical research suggests that corporate governance deteriorates when index funds replace other institutional investors and that passive funds are more likely to defer to managerial recommendations on shareholder votes [12](#page=12). * **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. In concentrated ownership systems, dominant shareholders can often dictate outcomes regardless of other shareholders' stances. Additionally, the "Big Three" hold smaller stakes in companies with dominant shareholders because index fund tracking is based on "free float" rather than total market capitalization, and dominant shareholders' shares are typically excluded from the free float [12](#page=12). ### 2.5 Reforms to foster shareholder engagement: Stewardship codes Recognizing the potential benefits of shareholder engagement for managerial accountability and the incomplete disruption of shareholder passivity, reforms have been introduced to encourage greater engagement. A key strategy has been to incentivize asset managers and institutional shareholders to actively participate in corporate governance through disclosure requirements regarding their engagement approach [13](#page=13). #### 2.5.1 The genesis of the global stewardship movement The U.K.'s Financial Reporting Council (FRC) promulgated a Stewardship Code in 2010, which is considered "the genesis" of the global stewardship movement. This code aimed to address the issue of rationally passive institutional investors in the U.K.'s dispersed ownership structure. The U.K. Code, and its subsequent 2012 revision, served as a model for similar initiatives in nearly twenty other jurisdictions. The European Union followed suit by requiring Member States to enact laws obliging institutional investors and asset managers to disclose their shareholder engagement policies as part of a 2017 revision to its shareholder rights directive [13](#page=13). > **Tip:** Stewardship codes are designed to enhance transparency and accountability by requiring investors to report on their engagement activities. #### 2.5.2 Effectiveness and limitations of stewardship codes By 2019, a significant number of asset managers and institutional shareholders in the U.K. had become signatories to the Stewardship Code, obliging them to disclose their compliance with its principles and explain any failures. However, despite these disclosure efforts, shareholder passivity in the U.K. persisted. A 2018 government review found the Stewardship Code "not effective in practice". This assessment is concerning for stewardship codes elsewhere, especially since many are entirely voluntary and lack enforcement mechanisms to encourage disclosure. Consequently, the effectiveness of stewardship codes and related disclosure initiatives in substantially changing shareholder passivity in public companies remains questionable [13](#page=13). --- # Shareholder litigation as a governance tool Shareholder litigation, encompassing both derivative and direct suits, serves as a critical, albeit often underutilized, mechanism for shareholders to enforce their rights and hold corporate insiders accountable [8](#page=8). ### 3.1 Types of shareholder litigation Shareholders possess rights that can be exercised collectively through resolutions or individually. When directors breach their duties, which are typically owed to the company, the company itself is the proper plaintiff. However, a significant governance challenge arises when the board of directors, due to loyalty or self-interest, fails to initiate a lawsuit against wrongdoing directors [8](#page=8). #### 3.1.1 Derivative litigation To address the potential for unaddressed director misconduct, individual shareholders can be permitted to initiate litigation on behalf of the company. These actions are known as "derivative suits" because the shareholder enforces a right "derived from" the company, rather than a personal right [8](#page=8). * **Purpose:** To allow shareholders to sue when the board fails to do so, particularly in cases of director misconduct [8](#page=8). * **Jurisdictional prevalence:** While available in many countries, it is not universally provided [8](#page=8). * **Filters and limitations:** To prevent frivolous or duplicative litigation, most jurisdictions implement filters for derivative suits. These commonly include [8](#page=8): * Notification to the board of directors [8](#page=8). * Court approval (leave) before proceeding [8](#page=8). * Share ownership thresholds and/or specific ownership periods [8](#page=8). > **Tip:** The mechanisms for filtering derivative suits vary significantly by jurisdiction, making it crucial to consult specific legal frameworks. #### 3.1.2 Direct litigation Shareholders can bypass the procedural hurdles of derivative litigation if they can demonstrate an infringement of their own legally protected personal right. In such cases, the shareholder is acting on their own behalf, vindicating their personal rights rather than those derived from the company [8](#page=8). * **Basis for direct suits:** * Infringement of a legally protected personal right [8](#page=8). * Wrongful deprivation of entitlements, such as the non-receipt of declared dividends or denial of voting rights at properly called meetings [9](#page=9). * Challenging the propriety of resolutions adopted by shareholders collectively [9](#page=9). * Allegations of a dominant shareholder breaching duties owed to other shareholders [9](#page=9). * Seeking relief under statutory measures for oppressive or unfairly prejudicial operation of the corporation (e.g., in the U.K.) [9](#page=9). * Exercising statutory "appraisal rights" to demand a company purchase shares at fair value during transformative transactions like mergers [9](#page=9). > **Example:** A shareholder is denied their right to vote at a shareholder meeting. This is a personal right, and the shareholder can bring a direct suit to remedy this infringement. ### 3.2 Shareholder litigation in practice and deterrents Despite the existence of these legal avenues, shareholder litigation is often the exception rather than the rule in publicly traded companies, indicating a gap between "law in books" and "law in action" [13](#page=13) [14](#page=14). #### 3.2.1 Factors deterring shareholder litigation Several factors discourage public company shareholders from resorting to litigation to enforce their rights [14](#page=14): * **Doctrinal challenges:** Even when remedies like oppression/unfair prejudice exist, courts may be unreceptive to cases from minority shareholders in publicly traded companies, particularly when informal undertakings are involved [14](#page=14). * **Practical litigation deterrents:** * **Distraction and Legal Expenses:** Preparing for trial can be a significant distraction, and legal expenses can be substantial due to the complexity of shareholder litigation [14](#page=14). * **"Loser Pays" Rules:** In most countries, losing litigants are required to pay a portion of the winning party's legal expenses. This "loser pays" regime, though varying in rigor, makes prospective litigants wary of being burdened with both their own and the defendant's costs [14](#page=14). * **"Free Riding":** This is a significant deterrent, especially in derivative litigation. When a shareholder successfully brings a derivative suit, the benefit accrues to all shareholders through increased share value, yet the litigating shareholder receives no disproportionate benefit compared to non-litigating shareholders. This collective action problem incentivizes shareholders to let others bear the burden of litigation [14](#page=14). * The "free riding" problem also reappears in direct litigation if framed as a class action, though scope for such multiparty litigation is often restricted [14](#page=14). #### 3.2.2 Exceptions and prevalence of shareholder litigation While deterrents are significant, there are exceptions where shareholder litigation occurs with some frequency [14](#page=14): * **Japan:** Lawsuits filed by activist attorneys with political agendas, aiming to "send a message" to Japanese public companies [14](#page=14). * **Germany:** A considerable number of lawsuits where "professional" minority shareholders with small stakes challenge shareholder resolutions, leveraging German company law to extract side-payments by threatening to delay essential corporate actions [14](#page=14). #### 3.2.3 The United States as a litigation hub The United States stands out as the jurisdiction where public company shareholder litigation is most prevalent. This can be attributed to a litigation environment that is uniquely hospitable to such lawsuits [15](#page=15). * **The "American Rule" on Legal Expenses:** In contrast to the international "loser pays" standard, the U.S. generally follows the "American rule" where litigants typically pay their own legal expenses, regardless of outcome. This rule is intended to facilitate access to justice and encourages long-shot lawsuits [15](#page=15). * **Contingency Fees:** The U.S. widely accepts "no win/no fee" contingency fee arrangements between lawyers and clients. This shifts downside litigation risks to lawyers, reducing shareholder plaintiffs' worries about losing [15](#page=15). * **"Common Fund" Doctrine:** This convention provides a financial incentive for plaintiffs' attorneys to act as legal entrepreneurs. When a shareholder lawsuit creates a "common fund" or confers a substantial benefit on other shareholders (either through trial or settlement), the plaintiff's attorney is entitled to a fee award, typically a percentage of the recovery or paid by the corporation [15](#page=15). * Strikingly, these settlements often do not involve monetary compensation but may result in undertakings for additional disclosures or governance adjustments. Judges traditionally approve these attorney fee awards [15](#page=15). * **Role of the Legal Profession:** The U.S. legal profession, acting as the engine driving shareholder litigation, actively seeks out potential legal violations and suitable clients. Publicly traded companies are particularly targeted due to their extensive disclosure requirements under federal securities law [15](#page=15). > **Key takeaway:** The U.S. legal system, through its approach to legal costs, fee arrangements, and attorney incentives, creates a fertile ground for shareholder litigation that is less common in other jurisdictions. --- ## 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 | |------|------------| | Corporate governance | The system of rules, practices, and processes by which a company is directed and controlled, involving the balancing of the interests of a company's many stakeholders. | | Shareholder | An individual, company, or institution that owns at least one share of a company's stock, representing a claim on the company's assets and earnings. | | Agency cost theory | This theory suggests that the costs incurred by the principal (e.g., shareholders) to ensure that the agent (e.g., managers) acts in the principal's best interest are known as agency costs. | | Stakeholder | Any party that has an interest in a company and can affect or be affected by the business. This includes shareholders, employees, customers, suppliers, creditors, and the community. | | Contractarian perspective | An economic theory that views the corporation as a nexus of contracts, where all relationships are based on voluntary agreements between self-interested parties. | | Residual claimants | Shareholders are considered residual claimants because their return on investment is based on what is left over after all other claims against the company (such as those of creditors and employees) have been satisfied. | | Gap-filling | In contract law, gap-filling refers to the process by which courts or legal systems supply terms or provisions to a contract that were not explicitly agreed upon by the parties, often based on hypothetical bargaining under ideal conditions. | | Shareholder democracy | A concept suggesting that shareholders, like citizens in a democracy, should have a say in how the company they "own" is managed through voting rights and participation in corporate decision-making. | | Derivative suit | A lawsuit brought by a shareholder on behalf of a corporation against a third party, typically corporate directors or officers, for alleged wrongdoing that has harmed the corporation. | | Direct suit | A lawsuit brought by a shareholder to enforce a personal right or to seek redress for harm directly suffered by the shareholder, rather than on behalf of the corporation. | | Common fund doctrine | A legal principle in the United States that allows attorneys' fees to be awarded from a fund created for the benefit of a group of people, typically in class action or derivative lawsuits, when the attorney's work has generated that fund. | | Stewardship Code | A set of principles designed to guide institutional investors and asset managers on how to engage responsibly with the companies in which they invest, promoting good corporate governance and long-term value creation. | | "Law in books" vs. "Law in action" | This distinction refers to the difference between the legal rules as written in statutes and case law ("law in books") and how those rules are actually applied and interpreted in practice ("law in action"). | | "Loser pays" rule | A legal cost rule, common in many countries outside the U.S., where the losing party in a lawsuit is required to pay a portion of the winning party's legal expenses. | | "American rule" | In the U.S. legal system, this rule generally states that each party in a lawsuit pays its own legal expenses, regardless of whether it wins or loses, though exceptions exist. | | "No win/no fee" contingency fees | A fee arrangement where a lawyer's payment is dependent on winning a case; the lawyer receives a percentage of the damages awarded to the client, and if the client loses, the lawyer receives no fee. |