In a developing country, in many transactions, a controlling shareholder is dominant on both sides of transactions and, as a corporate decision-maker, she is able to determine the terms of transactions such that they are more favorable to herself at the exclusion of minority shareholders. As such, a controlling shareholder often diverts corporate assets from a corporation to herself like a parent company in the
case of Sinclair Oil Corp. v. Levien.99 Unless a controlling shareholder is found liable for the breach of fiduciary duty in her jurisdiction – which is not likely to happen in bad-law country –, she could earn undue profits from minority extraction through self-dealing. In response, although public investors understand that expropriation itself is given, it is natural that they are concerned about the extent of controllers’ expropriation.
(a) A Simple Model on a Controller’s Extraction – Rates of Loss and Return
What precisely is meant by the “extent” of a controller’s extraction, and how is it measured? Perhaps, the total amount of corporate value that a controller illicitly transfers to herself from all of the minorities might be an important issue to minority shareholders. However, rather than the collective damage of all minority shareholders as a single group, minorities are more interested in their own individual losses that are caused by a controller’s extraction when they invest a particular amount of money in a corporation. In that sense, each minority shareholder is concerned with what I will call the minorities’ “rate of loss in extraction,” which measures how many cents a controller extracts from an individual minority when this
individual minority invests one dollar in a corporation. Against this backdrop, a
simple model can be induced as follows.
A controlling shareholder has a certain portion of equities in a corporation – whether it is the majority or not – depending on the types of ownership structures. As
denoted previously, the weight of her cash flow rights (i.e., a controller’s economic interest in a corporation) is α (0 ≤ α ≤ 1). On the other hand, all minority shareholders hold the remaining portion of equities in a corporation – algebraically, the weight of minorities’ aggregate cash flow rights can be denoted as (1 – α). Let us denote the total value of equities in the corporation as E. As a result, the value of equities that the controller and minorities hold is expressed as α E and (1 – α) E, respectively. In addition, let us use B to represent the amount of the pecuniary private benefits of control that the controlling shareholder extracts from the corporation at the exclusion of minority shareholders. More specifically, B is equal to β E; here, β stands for the portion of corporate value that is diverted to the controlling shareholder (0 ≤ β ≤ 1). For example, when a controlling shareholder transfers 10 percent of corporate value to herself, the value of β is 0.1.
Recall that minorities’ rate of loss in extraction measures how many cents a controller extracts from an individual minority shareholder when this minority shareholder invests one dollar in a corporation. Thus, minorities’ rate of loss in extraction can be expressed as B / [ (1 – α) E ], which is equal to [ β E ] / [ (1 – α) E ]. Ultimately, it can be reduced to [ β / (1 – α) ]. In order to make this notation simpler, let us refer to minorities’ rate of loss, [ β / (1 – α) ] as δ.
In a developing bad-law country, it is the minority shareholders’ fate that a controlling shareholder misuses corporate transactions in order to tunnel corporate value. Minority shareholders may endure a controller’s looting as long as their rate of loss in extraction is set within the acceptable range. However, if a controller overreaches and returns after a controller’s extraction (i.e., returns that minority
shareholders ultimately attain) falls too low as compensation for minorities’ equity investment, then minority shareholders would withdraw their investment from the corporation in the next stage. As such, if a controller wishes to stay in the business in the next stage, she cannot determine the rate of loss in extraction arbitrarily. Accordingly, the value of δ (i.e., minorities’ rate of loss) is confined up to the maximum acceptable rate that minorities can tolerate.
So far, we have reviewed minorities’ loss rate in extraction. Now, let us turn to a controller’s “rate of return in extraction,” which measures how much a controller can extract from a corporation when she invests one dollar as equity in a corporation. According to this definition, a controller’s rate of return in extraction is expressed as B / (α E). Since B is equal to β E, a controller’s rate of return in extraction is the same as (β E) / (α E). Again, this formula is reduced to β / α. Since minorities’ rate of loss in extraction, [ β / (1 – α) ], is replaced by δ as aforementioned, β is equal to [ δ (1 – α) ]. Therefore, a controller’s rate of return in extraction can be transformed into [ δ (1 – α) / α ].
Figure 1: A Controller’s Rate of Return in Extraction
Y axis: a controller’s rate of return in extraction X axis: a controller’s economic interest (α) (0 ≤ α ≤ 1) Y = [δ (1 – α) / α]
What does this formula imply? For the purpose of analyzing the effect of the different economic interest (i.e., cash flow rights) of controllers under ceteris paribus (i.e., other conditions are equal), suppose that for some reasons, two controllers impose the same rate of loss in extraction from their minorities. In turn, this would mean that minority shareholders in each corporation would tolerate the same rate of loss in extraction and that δ is a constant number. Accordingly, the rate of return in extraction is a function of “one” variable, α (i.e., the portion of cash flow right of a controller). As a result, the formula (i.e., [ δ (1 – α) / α ]) states that as α (i.e., a controller’s economic interest in a corporation) decreases, the numerator, δ (1 – α)
increases and, at the same time, the denominator, α decreases. In sum, as α becomes
smaller, a controller’s rate of return in extraction increases geometrically. The interpretation of this phenomenon is that a controller with small economic interest may attain disproportionally more pecuniary private benefits of control than a controller with large economic interest, despite the fact that two controllers face the same degree of minority shareholders’ resistance, which is measured by δ. Therefore, a controlling shareholder has a financial advantage when she has more minority shareholders in a corporation that she controls.100
100 One may argue that the assumption that δ (i.e., minorities’ rate of loss in extraction) is the same in the above model is untrue. Thus, according to this logic, even if α (i.e., the cash flow rights of a controller) becomes larger, a controller can maintain the previous level of the rate of return in extraction by raising δ (i.e., minorities’ rate of loss in extraction) according to the formula – recall that the rate of return in extraction is [ δ (1 – α) / α ]. My responses are as follows. First, I do not assume that δ is same in reality. What I merely say is that “if” δ is same, a controller’s rate of return in extraction increases geometrically as a controller reduces α. In other words, I use ceteris paribus analysis by fixing δ as the same across corporations in order to understand the effect of reduced α on the controller’s rate of return.
Second, it is still theoretically possible that δ is at least similar – if not same – across corporations which are comparable in terms of business, risk profiles, or managerial capacity in the same economy. Why? Suppose that two controlled-corporations (“Corporation AA” and “Corporation BB” respectively) are comparable except controllers’ economic interests in corporations. Then, they are likely to generate the similar “rate of return in gross terms” (i.e., the rate of return before expropriation by controllers). The rate of return that shareholders of two corporations care is not the “rate of return in gross terms” but the “rate of return after expropriation.” If the “rate of return after expropriation” of Corporation AA is lower than that of Corporation BB, shareholders of Corporation AA will move to Corporation BB. Thus, in order not to lose minority shareholders and equity capital, both corporations have incentives to maintain “the rate of return after expropriation” at the similar level. Then, please note that the “rate of return after expropriation” is approximately the “rate of return in gross terms” minus the “minorities’ rate of loss.” Therefore, if the “rate of return in gross terms” and the “rate of return after expropriation” are similar among comparable corporations, the “minorities’ rate of loss” is similar for two corporations as well. In other words, when a controller overreaches and raises δ (i.e., minorities’ rate of loss in extraction) by large-scale looting, minorities can withdraw their equity investment from the corporation, which is ultimately harmful to a controller who wants to keep a large business empire and maximize the long-run pecuniary benefits. In this context, it can be said that a controller has less discretion (than we have thought) on raising the value of δ above a certain critical point. Put differently, even if the value of δ is not exactly same across corporations, it is confined within the narrow range that is tolerable to minorities.
In that sense, it is relatively relevant to assume that the rate of return in extraction is only a function of α and δ is a constant number (although in fact δ is not exactly same across corporations). Consequently, from the perspective of a controller, raising δ while having a high value of α is not a practical way to maintain the rate of return in extraction. Moreover, even if a controller can raise the value of δ at her full discretion, the effect of δ on the rate of return in extraction is much smaller than that of α for the following reason; as α decreases, its impact on the rate of return in extraction is
When a corporation relies on equity finance, a controlling shareholder has to bear the additional cost (for example, α (Y – X)). On the other hand, issuing the new equity for capital is monetarily (rather than psychologically) beneficial to a controlling shareholder when she is able to expropriate minorities; by having more minority shareholders, α (i.e., the portion of a controller’s cash flow rights in a corporation) will be lowered; as a result of reduction in α, a controller’s rate of return in extraction is enhanced so that a controller is able to gain a huge amount of pecuniary benefits; moreover, it should not be overlooked that the additional cost of equity finance, α (Y – X) decreases as the new shares are issued.101 Another beauty of lowering α by raising new equities from the capital market is that a controlling shareholder can improve the rate of return in extraction “benevolently” – in other words, by having more equity capital from public shareholders (i.e., lowering α by raising new equities from the capital market), a controller can collect more pecuniary
benefits without aggravating individual minorities’ welfare 102 (although the
minorities’ total welfare would be aggravated by lowering α). Table 4 summarizes notations, formulas and their implications.
magnified through simultaneous changes in the formula’s decrease in denominator and increase in
numerator; in contrast, the rise of δ – even if possible – increases only the numerator part of the formula.
101 It is because α (the economic interest of a controlling shareholder) becomes smaller when the new shares are issued.
102 Put differently, even if the “tax rate” on individual minorities remains constant, a controller can have more “tax payers” by issuing new shares to public investors. As a result, a controller can collect more “tax revenue” without raising the “tax rate.”
Table 4: Minority Shareholders’ Rate of Loss and a Controller’s Rate of Return in Extraction
Minority Shareholders’ Rate of Loss in Extraction = B / [(1 – α) E]
(1) B / [(1 – α) E] = [ β E ] / [ (1 – α) E ] = [ β / (1 – α) ]
(2) Put δ = [ β / (1 – α) ] → β = δ (1 – α)
A Controller’s Rate of Return in Extraction = B / (α E)
(1) B / (α E) = (β E) / (α E) = β / α
(2) Since β = δ (1 – α) → A Controller’s Rate of Return in Extraction = [δ (1 – α) / α]
(3) Therefore, as α decreases, the value of [δ (1 – α) / α] would rapidly decrease due to two reasons – the numerator increases and denominator decreases.
(4) It can be interpreted that, as the cash flow rights of controller decrease, a controller’s rate of return in extraction increases geometrically.
Note
- α : the portion of cash flow rights that the controlling shareholder holds (0 ≤ α ≤ 1)
- (1 – α) : the portion of cash flow rights that minorities hold (0 ≤ 1 – α ≤ 1)
- E : the total value of equities of the corporation
- B : the value of private benefits of control that the controller can extract
- β : the portion of corporate value that is diverted to the controlling shareholder
- Thus, B = β E
- α E : the value of equities that the controlling shareholder holds
- (1 – α E) : the value of equities that minority shareholders hold
(b) A Numerical Example – Rates of Loss and Return in Extraction
A numerical example can make this explanation more concrete. Suppose that there are two corporations, “Corporation A” and “Corporation B,” which are managed by “Controller A” and “Controller B” respectively who have more than
majority voting rights in each corporation. These two corporations are comparable in terms of characteristics of business, risk profiles, managers’ capacity, and capital structure.
However, Corporation A is a deep CS-style corporation and Corporation B is a deep CMS-style corporation. More specifically, Controller A owns 75 percent of all outstanding common stocks of Corporation A of which the total equity is worth 100 million dollars – thus, her invested capital in the corporation is 75 million dollars. On the other hand, Controller B invests 75 million dollars, which is the same amount of equity investment as Controller A has. However, the cash flow rights that Controller B holds are only 5 percent due to the pyramiding mechanism. Accordingly, the total amount of equity in Corporation B is 1.5 billion dollars, which is fifteen times larger than that of Corporation A. Subsequently, suppose that these two controllers extract corporate value from both corporations and the same rate of loss in extraction (δ) is levied on minorities of both corporations. If the extent of expropriation is different in the two corporations, minorities would move from the corporation with the higher rate of loss to the corporation with the lower rate of loss.
Accordingly, the rate of return in extraction of Controller A is expressed as (0.25 δ / 0.75), which is reduced to 1/3 δ. On the other hand, the rate of return in extraction of Controller B is calculated as (0.95 δ / 0.05), which is reduced to 19 δ. In sum, given the same amount of a controller’s capital contribution (i.e., 75 million dollars) and minorities’ rate of loss (i.e., δ), she can attain 57 times more pecuniary private benefits of control, if a controlling shareholder is able to reduce her cash flow rights from 75 percent to 5 percent by having more minority shareholders. For
example, if minorities’ maximum acceptable rate of loss in extraction is 1 percent, while Controller A is able to annually extract 0.25 million dollars (i.e., 1/3 x 0.01 x 75 million dollars) from the corporation, Controller B can extract 14.25 million dollars (i.e., 19 x 0.01 x 75 million dollars). At the same time, it is noteworthy that Controller B’s rate of extraction is enhanced without worsening individual minorities’ welfare since the extraction rate that individual minorities face is the same. In this sense, the pyramiding scheme of Corporation B provides Controller B with not only
voting leverage but also a leverage of pecuniary extraction.