Shareholder Protection

Corporate governance legal
and voluntary regulation:

Shareholder protection
Dr Udo C Braendle
Reference:
Braendle (2005),
Shareholder
Protection in the
USA and Germany
on the Fallacy of
LLSV
2001 The Economist
Majority rule and minority

protection
z
Person or group of people holding 50% of the

shares will always have the right to dismiss
the directors (section 303 CA 1985)
z
Majority shareholders have a great deal of

influence
Shareholders in general meeting can

influence the companys decision making in a
more direct manner
z
Ratify transactions otherwise would have

amounted to a breach of fiduciary duty
2

protection
z
The rule in Foss v Harbottle (1843) 2 Hare 461

z
The directors of a company arranged for it to

z Purchase land from the directors at an overvalue
z Enter into an ultra vires loan arrangement
Action against the directors brought by two shareholders!
z Shareholders were trying to bring an action to enforce rights
belonging to the company
One would expect the company, acting through the board, do this for itself
Did it as companys assets had been depleted and if the company

did nothing to repair the damage then the value of its shares
would fall
As directors were the wrongdoers, they would not bring legal proceedings
against themselves
Court held that the shareholders could not sue to enforce the
companys rights against the directors
3

protection
z
The rule in Foss v Harbottle (1843) 2 Hare 461

z
Two elements
z
The proper plaintiff in an action in respect of a wrong

alleged to be done to a company is the company itself
proper plaintiff principle

The duties of the directors were owed to the company and not
to the individual shareholders
It was the company which could sue
Where a majority of the members can ratify the transaction
and, by doing so, bind the company and all its members, no
individual member can bring an action
4

protection
z
Exceptions to the rule in Foss v Harbottle

z
Fraud or ultra vires

Park v Daily News [1962] Ch 927
A shareholder could stop the company from making ultra

vires gifts to the employees
Special majority required

Edwards v Halliwell [1950] 2 All ER 1064
Two members of a trade union successfully restrained an

attempt to increase the members contributions without
obtaining the two-thirds majority required under their rules
Majority rule and minority protection

z
Exceptions to the rule in Foss v Harbottle

z
Personal rights
z Pender v Lushington (1877) 6 Ch D 70
Wood v Odessa Waterworks Company (1889) 42 Ch D 636
The chairman of a general meeting refused to take the votes of certain

shareholders into account. The members were able to bring an action to
have their votes counted. Members have a personal right to have their
votes counted.
The general meeting approved a resolution to pay dividends not in cash
but by issuing bonds. The members had a personal right to enforce their
right under the articles to receive dividends in cash
Fraud on the minority and the wrongdoers are in control

z Fraud on the minority
Cook v Deeks [1916] 1 AC 554; Menier v Hoopers Telegraph Works

(1874) 9 Ch App 350
Both cases involved breach of fiduciary duty by directors. This
amounts to fraud in this context. So, for example, if the directors are
6
making use of opportunities that come their way because they are
company directors

protection
z
Action by shareholders: procedural aspects

z
Personal action
z Action brought by a shareholder to enforce some right belonging to
him or her personally. Action in his or her own name asking the
court to declare that the relevant resolution is invalid.
Derivative action
z Action brought by a shareholder in his own name and in the names
of the other shareholders on behalf of the company
Proceeds of the action go to the company and not to the shareholder

personally
Costs of the action are born by the shareholder bringing the action. Basic
rule: loser pays all of the costs => Unfair procedure
In Wallersteiner v Moir (No 2) [1975] QB 373 the court said that the
company, rather than the individual shareholder, could be ordered to pay
the legal costs in certain circumstances
Shareholder must have acted in good faith and on reasonable grounds
7
Plaintiff who brings a derivative action must be a proper person to do so

protection
z
Action by shareholders: procedural aspects

z
Representative action
z Action brought by a shareholder on behalf of
himself and other shareholders to enforce their
collective rights
SH protection in the USA and

Germany on the fallacy of LLSV
z
z
z
Company laws of USA and Germany have much in

common but in many particulars they are the
opposites
Common Law vs Civil Law
Civil Law
z
z
z
Continental Europe, wide parts of Asia, Latin America and

former colonies of Continental European countries
Factured into separate national laws such as in France,
Germany and Switzerland
Germany rising power in the late 19th century
z Basis for legal systems in Japan and South Korea
z Introduced in China in the later years of the Qing Dynasty
Today three major families
z French, German and Scandinavian Civil Law

z
Common Law
z
z
z
z
Developed in 12th century

Mainly case law
Parts of the law are codified since the 20th and 21st century
UK, Ireland, USA (except Louisiana), Canada, Australia,
New Zealand, Southern Africa (in parts), India, Malaysia,
Singapore and Hong Kong are affected by this legal
tradition
Law developed by custom
Civil Law developed out of Roman Law of

Justinians Corpus Juris Civilis from broad legal
principles and the interpretation of doctrinal writings
10

z
Law and Finance

z
z
z
The allocation of countries to the legal families

strongly influences the design of shareholder
protection
LLSV attempted in a series of articles (LaPorta et
al., 1997, 1998, 1999, 2000, 2002)
Law and Finance (1998)
z
z
Evironments favourable to shareholders are provided

by Common Law countries
Best shareholder protection by Common Law
countries while Civil Law counties perform badly
11

z
Law and Finance

z
mean ownership regressed against a variety of

distinctions
z
Correlation between ownership concentration and

those legal issues
Investigate 49 countries disposed to their legal

family according to shareholder- and creditor
protection as well as law enforcement
357 citations in the Social Science Citation Index
12

z
Law and Finance

z
z
law matters thesis

Compliance with a certain, ex-ante determined
criterion gives a point for the legal system
z
The more points, the better the shareholder protection
13

z
The criteria
z
z
z
z
z
z
z
One share one vote. The measure for this criterion is very
strict. If the law allows non-voting stocks and multiple voting
the criterion is not fulfilled
Proxy by mail allowed
Shares not blocked before Meeting
Cumulative Voting / Proportional Representation
Opressed Minority
Preemtive right to Ne Issues, whereas shareholders can
waive this right
The percentage of Share Capital to Call an Extraordinary
Shareholder Meeting has to be less or equal to 10% of the
votes
=> sum of these points of a certain legal system

highlight the respective Antidirector Rights
14

z
Results of Law and Finance
15

z
The results
z
z
z
z
Common Law: 4 points

Scandinavian Civil Law: 3 points
German Civil Law: 2.33 points
French Civil Law: 2.33 points
Impact and criticism

z
Index used in many other articles: Correlation of

shareholder protection and capital markets (LLSV, 1997),
dividends (LLSV, 2000), evaluation of companies (2002)
Caused criticism, especially in Civil Law countries
z Vagts (2002) arguing against the relevance of some criteria
z Simplicity of judgement
16

z
Criticism
z
z
Restriction zero one is problematic

Different board systems are not taken into
consideration (Braendle and Noll, 2004)
Only seven criteria?
17

z
LLSV index reconsidered Germany and USA

z
Weaknesses and pitfalls of LLSV index
One share one vote

z
LLSV grant one point for a legal system if the Company Law
or Commercial Code of the country requires that ordinary
shares carry one vote per share or when the Law prohibits
the existence of both multiple-voting and nonvoting ordinary
shares and does not allow firms to set a maximum number of
votes per shareholder irrespective of the number of shares
owned, and zero otherwise (LaPorta et al., 1998, 1122).
Neither Germany nor the United States accomplish this
criterion.
Generally in the United States shareholders are assigned
one vote per each share. But in many States including
Delaware shares with multiple voting as well as fractional
voting are llowed.
18

z
One share one vote

z
z
Agree to evaluation of LLSV BUT

But Khatchaturyan (2004) points out that one share one
vote is a sub-optimal voting mechanism in a world of
specific investments
Concerning takeovers, even parts of LLSV claim that
deviations from the rule are necessary to extract the
highest value from the bidder (Shleifer and Vishny, 1986
and 1988). It is therefore incomprehensible that the
Economist (March 23rd, 2005) refers to Europes unfair
voting rights because of deviations from one share one
vote.
19

Proxy voting
z
Proxy voting allows for voting without personal attendance or

representative in a general meeting. According to LLSV a point is
assigned if the company law or commercial code allows
shareholders to mail their proxy vote to the firm (LaPorta et al.
1998, 1127). A point was assigned to the United States, whilst
Germany misses out
For the German Company Law proxy voting per se is alien.
Nevertheless we should think of similar instruments fulfilling the
same purpose, namely saving time, money and effort. Obvious are
depositary proxy votes of banks. Proxy voting by banks is
available after the assignment of legitimation to a bank ( 135 para
7 AktG). This is a legal disposition of the voting rights without
transferring the ownership. The bank receives the right to exercise
the vote either on behalf of the owner ( 135 para 4 AktG), if she
gives clear instructions or on its own behalf if these instructions
are missing ( 135 para 5). In the latter case, banks are not
obliged to disclose the owner of the shares.
20
10

z
Deposit of shares prior to a general meeting

z
z
z
Concerning this antidirector right LLSV assign one point if the

Company Law or Commercial Code does not allow firms to
require that shareholders deposit their shares prior to a
general shareholders meeting, thus preventing them from
selling those shares for a number of days, and zero
otherwise (LaPorta et al., 1998, 1122)
z Point for USA, no point for Germany
Within the United States it is not intended to deposit the
shares before the general meeting
In Germany the deposit of shares is not mandatory.
Generally, the ownership of bearer shares or the entry in the
register of shareholders for registered shares is sufficient.
The deposit is permitted by law ( 123 para 3 AktG) and by
all means customary for larger corporations
21

z
Deposit of shares prior to a general meeting

z
The existence of both, bearer and registered

shares in Germany may be the very reason why
the deposit of shares is not forbidden by law,
whereas the United States corporations only
issue registered shares and therefore no need for
deposit is given. In systems with registered shares
only, a deposit would not make sense, as the
identification of the shareholders is easily possible
The evaluation of LLSV for Germany is therefore
acceptable for this criterion. Nevertheless, the
criterion itself is not accurate
22
11

z
z
Cumulative voting and proportional representation

LLSV assign a point here if the Company Law
allows shareholders to cast al their votes for one
candidate standing for election to the board of
directors (cumulative voting) or if the Company Law
allows a mechanism of proportional representation
in the board by which minority interests may name a
proportional number of directors to the board, zero
otherwise (LaPorta et al., 1998, 1122).
z
USA increase to three points, Germany still 0

23

z
Cumulative voting and proportional representation

z Cumulative voting is a common practice in the United States to elect the
members of the board of directors
z In many other States, amongst others Delaware, cumulative voting does
not apply if it is excluded from the articles (opt-out election). In some
States cumulative voting is only allowed if the articles allow for it
specifically (opt-in election)
z
z
z
According to 7.28 R.M.B.C.A it is up to the corporation to allow for

cumulative voting in their articles or prohibit it specifically. Cumulative voting is
in general regulated within the articles of incorporation, where changes are
more difficult than in bylaws.
According to LLSV a point is justified if the Law provides for the possibility
not obligation to introduce cumulative voting in corporations.
Regarding the other criteria this perception is astonishing
Contrary to United States, Germany does not allow the shareholder
meeting for a direct election of the managing board
=> Germany could only score if it changes its board system
24
12

z
Opressed minority
z If the Law provides for mechanisms such as shareholder claims or
compensation rights for minority shareholders in case of changes
in the company structure, the respective country scores
z
z
z
USA 4 Germany 0
Derivative and direct suit in the USA

In Germany the single shareholder cannot file suit in the name of
the company. However, 147 AktG allows minorities (> 10% of
share capital) to claim for damages for the corporation in their right.
This instrument within the German Company Law differs from the
American derivative suit in the requirement for 10% of the share
capital. Direct and class suits are unknown to the German Law.
Even if not all mechanisms proposed by LLSV are totally fulfilled by
Germany, we would nevertheless assign a point to the legal
system. The 147 AktG allocates to the shareholder an equivalent
to the derivative suits. As LLSV themselves define a minority with
less or equal 10% of the share capital, they accompany the same
definition as the German Law.
25

z
Preemptive right to new issues

z
A country could score when the Company Law or

Commercial Code grants shareholders the first opportunity
to buy new issues of stock, and this right can be waived
only by a shareholders vote (LaPorta et al., 1998, 1123)
z Neither the United States nor Germany scored with this
criterion
According to 102 (b) (3) Delaware General Corporation
Law the articles of incorporation have to provide explicitly
for such preemptive rights. This opt-in regulation can also
be found in 6.30 (a) R.M.B.C.A. Some States like New
York dispose of an opt-out regulation. In other words, here
the shareholder is in general protected by preemptive
rights, but these can be excluded in the articles of
incorporation.
26
13

z
Preemptive right to new issues

z
In Germany, according to 186 AktG, each shareholder is

granted the opportunity to buy new issues of stock according to
the previous stakes held. 75% of the share capital can exclude
these rights in the general meeting. As the right can only be
waived by a shareholders vote, Germany definitively fulfils this
criterion and should get a point here
As Austria and Germany have almost the same Company Law it
is very surprising that Austria with an identical legal regulation
concerning preemptive rights ( 153 Austrian Company Law)
scores for this criterion whereas Germany did not. It is worth
mentioning that we find these regulations in both Germany and
Austria since 1965
This highlights the weaknesses of this index and questions the
quotability of Law and Finance
27

z
Call for extraordinary shareholder meeting

z
The award of points complied with the minimum

percentage of share capital necessary to call for an
extraordinary general meeting. A point is assigned if the
percentage is less or equal to 10%. Both, the United States
and Germany scored here
It is surprising that the United States score here. According
to 211 (d) Delaware General Corporation Law an
extraordinary shareholder meeting can be called up either
by the board of directors or by other persons authorized in
the articles of incorporation or bylaws. In default of
mandatory rules, shareholders of corporations incorporated
in Delaware might de deprived of calling up a general
meeting
In other states even 25%
28
14

z
Implication
z
Re-evaluation
29
15

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Shareholder Protection

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Corporate governance legal

and voluntary regulation:

2001 The Economist

Majority rule and minority

Person or group of people holding 50% of the

Majority shareholders have a great deal of

Shareholders in general meeting can

Ratify transactions otherwise would have

Majority rule and minority

The rule in Foss v Harbottle (1843) 2 Hare 461

The directors of a company arranged for it to

Did it as companys assets had been depleted and if the company

Majority rule and minority

The rule in Foss v Harbottle (1843) 2 Hare 461

The proper plaintiff in an action in respect of a wrong

proper plaintiff principle

Majority rule and minority

Exceptions to the rule in Foss v Harbottle

Fraud or ultra vires

A shareholder could stop the company from making ultra

Special majority required

Two members of a trade union successfully restrained an

Majority rule and minority protection

Exceptions to the rule in Foss v Harbottle

Wood v Odessa Waterworks Company (1889) 42 Ch D 636

The chairman of a general meeting refused to take the votes of certain

Fraud on the minority and the wrongdoers are in control

Cook v Deeks [1916] 1 AC 554; Menier v Hoopers Telegraph Works

Majority rule and minority

Action by shareholders: procedural aspects

Proceeds of the action go to the company and not to the shareholder

Majority rule and minority

Action by shareholders: procedural aspects

SH protection in the USA and

Company laws of USA and Germany have much in

Continental Europe, wide parts of Asia, Latin America and

SH protection in the USA and

Developed in 12th century

Civil Law developed out of Roman Law of

SH protection in the USA and

Law and Finance

The allocation of countries to the legal families

Evironments favourable to shareholders are provided

SH protection in the USA and

Law and Finance

mean ownership regressed against a variety of

Correlation between ownership concentration and

Investigate 49 countries disposed to their legal

SH protection in the USA and

Law and Finance

law matters thesis

The more points, the better the shareholder protection

SH protection in the USA and

=> sum of these points of a certain legal system

SH protection in the USA and

Results of Law and Finance

SH protection in the USA and

Common Law: 4 points

Impact and criticism

Index used in many other articles: Correlation of

SH protection in the USA and

Restriction zero one is problematic

SH protection in the USA and

LLSV index reconsidered Germany and USA