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A carrot and stick approach to discipline to discipline self-dealing by controlling shareholders

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46 pages

This paper presents an innovative approach to the regulation of self-dealing by controlling shareholders. Our proposal is grounded on the identification -through the lenses of economic analysis- of the shortcomings inherent in the existing legal solutions, ranging from the absolute prohibition of self-dealing, to the prohibition of voting with conflicting interests, or to the imposition of fairness duties to the majority shareholders. We present our proposal for an alternative regulation, based on the use of options, in a two period game between the controlling shareholder, who is able to pursue an identifi ed selfdealing opportunity, and the minority shareholders, who desire to determine the merits of this business opportunity. We show that our regulatory proposal is more efficient than existing regulation in the circumstances of our model. The enhanced efficiency of our proposed regime is mainly due to two novel characteristics of our approach. First, it takes advantage of the repeated nature of the relationship between the controller and the corporation. In particular, our proposal implies that obtaining future private benefits requires limiting current private benefits. By doing this we can provide at no cost an additional incentive that aligns the interest of the controller with that of the small shareholders. Second, we allow the controller to determine the level of private benefits that he will extract in each period and apply an automatic penalty for excessive levels. By doing this we eliminate both the costs of collective action, and the costs of legal action that critically affect the outcome of the existing regulatory regimes
This research is supported by a research grant from the Dirección General de Universidades de la Comunidad de Madrid (DGUCMME 2008/00059/002)
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© María Gutiérrez and María Isabel Saez 2010. Allrights reserved. Short sections of text, not to exceedtwo paragraphs, may be quoted without explicit per-mission provided that full credit, including © notice,is given to the source.This paper can be downloaded without charge from:http://ssrn.com/abstract=1549403www.ecgi.org/wp
Law Working Paper N°. 138/2010January 2010
A Carrot and Stick Approachto Discipline Self-dealing byControlling Shareholders
María GutiérrezUniversidad Carlos III and ECGIMaría Isabel SaezUniversidad Autónoma de Madrid
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This research is supported by a research grant from the Dirección General de Universidades de laComunidad de Madrid (DGUCMME 2008/00059/002).The authors wish to thank Andres Almazán, Fernando Gómez Pomar, Bing Guo, Claire Hill, JavierLuque Pérez, Eduardo Melero, Petya Platikanova and Pablo Ruiz Verdú for their helpful comments.We also thank seminar audiences at EALE 2009, JEI 2009, XVII Foro de Finanzas and UnversidadCarlos III for many useful comments. A previous version of this paper won the CNMV price for bestpaper on nancial regulation presented at the XVIIForo deFinanzas.©María Gutiérrez and María Isabel Saez 2010. All rights reserved. Short sections of text, notto exceed two paragraphs, may be quoted without explicit permission provided that full credit,including © notice, is given to the source.
ECGI Working Paper Series in Law
María GutiérrezMaría Isabel Saez
Working Paper N°. 138/2010January 2010
A Carrot and Stick Approach to DisciplineSelf-dealing by Controlling Shareholders
AbstractThis paper presents an innovative approach to the regulation of self-dealing by controllingshareholders. Our proposal is grounded on the identification -through the lenses ofeconomic analysis- of the shortcomings inherent in the existing legal solutions, rangingfrom the absolute prohibition of self-dealing, to the prohibition of voting with conflictinginterests, or to the imposition of fairness duties to the majority shareholders.We present our proposal for an alternative regulation, based on the use of options, in a twoperiod game between the controlling shareholder, who is able to pursue an identified self-dealing opportunity, and the minority shareholders, who desire to determine the meritsof this business opportunity. We show that our regulatory proposal is more efficient thanexisting regulation in the circumstances of our model.The enhanced efficiency of our proposed regime is mainly due to two novel characteristicsof our approach. First, it takes advantage of the repeated nature of the relationship betweenthe controller and the corporation. In particular, our proposal implies that obtaining futureprivate benefits requires limiting current private benefits. By doing this we can provideat no cost an additional incentive that aligns the interest of the controller with that ofthe small shareholders. Second, we allow the controller to determine the level of privatebenefits that he will extract in each period and apply an automatic penalty for excessivelevels. By doing this we eliminate both the costs of collective action, and the costs of legalaction that critically affect the outcome of the existing regulatory regimes.Keywords: Self-dealing, Minority Expropriation, Private Benefits, Corporate Governance,Corporate Law.JEL Classifications: G32, G34, K22María GutiérrezUniversidad Carlos III de Madrid-Departamento de Economía de laEmpresaCalle Madrid 12628903 GetafeSpainphone: +34-91 624 58 40, fax: +34-91 624 96 07e-mail:maria.gutierrez@uc3m.esMaría Isabel SaezUniversidad Autónoma de MadridDepartamento de Derecho PrivadoCalle Kelsen, 1Ciudad Universitaria de Cantoblanco28049 Cantoblanco (Madrid)Spainphone: +34-914977696, fax: +34-91 497 8216e-mail: maribel.saez@uam.es
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Investment fund SageCrest II ended 2006, according to accounts submitted to non-managing partners,with over $995m ($512m, 648m) in assets. Now redemptions and pay-outs have been suspended, forensicaccountants are picking over the reports, and a complaint has beenÞled in the Connecticut Superior Courtby an investor, Westerly Capital LLC. The complainants allege that SageCrests managers, WindmillManagement LLC, Alan Milton, and Philip Milton, and an associate, Richard Weyand, [...] mismanagedthe funds business and investments by ... excessively concentrating the funds investments on businessesoriginated and operated by an individual defendant who was both the funds majority owner and aprincipal of its manager ... [and] overly concentrating the funds loan relationships on one of the businessesoperated by the funds majority owner, in eect allowing him to siphon out most of the funds availablecash.
Financial Times, June 15 2008The chief executive of a small digital rights management (DRM) software group is suing Microsoft andTime Warner on the grounds that their roles as both shareholders and customers of the DRM maker hasenabled the two giants to enrich themselves at the expense of the company and employee shareowners.The lawsuit wasÞled by Michael Miron, founder and chief executive of ContentGuard, which makessoftware to protect digital media against piracy. The suit alleges that as major shareholders, Microsoftand Time Warner have caused ContentGuard to grant them extremely broad and valuable technologylicences to its intellectual property for a nominal consideration. Mr Miron also claims that the twocompanies sub-license ContentGuards technology to groups that might otherwise be its customers. Thelawsuit alleges that Microsoft and Time Warner have pressured employee shareholders to sell their stakefor $2.098 per share, an oer considered too low because the companys valuation has been materiallydiminished by . . . self-dealing conduct.
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Financial Times, March 9 2005