Shareholder voting and corporate governance

Voting rights are an important part of corporate governance and legal arrangements applying to publicly held companies. Shareholders derive benefits from owning shares which have voting rights attached to them, since they can be used to influence decisions of the company and therefore increase the value of the firm. Shareholders can, in conjunction with monitoring the managers of the firm, use their voting rights to replace a poor management team. This section examines some economic aspects of shareholder voting rights.

One share/one value

One of the most important corporate governance arrangements involves the extent to which ownership of a company's shares allows the shareholder to vote on motions and influence the future direction of the company. Do these arrangements matter for efficiency? Why not, for example, allow different classes of shares, some of which entitle the owner to a share of the dividends where this entitlement differs from their entitlement to vote on motions?

Grossman and Hart (1988) argue that there is a good efficiency reason for the one share/one vote rule: it protects shareholder property rights. They develop their argument using the following example, which assumes that for one class of shares, the entitlement to the firm's dividends is not identical to the entitlement to vote. Suppose there are two classes of shares in a company: [1]

The key point in this example is the discrepancy between voting rights and rights to the company's dividend stream: in other words, a departure from the one share/one vote legal arrangement. In particular, class A shares have 100 per cent of the voting rights but are entitled to only 50 per cent of the firm's dividends.

Let us see why this matters. Suppose that the total value of all shares is $200 under the incumbent management team. In addition, suppose that there is a raider that wishes to take over the company, and that the value of the shares is only $180 under the raider. Then clearly it would be inefficient for the takeover to proceed. Suppose, however, that the raider is the only party with significant private benefits of corporate control. We will see that the presence of these benefits, combined with an absence of a one share/one vote rule, can lead to an inefficient allocation of resources.

To see this, suppose that the raider makes an offer to buy class A shares for $101. Then the owner of class A shares will certainly sell them, since if he does not, he will only receive $100 if the raider fails, and $90 if he succeeds. Thus, since the class A shares have 100 per cent of the voting rights attached to them, the raider will be able to assume control of the company. But this now imposes a negative externality on the owner of the Class B shares: his shares are now only worth $90. The total value of the firm falls to 191. The raider's loss is $11, but if his private benefits of control are (say) $12, then he still gains.

To see how the one share/one vote rule matters here, let us change the example and move partially towards a one share/one vote arrangement. Suppose that class A shares have a claim to 75 per cent of the firm's dividends. These shares are therefore now worth $150 (= 0.75 x $200) under the incumbent. The raider's offer of $101 for these shares would be rejected; indeed, the raider must now pay $151 to gain the shares and gain control of the company. If this happened, then a negative external effect is still imposed on the owners of the class B shares - but the external cost is much smaller. The value of the class B shares now falls from $50 to 0.25 x $180 = $45, and the total value of the company only falls from $200 to $196 (= $151 + $45). The raider's loss is now higher, and is equal to $151 - 0.75 x $180 = $16. If the raider's private benefits of control are $12, then he would not gain from purchasing these shares, and would therefore no longer attempt to gain control of the company.

This example illustrates the basic point that moving towards a one share/one vote corporate governance arrangement enhances the security of shareholder property rights by reducing the possibility of value-reducing takeovers. It also illustrates the basic idea that a misalignment of voting rights and rights to the company's dividend stream can lead to situations where one class of shareholders can impose a negative external cost on others.

  • [1] 'A' class shares: these have a claim to all of the voting rights but 50per cent of the dividends; • 'B' class shares: these have a claim to no voting rights and 50 per centof the dividends.
 
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