Justifications for minority co-owned groups and their corporate law implications

Introduction

Corporate groups are an important reality of the modern corporate landscape. Virtually every large firm is organized as a group,^[1] i.e., as a network of formally independent companies, each having separate legal personality^[2] (and thus its own assets and liabilities, creditors, and shareholders), under the common control of a “parent” company.^[3]

A significant number of corporate groups around the world are minority co-owned groups (MCOGs),^[4] namely groups with one or more listed subsidiaries. Some of them are long-lived, others are newly formed. A prominent example of the former is South Korea’s Samsung Group, which has existed since before WWII^[5] and comprises today numerous listed subsidiaries operating across several different businesses.^[6] A very recent example of an MCOG is the Volkswagen group after Porsche was listed on the German stock exchange as a subsidiary of Volkswagen, itself a listed company in turn controlled by a holding company.^[7] Multiple layers of listed companies, also known as pyramids (of which Figure 1 provides an extreme Italian example from the 2000s), are not the only form of MCOG.

Figure 1

the Pirelli/Telecom Italia group in 2001^[8]

A simpler structure is one where a holding company directly controls both a listed company and some wholly owned subsidiaries, as in Figure 2.

Figure 2

stylized non-pyramidal MCOG

A prominent real-world example combining the two stylized forms of MCOGs (pyramidal and non-pyramidal) is French media conglomerate Vivendi, a listed company controlled by the Bolloré family, which controls (or has a considerable block of shares in) a number of listed companies, such as leading French defense firm Lagardère and Universal Music Group,^[9] and also owns a 100% stake in many non-listed ones (Figure 3).

Figure 3

Vivendi group simplified organizational chart as of Sept. 30, 2022^[10]

MCOGs are well-known to entail significant risks for minority shareholders. Relative to other corporate structures (the multidivisional single-entity firm and wholly owned groups, where minority shareholders are present, if at all, only at the parent company level),^[11] MCOGs facilitate controllers’ tunneling,^[12] which in turn increases agency costs.^[13]

By structuring their firms as MCOGs, controllers can engage in frequent intragroup transactions (IGTs)—the chief tunneling technique in groups—and obfuscate their negative effects on minority shareholders more easily, because conflicted transactions like IGTs tend to become routine business transactions.^[14] This is especially the case for groups where minority-participated subsidiaries operate in related businesses and (perhaps even more so) for vertically integrated groups, namely groups where minority-participated subsidiaries operate along the production chain of the same product or class of products. There, IGTs, far from being episodic, are by their very nature part of the firm’s day-to-day operations. So much so that, for example, in France IGTs are regularly treated by companies as exempt from the rules on related party transactions following their qualification as entered into under normal conditions in the ordinary course of business.^[15]

In addition, IGTs are often bilateral-monopoly transactions—a feature that makes it hard to assess whether they are an instrument for tunneling, since there is no readily available market benchmark against which to measure their fairness.^[16]

Importantly, tunneling entails social costs. First of all, widespread tunneling is likely to generate adverse selection in equity capital markets. The cost of capital will be unduly high for entrepreneurs who tap those markets but have no intention (for whatever reasons) to steal from outside investors. At the margin, some firms may have to forgo positive net present value projects and/or a listing on the stock exchange.^[17] Second, the ability to extract private benefits of control via tunnelling will lead controlling shareholders to structure and manage the group with a view to maximizing the value of the controlling block rather than firm (or share) value. For instance, they may retain an MCOG structure even when a wholly owned group structure would be more cost-effective (net of transition costs).^[18] Or they may retain control of an affiliated business not because of synergies but rather for the private benefit extraction opportunities its control creates. More generally, the ability to extract large private benefits of control may lead to investing,^[19] financing,^[20] and operational decisions, such as on whether to retain a controlled entity as a supplier rather than switch to a non-affiliate one or on how to allocate a certain asset (including a corporate opportunity) across subsidiaries, based on the rents they allow controllers to extract rather than on the impact of those decisions on the bottom line.^[21] Finally, because tunnelling is (usually) illegal also where it is ineffectively policed, it must be hidden or disguised,^[22] which generates costs (both direct and indirect) that, from a societal standpoint, are a pure deadweight loss.^[23]

Despite the social costs of tunneling and the fact that MCOGs facilitate it, across continental Europe various national legislatures, some courts, and a large number of legal scholars have taken a much more positive view of groups, including MCOGs, respectively devising or advocating a special, laxer regime for IGTs. As a matter of fact, some national corporate laws in continental Europe relax directors’ fiduciary duties by allowing subsidiaries’ directors (under certain conditions) to prioritize the “interest of the group” over that of the subsidiary^[24] (that is, to adopt decisions that harm the subsidiary but benefit the whole group) and by exempting IGTs from the procedural requirements applying to related-party transactions.^[25]

Explicitly or, more often, implicitly, this regime and the scholarly support for it are premised on the view that organizing firms as groups, including MCOGs, creates value for society overall.^[26] In a companion article we describe the special regimes in place in some European jurisdictions and the similar ones advocated by academics and policymakers.^[27] We also offer an efficiency-based critique of these special regimes.^[28] In this Article, we complement that critical analysis by taking a closer look at the question of how MCOGs may create value for shareholders as such rather than controllers. More specifically, we identify five ways in which the MCOG form may create value for all parties involved rather than acting as a mere tunnelling infrastructure. For the sake of argument, we assume that the benefits stemming from the MCOG form are higher than the costs of allowing for the existence of MCOGs. However, we also note that, for MCOG-related benefits to materialize, minority co-owned entities must be managed independently from the rest of the group. Because a European-style laxer regime for groups would be inconsistent with this independence requirement, we conclude that this regime is inconsistent with the reasons why MCOGs may be justified as a value-enhancing organizational structure. We thus provide a critique of the special rules on groups, building on the very premises they are based on.

The Article proceeds as follows. First, we recall the major efficiency reasons for organizing a firm as a group, rather than as a single entity, and show that they do not also justify the choice of an MCOG structure (Part I). Next, we turn to the question whether there are rationales, other than controllers’ intent to maximize private benefits of control, for structuring a firm as an MCOG (Part II). We find five non-mutually exclusive rationales: first, the MCOG structure may increase firm transparency, potentially decreasing the group’s cost of capital. Second, it allows subsidiaries to compensate their managers with equity-based compensation linked to the performance of those subsidiaries rather than the group’s, which may lead to reduced managerial agency costs and a lower cost of capital. Further, the MCOG structure may be used to circumvent inefficient restrictions on dual-class shares or to facilitate acquisitions by foreign firms. Finally, the MCOG structure may find a justification in path dependency and the high costs of switching to more efficient organizational structures.

If, across the board, the benefits arising from MCOGs performing these functions are higher than the related agency costs, then MCOGs perform a positive function in the economy. In turn, this may cast a more positive light on European policymakers’ favor for laxer corporate law constraints on self-dealing when it takes the form of IGTs. Indeed, by decreasing group management costs this regime would facilitate the management of MCOGs and therefore incentivize their use, supposedly to the advantage of society as a whole.

However, this would be the wrong implication to draw from our analysis. As argued in Part III, none of the value-enhancement justifications for MCOGs that we identify are aligned with the claim that corporate law’s constraints against unfair self-dealing should be relaxed for firms organized as MCOGs. Quite the opposite, because each of those justifications presupposes the managerial independence of the minority co-owned entity from the rest of the group, they actually reinforce the proposition that rules on IGTs should be rigorous or, at the very least, not less rigorous than those established for other conflicted transactions.

I Justifications for the Existence of Groups

MCOGs are a powerful tool for tunnelling. Does that mean that controllers’ opportunism is the sole rationale behind organizing a firm as an MCOG?

For sure, MCOGs exist because controllers choose to structure the firms they control as such. Rational controllers can be expected to choose the organizational structure that allows them to maximize the sum of (1) their equity stake as valued in the public market and (2) the private benefits of control.

Yet, the fact that MCOGs can only be observed when they allow controllers to maximize the value of their controlling stake does not necessarily imply that they are always an inferior form of business organization. If an MCOG structure creates benefits for shareholders as such that are greater than the increase in agency costs that it entails, then MCOGs create value not only for the controllers but also for society as a whole. The goal of Part II is to identify such benefits. Before we do that, however, we have to make it clear that what matters for our purposes are potential benefits attached to the use of MCOGs rather than, more generically, group structures. In fact, there are a number of good reasons why organizing a firm as a group rather than as a single entity may create value. In this Part, we briefly identify the main business rationales for structuring a firm as a group to make the point that none of them requires the presence of minority shareholders at the level of one or more subsidiaries and, hence, that the benefits attaching to such rationales are irrelevant to the question of what the optimal corporate law regime should be for MCOGs.

The vast economic and legal literature on corporate groups has provided several value creation-based explanations for the existence of wholly owned groups. We do not aim here at providing a comprehensive account of these explanations—a task that would far exceed the more limited goals of this Article. Rather, we report here only the most common and widely accepted ones and, without engaging with the question whether these explanations support the proposition that organizing as a group creates value,^[29] we highlight that they fail to answer the separate question whether groups where minority shareholders are present at the subsidiary rather than exclusively at the top company level also create value for all the relevant shareholders, let alone whether they are efficient.

First, groups are frequently regarded as capable of providing better risk management than single-entity firms, thanks to the opportunities offered in this respect by the subsidiaries’ limited liability.^[30] Limited liability allows investors to control risk exposure when the firm expands into new businesses and markets. It isolates the firm’s existing assets from the risks associated with the new venture, allowing the firm (its investors) to diversify^[31] and exploit new business opportunities more cheaply.

Second, scholars frequently point out that groups allow for better firm management. The fact that each member of the group is a separate legal entity with its own governance bodies, assets, and liabilities, “facilitates the delegation of activities and decision-making”^[32] and provides managers, employees, and stakeholders of the subsidiary with improved incentives,^[33] thus reducing the firm’s overall agency costs of management. These benefits can be particularly valuable for firms displaying a high degree of internal complexity, such as those operating across multiple jurisdictions (multinational enterprises), unrelated businesses (diversified conglomerates), or different levels of the production chain (vertically integrated firms).

Third, a group structure may help the firm to get external finance at a lower cost, especially when the firm operates across a number of unrelated businesses: the firm is partitioned into two or more legally distinct subsidiaries under common control, each running one of the firm’s businesses, allowing creditors (especially trade creditors, like customers or suppliers, or industry-specialized lenders) to focus on the business they know best. This, in turn, reduces creditors’ screening and monitoring costs, thus lowering the firm’s cost of funding.^[34]

Other value creation-based justifications for groups point to their “gap-filling” role in economies that lack well-developed market-supporting institutions.^[35] More precisely, groups represent, from this perspective, an adaptive response to the absence of well-developed key input markets, such as financial^[36] or labor markets.^[37] Consider financial markets. Where, due to their absence or underdevelopment, external finance is unavailable or excessively costly, a group’s internal capital market can make up for it and provide the necessary funds. Thus, courtesy of the cash flows produced by other group affiliates, new profitable entrepreneurial projects (e.g., entry into an unrelated but promising new business) that would otherwise be forgone may be financed.^[38]

Finally, the choice in favor of a group structure might be (and in practice often is) driven by tax and/or regulatory arbitrage considerations.^[39] The underlying goal is to minimize a firm’s tax burden or to choose the most favorable legal regime for the firm’s shareholders (e.g., by locating labor-intensive production in countries with poor labor protection).

One common element of the various functions of group structures that we have briefly described is that none of them postulates the presence of minority shareholders in the group’s subsidiaries. For instance, more effective risk management via the exploitation of a company’s legal personality and limited liability may be achieved equally effectively in a group comprising only wholly owned subsidiaries or in one with minority co-owned ones. And common tax arbitrage techniques, such as the channeling of group profits where they are taxed less via IGTs (transfer pricing),^[40] may take place with no minority shareholders at the subsidiary level. Indeed, what usually suffices to this end is that the transacting companies have separate legal personalities. With the obvious exception of pyramids as a tool to circumvent limits or bans on dual-class shares,^[41] that is the case also for other regimes that a group structure enables the avoidance of.^[42]

To sum up, a number of good reasons may justify the choice of the group structure over the single entity structure. However, none of them postulates the presence of minority shareholders at the subsidiary level and hence provides an efficiency rationale for the choice of the MCOG structure.

II Justifications for the existence of minority co-owned groups

The previous Part showed that the most commonly agreed-upon value-creation rationales for the existence of corporate groups are of no use to explain why MCOGs exist other than to facilitate tunnelling, because their benefits can be achieved also without the presence of minority shareholders at the level of a group’s subsidiaries. This Part lays out the five ways in which MCOG structures themselves can create value for all shareholders. Two of them—MCOGs’ ability to improve information about listed firms’ operations and performance, and their potential for reducing managerial agency costs—are inherent to the MCOG form. The remaining three arise from the interaction between MCOG characteristics and market and/or regulatory features that some jurisdictions may display and therefore are contingent on the presence of those features in the jurisdiction where the MCOG operates. These are: (1) using MCOGs to circumvent (presumptively) inefficient restrictions on dual-class shares; (2) using them to assuage national governments’ aversion (but not total closure) to foreign acquisitions; and (3) their working as a second-best organizational choice where high transition costs make it inefficient for all involved shareholders to have them converted into a different organizational form.

III Relaxing Corporate Law Constraints Against Self-Dealing to Facilitate the Integrated Management of MCOGs?

Explicitly or implicitly, the view that more lenient rules on self-dealing to ease the integrated management of MCOGs are justified rests on the idea that MCOGs serve a useful function in modern economies rather than being merely instrumental to facilitate tunnelling. In Part II, we followed this logic and gave substance to this claim by identifying five possible rationales, some inherent to MCOGs, others contingent on specific circumstances, for that organizational form. Having done that, we need not venture into a cost-benefit analysis to answer the question whether the positive effects of MCOGs for shareholders as a whole more than offset the drawbacks of MCOGs in terms of facilitating tunnelling and therefore contributing to adverse effects on corporate governance and capital markets at the macro level.

For the purposes of this Article, we can simply assume a positive answer to that question. In fact, what we are interested in is the further question whether, once it is assumed that the presence of MCOGs does create value for society, it follows that more lenient rules for groups of companies are justified. Anticipating our conclusion, our answer is negative: even if we accept the idea that MCOGs do serve a socially positive function, laxer rules on self-dealing to facilitate the integrated management of MCOGs would be unwarranted, because such rules would be inconsistent with the rationales for MCOGs that we have identified. In fact, these rationales presuppose, logically or politically, stringent rules to ensure the separate management of minority co-owned subsidiaries.

More precisely, the fallacious reasoning we want to debunk runs as follows:

1. For the reasons discussed in Part II, MCOGs (can be presumed to) enhance value creation compared to single-entity firms and groups where minorities only own shares at the parent company level.

2. MCOGs integrate the various entities into an individual firm via their de facto unitary management as a single group-level firm.

3. The sheer number of intragroup interactions, mainly in the form of IGTs, needed for the various entities to act as an individual firm often make corporate law’s ordinary protections against self-dealing impractical, if not incompatible with the group’s efficient management altogether.

4. Hence, special rules aimed at easing intragroup interactions should be devised for MCOGs.

This kind of reasoning underlies the choice of some continental European jurisdictions to establish special, more lenient regimes for MCOGs (and groups more generally).^[68] The details of these special regimes vary across jurisdictions, but what they have in common is that they provide for a relaxation of directors’ fiduciary duties. Their key principle, as expressed in German and Italian corporate law statutes as well as by French courts, is that directors of a group subsidiary may adopt decisions that are functional to the “interest of the group,” even when they are disadvantageous for the subsidiary itself, provided that the harm so inflicted upon the subsidiary receives proper compensation^[69] or, in an even more enabling version of this rule, compensation may reasonably be expected to occur in the future.^[70]

In a companion paper we show that the benefits of this special regime are much more limited than its supporters believe, at least wherever, as is the case in continental Europe, litigation over director fiduciary duties is rare.^[71] We also highlight that the risk of increased agency costs and adverse selection problems that these regimes entail is high.^[72] Here, the point we make is that none of the rationales for MCOGs that we have identified in Part II can be relied upon to support a special group law regime. Quite the opposite, they reinforce the idea that intragroup interactions should be treated no differently than other conflicted transactions.

Consider, first, the two benefits inherent to the MCOG form, namely enhanced transparency/reduced information asymmetry^[73] and improved firm management.^[74] For either of those benefits to play out, the listed subsidiary must be granted a significant degree of independence from the rest of the group. Were that not the case and the listed subsidiary were to be managed just like any other division of the larger group (i.e., as a company engaging frequently in intragroup exchange and free from fair-price constraints), the gains in transparency and incentive alignment from the separate listing would be lost. In fact, the high number of IGTs, coupled with the uncertainty as to their fair pricing, would blur the separate picture that the subsidiary’s financial reports would be meant to provide, making it much harder to gauge the financial performance of the subsidiary and hence of its management team. This is precisely the effect of special group rules, as they allow controllers to deviate from fairness constraints in intragroup exchange by letting subsidiary directors execute IGTs at disadvantageous terms for their company. Thus, a regime of this kind would undercut MCOGs’ specific functions of improving transparency and management and hence the related benefits for shareholders.^[75] In other words, it would make it harder for MCOGs to perform their value-creation function.

Let us now turn to MCOGs’ contingent benefits, beginning with achieving the same result as dual-class shares where the relevant jurisdiction prohibits or restricts such arrangements.

The main rationale for restrictions against dual-class shares is the risk of mismanagement and abuse (including tunnelling) that they entail.^[76] If MCOGs are a way to avoid such restrictions,^[77] why should policymakers treat them more benevolently? The presence of multiple different entities linked by a chain of controlling equity stakes, in addition to increasing incentives for value diversion much in the same way as dual-class shares do,^[78] makes tunnelling easier than in the case of a single-entity firm (or wholly owned group).^[79] If the aversion to dual-class shares is motivated by concerns over tunnelling and mismanagement, the same concerns should lead policymakers not to enact lenient rules for MCOGs when they are used as functional substitutes for dual-class shares.

Rather, if policymakers tolerate MCOGs as a way to let controllers avoid the strictures of one-share-one-vote policies, the straightforward solution would be to abandon such policies. And, to deal with the stock of pyramidal groups present when such policies are reviewed, rather than relaxing self-dealing rules across the board, it would be best to provide for rules easing the transition from a pyramidal group to one where the controller retains stable control over the single listed entity arising out of the restructuring.

Now consider the political justification for MCOGs as tools to enable foreign control of domestic firms in countries with mildly protectionist barriers to cross-border takeovers: its underlying logic is at odds with a regime that grants greater discretion—and thus, greater power—to controllers as a matter of corporate law. By increasing controllers’ power over the company, such a regime would correspondingly decrease domestic policymakers’ direct or indirect influence over it. While lower political influence might be good for the subsidiary’s profitability, it would clearly be at odds with policymakers’ aversion to foreign control over domestic firms.

Finally, consider the path dependence rationale for MCOGs.^[80] In line with this rationale, these groups would be worth more if they were organized as non-MCOGs, transition costs being the reason for their persistence. Here again, a regime favoring the transition to more efficient ownership structures, that is, reducing transition costs, would be the best solution. Relaxing rules on self-dealing to ease the integrated management of the MCOG would have the side effect of also facilitating the extraction of private benefits of control by the controlling shareholder, and therefore of raising transition costs, because the controlling shareholder will have to be compensated for the loss of a higher amount of private benefits than under a more stringent regime. And, incidentally, if the reason why MCOGs persist is in fact that controllers can extract high private benefits of control, then it stands to reason that policymakers should not adopt policies making the extraction of private benefits easier, as this would make controllers even more hostile toward the transition to more efficient structures.

To sum up, from the finding that there may be specific rationales that may make MCOGs efficient (assuming that the benefits attached to those rationales are higher than the costs of allowing them), it does not follow that standard self-dealing restrictions must be relaxed or removed. Quite to the contrary, we have seen that those specific rationales rather justify stringent rules on self-dealing that ensure (or at least are not detrimental to) the independent management of minority co-owned subsidiaries.

Conclusion

Minority co-owned groups are notoriously problematic: structuring an economically unitary firm as a constellation of minority-participated subsidiaries is a tremendously effective way for controllers to extract larger private benefits to the detriment of minority shareholders. Despite this, continental European policymakers and legal scholars have either already adopted or proposed special regimes that, by relaxing directors’ fiduciary duties in the context of groups, make not only their integrated management but also tunnelling easier. Underlying these policies is the idea that there are benefits attached to this organizational form. This Article accepts this logic and explains the presence of MCOGs as being linked to value-enhancement features which may justify this organizational structure other than as an instrument to facilitate tunnelling.

After assuming, for the sake of argument, that MCOGs’ benefits to the economy are higher than their costs, this Article has shown that none of the value-enhancement features it identifies justifies the policy of relaxing directors’ fiduciary duties to facilitate the integrated management of MCOGs. Quite the opposite, each of the value-enhancement features identified and discussed here is consistent with the view that directors’ duty to always act in the company’s best interest (and, more generally, standard corporate law rules against unfair self-dealing) should fully apply to these groups’ subsidiaries.