The Agency Problem of Majority Vs. Minority Shareholders: The Tug of War

I. Introduction

(A) Concentrated and controlling shareholding

Separation of ownership and management is one of the key features of a body corporate.² Therefore, if the promoter predominately ends up taking the majority shares of a company or selling them only to his near and dear ones, it gives rise to concentrated or controlling shareholding, which defies this key feature and often results in the exploitation of minority shareholders. In such cases, if a decision only requires for an ordinary resolution to be passed, considering that the majority shareholding rights are with the person wanting to make such a decision, it becomes easier to simply ignore the wishes and concerns of the minority shareholders. Even in cases of special resolutions, if the majority shareholders together hold more than 75% of the shares in a company, they are easily capable of making decisions according to their prerogative.

This problem can be seen to be more dominant in India, where businesses are family-run, with majority shareholding rights with the family members and friends.³ Moreover, considering that there are fewer checks and balances on this practice due to the shortage of Independent Directors, the magnitude of this problem continues to grow as decisions are taken unilaterally.

II. Negative control rights

It is important to note that minority shareholders are not always at a disadvantaged stage in negotiations. There are times, when minority shareholders take the help of their Veto Rights to block the majority shareholders from bringing in more investors, blocking the issuance of shares, reducing share capital, or any other action related to takeovers. Moreover, minority shareholders seem to be in a powerful position during special resolutions, where even if the 75% requirement is stopped by 1% shares of the minority shareholder, the majority shareholder can't go ahead with the decision without convincing the minority shareholder and obtaining his consent. This gives them negative control rights, wherein their refusal to cooperate with the majority shareholders blocks their way of going forward.

However, minority shareholders are rarely able to act in accordance with their whims and fancies, considering that minority squeeze-outs act as an effective way of taking over minority shares altogether.⁴

III. Minority squeeze-outs

“Squeeze out” (also known as “Freeze out” sometimes) provisions allow the majority shareholders to acquire the equity shares of the minority shareholders, in return for giving away some compensation to them.⁵ There are different methods in law for squeezing out minority shareholders:⁶

1. Firstly, Section 235 of the Companies Act, 2013⁷ (“Act”) provides that shareholders having at least 90% shareholding in a company, are capable of acquiring the minority shares, during the process of takeover. This provision is compatible with the majority principle established in the Foss v. Harbottle case⁸, where the court refrained from interfering in the majority decision of the company, considering that there was no fraud or oppression involved in the process. However, when the same was challenged before the court in AIG (Mauritius) LLC v. Tata Tele Ventures⁹, it was held that this 90% requirement can only be met when the shareholders are “different and distinct persons”¹⁰ in the company. This helped in upholding shareholder democracy.

2. Secondly, Sections 230(11) and 230(12) of the Act,¹¹ as notified by the Ministry of Corporate Affairs through the Companies (Compromises, Arrangements, and Amalgamations) Amendment Rules, 2020¹², have allowed the shareholders of unlisted companies with at least 75% shares, to make an arrangement application to take over the minority shares, after the parties have reached a court-approved compromise between them.

3. Lastly, Section 66 of the Act allows the company to buy back the issued shares and cause the exit of a shareholder by reducing the share capital. This is done through the cancellation of minority shareholder shares, and a subsequent altering of the Memorandum of Association. Ideally, the National Company Law Tribunal (NCLT) approves such applications only if the minority shareholders have been provided with fair compensation for their shares, as was also held in the case of Sandvik Asia Limited v. Bharat Kumar Padamsi and Ors.¹³

Even though all the above methods can be very effectively to accomplish the task of minority squeeze out, these methods often leave the minority shareholders in a vulnerable position, considering that squeeze out’s can only be beneficial for them when the valuation of the shares is done in a just and fair manner. The case of Cadbury India Ltd.¹⁴ has further made it necessary for the company to fairly evaluate share prices, by keeping the previous share offers and prices into consideration. However, the same judgment has also held that lesser monetary compensation to minority shareholders than their expectations shall not amount to “prejudice”.¹⁵ This reasoning can become problematic in a situation where the squeeze-out procedure is deliberately initiated at a transitory stage, where either the shares are lowly valued, or when the shares are just about to obtain their highest profits.

Minority squeeze-outs can be said to have a risk of expropriation, which is “a transfer of value from the minority shareholders to the controlling shareholders”.¹⁶ Therefore, a balance must exist between the majority and minority shareholders to mitigate these risks.

IV. Suggestions to combat the problem

Even though India is said to have one of the most strongly written laws in relation to the minority shareholders, it is unfortunate, that the implementation of these laws is extremely weak. One of the main reasons can be the absence of appropriate checks and balances to ensure that the minority shareholders are not discriminated against. There can be further ways of combating this agency problem between the majority and minority shareholders:

1. The fiduciary responsibility of controlling shareholders

India currently does not have any legal requirements specific to controlling shareholders which they need to adhere to. However, UK’s listing rule consists of a trust deed-like shareholding agreement.¹⁷ In this, the promoter shareholders are expected to enter into a relationship agreement with the listed company, where they need to comply with a certain set of requirements. Depending on the negotiations between the parties, such agreements can also shift the burden on independent and minority shareholders to have a say in the functioning of the company, then the majority shareholder. This has also been recognised by the Securities and Exchange Board of India (SEBI) to be a good value addition to the current Indian laws.¹⁸

2. Procedure for the appointment of Independent Directors

Independent Directors play a major role in maintaining a balance between the majority and minority shareholders. However, considering that the current laws require the appointment of independent directors to be done by casting a vote in the general meeting,¹⁹ it becomes likely for the independent director to be biased towards the majority shareholders instead. This limits the efficacy of their position altogether. This requires a more professional approach instead, which can be similar to the approach taken by the United Kingdom. There, the Financial Services Authority (FSA) has proposed a dual voting structure, which requires the independent directors to first be approved by the majority shareholders, and thereafter, be approved by the minority shareholders as well.²⁰

Another way can be the “majority of minority” approach, as taken by countries like Italy and Israel.²¹ The role of controlling shareholders is limited here, as only the minority shareholders are expected to vote in the Resolution passed. While it may be argued that the biasness can now be shifted towards the minority shareholders, it is important to note that only the appointment is shifted towards the minority shareholders, however, the majority shareholders continue to have a say in the other matters related to recommendations and removal of the independent directors.

3. Appointment of Board of Directors

Current laws require the majority votes to be cast in favour of a person, for him to gain a seat at the board. However, in countries like India, where problems like concentrating shareholding exist, it can be expected by the board to favour the majority shareholders. In such a case, a wider search can be conducted to appoint the board of directors, which can be done through the Italian principle of ‘voto di lista’, wherein all voting shareholders are allowed to put their name in the slate of nominees, and it is compulsory for at least one director to be elected from the minority shareholder’s slate.²² A mechanism similar to this can allow more protection towards the minority shareholders in a company.

The other ways can still be the regulatory (rules, standards, and terms of entry and exit) and governance (selection, removal, initiation, ratification, trusteeship, and rewards) strategies, with main focus on the ‘sharing rule’, wherein there can be a pro-rata distribution of dividends between the shareholders. This keeps in check the majority shareholders' decision-making skills as their decisions shall affect the profits earned by them.

V. Conclusion

Even though laws exist for the benefit of minority shareholders, the agency problem is more difficult for the minority shareholders, considering that most of the decisions taken in a company are based on the majority voting structure, which is influenced purely by the families, especially in India. Even though transferring all the voting power to the minority shareholders cannot be held to be a solution to the problem, efforts should be made to divide this procedure equally between the majority and minority shareholders. Moreover, concentrated shareholding with a mala fide intention of victimising the minority shareholders must be strictly acted against, which is still something rare in India.

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Footnotes

1. Author is a student at O. P. Jindal Global University in India.

2. Aadhya Shrotriya and Siddhartha Goswami, Overview Of Agency Problem: Its Types & Legal Strategies To Control It, Taxguru (Sep. 30, 2020), https://taxguru.in/corporate-law/overview-agency-problem-types-legal-strategies-control.html.

3. Tunia Cherian, India Has Third Highest Number Of Family-Owned Businesses, Businessline (Jan, 08, 2018), https://www.thehindubusinessline.com/economy/india-has-third-highest-number-of-familyowned-businesses/article9925495.ece.

4. Jay Parikh and Ayushi Toshniwal, Minority: (Ex)Squeeze Me! - Corporate/Commercial Law – India, Mondaq (May 19, 2020), https://www.mondaq.com/india/shareholders/936234/minority-exsqueeze-me.

5. Anurag Shah and Vijay Nekkanti, Ease Of Minority Squeeze Out: An Analysis Of The New Squeeze Out Provisions - The CBCL Blog, The CBCL Blog (Jun. 30, 2020), https://cbcl.nliu.ac.in/company-law/ease-of-minority-squeeze-out-an-analysis-of-the-new-squeeze-out-provisions/.

6. Shuchi Agrawal and Isha Ahlawat, Minority Squeeze Outs Under Takeover Law: An Analysis, The RMLNLU Law Review Blog (Oct. 05, 2021), https://rmlnlulawreview.com/2021/10/05/minority-squeeze-out/.

7. The Companies Act, 2013, § 235, No.18, Acts of Parliament, 2013 (India).

8. Foss v. Harbottle 2 Hare 461, 67 ER 189.

9. AIG (Mauritius) LLC v. Tata Tele Ventures, 2003 IIAD Delhi 672 [Delhi High Court].

10. Id.

11. The Companies Act 2013, § 230(11) and 230(12), No.18, Acts of Parliament, 2013 (India).

12. Companies (Compromises, Arrangements And Amalgamations) Amendment Rules, 2020, Ministry of Corporate Affairs Notification (Feb. 03, 2020), https://www.mca.gov.in/Ministry/pdf/Rules1_04022020.pdf.

13. Sandvik Asia Limited v. Bharat Kumar Padamsi, 2009 (3) Bom CR 57:2009 (4) BOM LR 1421 (Bombay High Court).

14. Cadbury India Limited, [2015] 125 CLA 77 [Bombay High Court].

15. Harshit Sharma and Rishav Dixit, Minority Squeeze Out: In Re Cadbury India Ltd. (Part II), The Law Blog (Jun. 25, 2020), https://thelawblog.in/2020/06/25/minority-squeeze-out-in-re-cadbury-india-ltd-part-ii/.

16. Tom Vos, ‘Baby, It's Cold Outside…’ – A Comparative And Economic Analysis Of Freeze-Outs Of Minority Shareholders, SSRN (Jun. 17, 2017), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2898461.

17. LR 6.5 Controlling Shareholders - FCA Handbook, Handbook.Fca.Org.Uk, https://www.handbook.fca.org.uk/handbook/LR/6/5.html.

18. Consultative Paper on Review of Corporate Governance Norms in India, SEBI, https://www.sebi.gov.in/sebi_data/attachdocs/1357290354602.pdf.

19. The Companies Act 2013, § 150, No.18, Acts of Parliament, 2013 (India).

20. OECD, Improving Corporate Governance In India: Related Party Transactions And Minority Shareholder Protection, OECD iLibrary (Aug. 11, 2014), http://dx.doi.org/10.1787/9789264220652-en.

21. Id.

22. Gerard J. Sanders, Good Governance and Modern International Financial Institutions, AIIB Yearbook of International Law, 43-44 (2018).