Are loyalty voting rights efficient?

Some reflections on the Belgian proposals

Especially after the financial crisis, many people have drawn attention to the problem of short-termism. There are many possible strategies to address this problem, including awarding additional voting rights to loyal shareholders (“loyalty voting rights”). Both France and Italy have introduced loyalty voting rights, and now the Belgian proposal for a new Companies and Associations Code also contains the possibility of loyalty voting rights in listed companies (discussed in previous blog posts here and here).

Of course, this raises the question how effective loyalty voting rights, as proposed in the Belgian Company Law Reform, are in addressing the short-termism problem. In this blog post, I argue that loyalty voting rights are unlikely to increase the holding periods of investors, as the evidence suggests that they are only used by the controlling shareholders. However, loyalty voting rights will allow a controlling shareholder to insulate itself from short-term market pressures. On the other hand, insulation also comes with the disadvantage of higher agency costs.

Therefore, I argue that loyalty voting shares are in fact nothing else than a type of control-enhancing mechanism. This implies that shareholders should be protected against midstream introductions of loyalty voting rights. On this ground, I question the wisdom of lowering the threshold to introduce loyalty voting rights, as the Belgian legislator is proposing, inspired by the French and Italian examples. In addition, I propose an additional majority for the introduction of loyalty voting rights, inspired by the idea of “majority of the minority” approval.

The short-termism problem

One of the hottest topics in corporate law scholarship has recently been the debate on short-termism. Some authors have argued that short-termism is a problem because of the short-term horizons of investors. There is some empirical evidence that supports these claims. Graham, Harvey and Rajgopol (2005) have surveyed CFO’s about short-termism and find that 80% of surveyed CFOs are willing to decrease discretionary spending on R&D, advertising, or maintenance to meet earnings targets.

In addition, Ladika and Sautner (2018) find that following a reduction in stock option vesting periods for managers (due to a change in accounting rules), managers cut investment in capital expenditure and R&D by 27%. They also find that while this has a positive effect on those firms’ share price in the short-term, firms that cut their investment underperform the market by 10% in the slightly longer term (two years). The evidence also points out that executives sell more equity and leave the firm more often after cutting investments, suggesting that they benefit from the short-term spike in share price.

Finally, another paper by Cremers, Pareek and Sautner (2018) finds that the arrival of investors with short-term horizons leads to pressure on executives to cut long-term investments, increasing short-term earnings. They also find that, while this leads to a temporary boost in the share price, the firm value gradually decreases again to below the original value after the investors have exited.

Others have disputed that short-termism is a problem, most notably Mark Roe (see for example here and here). He has argued that (1) average holding periods of institutional investors have not shortened recently; (2) short-termism in the stock markets may be offset by long-term investments in other markets, such as the private equity and venture capital market; (3) insulating managers (for example with dual class share structures) may also lead to more short-termism, especially if managers’ remuneration remains tied to the stock price; and (4) the economy-wide data does not support the conclusion that short-termist stock markets lead to a decline in investments in capital expenditures and R&D.

Therefore, the debate remains unsettled, especially since the empirical studies mainly rely on data from the US. In any case, many legislators in Europe seem to believe that short-termism is a problem, and have turned to loyalty voting shares to solve this problem. The question is of course: are loyalty voting shares an effective remedy against short-termism? And are we sure that the cure is not worse than the disease?

Loyalty voting shares as a solution to the short-termism problem?

To address the short-termism problem, the Belgian legislator has proposed to allow loyalty voting shares in listed companies. To quickly recapitulate, both before and after the Belgian Company Law Reform, shares with multiple voting rights are in principle not possible. However, the new Companies and Associations Code will allow companies to substantially deviate from this principle: if the articles of association provide for this, loyal shareholders can receive double voting rights.

The precise conditions for loyalty voting rights are that the shares are held in registered form by the same shareholder for an uninterrupted period of two years (article 7:53 New Companies and Associations Code). This period starts from the day that the shares are registered in the name of the shareholder concerned, even if the loyalty voting rights clause is only introduced later on. The loyalty voting rights are lost when the shares are de-registered or when the shares are transferred, with some exceptions for donations, inheritances, mergers without change of ultimate control, etc.

The Belgian provisions are very similar to the ones in France (article L225-123 and L225-124 Code du Commerce) and Italy (article 127-quinquies TUF). An important difference, however, is that both Italy and Belgium have a rule that prevents circumvention of the loss of double voting rights when the shares are transferred: if the shares with loyalty voting rights are held by a company and control over this company is transferred, the loyalty voting rights will be lost as well. France, on the other hand, has no such rule.

Other differences between France, Italy and Belgium is the relationship with the mandatory bid rule (discussed in a previous blogpost) and the required majority to introduce loyalty voting rights (discussed further below).

According to the Belgian parliamentary proceedings, the goals of loyalty voting shares are (1) to counter short-termism; and (2) to facilitate the listing of companies with a controlling shareholder without the loss of control. Not officially outspoken, the goals of loyalty voting shares could also be to protect listed companies against takeovers, and to allow the state to unwind its equity stake in listed state-owned companies without losing control.

The question then is: do loyalty voting rights counter short-termism? Becht, Kamisarenka and Pajuste (2018) provide empirical evidence on this for France: they find that there is no significant difference in the average holding periods of investors between firms with and without loyalty voting shares.

This corresponds with anecdotal evidence that neither institutional investors nor retail investors make use of loyalty voting rights to a significant extent, and that it is almost exclusively the controlling shareholder who benefits from it (see here for example). At a recent roundtable on loyalty shares organized by the European Corporate Governance Institute, the conclusion was therefore: loyalty voting shares are nothing more than a control enhancing mechanism, i.e. a form of dual class shares.

Loyalty shares as a form of dual class shares

This does not mean that loyalty voting shares cannot reduce short-termism: arguably, enhancing the control of controlling shareholders and insulating them from the demands of short-term investors could facilitate the pursuit of a long-term strategy. It does mean, however, that we should debate the benefits and drawbacks of dual class share structures. This includes the potential agency costs associated with dual class shares, due to the risk of extraction of private benefits of control and due to the entrenchment of insiders, which prevents the disciplining effect of hostile takeovers.

Proponents of dual class share structures argue that optimal governance arrangements differ from firm to firm, and can even differ over time within one firm, suggesting that companies should be allowed contractual freedom to adopt dual class shares (see for example: Goshen and Squire, 2017; Sharfman, 2018). In addition, they argue that market prices in an efficient stock market will reflect the benefits and risks of dual class share structures, which means that investors will not be harmed.

However, behavioral finance research (discussed in a previous blogpost) sheds doubt on whether markets are truly efficient and are able to adequately incorporate the negative effects of dual class shares. For this reason, some authors (for example: Bebchuk, Kraakman and Triantis, 2000; Clottens, 2012) have argued that dual class share structures should be prohibited. They rely on some of the empirical evidence that finds that dual class structures are associated with lower firm value and higher extraction of private benefits (see for example: Masulis, Wang and Xie, 2009; Gompers, Ishii and Metrick, 2010).

On the other hand, more recent empirical evidence (Anderson, Ottolenghi and Reeb, 2017) suggests that once one controls for confounding variables, and especially family ownership, the negative effect on firm value for dual class structures disappears. This supports the idea that dual class structures may not be harmful for all companies.

Recently, Bebchuk and Kastiel (2017) have reframed the debate: they argue that the benefits of dual class structures are likely to erode over time, while the agency costs are likely to increase. Therefore, they argue that if dual class share structures should be allowed, they should be subject to sunset provisions. This means that their continuation should be approved by shareholders, for example every 10-15 years. There is some empirical evidence that firm valuation of dual class companies indeed declines after a few years (Cremers, Lauterbach and Pajuste, 2018; Kim and Michaely, 2018; Jackson, 2018). However, others have argued that it is difficult to establish duration for the sunset provision that is right for every company, and believe that the application of a sunset provision should be left to the market.

In conclusion, the debate on whether dual class share structures should be allowed remains inconclusive. Due to the similarity in their nature, the same can be said about loyalty voting shares.

On the other hand, loyalty voting shares are different from dual class share structures in important regards. Firstly, the most extreme forms of dual class shares are prevented by the strict mandatory limits to loyalty voting rights, such as the limited multiplier of two and the holding period requirements, implying that the agency costs may be less. However, these limits to contractual freedom also limit the possibility to customize voting rights to the needs of individual companies.

Loyalty voting shares in the midstream phase

Another important difference of loyalty voting shares as compared to dual class shares is that loyalty voting shares can generally be introduced more easily in the midstream phase, i.e. after the company has already gone public and without approval of all shareholders. According to French, Italian and (proposed) Belgian law, loyalty voting shares do not constitute a separate class of shares, as all shareholders have an equal possibility to acquire loyalty voting rights. Therefore, loyalty voting rights can simply be introduced by an amendment to the articles of association.

The French legislator has gone the furthest in this regard: loyalty voting rights are actually the default rule for listed companies, and it is only possible to opt out with a majority of two-thirds of the shareholders. Under Italian law, amendments to the articles of association, including clauses on loyalty voting rights, in principle require a two-thirds majority. However, from 21 August 2014 (when the new law entered into force) until 31 January 2015, these amendments could be approved with a simple majority of shareholders.

The proposed rule in Belgium follows the Italian model: the traditional supermajority requirement for amendments of 75% is permanently lowered to a two-thirds majority for an amendment to introduce loyalty voting rights (article 7:53§1 new Companies and Associations Code). In addition, until 30 June 2020, these amendments can even be introduced by a simple majority (article 31 of the law introducing the new Companies and Associations Code). According to a Belgian financial newspaper, this was due to lobbying of the Federation of Enterprises in Belgium (FEB) and was finally decided by Belgium’s prime minister, Charles Michel, himself (De Tijd, 2 June 2018, p. 24).

These low thresholds to introduce loyalty voting rights are problematic, and even raise constitutional questions: can it be justified under the non-discrimination principle that minority shareholders are less protected when loyalty voting rights are introduced (because of the lower majority), as compared to other amendments of the articles of association? And isn’t it an infringement of the right to property under article 1 of the First Protocol of the European Convention on Human Rights that the relative voting rights of some shareholders are decreased in the midstream phase without adequate minority protection?

Even proponents of dual class share structures usually only support their introduction at the moment of the IPO. At that moment, efficient markets can price such structures and therefore protect shareholders. If a dual class share structure is introduced in the midstream phase, there is no such mechanism. There is a high risk that insiders (such as a controlling shareholder) will act opportunistically to enhance their control, in spite of the (implicit) contractual bargain with the minority shareholders who invested in the company. For this reason, the listing rules in both the NYSE and Nasdaq in the US severely limit the introduction of dual class share structures in the midstream phase. The same risk exists for loyalty shares: while in theory, all shareholders have an equal opportunity to acquire loyalty voting rights; in practice, loyalty voting rights are almost exclusively used by controlling shareholders.

Empirical evidence on the Loi Florange in France by Becht, Kamisarenka and Pajuste (2018) shows how problematic the midstream introduction of loyalty voting rights can be. Their paper found that 14 firms switched from “one share, one vote” to loyalty voting rights after the Loi Florange. In 7 cases, there even was no vote that proposed to retain the “one share, one vote” structure, simply because there was no point: the controlling shareholder had the necessary one-third blocking minority to block an amendment to disapply loyalty voting rights. In the 7 other companies, which did vote, the vote failed 5 times even though a simple majority of the shareholders had voted in favour of “one share, one vote”, because a two-thirds majority was required to block the loyalty voting rights. The paper also found that the state was dominant in 6 out of 7 of these cases. The authors conclude that it was mainly because of the presence of conflicted parties, and especially the French state, that loyalty voting rights were introduced. This raises serious questions about whether these midstream introductions of loyalty voting rights were value increasing for shareholders generally.

In fact, it can be argued that even a two-thirds or 75% majority is not high enough for the introduction of a dual class structure, such as loyalty voting shares, especially in case of a large block of controlling shareholders. One of the counterarguments that is often raised against this, is that a high threshold to introduce loyalty voting rights would be impossible to reach for many corporations. I find this unconvincing from a Belgian perspective. Many listed corporations in Belgium have a controlling shareholder owning more than or close to 50%, which makes it relatively easy to introduce loyalty voting rights. Indeed, a controlling shareholder owning 50% would only need to convince a simple majority of the minority shareholders. If this proves impossible, it is questionable whether loyalty voting rights will increase shareholder value. True, for companies without a large controlling shareholder, a 75% or higher threshold may be hard to reach. For this reason, I propose a different rule, grounded in the idea of approval by a majority of the minority shareholders.

From the 20 companies in the BEL 20 index, 7 have a (group of) controlling shareholder(s) owning more than 50% of the shares.[1] These controlling shareholders can unilaterally decide to introduce loyalty voting rights, without the need for support of any other shareholders. In 2 companies out of those 7, Proximus and Bpost, a majority of the shares is held by the Belgian state. In these cases, the Belgian government has a direct interest in lowering the threshold to introduce loyalty voting rights, to facilitate the unwinding of its equity stake while retaining control. In addition, loyalty voting rights could also prove useful in the IPO of Belfius, currently 100% owned by the Belgian state, that has long been announced (although this would be less of a problem, because not a midstream change).

Finally, in 5 companies from the BEL 20, a (group of) controlling shareholder(s) holds between 30% and 50% of the shares.[2] Taking into account the low level of attendance of general meetings by minority shareholders, as well as the suspended votes attaching to the shares owned by the company itself, it is very likely that loyalty voting rights can be introduced under the lowered 50% threshold in most, if not all, of these companies as well. This is especially true for KBC and Aperam, where the controlling shareholder holds more than 40% of the voting rights.

This suggests that the introduction of loyalty voting rights is very likely in 12 out of 20 of the largest Belgian companies, regardless of shareholder opposition. If loyalty voting rights are to be introduced in the midstream, the very minimum should be that they are supported by a majority of the minority shareholders that are unrelated to the controlling shareholder. The reason is that loyalty voting rights upset the existing power bargain, which was part of the conditions on which the minority shareholder invested. As the controlling shareholder is self-interested in introducing loyalty voting rights in order to enhance its control, its votes should be treated with suspicion.

Therefore, I would argue to introduce an additional majority rule for loyalty voting rights: loyalty voting rights can only be validly adopted if they are also approved by a majority of the shareholders who would not immediately benefit from the loyalty voting rights, a “majority of the minority”. The difficulty is in defining who is part of “the minority”. One option is to exclude a controlling shareholder and its affiliated parties from the vote. Another option is to exclude all shareholders holding registered shares, as they would directly benefit from loyalty voting rights. The advantage of the latter approach is that it is easier to enforce, although it is also easier for the controlling shareholder to manipulate. A final option is to combine both of two previous approaches, and exclude all registered shareholders as well as all shareholders exceeding a certain percentage.

Such a rule would already be an improvement in the protection of shareholders in the midstream phase. Indeed, if a company fails to convince even a simple majority of the minority shareholders that loyalty voting rights would be in their interests, it is unlikely that the rule will be in the shareholders’ interests. But my proposal has as an advantage in comparison with a high threshold that loyalty voting rights can also be introduced in a company with a dispersed shareholder structure or with a smaller controlling shareholder, as long as they are supported by a majority of the minority shareholders.

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In conclusion, I have argued that loyalty shares are nothing more than a form of dual class shares, which will enhance the control of controlling shareholders. Whether or not dual class share structures are a good thing is still up for debate, and a nuanced position is probably justified. What is important, however, is that the arguments in favour of dual class share structures rely on the assumption that the shareholders have willingly invested in the company with a dual class structure. The problem is that this is not the case for loyalty voting shares: if the current proposal is adopted, it will be possible to introduce them with a simple majority in Belgium, even in the midstream phase. As this was not possible in the past, shareholders could not anticipate this and markets could not efficiently price this. I have argued that we should actually be more suspicious of the midstream introduction of loyalty voting rights compared to other amendments, and not less. Therefore, I propose to introduce an additional majority requirement, grounded in the idea of a majority of the minority shareholders.

Tom Vos
PhD researcher Jan Ronse Institute (KU Leuven)

[1] These companies are: AB Inbev, Colruyt, GBL, Proximus, Bpost, Sofina and Telenet Group. Based on the companies’ websites (accessed on 3 July 2018).

[2] These companies are: Ackermans & Van Haaren, Aperam, KBC, Solvay and UCB. Based on the companies’ websites (accessed on 3 July 2018).

Author: Tom Vos

Tom Vos is a PhD Researcher at the KU Leuven, where he is currently preparing a PhD on shareholder protection in share issues at the Jan Ronse Institute for Company and Financial Law. He is strongly interested in corporate law, financial law, corporate finance, mergers and acquisitions, private equity, law & economics and negotiation.

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