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Investor protection is an eternal topic for the securities market. It is also a subject of intense interest for colleagues from the Securities Law Research Society. With development in the capital market and improvement in rule of law, research in investor protection will go into depths and various disputes and debates will surface. A prominent controversy is whether the advocacy of protection of mid- and small-cap investors goes against the fundamental principle of equitability in the securities market, and whether it is contrary to the equitable treatment of shareholders provideed in the Company Law? I would like to elaborate on my understanding of the issue.
I. The meaning of equitable treatment of shareholders
The equitable treatment of shareholders is a fundamental principle for investor protection, permeating in all aspects of the Company Law and theSecurities Law. The equitability principle, so to speak, refers to the equitable treatment of shareholders according to the nature, content and amount of shareholdings and safeguards against unfair and unequitable treatment on the basis of relationships between the company and shareholders and between different shareholders.
It is specifically prescribed in Chapter II of Principles of Corporate Governance issued by OECD in May, 1995. “The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.” China’s Company Law has not raised the concept of equitable treatment of shareholders, but the essence has been reflected in various provisions. For example, Article 127 prescribes that “the shares of the same class shall have the same rights and benefits and the shares issued at the same time shall be equal in price and shall be subject to the same conditions.” Article 104 Section 1 promulgates “one voting right for each share” and Article 187 Section 2 stipulates the residual assets should be “distributed according to the proportions of capital contributions of the shareholders”.
From the perspective of legal principles, the equitable treatment of shareholders should include the following aspects:
First, all shareholders have equal legal personality and their rights based on the shareholding are the same in nature and types.
Second, all shareholders have the same legitimate right to expect income accrued from the assets they have invested in and such right is under legal protection.
Third, in corporate practice, there may be differences in the status of exercising shareholders ’rights. But such differences can change according to voluntary increase or decrease of shareholdings.
Fourth, controlling shareholders shall not seek, by any special means, benefits other than those from share ownership. Nor shall Controlling shareholders by any means make up for their own share losses solely and unilaterally.
People may interpret the equitability principle in such a manner: all shareholders are equal, and the presupposition determines the fact that we should not only protect the interests of mid- and small-cap shareholders, but also major shareholders. They especially emphasize the importance of protecting the interests of state-owned assets accordingly. So is the equitable treatment principle in contradiction to our advocacy of protecting the interests of mid- and small-cap shareholders? To find answer to the question, first and foremost it is necessary to clarify meanings of the equitability principle in form and substance.
For its meaning in form, the equitable treatment of shareholders basically means the equality of shares. This can be understood in two layers: on the one hand, all shares within the same class of issuance bear the same content and benefits; and on the other hand, shareholders in possession of the same type and amount of shares shall enjoy equal treatment according to shareholdings in legal relationships based upon shareholdings. In line with the equitability of shares, the company should take a neutral, fair and detached position and show no preference or prejudice for or against any shareholder in possession of the same content and amount of shares.
For its meaning in substance, the equitable treatment of shareholders does not imply absolute and formal equality, but relative and substantial equitability. The equitable treatment of shareholders does not prohibit all inequitable treatments indiscriminately; instead, it prohibits inequitable treatments without proper reasons. The reason we advocate the protection of mid- and small-cap investors lies in the fact that mid- and small-cap investors are subject to plundering and undermining by controlling shareholders and insiders. Whether state-owned asset shareholders need legal and regulatory protection depends on whether they have been treated inequitably. For instance, it depends on whether there are cases for insiders to plunder state-owned assets and for related party transactions and transfer of benefits to detriment of shareholders of state-owned assets. At same time, it depends on the seriousness and pervasiveness of the inequitable treatments.
II. The balance between equitable treatment of shareholders and protection of minority investors
The capital majority rule is a fundamental principle of the Company Law. According to the capital majority rule, shareholders have voting power proportional to the shares they hold. The law presumes the intention of the major shareholders is the intention of the company, and once the will of the controlling shareholders become the will of shareholders’ general meeting, it has a binding power for minority shareholders.
The generation of capital majority rule is an inevitable historical process. The autonomy of private law, the legal person theory, and the freedom of exercising shareholder rights have laid the theoretical foundation for the capital majority law. But for a quite a long time in the past, the rule has been abused and dogmatized, resulting in disablement of minority shareholders’s access to legal redress when the interests of the company or of their own have been violated. As in the widely known Foss v.Harbottle case in the UK, the controlling shareholders are the final decision makers for bringing up in a lawsuit against relevant culprits in the name of the company or setting it aside.
After realizing the abuses of the capital majority rule, many countries have strengthened the legal remedy measures for the protection of investors. The German court adopts the provisions for violation of good morals in Articles 138 and 826 of German Civil Code, whch intervenes in the abuse of the capital majority rule and construes the decision of the general meeting to be invalid if it is “for major shareholders to squeeze money out of minority shareholders and against good morals”. German legal community has reached a consensus to the problem by adopting the “abuse of power” theory. In the UK, when trying to get rid of the abuse of the capital majority rule, a theory of “scam of power” has been developed. And in US, the “fiduciary duty theory” is widely accepted to interpret the phenomenon. In China, the provisions in Article 20 of the Company Law can be considered as restrictions to the capital majority rule. “The shareholders of a company shall comply with the laws, administrative regulations and articles of association, and shall exercise the shareholder's rights according to law. None of them shall infringe on any of the interests of the company or of other shareholders by abusing the shareholder's rights, or injure the interests of any creditor of the company by abusing the independent status of legal person or the shareholder's limited liabilities.”
The exercise of the capital majority rule is also related to deeper legal issues involved investor protection, that is, relationship between the equitability and the fairness principles. If capital majority rule were adopted for companies with shareholders of similar amount of shareholdings or with dispersed ownership of shares, it would create a situation to the effect that “equitability equals fairness.” However, in China, listed companies feature single dominant shareholder and wide participation by a huge number of mid- and small-cap investors. Under such circumstances , If we were to dogmatize the capital majority rule, the equitability in form would lead to an inequitable result in substance. There are large gaps in shareholding and consequently voting power between major shareholders and mid- and small-cap shareholders. If we were to measure “equitability” by the same standards and in the same dimensions, and we would be implementing absolute and indiscriminate “equality.” It is very likely that the result will go opposite to our expectations.
Therefore, protection of minority shareholders and the capital majority rule are not in contradiction. The capital majority rule is premise for the existence and operation for the corporation and power source for investment attraction and growth. As we advocate the protection of mid- and small-cap shareholders, we should not deny the controlling power of major shareholders in decision-making processes. Otherwise we would be threatening the institutional foundation of the modern corporate system. However, we should not put the capital majority rule in an absolute unshakable position. As long as there is evidence of major shareholders abusing their voting power to the detriment of the interests of the company or minority shareholders, the law shall specify reasonable exceptions restraining the capital majority rule, in such mechanisms as related shareholder challenge system, cumulative voting, special voting mechanism for minority shareholders. Thus we can ease the conflicts of interest between major shareholders and minority shareholders and render special legal protection and remedies for the disadvantaged party in the capital market.
IIIļ¼ˇExact Connotation of Mid- and small-cap Investor Protection
It is often found that people often equate mid- and small-cap investor protection with restraining major shareholders’ rights. It seems that the interest of major shareholders has been put against that of their smaller counterparts. It is not only unreasonable in academic theory but also harmful in practice to theorize on this misconception and treat it as a new normal. Such terms as “single dominant shareholder, controlling shareholder or de facto controller” emerge in situations of concentrated ownership. However there terms should be understood as neutral concepts. In terms of original legal status as well as rights and obligations, major shareholders or de facto controllers should be treated equally as mid- and small-cap shareholders, justifying no special protection nor special regulation. This is the meaning of equality of shareholders in form.
At the same time, however, we must pay attention to possible non-compliance and motivations for benefit transfer in situation of ownership concentration dominated by single major shareholder. According to Controlling Shareholders and Corporate Governance: Complicating the Taxonomy by Ronald Gilson, an American professor, major shareholders and de facto controllers tend to make profits by sacrificing interests of mid- and small-cap investors in emerging and transitional markets where rule of law and investors redresss are not well developed. Therefore,the advocation for protection of mid- and smal-cap investors aims to restore the normal status of “equitable treatment of shareholders” rather than discrimination against major shareholders. This is the meaning of equality of shareholders in substance.
As a result, protection does not mean privileging mid- and small-cap investors in China. The purpose of protection is to close the gap and restore fairness between the two groups. For instance, major shareholders often by-pass mid- and small-cap shareholders in reaching resolutions, which are ironically legally binding to the latter. Major shareholders have complete control over changes of corporate information and rhythms of information disclosure. Mid and small-cap investors are only at the quality quality of the issuers’ information disclosure and make decisions accordingly. Furthermore, such gap of treatment exists while major shareholders are abiding by laws and ethical standards. If major shareholders purposely engage in irregular practices, the result of the game is obvious. The last straw of fairness is judicial relief, which is not optimistic either. Major shareholders who ignore integrity obligations and infringe mid and small-sized investors’ interests are not always subject to legal sanction. The probability of being caught is not high and the cost of violation is low. On the contrary, mid and small-sized investors are faced with prohibitively high cost and hurdles in seeking judicial relief.
Protecting mid- and small-cap investors is not to give them special privileges, but to return to the normal state of safeguarding investors’ interests, protecting legal rights in aspects of information, fair trade, dividend, proposal, voting and judicial relief. Protection involves provision of a more relaxed, convenient and effective environment for mid- and small-cap investors to exercise these rights. Besides, protective measures are also aimed at overcoming the inherent weakness of this group, for instance, weak risk awareness, low level of self-protection and herd behaviors. Necessary training, warning, and reminder are necessary. Thus, the protection of mid- and small-cap investors is not to limit or infringe on major investors’ interests. Nor is it a simple divison of interest or win-lose game. It is in the benefit of companies, major investors and the entire capital market to foster a rational and mature group of mid- and small-cap investors.
IV. Judicial relief is the key point
Of course, we should not go to the other extreme to limit major investors in order to protect mid- and small-cap investors. Under the current shareholding structure, major shareholders and long-term strategic shareholders bear greater risks and responsibilities. It is more flexible for mid- and small-cap shareholders to acess and exit companies according to the business and risk profiles. However, major shareholders have to be bound by the long-term business strategy of companies. Thus, it stands to reason that the law permits greater power of speech an decision making. However we should bring our attention to minority shareholders’ access to legal relief and efficiency of execution when major shareholders abuse their controlling power and willfully harm minority investors’ interests. In mature markets, such relief is achieved through subsequent judicial processes, rather than changing the rules of the game in advance. And such judicial relief is decisive and effective, forming credible deterrence to major shareholders. In China, minority shareholders have limited access to judicial relief and law suits against major shareholders and actual controllers are few and far in between. Thus, the front-end control against major shareholders’ abuse of power has been continuously moved forward. Executive and self-regulatory organizations are playing the roles of judicial authorities. Although innovative efforts have been made to Chinese regulations and rules, such as signing major shareholder commitment and issuing guidelines to de facto controllers, these self-disciplinary constraints are not effective for major shareholders who decide to cheat. Administrative law enforcement is compromised by the burden of proof, thus it is diffiult to root out the backstage manipulator. In many cases, punishment can only reach corporate executives and listed companies themselves. Under some circumstances, the executives might be the “scapegoat” of the de facto controllers, and punishment to listed companies bring harms to mid- and small cap investors as well. What’s more, such punishment and sanctions occur after the exposure of serious issues. Listed companies and minority investors have already suffered from the consequences of violations. Therefore, from the perspective of protecting mid- and small-cap investors, what is in great need in China is a mechanism that enables mid- and small-cap investors to participate in corporate governance ex-ante and during the course of the event. Mid- and small-cap investors can raise proposals in general meetings of stakeholders, execute collective voting power, nominate their representatives and sue the major shareholders or companies to halt illegal behaviors, protect themselves, and demand compensation. China still lacks implementation of such a set of judicial rules accustomed to by international society. Though the laws and regulation exist, more is expected of their enforcement.
