Do Majority‐of‐Minority Shareholder Voting Rights Reduce Expropriation? Evidence from Related Party Transactions

• Published date: 01 September 2021
• Author: NAN LI
• Date: 01 September 2021
• DOI: http://doi.org/10.1111/1475-679X.12357

DOI: 10.1111/1475-679X.12357

Journal of Accounting Research

Vol. 59 No. 4 September 2021

Printed in U.S.A.

Do Majority-of-Minority

Shareholder Voting Rights Reduce

Expropriation? Evidence from

Related Party Transactions

NAN LI∗

Received 14 May 2019; accepted 10 February 2021

ABSTRACT

In the presence of business groups, the expropriation through related party

transactions (RPTs) is common and costly to minority shareholders. Using

the setting of India’s RPT voting rule, I find that a majority-of-minority

shareholder voting mechanism helps mitigate expropriation. Minority share-

holders actively raise their voice against RPT resolutions. A difference-in-

differences analysis reveals that shareholder voting has a significant deter-

rence effect on RPT volume. I also find that stock markets react positively to

∗Carlson School of ManagementUniversity of Minnesota

Accepted by Luzi Hail. I am grateful for the support of my dissertation committee, Fab-

rizio Ferri (cochair), Shiva Rajgopal (cochair), Tim Baldenius, Trevor Harris, and WeiJiang.

I greatly benefited from the comments of the associate editor, the referee, Bernard Black,

Hans Christensen, Jonathan Glover, Urooj Khan, Robert Stoumbos, and workshop partici-

pants at Columbia University, University of Colorado-Boulder, University of Illinois-Chicago,

University of Minnesota, University of Texas-Austin, and the Ohio State University. All errors

are my own. I am thankful for financial support from the W. Edwards Deming Center and

the Jerome A. Chazen Institute. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

1385

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business

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the voting rule’s passage, and that the rule makes Indian firms more attractive

to foreign institutional investors.

JEL codes: G34, K22, M40

Keywords: related party transactions; shareholder voting; corporate gover-

nance

1. Introduction

I study how shareholder votes can function as effective tools for corpo-

rate governance. A central corporate governance challenge faced by many

companies is how to protect minority shareholders from expropriation

attempts by controlling shareholders (La Porta, Lopez-de Silanes, and

Shleifer [1999]). In companies with concentrated control rights, the con-

trolling shareholders have the incentive to transfer public companies’ re-

sources through related party transactions (RPTs), ultimately to their own

pockets. Such a transfer, also called “tunneling,” can take many forms, such

as financial assistance, purchasing or selling of assets, and transfer pricing.

If pervasive, the fear of expropriation can dampen corporate valuation, im-

pede market development, and even aggravate financial crises (La Porta

et al. [2002]).

Previous studies find expropriation through RPTs is common and costly

to minority shareholders (Bertrand, Mehta, and Mullainathan [2002], Che-

ung, Rau, and Stouraitis [2006], Kohlbeck and Mayhew [2010]). At the

same time, though, when certain market mechanisms are not well devel-

oped (e.g., contract enforcement, capital markets), within-group transac-

tions, such as vertical integration and internal capital markets, can serve as

alternative means to overcome market shortcomings (Khanna and Palepu

[2000]). Outright prohibition of RPTs would be too costly, and identifying

mechanisms that preserve the benefits of RPTs while limiting their abuses

has proven to be difficult.

I investigate whether a mandatory and binding shareholder vote on RPTs

reduces the expropriation of minority shareholders and whether its net

effect on shareholder value is positive. A mandatory and binding voting

mechanism enables shareholders to block transactions perceived as detri-

mental to shareholder value. Furthermore, a large number of votes against

an RPT resolution, even if not sufficient to outright block the RPT, can

impose reputation costs on controlling shareholders or board members,

who may decide not to proceed with the transaction or revise it based on

the input received via the shareholder vote. In anticipation of the potential

cost of shareholder dissent, controlling shareholders may be deterred from

proposing transactions that would be perceived as hurting minority share-

holders.

By leaving the trigger to the collective wisdom of voting shareholders,

the voting mechanism can offer the flexibility to curb the negative ef-

fects of RPTs without disrupting their value-creating potential. In principle,

majority-of-minority voting and rpt 1387

informed shareholders will vote against transactions deemed detrimental to

shareholder value and support those arranged to facilitate business strate-

gies. In practice, however, the efficacy of shareholder voting remains an

empirical question that may be influenced by frictions. For example, mi-

nority shareholders may choose not to actively exercise their voting rights,

because they may believe that their individual vote will not affect the out-

come (“shareholder passivity,” Black [1990]). In addition, if shareholders

do not have adequate sophistication or information, the votes may not suc-

cessfully separate expropriation from value-creating transactions.

I examine the adoption of a mandatory voting rule on RPTs in India.

India’s corporate sector is dominated by large business groups. A single in-

dividual (i.e., promoter) or family usually maintains the de facto control

of all group firms, making RPT abuse a major concern (Bertrand, Mehta,

and Mullainathan [2002]). In 2009, the concern escalated following the

Satyam scandal, which was at first exposed by suspicious RPTs. In the subse-

quent revision of corporate law, known as the Companies Act 2013, the In-

dian legislators included a provision mandating that listed companies seek

shareholder approval for material RPTs before they take place. The Securi-

ties and Exchange Board of India (SEBI) also adopted a similar rule in the

revised listing agreement. Under the SEBI’s rule, if a firm’s expected sum

of RPTs with an individual party in a fiscal year exceeds 10% of the firm’s

most recent total revenue, all RPTs with that party are classified as mate-

rial. Importantly, the rule only allows “disinterested” shareholders to vote,

meaning shareholders classified as connected to the related party (typically

the case for promoters) are not eligible to vote on RPT resolutions. Hence,

material RPTs must be approved by shareholders who have no connection

to the related parties.

As a first step in the empirical analysis, I use voting data to provide de-

scriptive evidence on how shareholders vote on RPT resolutions. In a sam-

ple of 348 RPT resolutions in the first two years after the regulation, I

find that 9.77% of the RPT resolutions receive more than 25% “against”

votes of the votes cast from eligible shareholders, significantly higher than

the corresponding frequency of non-RPT resolutions (0.56%) at the same

firm. Notably, 7.78% of RPT resolutions fail to pass, suggesting that share-

holder votes can act as a credible threat.1In cross-sectional regressions, I

find shareholder dissent is positively associated with the firm’s RPT volume,

especially financing RPTs.

In the second step, I examine the voting rule’s overall deterrence effect

on the use of RPTs. To do so, I employ a difference-in-differences (DID)

design comparing the change in volume and type of RPTs around the treat-

ment event between treated and control groups. To construct a control

1As a benchmark, Ertimur, Ferri, and Oesch [2013] find only 1.9% of mandatory (non-

binding) “say-on-pay” proposals in the United States fail to pass the 50% threshold, suggesting

the dissent received by RPT resolutions in India is high even when compared with a country

and a topic (the U.S. say-on-pay) characterized by substantial activism via voting.