Protecting Minority Investors Methodology

Table 1 - What do the protecting minority investors indicators measure?

Doing Business measures the protection of minority investors from conflicts of interest through one set of indicators and shareholders’ rights in corporate governance through another (table 1). The data come from a questionnaire administered to corporate and securities lawyers and are based on securities regulations, company laws, civil procedure codes and court rules of evidence. The ranking of economies on the strength of minority investor protections is determined by sorting their distance to frontier scores for protecting minority investors. These scores are the simple average of the distance to frontier scores for the extent of conflict of interest regulation index and the extent of shareholder governance index (figure 1).

Figure 1 - How strong are minority shareholders’ rights?

Protection of shareholders from conflicts of interest

The extent of conflict of interest regulation index measures the protection of shareholders against directors’ misuse of corporate assets for personal gain by distinguishing 3 dimensions of regulation that address conflicts of interest: transparency of related-party transactions (extent of disclosure index), shareholders’ ability to sue and hold directors liable for self-dealing (extent of director liability index) and access to evidence and allocation of legal expenses in shareholder litigation (ease of shareholder suits index). To make the data comparable across economies, several assumptions about the business and the transaction are used (figure 2).

Assumptions about the business

Figure 2 - How well are minority shareholders protected from conflicts of interests?

The business (Buyer):

  • Is a publicly traded corporation listed on the economy’s most important stock exchange. If the number of publicly traded companies listed on that exchange is less than 10, or if there is no stock exchange in the economy, it is assumed that Buyer is a large private company with multiple shareholders.
  • Has a board of directors and a chief executive officer (CEO) who may legally act on behalf of Buyer where permitted, even if this is not specifically required by law.
  • Has a supervisory board (applicable to economies with a 2-tier board system) on which 60% of the shareholder-elected members have been appointed by Mr. James, who is Buyer’s controlling shareholder and a member of Buyer’s board of directors.
  • Is a manufacturing company.
  • Has its own distribution network.

Assumptions about the transaction

  • Mr. James owns 60% of Buyer and elected 2 directors to Buyer’s 5-member board.
  • Mr. James also owns 90% of Seller, a company that operates a chain of retail hardware stores. Seller recently closed a large number of its stores.
  • Mr. James proposes that Buyer purchase Seller’s unused fleet of trucks to expand Buyer’s distribution of its food products, a proposal to which Buyer agrees. The price is equal to 10% of Buyer’s assets and is higher than the market value.
  • The proposed transaction is part of the company’s ordinary course of business and is not outside the authority of the company.
  • Buyer enters into the transaction. All required approvals are obtained, and all required disclosures made (that is, the transaction is not fraudulent).
  • The transaction causes damages to Buyer. Shareholders sue Mr. James and the other parties that approved the transaction.

Extent of disclosure index

The extent of disclosure index has 5 components:

  • Which corporate body can provide legally sufficient approval for the transaction. A score of 0 is assigned if it is the CEO or the managing director alone; 1 if the board of directors, the supervisory board or shareholders must vote and Mr. James is permitted to vote; 2 if the board of directors or the supervisory board must vote and Mr. James is not permitted to vote; 3 if shareholders must vote and Mr. James is not permitted to vote.
  • Whether immediate disclosure of the transaction to the public, the regulator or the shareholders is required (1). A score of 0 is assigned if no disclosure is required; 1 if disclosure on the terms of the transaction is required but not on Mr. James’s conflict of interest; 2 if disclosure on both the terms and Mr. James’s conflict of interest is required.
  • Whether disclosure in the annual report is required. A score of 0 is assigned if no disclosure on the transaction is required; 1 if disclosure on the terms of the transaction is required but not on Mr. James’s conflict of interest; 2 if disclosure on both the terms and Mr. James’s conflict of interest is required.
  • Whether disclosure by Mr. James to the board of directors or the supervisory board is required. A score of 0 is assigned if no disclosure is required; 1 if a general disclosure of the existence of a conflict of interest is required without any specifics; 2 if full disclosure of all material facts relating to Mr. James’s interest in the Buyer-Seller transaction is required.
  • Whether it is required that an external body, for example, an external auditor, review the transaction before it takes place. A score of 0 is assigned if no; 1 if yes.

The index ranges from 0 to 10, with higher values indicating greater disclosure. In Poland, for example, the board of directors must approve the transaction and Mr. James is not allowed to vote (a score of 2). Buyer is required to disclose immediately all information affecting the stock price, including the conflict of interest (a score of 2). In its annual report Buyer must also disclose the terms of the transaction and Mr. James’s ownership in Buyer and Seller (a score of 2). Before the transaction Mr. James must disclose his conflict of interest to the other directors, but he is not required to provide specific information about it (a score of 1). Poland does not require an external body to review the transaction (a score of 0). Adding these numbers gives Poland a score of 7 on the extent of disclosure index.

Extent of director liability index

The extent of director liability index has 7 components (2):

  • Whether a shareholder plaintiff is able to hold Mr. James liable for the damage the Buyer-Seller transaction causes to the company. A score of 0 is assigned if Mr. James cannot be held liable or can be held liable only for fraud, bad faith or gross negligence; 1 if Mr. James can be held liable only if he influenced the approval of the transaction or was negligent; 2 if Mr. James can be held liable when the transaction is unfair or prejudicial to the other shareholders.
  • Whether a shareholder plaintiff is able to hold the approving body (the CEO, members of the board of directors or members of the supervisory board) liable for the damage the transaction causes to the company. A score of 0 is assigned if the approving body cannot be held liable or can be held liable only for fraud, bad faith or gross negligence; 1 if the approving body can be held liable for negligence; 2 if the approving body can be held liable when the transaction is unfair or prejudicial to the other shareholders.
  • Whether a court can void the transaction upon a successful claim by a shareholder plaintiff. A score of 0 is assigned if rescission is unavailable or is available only in case of fraud, bad faith or gross negligence; 1 if rescission is available when the transaction is oppressive or prejudicial to the other shareholders; 2 if rescission is available when the transaction is unfair or entails a conflict of interest.
  • Whether Mr. James pays damages for the harm caused to the company upon a successful claim by the shareholder plaintiff. A score of 0 is assigned if no; 1 if yes.
  • Whether Mr. James repays profits made from the transaction upon a successful claim by the shareholder plaintiff. A score of 0 is assigned if no; 1 if yes.
  • Whether both fines and imprisonment can be applied against Mr. James. A score of 0 is assigned if no; 1 if yes.
  • Whether shareholder plaintiffs are able to sue directly or derivatively for the damage the transaction causes to the company. A score of 0 is assigned if suits are unavailable or are available only for shareholders holding more than 10% of the company’s share capital; 1 if direct or derivative suits are available for shareholders holding 10% of share capital.

The index ranges from 0 to 10, with higher values indicating greater liability of directors. Assuming that the prejudicial transaction was duly approved and disclosed, in order to hold Mr. James liable in Panama, for example, a plaintiff must prove that Mr. James influenced the approving body or acted negligently (a score of 1). To hold the other directors liable, a plaintiff must prove that they acted negligently (a score of 1). The prejudicial transaction cannot be voided (a score of 0). If Mr. James is found liable, he must pay damages (a score of 1) but he is not required to disgorge his profits (a score of 0). Mr. James cannot be fined and imprisoned (a score of 0). Direct or derivative suits are available for shareholders holding 10% of share capital (a score of 1). Adding these numbers gives Panama a score of 4 on the extent of director liability index.

Ease of shareholder suits index

The ease of shareholder suits index has 6 components:

  • What range of documents is available to the shareholder plaintiff from the defendant and witnesses during trial. A score of 1 is assigned for each of the following types of documents available: information that the defendant has indicated he intends to rely on for his defense; information that directly proves specific facts in the plaintiff’s claim; and any information relevant to the subject matter of the claim.
  • Whether the plaintiff can directly examine the defendant and witnesses during trial. A score of 0 is assigned if no; 1 if yes, with prior approval of the questions by the judge; 2 if yes, without prior approval.
  • Whether the plaintiff can obtain categories of relevant documents from the defendant without identifying each document specifically. A score of 0 is assigned if no; 1 if yes.
  • Whether shareholders owning 10% of the company’s share capital have the right to inspect the transaction documents before filing suit or request that a government inspector investigate the Buyer-Seller transaction without filing suit. A score of 0 is assigned if no; 1 if yes (3).
  • Whether the standard of proof for civil suits is lower than that for a criminal case. A score of 0 is assigned if no; 1 if yes.
  • Whether shareholder plaintiffs can recover their legal expenses from the company. A score of 0 is assigned if no; 1 if yes (4). A score of 0 is assigned if no; 1 if plaintiffs can recover their legal expenses from the company only upon a successful outcome of their legal action or if payment of their attorney fees is contingent on a successful outcome; 2 if plaintiffs can recover their legal expenses from the company regardless of the outcome of their legal action (5).

The index ranges from 0 to 10, with higher values indicating greater powers of shareholders to challenge the transaction. In Croatia, for example, the plaintiff can access documents that the defendant intends to rely on for his defense (a score of 1). The plaintiff can examine the defendant and witnesses during trial, without prior approval of the questions by the court (a score of 2). The plaintiff must specifically identify the documents being sought (for example, the Buyer-Seller purchase agreement of July 15, 2006) and cannot simply request categories (for example, all documents related to the transaction) (a score of 0). A shareholder holding 10% of Buyer’s shares can request that a government inspector review suspected mismanagement by Mr. James and the CEO without filing suit in court (a score of 1). The standard of proof for civil suits is the same as that for a criminal case (a score of 0). The plaintiff can recover legal expenses from the company only upon a successful outcome of the legal action (a score of 1). Adding these numbers gives Croatia a score of 5 on the ease of shareholder suits index.

Extent of conflict of interest regulation index

The extent of conflict of interest regulation index is the sum of the extent of disclosure index, the extent of director liability index and the ease of shareholder suits index. The index is divided by 3 so that it ranges from 0 to 10. Higher values indicate stronger regulation of conflicts of interest.

Shareholders’ rights in corporate governance

The extent of shareholder governance index measures shareholders’ rights in corporate governance by distinguishing 3 dimensions of good governance: shareholders’ rights and role in major corporate decisions (extent of shareholder rights index), governance safeguards protecting shareholders from undue board control and entrenchment (strength of governance structure index) and corporate transparency on ownership stakes, compensation, audits and financial prospects (extent of corporate transparency index) (6).

Extent of shareholder rights index

For each component of the extent of shareholder rights index, a score of 0 is assigned if the answer is no; 1 if it is yes; and 1.5 if it would also apply if Buyer were a privately held joint company not listed on any stock exchange. The index has 7 components:

  • Whether shareholders have the right to amend Buyer’s bylaws or statutes with a simple majority.
  • Whether shareholders owning 10% of Buyer’s share capital have the right to call for an extraordinary meeting of shareholders.
  • Whether shareholders have the right to remove members of Buyer’s board of directors before the end of their term.
  • Whether Buyer must obtain its shareholders’ approval every time it issues new shares.
  • Whether shareholders are automatically granted preemption or subscription rights every time Buyer issues new shares.
  • Whether shareholders are required by law to approve the election and dismissal of the external auditor.
  • Whether shareholders have the right to freely trade shares prior to a major corporate action or meeting of shareholders.

Strength of governance structure index

For each component of the strength of governance structure index, a score of 0 is assigned if the answer is no; 1 if it is yes; and 1.5 if it would also apply if Buyer were a privately held company not listed on any stock exchange. The index has 7 components:

  • Whether the CEO is barred from also being chair of the board of directors.
  • Whether the board of directors must include independent board members.
  • Whether Buyer must have a separate audit committee.
  • Whether changes to the voting rights of a series or class of shares must be approved only by the holders of the affected shares.
  • Whether a potential acquirer must make a tender offer to all shareholders upon acquiring 50% of Buyer.
  • Whether cross-shareholding between 2 independent companies is limited to 10% of outstanding shares.
  • Whether a subsidiary is barred from acquiring shares issued by its parent company.

Extent of corporate transparency index

For each component of the extent of corporate transparency index, a score of 0 is assigned if the answer is no; 1 if it is yes; and 1.5 if it would also apply if Buyer were a privately held company not listed on any stock exchange. The index has 6 components:

  • Whether Buyer must disclose ownership stakes representing 10%.
  • Whether Buyer must disclose information about board members’ other directorships as well as basic information on their primary employment.
  • Whether Buyer must disclose the compensation of individual managers.
  • Whether Buyer must have its annual financial statements audited by an external auditor.
  • Whether financial statements must contain explanatory notes on significant accounting policies, trends, risks, uncertainties and other factors influencing the reporting.
  • Whether audit reports must be disclosed to the public.

Extent of shareholder governance index

The extent of shareholder governance index is the sum of the extent of shareholder rights index, the strength of governance structure index and the extent of corporate transparency index. The index is divided by 3 so that it ranges from 0 to 10. Higher values indicate stronger rights of shareholders in corporate governance.

Strength of minority investor protection index

The strength of minority investor protection index is the average of the extent of conflict of interest regulation index and the extent of shareholder governance index. The index ranges from 0 to 10, rounded to the nearest decimal place, with higher values indicating stronger minority investor protections.

This methodology was developed by Djankov, La Porta and others (2008).
The extent of shareholder governance index was introduced in Doing Business 2015
.


-------------

1- This question is usually regulated by stock exchange or securities laws. Points are awarded only to economies with more than 10 listed firms in their most important stock exchange.
2- When evaluating the regime of liability for company directors for a prejudicial related-party transaction, Doing Business assumes that the transaction was duly disclosed and approved. Doing Business does not measure director liability in the event of fraud.
3- This component is revised in Doing Business 2015;it combines 2 previously separate components.
4- This component is new in Doing Business 2015.
5- This component is new in Doing Business 2015.
6- This component is new in Doing Business 2015.