The Effect of Minority Veto Rights on Controller Tunneling
Most publicly traded firms around the world have a controlling shareholder. In these firms, a key objective of corporate governance is protecting minority shareholders from tunneling via related party transactions. The standard tools for constraining controllers — the use of independent directors and the duty of loyalty — are often seen as insufficient. A potentially more powerful protective tool is subjecting related party transactions to advance minority approval. This approach, now favored by the OECD, has been adopted by Israel, the securities regulators of the major Canadian provinces, Australia, Hong Kong, Indonesia, and Mexico. However, there has been little empirical evidence on whether minority veto rights work.
We exploit a 2011 regulatory reform in Israel to test the efficacy of minority veto rights. The Israeli reform gave minority shareholders veto rights over proposed related party transactions, including the proposed pay of controllers and their relatives serving as officers or directors (“controller executives”). The 2011 reform did not alter the approval mechanisms for the pay of executives unrelated to controllers, creating a suitable control group.
Using data on the pay of the thousands of executives in hundreds of firms in a six-year period around the reform, we examine whether giving veto rights to the minority had a systematic effect on the pay of controller executives. We find that the grant of minority veto rights constrained the pay of controller executives. In particular, we find that, controlling for other factors, the reform is associated with an average decline of 10% in controller-executive pay — an economically and statistically significant reduction. We also find that this decline is partly driven by a substantial increase in the frequency of pay cuts for controller executives. Some of the pay cuts exceed 50%. But minority investors appear to be selective in wielding their veto power, forcing some controller executives to accept massive pay cuts, but not others.
We also examine the reform’s effect on the rate at which controller executives disappear from a firm’s list of highest paid executives. Such a disappearance means that the controller executive either stops working at the firm or continues working for limited or no pay. We find that the likelihood of controller executives disappearing increased by about 40% after the reform, often in circumstances indicating that the controller executives might have had their pay package vetoed. Our estimate of the effect of minority veto rights on controller-executive pay — and on firm governance — is thus downward-biased.
The exogenous change in the voting regime, together with the presence of thousands of non-controller executives as a control group, make the 2011 reform a unique setting for identifying the power of minority veto rights for policing controller pay and related party transactions more generally. Our work also shows that a binding Say-on-Pay vote can impact not only the level of executive pay but also whether executives remain in their jobs.