De Facto Control: Applying Game Theory to the Law on Corporate Nationality

📝 Abstract

One unexamined assumption in foreign ownership regulation is the notion that majority voting rights translate to ’effective control’. This assumption is so deeply entrenched in foreign investments law that possession of majority voting rights can determine the nationality of a corporation and its capacity to engage in partially nationalized economic activities. The fact, however, is that minority stockholders can possess a degree of voting power higher than what their shareholding size might suggest. Voting power is not the same as voting weight and is not measured simply by the proportion or number of votes a stockholder may cast in a stockholder meeting. This paper proposes and demonstrates a method for calculating ’effective control’ based on given voting thresholds and voting weights. It also shows instances where the ’effective control’ of a foreign minority stockholder appears to comply with foreign equity limitations, but has a ‘real’ voting power grossly beyond the allowable threshold.

💡 Analysis

One unexamined assumption in foreign ownership regulation is the notion that majority voting rights translate to ’effective control’. This assumption is so deeply entrenched in foreign investments law that possession of majority voting rights can determine the nationality of a corporation and its capacity to engage in partially nationalized economic activities. The fact, however, is that minority stockholders can possess a degree of voting power higher than what their shareholding size might suggest. Voting power is not the same as voting weight and is not measured simply by the proportion or number of votes a stockholder may cast in a stockholder meeting. This paper proposes and demonstrates a method for calculating ’effective control’ based on given voting thresholds and voting weights. It also shows instances where the ’effective control’ of a foreign minority stockholder appears to comply with foreign equity limitations, but has a ‘real’ voting power grossly beyond the allowable threshold.

📄 Content

DE FACTO CONTROL: APPLYING GAME THEORY TO THE LAW ON CORPORATE NATIONALITY

By Russell Stanley Q. Geronimo*

INTRODUCTION

One unexamined assumption in foreign ownership regulation is the notion that majority voting rights translate to “effective control”.1 This assumption is so deeply entrenched in foreign investments law that possession of majority voting rights can determine the nationality of a corporation and its capacity to engage in partially nationalized economic activities.2 The fact, however, is that minority stockholders can possess a degree of voting power higher than what their shareholding size might suggest.3 Voting power is not the same as voting weight and is not measured simply by the proportion or number of votes a stockholder may cast in a stockholder meeting.4 An example is a voting situation requiring a simple majority (51%) with stockholders 𝑃1, 𝑃2 and 𝑃3 having 50%, 49% and 1% voting weights, respectively. 5 While intuition tells us that 𝑃2 has a disproportionate degree of control compared to 𝑃3, it is not true that 𝑃2 has more “effective” voting power than 𝑃3.6 And while intuition also tells us that the 1% difference in voting rights between 𝑃1 and 𝑃2 is insubstantial, 𝑃1 still wields a more significant degree of control compared to 𝑃2.7 First, note that none of the stockholders can single-handedly pass a motion, and that we have no prior knowledge of their preferences in forming alliances. Thus, it is fair to assume that each stockholder is equally likely to form a coalition with any other stockholder, which means a coalition between 𝑃1 and 𝑃2 is just as likely to form as a coalition between 𝑃2 and 𝑃3, and 𝑃1 and 𝑃3.8 All the possible winning coalitions are: {𝑃1, 𝑃2}, {𝑃1, 𝑃3} and {𝑃1, 𝑃2, 𝑃3}. Second, note that 𝑃1 only needs one more vote to muster the required minimum votes to pass a desired stockholder resolution, and it is a matter of indifference to 𝑃1 whether that vote comes from 𝑃2 or 𝑃3. Third, 𝑃2 cannot prevail if he forms an alliance with 𝑃3 alone. 𝑃1 is a swing voter in all these three instances, while 𝑃2 is a swing voter in only one instance. By “swing voter”, we mean a voter who can make

• Juris Doctor, University of the Philippines – College of Law 1 Gamboa vs. Teves, G.R. No. 176579, October 09, 2012 2 The foreign equity limitation “must [likewise] apply separately to each class of shares, whether common, preferred non-voting, preferred voting or any other class of shares.” (Gamboa vs. Teves, G.R. No. 176579, October 9, 2012) 3 Leech, D., Shareholder Voting Power and Corporate Governance: A Study of Large British Companies, 27 NORDIC JOURNAL OF POLITICAL ECONOMY 1, 33-54 (2001) 4 Holler, M.J., Forming Coalitions and Measuring Voting Power, 30 POLITICAL STUDIES 2, 262-271 (1982) 5 A classic example in introductions to weighted voting systems. See Citroen, R., and Penn, M., Fair Division in Theory and Practice, available at: http://www.cs.wustl.edu/~cytron/fdiv/PDFs/8.pdf (accessed on 16 August 2016) 6 Prigge, S. and Kehren, S., Ownership Structure Metrics, INTERNATIONAL CORPORATE GOVERNANCE AFTER SARBANES-OXLEY, Paul Ali, Greg N. Gregoriou, eds., Wiley (2006) 7 Id. 8 Applying the principle of a priori probability in weighted voting systems. See Stenlund, H., and Lane, J, The Structure of Voting-Power Indices, 18 QUALITY AND QUANTITY 367-375 (1984) a coalition lose by dropping out of the coalition.9 𝑃2 cannot block a motion by 𝑃1 once the latter forms an alliance with 𝑃3. 𝑃2 also cannot make the grand coalition of all three stockholders lose by dropping out. In this context, 𝑃2 is in the same position as 𝑃3.
  There is no doubt, therefore, that 𝑃1 has a voting power disproportionately larger than 𝑃2, and we are only talking about a difference of 1% in voting rights between them. There is also no doubt that 𝑃2 has a voting power equivalent to that of 𝑃3, even though they have a seemingly substantial difference of 48% voting rights. This simple voting situation demonstrates that voting weight has a non-linear relationship with actual voting power.10 Clearly, “the largest shareholders are not always winners, nor are the smaller shareholders predestined losers.”11 A share of stock represents a bundle of stockholder rights, 12 which include economic rights and control rights.13 Economic rights pertain to pecuniary interests, such as the right to dividends, right to sell shares, and right to a portion of the net asset value upon dissolution and liquidation of the company.14 Control rights, on the other hand, allow stockholders to participate in making business decisions. 15 These are expressed in terms of voting rights in stockholder meetings, where one share of stock is usually equal to one vote.16 Increasing the number of shares (i.e. the shareholding size) leads to an increase in economic and control rights. In the case of economic rights, the increase is

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