A carrot and stick approach to discipline to discipline self-dealing by controlling shareholders

Abstract

This paper presents an innovative approach to the regulation of self-dealing by controlling shareholders. Our proposal is grounded on the identification -through the lenses of economic analysis- of the shortcomings inherent in the existing legal solutions, ranging from the absolute prohibition of self-dealing, to the prohibition of voting with conflicting interests, or to the imposition of fairness duties to the majority shareholders. We present our proposal for an alternative regulation, based on the use of options, in a two period game between the controlling shareholder, who is able to pursue an identifi ed selfdealing opportunity, and the minority shareholders, who desire to determine the merits of this business opportunity. We show that our regulatory proposal is more efficient than existing regulation in the circumstances of our model. The enhanced efficiency of our proposed regime is mainly due to two novel characteristics of our approach. First, it takes advantage of the repeated nature of the relationship between the controller and the corporation. In particular, our proposal implies that obtaining future private benefits requires limiting current private benefits. By doing this we can provide at no cost an additional incentive that aligns the interest of the controller with that of the small shareholders. Second, we allow the controller to determine the level of private benefits that he will extract in each period and apply an automatic penalty for excessive levels. By doing this we eliminate both the costs of collective action, and the costs of legal action that critically affect the outcome of the existing regulatory regimes