Carl Fuerstenberg, one of the most prominent German bankers of his generation, famously said more than a century ago that shareholders are irrational and impertinent. They are irrational, he said, because they entrust their money to people they don’t control, and impertinent because they expect to receive dividends as a reward for their foolishness.
This dynamic lies at the very heart of the corporate governance challenges faced by many companies and is especially acute in Latin America.
It’s no secret that ownership in many Latin American firms is concentrated in the hands of a small number of shareholders, often with just one controlling owner. As a result, these owners or company management can take advantage of minority shareholders. Indeed, the very perception of this risk can discourage foreign investment in Latin American firms, presenting a critical barrier to local capital market development and, ultimately, economic growth.
All over the world, the presence of active independent directors has been one of the most common and cost-effective means to support minority shareholders because one of their key functions is to act as a watchdog, ensuring the interests of all shareholders are considered.
Independent directors, a valuable, but underutilized, asset
But there is still a long way to go in ensuring the most effective implementation of this vital measure. The mere presence of an independent director on the board is not enough. Appointing someone as an independent board member, just because he or she is respected, well-known and experienced, as is common practice in many Latin American firms, does not go far enough.
The independent board member, critically, must also be ready, willing, and able to challenge and ask the difficult questions of other board members and the company management. If he or she doesn’t, who will? Too often, an independent director may satisfy the local legal requirement for ’independence,” but does not act in a genuinely removed and objective manner.
This, in turn, could make these minority investors more willing to invest in the region’s listed firms and bring greater dynamism and liquidity to Latin America’s capital markets, fueling private sector growth and generate new jobs.
Majority then minority
Independent directors are still directors. They are usually appointed by the majority of shareholders at a general meeting. Frequently, they are appointed by the very controlling shareholder against which the minority investor wishes to be protected. Confidence being everything in capital markets, one could argue that this traditional system of appointment does little to calm the potential fears of minority investors and could end up limiting firms’ ability to access finance.
There are options that would inspire greater investor confidence, while still maintaining the privileged position of the controlling shareholder. One of them—which Aurelio Gurrea Martinez, Executive Director of the Ibero-American Institute for Law and Finance, and I have presented—is that the appointment of independent directors should be based on two separate levels of approval:
- A majority vote among all the shareholders
- A favorable vote from more than half of the minority shareholders.
Minority investors would then be able to—at least initially—block the candidate proposed by the controlling shareholder. This would encourage the controlling shareholder to think carefully about who it plans to nominate in the first place, creating the conditions for dialog between shareholder groups. However, to prevent potential deadlock and dispute and to manage potential concerns of the controlling owner, this requirement would only apply at the first round of voting. In the second round, if it gets there, the candidate could be approved by the majority shareholders, plus a specified minimum, say 10-15 percent of minority shareholders.
While some companies and shareholders may worry that this approach could disempower the majority owner, and even disincentivize companies from listing, the reality is that a truly independent and objective board member, a real outsider, will also benefit the majority shareholder by enhancing the quality of decision-making at the board level, and by the increased confidence on the part of potential investors. And the controlling shareholder would still be able to continue pursuing its long-term business strategy.
In this way, more firms in Latin America may find they are better able to access foreign capital, leading to deeper capital markets that can support the promotion of economic growth in the region. Carl Fuerstenberg may then be proven wrong, and shareholders may not be seen as quite so irrational after all.