Expert Opinion (#11 November 2014)

Shareholders in Name Only Echoes of Soviet-style Mass Privatization

by Illya O. Tkachuk

Minority shareholders have always had a unique status in Ukraine. Besides those individuals who invested their money in companies and bought their shares, there are many minority shareholders who obtained shares during the privatization and have never really thought of themselves as investors and, therefore, neglected their right to participate in the companys life.

It is needless to say that this situation was caused by mass privatization which was so popular in the 1990s. At that time, most of the people did not realize what to do with shares of companies as private ownership was to a large extent an alien idea in post-Soviet society.

As a result, a separate class of shareholders was created in Ukraine people who have never viewed themselves as retail investors or shareholders. These are formal shareholders, who have never participated in the companys general meetings of shareholders, have never opened securities accounts in their names, or, even worse, lost their shares and forgot about them. These shareholders are often called dead souls as the company knows about their existence only from the shareholders register.

While the phenomenon may not be Ukrainian by design, in Ukraine, such minority shareholders usually exceeded 100 in number for any given company which is the maximum number of shareholders established by the On Joint Stock Companies Act.1 This means that many private companies may not exist as such and must transform themselves into public joint stock companies, which creates a tier of artificial public companies which are obliged to comply with burdensome regulatory requirements and to bear additional costs attributed to public status.

After adoption of On Joint Stock Companies Act, many joint stock companies and their majority shareholders tried to find dead souls and buy their shares in order not to have to become a public company. However, only a few of them managed to do this. In fact, many dead souls changed their residential addresses, contact details, lost their share certificates or even died without transferring their shares to successors.

This article aims to draw attention to main issues relating to these shareholders, their status and chances to become real private investors or disappear under the pressure of majority shareholders to squeeze them out.

Basic elements

Regardless of whether a minority shareholder actively participates in the life of the company or humbly waits for the dividend, he should have a possibility to sell his shares to other shareholders or third parties in case he disagrees with the companys activity. This is very important for attracting new minority shareholders as they should be made feel secure.

In case minority shareholders are able to organize themselves, they can seek for conclusion of a shareholders agreement with the majority shareholder or even ask the company to spin-off a part of its assets in exchange for the shares of the minority shareholders.

Therefore, minority shareholders may become retail investors who can actively participate in the companys activity or sell their stakes in the company at their discretion.

This status of minority shareholders is somehow compensated with the right of the majority shareholder to force the sale of the minority shareholders shares (squeeze-out).

Such a balance of interests enables the creation of a favorable environment for attracting minority shareholders without infringement of the interests of majority shareholders.

Ukrainian reality

Ukraine has thousands of minority shareholders whose status is poorly regulated and who are limited in remedies for influencing a companys activity or to divest of their shareholding. Moreover, there is no mechanism for the majority shareholder or the company itself to get rid of dead souls in consideration of adequate compensation.

Looking back at the evolution of legislation on joint stock companies it can concluded that the minority shareholders were even somehow forced to be shareholders.

Indeed, many joint stock companies with thousands of shareholders went through the adaptation to the On Joint Stock Companies Act and dematerialization of shares. However, most minority shareholders have never participated in these processes. As a result, numerous people who become shareholders during privatization have no real link today to the companys activity or even securities accounts opened by joint stock companies in their names. The more EU standards of regulation of joint stock companies we implement the fewer ties we keep to dead souls as formal shareholders.

It may sound harsh, but the historical background of dead souls in Ukraine prevents us from adapting our legislation to EU standards. Today, the government is considering the possibility of further implementation of such effective mechanisms as squeeze-out and sell-out through the prism of the social aspect of minority shareholders, who might be stripped of their shares.

Stripping of ownership right

The main argument used by defenders of existing dead souls in Ukraine is the inviolability of the ownership rights to shares. Following this logic the squeeze-out amounts to stripping of the ownership right to shares of minority shareholders which brings benefits only to big corporations.

Many European countries have found an answer to this argument in favor of effective operation of the company. For example, in 1997 the Court of Cassation of France considered the case of minority shareholders who were squeezed-out from Société Générale,2 a big French bank. Notwithstanding the inviolability of ownership rights, the Court came to a conclusion that the squeeze-out of minority shareholders was in favor of the company and, consequently, to the countrys economy.

Therefore, the stripping of the ownership right to shares can, in principle, be used in certain cases subject to adequate compensation.

Possible consequences of ignoring the problem

Further games with protection of minority shareholders rights may lead to even more unfavorable results. The sharp minds of Ukrainian top managers of joint stock companies have already tested the reorganization of joint stock companies into limited (additional) liability companies.

As you well know, the laws of Ukraine grant much fewer rights to minority participants of limited liability or additional liability companies compared with minority shareholders of joint stock companies. Even more, the On Business Companies Act 3 provides for a possibility for expulsion of minority participants in case they prevent the company from achievement of its goals.

As you see the law gives priority to the companys interests rather than to the right of ownership of minority participants. Such difference in approaches between a limited (additional) liability company and a joint stock company seems to be rather unexplainable assuming the similarity of forms of the company.

Would the rights of minority shareholders be restricted in case of reorganization of a joint stock company into a limited (additional) liability company? Most probably yes, as the form of a limited (additional) liability company in principle provides for fewer rights of minority participants.

Would the minority shareholders be able to get better compensation for their participation in the limited (additional) liability company in case of expulsion? This is extremely doubtful, as limited (additional) liability companies are less regulated and, therefore, there is room for manipulation with the amount of the compensation.

Therefore, using the more complicated process of reorganization, a joint stock company can still be able to strip minority shareholders of their shares. However, in the latter case, it is very unlikely that minority shareholders will be able to get an appropriate compensation for their shares.

Summary

Unlike many European countries, a section of minority shareholders in Ukraine named dead souls became an awkward point rather than a strong source of investment. Further smart steps should be taken shortly in order to prevent the ultimate cheapening of the status of all minority shareholders in Ukraine.

It is apparent that the social effect of implementation of the squeeze-out, sell-out and other mechanisms for resolution of deadlock situations between the company, its majority and minority shareholders should be carefully considered.

In this regard, it might be reasonable to distinguish, first, between the dead souls and minority shareholders who participate in the management of the company on regular basis. For example, the defining point could be participation in the general meeting of participants for the last three years or opening of a securities account by the minority shareholder in his name.

Another possibility could be granting joint stock companies with the right to buy back the shares of minority shareholders subject to a trial period of one year. During this trial period, a minority shareholder will have a call-option right for the same number of shares and at the same price. In this case, those minority shareholders who failed to exercise their call-option right will be considered to have waived the right of ownership in accordance with the logic of the Civil Code of Ukraine.4

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