Loyalty shares

Definition

Strictly speaking, loyalty shares are new shares or holdings that the company grants to reward certain partners. The expression loyalty shares can also be used to describe all kinds of loyalty benefits. These benefits see below, are the improved dividend, the double vote and the loyalty warrants.

Favoured partners are those who stay in the company for a period of time longer than two years. However, the exact period is discretionary. This period is established because it marks the end of the so-called short term. Therefore, partners with a medium or long term view are rewarded. Their permanence implies that they have not decided to sell their initial shares during the established period. Such period will be established either by legal imperative or by the company’s statute. The shares or holdings given to such partners may be either released or held as treasury stock. The first are shares or holdings due to a capital increase financed by reserves or profits. The other option is shares that the company itself owned, as treasury stock. This type of shares or holdings may be granted to shareholders by a statutory agreement. Thus, for example, it could be agreed that if there were script dividends the loyal shareholder would receive more shares than another. A premium in shares would then be granted in comparison to the rest of the partners.

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Problem solved by them: corporate short-termism

Today there is a problem, and that is that those partners who have short term objectives can infect the whole. These partners will try to seek short-term returns from their investment in the company. In this way, economic and financial decisions will be forced to be made with a two-year maturity. This shareholders´ decision will put pressure on managers which its decision-making process will be disturbed.

This pressure can be detrimental to the survival of the company because it forgets about the results in the long term. Thus, it is a problem that affects listed and unlisted companies alike. Nowadays loyalty shares are being introduced only in listed companies. However, this problem cannot only be between majority or controlling shareholders and minority shareholders. It can also arise between managers and partners, or between partners and creditors. For example, minority shareholders are more likely to have a speculative view, which increases their concern about short-term profits. This may be the case with investment funds or other entities considered to be institutional investors. Examples are “vulture funds” or activist hedge funds. With these loyalty shares, there is a duality to be chosen by the partners. They may not transfer their shares and lose liquidity or they may transfer them freely and obtain liquidity. As the loyal ones are those who lose liquidity they are given these new shares to compensate them.

Arguments for and against

As will be seen later, in Spain such loyalty actions are not yet included in the regulations. This makes the debate on them open. Thus, the experts have arguments for and against the use of these loyalty actions in Spain. They focus especially on the issue of listed companies.

– In favour

Those in favour argue that these actions will enable longer-term corporate governance policies to be implemented. Thus, they will also increase the transparency of the company’s corporate governance. Also they will increase the number of companies with good long-term prospects listed on the stock exchange. This is because sometimes economically stable companies do not go public out of fear. Such fear is none other than losing control over their company. Likewise, as mentioned above, the short-term conflict could be between the managers and shareholders. When compensating the loyalty of the shareholders, the loyalty of the managers will be indirectly increased. This results from shareholders putting pressure on managers to create long term policies and so changing its short-tem view.

– Against

Opponents believe that there is a lack of short-termism because listed companies are hardly influenced by minority shareholders. Furthermore, the principle of equal treatment is against the use of these loyalty shares. This principle is regulated in Article 320 of the Corporate Enterprise Act (CEA). This provides for proportional effects for shareholders in the event of a capital reduction according to the nominal value of the shares. However, there is an exception that will allow using loyalty shares in that article. It establishes that the privileges granted both legislatively and statutorily to certain shares must be respected.

Another disadvantage is that, under their definition, they favour permanence. And as a result they may favour not only the minority shareholder to change his mind. The majority partner will also increase its power. This is potentially detrimental to the minority shareholders, as the controlling partners can exert opportunistic pressure. For example by agreeing on certain transactions, etc. that only benefit their majority. Because of these consequences some believe that this will discourage foreign investors from investing in Spanish companies.

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Distribution of dividends

Until now, the distribution of dividends depended on a general meeting without any limitation. Limitations apply to the reform of article 348 LSC. When is the obligation to distribute dividends? What happens if that obligation is breached?

Other loyalty actions

The other possibilities that are contemplated to favor the partners in the long term are:

• The improved dividend: by this technique the loyal shareholder will receive a higher dividend than the short term shareholder. This improvement will be an increase percentage of what he or she currently receives. And in addition, to avoid an excessive disproportion, there will be a limit to this improvement. In France, for example, this limit is set at 10%. Although this dividend is not considered as such in the Spanish legislation, it could be approved by analogy. The analogy of Article 95 CEA which allows for a preference in the distribution of social benefits.
• The double vote: it establishes a reinforced decision-making power for the shareholder who has been loyal in terms of permanence. In Spain, the current regulations expressly prohibit this in Article 96 CEA for public limited companies. It establishes that there must be a proportion between the nominal value of the shares and the right to vote.
• Loyalty warrants or options: these are contracts derived from options on company shares or others from third parties. This third party may be another company of the same group of entities. Thus, the beneficiary of this purchase right may acquire old or new shares at a price agreed in advance. All this at the expiration date of the option. The purchase of old shares refers to those that the company itself holds as treasury stock. In this case there would also be a limitation on the number of shares to be awarded. This is similar to the provisions of article 219 CEA on remuneration with share options for directors.

European regulation

On February 26^th 2014 the European Parliament issued resolution 2013/2175. It recommended that the Commission should include various loyalty incentives in its legislation on listed companies. These incentives are enhanced dividends, loyalty shares and double voting. Therefore, Parliament states that European Union should promote sustainable or long-term capitalism. The Parliament therefore proposed that these incentives be incorporated into the reform of Directive 2007/36/EC. However, such benefits have not been included at present in its amendment by Directive 2017/828. Thus, there is a lack of harmonisation in Europe on this concept. There are laws, such as the French one or Italian laws, that do expressly include them in their regulations. On the other hand, there are countries such as Spain where they are not yet included in the CEA. However, this does not mean that it will not be harmonised in the near future. As the European legislator has wanted to include these advantages for six years.

Conclusions

Loyalty shares are a form of positive discrimination against loyal partners. These are those who remain in the company for more than two years. In this way, the problem of short-termism is avoided. This problem implies a risk in terms of the long-term sustainability of a firm. This implies a initial risk or harm to the partner who remains in the company. Thus, these actions are intended to correct this problem.