Cross shareholding

What Is Cross Shareholding?

Cross shareholding is a practice in Corporate Finance where two or more companies own shares in each other, creating an intricate web of mutual ownership. This arrangement differs from a simple equity investment in that the ownership is reciprocal, often with strategic rather than purely financial objectives. Companies engaging in cross shareholding typically aim to solidify business relationships, prevent hostile takeover attempts, or enhance collaboration within a business group. This intertwining of equity stake can create stable partnerships but also introduces complexities in corporate governance.

History and Origin

The practice of cross shareholding has deep historical roots in various global economies, most notably in Japan and Germany. In post-World War II Japan, it became a cornerstone of the "keiretsu" system—large, interconnected business groups that replaced the pre-war "zaibatsu" conglomerates. These keiretsu utilized cross shareholding to foster long-term, stable relationships between companies and their financial institutions, aiding in the nation's economic reconstruction and shielding member firms from external market pressures and takeover bids. The Japan Exchange Group (JPX) has noted that cross-shareholdings became a distinctive characteristic of the Japanese stock market.

⁷Similarly, in Germany, the "Konzern" structure historically featured banks and industrial companies holding significant stakes in one another to create stable industrial groups. Over time, however, the economic and regulatory landscape shifted, leading to a gradual unwinding of extensive cross-shareholding arrangements in many countries. Reforms, particularly in Japan, driven by improved corporate governance standards, have encouraged companies to reassess the strategic rationale and economic efficiency of such holdings.

⁶## Key Takeaways

• Cross shareholding involves reciprocal ownership stakes between two or more companies.
• It is often employed for strategic reasons such as solidifying business alliances, deterring takeovers, or ensuring stable relationships.
• While promoting stability, cross shareholding can reduce market liquidity and potentially entrench existing management.
• Regulatory reforms and evolving governance standards, especially in Japan, have led to a decline in extensive cross-shareholding practices.
• Such arrangements can complicate financial analysis and transparency, impacting shareholder value.

Interpreting the Cross Shareholding

Interpreting cross shareholding requires understanding the motivations behind the arrangements and their impact on corporate control and accountability. When companies hold shares in each other, it can significantly dilute the actual voting power of external shareholders, as the cross-held shares might not be actively used to challenge management decisions. This can lead to a less transparent ownership structure, making it challenging to identify the ultimate controlling parties.

From a strategic perspective, extensive cross shareholding can indicate a strong, long-term strategic alliance aimed at mutual support, shared R&D, or integrated supply chains. However, it can also suggest a defensive posture, where companies use reciprocal holdings to create a bloc of "friendly" shareholders resistant to external influence or mergers and acquisitions. Analyzing the percentage of shares held and the stated purpose of these holdings, often disclosed in financial statements and corporate governance reports, is crucial for interpretation.

Hypothetical Example

Consider two hypothetical companies, Alpha Corp and Beta Inc., both publicly traded.

• Alpha Corp manufactures automotive components.
• Beta Inc. produces specialized machinery used in component manufacturing.

Alpha Corp holds 10% of Beta Inc.'s outstanding shares. In return, Beta Inc. holds 5% of Alpha Corp.'s outstanding shares. This represents a cross-shareholding arrangement.

Step-by-Step Walkthrough:

1. Initial Relationship: Alpha Corp is a significant customer for Beta Inc.'s machinery, and Beta Inc. relies on Alpha Corp for steady orders.
2. Strategic Investment: To solidify their business relationship and ensure a stable supply chain, Alpha Corp decides to acquire a 10% equity stake in Beta Inc. This provides Alpha Corp with influence over Beta Inc.'s strategic direction and helps secure its supply of crucial machinery.
3. Reciprocal Investment: To further strengthen the bond and as a gesture of mutual commitment, Beta Inc. invests 5% in Alpha Corp. This reciprocal investment signals a long-term partnership, potentially deterring competitors from attempting to acquire either company and disrupting their intertwined operations.
4. Impact on Control: While neither company achieves majority control over the other through this cross-shareholding, the mutual stakes grant each significant influence and a voice on the other's board of directors (depending on the specific agreements and voting rights attached to the shares). This mutual dependence can lead to coordinated decision-making that benefits both entities over the long term, potentially at the expense of external minority shareholders if not managed transparently.

Practical Applications

Cross shareholding, while less pervasive than in its historical peak, still finds application in certain contexts today.

One primary application is in forming and maintaining strategic alliances or corporate groups, particularly in markets where long-term relationships are highly valued. By holding stakes in each other, companies can signal commitment and align interests beyond simple contractual agreements. This can be seen in joint ventures or long-term supplier-customer relationships where a stable partnership is critical to both parties' success.

Another application is as a defensive mechanism against potential hostile takeover attempts. If a significant portion of a company's shares is held by a "friendly" partner, it becomes harder for an external bidder to accumulate enough shares to gain control. This entrenchment can provide stability for management but may also limit the market's ability to discipline underperforming companies. The Financial Services Agency (FSA) of Japan highlights ongoing corporate governance reforms aimed at addressing such structures, particularly the disclosure requirements for cross-shareholdings to promote transparency.

⁵Finally, cross shareholding can appear in complex consolidation scenarios, where a parent company and its subsidiary might hold shares in each other as part of a historical or structural arrangement, although pure parent-subsidiary relationships typically involve a clearer one-way control.

Limitations and Criticisms

Despite potential benefits such as stability and long-term cooperation, cross shareholding faces significant limitations and criticisms, largely centered on issues of transparency, market efficiency, and shareholder rights.

A major criticism is the potential for managerial entrenchment. When a company's shares are held by friendly corporate partners, the management can become insulated from market pressures and the demands of external shareholders. This can lead to complacency, reduced accountability, and a focus on group interests over maximizing shareholder value. Such structures can also limit the market for corporate control, making it difficult for poorly performing companies to be acquired and restructured.

⁴Furthermore, cross shareholding can reduce market liquidity and distort fair valuation. Shares held in reciprocal arrangements are often not actively traded, effectively reducing the free float of shares available on the market and making the true market capitalization less reflective of tradable value. This can also tie up capital that could otherwise be deployed more efficiently in an investment portfolio or for other corporate purposes. The OECD has noted that intra-industry common ownership, which includes cross-shareholding, can correlate negatively with firm-level productivity, potentially due to lower competition.

³Regulatory bodies, such as the SEC, have mechanisms to ensure disclosure of significant ownership, partly to address concerns about hidden control or lack of transparency that cross-holdings might introduce. For example, some regulations limit the voting rights of cross-held shares to prevent undue influence.

²## Cross Shareholding vs. Joint Venture

Cross shareholding and a joint venture are both mechanisms for inter-company cooperation, but they differ fundamentally in their primary purpose and structure.

While cross shareholding creates a web of interconnected ownership between established entities, a joint venture involves the creation of an entirely new entity by two or more parent companies to pursue a specific shared objective. The ownership in a joint venture is of the new entity itself, not typically reciprocal ownership of the parent companies involved.

FAQs

What is the main reason companies engage in cross shareholding?

Companies primarily engage in cross shareholding to forge and maintain strong, long-term strategic alliances, protect themselves from hostile takeovers by creating a network of friendly shareholders, and ensure stable business relationships.

Is cross shareholding common in all countries?

No, the prevalence of cross shareholding varies significantly by country. It was historically very common in Japan and Germany but is less prevalent in Anglo-American economies due to different corporate governance traditions and regulatory environments.

How does cross shareholding affect a company's financial statements?

Cross shareholding can complicate financial statements, particularly in terms of consolidation and ownership reporting. The value of cross-held shares is typically reported as an investment on the balance sheet, but the reciprocal nature means that both companies' balance sheets reflect these interlocking investments, which can obscure true economic ownership.

Can cross shareholding lead to conflicts of interest?

Yes, cross shareholding can lead to conflicts of interest, especially if the interests of the mutually-owning companies diverge from the interests of their independent shareholder rights. Decisions might be made to benefit the alliance rather than optimize returns for all shareholders, and the lack of external oversight can entrench management.

Has cross shareholding increased or decreased globally?

Globally, and particularly in developed economies like Japan, the trend has been towards a decrease in extensive cross shareholding. This decline is largely driven by corporate governance reforms pushing for greater transparency, accountability, and a focus on return on capital, as well as pressure from institutional investors.¹