Separation of Ownership and Control in the US and EU - Case Study Example

To what extent separation of ownership and control is an issue in the US and EU and its implication on the effectiveness of corporate governance mechanism and performance. Student Name Instructors Name Course University Date of Submission Separation of ownership and control in the US and EU and its implication on corporate governance mechanism and performance. Introduction: The leading and concerning problems with the organization’s structures were manager’s conflict of interests between shareholders and his own interests where the managers worked to increase their own private utilities rather company’s profits. Such circumstances often led mangers to act in their own interests like divert corporate resources for their own benefits, may not be willing to work hard or may employ corporate resources poorly and avoid risk taking with a play safe approach that wouldn’t benefit the company and would only benefit themselves. (MORCK. 2000) Concentrated Ownership: Ownership concentration refers to the giant block of shareholders and the number of shares held by them. In concentrated ownership a large shareholder owns atleast 5% of the total equity. Ownership concentration gives the large block of shareholders the advantage to dominate the decision making in the organization and influences effective measures of corporate governance to control management decisions. In general it is argued that large numbers of small shareholders are unable to monitor management’s decisions effectively and coordinate their actions. Researchers suggested that there are chances that high concentrated shareholding may increase management’s strategic decisions that add to shareholders’ value. (HOSKISSON & HOSKISSON. 2008) Separation of Ownership and Control: The separation of ownership and control has a long term implication on the corporate governance issues. The ownership structure of the organization is a basis of distribution of powers in an organization. Vigilance is required to ensure that managers do not have absolute powers to take the decisions within the organization. Separation of ownership and control is seen where complete ownership is diluted to minority control and the shareholding is distributed to such a great extent that no minority interest is powerful enough to dominate decision making in the organization and even the largest single interest represents a small shareholding in the company. A proxy committee is usually appointed by the management who nominates the directors, since the committee is appointed by the management usually they dictate this decision. Management being one of the stockholders has minority interest in the company but due to dilution of shares and widely distributed stocks no minority group dominates the decisions. Thus the separation of ownership and control which have no legal basis makes the shareholders in an insignificant position to exercise control and on the other hand the management who has control over the company have little share in the shareholding. (CLARKE. 2007) Conflict of Interests and Agency Issues: In order to overcome the problem of conflict of interests, many theorists suggested the solution related to separation of ownership and control. To reduce the increasing agency costs- that is the costs of monitoring the management whether they are working in the best interests of shareholders and there is no conflict of interest, one of the solutions suggested were to increase the numbers of shares held by the management so that the interests of management and shareholders can be aligned by manger’s increased interest in the company’s performance as it will affect their shareholding and returns there on too. Other suggested measures for managers are take over and the market for corporate control, arrangements for executive compensations, the managerial labour market, product market discipline, by establishing obligation for disclosure and enforcing fiduciary duties etc. (MORCK. 2000; CHONG & LOPEZ-DE-SILANES. 2007) If the divergence of interest between the shareholders and mangers are reduced, it reduces the agency costs of the company to a great extent too. However in the recent researches it became evident that as a more concentrated structure of ownership is seen it isn’t necessary that it will reduce the agency costs. The concentrated ownership structure gives rise to lowering to private agency costs which can on the other hand increase the likelihood managerial self-indulgence. Private costs of managerial diversion comprise of the opportunity costs related to suboptimal use of resources by the manager, costs that increase with managerial ownership of firm, costs that arise due to disciplinary action for suboptimal use of resources. The disciplinary costs associated with suboptimal use of resources are likely to decrease when ownership increases due to increase in control of shareholders as the majority shareholders are likely to exert greater control over the decisions of the company converting their plans into action. Another point to be mentioned is that with the increase in ownership concentration the private cost of managerial self indulgence decreases, increased concentration in ownership structure may give rise to problems of agency between dominant and minority shareholders. (MORCK. 2000) CORPORATE OWNERSHIP AND GOVERNANCE SYSTEM IN THE USA: Conflict of Interests and Agency Issues in USA: It is seen that a weak owner leads to a strong manager where agency problem arises due to entrenched managers and dispersed shareholding. Conflict of interests is an important aspect that corporate governance addresses to. The separation of ownership that is the shareholders and control that is the management gives rise to agency issues. This separation is usually seen in firms where the shareholding is dispersed. The best and ideal situation in the scenario is when the manager’s interest is aligned with the shareholders interests and they work for shareholders interests. Agency conflicts arise when the ideal situation isn’t achieved and the managers prefer their interest over shareholder’s interest. Agent principal relationship is governed by the agency costs that the principal incurs to align the interest of his agent with that of his own. Corporate governance deals with the minimization of the conflict of interests in the organization. Proper incentives linkage to the remuneration can help prevent the conflict of interests and align the interests of managers and shareholders. Stock option plans can be a good way to make interests common because the managers become the shareholders and put in the efforts to increase the wealth of the shareholders. Another option could be the board of directors, as they have the power to dictate decisions in the organization and control the company, they can serve as a solution to align the interest of both. Stock options have prove to be quite efficient, however it the linked remunerations to the shareholders interest ca also induce the managers to act dishonestly and adopt a short term behavior because of quarterly disclosures and market situations. A third solution is the effective external market which forces to discipline the firms and their management. In some cases takeovers also serve as a mechanism but usually they are undertaken for empire building and tax minimization. (ALI & GREGORIOU. 2006; BERGHE, ELST, CARCHON & LEVRAU. 2002) Corporate Governance Structure in USA Companies: The existing statutory framework in the USA is very different from that one operated in UK. The main difference is seen as the company law exists on the state level and not on federal level. Mostly US companies choose to incorporate in Delaware, with no legal framework or control and gives weak shareholders rights protections. In US, Security Exchange Commission (SEC) exists to give protection to the shareholders, investors, maintenance of efficient markets and facilitation of capital formation. The SEC’s main function is to make and implement regulations and legislations and make it pass by the president, which is then subject to enforcement with which all the companies operating in US must comply. There is no Federal companies Act in the USA and 41% of the companies have been registered in Delaware. Since the governance is based on state laws, despite of the differences the common practice is that the Board of directors will be elected by the shareholders and will be accountable to the shareholders for all affairs of the company. (DAS. 2010; CALDER. 2008) The company’s structure and governance operated in US is usually looked after by the CEO who run all affairs of the company and dominates the agenda, flow of information to the directors in the company, heads the meetings and acts as a company’s representative to the external parties. The chairman of the company is elected by the other directors on the board. In 75% of the companies operated in US this role is played by the same person who is the CEO making the position extremely powerful. Regarding CEOs compensation and remuneration packages a board committee comprising of non-executive directors should decide his remuneration, the basic feature expected in his remuneration package will be the direct linkage with the performance of the company so that no conflict of interest arises. In most US companies the Board is single tier where the shareholders elect their directors in a democratic way. The board is made up of executive and non-executive independent directors. In order to be incorporated as a listed company on NYSE, the companies are required to have an audit committee that comprises of non-executive directors. On the other hand the board should be made up of three committees namely audit committee, compensation committee and nomination committee. These committees should be made up of non executive directors and should be involved in independent functions. The audit committee’s role is to monitor the activities of internal and external audit function. The compensation committee is designated to independently set remunerations for the executive management so that no conflict of interests arises and the management is motivated to work in shareholder’s best interest. The nomination committee’s role is to appoint the non-executive directors and to so succession planning for the CEO of the company, this role needs to be independent in order to avoid any overlapping of interests. Thus the code of corporate governance recommends a board’s structure which on every step protects the rights of the shareholders and keeps an independent check on the management of the company to ensure that they work for the best interests of their shareholders and provides a basis that helps reducing the agency costs for the shareholders. (DAS. 2010) In US the corporate governance thinking and approaches have focused on the separation of ownership and control and the creation of agency costs that the shareholders might have incur in order to make the management work in the best interest of the shareholders and the financial incentives offered to maximize the value for shareholders. As shareholders are the real owners and risk bearers of the company they expect the management to take decisions for the company on their behalf, despite of all the rights given to them relating to the election of directors they might often feel their ideas are not turned into actions by the management. In order to reduce the agency costs the corporate governance in US focuses on the reduction of the agency cost by providing a transparent corporate structure, extensive financial and other disclosures, encouraging institutional shareholders and aligning the interest of shareholders with that of the executive management. (KEASEY, THOMPSON & WRIGHT. 2005) CORPORATE OWNERSHIP AND GOVERNANCE SYSTEM IN EU COUNTRIES: Conflict of Interests and Agency Issues in EU: In contrast to US the corporate governance issues in European countries are different. In these countries there are few listed companies which shares are widely held by the shareholders. The majority of the shares in these countries are owned by a single individual or family who is a dominant shareholder in stock exchanges firm. A controlling shareholder is generally refers to a family or an individual who owns over 20% of the voting rights in a company. It is often seen that a controlling shareholder uses pyramidal ownership, dual classes of shares and shareholder agreements to exercise control without owning large cash flow rights. Unlike US, the approach of corporate governance changes in such a structure mainly due to two reasons; firstly the dominant shareholders due to their extensive control have management at their discretion and secondly the concentrated ownership can create agency problems due to non alignment of interests of the minority shareholders and the controlling shareholders. The dispersed ownership structure is rarely seen in the European countries. One way of controlling shareholding in Europe is by pyramidal ownership in which a controlling shareholder exercises his control over one company through controlling at least one other listed company. One of the factors of such an ownership structure seen in the EU countries is because the shareholding of companies in EU is concentrated in the hands of small number of wealthy individuals and families. (BEBCHUK, KRAAKMAN & TRIANTIS. 1998; ENRIQUES & VOLPIN. 2007) In a concentrated ownership the conflict of interest doesn’t arise between shareholders and the managers, instead the conflict of interest arises between the minority shareholding and the majority controlling shareholding. The concentrated ownership firms are since usually controlled by one family or an individual, they tend to exercise control rights often exceeding their cash flow rights. Such an ownership structure and the exercise of control greatly influence the corporate governance approach and practices and affect the firm’s economic value. Morck and Yeung suggested in one of their theories that a direct relation is seen between the level of control exercised by the family or individual with the corruption and compliance with laws etc. (MALLIN. 2006; ENRIQUES & VOLPIN. 2007) Corporate Governance Structure in EU Companies: It is widely accepted that family or single individually controlled firms are better managed and controlled than widely dispersed ownership firms, however it isn’t accepted that these are better governed. Family owned businesses are better taken care of and have a better control over the management of the firm as compared to dispersed shareholding firms as the owners of the firms are highly interested in the success of the company in the long run. However the conflict of interest arises when these large shareholders abuses their power and use the resources for their own advantage and the minority shareholders do not have a say. Such a situation is difficult to handle as it couldn’t be controlled by replacing management or shareholders easily. On the other hand the power of control that the controlling shareholder posses makes the value of the company different for him as compared to the minority shareholder because of the disposable of company’s resources at his end, this difference in the value is known as private benefits of control. This affects the company’s value for both the shareholders which are measurable when shares transfers and voting premiums are measured. (ENRIQUES & VOLPIN. 2007) Concentrated ownership structure with dominant shareholders has the power to exploit the minority shareholders and investors in the company. In order to reduce this power measures have been adopted to give protection to these shareholders in different ways. The internal governance mechanism needs to be strengthening in such organizations. The board of directors is the shareholders representatives that act in their interest. Problem arises when these are influenced by the management or majority shareholders who elected them, in such cases they are able to provide no protection to the minority shareholders. For the purpose the corporate governance has regulated greater independence for the directors and defining their duties and powers clearly in the matters like remuneration setting, appointment of new director, disclosure for related party transactions and monitoring of information flows etc may help the minority shareholders to protect their rights against the concentrated ownership structure. Secondly, the empowerment given to the shareholders can also help minority shareholders to protect their interest. This empowerment can be done by giving the rights to the shareholders to sue the company and its directors. This can also be done by giving the shareholders a say in the corporate governance matters of the company, which can be done by extending the corporate governance issues to be decided at the shareholders meetings, mandating requirements of super-majority, minority’s representation on the board, limiting deviation from one share one vote etc. Thirdly access to information is crucial for the shareholders to make decisions and to know whether they are being derived of their rights or not, for the purpose an extensive regime of disclosure may help to solve the agency problems to a great level. Disclosures can also help in preventing frauds and huge corporate failures to a large extent. (ENRIQUES & VOLPIN. 2007) Implications of Ownership Structure on the Effectiveness of Governance and the Performance of Corporations: The ownership structure of the company can have a great impact on company’s performance and provides the basis for corporate governance in a company. It is widely accepted by many theorists that concentrated ownership structured companies tend to have higher returns and outperforms the manager-controlled firms. Concentrated ownership provides greater monitoring opportunities and performs well. An added disadvantage to the structure is that the controlling shareholder might use the firm’s resources for his own private benefits at the expense of minority shareholders. Since the principal agent model suggest that the managers are likely to work less in the interest of the shareholders if they are not strictly monitored by the shareholders. Therefore if it is generally seen that concentrated ownership firms perform better than the managerial controlled firms which could be because of the reason that these firms are better monitored. Large owners will monitor the management closely as they have more power to exercise over the managers which can make the managers work for the best interests of the shareholders. On the other hand smaller shareholders have low incentive and power to monitor the managers because the gains and monitoring controls are shared by the other investors. With the ownership share increase the added risk or owner “entrenchment” due to private benefits of control, the separation between ownership and management become vague. There is a positive relationship seen between ownership concentration and company’s performance. (ONGORE. 2011) Conclusion: The corporate governance structure and its implication vary from country to country around the world. Besides many factors affecting the structure like local regulations and law, a firm’s internal factor such as the ownership structure plays a great role in determining the application of corporate governance and the solution to possible agency issues that could arise from the ownership structure determines the power that could be exercised by the principal- the shareholders over the agents- the management and to the extent this power could be exercised, which lays the basis of corporate governance codes adopted in a particular country to protect the rights of the shareholders and for the better overall performance of the company. Bibliography ONGORE V.O. (2011). The relationship between ownership structure and firm performance: An empirical analysis of listed companies in Kenya. African Journal of Business Management. 5, 2120-2128. MALLIN, C. A. (2006). Handbook on international corporate governance: country analyses. Cheltenham, UK, Edward Elgar. BEBCHUK, L. A., KRAAKMAN, R. 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MORCK, R. (2000). Concentrated corporate ownership. Chicago, University of Chicago Press. CLARKE, T. (2007). International corporate governance: a comparative approach. London, Routledge. Read More