Shareholder Activism: Effects on Corporate Governance and Accountability - Case Study Example

Shareholder Activism: Effects on Corporate Governance and Accountability By Introduction Shareholders have become increasingly aware of their roles in effective corporate governance today. Concepts like shareholder activism gained widespread popularity in the recent years particularly after the detection of accounting fraud that led to the failure of the corporate giant Enron. Governments and other responsible corporate bodies also support a reasonable degree of shareholder involvement in corporate governance so as to make board of directors and top executives accountable for their actions and to increase the value of shareholders. It is identified that a modest level of shareholder involvement in corporate governance is good to enhance the competitiveness of the organisation and to guarantee an improved rate of return on investments. However, when shareholder engagement is extended to a level where board of directors and executives would find it difficult to enjoy operational freedom and autonomy of decision making, it can negatively affect the corporate governance of the organisation. This paper will critically evaluate the role of the shareholder in corporate governance and also the influence of shareholder activism on corporate governance. The paper will also focus on the role of the shareholder in effective corporate governance in different countries such as UK, US, and Australia. Shareholder Activism The term ‘shareholder activist’ may refer to any shareholder of a publicly-traded organisation who uses his/her rights and privileges to achieve a social change and to promote the betterment of the business. Shareholder activists primarily work on issues related to investments and the environment in politically and ecologically sensitive parts of the world, and they also give particular focus to workers’ rights (Glac, 2010). A shareholder activist may sometimes be an investor who holds the belief that the company management is operating inappropriately and who attempts to gain control over the company and replace the existing management team for the good of the shareholders. Hence, the concept of shareholder activism simply reflects the way in which shareholders can influence the organisational management or organisational behaviour by exercising their ownership rights. According to Sjostrom, shareholder activism is defined as the “use of ownership position to actively influence company policy and practice” (as cited in Davila, 2012, p.50). The concept of shareholder activism is gaining wider popularity because some shareholders want to actively take part in the corporate decision making process (Ibid). Although it is corporate or institutional investors who usually engage in shareholder activism, other stakeholder groups such as employees and the general public are also benefitted when shareholders use their ownership rights to promote CSR and corporate governance. It is important to note that although shareholders are not given the power to run a company, they can influence the board of directors and the management in several ways, ranging from dialogue with the management to formal proposals that are voted on annual company meetings. Role of Shareholders in Corporate Governance While analyzing the role of modern shareholders in corporate governance, it is identified that they tend to hold great control over corporate governance matters because they are the real beneficiaries of business outcomes. One of the current crucial roles of shareholders worldwide is to assess the fairness of executive compensation and to stimulate the top management morale (Krause, et al 2013). The Enron failure, one of the largest corporate scandals in the world history, occurred when the firm’s top executives used fraudulent accounting practices to take advantages of executive compensation plans like bonuses and stock options. Hence, today shareholders pay attention to the corporation’s executive compensation policies in order to make certain that executives are not paid unreasonably. In most cases, the board of directors tends to pay the top executives like CEO unreasonably high with intent to keep them loyal to the organisation in the long term. However, this approach greatly hurts the interests of shareholders because actually the additional amount paid to top executives belongs to them. Therefore, today many countries require the board of directors to obtain the prior approval of shareholders for paying executives greater than industry standards. Indisputably, shareholders play a noticeable role in corporate governance by using their voting rights effectively. Shareholders can use their voting rights to elect directors and to take sound strategic decisions on proposals for fundamental structural changes affecting the long-term sustainability of the company such as merger and acquisitions or liquidation (Gregoriou & Renneboog, 2007, p.135). Therefore, it is possible for shareholders to reject a merger/acquisition proposal that seems to be harmful to the firm’s market competitiveness or to support a proposal that is potential enough to increase the business turnover. Shareholders are even allowed to use the proxy voting facility (the practice of delegating voting powers by an individual to other members of the same body to vote on behalf of him/her in his/her absence) to play their part in the corporate governance (Little, 2008, p.156). Similarly, shareholders have the right to inspect the corporate books and records so as to assess the current state of affairs of the company (Eisenhofer & Barry, 2005, p. 6.01). In the case of public companies, this is not a big deal because today public companies are required to publish their financial reports at the end of fiscal periods. However, this provision is really beneficial for private companies that do not generally make their financial records public. By inspecting the books and records of the company, shareholders can determine whether the books of accounts are kept adhering to the accepted standards and procedures. In addition, shareholders may capitalize on the shareholders rights plan to influence the firm’s operations in relation to corporate governance. The shareholder rights plan describes the rights of a shareholder in a particular company (Branson et al, 2012, p.na). A company’s shareholder rights plan is usually provided in the investor relations section of its official website. Shareholders may also obtain the details of this plan by contacting the company directly. Keeping well informed of the provisions of the shareholder rights plan, shareholders can ensure that the board of directors takes efforts to protect the shareholder interests in the organisation adequately. The growing degree of shareholder involvement in corporate governance has led to the expulsion of many company executives who were acting against the common good of the organisation. To illustrate, Chesapeake Energy (an American oil and natural gas company), with the strength of its shareholders, made some crucial reforms to its corporate governance and forced its controversial CEO Aubrey McClendon to retire (The Economist, Mar 9th 2013). Although this type of shareholder participation is effective to promote flawless corporate governance, sometimes unnecessary shareholder involvement becomes an operational constraint to the organisational management. It is observed that many of the shareholders activists emphasise only on the short-term financial gains of the company and therefore the top management is often forced to compromise the firm’s long term business sustainability in an effort to protect the interests those shareholders (Correia, 2014). Shareholder Roles in UK The UK Corporate Governance Code was formed with intent improve the operations of publicly traded companies in UK, and it describes the role of shareholders in the country’s corporate governance practices. This Code encourages shareholders to engage in the activities of the companies in which they invest (FRC, 2010). In UK, shareholders play a vital role in scrutinising and ensuring that their companies operate in compliance with established laws and practices and are led in the right direction. As a result, companies are forced to promote transparency and accountability of their operations and this in turn would influence their growth positively. As the UK Corporate Governance Code suggests a strong relationship between the company and its shareholders, the potential shareholders obtain the opportunity to engage in dialogue with the board of directors on corporate governance matters (Financial Reporting Council, 2014, p.3). Since the shareholders enjoy voting rights and the right to information as per the company law and the Listing rules, they are able to influence the board decisions to a great extent and enhance managerial accountability. In addition, shareholders are encouraged to assess whether the company’s governance efforts are effective in supporting the sustainable development and long-term success of the organisation. In order to promote better corporate governance, shareholders are given extensive voting rights in the UK. They play a significant role in the appointment and dismissal of individual directors and are authorised to call a general meeting of the company in certain circumstances. Shareholders enjoy the power of an advisory vote on directors’ remuneration and this provision greatly benefits shareholders to ensure that directors and other top executives do not take unfair advantages of their positions. In addition, the powerful shareholder rights with respect to executive remuneration can promote formal and transparent procedures for determining executive payments. Since all appointments and re-appointments of directors should be ratified by shareholders, the board of directors cannot include members in the board according to their own interests. In short, the strong involvement of shareholders in company’s managerial affairs adds value to corporate governance in the UK context. Shareholder Roles in US The Sarbanes-Oxley Act or Sarbox is a US federal law enforced with intent to set enhanced standards for publicly-traded companies in the United States. As Greenspan (May 15, 2005) points out, the Sarbox requires the corporate managers to work on behalf of shareholders and listen to them so as to get informed of their interests and long-term goals. In response to a number of popular corporate scandals and a series of bank failures occurred in the United States last decade, the US shareholders are keen to engage actively in corporate affairs and to ensure that there is improved operational transparency and managerial accountability in companies in which they hold an investment interest. In US, shareholders widely exercise their voting rights to take sound decisions regarding issues that can have a potential impact on the corporation as a whole (USLegal, n.d.). In certain crucial circumstances, shareholders inspect the books and records of the corporation to make sure that the financial statements published express a true and fair view of the state of affairs of the organisation (Ibid). In addition, shareholder may sue the corporation for the misconducts of its directors and executives in order to protect their interests in the firm. As shareholders are authorised to nominate board candidates, they can play a notable role in the election of potential board members who will be capable of improving the overall organisational performance. In total, shareholders in US corporations have relatively more responsible roles to play in enhancing the corporate governance practices in the country. Shareholder Roles in Australia While evaluating the role of shareholders in enhancing corporate governance practices in the Australian context, it is clear that they are given wider powers and privileges. In Australia, shareholders are encouraged to participate actively in key corporate governance decisions including nomination and election of board members (ASX, 2010). In addition, they are given the opportunity to express their views on the remuneration policy for board members and top executives. Before making decisions regarding the equity component of compensation schemes, the board of directors is obliged to obtain the shareholder approval. The Corporations Act allows the shareholders in Australia to amend the company’s articles of association and to inspect the company’s books of accounts (OECD, 2011, p.74. They have also the right to appoint or terminate a director board member and conduct a shareholder meeting (Ibid). A director candidate will be elected to the board of directors only if he/she garners a simple majority of the total votes cast. Likewise, upon the request of 100 shareholders or investors holding voting shares of 5% or more, a shareholder meeting may be convened at any time to expel a director. The Australian government has introduced a ‘say on pay’ policy in response to the widely publicised claim that top executive remuneration was too high. Another policy introduced in Australia to foster shareholder participation in corporate governance is that companies are required to seek shareholder approval prior to making any additional termination payment to executives in excess of the standard set. The greater influence of shareholders on executive compensation can assist the stakeholders to ensure that only a fair amount of remuneration is paid to top executives. Shareholder Roles in Germany In Germany, the role of shareholders and institutional investors is limited by the corporate law. Here, even a controlling shareholder faces many difficulties if he/she wishes to alter the business model. For this, first it is necessary to change the SB which in turn then changes the management board (OECD, 2011, p.118). However, it is important to note that a number of significant powers are given to shareholders as a class, and they are empowered to reject company actions that would hurt the common interests of investors and shareholders. The Ten Step Program implemented by the German authorities during the 2003-2005 period paid specific attention to protecting the rights of minority shareholders (International Monetary Fund, 2008, p.38). Since management liability policies were liberalised in Germany, only limited remedies including derivative law suits, special audit request, and investigation request were available to shareholders until recently (Ibid). In addition, those were collective rights. As a result, a single shareholder is not allowed to sue the company but minorities holding over 10% share capital can launch a suit. This provision greatly limits the role of shareholders in promoting the firm’s corporate governance policy. Shareholders are permitted to call special shareholder meetings if they hold an aggregate of at least 5% shares. The negative aspect of the German corporate governance system is that it does not give much emphasis on management liability claims by shareholders. Hence, the top management may not be discouraged to abstain from unethical business practices. However, an individual shareholder with a single share can appeal against the Annual General Meeting decision in a court of law. Shareholder Roles in Chile While analysing the role of shareholders in the Chilean context, it seems that institutional investors, particularly Pension Fund Administrators (AFPs), play a significant role in structuring the corporate governance environment of Chilean corporations (OECD, 2011, p.90). The Chile’s company law provides shareholders with extensive rights to influence the firm’s crucial business decisions. Principle II.G states that “shareholders, including institutional shareholders, should be allowed to consult with each other on issues concerning their basic shareholder rights as defined in the Principles, subject to exceptions to prevent abuse” (OECD, 2011, p.99). When shareholders are really aware of their rights and powers regarding the company’s corporate governance, they can guide board of directors and executives effectively in crucial situations. Shareholders in Chilean companies have strong rights in relation to the election of board directors and they are legally allowed to vote as a group so as to increase the number of directors on the board. In the country, even minority shareholders are allowed to co-ordinate their positions for the purpose of appointing external auditors and determining the level of pay for board of directors and executives. Although certain groups of institutional investors such as mutual funds are not permitted to engage in the management of the company, all other institutional investors are free from any specific regulation in terms of shareholder co-operation. Compared to the roles played by shareholders in Australia in corporate governance, it is obvious that shareholders in Chilean companies have lesser roles to play. How shareholder activism influences corporate governance? Empirical evidences suggest that practice of shareholder activism can have positive as well as negative impacts on the business. The shareholder activists attempt to bridge the governance gap through a variety of negotiation and pressure tactics (Davila, 2012, p.50). Undoubtedly, the concept of shareholder activism is effective to put a moral check on the board of directors and top executives and thereby make them accountable for their operations (Romano, n.d.). Corporate analysts claim that shareholder activism can make a positive difference to returns because this practice would force board of directors and the top executives to take intense efforts to meet the financial interests of investors and thereby eliminate the chances of lawsuits (Prosser, 2013). The probability of accounting errors and fraud may be limited when shareholder activists are constantly exerting pressure on the management to improve the operational outcomes. Furthermore, shareholder activism is a potential way to reverse a wrong business decision taken by the board of directors. However, it is clear that the board of directors is the rightful body to monitor the organisation’s managerial affairs and to lead the governance process; and, the board is in a better position to perform these duties for the common good of the organisation than individual shareholders with conflicting interests. The reason is that the shareholders are not often consistent with the interests of others. In simple words, the shareholder activists may not represent the interests of the whole shareholders and therefore it becomes difficult for the board of directors to determine whether to consider the concerns raised by the shareholders. When shareholder activists engage in direct negotiation with the management and place immense pressure on the management/board of directors using different tactics, they actually deceive the rest of the shareholders and the board of directors (Davila, 2012, p. 52). The authors add that when the shareholders activists use negotiation and pressure tactics to influence the decisions of the board of directors, they pose serious threats to the legitimate interests of the remaining shareholders (Ibid). Conclusion From the above discussion, it is clear that the practice of shareholder activism has been on the rise since the 2008 global financial crisis. Although shareholder activism is a better way to promote the quality of corporate governance, it often hurts the interests of many other shareholders who do not want to be part of the activist campaign. Today, shareholders are given increased control over the organisational affairs of the corporation so as to make sure that the board of directors is in compliance with the accepted norms and policies. The United States implemented the Sarbanes-Oxley Act to improve its corporate governance practices and shareholder engagement whereas UK regulators framed the UK Corporate Governance Code to deal with the same. In Australia, shareholders enjoy great powers and privileges and they play an inevitable role the promoting the corporate governance laws of the country. The Chilean regulators also provide the shareholders with wide powers to influence the activities of board of directors appropriately. In contrast, shareholders of German companies have many limitations in charging liability claims against the management. To conclude, excess degree of shareholder activism may adversely affect the long term sustainability of the organisation. 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