Separation of Ownership and Control for Modern Corporations - Essay Example

?The effect of the phenomenon of separation of ownership and control for modern corporations Introduction The de-facto owners of joint stock companies are the share-holders who cannot take part in the day to day management of their companies although they carry the burden of risk in the business. This phenomenon is known as separation of ownership from control. This paper examines the effect of the phenomenon. In other words, whether the separation has the positive effect or negative effect on corporate governance. Or rather the impact of the separation on corporate performance. Corporate Governance Share-holder activism in 1990s stimulated interest on corporate governance. In fact, it became a household name in the United States when a California based company “California Public Employees Retirement System” (CalPERS) questioned the listed companies in which it had invested the funds of its members, for their practice of buying back their shares at higher prices. This literally resulted in reduction the value of shares held by CalPERS. Contemporary companies all over the world including the U.K. followed suit to safeguard the interests of their widely dispersed shareholders. What started as a means of funds mobilization by an entrepreneur for engaging in large scale activities and to achieving large scale economies, soon became handy for the entrepreneur to exploit the small and widely dispersed investors.1 In the 19th century, even the privately owned large companies who had accumulated wealth overtime had to resort to procurement of funds from the capital market as they had outgrown themselves. Agency theory that explains separation of ownership from control was first discussed by Adolf A Beale and Gardiner C Means2. One can still go backwards to the times Adam Smith who in his “The Wealth of Nations” 3 has said that company directors would not care for shareholders’ money as their own and this is the problem with agency theory as observed by Letza, Sun and Kirkbride.4 Fame and Jensen 5 argue that separation of decision making (control) and risk-bearing (ownership) become viable because of the need for specialization of management and risk bearing besides the need for controlling agency problems. They cite the nature of an organization as a nexus of contracts both written and oral among the owners of factors of production and customers which are the internal “rules of the game”. The rights of owners of each factor of production and customers are specified and their performances evaluated. These factors of production are rather stake-holders in the organization. The authors assert survival of a form of an organization depends on its ability to sell their output required by their customers at the lowest price while at the same time fully recovering costs. There are two types of organizations wherein risk-bearing (ownership) and decision (control) functions are separated and wherein the two functions are combined in the same agents. In the contractual nature of organizational forms, the residual claimants are the residual risk bearers having claim over the net cash flows after meeting the contracted payments to the factors of production from out of stochastic inflows of resources. Thus, residual risk is known by the “difference between stochastic inflows of resources and promised payments to agents.”6 These residual claimants are the ones who bear the most uncertainty and it is considered worthwhile as it reduces costs of monitoring contracts with the rest of the agents. This contributes to the survival value of the organizations as distinct entities. It is mandatory to produce outputs at lesser costs so as to ensure increased net cash flows to safeguard the residual claimants’ interests. Restriction on residual claims differs from each form of organization. For example, large corporations where common stocks are in use have the least restricted residual claims. That is, the shareholders have no role to play in the organizations. Because of this, risk sharing is unrestricted for the shareholders. They are called open corporations. There are closed corporations which are smaller in size with restricted residual claims confined to internal decision agents. Therefore, separation of ownership from control results in systems “that separate decision management from decision control.”7 Where there is decision management and decision control combined, residual claims are confined to the concerned agents themselves. There can be no agency problem where the two functions are combined but they are prevalent in proprietorships, small partnerships, and closed corporations involved in small scale production or service. In organizations characterized by ownership separated from control, role of specify knowledge necessitates separation. It is complex because decision process is diffused among the various stakeholders in the organization. Hence, it can be said that the separation arises because better decision making necessitates delegation of decision making among the various levels of the organization having specific knowledge. However, the agency problems that arise because of separation are avoided by separation of ratification and monitoring from those who actually initiate and implement the decisions8. The agency problem arises because in open corporations, managers enjoy incentives to take decisions to increase their own benefits rather than maximizing the returns to the shareholders. This is why corporate control mechanisms are in place now as a means of disciplining the mangers to act in the interest of shareholders. Thus, the apex body of the internal governance comprising of the independent and non-executive directors who act to reduce agency problems through controlling the managers whenever they tend to act opportunistically. There is evidence to show that independent directors have acted to protect the interests of shareholders. The non-executive directors whose external expertise is crucial for decision making have also been found to protect the interests of shareholders besides giving access to valuable resources and information. It is because they are not concerned with employment or promotional opportunities.9 Jensen and Meckling (1976) have said that relationship between the directors and shareholders is that of agent and principal. Because of the constant conflict of interest between shareholders and managers, presence of non-executive directors on the board serves to reduce the conflict. However, hegemony theory suggests that the board of directors is not efficient enough in its overseeing role and protection of shareholders’ interest. The non-executive directors are capable of only offering valuable advise but incapable of monitoring the company’s performance. Further, they are engaged for their social status and they are selected by the CEO directors who actually are in control of the board.10 Corporate scandals have proved that the traditional corporate governance characterized by separation of ownership from control has not been effective. Separation is inevitable as shareholders are capable of producing capital but not the management enterprise while managers do not have the capital but are rich in management expertise. The shareholders whose capital is at stake, have developed strategies to reduce agency costs through enactment of fiduciary duties of directors owed to the shareholders and contractual arrangement between management and shareholders in an effort to mutually align financial interests of both the parties. Thus, duty of care expects that board of directors must manage the company for the sole benefit of shareholders. Thus, directors are required to discharge their duties and make decisions as a reasonably prudent person would in similar circumstances. Courts protect the management from the prudential requirement as long as there is no conflict of interest. Apart from duty of care, the directors are required to display duty of loyalty which prevents them from engaging in self-enriching transactions or usurping corporate opportunities to their own benefit. Apart from these internal checks, market forces play an important role in curbing the management activities detrimental to the shareholders. Thus, the management has to maintain market reputation as otherwise stock prices will fall due to offloading of shares by the shareholders as a result of bad performance. The contractual arrangements refer to executive remuneration and bonus linked to stock’s performance. This motivates managers to aim high to match with the shareholders’ aims. However, these traditional approaches could not prevent corporate failures such as Enron, WorldCom, Adelphia, Qwest, Tyco from happening. These controls have only punished the corporate wrong-doers and not helped protect shareholders equity. This is where shareholder activism comes into play. It will be more beneficial if institutional investors engage themselves in shareholder activism.11 CalPERS has been a live example.12 Institutional investors’ activism characterizes the British corporate history since 2000. The interventionist shareholders have been agitating for a corporate policy change. Post 2000 period has witnessed high profile private equity buyouts with the aim of privatizing publicly owned companies. But this trend does not seem to mitigate the agency problems arising out of separation ownership form control. Institutional investors like pension funds and insurance companies are quietly slashing down their investments in public listed companies. Since private equity buyouts are only a small fraction, the separation of ownership and control will continue to play a dominant role in the U.K. corporate scenario.13 There are three major actors in a corporate scenario such as managers, owners and the board of directors. The perfect scenario expects all the three groups to work towards a common purpose so that economic efficiency is achieved through making available all the resources to the corporation. Sharing the hitherto to secret information for future decisions helps all the actors to become more efficient. Thus, separation in this manner increases efficiency that helps reduction of agency costs inherent in the separation of ownership from control.14 Concentrated ownership, on the other hand, provides only greater leverage without a scope for efficiency and without a guarantee for protection for minority shareholders. The U.K‘s ownership pattern is institutional investment while in the U.S. individual investors are the dominant group. In the U.K., there is an effective market for corporate control as also in the U.S. Theoretically, the market for corporate control is supposed to avert or correct managerial failure. But practically there is link between hostile takeovers to poor corporate performance. In U.K., performance targets of both the hostile takeovers and average quoted companies are the same. Hostile takeovers undergo significant restructuring and managerial turnover. Suitability of dispersed ownership or concentrated ownership depends up on the activity the companies are engaged in. Concentrated ownership facilitates long term relationship with the investors especially return on investment is with long-term orientation. But it can result in costly delays in corrective action. Dispersed ownership is ideal for riskier ventures requiring new investments.15 Market theorists who prefer market to regulatory solutions aver that market forces ensure adequate alignment of management and shareholder interests and hence there can be no concern for non-participation of shareholders in the internal management and there is no need for external intervention too. Shareholders are considered to have failed to control like owners only if they are categorized as owners. The nexus of contracts principle does not see shareholders as owners. They are just one of the parties who make contract with the management to provide a factor of production (capital) for a common benefit. (This leads to development agency theory to stakeholder theory discussed elsewhere). As rational actors, they ensure that contract with the management contains necessary safeguards against management abuse. The shareholder’s involvement is not part of optimal control structure and non-participation of shareholders cannot be an issue. However, the fact remains that a weak owner control points to the inadequacy of management discipline. Bearle and Means have already observed as early as in 1932 that large public limited companies have no effective shareholder control. In Great Britain, Cohen Committee observed in 1945 that shareholder control remained attenuated. 16 If collective action by the shareholder is the answer for the weakness of shareholder control, then it is rational for them to be individually passive. Voting by a single shareholder for or against a resolution is not a guarantee for its successes. They either abstain from voting or vote with the management as a low cost rule of thumb. For shareholders to organise themselves is time consuming and cost of educating and canvassing support from the fellow shareholders would outweigh the benefits since the resultant increase in company value would be evenly distributed to all the shareholders. Thus, shareholders’ inactivity because of these perceptions, encourages managers to pursue their own goals and they can be self-serving. Berle and Means state that there is a possibility for the managers to act in the interest of society as a whole instead of acting in furtherance of their own or shareholders’ goals. This is according to theory of managerial autonomy. There are altogether different possibilities of managers’ discretionary actions. This becomes possible because dispersal of ownership facilitates effective control of the company being assigned to the management. Next, managers and directors have different self serving goals than that of the shareholders and hence their actions will not aim at maximizing profits. Lastly, management can pursue divergent objectives on two counts. One, lack of control by the shareholders; two, weak competitive conditions.17 The above three possibilities are discussed below. The Location of control The issue of importance is who controls the company so that it can be determined if the goal of profitability is pursued. Control lies in the ability to appoint the board. If the board is a self-appointed one, it can remain immune to shareholders’ adverse reaction. In this manner, not only the day to day management becomes out of their scope but also the long-term strategy. This is the advantage of the corporate form divesting ownership from control but at the same time shareholders cannot force management to maximize profits or tell management how to run the business. In this connection it is worthwhile to note that though The Companies Act stipulates that a company should have directors, their functions are left for the articles to decide. It is a universal principle to vest the board with all powers required for efficient conduct of business except those reserved by the act to be exercised by the shareholders in a general meeting.18 Scot is quoted as having argued that collaborative action by the shareholders is possible in form of ownership. The institutional investments make possible collective action.19 According to Herman, a company is considered under minority control if there is a hold in excess of 10 % along with board representation. He cites Solvay’s 9.7 % stake in Allied Chemical still had no control in the absence of right to participate in the management. It serves, however, as latent power as a restraint on management’s freedom of action.20 Managerial Motives This refers to managers’ behaviour prompted by the weakness of ownership control towards failing to maximize profits. Shirking is one kind of behaviour that is evidenced by insufficient effort to maximize profits. However, a sense of professionalism and self-esteem may not motivate them to shirk. Shirking can also mean incompetence for which if the shareholders are unable to react to replace the shirkers, the company will suffer from a weak leadership apart from non-observance of managerial diligence.21 It is claimed that profit maximization is not a goal of the management but maximization of sales and growth and therefore their other goals of status, power, salary and security are not linked to profit maximization.22 Though not as a goal, profit is regarded as a constraint since minimum profitability is a condition for survival or it is essential as a protection from takeover. This leads to the proposition that profitability and growth are mutually dependant23. Market constraints: The last ingredient of the managerial theory is that there is no strong competitive pressure. For inefficient managements, lack of competition is a condition for survival.24 Studies on the effect of weak control over management are inconsistent in that Herman’s reference to 14 such studies indicates nine companies controlled by owners performed better than those under management’s control. But this could be due to different methodology adopted for each study. However writers are emphatic that weak supervision over company’s management leads to poor performance.25 Institutional investors’ activism is the not answer. Encouraging activism by the institutional investors is like taking one step backward. It does not solve the problem of separation of ownership from control. However, it is not clear whether this is a problem requiring a solution at all. The authors contend that the system of corporate governance has functioned very well without shareholders’ intervention.26 U.K. case study Until 19th century, only 5 to 10 % of Britain’s business enterprises were owned by incorporated joint stock companies. By the turn of the 20th century, corporate businesses were increasingly being listed in London Stock Exchange. By 1907, there were 600 quoted companies in the U.K. After the war, there were listed 3500 companies in 1951. But the concentrated ownership characterised the stock holding by the family members of the entrepreneurs who had started the companies. The family dominance was the norm until the middle of 20th century. It was only during the second half of the 20th century, share ownership became widely dispersed. After 1950s, the U.K. companies were so widely dispersed in ownership that they were vulnerable to takeover offers. During 1970s, the managerial autonomy came to be established but dispersal was not complete until 1980s. The regulations of companies were in favour of minority shareholders. Partly because, the English judiciary was honest and not corrupted. Though the judges were condemning the directors involved in fraudulent behaviour and dishonest practices, they did not put the corporate decision making under too much scrutiny. Lord MacNaughten observed in the National Bank of Wales case that judiciary should not interfere in corporate where Parliament did not choose to meddle with. 27 In Burland v Earle, Lord Davey stated that it was an elementary principle of the court not to interfere in internal management of the companies where the managing acted within its powers. 28 Specific cases of corporate governance failure of recent origin were BCCI, Robert Maxwell and Nick Leeson and Barings. BCCI which was a bank with global operations had been characterised by “multiplying layers of entities, related to one another through an impenetrable series of holding companies, affiliates, subsidiaries, banks-within banks, insider dealings and shareholder (nominee relationships”.29 This kind of corporate structure and the reckless record keeping practices led to the collapse of the bank primarily because it was not under government control. Barings Bank is another case of corporate failure because of the actions of one Singapore based Leeson whose investments on company’s behalf were not being checked and were simply trusted at the face value of the said Leeson. A third case is the case of Robert Maxwell who borrowed heavily from employees’ pension funds but failed to repay. The delinquent auditing firm now part of Pricewaterhose Coopers was made to pay ? 67 million and a fine of ? 3.3 million. 30 Cadbury Report Responding to the above challenges to the corporate governance, Cadbury committee’s report of 1991 stressed the importance of non-executive directors who should be independent and of high calibre for an effective internal control. The impact of these internal control mechanisms recommended by the committee was assessed from a sample 312 U K quoted companies which were following the Cadbury committee’s best code of practice. It was found that in spite of the best code of practice being followed, the impact was not positive on companies’ performance. On the other hand, market for corporate control impacted positively on performance. The authors feel that internal governance does not guarantee protection of shareholders. This suggests that external control mechanisms are more effective than internal control on corporate performance. 31 Conclusion This foregoing literature on separation of ownership and control gives mixed results. Agency theory that explained the separation of ownership from control seems to be no longer relevant. Since the managers are agents of the company and not the shareholders, the latter cannot expect the managers to be subservient to them. Profit maximisation also takes a back seat when stakeholder theory has taken over the agency theory in the matters of management of companies. All the owners of factors of production are stakeholders whose interests are to be equally safeguarded. One cannot enrich at the expense of the other. Corporate social responsibility places greater emphasis on the safeguarding the interests of the stakeholders and not the shareholders alone. As such, the separation of ownership from control has resulted in mixed results. Separation of ownership from control is for the good of all the stake holders and not necessarily the shareholders. If the shareholders are given the control, stakes of other stakeholders such as employees, environmental agencies, suppliers, financial institutions, governmental agencies cannot be ensured. In fact, if all the stakeholders’ interests are valued in monetary terms, stake of shareholders would be only minimal. Therefore separation of ownership from control has only evolved into its logical justification for safeguarding the interests all the stakeholders on equal footing and shareholders cannot claim the sole right of control on the management. In the event of liquidation, the shareholders lose only to the extent of unpaid value of shares while the other stake holders would lose their entire stake if sufficient net worth is not available. Interests of shareholders and other stakeholders aside, the phenomenon of separation of ownership from control is inevitable for survival of corporate form organisations. Bibliography Cases Burland v Earle [1902 ] AC 83 at 93, p 18 in Brian R.Cheffins, Does Law Matter ?: The Separation of Ownership and Control in the United Kingdom (2010) Working Paper No 172, ESRC Centre for Business Research, University of Cambridge, p18 Dovey v Cory (1901) ACC 477 at 488 in Brian R.Cheffins, Does Law Matter?: The Separation of Ownership and Control in the United Kingdom (2010) Working Paper No 172, ESRC Centre for Business Research, University of Cambridge, p18 Official materials Company Law Amendment Committee, cmd 55659 (1945) para 7 (e). in J.E.Parkisnon, Corporate power and responsibility: issues in the theory of company law, ( Oxford University Press, Oxford, 1995) 54 Books Berle Adolf A and Means Gardiner C, The Modern Corporation and Private Property. (2 ed Transaction Publishers, New Jersey 1991) ix Franks Julian and Mayer Colin, Corporate Ownership and Control in the U.K., Germany in Chew Donald H and Gillan Stuart L, Corporate Governance at The Crossroads: A Book of Readings, (Tata McGraw Hill Education, New York 2006). Hebb.Tessa No small change: pension funds and corporate management (New York Cornell University 2008) 375 Herman, Corporate Control, Corporate Power in J.E.Parkisnon, Corporate power and responsibility: issues in the theory of company law, (Oxford University Press, Oxford 1995) 62 Kieff Scott F and Paredes Troy. Perspectives on Corporate Governance. ( Cambridge University Press, Cambridge 2010) 8 McKibben, Gordon Cutting edge; Gillette’s journey global leadership (U.S.A., Havard Business Press, 1998). 170 Marris, R The Economic Theory of ‘Managerial Capitalism’ (1964) in J.E.Parkisnon, Corporate power and responsibility: issues in the theory of company law, Parkisnon J.E., Corporate power and responsibility: issues in the theory of company law, (Oxford University Press, Oxford 1995) 54 Plessis, J J Du, McConvill, James Bagaric, Mirco, Principles of contemporary corporate governance (Cambridge, Cambridge University Press, 2005) 325 (Oxford University Press, Oxford 1995) 54 Journal Articles Adams, Edward S ‘Bridging the Gap between Ownership and Control’ (2009) 34 (2). Journal of Corporate Law p 409 Fama, Eugene F and .Jensen, Michael C ‘Foundations of Organizational Strategy’ (1983) XXVI Journal of Law and Economics. 1 Kota Hama Bind and Tamar, Sarema ‘Corporate Governance Practices in Indian Firms’ (2010) 16 (2) Journal of Management and Organization, 266 S. Letza , X., Sun , J,Kirkbride (2004), "Shareholding versus stake holding: a critical review of corporate governance",(2004) 12 Corporate Governance: An International Review,.242 Wines, Graeme ‘Corporate Ownership and Control: British Business Transformed’ (2010) 15(1) Accounting History P 133 Working Papers Matyjewicz, George and Blackburn, Sarah (2010) The Need for Corporate Governance < http://www.auditnet.org/articles/Need%20for%20Corporate%20Governance%20July%202003.htm > Accessed 17 April 2011 Weir, Charlie Laing, David and McKnight, Phillip J‘An empirical analysis of the impact of corporate governance mechanism on the performance of UK firms. 2000 Working Paper Series < papers.ssrn.com/sol3/papers.cfm?abstract_id=286440 - > accessed 17 April 2011 Read More