The Concern of the Separation of Ownership and Control - Case Study Example

The Separation of Ownership and Control In the publicly held business corporations, the separation of ownership and control is an important concern because the shareholders of the company do not have a direct control over the management decisions of the company. Since the separation of ownership and control allow the organisations to make superior decisions, however, this attempt result in collective actions problems, which are linked with dispersed share ownership. Today, the basic problems regarding governance by shareholders are to regulate active or large shareholders to achieve the suitable balance between managerial decisions and small shareholders protection (Constantinides, Harris, Stulz, 2003). According to Jensen and Meckling (1976) as cited by He & Sommer (2006), agency problem is a contract under which one party engages another party to conduct some service on their behalf and delegates the decision making authority to the other party. The separation of ownership and control is an example of agency relationship. According to Hutton (1995), the agency problems rests in the abuse power by elites because the excess power is in the hands of senior management and some of them use the power in their own interests, thereby, damaging the shareholders (Oba, 2004). Agency theory is being considered very important in corporate governance. Corporate governance includes the principles which are designed to direct and control the businesses. Corporate governance has been defined by The Financial Aspects of Corporate Governance (Securities and Exchange Commission of Pakistan, n.d.). “Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders' role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place …” Since 1995, corporate governance has been assisting the shareholders to better govern corporations and to enhance the corporate accountability of controllers (McRitchie, 2010). A clear allocation of control to a majority shareholder is favoured by the legal US provisions (Hauswald & Hege, 2006). U.S. Corporate governance differs from the corporate governance in Japan or Germany (Blair, 1995). However, the corporate governance policies related to agency theory are quite similar. Agency theory actually defines the relationship and divergent interests of managers and shareholders. Agency theory conveys that the delegation of power or decision making authority becomes problematic when it is transferred from principal to agent and the interests of both diverge, when principal may not perfectly and costless monitor agent actions or principal may not acquire information possessed by the agent (Oba, 2004). Agency problem is the conflict which appears between the managers, shareholders and other parties (Investopedia). Agency theory encourages the concept of separation of ownership and control in organisations. The separation of ownership and control does not rise in all businesses, for example, if manager is the only equity owner of a business, the agency problem does not exist because the control is in the hand of owner. On the other hand, in the case of public traded organisations, the divergence of the interests of owners and managers lead to agency problems. In order to resolve agency issues in a firm, the separation of authority and control becomes essential. The separation phenomenon gives the shareholders little or no control over the management decisions. The proportionate principle also favours separation of ownership and control because it advocates “one share-one vote” right (Shearman & Sterling, 2007). The separation of authority and control has been always remained an important area of investigation for researchers, therefore, knowing what exactly, the researchers have found can provide a deep insight to the topic under discussion. The separation of authority and control if at one end, gives benefits such as capital requirement, division of labour and reduction of financing costs then at the other end, it may also create the problems like less control of owners, divergent interests and higher monitoring costs (Davies & Lam). Owners prefer maximum profits by giving preference to the lower prices for outputs or higher prices for inputs. Managers are influenced by two basic instincts including survival and interdependency or self sufficiency (Anonym). In the small organisations when the managers are the owners of the business, the agency problems do not rise because the managers have the claims to the profits and they make management decisions. On the other hand, in large organisations, shareholders have little control over the management decisions and they have interest in profits of firm whereas, managers have relatively more authority over management decisions. In a publicly help corporation, the shareholders have limited legal control and the lack of control is recognised as free-rider. The shareholders do not have the right to participate in daily operations, decisions of the company and setting the policies. Being the owners of the company, shareholders want to share decision making authority however; the managers being the controller do not want this interference. In the previous years various such cased have emerged therefore, the separation of ownership and control has become an important area of investigation. The concerns of moral hazards also give birth to agency problems because most of the actions of managers are hidden from the shareholders. Shareholders being the owners of the business want to get all kind of information. Another problem is the adverse selection, which arise when shareholders find it costly or difficult to obtain some information possessed by the managers. Moral hazard and adverse selection are two route causes of agency problems. In addition, when the organisation grows the managers become risk averse because they have to protect their positions by achieving success and the success rate assists them to increase their control. The importance of separation of ownership and control is much highlighted in many European firms, where the single shareholder has the legal authority (Kirchmaier & Grant, 2004). In organisations, the separation of decisions and risk bearing functions survive because of the benefits of specialisation or management and the common approach to control implied agency problems (Fama & Jensen, 1983). The true identity of investor and his role is being questioned when separation of ownership and control is implemented (Morel, 2006). Therefore, shareholders seek to interfere in the matters of the company sooner or later. Apart from solving the agency problems, separation of ownership and control brings various benefits to a firm. First, for various decisions of the company, hierarchical decision making is far more superior to market allocation decisions. Second, the large organisations usually have a large number of shareholders, and it is not possible that each shareholder may get the control over company’s decisions, therefore, authority is delegated. Third, managers need to make quick responses according to changing market conditions to diversify their risks. Fourth, the aim of an organisation is to promote simplicity of promotions and it is only possible when authority is in the hands of few people. Another benefit which enhances the importance of separation of ownership and control is that if investors get involved in the activities of management, the issues of insider information increase (Jones, 2003). This issue does not only have legal implications but it also brings the bad name for the company. Based on evidences, the researchers also argue that the firms which do not have separation of ownership and control, outperform the other firms. In a research conducted in UAE firms, it was found that owner controlled UAE firms outperform the firms which are controlled by management (Moustafa, 2005). Separation of ownership and control is opposed by various groups because of the agency costs which are enhanced as a result of this separation. These groups of opponents argue that agency costs such as monitoring, bonding and residual losses of principles are enhanced with the lack of control of shareholders. However, there are various ways through which corporate governance has been regulating the agency problems. “Much of the traditional Company Law doctrine considers that Corporations must be managed to promote, above all, shareholders’ rights (Carrillo, 2007).” Therefore, the opponents argue that separation may harmfully affect the interest of shareholders. “Ownership structure doesn't seem to affect management turnover or the management turnover-corporate performance relation (Oijen).” Moreover, the opponents believe that shareholders interest come first and separation of ownership and control is really not encouraged. The top management actually controls the corporation over long periods otherwise; the links between directors, managers and shareholders are very weak (Lipsey & Chrystal). The separation of ownership and control might increase the power of managers to use the wealth of shareholders in their own interest and these concerns changed the ownership concentration, theories of corporate governance and stock trading (Margotta, 1989). Ownership and capital are only alternatives and not more than that and a profitable stock ownership strategy does not need any knowledge about the firms in which one invests (Hovenkamp, 2009). With the increase in the separation of ownership and control, the use of external board of directors increases (He & Sommert, 2006). Corporate governance resolves the fundamental issue of corporate governance not only through separation of ownership and control but also through finding a balance where the owners may get the maximum output at minimal cost and managers may get the maximum remuneration with minimum efforts. The increasing privatisation is also creating problem related to separation of ownership and control. For example, previously British Rails and British Steel was being controlled by government however, after their privatisation, government had to establish regulatory framework for these industries. As a result, the ownership authority passed from government to shareholders and control was passed from state appointed managers to shareholders appointed managers (The Times 100). When control shifts, more measures have to be taken by shareholders and they start interfering in organisation’s internal matters. Corporate governance does play a very important role in such situations. It is very important to understand how agency conflicts are being resolved in organisations. In order to resolve the agency problems, in the modern and large organisations, the actions of monitoring and bonding are promoted. Monitoring is done to observe the behaviour of the managers and bonding includes the arrangements to penalise the managers for their actions that influence the shareholders. Nowadays, companies make special contracts which define the monitoring and bonding arrangements. For example, to observe the behaviour of managers, the contracts such as behavioural and outcome based contracts can be made. Moreover, board of directors also play a very significant role in the separation of ownership and control. The board usually consist of internal and external members who become the legal trustee of shareholders investment. In the UK, ownership and control were separate in large organisations during 1950s and 1980s however, when later on large corporations emerged with less visible separation, the managerial capabilities of British companies improved. Moreover, stock ownership programs and quality of management programs were reconfigured during this time (Cheffins, 2004). The control of listed companies in Belgian is highly concentrated and this concentration is brought by business groups, voting pacts and holding companies (Becht, Chapelle & Renneboog, 1999). Most of the times in the family held businesses, the shareholders give control to the managers who are trustworthy. In a research, it was found that 2980 corporations in nine Asian countries, the separation of ownership is visible in family controlled businesses and small firms and managers are usually the relatives of the shareholders (Claessens, Djankov & Lang, 2000). Therefore, based on above discussion, it can be concluded that the separation of ownership and control is important in an organisation; however, measures need to be taken to monitor the performance of the managers. Moreover, the importance of corporate governance cannot be ignored in managing the interests of stakeholders in organisations. References Anonym, (n.d.) 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