The Role of Shareholders in Managment - Essay Example

?Role of Shareholders Shareholders are the owners of a firm in proportion to the percentage of shares they hold in the firm. These can be al investors, founders of the firm, corporate investors, government investors and individual investors. As partial owners of the firm, they have right over the firm’s profits but also have to suffer losses when the firm experiences financial failures. Because of the stake they hold in a firm, they have a right to monitor its working and ensure that their interests are not compromised. To enable this influence, the shareholders are empowered to vote in the shareholder meetings for certain actions which the company proposes to take or have taken (Reference for Business 2012). However, state laws and company bylaws determine the areas in which shareholders are entitled to vote Shareholder powers One of the main areas where shareholders are generally entitled to use their power is the election of the board members who are the “agents” of the corporation. The board of directors “acts on behalf of the shareholders” and is responsible for the maximization of shareholder value by incorporating appropriate policies through the managers they select for corporate operations (Reference for Business 2012). Any fundamental change which the organization plans to incorporate needs to be approved by the shareholders before implementation (Miller 2012). This implies that they have the power to approve a merger, change or amend the articles of incorporation of a firm, affect the sale of all or part of the company’s assets or even approve the dissolution of the corporation (Ronen and Yaari 2007). However, in many of such decisions prior board approval is required. They not only have the power to choose the members of the board of Directors but also to vote against them if found to be inefficient and remove them from the board. Generally a director is removed if there is sufficient cause for voting him out. However, certain state statutes and corporate articles allow their removal without any cause (Miller 2012). This means that if majority of shareholders feel that a particular director is not required, they can vote him /her out of office without giving any justification for their action. Shareholders can impact a company policy by proposing their own ideas for shareholder vote. However, for this they need to present their idea to the board of directors and ask them to distribute it to all the shareholders before the shareholder meeting by including it in the proxy papers sent to them (Miller 2012). However, this power is limited by the fact that SEC (Securities and Exchange Commission) has set a limit to who can forward these proposals. As per SEC, only those shareholders who have stocks worth at least $1000 can submit such proposals (Miller 2012). This submission is also limited by the fact that the proposal should be related to some noteworthy policy concern and not any ordination day to day operational consideration (Ronen and Yaari 2007). Thus, we can see that though the shareholders have the powers to affect change, they are limited in their use of power. In general, each shareholder has voting rights in proportion to the number of shares held by him/ her. However, the company can limit the voting rights of certain categories of shareholders (Miller 2012). For example, most organizations do not give voting rights to preferred shareholders. The companies can do this by incorporating the same in the articles of incorporation. However, if the laws of the State of operation do not allow such provisions, then the organization has to abide by the law. Some times preemptive rights are granted to shareholders. This gives them the right to subscribe to the “same percentage of new shares being issued as they already hold in the company” (Miller 2012). This helps them to maintain their “proportionate control” over the organization in terms of voting power and financial interest (Miller 2012). The implication of this right is significant when the organization plans to issue new shares to increase their capital. Usually if a shareholder does not have the preemptive right, he/ she is unable to subscribe to an equal percentage of shares he/she already holds. This dilutes the shareholder power and the say in company affairs as the shareholder base increases with the issuance of new shares and his proportion of share decreases. However, the shareholder is usually allotted a time limit within which this right can be exercised. Shareholders can also inspect company records by virtue of company law as well as statutory requirements (O’Rourke 2002). However, this right is limited by the fact that only specified books and records can only be inspected and that too with a prior request. Though the shareholder can do the inspection himself/ herself or through an agent, the companies have been given the right to protect themselves from potential abuse of this power. Such inspections can be misused to leak trade secrets or harass the company managers. Thus, the organizations can deny such inspections on such grounds. However, this right has a potential to be successfully used against preventing malpractices within the organization if the shareholder is able to establish sufficient ground and right intentions to carry out such inspections. The shareholder can greatly influence the board’s decision to work in a particular way or remove or elect certain board members. Board of Directors has the power to bring a lawsuit on behalf of the organization against a third party if they find that the third party’s action has caused some harm to the organization. However, if the Board of Directors fails to do so, the shareholders can bring about what is called “shareholder’s derivative suit” (Miller 2012). This is an important power of the shareholders where they can intervene in the director’s or officer’s powers where they are showing inaction towards the party which has caused loss to the corporation. Here the shareholders are not pursuing the suit for their personal benefits but for the benefit of the organization. Similarly, the shareholders can also proceed to dissolve the corporate entity under following conditions – It has been proved that corporate assets are being wasted or applied in an inappropriate way The shareholders are unable to elect a director whose term has either expired or is about to expire due to a deadlock in the voting power. The directors have been found to indulge in illegal or fraudulent activities in running the organization There has been an irreparable loss due to a deadlock in the functioning of the directors in operating the organization. Institutional investors form an important component of shareholder composition in today’s business environment. Until recently, these shareholders were not interested in exercising their voting rights. They were only interested in investing in companies which they found to be fundamentally strong and later selling off their stake in order to exploit the variances in their share prices (European Corporate Governance institute). However, they now form an important component of the total share holders and have shown interest in voting on all resolutions. At the same time, it should be kept in mind that these investors owe allegiance to a different group of stakeholders and hence may focus more on short term dividend returns and not support proposals by the board that do not give them these short term benefits (European Corporate Governance institute). Hostile takeovers became a trend in the early 20th century when companies bought shares of another firm to influence its operational decision. Hence, rival firms try to forcefully influence the decisions by buying majority shares in the other company. Management tries to discourage this trend by keeping the stock prices artificially high or giving stock options to the higher management which will also help in aligning the management’s objective to the company’s objectives as good performance will result in increase in share prices. SEC also has tried to discourage this practice by issuing relevant rulings (Reference for Business 2012). However, researchers feel that shareholder’s powers are limited by legal considerations (Ronen and Yaari 2007). This they feel is not only due to the fact that shareholder ownership is dispersed but also more so due legal hassles which “insulate the management from shareholder intervention (Ronen and Yaari 2007). For example, the shareholders can only veto any major decisions that can immensely impact their wealth. They do not have the power to initiate such decisions. Under such circumstances, the shareholders can either leave the organization by selling their stake which is also called “voting with the feet” or purchase substantial shares in the company so that they have a say in its affairs or they can become activists (Ronen and Yaari 2007). Activists are those shareholders who try to exert their influence over the board’s decisions through means other than hostile takeovers or increase of shares to influence the decision making process of the board. One of the ways of doing this is to prepare shareholder resolution which has also been discussed in the previous sections. However, there is a cost attached to indulging in such activism. This has been seen as an unhealthy provision necessitated by the SEC and is more in favor of the management than the shareholders or other affected parties. This is because the SEC has outlined a long procedure for effecting shareholder resolutions. The procedure for shareholder process is summarized in appendix figure 1. In the US, a shareholder can introduce the proposal, have it circulated to the other shareholders and present it at the AGM (Annual General Meet) in person. There are other requirements for floating such proposals. For example, in US, there is no limit to the number of shareholders required to back the resolution before it is proposed. However, in UK and Australia, it cannot be placed in the proxy unless it has a backing of at least 100 shareholders. In the US, the shareholder should own at least $2000 or 1% of the shares, for at least a year before proposing a resolution (O’Rourke 2002). The advantage of shareholder activism is that it opens a way for dialogue with the company. The proposal can either be withdrawn if there is some settlement being reached with the company or it can be omitted by the firm. The SEC has provided 13 grounds for the companies to reject the proposals. The proposal can also go for voting at the AGM. If it goes for voting, then the activist needs to gather support for it from other shareholders. This entails costs in terms of advertisements, contacting other shareholders, preparing material etc. The issue can also be resubmitted in the next AGM on receiving a certain number of votes. However, even if the issue gets a majority support, it is not binding on the management to implement it (O’Rourke 2002). But nevertheless, many of the activists have been successful is forcing the company management to change their plans for the betterment of shareholders and the society as a whole. For example, McDonalds was forced to phase out of polystyrene, Home Depot had to withdraw from using wood from environmentally sensitive areas and Ford had to pull out of the Global Climate Coalition (O’Rourke 2002). Thus, shareholders’ activism has helped in influencing the corporate culture and forcing the top level management to listen to them even though many of the proposals face rejection. Though the shareholders are assumed to be empowered through the right to vote and present resolution, we have seen that this power is limited to a great extent. Shareholders can also impact the payouts of the board members but only to a limited extent. In fact, many researchers feel that this is only a myth and most of the times the directors are not fully aligned to the shareholder interests. They have found that too many powers have been given to boards in deciding compensations as they are thought to be working for the benefits of shareholders and they have been insulated from the shareholder interventions (Bebchuk and Fried 2005). This can be seen from the fact that though the directors are selected by the shareholders, the names are usually proposed by the management. Hence, the board members tend to go with the top executives in compensation matters to ensure their election. CEOs on the other hand can use his corporate resources to impact a director’s rewards. For example, there are no prohibitions that discourage dealings between a firm and its independent director’s firm. So CEOs can use their powers to compensate them in various ways. Here the shareholders cannot do much to discourage such practices. However, they can exercise their say in selecting more independent directors into the boards (Bebchuk and Fried 2005). However, independence of directors does not imply that they will always work in the interest of the shareholders. Should shareholder role be strengthened? There has been a debate in literature about whether the shareholder’s role should be strengthened or not. It is important for the organization to work in a stable internal environment. If there are too many changes at the top management and board level, there will be instability and widely varying messages going down the line. For example, there could be varying interests or working styles of new board members. So every time there is a change at the board level, there will be changes in processes down the line. This inconsistency and change of direction every now and then can lead to problems in functioning of the firm. There needs to be concrete evidence that the desired change will be impacted by change in the top management. However, it has been found that high insulation of the incumbents from removal has had a negative impact on the managerial effectiveness (Bebchuk 2006). Researchers have found that executives who have been provided strong anti takeover defenses usually have very high compensations (Bebchuk 2006). It is also thought by those who oppose greater shareholder role that market forces offer enough sources for accountability. The threat of hostile bids is one of the factors that can force the board to show good performance. However, the current legal framework to discourage these bids works in a counterproductive way towards this end. It is generally believed that if a firm performs contrary to shareholder interests it would lose to competitors and eventually face a loss of market share. However, low performance may just lead to reduced profits and may not result in any drastic loss of market share. Thus, as long as the board members are receiving benefits which are higher than the cost of failure, they will not be discouraged to overlook shareholder interests. Though the capital markets are seen to be exit root for the shareholders who feel that the board is underperforming, their sale may not be able to impact the company’s prices due to the small number of shares they hold. They will also suffer losses if they sell at a price which they think is undervalued because of the poor board performance (Wheelen and Hunger 2007). On the other hand it has been observed that managers of an organization are specialized set of individuals who have special skills and knowledge to take the best decisions (Bratton and Wachter). Most of the shareholders of a firm are not skilled enough to take business decisions. Moreover, involving them in taking decisions will also be a costly affair and hence agency cost reduction is an important factor for this division of power. Going further if shareholders were given powers to vote on business-policy matters, they would do so based on the market price of the company’s shares assuming that it reflects the company’s fundamentals which may not always be the case. Hence, if the management wants to get shareholder support in favor of a particular policy, they can manipulate the market price in favor of increased speculation. The financial crisis of 2008 is evidence to the fact that the share price maximization motive, which was thought to be giving maximum shareholder return, was behind the crisis. Even if shareholders were empowered, it would not have stopped the crisis because they were supporting the firms that took high risk high return strategy and hence fuelled speculations. The executives who supported this strategy were showered with incentives and no one objected to this. Even if the shareholders had the power, they would not have blocked such high return strategies. Conclusion The above discussion brings us to a cross road where it is difficult to say whether one way is better than the other. However, we can say that the solution to all problems does not lie completely in empowering shareholders. If management can fall prey to their personal interest, shareholder too can. Moreover, they are less informed individuals (excluding the institutional investors) than the company managers and hence have higher chances of taking incorrect decisions. However, the legal environment that surrounds the corporate world should be fortified to ensure that shareholder interests are not compromised. Shareholders should be given more powers on certain issues like game-ending or scaling-down options (Bebchuk 2004). By doing so, the shareholders will be able to discourage the management’s tendency to continue a company despite losses or to over diversify and engage upon empire building exercise. In both these instances, the management does not have enough incentives to take decisions which might be favorable to the shareholders. Thus, restrictive empowerment of shareholders can bring about fruitful results in the form of stakeholder maximization strategy. References Bratton, WW and Wachter, M. The case against shareholder empowerment, University of Pennsylvania, [Online] Available at http://pennumbra.com/issues/pdfs/158-3/BrattonWachter.pdf (Accessed on 8 May 2012) Bebchuk, L., 2004. The case for increasing shareholder power, Harvard Law School, John M. Olin Center for Law, Discussion paper No.500 Bebchuk, L and Fried, JM., 2005. Pay without performance: Overview of the Issues, Harvard Law School, John M. Olin Center for Law, Discussion paper No.528 Bebchuk, L., 2006. The myth of shareholder franchise, Harvard Law School, John M.Olin Center for Law, Discussion paper No.565 European Corporate Governance institute, The role of shareholders, [Online] Available at http://www.ecgi.org/codes/documents/hampel27.pdf(Accessed on 8 May 2012) Miller, RL., 2012. Fundamentals of business Law: Excerpted Cases, Cengage Learning O’Rourke, A., 2002. A new politics of engagement: Shareholder Activism for Corporate Social Responsibility, 10th International conference of the Greening of Industry Network, Sweden Reference for Business., 2012. Shareholders, Encyclopedia of business, [Online] Available at http://www.referenceforbusiness.com/management/Sc-Str/Shareholders.html(Accessed on 8 May 2012) Ronen, J and Yaari, V., 2007. Earnings Management: Emerging insights in theory, practice and research, Springer Wheelen, TL and Hunger, D., 2007. Strategic Management and Business Policy. Prentice Hall. Appendix Figure 1 Source: O’Rourke 2002 Read More