#19678 - 6. Corporate Governance In Larger Companies - Company Law

TOPIC 6:

CORPORATE GOVERNANCE

Essential Reading:

Dignam and Lowry: Chapters 15 and 16

Economic theories that have influenced corporate legal scholarship – to challenge corporate realism

Economic theory is concerned primarily with efficiency: 1) resources are allocated efficiently; and 2) the production is efficient (meaning output is maximised from a given input). However, the focus of neo-classical economics is on the market and its equilibrium, it had no real insight of the separation of ownership from control.

Additional Reading:

Kraakman, Armour, Davies et al, The Anatomy of Corporate Law, (3^rd edition, OUP, 2017)

S.Deakin, ‘The coming transformation of shareholder value’ (2005) 13 Corporate Governance: An International Review 11

M.Moore, ‘Whispering Sweet Nothings: The Limitations of the Informal Conformance in UK Corporate Governance’ (2009) 9 Journal of Corporate Law Studies 95;

Kershaw, ch.5-7; or

Worthington, ch.5.

A. INTRODUCTION

1. Defining corporate governance

‘Corporate Governance is the system by which companies are directed and controlled.’ (Cadbury Report, 1992 at para. 2.5).

‘Although the term ‘corporate governance’ literally applies to any incorporated entity, corporate governance scholars tend to be primarily concerned with ‘public’ or listed corporate entities, whose securities are traded on regulated liquid investment markets’. (M. Moore and A. Rebérioux, ‘Revitalizing the Institutional Roots of Anglo-American Corporate Governance’ (2011) 40 Economy and Society 84 at 85).

2. The separation of ownership and control

Traditional enterprise model refers to the unincorporated business associations where the individual owners were also the controllers.

[t]he building and operating of the rail and telegraph systems called for the creation of a new type of business enterprise. The massive investment required to construct those systems and the complexities of their operations brought the separation of ownership from management.

The emergence of large publicly held enterprises in the late nineteenth century brought about a degree of separation of ownership (shareholders) from day-to-day control (management).

In UK listed companies, the board of directors typically does not exercise managerial control. Listed companies are generally run by a team of senior executives, led by the chief executive officer (CEO). On boards delegating managerial power to executives, see Model Articles, art. 5(1). If shareholders are passive the result will be what Berle and Means described as a “separation of ownership and control”

A. Berle and G. Means: The Modern Corporation and Private Property (New Brunswick, 1932).

• Berle and Means made two observations –

Shareholders were so numerous that no individual shareholder had an interest in attempting to control management. 65% of the largest 200 US companies were controlled entirely by their managers.

Managers were not only accountable to shareholders but also exercised enormous economic power which had the potential to harm society.

Berle and Means’ concern about the separation of ownership from control was not only about the lack of accountability to investors – it was also a concern about the managers’ lack of accountability to society in general.

• They spoke a small group, sitting at the head of enormous organizations, with the power to build, and destroy communities, generate great wealth and productivity, but also to control the distribution of that wealth, without regard for those who elected them (stockholders) and those who depended on them (the larger public) (Mizruchi 2004)

• Berle and Means expressed considerable concern about this development

These managerial corporations continued to grow and became the dominant business form of the 1900s. however, by the 1970s legitimacy of the managerial corporation was questioned… in the 1980s, reform in State Pension and Healthcare funding had pushed enormous amounts of money into equity markets through institutional investors (pension funds, investment funds, insurance companies). Simultaneously, barriers to capital inflows and outflows were removed in many countries resulting in international investment funds operating in both London and NY markets.

• Emerging institutional investor as a dominant force in these markets.

  • Organizations who pool together funds on behalf of others and invest those funds in a variety of different financial instruments and asset classes.

Institutional investors – preferred to remain largely passive investors – they favoured market mechanisms in order to promote shareholder wealth. These market mechanisms included share options – which grew as a percentage of managements’ total salary. The 1980s saw once again a public disquiet about corporate accountability.

Particularly the German economy and its company law system oriented toward the ‘inclusive stakeholder’. Resultingly, pressures increased on companies to recognize broader ‘stakeholder’ constituencies which continue on to present day.

Institutional investors have been retreating from shares as they seek better returns elsewhere – this may be indication that Berle and Means corporation has transformed as the largest shareholders withdraw to be replaced by more activist investment and hedge funds (Dignam 2013)

The UK has an “outsider/arm’s-length” system of ownership and control, characterised by widely dispersed shareholders. “Insider/control-oriented” corporate governance typically prevails elsewhere, characterised by concentrated and controlling shareholders.

As for publicly traded companies in the UK with “blockholders” (concentrated, controlling shareholders) the number of companies of this sort increased in the 2000s due to a growing number of companies established elsewhere listing on the London Stock Exchange.¹ The Listing Rules were amended in 2014 in response to this.²

3. The implications for the governance of large, and especially listed, companies:

• Management versus (all) shareholders: the problem of ‘agency costs’

Within publicly listed companies there is a separation of ownership and control. Shareholders are unlikely to be in a position to run companies (consider the number of shareholders in largely quoted companies – averaging some 300,000 members in a FTSE 100 company in the UK).³ Executives, however, may not act in the best interests of their shareholders, and may engage in self-interested behaviour, which generates ‘agency costs’.

The term ‘agency costs’ was developed by economists and now is widely used (e.g. Walker Report at 68), and can take the form of improper diversion of corporate assets or profiteering at the expense of shareholders. The usual inference is that the exercise of executive power must be managed and contained through (public) legal-regulatory intervention or (private) market mechanisms.⁴

Within companies, three basic types of agency problems arise: those between managers and shareholders; between controlling shareholders and minority shareholders; and shareholders as a class and other corporate constituencies, such as corporate creditors and employees.

Agency costs – the costs of the shareholders acquiring enough information themselves about the firm’s operation to be able to check on management. “Shareholders will only bear these costs if the part of the firm’s earnings that flows to them is greater than the costs of monitoring” (Jensen and Meckling)

Shareholders are given the monitoring role as they have the primary claim over the earnings of the firm once the creditors have been paid (risk argument) – in essence, all others within the team have the security of being paid (they are contracted for a fixed sum) whereas shareholders hold no such security and so have the incentive to monitor. They are allowed to change membership of the team where it becomes necessary

• Alchian and Demsetz (contracts analysis) place the shareholders in the monitoring role, and directly attacks the managerial firm as being inefficient because it is unconstrained by shareholders. The managerial firm thus does not contain the necessary mechanisms to focus managerial power on the goal of profit maximisation.

• Jensen and Meckling (1976) – adds on to A&D, arguing the relationship is between agent and principal. However, the manager knows more about the firm’s operation; so in order for shareholders to effectively ensure the manager is efficiently making decisions, shareholders incur agency costs. Such agency costs are the costs of the shareholder acquiring enough information about the firm’s operation to be able to check on management.

• Owner-managed firms have few or no agency costs but the agency cost increase as management’s ownership decreases. The managerial firm creates the highest agency costs where management has no significant ownership.

High agency costs are reflected in low share price. A takeover bid will replace inefficient management.

High levels of debt increase the risk of a firm entering insolvent liquidation resulting from management failure. Debt thus results in the absence of discretionary cash surplus for management to satisfy their own self-interest and operates to keep management efficient.

• Where the firm produces a discretionary cash surplus, this will be returned to the shareholders to replicate the effect of debt on management.

Management is highly disciplined where the firm operates competitively – the threat of insolvency is automatically exacerbated because of the need to reducing costs to remain competitive.

Agency cost theory – Williamson 1975

• Argued like Coase, transaction costs...