The Real Problem With Corporate Governance

Introduction

In the present economic crisis scenario, institutional investors across the globe have become increasing active and have been seen in taking active participation in various aspects of corporate governance. For instance, Legal & General and Aviva who have a stake of 5 percent and 1 percent respectively in Barkley’s Bank have warned to intervene in the bank’s governance if they failed to keep the bank safe from an impending government bail-out (Burgess and Larsen 2008)¹. Again, in another incidence of institutional investors intervened in voting of “gross-ups” of corporate executives (Dvorak 2008)². Analysts believe that in the present financial crisis shareholders must take active position in corporate governance, as it has not been in place for the last decade and needs control. Thus, we see that today due to the fear of financial crisis shareholder activism has heightened.

As early as the 18^th century Adam Smith presented an idea that when ownership and control of corporations are not fully coincident, there is potential for conflicts of interest between owners and controllers (Smith 1976)³. This idea has been formalized later in the form of agency theory which is applied on modern organizations and model the agency cost of outside equity (Jensen and Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure 1976)⁴.

This conflict of interest, along with the powerlessness of owners to write perfect contracts without any cost and/or scrutinizes the controllers, which eventually reduce the value of the firm, ceteris paribus. These form the basic idea for corporate governance research and for this paper too. This paper tries to establish a relation between corporate governance and shareholder ownership. We conjecture that the real problem with corporate governance is the dominance of institutional shareholders in publicly quoted companies-they rarely act like owners.

This paper is dedicated to understand the framework of institutional ownership and how their dominance may affect the governance activities of firms. The article thus explores the meaning of corporate governance and how the prevalence of different interest of the shareholders and the management leads to a problem of governance. Further, there is also a question of ownership. The question that the paper tries to answer is that if the shareholders are the owners of the firms? Legally they have a “partial-ownership” status, but in reality, their actions show differently.

Corporate Governance

Before we dwell further into the topic, it is important to understand what is corporate governance? Corporate governance may be defined as an aggregate of mechanisms, which are both institutional and market-based in nature, which stimulates the controllers of an organization to make decisions that maximize the value of the company to its owners. Here by controller, we refer to an individual or group who are responsible for making decisions regarding company operations and owners are those who invested capital in the company. To explain in a different manner, “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.” (Shleifer and Vishny 1997, 737)⁵

Corporate governance is a tool to ensure that shareholders receive their share of the profit. Corporate governance has enormous practical implications and thus even in advanced market economies it is said to be flawed (Scheifer and Vishny 1997)⁶. Even though there are many optimistic assessments of corporate governance in the US, some believe that it is hugely flawed and believe a move from the current corporate structure is to make it highly leveraged (Jensen, 1993) ⁷.

Corporate governance process is legal and economic institutions which can be changed through political process. One line of argument professes that corporate governance should not be a problem as, in the long run, completion in the product market will induce firms to reduce cost, which will force them to adopt rules, including corporate governance mechanisms, letting them to raise external capital at the lowest possible cost. Thus, this theory believes that it is the competition which will take care of corporate governance (George 1958, Armen, 1950)⁸.

Even though we tend to agree that product market forces are the strongest influencers of the economic efficiency of the world, it is arguable if it is solely capable of solving corporate government problems. Hence, evolution of the agency perspective of corporate governance, which is also termed as separation of ownership from control, need to be reviewed. Due to this reason, managers and financers need to formulate residual control rights which are the powers exercised in situations which could not be foreseen.

Given this contractual situation, financers get to make decisions any time when something unforeseen takes place. But this does not usually happen as financers are not qualified enough to handle such complex management situations. This provides mangers substantial residual rights and discretion to allocate fund wherever they deem fit. Moreover, if the finances are gathered from large number of financers then they are too poorly informed to exercise the control rights that they possessed. The free rider problem that is faced by investors regarding the firms they have financed, and uninterested even to participate in its governance process. Thus, this shows that managers are bestowed with extensive discretionary power in reality.

Agency Problem

Agency problem pertains to solving the problems arising in an agency relationship. The agency problem arises when there is a principal and agent goal conflict or when it is difficult or expensive for the principal to verify what the agent is actually doing (Eisenhardt 1989)⁹. The problem here is that the principal and the agent prefers different actions due to different risk preferences. The essence of the agency problem is in its separation of the management from the finances of the firm. In other words, the theory’s main idea lies in separation of ownership and control. An entrepreneur or managers raises funds from investors to put in productive use or to cash out his holding firm. The financers too require the manager’s human capital to earn return on their capital. But then once he fund is transferred to the manager, how can the financer be sure that his capital is not wasted or expropriated on loss making projects?

In most cases, the financer and the manager signs a contract that specifies what the manger is allowed to do with the fund, and how the returns will be divided between him and the financer. Even though all the details regarding the project and the manager’s responsibilities are mentioned in the contract, it is not always possible to foresee all future contingencies. Due to this reason, complete contracts are infeasible.

Given the agency problem that a firm faces, i.e. there are two distinct interests of the mangers and the financers, it is important to bring the two parties into line so that the organization functions properly. Corporate governance fills the void between the two. Thus, corporate governance is concerned with ways of bringing the interests of the two parties into line and ensuring that firms are run for the benefit of investors.

Shareholders and Ownership

The question of shareholder ownership has been a long lasting debate in corporate governance theory. Shareholders are often referred to as the owners of the organization, but the question arises is that if the corporation which has a “legal personality” can actually be “owned”. Before we dwell into the question of corporate ownership, we first must clarify the idea of “ownership”. Ownership may be defined as a combination of rights and responsibilities with respect to a specific property. In most cases the rights and duties are clearly mentioned, though much of the problem that arises in this case with the responsibilities of the “ownership”.

Now it is important to understand what it means to own a “part” of something? Shareholders are said to “own” the company. But a share does not translate to the whole company, but refers to a specified section of the company’s assets till the time the company is dissolved. Once the company is dissolved, and the creditors get what they are owed, the rest goes to the shareholders. In this case, shareholders have limited liability, limiting their responsibility to prevent or stop the management’s wrong doings.

Separate ownership and control

The problem then arises in separation of ownership and control which is rarely completely separated within any firm. In reality, controllers usually have some degree of ownership of the shares of the firms they control. Again, some owners i.e. shareholders by virtue of the sheer size of their holding exercise some control over the firm. Therefore, structure of ownership of firm i.e. who are the shareholders of the firms and the size of their holdings is an important element of corporate governance.

A presumption in this respect can be made that when there is greater overlap between ownership and control, there should be to a reduction in conflicts of interest and which would lead to higher firm value. If the ownership of the firm lies with the company’s management, for instance, can lead to better alignment of managers’ interests with that of the shareholders. But if the managers’ and shareholders’ interests are not fully aligned, large shareholders can provide managers with greater degree of freedom to pursue their own objectives without fear of reprisal. Thus, shareholders are in a position to influence the actions of the management. But with large number of small shareholders, the problem of free riders increases.

Another problem that can be observed in case on institutional shareholders, who own a “block” of the firm, is that the they can influence the management so that it becomes more likely to make decisions that increase overall shareholder value. Thus, a large institutional shareholder exercises their majority power and exercise control and all the shareholders reap the benefit. But there are private benefits from which only the institutional shareholders benefit and these can be harmless from the perspective of other shareholders. But at times, they try to use their power to extract corporate resources; the private benefits they receive will lead to reductions in the value of the firm to the other shareholders. Therefore, the effect of institutional shareholder control over the firm ownership on depends upon the trade-off between their shared benefits from their control and any private extraction of firm value by them. This may seriously hamper effective corporate governance.

Institutional Shareholders

The basis of the discussion rests on the activism of large shareholders, primarily, institutional shareholders. Their actions are usually dominated by actions such as presenting (or intimidating to present) a proposal on a corporate governance issue at a company’s annual shareholder meeting and forcing the management to undergo a change in management or strategy. Research indicates that shareholder proposals are more often than not “precatory” in nature which the management usually overlooks (Black, Shareholder Activism and Corporate Governance in the United States 1998)¹⁰. Even the institutions which are the most active spend less than less than.005 percent per year on corporate governance issues (Guercio and Hawkins 1997)¹¹.

These shareholders deliberate on governance issues without any competence needed to decide company-specific issues such as whether a particular company is pursuing a sensible business strategy or has the right CEO. Their reluctance to spend significant amounts on activism is an indication towards the returns that they expect from this activity (Pozen, 1994).¹²

Research on institutional shareholder’s voting habits show that their proposals typically are concerned with “redeem or weaken a company’s poison pill; eliminate staggered board terms, so that all directors can be replaced in a single election; make shareholder voting confidential; adopt cumulative voting for directors; put the company up for sale; separate the positions of chairman of the board and chief executive officer; and create a nominating or compensation committee of the board composed entirely of independent directors” (Black, 1998, 4)¹³. The majority of the proposals are concerned with structural issues. Many institutions in the US have developed policies as to how shareholders should vote on recurring issues.

Voting by institutional shareholders takes place on numerous issues annually and so they devote limited effort in deciding how to vote on a particular issue in a firm. Most of the cases show that the institution will either support management decisions or follow a preexisting voting policy rules. Shareholders, who are active partially informed, usually present proposals which have already been presented by other shareholders in other firms. It is seldom that shareholders actively make a unique proposition which is company-specific and unique.

As discussed by Black (1990, 1992)¹⁴ the economies of scale that lead activist institutions to concentrate their efforts on structural and process issues. He found that shareholder proposals submitted by institutional investors arrive usually from pension funds (Gillan and Starks 1997)¹⁵. The proposals arrive from the public pension funds as they face weaker conflicts of interest in challenging managers than other institutions (Black, 1990)¹⁶. But it should be noted that the lack of principal-agent conflict of interest arises from the pension funds political rather than profit maximization motives (Romano, 1993)¹⁷. In terms that are more general it can be said that institutional shareholders have their own agency and information costs, which may reduce their effectiveness as monitors.

Corporate governance and Shareholder Responsibility

With the presence of principal-agent problem, it is important to understand the differences that arise due to diverse interests. It is also required to understand if either of the two causes any problem in establishing corporate governance in firms. In this section, we try to carry out an exercise to understand how corporate governance affects the interests of each group.

The process of exercising corporate governance is often associated with the structure and function of the board of directors of the company. The role of the non-executives, chairmen and chief executive officers (CEOs), and remuneration, audit, and nominating committees has been discussed in details. It has been widely believed that the primary duties of the directors are to represent the interests of shareholders. In United Kingdom and the United States, the role of institutional shareholders in exercising good governance and are expected to play a more active role in the monitoring and control of firms.

It has been argued that the duties that shareholders have in overseeing the functioning of companies extends beyond their own financial interests to the proper governing and functioning of the firm (Donaldson and Davis 1991).¹⁸ This view holds that it is the implicit duties of the shareholders to see to the proper functioning of the firms and it safeguards the interest of all the shareholders. Recently the debate has been extended to the notion that firms have responsibilities to parties other than shareholders, with the extension of the stakeholder theory of firms. This idea further extends by stating the stakeholder theory actually, is in the interests of shareholders to take account of a broader population including employees, suppliers, and purchasers from the firm. This view stresses on development of long-term relations which instills trust and commitment which helps in development of the firm successfully. According to this line of thought, the best run organization is one which safeguards the interests of all the stakeholders like the customers, suppliers, employees, and the shareholders.

Moreover there is a present concept that has gained prevalence is that firms should not simply be run in the interests of their shareholders. The firm’s responsibilities to other stakeholders need to be fulfilled too for proper corporate governance even when the management and shareholder interest conflicts with their objective of wealth maximization for shareholders. According to this line of argument, firms are seen as an entity which is distinct from its shareholders, where ownership and control is spread amongst a number of shareholders. Thus, Mayer (1997)¹⁹ states, “the central problem of governance is to devise specialized systems of incentives, safeguards, and dispute resolution processes that will promote the continuity of business relationships that are efficient in the presence of self-interested opportunism” (11).

The criterion by which a firm’s performance is judged has two point-of-views. According to the shareholder model, the objective of the firm is to maximize its market value through proper allocation of resources, high productivity, and dynamic efficiency. But the stakeholder approach states that performances is judged by safeguarding the interests of other stakeholders and maintain employment, market share and growth in trading relations with suppliers and purchasers as well as financial performance.

The persistent differences in participation in corporate control by shareholders show different patterns of ownership of the firm. It has been found that in the UK and the US, the ownership is primarily associated with institutional investors, but the share of individual ownership by the institutions is greater in the US than in the UK (Mayer 1997)²⁰. In both the countries, the dominance of institutional shareholders is prominent and prevalent but not the case in most countries. In most cases, ownership vests in corporations or individual shareholders. As has been observed by Mayer, “Cross-ownership of shares by one firm in another is commonplace and large family holdings frequently dominate institutional investments” (11)²¹.

This shows the development of a different system of ownership called the “insider system” (Franks and Mayer 1996)²² which is different from the predominant model of “outsider system” of the UK and US where ownership and control lies with institutional investors who are outsiders.

The structure of ownership of a company affects its corporate governance and how they are managed and controlled. There are a number of forms which these differences can take:

Firstly, there arises a difference in the flow of information to investors. For instance, the prevalence of closer relations between investors in European and in Japanese companies may help in making better, informed, and more active shareholders. It has been often suggested that the information that German investors derive is usually through the supervisory boards. However, critics have pointed out that the failure as Metallgesellschaft as an example that information flows in the German system was seriously flawed (Mayer 1997)²³.

Secondly, shareholder dominance in terms of their share of the firm ownership and the proper corporate governance are directly likened (Mayer 1997)²⁴. Large number of shareholders in the UK and the US systems of corporate governance may provide insufficient incentives for any one investor to monitor and control the performance of firms. This indicates that the presence of large dominant shareholders there arise greater returns through active governance.

Thirdly, the situation of corporate control, especially in case of hostile takeover, is less active in most countries other than in the UK and the US. The market for corporate control is regarded as an important restraint on the behavior of firms.

The above differences in monitoring and control will manifest themselves in a number of ways. First, according to the principal-agent models of the firm, profits and dividends are the prime drivers of performance. As the incentive systems are a function of information irregularities between shareholders and managers, the relative degree of risk aversion of shareholders and managers influence the incentives on the productivity of managers. Further difference in ownership pattern may influence the flow of information to shareholders and the degree of risk sharing between shareholders and managers may differ. For example, prevalence of dominant shareholders may increase unobtrusive flow of information, but may decrease the firm’s capability to spread risks than small dispersed shareholders. This leads to the imposition of large incentives on managers which are more directly related to the performance of the firm.

Second, the alignment of objectives of managers and that of the shareholders, according to the principal-agent model, is necessary. The presence of large shareholders indicates greater willingness to discipline poorly performing management; moreover, large shareholders have a greater amount at stake and a larger incentive to intervene and exercise their control rather than “exit”.

Further in case of financial restructuring the role played by financial institutions in bailing out the ailed organizations is viewed differently in different country’s governance systems. For instance, the role of Japanese banks in restructuring poorly performing firms is thought to be an important feature of the country’s financial system. Again, in the United Kingdom and United States, it is sometimes asserted that financial institutions (banks, pension funds, and life assurance companies) intervene too late in corporate restructurings.

Thus, we see that presence of large and active shareholders help in effective corporate governance practices. But this is true only to a certain level. This is so because the interest of large institutional shareholders may override the interests of minority shareholders (La Porta, Lopez-Silanes and Schleifer 1999)²⁵. Research has also indicated that profitability is higher for firms with shareholders that have up to 5% stakes, but beyond this limit, profitability falls (Morck, Schleifer and Vishny 1988)²⁶. This pattern may indicate that larger, block-holding investors seek to generate private benefits of control that are not shared by minority shareholders. Institutional shareholders are often limited, either by regulation or by a desire to maintain liquidity, to holding a maximum 5% of a firm’s equity, so their holdings appear likely to be at the optimal level to generate profitability.

Clearly, intervention of shareholders and their active participation is required but to what degree is a question that needs to be answered. Further, we need to discuss in what ways shareholder activism may cause hindrance in corporate governance and the reason lies in the fact test shareholders neither are nor complete owners of the firms but partial owners.

Institutional Shareholders and Corporate Governance

A new line of thought suggests that outside control by shareholders in the governance activities is beneficial has been challenged by recent researches. This line of thought argues that constraints on managers through monitoring may also be costly precisely because managerial discretion comes with benefits. More precisely, even if managerial discretion is ex post disadvantageous to shareholders, it can be beneficial ex ante as it favors firm-specific investment, like searching for new investment projects. The manager is less inclined to show such initiative when shareholders are likely to interfere. Hence, to the extent that managerial initiative (or any firm-specific investment) contributes to firm value, there is a trade-off between the gains from monitoring and those from managerial initiative.

The cost of dominance of large institutional shareholders is related to the tendency of blockheads to undergo risk diversification profits (Demsetz and Lehn 1985) ²⁷or they may promote their personal interest at the cost of other shareholders (Shleifer and Vishny, A Survey of Corporate Governance, 1997)²⁸. If the block holders reduced the stock’s liquidity, large institutional shareholders may also slow down information production in the stock market (Holmstrom and Tirole, 1993)²⁹. In addition, aggressive counter bidding by present institutional shareholders may reduce the likelihood of takeover attempts (Burkart 1995).

Grossman and Hart (1986) and Hart and Moore (1990) argues that entities without ownership should be discouraged from commissioning asset-specific investments since the owners of the assets can use control rights to hold them up. Moreover, control rights of shareholders can be translated to effective control if and only if the shareholders have the motivation to exercise them (Aghion and Tirole 1997)³⁰. Hence, it can be said that the structure of ownership is a powerful technology to allocate effective control in a way that lessens the holdup problem (Burkart, Gromb and Panunzi, 1997)³¹.

Further many researches show the institutional shareholder’s inability to commit to refrain from rent extraction has undesirable effects on the agent’s interests. The situation of informational monopoly allows a large institutional lender to dominate the terms of continuance finance, thus altering and at times distorting the firm’s investment choices (Rajan, 1992, von Thadden, 1992)³². According to Shleifer and Summers (1988) hostile takeover is a means of to extort stakeholders’ ex post rent of the stakeholders by removal of the managers’ commitment to sustain implicit contracts³³. Acemoglu (1995), Myers (1996), and Burkart, Gromb and Panunzi (1997)studied the trade-off between the benefits of tighter shareholder control over corporate governance and lower incentives for insiders associated with outside ownership concentration³⁴.

All the studies consider a free cash flow framework with existence of exogenous costs of exercising control. They showed that the latter declines, as there are an increase in the former. The argument about competing evaluation systems was studied by Cre´mer (1995)³⁵. His study showed that the principal’s trade-off between solving a moral hazard problem by remaining ignorant about his agent, and solving an unfavorable choice problem by becoming knowledgeable. The study assumes that the principal is able to commit to his choice.

Morck, Shleifer, and Vishny (1988)studied cross-sectional documents which showed an S-shaped relationship between board ownership and organizational performance when it is measured either by Tobin’s Q or accounting rate of return³⁶. So when there is a rise of the large principal’s holding from 0 to 5 percent range, decreasing between 5 and 25 percent and increasing again over 25 percent, but at a slower rate. They found the same relationship while examining the ownership by executive and outside directors separately. Wruck’s (1989) confirms the former study through her events study of organizations experiencing a change in ownership concentration³⁷. According to her study, she concludes that the declining relationship in the 5 to 25 percent range is consistent with the effect of taking initiative dominating effect of control. Her study also indicates that when ownership is beyond 25 percent it has an adverse effect on the value and wealth maximization of the firm.

Researchers have constantly asked the question if there exists a correlation between ownership concentration and firm performance and governance. Some studied shave actually shows that increased concentration of ownership by shareholders lead to underperformance of the firm (Carvell and Strebel, 1987)³⁸.

The question that arises is that if such a large block holders can be considered an outsider? Probably not, as they are usually directly involve in the running of the company (Burkart, Gromb and Panunzi 1997)³⁹. The negative relationship between ownership concentration and firm performance has also been confirmed by Agrawal and Knoeber (1996)⁴⁰.

A study by Burkart, Gromb and Panunzi (1997) shows that there is a negative relationship between divestitures and higher managerial turnover following good performance and concentrated ownership. Further, they expect ownership concentration to increase in the gap between long-term and short-term returns. Firms which are new start-up and which usually have low current income relative to their future earning capacities can be categorized accordingly. Institutional shareholders hold substantial stake in such small and new companies, usually sitting on boards and dominating the decision-making process. As regards inter-industry comparisons, our model predicts high concentration in growth industries and more dispersed ownership in mature or declining industries (with a low Tobin’s Q). Yet, large shareholders are always desirable when sweeping restructuring or downsizing is at hand. In such situations, the advantages of choosing the correct long-term option, e.g., exit, may be particularly large. For a sample of British organizations, Franks, Mayer, and Renneboog (1996) showed that ownership concentration increases during periods of financial difficulty⁴¹.

In the end, relative short-term actions should remain when ownership is largely scattered for exogenous reasons. Several authors like Roe (1990) have shown that the legal environment in the US depresses the formation of large shareholders to the extent that the legal system is exogenous⁴². So it can be said that American organizations tend to put more stress on short-term objectives than their German counterparts which are subject to tighter internal control (Burkart, Gromb and Panunzi 1997)⁴³.

Conclusion

This paper discusses that the managerial discretion comes at a price as well as benefits. Control over management by large institutional may be ex post efficient but constitutes ex ante an expropriation threat that reduces the level of non-contractible investments by managers (Burkart, Gromb and Panunzi 1997)⁴⁴. Clearly, ownership concentration of shareholders involves a trade-off between control and initiative of the firm. Even though institutional shareholders are partial applicants at the IPO stage, initial owners have a further reason to limit monitoring through dispersed ownership. Investors might over monitor because they do cannot extract private gains. Private equity holders are said to show to assign effective control on a contingent basis. Further, we see that academic literature supports the idea that shareholder ownership concentration above a limit affects the overall governance of the firm.

Institutional shareholder dominance on firms shows that after a certain level of ownership concentration there arises a high degree of dissonance in the interest of the management and the shareholders which leads to a negative performance of the firm and ill managed governance. The study also shows that there are instances when the institutional shareholders dominantly force the management to take decisions which are good for their interest but do not do any good for other stakeholders like the employees or suppliers or customers. If such a policy is undertaken, then stakeholder dissatisfaction will lead to lower growth or performance of the firm. Clearly, this indicates a failure of the corporate governance procedure.

Moreover, it is believed that shareholder activism and proposal requesting for a drastic structural change in the organization may lead to changes in the culture of the organization. With a change in the corporate culture, there can be a change in the performance of the firm. But researchers doubt the credibility of such a change as they believe it may change the performance matrix of the organization (Black 1998)⁴⁵.

The influence of institutional shareholders leads to a drastic change in the firm is not necessarily for the best interest of all the stakeholders. They are driven by self motivation and self-profit interest. This brings the question of the “ownership” by shareholders. Revisiting the ownership question, it can be pointed out, as the shareholders are partial holders of the stake, they are disinterested in formulating proposals that will improve the overall governance of the firm and facilitate all the stakeholders. Their partial ownership fails to imbibe ownership for the whole firm or the system, which will lead to a betterment of the whole company. Thus, they are more concerned with their limited liability status and are concerned only when there is a problem with their profit from the firm, but not otherwise. The interest of the shareholders thus, can have mixed effect on the company governance activates but the problems that arises in their intervention is due to their self-conceited interest which fails to see the holistic benefit of all the stakeholders.

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Footnotes

1. Burgess, Kate, and Peter Thal Larsen. “Retreat by Barclays fails to end revolt.” FT.Com.
2. Dvorak, Phred. “Proxy Firm Targets Practice of Paying Executives’ Tax Bills.” The Wall Street Journal, 2008.
3. Smith, Adam. An Inquiry Into the Nature and Causes of the Wealth of Nations. London: Regnery Gateway, 1976.
4. Jensen, M. “Teh modern industrial revolution, exit, and the failure of internal control systems.” Journal of Finance vol. 48, 1993: 831-880.
5. Scheifer, Andrei, and Robert W. Vishny. “A Survey of Corporate Governance.” The Journal of Finance vol. LII no. 2, 1997: 737-85.
6. ibid.
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20. Ibid.
21. Ibid. p.11
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24. Ibid.
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46. Ibid.
47. Black, Bernard S. “Shareholder Passivity Reexamined.”