The Separation of Ownership and Control

The issue of the separation of ownership and control has been discussed for numerous years. But has come to prominence after recent scandals in the past two decades such as Enron, Maxwell, Pollypeck, BCCI and recent Satyam scandal to name a few. Most of these had major impact within the UK and led to many reports and committees such as the Cadbury, Hampel and Higgs which aimed to alleviate the possibility of past events re-occurring. The banking crisis of 2008 and recession has led to the corporate governance mechanisms employed within the UK to be questioned.

A corporation is made up of ‘two organs’ the board of directors and its shareholders. The view that directors would do as instructed by shareholders has long disappeared. After the 20th century, this view had been altered to the effect that the board were capable of exercising powers independently from shareholders. With this and the growth of public listed companies on the stock exchange, whereby shares are available for the public to buy; shareholder control of the company become more difficult to contain. This meant that shareholders were more geographically dispersed and the amount of shares shareholders held differed considerably, affecting voting rights. This can be contrasted with company structures such as sole-traders, partnerships or small private companies where those who own shares generally manage the company.

This has led to what has been described as the ‘agency problem’ whereby the directors of the company are managers of the shareholders money and there is an element of risk that the directors will act in their own interests rather than the interest of shareholders. UK law has sought to overcome this problem through s172 Companies Act 2006 (CA 2006), which holds that shareholders interest are viewed as the primary interest which directors must oblige to. However Equitable Life Assurance Society v Bowley illustrates the difficulty of holding directors to account and the cost and delay in doing so.

As Hannigan states ‘no single mechanism can provide an answer to the problems presented by the separation of ownership and control’ but the UK law employs three mechanisms to bridge the gap between the separation of ownership and control of listed plc’s.

Shareholders play a crucial role in governing a company, but this depends on their ability to take active steps to review performance of management and hold them to account. The CA 2006 reserves certain rights exclusively for shareholders these include varying the constitution of the company, altering the rights attached to shares and approving certain contracts between the directors and the company. Shareholders also have additional governance responsibilities such as reviewing the performance of the board and taking action if they believe that performance is not up to expectations, this may include removal of directors.

However as has been noted by Berle and Means, shareholders are not interested in using the powers conferred to them by the articles in holding the board to account and reviewing performance. They argue that the time and effort required by shareholders to hold management into account did not make it worthwhile. The alternative of accepting takeover bids or selling shares which are easily sellable on the free market provided a trouble-free solution to shareholders.

As s281 CA 2006 provides, shareholder decision-making can only be made by way of meetings for public companies, and are viewed as an important arena for members to voice concerns. Historically, they were often well attended with vigorous debate and meaningful voting. Now, as Hannigan states it is ‘weak and ineffectual method of control’ as it is poorly attended and shareholders are ill-informed. Moreover, those that do attend, attend in small numbers and are unrepresentative of all shareholders. As Davies states, shareholders allow general meetings to be captured by single-issue pressure groups who wish to communicate self-interest issues.

The lack of private shareholder interest has shifted emphasis on institutional shareholders who hold a very large proportion of shareholdings estimated at 60% of listed companies on the London Stock Exchange (LSE). Institutional investors include pension funds and insurance companies. The Combined Code provides that institutional shareholders should enter into dialogue with companies. One commentator argues that listed companies should communicate risks and uncertainties, which would better explain the current situation of the company, which may influence shareholder-board relationship. This provides the emphasis on the institutional shareholder ‘voicing’ concerns rather than exiting. But the success of this is currently uncertain.

There is growing concern that institutional investors are acting as silent giants by not making ‘considered use of their votes’ in general meetings which is a concern as some see them as ‘effectively policing large companies for the benefit of all’ and help to maintain high standards of corporate governance. This allows power to remain concentrated in the board which is a concern.

The Combined Code (CC) is not enshrined under legislation but a rather ‘soft law’ approach is adopted; therefore a breach does not lead to legal consequences. In relation to listed companies, there is a ‘hard-core obligation’ for listed companies to abide by the CC as found under The Listing Rules. The listing company should explain how it has abided by the CC and explain any non-compliance in their annual report. This is commonly called the ‘comply and explain approach’.

The CC has been described as “an authoritative ‘good corporate governance’ standard for companies throughout the world”.The Association for British Insurers have found that companies who practise good corporate governance produce 18% higher returns than companies with bad corporate governance. In the same article, it was also stated that over 75% of companies were compliant in areas such as audit, separating chairman and chief executive and structured independent remuneration committees. Additionally one may argue that it is easier to monitor details of manager compliance to the CC rather than management decision making.

Section 1 of the CC includes several important concepts which affect the separation of the ownership and control. The CC states that the company should be headed by an effective, collectively responsible, board. The banking crisis of 2008, which led to near collapse of the UK financial sector, has put this part as well as numerous other parts, of the CC into question. The board of these particular banks were not effective in safeguarding the interest of shareholders which led to a dramatic drop in share prices of banks and other companies listed on the LSE.

Additionally, the CC states that one person should not take the dual role of chairman and CEO; this person would enjoy too much concentrated power. The recent example of Sir Stuart Rose taking the dual-role of chairman and CEO at Marks and Spencer has brought past scandals such as that of Maxwell, where one individual had unfettered power, back to light.

The ‘soft law’ approach adopted by the UK, shifts reliance on shareholders to take action on non-compliance. As discussed above, shareholders have limited interest in managing the company. This would then shift reliance on institutional investors to promote good corporate governance with listed companies, but no concrete evidence states that this is being done. Davies contends that “the level of enforcement by the Financial Services Authority is relatively low”. This raises an important question: who is ensuring these companies abide by the Combined Code?

In light of the above question, Chiu argues that certain aspects of the CC particularly the remuneration, nomination and audit committees’ should rather be encompassed in legal framework under company law. This can be seen in USA where a stricter from of legislative regulation, namely the Sarbanes-Oxley Act 2002 is adopted which allows enforcement by a regulator or instigation by private legislation if there is failure to abide. This overcomes problems relying on shareholder activism. Recent reports such as the FRC report (2009) and Walker review (2009) conclude that the core of the CC is still effective, therefore radical changes are unlikely.

One commentator states that there is ‘some degree of non-compliance with the Listing Rules’; some companies failed to explain non-compliance, of those who explained non-compliance, some were inadequate. The writer also speculates that rather than explaining non-compliance, the listed company will overcome this problem by complying with the code instead of providing a fuller explanation; which can lead to box-ticking application of the CC rather than thoughtful application the code. A report, relating to FTSE companies found that 25% of companies failed to provide details of appointment of non-executive directors and 15% of companies did not identify a person within the audit committee.

The view on non-executive directors (NEDs) has changed drastically; ‘…from a useless nonentity scarcely worthy of a mention to a pivotal role at the centre of the debate on corporate governance.’ Their expertise and experience can assist the board or help inexperienced directors. The role of the NED can be categorised into developing strategy and monitoring executive directors. They are viewed as ‘guardians’ of shareholder investment and responsible for sensitive aspects of the corporation such as remuneration and audit.

The CC states that the board should include a balance of executive and non-executive directors, which removes possibility of an individual director dominating the board decision making. Half of the board, excluding the chairman, in large companies (thus PLC’s) should compromise of independent non-executive directors.

The effectiveness of NEDs has facilitated in considerable debate, there are those who believe that NEDs sufficiently address the issue of separation of control and ownership in plc’s, but there are also those who offer dissenting views.

Kiarie offered the view that NED bring about an external viewpoint which allows for the development of wider, fresh and a objective perspective within the boardroom. Moreover, their expertise and experience allows them to see the potential risks and opportunities which improves the listed companies’ performance. Not only will this safeguard the investment of the shareholders but will also provide confidence for management, which in turn could lead to further investment from new/existing shareholders. With the right NEDs appointed to the board, Kiarie argues that there is added prestige to the company’s profile with creates a more favourable corporate governance image. In a practical setting, one commentator questions if there are ‘second thoughts for NEDs?’ he concludes ‘not at all’; the potential benefits, in the writers opinion of NEDs are now ‘more than ever’. This could be argued to directly address the issue of separation of ownership and control; NEDs are acting as guardians to shareholder investment, promoting direct success of the company through financial returns and stability and strategically pushing the listed company in a more favourable direction.

Sweeney-Baird offered a dissenting view stating that the function of a NED ‘creates an essential conflict’. If a NED devotes less time to their role, they have less time to discharge their monitoring function, but if they are full time, their independence is questionable. Likewise, if a problem required a NED to become a whistleblower, this could tarnish any working relationship with the board. Illustrating that NEDs are ‘stuck between a rock and a hard-place’.

The independence of NEDs cannot be understated; Kiarie states that independence is ‘compromised from the outset.’ NEDs are recommended by executive directors and shareholders rubber-stamp this. The lack of actual independence obscures their role to challenge the board and discharge their role in sensitive areas of listed companies such as remuneration; for example they are less likely to take a firm stance on excessive director remuneration in the hope the favour will be returned. An example can be seen in the excessive pay of Fred Goodwin who was paid £4 million in 2007 and his £703,000 per annum pension is seen as an award for failure and illustrates the ability of executive directors to still demand excessive payments whilst NEDs are responsible for determining their pay.

The forced reliance by NEDs on information by the board, due to lack of time spent with the concerned plc puts the power in hands of executive directors to ‘edit, delay or incompletely disclose information to NEDs’. This has been attributable to corporate scandals such as Enron and Maxwell where there was lack of clear information provided, affected ability of NEDs to challenge information. The lack of remedy available to NEDs if executive directors withhold information can be detrimental for NEDs discharging their role effectively.

A commentator has stated that ‘the sheer scale of the expectation of the non-executive director is a concern’. With this statement, coupled with NEDs not devoting all their time to the listed company; importance on training and development of NEDs would be high on the agenda. The Higgs Report acknowledged that less than 25% of NEDs received any formal briefing 66% didn’t receive any developmental training. Without this, one could argue that they may not be actually aware of their role and therefore effective monitoring is undermined. NEDs are not directly accountable to shareholders and the problems discussed above severely outweigh the potential benefits of NEDs, who would otherwise be an effective tool in the separation of ownership and control.

Conclusively, the UK has utilised several mechanisms, discussed above, to overcome issue of separation of ownership and control. The constant review by the UK provides comfort in making sure that corporate governance remains adaptable to changes. However, the weaknesses of the mechanisms are highly significant and this may lead to the unfortunate consequence of more corporate failings. It is hoped the three mechanisms will work more successfully in collaboration, rather than in isolation, to hold the controllers of the company more accountable.

Bibliography

Primary Sources:

Companies Act 2006, s 168

Companies Act 2006, s 626-640

Companies Act 2006, s 188.

Companies Act 2006, s 21

Equitable Life Assurance Society v Bowley [2003] EWHC 2263.

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