A2 Micro: Ownership and Control in Modern Businesses

The owners of a private sector company normally elect a board of directors to control the business’s resources for them. However, when the owner sells shares, or takes out a loan or bond to raise finance, they may sacrifice some of their control. Other shareholders can exercise their voting rights, and providers of loans often have some control (security) over the assets of the business. This may lead to conflict between them as these different stakeholders may have different objectives.

The Principal Agent Problem

How do the owners of a large business know that the managers they have employed operate with the aim of maximising shareholder value in both the short term and the long run? This lack of information is known as the principal-agent problem or “agency problem”.

The principal agent problem revolves around a simple issue - how best to get your employees to act in your interests rather than their own. Shareholders tend to want good returns in the form of dividend payments and a rising share price. Managers may have different objectives such as power, bonuses, large expense accounts, prestige and status. The problem is the many shareholders - including ordinary people who pay into an occupational pension scheme or who dabble with a series of small investments on the stock market - have little or no day-to-day control over managers. Pension fund managers cannot dictate what chief executives of businesses decide to do and senior executives may have little knowledge of what their own managers are doing. This is the essence of the agency problem.

Many investors in a business are ‘passive’, they might monitor the performance of the corporation by following the news in the financial press and (occasionally) attending and voting at annual general meetings but their direct involvement is limited and unlikely to have a bearing on the crunch decisions of the business. The biggest investors in UK listed companies tend to be large institutional shareholders such as pension funds and insurance companies.

Examples of the principal-agent problem that have hit the headlines recently in the UK include the mis-management of financial assets on behalf of investors (e.g. the case surrounding Equitable Life) The classic case in the United States is of course the Enron fraud and debacle. Follow this BBC news link for more background on the Enron case.

More recently the credit crunch focused attention on the failure of shareholders in the major banks to understand the complex and risky behaviour that was being undertaken by bank employees involved in the sub-prime mortgage boom and the growth of securitised lending.

In the banking crisis it became clear that senior management at many of the world’s biggest banks simply did not understand the complexity of what their traders were doing. Traders stood to earn huge bonuses if their risky loans worked, but faced little sanction or loss if they went bad. This skewed their incentives and created a problem of moral hazard. This term originated in insurance, recognising the idea that people with insurance may be careless – for example, paying for secure off-street parking looks less attractive if your car is insured.

A separation of ownership and control in banks and insurance companies contributed to the sub-prime crisis and the result has been a collapse in shareholder value as the stock market prices of banks and insurance companies has fallen sharply.

Employee Share Ownership Schemes

There are various strategies available for coping with the principle- agent problem. One is the expansion of employee share-ownership schemes. But the use and occasional misuse of share options schemes has been controversial for several years. A recent example involved the US computer giant Apple.

The growth of “shareholder activism”

There are plenty of examples in recent times when institutional and individual shareholders have exercised their voting rights to express views on the direction that a company is taking or its performance. Typically they are critical of a perceived failure of a business to maximise shareholder value measured in terms of share price, the flow of dividend incomes etc.

Increasingly we are seeing shareholders who are more proactive in putting executive management under pressure - these are known as activist shareholders. At the forefront of this change has been the expansion of hedge funds and a number of wealthy private investors. Latterly, the sovereign wealth funds have appeared on the scene.

An activist shareholder uses an equity stake in a corporation to put pressure on its existing management. The goals of activist shareholders range from financial (e.g. increase of shareholder value through changes in dividend decisions, plans for cost cutting or investment projects etc.) to non-financial (e.g. dis-investment from particular countries with a poor human rights record, or pressuring a business to speed up the adoption of environmentally friendly policies and build a better reputation for ethical behaviour, etc.).

Activist shareholders do not have to hold large stakes in a business to make an impact. Even those with relatively small stakes or 3 or 4 per cent can launch publicity campaigns and make direct contact with the senior management. Private equity / hedge funds have been among those most involved in the rise of shareholder activism. They tend to focus on under-performing businesses

Is this new breed of shareholder activists an important voice and counter-balance to the power of entrenched management and willing to stand up to corporate corruption and highlight poor management? Can they help to overcome the principle-agent problem? Or are they aggressive corporate raiders seeking short-term corporate change merely for their own personal gain?

Environmental groups such as Friends of the Earth have also latched onto the potential for shareholder activism to impact on businesses especially in the areas of the environmental impact of their business activities.

It remains the case that ownership and control within British industry is dispersed. Typically the largest shareholder in any large business listed on the stock market is likely to own a minority of the shares. Majority ownership by a single shareholder is unusual.

Examples of recent shareholder activism

*Disney: In 2004, Michael Eisner, the chairman and chief executive of Disney, resigned after 43% of Disney shareholders voted against his re-election.
*EuroTunnel: In 2004, the board of Euro Tunnel was ousted at the company’s AGM.
*Vodafone: In May of 2006, Vodafone announced the biggest loss in British corporate history (£14.9 billion). In July 2006, the CEO of Vodafone Arun Sarin came under huge pressure from a group of shareholders unhappy about the performance of the struggling telecoms company. In the event, shareholders voted 86% in favour of Mr Sarin, with 9.5% voting against, and 4.5% abstaining.
*Shareholders in Lloyds banking group have demonstrated against the Board with their anger over the troubled merger with HBOS.
*Ryanair has taken a large stake in their rival Aer Lingus and has twice tried to take over the business. Other Aer Lingus shareholders have put management under pressure because of recent losses.
*In July 2009, executives at Tesco came under pressure at their AGM for bonus payments and the treatment of agency workers.
*In July 2009, shareholders of Marks and Spencer lobbied to change Sir Stuart Rose’s dual-role as both chairman and chief executive of the company and put pressure on management for the level of bonuses for senior executives.
*During 2009-10, the founder and largest shareholder of EasyJet Sir Stelios Haji-Ioannou campaigned for the airline to drop ambitious growth plans claiming that aggressive expansion could threaten the future of the business.

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