Separation of Ownership and Control, and Agency Costs

The classic study of the ownership and control of corporations is Berle and Means, 1932.  On the basis of an analysis of US corporations, they concluded that ‘the separation of ownership from control has become effective – a large body of security holders has been created who exercise virtually no control over the wealth which they or their predecessors in interest have contributed to the enterprise.

 The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge, and where many of the checks which formerly operated to limit the use of power disappear’ (Berle and Means 1932).Berle and Means’ analysis stimulated a huge literature on the control problems created by the separation of ownership and control.  Their arguments were amplified in the 1960s when ‘managerial discretion’ was either praised as a superior alternative to pure profit maximization, or cursed as the driver of an economic concentration that would choke the economy as a whole.  Manne (1965) argued that the market for corporate control, not management, governs the ‘modern corporation’ but Grossman and Hart (1980) cast doubt on the effectiveness of this mechanism.

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Pessimism culminated in Jensen’s (1989) prediction of ‘The Eclipse of the Public Corporation’ and a move to private corporations with high levels of debt.  Leveraged buyout partnerships and blockholders, in particular German and Japanese banks, were the favourite monitors.  Recently the US public corporation, with apparently strong outside directors, shareholder activists, and strong legal protection of shareholders, is again the global favourite.  But the latest evidence suggests that managers are as powerful as ever.  Weak boards with ample formal power, insurmountable takeover barriers, and anti-blockholder regulations continue to prevent owners from exerting control.To date, very little is known about the control of corporations outside the United States.

 In fact, such has been the influence of Berle and Means that the textbook description of dispersed ownership and separation of ownership and control has been presumed to be universally applicable.  But over the last few years, evidence has emerged that has questioned this view.Franks and Mayer (1995) described two types of ownership and control structures – what they termed the ‘insider and outsider’ systems.

 The outsider system corresponds to the Berle and Means description of the USA – ownership is dispersed amongst a large number of outside investors. Both the UK and USA have outsider systems.  In the UK, a majority of equity is held by financial institutions, predominantly pension funds and life assurance companies.

 In the USA, individual shareholders are more widespread.  But in neither country do institutions or individuals hold a large fraction of shares in a company.  As a consequence, they exert little direct control over corporations and the separation of ownership and control described by Berle and Means is observed.However, Franks and Mayer also noted a quite different system that existed in Continental Europe.  There, few companies are listed on stock markets and those companies that are listed have a remarkably high level of concentration of ownership.  Franks and Mayer observed that in more than 80% of the largest 170 companies listed on stock markets in France and Germany, there is a single shareholder owning more than 25% of shares.  In more than 50% of companies, there is a single majority shareholder. The corresponding figures for the UK were 16% of the largest 170 listed companies had single shareholders owning more than 25% of shares and 6% had single majority shareholders.

Concentration of ownership is staggeringly high on the Continent in comparison with either the UK or USA.Franks and Mayer noted that the ownership of Continental European companies is primarily concentrated in the hands of two groups: families and other companies.  Cross-shareholdings and complex webs of intercorporate shareholdings are commonplace in some countries.  Companies frequently hold shares in each other in the form of pyramids by which company A holds shares of company B which holds shares of company C, etc.

 They also observed that bank ownership of corporate equity was generally quite modest, despite the attention that has been devoted to the role of bank shareholdings in cementing bank-firm relations.  In some but by no means all Continental European countries, ownership by the state is appreciable.  Barca et al. (1994) report similar results for Italy.La Porta et al. (1997 and 1999) have recently extended Franks and Mayer’s study to many more countries.

 They have found that the observation on insider systems which Franks and Mayer made about Continental European countries applies widely around the world.  They conclude that the Berle and Means corporation is much less applicable than previously thought.  Instead, the insider system appears to dominate.Evolution of OwnershipWith regards to ownership and control, researches from different authors have shown that virtually all unlisted companies have a high ownership concentration while listed companies tend to have a dispersed ownership structure.   This raises the question of how long it takes for a new firm to reach a diffuse shareholding structure and the separation of ownership and control as defined by Berle and Means (1932).  Brennan and Franks (1997), Goergen (1998 , 1999), and Goergen and Renneboog (2001) address this question and analyse the evolution of ownership and control in UK firms from the time they go public.

 Brennan and Franks find that in a sample of 69 IPOs, two-thirds of the equity, on average, is owned by new shareholders after seven years.Goergen finds that British firms reach low ownership concentration faster than their German counterparts.  German IPOs floated by individuals between 1981 and 1988 were matched with British IPOs of similar size or industry, also floated by individuals.  Within six years of going public a third of the British companies are taken over, a third becomes widely held, and a third remain controlled by the family shareholder.  Five years after the IPO, the old shareholders of a German corporation still own a majority of the voting rights, while old shareholders in UK companies own less than a third.  This study also reports that at the time of the IPO firms have an average life of 14 years, whereas German firms only go public about 50 years after their creation.

Lack of Separation DevicesAlthough some devices to separate ownership and control – such as non-voting shares – are legal in the UK, firms tend to avoid them for two reasons.  For one thing, such devices have been discouraged by institutional shareholders as well as by the Stock Exchange.  Second, the high degree of dispersion of corporate ownership does not spur creation of such devices.  In this part of the article it is important to first discuss the legal separation devices that are available and the reasons why these devices are not normally used by companies.  Second, this article also finds essential to examine how the substantial power of company directors is further increased by the characteristics of the British system of corporate governance.Non-voting Shares and Restrictions on Share TransferEven though UK companies are legally entitled to issue non-voting shares, they are rare, especially for listed firms.

  Brennan and Franks (1997) state that ‘investing institutions and the London Stock Exchange have discouraged the issuance of non-voting shares and other devices for discriminating against different shareholders.’  Also, most of the few companies that still had non-voting shares – such as Boots, Great Universal Stores, and Whitbread – cancelled them at the beginning of the 1990s.  As the LSE allows no restriction on the transfer of shares, only unlisted companies have them, especially private companies (Keenan 1996).Proxy VotingThe board of directors often sends proxy forms to shareholders.  The Listing Rules require that proxy forms ‘provide for two-way voting on all resolutions intended to be proposed…’, i.e. shareholders must always be offered the choice to vote for or against any resolution.

 However, shareholders are free to appoint their own proxy, and are not required to use the proxy form provided by the board of directors.  If a shareholder does not specify how the proxy should vote on an issue, the proxy is free to vote as he pleases.Proxy voting in the UK differs from proxy voting in Germany, where proxy votes are normally exercised by the bank with which the shareholder deposits his shares.  If the shareholder does not express his voting intentions, the bank is free to vote as it pleases.  In the contrary, proxy votes in the UK are normally exercised by company directors and thus confer additional power on the latter.

 Davies and Prentice (1997) argue that the provision for two-way voting does little to prevent this (p. 580).On the other hand, it cannot be said that these provisions have done much to curtail the tactical advantages possessed by the directors.

 They still strike the first blow and their solicitation of proxy votes is likely to meet with a substantial response before the opposition is able to get under way.  Even if their proxies are in the ‘two-way’ form, many members will complete and lodge them after hearing but one side of the case, and only the most intelligent or obstinate are likely to withstand the impact of the, as yet, uncontradicted assertions of the directors.  It is, of course, true that once opposition is aroused members may be persuaded to cancel their proxies, for these are merely appointments of agents and the agents’ authority can be withdrawn either expressly or by personal attendance and voting.  But in practice this rarely happens.Voting at Shareholders’ MeetingsThe way voting is conducted may further enhance the directors’ power.  Unless a resolution is controversial, voting is normally by show of hands only.  Consequently, each shareholder has only one vote, however large his stake, and proxy votes are excluded.  Unless the articles of association state otherwise, the chairman has complete discretion to decide whether an item on the agenda is controversial or not.

 If an item is controversial, a poll can be taken, even before a vote by hand has been held.  In a poll, shareholders will have as many votes as their shares confer and proxy voting is allowed.The voting procedure at meetings, i.e. the show of hands, is probably a weak point in the British system of corporate governance.  Minority shareholders typically do not attend, and proxy voting is only allowed in a poll.  As British company directors normally hold shares, they will be voting by show of hands along with the other shareholders attending and can thus decide corporate issues in their own interest.One-tier Board StructureUnlike German public companies (Aktiengesellschaften), British companies do not have a two-tier board structure.

 Both executive and non-executive directors sit on the same board, and the chairman may be an executive director.  One of the main recommendations of the Cadbury (1992) report is to increase the independence of non-executive vis-à-vis executive directors, calling for an increase in the proportion of non-executive directors and the separation of the roles of the chairman and the chief executive.Stapledon (1996) shows that the portion of non-executive directors in listed industrial companies rose from 30% in 1979 to 44% in 1993. Franks, Mayer, and Renneboog (2001) confirm that executive directors still outnumber non-executive directors in listed industrial companies (60% versus 40%).  The proportion of listed firms with separate chairmen and chief executives also increased substantially, but 23% still do not separate the two roles.

 They are potentially liable to serious failures of monitoring of the board.  Franks, Mayer, and Renneboog (2001) report that corporate restructuring triggered by poor performance usually enhances the independence of the non-executive directors from management.The Hampel Committee – headed by Sir Ronald Hampel, the chairman of ICI – was set up at the end of 1995 as the successor to the Cadbury Committee.  It has raised the issue of whether the United Kingdom should move towards a two-tier board structure.  It is also considering whether institutional investors should be forced to vote at shareholders’ meetings as in the United States.

 On the other hand, the Committee seems inclined towards a non-interventionist approach, not compulsory rules.The Market for Corporate ControlTheoreticians argue that managers who perform poorly will eventually be disciplined by the market for corporate control.  If a company does badly, then it should be profitable for an investor to take control and increase shareholder value by replacing the management.  Along with the USA, the UK is one of the few countries with an active market for corporate control.

 Franks, Mayer, and Renneboog (2001) report that on average every year 4% of listed companies are taken over.  Franks and Mayer (1996) point out that there were 80 hostile takeover bids in 1985-6, as against just three hostile takeovers in Germany since World War II.On the other hand, two recent empirical studies – Franks and Mayer (1996) on the UK and Schwert (2000) on the USA – question the disciplining role of takeovers.  They concur that the performance of targets of hostile bids is not significantly different from that of targets of friendly bids or non-targets.  This suggests that the main device for disciplining poor managers does not work efficiently and that managers are in general free to do whatever they choose.ConclusionThe ownership structure of British listed companies differs radically from that found on the Continent.  Above all, British ownership is diffuse: a coalition of at least eight shareholders is required to reach an absolute majority of voting rights in the average company.

 Despite the fact that dispersed ownership is the rule, in about 10% of firms the founder or his heirs still hold more than 30%.  The structure is also shaped by regulation; the mandatory takeover threshold of 30%, for example, has an important impact.  In about 4% of the sample companies, corporate shareholders hold stakes of just under 30%.  Second, institutional investors are the most important category of shareholders.  However, they tend to be passive and often fail to exercise their voting rights.  Third, the passive stance adopted by institutions works to increase the already significant power of directors, who are the second most important category of shareholders.  Franks, Mayer, and Renneboog (2001) show that when directors own substantial holdings they use their voting power to entrench, and can impede monitoring by other shareholders with a view to changing the board, even corporate performance is poor.  Fourth, there is an important market for significant stakes.

 Fifth, some of the features of the British system of corporate governance, such as proxy voting and the one-tier board, further strengthen the discretionary power of directors.  In short, given the diffuse ownership structure, the main agency conflict is the potential expropriation of shareholders by management.Corporate governance mechanisms such as hostile takeovers (Franks and Mayer 1996) and the market for controlling stakes (Franks, Mayer, and Renneboog 2001) do not seem to work very well in the UK.  As a consequence, more independent non-executive directors or a separate supervisory board would appear to be needed to curb the potential agency conflicts between management and shareholders.  Executive compensation linked directly to performance would also produce a better alignment of managerial and shareholder goals.  A stricter legal definition of the fiduciary duty of directors would allow courts to rule more effectively on directors’ responsibilities.

 The Cadbury Committee (1992), the Greenbury Committee (1995), and now the Hampel Committee have proposed codes of corporate governance and executive compensation.  The establishment of an independent regulatory body to advise on pay-for-performance issues, control board composition, and safeguard minority interests would limit the potential agency conflicts.