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For the week of October 24, 2012



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Divorce of ownership and control



Gradually, over the course of decades, as companies grew larger and more diversified, so did the number of shareholders. Over time, the control of large, publicly traded companies shifted, from the owners to the managers. That has raised issues of conflict of interest, of managers putting their interests before those of the company and its owners — as vividly illustrated in the financial crisis of 2008. Now, there are those who are looking to institutional shareholders to be the white knights of corporate governance.

Adolf Berle and Gardiner Means were the first to notice the impact of the ballooning size of corporations and the dilution of owners' power. In 1932, the two academics (a lawyer and an economist, respectively) published a ground-breaking book in the United States called The Modern Corporation and Private Property. They noted that some companies had become very large and had numerous shareholders spread across the country. From this, they wrote, arose particular problems.

Although owners, as shareholders, have the right to vote people onto the board of directors, Berle and Means found that shareholders were so spread out geographically that they were unable to organize themselves effectively. Thus the directors, who usually have only a small ownership position in the company, could evade the shareholders' control and act in ways that benefited the directors themselves, and not the company as a whole.

The functioning of modern company law, wrote the authors, "has destroyed the unity that we commonly call property.” This has occurred for a number of reasons, the foremost of which is the dispersal of ownership of big corporations. Removed from the day-to-day affairs of the company, the typical shareholder takes less interest in the company. Those who are directly interested in day-to-day affairs, the management and the directors, can then manage the resources of companies to their own advantage, without effective shareholder scrutiny.

Come to save the day? Today, institutional investors — pension funds, mutual funds, foundations, insurance companies — are often the largest shareholders of major corporations. As they take a more active role, they have the potential to mend the divorce of ownership and control. But progress has been slow, for a number of reasons.

Although institutional investors collectively may own a high proportion of a company's public shares, individually an institutional investor typically holds no more than 5%. To exercise any degree of control, institutional investors need to form coalitions — and this can be difficult.

As the benefits of shareholder activism usually go to all shareholders, not just the active few, it follows that passive shareholders have no real incentive to expend resources and aid the active shareholders. This "free ride” reduces passive shareholders' incentive to co-operate, making it harder for active shareholders to form coalitions.

Shareholder activism also requires time, effort and money. The ones willing to meet those requirement are most likely institutional investors; they have the resources to acquire and disseminate information to the other shareholders. But they will want to be sure the benefits of their actions outweigh the costs.

It is hard to get a handle on how much cooperation goes on between institutional shareholders. Often, they negotiate behind the scenes; if their grievances were made public, it might cause other investors to jump ship, sinking the share price. Then, everyone loses.

But shareholder activism in Canada is just beginning to get its legs. As these shareholders work to create value for their planholders and unitholders, they may fill the gap in corporate governance left by the supersizing of corporations. But it is a long road to making managers and directors of publicly trades companies put the interests of the company ahead of their own. Governments have stepped up with securities regulators introducing rules and organizations such as the International Corporate Governance Network (ICGN) — a global membership organization of over 500 leaders in corporate governance based in 50 countries — are doing their part. So, reuniting ownership and control is certainly on the radar and countries and companies are rising to the challenge.

Greer Jacks is updating jurisprudence in the EverGreen Explanatory Notes, an online research library of assistance to tax and financial professionals in working with their clients.