Boards not Shareholders Rule the Company

July 14, 2022

In this brief article, I intent to help prospective investors become aware of how corporations actually operate and how this affects their investment in a company. There is a general misconception that shareholders rule a company.  That they are the definitive authority with ultimate voting power.  Wrong.  It’s the board of directors, a small group of selected individuals that run the show.  As an investor you should be aware of this flawed misunderstanding and what are the two main reasons for this balance of power.

The first is the law. Corporate law favors directors and authorizes them to administer the company in very broad terms. We will get to this in detail. The second is the nature and composition of shareholders.  Except for closely held, family-owned corporations, most large companies are comprised of numerous or thousands of shareholders which have within themselves diverse interests and objectives.

Shareholder composition

As a shareholder of a large, publicly traded company, there is little you can do to promote your opinions but at least you are aware of the limitations when considering to invest.  Shareholders are detached from the operations for the company, they get to meet once a year.  Reports are circulated in a need-to-know basis. If you want to know where the company is going, its best to seek out documentation prepared by, guess who, the directors of the board.

However, if you are an investor and thinking of buying shares of a small or closed corporation and plan to have your opinion counted, you need to be aware of what are the general rules and the content of existing or intended bylaws that will govern the entity and your participation.

Board rights under the law regulations

While shareholders own the company as shares owners, the law assigns the decision to the board of directors, who in turn delegate powers to officers that run the day to day operation.  Once a company is large enough, it is not feasible to have shareholders run the show.   That is where the law steps in.

The same is the case with a limited liability company.   Members can operate a company but as new members come in, it becomes necessary to have the company be administered by managers and not the members themselves.  It’s the same with the government, you cannot have the population run the country, you delegate this task to the legislators who supervise the officers that run the government.  One difference with this analogy is that while the head of state or governor is elected by the public, in corporations, it is the board that has this authority.  The company operates more like a parliamentary system in which most of the members of the parliament form the government beginning with the prime minister. In the end the role of shareholders and constituents of a country are very much alike, they are limited to voting rights on certain areas.

Boards have power under the law to appoint, compensate and remove their executive officers as well as veto and decision-making powers over their actions. Since the law support board independence and detachment from shareholders, it is not uncommon that boards pursue their own interests at the expense of the owners. Whether the boards are effective, controlled and or manipulated by the chief executive officer is another story, but it happens and has to do with the weakness of the board and the mechanisms by which shareholders hold them accountable.

Shareholders rights under the law regulations

In general, shareholders can exercise three types of rights: decision rights, appointment rights and removal rights.  They help curtail power abuse by boards and officers. Appointment and removal rights generally refers to board members.  If shareholders consider a board member is not behaving properly, they can vote to remove him/her. When and how depends on many factors.    Corporate law is regulated by each state independently, so the extent of these rights varies depending on the jurisdiction where the company is organized.   The same applies to decision rights. There are specific decisions which should be left to shareholders, but which decisions and how will they be exercised by the shareholders will depend on the restrictions that are imposed by government regulations and the limitations provided in the bylaws of the company. Bylaws are the internal rules and contract that determine how shareholders, board and officers participate and interact.  These could include restrictions on when and how shareholders can meet and what issues will be covered.  Again, the criteria which determine this depends on the jurisdiction.

The future of shareholders

There is ongoing debate for decades as to how to improve the relationship between shareholders, directors and the long-term objectives of a company.  Many obstacles are on the way for numerous factors including the broad spectrum of investor composition that share ownership of a company These include individual, day-traders, institutional investors, pension and hedge funds, and others.  Each has its own objectives and agenda, that may conflict with other shareholders and with the long-term viability of the company.  Some are looking for a quick buck.  Other seek long-term growth. Each objective requires different management approaches.

I do not seek to present a comprehensive exposition of how shareholders and boar members interact.  The point of this article is to have investors of small, medium, or large corporations be aware of what their roles will be as they acquire ownership participation.