An inherent dichotomy exists between shareholders, board members, and officers. Although they are meant to work together, their individual goals and objectives often cause friction between them. The system by which companies are directed and controlled is commonly known as corporate governance. If you own a small family business, this may not be as much of an issue. Likely, you are the shareholder, director, and officer, all hidden within the company’s distinct identity and limited liability shield.
A small business owner usually believes that shareholders lead and guide the company. But this is not always the case with multi-person businesses. According to corporate law, board members are the ones in control, while shareholders are supposed to remain passive and only have a say in annual meetings and board member elections. This is how the typical corporation works.
A similar disconnection can be seen in limited liability companies (LLCs) when they are operated by managers. Members can be completely isolated from the company, and if a board is created within there may be more disengagement. All of this becomes important if you are investing in a company as a shareholder of a corporation or as a member of an LLC. It is wise to learn about the internal structure of the company, to better understand how executives and board members are elected, replaced, and compensated, how your assets will be used, and the decision-making power you have over the business. Are there any mechanisms in place to hold board members accountable?
Have you ever wondered what the potential drawbacks are of delegating management and operating tasks to officers and corporate boards? Although there may not be many bad managers, there is a concern with the lack of restriction these corporate entities have to benefit themselves personally. There are legal and contractual mechanisms, but these are limited and can’t always control and constrain improper behavior. This creates an ideal environment for those with power and ambition.
The inherent dilemma with having people manage the business of others is that although managers and board members have sworn their loyalty to shareholders, they have a lot of freedom to act in their own interests. It’s difficult for shareholders to evaluate and supervise managers because they lack the resources and knowledge to do so. For example, it’s difficult to fire those people assigned to protect shareholder investments if they didn’t do their job, especially in larger companies like Twitter. Shareholders may not even be aware of the problem until it’s too late.
Corporate law and charters may permit shareholders to act, but too many proprietors cannot manage a business on their own. It would be chaotic. There are far too many of them to create consensus and those who are interested in management, do not have the time, capacity, power, or assets to run the business. For instance, of the ten largest Twitter shareholders only 6 had less than 3% stake and 8 had less that 5%. Picture the minuscule part of control that thousands of other independent investors hold. Even those large investors have their hands tied since they are commonly investment funds that manage many other investments to keep an eye on.
This dependence on agents to do the job raises a genuine issue known as the corporate agency problem. Shareholders trust their welfare based on activities taken by other individuals called agents which may act, not motivated by the shareholders’ interests but on behalf of their own.
There are numerous approaches to make administrators responsible. For example, a corporate board of directors. It is made and organized to pick and monitor the company’s officers. Board structure exist by law and by internal corporate agreements. Officers are supervised by the board and shareholders monitor the board. The need to address the agency problem cascades right to the proprietors of the company.
When a company chooses its board members, it’s important to remember that they don’t always work together or effectively supervise their officers. In some cases, the chief officer is part of the board and even the chairman, which can lead to them being supervised by themselves. This can be disastrous, especially if board members are not involved in the company’s operations and shareholders are unable to hold them accountable.
CEOs with unchecked egos can cause a company to go downhill, and board members may not take their fiduciary duties seriously, choosing instead to use their position to retire in prestige. Even if a board member is working to the best of their ability, there is still an information gap between day-to-day business conducted by managers and limited board meetings. This prevents board members from gathering the key operational facts they need to properly monitor the company.
The departure of the officers and board members of Twitter is a result of shareholders taking action. By selling their shares if they are unhappy with the direction of the company, they can move to invest their money elsewhere. Alternatively, they have the power to gather a corporation or group of corporations to take over the company and replace the management, as is what happen in Twitter. This complex way of holding agents accountable is a key factor to consider for investors, especially when it comes to the agency problem between the interests of majority and minority stakeholders. It’s important to think about the leeway that management has before being held accountable, and if large investors are using their influence to direct the company. Ultimately, these are serious questions to consider.
If you’ve invested in a public company, have you ever examined how shareholders are tackling the agency problem between majority and minority stakeholders? How much leeway do officers have before being held accountable? Could large investors be pushing the company in a certain direction? Corporate Governance is definitely something to think about!
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