A Summary on Corporate Governance and the Impact of Controlling Shareholders

The recent financial scandal at Hollinger Inc. reminded investors to be more cautious with the presence of controlling shareholders. To help investors who is considering investing in companies where controlling shareholders are present, in an article titled "Corporate Governance and the Impact of Controlling Shareholders", published in January 2010, the group of authors including Dirk Schlimm, Lisa Mezzetti and Bernard S. Sharfman have provided investors with analysis on the issues related to the presence of controlling shareholders and criteria to evaluate the independence of the board from the controlling shareholders.

The number one issue of inserting the presence of controlling shareholder into the board of directors is that this controlling shareholder may try to use his or her authority to benefit himself or herself at the expenses of the corporation or other shareholders. There are two forms of private benefits. The first type is pecuniary benefits, including tunneling transactions, corporate perks and theft. The second type is non-pecuniary benefits including the private benefits other than pecuniary benefits. No matter what type of benefits of which the controlling shareholder takes advantage, this practice will harm the value of the corporation and benefits other shareholders.

To avoid the issues concerning a controlling shareholder, it is crucial for a corporation to have an independent board of directors. The value of the independent board is ensured by two elements. Firstly, they help limit the potential agency costs created by the presence of the controlling shareholder. Secondly, they objectively monitor the activities of the controlling shareholder. To insure the independence of the board, it is critical to have a strong legal system which equipped the board with authority to do their jobs well. By monitoring the controlling shareholder's activities, an independent boar will contribute to shareholders' wealth maximization.

The value of an independent board brings about some best practices that have to be counted when evaluating the corporate governance. These practices include the independence of board members in term of both the controlling shareholder and the corporation, the presence of charter amendments which protect directors from being dismissed prior to the expiration of their term except for causes, the independence of the Chairperson of the Board from both the controlling shareholder and the CEO, the exclusion of the controlling shareholder from board nominating, the exclusion of family members of controlling shareholder from the executive management team and the necessity of supermajority voting.

In addition to keeping in mind the best practices, understanding the controlling shareholder will be helpful. In the worst scenario, the controlling shareholder will utilizes every opportunity to enrich himself or herself by imposing his or her will and whim on the corporation. In the best case, the controlling shareholder applies all his or her passion and ambition to make the corporation succeed no matter what. However, in reality, most the controlling shareholders fall somewhere in between these two extremes. Such a controlling shareholder has sense of ownership and to some extension tries to convince the board of his or her ideas. In this case, the directors will have opportunities to provide counsel and influence his or her thinking.

With the understanding of the controlling shareholder, investors will look for board of directors who on one hand are independent from the board of management and the controlling shareholder and on the other hand have the independence of mind. Therefore, to assess the independence of directors, investors are required to know each director's personality and what he or she is made of. Moreover, the independence is effective only if the directors have skills and experience to engage the controlling shareholder to get things done while maintaining their standard.

Even though the best practices are seen in the corporate governance, it will be helpful for investors to watch out for red flags which signal the problems in the dependence of the board of directors. These red flags include but not limited to the pursuit of unconventional strategies, excessive turnover both on the board and in the executive ranks, the resignation outside the regular cycle, unreasonable related-party transactions, the absence of an independent lead director when the controlling shareholder is both Chairperson and CEO of the Board, an unreasonable compensation in the employment contract between the controlling shareholder and the corporation and too much authority for the controlling shareholder when he or she is a CEO.

As summarized above, when there is the presence of controlling shareholder, in addition to monitoring the corporate operations, the directors have to play another role: engaging the controlling shareholder while protecting the values of the corporation and benefits of all other shareholders. To perform this role well, the directors need to be independent from the controlling shareholder in term of finance, emotion and mind and have necessary skills and experience. Even with the best practices, it is recommended for investors to always look out for the red flags.

Reference:

Schlimm, D., Mezzetti, L., & Sharfman, B. (2010, January). Corporate Governance and the Impact of Controlling Shareholders. The Corporate Governance Advisor, 18(1), 1-10. Retrieved July 29, 2010, from ABI/INFORM Complete. (Document ID: 1937926521).