Shareholders have a very special (and difficult) position among financiers. They provide funds to the firm in return for nothing but the promise of an uncertain future return. The realisation of this profit, however, is not delegated to them directly, or at least not to all of them, but rather, it is entrusted to the corporate controller who may, or may not, be a shareholder himself (Pacces, 2008). Thus, the nature of the shareholder’s claim over the firm’s assets differs from a typical ownership claim. Normally, property rights over an asset include both the asset management (control rights) and its profit stream (cash flow rights) (Hart, 1995). However, the ownership of a corporate enterprise works quite differently as shareholders are only entitled to what is left of the firm’s income after all other providers, including lenders, have been compensated (Easterbrook and Fischel, 1991). Given their position as ‘residual claimants’, shareholders have the strongest interest in the maximization of the firm’s profits and the firm value (Fama and Jensen, 1983).
The same remains true for control rights over the assets that they own. The lack of expertise and coordination (given their dispersed nature) between shareholders forces them to contract managers to take care of their affairs. This matter of separation of residual control rights from the residual claim on the firm’s assets is usually referred to as separation of ownership and control (Sheifer and Vishny, 1997).
The separation of ownership and control problem was first studied by lawyers in the eighteenth century. In an often-quoted passage, Adam Smith (1776) – the lawyer philosopher who founded the modern study of economics – in his publication of An Inquiry into the Nature and Causes of the Wealth of Nations expressed his concern about the management of “other people’s money” by directors of joint-stock companies who may have conflicting interests. In the eighteenth century this may not have been an extensive problem, but by the early twentieth century, at least in one specific location of the world: the United States of America, once again a lawyer (together with a economist) pointed to the problems of separation of ownership and control as a major problem of corporate business (Berle and Means, 1932).
Berle and Means in their book The Modern Corporation and Private Property, (1932) analysed the largest U.S. companies in the 1930s. They looked at the way in which the rise to power of the public corporation, and how the equity finance of which could be freely traded in stock markets, affected private property, the very foundation in which the economic order of past three centuries had rested, according to which ownership and control should lie in the same hands (Anderson and McChesney, 2003, p16).
They draw a distinction between the concept of legal property “ownership” and the concept of control – the capacity to influence the board of directors or the executive body of the firm – as well as distinguishing between the five following forms of control (Aglietta and Reberioux, 2005, p 24): The first form is the conventional form of control through almost complete ownership. These are entrepreneurial firms (in economic terms) for which the non-tradability of equity capital enables one individual or family to direct the company. The second form is majority control. One or more shareholders possess a sufficiently large proportion of the equity capital to control the board of directors by legal means. The third form of control is minority control, whereby small shareholders delegate their voting rights in general assemblies to professionals by means of proxies. The fourth form is control through a legal device without majority control, in which a group of shareholders have real control of the company without possessing a majority of the capital. This control can be achieved through different methods, such as pyramid or cross-shareholding, or possessing of shares with multiple voting rights. The fifth form is management control whereby equity capital is so dispersed that shareholders have little opportunity or incentive to get involved in the internal affairs of the company.
Berle and Mean’s (1932) survey of 200 of the largest non-financial corporations in the United States indicated that 44 per cent of firms were under managerial control (compared with 21 per cent under control through a legal device and 23 per cent under minority control). From this data they concluded that because of the tradability of equity and the development of financial markets, the US economy had arrived at a new stage in development, one characterised by a separation between the financing and the management decision or a separation between ownership and control (Berle and Mean, 1932). They viewed the corporation as illustrated in Figure 2 as a nexus of contracts, where corporate managers would negotiate and administer contracts with all stakeholders of the firm. However, they would be writing these contracts as agents for the shareholders and in the interest of the shareholders (Kaen, 2003, p. 14). By the 1970s, economic theory involved itself in this issue and ‘agency theory’ became more developed as a tool for analysing the separation of ownership and control as a matter of delegation of tasks under asymmetric information.
The following section will present aspects arising from the ‘agency problem’ and how various managerial compensation and ownership schemes could be used to minimise this problem, but create other possibilities of misappropriation of the wealth of minority shareholders by controlling majority shareholders. This will justify the thesis’ aim to examine the role played by legal protection for shareholders in minimising such expropriation and hence financial market development.