What about the shareholders?

One of the pillars of the popular capitalist model is wider ownership of equity capital. The more people that have a stake in society’s economic growth, the better. Likewise, the more people that believe they will have an opportunity to create wealth in a capitalist society, the better off we all will be.

We’ll be discussing the idea of wider wealth ownership more generally in the coming weeks. Today, we’re considering another important question: what does ownership of equity capital actually mean, and how do we ensure that people can properly realize the value of that equity capital in practice?

Equity capital is most commonly held in the form of share capital – shares in companies (publicly traded or not) which entitle the owner to a set of rights, most notably a “share” in any profits of the company.

Share ownership is not just an end – a right to a slice of the pie. Share ownership also holds practical value: capital gets to hold companies accountable. This is a key element of the capitalist model (popular or otherwise), yet to give full effect to this value, the accountability measures must work in practice and not just in theory.

The ultimate question being answered here is “who runs a corporation – its owners/directors, or its management?”

The textbook answer is that management runs a company day-to-day, but the board of directors (elected by the shareholders) hire and fire the management. Shareholders have the opportunity to vote at an annual general meeting of each company on specific issues and electing the board, and in some cases have additional oversight over specific decisions of the company (such as major loans, asset acquisitions or sales, etc.) However, much like we vote every few years to send representatives to Parliament, shareholders vote to send director representatives to a corporate board then are largely at the mercy of those directors for any say in what happens with the company.

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Yes, there are exceptions to this, and yes, the law builds in certain protections for shareholders. For example, a company can’t change its classes of shares without the approval of 2/3rds of shareholders.

But the normal situation for Canadian shareholders is this basic relationship – you vote in a board, they represent you. As is commonly said regarding our elected representatives in government, “you’ll have the chance to send them a message in the next election”.

But if holding share capital is to be an equalizing function across society, do we need to find a new balance between the ability for a company to run its affairs versus its owners (the shareholders) legitimate expectation of having an active say in how their equity is deployed?

Boards hire and fire the top executives in a company. If there is a disconnect between the board and the shareholders who elected them, boards can be voted out and replaced. Proposing such a change has a fairly low bar to entry in Canada – shareholders representing 5% of the market value of a company can initiate such a change.

However, beyond the nuclear option of replacing a board, shareholders lack a full toolkit of remedies to deal with other situations that warrant shareholder intervention but not wholesale replacement of the board and management.

Suppose a board is functioning well and holds the confidence of shareholders, but they approve compensation packages for management which create incentives to push for short-term stock price movement rather than sensible, long-term growth of the company. The board (often made up of large shareholders) may be happy to have their share value grow in this way and reward management while shareholders disagree.

In Canada, shareholders are essentially left with the following choice: (1) allow management to get what it wants and retain the existing team despite misaligned incentives, or (2) replace much or all of the board and perhaps management, almost certainly leading to major disruption in the company. Both options are poor ones, and both potentially leave equity capital without the means to properly realize its assets.

A 2018 Harvard Business School study showed that when looking at S&P 1500 companies from 1977 to 2017, director compensation suffered from the same issues as management compensation in that they kept raising compensation in response to what was viewed as competitive pressure to keep directors and management on board. As a result, the study concluded that “directors have weak incentives to pursue shareholder interests in executive pay”.

To combat this clear misalignment in incentives, some jurisdictions have recently given shareholders additional specific powers that adjust this balance back towards shareholders. For example, in the United Kingdom, executive compensation policy is now subject to a binding vote. Preliminary studies suggest that this has led to lower executive compensation without affecting performance (further suggesting that shareholders are correct in their caution on these issues).

Some may counter these ideas saying “you know you’re buying shares with limited rights – these are priced into their value – if you don’t like this structure then don’t buy the shares”. This is not a helpful attitude in solving the overall tension between a company’s management and its owners, nor creating a society where we can count on wider equity ownership to allow more people to benefit from economic growth. Shareholders need a remedy with teeth to enforce their rights such as those given to investors in UK companies.

If our policy aim is to have both wider and more meaningful equity ownership across society, reforms in this direction must include robust shareholder rights and a meaningful discussion over how share capital can protect its interests without harming business innovation. The UK is a leader in this regard, and it’s time for Canada to take steps in the same direction. While individual companies and activist shareholders occasionally achieve similar outcomes, it’s clear that the broad-based reforms being contemplated here must be backed by legislation.

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