Changing Nature of the Corporation

The latest issue
of the Economist carries two columns (here
and here)
that analyze the significant changes that have occurred in the nature of the modern
corporation, particularly with respect to ownership. This is an addition to an earlier
column
in September. These columns highlight the more recent developments
relating to the nature of the corporation, and question whether the diffused
shareholding model that has been prevalent in countries such as the US and UK
is likely to be prominent in the future.
According to the
Economist, the anonymity in the large listed corporation with diffused
shareholding creates several problems. The first is in the typical agency
problem between the managers and the shareholders, which tends to be prevalent
in such companies. Other problems include the lack of clarity over who controls
the company. More recent concerns relate to phenomenon of short-termism due to
the pressure of maintaining strong quarterly financial performance. While over
the years tighter regulation has been introduced as a measure to curb the
excesses of managers, it has also had the unintended effect of increasing the
costs of regulation due to which more companies are either not entering the
public capital markets or, if already listed, are going private. Furthermore,
there is a drastic change in the nature of shareholding even in listed
companies. For instance, institutional shareholding has become much more
prominent in the US, and has overtaken shareholdings held by individuals.[1]
For this reason,
it has been found that a new type of corporation is becoming more prominent in
the contemporary business world, which is focused on technology and disruptive
innovations. The columns refer to the increasing presence of start-ups, which
operate with a clearer ownership structure, due to which some of the problems
present in the large corporations with diffused shareholding may not exist. They
note that in this “novel type of corporate arrangement … [i]nvestors, founders,
managers and, often, employees have stakes that are delineated by carefully
drawn contracts, rather than shares of the sort that trade on exchanges”. The
role of lawyers too has attracted attention not only in terms of their role in
structuring these arrangements, but also in the manner in which they themselves
are incentivized. As one column notes:
Lawyers in the startup world play a vastly different role from those
who advise—or sue—large companies. This is in part because of the nature of
their clients; often tottering between failure and success they rely more
heavily on outside advice. But it is also because lawyers, in the early stages,
have replaced banks as the key intermediary for financing. But most importantly
they negotiate directly with investors and physically maintain the “cap
structure”—the all-important legal contract noting who owns what.
The ambiguities and obfuscation of public companies contrast sharply
with the new corporate structures set out by legal contracts that make the
rights of both investors and owners more explicit. These legal agreements
tackle two fundamental difficulties. The first is the need to mitigate agency
problems. This is handled by detailed agreements that include control issues,
such as the allocation of board seats. Investors usually insist that
management, and often employees, own large stakes to ensure their interests are
aligned to the success of the venture.
The second difficulty concerns enabling investment in the absence of
an important detail: a plausible valuation. Startups are pioneering a novel
answer: an agreement at the early investment stages that enables an investor to
buy a proportion of the venture, but at a price determined at a subsequent
round of fund-raising, typically a year or two in the future.
Even if the modern
startups subsequently access the capital markets, they may structure their
offerings differently on the lines adopted by firms such as Google, Facebook
and Alibaba whereby the founders will continue to maintain strong control over
the firms so as to provide clarity to the investors on this count.
Although the
columns in the Economist do not discuss these in detail, they refer to another
alternative to the Western corporation, being companies from the emerging
markets that are gaining influence on the global scene. Such companies tend to
be either family-owned companies or state-owned enterprises (SOEs). In these
cases, while the question of control is rather clear and categorical, they give
rise to the agency problems between controllers and minority shareholders. Typical
problems with such companies tend to be governance issues such as related party
transactions and tunneling. However, arguably the issues associated with
dispersedly held companies such as short-termism may operate to a lesser extent
given the longer term interests and outlook of the controlling shareholders
(whether the business family or the state) who are in the business in the
longer run. A lot more effort is now being spent in understanding and analyzing
the benefits and disadvantages of such companies which carry concentrated
shareholdings.
In all, there
appears to be a radical change in the outlook among analysts and commentators.
It was only at the turn of this century that arguments were proffered about the
supremacy of the American shareholder-centric model with dispersed shareholding
that should form the paradigm for companies from other countries to follow, resulting
in a convergence of corporate governance around the world on the lines of the U.S.
model.[2] Just over a decade later,
serious doubts are being raised regarding the efficacy of the model, especially
when alternative models are beginning to look attractive.



[1] See, Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the
Revaluation of Governance Rights
(2013), available at http://ssrn.com/abstract=2206391.
[2] Henry Hansmann & Reinier Kraakman, The End of History for Corporate Law (2000), available at http://ssrn.com/abstract=204528.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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