The debate over short-term thinking at corporations has so far focused largely on companies in the U.S. and the UK. The fact that controlling shareholders are less common in those countries than in many others may explain why the extensive literature on short-termism has often ignored the role of controlling shareholders. I believe that this oversight is important, as controlling shareholders can have a substantial impact on whether a company takes a short-term approach, as I argue in a recent working paper.
Some people believe that institutional investors and asset managers cause short-termism, transmitting it to management by, for example, voting in favor of short-term based executive compensation or shareholder activists. I call this “investor short-termism.” Whether it is a problem is heavily disputed. However, investor short-termism is unlikely to arise in the presence of a controlling shareholder, who can block the transmission of short-termism from investors to managers through control over the corporation.
Second, short-termism could also be caused by the preferences of managers. For example, managers may want to demonstrate good results to improve their chances of obtaining a better job at another corporation. Such managerial short-termism can only persist if the long-term shareholders do not have the ability or incentives to monitor the short-termist managers and directors. This type of short-termism is therefore just an example of the classic managerial agency problem, which arises due to a lack of accountability of the managers to shareholders. Again, controlling shareholders can solve this type of short-termism: Their large ownership stake gives them the incentives and ability to monitor management. For example, controlling shareholders can use their voting rights to nominate directors who will stay with the corporation for the long term and approve executive compensation that is long-term oriented.
This analysis illustrates that controlling shareholders can solve the investor and managerial short-termism – provided that they do not take a short-term view themselves. That will depend on the circumstances and particularly the type of controlling shareholder. On the one hand, controlling shareholders have stronger incentives to think in the long term than do other shareholders, due to the size and illiquidity of their investment, which gives them greater exposure to the long-term cash flows of the corporation. In addition, controlling shareholders typically enjoy idiosyncratic private benefits of control, which cannot be transferred easily. For example, a family shareholder may enjoy private benefits from keeping control of the corporation within the family. This locks in controlling shareholders and forces them to think of the long-term cash flows of the corporation. However, private benefits of control may also give controlling shareholders incentives to act in a short-termist manner. For example, a family controlling shareholder may prioritize the short-term liquidity needs of the family over the long-term investments needed by the corporation.
What can we conclude from this analysis? First, some of the proposed solutions to short-termism will likely be ineffective in corporations with a controlling shareholder. For example, discouraging short-term activists or encouraging long-term shareholder stewardship is unlikely to make a difference, as controlling shareholders dominate the general meeting anyway.
Second, if we believe that controlling shareholders are generally more long-term oriented, we can facilitate the creation of control by separating it from cash flow rights through, for example loyalty voting rights or dual-class share structures. This allows controlling shareholders to diversify, even when they have limited liquidity.
The disadvantage of this solution is that a wedge between cash flow rights and control also increases the risk of the extraction of private benefits – precisely the source of potential short-termism. Therefore, initiatives to facilitate controlling shareholders through multiple voting rights must be accompanied by mechanisms that protect minority shareholders, such as approval by a majority of the minority shareholders. Only in this way can we arrive at a corporate governance system that truly facilitates long-term value creation.
This post comes to us from Tom Vos, a visiting professor and researcher at the University of Antwerp, a voluntary scientific collaborator at the Jan Ronse Institute for Company and Financial Law of the KU Leuven, and a part-time attorney at Linklaters LLP. It is based on his recent paper, “The missing role of controlling shareholders in the short-termism debate,” available here