Question

Question Five: Conglomerate plc was a family company which was so successful that the founding Alexander family could not fully finance its expansion. So the company was floated on the Stock Exchange, with the Alexander family holding A class shares. A class shares held the right to appoint six of the eleven directors. The company could not be wound up unless a resolution was passed by 75% or more of A class shareholders. Required: 1).Is there any risk of a governance failure. Discuss. (10 marks) 2).what are the effects of good corporate governance on capital markets. (10 marks)

Answer 1

1. Yes, the case in question is a case of family business with dual-class shares, wherein the voting rights are skewed in favor of the founding family. Such, dual-class shares (DCS) pose risk of corporate governance failure in the following possible ways:

• When such DCS shareholders have majority in the Board, it is straightforward that the Company will move as per their will. Further, the DCS shareholders have more decision power, while at the same time, less economic stakes. This imbalance of of power and responsibility may induce them to be reckless in their decisionmaking, which may pose bad for public shareholders and their economic interests.
• Since they are majority shareholders, they get open right to easily execute their personal interests at the cost of Company interests such as heavy executive compensation packages for themselves or floating associated companies and siphoning off of Company funds. This can be a major setback for the Company.
• Companies with dualclass share structures are more likely to lack independent board leadership, which is a major corporate governance concern. As per a report by Harvard Law School Forum on Corporate Governance, available online, “approximately 52% of controlled, DCS do not have an independent lead director nor an independent chair on their Board, as compared to only 12% of one-share, one-vote non-controlled firms.”
• Major shareholders are not incentivized to maximize the company’s potential—after all, given their low equity ownership, few benefits would accrue to them.
• A company may have an excellent track record, but there is no assurance that such outperformance will continue indefinitely. When things go wrong, public shareholders of listed DCS companies have little influence—without a vote, they cannot provide oversight of boards or management. As is mentioned in the case, the Company cannot be wound up without consent of 75% of class A shareholders. This implies that even if the Company is going in losses, the public shareholders could not salvage a portion of their investments by liquidation since liquidation rights are also skewed in favor of majority shareholders.

2. A good corporate governance implies fair ownership structures with equitable rights of all shareholders, independence of decision-making and accountability of the Board and management, appropriate disclosures and auditing processes, protection of minority shareholders’ interests. A good corporate governance is one of the major qualitative factors on the ranking scale of companies.

Some of its effects on the capital markets are:

• Firstly, the quality of corporate governance determines a Company’s access to capital market. Borrowing is easy for companies with good governance and viceversa. Investors will hardly lend their money to badly governed companies for the anticipated risk of their capital.
• Another setback for companies with poor corporate governance practices is the cost of capital. It is difficult for them to raise capital and even if they raise it, their cost of borrowing is substantially high due to less investor faith.
• Conversely, if a company has good corporate governance, it has a positive image in the market, investors are willing to invest easily, which gives it access to large amount of capital at low costs. This fuels the company’s growth rapidly and easily.
• Higher growth implies good numbers out in the market, which will further induce investment. So, basically, good governance can induce a positive circle for the company by allowing it access to funds to fuel expansion and create value. Created value induces further investor confidence.
• Good corporate governance of companies is eventually also beneficial for the capital market of a country. When investors invest in companies based on confidence they have on them, they provide companies an opportunity to grow. When companies grow, the capital markets expand and develop further.