Introduction

THE STOCK MARKET ACTS AS THE NEXUS OR LINK between the owners of a company and its managers. The stock market assists owners (shareholders) in disciplining managers, for it is through the market that shareholders can vote their pleasure or displeasure about management's actions through the sale and purchase of the company's stocks. In the next two chapters we examine several aspects of the stock market's role in corporate governance as one of the social benefits of this particular mechanism for allocation of resources.

Holders of common stocks, unlike those of other financial assets, are the owners of the company, and the trading of stocks allocates the ownership of companies listed on the stock exchange. This chapter focuses on two aspects of ownership with particular reference to Canadian stock markets: the separation of ownership and control, and differential voting shares. Corporate takeovers, through which the "market for corporate control" disciplines managers who ignore shareholder interests, are discussed in chapter 3.

The separation of ownership and control in a company can lead to agency problems. That is, the manager acts as the agent for the owners and may pursue self-serving behaviour at the expense of the shareholders. The board of directors is supposed to act as a monitor of management, but there are areas of weakness in this role. The stock market provides a means of controlling these problems. It has also been alleged (by Porter, among others) that institutional shareholders have a short-term performance focus that tends to force management into myopic decision-making. We conclude that Canadian firms are no worse in this regard than are American firms, but they may be at a competitive disadvantage relative to Japanese and European competitors.

An area of increasing controversy is differential voting shares - different classes of shares for a company may have a different number of votes. We outline some of the dangers of concentrated ownership that result from different votes for some shares, and explain why institutional investors have been recently more aggressive in demanding shareholder democracy.

Separation of ownership and control

Modern corporations are, with notable exceptions, too large and too complex to be owned and managed by a single owner or family group. [This is less the case in Canada than in the U.S., but even here the legacy of legendary corporate pioneers and entrepreneurs is becoming dissipated as new generations are often not able to or interested in carrying on the family business. Occasional intra-family battles such as those of the Billes and McCain families also threaten the continuity of family ownership.] . Inevitably, the professional manager has emerged - a corporate executive who, although very capable, may have goals and objectives other than maximizing the value of the owners' investment. The managers report, through the board of directors, to the company's owners, the stockholders, who (at least in principle) have the final say. [There is a large literature (known as agency theory) on the problem of how owners can control management behaviour, the seminal work being that of Jensen and Meckling (1976). Our treatment differs from their approach: while, in general, agency theory assumes that the goals of the firm and the owners are congruent, we see them as possibly being in conflict.] .

The board of directors is the main instrument of shareholder control over management decisions, even though its effectiveness is questionable, since managers typically control the selection of directors. The directors who are insiders are usually loyal to management, and those who are outsiders frequently have a financial interest in the continuity of management (e.g., directors who are lawyers or advertisers for the firm). Similarly, handling management succession is typically the prerogative of the departing chief executive officer (Shleifer and Vishny, 1988, pp. 8-9).

Boards of directors are at a disadvantage (as compared to management) in fulfilling their mandates of governance. Their main limitation is the insufficient amount of information they possess, especially with respect to decisions as to which lines of business the firm should enter or exit.

The ability of a CEO to pursue non-value-maximizing behaviour is enhanced by the lack of effectiveness of the boards, as well as by the "business judgment" rule, which limits the power of courts to interfere in the affairs of corporations. [The Canadian common law doctrine that guides courts in this area derives from the English case Re City Equitable Fire Insurance Company Limited [1925]1, ch. 407.] . When internal incentives and other devices for disciplining managers fail, the stock market may have to come to the rescue: hostile takeovers are an alternative mechanism for replacing non-value-maximizing managers (as we discuss in chapter 3).

Several recent corporate failures have heated up the debate as to whether boards of directors, and particularly independent directors, have been exercising sufficient diligence over management activities. [For an interesting discussion of the case of Royal Trustco, see the Globe and Mail's "Report on Business," July 19, 1993, pp. B1 and B3.]. In 1993, the Toronto Stock Exchange established a Committee on Corporate Governance in Canada to study and make recommendations to improve Canadian corporate governance. The committee, under the chairmanship of Peter Dey, reported in May 1994. Its recommendations relate to the need for more independence for outside board members. TSE president Pearce Bunting commented on the report as follows: "The Exchange believes that good governance plays a vital role in promoting [e investor confidence in our capital markets." [The Globe and Mail , May 17, 1994, p. B1.]. This need for investor confidence is an important theme, which we encounter frequently in this book. As we will see in this chapter, the stock market is capable of dealing with these problems.

Institutional investors

Some concerns

Institutional investors are financial institutions, such as pension plans, insurance companies, and mutual funds, that invest money on behalf of others. For Porter (1992), "transient" institutional investors who seek near-term results as reflected in quarterly financial reports are the key reason for the divergence of interest between owners and managers. This short-term focus pressures managers to make myopic (short-sighted) investments instead of more far-sighted, longer-term investments. Porter contrasts this "fluid capital" behaviour (i.e., capital with no loyalty, that can be moved quickly from one company to another) with the Japanese and German concept of "dedicated capital" (i.e., capital that is invested for the long term). He claims that the fluid capital myopia hampers longer-term investment planning, particularly in intangible investments such as human capital and research and development (R&D). In a global, technologically driven economy, the ultimate consequences of failure to invest in knowledge and R&D are dim; hence, the story goes, the alleged shortsightedness of North American stock markets has contributed to the current dominance of Asian and European companies in world trade.

There are three other complaints about institutional stock ownership. Institutional stock owners come under fire for their purported "herd" mentality. Since few fund managers want to appear to be different from the rest, individual stocks or sectors of stocks move in or out of favour with most of them at the same time, and large price swings result. It is also alleged that smaller, and especially newer, companies find it difficult to attract institutional interest. This is partly because many institutions are legally bound to invest in older, more established companies. As well, the liquidity needs of the institutions are also important. They have large capital bases and tend to trade stocks in large blocks; when the company in question is small, its stock price may be drastically affected by large trades. Finally, institutions may have preferential access to new stock issues, for example through private placements (which can only be marketed to "sophisticated investors"). [For a discussion of the potential adverse effects of private placements and bought deals on the retail market (the individual investor segment), see Andrews (1991).]

The evidence on institutional ownership

In spite of some of these complaints, institutional ownership is a positive force for the stock market. The sheer size of institutional owners serves to ensure that they are able to get the best prices for their clients. The collective power of institutions can also act to discipline management more effectively than can small shareholders. This mitigates potential agency problems, i.e., the possibility that managers pursue their own interests, which may conflict with enhancing the wealth of shareholders.

A number of observers have commented on the relationship between institutions and corporations. Waitzer (1991, p. 9) discusses some of the contributions of institutional ownership to corporate governance, especially the institutions' success in changing the takeover process, but notes that there are still "substantial legal, political and organizational barriers [that] stand in the way of fundamental change." Por (1993) examines the role of institutions in corporate governance and recommends cooperation rather than conflict as a way of exercising fiduciary responsibility. Jarislowsky et al. (1991) offer several recommendations for better institutional-governance relations, including greater board independence, more shareholder rights activism, more effective use of share votes, and improving performance measurement. Thain and Leighton (1991) note the prevalence of companies with control block shareholders in Canada (they claim that only 15 of the top 100 companies are widely held), which enhances the importance of independent board members, who represent minority shareholders. In this environment, institutions have more ability to exert pressure on managerial discipline than do individual shareholders.

Porter (1992) estimates that institutions own 60 percent of the equity of publicly traded American companies; for the New York Stock Exchange, the figure may be as high as 70 percent (Andrews 1991). In Canada, it is estimated that institutions own 65 to 70 [#' percent of publicly traded stocks. [See, for example, the Globe and Mail , November 17, 1992, p. C1. The Toronto Stock Exchange would not provide more accurate information on the grounds of confidentiality. (Telephone conversation with the TSE, July 1993).] This is a dramatic change from the 1960s, when individual investors dominated the market. Nearly a quarter of Canadians own common stocks, but much of the recent growth has been in equity mutual funds and other institutional vehicles. [See the results of the latest (at time of writing) TSE survey of individual investors entitled "Canadian Shareowners: Their Profile and Attitudes," dated December 1989.]

In terms of trading activity, institutions in Canada currently account for over 60 percent [v of trading volume, with even higher totals on the TSE Toronto Stock Exchange Review, April 1994, p. 2.Note (which has the highest concentration of larger companies). Prior to the market meltdown of October 1987, which sent many individual investors scurrying for shelter, trading was split evenly between institutional and individual investors. The Financial Post , January 4, 1991, p. 38.Note These individual investors also have an important role to play: John Bart (president of the Canadian Shareowners Association) and Pearce Bunting (president of the TSE) agree that individual investors stabilize share prices and provide needed liquidity for smaller companies. [The Globe and Mail , November 17, 1992, p. C1.]

Are stock markets myopic?

The question as to whether the growth in institutional ownership has led to a "market failure" of the type envisaged by Porter has been addressed in a number of empirical studies. For example, Bernstein (1992a) disputes Porter's thesis and presents empirical evidence that shareholders have not exhibited impatience or myopia. He cites findings (e.g., Woolridge, 1988) demonstrating that American investors value research and development expenditures and growth in capital budgets. These are examples of longer-term investments with little immediate short-term payoff, as opposed to short-term decisions, and are the kind of investments which Porter would claim will not be made by myopic markets. Woolridge found that a stock's price jumps around the time that the company announces major R&D and investment projects.

Ben-Zion (1984) measured the effect of R&D expenditures on stock prices directly, and determined that markets did react positively to such investments, but their value was not fully reflected in stock prices. That is, a stock's price did not go up as much as it should when an investment in R&D was made. A partial explanation could be that the cost of capital is higher for R&D investments than for more tangible investments, which would make the R&D investments less attractive.

The authors (Johnson and Pazderka, 1993) found that Canadian stock markets value investment in knowledge, but not fully. The market appears to reward about one-quarter to one-third of the value of R&D investment in the form of higher stock prices (a comparable magnitude to that which Ben-Zion calculated for the U.S.) See details of the study in appendix 2a.

One can conclude that markets appreciate a large part of the investment that firms make in long-term projects such as R&D. This means that markets are not myopic. Moreover, Canadian companies - in this respect - compete on a level playing field with their American competitors, who face similar market responses. While Canadian firms do not appear to be disadvantaged in the North American context, [For a discussion of this and other comparative international governance issues, see Johnson and Neave (1994).] the degree of market support they receive may be inadequate when competing against companies whose stocks trade in other countries such as Japan and Germany. We review the related evidence from other countries in chapter 4.

Differential voting shares

Different classes of common shares are issued with different voting rights, which on the surface may seem to disadvantage some shareholders. Historically, family-owned enterprises have been able to issue new equity while retaining control by means of differential voting shares (also called restricted voting shares). Such shares also served to circumvent foreign ownership restrictions, especially during the 1980s. Companies wishing to access foreign capital, but subject to foreign ownership restrictions, were able to issue new capital offshore, in the form of restricted voting shares, without violating foreign control limits.

The existence of differential voting shares is a common feature of Canadian stock markets, whereas they have historically been banned in the U.S. where shareholder democracy has more tradition. A recent count from the financial press showed that the TSE had 175 listings of such shares out of approximately 1500 listings (12 percent), the ME had 96 out of 600 (16 percent), while the VSE and ASE had no identifiable differential share issues. [Neither the Vancouver nor Alberta exchanges prohibit multiple share classes in principle, although there are restrictions on junior companies. Companies with multiple share classes tend to be inter-listed on the Toronto and/or Montreal exchanges, hence they do not appear in the media stock market summaries for the Vancouver and Alberta exchanges.] An example of a company with multiple share classes is Unigesco, whose Class A shares have 10 votes each and Class B shares have one vote each.

Several institutional investors led by William Allen and Stephen Jarislowsky repeatedly expressed concern that non- or lesser-voting shareholders might be abused by the control group (those holding the higher-voting shares), especially during takeovers. From March 1982 to October 1984, the Ontario Securities Commission prohibited the listing of restricted voting shares unless there was adequate takeover protection (Jog and Riding 1986, 65). In response, a number of companies instituted so-called "coattail provisions." A typical coattail provision ensures that all classes of common shares will receive equal treatment in the case of the transfer of ownership of some specified amount (such as a majority) of the higher-voting class. This is an example of how the market corrects its own deficiencies.

Institutional activism is taking many forms. An example of institutional reaction to the concern about shareholder rights is the statement of proxy voting guidelines drawn up by the Ontario Municipal Employees Retirement Board, which contains four basic principles:

1.All shares should have equal voting rights. We believe it is inappropriate for a fiduciary to purchase an asset if ownership rights have been subordinated.

2.All shareholders should be treated equally, which prevents "greenmail" and exclusionary tender offers.

3.Shareholders should be permitted to vote on issues that have a material financial impact upon their investments.

4.In cases where voting policies based on moral and social attitudes come in conflict with the financial integrity of the fund, the economic impact will prevail. [As enunciated by James Maunder of OMERS in Jarislowsky et al. (1991).]

The 1986 controversy surrounding the treatment of restricted voting shares of the Canadian Tire Corporation illustrates some of the issues at stake. The controlling Billes family owned 60 percent of the voting shares of Canadian Tire, which in total represented only 4 percent of the total shares outstanding (the remaining shares were non-voting). The Billes family attempted to tender 49 percent of their voting shares to a group of Canadian Tire dealers, in order to transfer control of the corporation from the family to the dealer network. The family argued that this amount of shares did not constitute a majority, and hence would not trigger the coattail provision. If the takeover protection were operative, the cost of the control of the company would be about 25 times higher, since shareholders other than the Billes family would also have to be offered a premium price for their shares, and the deal would be in jeopardy. A group of non-voting shareholders, led by Allen and Jarislowsky, fought the proposal, arguing that the 49 percent represented a control position (although not technically a majority), and thus violated the spirit of the coattail provision.

The Ontario Securities Commission ruled against the Billeses. The following excerpt from OSC Chairman Stanley Beck's lengthy Reason for Decision eloquently expresses the potentially dire consequences of tampering with shareholder rights:

A transaction such as is proposed here is bound to have an effect on public confidence in the integrity of our capital markets and on the public confidence in those who are the controllers of our major corporations. If abusive transactions such as the one in issue here, and this is as grossly abusive a transaction as the Commission has had before it in recent years, are allowed to proceed, confidence in our capital markets will inevitably suffer and individuals will be less willing to place funds in the equity markets. [Quoted in Brown (1989), who presents a detailed summary of the Canadian Tire case.]

Clearly investor confidence is at stake in this issue, a topic that is examined further in chapter 4."

The stock market reaction to differential voting shares is manifest in relative stock prices. That is, the market includes in its valuation the relative value of the vote. For example, Robinson and White (1991) note that before the sale by the Billes family was announced, the voting shares of Canadian Tire were trading at $36 and non-voting shares at $15. Subsequently, the non-voting shares fell to $13.75, and the voting shares reached the high of $91. In general, the price differential between the two classes of shares is a function of the degree of takeover protection, the concentration of ownership, and the degree of voting leverage (the ratio of voting to non-voting shares). White, Robinson, and Chandra (1985) also show that the value of voting rights depends on ownership structure and the right to participate in takeovers. More formally, Maynes, Robinson, and White (1990) cite evidence showing that the share vote is worth between one to sixteen percent of total equity value.

A number of Canadian studies have analyzed the returns on differential voting shares. For example, Jog, Riding, and Seguin (1985) concluded that there were negative abnormal returns associated with issuances of restricted voting shares. This is the case because shareholders suffer a capital loss as the share prices drop due largely to a lack of takeover protection. Jog and Riding (1986) observed that a significant number of firms experienced declining share prices when restricted shares were issued. The decline was concentrated in the restricted voting shares: superior voting shares enjoyed an average positive premium of seven percent over restricted voting shares. However, Maynes (1991) found that the Ontario Securities Commission threat to delist restricted voting shares in 1981 led to negative abnormal returns on this type of shares. This suggests that the listing of these shares had value in spite of their junior ranking.

In fact, not all shareholders are concerned with the vote attached to a share. They may be more interested in sharing the company's wealth by buying the cheaper, lesser-voting shares than by paying for a vote they don't want. Such shares are simply another financial instrument with a specific purpose, which investors are free to buy or not with their eyes open. The concern that differential voting shares are necessarily bad is just another of the myths surrounding the stock market.

Summary

The tensions inherent in corporate governance arise among people, owners on the one hand and managers on the other, and controlling owners versus minority owners. The stock market acts as a dispassionate referee in this conflict, providing a vehicle (the market place for shares) through which parties can express their opinions about the way in which a corporation should be run.