A Legal Entity

While the birth of a company involves entrepreneurial effort and risk taking, the actual creation of the company is a legal matter. Once entrepreneurs decide that the time has come to put formality and ownership around their work, they can choose from a variety of legal structures including corporations, S-corporations, benefit corporations, limited liability companies, sole proprietorships, and partnerships. We will primarily focus on corporations because most (though not all) companies that have boards of directors are incorporated.

Corporations are chartered by states, a throwback to the centuries when the English crown, wishing to achieve certain goals for the nation but not wishing to risk its own capital, chartered companies. The first was the East India Company, granted a Royal Charter by Elizabeth I on December 31, 1600, for the purpose of fostering trade with India.

It is hard to overstate the ingenuity and effectiveness of the corporate form of organization. Without it, large-scale deployment of new technology (e.g., canals in the eighteenth century, railroads in the nineteenth century, and automobiles, airplanes, and airlines in the twentieth) would have been impossible. Shares of ownership and their dividends and growth in value incented people to invest their savings in these companies. Limited liability ensured they could lose no more than they invested. The former appealed to people's animal spirits and encouraged them to take risk. The latter helped assuage their fear of loss and helped protect them from personal financial catastrophe.

Ownership is important to directors because boards are accountable to the owners of public companies who elect them and private companies who select them. While there is substantial overlap in the duties of directors of public and private companies, there are also important differences.

 

Private Companies. In America, private companies are far more numerous than public, even though you would think just the opposite if you only read about business in the Wall Street Journal and New York Times. While there are 15,000 publicly traded companies in the United States, a third of which trade on exchanges, there are 27 million private firms, of which 5.7 million have employees.

A private company, whatever its legal structure—corporate, sole proprietorship, partnership, limited liability company—is owned by one or more individuals. The owners take the risks and call the shots.

Many private companies are multi-generational family businesses. Some are enormous like Cargill and Koch Industries. Others are large, like Gordon Food Service. Most are small. For many families, the business is not only a source of employment and wealth but also a projection of family values and a point of pride. Given human nature, the family business can also be a catalyst for conflict.

Family-owned and -controlled businesses are not the only private companies in America. Private equity is an important owner. Governance in this case is simple. The private equity firm installs the management and calls the shots, sometimes with a handpicked board, sometimes with no board at all. My focus is not on these situations but on private companies that are owned or controlled by a family or some other group that chooses to create a board to which management is accountable.

In my years of fundraising as a dean and president, I met many corporate executives. I found that few private business owners wished their companies were public, while many public company executives quietly envied the advantages of their private company peers. Private companies are typically taken public to secure access to capital for growth, to establish a market for the company's stock for estate-planning purposes, and to satisfy the liquidity and financial diversification desires of family members. These are powerful reasons for going public. But there is a lot of baggage in being a public company including governance, reporting, and compliance requirements.

Some, but not all, private companies choose to have formal governance—that is, a board of directors or a family council that serves as a quasi-board. In small companies, the owner usually runs the business. Period. As a company grows, the owner must choose whether or not to create a governance structure. The default is not. There's a lot to be said for not creating a governance structure, such as untrammeled freedom and no relationships to manage with overseers and advisors.

Why, then, do the owners of many private companies choose to create a board of directors and—let's be honest—subject themselves to it? My experience with Gordon Food Service is instructive in this regard.

When I met Paul and John in 1987, they said they thought it would benefit the company over the long term to have a more formal board with outside directors. They were facing generational succession—from themselves to their sons and others—in senior management. They were also interested in creating durable ownership and control arrangements for the company that would enable it to continue in perpetuity. They thought that outside directors might be helpful in meeting these challenges.

I remember well my first meeting with Paul and John in Grand Rapids. It was on Black Monday, October 19, 1987, when the Dow Jones Industrial Average dropped 508 points, or 22 percent.

It was a striking experience to be with the Gordons that afternoon as their assistant provided occasional updates on the market mayhem. They seemed interested but not particularly concerned. Our meeting continued without a hitch. The Gordons' connection to the stock market was (and is) dramatically less than that of public companies and their executives.

The financial performance of GFS is measured on revenue, earnings, cash flow, and return on assets and investment, not stock price. The Gordons do not look to the equity markets as a source of capital, preferring to fund the business internally and with conservative, secured borrowing. Other things being equal, they would rather have the market high than low because it affects the value of investments in the employee' profit-sharing plan and the general mood of the economy. But it's far from life-or-death with them.

I believe that the Gordons, like many private business owners, feel more in control of their destiny than do most public company executives. They probably are. With only the family and a board they created to whom to be accountable and without quarterly public reporting of results and an ever-fluctuating share price, they can take the long view in making decisions about what's best for their customers and the company. They really like it that way. In my experience, so do most private owners.

A variation on private company ownership is the ESOP (Employee Stock Ownership Plan). While public companies can have ESOPs, they are more often found in closely held private companies where they can be used to buy part or all of the shares of existing owners. The ESOP is a type of employee benefit plan that buys and holds company stock for the benefit of a broad group of employees. Federal law provides significant tax advantages. Private companies with ESOPs have special governance considerations including proper representation of employee interests. The National Center for Employee Ownership is an excellent resource for all aspects of ESOPs, including governance.

 

Controlled Public Companies. This is a special category of public company that retains aspects of private ownership while creating the opportunity for public ownership of shares. Some of America's best-known companies, including Berkshire Hathaway, Dreamworks, Facebook, Ford, Google, Hershey, and the New York Times are controlled public companies. I've been a director for some time of such a company, Kelly Services, which is controlled by Terence Adderley and his family.

In 2005, the New York Stock Exchange defined controlled companies as those in which more "more than 50 percent of the voting power is held by an individual, group [often a family], or another company" and "which is therefore exempt from the director independence requirements for the board, nominating/corporate governance committee and compensation committee."

Such companies represent an effort to achieve the best of public and private company ownership. The public aspect provides access to capital, liquidity, and estate planning and diversification benefits to controlling shareholders. It also creates the opportunity for other shareholders to take what they hope will be a profitable ride with the controlling shareholders at the wheel. The controlled aspect can to a degree insulate the company from certain public company pressures that, some say, involve short-termism (e.g., to achieve quarterly earnings goals) and serious distractions (e.g., unwelcome takeover bids).

A controlled public company is something of a compromise between public and private. There are, of course, downsides to any compromise. Critics of this ownership structure, which is often achieved through a dual class share structure (one class with voting privileges, the other without), believe that conflict of interest is inherent in controlled public company ownership. They worry that the interests of minority shareholders can be subjugated to the interests of those in control and that absence of opportunity for takeover without the consent of the controlling shareholders reduces the value of shares for owners. The view of controlling shareholder tends to be (though stated more politely than this) "if you don't like the arrangement, don't buy the shares."

In terms of governance, directors of controlled public companies have three key responsibilities in addition to those shared by all public company directors: (1) to advise the controlling shareholder(s), (2) to plan for orderly transition of ownership and management, and (3) to ensure proper representation and fair treatment of all shareholders, including those in the minority and without a vote. This means, among other things, being attentive to what are called related parties transactions—that is, contracts, deals, and other arrangements between the company and controlling shareholders and their friends and relatives. An example would be the company leasing office space from a controlling shareholder. Directors need to ensure that there is no sweetheart deal that enriches the controlling shareholder at the expense of others. Due diligence on the part of directors would include requiring that the lease be based on market rates.

Warren Buffett and his long-time partner, Charlie Munger, have offered a spirited defense of controlled public company governance, specifically of Berkshire Hathaway. This has taken the form of caustic criticism of the performance of some other public company boards and some governance reforms advocated by activists, Congress, and the S.E.C.

Here is Buffett speaking about the Berkshire board:

 

We have real owners on our board. What they make for being board members is really inconsequential … compared to their investment. They are friends of mine. They are smart. They are very smart. I mean they are handpicked in terms of business brain power and quality of human being. I really think that we have the best board in the country. But for the people that make their evaluations by check lists, either in terms of diversity or in terms of supposed independence (although I don't know how anybody that is getting half of their income from board memberships can be independent) we may not stack up so well. But … there is no group of people I would rather have in charge of the decision subsequent to my death [as to who my successor will be] than the people that we have got on our board.

 

Here is Munger speaking on governance reform:

 

A lot of people think that we'll fix our corporate governance problems by making the corporate directors have more power, kind of like the justices of a typical Supreme Court, or the council members of a typical city. But a Supreme Court makes a hundred decisions a year … very pompously and slowly, and a typical city council are people up there posturing, playing to one group or another. It's a disastrous system of governance … we don't want those systems in our corporations.

 

Berkshire Hathaway's great financial performance insulates it from effective criticism of its governance practices. As a general case, I think it's desirable for controlled public company boards to comprise mainly directors whose stature and independence would make them welcome on any board.

 

Public Companies. When people think about corporate governance and boards of directors, they usually have in mind public companies with broad ownership and no controlling shareholder. This is where the agency problem of separation of ownership and control is most obvious and a competent, effective board of directors to represent shareholders and appoint, monitor, and assist management is the solution.

EQR is such a company. EQR is the United States' largest multi-family real estate investment trust. Sam Zell, the chairman, has a significant holding of EQR stock—about 3.2 percent, or over 10 million shares. But neither he nor any other shareholder has a controlling interest.

EQR, like other non-controlled companies, is truly public in the sense that there is only one class of common stock, and every share has an identical voting right. No shareholder has the ultimate or determining say on any matter, including the election of the board of trustees, appointment of the CEO, or whether to accept or reject a tender offer for the entire company. Shareholders elect the board annually on a one-share-one-vote basis, and the board has authority over most key corporate decisions on a majority rule basis.

Ownership in large public companies like EQR is broadly distributed across institutional and individual investors. EQR has thousands of shareholders. Institutions, including mutual fund companies such as Fidelity and Vanguard and pension funds such as TIAA-CREF and Calpers, own large blocks of EQR on behalf of millions of investors and beneficiaries. Individual shareholders in EQR range from those with large holdings, like Zell, to mom and pop investors who may own only a few, or a few hundred, shares. The board of trustees represents them all.

In the case of private companies with boards of directors and controlled public companies which must have boards, the answer to the question of who selects or elects directors is obvious: the private owner(s) or controlling shareholder(s). In the case of public companies, the answer is not so obvious. Who decides who will be slated for election? And among the directors elected, who will lead the board?

Traditionally, the answer to these questions was that one individual, serving as both chairman of the board and chief executive officer of the company, played the dominant role in selecting board nominees and running the show. Sometimes this worked extremely well. There is a lot to be said for having a strong leader and a minimum of organizational ambiguity (e.g., Warren Buffett at Berkshire Hathaway for the last forty-plus years). But it has not always worked well and has sometimes led to disastrous results (e.g., WorldCom, Tyco, and other infamous implosions associated with a dominant chairman and CEO and a pliable board).

The result has been substantial reform in how directors are slated for nomination and how boards are structured and operate. In the past, the chairman/CEO played a key role in board elections. Today, a governance committee of independent directors plays that role. In the past, separating the chairman and CEO role was rare; today it is quite common. In the past, the chairman/CEO set the agenda and ran the meetings. Today, there is usually a lead independent director who works with the chairman to set the agenda and run regularly scheduled executive sessions of the independent directors. In the past, there were often a number of company executives on the board. Today, there is usually only one, the CEO. As a result—and as required by listing exchanges—independent directors dominate public company boards and only they serve on key committees including audit, compensation and governance.