Ownership and Control: Partnership vs. Corporation

One of the reasons why general partnerships can work out so well is because there is unity of ownership and control. The same people that are making management decisions about the partnership are the same people that own it. This does not guarantee that everything will work out well, but it at least means that the self-interest of the owners and managers is one and the same. This natural unity of ownership and control can be broken through a partnership agreement that grants one partner extra-managerial rights to control of the partnership, but the default state is one of unity between ownership and control. If there are two partners putting up $50,000 into a partnership that is capitalized with $100,000, each partner has an equal say in the management of the partnership and an equal claim on the profits and losses. This can be modified through a partnership agreement.

This is an important characteristic of a partnership: The residual claimants are the same as the people that are exercising control over the management of the partnership. When there is a dissolution of the partnership, and all creditors have been paid and the terms of the dissolution clause of the partnership agreement have been met, the remaining profits or losses are distribution equally among the remaining partners. Each partner has a right to accounting, and this is something that varies according to state law. For instance, in Missouri, a right to accounting arises when: a partner is wrongfully excluded from some aspect of the partnership, the partnership agreement permits it, the partnership liquidates or a partner dies. There is also a catch-all provision under Missouri Statute §358.220 that provides for circumstances that would render it “just and reasonable” for a right of accounting to take place.

Have four partners with 25% ownership interests and $10,000 remaining? Each gets $2,500. End up with a $10,000 bill? Each partner, again assuming a general partnership structure, owes $2,500 because personal liability attaches. The exhaustion of general partnership assets does not extinguish any remaining legal claims.

While the partners own the residual earnings in a general partnership structure, a corporation has the omnipresent tension because control of the firm and ownership of the residual earnings are not united. The financial rights to residual earnings are determined by the proportionate amount of common stock owned (if you own 10,000,000 shares of Hershey, then you get a 6.41% residual claim on the earnings of the firm. If it was liquidated, and all contract and tort claims were satisfied, you would get 6.41% of whatever is left over). Publicly traded corporations with different classes of stock are subject to different rules.

However, shareholders never get to make management decisions for the firm. The control of the firm is always in the hands of the Board of Directors–it is the Board that approves all dividends, buybacks, and strategy decisions. The Articles of Incorporation or the by-laws of the firm may permit shareholders to appoint members to the Board based on the size of the ownership position, but it is the ability to appoint Board members rather than the ownership position that truly creates the control. Any other influence is reputational or social. The term for people that wield influence in this manner is “shadow director”–they do not exercise any formal or legally recognized authority over the firm, but the directors nevertheless feel compelled to follow his advice and direction.

It is a common practice for bylaws to not permit shareholders to automatically appoint Board Members, but it may effectively occur indirectly. The great power that shareholders wield over control over the corporation is the ability to vote on Board members. If three shareholders collectively own 60% of the common stock voting shares, then they can block individuals from joining the board that they do not like.

However, the notion of owning 51% of the corporation and then getting control of the publicly traded firm is partially the stuff of Hollywood drama. Unless there is a bylaw or Article of Incorporation stating otherwise, no power vests to someone for owning 51% of the shares. Instead, it is the power to vote elect or not elect certain Board Members that require majority approval that is the corresponding power which arises alongside majority ownership of a publicly traded corporation. As of last year’s proxy vote, the Walton family controlled 50.6% of Wal-Mart’s voting shares through their holding company Walton Enterprises.

It is important to understand that owning a substantial block of common stock never confers the ability to make decisions. Instead, you get the power to vote for the Board members that will carry out your will of furthering the corporation’s interests. In terms of power, there is no unity between ownership and control–the people controlling the decisions of the firm are different from the people owning the firm unless someone with a sizable stake becomes a director or officer of the firm–think of CEO and Chairman Warren Buffett also owning a third of Berkshire Hathaway A stock for an example of this.

Also, it has become a common practice since the 1980s for the Board of Directors to become elected in staggered terms to avoid corporate raiders and activists. This is usually mentioned in the Articles of Incorporation for the corporation, although Delaware corporation law permits its inclusion in the bylaws (the bylaws are considered more malleable because they are left to the discretion of the firm and are regulated internally within the firm; there is no requirement to file bylaws with the state).

For instance, freshly minted corporations will often have some directors serve a one-year term, some serve a two-year term, and some serve a three-year term, and then all directors serve a three-year term thereafter. This can make it difficult for a corporate raider looking to make a quick buck because he may have to wait at least two years before choosing directors that is proportionate to the common stock voting interest, and it also gives the existing board additional time to plan anti-takeover measures.

But is should be remembered that the directors and officers have no claim on the residual earnings of the firm–any stock they acquire is either through the open market or fixed by contract as a condition of employment. This disunity between ownership and control can create a risk of negligence or opportunism on the part directors and officers because their personal interests may conflict from the interests of shareholders.

There are three ways that this is combated, some of varying satisfaction. The first is that the Articles of Incorporation or the bylaws can include restraints on self-serving action or provide formal processes for decisionmaking. You can review these terms before purchasing common stock, and may seek to enforce them through a shareholder action.

The next is reputational–if someone becomes a self-serving executive and contributes no value added to the best interests of the corporation, then this acts against his self interest for subsequent employment. This may be the least satisfying form of protection, as it is quite attenuated–future employment prospects may not be harmed in direct proportion to the offense that causes disgust at the corporate level, and it also misapplies justice in the sense that it does not help the shareholders that must endure the behavior that creates a hiring deterrence.

The best protection for shareholders to fix this disunity between control and ownership of the residual earnings is fiduciary duties. Delaware has well explained laws regarding the duty of care and duty of loyalty, and this can provide some protection for shareholders against egregious stewardship of the assets.

With partnerships, this issue is mitigated because the people that contribute capital and own the firm are also the ones that control the decisionmaking of the firm (unless the partnership agreement provides otherwise). But in corporations, the ownership of residual earnings and control of the corporation is separated. The remedies are legal (governing documents of the firm can be enforced, as can fiduciary duties) and non-legal (executives and officers have reputations that presumably want to be maintained). Attempts to resolve the potential for opportunism and negligence on the part of directors and officers have been ongoing for over two centuries, as this presents the central tension at the heart of every corporation. It exists by design.

Notice: This article, which I believe may be of interest to readers, is for general information and entertainment purposes only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal or investment advice.

Sources Consulted: http://www.lexisnexis.com/legalnewsroom/lexis-hub/b/commentary/archive/2009/07/10/the-right-to-an-accounting-in-disputes-among-members-or-during-dissolution-of-llcs.aspx