Corporate governance challenges in law firms: Ownership structure

Law firms take the form of a sole proprietorship, partnership or private company. The only form of a commercial juristic entity that is permitted to operate a trust bank account is a private company (see section 34(7) of the Legal Practice Act 28 of 2014 (LPA)).  In terms of section 34(7) (a) of the LPA, only a private company comprising exclusively of legal practitioners may conduct a legal practice. A private company is a personal liability company and the directors/shareholders are the risk-bearers in the management of a private company (see section 8(2) (c) of the Companies Act 71 of 2008),

The funds or property entrusted to legal practice are not owned by the legal practitioner – they are only controlled by the legal practitioner by virtue of a fiduciary relationship for the client (The New York Lawyer’s Fund ‘Attorney Trust Account and Record Keeping for Client Protection of the State of New York: A Practical Guide’ (April 2021) (www.nylawfund.org, accessed 20 – 07 – 2022)). Internal ownership under the agency model indicates managerial entrenchment. The concentrated ownership structure aids the entrenchment of the controlling owners since they have significant controlling rights of the firm and the minority shareholders are excluded from the management of the firm (Samuel N.Y Simpson Ph. D ‘Non -Governmental Organisations NGOs Boards and Corporate Governance: The Ghanaian Experience’ (2007) Corporate Ownership and Control (www.academia.edu, accessed 20 – 07 – 2022)). In legal practice, the client represents the investor and the practitioner the management of the firm.

In a concentrated ownership structure, a conflict of interests exists between the controlling shareholders (managers) and the minority shareholders (investors) since the minority shareholders are excluded from controlling and managing the resources of the firm.  The concentration of ownership encouraged more active corporate governance as well as the establishment of long-term relations but could be used to extract private benefit from firms rather than to pursue wider corporate interests (Mayer, F. 1997- “Corporate governance, competition and performance in Deakin, S and Hughes A (Eds), Enterprise and Community: New Direction in Corporate Governance, Blackwell Publishers, Oxford). The controlling entrenched owner not only controls the firm but also operates its reporting policies. The effective control and type of control have an association with the informativeness of disclosure of financial and accounting information. By gaining effective control the controlling owner is able to exercise exclusive control over the company’s information and resources. When there is a divergence between the controlling and the ownership rights, the credibility of the accounting information is reduced (Samuel N.Y Simpson Ph. D (op cit)). The credibility of the financial information disclosed by the control group is compromised since only the discretion of the controlling group is used.

The levels of ownership stake without control by the minority shareholders are related to the informativeness of the financial or accounting information reporting  (Dr Diksha Kakkar ‘Linking Corporate governance Reforms and Company Performance: A Review’ (www.academia.edu, accessed 20 – 07 – 2022)). The likelihood of financial information asymmetry decreases when voting rights are increased. The higher the controlling interest of shareholders the more effectively the management behaviour can be monitored and the greater the positive impact on performance. The agency theory agrees to the use of incentives for management to align their interests. The management should bring integrity and transparency through voluntary practices. Information asymmetry creates conflict between principals and agents. Transparent and qualitative reporting on financial and accounting matters reduces agency costs.

Corporate governance refers to how corporations are directed and controlled (Godfried Asamoah ‘Corporate governance mechanisms, Agency Cost and Financial Performance: A panel Regression Approach’ (www.academia.edu, accessed 20 – 07 – 2022)).  It is about putting in place the structure, processes and mechanisms by which business and affairs of the firm are directed and managed in order to enhance long-term shareholder value through accountability of managers and enhancing firm performance. The corporate governance reforms have an impact on the internal as well as external environment of the organisation and maximise the shareholders’ wealth by reducing the cost of capital and agency (Dr Diksha Kakkar (op cit)). The management and the internal control systems have a crucial role to play in the development of a corporate governance structure of the organisation.

The existence of divergent and sometimes conflicting objectives between managers and shareholders has given rise to the design of concepts and mechanisms to ensure that the cost associated with such divergent interests is minimal (Kyereboah-Coleman. A & Biekpe N (2006). Do boards and CEO matter for banks’ performance. A comparative analysis of banks in Ghana, Journal of corporate ownership and control, 4(1); 119-126). Instruments used in implementing corporate governance include the board of directors, independent directors, CEO, etcetera.  Through such structures, processes and mechanisms, the agency problem which gives rise to conflict of interest within the firm may be addressed such that the interest of the managers is more aligned with that of the shareholders. By giving managers the right incentives to make decisions aligned with shareholder interests, you are addressing opportunistic behaviour from managers within the agency theory (Godfried Asamoah (op cit)). Corporate governance mechanisms have an effect on agency costs and shareholder value.

Godfried Asamoah argues that corporate governance has assumed the centre stage for enhanced corporate performance and structuring of the governing organs (the board/management), and plays a major role in ensuring the success and survival of the firm. The functioning of the board and its characteristics is associated with the distribution of power within the firm (Lara, Osma and Penalva, 2007. Board of Directors’ Characteristics and Conditional Accounting Conservatism: Spanish Evidence, European Accounting Review vol 16. 2007 – Issue 4 Pages 727 – 755)). The fundamental function of the board is to control managerial behaviour and ensure that managers act in the best interest of shareholders. Providing ownership to management may be used to bring consistency in the competing interests of the controlling owner and the minority shareholders (Dr Diksha Kakkar (op cit)).

The strength of a corporate organisation lies in the amount of relevant information it has at its disposal (Godfried Asamoah (op cit)). Competent and effective management fosters good governance. The codes of good practice are designed to ensure that corporate form does not become a device for management or controlling shareholders to fleece investors or other third parties or to oppress minority shareholders. Corporate governance is needed to prevent the control group (managers) to digress from the goal of shareholders. Corporate governance failures or lapses occur as a result of insufficient board oversight, inadequate risk management, and complex or opaque organisational structures and activities.

The board should understand the purpose of any structures that impede transparency, be aware of special risks that such structures may pose and seek to mitigate the risks identified (Samuel N.Y Simpson Ph. D (op cit)). Disclosure and transparency help emphasize and implement the main principle of good corporate governance. The value of corporate governance is to reduce the risk of false/deceptive financial reports. Adopting better governance mechanisms and practices that protect the interest of the shareholders will help firms maintain investor confidence and those of other stakeholders. The corporate governance principles aim to assist in the efforts to evaluate and improve the frameworks for corporate governance and to provide guidance to participants and regulators.

The board bears the overall responsibility for the corporation, including its business and risk strategy, organisation, financial soundness and governance and effective oversight over senior management. Senior management should ensure that the corporation’s activities are consistent with the business strategy, risk tolerance/appetite, and policies approved by the board. Risk management and internal controls consist of risk management function, compliance function and internal audit function, with sufficient authority, stature, independence, resources and access to the board (Godfried Asamoah (op cit)).

Godfried Asamoah argues that outside directors play a positive role in the board’s monitoring and control function. The role of corporate governance is to minimize agency costs by realigning the interests of agents and principals. The board is responsible for the management of the firm and must ensure the integrity of the financial reporting system that fairly presents its financial position. Boards dominated by non-executive directors are more likely to act in shareholders’ interests (Kenneth A. Borokhovic, Robert Parrino and Teresa Trapani ‘Outside Directors and CEO selection’ – The Journal of Financial Qualitative Analysis, Vol. 31, No 3 (Sep., 1996). The greater the percentage of non-executive directors on the board whose interests are aligned with those of shareholders helps reduce the agency costs and maximize the shareholder value.

There is a convergence of interests between the shareholders and managers as the manager ownership increases (Jensen and Meckling (1976 -Theory of the firm: Managerial behaviour, agency costs and ownership structure, Journal of financial economics, 3, 305-350). Management shareholdings provide an incentive to directors to act like owners in terms of rigour of their monitoring efforts (Kren, L. & Kerr, J.K. 1997. The effect of outside directors and board shareholdings on the relation between chief executive compensation and firm performance, Accounting and Business Research, 27(4): 297-309), i.e. the higher managerial ownership reduces agency costs. Corporate mechanisms must be in place to minimize agency costs and maximize shareholder value while fulfilling the stakeholder interests. Board composition and managerial ownership enhance shareholder value (Young, 2003 ‘Corporate governance and firm performance: Is there a relationship?’ Ivey Business Jornal online, 1-4). Improvement in corporate governance mechanisms could maximize shareholder wealth/value. Internal corporate governance mechanisms are the board of directors, size, composition managerial ownership, risk management and internal control functions.

The LPA and the rules made thereunder, provide an external corporate governance mechanism for the protection of the interests of the clients (investors). The legal and regulatory framework can be used as voting rights of the minority shareholders for effective enforcement of their property rights. Gaining effective control of a firm enables the controlling owner to entrench themselves by diverting resources for private use. Once effective control is obtained, any increase in the voting rights does not further entrench the controlling owner. Higher cash flow rights in the firm cost more to divert the firm’s cash flow for personal gain.

High ownership concentration coupled with equity commitment mitigates the entrenchment effect of ownership concentration (Dr Diksha Kakkar (op cit)). Gomes, A, and W Novaes ( 2000), (“Sharing of control as a corporate governance mechanism”, Discussion Paper (Wharton School of Business, Philadelphia, PA) argue that the high ownership concentration can also serve as a credible commitment that the controlling owner is willing to build a reputation for not expropriating minority shareholders. The entrenchment effect of the controlling owner is mitigated by the alignment effect and decreases with the increase in the level of ownership stake beyond the minimum level needed for effective control, and thus has lower private benefits to divert the company resources when cash flow rights increase (Samuel N.Y Simpson Ph. D (op cit)).

Insiders do not have full cash flow rights but significant controlling rights of the firm (Berle, A.A., &  Means, G.C. (1932) ‘The modern Corporation and private property, Macmillan, New York). The controlling shareholder controls and manages the company thereby depriving the minority shareholders who are excluded from controlling and managing the resources of the company, and may result in the manipulation of financial and accounting information. Sufficient voting rights of the minority shareholders (investors) will minimize the entrenchment effect of the controlling shareholders (owners). The manager’s stake in ownership has the same relationship with the quality of financial reporting. The entrenchment effect decreases with the increase in the level of ownership stake which can be achieved by the enforcement of the minority owners’ rights through legal and regulatory mechanisms.

Improvement and strengthening in external corporate governance mechanisms that include the presence of external auditors could reduce the agency costs of concentrated ownership and hence maximize shareholder wealth/value (Godfried Asamoah (op cit)). The agency costs emanate from the risk that agents (managers) will use organisational resources for their own benefit and the costs of techniques used to mitigate the problem associated with using an agent (costs of producing financial statements) or employing mechanisms to align the interests of the agent with those of the principal, e.g. equity payment. Imposing premiums for fidelity guarantee is one such option in legal practice. If the practitioners pay high premiums for guaranteeing the fidelity of the funds entrusted to the practice and professional indemnity of the practitioners, their interest in the practice will be aligned with those of the minorities, which will reduce the agency costs of concentrated ownership to ensure the protection of the minority shareholders’ interests in the firm.

Heightened regulations and greater strictures in the law firms’ activities will have an effect of increasing the voting rights of the minority shareholders, and hence the alignment effect on the entrenchment of controlling owners. The role of corporate governance is to minimize agency costs and maximize shareholder value. Effective corporate governance enhances firm financial performance (Hutchinson, M. (2002) ‘All analysis of the association between firms investments opportunities, board composition, and firm performance, Asia Pacific Journal of Accounting and Economics, 9, 17-39). The application of the principles of corporate governance in legal practice will enhance the protection of the interests of the minority shareholders (investors) in the corporate ownership structure of legal practice and maximize the benefits of running a legal practice in a fair, efficient and transparent way.