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There are control issues and there are voting control issues

Daisy Medici is Managing Director of Genus Resources, a US-based firm that provides consultation to family controlled enterprises across the US and internationally.

Recent events around corporate scandal present new challenges for family controlled public companies and their shareholders. Among the challenges is the diversification of the composition of boards, but just how far should reforms go?

It seems these days that Aristotle's ideal of the natural relationship between moral virtue, families and governing bodies is under constant siege as headlines shout out bold accusations of corporate boards, including some controlled by families, that have been self-dealing or otherwise up to no good. While the black cloud of corporate scandal continues to hover, public boards across the US are now forced to meet new SEC rules and regulations around management accountability and corporate governance (Sarbanes-Oxley Act 2002) to satisfy shareholders and promote investor confidence. In the case of family-controlled publicly traded enterprises (FCPCs) whose boards can be heavily loaded with family members there's greater inquiry into whether a board that looks so much like a family club can really provide effective oversight for a public company. And when headlines about companies like Adelphia Communications, the cable-television giant, expose less than savoury dealings, board practices of all FCPCs suffer even greater scrutiny. A victim of alleged fraud by its controlling shareholders, the Rigas family of Adelphia Communications has been mired in Chapter 11 bankruptcy proceedings since June 2002.

At the same time, large FCPCs have moved into the spotlight as potentially safer havens for hard earned and enormously vulnerable investment dollars. It seems every week there's yet another article from a leading publication or another citing how FCPCs almost always outperform their publicly traded industry rivals. In November BusinessWeek published a special report focused on the top 100 S&P companies with founding families in management, tracking the performance of these companies over the past decade. It suggested that the project was sparked by the results of a research report conducted by Ronald Anderson and David Reeb published earlier this year in the Journal of Finance. So what of it?

The problem is that many of the scandalous incidents of self-dealing and other malfeasance and nonfeasance uncovered at Adelphia Communications have created a lot of bad news for FCPCs. The investment community discovered that while family-controlled companies might outperform their competitors and might be more values driven, not all family-controlled companies are driven by the same values. Consequently, these enterprises face tougher challenges attracting new capital, keeping shareholders happy, maintaining investor confidence, and allowing family members to honour and uphold their family legacy through voting control of the board.

Family first?
There is no easy solution to this dilemma. As with most family business issues there is an emotional component that may make decisions seem like 'family first' decisions when, in essence, the family believes them to be 'business first' decisions. The family, after all, has much to protect: the enterprise that bears the family name, promotes its values and enshrines its legacy. It's through the family's passion and sweat equity that a successful enterprise grows from a small firm to a substantial publicly traded company.

Contrary to current suspicion, it may indeed be sound business practice to have the board front-loaded with family members. However, when a family agrees it is in the company's best interest to reconstruct the board, should the family maintain voting control of the board? One would argue that if the company is well managed and profitable, that's all that matters. But given that times have changed, shareholders are no longer buying into this philosophy. They want the belt of good management supported by the suspenders of an effective board of directors.

Here are some answers to questions frequently asked about FCPCs.

Why do family controlled companies go public?
The most common reasons for a family sell off a portion of its shares are funding either for internal growth or acquisitions or for lifestyle funding of family members who wish to enjoy some of the monetary benefits of the family's business success.

When a private company sells public shares, should it meet a higher level of reporting standards?
Yes. The company must abide by the same SEC regulations that pertain to all public companies. This cultural change of legally mandated openness is the real cost to a family group that controls a private business going public. The so-called regulatory and legal burdens can be overcome readily with good professional advice, which is widely available. But managing the cultural transition from living in the privacy of a private company to the transparency of a publicly listed company is the real trick.

Should shareholders put more pressure on family members to diversify boards weighted with family members?
The only control that shareholders should have in these scenarios is to take their money and invest elsewhere. Regardless of shareholder pressure, the controlling family should want to protect its largest asset by strategically structuring the board to hold management accountable. It doesn't mean that the family can't hold the majority of board seats or maintain voting control. The company bears too much risk when board seats are held solely by family members active in management. The core purpose of a board is to ensure accountability. In a values-driven company, removing management from the board reduces the potential for self-dealing and accounting malpractice. Entrepreneurial families and their ancestors who choose to learn from the scandalous events of the last year and take appropriate steps to reduce their level of risk by restructuring their boards will be rewarded with both better management and higher stock valuations.

Are there advantages to having family members on the board of directors?
There are several advantages to having family members on the board of directors. With regard to management accountability, nobody can hold family (management) accountable better than other family members. The fact that this tenet is sometimes honoured in the breach is no reason to ignore the power family members have to hold other family members accountable. Second, few people understand the culture within an organisation better than the founding family. Given their intimate relationship to the business, family members can respond to opportunities or react to time-sensitive decisions more quickly than boards without founding family representation.

Ironically, the day before BusinessWeek published its special report The Oregonian in Portland ran a story on an Oregon-based family enterprise, Schnitzer Steel Industries. The story line features a large, successful multi-generational family controlled enterprise with both inside and outside shareholder interests. By all appearances the company is well managed and enormously profitable, making the company a gold mine for current investors and a hot prospect for would be acquirers. While the family owns only 36% of the Class A shares, they have complete voting control via a special separate class of shares (Class B). The board of directors has 10 members, seven of whom are family members.

The story made news because the company's largest outside shareholder, Cascade Investment (6%), is upset over the composition of the board and pressuring the company to bring in more independent directors, thereby reducing the potential for self-dealing. If what Cascade Investment wants is more directors independent of management, there is ample support in recent studies by Anderson and Reeb that link the existence of boards having a majority of directors independent of management with superior performance by a family controlled public company. To ensure greater accountability, Schnitzer Steel Industries should add directors independent of management so that they comprise a majority of the board of directors. The majority of directors should be family members as long as they are independent of management.

Control is the real issue
I think the real issue for Cascade, which they dare not state publicly, is emphatically not that Schnitzer Steel Industries has too few directors independent of management (although it is a legitimate question) but that they are simply agitated that they can't acquire voting control of this company. While some members of the family can and have sold shares during the recent run-up in the price of the company's shares, the family still controls the company through a special class of stock. Cascade wants to have its cake and eat it too. Complaining about governance is simply pressure politics to get what they really want: removal of family control. If Cascade can create enough clamour to force the family to give up voting control of the board by vacating its seats, a majority of new non-family directors might just be persuaded to sell the entire enterprise, maximising the windfall for the financial engineers at Cascade.

The controlling family stockholders at Schnitzer should indeed entertain reform of the board because there is ample evidence that a majority of directors independent of management supports superior management performance. But there's no need to introduce the idea of a majority of directors independent of the family. The family built this business. It has more financial capital invested in it than any other shareholder – and certainly more emotional capital as well. After the board composition is changed to add more directors independent of management, Cascade should either say, "thank you," and enjoy the benefits of being a long term Schnitzer Steel Industries shareholder, or sell its shares and find another investment it deems worthy of its interest.

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