Inverting Management’s Duty to Shareholders

Inverting Management’s Duty to Shareholders

By Dr. Jonathan Tiemann, March 23, 2015

While we’re on the subject of fiduciaries (see the post just before this one), there’s another important principal (owner) – agent (person acting on owners’ behalf) relationship in finance. That’s the relationship between shareholders and corporate managers. The extent of managers’ fiduciary duty to shareholders isn’t really clear under the law, especially since public companies have a mechanism, the Board of Directors, whereby shareholders elect representatives to monitor management. But the subject does come up from time to time. It was a big issue in the 1980s, when financiers trying to take over underperforming companies (we used to call them raiders, but nowadays CNBC calls them activists) accused managers that tried to resist them of breach of fiduciary duty. The basic argument was that managers entrenched themselves so they could continue in their jobs, even though shareholders would be better off replacing them.

We only occasionally hear the fiduciary argument in corporate control contests these days, perhaps because Boards have become a bit more responsive to activists, and more corporate managers have significant shareholdings in their firms. Many may welcome the opportunity to make a profitable exit. But the interests of managers and public shareholders – especially individuals with small holdings – can still be in conflict. One area where the conflict arises in a curious way is in the so-called corporate tax inversions. These are transactions in which a US company merges with a company in a country with a lower corporate tax rate (Ireland has been a leading choice), and then reincorporates the parent company in the overseas jurisdiction. On the surface, this would seem like a good deal for shareholders. After all, lowering the firm’s tax rate should improve its net earnings, and thence possibly it’s stock price. Ironically, some managers have answered objections to inversions by arguing that failing to capture the inversion’s tax advantage would be a fiduciary breach. Corporate management has become more subtile in the past 30 years.

There’s a problem for many shareholders in tax inversions, though. Because the goal of the deals is to reduce corporate income tax, the best candidates are successful companies, and most of those have seen their share prices rise significantly in the past few years. As a result, many of their long-term shareholders have substantial unrealized capital gains. In a stock-for-stock acquisition deal between US companies, the share exchange is usually tax-free. But in a tax inversion, shareholders receive shares of a foreign company, so the deal is taxable. It causes shareholders to realize their capital gains whether they want to or not.

Managers are well aware of the problem. In a recent deal, Mylan Laboratories moved its domicile to the Netherlands after acquiring certain overseas generic drug assets that Abbott Laboratories spun off into a new firm. Anticipating a substantial tax impact on managers with substantial shareholdings (from various tax effects, not just realization of capital gains), the firm paid a group of senior managers concessions amounting to about $50 million to offset those taxes. Mylan’s other shareholders, in effect, paid not only their own taxes, but those of senior management. All in the name of fiduciary duty.

About the Author:

Jonathan Tiemann
Dr. Jonathan Tiemann, TIA’s founder, president and chief investment “guru,” has 30 years of investment experience, which include nearly a decade in academia and now more than twenty years managing money and designing investment services. He earned his B.S. in Applied Mathematics from Yale University, an M.S. in Operations Research from Stanford University, and his Ph.D. in Finance from Yale University. Dr. Tiemann taught Finance at Harvard Business School for five years before leaving academia for Barclays Global Investors (formerly Wells Fargo Nikko Investment Advisors and currently Blackrock), where he became Chief Investment Strategist, responsible for nearly $200 billion in institutional assets.

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