A large separation between ownership and control characterizes a state-owned enterprise.  In a state-owned enterprise, government bureaucrats typically have significant control rights.  They may, for example, determine the pricing of products or services; they may propose, review, or block new investments; or they may determine company employment policy.  In contrast, ownership rights are public property, and company profits accrue to the government budget.

Wide dispersal of shareholding in a private company can also produce a large separation between ownership and effective control.  A small shareholder has little incentive to expend personal resources to exercise control of a company, since any returns from improvements in the company accrue to all shareholders.  To see the problem in a simple model, let R be the company's increase in value from a shareholder expending personal resources Z to improve the company's efficiency.  Assume that R=Klog(Z), where K is a constant.  Suppose that N shareholders each own an equal stake in the company.  An individual shareholder will expend resources to improve the company's performance up to the point at which his personal return equals his personal cost: (1/N)(K/Z)=1, or Z=K/N.  As the number of shareholders increases, and hence the size of each shareholder's stake decreases, the amount of resources Z that the shareholder expends to improve the company's performance falls to zero.

Having a single investor with both significant ownership and control generally improves a company's performance.  Since state ownership intrinsically involves a separation of ownership and control, a significant share of a company often needs to be privatized in order to improve company performance.   Yet widely dispersed private ownership does not address the problem of separation between ownership and control.  This suggest that privatization, in order to improve corporate governance, should encourage the emergence of a major investor.

Attracting a strategic investor was a key part of the Kenya Airways privatization.  KLM became a strategic investor in Kenya Airways. It purchased 26% of the shares of Kenya Airways and agreed that it would not sell its stake for at least five years.  This shareholding gave KLM a significant stake in the profitability of Kenya Airways.  KLM's control rights included the voting rights for these shares as well as some specific rights:

• The right to appoint two Directors to the Board of Directors of Kenya Airways
• Under a Cooperation Agreement, the right to veto major strategic decisions, including new aircraft acquisitions or material changes in Kenya Airways route network.
• The right to nominate future candidates for the positions of Managing Director and Finance Director to the Board for approval.

Effective legal protection for investors benefits from a clear understanding of responsibilities and objectives. State owned enterprises typically impose a wide variety of objectives on managers and bureaucrats with control rights. These objectives could include regional development, employment generation, industrial policy, and political patronage, among others. Since these objectives often conflict and change, and often are never explicitly described, managers and bureaucrats of state enterprises have considerable discretion in the objectives that they pursue. In contrast, the fiduciary responsibility of the manager of a private company is clearer: maximize the return to shareholders through actions consistent with the law and widely accepted social norms and values. Thus it tends to be easier to establish effective legal standards of responsibility for managers of private companies than for public sector managers.

While legal protection for investors relates to the institutional structure of financial markets in general, the characteristics of a privatization can affect the ability of managers to protect themselves from malfeasance by managers or other investors. Privatizations that give large stakes to insiders -- current managers and employees -- may lead to less effective corporate governance. When insiders have large shareholdings, outside investors are likely to receive less accurate information about the company's performance, particularly if such information might imply the need for a change in management or a restructuring of employment. Such a hazard makes outsider investors less willing to invest.

Three aspects of the Kenya Airways privatization have implications for legal protection of investors.   First, employees and managers of Kenya Airways held after the initial offering about 3% of the shares of the company. This size of insider shareholding is not likely to have significant implications for corporate governance. Second, Kenya Airways has significant minority investors.  Over 100,000 individual Kenyans are investors in Kenya Airways.  Kenyan and international financial institutions also hold minority stakes.  Third, Kenya Airways is a significant part of the Kenya stock market.  At its offer price, Kenya Airways had a market capitalization of KShs 5.2 billion, which was about 5% of the market capitalization on the Nairobi Stock Exchange at the time of the offer.  Thus the minority shareholder protection rules that govern Kenya Airways shareholders and the fiduciary responsibilities that govern Kenya Airways management will play an important role in shaping the Kenyan capital market in the future.
 

1. In the summer of 1997 Kenya Airways share price was almost 30% below the initial offering price.  Does this represent a violation of investors' rights?

 
2. Does the importance of large shareholders imply that a country needs a few very rich individuals or families?

 
3. One type of managerial fiduciary responsibility is to provide relevant, accurate information to shareholders.  What kind of information should shareholders have the right to receive?