Man has always desired power. Ownership of property gives this power. Man hankers also after posthumous fame based on power. This cannot be had if property is progressively cut up in pieces, as it must be if all the posterity becomes equal co-sharers.
Mahatma Gandhi
‘I have seriously considered how far a man is justified in giving away the heritage of his children and have come to the conclusion that my children will be all the better for being deprived of this money. Great wealth is not to be desired and in my experience it is more of a curse than a blessing to the families that possess it.’1 So on 14 December 1900 George Cadbury, standing in front of the Friends Meeting House on the idyllic village green of Bournville near Birmingham with 370 cottages and 500 acres of land around him, declared that he was giving away his wealth to the Bournville Village Trust. The aim of the Trust was ‘the amelioration of the conditions of the working class and labouring population’.2
The idea of social welfare and reform was just emerging at the end of the nineteenth century, spurred on by the writings of John Ruskin.3 Ruskin argued for an ethical approach to economic transactions and said that with wealth comes a moral obligation by which profit is only legitimate if it does not harm the rest of society.
Inspired by what George and his brother Richard Cadbury had created, Joseph Rowntree—another Quaker, fierce competitor of Cadbury in the chocolate business, and father of Seebohm Rowntree, the author in 1901 of Poverty: A Study in Town Life—built New Earswick between 1902 and 1904 on 150 acres near to York. And others followed the Cadbury and Rowntree lead—James Reckitt in Hull, Ebenezer Howard in Letchworth in Hertfordshire, and Henrietta Barnett in Hampstead Garden Suburb in London. Business was not just responding to social reform but shaping it and the societies within which it operated.
Meanwhile a less wholesome aspect of chocolate production was taking place off the coast of West Africa. At the beginning of the nineteenth century, the Portuguese had introduced cocoa into the islands of São Tomé and Príncipe. The climate and rich volcanic soils of the islands made them well suited to growing the crop, and in 1900 Cadbury bought 45 per cent of its beans from São Tomé and Príncipe. But the Portuguese had imported something else into the islands as well—slave labour. The Portuguese had officially ended it in the 1870s but in 1901 the board of Cadbury became aware of its continued use on the estates. On 26 September 1908, the London newspaper, the Standard, published an article accusing Cadbury of blatant hypocrisy, claiming that: ‘It is the monstrous trade in human flesh and blood against which the Quaker and Radical ancestors of Mr Cadbury thundered in the better days of England.’4
The Cadbury board were aggrieved, believing that they had done what they could to pressurize the Portuguese government ‘to put a stop to the conditions of slavery––not merely to wash our own hands of any connection with them’ and that if they had withdrawn from the islands they would have lost the little influence they had over the Portuguese.5 They sued the Standard for libel, and on 29 November 1909 the case came to court. The jury found in favour of Cadbury but the court awarded damages of ‘one farthing’, clearly unimpressed by how Cadbury had handled the slavery issue. A company renowned for the enlightened treatment of its employees had profited from less admirable practices further from home.
Cadbury was an example of the most common form of corporate ownership that exists everywhere in the world—family ownership. Most companies start off being family owned. More surprisingly, many of them remain so even when they become large multinational organizations with listings on national stock markets, and families retain the largest shareholdings in many of the largest companies listed on stock markets around the world.
In 2006, families controlled a third of companies listed on stock exchanges in France and Germany, and nearly one-half in Italy.6 In contrast, they only controlled around one-tenth of listed companies in the United Kingdom. Cadbury illustrates why. It was a family-owned company at the beginning of the twentieth century, it was not by the end, and it had ceased to exist altogether as an independent company by the end of the first decade of the twenty-first century, having been acquired by the US food and beverage company, Kraft, in 2010.
The reason why it was taken over by Kraft in the face of vehement opposition from the board of Cadbury was that the family was no longer in control of the company. Had they been so, then they could have stopped the acquisition by refusing to sell their shares to Kraft, and, in fact, Kraft would not even have attempted to launch a bid for Cadbury in the first place in the full knowledge that the family would not have been prepared to sell their shareholding. Instead, Kraft had merely to convince the financial institutions, into whose hands the shares of Cadbury had by then fallen, to sell their holdings at the generous price that was on offer.
On the other side of the Atlantic, another chocolate manufacturer, which had previously been an arch-rival of Cadbury, continues to thrive and survive as a family business to this day. In 1920 Frank Mars lived in Minnesota making candy, which his second wife Ethel sold to retail stores. Frank experimented with candy bars and around 1923 struck on the recipe for the Milky Way bar, which in one year increased its sales more than tenfold. The company moved to Chicago, and, shortly after graduating from Yale in 1928, Forrest Mars joined his father in the business. In 1930 they launched a peanut, caramel, and chocolate product called Snickers. However, father and son did not always see eye to eye and in 1934 Frank sent his son packing with $50,000, the foreign rights to Mars, and the words: ‘This company isn’t big enough for both of us. Go to some other country and start your own business.’7
In 1933, Cadbury’s sales team became aware of a company operating from a small flat in Slough in the United Kingdom. In one of the most remarkable pieces of commercial chutzpah, Forrest Mars approached Cadbury with a request that it supply him with chocolate to coat his new confectionary. To what must have been his complete amazement, they agreed. It was a decision about which a subsequent chairman, Sir Adrian Cadbury, has with some justification mused, ‘Why ever did we do that?’8 The resulting Mars bar was one of the most successful confectionaries ever produced.
Leaving aside this slight tactical error, the question remains as to why Mars has survived when Cadbury has not. One critical difference is that Mars to this day remains 100 per cent owned by the Mars family. Until the recent acquisition of Wrigley, Mars has raised little external finance at all, let alone sought a listing on a stock market. In contrast, following the merger with J. S. Fry and Sons of Bristol, the Cadbury family holding in the merged firm was diluted to just over 50 per cent by 1919. In 1962 following pressure from some members of both the Cadbury and Fry family to determine the value of their company’s shares and cash out, the company went public and was listed on the London and Birmingham stock exchanges. By 1969 when Cadbury merged with Schweppes plc, 40 per cent of the shares were dispersed amongst 200 shareholders.
This pattern of share issuance to fund growth and in particular acquisitions was repeated across the British corporate sector in the twentieth century. It resulted in family shareholdings being steadily diluted to the point that families lost control of their firms, rendering them vulnerable to the fate of the takeover that befell Cadbury.9
Why does it matter? Some argue that family ownership is a bad thing. It leads to the type of crony capitalism that was thought to afflict Asian economies after the Asian Financial Crisis in the second half of the 1990s. It is associated with the pursuit of self-interest of families at the expense of the commercial well-being of firms. It creates conflicts between family members, which eventually lead to their and their firms’ disintegration. So the emergence of institutional from family ownership can be regarded as economic advancement, democratizing the control of companies, making them more accessible, accountable, and transparent to the societies in which they operate. On this score, the United Kingdom is leading the way in showing the rest of the world where corporate ownership is heading.
Underpinning this view is the economic conceptualization of corporate ownership. As described in Chapter 1, since Ronald Coase first provided a rationale for the existence of the corporation based on the theory of transaction costs, and Adolf Berle and Gardiner Means documented the separation of ownership and control in the 1930s, economists have become fixated on one and only one aspect of the firm—the agency problem—the problem of aligning the interests of the managers running the firm with those of their masters, their shareholders. It is this which is regarded as being the primary function of ownership—to control the otherwise wayward tendencies of management to build corporate empires, award themselves egregious salaries, and indulge in lavish lifestyles at their corporations’ expense. And it is this that is the justification for changes in ownership through takeovers and shareholder activism when the existing owners fail to rectify the deficiencies of their managers.
The economic concept of ownership therefore equates it with corporate control, in particular the control of corporate assets, the determination of investment decisions, and the allocation of resources to different activities. In essence, this view of the firm sees owners sitting at the top, controlling their executives as puppets, pulling the purse strings of financial resources at their disposal. Ownership should reside with those who work their puppets most effectively, and it should be transferred immediately to those with greater skills at doing so.
At best, this is an incomplete and, arguably, highly damaging description of the firm. It is incomplete because it fails to appreciate the far more significant functions that ownership performs, and it is damaging because the misconception has been the source of profound corporate failures and substantial economic hardship. The case of the most successful and significant product of all times illustrates this.
To quote Zohar Goshen and Assaf Hamdani, Henry Ford:
did not invent the automobile, nor did he own any valuable intellectual property in the technology. He was competing with hundreds of other entrepreneurs attempting to create a ‘horseless carriage’. Ford, however, had a unique vision regarding car production. Investors exercised considerable control over the first firm that he founded, the Detroit Automobile Company, and this led to irreconcilable conflicts. While Ford’s investors demanded that cars be immediately produced and sold, Ford insisted on perfecting the design prior to production, leading to delays, frustration on both sides, and the eventual shutdown of the firm by the investors.
Investors continued to control Ford’s second attempt, the Henry Ford Company. Again, after designing a car, Ford resisted investors’ pressure and interference to move directly into production. Eventually, his obstinacy led to the investors replacing Ford with Henry Leland, changing the company name to the Cadillac Automobile Company, and producing the car designed by Ford with great success.
In his third attempt, the Ford Motor Company, Ford insisted on retaining control. This time, with no outside investor interference, Ford transformed his ideas for car design and production into one of the great corporate success stories of all time. Finally, with yet another move along the spectrum of ownership structures, Ford’s grandson, Henry II, took the corporation public in 1956 with a dual-class share structure, ensuring that control stayed with the Ford family to this day.10
In some cases, entrepreneurs’ vision borders on fanaticism. In 1964 at the age of sixty, Forrest Mars ‘had finally got his hands on his father’s company, merging it with his own Food Manufacturers, Inc. Soon after, he summoned a group of executives and other employees to a buff-colored conference room. Mars did not just walk into the room; he charged in…After a few quips, which sparked a little dutiful laughter, Mars talked of his plans and hopes for the Mars Candies Division, as the Chicago operation was henceforth to be known. He paused. “I’m a religious man,” he said abruptly (he was an Episcopalian). There was another long pause, while his new associates pondered the significance of his statement. Their mystification increased when Mars sank to his knees at the head of the long conference table. Some of those present thought that he was groping on the floor for a pencil that had slipped from his hands. From his semi-kneeling position, Mars began a strange litany: “I pray for Milky Way. I pray for Snickers…” For men accustomed to an orderly kind of life within a closely held, profitable company, it was an unnerving moment. But Mars’s litany had purpose. His listeners, without knowing it, were being introduced to a basic tenet of Forrest Mars’s management system: all members of an organization must be united in a coordinated drive to a single objective––profit through faith in the company’s leadership and product.’11
In nearly all cases, success involves immense innovation and endurance: ‘The Cadburys had wrestled with the problem of milk chocolate for fifteen years, but had failed to find a breakthrough recipe. The challenge seemed insurmountable: to create and mass-produce a bar that was milkier and creamier than those of the competition…George Cadbury was so caught up in the process that it is said that one night sleepwalking and delirious, he “rose in the small hours and trundled his young wife, Edith, around the bedroom under the impression she was a milk churn”. Late in 1904, an exhausted George Junior and his team hit on the exact combination of temperature, pressure and cooling that would condense the milk in such a way that large volumes of it could be mixed with the cocoa without spoiling’12 and so was born Cadbury’s Dairy Milk chocolate in 1905.
Goshan and Hamdani describe these as examples of the pursuit of ‘idiosyncratic value’—value that is recognized by entrepreneurs and innovators of vision but no one else. In particular, the visionaries are dismissed as cranks and fanatics by the people who really matter—the more sober-minded investors, who see cost, waste, and risk where the visionary senses creativity, worth, and riches. As the case of Henry Ford illustrates, the divergence of view can be fatal to the development of radical new innovations where control resides with investors, as it did in the first two examples of Henry Ford’s companies. But where ownership coincides with vision, as it did in the third case, and in Cadbury (as it did at the beginning but not by the end of the twentieth century) and in Mars, vision is supported not extinguished by ownership.
Ironically, stock market ownership, which is often regarded as particularly conducive to the promotion of entrepreneurship and innovation through providing the means of accessing large pools of diversified investment, is exactly the opposite—the mundane views of investors stifling and snubbing the spark of creative inspiration. This is not to suggest that entrepreneurs and innovators are always right or that investors are not often perfectly justified in pulling the rug from under their feet, but instead it emphasizes that ownership involves committing to, not controlling, entrepreneurship and innovation.
What underpins the successful relation between the two parts of the corporation is trust—trust that management will not abuse their power to exploit their owners and defraud them of their earnings, and trust that owners will not exploit their power over other investors and parties to the firm. As we will see, the history of the emergence of stock markets around the world in the twentieth century is one of creation of institutions of trust to sustain these relations in the absence of regulation.
The Fords and Mars are the norm not the exception in being dominated by families. Family ownership is the most common form of ownership of companies around the world, not just as we might expect in small firms but perhaps more surprisingly in the largest listed companies as well. They are part of a more general class of shareholders who are sometimes termed ‘block holders’—shareholders who own a substantial fraction of shares in a company, often defined as being in excess of 25 per cent on the grounds that 25 per cent represents a ‘blocking minority’ that allows the owner of the shares to veto certain actions by the firm.
Block holders are ubiquitous. In most countries, three shareholders control a majority, i.e. more than 50 per cent of the shares in companies and in some countries a single voting block (i.e. a group of shareholders voting together) control a majority of shares in companies. The nature of those block holders varies across countries. In some, such as China, they are the state, but in most they are families. This is true in Asia, Europe, and South America.
As noted above, the one country that stands out in this regard is the United Kingdom. It has far fewer family owners than most countries around the world, and even those that are family controlled display a high level of attrition through takeovers, financial failure, or transitioning into some other form of ownership.
The United Kingdom is often categorized with the United States as being the archetypal form of stock-market economy—what is described as ‘Anglo-American’. However, while they are superficially similar in having large active stock markets, the differences between the two countries are actually more pronounced than their similarities. In particular, the prevalence of block holders in the United States appears to be significantly greater than in the United Kingdom.
The contrast between Ford and Mars on the one hand and Cadbury on the other is therefore by no means exceptional, and one aspect of Ford explains why—the Ford family was able to retain control of the company to this day through a ‘dual-class share structure’. What this means is that, while Henry Ford sold shares in his company on the stock market, he retained control through keeping the voting rights. In other words there were two types of shares—those sold to the public at large with few voting rights attached to them and those retained by the family with a large number of voting rights.
Dual-class structures are commonplace around the world, including in the United States, and, as was mentioned in Chapter 1, some of the most successful newly established companies such as Facebook, Google, LinkedIn, and Snapchat came to the stock market with dual-class structures that gave Larry Page and Sergei Brin, in the case of Google, and Reid Hoffman in LinkedIn shares with ten times the voting rights of those sold on the stock market. The justification for this was the same as Ford’s, namely to allow the founders to retain and promote the purpose and values of the firms. They were idiosyncratic value-preservation devices.
In contrast, dual-class shares are not permitted in the United Kingdom, and, according to the listing rules of the UK stock market, companies cannot be ‘premium listed’ with dual-class structures. Such arrangements are perceived to be a violation of the equal treatment of all shareholders, and indeed there is evidence that they have allowed controlling shareholders to ‘tunnel’ financial resources out of companies.13 But equally, as noted in Chapter 1, there is evidence of shareholders doing very well in companies with dual-class structures.
The importance of the acceptance or rejection of dual-class shares is that it is highly relevant to the survival or extinction of family firms. As will be documented later, the Cadbury story of a firm that grew through issuing shares to fund its expansion, which caused the ownership of the founding families to be diluted to a point that they lost control and were eventually taken over is by no means exceptional. It happened repeatedly, and it did so because, in the absence of a supportive banking system, families were faced with a choice of starving their firms of funds or losing control of them. While Ford was able to present its customers with the Hobson’s choice of ‘You can have any colour you like provided it is black,’ the owners of British family firms were given the choice of ‘You can have as much funding as you like provided you are not there to use it.’
Dual-class shares are not the only respect in which the United States differs from the United Kingdom. The United States is also much more permissive of limitations on the degree of control that shareholders can exercise on companies. For example, it allows companies to protect themselves against threats of takeovers through the use of ‘takeover defences’ such as ‘poison pills’, and restrictions on removal rights of shareholders to replace directors through ‘staggered’ or ‘classified’ boards that rotate the composition of boards over extended periods of time.
The effect of these provisions in the United States is to make directors less exposed to external interventions or shareholder actions than in the United Kingdom. While both systems promote the primacy of shareholder interests above others, the effect of dual-class shares, takeover defences, staggered boards, and other provisions is to allow US management to exercise a greater degree of ‘business judgement’ than their British counterparts. So whether it be through founder or family control or through management discretion, US firms are better able to protect idiosyncratic value against the type of ravages by investors to which Henry Ford was exposed.
What lies behind these marked international variations in the nature of superficially similar capitalist systems is a fascinating history of divergent social, political, as well as commercial and economic influences. The next sections tell the story of how the United Kingdom ended up with one of the most diversified least family-owned corporate sectors in the world; how Germany today has some of the most persistent family ownership; how Japan switched from family to no family control in a matter of a few years; and how the United States looked initially similar to the United Kingdom but ended markedly different. We will demonstrate how, despite their divergent histories, all four countries establish the importance of trust and the existence of trustworthy institutions in the development of financial systems, and why it is these, rather than regulation, that hold the key to the promotion of idiosyncratic value and flourishing corporate sectors.
In the first half of the nineteenth century Britain had a plethora of local banks all over the country that were actively involved in the financing of small and medium-sized firms. However, the existence of these local banks empowered to engage in note issuance caused serious stability problems. Between 1809 and 1830, there were 311 bankruptcies that prompted the Bank of England to encourage banks to withdraw from illiquid investments in small companies and spread their activities more widely through mergers with other banks. As a consequence, a mutually attractive arrangement emerged by which, as concentration in the banking sector increased, the clearing banks faced decreasing competition during the nineteenth century and the Bank of England diminishing risk of bank failures.14
The result was that, in place of the highly decentralized but fragile banking that existed at the beginning of the nineteenth century, by the start of the twentieth century there was a highly concentrated banking system, a noticeable absence of local banking, and, at least until the secondary banking crisis in the 1970s and the financial crisis in 2008, little bank failure. There was only one party that was made worse off as a result and that was the corporate sector, in particular small and medium-sized enterprises, that found themselves unable to raise the finance for investment that was previously available to them from local banks.
As the supply of bank finance for small and medium-sized enterprises dried up, companies turned to the stock market instead. As in the case of banking in the first half of the nineteenth century, stock markets in the United Kingdom in the first half of the twentieth century were highly localized. There were more than nineteen provincial exchanges all over the country that specialized in particular industries: for example, the Birmingham exchange was important for cycle and rubber tube stocks, Sheffield for iron, coal, and steel, and Bradford for wool. ‘The number of commercial and industrial companies quoted in the Manchester stock exchange list increased from 70 in 1885 to nearly 220 in 1906. Most of these were small companies with capitals ranging from £50,000 to £200,000’ and ‘by the mid 1880s Sheffield, along with Oldham, was one of the two most important centres of joint stock in the country, with 44 companies, with a paid up capital of £12 million.’15
As in the case of banking in the first half of the nineteenth century, the local nature of stock markets in the first half of the twentieth century was important in allowing companies to access sources of finance. Directors were keen to uphold their reputations amongst the local communities from which they were raising finance, and their dependence on local investors acted as a commitment device—‘institution of trust’. Writing in 1921, one author noted that ‘local knowledge on the part of the investor both of the business reputation of the vendor and the prospects of his undertaking would do a good deal to eliminate dishonest promotion and ensure that securities were sold at fair prices fairly near their investment values.’16 Concentrating ownership among local investors was recognized as a method of reducing information problems as well as fraud.
As one stockbroker put it, ‘The securities are rarely sold by means of a prospectus and are not underwritten, they are placed by private negotiation among local people who understand the [cotton] trade.’17 As a result, securities were traded in the city in which most investors resided. For example, shareholders in Manchester were anxious that the shares of Arthur Keen’s Patent Nut and Bolt Co. of Birmingham should be listed in Manchester where most of the shareholders resided. The reason was that proximity between brokers and directors was thought to create better-informed markets.
What then happened and continued to happen throughout the twentieth century was that firms issued shares to fund their growth and in the process they diluted the shareholding of their directors, family owners, and founders. For example, if a family initially owned all 1 million shares in a company and issued another 1 million to fund the growth of the firm then the family’s shareholding declined from 100 per cent to 50 per cent. Furthermore, as firms grew, their activities expanded beyond their hometowns and their shareholder base no longer remained geographically concentrated. So for example by 1920, shares in Guest, Keen, and Nettlefolds were quoted in Birmingham, Bristol, Cardiff, Edinburgh, Glasgow, Liverpool, and Sheffield, as well as Manchester.
As companies’ dependence on local stock markets diminished, the need for more formal systems of information disclosure through company accounts and listing rules intensified. The result was the 1948 Companies Act and the London Stock Exchange Listing rules that together substantially strengthened information disclosure and fundamentally changed the nature of the UK stock market to one concentrated on a single stock market in London. From an economy based first on local banking in the first half of the nineteenth century to one dependent on local stock-market institutions of trust in the first half of the twentieth century, Britain became a country with highly concentrated banking and few stock markets in the second half of the twentieth century and a heavy dependence on regulation to substitute for the disappearance of institutions of trust. Most seriously of all, as in the case of Cadbury, Britain became a country in which family ownership was diluted largely out of existence, and the external funding of small and medium-sized companies became seriously constrained. In both respects, it differed markedly from Germany.
At first sight, German financial markets at the beginning of the twentieth century looked remarkably similar to those in the United Kingdom. There were many firms listed on German stock markets and firms raised large amounts of equity finance. Contrary to the conventional view of Germany as a bank-oriented financial system, firms raised little finance from banks and surprisingly large amounts from stock markets.18
The mechanism by which this occurred and trust was upheld in Germany was quite different from that in the United Kingdom. In Germany, it was not so much associated with local stock markets as with banks acting as promoters of new equity issues on behalf of companies and custodians of shares on behalf of individual investors. Where equity was widely owned by individual investors it was generally held on their behalf by custodian banks. As a consequence, banks were able to cast large numbers of votes at shareholder meetings, not only in respect of their own shareholdings, which were in general modest, but more significantly on behalf of other shareholders.
The economic historian Frederick Lavington argued that banks provided a more secure basis for the issuance of initial public offerings (IPOs) in Germany than promoters in the United Kingdom whose interests were primarily confined to selling issues rather than ongoing relationships with companies.19 In the same way as firms in Britain upheld their reputation amongst local investors to gain access to equity markets, so German firms depended on banks as the gatekeepers to stock markets.
In the United Kingdom, much of the new equity was used to fund acquisitions of other companies, but not in Germany. It was predominantly directed towards internal investment and contributed to the rapid expansion of German relative to British manufacturing during the twentieth century. Companies did not grow through full acquisitions of other companies as in the United Kingdom but by taking partial share stakes in each other. Equity therefore came to be held by companies and banks in the form of pyramids and complex webs of inter-corporate shareholdings, bank custodianship, and family ownership.
This resulted in a fundamental difference in the way in which corporate control was exercised in Germany and the United Kingdom. In Germany, voting control remained within corporate and banking sectors and families, and was not transferred to outside individual and institutional shareholders, as occurred in the United Kingdom. As a consequence, an ‘insider system’ of ownership and control of corporations in banks, companies, and families emerged in Germany in contrast to ‘outsider’ ownership by individuals and institutional investors in the United Kingdom. These distinct forms of ownership persisted into the second half of the twentieth century, and both differed from what happened in Japan.
Japan and Germany are often categorized together as ‘bank-oriented’ systems. In fact, banks were not primary funders of German corporate investment, and Japan did not have a bank-oriented system in the first half of the twentieth century. Japan actually bore greater resemblance to the United Kingdom than Germany in having low concentration of ownership, widely dispersed amongst institutional investors. Of the three countries discussed to date, dispersion of ownership was greatest in Japan, as ownership of the newly industrialized companies, such as the cotton-spinning firms, became widely held on stock markets. So pronounced was the dispersion of ownership that measures of concentration of ownership were lower in Japan than they were at that time in the United Kingdom.20
As in Germany and the United Kingdom, informal arrangements of trust were critical to the development of Japanese stock markets. Unlike in the United Kingdom, they were not attributable to the prevalence of local stock exchanges, and most companies were listed on one of two stock exchanges—Osaka and Tokyo. Nor, unlike in Germany, did banks play an important role in relations between investors and firms in the first half of the century. Instead, in the first two decades of the twentieth century particular individuals rather than institutions were critical to the ability of companies to be able to access stock markets. These individuals, known as ‘business coordinators’, had some of the characteristics of today’s private equity investors and business angels. They were prominent members of the business community, sometimes senior figures in the local chambers of commerce, who sat on the boards of several firms. Their reputation acted as a validation of the soundness of the companies with which they were associated.
The role of business coordinators diminished from the 1920s onwards and their place was instead taken by zaibatsu, family firms. These were established during and after WW1 and sold their subsidiaries on Japanese stock markets during the 1930s. In this case, it was the reputation of the zaibatsu families that facilitated their access to stock markets. However, the success of the zaibatsu was the source of their subsequent downfall, because in the aftermath of WW2, the American occupation attributed the power of the Japanese military machine to the zaibatsu and dismantled them.
In their place, the American occupation sought to create US-style widely held companies and, to achieve this, it introduced US investor protection that transformed weak regulation in the first half of the century into some of the strongest in the world in the second half of the century. However, the effect was exactly the opposite of what was intended. Instead of promoting a US outsider system of corporate ownership, banks and companies began to acquire cross-shareholdings in each other. The dismantling of the zaibatsu in the aftermath of WW2 and the introduction of investor protection left a vacuum that individual and institutional investors failed to fill, and instead an insider system of corporate control in the hands of banks and corporations, similar to that in Germany, emerged in the second half of the twentieth century.
The dispersion of ownership in the first half of the century had occurred in the absence of any significant investor protection but the introduction of strong regulation resulted in Japan moving from essentially an Anglo-American outsider system to a German-style insider system in the second half of the century. This presaged the collapse of the Japanese banking system in the 1990s and the ‘lost decade’ before an outsider system began to re-emerge in Japan at the beginning of this century.
Surprisingly, it is harder to undertake long-run analyses of ownership of corporations from the beginning of the twentieth century in the United States than in most other major developed economies. The reason is that until the formation of the Securities and Exchange Commission (SEC) in the 1930s in the wake of the 1929 stock-market crash and the Great Depression, there was little requirement on companies to disclose information. Most of our knowledge about corporate ownership in the United States at the beginning of the twentieth century comes from the work that Gardiner Means did, some of it in conjunction with his co-author Adolf Berle.21
As in the other three countries, Gardiner Means reports a rapid dispersion of ownership from the beginning of the century. It gave rise to Berle and Means’ concern about a separation between the ownership of shareholders and the emergence of managerial control in the absence of the banks, families, or holding companies that held management to account in other countries.
More recent work casts doubt on this conventional view. It shows that between 1926 and 1950 business groups were the most dominant force in the US stock market.22 They comprised about one third of all corporate assets, one half of non-financial assets, and collectively controlled over 1,000 firms. They were important in utilities, railroads, and transportation as well as in manufacturing. Wealthy families, such as Morgan, Du Pont, and Mellon controlled some business groups and others were ultimately widely held, particularly those in the utility industries. Despite the much-publicized dispersion of ownership in the United States in the first half of the twentieth century, family ownership persisted in business groups for most of this period.
Business groups went into decline in the United States from the beginning of the 1940s as a consequence of regulation. By seeking to improve both transparency of accounts and shareholder rights, the Securities Act of 1933 and the Securities and Exchange Act of 1934 curbed the means by which parent firms could transfer wealth from one part of a business group to another. The introduction of double taxation of inter-corporate dividends in 1935 and the imposition of greater disclosure standards on listed firms investing in other companies’ shares in 1940 were the final nails in the coffins of the business groups.23 Family ownership through business groups therefore disappeared in the second half of the twentieth century but, as described above, it persisted in a form that was not available in the United Kingdom, namely through dual-class shares.
All four of the United Kingdom, Germany, Japan, and the United States displayed rapid dispersion in ownership in the first half of the twentieth century. However, the United Kingdom differed from the other three countries in one important respect and that is, while concentrated family ownership persisted in all the other countries, it was steadily eroded in the United Kingdom as companies expanded through equity issuance and acquisitions. The decline of the United Kingdom as a major economic power during the twentieth century and the rise of Germany, Japan, and the United States were associated with the persistence of family block holdings in Germany, Japan, and the United States but not in the United Kingdom.
The growth of stock markets occurred in the absence of regulation. Regulation and investor protection were largely absent in all four countries in the first half of the twentieth century, and when they were introduced in the United States in the 1930s, and in Japan and the United Kingdom in the 1940s, they undermined the very institutions of trust on which they depended. Post-WW2, investor protection had the unintended consequence of promoting the emergence of an insider bank-oriented rather than an outsider individual and institutional system of corporate control in Japan, of hastening the demise of family ownership in the United Kingdom, and of intensifying separation of ownership and control in the United States through the elimination of business groups.
Investor protection was neither necessary for the development of outsider systems of corporate ownership in any of the United Kingdom, Germany, Japan, or the United States in the first half of the twentieth century nor sufficient on its own to promote an outsider system of ownership in Japan in the second half of the twentieth century. On the contrary, the introduction of regulation undermined the institutions of trust (local stock markets in the United Kingdom, family owners in Japan, and business groups in the United States) on which dispersed outsider ownership systems depended.
It was institutions of trust rather than regulation that were the necessary ingredient for the successful development of flourishing stock markets in all four countries. In the case of the United Kingdom it was local stock markets, in Germany the banks, in Japan business coordinators and zaibatsu families, and in the United States business groups and families. Despite the fact that many German firms such as Krupp, Siemens, and Volkswagen were intimately involved in the Nazi war effort, unlike the zaibatsu family firms in Japan, the allied occupation forces did not dismantle them in the post-war period. They continued to exist and thrive. In addition and again in contrast to Japan, there was no fundamental restructuring of German investor protection. As a consequence, while family firms went into decline and never recovered in Japan, they continued to dominate ownership and control of German industry.
The twentieth century reveals the importance not only of dispersion of ownership amongst individual and institutional investors but also of the parallel existence of block holdings. Where block holders reflect outsider as well as their own interests then they promote dispersed ownership by acting as institutions of trust. We associate block holders with the exercise of corporate control but what this chapter has revealed is that they can also enhance not diminish ownership dispersal by acting on behalf of all shareholders. In this respect they are institutions of trust not control since, in the absence of regulation, dispersed minority owners have few powers of redress. Well-designed regulation and investor protection can assist block holders in acting in this way but excessive regulation undermines their ability to do so. Financial theory provides us with some clues as to why block holders as well as dispersed shareholders, institutions of trust, and careful design of regulation and investor protection are all necessary ingredients of successful financial development.
Modern theories of finance demonstrate the benefits that investors derive from holding well-diversified portfolios of different companies’ shares. By so doing, they are able to minimize their exposure to any one company and only have to endure the risks associated with overall movements in the market as a whole. Even if they cannot distinguish between the Henry Fords and charlatans of this world, by holding combinations of the two they can achieve the equivalent of a riskless investment—investment in genius plus investment in lunacy equals the return on a government security
The allure of this has been that, by apparently having to do nothing other than purchase funds of multiple company shares, investors are able to extinguish much of the risk associated with investing. Not only are the risks of such portfolios low, but if the funds can be traded on exchanges, then they are also liquid in the sense that they can be cashed in when investors wish to do so. While economics repeatedly asserts that there is no free lunch, the practical application of what in mathematics is termed the central limit theorem to financial investment appears to come very close to achieving it.
The strength of this has been to allow large numbers of people with no interest in or knowledge of investing to participate in equity markets. It has permitted companies to draw on far greater volumes of capital than would otherwise have been the case. This is unequivocally good and here the matter would rest, were it not the case that this capital that firms raise can come back and bite them.
Recall the problem that Henry Ford encountered in the mark one version of his company—he wished to improve the design of the car when investors wanted to start selling it, and, because they controlled the firm, they could close it down when Ford failed to cooperate. The problem in mark two of his company was that when Ford resisted pressure to move swiftly to production, investors could remove him because again they controlled the firm. In other words, the problem that Ford encountered in both the first two versions of his company was the control that investors could exercise over him and his company after he had raised finance. The solution that he found in mark three of his company was to retain ownership and control himself.
The strengths that portfolios create in pooling capital are precisely their weakness in promoting enterprise and innovation. They increase the supply of finance and thereby reduce the cost of capital but they undermine the ability of entrepreneurs and innovators to pursue idiosyncratic value that the market does not immediately recognize. The depressed value of companies pursuing idiosyncratic policies leaves them exposed to the type of interventions that Henry Ford experienced or their modern equivalents—takeovers and hedge-fund activism.
We have therefore created highly liquid, low-risk equity markets that reward investors handsomely at little risk and cost to themselves. The only problem is that they provide forms of finance that innovative firms do not want. The consequence is that firms shun the markets and seek refuge from the pressures of activist investors and hostile bidders in the safe harbours of private equity, as Henry Ford found. That is precisely what has happened; only it has become worse than it was in Ford’s time.
At the turn of the century in 2000 there were more than 2,000 companies listed on the main market of the London Stock Exchange (LSE) in the United Kingdom. Today eighteen years later there are less than 1,000 firms. The reason for this is that the number of companies choosing to exit (delist) from the LSE has far exceeded the number choosing to enter, i.e. list for the first time—what are termed initial public offerings (IPOs). At the beginning of the century the number of delistings was in excess of 200 per annum while the number of IPOs was only around half that.
The United Kingdom is not the only country to have witnessed a marked decline in the size of its stock market; so too has the United States. The Economist reported in May 2012 that the number of public corporations in America had dropped by 38 per cent from 1987. Michael Jensen, the well-known Harvard Business School finance professor, predicted the ‘eclipse of the public corporation’ in the 1980s;24 Jensen’s prediction appears to have been realized in both the United Kingdom and the United States in the 2010s.
But it has not been realized everywhere. As their names suggest, emerging markets have experienced rapidly expanding stock markets. So too have some developed markets such as Japan where the number of listed companies on the First Section of the Tokyo Stock Exchange has increased from 1,400 to 1,800 over the same period that the number listed on the LSE main market has halved.
On average around the world, the number of companies listed on stock markets has remained constant since the beginning of the 1990s at approximately ten per million of population. However, in the United Kingdom and the United States the number has declined from closer to 30 per million of population to just in excess of the global average. Why is this happening? Why are companies choosing to leave the UK and US stock exchanges, but not others?
Some idea of the answer to this comes from observing the changing composition of ownership of shares of listed companies. Until the beginning of the 1970s, share ownership in the United Kingdom and the United States was dominated by individual investors. At that stage, institutional investment increased rapidly, and pension funds, life insurance companies, and mutual funds replaced individual investors. Like individual investors, the institutional investors tended to hold shares for extended periods of time.
Over the last few years, other institutions have replaced these domestic institutional investors—hedge funds, private equity investors, and, above all, foreign institutional investors. Foreign ownership has increased markedly as investors have begun to appreciate the benefits associated with international as well as domestic portfolio diversification.
With this has come a marked decline in the period for which investors on average hold the shares of companies. Seventy years ago the average holding period of shares was around eight years, thirty years ago it was about four years. Today it is on average a matter of a few months. What was previously a long-term investment for individual and then institutional investors has become an increasingly short-term investment.
The changing nature of ownership and the shortening holding period of shares has been a global phenomenon not restricted to the United Kingdom or the United States. However, its significance for companies outside the United Kingdom and the United States has been much less than in these two countries. The reason for this is that the changing nature of institutional ownership has come against the backdrop of remarkable stability in the ownership of those people who ultimately control most listed companies in the world, namely families.
While many large companies are listed on stock markets, families retain the dominant controlling shareholders of even the largest of them. For example, in Germany the proportion of companies with dominant family owners controlling more than 25 per cent of shares of the largest 200 non-financial companies has remained in excess of 30 per cent over the last twenty years.25
The significance of the dominant family ownership is that it lends stability to the ownership of companies whose other shareholders are turning over rapidly. While the dispersed and changing ownership of UK and US firms can have profound effects on their control, this is not in general the case in other listed companies around the world: ultimately it is the families not the mass of institutional investors who determine how these companies are run. They act as ‘anchor’ shareholders. In contrast, listed companies in the United Kingdom and United States have enjoyed no such protection, and for them idiosyncratic value is not preserved in the hands of founders and their families but instead is at the mercy of institutions whose vision extends little beyond the next dividend payment.
Faced with the conflict that this creates, many firms have chosen to follow Henry Ford’s example and decided to go private. In essence, UK and US firms have been voting with their feet by moving from the turbulent waters of stock markets to the safe harbours of private ownership.
In creating almost perfectly liquid, low-cost equity investments for shareholders, we have lost sight of the ultimate purpose of stock markets—to fund risky investments by companies. The provision of liquid, low-risk, short-term finance satisfies one end of the investment chain—the investors’ end. At the other end sit companies that are engaging in exactly the opposite activities—illiquid, high-risk, long-term investments. They are investing in physical assets, such as buildings, equipment, plant, and machinery, and above all in intangible assets—ideas, innovation, and research and development—that can take years and sometimes decades to come to fruition.
What the stock market and in particular the investment chain is there to do is to transform shareholders’ desire for liquid, low-risk, short-term investments into companies’ requirements for illiquid, high-risk, long-term sources of capital. What it does, and has done increasingly effectively, is the first of these. It has become progressively easier for investors to trade shares at low cost, hold highly diversified portfolios that reduce the risks of their investments, and cash in their shares. But at the same time, this has made it progressively harder for companies to raise patient, long-term capital that does not impose high cash-flow requirements on them. Instead of transforming investments, stock markets have forced the type of finance demanded by one end of the investment chain on the other end, and the reaction of the latter has been to shun the finance offered by the former.
One way of thinking about this is in terms of ‘realization’ and ‘influence’ periods. It takes a certain period of time for corporate investments and strategies to come to fruition. In some cases, in particular in relation to new innovations and inventions, realization periods might be decades. Over those periods, the investments and strategies are vulnerable to the interference of investors who lose faith in or do not perceive their vision and objectives. To avoid this, those with the ideas and vision need to be able to control the investments and strategies for corresponding periods. In other words, their influence periods have to correspond with the realization periods.
If the influence periods of innovators and inventors are shorter than the realization periods then innovators and inventors face the type of hold-up risk from investors that confronted Henry Ford in the first two forms of his company. On the other hand, if they are much longer than the realization periods then investors are exposed to innovators and inventors wasting their money on activities that are unrelated to the companies’ investment needs.
Balancing influence and realization periods is therefore critical to successful investment and innovation. By conferring control on investors who are not committed to long-terms investments with substantial realization periods, stock markets have failed to offer innovative firms the long influence sources of finance that they need. The United States and, in particular, the United Kingdom have become markets with too few investors who are willing to support companies for the periods that their investments require, and regulation has continued to exacerbate the problem.
Agency theories of the firm and concerns about the separation of ownership and control have resulted in a preoccupation amongst policymakers with minority shareholder rights. This has been supported by a body of academic opinion that points to the association between investor protection and the development of financial markets and systems.26 Stronger minority investor protection is associated with better-developed financial markets, and, as a consequence, there has been a steady strengthening of shareholder rights on stock markets around the world.
There are two justifications for this. First, in the context of dispersed ownership systems such as the United Kingdom and the United States, shareholder rights give minority investors the power to control otherwise self-interested corporate executives and managers. Second, in concentrated ownership systems outside of the United Kingdom and United States, it provides minority investors with protection against dominant shareholders.
Shareholder rights are therefore viewed as critical to the efficient operation of equity markets in all countries, and there is no doubt that they have been important in avoiding the conflicts identified by Berle and Means some eighty years ago. However, in the process of regulating to strengthen minority shareholders, we have diminished the incentives for other investors to provide the more engaged long-term investment that is required to match shareholder needs with those of the companies in which they are investing. No one is minding the shop. Britain, ‘a nation of shopkeepers’,27 has sold its shopkeepers to stock pickers, securitized them, and sent them packing. In other words, we have lost the transformative role of stock markets to convert liquid, low-risk, short-term shareholdings into illiquid, high-risk, long-term investments that match influence with realization periods and promote idiosyncratic value as well as risk diversification.
George Cadbury’s vision survives in the form of Bournville, a model village on the south side of Birmingham in the United Kingdom. A hundred years on from when George Cadbury stood on that idyllic village green, it has been described as being ‘one of the nicest places to live in Britain’.28 A study by the Rowntree Foundation in 2003 found that ‘the area, as a whole, scores well in terms of resident satisfaction and participation. It has relatively high levels of social and infrastructural capital. However, it is also a highly mixed neighbourhood with areas that are predominantly owner-occupied, areas that are predominantly council rented, and areas that are predominantly managed by a major, successful housing association––the Bournville Village Trust.’29
The village survives but the company does not. So does New Earswick near York, created by Joseph Rowntree, as does the Rowntree Foundation that undertook the study of the Bournville village, but the Rowntree company in York that Joseph Rowntree created does not. In contrast, Slough, where Forrest Mars opened his factory in 1932, might not be quite as idyllic a place as Bournville or New Earswick to live but the company that Frank and then Forrest Mars created survives. It survived because the Mars family retained ownership even as it grew to today’s $30bn company employing 80,000 people. Cadbury and Rowntree did not.
Ownership by Mars has allowed the family to retain an influence in ensuring the realization of the original purpose, vision, and values of its founders. Far from acting as a straightjacket restraining it from pursuing new directions, that family influence has been an inspiration to realizing new innovative ways of doing business that have brought mutual benefits to more than just the owners. Anchor shareholders provide the vision and values that it is for the board of directors to implement.