In contrast to most other countries, in both Britain and the United States, a hallmark of corporate governance is a separation of ownership and control in major business enterprises. Various theories that have been advanced to account for why patterns of ownership and control differ across borders, with the most influential being that the “law matters” in the sense that ownership dispersion is unlikely to become commonplace in public companies unless company law provides substantial protection to outside investors. As one of us has argued elsewhere, these theories do not explain effectively why a separation of ownership and control became the norm in the UK. In our paper “Ownership Dispersion and the London Stock Exchange’s ‘Two-Thirds Rule’: An Empirical Test”, recently published on SSRN we analyze a different law-related hypothesis concerning the evolution of ownership patterns and show that it similarly lacks substantial explanatory power.
From the mid-19th century until the late 1940s the London Stock Exchange listing rules prohibited the quotation of a class of securities unless two-thirds of the securities had been subscribed for and allotted to the public. While the intention was to inhibit market manipulation and foster liquidity, what can be characterized as the “two-thirds rule” seemingly put those backing and running a company joining the stock market under an onus to dilute considerably their stake in the company. Research on how companies structured their affairs in response to the two-thirds rule is lacking. Correspondingly, we have tested its impact empirically, hypothesizing that with most companies quoted on the London Stock Exchange when the two-thirds rule was in force key shareholders would have owned no more than one-third of the shares and controlled no more than one-third of shareholder votes following the move to the London Stock Exchange.
To carry out our test we turned to an existing dataset of IPOs occurring between 1900 and 1911 and focused on 222 domestically based companies that survived at least five years. Not all of these companies were in fact subject to the two-thirds rule, which only applied to companies that became officially quoted on the London Stock Exchange. Of the 222 companies in question, 94 (42%) secured a London Stock Exchange platform for the trading of their shares by way of a “special settlement” and were not subject to the two-thirds rule. Our empirical analysis focused primarily on quoted companies, but special settlement companies nevertheless provided us with a control group that we could rely upon to help to gauge the impact of the two-thirds rule.
We relied on three data sources to identify patterns of ownership and control in our sample companies. These were 1912 to 1915 volumes of an investors’ guide known as the Investors’ Four-Shilling Year Book (IYB) that provided data on director share ownership in important publicly traded companies, prospectuses published by the companies that went public on the London Stock Exchange and shareholder returns filed in accordance with UK companies legislation and held in the National Archives at Kew Gardens. Shareholders returns constituted potentially the most reliable source but major documentation gaps and resource constraints meant we could only investigate shareholder returns filed within one year of an IPO for 46 of the 222 companies in our sample.
Various features of our data reveal that the two-thirds rule did not have the predicted impact on ownership and control. Data from the IYB indicated that in one out of three of the 116 IYB companies that went public between 1900 and 1911, the directors collectively owned more than 33% of the shares. Among IYB companies for which prospectuses provided data on share ownership, “insiders” owned, on average, 48% of the shares and controlled 63% of the votes, well in excess of the predicted one-third stake. With the 46 companies where we examined shareholder returns filed within one year of the IPO, there were 24 where the collective ownership stake of the directors and their families was greater than one-third and in 20 companies directors and their families had outright voting control. Strikingly, with these 46 companies the average percentage of shares owned and votes controlled by directors and their families was lower among the 16 “special settlement” companies than it was among 30 companies that became quoted and thus had to comply with the two-thirds rule.
Why did the two-thirds rule not have the predicted impact on ownership and control? The fact the rule only applied to classes of shares that were subscribed for and allotted to the public was an important part of the story. This feature of the rule meant those organizing an IPO for a quoted company could ensure that directors and other insiders retained control by retaining all of the shares in an unquoted class of shares representing a sizeable proportion of overall voting rights. To the extent this was occurring, one would expect that it would be more common for companies seeking a full quotation to refrain from issuing all classes of shares to the public than it would be for companies going public by way of special settlement. This in fact is what occurred, with only 38% of quoted IPO companies issuing shares of all classes to the public as compared with 57% of the special settlement IPO companies.
We did not have access to archival evidence indicating how companies arranged their affairs in response to the two-thirds rule. Correspondingly, we acknowledge that among the companies that became officially quoted there may well have been dominant shareholders who, in the absence of the two-thirds’ rule, would have retained tighter control over voting rights than they in fact did. Nevertheless, our analysis indicates that to the extent that a divorce between ownership and control was the norm in UK public companies during the early 20th century, explanations for this state of affairs extend well beyond the two-thirds rule.
The full paper is available for download here.