Alternative Explanations for Changes in Ownership Structure
By
Martin Ricketts
This comment concerns historical changes in the ownership structure of firms. In recent years a trend away from mutual and co-operative enterprise has occurred in certain sectors in the UK and the US although economy-wide data are not available. The New Institutional Economics offers a range of theoretical explanations for observed changes but it is still not clear how far spontaneous developments in the transactional environment are responsible and how far government intervention has played a part.
1. Introduction
The governance of the public limited company has been a continuing and mainstream interest of economists since Berle and Means [1932] made the ‘division of ownership from control’ the central feature of their investigation into US-style capitalism. This concentration on the investor-owned public limited company, however, diverts attention from alternative forms of governance which have featured prominently in the past, at least in certain industries. As Hansmann [1996] shows convincingly, organisations such as consumer and supply co-operatives, mutual organisations, nonprofit enterprises and even workers’ co-operatives have represented a significant part of the organisational landscape in the United States. Very similar observations can be made of the history of corporate enterprise in the UK [Ricketts, 1999].
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Changes in the ownership structure of companies have often accompanied economic development. These changes may be economy wide, as in the gradual substitution of the public limited company for the unlimited partnership or private company during the late 19th and 20th centuries. Changes may take place in particular industries or sectors as in the recent trend away from mutual governance in parts of the financial services sector in the UK. Pencavel [2001] studies the rise of worker co-operatives in the plywood industry in the Pacific Northwest of the United States after the First World War, and their subsequent decline after the 1950s as the main centres of production moved elsewhere. Competition between governance arrangements does not occur entirely through the processes of new firm formation and bankruptcy, however, but also through changes to the governance structures of individual firms.
Scottish Mutual, a Life Insurance Company in the UK, for example, was established as a proprietary company in 1883. It became a mutual company in 1952 by Private Act of Parliament, but then demutualised in 1991 and was acquired by Abbey National (itself a recently demutualised Building Society) 1. In some periods and sectors there seem to be countervailing moves of firms between forms of ownership. In US life insurance, for example, fifteen stock firms changed to mutual status and seventeen demutualised between 1900 and 1936. 2 In other periods a long-term trend in favour of a particular form appears to be in operation. For example between 1947 and 2002 the mutual sector’s market share of life insurance in the US fell from 69 per cent to approximately 23 per cent.3 In recent years the UK economy has experienced a
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A history of a selection of UK life insurance companies can be found in Guijarro and Hare [2002], Appendix A. 2 See Hansmann [1996, 274-5]. 3 See Hansmann [1996, 275] and Swiss Re [1999, 18].
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similar trend away from mutual and co-operative forms of enterprise towards investor ownership especially in financial services such as banking and insurance. 4 Some changes seem to be world-wide and relatively sudden, for example the demutualisation of stock exchanges and other exchanges from Stockholm in 1993 through Athens in 1999 and Hong Kong in 2000 to the Deutsche Börse and Oslo in 2001. In other cases change seems to be more specific to particular countries. For example, the market share of mutual insurers in Japan and Germany has changed much less dramatically than in the UK and the US.5
In this paper alternative possible explanations of these observations are considered. In section 2 a range of possible theoretical approaches to explaining the assignment of ownership rights is reviewed. Section 3 then considers the impact of government intervention on the recent trend towards demutualisation in the UK. The paper sets out a research agenda rather than a set of conclusions.
2. Theories of Ownership
Although the concept of ‘ownership’ has not historically been well defined in economics, modern theory follows Grossman and Hart [1986] in emphasising that the owner holds residual rights of control in physical assets. Specific rights of control are those actually mentioned in contracts. Those rights not so specified are residual rights. ‘Ownership is the purchase of these residual rights of control’. 6 Any theory of
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For details of the demutualisation of building societies in the 1990s see Stephens [2001, 346], Table 2. 5 From 93 per cent to 89 per cent between 1987 and 1997 in Japan; and from 31 per cent to 26 per cent between the same dates in Germany. See Swiss Re [1999]. 6 Grossman and Hart [1986, 692]. An alternative tradition emphasises the owner’s possession of rights to the residual (i.e. profit). Pencavel [2001, 93], for example, takes this position – ‘throughout this
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ownership must therefore explain the allocation of residual rights. Much of the theoretical literature focuses on vertical integration and the question originally raised by Coase [1937] and later by Klein et al. [1978] and Williamson [1979] of what determines the scope of the firm. Why, in other words, do the owners of one firm sometimes find it expedient to extend their ownership to the assets of other firms? In this comment attention is directed at the governance of the firm and to the question of what determines the location of ownership rights within the firm – are they held primarily by investors, consumers, workers, some sub-categories of these groups or by some combination?
Four broad theoretical approaches to this problem may be identified – property rights theory, transactions cost theory, Austrian subjective cost theory and the theory of rent seeking. These approaches are not entirely unrelated. There are common elements, but each has a distinctive emphasis.
2.1 Property Rights Theory
Why is it sometimes advantageous to own assets? Ownership confers the ability to determine how an asset is used when contract is silent or fails. According to modern property rights theory, therefore, the value of ownership rights derives from the fact that they provide re-assurance that assets will be available for use by the owner in the event that agreements with others are unsuccessful and are terminated. The option to
book, the owners are understood as those who appropriate the enterprise’s net earnings’. Clearly residual control rights and residual income rights are highly complementary so that in many cases the two approaches will not produce contradictory results. Traditional doctrine is exemplified in the adage ‘where the risk lies, there lies the control also’. Robertson and Dennison [1960, 75] see this proposition as representing capitalism’s ‘golden rule’. However, given that the separation of effective control from
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use an asset for different purposes in the event of contract failure with a particular trading partner may encourage greater ex ante investment by the owner in performance or reliance than would otherwise take place. If these ex ante investments are non-contractible, the incentive to undertake them will depend to some degree on how ownership of physical assets is assigned. This is because the threat points or opportunity costs of transactors and the gains to trade available in ex-post bargaining will be affected. Ownership of an asset will be re-assigned between potential trading partners and social surplus will rise if the induced higher ex-ante investment of the new owner more than offsets any reduction in ex ante investment of the original owner.
Recent property rights theory has been developed primarily as a means of analysing the scope of the firm rather than its governance. The firm is seen as a set of assets controlled by owner–managers and the primary interest concerns the nature and extent of the owned assets. However, the theory can be used to consider the converse question of principal interest in this paper - the nature and extent of the group of owners of an asset. Hart and Moore [1990] derive worker cooperatives and consumer cooperatives as special cases of their theory. Consumers, for example, might be owners of an asset if they are indispensable trading partners or if they are a key group with important ex ante investments to make. If control of an asset confers no advantage unless a consumer or group of consumers is also part of the controlling group, it makes sense for consumers to own the asset. Alternatively, if ex ante investments by consumers are what really count in increasing the social surplus derivable from an asset then consumer control makes sense. residual claims is at the heart of many disputes about corporate governance the potential for confusion over the location of ‘ownership’ within the firm is apparent.
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A consumer might be indispensable if he or she has highly idiosyncratic requirements that other transactors are engaged to satisfy. 7 This, however is a rather unpersuasive explanation of consumer co-operatives where these are observed to produce apparently rather standard services. Where co-operatives take advantage of preexisting bonds of trust, a group of consumers might more plausibly fit into the HartMoore framework. The consumer co-operatives of mid 19th century England, for example, appealed to particular social groups such as civil servants or army and navy officers.8 In the context of that era, we might regard these groups as indispensable trading partners for suppliers and workers. Even though the consumer groups made no ex ante human capital investments, it was their control that rendered the noncontractible investments of others more productive.
If property rights theory is to be used to explain recent moves away from mutual or consumer governance in the UK and the US it will be necessary to identify factors which have undermined the position of consumers as indispensable trading partners or rendered contractible actions which were previously non-contractible. Such changes are not inconceivable. For example, the gradual evolution of brand names on the part of investor owned retailers could be seen as removing the status of particular social groups of consumers as indispensable trading partners and hence as undermining the advantage of the consumer co-operative. The loss of social cohesion and peer pressure associated with an increasingly mobile population, both geographically and socially, might also produce a similar result. Such changes may have been at work in the late
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Hart and Moore [1990] give the example of a ‘tycoon’ who is the efficient owner of a yacht rather than a skipper or chef, even though the tycoon takes no ex ante actions while the chef and skipper may both have non-contractible investments to make.
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19th and early 20th centuries. The rapid demutualisation of certain financial services, however, after a long history of mutual governance, as briefly documented in section 1, would appear difficult to reconcile with property rights theory.
2.2 Transactions Cost Theory
For transactions cost theorists, the firm is a nexus of transactors rather than a set of assets under common ownership. In Hansmann’s [1996] taxonomy the relationship between a transactor and a firm is either one of market contract or one of ownership. 9 There is agreement with the property rights idea that the essence of ownership is the holding of residual control rights and hence the opportunity to take part in the governance of the firm. Market contracts may be long term or short term; payment may be by time rate or piece rate; provisions may be relational and implied or arm’s length and highly specified; but market contracts will not confer rights of ownership. Unlike property rights theory, however, the processes of ex ante contract formation, ex post bargaining and collective decision-making are central to transactions cost analysis.
Rights of ownership in transactions cost theory are assigned to maximise the social surplus net of all costs of transacting and ownership. Costs of transacting include the costs of search, bargaining and contract enforcement. Costs of ownership include the exercise of control, the bearing of uncertainty concerning the value of control rights, and the making of collective decisions. According to this approach, the owners of a
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For example the Civil Service Supply Association (1864) or the Army and Navy Cooperative Society (1872). 9 Hansmann [1996, 20] recognises that there can be ambiguous cases ‘between ownership and market contracting’ but argues that the dichotomy is useful.
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firm will tend to comprise that group of people that would otherwise face the highest costs of market transacting – for example those most subject to moral hazard or hold up potential. Groups that make efficient owners will also tend to face low ownership costs, perhaps because they can monitor resources at low cost, have access to local information or comprise a fairly homogeneous interest group.
Explanations of recent trends using transactions cost analysis will need to identify factors which have led to a change in the relative costs faced by differing ownership structures. Certain transactors may see market contracting as less hazardous than before and therefore they may be less inclined to demand rights of ownership. Consumers will see a smaller advantage in ownership if information about product quality is good or if a competitive environment makes monopoly exploitation less likely. Alternatively, changes may have occurred which have influenced the relative costs of ownership faced by different groups of transactors. Hansmann [1996], for example, emphasises the cost of making collective decisions as an important determinant of ownership structure. Innovations that lead to greater diversity of interest and less cohesion or homogeneity within a group will be likely to subvert that group’s role as owners by raising decision-making costs.
2.3 Austrian Subjective Cost Theory
‘Austrian’ ideas concerning ownership emphasise the role of the entrepreneur and the non-tradability of entrepreneurial services. Although the rhetoric is different there are close affinities with both property rights and transactions cost theories. From a property rights point of view, entrepreneurial discovery could be seen as a form of
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non-contractible ex-ante investment which will be discouraged if ownership of complementary assets is not secure. From a transactions cost point of view, the more people whose agreement must be secured and with whom the entrepreneur has to bargain ex post, the greater the dissipation of entrepreneurial rents will be and hence the greater the barrier to entrepreneurial initiative. Ownership of relevant assets will cut down on these transaction costs.
Re-assignment of ownership rights from this perspective is part of the process of entrepreneurial discovery. The rapidity of certain changes in ownership structure observed recently would seem consistent with an entrepreneurial explanation. One of the characteristics of mutual and co-operative ownership structures is that rights are not widely and cheaply tradable. It can be argued therefore that the re-assignment of rights so necessary for the process of entrepreneurial discovery is thereby inhibited. In a highly dynamic and technically innovatory environment, mutual governance faces a greater relative disadvantage from this point of view than would be the case under more stable or stagnant conditions. We would then expect dynamic conditions to be associated with a fall in the market share of mutual firms and a greater willingness to change from one form of governance to another notwithstanding the transaction costs involved in effecting the change.
Explaining recent changes in ownership structure using this type of reasoning would require us to identify factors related to entrepreneurial opportunities such as technological innovation or adjustments in public policy such as regulatory change or alterations to the rules of international trade. If these factors were expected to widen market opportunities they would give an advantage to investor owned rather than
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consumer owned or mutual enterprises assuming that they did not simultaneously create serious hazards in consumer product markets. 10
2.4 Rent Seeking Theory
Changes in ownership may bring about efficiency gains through entrepreneurial activity. An alternative view is that they may reflect distributional conflict and may waste resources. Agency problems between managers, investors, workers and consumers mean that rights of control and rights to profit streams are open to challenge. Mediating the inherent conflicts between interest groups within the firm is an important function of governance arrangements. Just as different constitutional structures determine the returns to rent seeking by interest groups at the level of the state, different ownership structures give rise to interest-group pressures within the firm.
Changes in ownership, according to this approach, will reflect attempts by particular groups to gain greater control over assets in pursuit of sectional goals. Managerial interests are obvious candidates for investigation here. Managers might find it advantageous, for example, to support a move from consumer ownership to investor ownership. Reasons cited have included a greater ability to raise finance for expansion and empire building in a public limited company compared with a mutual or consumer owned enterprise. Unfortunately, managerial interests are complex to
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This argument that dynamic conditions favour investor ownership is far from decisive. It was precisely the greater complexity and variety of consumer goods in the mid-19th century that created the conditions favourable to the consumer co-operative. Innovation may have encouraged investor owned firms in many fields but it simultaneously made transacting with consumers more hazardous. Consumer-entrepreneurs rather than investor-entrepreneurs were, for a period, the motivating force behind the revolution in retailing.
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model and plausible alternative assumptions can easily produce different results. For example, a desire for managerial security and the avoidance of consolidation and takeover have been used to explain earlier moves from stock companies to mutual companies in the life insurance market.11 Conversely, and somewhat paradoxically, it can be argued that managerial fear of takeover motivated a change towards joint stock status in the case of UK building societies. This occurred because the rules permitting 'demutualisation' had been clarified12 and it was no longer plausible to see mutual status as a reliable protection against takeover. In the 1990s, building society members were very persuadable, and managers of well-established societies were vulnerable to acquisition while unable themselves to take pre-emptive action and to threaten others.13 From a methodological point of view there are obvious difficulties in distinguishing a desire on the part of managers to protect their interests from an upsurge in entrepreneurial activity spurred by liberalisation and greater competition.
Rent seeking on the part of consumers or members of mutual societies was also a possible source of pressure for ownership change. Here the main suggested motivation was the desire to establish private and tradable claims over assets that were collectively held. These assets included, in the case of some life insurance companies, reserves accumulated from earlier generations of members and retained within the organisation by managers. Existing members would expect to benefit from the return on such assets but agency problems would enable managers to appropriate a proportion of the benefit. Further, the return would always be vulnerable to dilution
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In Canada, five large insurance companies converted to mutual status in the 1950s and 1960s. This has been interpreted as a move ‘to ensure that foreign interests would not acquire them’. Swiss Re [1999, 25]. 12 In the 1986 Building Societies Act conversion required a special resolution to be passed by 75 per cent of shareholding members in a 50 per cent or more turn out. It also required a majority of borrowing members to approve with no minimum turn out required. See Stephens [2001, 342].
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from new members. 'Windfall' payments to members of a society were a feature of demutualisations in the UK during the 1990s. 14
Once again, however, interpretation is difficult. Such payments can be viewed as similar to the resources disgorged to shareholders during the takeover wave of the 1980s. According to Jensen [1988] and other free-cash flow theorists this process was efficiency enhancing as resources were prized away from managerial interests. For supporters of mutual organisation in contrast, the 'raiding' of accumulated reserves and the sale of valuable brand names to investor owned firms is another example of the 'short-termism' associated with Anglo-American capitalism. Mutual forms of organisation, according to this point of view, by insulating managers from the market in corporate control, overcome the pressure on them to pursue short-term profitability and to engage in 'wasteful' signalling to the capital market. When the cost of demutualisation is reduced, managers are exposed to the same pressures as those in public companies, and one of the potential advantages of mutual organisation in a second best world is lost.
3. The Influence of Government Regulation
In reviewing possible theoretical approaches to demutualisation in section 2 the impact of government action in liberalising financial markets has already been mentioned. Greater supervision of financial markets and the strengthening of regulatory agencies were also associated with the decades of the 1980s and 1990s however, and a further problem confronting attempts to explain changes in ownership 13
The 1986 Act gave protection from take-over to a converted Building Society for a period of five years. Hostile action on the part of the converted society would, however, remove the protection.
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over the period is to disentangle the influence of liberalisation from that of regulation. Both might be expected to favour moves away from mutual governance.
Historical examples of ownership change have often been interpreted as deriving from government regulation. In Australia, for example, mutual life insurance companies entered the market in 1848 and were dominant into the 1870s. Insurance regulation in the 1880s enabled stock companies to compete more effectively. Similarly, the introduction of regulatory measures by states in the US in the second half of the nineteenth century led to a weakening of the competitive position of mutual societies. 15 The general point is that if mutual governance is a response to transactional hazards, state regulation (assuming it to be effective) acts as a substitute. The old regulatory functions of the London Stock Exchange, for example, are now undertaken by the Financial Services Authority (FSA). Consumers or other transactors have a reduced incentive to incur the costs of ownership if their contractual relations are policed by a state agency. Hansmann [1996, 294] points out that the tendency for regulation to undermine the competitive position of mutual, cooperative or non-profit enterprise is not confined to financial regulation but applies also to areas such as health or anti-trust.
Other legal developments also reflect the changing comparative advantage of mutual governance. In an important recent case in the UK, the Equitable Life Assurance Society was prevented from allocating final bonuses to its with profits policy holders in a way that discriminated against members with guaranteed annuity rates and
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See Stephens [2001] Table 2 for UK Building Societies. Swiss Re [1999, 11]. The apparent failure of regulation to control abuses in the US led to the Armstrong Commission in 1905 and a move towards mutual governance in the early twentieth century 15
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favoured members without such guarantees in their policies. The Society argued that it was a mutual organisation and that members of a mutual should not receive more than their appropriate share in the assets of the society. The method of distributing final bonuses reflected this desire to treat all members equally according to the ‘asset share’ criterion. The complainants, on the other hand, argued that the Society was abrogating clear contractual commitments. They were promised guaranteed annuity rates and were not warned that this might result in their receiving a lower final bonus.
From the point of view of this comment, the case is interesting because it reveals the law having to adjudicate between the claims of contract and the claims of ownership. At the first hearing the claims of ownership dominated. 16 All policyholders were members of the Society. No policyholder had been treated in an arbitrary or capricious manner and the directors had exercised their (very wide) discretion in a reasonable manner. At appeal, however, the judgement was reversed and a final appeal to the House of Lords upheld this reversal arguing that ‘it was a breach of contract for the directors to exercise their discretion in such a way as to subvert the terms of the policy documents’. 17 As finally determined, therefore, the policyholders of a mutual society were treated in a manner indistinguishable from ‘customers’ of an investor owned insurance company. Savers are thus likely to view ‘ownership structure’ as of little relevance in determining where to place their funds. Financial services providers, whatever their formal legal structure, are competing to sell ‘products’ to ‘consumers’ and are regulated by government agencies. This will tend to favour investor owned companies.
although, as Hansmann [1996, 274] comments, ‘it was not entirely clear that abuses were much more prevalent among stock than among mutual companies.’ 16 Equitable Life Assurance Society v Hyman, Chancery Division, 9th September 1999. 17 Equitable Life Assurance Society v Hyman, House of Lords, 20 th July 2000.
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References
Berle, A. A., and G. C. Means [1932], The Modern Corporation and Private Property, revised ed. [1967], Harcourt, Brace and World, Inc: New York Coase, R. H. [1937], “The Nature of the Firm,” Economica, 4, 386-405. Grossman, S. J. and O. D. Hart [1986], “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration,” Journal of Political Economy, 94, 691-719. Guijarro, P. and D. J. P. Hare [2002], Corporate Diversity and the Provision of Financial services, Institute of Actuaries and Faculty of Actuaries, Edinburgh and Dublin Hansmann, H. [1996], The Ownership of Enterprise, Harvard University Press: Cambridge, MA Hart, O. D. and J. Moore [1990], “Property Rights and the Nature of the Firm,” Journal of Political Economy, 98, 1119-1158. Jensen, M. C. [1988], “Takeovers: Their Causes and Consequences,” Journal of Economic Perspectives, 2, 21-48. Klein, B., R. G. Crawford, and A. A. Alchian [1978], “ Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” Journal of Law and Economics, 21, 297-326. Pencavel, J. [2001], Worker Participation: Lessons from the Worker Co-ops of the Pacific Northwest, Russell Sage Foundation, New York. Ricketts, M. [1999], The Many Ways of Governance: Perspectives on the Control of the Firm, Research Report 31, Social Affairs Unit, London.
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Robertson, D. H. and S. R. Dennison [1960], The Control of Industry, Cambridge University Press, Cambridge. Stephens, M. [2001], “Building Society Demutualisation in the UK,” Housing Studies, 16, 335-352. Swiss Re [1999], “Are Mutual Insurers an Endangered Species?” Sigma, 4, 3-35. Williamson, O. E.
[1979], “Transaction-Cost Economics: The Governance of
Contractual Relations,” Journal of Law and Economics, 22, 233-261.
Martin Ricketts Department of Economics and International Studies University of Buckingham Hunter Street Buckingham MK18 1EG UK E-mail:
[email protected]
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