OWNERSHIP AND TRUST

http://www.london.edu/newsandevents/news/2009/05/Ownership_and_trust_986.htmlOwnership and
trust

In unique research, Julian Franks, Professor of Finance at London Business School, has looked
back at over 100 years of data on corporate ownership. The research (carried out with Colin
Mayer and Stefano Rossi) found that relationships of trust were a crucial historical ingredient
in the ownership of firms

Owners often knew each other and lived relatively locally. But does this have any relevance in the
era of international corporations with hugely dispersed shareholders? Professor Franks argues
that trust is not an historical concept. Indeed, organisations such as eBay are built very openly on
notions of trust - as, too, is the London Stock Exchange whose motto is "my word is my bond".
Relationships of trust are as important as ever.

One of the best known facts about corporate ownership is that ownership of large listed companies
is dispersed in the U.K. and U.S. and concentrated in most other countries. In more than 50 per
cent of European companies there is a single voting block of shareholders that commands a
majority of shares. In contrast, in the U.K. and U.S. it is less than 3 per cent.

Two theories have been proposed to explain these differences. The first is that U.S. legislators
responded to a populist agenda in the 1930s by limiting the power of large financial conglomerates.
The second argues that concentrated ownership is a response to inadequate investor protection. In
the absence of protection, investors seek to protect their investments through large share blocks.

In both these theories dispersed ownership is associated with strong investor protection. The
difference in ownership concentrations can be attributed to weak investor protection in Continental
Europe and strong investor protection in the U.K. and U.S.

Differences in legal structures are deep rooted with a long history. One would expect differences in
investor protection also to have a long history, particularly in the U.K. where common law
originated. But this is not the case. At the beginning of the twentieth century, the U.K. was actually
devoid of anti-director rights provisions and protection of small investors.

Our research examined how the ownership of a panel of firms evolved over a hundred years and
the extent to which law contributed to that evolution. The research was made possible by the
existence of an unusually rich source of data in the U.K. For more than a century, Parliament has
required companies to deposit information, including accounts and a register of shareholders, at a
central depository open to the public.

From this, we selected three samples - one from companies incorporated around 1900 that have
been in existence since then, a second from firms incorporated at the same time but which are no
longer in existence and a third from companies incorporated around 1960 and still in existence.

We found that ownership of the sample of firms incorporated around 1900 was rapidly dispersed
with the shareholdings of inside directors more than halving over the 40 years to 1940. Interestingly,
when investor protection was finally strengthened in the second half of the century, it had little effect
on either levels or rates of ownership dispersion. Ownership of well-established companies was
already dispersed and rates of dispersion of newly incorporated firms, for example of the sample of
firms incorporated around 1960, were similar to those of firms incorporated at the start of the
century.

An obvious question this raises is how ownership dispersion could have occurred in the absence of
investor protection? Our conclusion is that informal relations of trust, rather than formal systems of
regulation, promoted the development of capital markets and dispersion of ownership.

In trust we trust
In economics, trust is associated with reputation and commitment between players engaged in
repeated games with each other and with the emergence of particular institutional arrangements. In
law, a distinction is drawn between contracts where there are reciprocal arrangements between
parties and trust law where there are unidirectional agreements between beneficiaries and trustees.
Where there is no reciprocity in trusts on the part of the beneficiary there is a greater fiduciary
responsibility on the other party, namely the trustee. Trust arrangements carried over to company
law because of the analogous relationship between directors and their dispersed shareholders with
that of trustees and their beneficiaries.

Our concept of trust in a corporation draws on both economics and law and refers to actions by the
director of a firm that are dictated neither by contract nor by regulation. By trust we mean conformity
with accepted norms of behaviour in the absence of explicit incentives or penalties to do so. Trust
can derive from repeated interactions, from moral and ethical codes, or from social conventions and
networks.

Our research found informal relationships of trust existed in a number of ways. For example, we
found that the local nature of stock exchanges played an important role in the development of trust
between directors and investors. Ordinary shareholders lived close to the company's city of
incorporation and its board of directors and relations of trust flourished as a result.

In addition, relations of trust created the conditions in which interactions between firms and
investors were repeated and where directors had incentives to sustain their reputations among local
communities. For example, looking at the way in which firms made offers to shareholders in
takeovers and mergers, we found the same price was offered to all shareholders even in the
absence of specific regulatory or contractual requirements.

Among the most interesting aspects of the research was the comprehensive data gathered on the
shareholder records of twenty-six companies in 1910. We recorded the names and addresses of
shareholders, and calculated the distance between the shareholder's address and the city of
incorporation. In the 1910 sample, the average number of shareholders was 320; the mean
distance between ordinary shareholders' addresses and firms' cities of incorporation was 52.2 miles
and the median 15.4 miles. The proportion living within six miles of the city of incorporation was 56
per cent.
Geographical concentration was remarkably high even where ownership was dispersed. For one
company, GKN, we found that geographic dispersion sharply increased over the period 1910 to
1950. The average distance of the shareholders to the head office in Birmingham rose from 69.5 to
more than 150 miles.

Looking back, it was clear that shareholders had little recourse in courts but much influence in the
communities and local markets of which they and their firms were a part. Even as it became
dispersed, ownership remained geographically concentrated and directors were concerned to
maintain their reputations among local investors. All shareholders, including insiders, sold their
shares to acquiring firms at the same price and directors of target firms were frequently promoted to
the boards of merged firms. Eventually, as local relations of trust became harder to sustain then
formal investor protection emerged to substitute for them.

Was the U.K. an isolated case? Our previous research found a surprisingly high level of ownership
dispersion in Japan at the start of the twentieth century, with a large number of listed companies
and a very large number of shareholders. Again ownership dispersion cannot be attributed to
investor protection. It was almost as weak in Japan as it was in the U.K. But there were
differences. Takeover waves were less in evidence in Japan and the purpose to which new equity
was put was primarily to finance internal rather than external expansion.

Again ownership dispersion appeared to have more to do with informal relations of trust than
investor protection. However, the institutional arrangements that fostered trust were not the same.
Local stock markets were not prevalent in Japan. Individual promoters of shares took on a more
active role in the oversight and management of firms in Japan than in the U.K. As a result, different
mechanisms evolved to establish the basis of trust on which ownership could become dispersed.

Trust now
How is all of this relevant to today's turbulent and truly global trading environment? Well, the motto
of the London Stock exchange remains "My word is my bond", as it has been for centuries since
brokers traded with each other literally across the floor of the exchange. The globalization of the
capital markets has changed all that. Trust is usually no longer so intimate an experience. But, we
still need to create or generate new mechanisms of trust.

One trust generating mechanism using modern technology is eBay. Here anonymous buyers and
sellers are able to access the views of past purchasers and sellers, when selling or buying an item
on the site. If a purchaser has previously sold ten items, the levels of satisfaction of past purchasers
are stored and made available to the next buyer. Trust rules.

The relationships of trust discovered by our research are timeless. This means there is still a home
bias for investors, a preference for buying investments in one's own country and even in one's own
state or region. This home bias reflects a view that common cultures, common laws, and
geographic proximity are more likely to produce honest and fair outcomes between investors.