Contractual Freedom and the Evolution of Corporate Control in Britain, 1862 to 1929

Ron Harris is Professor of Legal History and Dean at Tel Aviv University Law School. This post is based on a paper authored by Professor Harris; Timothy W. Guinnane, Philip Golden Bartlett Professor of Economic History at the Department of Economics Yale University; and Naomi R. Lamoreaux, Stanley B. Resor Professor of Economics & History, Chair of the History Department at Yale University, and Research Associate at NBER.

British general incorporation law granted companies an extraordinary degree of contractual freedom to craft their own governance rules. It provided companies with a default set of articles of association, but incorporators were free to reject any part or the entire model and write their own rules instead. We study the uses to which incorporators put this flexibility by examining the articles of association filed by random samples of companies from the late nineteenth and early twentieth centuries, as well as by a sample of companies whose securities traded publicly. One might expect that companies that aimed to raise capital from external investors would adopt shareholder-friendly corporate governance rules. We find, however, that regardless of size or whether their securities traded on the market, most companies wrote articles that shifted power from shareholders to directors. We also find that there was little pressure—from the government, the financial press, shareholders, or the market—to adopt governance structures that afforded minority investors greater protection. Although there were certainly abuses, it seems that incorporators made an implicit bargain with investors that offered them the chance to earn high returns in exchange for their passivity.

Most scholars of corporate governance agree on the normative principle that corporations should be managed in the long-run interests of their shareholders. They also generally agree that Anglo-American legal rules do a better job of promoting shareholders’ welfare than those in effect in most other countries. These two claims come together in the so-called “law and finance” literature. Growing out of the work of Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny (hereafter LLSV), this literature claims that external investors in corporations are better protected in countries with legal systems derived from British common-law than from European civil-law, in large measure because of the common law’s superior flexibility. Whereas the commercial codes put in place in France and elsewhere on the European continent in the nineteenth century locked businesses into a particular set of legal rules, the common law was able to evolve in accordance with the changing needs of business and the economy. For example, shareholder friendly corporate-governance rules emerged because managers had to be able credibly to commit not to exploit potential investors. Because of the common-law’s superior adaptability, countries that inherited this type of legal regime or adopted it at some point in the past were able to achieve significantly higher levels of financial development by the late twentieth century than those with civil-law systems.

This paper uses data on corporate governance practices in Britain during the late nineteenth and early twentieth centuries to challenge the connection between the greater flexibility of the Anglo-American legal regime and shareholder-friendly corporate governance. The general incorporation laws that Parliament enacted beginning in 1856 conferred a remarkable degree of contractual freedom on British companies. The statutes themselves included few provisions regulating corporate governance. Instead, Parliament provided companies with a model set of articles of association that applied only to firms that did not write their own articles. Although the model covered most aspects of corporate governance, its provisions were default rules. Companies could reject any or all parts of the model articles and write alternative clauses of their own choosing. They could even write substitute clauses that explicitly negated provisions in the model table. So long as the provisions were not illegal, whatever articles companies chose to adopt were enforceable as contracts in the courts.

To explore the governance choices that incorporators made when they organized their businesses, we collected the articles of three random samples of companies formed in the late nineteenth and early twentieth centuries. We also collected the articles of a sample of companies whose securities traded on the London Stock Exchange (LSE) and other major British exchanges. Contrary to the literature, we find that incorporators revised the model articles in ways that were anything but shareholder friendly. Whether companies were small or large or private or public, they tended to adopt governance structures that shifted power from shareholders to directors to such an extent that shareholders were for all practical purposes disenfranchised. These patterns, moreover, seem to have become if anything more pronounced over time.

These findings have implications for the literature on corporate control, for the “law-and-finance” argument that corporate governance in common-law countries was more shareholder friendly than in civil-law countries, and for the debate about entrepreneurial failure in Britain during the late nineteenth and early twentieth centuries. Our findings contradict those of recent scholars who have argued for the shareholder-friendly character of British corporate governance in the late nineteenth and early twentieth centuries. As we will show, an important reason we obtain different results is that we look at how the governance rules written into firms’ articles of association worked in combination, whereas other studies either examine a narrower set of practices or do not pay adequate attention to the ways in which the various elements of a company’s governance framework interacted with each other. In offering this corrective, however, we are not siding with scholars who have emphasized the more nefarious aspects of British corporate governance during this period. Of course there were plenty of examples of bad or even fraudulent management, but the practices that contemporaries complained about are not generally the ones we have uncovered. To the contrary, there seems to have been a general understanding at the time that corporations were entrepreneurial vehicles that offered external investors the potential to earn high rates of return in exchange for giving entrepreneurs a free hand in running their enterprises. Shareholders had voice, but they did not have much power within the enterprise, and there is little evidence that they pushed for more.

The full paper is available for download here.

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