The Scrutiny Model of Shareholder Supremacy

The orgy of speculation of the South Sea Bubble led to the introduction of the Bubble Act in 1720, which banned the formation of joint-stock companies by private individuals (Harris, 1994). Naïve shareholders had suffered at the hands of company promoters, who had promised spectacular returns from investments in unlikely projects: wheels of perpetual motion, machine guns, and the untapped resources of distant lands (Anon, 1825). Regulation created impediments to incorporation, which was now achieved through parliamentary authorization, or increasingly, by establishing a deed of settlement, in which a trust held the firm’s assets on behalf of investors. Both routes were risky and involved significant transaction costs and legal uncertainties (Cheffins, 2008, pp. 148–149).

However, once registered, the typical company had appealing governance features based on effective shareholder scrutiny. Projects such as dock and canal infrastructure were attractive to locally-based investors, who purchased significant blocks of shares, generally without further diversification. Most importantly, shareholders enjoyed open access to accounting records. Using a large sample of constitutions and bylaws of companies incorporated between the Bubble Act of 1720 and the Companies Act of 1844, Freeman et al. show that over two-thirds (68.0%) “explicitly permitted shareholders to inspect the account books at all times” (Freeman et al., 2012, pp. 14, 215). A shareholder could simply turn up at the company’s office and ask to inspect ledgers and books of account. Audits were instigated and carried out by shareholders’ nominees, often shareholders themselves (Taylor, 2018). Where there was suspicion of managerial malpractice, such as embezzlement of funds, the shareholders would form an investigation committee. Where guilty of malpractice, directors faced criminal penalties (Freeman et al., 2012).

In many respects, the system fulfilled the objectives of modern corporate governance. Shareholders utilized their rights to access the accounts, while directors abandoned self-interest in the face of continual scrutiny and the threat of the criminal law. All led to the withering of moral hazard.

Yet, there was a contradiction that meant this early phase of shareholder supremacy was a temporary phenomenon. Direct shareholder scrutiny was effective in some cases, but there was also apathy, and an increasing tendency to rely on summary accounts and professional auditors. Moreover, a competitor could access accounts and other operating details through the simple act of becoming a shareholder. For this reason, firms in competitive markets, such as financial services and insurance, opted for private partnerships. (Cheffins, 2008, p. 2; Freeman et al., 2012).

In competitive markets, then, there can be too much information and too much accountability. Industrialization and the emergence of new sectors brought increased competition and ironically reduced accountability and dissipated shareholder power. The financial crisis of 1825 illustrated some limitations of a relatively narrow investment base and unlimited liability in the British country banking system, which worsened the liquidity crisis (Turner, 2014). The problem led to the reintroduction of limited liability joint-stock companies, first in banking and subsequently in all sectors in the 1850s. Preexisting charter and statute companies retained many of the governence features of the shareholder scrutiny model under the provisions of the Companies Clauses Consolidation Act (CCCA), 1845 (Foreman-Peck & Hannah, 2016; Freeman et al., 2012). The active shareholder model gradually broke down with significant financial development. More expansive pools of retail investors were drawn first into specific industries, most notably banks and railways and then the broader economy. At the same time, government budget surpluses around the middle of the nineteenth century created a surge in demand for private sector savings, assuaged in part by the establishment of regional stock exchanges.

As the shareholder scrutiny model broke down, the involvement of passive and sometimes naïve investors empowered directors, while the legal framework offered shareholders minimal protection, in newly formed businesses incorporated under the Companies Acts. Moreover, industrial expansion accentuated information asymmetry, mainly in industries at the early stages of their product life cycle and experiencing rapid technological innovation. Unscrupulous promoters, like the “railway king” George Hudson, took full advantage. Significant banking failures in the 1850s and 1860s resulted in substantial losses for shareholders. William Gladstone, then Chancellor of the Exchequer, refused to assist shareholders in the Overend Gurney banking collapse of 1866, arguing that they invested at their own risk (Toms, 2017). It was the height of laissez-faire economics, yet shareholders lacked reliable information to base investment decisions.

The Companies Act 1862, which consolidated the series of Acts enshrining limited liability following the repeal of the Bubble Act in 1825, offered little in terms of shareholder protection. There were no compulsory accounting disclosures, audit requirements, limitations on insider trading or specific rights for minority shareholders, restrictions on differential voting rights and no preemption rights for existing shareholders. Table A of the Companies Act 1862 retained substantial anti-director provisions from the CCCA, but these were nonmandatory (Foreman-Peck & Hannah, 2016). The collapse of the City of Glasgow Bank in 1878 once again revealed the exposure of unprotected shareholders and led to balance sheet publication and audit requirements for banks at least. These requirements aside, with so few anti-director provisions in place, boards could also promote passivity in Victorian shareholders by paying high and reliable dividends (Campbell & Turner, 2011; Cheffins, 2008, pp. 77–80, 108–115). In the space of 50 years, the rise of middle-class portfolio investment transformed the scrutiny-based model of shareholder activism into the passive receipt of dividends.

Yet in one industry, there was a significant renaissance of shareholder activism. A substantial section of the cotton industry took advantage of the permissive voting rules of the Companies Act 1862, which carried forward anti-director provisions of the CCCA on a voluntary basis, including the democratic system of one shareholder one vote. Firms in the cotton spinning districts of south-east Lancashire took advantage of these provisions to raise significant amounts of capital from millworkers and the local middle classes. The shareholder audit mechanism remained important, not least because operatives who were shareholders had the business-specific expertise to conduct them. Shareholders kept directors’ salaries to minimal levels and frequently removed them at quarterly meetings when unimpressed with the balance sheet. In general, such scrutiny achieved significant economic benefits if the financial performance of democratically controlled mills is compared with their conventional counterparts (Toms, 2012).

Notwithstanding the success of democratic governance mechanisms, shareholders nonetheless demanded high dividends. Unlike companies elsewhere with portfolio investors, dividends were not paid to reduce agency costs, already minimized through governance accountability structures, but instead reflected the demand for cash payouts from relatively poor and undiversified operative shareholders. Despite the appeal and success of this model, it was in decline by the end of the nineteenth century. A trade slump meant that shares could be purchased cheaply, such that groups of directors and financiers took control of the mills and quickly altered the governance rules. Financial secrecy now replaced financial transparency and scrutiny of balance sheets (Toms, 2001, 2005).

Lancashire is interesting for historical reasons as an experiment in industrial and shareholder democracy, but also worth noting for more generic reasons. In the rest of the economy, the introduction of limited liability did not diminish shareholder protection in and of itself. However, the financial development and broader share ownership that it facilitated came without associated minority protection. In the Oldham system, this was not a severe problem. Here, the scrutiny model was complemented by wider share ownership because it was not portfolio-based but instead focused on the specific cotton sector. It resembled the generic pre-1850 scrutiny model in this respect. Although not a local monopoly, the industry was nonetheless a form of monopolistic competition. Firms produced differentiated albeit closely related outputs, with common well understood and easily scrutinized production processes. In short, the scrutiny model could work and survive monopoly or undiversified businesses.

The Collaboration Model of Shareholder Supremacy

From 1900, cotton mills, along with the rest of British industry, were now subject to the rules of a new Companies Act, which made published audited balance sheets compulsory. Portfolio investors lacked the expertise for direct governance and relied on professional audits. A laissez-faire attitude prevailed and anti-director provisions, measured according to a scale developed by la Porta et al., remained minimal (Cheffins, 2001; Franks et al., 2008; la Porta et al., 1997). Shareholder protection was at the same time more problematic as companies became more complex in terms of scope, product, and process, and influential directors used their connections to create multiunit business empires. Manipulation of accounts at the expense of shareholders was facilitated, for example, by Gerard Lee Bevan in the City Equitable case of 1925 and Lord Kylsant in the Royal Mail scandal of 1931.² Financial intermediaries, notably merchant banks, offered some shareholder protection but only for IPOs before 1945 (Cheffins, 2001).

In the three decades after the Second World War, these same intermediaries were crucial players in the collaboration model. The manufacturing industry became highly concentrated, and the financial sector even more so. On top of this, acquisitions created holding company structures with multiple subsidiaries corporations. Networks of interlocked directors thus consolidated their power through amalgamation, where interlocks frequently spanned manufacturing and finance (Useem, 1986, p. 35).³

The post-1945 period is commonly viewed as the age of managerial capitalism (Dore et al., 1999). During this time, governments restricted credit, international trade, and the banking sector, while relatively high inflation reduced the value and importance of debt and made equities attractive. These changes help explain why the United Kingdom overtook French civil law countries when it came to financial market development in the 1950s (Rajan & Zingales, 2003). However, it was not legal protection but trust and intermediation by financial institutions that accounted for Britain’s financial development (Cheffins, 2001; Franks et al., 2008). Moreover, restrictions on dividends led to surplus assets and relative undervaluation, particularly for firms with property assets. Finally, in the 1960s, in particular, governments encouraged mergers to promote concentration and economies of scale, while controlling blocks of shareholders became less prominent (Cheffins, 2008, p. 363; Stamp & Marley, 1970). Improved disclosure requirements in the Companies Act 1948 facilitated screening of potential targets, and a provision to allow shareholders to dismiss directors with a simple majority vote, created the opportunity for hostile takeovers (Cheffins, 2001). The takeover boom of the later 1960s was triggered by concerns over currency devaluation and a flight into equity. Such exogenous changes led to takeover pressures on all managers, whether inefficient or not. Managers in companies with property assets were particularly vulnerable, regardless of their efficiency or competence otherwise (Stamp & Marley, 1970).

Following the Companies Act 1948, there were only modest improvements to shareholder protection; before 1980 (Cheffins, 2008, pp. 328–329),⁴ repression of the international financial sector highlighted the opportunities of domestic corporate restructuring available to British merchant banks. Conglomerate diversification, meanwhile, was seen as efficient in terms of managing risk and allocation through internal capital markets (Roe, 1996). Coalitions of insiders, either directors or blockholders, and institutional investors, typically merchant banks, were frequently at the center of deals that threatened the interests of minority or individual investors. The problem was not so much shareholder empowerment or disempowerment but rather the asymmetric power distribution between well-connected insiders and unsuspecting private investors.

Merchant banks were a crucial element of the collaboration model that emerged in the takeover battles of the 1960s. As noted earlier, interlocked directors enlisted merchant banks to access and mobilize shareholder votes in takeover battles. The contest for British Aluminium (B.A.) in 1958 shattered the illusion of gentlemanly capitalism and the informal codes of honor that traditionally characterized the City of London. When B.A. was targeted by a hostile bid from Tube Investments (T.I.) and Reynolds, backed by merchant bankers S.G. Warburg, Schroders and Helbert Wagg, its board invited a counter bid from Alcoa, proposing a perfectly legal variation in shareholders rights in the process. B.A. lined up a consortium of merchant banks, led by Lazards and Hambros, to support the rival offer. However, other institutional investors, the trusts and insurance companies, unloaded their shares in the open market, leaving the way clear for the Reynolds/T.I./Warburg bid (Stamp & Marley, 1970, pp. 4–6). The B.A. example shows how institutional investors were crucial as instigators and in determining the outcome of takeover bids, and the power of shareholders to act against incumbent directors using this mechanism (Littlewood, 1998).

Mergers and acquisitions provided the primary vehicle for entrepreneurship from the boom of the 1960s onward. Chief executive officers and senior directors, through connections with merchant banks, provoked a series of takeover battles reminiscent of B.A. Some, most notably Jim Slater of Slater Walker, arbitraged the gap between firms’ productive assets and property values. Others, like Frank Kearton of Courtaulds, the textile manufacturer, aimed to exploit economies of scale and scope through integration and vertical control (Toms, 2020; Toms et al., 2015). While these dealings were underpinned in some cases by market logic and may have disciplined some potential target company managers who were inefficient, the outcome of bids was often predicated on other factors. Whether B.A. would be more efficient if managed by Reynolds or Alcoa was subsumed by nationalist arguments about the foreignness of the predators. In many cases, there was nothing to say that predator firm managers would be any more efficient than target firm managers. When Charles Clore attempted to diversify into brewing by acquiring Watney’s, his experience as a shoe magnate was not an obvious substitute for the experience of the incumbent board of directors, and he, in any case, based his bid on a significant misalignment of property values (Sharpe, 2016).

A further determinant of the success or failure of a takeover bid was collaborating entrepreneurs and investment groups’ exploitation of the lack of regulation. Defenses were facilitated by differential classes of shares, the possibility of issuing new shares during bids to be given to a friendly block, like Alcoa in the B.A. battle (Cheffins, 2008, p. 368),⁵ and the rights of minorities to hold out against otherwise well-supported bids. Predatory raids, in most cases aimed for full control, facilitated by the 1929 provision to buy out minorities and encouraged by City codes of conduct (Cheffins, 2008, p. 43). In a minority of high-profile cases, raids were enabled by the possibility of acquiring control through partial offers, including offers limited to only specific buyers or differential offers to different shareholder groups. Shareholders were treated differentially in the Richard Thomas and Baldwins bid for Whitehead, losing out to institutional investors and resulting in a minor scandal (Stamp & Marley, 1970). This and similar cases challenged the City regulators to clarify the rules.

The case was critical because it created the principle, violated in B.A., that all shareholders should receive the same offer. The City of London, which had been ahead of company legislation mandating disclosure and transparency likely to benefit retail and minority investors, developed a self-regulatory code of practice. The City Code on takeovers and mergers offered significant minority protection, such that all shareholders were treated equally in bids. Protection was underpinned further by the provisions of the Companies Act 1980 (Cheffins, 2008, pp. 329–330). By forcing directors to adopt a neutral position once a takeover bid was tabled, the Code enhanced the power of shareholders (Deakin, 2005).

However, the regulatory structure took time to evolve. In early test cases, the newly formed Panel applied the Code leniently to merchant banks, and they escaped significant sanction, notwithstanding clear violations (Stamp & Marley, 1970, pp. 25–34). Fortunately for the City, which wanted to avoid formal regulation without impeding the activities of its constituents, the merger wave dried up in 1972, following a series of exogenous shocks: the spike in oil prices in 1973 and the sharp recession that followed, the end of the Bretton Woods system and a secondary banking crisis. Company profits, already in decline, were squeezed further (Useem, 1986), and an inflationary spiral created additional pressures. Overdiversification led to poor investment decisions, and the end of managed trade under the Bretton Woods system led to growth in international competition. The takeover boom was over by 1972, and firms were increasingly considered to be overdiversified and experiencing diseconomies of scale and scope (Lazonick & O’Sullivan, 2000).

Even so, the collaboration model persisted for another decade or more. Block shareholdings, including family groups, were in decline but remained significant until well into the 1980s. Self-regulation by the London Stock Exchange also persisted (Cheffins, 2001). These factors explain the relatively slow diffusion of the shareholder value model in the United Kingdom compared to the United States.

The Valuation Model of Shareholder Supremacy

In the United States, the retain and reinvest strategy of the 1950s and 1960s conglomerates was now replaced by a recognition that takeovers would reduce managerial access to free cash flow and return value to shareholders through increased dividends and share buybacks (Jensen, 1989; Lazonick & O’Sullivan, 2000). The dominance of conglomerates led to accusations of managers destroying shareholder value. Declining profit rates into the 1970s provided the impetus for reform in terms of checks on executive power and unlocking the conglomerate discount (Toms & Wright, 2002). Institutional portfolio investors were a crucial factor in the rise of the valuation model of shareholder supremacy. A valuation technique based on the capital asset pricing model and economic profit provided otherwise passive investors with a common decision-making rule (Aglietta, 2000). However, these changes were not sufficient as incentives for corporate managers to move shareholders up their list of priorities. The merger wave of the 1980s created a “fear quotient” for managers of undervalued companies. Institutional investors, where they did intervene in corporate affairs, pushed for executive pay to be linked to stock price performance (Cheffins, 2019, pp. 195, 245). These changes, rather than legal and regulatory developments, were therefore crucial in the development of the new valuation model of corporate governance in the Anglosphere.

However, there were essential differences between the United Kingdom and the United States. Lazonick and O’Sullivan argue that between 1980–2000, the ideology of shareholder value became “entrenched as a principle of corporate governance among companies based in the United States and Britain. However, there is scant evidence offered on Britain, only that the shift to shareholder value resulted from the Reagan and Thatcher revolutions” (Lazonick & O’Sullivan, 2000, pp. 13–14).

In reality, the United Kingdom lagged the United States significantly in adopting the valuation model of shareholder supremacy. What were the reasons for the lag? In the United Kingdom, institutional ownership had been rising, albeit slowly, as noted earlier, increasing significantly after 1980. The rate at which institutional investors voted rose to 50% in 1999 from 20% in 1990. The Big Bang reforms of 1986 had a significant impact, allowing the takeover of British stock market firms by U.S.-dominated integrated investment banks (Toms & Wright, 2005). As an intellectual and conceptual device that impacted practice, shareholder value was developed in the United States by an expanding management consultant sector. Using accounting numbers as inputs to mathematical models, it built upon the Boston Consulting Group and Profit Impact of Market Strategy approaches to managing multiunit businesses (Berry & Lorenz, 1983; Kullberg, 1983). Early adopters were U.S. oil companies like Gulf Oil and Phillips Petroleum, typically as rationales for takeover defenses or restructuring. As the principle of shareholder value creation gained ground in the mid-1980s, in the United States at least, the primary justification was corporate restructuring and divestment, for example, by Union Carbide, Westinghouse, and Borg-Warner (Financial Times, 1983, 1985a, 1985b; Hall, 1985; Oram, 1986). Corporate boards enlisted merchant banks and leveraged buyout funds to advise how to release shareholder value through restructuring.

For almost the whole of the 1980s, U.K. boards lacked any similar focus on shareholder value. Where used at all, the term reflected the transatlantic nature of the deals on offer. Reliance set up a U.K.-based Leveraged Buy Out fund in 1986 to release shareholder value. In another early U.K. example, Cadbury adopted a shareholder value mantra to convince investors of the advantages of a strategic alliance with Coca-Cola (Financial Times, 1988; Hall & Lascelles, 1986). Even so, writing in 1988, one financial commentator noted U.K. companies’ reluctance to gear up their balance sheets or buy back their shares. Their laxity was despite “promptings” from the Bank of England and showed that “maximizing shareholder value [was] not the top priority of most companies,” unlike in the United States (Lex, 1988). A year later, a financial columnist at The Times noted that the United Kingdom had to thank Sir James Goldsmith for finally waking up U.K. boards to shareholder value. By leading a record leveraged bid from U.S. firm Hoylake Investments, a Bermuda-based vehicle, for B.A.T., Goldsmith had prompted the B.A.T. board in their defense to adopt the slogan “building shareholder value” (The Times, 1988a, 1988b).

The adoption of the shareholder model gathered pace and reached its peak with the bull market of the 1990s. With rising share prices and remuneration linked to stock options, adopting the model was an easy win for senior managers (Aglietta, 2000). Implementing the U.S. model of shareholder-based governance offered a new route to shareholder supremacy in the United Kingdom, at least, if not in the rest of Europe and Japan.

The valuation model of shareholder supremacy has been successful, if only according to its own standards. There is substantial quantitative evidence that resulting developments in corporate governance have increased firm value relative to underlying assets and mergers and acquisitions (Cremers & Nair, 2005; Daines, 2001). Such benefits arise from monitoring by the board of directors, institutional investors, and the market for corporate control (Huson et al., 2001; Li et al., 2006; Masulis et al., 2012). Nonetheless, the evidence is ambivalent, and the model has faced increasing criticism. For example, it has been accused, among other things, of promoting earnings manipulation, lack of engagement and monitoring by passive institutional investors, short-termism, and fraud (Charreaux & Desbrières, 2001; Deakin, 2003; Kury, 2007).

These limitations, in the wake of the financial crisis led to efforts to refine the stewardship approach to shareholder engagement. In practice, this meant neutralizing investors’ focus on share price as a substitute for more meaningful longer-term engagement (Chiu, 2021). More recently exogenous developments associated with climate change and social pressures have promoted the stakeholder model as an alternative. The U.K. Stewardship Code 2020 sets high stewardship standards for those investing money on behalf of U.K. savers and pensioners and those that support them. Stewardship is the responsible allocation, management, and oversight of capital to create long-term value for clients and beneficiaries, leading to sustainable benefits for the economy, the environment, and society (Financial Reporting Council, 2020).

Whether the stewardship model replaces the shareholder model fully or partially depends on the extent to which valuation models can incorporate externalities associated with environmental degradation in the face of the climate change threat.