Hail Britannia?: Institutional investor behavior under limited regulation.

• Author: Black, Bernard S.
• Position: United Kingdom

TABLE OF CONTENTS

1. INTRODUCTION: THE RELEVANCE OF BRITAIN 1999 II. A PROFILE OF THE BRITISH INSTITUTIONAL MARKETPLACE 2007 A. The Institutions 2007 1. Insurance Companies 2009 2. Pension Funds 2012 3. Mutual Funds 2015 4. Commercial Banks 2016 5. Investment Banks 2017 B. Self-Regulatory Organizations 2017 1. Industry Trade Organizations 2018 2. The Institutional Shareholders' Committee 2019 3. Corporate Governance Reform and Boards of Directors 2021 4. PRO NED 2023 III. FORMAL AND INFORMAL REGULATION OF INSTITUTIONAL BEHAVIOR 2024 A. British Company Law 2024 B. Securities Industry Regulation 2025 C. Takeover Panel Rules 2026 D. Stock Exchange Rules and Preemption Guidelines 2028 IV. INSTITUTIONAL MONITORING IN THE UNITED KINGDOM: WHAT DOES AND DOES NOT HAPPEN 2028 A. Prior Research 2029 B. Money Manager Statements 2033 C. The Extent of Informal Shareholder Action 2034 1. Protecting Shareholder Rights 2034 2. Protecting the Preemptive Rights Weapon 2036 3. CEO Replacement 2037 4. Board Structure and Membership 2037 5. Voting Behavior 2038 6. Management and Director Compensation 2040 7. Diversification: The Objections Not Made 2041 D. Proxy Fights: The Exceptional Case 2041 E. The Process of Coalition Formation 2046 F. Summary 2053 V. THE LIMITS ON INSTITUTIONAL ACTIVISM 2055 A. Direct and Indirect Costs of Coordination 2055 B. Conflicts of Interest 2059 C. The "Race to the Exit" Scenario 2061 D. "Underweighting" as a Cause of Passivity 2063 E. Coalitions Among Rivals 2064 F. Legal Barriers 2064 G. The Role of Political History 2066 H. Organizational Capability 2068 I. Are Banks Unique? 2073 1. Why Do Banks Invest in Monitoring? 2073 2. Why Don't British Banks Hold More Equities? 2074 VI. IMPLICATIONS: WHAT THE BRITISH EXPERIENCE MEANS FOR THE UNITED STATES 2077 A. How Will Institutional Cooperation Evolve in the United States? 2078 B. Can Regulation Explain Bank and Insurer Behavior? 2079 C. Path Dependence 2082 D. International Convergence 2084 E. Is British-Style Intervention Dsirable? 2085 VII. CONCLUSION: THE HALF-FULL GLASS 2086 I. INTRODUCTION: THE RELEVANCE OF BRITAIN

   A central puzzle in understanding the governance of large American public firms is why most institutional shareholders are passive. Why would they rather sell than fight? Until recently, the Berle-Means paradigm -- the belief that separation of ownership and control naturally characterizes the modern corporation -- reigned suppereme.(1) Shareholder passivity was seen as an inevitable result of the scale of modern industrial enterprise and of the collective action problems that face shareholders, each of whom owns only a small fraction of a large firm's shares.

   A paradigm shift may be in the making, however. Rival hypotheses have recently been offered to explain shareholder passivity. According to a new "political" theory of corporate governance, financial institutions in the United States are not naturally apathetic but rather have been regulated into submission by legal rules that -- sometimes intentionally, sometimes inadvertently -- hobble American institutions and raise the costs of participation in corporate governance.(2)

   The principal policy implication of this new political theory of the American corporation is obvious: deregulate in order to lower the costs of coordination among shareholders. Relaxing various legal restrictions and barriers -- including the Glass-Steagall Act's prohibition against combining commercial and investment banking and federal securities rules that chill group formation by institutional investors -- would significantly enhance the ability and incentives of institutional investors to monitor corporate managers. This is an important claim, but also one not easily tested.

   The new political theory of the corporation has not, however, won universal acceptance. Although agreeing that American institutional investors are in some respects overregulated and thereby chilled from fuller participation in corporate governance, other scholars have doubted that legal restraints can serve as the central pillar of a revised theory of shareholder passivity.(3) In contrast to the political theorists, who focus on regulatory barriers that raise the costs of participation in corporate governance, these critics respond that existing incentives -- particularly those of fund managers -- are too weak to motivate active institutional monitoring, even if regulatory barriers were reduced.(4) The attractions (real or imagined) of the exit option of selling into a liquid securities market further reduce the likelihood that even large shareholders will organize to resist management.

   The two authors of this article have been on opposite sides of this debate, but both recognize that no single explanation is complete and that other factors, such as the self-interest of fund managers, the conflicts of interest faced by institutions who want to retain corporate business, cultural forces, collective action problems, and what we can call path dependence -- the difficulty of changing the structure and behavior of highly evolved and specialized institutions -- have causal roles in explaining shareholder passivity.(5) The central question in research on American corporate governance is how these forces interact to produce the characteristic passivity of most American institutions.

   The debate between the proponents and critics of a political theory of American corporate governance is in some respects untestable. We cannot run the legal experiment of changing our laws to facilitate institutional oversight of corporate managers and observe how the institutions act. Still less can we go back sixty years or more, change our laws then, and see how the institutions would act if they had grown up in a different legal and political environment. In similar settings, however, social scientists have long used "natural experiments" to gain insight into how a particular legal rule affects behavior across otherwise similar societies.(6) Comparative study of corporate governance in other industrialized countries offers insight into how American corporate governance might have developed under a different legal regime and how governance practices might change if legal rules were changed today.

   To explore whether the paradigm American corporation, with its strong managers and widely dispersed shareholders, could be a product of American politics and the path-dependent evolution of American financial institutions, scholars have recently examined corporate governance in Japan and Germany, where commercial banks and, to a lesser extent, insurance companies control large equity stakes and sometimes closely monitor managements.(7) The merits of these bank-centered systems, compared to more market=centered systems (such as those in the United States and the United Kingdom), and the transportability of bank-centered monitoring to other cultures and economic environments, have fueled a stimulating debate that will occupy corporate law scholars for some tim to come.

   At this point, our interst in the United Kingdom begins to come into focus. The role of financial institutions in corporate governance in the United Kingdom has attracted much less attention than the role of German and Japanese banks.(8) Yet the United Kingdom has unique advantages for the effort to put American corporate governance in comparative perspective and to understand how it might be improved and what role legal rules and other factors play in shaping our system of corporate governance. The legal culture of Britain is as similar to our own as we are likely to find; in Britain, like the United States and unlike most of the rest of the world, most large corporations are public and not family-controlled; the United Kingdom has long had a liquid securities market; the British "City" has the same array of financial institutions that we do (commercial banks, insurers, mutual funds, investment banks, private and public pension funds); stock ownership in both Britain and the United States has come in the last few decades to be dominated by institutions; and, most centrally, financial institutions in the United Kingdom are significantly less regulated than their American counterparts -- though less regulated does not mean unregulated. In particular, Britain has no counterpart to the Glass-Steagall Act or to U.S. restrictions on interstate banking, which limit the size and power of American banks. Nor does it have our history of limiting stock ownership by insurance companies or regulating collective shareholder action.

   Not only is the United Kingdom context similar to that of the United States, but British patterns of corporate governance may foreshadow future developments in the United States. The U.K. equities market is considerably more institutionally dominated than the U.S. stock market. U.K. institutions hold about two-thirds of all publicly traded British stocks, while U.S. institutions only hold around half of U.S. publicly traded stock.(9) Shareholder concentration is also higher. The twenty-five largest institutional shareholders hold an absolute majority of the stock of many U.K. companies.(10) For smaller U.K. firms, the five largest institutional holders control 30% or more of the shares. Prudential Corporation PLC, the largest British institutional investor, alone holds about 3.5% of the entire British equity market.(11) Several other institutions are almost as large. Equally important, the world of British institutional investors is close-knit. Communication among them is easy and unregulated. This reduces the coordination costs and free rider problems that plague collective action in the United States. In short, Britain presents a model of what U.S. securities markets might look like if U.S. institutional holdings continue to grow -- and with many fewer legal barriers to institutional investor participation in corporate governance.

   To understand the behavior of British...