Trusts versus corporations: an empirical analysis of competing organizational forms.

• Author: Warburton, A. Joseph
• Position: United Kingdom

1. Introduction II. The British Mutual Fund Industry III. RELATED LITERATURE IV. DATA V. Expenses VI. Performance VII. Endogeneity Concerns A. Matched Samples Approach B. Sample Selection Model Approach C. Fund Fixed Effects Approach D. Evaluation VIII. Conclusion I. INTRODUCTION

   We have witnessed the worst capital markets meltdown since the Great Depression. One cause of the financial crisis was a cavalier attitude toward risk and responsibility that led to firm managers making major mistakes in judgments and, in some cases, to outright expropriation of investors. The ensuing economic turmoil has led to a popular recommendation: expose firm insiders to greater fiduciary liability for their decisions. (1)

   This Article explores the ramifications of altering fiduciary standards by studying how two different business organizations, trusts and corporations, regulate their insiders. Trust law imposes stricter fiduciary obligations on insiders than corporate law does. Might insiders be less likely to misbehave in a trust as opposed to a corporation? Does the difference in organizational form influence management's performance or risk tolerance? By leaving less flexibility for management, strict fiduciary responsibilities can limit opportunistic behavior. But that strictness can also constrain business decision making. In other words, trusts and corporations strike different tradeoffs between agency conflict and flexibility in decision making. This Article quantifies the effects on managerial behavior and firm performance of the different standards of conduct required by these two organizational forms.

   This Article exploits a variation generated by a change in British regulations in the 1990s that allowed mutual funds to organize as either a trust or a corporation. The parallel existence of alternative types of organizational forms within one industry provides the key design feature of this study. The existence of the two types of funds offers a unique laboratory for the study of the effect of organizational form on agency conflict and firm performance. This Article is among the first to take an empirical approach to the subject and, hence, it fills a crucial gap in the literature.

   This Article examines governance at a more fundamental level than does the existing literature. A large amount of literature in corporate law and finance studies the effectiveness of governance mechanisms and investor protections on managerial behavior and firm performance. (2) While there is a large amount of empirical literature, most of that literature focuses on the corporation and, hence, takes organizational form as given. one strand of that literature examines the impact on firm performance and firm value of the many governance devices and concessions corporations can make to investors--such as covenants, control rights, voting rules, board composition, and takeover defenses--within the corporation. (3) However, these arrangements do not occur within an institutional vacuum; rather, they occur in an environment of laws and regulations. These laws and regulations may vary across organizational forms. For instance, the fiduciary responsibilities imposed upon decision makers in corporations are not the same as those imposed upon decision makers in trusts. (4) Yet the existing literature largely neglects study of non-corporate organizations. A second strand of literature examines differences in corporate governance structures across countries. (5) Such research focuses on exploiting variation in governance environments across countries, but within the corporate form. In contrast, this study exploits variation across organizational forms. This approach offers sharper variation at a fundamental level of governance and can help shed light on whether governance matters at all.

   The traditional (Miller-Modigliani) view of corporate finance assigns organizational form no role, since it is irrelevant in a frictionless environment. (6) But in a world with agency conflict, fiduciary duties are important and organizational form might have implications. In business organizations a crucial task is to minimize the agency costs that arise from separation of ownership and control. In the corporation, ownership is vested in the shareholders and control is exercised by management. Similarly, in the trust ownership is vested in the beneficiaries and control is exercised by the trustee. In the absence of complete information about managerial activities, owners/beneficiaries cannot design and enforce a contract specifying the managerial actions to be taken in each state of the world. Fiduciary duties provide a set of standards which the law applies to restrain insiders from exercising their discretionary power in contingencies not specifically foreseeable and over which the parties could not contract. Corporate law resolves agency conflict by imposing on corporate officers and directors a duty of loyalty in pursuit of the corporation's objectives and a duty of care in performance. Likewise, trust law resolves the conflict between beneficiaries and trustees by imposing on the trustee a duty of loyalty and a duty of care.

   While similar, the fiduciary duties supplied by trust law and corporate law are not the same. The duty of loyalty and the duty of care under trust law are stricter than those under corporate law. (7) For instance, under both corporate law and trust law the duty of care requires that decision makers discharge their duties with such care and skill as a person of ordinary prudence would exercise. Understanding that excessive liability can deter economically desirable business activity the courts apply the duty of care in a way that defers to officers and directors of corporations. That deference is embodied in the business judgment rule, which presumes that in making business decisions corporate officers and directors complied with the duty of care. The business judgment rule places the burden of rebutting the presumption on a plaintiff challenging a business decision within a corporation, as the rule recognizes that reasonable decisions can sometimes result in unfavorable outcomes. (8)

   In contrast, trust law applies no business judgment rule in reviewing managerial actions, even when trusts are used in a commercial context. In effect, the burden is placed upon trust management to show that their business decisions were prudent despite the unfavorable outcome. (9) The end result is that it is easier to hold decision makers personally accountable for their business decisions in trusts than in corporations. The other fiduciary duty, the duty of loyalty, requires that decision makers act without any conflict of interest. However, corporate law interprets the duty loosely so as to permit conflict of interest transactions so long as they are "fair" to the corporation. In contrast, trust law prohibits all such transactions, even if they would benefit the trust. In short, due to the different fiduciary standards, decision makers are exposed to greater personal liability in trusts than in corporations. Tight fiduciary duties might impact a lot within a business organization. They might lower agency conflict and reduce opportunistic behavior by insiders, but by leaving less flexibility for management, they might also impact performance and risk taking.

   This Article examines mutual funds in the United Kingdom, where funds can organize in either corporate or trust form. This Article empirically identifies costs and benefits associated with these competing organizational forms. The results suggest that trusts are more effective than corporations in curtailing opportunistic behavior by managers. Managers of trusts charge significantly lower fees than their corporate counterparts even after controlling for potential differences in managerial ability and job complexity. The Article confirms that these results are driven by differences in organizational form and not by self-selection. It employs both matched samples analysis and sample selection models to reach this conclusion. One technique addresses selection on observables and the other selection on unobservables. Both techniques support the conclusion that the difference in fees is a treatment effect of organizational form, not a selection bias. The results suggest that trust law's strict fiduciary duties are a superior mechanism for mitigating managerial opportunism and agency conflict within business organizations.

   While strict fiduciary responsibilities limit opportunistic behavior, they might also constrain managerial flexibility in business decision making. Indeed, the results indicate that trusts exhibit greater risk aversion than corporations. Evidence also suggests that trusts generate lower returns than corporations, even after adjusting for the difference in risk.

   In an equilibrium context the trust's underperformance would more than offset its agency cost savings. A hypothetical investor with $100,000 to invest would save, on average, about $100 per year in management fees by investing in a trust instead of an equivalent corporation. But on average, that investor would earn about $1300 per year less in gross risk-adjusted returns. On a net basis the investor is worse off having invested in a trust instead of an equivalent corporation. The business flexibility granted to the corporate funds leads to greater risk-taking behavior and agency costs, but also sufficiently superior risk-adjusted performance to more than compensate for those costs. The results have implications for corporate governance design, suggesting that heightened fiduciary duties can enhance investor protection by mitigating agency conflict and reducing managerial risk taking, but at the potential cost of inferior risk-adjusted performance.

   One caveat is that, due to data limitations, the risk-adjusted performance tests do not have sufficient power to conclusively establish the statistical significance of certain...