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Why Did Shareholder Liability Disappear?

Journal: Journal of Financial Economics

Date: 20240201

Author: Bogle, David A.; Campbell, Gareth; Coyle, Christopher; Turner, John D.

Abstract:
Why did shareholder liability disappear? We address this question by looking at its use by British insurance companies until its complete disappearance. We explore three possible explanations for its demise: (1) regulation and government-provided policyholder protection meant that it was no longer required; (2) it had become de facto limited; and (3) shareholders saw an opportunity to expunge something they disliked when insurance companies grew in size. Using hand-collected archival data, our findings suggest investors attached a risk premium to companies with shareholder liability, and it was phased out as insurance companies expanded, which meant that they were better able to pool risks.

Link: Google Scholar

Background and Context

Historical Context

Until the 1970s, shareholders in British insurance companies had "extended liability" meaning they could be required to pay additional capital if the company experienced financial difficulties.

Research Focus

The study examines why shareholder liability disappeared from the British insurance industry by analyzing hand-collected data on insurance companies from 1830 to 1965.

Methodology

The research combines analysis of financial statements, stock market data, shareholder records, and corporate governance information to examine how company characteristics influenced the decline of shareholder liability.

Sharp Decline in Uncalled Capital

  • Shows dramatic decline in shareholder liability from 1880 to 1965
  • By 1930, only 4% of assets were covered by uncalled capital, down from 57% in 1880
  • Demonstrates the complete transformation of the industry's liability structure

Growth in Company Size as Industry Consolidated: 1880-1965

  • The insurance industry consolidated significantly, with the number of companies falling from 171 in 1911 to just 63 by 1965
  • Consolidation occurred through mergers and acquisitions, creating larger and more diversified companies
  • Larger companies were better able to pool risks, reducing the need for shareholder liability as a buffer against losses

Higher Returns Required for Companies with Shareholder Liability: 1900-1929

  • Companies with shareholder liability had to offer higher returns to attract investors
  • The difference in returns was 3.8% annually, representing the risk premium investors demanded for potential liability
  • This higher cost of capital created an incentive for companies to remove shareholder liability

Dramatic Increase in Average Company Assets: 1880-1965

  • Average company assets grew dramatically from £0.825m in 1880 to £19.65m in 1965 (in 1900 prices)
  • Growth came through both organic expansion and mergers
  • Larger size meant companies could better diversify risks, reducing the need for shareholder liability as protection

Different Paths to Removing Shareholder Liability

  • Most companies (172) removed shareholder liability through being acquired by larger firms
  • A smaller number used other methods like voluntary liquidation (29) or capitalizing reserves (21)
  • This shows consolidation was the primary driver of liability removal

Contribution and Implications

  • The study shows that shareholder liability disappeared naturally as the insurance industry evolved, rather than due to regulatory changes
  • Growth in company size through consolidation made extended liability unnecessary as firms could better manage risks
  • The findings suggest that extended liability may be less necessary in modern financial institutions due to their large size and diversification

Data Sources

  • Decline Chart: Based on Table 1 showing uncalled capital as a proportion of assets
  • Size Chart: Based on Table 1 showing number of companies over time
  • Returns Chart: Based on analysis presented in text showing returns from 1900-1929
  • Assets Chart: Based on Table 1 showing average assets per company
  • Removal Chart: Based on Table 8 showing methods of liability removal