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Why did shareholder liability disappear?

Journal: Journal of Financial Economics

Date: 2024

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

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 Importance

Limited liability is ubiquitous in modern financial systems, but shareholder liability was once common and might help prevent excessive risk-taking by financial institutions.

Research Approach

The authors examine British insurance companies over time to understand when and why shareholder liability disappeared from this important financial sector.

Data Collection

The study uses hand-collected archival data including financial statements, share prices, and unique shareholder wealth information spanning from 1830 to 1965.

Dramatic Decline in Shareholder Liability Over Time (1880-1965)

  • In 1880, nearly all insurance companies (96.7%) had shareholder liability, but by 1965 only 15% maintained it.
  • The ratio of uncalled capital to paid-up capital fell dramatically from 5.67 in 1880 to 0.01 in 1965.
  • By 1975, there were no companies left with shareholder liability in the British insurance industry.

Shareholders Attached a Risk Premium to Companies with Extended Liability

  • Stocks with shareholder liability consistently earned higher returns than those without, especially during 1900-1929.
  • The difference grew over time, reaching 0.29% higher monthly returns (approximately 3.8% annually) from 1900-1929.
  • This indicates investors demanded a risk premium for holding shares with potential liability obligations.

Three Hypotheses for the Disappearance of Shareholder Liability

Hypothesis 1: Regulation made it unnecessary NOT SUPPORTED Hypothesis 2: It was already de facto limited NOT SUPPORTED Hypothesis 3: Growing company size SUPPORTED Larger firms needed less shareholder liability as they could better diversify risks
  • Regulation couldn't explain the decline, as shareholder liability disappeared before significant regulatory changes.
  • Shareholders had sufficient wealth to cover liability calls, contradicting the "de facto limited" hypothesis.
  • Growing company size emerged as the supported explanation for the disappearance of shareholder liability.

Larger Companies Had Significantly Lower Shareholder Liability Ratios

  • In every year studied, small firms had much higher uncalled capital to assets ratios than large firms.
  • The difference was dramatic, with small firms having 4 times more liability than large firms.
  • By 1965, even small firms had nearly eliminated shareholder liability, showing a complete industry transformation.

How Company Growth Reduced the Need for Shareholder Liability

Small Companies High Shareholder Liability Medium Companies Moderate Liability Large Companies Low/No Liability Larger Companies Could Better Pool Risk More policies = Lower volatility of claims Reduced need for shareholder liability as backup
  • Insurance companies grew through organic expansion and mergers, with larger firms acquiring smaller ones.
  • As companies grew, they could diversify risks across more policies, reducing the volatility of claims.
  • Established companies kept nominal uncalled capital steady but let it become less significant as assets grew.

Contribution and Implications

  • Shareholder liability disappeared because insurance companies grew in size and became better able to pool risks.
  • This contrasts with U.S. banking, where branching restrictions prevented growth necessary to remove liability.
  • The findings help explain why limited liability became dominant in financial sectors despite potential benefits of extended liability.
  • Results may translate to banking but not other industries where uncalled capital played different roles.
  • The emergence of deposit insurance and policyholder protection may have been necessary after shareholder liability disappeared.

Data Sources

  • Visualization 1 uses data from Table 1, showing the percentage of companies with shareholder liability from 1880-1965.
  • Visualization 2 uses data from Table 3, showing monthly returns for insurance stocks with and without shareholder liability.
  • Visualization 3 is a conceptual representation of the three hypotheses tested in the study and their findings.
  • Visualization 4 uses data from Table 5, showing the uncalled capital to assets ratio for large vs. small firms.
  • Visualization 5 is a conceptual illustration of how company growth led to the disappearance of shareholder liability.