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E-MailBrian Cheffins is the S. J. Berwin Professor of Corporate Law at the University of Cambridge. This post is based on a recent paper, co-authored with Bobby Reddy, also of the University of Cambridge, and forthcoming in the Oxford Journal of Legal Studies.
In a recent Harvard Law School Forum on Corporate Governance post we drew attention to declining equity markets in the United Kingdom and canvassed various possible explanations for the trend. Hectic reform activity is currently under way, including a set of proposals by the Financial Conduct Authority (FCA) designed to make the UK listing regime ‘more straightforward’, justified on the basis the FCA wants ‘to make sure that the UK public markets remain an attractive and trusted place to list companies to support growth and innovation.’ In a new paper we address the issues involved from an historical perspective.
The UK has, the United States aside, a uniquely well-developed equity market, with origins traceable back to the 16th century. One might correspondingly assume that the current weakness of equity markets is an aberration. Moreover, the emphasis on reform intended to correct matters seems entirely logical given an influential ‘law and finance’ thesis that strong legal protection for investors is an essential prerequisite for a vibrant stock market. We show in our paper that with respect to the strength of UK equity markets and law’s role in fostering stock market development the situation is more complicated than the foregoing implies. Britain, despite being a stock market ‘citadel’, has suffered periodic serious stock market reversals over time and, to the extent equity markets have thrived, this has been as much in spite of rather than because of law.
We begin our paper by providing context in the form of a succinct overview of the ‘law matters’ thesis that suitable investor protection is a crucial pre-condition for a well-developed stock market. We then address UK developments chronologically. As we describe, in the 1690s the UK experienced its initial substantial wave of company formations yielding a market for company shares. Stock market-related activity then lulled considerably but the situation changed markedly in 1719 and 1720. With the share prices of existing firms rising dramatically, opportunistic company ‘promoters’ launched numerous companies, sometimes merely to profit from unloading shares on eager investors at the earliest opportunity. The ephemeral ventures involved were referred to derisively as ‘bubbles’. The enactment of legislation subsequently labelled ‘The Bubble Act’ set the scene for a share price crash in the second half of 1720 that brought the frenzy to an abrupt and enduring end.
The Bubble Act prohibited, and prescribed penalties for, any undertaking that acted as a corporate body or raised capital by the issuance of transferable shares without specific authorization from a statute or Royal Charter. Numerous commentators maintain that the legislation substantially deterred the growth of corporate enterprise in the UK until its repeal in 1825. This is doubtful.
The enactment of the Bubble Act does show that UK lawmakers could promulgate laws designed to hamper equity markets. It is unlikely, however, that the legislation had a substantial sustained adverse impact on corporate development. Britain experienced the Industrial Revolution in the second half of the 18th century and the opening decades of the 19th century despite the Bubble Act, with the manufacturing concerns at its heart rarely needing to contemplate adoption of the corporate form because they operated on a modest scale and could finance operations without tapping capital markets. Moreover, by the time the Bubble Act was repealed well over 200 companies had shares traded on the London Stock Exchange, primarily because with businesses akin to public utilities it was time consuming but feasible for proprietors to generate the public support necessary to secure parliamentary incorporation.
While the Bubble Act was an affirmative, if not particularly potent, barrier to the development of the publicly traded company in Britain, a different anti-stock market charge – counterproductive neglect of equity markets — can be laid against UK lawmakers from the mid-19th century through to the opening decades of the 20th century. During this era regulation of publicly traded firms was rudimentary, with caveat emptor being the order of the day. Mid-19th century companies legislation simplified company formation considerably but offered little explicit protection to investors. Indices used by present-day empirical researchers to measure the quality of corporate law illustrate the point, with UK company law scores being very low by contemporary standards until well into the 20th century.
A case can be made that regulatory neglect had an adverse impact on Britain’s economy, with the UK losing economic pre-eminence to the US and Germany partly because British firms operating in key industries were struggling to raise sufficient equity capital on satisfactory terms. In fact, it is open to question whether Britain ‘failed’ economically in the late 19th and early 20th centuries. Furthermore, industrial and commercial firms in the UK in this era typically needed no more than a combination of retained earnings, bank lending and capital raised privately to operate successfully. For business enterprises that were looking to go public, equity markets were generally well-developed, both in London and in a number of ‘provincial’ (regional) centres.
In 1914, government officials responded to the start of World War I by abruptly dropping the hands-off approach to equity markets that had governed previously and severely curtailed their operation to clear the way for government borrowing to finance the war. The same occurred when World War II got underway in 1939. During the intervening years, with respect to statutory regulation of publicly traded firms the laissez-faire pre-World War I stance tended to prevail.
The years between the end of World War II in 1945 and the end of the 1970s were something of a stock market dark age in the UK. Amendments to companies legislation in 1948 and 1967 did increase shareholder rights in various ways, but other policies were antithetical to stock market development. Most strikingly, nationalization of industry shrank the size of the stock market by one-third. Dividend controls and harsh taxation of investment income also discouraged stock market investment. The ratio of the aggregate market capitalization of publicly traded shares to Gross Domestic Product (GDP) accordingly hit historic lows as the 1970s drew to a close.
In contrast with the immediately preceding decades, 1980 to 2000 was akin to a stock market golden era in the UK. Publicly traded shares delivered robust results for investors and various pro-stock market policy moves accompanied and fortified the stock market revival. The policy changes included cancelling dividend controls, dismantling the harsh tax bias that had discouraged share ownership and privatizing by way of public offerings of shares a substantial range of state-owned industries. The UK’s aggregate market capitalization/GDP ratio hit a record high in 1999 that has yet to be matched.
In contrast with the 1980s and 1990s, the UK stock market faced substantial post-2000 headwinds. Share prices were in the doldrums. Pension and insurance regulation encouraged domestic pension funds and insurance companies, stalwart stock market investors during the second half of the 20th century, to forsake U.K. equities. The number of publicly traded companies fell substantially, particularly following the 2008 financial crisis.
The UK government’s initial response to growing evidence of stock market decline was ambivalent, despite the ostensibly market-friendly Conservatives returning to power in 2010. A major 2012 government-commissioned review of equity markets acknowledged the number of companies traded on the London Stock Exchange had declined but indicated there were no policy arguments in favor of promoting the use of public equity markets as an objective in itself. Less than a decade later, however, the Conservative government was saying it wanted more companies to list in the UK and launched a deregulation initiative designed to achieve this objective that is continuing today. Brexit helped to foster the change of heart, as the Conservative government somewhat belatedly realized Britain’s departure from the European Union had put London’s status as a global financial centre in jeopardy.
At first glance, introducing reforms to foster stock market development tallies fully with the tidy law and stock market logic summarized earlier. The current direction of travel is, however, quite different than what the ‘law matters’ thesis concerning stock market development counsels. The emphasis with current reforms is on relaxing existing requirements rather than bolstering investor protection, which is the ‘law matters’ prescription for robust equity markets. Correspondingly, if the current reforms do foster stock market development this will not serve as a belated UK-related validation of the law matters thesis.
The current pattern tallies with historical trends regarding the awkward ‘fit’ between law and stock market development in the UK. As our paper shows, law and the stock market have been uneasy bedfellows in Britain. While the law matters thesis implies strong investor protection is essential for robust equity markets, given the historically dominant ‘hands-off’ regulatory stance in Britain and given various policies antithetical to stock market development, it seems equity markets have flourished in the UK more despite regulation than because of it. The current era stands out as a potential aberration because regulatory reform is on the agenda explicitly to bolster the stock market. History implies, however, that factors other than regulation are likely to dictate the future fortunes of the UK’s equity markets.
