Monday, September 16, 2013

Why the US Does Not Have Business Groups

My favorite research projects are analyzing and writing about business conglomerates in Asia.  For me it is an easy way to quickly come-up to speed on a country's key people, capital allocation structure, and power chain.  After completing the reports I feel I know who is actually in control, their background and their relationships with important business and government personalities and entities.  I also get a sense of the who the good groups are and who the not-so-good groups are.  So far I've mostly been correct (see a case study type write-up here).

In the past several years I've been investing my own money using much of the same research methodology I used in writing the reports. The best example is my trip to Greece last year.  Other investments closer to home and based on recent reports have also done well.

So far I've been content doing my bottom-up research and have not really looked into why Asia and the rest of the world's corporations are organized differently than companies in the US and the UK.  The few US and UK companies I've looked at have a very flat corporate structure, and I've been told that neither country has business groups. 

However virtually all of my analysis and investment experience has been outside the US and UK, and the group structure is my base case when looking at companies.  Because of this, my research and investment methodology doesn't really fit with the US and UK's flat corporate structure.

I've always been a bit curious as to why the US and UK are different than the rest of the world.  But like a myopic-race-horse-with-blinders, I've accepted the structure for what it is and concentrated on trying to make good investments and recommendations.  

Thanks to to UC Berkeley PhD candidate Matthew Sargent for turning me onto the very well written, but long-titled, "How To Eliminate Pyramidal Business Groups - The Double Taxation of Inter-Corporate Dividends and Other Incisive Uses of Tax Policy". 

Written by Dr. Randall Morck in 2004, the paper states that a key reason that US corporations do not have the pyramidal business group structure is due to the 1935 imposition of inter-corporate taxes.

Apparently after the 1929 US stock market crash many business groups defaulted on their loans, and the public blamed the large conglomerates for causing the crash and subsequent depression. It sounds like this gave President Roosevelt's administration enough political capital to change how America's corporate sector is taxed and, by extension, organised.

The new tax regulations made dividend payments from a company to all the entities that owned it subject to taxes.  Each layer is subject to pay taxes on the dividends it receives from companies that it has a stake in.  If a conglomerate has many layers, each layer is subject to tax charges.  This makes each additional layer very expensive. This creates a  tax penalty on the pyramidal structure of business groups.  

America's utilities were given special attention.  The Public Utilities Holding Company Act (PUHCA), also passed in 1935, subjected utilities to US federal regulation and did not allow an owner with more than two corporate levels to hold any public utility.

After the two new rules were implemented, the group structure that was so prevalent in the US, was quickly broken up.  According to the paper, stock liquidations surged in 1936.   America has had a flat business structure ever since.

The paper attributes the UK's flat business structure to pressure from British institutional investors who were 'dismayed over corporate governance problems in business groups'.  As a result, the London Stock Exchange Takeover Rule was issued in 1968.  The rule said that any acquisition greater than 30% of a listco needed to be at least a 100% acquisition.  This forced the parent company of a listco to own all 100% of its subsidiaries or less than 30%. 


What I found very interesting is that the pyramidal business group structure that I'm used to was very common in the United States.

They were so common, that in 1928 the US Federal Trade Commission wrote a report on the abusive nature of business groups.  The report found the same transgressions of business groups that I focus on when investigating corporate structures.  Morck notes that the 1928 report on US business groups said that US conglomerates had '...widespread instances of tunneling, poor governance, and monopolistic practices'.

Other government reports in the 1930s noted that many groups transferred profits between entities to avoid taxes.  "Listed companies in a business group could trade with, finance or insure each other at artificial prices, transferring taxable income from companies with few deductions to companies with many".

In other words, many business groups were ripping off the government as well as minority shareholders.  

This is very similar to what I've seen amongst many, but certainly not all, business conglomerates that I've researched. 


This is a great paper, and I sincerely appreciate Matt for bringing it to my attention

But most of the thanks and appreciation goes to the author, Dr. Randall Morck, for researching and writing it.

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