Permanent Capital and Risk Management: The Case of the VOC Insurance Contract of 1613

Transcription

1 Permanent Capital and Risk Management: The Case of the VOC Insurance Contract of 1613 by Oscar Gelderblom (UU), Abe de Jong (EUR) and Joost Jonker (UU) Abstract This paper analyses an insurance contract of the Dutch East India Company (Verenigde Oost-Indische Compagnie, VOC) initiated in By then the business organization of the VOC was aimed at continuity and the company had outside investors, which requires limited liability, transferability of shares and separation of control and ownership. As these characteristics were all in place, the next step was to ensure viability anticipating situations where survival would be threatened, via risk management. The 1613 insurance contract illustrates the transition from financing of individual voyages via partnerships to permanent equity capital and the effects of permanence and limited liability for shareholders. In addition, the contract is an early example of risk management motivated by the theory of Froot, Scharfstein and Stein (The Journal of Finance 48, 1993, ), in which growth opportunities and costly external financing induce a risk management strategy resembling the VOC contract. This paper also compares the VOC with the English East India Company (EIC) to explain part of the VOC s early success by its business organization and corporate financing. The EIC became more successful when this company started to copy elements from the VOC s business organization. This version: 10 December 2010 Preliminary draft, please do not quote or circulate. The authors thank participants of the Financial History Workshop, Antwerp (May 2010) for helpful comments and Karen Hollewand for assistance with Section 5 (EIC). Comments welcome at o.gelderblom@uu.nl, ajong@rsm.nl or j.jonker@uu.nl. 1

2 1. Introduction In modern economies both continuity and permanent capital are basic characteristics of corporations. In the colonial trade in the late 16 th and early 17 th century, however, finance was typically allocated via partnerships to individual voyages and the partnership was dissolved after the trip. A major innovation in the Dutch East India Company (Verenigde Oost-Indische Compagnie, VOC) was the allocation of equity capital independent of specific fleets, initially for a period of twenty-one years, which later turned out to be permanent capital, i.e. continuity of operations became one of the goals of the corporation. The crux of this paper is that we describe two closely related aspects, which are consequences of the aim for continuity in a firm. The first is the logic of the business organization of the VOC. We compare the model with other firms, both internationally and through time and find that the model is unique in both respects, when compared with English, French and American large firms for about three centuries. The second is that the aim of continuity affects the company s policies. In particular, we describe the VOC in 1613, when permanence of capital seems to be a fact and the company writes an ingenious risk management contract. Jointly with permanent capital the VOC had limited liability, transferability of shares and separation of control and ownership. After the VOC, very few firms have combined these features with successful large-scale activities, until well into to 19 th century (see Harris (2000) for the UK, Freedeman (1979) for France, Blumberg (2001) for the US, and Guinnane et al. (2007) for Germany France, the US and the UK). This paper documents the transition in the VOC from the conception based on a finite existence towards the notion of permanent activities and capital, including the role of the VOC s business organization in the period between 1602 and Although the starting capital was sufficient to equip fleets in the first years, the revenues from these voyages were supposed to yield the (internal) financing for subsequent fleets. As the outcomes of the Asian trade were highly uncertain, the availability of internal funds was also unsure. In a constellation of an aim of continuity, risk, financial constraints and future investment opportunities, risk management is valuable for the financiers. As argued by Froot, Scharfstein and Stein (1993), risk management adds value for financiers when it can ensure that the corporation obtains 2

3 sufficient internal funding in order to invest in valuable growth opportunities. The authors construct a model based on costly external financing and derive optimal risk management strategies. This paper describes the rationale and implementation of an insurance contract from 1613, which is an early application of risk management helping firms to secure future growth and to enhance continuity. In the literature about the VOC, the 1613 insurance contract is often mentioned but remains unexplained (Van Dam, 1927, p ; Gaastra, 2007, p.24) or is incorrectly explained. For example, Stapel and Den Dooren de Jong (1928, p.83-84) argue that vroede bewindhebbers set up the contract to mislead participants, who were trapped, blinded by the 5% premium, while Van Niekerk (1998, p.83) claims that the contract served as a guarantee to pay dividends. Van Dillen (1958, p.73-78) provides a careful description, but does not relate the contract to risk management. The VOC was founded in 1602 and raised ƒ 6.4 million of new equity (Van Dillen, 1958, p.35). Until 1613 the VOC has been using their starting capital to finance fleets and always self-insured the voyages. However, by 1613 the corporation was about to send a fleet to Asia, which had exhausted most of VOCs cash. We argue that in case this fleet would not have returned with sufficient goods, the VOC could not equip new fleets. Obviously, in this situation the VOC would also be unable to attract new financing at reasonable costs. In line with the Froot, Scharfstein and Stein (1993) model, the management (bewindhebbers) of the VOC designed an insurance contract to guarantee to continuation of the Asian trade, in case the 1613 fleet would not return or would yield insufficient internal funds. The insurance contract was drafted on March 1, 1613 and mainly sold to current shareholders of the VOC. In case the revenues by Augustus 1616 would be below ƒ 3.2 million, the participants would pay the difference between the revenues and the amount insured, while participants were entitled to receive a premium of 5%. The 1613 contract is relevant for three reasons. First, the contract is an early example of risk management, in line with the arguments of Froot, Scharfstein and Stein (1993). Second, the contract emphasizes the effects of permanent capital on corporate policies. More specifically, the contract illustrates the effects of shareholder s limited 3

4 liability. Third, the contract has been later used in other corporations, in particular by the English East India Company (EIC) as of the 1630s. Our paper is organized as follows. Section 2 describes the business organization literature and the modern risk management and insurance theory. In Section 3 we discuss the business organization of the VOC and its operations until Section 4 provides a description and analysis of the 1613 contract. In Section 5 we describe the competition between the VOC and the EIC and the role of business organization and financing. Section 6 concludes. 2. Background This section discusses the contemporary literature on business organization and risk management Business organization In the literature on business organization, researchers in company law have defined a set of legal characteristics of the large modern business corporation. These characteristics are legal personality, limited liability, transferable shares, delegated management under a board structure, and share ownership by investors. Hansmann and Kraakman (2004) describe that nowadays in market economies, almost all large-scale businesses adopt these five characteristics. Also corporate laws in market economies provide corporations with legal forms that possess these five attributes, while institutions such as stock exchanges facilitate the well-functioning of this legal form. The first characteristic is legal personality, meaning that the company can own assets, instead of individuals being its owners. This characteristic is important in the interaction with creditors, because the assets can be used credibly to serve as collateral for company debts. Company-owned assets are shielded from the creditors of owners and managers. The second characteristic is limited liability. The liability of owners of a company towards creditors is limited, typically by their capital inlay. Legal personality and limited liability act in a tandem, in which shareholders creditors can only claim personal assets and companies creditors can exclusively claim company assets. As will be noted later, limited liability also facilitates delegated management. 4

5 Transferable shares are the third characteristic, which allows a corporation to continue its business, independent of changes in the ownership base. Moreover, when shares are liquid, investors can construct optimally diversified portfolios. Obviously, transferability is closely related to the legal personality and limited liability, because the creditworthiness of the company is independent of share transfers (legal personality) and the wealth of new shareholders is irrelevant in transfers (limited liability). The fourth characteristic of large corporations is delegated management, where owners delegate decision and contracting power to centralized management. This management the board(s) of directors is distinct from the owners, in order to provide clarity about contracting rights and to improve decision-making efficiency. As boards are typically composed of multiple members, continuity is also enhanced via boards. The fifth and final attribute is investor ownership, where the owners have the ultimate control and receive the net earnings, i.e. the cash left after all other contracts have been settled. For specific business activities a sufficiently large scale can be a key requirement for a successful operation. A consequence of the aim for a large scale is the needs for continuity, because the build-up of a company producing or trading on a large scale takes time and large investments and the value-added of the large scale is destroyed when operations are discontinued. Large-scale operations and continuity typically are organized in corporations and these institutions share the five before-mentioned characteristics legal personality, limited liability, transferable shares, delegated management under a board structure, and share ownership by investors allowing these corporations to benefit from the large scale and permanence. In the law and economics approach agency theory has been applied successfully to demonstrate the internal logic of the legal characteristics of the corporation, as well as to point at its costs. The costs stem from agency conflicts between shareholders and managers, among shareholders, and between shareholders and other stakeholders, such as creditors, employees and the state (see Hansman and Kraakman, 2002; Kraakman et al., 2004). In an earlier paper, we have discussed the agency problems involved in the VOC (Gelderblom, De Jong and Jonker, 2010). 1 1 Several studies have related differences in business organization structures and solutions to agency problems between countries to their economic growth. See Harris (2009) for an attempt to relate the VOC and EIC incorporations to this finance and growth literature. 5

6 In order to guarantee the permanence of the business, the legal organizational structure is a first step, but the company s operational and financial policies also need to be set in accordance with this goal. Continuity is enhanced though three mechanisms. The first mechanism is simply a sound business model with sufficient cash inflows, which is sustainable on the long run. This implies that to firm needs to obtain a competitive advantage on the product market and needs to keep investing in the operations in order to grow towards the optimal scale. The second mechanism is financing of the operations, via retained earnings, debt and new equity. Obviously equity financing has a positive effect on continuity, acting as a buffer against losses. Debt financing creates fixed obligations towards creditors and continuity is threatened when interest obligations and principal repayments cannot be covered via liquid assets and cash inflows from operations. The third mechanism is active risk management, as a tool to provide financing in case retained earnings fall short and access to debt/equity is constrained or expensive. This mechanism will be discussed in detail in the next section Risk management In modern businesses insurance contracts are regularly purchased in order to insure against exceptional events, such as fires and hurricanes. In a broader perspective, corporate risk management deals with the effects of risk and uncertainty on firm value, as well as the ways to manage risk and uncertainty. In the contemporary finance literature, the risk management decision is treated similar to other financial decisions, for which Modigliani and Miller (1958) show irrelevance in case market imperfections such as taxation, contracting costs and distortions of optimal investment policies are absent. In other words, the motivations for risk management can be derived from real world imperfections. Mayers and Smith (1982) are the first authors to analyze motives for corporate insurance. A general idea is that insurance allows value creation through risk shifting, because firms with access to financial and insurance markets have a comparative advantage in bearing risks, over firm claimholders as employers and managers. Also bankruptcy costs can be reduced through insurance, because risk management reduces the 6

7 downside risk. Building on agency theory, Mayers and Smith argue that insurance can serve as a bonding device towards prospective bondholders (see also Myers, 1977). Finally, the authors describe a set of characteristics of the US tax laws, which induce incentives to insure. The argument that risk management may be motivated by a firm s investment policies has been forwarded by Froot, Scharfstein and Stein (1993). In their model firms face variability in cash flows, which result in either a demand for external financing or fluctuations in investments. In a setting with valuable growth opportunities it is undesirable that investments are driven by volatile cash flows, because the firm may forego value-creating investment projects. In a perfect capital market external financing will always be available in situations with growth options and insufficient cash flows from internal financing. However, in a more realistic setting with increasing marginal external financing costs, firms with volatile internal financing will face financial constraints and valuable growth options are not exercised. Since risk management can reduce the volatility of cash flows, these policies will secure a firm s investment policy from internal financing, and thus enhance firm value. The costs of external financing are based on information problems between firm management and outside investors (Myers and Majluf, 1984). An interesting outcome of the Froot, Scharfstein and Stein model is that full insurance is typically not the optimal strategy, because safeguarding future investments is a sufficient goal for risk management. Moreover, the authors find that nonlinear (option-like) instruments are better in coordinating financing and investment policies, when compared with linear instruments (such as futures and forwards), because the value-creation stems from preventing downside cash flow surprises. In addition to the previous arguments, based on maximization of shareholder value, Smith and Stulz (1985) have introduced managerial risk aversion as a motive for risk management. Because managers are typically poorly diversified with human (reputation) and financial (shareholdings plus future salary) capital, bankruptcy costs are high. In case managers cannot hedge personally against these bankruptcy costs, it is optimal for them that the firm reduces its risks. 7

8 It is interesting to note that Lessard (1991) claims that two key arguments for hedging can be derived from ensuring the firm s ability to meet two critical cash flow commitments: dividends and futures investments. As explained before, the investments argument has been theoretically developed. However, the dividends argument has never been formalized. At best, one can argue that a stable dividend policy reduces the costs of external equity financing, which indirectly reduces the motivation for risk management. Nance, Smith and Smithson (1993) measure differences between US firms users of derivative instruments versus non-users and find that tax functions, debt financing and growth options are key determinants of risk management. Tufano (1993) studies the North-American gold-mining industry and finds most support for theories based on managerial wealth maximization in particular, managers with more shares are more inclined to manage gold price risk. The most comprehensive analysis is provided by Bartram, Brown and Fehle (2009), for over 7000 firms in 50 countries. The authors find that risk management strategies are largely determined endogenously with other financing and investment decisions. 3. The business organization and financing and operations of the VOC until 1613 In the section we discuss the business organization of the VOC, as well as the operations and financing in the period We end with the opportunities for the company as per The business organization of the VOC The organizational structure of the VOC in the largely defined via the charter. As discussed in Gelderblom, De Jong and Jonker (2010) the role of the Dutch state, the States-General was very important in the VOC. In this section we will focus on the shareholders (participanten) and the board (bewindhebbers), in relation to the five characteristics of modern corporations, i.e. legal personality, limited liability, transferable shares, delegated management under a board structure, and share ownership by investors. When the VOC was founded in 1602, a monopoly on Asian trade the area between Cape of Good Hope and the Straits of Magelhan was granted for a period of 8

9 twenty-one years. The idea underlying this monopoly was to create market power for this single company in dealing with the Asian counterparties (Van der Chys, 1856, p ). An obvious consequence of this monopoly was that active merchants in various Dutch regions needed to be convinced to participate, which resulted in the establishment of six chambers based in six Dutch cities. The charter stipulates in its introduction that the new company should benefit the residents of the United Provinces. The VOC s legal personality is an implicit element of the charter, which refers to the VOC as Compagnie and describes the rights of the company representatives, on behalf of the company. The limited liability for shareholder is not mentioned in the charter. Among Dutch legal scholars, since the early 20 th century there is consensus that shareholder liability was limited to the participation (Van der Heijden (1907) and particularly Van Brakel (1908, after p. 161)). The transferability and resulting liquidity of shares of the VOC has been described in Gelderblom and Jonker (2004) 2 Key characteristics here are that the charter already provided clear rules about the transfer of ownership. Already in March 1603 the first share transfers are recorded in the Amsterdam chamber. Between 1603 and 1607 between 100 and 200 shares were traded per year, which is about 6-7 percent of Amsterdam s capital. The transferability of shares seems the result of the long period over which the accounts are settled, i.e. over a ten-year period. Participants were not allowed to withdraw their monies before the first ten-year settlement, but because for many investors locking-in capital for ten years would be too long, transferability made the subscription attractive. The VOC charter is largely dedicated to defining the roles of the delegated management, although this delegation is to a large extent about the rights of the States- General (see Gelderblom, De Jong and Jonker, 2010). Share ownership by investors is an explicit element of the charter, which states that all of the residents of these United Provinces shall be allowed to participate in the VOC and to do so with as little or as great an amount of money as they choose. This characteristic is consistent with the idea that inhabitants of the Republic should benefit from the state-granted monopoly. In a way, the 2 Van Dam 1 st book part 1 page 142 mentions that in 1603 already the secondary market in VOC shares is a reason to ignore article 7 of the charter. 9

10 opportunity to participate will also mute merchants not involved as bewindhebbers in the VOC, because they can profit from the monopoly by subscribing to the share issue. The VOC gradually transitions from a finite project to a permanent company. It remains an open question when the notion that the company would continue after the first twenty-one years became clear among the bewindhebbers. It seems plausible that in the first ten years, the scale and investments were already at a level where dissolving the company after the first charter would be highly inefficient. 3 In other countries, the development in company law for large corporations followed different patterns (see Harris (2000) for the UK, Freedeman (1979) for France, Blumberg (2001) for the US, and Guinnane et al. (2007) for Germany France, the US and the UK). For example, in France in the 17 th century two forms prevailed: the partnership with unlimited liability for the partners and the limited partnership, where the active partner have unlimited liability and limited liability for financiers not active in management. Public registration was required. In addition, the French EIC (1664) was a quasi-public institution with unlimited liability (Freedeman, 1979, p.4) for shareholders. In France, As late as 1780 limited liability for shareholders appeared, together with a reappearance of bearer shares. For the VOC, in particular the English EIC was an important competitor. This company had unlimited liability for shareholders (Harris 2000, 2009) Operations and financing of the VOC The VOC was founded in 1602 and shareholders (participanten, participants) subscribed to the capital of ƒ 6.4 million. 6 To allow shareholders to use their earnings from earlier 3 In this section, future analysis should devote attention to the discussions about the charter in order to explain the motive for each of the five key characteristics. Although in modern law and economics literature these characteristics are explicit elements in law and company charters, in the VOC they may have arisen for other reasons. In addition, future research should investigate the transition for finite to permanent capital, in order to present a plausible range of years in which this transition took place. 4 Harris (2009) writes on the EIC and VOC note 12 This depends on which part of the company s assets would be subjected to the risks in Asia and on the ocean and on whether the company offered their shareholders limited liability. Though some scholars claim that the VOC was a limited liability company, others do not find evidence for this. The debate about the legal nature of EIC is not developed. I side with those who do not find support for the limitation of liability of members in either of the corporations.. He is clearly incorrect on the VOC. 5 Expand description of the English EIC. 6 See Van Dillen (1958), Gaastra (2003) and Den Heijer (2005). 10

11 voyages to finance their investments, the share capital was paid up in four terms between 1603 and 1606, while the VOC provided 8% interest to participants between the payments of the terms and the actual date the fleets sailed for Asia (Den Heijer, 2005, p.61). The charter of the VOC stated that after ten years accounts would be published, and that participants could withdraw their inlay or fund a second ten-year term. The VOC s first fleet, sailing in December 1603, was financed almost entirely with money from the first installment. Preparations for the second and third fleet, however, started long before the next installments were due. To fund these operations the company directors borrowed money in two different ways. On the one hand, VOC directors used rebates to fund their expenditure. Buyers of spices who paid cash, instead of the usual 12 months delay, were given an eight per cent rebate effectively a one year loan at eight per cent. In addition to the anticipation of sales revenues, the VOC Chamber Amsterdam took out more than 400 short-term loans (mostly 6 months, some longer, some shorter) to fund the equipment of ships (see Figure 1). The value of loans outstanding, calculated on the basis of these individual contracts, is consistent with the known equipment of fleets in 1605 and The absence of large deposits in 1607 is somewhat surprising given the fact that a big fleet of thirteen ships, including six from Amsterdam, set sail in December of that year. Pending our reconstruction of rebates, we can only surmise that sales revenues were used to fund these ships. The relatively large loans in early 1608 were certainly not used to equip new ships since no fleet sailed in that year. [please insert Figure 1 here] Ruben Schalk (2010) has made a more comprehensive analysis of the funding strategy of the Enkhuizen Chamber of the VOC between 1608 and His analysis shows how the directors in this city thirty miles northeast of Amsterdam used both deposits and rebates to fund the equipment of their fleets (see Figure 2). The value of deposits outstanding was more or less stable at 200,000 guilders between 1609 and 1614 before it soared to almost 600,000 guilders in 1616, and again dropped to 200,000 guilders in Rebates were especially important in 1611 (250,000 guilders) and in 1618 (550,000 guilders). In

12 rebates had replaced deposits as the most important source of external funding. Most of the rebates were granted to customers in Amsterdam, Holland s principal commodity market. [please insert Figure 2 here] In these early years the VOC was reasonably successful, both in military and commercial operations, but it remained strapped for cash. In 1608 and 1609 only four yaughts were dispatched from the Dutch Republic, including Henry Hudson s Halve Maan sailing to North America (Figure 3). In 1610 the tonnage of ships sent to Asia returned to the level of but the funding of operations remained problematic, the more so as disgruntled shareholders pressured the directors into dividend payments in The dividends paid in 1611 were partially in kind (with a value of 125% of the nominal share value) and partially in cash (7.5%). Several participants refused the dividends to be distributed in goods; these participants we not entitled to receive the cash dividend. In 1612 a second dividend in kind was distributed (30%). Shareholders were very critical about the low dividends, which stood in stark contrast with the very high returns (27% per annum) on investments in the early companies. 7 [please insert Figure 3 here] The dividend payments did not end the company s shortage of liquidity, however. Quite the contrary, it seems to have exacerbated cash shortages. This is apparent from the equipment of ships by the Enkhuizen Chamber (Table 1). Between 1610 and 1618 Enkhuizen contributed eight vessels to six different company fleets. The interest payments attributed in the company accounts to each of the ventures reveal the importance of loans to pay for the ships. The value of these ships varied considerably, and so did the amount of money shipped to Asia. In 1611 the very year the chamber offered large rebates to its customers Spanish realen worth 87,000 guilders were sent 7 To be further completed. The sources disagree about the timing of the dividend payments. Note that Van Dillen (1958, pp ) finds that ƒ of the dividends has not been claimed on December 5,

13 but in 1614 and 1616 no cash at all was taken to Asia. Then, in 1617 and 1618 the company sent Spanish realen for 320,000 guilders. [please insert Table 1 here] From this description of the financial operations in Amsterdam and Enkhuizen we conclude that the VOC expanded its activities using the initial financing and retained earnings, bridging over temporary cash shortages with rebates and short-term loans. Obviously, the trading activities with Asia of the VOC were a highly risky business. In the early 17 th century, merchants in the Netherlands were well aware of the possibilities to insure against the perils of maritime trade. However, insurance contracts were used rarely (Van Niekerk, 1998, p.575). Instead most merchants either self-insured by spreading the risk over multiple ventures (e.g., by spreading cargo over multiple ships and by engaging in multiple partnerships), or were simply uninsured. According to Van Niekerk (1998, p.577) the VOC in the 17 th century did not use any form of insurance in contractual form. This practice changed after 1727 (Stapel and Den Dooren de Jong (1928, p.85-86), even though one of the VOC s predecessors, the Oude Oostindische Compagnie already used insurance contracts in The absence of insurance can be explained by two reasons. First, the VOC was large enough to bear losses from some of the voyages and these losses were relatively low. Second, the capacity of the insurance market in the Netherlands to underwrite the VOC activities was not large enough (Van Niekerk, 1998, p.577; Stapel and Den Dooren de Jong, 1928, p.93) The growth potential of the VOC in 1613 In contrast with the financial constraints imposed by the limited access to additional financing, by 1613 confidence in the future of the VOC activities had grown significantly. As proposed by Myers (1977, p.150), the market value of a company can be broken down 8 See Van Niekerk, 1998, p.577, note 72 for a description of the practices of the English East India Company. 9 This section will be expanded with more attention to two aspects of risk for the VOC, i.e. the price movements and volatility in the spice market and its investments in warfare. 10 A plausible reason for the absence of new equity issues is the dilution effect: current shareholders may find it unfair to have paid for the initial fleets and investments, while new shareholder will share equally in the revenues. Simple solutions are issuance against market prices or rights issues (WIC). 13

14 into the value of the assets in place and the growth opportunities, i.e. the value of future investments. Given the limited use of external financing and the presence of a secondary market for VOC shares (Gelderblom and Jonker, 2004), the development of share prices relative to par values over the period provides an excellent overview of the perceived value of the VOC s growth options. The high value represents both the value of retained earnings and the value of future growth opportunities of the company (Myers, 1977). The price in March 1613 is 262. As a comparison two years earlier (March 1611) the price was 200 and in March 1609 the recorded price equaled only 124 (See Figure 4). [please insert Figure 4 here] Then in 1613 a fleet was about to sail for Asia. In this year the VOC was under pressure from shareholders to pay dividends and had limited access to new debt or equity financing. Moreover, its liquidity position was weak, because all previous fleets were mainly financed from the initial equity issue and retained earnings. Despite this fragile financial position in terms of cash and access to external finance the VOC had proven to be successful in their voyages and already build-up a valuable trading network. Therefore, the success of the 1613 fleet was crucial for the company to ensure the continuity of its activities. 4. The 1613 contract On March 1 of 1613 the VOC initiated a contract with a large number of counter-parties in order to guarantee the revenues from the fleet, which was ready to sail in the Spring of The contract has been described in detail by Van Dam (1927, p ), Stapel and Den Dooren de Jong (1928) and Van Dillen (1958, p.73-97). The contract specifies that the subscribers are insuring the VOC against revenues below ƒ 3.2 million: Ende dit alleenlijck voor geen ander peryckel, dan datter van Oostindiën in dese landen van Hollant of Zeelant voor de voorschr. Compagnie zullen comen, ende int packhuys of packhuysen aen retouren zullen opgeslagen worden de wardye van tweeendertich tonnen gouts. and Stellende ons in alsulcken gevalle in U 14

15 plaetse om U te guaranderen van alle verlies ende schade. Ende het retour van twee en dertif tonnen gouts (dat Godt verhoeden wil) niet overghecomen wesende tusschen dit en ultimo Augusto 1616 verbinden wij ons bij dezen te betalen aen de Bewinthebberen van de Generale Oostindische Compagnie de voorgeschreven twee en dertig tonnen gouts ofte soo veel daer sal ontbreken.. The insurers would pay the difference between the revenues and this amount insured and received a premium of 5% in May The ships and equipment were not part of the contract. The contract expired by Augustus 1616 and payments were due in February 1617 (50%) and August 1617 (50%). The value of the revenues is based on fixed prices for pepper, nuts, cloves and macis/foelie and market prices for other goods. 11 According to Van Niekerk (1998, p.83) the contract was unusual in that a specific value for the return cargo was written. Shareholders of the VOC had a preferential right to participate in the contract According to Van Dillen (1958, p.74), until March 20 the subscription was exclusively open to participants and the goal was to have all participants subscribe up to 50% of the nominal value of the shareholdings. Only for the Amsterdam chamber the register is available: the total inlay is ƒ 1,825,576, which amount to about 50% of the equity participation of ƒ 3.7 million in The register shows that some entries are literally for half of the share value (Van Dillen, 1958, p.76). Although initially 50% of the share value is also the maximum subscription allowed, as of April 1, participants are allowed to subscribe up to the total nominal share value. Van Dillen (1959, p.78) describes that the subscription was problematic (source: resolutieboek of the chamber of Amsterdam). Until May 4 only shareholders subscribed. In the Amsterdam chamber, 252 entries were made (compared to 830 shareholders in 1612), including bewindhebbers (Van Dillen, 1958 p describes the Amsterdam subscribers, which was according to Stapel and Den Dooren de Jong, 1928, p.84 not public information). A significant number of participants had never claimed the dividends, which serves as a collateral for potential payouts. Obviously, this also holds for the 11 An open question is why some goods were included against fixed prices and others were not. To do: check volatility of prices. 15

16 shareholdings. Van Dam (1927, p.207) mentions that the VOC preferred subscribers, which had refused the dividend. 12 Now, the insurance contract will be interpreted from the perspective of the contemporary finance literature on insurance and risk management. Two characteristics of the VOC are relevant. First, the very limited use of debt financing leads to a minor role for bankruptcy costs and bondholder-driven agency costs as motives for risk management. Secondly, convex tax curves are also not relevant in the VOC setting. This leaves us with two potential motives for the insurance contract: investment options and managerial risk aversion. These motives will be discussed in detail. The relevance of the theory of Froot, Scharfstein and Stein (1993) seems plausible from the perspective of the VOC. In case of a return of the 1613 fleet of at least ƒ 3.2 million, the revenues will be sufficient to equip a new fleet. In case of lower revenues, the VOC will use the guarantee. This way, the VOC will be able to benefit from the trading network in place. In this respect, it is interesting to consider a situation without an insurance contract and insufficient returns to equip a new fleet. In this setting the VOC bewindhebbers would have to raise external financing. Although the stock prices around 1613 are relatively high, it can be expected that without sufficient returns the stock price will drop and current or new shareholders will be willing to participate in new equity only against high costs. Moreover, the debt overhang (Myers, 1977) will make shareholders hesitant to contribute to future growth. Finally, debt financing will only be possible against high interest rates. Thus, it can be expected that the VOC would have been severely financially constrained. From the perspective of a participant in 1613, it is important to distinguish between (1) shareholders who had not claimed their dividends, (2) shareholders who had claimed all dividends, and (3) other participants. The first group of participants receives the 5% premium in May 1614 (note that this is only 1.25% of the market value in case of a price of 200 and 50% participation). In case the 1613 fleet would return with sufficient cargo, the contract would have no consequences. In case of insufficient returns, 12 As a protection against counter-party risk the VOC decided against allowing participants which received the dividend ( niet soude laten teyckenen, tensy die men voor sufficant quam te houden. ). 16

17 the participant will contribute cash for the equipment of future voyages. In case of personal distress, the guarantee will first be netted with the dividends and the shares serve as collateral for any remainder. In case a shareholder had already claimed all dividends, the netting is not possible, but the shares still serve as collateral. For participants in the contract without shareholdings, the VOC had no collateral. The insurance contract has several features, which are in line with the Froot, Scharfstein and Stein (1993) theory. In particular, the presence of growth opportunities in the VOC is an important element. The presence of fleets, equipment and trading posts together with a demand for spices and other goods from Asia is well-documented in the literature (see, e.g. Gaastra, 2007). Moreover, judging from the share price, the expectations of the shareholders in 1613 were very positive about the firm s future growth potential. At the same time, the VOC was financially constrained in terms of cash availability. This conclusion can be drawn based on the cash and debt overviews in Section 3 as well as the late payment of the 5% insurance premium (May 1614). Moreover, the VOC was financially constrained with respect to its ability to raise external financing in case the 1613 would not return with sufficient goods. Given the enormous information asymmetries between insider bewindhebbers and prospective shareholders or bondholders, it seems highly unlikely that debt or equity can be raised on attractive conditions. The idea to construct ex ante an option-like contract on the returns of the 1613 fleet allowed the bewindhebbers to protect the company against the probability of cash shortage and thus to secure future growth. The role of shareholders in the insurance contract is interesting, because Stapel and Den Dooren de Jong (1928, p.84) are very critical about the bewindhebbers and claim that the shareholders were trapped in a syndicate to guarantee their own dividends. In our view, this idea is incorrect for three reasons. First, there is no strong rationale for the VOC to aim to guarantee dividends through this contract. In case the fleet would return with insufficient cargo, the shareholders may receive a self-paid dividend, but prices would collapse because of the loss of faith in the company. Second, the shareholders benefit from the value creation via the insurance contract, which safeguards 17

18 the continuation of the company. Third, it seems implausible that the participants of the insurance contract would be lured into an unattractive contract on such a large scale. At best, one can be surprised that many shareholders decided to further increase their exposure to the returns of one company. Although the insurance contract closely resembles the Froot, Scharfstein and Stein (1993) thesis, it is also possible to find elements that may refute the applicability of this model. First, the 5% insurance premium to be paid in May 1614 is a payment of 160,000 guilders, which has a negative effect on the cash balance. Apparently, the market conditions required this upfront payment, because a later payment would have been more attractive for the VOC. Second, the contract specified the return value mainly against fixed prices for the spices. This implies that in case market prices are below the contract prices the VOC will realize lower revenues. Again, most likely market conditions did not allow the VOC to sell both the quantity and price risks to the participants. The most likely alternative explanation for the insurance contract is managerial risk aversion. The bewindhebbers of the VOC held significant stakes in the company s shares. For these merchants it would have been very attractive to reduce the riskiness of their poorly diversified portfolios through insurance. However, this consideration does not seem very relevant in the 1613 contract, because Van Dillen (1958, p.76) describes for the Amsterdam chamber the bewindhebbers were among the largest subscribers to the contract. Four managers signed for over 70,000 guilders (Jacques de Velaer, 91,000; Leonart Ranst, 75,000; Jan Jansz. Kaerel, 73,100; and Albert Symonsz. Joncheyn, 70,000). 5. EIC In the 17 th and 18 th century the VOC and the English East India Company (EIC) were the largest corporations in the world. In this section we compare developments with the EIC with our analysis of the VOC. Stapel and Den Dooren de Jong (1928, p and appendices) describe a set of insurance contracts of the EIC used after 1629 with close 18

19 resemblances of the 1613 contract. 13 Although the EIC was raised in 1600, Stapel en Dooren de Jong claim that the first insurance contracts are written date from 1629 and that these contracts are plain maritime insurance contracts, although they also find four contracts resembling the VOC 1613 contract. On October, the EIC court minutes mention Motion of Mr. Prior, of the Assurance Office, to be recompensed for the policy he made for the Company upon assuring of the L. taken up at interest and sent out on the second Persia voyage; the Court remembered he had refused 10L. and intreated Alderman Garway to speak with him at the Exchange and give him fitting satisfaction. 14 Een verzekering is dus opgesteld voor de genoemde reis. Ook in de tweede vermelding wordt gerefereerd aan het opstellen van verzekeringen door mr. Prior. Sainsbury argues that were years in which the EIC faced distress, among other due to a significant debt position. In 1636 the Committees hit upon a curious expediënt to steady matters. 15 And decided to write a policy of assurance : guaranteeing (for a percentage) that L. (over and above charges) would be returned from the Indies within two years 16 This policy was offered for public subscription. On November 11, 1636 the minutes of the Court of Committees mention:; Consideration had of the present low state of the Company s cash consequent on their recent great loss, and that many to whom money is due on interest are beginning to call it in; whereupon a proposition is made to assure L., which, with the estate at home, will be sufficient to pay all debts, and prevent any question as to the security of the Company. After mature deliberation, the Court resolves to assure L., and directs that a policy be drawn up to assure that the said sum be returned in two years in ships (over and above charges) from the Indies. A draft of this policy is to be presented to the Court before it is engrossed, with the names of those who intend to underwrite, that they may be approved before being allowed to subscribe the said policy; none to assure for more than 1.000L. 17 On 13 Additional sources are W.N. Sainsbury, Calendar of State Papers, colonial series, East Indies, China, Japan and Persia (London 1892), reprinted by: Kraus (Vaduz ) volume 2, 3, 4, 6, 8. And E.B. Sainsbury, A Calendar of the Court Minutes etc. of the East India Company (Oxford ) 11 volumes. 14 W.N. Sainsbury, Calendar of State Papers, VIII, E.B. Sainsbury, A Calendar of the Court Minutes etc. of the East India Company (Oxford ), xx. 16 Ibidem xx. 17 E.B. Sainsbury, A Calendar of the Court Minutes, ,

20 February 1, 1637, Court of Committees; Mr. Governor desiring to know whether or not to inform the General Court this afternoon of the Company s great debt, he is answered that, the same having been already made public, the generality better be told, as also the Court of Committees have taken care to secure by a policy of assurance all that they are indebted over and above what they have in the land ; and of the necessity of dispeeding the Jonas this year, with rials of eight to lessen her charge. 18 In the period similar contracts are written. Due to the costs of four more ships, the debts of the EIC rise to L., which induces another contract. February 7, 1640, General Court; The generality desiring to know how the Company s affairs stand, the Auditor and the Accountant report that there will be L. remaining after the payment of all debts, but on the four ships being supplied and the dividend issued, the Company will be indebted L.; and for this sum Mr. Deputy declares a policy of assurance is to be made, as was done on a former occasion; also that three ships are expected home from Bantam and one from Surat, with sufficient stock to enable the Company to pay off all its debts. Thereupon the generality agrees by erection of hands to be abovementioned proposals. 19 And in March a similar contract is written: March 30, 1640, Court of Committees; A new policy is ordered to be made for assurance of L., after the manner and time of the former policy, and to be underwritten in the same way. 20 In September 1640 and July 1641 new propals are put forward. September 2, 1640, Court of Committees; the remainder of the debt will be paid from money due to the Company for goods, and by its estate abroad; and if there is any doubt, then a policy be drawn for L. upon the estate abroad at two per cent. 21 September 9, 1640, Court of Committees; Mr. Sambrooke reads an account of the present state of affairs, by which it appears that there is L. at home, over and above the payment of the Company s debt, towards the said division and dispatch of ships this year to the Coast, and to the northwards and southwards, while the division would amount to above L. Hereupon some propose an assurance of L.; but the Lord Mayor replies that an assurance is but a shadowe ; that in case of casualty or no casualty, the money to pay 18 Ibidem E.B. Sainsbury, A Calendar of the Court Minutes, , E.B. Sainsbury, A Calendar of the Court Minutes, , Ibidem

21 the Company s debt will not be obtained in three years, and that if the ten per cent were paid in it would only come to L. and it is very doubtful whether half even would come in; so that if the division proceeds and the goods are divided, it will be at one blowe breake the neck of the trade by overthrowing the credit of the Company. After further argument, the Governor also thinking that to divide might bring dangerous consequences, it is put to the question and agreed that it will not be safe to divide at present. 22 July 7, Court of Committees; this division should bring the Company into a debt of L. or L., then a policy of assurance may be made for the amount, there being seven or eight ships abroad and the return of one would redeem the said debt. 23 After 1644 no similar contracts are found. From the previous we can conclude that the EIC has used contracts between 1636 and 1644, which are similar to the VOC 1613 contract. Stapel and Dooren de Jong (p. 87) also claim that it is plausible that the EIC was informed about the VOC contract. However, the purpose of the EIC contracts was completely different. The EIC shareholders faced unlimited liability. Therefore, the debt burdens were threatening the wealth of the shareholders. In this perspective, the EIC insurance contracts were purely defensive measures, while the VOC contract was meant to secure future growth options Conclusion The fleet of 1613 returned safely and with sufficient cargo. The insurance contract therefore expired without any further financial consequences. As late as June 1619 a dividend (of 37.5%) was declared and paid in March This late dividend is a further indication that dividends were not a likely motive for the contract. The VOC regularly paid dividends as of 1620 and was liquidated in In our view the 1613 contract is interesting for at least three reasons. First, the contract presents an exceptionally early case of risk management in which the conditions 22 E.B. Sainsbury, A Calendar of the Court Minutes, , Ibidem A conjecture arising from the comparison between the EIC and VOC structures is that the incentives for risk taking were importantly different. The low leverage and limited liability in the VOC leads to more appetite for risk, when compared with the unlimited liability for shareholders and higher debts in the EIC (although counter arguments are also possible; see Jensen and Meckling s (1976) asset substitution/risk shifting). 21