11

Critique of Law and Finance TheoryCritique of Law and Finance Theory

LLSV claim: LLSV claim: legal originlegal origin has predetermined the has predetermined the development of institutions of property rights (investor development of institutions of property rights (investor protection, in particular)protection, in particular)

Common law (Anglo-Saxon countries) protects minority Common law (Anglo-Saxon countries) protects minority shareholders better than civil law (especially French)shareholders better than civil law (especially French)

What is there in legal origin that makes civil law systems What is there in legal origin that makes civil law systems worse? Still unclearworse? Still unclearDegree of investor protection has varied substantially Degree of investor protection has varied substantially over time (Anglo-Saxon countries have not always been over time (Anglo-Saxon countries have not always been “better” than civil law countries)“better” than civil law countries)Historical puzzles (e.g. US, UK, France in early 20Historical puzzles (e.g. US, UK, France in early 20thth century)century)

22

Stock market cap over GDP (Rajan and Zingales (2003))Stock market cap over GDP (Rajan and Zingales (2003))

33

Other theories of financial development Other theories of financial development (not necessarily contradictory to Law and (not necessarily contradictory to Law and Finance, they just don’t emphasize legal Finance, they just don’t emphasize legal origin)origin) Endowment (environment, encountered by Endowment (environment, encountered by

colonizers)colonizers) Ideology and culture (European social Ideology and culture (European social

democracies vs. Anglo-Saxon democracies)democracies vs. Anglo-Saxon democracies) Political economy (interest groups’ influence)Political economy (interest groups’ influence)

44

Political economy story of Rajan and Political economy story of Rajan and Zingales (2003)Zingales (2003)

Financial development is determined by political forces in favor of or Financial development is determined by political forces in favor of or against fin. developmentagainst fin. developmentOn aggregate, fin. development is beneficial. However people who On aggregate, fin. development is beneficial. However people who benefit from it are disorganized and lack resources. On the contrary, benefit from it are disorganized and lack resources. On the contrary, groups who don’t want fin. development are few, organized and groups who don’t want fin. development are few, organized and command large resources (incumbents)command large resources (incumbents)Incumbents do not benefit much from financial markets, at the same Incumbents do not benefit much from financial markets, at the same time they don’t like competition time they don’t like competition → oppose fin. development→ oppose fin. developmentWhat can reduce the power/incentives of incumbents?What can reduce the power/incentives of incumbents?

Rajan and Zingales: “openness to both trade and capital flows”Rajan and Zingales: “openness to both trade and capital flows” Decision to open is itself subject to political influence, but there exist Decision to open is itself subject to political influence, but there exist

exogenous factors too.exogenous factors too.Rajan and Zingales: The history of financial development over the Rajan and Zingales: The history of financial development over the 2020thth century can be largely explained by the incumbents’ interest century can be largely explained by the incumbents’ interest group influence on the one hand, and the events that triggered group influence on the one hand, and the events that triggered opening borders on the other hand opening borders on the other hand

55

Political connectionsPolitical connections

Potential benefits for minority shareholders:Potential benefits for minority shareholders: Preferential treatment of a company, subsidies, Preferential treatment of a company, subsidies,

bailouts in case of problems, entry barriers for bailouts in case of problems, entry barriers for competitorscompetitors

Potential costs for minority shareholders:Potential costs for minority shareholders: More discretion for controlling shareholdersMore discretion for controlling shareholders Resources devoted to establishing and keeping Resources devoted to establishing and keeping

connections at the expense of the companyconnections at the expense of the company Politically connected firms may pursue goals different Politically connected firms may pursue goals different

from profit maximization (political, social goals) from profit maximization (political, social goals)

66

Idea:Idea: look at stock returns following rumors about look at stock returns following rumors about

Suharto’s healthSuharto’s health see if these returns are lower for Suharto-see if these returns are lower for Suharto-

connected firms and by how muchconnected firms and by how much

Data:Data: 79 firms79 firms 6 (negative) events from Jan 1995 to April 6 (negative) events from Jan 1995 to April

19971997

Fisman (AER 2001) “Estimating the Fisman (AER 2001) “Estimating the value of political connections” value of political connections”

77

Suharto group Suharto group

Suharto. President of Indonesia from 1967 to 1998.

Embezzled $15-35 billion (Transparency International estimate)

88

ResultsResults

99

Results (cont-d)Results (cont-d)

POL – Suharto Dependency IndexPOL – Suharto Dependency IndexNR(JCI) – Return on Jakarta Stock Exchange Index net of broader NR(JCI) – Return on Jakarta Stock Exchange Index net of broader Southeast Asian effectsSoutheast Asian effectsImaginary event “death of Suharto” Imaginary event “death of Suharto” → 20% drop in the index → → 20% drop in the index → returns for firms with POL=4 would be 23% lower than for those with returns for firms with POL=4 would be 23% lower than for those with POL=0POL=0

1010

Faccio (AER 2006). Politically Faccio (AER 2006). Politically connected firmsconnected firms

Looks at 20,202 publicly traded companies Looks at 20,202 publicly traded companies in 47 countriesin 47 countries

Questions:Questions: In which environments politically connected In which environments politically connected

firms are more common?firms are more common? Do political connections matter for firm value? Do political connections matter for firm value?

1111

Results:Results: Political connections are more common in Political connections are more common in

countries with high corruption and barriers to countries with high corruption and barriers to foreign investment by residentsforeign investment by residents

When an officer or large shareholder enters When an officer or large shareholder enters politics – positive abnormal return of politics – positive abnormal return of ~~2%.2%.

However, no significant reaction when the However, no significant reaction when the opposite happensopposite happens

1212

So, are political connections So, are political connections beneficial for shareholders?beneficial for shareholders?

From Faccio (2006) it seems that rather From Faccio (2006) it seems that rather yesyes

However, Faccio (2002) finds that ROE of However, Faccio (2002) finds that ROE of politically connected firms is lower by politically connected firms is lower by 4.36%, MTB is lower by 0.13%, stock price 4.36%, MTB is lower by 0.13%, stock price return is lower by 2.63%return is lower by 2.63%

Caveat: Sample problemsCaveat: Sample problems

1313

Other studies:Other studies: Faccio, Masulis, and McConnell (2006): politically connected Faccio, Masulis, and McConnell (2006): politically connected

firms are more likely to be bailed out by governmentfirms are more likely to be bailed out by government Faccio and Parley (2007): negative effect on value, sales growth Faccio and Parley (2007): negative effect on value, sales growth

and access to credit to firms headquartered in the politician's and access to credit to firms headquartered in the politician's home town following his sudden deathhome town following his sudden death

Ferguson and Voth (2008): Hitler-connected German firms Ferguson and Voth (2008): Hitler-connected German firms outperformed the market following Hitler’s accession to poweroutperformed the market following Hitler’s accession to power

Dombrovsky (2008): Latvian firms that provided contribution to Dombrovsky (2008): Latvian firms that provided contribution to winning (losing) parties experienced better (worse) operating winning (losing) parties experienced better (worse) operating performance after the election.performance after the election.

So, political connections seem beneficial, especially in a So, political connections seem beneficial, especially in a country with weak institutionscountry with weak institutionsApart from political connections, are there other ways Apart from political connections, are there other ways companies can raise value and attract external funds? companies can raise value and attract external funds? The answer is “yes” but there are limitations (see further)The answer is “yes” but there are limitations (see further)

1414

Corporate Governance in Weak Corporate Governance in Weak Legal EnvironmentLegal Environment

Can firms compensate for weak legal Can firms compensate for weak legal shareholder protection with good firm-level shareholder protection with good firm-level corporate governance?corporate governance?

Does good CG raise value?Does good CG raise value?

Which firms choose to practice good CG?Which firms choose to practice good CG?

How do their incentives to practice good How do their incentives to practice good CG depend on the institutional CG depend on the institutional environment?environment?

1515

What is “good” corporate What is “good” corporate governance?governance?

OECD principlesOECD principlesCodes of corporate conductCodes of corporate conductWhich criteriaWhich criteria Shareholder rights (voting for transactions (especially Shareholder rights (voting for transactions (especially

with related parties), election of directors (cumulative with related parties), election of directors (cumulative voting), right to call a meeting, preemptive rights, right voting), right to call a meeting, preemptive rights, right to sue a director, etc…)to sue a director, etc…)

Board structure (independent directors, minority Board structure (independent directors, minority shareholder representatives, committees)shareholder representatives, committees)

Disclosure and Transparency (Independent auditor, Disclosure and Transparency (Independent auditor, disclosure of actual ownership, disclosure of related-disclosure of actual ownership, disclosure of related-party transactions, disclosure of financial on operating party transactions, disclosure of financial on operating results, etc…)results, etc…)

……

1616

Can firms compensate for weak legal Can firms compensate for weak legal shareholder protection with good firm-level shareholder protection with good firm-level

governance?governance?

Yes they can.Yes they can.

But only partiallyBut only partially

Countries (legal institutions) matter for corporate Countries (legal institutions) matter for corporate governancegovernance

Corporate governance (as well as ownership Corporate governance (as well as ownership concentration) has greater effects on insider concentration) has greater effects on insider expropriation, investment, firm value in weak expropriation, investment, firm value in weak legal environmentlegal environment

1717

Durnev and Kim (2005)Durnev and Kim (2005)(see also Klapper and Love (2002))(see also Klapper and Love (2002))

Sample of 494 firms in 24 countriesSample of 494 firms in 24 countriesTake certain measures of firm-level CG (firm-level Take certain measures of firm-level CG (firm-level shareholder protection)shareholder protection)

Credit Lyonnais Securities Asia (CLSA) scores in 5 categories Credit Lyonnais Securities Asia (CLSA) scores in 5 categories (managerial discipline, transparency, board independence, (managerial discipline, transparency, board independence, board accountability, managerial responsibility, minority board accountability, managerial responsibility, minority shareholder protection, social responsibility)shareholder protection, social responsibility)

S&P Transparency (for robustness)S&P Transparency (for robustness)

Run:Run: CG = f(investment opportunities, need for external finance, CG = f(investment opportunities, need for external finance,

ownership concentration, legal environment, controls)ownership concentration, legal environment, controls) Valuation = g(CG, legal environment, controls)Valuation = g(CG, legal environment, controls)

1818

ResultsResults

Firms with better investment opportunities, Firms with better investment opportunities, greater need for external finance, higher greater need for external finance, higher concentration of ownership practice better concentration of ownership practice better governancegovernanceFirms that practice better governance are valued Firms that practice better governance are valued higherhigherIn weak legal environments these relationships In weak legal environments these relationships are stronger (and greater variation in CG are stronger (and greater variation in CG practices)practices)Firms in countries with better legal environment Firms in countries with better legal environment practice on average better governancepractice on average better governance

1919

The positive effect of ownership on corporate The positive effect of ownership on corporate governance and valuation and of corporate governance governance and valuation and of corporate governance on valuation in developing/transition economies are on valuation in developing/transition economies are confirmed by other studies:confirmed by other studies:

Black, Jang and Kim (2005, 2006) on KoreaBlack, Jang and Kim (2005, 2006) on Korea Black, Love and Rachinsky (2005) on RussiaBlack, Love and Rachinsky (2005) on Russia Guriev et al (2004) on RussiaGuriev et al (2004) on Russia

That firm level variables (ownership, governance) matter That firm level variables (ownership, governance) matter less in countries with good legal environment is also less in countries with good legal environment is also confirmed by studies on US. Notably:confirmed by studies on US. Notably:

Demsetz and Lehn (1985): ownership has no effect on Demsetz and Lehn (1985): ownership has no effect on performanceperformance

Morck, Shleifer and Vishny (1988): non-monotonic relationship Morck, Shleifer and Vishny (1988): non-monotonic relationship between insider ownership and performancebetween insider ownership and performance

Many studies on board structure:Many studies on board structure:ambiguous link between board structure and performanceambiguous link between board structure and performancesome find some find negativenegative link between managerial ownership and board link between managerial ownership and board independenceindependence

Note:Note: Gompers, Ishii and Metrick find a positive effect of CG on Gompers, Ishii and Metrick find a positive effect of CG on equity pricesequity prices

2020

Russian Corporate GovernanceRussian Corporate Governance

Main mechanism – ownership concentration Main mechanism – ownership concentration (very costly, but inevitable)(very costly, but inevitable) Only large owners have incentives and ability to Only large owners have incentives and ability to

restructure and develop their businessesrestructure and develop their businesses

Corporate governance has been improving for Corporate governance has been improving for the last several years:the last several years: Need to attract external funds (after wars for Need to attract external funds (after wars for

ownership are over, the only way to build value is to ownership are over, the only way to build value is to invest)invest)

Desire to sell part of the business at good price (or to Desire to sell part of the business at good price (or to exit completely), e.g. via IPO or sale to a strategic exit completely), e.g. via IPO or sale to a strategic western investorwestern investor

2121

• Note that CG is improving only in the largest companies.• Smaller non-listed firms with no IPO plans do not care that much about CG• Obstacles to improving CG:

- Weak enforcement - Predatory state and other private parties (reason for staying non-transparent)

2222

Ex. of index: Brunswick-Warburg indexEx. of index: Brunswick-Warburg index

2323

Black, Love and Rachinsky (2005) find:Black, Love and Rachinsky (2005) find: Good corporate governance increases valuationGood corporate governance increases valuation Not everything matters in corporate governance. E.g. Not everything matters in corporate governance. E.g.

RID index has no predictive power and S&P CG RID index has no predictive power and S&P CG scores have little predictive power, while Brunswick scores have little predictive power, while Brunswick Warburg, Troika Dialog and ICGL measures are Warburg, Troika Dialog and ICGL measures are strong predictors.strong predictors.

There must be some important differences in the CG There must be some important differences in the CG components that different indices focus oncomponents that different indices focus on

BLR find a subset of components that matter:BLR find a subset of components that matter:Asset transfers/transfer pricing risk (recent track record of Asset transfers/transfer pricing risk (recent track record of controlling shareholder behavior + clearness of trading controlling shareholder behavior + clearness of trading environment, use of offshore companies)environment, use of offshore companies)Disclosure, especially financial (accountings standards, Disclosure, especially financial (accountings standards, independence of auditor, disclosure record, ADR,…)independence of auditor, disclosure record, ADR,…)

2424

Why is legal environment so Why is legal environment so important?important?

Enforcement is the key thing! Not laws on the booksEnforcement is the key thing! Not laws on the books If enforcement is strong, parties can themselves learn how to If enforcement is strong, parties can themselves learn how to

write efficient contracts; they can be sure that courts will enforce write efficient contracts; they can be sure that courts will enforce themthem

Example: Kaplan, Martel and Strömberg (2004) show that the most Example: Kaplan, Martel and Strömberg (2004) show that the most successful venture capitalists are the ones that use US-type successful venture capitalists are the ones that use US-type contracts, no matter in which country they are, and that for them contracts, no matter in which country they are, and that for them legal regime does not matter (KMS look almost only at countries legal regime does not matter (KMS look almost only at countries with good enforcement)with good enforcement)

If enforcement is bad: offshore incorporation, London arbitrage If enforcement is bad: offshore incorporation, London arbitrage court, cross-listing (though there is evidence that it might not court, cross-listing (though there is evidence that it might not matter so much),…matter so much),…

Government predationGovernment predation

2525

Predatory government and Predatory government and corporate governancecorporate governance

Durnev and Fauver (2007), “Stealing from Durnev and Fauver (2007), “Stealing from Thieves”Thieves” If government can steal part of your firm’s profits, you If government can steal part of your firm’s profits, you

are less interested in profit maximization and more are less interested in profit maximization and more interested in stealing from minority shareholders interested in stealing from minority shareholders lower incentive to practice good CGlower incentive to practice good CG

Data: few hundreds of firms from 85 countriesData: few hundreds of firms from 85 countries Results:Results:

firms located in more predatory regimes practice weaker CG firms located in more predatory regimes practice weaker CG and disclose lessand disclose lessPositive relationship between CG and performance is weaker Positive relationship between CG and performance is weaker in predatory regimesin predatory regimes

2626

Durnev and Guriev (2007). “The Resouce Curse: Durnev and Guriev (2007). “The Resouce Curse: A Corporate Transparency Channel”A Corporate Transparency Channel” In predatory states, firms in the natural resource In predatory states, firms in the natural resource

sector are more vulnerable to expropriationsector are more vulnerable to expropriation Especially in the periods of high commodity pricesEspecially in the periods of high commodity prices Hence, in predatory states, they have incentive to Hence, in predatory states, they have incentive to

hide their profits or value, especially in periods of high hide their profits or value, especially in periods of high pricesprices

This creates obstacles to raising external finance This creates obstacles to raising external finance underinvestment underinvestment slower growth slower growth

Data: 72 industries from 51 countries over 16 yearsData: 72 industries from 51 countries over 16 years

2727

Opacity of the oil and gas sector and government Opacity of the oil and gas sector and government predation (Durnev and Guriev (2007))predation (Durnev and Guriev (2007))

2828

Industry oil dependency and risk of Industry oil dependency and risk of nationalization (Kolotilin (2007))nationalization (Kolotilin (2007))

2929

Results of Durnev and Guriev (2007):Results of Durnev and Guriev (2007):More expropriation-susceptible industries are less More expropriation-susceptible industries are less transparent when government is more predatorytransparent when government is more predatoryThis effect is larger when oil prices are high or in This effect is larger when oil prices are high or in countries abundant with oil reservescountries abundant with oil reservesOpacity increases when government is more Opacity increases when government is more autocratic or leftistautocratic or leftistCapital allocation is less efficient in oil-sensitive Capital allocation is less efficient in oil-sensitive industries in countries with predatory or autocratic industries in countries with predatory or autocratic gov-s, and such industries there grow slower.gov-s, and such industries there grow slower.

E.g. in Venezuela the oil and gas extraction industry E.g. in Venezuela the oil and gas extraction industry would grow slower than agriculture by 1.3%; in Norway would grow slower than agriculture by 1.3%; in Norway there would be no differencethere would be no difference

3030

Caprio, Faccio, and McConnell (2008). Caprio, Faccio, and McConnell (2008). “Sheltering Corporate Assets from Political “Sheltering Corporate Assets from Political Extraction”Extraction” Threat of government expropriation Threat of government expropriation → incentive to → incentive to

invest in assets which are less attractive for invest in assets which are less attractive for expropriation (or not to invest at all)expropriation (or not to invest at all)

Hence, don’t hold cash, invest in “hard” assets, pay Hence, don’t hold cash, invest in “hard” assets, pay dividendsdividends

Data: 29,000 firms from 109 countriesData: 29,000 firms from 109 countries Results. Firms in countries with higher risk of Results. Firms in countries with higher risk of

government expropriation have:government expropriation have:lower Cash/TAlower Cash/TA

higher (Net Capex + ∆Inventory + Dividends)/Saleshigher (Net Capex + ∆Inventory + Dividends)/Sales

3131

Corporate Governance. ConclusionCorporate Governance. Conclusion

There are conflicts of interest between managers and There are conflicts of interest between managers and shareholders and between controlling shareholders and shareholders and between controlling shareholders and small shareholderssmall shareholdersThese conflicts are costly as they raise the cost of These conflicts are costly as they raise the cost of external finance for firmsexternal finance for firmsOwnership and control concentration (both at the firm Ownership and control concentration (both at the firm and country level) arise in response to poor legal and country level) arise in response to poor legal institutions (they are both manifestation of and a way to institutions (they are both manifestation of and a way to compensate for bad institutions)compensate for bad institutions)Practicing good corporate governance creates valuePracticing good corporate governance creates valueEven in a bad institutional environment firms can raise Even in a bad institutional environment firms can raise their value and lower cost of capital by practicing good their value and lower cost of capital by practicing good CG, but incentives to do it and credibility of commitments CG, but incentives to do it and credibility of commitments are undermined by the environmentare undermined by the environment

3232

Summary of the courseSummary of the course

Raising external finance for doing NPV > 0 projects is Raising external finance for doing NPV > 0 projects is hampered by the agency and asymmetric info problemshampered by the agency and asymmetric info problemsCapital structure and (more generally) proper financial Capital structure and (more generally) proper financial contracts and mechanisms of corporate governance help contracts and mechanisms of corporate governance help alleviate the problemsalleviate the problemsThere is generally tradeoff between ex-post efficiency There is generally tradeoff between ex-post efficiency and ex-ante willingness to do investments by parties and ex-ante willingness to do investments by parties (monetary and non-monetary). The (second-best) (monetary and non-monetary). The (second-best) solution is proper allocation of (real) controlsolution is proper allocation of (real) controlThe optimal mechanisms to solve the agency problem The optimal mechanisms to solve the agency problem depend on the institutional environment (legal depend on the institutional environment (legal shareholder protection in particular)shareholder protection in particular)