Investors face expropriation all over the world; they have fear that they might not get returns on their investment

Corporate Governance: Theory & Research (C31CG)How important is the level of investor protection for financial market development and development of real economy? Madiha Ashraf

Registration number: H00203491

Username: ma24

Lecturer: Dr Faizul Haque

Date: 16th Oct 2014

Table of Contents

1.Introduction1

2.Investor Expropriation1

3.Laws and Regulations1

4.Effects of Investor Protection1

5.Conclusion2

6.References3

Investors face expropriation all over the world; they have fear that they might not get returns on their investment. Insiders may divert the profits for their private benefits, invest in risky projects, do transfer pricing, expand the firm beyond necessary and stay on the job even if they are no more required. Creditors also have fear that company might not be able to repay them, even they need protection again companys default. Why investors should get returns is explained by many researchers. Firms are a collection of investment projects and cash flow it creates are claims by the investors (Modigliani and Miller 1958). Investors have power to vote and change directors, sue them for expropriation and even liquidate the firm, this power makes them get cash (Hart 1995). In this essay I will first discuss the ways of investor protection; I will then move on to describe how these ways differ among countries and firms. I will end up discussing the effects of these laws and protection on the valuation of the firms and the growth of economy. Nobody is fool here to invest his money unless he is sure of the returns or at least knows that he has some legal protection. When investors are protected then only they buy securities. If their protection is weak they would demand higher returns for the risk they bear; increasing cost of equity and cost of external funds. Lets talk about how investors are protected. They are protected by the enforcement of regulations and laws. But that also depends as in some countries courts are not willing to intervene in expropriation issues, they are corrupt or have political influences. Therefore the effectiveness of judicial enforcement matters more than what have been described in the books of law. Firms itself can provide protection by increasing disclosure, appointing independent boards, monitor shareholders and managers to limit the expropriation of minority shareholders. These laws vary from country to country thats why every country have different protection for investors .The legal system of majority of the countries falls between three of the systems; the English (common law), the French and the German. (David and Bierley 1985). The common law provides the strongest protection while French law is the weakest. In common law countries judges can apply fairness opinions unlike civil law that is only based on statutes. In civil law countries courts do even intervene in the expropriation transactions and state have greater control to regulate business activities. Civil law countries turn out to be not much protective of investors. Therefore in countries with weak protection control is concentrated and pyramidal structure is also common. In my opinion control in these countries should be spread among numerous large shareholders; so that together they may exert great pressure to limit expropriation. Investor protection encourages the development of financial markets. A lot of research has been done on this. Stocks are more valuable in countries that are protecting shareholders; they have high Tobins Q ratio and higher number of listed firms (La Potra et al 1997). Claessens et al (1999) discusses the effect of greater insider control; using a sample of East Asian firms he proved that if firms have great insider control on voting rights their assets have lower valuation. Johnson et al (2000) defined a relation between investor protection and financial crises. It tells that countries with poor investor protection treat outsiders well as long as the market is growing because at that time they need a lot of external financing. This was proved by taking sample of 25 Asian countries during the crises of 97-98; the result was that the currency depreciated and stock markets declined. So it can be noted that corporate governance patterns itself affect the value of the company.All the evidences prove that the basis of healthy financial markets are laws, regulations and courts; the extent to which they protect shareholders and creditors. Where the laws are protective of investors they are willing to finance firms. They are willing to pay more as they know more profits would come to them as dividends. This increased confidence of investors result in increased equity demand; increasing the valuation of companies. It increases the profitability and makes it easier to access capital. More equity purchases means more capital availability to firms expanding the financial markets. Entrepreneurs would now have more resources to put them into productive use boosting the real economy. Not every country have developed stock markets because of the laws there. The reform can be brought by making civil law countries shift to common law practices. But this can bring opposition from family dominated firms because it would limit their expropriation which are in domination since ages. We can conclude that legal rules governing corporate law have a great impact on stock market development and the economic growth of the country. ReferencesJensen, M., Meckling, W., 1976. Theory of the firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics.Modigliani, F., Miller, M., 1958. The cost of capital, corporation finance, and the theory of investment. American Economic Review.La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny (1999) Investor Protection and Corporate Governance, Journal of Financial Economics.Claessens, S., Djankov, S., Lang, L., 2000. The separation of ownership and control in East Asian corporations. Journal of Financial Economics.

Johnson, S., Boone, P., Breach, A., Friedman, E., 2000a. Corporate governance in the Asian financial crisis, Journal of Financial Economics.