Transcript What corporate governance is about?

Critique of Law and Finance Theory
LLSV claim: legal origin has predetermined the
development of institutions of property rights (investor
protection, in particular)
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Common law (Anglo-Saxon countries) protects minority
shareholders better than civil law (especially French)
What is there in legal origin that makes civil law systems
worse? Still unclear
Degree of investor protection has varied substantially
over time (Anglo-Saxon countries have not always been
“better” than civil law countries)
Historical puzzles (e.g. US, UK, France in early 20th
century)
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Stock market cap over GDP (Rajan and Zingales (2003))
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Other theories of financial development
(not necessarily contradictory to Law and
Finance, they just don’t emphasize legal
origin)
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Endowment (environment, encountered by
colonizers)
Ideology and culture (European social
democracies vs. Anglo-Saxon democracies)
Political economy (interest groups’ influence)
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Political economy story of Rajan and
Zingales (2003)
Financial development is determined by political forces in favor of or
against fin. development
On aggregate, fin. development is beneficial. However people who
benefit from it are disorganized and lack resources. On the contrary,
groups who don’t want fin. development are few, organized and
command large resources (incumbents)
Incumbents do not benefit much from financial markets, at the same
time they don’t like competition → oppose fin. development
What can reduce the power/incentives of incumbents?
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Rajan and Zingales: “openness to both trade and capital flows”
Decision to open is itself subject to political influence, but there exist
exogenous factors too.
Rajan and Zingales: The history of financial development over the
20th century can be largely explained by the incumbents’ interest
group influence on the one hand, and the events that triggered
opening borders on the other hand
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Political connections
Potential benefits for minority shareholders:
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Preferential treatment of a company, subsidies,
bailouts in case of problems, entry barriers for
competitors
Potential costs for minority shareholders:
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More discretion for controlling shareholders
Resources devoted to establishing and keeping
connections at the expense of the company
Politically connected firms may pursue goals different
from profit maximization (political, social goals)
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Fisman (AER 2001) “Estimating the
value of political connections”
Idea:
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look at stock returns following rumors about
Suharto’s health
see if these returns are lower for Suhartoconnected firms and by how much
Data:
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79 firms
6 (negative) events from Jan 1995 to April
1997
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Suharto group
Suharto.
President of
Indonesia from
1967 to 1998.
Embezzled $1535 billion
(Transparency
International
estimate)
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Results
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Results (cont-d)
POL – Suharto Dependency Index
NR(JCI) – Return on Jakarta Stock Exchange Index net of broader
Southeast Asian effects
Imaginary event “death of Suharto” → 20% drop in the index →
returns for firms with POL=4 would be 23% lower than for those with
POL=0
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Faccio (AER 2006). Politically
connected firms
Looks at 20,202 publicly traded companies
in 47 countries
Questions:
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In which environments politically connected
firms are more common?
Do political connections matter for firm value?
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Results:
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Political connections are more common in
countries with high corruption and barriers to
foreign investment by residents
When an officer or large shareholder enters
politics – positive abnormal return of ~2%.
However, no significant reaction when the
opposite happens
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So, are political connections
beneficial for shareholders?
From Faccio (2006) it seems that rather
yes
However, Faccio (2002) finds that ROE of
politically connected firms is lower by
4.36%, MTB is lower by 0.13%, stock price
return is lower by 2.63%
Caveat: Sample problems
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Other studies:
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Faccio, Masulis, and McConnell (2006): politically connected
firms are more likely to be bailed out by government
Faccio and Parley (2007): negative effect on value, sales growth
and access to credit to firms headquartered in the politician's
home town following his sudden death
Ferguson and Voth (2008): Hitler-connected German firms
outperformed the market following Hitler’s accession to power
Dombrovsky (2008): Latvian firms that provided contribution to
winning (losing) parties experienced better (worse) operating
performance after the election.
So, political connections seem beneficial, especially in a
country with weak institutions
Apart from political connections, are there other ways
companies can raise value and attract external funds?
The answer is “yes” but there are limitations (see further)
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Corporate Governance in Weak
Legal Environment
Can firms compensate for weak legal
shareholder protection with good firm-level
corporate governance?
Does good CG raise value?
Which firms choose to practice good CG?
How do their incentives to practice good
CG depend on the institutional
environment?
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What is “good” corporate
governance?
OECD principles
Codes of corporate conduct
Which criteria
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Shareholder rights (voting for transactions (especially
with related parties), election of directors (cumulative
voting), right to call a meeting, preemptive rights, right
to sue a director, etc…)
Board structure (independent directors, minority
shareholder representatives, committees)
Disclosure and Transparency (Independent auditor,
disclosure of actual ownership, disclosure of relatedparty transactions, disclosure of financial on operating
results, etc…)
…
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Can firms compensate for weak legal
shareholder protection with good firm-level
governance?
Yes they can.
But only partially
Countries (legal institutions) matter for corporate
governance
Corporate governance (as well as ownership
concentration) has greater effects on insider
expropriation, investment, firm value in weak
legal environment
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Durnev and Kim (2005)
(see also Klapper and Love (2002))
Sample of 494 firms in 24 countries
Take certain measures of firm-level CG (firm-level
shareholder protection)
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Credit Lyonnais Securities Asia (CLSA) scores in 5 categories
(managerial discipline, transparency, board independence, board
accountability, managerial responsibility, minority shareholder
protection, social responsibility)
S&P Transparency (for robustness)
Run:
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CG = f(investment opportunities, need for external finance,
ownership concentration, legal environment, controls)
Valuation = g(CG, legal environment, controls)
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Results
Firms with better investment opportunities,
greater need for external finance, higher
concentration of ownership practice better
governance
Firms that practice better governance are valued
higher
In weak legal environments these relationships
are stronger (and greater variation in CG
practices)
Firms in countries with better legal environment
practice on average better governance
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The positive effect of ownership on corporate
governance and valuation and of corporate governance
on valuation in developing/transition economies are
confirmed by other studies:
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Black, Jang and Kim (2005, 2006) on Korea
Black, Love and Rachinsky (2005) on Russia
Guriev et al (2004) on Russia
That firm level variables (ownership, governance) matter
less in countries with good legal environment is also
confirmed by studies on US. Notably:
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Demsetz and Lehn (1985): ownership has no effect on
performance
Morck, Shleifer and Vishny (1988): non-monotonic relationship
between insider ownership and performance
Many studies on board structure:
ambiguous link between board structure and performance
some find negative link between managerial ownership and board
independence
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Note: Gompers, Ishii and Metrick find a positive effect of CG on
equity prices
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Russian Corporate Governance
Main mechanism – ownership concentration
(very costly, but inevitable)
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Only large owners have incentives and ability to
restructure and develop their businesses
Corporate governance has been improving for
the last several years:
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Need to attract external funds (after wars for
ownership are over, the only way to build value is to
invest)
Desire to sell part of the business at good price (or to
exit completely), e.g. via IPO or sale to a strategic
western investor
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• 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 nontransparent)
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Ex. of index: Brunswick-Warburg index
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Black, Love and Rachinsky (2005) find:
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Good corporate governance increases valuation
Not everything matters in corporate governance. E.g.
RID index has no predictive power and S&P CG
scores have little predictive power, while Brunswick
Warburg, Troika Dialog and ICGL measures are
strong predictors.
There must be some important differences in the CG
components that different indices focus on
BLR find a subset of components that matter:
Asset transfers/transfer pricing risk (recent track record of
controlling shareholder behavior + clearness of trading
environment, use of offshore companies)
Disclosure, especially financial (accountings standards,
independence of auditor, disclosure record, ADR,…)
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Why is legal environment so
important?
Enforcement is the key thing! Not laws on the books
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If enforcement is strong, parties can themselves learn how to
write efficient contracts; they can be sure that courts will enforce
them
Example: Kaplan, Martel and Strömberg (2004) show that the most
successful venture capitalists are the ones that use US-type
contracts, no matter in which country they are, and that for them
legal regime does not matter (KMS look almost only at countries
with good enforcement)
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If enforcement is bad: offshore incorporation, London arbitrage
court, cross-listing (though there is evidence that it might not
matter so much),…
Government predation
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Predatory government and
corporate governance
Durnev and Fauver (2007), “Stealing from
Thieves”
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If government can steal part of your firm’s profits, you
are less interested in profit maximization and more
interested in stealing from minority shareholders 
lower incentive to practice good CG
Data: few hundreds of firms from 85 countries
Results:
firms located in more predatory regimes practice weaker CG
and disclose less
Positive relationship between CG and performance is weaker
in predatory regimes
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Durnev and Guriev (2007). “The Resouce
Curse: A Corporate Transparency Channel”
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In predatory states, firms in the natural resource
sector are more vulnerable to expropriation
Especially in the periods of high commodity prices
Hence, in predatory states, they have incentive to
hide their profits or value, especially in periods of high
prices
This creates obstacles to raising external finance 
underinvestment  slower growth
Data: 72 industries from 51 countries over 16 years
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Opacity of the oil and gas sector and government
predation (Durnev and Guriev (2007))
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Industry oil dependency and risk of
nationalization (Kolotilin (2007))
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Results of Durnev and Guriev (2007):
More expropriation-susceptible industries are less
transparent when government is more predatory
This effect is larger when oil prices are high or in
countries abundant with oil reserves
Opacity increases when government is more
autocratic or leftist
Capital allocation is less efficient in oil-sensitive
industries in countries with predatory or autocratic
gov-s, and such industries there grow slower.
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E.g. in Venezuela the oil and gas extraction industry
would grow slower than agriculture by 1.3%; in Norway
there would be no difference
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Caprio, Faccio, and McConnell (2008).
“Sheltering Corporate Assets from Political
Extraction”
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Threat of government expropriation → incentive to
invest in assets which are less attractive for
expropriation (or not to invest at all)
Hence, don’t hold cash, invest in “hard” assets, pay
dividends
Data: 29,000 firms from 109 countries
Results. Firms in countries with higher risk of
government expropriation have:
lower Cash/TA
higher (Net Capex + ∆Inventory + Dividends)/Sales
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Corporate Governance. Conclusion
There are conflicts of interest between managers and
shareholders and between controlling shareholders and
small shareholders
These conflicts are costly as they raise the cost of
external finance for firms
Ownership and control concentration (both at the firm
and country level) arise in response to poor legal
institutions (they are both manifestation of and a way to
compensate for bad institutions)
Practicing good corporate governance creates value
Even in a bad institutional environment firms can raise
their value and lower cost of capital by practicing good
CG, but incentives to do it and credibility of commitments
are undermined by the environment
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Summary of the course
Raising external finance for doing NPV > 0 projects is
hampered by the agency and asymmetric info problems
Capital structure and (more generally) proper financial
contracts and mechanisms of corporate governance help
alleviate the problems
There is generally tradeoff between ex-post efficiency
and ex-ante willingness to do investments by parties
(monetary and non-monetary). The (second-best)
solution is proper allocation of (real) control
The optimal mechanisms to solve the agency problem
depend on the institutional environment (legal
shareholder protection in particular)
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