1 Critique of Law and Finance Theory LLSV claim: legal origin has predetermined the development of institutions of property rights (investor protection, in particular) Common law (Anglo-Saxon countries) protects minority shareholders better than civil law (especially French) 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 20 th century)

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

3 Other theories of financial development (not necessarily contradictory to Law and Finance, they just dont emphasize legal origin) Endowment (environment, encountered by colonizers) Endowment (environment, encountered by colonizers) Ideology and culture (European social democracies vs. Anglo-Saxon democracies) Ideology and culture (European social democracies vs. Anglo-Saxon democracies) Political economy (interest groups influence) Political economy (interest groups influence)

4 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 dont want fin. development are few, organized and command large resources (incumbents) Incumbents do not benefit much from financial markets, at the same time they dont like competition oppose fin. development 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 exogenous factors too. 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 20 th 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

5 Political connections Potential benefits for minority shareholders: Preferential treatment of a company, subsidies, bailouts in case of problems, entry barriers for competitors Preferential treatment of a company, subsidies, bailouts in case of problems, entry barriers for competitors Potential costs for minority shareholders: More discretion for controlling shareholders More discretion for controlling shareholders Resources devoted to establishing and keeping connections at the expense of the company 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) Politically connected firms may pursue goals different from profit maximization (political, social goals)

6 Idea: look at stock returns following rumors about Suhartos health look at stock returns following rumors about Suhartos health see if these returns are lower for Suharto- connected firms and by how much see if these returns are lower for Suharto- connected firms and by how muchData: 79 firms 79 firms 6 (negative) events from Jan 1995 to April (negative) events from Jan 1995 to April 1997 Fisman (AER 2001) Estimating the value of political connections

7 Suharto group Suharto. President of Indonesia from 1967 to Embezzled $ billion (Transparency International estimate)

8 Results

9 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

10 Faccio (AER 2006). Politically connected firms Looks at 20,202 publicly traded companies in 47 countries Questions: In which environments politically connected firms are more common? In which environments politically connected firms are more common? Do political connections matter for firm value? Do political connections matter for firm value?

11 Results: Political connections are more common in countries with high corruption and barriers to foreign investment by residents 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%. When an officer or large shareholder enters politics – positive abnormal return of ~2%. However, no significant reaction when the opposite happens However, no significant reaction when the opposite happens

12 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

13 Other studies: Faccio, Masulis, and McConnell (2006): politically connected firms are more likely to be bailed out by government 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 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 Hitlers accession to power Ferguson and Voth (2008): Hitler-connected German firms outperformed the market following Hitlers accession to power Dombrovsky (2008): Latvian firms that provided contribution to winning (losing) parties experienced better (worse) operating performance after the election. 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)

14 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?

15 What is good corporate governance? OECD principles Codes of corporate conduct Which criteria 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…) 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) Board structure (independent directors, minority shareholder representatives, committees) Disclosure and Transparency (Independent auditor, disclosure of actual ownership, disclosure of related- party transactions, disclosure of financial on operating results, etc…) Disclosure and Transparency (Independent auditor, disclosure of actual ownership, disclosure of related- party transactions, disclosure of financial on operating results, etc…) …

16 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

17 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) Credit Lyonnais Securities Asia (CLSA) scores in 5 categories (managerial discipline, transparency, board independence, board accountability, managerial responsibility, minority shareholder protection, social responsibility) 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) S&P Transparency (for robustness)Run: CG = f(investment opportunities, need for external finance, ownership concentration, legal environment, controls) CG = f(investment opportunities, need for external finance, ownership concentration, legal environment, controls) Valuation = g(CG, legal environment, controls) Valuation = g(CG, legal environment, controls)

18 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

19 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: Black, Jang and Kim (2005, 2006) on Korea Black, Jang and Kim (2005, 2006) on Korea Black, Love and Rachinsky (2005) on Russia Black, Love and Rachinsky (2005) on Russia Guriev et al (2004) 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: Demsetz and Lehn (1985): ownership has no effect on performance Demsetz and Lehn (1985): ownership has no effect on performance Morck, Shleifer and Vishny (1988): non-monotonic relationship between insider ownership and performance Morck, Shleifer and Vishny (1988): non-monotonic relationship between insider ownership and performance Many studies on board structure: Many studies on board structure: ambiguous link between board structure and performance some find negative link between managerial ownership and board independence Note: Gompers, Ishii and Metrick find a positive effect of CG on equity prices Note: Gompers, Ishii and Metrick find a positive effect of CG on equity prices

20 Russian Corporate Governance Main mechanism – ownership concentration (very costly, but inevitable) Only large owners have incentives and ability to restructure and develop their businesses Only large owners have incentives and ability to restructure and develop their businesses Corporate governance has been improving for the last several years: Need to attract external funds (after wars for ownership are over, the only way to build value is to invest) 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 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

21 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)

22 Ex. of index: Brunswick-Warburg index

23 Black, Love and Rachinsky (2005) find: Good corporate governance increases valuation 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. 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 There must be some important differences in the CG components 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 controlling shareholder behavior + clearness of trading environment, use of offshore companies) Disclosure, especially financial (accountings standards, independence of auditor, disclosure record, ADR,…)

24 Why is legal environment so important? Enforcement is the key thing! Not laws on the books If enforcement is strong, parties can themselves learn how to write efficient contracts; they can be sure that courts will enforce them 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) If enforcement is bad: offshore incorporation, London arbitrage court, cross-listing (though there is evidence that it might not matter so much),… If enforcement is bad: offshore incorporation, London arbitrage court, cross-listing (though there is evidence that it might not matter so much),… Government predation

25 Predatory government and corporate governance Durnev and Fauver (2007), Stealing from Thieves If government can steal part of your firms profits, you are less interested in profit maximization and more interested in stealing from minority shareholders lower incentive to practice good CG If government can steal part of your firms 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 Data: few hundreds of firms from 85 countries Results: Results: firms located in more predatory regimes practice weaker CG and disclose less Positive relationship between CG and performance is weaker in predatory regimes

26 Durnev and Guriev (2007). The Resouce Curse: A Corporate Transparency Channel In predatory states, firms in the natural resource sector are more vulnerable to expropriation In predatory states, firms in the natural resource sector are more vulnerable to expropriation Especially in the periods of high commodity prices 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 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 This creates obstacles to raising external finance underinvestment slower growth Data: 72 industries from 51 countries over 16 years Data: 72 industries from 51 countries over 16 years

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

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

29 Results of Durnev and Guriev (2007): 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. 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 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

30 Caprio, Faccio, and McConnell (2008). Sheltering Corporate Assets from Political Extraction Threat of government expropriation incentive to invest in assets which are less attractive for expropriation (or not to invest at all) Threat of government expropriation incentive to invest in assets which are less attractive for expropriation (or not to invest at all) Hence, dont hold cash, invest in hard assets, pay dividends Hence, dont hold cash, invest in hard assets, pay dividends Data: 29,000 firms from 109 countries Data: 29,000 firms from 109 countries Results. Firms in countries with higher risk of government expropriation have: Results. Firms in countries with higher risk of government expropriation have: lower Cash/TA higher (Net Capex + Inventory + Dividends)/Sales

31 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

32 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)