EC 2725 April Law and Finance. Effi Benmelech Harvard & NBER
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1 EC 2725 April 2009 Law and Finance Effi Benmelech Harvard & NBER
2 Broad Picture A market economy is not only laissez faire but it also requires a set of institutions that allow markets to work their magic. Market economies have institutions such as laws, regulations, police, courts, regulators, etc. The transformations of the late 20th century have provided great stimulus to research in institutional and comparative economics. There is a variety of capitalist institutions which may lead to different results. Although the goal of good institutions -- economic and political -- is to secure liberty and property rights, it is clear that countries have 2 different institutions to meet these goals.
3 Broad Picture One area where differences among institutions of market economies have been explored is financial markets. Recent research shows that a country can only develop good financial markets if its institutions protect investors from expropriation by corporate insiders. What are these institutions? Perhaps the most crucial ones are those of the law. 3
4 Why do some countries have broader and more valuable capital markets? U.S. U.K. Ger France Italy Ext.Mkt.Cap /GNP (%) Firms in Mkt /Mill. Pop. 4
5 Fundamental Problem of Corporate Governance The fundamental problem of CG is the expropriation of outside investors (shareholders and creditors) by insiders. Examples include: Transfer pricing. Transfer of assets. Targeted issues and repurchases of securities. Pursuit of non-profit maximizing projects. Consumption of perks / CEO compensation. The principal goal of CG is to restrict expropriation so as to facilitate external finance. 5
6 How is Expropriation Restricted? Legal Approach to Corporate Governance The law and its enforcement are key mechanisms of investor protection. When investors finance firms, they receive rights or powers in exchange. Without an ability to enforce rights, investors might end up with nothing. Company law Bankruptcy law Securities law Takeover law Courts & Regulators Protect Shareholders & Creditors Force timely disclosure of accurate information Implication: Strong investor protection leads to deeper financial markets & better financing terms for firms. 6
7 Diversity of Legal Institutions Systematic variation in laws, regulations, and enforcement quality across countries. Two broad legal traditions evolved in Western Europe since the 12 th C.: (1) Common Law emerged in England: juries, independent judges, judicial discretion (2) Civil Law -- derivative of Roman Law Substantive and procedural codes. French Legal Origin -- based on the Napoleonic Code of German Legal Origin -- based on the Bismarck Code of Scandinavian Legal Origin Socialist Legal Origin Countries from different traditions utilize different institutional technologies for social control of business Note: Legal origin is predetermined hundreds of years ago and traditions travelled mainly through transplantation. 7
8 Legal Origin Distribution Legal Origins = English = French = German = Scandinavian = Socialist
9 Measures of Investor Protection Antidirector Rights (0-6) Creditor Rights (0-4) Efficiency of the Judiciary (0-10) Accounting Standards (0-100) Common Law French Civil Law German Civil Law Scandinavian Civil Law World (49 countries)
10 Consequences of Investor Protection: Financial Markets Development External Cap / GNP # Firms / Mill. Pop. # IPOs / Mill. Pop. Debt /GNP Common Law 60% % French Civil Law 19% % German Civil Law 46% % Scandinavian Civil Law World (49 countries) 30% % 40% % 10
11 Corporate Governance and Ownership Concentration Ownership Concentration.6.4 BEL GRC COLMEXEGY LKA IDN PER PHL ITA TUR ZWE VEN ISR DEUTHA NGA PAK BRA AUT ARG ZAF DNK CHE NLD IND MYS PRT FRA ESP SGP CHL FIN IRL HKG NZL NOR CAN KOR TWN SWE Rule of Law*Shareholders Rights JPN AUS GBR USA.2 11
12 Investor Protection and Financial Crises Exchange Rate VEN MEX THA TUR KOR GRCBRA PHL ARG TWN COL ISR ZAF CHL DNI SGP MYS HKG.2 IND Judicial Efficiency * Anti-Director Rights 12
13 Why Does Legal Origin Matter? o Judicial Theories (Coffee, 1999) o Juries o Judicial Discretion and Fudiciary Duty = Better Protection o Oral hearings, simplified proceedures o Political Theories (LLSV, 1999) o Common Law Developed in Opposition to the State o Commercial Codes of Civil Law developed under the auspicies of Napoleon and Bismark. o Courts were more dependent on the head of the State o Laws incorporated interventionism 13
14 Institution Procedural Formalism Judicial Independence Outcomes Time to evict nonpaying tenant Time to collect a bounced check Property rights Legal Origin Regulation of Entry Labor Laws Company Laws Security Laws Corruption Unofficial economy Participation rates Unemployment Stock market development Firm Valuation Ownership structure Bankruptcy Law Private credit Interest rate spread
15 Court Procedures for Collection of a Returned Check and Duration of the Process coef = , (robust) se = , t = Log of Duration (orthogonal component) POL SVN ITA LBN MLT ARE CAN MOZ AUT COL LKA PRT AUS PAK HUN CYP ISR HRV URY KWT BGRBHR GRC SEN KEN TTO JAM TWN NGA GIB BGD FIN CZE EST ECU CHE ISL MEX ZMB ZWE VGBTHA UKR SWE IDN GEO CHN BRA EGY FRA DOM LUX ROM HND LVA RUS DEU MAR CHL BMU ZAF HKG BLZ NZL TCA UGAMWI TUR BRB GRDIRL BEL CYM CIV JOR LTU PHL VNM GHA MYS IND GBR TZA NAM KAZ DNK ANT NOR MCO KOR BWA USA JPN SLV SGP AIA NLD SWZ VCT BOL PER CRI VEN ARG GTMPRY PAN ESP TUN Formalism (orthogonal component)
16 Court Procedures for Collection of a Returned Check, Fairness and Impartiality coef = , (robust) se = , t = SGP EGY Legal System is Fair and Impartial (orthogonal component) NAMBWA TUN ZAF MWI THA BLZ TTO ZMB ZWE CAN MYS SWEBGD IND CHN PAK TZA SVN SEN TUR GBR GHA NGA FRA EST HUN CHL DEU PHL CRI UGA ROM USA CIV PRTPOL URY ITA KEN BRA COL DOM BGR HND PAN LTU GEO HRV UKR ESP CZE MEX RUS IDN SLVKAZ GTM BOL ECU PER ARG Formalism (orthogonal component) VEN
17 Independent Judiciary is Associated with Better Security of Property Rights coef = , (robust) se = , t = 4.44 Property Rights Index (orthogonal component) ALG FRN CHN DRV THI CHL PRK UGASAU PAK KUW NEP PHI HON TUR NEW AUS JPN GFR NTHGHA MZM SWZ COL POR BEL CAN LEBZAM KEN IND ETH MAL INS USA ZIM ICE FIN NOR SIN UK AUL IRE DEN EGY GRC NIC ARG NIG PANITA VEN SPN MEX SWD ISR PER BRA CUB HAI SAF SYR JOR BNG IRQ IRN Aggregate Judicial Independence (orthogonal component) Partial Scatter Plot Controlling for ethnolinguistic fractionalization, latitude, and log of 17 GNP per capita.
18 Corruption & Regulation of Business Entry 10 CAN NEW DEN NOR FIN SWDSWZNTH Corruption Index AUL IRE USA HKG ISR UK ZIM Log Number of Procedures BELSAFGFR AUS JPN SIN LKA THI CHL PRK TUNURY TUR TZA JOR ECU PER KEN IND VEN MEX ROM SENCOLDOM DRV LEBGHA MAR ZAM UGA EGY JAMPAN PAKNIG PHI BOL INS FRN MYSHUN SVNCZE SPN POL POR GRC TAW BGR CHN MZM MWI BRA ARGITA
19 Labor Market Rigidity and Unofficial Economy coef = , (robust) se = , t = 1.75 Size of the Unofficial Economy/GDP (orthogonal component) MYS BOL URY RUS ZWE UKR PHL TZA LVA THALKA NGA ZMB COL KAZ ROM BEL BGR LTU JAM CAN ISR AUS MWI GHA UGARG HUN KOR ECU BRA NOR SWE VEN DNK GRC FIN MARNZL USA ITASEN DEUPOL FRA TUN GBR EGY LBN DOM CZE MEX NID MOZ PAK JPN ZAF IRL KEN TUR CHE AUT TWA CHI ESP PRT HKG JOR IND IDN VNM CHN SGP PER Employment Laws Index (orthogonal component) PAN GEO
20 Impact on valuations 20
21 Impact on Private Benefits ita mex col ven deu che bra aut tur isr arg prt chl kor per tha phl idn swe dnk mys egy esp fin fra nld nor sgp aus can gbr nzl tai hkg zaf jpn usa antidirect rights LLSV Fitted values Control premium from DZ (2004) 21
22 What are the private benefits of control? 1) Psychic value some shareholders attribute to being in control 2) Perquisites enjoyed by top executives 3) Company value captured by the controlling shareholder Initially just a modeling device Grossman and Hart (1980). Now there is hardly a theory paper in corporate finance that does not use this concept. 22
23 Aside: How Can We Measure Private Benefits? By definition, private benefits are hard to measure Two possible ways to measure them: 1) Direct: amount of money stolen Benmelech and Bordo (2008): the crisis of Mironov (2007) amount of money siphoned out through special purpose entities Very difficult to have data consistent across countries 2) Indirect: premium for control Controlling shareholder pays a premium with respect to stock market price if and only if gets some private benefits. Control premium = present value of private benefits N.B.: Control premium is different from the premium paid for acquisitions, which includes also potential 23 improvements/synergies
24 Private benefits Two ways to measure control premia: #1:Using premia for controlling block price paid per share for controlling block includes discounted expected future dividends and private benefits price on exchange after announcement of control transfer reflects expected future dividends difference provides a model free estimate of private benefits Approach pioneered in Barclay and Holderness (1989) #2: Price difference between voting and non-voting stock If make assumptions about strategic value of votes in corporate control contests can infer value of control from difference in price of voting/ non-voting shares Approach followed in Rydvquist (1987), Zingales(1994 and 1995) and Nenova (2003) 24
25 Example Stock trades at 80. A 40% block is exchanged at 140 per share. After the announcement of the deal, stock price goes to = 40 per share control premium This premium is paid only on 40% of the stock. Thus 0.4* 40 =16 total premium paid Normalized by the market value after the announcement 16/100 = 16% This is the number that is reported. 25
26 How big are private benefits and do they differ across countries? Private benefits are big Average level across countries of 14% of equity (sample average of 10%) They vary systematically across countries Brazil, Czech republic, Mexico, Austria, Israel, Argentina, Colombia, Venezuela, Italy more than 25% of equity value Australia, Norway, Finland, Canada, France, US, Britain, Hong Kong, South Africa, Taiwan, Japan, Netherlands, less than 2% of equity value Not simply a function of GDP and establishment of markets (e.g. Germany, Austria have relatively high levels) 26
27 hkg can bra Block premium as a percent of equity value of firm 27 nld gbr fra zaf usa aus fin nzl sgp egy esp che swe mys id n dnk deu pol tha phl per chl kor prt arg isr ven col tur mex ita aut cze nor tai jpn
28 Effects of PB on financial development In country with high private benefits of control entrepreneurs 1) reluctant to take company public (Zingales, 1995) => fewer companies will list 2) and, if they do, will retain a controlling stake (Zingales, 1995), (Bebchuck, 1999) Why? Entrepreneur (and market) factors in possibility someone else will acquire controlling stake and loot company. That is, won t be able to get much for shares (price protection) => widely held companies will be smaller/ownership 3) will find it optimal to sell control in a private negotiation (Zingales, 1995 and Dyck (2001)). => Government will be privatize through private negotiations 28
29 Conclusions Transplantation of laws and institutions to colonies brought important Western market institutions to the developing world. But, it also created some dysfunctional institutions, particularly those associated with too much state intervention. While richer countries have adjusted their institutions, poorer countries have been more slow. However, we are making more progress understanding functional and dysfunctional aspects of institutions, and suggesting reforms. 29
30 References What works in Securities Laws? NBER working paper, August (with R. La Porta and F. Lopezde-Silanes). The Regulation of Labor, Quarterly Journal of Economics, November (with J.C. Botero, S. Djankov, R. La Porta, and F. Lopez-de-Silanes). Courts Quarterly Journal of Economics, May 2003, (with S. Djankov, R. La Porta and F. Lopez-de- Silanes). Investor Protection and Corporate Governance, Journal of Financial Economics 58, No. 1, October 2000, pp (with R. La Porta, F. Lopez-de-Silanes, and R. Vishny). The Regulation of Entry, Quarterly Journal of Economics CXVII, February 2002, pp (with S. Djankov, R. La Porta, and F. Lopez-de-Silanes). Law and Finance, Journal of Political Economy 106, December 1998, pp , (with R. La Porta, F. Lopez-de-Silanes and R. Vishny). 30
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