Law and Finance

1
Law and Finance
Legal Shareholder Protection
Possibilities for insider expropriation
Ability to attract external finance Ownership and
control structures
Development of financial markets

• Main messages of the Law and Finance theory
• Weak legal protection raises obstacles to
  financial market development through hampering
  external finance
• Weak legal protection results in greater
  ownership (and control) concentration in firms.
  Ownership concentration is a second-best
  response to bad institutions

2
How does it work?

• La Porta et al (2002), Shleifer and Wolfenzon
  (2002)
• Weak legal shareholder protection increases
  insiders (entrepreneurs, managers) benefits
  from diversion/self-dealing/private benefit
  extraction.
• Larger insiders share creates better incentives
  ? less diversion
• Hence, by retaining larger share insider could
  compensate for the lack of legal protection
• Assume insiders needs to raise external finance.
  Then two effects of an increase in his share
• Better incentives commitment not to expropriate
  investors too much ? investors are more willing
  to provide funds
• Lower share available for sale to outside
  investors limits insiders ability to raise funds
• In equilibrium (Shleifer and Wolfenzon) insider
  balances these effects. As a result, under weaker
  legal protection
• He prefers to retain more shares to compensate
  for quality of law
• However, this compensation is only partial.
  Despite an increase in insiders share there is
  still more expropriation under weaker legal
  protection

3

• Note The result on the effect of law on insider
  share is not quite robust. Apparently, the
  following feature is needed marginal increase in
  insiders share must have greater effect on
  incentives under weak protection.
• Conclusions.
• Under weaker legal protection
• Higher private benefits of control and more
  self-dealing
• Lower valuation of firms
• Higher ownership concentration
• Less funds is raised, i.e. smaller size of
  projects (firms)
• Fewer firms are set up (fewer firms go public)
• Capital markets (external) are smaller
• Empirics largely confirms these results (in fact,
  empirics came out first)
• ImplicationWhy capital does not flow to
  developing countries? Because they have worse
  investor protection

4
Another explanation of ownership concentration

• Burkart, Panunzi and Shleifer (2003)
• Examine the decision of a founder to resign and
  hire professional manager
• The founder can hire a manager, sell a part of
  his shares and remain a large outside shareholder
• Large shareholder monitoring reduces managerial
  opportunism
• Hence, it is more valuable when there is more
  room for opportunism, i.e. under weak shareholder
  protection
• I.e. outside ownership concentration is a
  substitute for shareholder protection
• However, monitoring/diversion tradeoff is costly.
  As legal protection worsens this cost goes up, at
  some point the founder decides to keep control
  in the family, instead of hiring a manager

5
What about concentration of control?

• Control is not the same as ownership they can be
  separated
• Shares with differential voting rights
• Pyramids
• Cross-ownership
• Trust agreements
• In fact, outside US and UK, this separation in
  large companies is very common
• Greater separation (and greater concentration of
  control) seem to be more common in countries with
  weak legal shareholder protection
• Not surprising control is very valuable there,
  more valuable than CFR
• Separating it from CFR gives possibility to
  retain control while selling CFR

6
Control structure of Microsoft
7
Control structure of Fiat
8
Control Premium

• Control premia are higher in countries with
  weaker shareholder protection
• Difference between price of voting and non-voting
  shares (Nenova (2003))
• 0 in Denmark, 2 in the US, 46 in Mexico
• Difference between price of block and market
  price of dispersed shares (block premium) (Dyck
  and Zingales (2002)).
• 2 in Denmark, 5 in the US, 30 in Mexico

9
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)
• 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 (US, UK, France in early 20th
  century, Italy)

10

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