Stealing from Thieves

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• Stealing from Thieves
• Firm Governance and Performance
• when States are Predatory
• ART DURNEV, MCGILL UNIVERSITY
• LARRY FAUVER, UNIVERSITY OF TENNESSEE

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MOTIVATION
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Governance studies

• Sizable empirical literature on effects of
  regulation concerning corporate governance issues
  at the country level
• La Porta et al. (1997, 1998, 2002), Rajan and
  Zingales (1998), Demirgüç-Kunt and Maksimovic
  (1998), Kumar, Rajan, ZIngales (1999), Wurgler
  (2000), Shleifer and Wolfenzon (2002)
• and firm level
• studies based on US data
• Gompers, Ishi, Metrick (2001), anti-takeover
  provisions
• Gillan, Hartzell, Starks (2003), various
  governance mechanisms
• growing number of international studies
• Bruno and Claessens (2007), ISS governance scores
• Aggarwal et al. (2007), ISS governance scores
• Doidge, Karolyi, Stulz (2006), CLSA, SP, ISS
  governance scores
• Black, Jang, Kim (2006a, 2006b), Korean companies
• Durnev and Kim (2005), CLSA, SP, ISS governance
  scores
• Klapper and Love (2004), CLSA governance scores
• Black (2000), Russian companies
• Doidge, Karolyi, Stulz (2003), firms with ADRs
• Klapper and Love (2003), governance scores

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Missing player?
1st generation
Self-dealing managers or controlling shareholders
Minority shareholders
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Missing player?
- La Porta et al. (2002) - Shleifer and
Wolfenzon (2002) - and at least 100 other papers
1st generation
Self-dealing managers or controlling shareholders
Minority shareholders
affects cash flow distribution
2nd generation
GOVERNMENT
- Stulz (2005)
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While the government is potentially the most
efficient provider of social infrastructure that
protects against diversion, it is also in
practice a primary agent of diversion throughout
the world
"In those unfortunate countries, indeed, where
men are continually afraid of the violence of
their superiors, they frequently bury and conceal
a great part of their capital stock. Adam
Smith (1776). An Inquiry into the Nature and
Causes of the Wealth of Nations
Khodorkovsky paid an ultimate price not because
he didn't pay taxes to the country, because he
wanted to be transparent.  Aleksei Kondaurov,
Los Angeles, Times December 19, 2004
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Question

• Governments affect cash flow distribution between
  minority investors and controlling shareholders
• violation of property rights, corruption, bribes,
  overregulation, confiscatory taxation, blatant
  expropriation
• When states are predatory
• How do government policies towards private
  businesses enhance or obstruct firms incentives
  to practice good governance and increase
  transparency?
• How does the relation between firm governance and
  performance change?

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MODEL
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Managers

• Double-agency problem model as in Stulz (2005)
• Owners (100), managers, government
• d proportion of cash flows that the manager
  diverts for private benefits
• Firm governance g managers incentives are in
  line with value maximization
• m government expropriation
• manager maximizes

governance-enhanced post-diversion post-expropriat
ion
cost of diversion
diversion
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Government

• Government is completely Machiavellian
• (1/k) degree of state predation
• violation of property rights, corruption, bribes,
  overregulation, confiscatory taxation, blatant
  expropriation

revenue from expropriation
cost of expropriation
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Firm governance and predation

• Prediction 1 In more predatory states, owners
  set up weaker governance structures
• if government expropriation risk is high, the
  owners have incentives to distort managerial
  incentives from pure value maximization by
  establishing weaker governance
• on the one hand, the owners lose out because now
  the managers divert more
• on the other hand, the owners benefit from the
  imperfect governance because when the managers
  divert more, the states expropriate a lower
  fraction of firm revenues. In equilibrium, the
  owners prefer managerial diversion to state
  capture because a greater fraction of firm
  profits would otherwise be seized by the
  governments

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Firm performance and predation

• Prediction 2 Firms are valued lower in more
  predatory states.
• value increase comes from two sources
• (i) there is a direct effect of lower
  expropriation under less predatory governments,
  (1 d)
• (ii) managers have lower incentives to divert
  firm resources in less predatory states, (1 m)

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Governance-performance and predation

• Prediction 3 The relation between firm
  governance and valuation is weaker in more
  predatory states
• when government predation is infinitely
  expensive, there is no room for government
  interference, and firm value monotonically
  increases with firm governance.
• if the government policies are extremely
  predatory, that is, when the cost of government
  expropriation is close to zero, a small decrease
  in managerial diversion (due to stronger
  governance) leads to a larger increase in state
  expropriation.

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What explains firm governance?

• Firm governance can be a function of multiple
  firm and industry parameters
• we conjecture that any firm or industry
  characteristics would matter less in countries
  where governments pursue the policies of
  self-enrichment. Extending this argument, we also
  expect that a within-country variation in
  governance practices is lower in more predatory
  states.

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DATA
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Data
StandardPoors
WBs WBES
ISS Governance Quotient
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Data

• CLSA Corporate Governance Scores
• 600 companies across 30 emerging markets
• based on 57 questions in 7 categories
• SP Transparency Ranking, 1997-2002
• 1,800 companies across 16 emerging markets and 12
  developed countries
• Institutional Shareholder Services Governance
  Quotient
• 3000 firms, 4 years, 24 countries
• Word Business Environment Survey
• a cross-section of more than 10,000 firms from 81
  countries
• based on firm-level survey of business and
  financing obstacles imposed by governments, gt 200
  variables like
• government intervention in investment decisions
• government intervention in sales
• government intervention in pricing
• government intervention in mergers and
  acquisitions
• government intervention in dividends

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Predation

• Follow existing literature
• build predation index
• build autocracy index
• PREDATION
• corruption (ICRG)
• risk of government expropriation (EIU)
• lack of property rights protection (EUI)
• government stance towards business (EIU)
• freedom to compete (EIU)
• quality of bureaucracy (EIU)
• impact of crime (EIU)
• AUTOCRACY (POLITY IV and ICRG)
• autocracy democracy 2 government
  instability

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Control for

• Legal Regime
• Financial markets development
• GDP/capita
• Freedom of press
• Black market premium
• Investment opportunities
• Reliance on external financing
• Ownership concentration
• Industry dummies
• Size
• RD
• Export
• ADR dummy
• Consolidation dummy

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GOVERNANCE AND PREDATION
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Abnormal firm governance and predation

• Regress governance on country, industry and firm
  characteristics
• Grab the residuals abnormal governance
• Regress abnormal governance predation

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Abnormal firm governance and predation
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Abnormal firm governance and predation
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Abnormal firm governance and predation
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PREDATION AND PERFORMANCE
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Relation between sensitivity of firm performance
to firm governance and predation
Run Q on governance and controls,
country-by-country
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Relation between sensitivity of firm performance
to firm governance and predation
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ADDRESSING ECONOMETRIC PROBLEMS
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Old and boring techniques

• Degree of government predation is unobservable
• measurement error
• Government quality is endogenous
• firms in more developed countries receive higher
  governance rankings
• reverse causality
• Utilize the panel structure
• express all variables in differences get rid of
  firm unobservable effects
• use past levels as instruments for
  contemporaneous changes
• Instrumental variables approach
• distance from equator
• English as primary language
• settlers death rates
• Western Europe discovered the ideas of Adam
  Smith, the importance of property rights, and the
  system of checks and balances in government

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Using Rajan-Zingales (1998) methodology

• One way to check whether the expropriation
  channel works involves testing whether industries
  that are more sensitive to a channel have worse
  governance in countries where that channel is
  likely to be more operative (predatory).
• Identify industries more sensitive to
  expropriation
• oil and gas extraction industries
• during the periods of high commodity prices,
  corporate profits in the natural resource
  industries are rents that are relatively easy to
  capture
• disentangle industry profitability into two parts
• part driven by luck (by oil prices)
• part determined by skill (not driven by oil
  prices)
• Regress governance and disclosure on
• sensitivity predation oil price
• country fixed effects, industry fixed effects,
  year fixed effects

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Number of expropriations in oil industry against
autocracy index
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More oil-dependent industries are less
transparent when governments are more predatory.
The adverse effect of predation is larger during
periods of high oil prices or in countries
abundant with oil reserves.
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Implications

• Improving firm governance standards is vital for
  well functioning capital markets
• Governments that pursue predatory policies
  aggravate firm governance problems
• Firms cannot fully capture the benefits of sound
  firm governance in predatory states
• Predatory policies also impose limits to the
  benefits of globalization