CHAPTER LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT.1 Literature Review..1 Legal Protection and Ownership Concentration Many researches on corporate governance around the world has documented large differences among countries in ownership concentration in publicly traded firms, in dividend policies, and in the development of capital markets (see, for instance, La Porta et al. (1998), (1999), (000); Fauver et al. (1998)). A popular element to the explanations of these differences is how well investors, both shareholders and creditors, are protected by legal rules from expropriation by the managers and controlling shareholders of corporations. La Porta et al. (1998) are the first one to examine the differences of laws and the ownership construction around the world. They examine legal rules covering protection of corporate shareholders and creditors, the origin of these rules, the quality of enforcement of the laws, and ownership concentration in 49 countries. The protection of shareholder rights, or anti-director rights, is measured in six criteria: (1) proxy by mail allowed, () share not blocked before general shareholders meeting, (3) cumulative voting or proportional representation allowed, (4) an oppressed minorities mechanism, (5) at least 10% of share capital needed to call an extraordinary 6
shareholders meeting, (6) preemptive right to new issues. The more scores a country gets the more favorable environment it is for shareholders. The authors show that laws vary a lot across countries, in part because of differences in legal origin. They find in particular that common law countries appear to have the best legal protection of minority shareholders, whereas civil law countries, and most apparently the French civil law countries, have the weakest protection. However, they discover that the countries usually develop substitute mechanisms for poor shareholder protection, such as mandatory dividends or legal reserve requirements. Finally, they verify that widely-held companies only prevail in countries with high shareholder protection, and propose a strong negative relationship between ownership and shareholder protection. Following their study in 1998, La Porta et al. (1999) continue to develop the issue of ownership structure and investor protection by using a sample of large and medium firms from each of 7 wealthy economies. They divide their sample into good and poor investor protection according to the anti-director rights index mentioned above. The authors find that relatively few of these firms are widely held except in economies with good shareholder protection. In addition, countries with poor shareholder protection tend to have controlling shareholders even in large corporations. Sometimes the controlling shareholder is the State; but more often it is a family that founded or acquired the firm. The controlling shareholders always manage 7
the firms they control. In other words, these firms are run not by professional managers without equity ownership but by controlling shareholders. The coupling of ownership and management deteriorate the agency problem between controlling shareholders and minority shareholders. Outside investors in low legal protection countries face more risk when they finance the firms and are reluctant to participate in equity market than those in high legal protection countries. As a consequence, equity markets tend to be much smaller in countries with poor legal protection of minority shareholders. On the contrary, legal power gives minority shareholders the right to monitor insiders in countries with good protection. For this reason, equity markets are both broader and more valuable in countries with good legal protection of minority shareholders Claessens et al. (000) analyze the ownership structure of 3000 firms in 9 East Asian countries, which are traditionally less protected countries except Japan. They find that the separation of management and ownership is rare and the control of most firms is family or State. Obviously, we can grasp an image from the literature that legal protection plays an important role in shaping the ownership structure, and maybe the most important one. 8
.1. Legal Protection and Corporate Governance To have come this far, we recognize that conflicts of interest between corporate insiders, including managers and controlling shareholders, and outside investors, including creditors and minority shareholders, are central to the analysis of the modern corporation finance. La Porta et al. (000) describes the legal protection of investors as a potentially useful way of thinking about corporate governance. The authors argue that investor protection turns out to be crucial because expropriation of minority shareholders and creditors by the controlling shareholders is extensive in some countries. Outside investors face a risk when they finance the firms that the returns on their investments will never realize because the managers or controlling shareholders might expropriate them. One of the principal remedies to agency problems is the law. Corporate and other laws give outside investors certain powers to monitor managers and controlling shareholders thus protect their own investment against expropriation by these insiders. These powers in respect of shareholders range from the right to receive the same per share dividends as the insiders, to the right to vote on important corporate matters, including the election of directors, and so forth. Consequently, better legal protection is deemed as a proxy for a less serious 9
agency problem, that is, high legal investor protection is associated with effective corporate governance, as reflected in valuable and broad financial markets, dispersed ownership of shares, and efficient allocation of capital resources across firms..1.3 Legal Protection, Ownership, and Valuation In addition to the issue of how the quality of legal protection affects corporate governance, a growing literature also investigates the relationships among dividends, cash holdings, ownership, and firm value under different investor protection environment (see, for instance, Gorton and Schmid (000), La Porta et al. (00); Claessens et al. (00); Pinkowitz et al. (006)). In particular, these authors show that the incentive effects of cash flow ownership are stronger in countries with poorer investor protection. Gorton and Schmid (000) show that higher ownership of the large shareholders is associated with higher valuation of corporate assets in Germany, which is regarded as a low legal protection country because its anti-director rights score is only 1. La Porta et al. (00) find evidence of higher valuation of firms in countries with better protection of minority shareholders and in firms with higher cash flow ownership by the controlling shareholder. The authors use a sample of the largest 0 firms with a shareholder who controls over 10 percent of the votes of the firms from 10
each of the 7 wealthy economies to evaluate the influence of investor protection and ownership by the controlling shareholder on corporate valuation. They present a simple regression model using Tobin s q as the dependent variable to measure valuation and dummies of the origin of a country s laws and the index of specific legal rules as indicators of shareholder protection. One of the results La Porta et al. (00) find is that higher cash-flow ownership by the entrepreneur (here means the controlling shareholder) is associated with less expropriation of minority shareholders. This is consistent with the incentive effect of managerial cash-flow ownership emphasized by Jensen and Meckling (1976). Meanwhile, they also find that poor shareholder protection is penalized with lower valuations, and that higher cash-flow ownership by the controlling shareholder improves valuation, especially in countries with poor investor protection. In spite of their findings, we try to examine the relationships among insider ownership, investor protection, and firm value using more general sample instead of just large firms in 7 wealthy countries by one year data. Claessens et al. (00) use a large sample of publicly traded corporations in eight East Asia economies, including Hong Kong, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand, to disentangle the incentive and entrenchment effects of large ownership. They show that greater insider cash flow 11
ownership is associated with higher valuation of corporate assets. This result is consistent with a large literature on the positive incentive effects associated with increased cashflow rights in the hands of a single or few shareholders under low investor protection. Furthermore, they also find a negative entrenchment effect with large controlling shareholders: Increases in control rights by the largest shareholder are accompanied by declines in firm values. This negative effect is particularly severe for large deviations between control and ownership rights. Their findings are consistent with the presence of agency problems between controlling and minority shareholders in low legal protection countries. According to agency theories, the value of corporate cash holdings should be less in countries with poor investor protection because of the greater possibility for controlling shareholders to extract private benefits from liquid assets in such countries. In other words, one dollar dividend payout would be valued more highly in low legal protection countries than in high legal protection countries. Pinkowitz et al. (006) use a sample of 35 countries and the Fama and French methodology in their cross-country study of cash, dividends and governance to verify the supposition. Consistent with the presence of agency problems, they find that investors in countries with below median governance scores (proxy by legal protection) place a lower value on a dollar of corporate cash holdings than investors in countries with above median 1
governance scores. The authors also find that the relationship between cash holdings and firm value is much weaker in countries with poor investor protection than in other countries, while the relationship between dividends and firm value is stronger in such countries. Accordingly, there is a positive relationship between legal protection and corporate governance, while there is a negative relationship between legal protection and ownership concentration. As we can learn from prior researches, agency problems, either between shareholders and managers or between controlling and minority shareholders, might be the most essential explanation for the relationship between legal protection and ownership construction. Weather insiders may hold on to a significant cash flow ownership depends on in what kind of legal environment they invest. Instead of the conventional argument that high ownership concentration in low legal protection countries is a by-product of legal protection, the view argues that high ownership concentration is a decision making by insiders to maximize their firm value. 13
. Hypothesis Development As we mentioned above, La Porta et al. (00) describe a positive relationship between ownership concentration and firm value, especially in poor protection countries. However, their sample is restricted to large firms in 7 rich countries. The authors focused on the incentive effect of managerial ownership and established their hypotheses using a simple model that a controlling shareholder, called the entrepreneur of the firm, wants to maximize his own wealth: U = α ( 1 RI + sri c( k, RI (1) where I is cash holdings of the firm while R is the gross rate of return, so the profits are RI (assuming no cost; α is cash flow ownership of the entrepreneur; s is the share of profit he diverts from the firm to himself; k denotes the quality of shareholder protection; c is the cost-of-theft function and c(k, is the share of profits he wastes when s is stole. Under the authors assumption, the marginal cost of stealing is positive, and better protection makes stealing costlier to the controlling shareholder. So c k >0, c s >0, c ss >0, and c ks >0. The first order condition for optimal s is given by U S = α + 1 cs ( k, = 0 () or c S ( k, =1 α (3) Then, differentiating (3) with respect to k, we get 14
ds * c = dk c ks ss ( k, ( k, < 0 (4) It means there is less expropriation of minority shareholders in countries with better shareholder protection. Next, differentiating (3) with respect to α, we get ds* = dα c ss 1 ( k, < 0 (5) It means the higher ownership the controlling shareholder has, the less he would steal from minority shareholders. Their model is good for a firm with a controlling manager who has a significant ownership. However, ownership concentration varies among different firms. Along with the increase of ownership, it becomes easier and less risky for controlling managers to steal (e.g. Burkart et al. (1997); Chirinko et al. (004)). Thus, the stronger incentive effect will be balanced against the higher agency costs of expropriation as the insider ownership increases. For the general firms, the cost of steal should be a function ofαtoo. We assume c is not only the function of k and s, but also α. Furthermore, because higher ownership makes it easier for the controlling shareholder to extract private benefits from his position and the marginal cost of stealing is lower when he has higher ownership, we assume cα< 0 and c αs < 0. Then, we replace c(k, with c(k, s,α), and condition (5) turns out to be 15
ds * 1+ cαs ( k, s, α) = dα c ( k, s, α ) ss < 0? (6) When c αs < -1, condition (6) is positive; when -1< c αs < 0, condition (6) is negative. That is, whether higher ownership by the entrepreneur is associated with less expropriation depends on how easily he can steal by holding more ownership. Now, we take a look at the valuation. La Porta et al. measure valuation in the model with Tobin s q, which is given by q = (1- s*) R. We differentiate q with respect to k and α, respectively: dq dk ds * = R > 0 dk dq ds * = R > 0? dα dα (7) (8) Condition (7) implies higher legal protection improves firm value. Condition (8), implies higher ownership does not necessarily improve firm value. When we consider the effect of ownership on cost of stealing, the model reveals different results from La Porta et al. (00). Increasing ownership, on the one hand, reduces controlling shareholder s incentive to expropriate. On the other hand, increasing ownership also reduces the cost of expropriation, thus increases his incentive to steal more! Last, we want to check whether the better legal protection reduces the impact of 16
ownership on valuation. We differentiate condition (8) with respect to k : d q dαdk d s * = R dαdk < 0? (9) Differentiating equation (6) with respect to k, we obtain d s* dαdk ds ds ds cαskcss cαss css + cssk + csss + cαscssk + cαscsss = dk dk dk (10) ( c ) ss If we follow La Portaet et al. (00), let c be a quadratic cost-of-theft function: (, *, ) 1 1 c k s α = ks α (11) In this case, all our assumptions on the function c hold and differentiation yields c αs c ssk = ksα 1 = α ; c sss ; c ks = sα 1 ; c ss ds * c = 0; = dk c Thus, expression (10) becomes = kα ks ss = 1 ; c s k αsk. = sα ; c αss = kα ; d q dαdk 1+ skα R 1 k α = < 0 (1) It means that the effect of the ownership on valuation is lower under good legal protection. According to the model inferences, we get two testable hypotheses: First, better legal protection can improve firm value; its effect reduces along with the increase of ownership concentration. 17
Second, the increase of ownership concentration on firm valuation is better in low legal protection countries than high legal protection countries. However, the sign of its effect is uncertain. In sum, the relationship between ownership and valuation is different under various protection environments. There is a substitute effect of legal protection and ownership concentration on firm valuation. 18