11

Plan for the remaining part of the Plan for the remaining part of the coursecourse

Corporate governance, ownership and control of Corporate governance, ownership and control of firms around the world. Why differences across firms around the world. Why differences across countries?countries? Law and Finance viewLaw and Finance view Other views (“political economy”, in particular)Other views (“political economy”, in particular) Implications for financial developmentImplications for financial development

Choice of corporate governance by companiesChoice of corporate governance by companies Does good CG create value?Does good CG create value? Incentives to practice good CG?Incentives to practice good CG?

Effect of legal environmentEffect of legal environment

Effect of government predationEffect of government predation

22

Law and FinanceLaw and Finance

La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV)La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV)Main messages of the Law and Finance theory:Main messages of the Law and Finance theory:

Weak shareholder protection raises obstacles to financial market Weak shareholder protection raises obstacles to financial market development through hampering external financedevelopment through hampering external finance

Weak shareholder protection results in greater ownership (and Weak shareholder protection results in greater ownership (and control) concentration in firms. Ownership concentration is a control) concentration in firms. Ownership concentration is a “second-best” response to bad institutions“second-best” response to bad institutions

Common law (Anglo-Saxon) countries have better shareholder Common law (Anglo-Saxon) countries have better shareholder protection protection more developed financial markets more developed financial markets

Legal Shareholder Protection

Possibilities for insider expropriation

Ability to attract external finance

Ownership and control structures

Development of financial markets

33

How does it work?How does it work?La Porta et al (2002), Shleifer and Wolfenzon (2002)La Porta et al (2002), Shleifer and Wolfenzon (2002)

Weak legal shareholder protection increases insider’s Weak legal shareholder protection increases insider’s (entrepreneur’s, manager’s) benefits from (entrepreneur’s, manager’s) benefits from diversion/self-dealing/private benefit extraction diversion/self-dealing/private benefit extraction larger agency cost larger agency cost

Larger insider’s share creates better incentives Larger insider’s share creates better incentives less diversion less diversion (meaning higher equity valuation) for a given protection(meaning higher equity valuation) for a given protection

Better shareholder protection Better shareholder protection less diversion (higher equity less diversion (higher equity valuation) for a given insider’s sharevaluation) for a given insider’s share

Assume an insider needs to raise external finance by selling shares. Assume an insider needs to raise external finance by selling shares. Then he bears the (agency) costs. He can try to minimize them by Then he bears the (agency) costs. He can try to minimize them by retaining a greater fraction of equity. But this has two effects:retaining a greater fraction of equity. But this has two effects:

Better incentives: commitment not to expropriate investors too much Better incentives: commitment not to expropriate investors too much investors are more willing to provide fundsinvestors are more willing to provide funds

Lower share available for sale to outside investors limits insider’s ability Lower share available for sale to outside investors limits insider’s ability to raise fundsto raise funds

44

Under weak protection the incentive effect dominates Under weak protection the incentive effect dominates (see Note below). As a result:(see Note below). As a result:

Insider retains more shares to compensate for low quality of Insider retains more shares to compensate for low quality of legal protectionlegal protection

However, it costs him a reduction in the funds raisedHowever, it costs him a reduction in the funds raised Moreover, this compensation is only Moreover, this compensation is only partialpartial. Despite an increase . Despite an increase

in insider’s share there is still in insider’s share there is still moremore expropriation under expropriation under weaker weaker legal protectionlegal protection

Note: The (theoretical) result on the effect of law on Note: The (theoretical) result on the effect of law on insider share is not quite robust. The following feature is insider share is not quite robust. The following feature is needed: marginal increase in insider’s share must have needed: marginal increase in insider’s share must have greater effect on incentives under weak protection.greater effect on incentives under weak protection.

La Porta et al (2002) test the latter, they get the predicted sign La Porta et al (2002) test the latter, they get the predicted sign but coefficient is insignificantbut coefficient is insignificant

55

Conclusions.Conclusions.Under weaker legal protectionUnder weaker legal protection

Higher private benefits of control and more self-dealingHigher private benefits of control and more self-dealing Lower valuation of firmsLower valuation of firms Higher ownership concentrationHigher ownership concentration Less funds is raised, i.e. smaller size of projects (firms)Less funds is raised, i.e. smaller size of projects (firms) Fewer firms are set up (fewer firms go public)Fewer firms are set up (fewer firms go public) Stock markets are smallerStock markets are smaller

Empirics largely confirms these results (in fact, empirics Empirics largely confirms these results (in fact, empirics came out first)came out first)

Implication:Implication:Why capital does not flow to developing countries? Why capital does not flow to developing countries? Because they have worse investor protectionBecause they have worse investor protection

66

Another explanation for ownership concentration Another explanation for ownership concentration in countries with weak shareholder protection in countries with weak shareholder protection

Burkart, Panunzi and Shleifer (2003):Burkart, Panunzi and Shleifer (2003):Examine the decision of a founder to resign and hire Examine the decision of a founder to resign and hire professional manager:professional manager:The founder can hire a manager, sell a part of his shares The founder can hire a manager, sell a part of his shares and remain a large outside shareholderand remain a large outside shareholder

Large shareholder monitoring reduces managerial opportunismLarge shareholder monitoring reduces managerial opportunism Hence, it is more valuable when there is more room for Hence, it is more valuable when there is more room for

opportunism, i.e. under weak shareholder protectionopportunism, i.e. under weak shareholder protection I.e. outside ownership concentration grows as shareholder I.e. outside ownership concentration grows as shareholder

protection worsens (i.e. is a substitute for shareholder protection)protection worsens (i.e. is a substitute for shareholder protection) However, monitoring/diversion tradeoff is costly. As legal However, monitoring/diversion tradeoff is costly. As legal

protection worsens this cost goes up, at some point the founder protection worsens this cost goes up, at some point the founder decides to keep control “in the family”, instead of hiring a managerdecides to keep control “in the family”, instead of hiring a manager

Indeed, family controlled firms are more widespread in countries Indeed, family controlled firms are more widespread in countries with weak shareholder protectionwith weak shareholder protection

77

What about concentration of What about concentration of control?control?

Control is not the same as ownership: they can be Control is not the same as ownership: they can be separatedseparated

Shares with differential voting rightsShares with differential voting rights PyramidsPyramids Cross-ownershipCross-ownership Trust agreementsTrust agreements

In fact, outside US and UK, such separation is very In fact, outside US and UK, such separation is very commoncommonGreater separation and greater concentration of control Greater separation and greater concentration of control seem to be more common in countries with weak legal seem to be more common in countries with weak legal shareholder protectionshareholder protection

Not surprising: control is very valuable there, more valuable than Not surprising: control is very valuable there, more valuable than CFRCFR

Separating it from CFR gives possibility to retain control while Separating it from CFR gives possibility to retain control while selling CFR selling CFR

88

Example. Control structure of Example. Control structure of MicrosoftMicrosoft

Bill Gates (chairman) – 9.2%Bill Gates (chairman) – 9.2%

Steven Ballmer (CEO) – 4.4%Steven Ballmer (CEO) – 4.4%

Almost all the rest is free float (institutional Almost all the rest is free float (institutional investors, mutual funds, individuals)investors, mutual funds, individuals)

No pyramids, no cross holdings, only one No pyramids, no cross holdings, only one type of sharestype of shares

99

Example. Nordström family control of Realia (Sweden)Example. Nordström family control of Realia (Sweden)

Nordström family is the largest shareholder of Realia: control rights are 39.3%, though CFR are only 2.66%

But its control is likely to be restricted by Blockfield Properties (14.1% of control rights)

Note: Realia has 2 classes of stock: 2.641 million of A-shares with 1 vote each and 42.922 million of B-shares with 1/10 vote each

1010

Ownership and control around the Ownership and control around the worldworld

La Porta et al (JF 1999)La Porta et al (JF 1999) Take 27 mainly developed countries, 20 largest firms Take 27 mainly developed countries, 20 largest firms

in each countryin each country Trace ultimate beneficial owners.Trace ultimate beneficial owners. At 20% control threshold only 36% of large At 20% control threshold only 36% of large

corporations in the world are widely heldcorporations in the world are widely held 30% of firms are family-controlled30% of firms are family-controlled In Continental Europe and Asia widely held firms are In Continental Europe and Asia widely held firms are

rare and family-controlled firms are more commonrare and family-controlled firms are more common In countries with high shareholder protection (mostly In countries with high shareholder protection (mostly

Anglo-Saxon) widely held firms are common and Anglo-Saxon) widely held firms are common and family-controlled firms are rarefamily-controlled firms are rare

1111

Control of large publicly traded firms over the world (LLS (1999)).Control of large publicly traded firms over the world (LLS (1999)).High antidirector rights subsampleHigh antidirector rights subsample

1212

Control of large publicly traded firms over the world (LLS (1999)).Control of large publicly traded firms over the world (LLS (1999)).Low antidirector rights subsampleLow antidirector rights subsample

1313

One-share one-vote, cross-shareholdings, and pyramids One-share one-vote, cross-shareholdings, and pyramids (LLS (1999)). High antidirector rights subsample(LLS (1999)). High antidirector rights subsample

1414

One-share one-vote, cross-shareholdings, and pyramids One-share one-vote, cross-shareholdings, and pyramids (LLS (1999)). Low antidirector rights subsample(LLS (1999)). Low antidirector rights subsample

1515

Family control in large traded firms (LLS (1999)). Family control in large traded firms (LLS (1999)). High antidirector rights subsampleHigh antidirector rights subsample

1616

Family control in large traded firms (LLS (1999)). Family control in large traded firms (LLS (1999)). Low antidirector rights subsampleLow antidirector rights subsample

1717

Example: Wallenberg familyExample: Wallenberg family

Controls about 40% of Swedish stock market. Mostly through Controls about 40% of Swedish stock market. Mostly through Investor AB.Investor AB.

Investor AB core investments (from Investor AB website):Investor AB core investments (from Investor AB website): ABB - power and automation technology (7.2% Stake, 7.2% Voting ABB - power and automation technology (7.2% Stake, 7.2% Voting

rights) rights) Atlas Copco - industrial tooling and equipment (15.4% Stake, 21.2% Atlas Copco - industrial tooling and equipment (15.4% Stake, 21.2%

Voting rights) Voting rights) Astra Zeneca - pharmaceuticals (3.5% Stake, 3.5% Voting rights) Astra Zeneca - pharmaceuticals (3.5% Stake, 3.5% Voting rights) Electrolux - consumer appliances (11.9% Stake, 28.2% Voting rights) Electrolux - consumer appliances (11.9% Stake, 28.2% Voting rights) Ericsson - telecommunications (5.1% Stake, 19.5% Voting rights) Ericsson - telecommunications (5.1% Stake, 19.5% Voting rights) Husqvarna - Auto, chainsaw and sewing machine manufacturer (14.1% Husqvarna - Auto, chainsaw and sewing machine manufacturer (14.1%

Stake, 27.5% voting rights) Stake, 27.5% voting rights) Saab - aviation and military technology (19.8% Stake, 38.0% Voting Saab - aviation and military technology (19.8% Stake, 38.0% Voting

rights)rights) Scania – heavy trucks, buses, engines (11% Stake, 20% Voting rights)Scania – heavy trucks, buses, engines (11% Stake, 20% Voting rights) SEB - banking (20% Stake, 20.3% Voting rights) SEB - banking (20% Stake, 20.3% Voting rights)

1818

Concentration of control at the country level.Concentration of control at the country level.East AsiaEast Asia

Source: Claessens, Djankov and Lang (JFE 2000), based on 2980 public corporations, ultimate owners are traced, control threshold is 20%

1919

Concentration of control at the country level. Concentration of control at the country level. EuropeEurope

Source: Faccio and Lang (2002), based on 5232 public corporations, ultimate owners are traced, control threshold is 20%

2020

How do controlling owners enhance How do controlling owners enhance their control in Asia?their control in Asia?

2121

How do controlling owners enhance How do controlling owners enhance their control in Europe?their control in Europe?

Source: Faccio and Lang (2002)

2222

How do controlling owners enhance their How do controlling owners enhance their control in Europe? Subsample of family control in Europe? Subsample of family

controlled firmscontrolled firms

2323

How large are largest How large are largest shareholders?shareholders?

Average largest holder in listed companies Average largest holder in listed companies (in terms of voting rights):(in terms of voting rights): East Asia: from 10.33% in Japan to 35.25% in East Asia: from 10.33% in Japan to 35.25% in

ThailandThailand Europe: from 25.13% in UK to 54.50% in Europe: from 25.13% in UK to 54.50% in

GermanyGermany

In Russia: average largest holder in listed In Russia: average largest holder in listed companies controls 50+% ?companies controls 50+% ?

2424

What’s the degree of separation of What’s the degree of separation of ownership and control?ownership and control?

Average ratio of cash flow rights to control Average ratio of cash flow rights to control rights:rights: East Asia: from 0.6 in Japan to 0.94 in East Asia: from 0.6 in Japan to 0.94 in

ThailandThailand Europe: from 0.74 in Switzerland to 0.94 in Europe: from 0.74 in Switzerland to 0.94 in

SpainSpain Russia ?Russia ?

2525

How valuable is control?How valuable is control?

Control premia are higher in countries with Control premia are higher in countries with weaker shareholder protection, weaker weaker shareholder protection, weaker enforcementenforcement Difference between price of voting and non-Difference between price of voting and non-

voting shares (Nenova (2003))voting shares (Nenova (2003))0% in Denmark, 2% in the US, 46% in Mexico0% in Denmark, 2% in the US, 46% in Mexico

Difference between price of block and market Difference between price of block and market price of dispersed shares (block premium) price of dispersed shares (block premium) (Dyck and Zingales (2002)).(Dyck and Zingales (2002)).

2% in Denmark, 5% in the US, 30% in Mexico2% in Denmark, 5% in the US, 30% in Mexico

2626

Ownership concentration around Ownership concentration around the world. Summarythe world. Summary

Except US and UKExcept US and UK ownership and control in firms are concentrated in the ownership and control in firms are concentrated in the

hands of one or few large shareholdershands of one or few large shareholders These large shareholders often belong to few families These large shareholders often belong to few families

that control large part of the country’s economythat control large part of the country’s economy

Concentration of control in firms and separation Concentration of control in firms and separation of CR from CFR seem more widespread in of CR from CFR seem more widespread in countries with weaker shareholder protectioncountries with weaker shareholder protection

Control is more valuable in countries with weak Control is more valuable in countries with weak shareholder protection, weak enforcementshareholder protection, weak enforcement

2727

RussiaRussia

Guriev and Rachinsky (2004)Guriev and Rachinsky (2004) Control structure of 1700 large firms in 45 Control structure of 1700 large firms in 45

sectors in 2003. 60% of Russia’s total sectors in 2003. 60% of Russia’s total industrial output.industrial output.

Traced ownership to 627 ultimate owners or Traced ownership to 627 ultimate owners or groups of ownersgroups of owners

Ended up with the list of 22 largest private Ended up with the list of 22 largest private domestic owners (or groups), each of them domestic owners (or groups), each of them controlling assets that either generate > $700 controlling assets that either generate > $700 million in sales or have > 20,000 employeesmillion in sales or have > 20,000 employees

2828

Ownership concentration in Russian Ownership concentration in Russian industryindustry

Source: Gurev and Rachinsky (2004). Numbers are calculated using the proportional method; if recalculated based on the majority rule numbers become bigger: 47% for employment and 43% for sales.

2929

Comparing Russia to other countriesComparing Russia to other countries

Top 10 oligarchs (or groups) owned 60.2% of Top 10 oligarchs (or groups) owned 60.2% of the stock market in June 2003the stock market in June 2003

In developed Continental European countries In developed Continental European countries top 10 families control 11-34% of the stock top 10 families control 11-34% of the stock market (Faccio and Lang 2002)market (Faccio and Lang 2002)

In East Asian countries top 10 families control:In East Asian countries top 10 families control: 58% of the stock market in Indonesia58% of the stock market in Indonesia 52% in Philippines52% in Philippines 43% in Thailand 43% in Thailand

3030

Costs and benefits of family control Costs and benefits of family control for a firmfor a firm

Benefits of ownership concentration:Benefits of ownership concentration: Reduces separation of ownership from control, typical Reduces separation of ownership from control, typical

for US and UK firmsfor US and UK firms No pandering to short-term market pressures, focus No pandering to short-term market pressures, focus

on long-term valueon long-term value Family values?Family values?

Benefits related to groups/pyramidingBenefits related to groups/pyramiding Internal markets (capital, managerial, product)Internal markets (capital, managerial, product) Insurance against shocks (reduces fin. distress costs)Insurance against shocks (reduces fin. distress costs) Political connections Political connections

3131

Costs of ownership concentrationCosts of ownership concentration Lack of diversification for large shareholdersLack of diversification for large shareholders Lack of liquidity of a firm’s stockLack of liquidity of a firm’s stock Agency problem: divergence of interest between large and small Agency problem: divergence of interest between large and small

shareholders, especially when controlling holder’s control rights shareholders, especially when controlling holder’s control rights (CR) > his cash flow rights (CFR)(CR) > his cash flow rights (CFR)

Uncontestable control – no market disciplineUncontestable control – no market discipline

Costs of pyramidsCosts of pyramids Magnify separation of control from CFRMagnify separation of control from CFR

Succession problem. What if a heir is less competent Succession problem. What if a heir is less competent than the founder? Dilemma:than the founder? Dilemma:

To pass control to the heirTo pass control to the heir To hire a professional manager, but then separation of To hire a professional manager, but then separation of

ownership from controlownership from control Note: Russian oligarchs are still too young to face the Note: Russian oligarchs are still too young to face the

succession problem (Felix and Tatiana Evtushenkov, Anton succession problem (Felix and Tatiana Evtushenkov, Anton Fedun, Olga Rashnikova…)Fedun, Olga Rashnikova…)

3232

Additional economy level costs of Additional economy level costs of family controlfamily control

What is good for a group may be bad for What is good for a group may be bad for economyeconomy Market power (especially in a closed Market power (especially in a closed

economy)economy) Misallocation of recourses (even if inside the Misallocation of recourses (even if inside the

group allocation is efficient)group allocation is efficient) Political influence may harm other economy Political influence may harm other economy

participants (later on that)participants (later on that)

3333

Empirical evidence on performance Empirical evidence on performance of family firmsof family firms

Free-standingFree-standing family controlled firms outperform family controlled firms outperform widely-held firms in the US (Anderson and Reeb widely-held firms in the US (Anderson and Reeb (2003))(2003))Especially if the firm is relatively young (Morck et Especially if the firm is relatively young (Morck et al(1988), Anderson and Reeb (2003))al(1988), Anderson and Reeb (2003))But (!) inherited control reduces firm value, But (!) inherited control reduces firm value, especially if the heir appointed as CEO did not especially if the heir appointed as CEO did not get proper education (Perez-Gonzales (2002))get proper education (Perez-Gonzales (2002)) Also, Anderson and Reeb (2003) find that firms Also, Anderson and Reeb (2003) find that firms

managed by the founder descendants are valued managed by the founder descendants are valued lower than those managed by founders lower than those managed by founders

3434

Pyramids/groups and bad?Pyramids/groups and bad? Morck et al (2000): family firms in Canada (often in Morck et al (2000): family firms in Canada (often in

pyramids) underperform similar Canadian and US pyramids) underperform similar Canadian and US widely-held firmswidely-held firms

Khanna and Rivkin (2001) on developing countries: in Khanna and Rivkin (2001) on developing countries: in the majority of countries group firms have higher ROAthe majority of countries group firms have higher ROA

Khanna and Palepu (2000) on India: benefits of Khanna and Palepu (2000) on India: benefits of pyramids depend on degree of diversification in a pyramids depend on degree of diversification in a group (moderate diversification is bad)group (moderate diversification is bad)

Why in developing countries pyramids perform Why in developing countries pyramids perform better?better? Political connections are especially beneficialPolitical connections are especially beneficial Underdeveloped markets (relying on internal markets Underdeveloped markets (relying on internal markets

have greater value)have greater value)

3535

Empirical evidence on expropriation of Empirical evidence on expropriation of small shareholders by familiessmall shareholders by families

Greater separation of control from cash flow Greater separation of control from cash flow rights leads to lower market valuation (many rights leads to lower market valuation (many studies on different countries)studies on different countries)

Firms in lower tiers of pyramids (i.e. where Firms in lower tiers of pyramids (i.e. where separation of CR from CFR is larger) suffer from separation of CR from CFR is larger) suffer from “tunneling” – transfer of recourses to the apex “tunneling” – transfer of recourses to the apex (Bertrand et al (2002) on India, Bae et al (2002) (Bertrand et al (2002) on India, Bae et al (2002) on Korea)on Korea) Holmen and Högfeldt (2002) do not find this for Holmen and Högfeldt (2002) do not find this for

SwedenSweden

3636

Why are control structures differ Why are control structures differ across countries?across countries?

Legal environment.Legal environment. Weak protection of minority shareholders Weak protection of minority shareholders

(weak enforcement of property rights in (weak enforcement of property rights in general) encourages concentration of controlgeneral) encourages concentration of control

Tax systemTax system taxation of intra-group dividends (US) taxation of intra-group dividends (US)

discourages pyramidsdiscourages pyramids

Openness of the economyOpenness of the economy Makes political connections less valuableMakes political connections less valuable

3737

Russia. How do oligarch-controlled firms Russia. How do oligarch-controlled firms perform compared to other firms? (Guriev perform compared to other firms? (Guriev

and Rachinsky (2004))and Rachinsky (2004))

Regression analysis results:Regression analysis results: Total factor productivity growth of oligarch-controlled Total factor productivity growth of oligarch-controlled

firms is 8% higher on average (controlling for other firms is 8% higher on average (controlling for other things)things)

This difference stems from a increase in output rather This difference stems from a increase in output rather than employment cutsthan employment cuts

Perhaps oligarchs simply acquired assets with Perhaps oligarchs simply acquired assets with faster productivity growth?faster productivity growth? No! Prior to 2002 productivity growth of oligarch-No! Prior to 2002 productivity growth of oligarch-

controlled firms was not different from other controlled firms was not different from other companies. Moreover, productivity companies. Moreover, productivity levelslevels were lower were lower

Thus, it seems oligarchs took over poorly performing Thus, it seems oligarchs took over poorly performing firms and turned them aroundfirms and turned them around