Current Draft: September, 2002
First Draft: April, 2002
Comments welcome
To Steal or Not to Steal:
Firm Attributes, Legal Environment, and Valuation
Art Durnev[*] and E. Han Kim[**]
GEL Classification: G32 (Financial Policy; Capital and Ownership Structure), K23 (Corporation and Securities Law)
Keywords: Corporate Governance, Investment Opportunities, External Financing, Ownership, Legal Environment
1
ABSTRACT
A simple model is presented in which the controlling shareholder chooses the quality of corporate governance under different legal regimes. The model identifies three firm-specific attributes that affect governance: investment opportunities, reliance on external financing, and ownership structure. Using firm-level corporate governance and transparency data on 859 firms in 27 countries, which reveal a wide variation in corporate governance and disclosure practices across firms within countries, we find results that are consistent with the hypotheses derived from the model. Firms with profitable investment opportunities, more reliance on external financing, and more concentrated ownership have higher-quality governance and disclose more. And firms with higher governance and transparency ratings are valued higher and invest more. Moreover, these relations are stronger in countries that are less investor-friendly, demonstrating that individual firms do adapt to poor legal environments to achieve efficient governance practices.
1
This paper examines the relation between firm-specific factors and corporate governance practices and how governance practices are in turn related to firm valuation. To this end we develop a simple model that shows firms with good investment opportunities, greater reliance on external financing, and higher ownership concentration practice better governance. The model also predicts that the relations are stronger in legal environments that are less investor friendly and that firms with better governance are valued higher. We test these predictions with newly released data on governance and disclosure practices for 859 firms in 27 countries. The results are consistent with the predictions of the model.
Previous studies have examined the effects of legal environment on corporate governance and the relation between corporate governance and firm valuation. Specifically, it has been shown that better legal protection for investors is associated with higher value of stock market (La Porta et al. (1997)), higher valuation of listed firms relative to their assets or changes in investments (Claessens et al. (2002), La Porta et al. (2002), Wurgler (2000)), and larger listed firms in terms of their sales and assets (Kumar et al. (1999)). Furthermore, industries and firms in better legal regimes rely more on external financing to fund their growth (Rajan and Zingales (1998) and Demirgüç-Kunt and Maksimovic (1998)).
Although these studies provide valuable insights into the effects of regulatory environment, they do not address firm-level issues such as what drives different governance practices across firms within a given legal regime and how corporate governance affects individual firm valuation. Current studies attempting to address these issues include Black (2001) and Black et al. (2002), who demonstrate a strong relation between corporate governance and firm valuation in Russia and Korea, and Doidge et al. (2001), who show that foreign firms listed on U.S. stock markets are valued higher. For a more complete survey on international corporate governance see Denis and McConnell (2002).
The relation between corporate governance and firm valuation has also been studied for U.S. firms (e.g., Bhagat and Brickley (1984), Bhagat and Jefferis (1991), Denis et al. (1997), Karpoff (1998), Demsetz and Lehn (1998), Denis (2001), Gompers et al. (2002)). Most of these studies show mixed results with the exception of Gompers et al., who find that corporate governance provisions related to takeover defenses are significantly related to firm valuation.
The contribution of this paper is three-fold. First, we identify three firm attributes that may influence individual firms’ choice of the quality of corporate governance within a given legal environment and empirically examine the hypothesized relations. Second, we extend previous studies on the relation between corporate governance and firm valuation using a large sample of firms for 27 countries. Finally, we document that the relations between firm attributes, governance practices, and firm valuation are stronger in less investor friendly countries, suggesting individual firms adapt to poor legal environments to effect efficient governance practices.
To identify the relevant firm attributes, we provide a simple model in which the controlling shareholder faces a trade-off between diverting resources for private benefits and sharing gains with minority shareholders by investing in profitable projects. Diversion of resources results in rejection of profitable projects, which lowers the value of the controlling stockholder’s share of the firm value. The diversion also imposes on the controlling shareholders private costs that depend on the quality of legal environment.
The model predicts that the quality of corporate governance in a given legal environment is positively related to the availability of profitable investment opportunities, concentration of ownership, and the need for external financing. It also shows firm valuation is positively related to the quality of governance practices. Equally important, it predicts that the above relations are stronger in weaker legal regimes.
The basic intuitions underlying the model are simple. One is less likely to commit crime if one has something valuable to lose–profitable investment opportunities; one does not spit into the well that one drinks from–external financing; one does not steal from oneself–ownership concentration; good rules and effective enforcement reduce thievery–legal environment. As for the interplay between firm attributes and legal environment, good corporate governance driven by private incentives becomes a more important complement to regulation when regulation is less effective. And of course, good corporate governance is valued higher where it is scarce–the stronger relation between firm valuation and corporate governance in weaker legal regimes.
To examine these issues we use data on corporate governance and transparency practices on 859 firms in 27 countries. The data show a wide variation in governance and disclosure practices. The variation appears to be greater in weaker legal regimes, dispelling the stereotype that all firms in weak legal regimes suffer from poor corporate governance and all firms in strong legal regimes practice uniformly high-quality corporate governance.
The data are consistent with the predictions of the model. We find that firms with better investment opportunities, higher concentration of ownership, and more reliance on external financing practice better governance. Furthermore, these relations are stronger in legal regimes that are less investor-friendly. Thus, in Coase’s sense (Coase (1960)) firms located in countries with poor legal protection appear to show the adaptability to achieve efficient governance practices.
The data also reveal that firms with better governance invest more and enjoy higher valuation. This is consistent with the contemporaneous findings of Klapper and Love (2002) who examine the relation between firm valuation and corporate governance using a set of data that partially overlaps with our data.
Section I presents the simple model, followed by hypotheses and empirical design in Section II. Section III describes data, Section IV reports empirical results, with Section V providing robustness checks. The concluding section contains summary and implications.
I. A Simple Model
This model assumes an environment that is similar to Johnson et al. (2000) and Shleifer and Wolfenzon (2002). The primary purpose of the model is to provide motivation for empirical tests and as such it is devoid of many interesting real world complexities like determinants of initial ownership and capital structure in different legal regimes[1]. Nor does it allow for a simultaneous determination of investment and financing decisions. Following the Modigliani and Miller (1958) tradition of examining investment and financing decisions separately, we first assume financing is given and then allow for external financing by assuming investment is given. The model does not consider the reputation-type issues discussedin Diamond (1991), Maksimovic and Titman (1991), and Gomes (2000).
In defining corporate governance practice, we take Shleifer and Vishny’s view, “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.” (Journal of Finance, 1997, p. 737). Thus, the quality of governance practice is defined as the degree to which non-controlling, outside shareholders get their fair share of return on investment, or more specifically, as (1-d) where d is the proportion of cash flows that the controlling shareholder diverts for private benefits at the expense of other shareholders.
Defined as such, a good governance system would make it difficult for the controlling shareholders to steal d, which depends on attributes such as independence and accountability of the board of directors, financial incentives and managerial disciplines for value creation, enforcement of managerial responsibility and accountability, timely and accurate disclosure of relevant information, assurance to maintain auditors’independence, and protection of minority shareholders[2]. Our definition of the quality of corporate governance captures these attributes and, hence, focuses on the overall practice of corporate governance instead of the standard notion of legally binding contracts that are designed to shape and constrain management actions.
We consider a single period model in which the profit per unit of physical capital invested in project j is equal to, where and the cost of a unit of capital is standardized at 1. We assume that is linear and decreasing in j for all firms with each firm having a maximum of , which varies across firms[3]. Thus, is the measure that distinguishes the level of profitable investment opportunities across firms. With this definition, the gross return for the jth unit of capital invested can be written as . For brevity and without loss of generality, we assume that the interest rate is zero and investors are risk-neutral. Thus, if a firm takes all non-negative NPV projects, it will invest until , and the last unit of capital invested will be ; that is, the firm’s total investment will be , and its market value will be . Figure 1 summarizes the investment opportunity, as well as the firm’s optimal investment and market value when d is suppressed to be zero.
Finally, we assume that the firm will liquidate at the end of the period when the controlling shareholder, who holds fraction of the firm, collects her share of liquidating dividends. The ownership fraction must be large enough to give her the controlling interest.
A. Internal Financing
To illustrate the effect of profitable investment opportunities on governance practice, we start with a firm that hasnd internal funds, , where e is a constant that indicates whether the firm has sufficient funds to invest in all non-negative NPV projects (e 0) or not (e < 0). The controlling shareholder makes the investment decision subject to the budget constraint F [4]. She is also free to divert any portion of F for private benefits but there are associated costs.
The costs of diversion are of three types. The first is the (expected) penalties imposed on the controlling shareholder when the diversion is illegal and she gets caught. Such penalties take the form of fines, jail terms, and loss of reputation that may hurt her future business or employment opportunities. The second is the cost of diverting corporate resources, requiring such transaction costs as bribes to internal and external agents. Additionally, private consumption or conversion of the diverted resources into cash equivalents incurs deadweight loss because the consumption value is often less than the replacement costs.
We assume the sum of all these costs is a fixed fraction, c, of the amount diverted[5]. These costs vary across countries due to differences in de jure and de facto regulation, and across industries within a legal regime due to differences in the nature of assets (e.g., tangible vs. intangible) and business models involved. For instance, the costs of diversion may be higher for tangible assets that are more visible and for firms in regulated industries[6].
In this setup, the controlling shareholder may not invest in all positive NPV projects; instead, she will invest in project j only if her share of the liquidating dividends from the project is greater than the after-cost diversion,
[1]
The right-hand side of [1] incorporates the possibility that if the rate of return from the project, , is negative, the controlling shareholder may keep the money rather than invest into a negative return project. For example, if but she will neither divert nor invest; instead, she will retain the funds within the firm, of which she has claim to fraction. Thus, the controlling shareholder will invest up to the point where[7]:
[2]
Hence, the optimal level of investment for the controlling shareholder is[8]
[3]
The funds remaining after the investment, , will be diverted if the after-cost diversion is greater than the controlling stockholder’s share of liquidating dividends from it: (F-j*)(1-c)>a(F- j*) or Thus, the optimal amount of diversion D* is equal to if and 0 otherwise. Since , it follows from Eq.[3] that:
[4]
Equation [4] shows that if the cost of diversion is high relative to non-controlling shareholders’ ownership such that , there will be no diversion and all the leftover funds will be kept within the firm. This is because for each dollar of diversion, the cost c is greater than the wealth transfer from the minority shareholders who own fraction of cashflow rights. Diversion takes place only if the cost, c, is less than the wealth transfer per dollar of diversion, [9].
Thus, our measure of corporate governance, d, the proportion of cash flows that are diverted as a percentage of the firm’s endowment, , is:
[5]
It follows from [5] that d* is negatively related to the cost of diversion c. Therefore, in more investor-friendly countries (high-c countries), firms will divert less and have better corporate governance[10].
A.1 Investment Opportunities
Proposition 1:Controlling shareholders of firms with more profitable investment opportunities divert less for private gains.
Proof: Since represents the profitability of investment opportunities, we take the partial derivative of d* with respect to :
[6]
This derivative is non-positive because diversion takes place only when for reasons explained earlier.
Q.E.D.
The intuition behind Proposition 1 is simple. When investment opportunities become more profitable, the controlling shareholder’s share of return from investment increases relative to the benefits from diversion. Thus, firms with profitable investment opportunities will practice low d, i.e. high quality governance.
Conversely, when a firm suffers a substantial drop in profitable investment opportunities, the controlling shareholders will divert more corporate resources. Johnson et al. (2000) document such behavior before the Asian financial crisis and the media alleges similar actions by the top management of Enron and other firms with subsequent scandals prior to their bankruptcy filings[11].
A.2 Legal Regimes
Proposition 2: A given increase in profitable investment opportunities has a lesser impact on diversion in a country with high costs of diversion than in a country with low costs of diversion.
Proof: This result follows because the derivative of Eq. [6] with respect to c is non-negative,
[7]
Q.E.D.
Proposition 2 implies that the sensitivity of diversion to investment opportunities falls as the cost of diversion rises. That is, the positive relation between investment opportunities and the quality of corporate governance is stronger in weaker legal regimes[12]. To illustrate, consider two countries, say the U.S., which has relatively low tolerance for diversion and imposes high cost, and Russia, which is more tolerant and imposes lower costs. Proposition 2 implies that the same increase in profitable investment opportunities will have a smaller negative impact on d in the U.S. than in Russia.
To demonstrate numerically, assume the cost of diversion, c, is equal to 0.6 in the U.S. and 0.3 in Russia and the excess cash, e, is equal to 0 in all cases. Also consider a firm that has low investment opportunity , and the controlling shareholder owns 30%. The payoff to the controlling shareholder can be defined as where the market value, MV, is the present value of gross returns from all projects that are undertaken. Since, the optimal diversion is if the firm is located in Russia, but if in the U.S. Now, if the firm’s investment opportunity improves to , the optimal diversion will decrease from 0.67 to 0.61 for the firm in Russia, whereas for the U.S. firm the decrease will be smaller, from 0.17 to 0.15 (see Figure 2).
This example can also be used to illustrate the relation between variation in the quality of corporate governance and legal regime[13].
Corollary 1: If the mean and variation in profitable investment opportunities across firms are held constant,thenvariation in diversion is greater in weaker legal regimes[14].
A.3 Ownership
Proposition 3: Controlling shareholders of firms with higher ownership divert less corporate resources for private gains.
Proof: Differentiating Eq. [5] with respect to controlling shareholder’s ownership we obtain
[8]