Private benefits of control versus block stock ownership
Amel BELANES[(]
Faculty of Economics and Management of Nabeul
University of Carthage
E-mail:
Raoudha DJEBALI
High Institute of Management of Tunis
University of Tunis 1
E-mail :
Abdelwahed OMRI
High Institute of Management of Tunis
University of Tunis 1
E-mail:
ABSTRACT. This research provides evidence on whether the block ownership breeds private benefits of control or that is the latter that incites the controlling holder to increase its stock ownership. Drawing on a french sample of 110 listed firms, during the years between 2002 and 2006, our modeling highlights a simultaneous relationship between block ownership and private benefits. Two proxies of private benefits are used: the excess managerial compensation and the amount of related-party transactions. This study provides empirical support for the rent-protection perspective in addition to the agency theory to prove the opportunistic decisions of the controlling party, either the manager or the block shareholder. It also offers insights to policy makers interested in enhancing the legitimacy of corporate governance within their nation. It is worth considering the specificities of the ownership structure and namely the aims of the controlling party so as to enact the suitable laws to protect the investors and enhance the investment. Policy makers should control manipulations through both related-party transactions and management compensations.
Keywords: Private benefits of control; block ownership; corporate governance; agency theory; rent protection theory.
Private benefits of control versus block stock ownership: Empirical evidence in french firms
1. INTRODUCTION
Although one can think of a host of issues concerning the private benefits of control, it remains unclear whether the block ownership breeds the private benefits of control or the benefits of control incites the stockownership concentration. While a large part of finance literature considers private benefits of control as an attendant implication of concentrated control, a clear understanding of the effects of private benefits on capital structure remains much unexplored. Most recent literature proved that under weak investor protection, large shareholders whose voting rights greatly exceed their cash flow rights are often given incentives to seek private benefits at the expense of minority shareholders (Grossman and Hart, 1980; La Porta et al., 2000; Coffee, 2001; Holderness, 2003). Concentrated ownership often emerges to mitigate agency problems between outside shareholders and managers (La Porta et al., 1999). A few recent studies however considered the effect of private benefits of control on stock ownership (Bebchuk, 1999) and none works investigated the possible interaction between them. Empirical studies focused less on the causality between the private benefits of control and the stock ownership which really deserve careful study.
This is in part due to the original theoretical formulation of private benefits of control. Private benefits are defined as benefits not shared by the other shareholders, but exclusively siphoned off by the controlling party, to its own interest (Grossman and Hart, 1980). However, the benefits of every shareholder should be proportional to his own stock ownership (Grossman and Hart, 1980; Coffee, 2001; Holderness, 2003; Dyck and Zingales, 2004). Private benefits are generated from the separation of the residual claim right and residual right of control attributed to the controlling holder (Weifeng et al., 2008). The residual claim right consists of the cash flow right in proportion to the owned shares, that is the return on investment. The residual right of control is the voting right that the controlling holder has. The inconsistency of both rights leads to private benefits of control.
In an attempt to fill this gap of the literature, the paper examines how the level of private benefits may affect ownership structure of french firms and correct simultaneity bias between stock ownership structure and private benefits of control, often ignored in the literature.
Moreover, previous theoretical and applied literature has highlighted the complex nature of the relationships between ownership structure and agency problems. Empirical literature proves the existence of both vertical and horizontal agency problems. While vertical agency problems deal with the conflict of interests between dispersed shareholders versus managers, horizontal ones stem from the relationships between controlling versus minority shareholders. These two kinds of problems should be clearly differentiated and separately analyzed. Empirically, this is quite straightforward. When there are horizontal agency problems, minority investors are vulnerable to expropriation problems. Block-holders can exclusively undertake the created wealth regardless the interests of minority shareholders (La Porta et al., 2000). When there is conflict of interests between managers and shareholders, namely when stock ownership is diffuse, the manager attempts to entrench himself and enjoy private benefits of control. Jensen and Meckling (1976) however argue that the introduction of managerial stock ownership may align both interests thereby reducing agency problems and eventually reducing private benefits. Empirically Shleifer and Vishny (1986) suggest that managerial ownership may improve firm performance while Morck et al. (1988) argue that it may be deteriorated.
The contributions of this study are five-fold. First, it investigates whether private benefits and block ownership are simultaneously related. However, most studies have been limited by an implicit assumption that ownership concentration has an immediate and deep impact on private benefits expropriation. Secondly, this study deals with private benefits accrued to both managers and controlling shareholders while most empirical studies focus more on private benefits of block shareholders than those of managers. Third, it offers a new measure of private benefits, namely the excess managerial compensation. Excess salaries represent the wedge between the management compensation and the sector-based average. To the best of our knowledge, there is no study using excess salaries to make inferences about private benefits. Fourth, the research is carried out in a developed country, namely France, where expropriation problems are expected to be trivial. Fifth, it is the first study that investigates private benefits through related-party transactions in french firms. Related party transactions include all business deals between the firm and the parties with which linked by a special relationship. Little empirical research on how controlling shareholders can expropriate wealth through related–party transactions. This is another neglected area of research as it is difficult to count and monitor such transactions (Levine et al., 1997; Lo et al., 2010).
The french case is interesting for at least three main reasons. First of all, the french governance structure resembles that of many continental European countries and developing ones (La Porta et al., 1999). The french judicial environment is deemed not to adequately shield minority shareholders due both to its weak legal protection rules and to its inefficient law enforcement system. Furthermore, most french listed firms show a highly concentrated ownership structure and are often controlled through pyramiding and/or double voting shares (Johnson and al., 2000). Large block-holders either manage the firm directly or tightly monitor delegated managers. The work of Windolf (2002) highlights the binary division of firms in France: half of them are being part of the State sphere, the other half being family-controlled companies. The largest shareholder owns control rights in excess of its cash flow rights (Faccio and Lang, 2002). The disparity between voting rights and cash flow rights gives the largest shareholder incentives to seek private benefits at the expense of minority shareholders (Barca and Becht, 2001; Faccio and Lang, 2002).
Secondly, average private benefits are particularly significant in magnitude in France (Johnson and al., 2000). They often exceed 28% of the value of a company and are even expected to be far larger than in other developed countries (Nenova, 2003). Besides, most of private benefits are non-pecuniary (Le Maux, 2004; Roosenboom and Schramade, 2006) and hence difficult to measure.
Third, ownership and control are often not separated. Block-shareholders are often themselves the controlling managers. These characteristics suggest that the striking agency problem is not the one between managers and shareholders but between the large controlling shareholders and minority shareholders (Boubaker and Labégorre, 2008). It is then inherently difficult to divide private benefits of control into ownership-related benefits and managerial control-related benefits. Decomposing such benefits into those accruing to managers and to block-owners is even meaningless (Ehrhardt and Nowak (2003).
The rest of the paper is organized as follows: Section 2 covers a brief literature review of the issue of private benefits of control and discusses the different estimates used in empirical research. Section 3 addresses the relationship between block ownership and private benefits of control. Section 4 describes the data and presents the research design. Section 5 summarizes the empirical results. A brief conclusion follows with implications of the findings and suggestions for future research.
2. REVIEW LITERATURE
In this paper, we survey the academic literature on block-holders and management private benefits of control and focus on what the literature tells us about two fundamental questions: Who is actually enjoying the private benefits of control? Does the block ownership breeds the private benefits of control or that is the benefits of control that incite the stockownership concentration?
2.1. Review of private benefits of control
There is a wide range of wealth expropriation. Generally, private benefits can be divided into two categories: pecuniary and non-pecuniary. Prior studies focus on pecuniary private benefits of control that are visible and that can be transferred to an outside acquirer. However, non-pecuniary or psychic private benefits may be equally important although they are inherently difficult to measure (Jensen and Meckling, 1976). Excess salaries, perks and larges bonuses as well as charitable contributions are some examples of pecuniary benefits. Excess salaries are measured by the difference between the management remuneration and the sector-based average. The excess payments of holding company and the underestimated or overestimated internal sale prices in firm-groups also reflect the pecuniary private benefits. The non-pecuniary benefits include the prestige and social status, the ability to employ family members and to appoint them on the board (Demsetz and Lehn, 1985; Ehrhardt and Nowak, 2003). Psychic benefits consist also in control privileges, the power to make decisions on business strategy, the disciplinary level of the employees, the independence from superiors and even personal relationships (Holderness, 2003; Weifeng et al., 2008). The amenities that apparently come from controlling corporations like professional sports teams and newspapers are non pecuniary private benefits as well. Private benefits can also be negative if block-holders incur personal costs from monitoring or from lawsuits brought by disgruntled minority shareholders or government officials. For instance, manipulating prices through related-party transactions is fraudulent and may lead to fines and penalties thereby, harming the firm reputation. Private benefits of control can potentially alter the initial objectives of the firm and conceal its effective performance (Liu and Lu, 2007). They endorse in fact one set of stakeholders over another and hide their real advantages and benefits from the outsiders (Cheung et al., 2009).
However who is actually enjoying private benefits of control: are they the large shareholders who are almost the owners of the company or managers? In fact, some studies focus on managers as the beneficiary while others consider that they are block-owners who enjoy such benefits. Yet most studies disagree on who is actually enjoying these private benefits. On one hand, block-shareholders are tempted to enjoy private benefits that are not shared with minority shareholders. They do not only have the motive to maximize corporate value of the controlled firms but also have an incentive to use their voting rights to consume corporate resources for their own interest. They already have the ability to exert control to achieve their personal gain (Tai et al., 2007). For instance, both the block-owners and their representatives can usually serve as directors and officers, which allows them to directly influence management decisions and above all receive excess salaries and bonuses (Shleifer and Vishny, 1986; Holderness and Sheehan, 1988).
Additional support for the owners’ private-benefits hypothesis comes from La Porta et al. (1999) and Johnson et al. (2000) studies which focus on tunneling. Tunneling includes activities ranging from outright theft to self-dealing transactions, namely transferring or selling assets or products at higher than market price to a block-holder-controlled firm, or buying at a low price from the firm. Block-shareholders can also obtain loans on preferential terms or even dilute the interests of minority shareholders by acquiring additional shares at a preferential price (Johnson et al., 2000; Cheung et al., 2009). Moreover, controlling shareholders want always to remain in control so as to enjoy private benefits over and above the financial return on their investment (Bebchuk, 1999). They can often refuse additional finance and forego some growth opportunities, if the latter are too expensive to be realized with debt finance alone (Mueller, 2008). Thus, companies with a high potential loss of control will have smaller equity increases, use more debt and grow more slowly.
On the other hand, managers can also reap private benefits at the expense of shareholders (Bebchuk, 1999; Dyck and Zingales, 2004; Hwang and Hu, 2009). Although there is little evidence that managers use their own voting power to extract higher salaries, there are various ways through which they can expropriate the created wealth. Top executives generally enjoy larger perquisites and exorbitant compensation packages (Jensen and Meckling, 1976). They can even abuse of their control rights to be engaged in projects that are beneficial for them rather than for the investors (Jensen, 1986). Furthermore, their resistance to takeovers aims essentially to preserve their private benefits of control (Field and Karpoff, 2002). In fact, managers want to reduce the likelihood of takeover which leads to the removal of incompetent management, and hence managerial shirking, perquisites consumption, or empire building (Lo et al., 2010). Management may also have a strong financial reporting incentive to shift income either to maximize their performance-linked bonuses or to avoid losses. This can be accomplished by different means: one-off transactions, earnings management, and manipulating transfer prices, which would in reality breed managers’ private benefits.
But who enjoy larger private benefits of control: managers or large shareholders? The top executives owning majority blocks are expected to receive higher salaries and bonuses than do top executives in similar size but diffusely held firms (Holderness and Sheehan, 1988). Nevertheless, managers do enjoy greater private benefits of control than owners (Hwang and Hu, 2009). In fact, private benefits increase slowly when stock ownership increases. On the contrary, they increase rapidly with respect to the increase of managerial control. But above all, private benefits are more sensitive to the acquired ownership level when the likelihood of managerial control in the firm is higher. These results consequently prove that private benefits of control come more from managing the company than from just owning the company (Hwang and Hu, 2009).