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Law and Finance Lessons?

Law and Finance Lessons?. Stephen Choi. LLSV Findings. Stock Mkt Cap / GDP # Listed Dom. Firms / Pop. # IPOs / Pop. Ownership Concentration Presence of Controlling SHs Dividend Payouts Corporate Valuation Enforcement levels. Legal Origin (Common v. French Civil) Antidirector Rights.

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Law and Finance Lessons?

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  1. Law and Finance Lessons? Stephen Choi

  2. LLSV Findings Stock Mkt Cap / GDP # Listed Dom. Firms / Pop. # IPOs / Pop. Ownership Concentration Presence of Controlling SHs Dividend Payouts Corporate Valuation Enforcement levels Legal Origin (Common v. French Civil) Antidirector Rights

  3. Criticisms of LLSV • 1. Coding Errors – Spamann (2008) • 33 of the 46 country-level observations used in LLSV (1998) antidirector rights were incorrect • correlation between corrected and original values is only 0.53 • inconsistent treatment of exceptions in the LLSV (1998) coding • corrected antidirector rights index is no longer significantly correlated with legal origin or stock market size (as measured by market capitalization to GDP, listed firms per capita, or IPOs per capita)

  4. Criticisms of LLSV • 2. Other Areas of the Law More Important How important relative to other investor protections (at least in U.S.) Vague…Lots of variation

  5. Criticisms of LLSV • 2. Other Areas of the Law More Important U.S. scores only a 2 out of sample max. of 5 corrected antidirector rights score (Spamann 2008) What about: ∙ Securities Regulation ∙ Private enforcement - Class Actions? - Derivative v. Direct? ∙ Anti-takeover - Poison Pill?

  6. Criticisms of LLSV • 3. Legal Origin Causality? United States “Common Law” Regime - Extensive federal bureaucracy - Federal Securities Regulation --Codified --Extensive SEC Rulemaking

  7. 3. Legal Origin Causality? Not like common law - Mandatory Disclosure (10-K, 10-Q, 8-K, etc) - Regulation FD - Sarbanes Oxley Act (CEO Certification Prohib. on auditors Internal Controls Penalty for restatement Prohib. on certain loans PCAOB) More like common law - Rule 10b-5 antifraud liability

  8. Criticisms of LLSV Rajan and Zingales (2003) - Level of financial development in France was greater than that of the U.S. in 1913 Coffee (2001) - Markets developed first; investor protections second in the U.S. at end of 19th century Cheffins (2000) - Similar story for U.K. as for U.S. Roe (2006) - War and destruction explains variation in capital market development in 20th century • 3. Legal Origin Causality?

  9. Criticisms of LLSV • Other Factors Correlated with Legal Origin • Initial Endowments (Beck et al. 2003a) • Ethnolinguistic Heterogeneity and religious makeup of a country (LLSV 1999) • Culture (Licht et al. 2005; Stulz and Williamson 2002) • 3. Legal Origin Causality?

  10. The Law Does Matter • Intuitive • Managers or controlling shareholders expropriating investments • Government expropriating profits at any time through exorbitant taxes or corrupt practices.

  11. Minimum Preconditions? • Secure Property Rights • Private contracting • Rule of law

  12. Possible Policy Levers?

  13. 1. Corporate Governance • Gompers, Ishii, and Metrick (2003) [U.S.] • 24 governance provisions from IRRC • Bebchuk, Cohen, and Ferrell (2004) [U.S.] • 6 provision “entrenchment” index • Staggered Boards • Limits to shareholder bylaw amendments • Supermajority voting for mergers • Supermajority voting for charter amendments • Presence of poison pill • Presence of golden parachutes

  14. 2. Limiting Tunneling • Cheung, Rau, and Stouraitis (2006) • Hong Kong listed companies • Non-operating earning items • Acquisition of assets from firm’s main owners • Consideration paid with stock • Cash assistance by firms to third parties • Likelihood of expropriation higher where owner is in mainland China – Rulings in Hong Kong are not enforceable in China.

  15. 2. Limiting Tunneling • Bulgaria’s experience limiting financial tunneling • Dilutive Equity Offerings and Below-Market Freezeouts post-1998 privatizations • Atanasov, Black, Ciccotello, and Gyoshev (2007) • Bulgaria’s 2002 securities law reforms • preemptive rights and appraisal rights • mandatory tender offer rule • majority of the minority shareholders vote to approve the terms of a mandatory tender offer • minimum “fair” price in tender offer • increase in the powers of the Bulgarian Financial Supervision Commission No more dilutive offerings and below-market freezeouts Valuation of firms at high risk of tunneling increase

  16. 2. Limiting Tunneling • Controlling Self-Dealing • Djankov, La Porta, Lopez-de-Silanes, Shleifer (2005) • Lex Mundi firm survey • Minimum (mandatory) legal requirements for self-dealing transaction • Aggregate Self-Dealing Index (ASDI) • Public Enforcement (formal maximum fines and criminal sanctions for self-dealing transactions) ASDI is higher in common law countries ASDI is correlated with larger capital markets

  17. 2. Limiting Tunneling • Lex Mundi Survey Questions • (1) who approves the transaction • (2) what needs to be disclosed to the board of directors or supervisory board, the shareholders, the stock exchange, and the regulators • (3) what are the duties of officers, directors, and controlling shareholders • (4) how the transaction’s validity could be challenged • (5) what causes of action are available if Buyer suffers damages • (6) what needs to be proved under each cause of action • (7) who has standing to sue under each available cause of action • (8) available of direct and derivative suits • (9) access to information and discovery rights; and • (10) fines and criminal sanctions

  18. 3. Securities Regulation • Importance of Transparency • La Porta, Lopez-de-Silanes, and Shleifer (2006) • Focus on regulation of IPOs from attorney surveys • Disclosure • Securities Liability • Authority (Formal) of Securities Regulatory Authority • Greater disclosure requirements and securities liability positively related with greater market capitalization, more publicly traded firms, and IPOs (also with lower cost of capital – Hail and Leuz (2005)). • Formal securities regulatory authority powers generally not significantly related

  19. 4. Other Regulations • Procedural Formalism (and Delay) • Djankov et al. (2003b) • Lex Mundi survey (tenant eviction case and bounced check collection) • Procedural Formalism Index • Richer countries have lower level of Formalism • More formalism correlates with longer duration • More formalism predicts lower enforceability of contracts, higher corruption, as well as lower honesty, consistency, and fairness of the system

  20. 4. Other Regulations • Procedural Formalism Index • (i) professionals versus laymen • (ii) written versus oral elements • (iii) legal justification • (iv) statutory regulation of evidence • (v) control of superior review • (vi) engagement formalities, and • (vii) independent procedural actions • Examples of Securities Arbitration in U.S. • Choi, Fisch, and Pritchard (2008)

  21. 5. Courts • La Porta, Lopez-de-Silanes, Pop-Eleches, and Shleifer (2004) (LLPS) • Judicial Independence (judge tenure, judicial decisions as source of law) • Judicial Constitutional Review power (rigidity of the constitution and power to review law for constitutionality) Judicial independence is correlated positively (and significantly) with greater economic freedom Judicial review is correlated positively and significantly with greater political freedom. English Common Law positively related with judicial independence

  22. 6. Enforcement • Jackson (2007) • United States is outlier in amount spent on financial regulation • Common law jurisdictions spend more than civil law countries on financial regulation • United States is outlier in the level of actual public and private enforcement actions and recoveries (and has a vigorous class action lawsuit system) • Jackson and Roe (2007) • Strong relationship between greater levels of public enforcement and greater financial development (particularly with stock market capitalization )

  23. 7. Other Mechanisms • Fauver and Fuerst (2006) • Employee representatives on the board bring with them information and expertise, making them powerful monitors of managers • Desai, Dyck and Zingales (2007) • Greater enforcement of the tax laws works to reduce the ability of those in control to expropriate private benefits of control and therefore may increase the market values of companies

  24. Preconditions for Strong Investor Protections?

  25. Simple Transplants Often Fail • Berkowitz, Pistor, and Richard (2003) • Indirect (not directly from origin country) and unreceptive transplants result in a lower level of legality

  26. 1. Interest Groups • Pagano and Volpin (2005) • More proportional the voting system of a country, the lower the level of investor protections and the stronger the level of employment protections • Rajan and Zingales (2003) • Financial and business incumbents in a country oppose financial development because with financial development typically follows greater competition. • The ability of incumbents to block financial development however is lessened as a country’s economy increases both cross-border trade and capital flows.

  27. 1. Interest Groups • Policy Levers • Antitrust Policy • Trade Policy • Foreign Investment Policy • Reducing the Level of Governmental Intervention in the Economy

  28. 1. Interest Groups • The Problem with Governmental Intervention • The availability of government rents will place a premium on private entities that are best able to capture such rents, even if the entities also result in greater expropriation of private benefits of control. • Bertain et al. (2002) • Leuz and Oberholder-Gee (2006) • Government officials may intervene in the economy to capture rents for themselves—at the expense of investor and societal welfare • Shleifer and Vishny (1993) • Djankov, McLiesh, Nenova, and Shleifer (2003a)

  29. 2. Regulatory Choice • Choi and Kim (2002) • Reduces opposition from entrenched controlling interests • Allows for experimentation and new information • Increases incentives for regulators and limits rent-seeking opportunities

  30. 2. Regulatory Choice • Examples • Neuer Markt • Novo Mercado

  31. 2. Regulatory Choice • U.S. Evidence • Romano (1985) • Daines (2001) • Bebchuk and Cohen (2001) • Outside U.S. • Pistor and Xu (2005) • Competition between specific regions in China

  32. 2. Regulatory Choice • What will companies choose? • Reese and Weisbach (2002) • French civil law firms cross-list into U.S. more than English common law firms • Subject themselves to SEC public filing requirements • Greater incidence of post-listing equity offerings

  33. 2. Regulatory Choice • What will companies choose? • Siegel (2005) • Mexican firms cross-listed in U.S. on Level II/III ADR did not have lower propensity of insider asset taking compared with Level I/IV ADR firms • Very infrequent SEC and private enforcement in U.S. against Mexican firms

  34. Concluding Thoughts • Law Matters • Key is to determine what law matters • Minimum Preconditions • What other preconditions? • Developing support for investor protections

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