Investor Protection and Corporate Valuation Summary and Critique
The article “Investor Protection and Corporate Valuation” from May 2001, Journal of Finance proposed the theory that the extent of the legal protection of investors from different countries determines the development of the countries’ financial markets. The authors of the article (La Porta, Lopez-de-Silanes, Shleifer, and Vishny) believed that when laws are protective of outside investors and are enforced well, financial markets do very well because investors are willing to put their money in those markets, as they are sure of getting returns on their money. However, when countries do not have laws that protect outside investors very well and are not enforced, the financial markets of those countries do not fare well, as no inside money comes in.
In support of this theory, several questions were raised: How does better protection of outside investors promote financial market development? Will outside investors be willing to pay more for financial assets if their rights were better protected by the law? How does limiting expropriation build up the financial market in those countries? Many of the countries in the sample did not have well-enforced laws that would protect outside investors from loss, or “misdirection” of funds. How would this affect future financial developments?
The article pointed out several examples of this happening in the sample countries used in the study. In countries where rights are not protected by the law, an entrepreneur could expropriate the funds into other areas that would not be approved by the law. This usually happens in countries where civil laws are used, enabling what the authors called, “influencing the policymakers”. In countries where common laws are used, a larger percentage of shareholders would control the companies, making it difficult for entrepreneurs to “misdirect” the funds.
Assumptions
Assumptions were made to construct the model used to conduct their study of 539 firms from 27 wealthy companies.
- Assumption number one: A firm is fully controlled by a single shareholder, called the entrepreneur. Many other “optimal ownership” structures were studied within this assumption, which depended on the levels of control each shareholder had. The ranges measured consisted of high private benefits of control, with the accompanying low levels of shareholder protection, up to the other side where the shareholders controlled the entire company.
- Assumption number two: The controlling shareholder has cash flow/equity in the firm. They may control a higher fraction of the votes, rather than cash flow rights. This is accomplished through owning shares with superior voting rights, or by controlling the board.
- Assumption number three: The entrepreneur is the manager. However, there are instances where this is not the case when they choose to hire professional managers. A common industry where this is done is real estate. Property owners do not want to manage the daily ins and outs of the landlord, so they hire a professional management company to do this for them.
- Assumption number four: The firm has no costs. The study assumed that the firm has a set amount of cash or income, which will then invest in a project with a gross rate of return. Where it gets tricky is when not all profits are distributed on a pro-rata basis. One of the benefits of controlling the firm is that the entrepreneur can divert a share of the profits from the firm to himself.
The 539 firms that were studied in this sample included the 20 largest firms each from 27 of the wealthiest countries in the world. Each of those firms also had a shareholder who controlled over 10 percent of the votes of the firm. However, using the larger firms made it harder to find the benefits of investor protection because the larger firms were able to limit their expropriation activities to minor shareholders through foreign shareholdings.
Several biases were acknowledged from the study. When talking about the liquidity of the companies, the lower valuation in poor investor protection companies might have been due to a higher rate of return that compensated for the lowered liquidity of these markets. Past sales growth may have also biased the results. Firms in common law countries are larger, meaning they have higher valuations. They also focused on firms that had only one shareholder who controlled a 10 percent or higher stake in the company.
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The Results
The results of the study confirmed that poor shareholder protection is penalized with lower valuations, while higher cash flow ownership of the controlling shareholder improves the valuation. It also proved that there is a need for stricter laws for protecting investors, which will, in turn, grow the financial markets.
There are some questions that this study did not answer, including but not limited to: Was the study inclusive of all possible scenarios? What does this study mean for the future of the laws and protection of outside investors? Will the “dead” financial markets revive once this study shows the data presented in this article? Will they actually put laws into place that will protect the outside investors?
- Question number one: Was the study inclusive of all possible scenarios? Meaning: did the study look at every possible situation where entrepreneurs might be using the money, and how would that affect outside investors if they wanted to invest? The study did not include expenses in its assumptions. Assuming the laws are favorable towards outside investors, and assuming there are costs to running a business, how would the law deal with this case? And, what effect would this have on the data?
- Question number two: What does this study mean for the future of the laws and protection of outside investors? Will this study prompt changes in the laws for those countries that favor the entrepreneur over the outside investor? The impact of the laws that do not favor outside investors is that the markets die because no extra money is coming into the country.
- Question number three: Will the “dead” financial markets revive once this study shows the data presented in this article? These are the markets in that laws are not favorable to outside investors, which makes the outside investors unwilling to put their money into an unsafe investment. Sometimes it takes some pretty disturbing news for anyone to change what isn’t working, even though at the time it may seem like it is working. Is the data in this study disturbing enough to the countries with dead financial markets for them to pressure their governments to change the laws?
- Question number four: Will they actually put laws into place that will protect the outside investors? This question is pretty self-explanatory. Only time will tell what the answer will be and if anything will come of this study.
While there are several questions that could have been addressed, the original theory was supported and addressed. To revisit the theory: “Recent research suggests that the extent of the legal protection of investors in a country is an important determinant of the development of its financial markets.” So, it did show that when the laws take care of the outside investors, the financial markets of those countries do well, just as when the laws do not take care of the outside investors, the financial markets of those countries do very poorly.
The consequences of when the laws do not protect the rights of outside investors are, as of yet, unknown. However, the article pointed out that the evidence presented indirectly “supports the importance of expropriation of minority shareholders by controlling shareholders in many countries.” What this is saying is that the law is not as effective in limiting expropriation, which in turn, allows many companies in such countries to decide their own rules and regulations about how and when they are going to pay their shareholders. With no regulation in these markets, these markets are going to die, and the economy in those countries will be struggling.
Reference list:
https://scholar.harvard.edu/shleifer/publications/investor-protection-and-corporate-valuation
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