OCTOBER 2004

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The Value of Control

Protecting Minority Shareholders and Developing Better Financial Markets

Research by Luigi Zingales

U.S. corporate scandals such as Enron and Tyco have highlighted the fact that insiders enjoy benefits above and beyond those of the average shareholder-the so-called "private benefits of control." How widespread are these benefits? What effects do they have on the development of a country's securities market? Furthermore, how can such benefits be curbed? Recent research indicates that in spite of the recent corporate scandals in the United States, other countries face much greater hurdles in curbing these private benefits, and in developing effective systems of corporate governance.

The enormous executive perks uncovered in the Enron and Tyco scandals brought mass media attention to something corporate finance scholars have been saying for decades: not all shareholders are created equal. Whoever is in control not only enjoys the "psychic value" of control, but also many unique privileges. For an extreme example, one need only consider Russian oil companies, where insiders divert a large fraction of profits by selling some of their oil to their own companies at a price below market. While some private benefits are clearly illegal, most venture into a gray area of borderline illegal activities. It is a country's overall corporate governance system that determines how easy it is for insiders to exploit minority shareholders. Hence, the size of private benefits is a good indicator of the efficiency of a country's corporate governance.

How Are Private Benefits Measured?

Private benefits are inherently difficult to measure because a controlling party is able to use corporate resources to his or her benefit only if it is difficult or impossible to prove these actions in court.

In a recent study, "Private Benefits of Control: An International Comparison," Luigi Zingales, a professor at the University of Chicago Graduate School of Business, and Alexander Dyck of Harvard Business School overcome the problem of quantifying private benefits by examining the price a controlling shareholder pays for control. Their measure is based on the premise that if control guarantees special privileges, the acquirer of a controlling block in a publicly traded company should be willing to pay for it. The difference between the price per share paid for a controlling block, and the price that prevails on the market, reflects the present value of the benefits enjoyed exclusively by the controlling shareholder.

By examining 393 transactions in which a controlling block of a company was sold in a study of 39 countries, Zingales and Dyck find that, on average, corporate control is worth 14 percent of the equity value of a firm. Their estimates of the value of private benefits of control ranges from -4 percent of firm value in Japan to +65 percent of firm value in Brazil.

Countries with high private benefits include Argentina, Austria, Brazil, Columbia, the Czech Republic, Israel, Italy, Mexico, Turkey, and Venezuela. At the other extreme are countries where private benefits are 3 percent of equity value or less, including: Australia, Canada, Finland, France, Hong Kong, Japan, the Netherlands, New Zealand, Norway, Singapore, South Africa, Taiwan, the United Kingdom, and the United States.

Hindering the Development of Financial Markets

Should countries with high private benefits worry?

Zingales and Dyck suggest that the answer is yes, because extensive private benefits hinder the development of financial markets. In countries with a higher degree of private benefits, entrepreneurs will be more reluctant to take their companies public, and if they do, they are likely to retain a controlling stake. As a result, fewer companies will go public, and the equity markets in such countries will be underdeveloped. This pattern makes it more difficult for young companies to access financing.

Countries with high private benefits also are likely to have more concentrated ownership. Such concentration is likely to continue in the face of massive privatization, because in these countries the government will find it convenient to sell the controlling blocks via private negotiation, rather than issuing shares in the public market.

Curbing Private Benefits

"One of the goals of our research is to understand what can be done to curb private benefits and improve these underdeveloped markets," says Zingales.

To examine this question, Zingales and Dyck undertake a systematic analysis of what factors are associated with low private benefits of control. The authors take note of traditional mechanisms (such as legal protection of minority shareholders), but they also explore the effects of alternative mechanisms for keeping controlling shareholders in check. For example, they argue that a combination of an inquisitive, independent press and a large set of educated investors can be a powerful sanction on improper insider behavior.

The authors find that lower levels of private benefits of control are associated with a high degree of legal protection for minority shareholders, a high degree of law enforcement, a high rate of tax compliance, greater diffusion of the press, and a high degree of competition in the market for a company's products or services.

In what is their most important new finding, Zingales and Dyck document the role of corporate tax enforcement in reducing private benefits. Tax claims make governments a de facto minority shareholder in all publicly traded companies. As for minority shareholders, the government has an interest in ascertaining the value produced by a company. Transfer pricing, for instance, is disciplined by the tax code. In the United States, transfers between related corporate entities are supposed to take place at the price the two units would have charged in a competitive market. Hence, how tax authorities enforce their rules on transfer pricing affects how much incentive insiders may have to transfer profits to related companies. The stricter the enforcement, the less likely it is that a controlling shareholder will use transfer prices to siphon off value at the expense of minority shareholders.

Unlike minority shareholders, however, governments have the incentive to enforce these laws even when the cost of prosecution is higher than the money recoverable. By aggressively prosecuting a company, governments can set an example that induces the corporate sector to stay in line. Once income has been established for tax purposes, it is much more difficult for insiders to divert it to themselves. Therefore, a better tax enforcement system can play an important role in reducing the private benefits of control.

Leveling the Playing Field

"Our research indicates that the fastest road to financial development is improving a country's corporate taxation system," says Zingales.

Lower rates and greater enforcement can significantly reduce the amount of private benefits and make investing a fairer process.

In the meantime, however, investors have many reasons to be cautious. "When you buy a share in a country that has high private benefits of control, you don't really know what you're buying," says Zingales. "In certain countries, a large percentage of a company's value can be easily appropriated by the controlling shareholders."

In markets where private benefits are large, control will tend to go to companies skilled at taking advantage of these benefits. This represents a comparative disadvantage for U.S. companies abroad. Reducing private benefits will help level the playing field.

"Don't expect all countries to look like the United States," says Zingales. "In spite of cases like Enron, control is much more valuable in other countries-a fact that managers and policymakers need to recognize."


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Luigi Zingales is Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business.

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