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."
