Why do minority investor protections matter?
One of the most important issues in corporate governance is self-dealing—the use of corporate assets by company insiders for personal gain. Related-party transactions are the most common example. High ownership concentration and informal business relations can create the perfect environment for such transactions, which allow controlling shareholders to profit at the expense of the company’s financial health—whether because company assets are sold at an excessively low price, assets are purchased at an inflated price or loans are given by the company to controlling shareholders on terms far better than the market offers.
Empirical research shows that stricter regulation of self-dealing is associated with greater equity investment and lower concentration of ownership.1 This conclusion is in line with the view that stronger legal protections make minority investors more confident about their investments, reducing the need for concentrated ownership to mitigate weaknesses in corporate governance.
Other aspects of corporate law are also indicative of the strength of minority shareholder protections. The literature provides evidence that corporate governance standards in certain areas are particularly important, such as those relating to board composition and independence, firm transparency and disclosure, and the rights of shareholders relative to the board of directors and management. Sound rules and regulations in these areas of corporate governance minimize the agency problem between majority and minority shareholders as well as that between minority shareholders and the board of directors and management.
Investor protections matter for the ability of companies to raise the capital needed to grow, innovate, diversify and compete. Without investor protections, equity markets fail to develop and banks become the only source of finance. Economies that have dynamic capital markets tend to protect investors effectively. In these economies investors receive financial information they can trust, they participate in major decisions of the company, and directors are accountable for their managerial decisions. If the laws do not provide such protections, investors may be reluctant to invest, unless they become controlling shareholders. 2
Minority investor protections can have important implications for firm valuation. Research on 539 large firms in 27 economies shows that firm valuation is higher in economies with good investor protections than in those with poor protections.3 Other research shows that corporate risk-taking and firm growth rates are positively related to the quality of the system of investor protections. Better systems may lead corporations to undertake riskier but value-enhancing investments.4
A study analyzing the effects of related-party transactions on companies listed on the Hong Kong Stock Exchange during 1998–2000 finds that the transactions led to significant losses in value for minority investors. Indeed, the mere announcement of a related-party transaction led to abnormal negative stock returns. The study concludes that investors considered companies with a history of such transactions (even if not prejudicial) to be riskier investments than those with no such history. Other research, using a sample of 462 Malaysian firms, shows that related-party transactions carried out by family-owned firms are more likely to be used opportunistically to expropriate minority investors.5
Another study finds that investment in firms is less sensitive to financial constraints and leads to greater growth in revenue and profitability in economies with stronger investor protections.6 Research also suggests that regulating conflicts of interest is essential to successfully empowering minority shareholders.7
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1 Djankov, Simeon, Rafael La Porta, Florencio López-de-Silanes and Andrei Shleifer. 2008. “The Law and Economics of Self-Dealing.” Journal of Financial Economics 88 (3): 430–65.
2 Dahya, Jay, Orlin Dimitrov and John McConnell. 2008. “Dominant Shareholders, Corporate Boards, and Corporate Value: A Cross-Country Analysis.” Journal of Financial Economics 87 (1): 73–100.
3 La Porta, Rafael, Florencio López-de-Silanes, Andrei Shleifer and Robert Vishny. 2002. “Investor Protection and Corporate Valuation.” Journal of Finance 57 (3): 1147–70.
4 John, Kose, Lubomir Litov and Bernard Yeung. 2008. “Corporate Governance and Risk-Taking.” Journal of Finance 63 (4): 1679–728.
5 Munir, Sa’adiah, and Reza Jashen Gul. 2010. “Related-Party Transactions, Family Firms and Firm Performance: Some Malaysian Evidence.” Finance and Corporate Governance Conference 2011 Paper. Available at http://ssrn.com/abstract=1705846.
6 Mclean, R. D., T. Zhang and M. Zhao (2012), “Why Does the Law Matter? Investor Protection and Its Effects on Investment, Finance, and Growth,” Journal of Finance 67: 313–50. doi: 10.1111/j.1540-6261.2011.01713.x
7 Hamdani, Assaf, and Yishay Yafeh (2012), “Institutional Investors as Minority Shareholders,” Review of Finance, February 7. doi: 10.1093/rof/rfr039.
