December 5_ 2006

							CORPORATIONS
     Finance
  December 5, 2006
            CORPORATIONS
            Issues In Finance
• Shares
    • Entitles shareholders to receive dividends
    • Entitles shareholders to vote for directors
• Debt
    • Entitles creditors to receive interest payments
    • Entitles creditors to receive collateral in default
CORPORATIONS
Issues In Finance




       Competing
       Shareholders
           CORPORATIONS
           Issues In Finance
• Shares
    • Property rights – Coasean Contract – Why?
    • Eliminates the prisoner dilemna in unenforceable
      investment:
           » If shareholders do not receive dividends, they have
             the right to vote out the directors
            CORPORATIONS
            Issues In Finance
• Rights
    • Property rights – Coasean Contract – Why?
    • Where do these rights originate?
    • Do these rights vary from jurisdiction to
      jurisdiction?
       CORPORATIONS
       Issues In Finance
• Answer – Look at what happens in each country
      » If a country has no publicly traded corporate shares -
        what does this mean?
      » If a country has a small stock market, but big banks,
        what does this mean?
      » Why is the price differential between the voting share
        class and non-voting share class small in some
        countries and large in other countries
           CORPORATIONS
           Issues In Finance
• The Laporta paper examined legal rules
  covering protection of corporate
  shareholders and creditors, the origin of
  these rules, and the quality of their
  enforcement in 49 countries.
           CORPORATIONS
           Issues In Finance
• The Laporta paper recognized two broad
  legal families of rules:

    • Common law (United States (Delaware), Canada
      (Ontario), Britain, India, ...)
          » Stronger enforcement of shareholder and debtor
            rights


    • Civil law (France, Germany, Sweden, ...)
          » Weaker enforcement of shareholder and debtor
            rights
               CORPORATIONS
               Issues In Finance
• What laws contribute to investor and
  creditor protection:
     •   Company law
     •   Insider trading law
     •   Bankruptcy law
     •   Chapter 11 laws
             CORPORATIONS
             Issues In Finance
• What happens in countries with weaker
  enforcement of shareholder and debtor
  rights?
• What would Jensen and Meckling expect
  to happen?
    • Pooling or concentration of public and private
      shares occurs.
    • Why? Monitoring or agency costs are higher
      because of weak external property rights.
    • Pooling reduces the per capita agency costs
             CORPORATIONS
             Issues In Finance
• Who benefits most by contractual opting
  out?
    • Insiders
    • Directors
    • Lawyers
• Who loses most by contractual opting out?
    • Outside shareholders
    • Minority shareholders
                 CORPORATIONS
                 Issues In Finance
• In common law jurisdictions, when contractual
  opting out is prevented
     • The rule “One Share – One Vote” applies
     • Outsider and minority shareholders have stronger rights
• In common law jurisdictions, when contractual
  opting out occurs
     • The rule “One Share – Many Votes” may apply as a matter of
       contract
     • The rights of minority and outside shareholders are
       weakened
               CORPORATIONS
               Issues In Finance
• In common law jurisdictions, when
  contractual opting out occurs, it may be
  limited by statute
     • The derivative law suit allows minority
       shareholders to challenge the directors’ decisions
       directly
     • Another “oppression remedy” allows minority
       shareholders to be bought out at a fair price
           CORPORATIONS
           Issues In Finance
• LaPorta’s results demonstrated that
  common-law countries generally have the
  strongest, and French-civil-law countries
  the weakest, legal protections of investors,
  with German- and Scandinavian-civil-law
  countries located in the middle. Why?
          CORPORATIONS
          Issues In Finance
• LaPorta also found that concentration of
  ownership of shares in the largest public
  companies is negatively related to investor
  protections. Why?
            CORPORATIONS
            Issues In Finance
• LaPorta’s result was consistent with the
  hypothesis that small, diversified
  shareholders are unlikely to be important
  in countries that fail to protect their rights.
CORPORATIONS
Issues In Finance




       Competing
       Creditors
                   CORPORATIONS
                   Issues In Finance
 • Imperfect Information
$C1   •Decreasing Marginal Costs Due to Precaution
      •Increasing Marginal Costs Due To Production


                        Strict Liability Rule –
                        MC1

                        Contracted Liability
                        Rule – MC1


                        Expected Liability –
                        MC1

                                                     a1
                            Banks
Secured Creditors           Debentures
                            Bonds


                       Preferred Creditors
                    Revenue Canada, Judgments

                      Unsecured Creditors

                     Employees, Suppliers

                         Shareholders
            CORPORATIONS
            Issues In Finance
• Debt
    • Property rights – Coasean Contract – Why?
    • Eliminates the prisoner dilemna in unenforceable
      debt:
          » If creditors do not receive interest payments, they
            have the right to seize collateral
                    CORPORATIONS
                    Issues In Finance
 • Limited Liability
$C1   • New Expectation Damages Rule Subject To The Limited Liability Rule




                         Limited Liability Rule




                                                                       a1
             CORPORATIONS
             Issues In Finance
• The right to seize collateral underlies two
  procedures
     • Liquidation
     • Corporate Reorganization
              CORPORATIONS
              Issues In Finance
• All of this relates to a fundamental
  question in economics
     • Do legal rules matter?
     • Recall Pigou:
           » No legal rules do not really matter – that is why he
             recommended taxation or subsidy based policies
            CORPORATIONS
            Issues In Finance
• If legal rules do not matter, then do
  contracts matter?
              CORPORATIONS
              Issues In Finance
• What would Neary and Winter expect to
  happen?
     • Not that much difference among jurisdictions.
       Why? Problems of verifiability are global
     • Long-Term Contracts do matter
• Similarly, Easterbrook and Fischel
     • Not that much difference among jurisdictions.
       Why? Corporations opt out of legal rules by way of
       contracts among the various hierarchies
     • Contracts matter
              CORPORATIONS
              Issues In Finance
• What can make contracts less important
  because they are less effective?
     • High transaction costs


• What happens if agency costs are even
  higher relative to high transaction costs?
     • Contracts will matter more
           CORPORATIONS
           Issues In Finance
• LaPorta’s study concluded
    • Legal rules do matter
          » In common law countries both shareholders and
            creditors receive stronger protection
    • Law enforcement is strongest in common law
      countries, especially if they have good accounting
      standards.
    • Countries do develop substitute mechanisms
      when the law provides poor investor protection.
    • Ownership concentration does occur in countries
      with poor investor protection
          » Average – The three (3) largest shareholders own
            50% of the shares