The Law and Economics of Self-Dealing
"Countries with successful stock markets mandate that shareholders receive the information they need and the power to act - including both voting and litigation - on this information. The empirical results further suggest that an effective strategy of regulating large self-dealing transactions is to combine full disclosure of such transactions with the requirement of approval by disinterested shareholders."
Investor expropriation -- also known as self-dealing or tunneling -- takes such forms as excessive executive compensation and perquisites, transfer pricing, insider trading, self-serving transactions, and outright theft. In The Law and Economics of Self-Dealing (NBER Working Paper No. 11883) by Simeon Djankov, Rafael LaPorta, Florencio Lopez-de-Silanes, and Andrei Shleifer, the focus is on the kinds of cases in which controllers of companies make deals that may benefit them at the expense of other investors, but in which -- unlike in the Enron and Parmalat scandals -- the controllers observe the laws regarding disclosure and approval procedures. One of the primary questions the researchers ask is: if a controlling shareholder wants to enrich himself without breaking the law, how difficult is it for minority shareholders either to thwart the deal or, if it is carried out, to recover damages?
In order to determine which nations best protect minority shareholders from such abuses - and to ascertain how those protections affect a nation's financial development - the researchers create a hypothetical scenario in which a corporate officer who owns large portions of two companies engages in a self-dealing sales transaction between the firms that benefits the officer via an inflated payment. They presented this scenario to members of Lex Mundi, an association of international law firms that operates in 108 countries. The lawyers were asked to describe the legal barriers in their countries to getting away with such a transaction.
Lawyers from 102 countries provided complete answers to the researchers' questionnaire. The researchers conducted follow-up inquiries, and the sample they used for this paper was based on the responses of 72 lawyers who confirmed the validity of the aggregate data.
The lawyers were asked to describe the minimum legal requirements in force in May 2003 regarding who approves a transaction such as described in the hypothetical scenario; what needs to be disclosed to the board of directors, the stock exchange, and the regulators; the duties of corporate officers, directors, and controlling shareholders; how the transaction's validity could be challenged; what plaintiffs would need to prove to recover damages; access to information; fines and other penalties, and the like. Based on the data, the authors reached several conclusions. Primary among these is that the index for minority shareholder protection is sharply higher in common law countries, such as the United Kingdom (which ranks fifth on the anti-self-dealing index), than in civil law countries, such as Italy (forty-second on the index). This is consistent with earlier studies that concluded that investor protection is higher in common law countries than in civil law ones.
The researchers also were interested in how the regulation of self-dealing might relate to the development of a nation's stock market. It was also clear that the index is a statistically significant and economically strong predictor of a variety of measures of stock market development across countries. Foremost among these measures is the ratio of stock market capitalization to GDP. The index results support earlier findings that demonstrated that common law countries have much more valuable stock markets relative to their GDPs than do civil law countries. The results also show that theoretical measures of investor protection are closely linked to financial development.
The researchers could not isolate a single "best" measure of shareholder protection, but concluded that measures of shareholder protection from securities laws appear to work best in terms of predicting stock market outcomes; the data for this, however, was available for only 49 countries. These measures moreover are particularly appropriate for studies of protection of investors buying securities, as opposed to corporate governance per se.
The researchers say that perhaps the most basic conclusion from their data is that laissez-faire - having no public regulation or oversight at all - is certainly not conducive to developing financial markets. Countries with successful stock markets mandate that shareholders receive the information they need and the power to act - including both voting and litigation - on this information.
The empirical results further suggest that an effective strategy of regulating large self-dealing transactions is to combine full disclosure of such transactions with the requirement of approval by disinterested shareholders. Similarly, the results suggest that ongoing disclosure of self-dealing transactions, combined with a relatively easy burden of litigation placed on the aggrieved shareholders, also benefits stock market development.
Finally, the evidence suggests that the government's power to impose fines and imprisonment for self-dealing transactions that meet disclosure and approval requirements does not benefit stock market development. The authors stress that this is a narrow conclusion, since it does not address the importance of public enforcement in situations where self-dealing transactions are concealed, as in the cases of Enron and Parmalat. To avoid self-dealing, however, it appears best to rely on extensive disclosure, approval by disinterested shareholders and private enforcement.
-- Matt Nesvisky