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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
• 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
• Imperfect Information•Decreasing Marginal Costs Due to Precaution
•Increasing Marginal Costs Due To Production
Strict Liability Rule –MC1
Contracted Liability Rule – MC1
Expected Liability – MC1
a1
$C1
Secured Creditors
Preferred Creditors
Unsecured Creditors
Shareholders
BanksDebenturesBonds
Revenue Canada, Judgments
Employees, Suppliers
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• New Expectation Damages Rule Subject To The Limited Liability Rule
Limited Liability Rule
a1
$C1
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
• 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