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 Decreasing Marginal Costs Due to Precaution Increasing Marginal Costs Due To Production Strict Liability Rule – MC 1 Contracted Liability Rule – MC 1 Expected Liability – MC 1 a1a1 $C 1

Secured Creditors Preferred Creditors Unsecured Creditors Shareholders Banks Debentures Bonds 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 a1a1 $C 1

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