Investor protection and the value of shares: Evidence from statutory rules governing variations of shareholders’ class rights in Russia

Муравьёв Александр Александрович

Институт изучения рынка труда (IZA), г. Бонн, Германия

Немецкий институт экономических исследований (DIW Berlin), г. Берлин, Германия

Высшая Школа Менеджмента СпбГУ, г. Санкт-Петербург

Investor protection and the value of shares: Evidence from statutory rules

governing variations of shareholders’ class rights in Russia

(Эмпирическая оценка влияния правовой защиты инвесторов

на цены акций российских компаний)

In the last few decades, scholars in economics, finance, and law have taken a growing interest in the effect of investor protection – which comes from law, stock exchange regulations, and firm-level provisions – on corporate governance and performance. Initially, the debate concentrated on the role of formal law, with two broad views on the subject-matter gradually crystallizing in the literature. One perspective suggests that corporate law is largely unnecessary because sophisticated suppliers and users of capital choose the efficient level of investor protection via private contracting (Grossman and Hart 1980; Easterbrook and Fischel 1991). Originating in the Coase (1960) theorem, it crucially relies on the assumption of costless contracting and well-functioning enforcement institutions. Corporate law may be trivial because many of its rules are market mimicking while others are avoidable, changeable, or unimportant (Black 1990). The other perspective emphasizes high payoffs from opportunistic behavior, as well as expensive and imperfect enforcement of contracts, which create incentives for users of capital to expropriate investors. In such circumstances, it is argued, explicit law can reduce the enforcement costs and restrain opportunistic behavior by providing standard form contracts for the parties involved (Coffee 1989; Mahoney 1995).

The debate about the role of investor protection and corporate law in particular was given a new impetus with the emergence in the late 1990s of the empirical “law and finance” literature (La Porta et al. 1997, 2000; La Porta, Lopez de Silanes, and Shleifer 1998). Based on cross-country comparisons, these studies have established a link between corporate law and the regulatory environment on the one hand and access to finance, corporate ownership, and company valuation on the other. More recently, there is a growing international literature analyzing the impact of changes in legal protection in a particular jurisdiction on shareholder returns and company value (Nenova 2006; Black and Khanna 2007; Litvak 2007). The Sarbanes-Oxley Act (SOX), passed in the US in the aftermath of the financial scandals and bankruptcies that unfolded at the turn of the century, is one of the most studied legal changes of this type (Li, Pincus, and O. Rego 2008; Jain and Rezaee 2006; Zhang 2007; Chhaochharia and Grinstein 2007; Wintoki 2007). Another rapidly developing field of research deals with corporate governance practices adopted by firms in order to protect investors (Gompers, Ishii, and Metrick 2003; Bebchuk, Cohen, and Ferrell 2004; Dahya and McConnell 2007). These strands of literature are bridged together in studies that ask how firm-level provisions interact with legal protection at the country level, including the cases when firms opt out of corporate law in order to provide better protection to their investors (Klapper and Love 2004; Bruno and Claessens 2007; Bergman and Nikolaevsky 2007).

Despite these numerous contributions, the empirical evidence concerning the importance of investor protection for corporate governance and performance is far from being conclusive (Black and Khanna 2007). This is partly due to serious modeling challenges facing empirical research in the field, among which identification of the causal effect of investor protection stands out. Indeed, cross-country studies such as La Porta et al. (1998), which have generated the strongest evidence of the importance of legal protection to date, suffer from endogeneity problems, in particular, due to the omission of confounding factors at the country level (Costa and Mello 2006). Endogeneity problems also plague studies that analyze corporate governance practices at the firm level. A fast growing firm, for example, may adopt better governance practices in order to ensure access to external financing at a lower cost (Klapper and Love 2004). The causation may, therefore, run not only from investor protection to firm performance, but also the other way around.

Identification based on changes in law in a particular jurisdiction has also proved to be difficult because such changes typically apply to all firms at the same time, which makes it difficult to establish a counterfactual outcome, against which the effect of the policy intervention is to be evaluated.1 Event studies, which are often used in the corporate finance literature in such circumstances, cannot perfectly rule out contemporaneous confounding factors. In addition, ambiguities associated with choosing appropriate event windows may lead event studies to opposite conclusions about the same policy interventions. For example, recent research by Zhang (2007) and Litvak (2007) finds a total negative effect of SOX on firm value while both Li et al. (2008) and Jain and Rezaee (2006) report a total positive effect, with some indication that the difference in the findings may be due to the different event windows chosen (Chhaochharia and Grinstein 2007; Li et al. 2008).2

This paper takes advantage of an experimental framework provided by recent changes in statutory rules governing dual class stock in Russia to study how legal protection affects share prices. Specifically, it investigates the effect of introducing a mandatory rule that can unambiguously be interpreted as an improvement in the protection of preferred (non-voting) shareholders in Russian companies with dual class stock. The law change considered took effect in January 2002 and endowed preferred shareholders with the right to veto any decisions of the shareholder meeting that could adversely affect their “class rights”.3 Importantly, the statutory change did not affect all dual class stock companies in the same way. Some corporate charters already contained the veto provision by the time the company law was altered in 2001. In statistical terms, this allows the researcher to divide all Russian firms with dual class stock into the treatment and control groups, the former embracing companies that were affected by the statutory change and the latter including companies that were not affected. These unique features of the country’s company law and dual class firms provide an excellent opportunity for identification of the causal effect of legal protection on stock values.

The paper is based on a novel hand-collected dataset of Russian dual stock companies that combines the 2000-2002 share trade data from the Russian Trading System (RTS) stock exchange with additional information from companies’ charters and quarterly reports to the Federal Financial Market Service (FFMS). We focus on the effect of the statutory change on the value of preferred (non-voting) stock. The latter is measured relative to the value of common shares, using the “voting premium” approach. This has two virtues. First, from the substantive viewpoint, the voting premium may be directly related to the risk of expropriation of non-voting shareholders (Goetzmann et al. 2003) and to private benefits of control (Dyck and Zingales 2004), which investor protection aims to curtail (La Porta et al. 2000). Second, from the econometric perspective, using the relative value of preferred stock is similar to additional differencing in that it helps eliminate idiosyncratic characteristics of firms that affect prices of both classes of shares.

Our main empirical results are derived from a multivariate regression analysis using several versions of the difference-in-difference (DID) estimator, including one with firm fixed effects and another one based on the median regression. The results show a statistically and economically significant effect of introducing a mandatory rule that protects preferred shareholders on the value of preferred stock. In particular, our estimates suggest that the premium on voting shares in Russian dual class stock companies comprising the treatment group declined by about 30 percentage points (relative to the average of 146 percent observed in the full sample in 2001) as a consequence of the statutory change and this result holds for a number of alternatively defined pre- and post-treatment periods. It should, however, be acknowledged that the legal change considered explains a relatively small fraction of the overall variation of the voting premium in 2000-2005 (according to Muravyev (2009), the premium was continuously falling from about 200% in 2000 to mere 45% in 2005) and therefore played only a limited role in the development of corporate governance in Russia.

The major strength of this paper stems from its identification strategy, which exploits an exogenous change in law affecting a clearly defined sub-sample of firms. This allows estimation of the causal effect of investor protection on the value of shares, which many previous studies found difficult to identify (Black and Khanna 2007). The paper contributes to the literature by documenting a key role of law and in particular, of its mandatory rules, in restraining shareholder expropriation and boosting share prices. It also highlights the importance of legal mechanisms protecting against “class rights” changes in companies with multiple classes of stock that deviate from the one share – one vote principle, a topic that has largely been overlooked in the literature. Because the paper focuses on Russia, a country which has been notoriously known for inefficient enforcement of law, its findings may also be useful in the ongoing debate concerning the role of formal law in the weak enforcement environment (Pistor, Raiser, and Gelfer 2000; Berglof and Claessens 2004; Nenova 2006). The present analysis suggests that law on the books may work even when law enforcement is far from perfect. The paper also extends international literature on investor protection, private benefits of control, and dual class shares, which still lacks systematic evidence from Russia despite the remarkable developments in its emerging stock market during the last decade.4

Few studies identify the causal effect of improved investor protection by exploiting various types of “natural experiments”, which generate well-defined treatment and control groups (embracing, respectively, firms that are affected and those that are not affected by changes in law). These include Black, Jang and Kim (2006), Black and Khanna (2007), and Litvak (2007), among others.

2 In addition, studies of changes in corporate law usually say little about specific provisions and norms, because law changes come in packages. As shown by Bebchuk et al. (2004), not all provisions may matter in corporate governance.

3 These include, for example, preferred shareholders’ dividend entitlements and their special rights in the event of reorganization and liquidation of the company.

4 Goetzmann, Spiegel, and Ukhov (2003), Black, Love and Rachinsky (2006), Dyck, Volchkova, and Zingales (2008) and Muravyev (2009) are among the few exceptions in this regard.

References

Bebchuk, Lucian A., Alma Cohen, and Allen Ferrell (2004) What Matters in Corporate Governance? Working paper, Harvard Law School and NBER.

Berglof, Erik, and Stijn Claesseus (2004) Corporate Governance and Enforcement. World Bank Policy Research Working Paper No. 3409, World Bank.

Bergman, Nittai K. and Nicolaievsky, Daniel (2007) Investor Protection and the Coasian View. Journal of Financial Economics, 84(3): 738-771.

Black, Bernard S. (1990) Is Corporate Law Trivial?: A Political and Economic Analysis. Northwestern University Law Review 84: 542-597.

Black, Bernard S., Hasung Jang, and Woochan Kim (2006) Does Corporate Governance Predict Firms' Market Values? Evidence from Korea. Journal of Law, Economics and Organization, 22(2): 366-413.

Black, Bernard S., Love, Inessa, and Rachinsky, Andrei (2006) Corporate Governance Indices and Firms' Market Values: Time Series Evidence from Russia. Emerging Markets Review, 7(4):361-379.

Black, Bernard S. and Khanna, Vikramaditya S. (2007) Can Corporate Governance Reforms Increase Firm Market Values? Event Study Evidence from India. Journal of Empirical Legal Studies, 4(4): 749-796.