corporations finance december 5, 2006. corporations issues in finance shares entitles shareholders...

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


CompetingShareholders


• 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


• Rights• Property rights – Coasean Contract – Why?• Where do these rights originate?• Do these rights vary from jurisdiction to

jurisdiction?


• 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


• 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.


• 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


• What laws contribute to investor and creditor protection:

• Company law• Insider trading law• Bankruptcy law• Chapter 11 laws


• 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


• Who benefits most by contractual opting out?

• Insiders• Directors• Lawyers

• Who loses most by contractual opting out?• Outside shareholders• Minority shareholders


• 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


• 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


• 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?


• LaPorta also found that concentration of ownership of shares in the largest public companies is negatively related to investor protections. Why?


• 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.


CompetingCreditors


• 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

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$C1

Secured Creditors

Preferred Creditors

Unsecured Creditors

Shareholders

BanksDebenturesBonds

Revenue Canada, Judgments

Employees, Suppliers


• 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


• Limited Liability• New Expectation Damages Rule Subject To The Limited Liability Rule

Limited Liability Rule

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$C1


• The right to seize collateral underlies two procedures

• Liquidation• Corporate Reorganization


• 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


• If legal rules do not matter, then do contracts matter?


• 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


• 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


• 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

corporations finance december 5, 2006. corporations issues in finance shares entitles shareholders...

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