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Do Differences in Legal Protections Explain Differences in Ownership Concentration?

By Harvard Law School Program on Corporate Governance

One of major findings of the law and finance literature comparing corporate governance across countries is that large-percentage shareholders in public corporations are a response to weak legal protections for investors. Thus, it is reported that common law countries have less concentrated ownership than civil law countries because they afford stronger legal protections for investors. Similarly, it is reported that ownership is less concentrated in countries with strong investor protection laws.

The papers that reach these conclusions analyze country averages of ownership concentration instead of firm-level data. I just released a paper in which I show that this creates omitted-variable and aggregation biases. Aggregation, in particular, eliminates all within-group (country) variation, leading to artificial clustering. Most papers also use small samples of large firms. This makes inferences to country populations problematic because ownership concentration is inversely related to firm size and firm size varies across countries.

I correct for these limitations by analyzing firm-level observations; control for firm-level determinants of ownership concentration, including size; and use a broad sample of firms from 32 countries. When I take these steps there is no support for the widely held theory that large shareholders are a response to weak legal protections for investors. In particular, there is no relation between ownership concentration and whether a firm comes from a common law country. Similarly, there is no systematic relation between ownership concentration and 14 broad indices of investor protection laws. An index is as likely to be positively associated with ownership concentration as it is to be negatively associated with ownership concentration.

Given these findings, I re-examine the theoretical literature that predicts a negative relation between investors? legal protections and ownership concentration. There are two branches to this literature, and they have diametrically opposed views on the role of large shareholders in public corporations. One branch models external blockholders who monitor management to stop the appropriation of corporate resources. The problem is that around the world blockholders typically are managers. The other branch, in contrast, models internal blockholders who appropriate corporate resources. Although this comports with the reality that most blockholders are insiders, it is inconsistent with evidence showing that in most countries firm value increases with ownership concentration. Both branches of the literature ignore the effects of large shareholders on management decisions. Given how broadly large shareholders can impact management and given that management decisions are not subject to judicial review, even in countries with strong legal systems, there is no reason to expect ownership concentration to vary with investors? legal protections.

The full paper is available here.

Full post as published by The Harvard Law School Corporate Governance Blog on May 16, 2008 (boomark / email).