Self‐dealing Regulations, Ownership Wedge, and Corporate Valuation: International Evidence

• Author: Michel Magnan,Mingzhi Liu
• Published date: 01 March 2011
• DOI: http://doi.org/10.1111/j.1467-8683.2010.00839.x
• Date: 01 March 2011

Self-dealing Regulations, Ownership Wedge,

and Corporate Valuation: International Evidence

Mingzhi Liu* and Michel Magnan

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Prior evidence suggests that investor protection enhances corporate valuation.Focusing on a key

investor protection measure, namely, self-dealing regulations, this study examines whether and to what extent the private

and public control components of that measure affect f‌irm value. Private control of self-dealing regulations emphasize

disclosure and shareholder approval mechanisms, while public control of self-dealing regulations imply enforcement

through prison terms, f‌ines, etc. Our analysis takes into account potential agency problems resulting from an ownership

wedge, i.e., situations in which cash f‌low rights are not consistent with control rights. Such situations are quite common in

many countries outside of the United States.corg_83999..115

Research Findings/Results: Based on 4,634 f‌irms from 22 countries, our empirical evidence indicates that private control of

self-dealing regulations enhances f‌irm value, while public control regulations lower f‌irm value. In addition, a high owner-

ship wedge, which proxies for agency problems between controlling shareholders and minority investors, dampens the

positive association between private control of self-dealing regulations and corporate valuation. However, ownership

wedge has no impact on the negativeassociation between public control of self-dealing regulations and corporate valuation.

Theoretical Implications: This study represents a ref‌inement and extension of prior work on the value implication from

investor protection regulations. It seeks to better def‌ine the implications of investor protection regulations by focusing on

some of its key components, thus leading to a better understanding of the relations between investor protection regulations,

ownership, and f‌irm value. Moreover, the study contributes to the current debate about the importance of country-level

institutions (versus f‌irm-level governance as proxied by ownership wedge) in determining f‌irm outcomes such as value.

Practitioner Implications: The paper’s empirical f‌indings may help policy markers better understand how investors react

to regulations about private and public control of self-dealing, thus enhancing their capability to enact more effective

regulations.

Keywords: Corporate Governance, Agency Theory, Corporate Valuation, Ownership Wedge, Self-Dealing Regulation

INTRODUCTION

Self-dealing, which is also called tunneling, represents a

controlling shareholders’ ability to expropriate corpo-

rate resources, thus transferring wealth away from non-

controlling shareholders. As such, it is essentially a

principal-principal agency problem and it has not been

investigated much in traditional agency theory research, the

focus being mostly on principal-agent problems (Khanna &

Palepu, 2000; La Porta, Lopez-de-Silanes, Shleifer, & Vishny,

2000b; Young, Peng, Ahlstrom, Bruton, & Jiang, 2008). Nev-

ertheless, in most countries with concentrated ownership,

self-dealing represents a critical challenge for investors,

auditors, market regulators, and agency researchers. Hence,

effective investor protection regulations, especially with

respect to self-dealing, are perceived to underlie equity

market development and equity values.

According to Bebchuk and Weisback (2010), investor pro-

tection research belongs to a subcomponent of corporate

governance research. Focusing on a specif‌ic aspect of inves-

tor protection, this study complements the mainstream cor-

porate governance research by investigating the relation

between self-dealing regulations and f‌irm value. More spe-

cif‌ically, we examine whether and how the private and

public control components of self-dealing regulations affect

f‌irm value. Private control of self-dealing emphasizes disclo-

sure regulations and shareholder approval of self-dealing

transactions, leaving shareholders with the responsibility to

*Address for correspondence: Mingzhi Liu, John Molson School of Business, Concor-

dia University, 1455 de Maisonneuve West, Montreal, Quebec, Canada H3G 1M8.

E-mail: l_mingzhi@jmsb.concordia.ca

99

Corporate Governance: An International Review, 2011, 19(2): 99–115

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00839.x

protect their interests. Public control of self-dealing relies on

regulatory or government monitoring of such transactions,

with penalties such as f‌ines and prison terms playing a key

dissuasive role.

Thus, our study extends prior work on self-dealing and on

the effectiveness of corrective investor protection regula-

tions. Shleifer and Vishny (1997), and Johnson, La Porta,

Lopez-de-Silanes, and Shleifer (2000) summarize various

methods that controlling shareholders can utilize to expro-

priate corporate resources: ineff‌iciency of resource alloca-

tions; personal loan guarantees using f‌irm’s assets as

collateral; special dividends; consumption of perquisites;

appropriation of corporate opportunities; outright theft of

corporate assets; and transfer pricing. La Porta, Lopez-de-

Silanes, Shleifer, and Vishny (1997, 1998) develop a series of

broad investor protection proxies that allow for the investi-

gation of the effect of investor protection on the variety of

country-level and f‌irm-level outcomes (e.g., Dyck & Zin-

gales, 2004; Haw, Hu, Hwang, & Wu, 2004; La Porta, Lopez-

de-Silanes, & Shleifer, 1999; La Porta, Lopez-de-Silanes,

Shleifer, & Vishny, 2000a, 2000b, 2002; Shleifer & Wolfenzon,

2002; Wurgler, 2000).

Consistent with prior investor protection research, we

argue that private control regulations restrict managers’ self-

dealing behaviors and thus enhance f‌irm value. Conversely,

we also predict that public control regulations may nega-

tively affect corporate performance and, ultimately, lower

f‌irm value. Based on agency theory, we argue that the need

for self-dealing regulations is most acute when there is a

divergence between cash f‌low and control rights – a situa-

tion referred to as an ownership wedge. For example, con-

trolling shareholders who havehigh ownership wedges may

exert their private control rights to decrease the effectiveness

of private control of self-dealing regulations. Therefore, we

expect private control of self-dealing regulations to be less

effective in enhancing f‌irm value when there is a high

ownership wedge. By contrast, the private control rights of

controlling shareholders have limited inf‌luence on the

effectiveness of the public control of self-dealing regulation

(e.g., f‌ines and prison terms). Thus, we predict that the own-

ership wedge of the largest controlling shareholder has no

signif‌icant impact on the association between public control

of self-dealing regulations and corporate valuation.

The agency problem resulting from the lack of conver-

gence between the interests of controlling shareholders and

those of minority investors is magnif‌ied when there is a

divergence, or wedge, between cash f‌low and control rights.

There is extensive research, especially in international set-

tings, on the impact of ownership wedges on the ability of

controlling shareholders’ to derive private benef‌its (e.g.,

Claessens, Djankov, & Lang, 2000; Claessens, Djankov, Fan,

& Lang, 2002; Faccio & Lang, 2002). These studies provide

empirical evidence that is consistent with the argument that

controlling shareholders’ with a high ownership wedge

have incentives to divert corporate resources through their

private control rights.

Despite the prevalence of self-dealing and ownership

wedges as critical investor protection issues in most coun-

tries around the world, there is scant evidence on their joint

impact on f‌irm value. On the one hand, most prior research

has considered the potential impact of self-dealing regula-

tions only through the prism of general investor protection

regulatory frameworks, such as an anti-director rights index

(e.g., see La Porta et al., 2000b). While an anti-director rights

index may serve as a proxy for a country’s investor protec-

tion, it captures broad regulatory governance concepts and

does not explicitly focus on any self-dealing. On the other

hand, protecting minority investors from self-dealing by a

controlling shareholder, often with an ownership wedge, is

the major investor protection challenge in most capital

markets. Bebchuk and Hamdani (2009) suggest that an anti-

director rights index mostly captures investor regulations

for widely-held f‌irms without a controlling shareholder

f‌irms. Addressing that issue, Djankov, La Porta, Lopez-de-

Silanes, and Shleifer (2008) develop a country-level anti-self-

dealing index to capture the strictness of mandatory

regulations with respect to self-dealing transactions. Besides

explicitly focusing on self-dealing, the index provides

detailed information about the regulations being enacted

and enforced. It consists of two components: private control

and public control of self-dealing regulations. In private

control of self-dealing regulations, enforcement is up to

shareholders, while in public control of self-dealing regula-

tions, enforcement is the responsibility of public authorities.

Our sample comprises 4,634 f‌irm observations from 22

countries (9 from East Asia and 13 from Western Europe).

Following previous literature (Chung & Pruitt, 1994;

Gompers, Ishii, & Metrick, 2003; Morck, Shleifer, & Vishny,

1988), we use Tobin’s q as a proxy for f‌irm value. Private and

public control of self-dealing are measured according to

Djankov et al. (2008). The agency problem between control-

ling and minority shareholders is captured by the owner-

ship wedge (Claessens et al., 2000, 2002; Faccio & Lang,

2002). We f‌ind that private control of self-dealing regulations

improve corporate valuation, while public control of self-

dealing regulations decrease corporate valuation. In addi-

tion, a high ownership wedge decreases the effectiveness of

private control of self-dealing regulation in improving cor-

porate valuation. However, ownership wedges have no sig-

nif‌icant impact on the negative association between public

control of self-dealing regulation and corporate valuation.

Our main results hold after some robustness checks.

We summarize the primary contributions of this study as

follows. First, and most importantly, the informationcontent

of the anti-self-dealing index makes it possible to compare

the effectiveness of the different components of self-dealing

regulations in enhancing f‌irm value. By focusing on the sub-

components of an investor protection regulation (private

and public control of self-dealing), our results help bridge

the gap in our understanding of the relation between inves-

tor protection regulations and f‌irm value. The differential

impact of private and public control of self-dealing regula-

tions on f‌irm value suggests that the use of highly aggre-

gated investor protection indices may hide or distort our

view of their outcomes on f‌irm performance or value. Such

a f‌inding is consistent with the view put forth by Bhagat,

Bolton, and Romana (2008) that composite governance

metrics may not capture the actual effectiveness of a f‌irm’s

governance. This f‌inding is important to market participants,

especially to policy makers.1

Second, by focusing on ownership wedges, our study

complements the ownership structure literature by jointly

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