Takeover Laws and Financial Development

Author:Tatiana Nenova
Profession:Senior Economist in SASFP

The issue of "an appropriate" legal framework, especially in the case of the takeover market, has been poorly studied in the case of emerging markets, yet it is of immediate relevance and practical policymaker interest. The study makes a first attempt to analyze takeover regulations in a comparative context across 50 countries. It proposes a methodology to create a detailed index on the most... (see full summary)


    Tatiana Nenova. The author would like to thank Simeon Djankov, Alex Berg, Mierta Capaul, Catherine Hickey, Teresa Barger, Mike Lubrano, Stijn Claessens, Vidhi Chhaochharia, Richard Symonds, Claire Grose, and Inessa Love for their comments. Toni Naneva provided excellent research assistance. Tatiana Nenova is a Senior Economist in SASFP, and can be reached at tnenova@worldbank.org.

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Capital markets are essential to the growth and development of a country's economy.1 First, they channel available funds towards growing businesses (funds may be available from corporate shareholders, domestic and foreign investors, pension funds, banks, insurance companies, or other institutional investors). Second, such markets fill in the gaps left by bank financing, which may not be offered at long maturities and often requires costly and scarce collateral. Equity financing, better than banks, can assume the risk of young fast-growing innovative businesses (such as the challenger airline in Brazil, GOL), which are in need of significant funds, and have grown beyond the self-financing pocket of their owner / entrepreneur, but are too risky for a single bank to finance, and too large for a venture capital firm to engage in. Third, capital markets provide a diversification strategy and growth outlet for key players in a nation's economy, such as pension funds, which can develop only in the presence of a set of markets that would permit their portfolio to reduce risk and reap returns for the beneficiaries.

Capital markets therefore have been a priority focus of national development strategies in the past 15 years. However, past experience shows that promoting a well-functioning and stable capital market that is effective in raising external financing has been an elusive goal for many countries. Policymakers have emphasized the importance of an appropriate regulatory framework to the successful pursuit of a capital markets development strategy. Two studies in the late 1990s first demonstrated convincingly in a cross-country context that laws and financial markets regulation have a tangible and important impact on markets and financial development (La Porta et al 1997, 1998). A veritable flood of research on the impact of laws and regulations on capital markets followed, further deepening our understanding of the area. In addition to cross-country studies, single-country research has been abundant, often focused on the US or UK, and other OECD countries, and recently complemented by research on Brazil, India, and Russia, on a wide range of capital markets topics including corporate control and takeover issues.2 Studies confirmed the importance of regulation for development. To name but one example, efficiently functioning legal frameworks were found to encourage firms to use external financing and grow. The literature also uncovered that markets do not react to the promulgated laws, but instead to the first signs of effective enforcement.3

Securities and corporate regulations present an entangled body of law which has been hard for academics to quantify in sufficient detail in order to study its impact on development and growth.4 As a result, though we know of the overall importance of laws for financial development, it has been difficult for policymakers and researchers alike to draw specific conclusions on the impact of particular legal provisions. One reason for the paucity of cross- country studies of specific regulations is the sheer complexity of gathering and systematizing the data. The standard approach has been to identify legal provisions and codify them into quantifiable variables, such as the LLSV six-component anti-director index on investor protection.5 On acquisition regulation, the sole cross-country index in existence is the Nenova (2001) three-component takeover rules index. The measures of regulations and laws used in such studies are too aggregated, however, and show a general level of legal protection. The measures do not reflect the regulations in detail; rather, they are useful in providing a proxy for the overall quality of capital markets rules. As such, the measures help in showing the importance of regulation and institutions; however, they are less informative on the pros and cons of specific legal mechanisms. Pioneering efforts in delving deeper into the body of law have been provided by World Bank's Doing Business Report, which codifies specific regulations in cooperation with Page 2 legal experts around the world. Topics of focus include company regulations on starting a business, labor laws, contract enforcement, creditor rights and information, bankruptcy, and investor protection, among others.6 La Porta, Lopez-de-Silanes, and Shleifer (2006) is perhaps the work using the closest approach to this paper, in that it codifies the securities laws in 49 countries along several dimensions, and uses the newly formed variables to examine the effect of securities laws on stock market development.

This study takes a first step in the above direction by offering a methodology that would fully characterize the set of rules and regulations concerned with changes of corporate control, takeovers, tender offers, and general acquisition activity. Should the methodology prove successful, it is replicable for other facets of capital markets regulation. The framework, allowing a detailed quantification of a given regulation, in this case takeover market rules, permits the exploration of policy implications of the securities laws as they relate to share acquisitions. Specifically, one can explore the effects of individual regulations, their substitutability and interplay, as well as the overall extent of friendliness of the laws to investors, or particular groups thereof (such as minority shareholders), and the links of specialized regulation with the overall legal system. Finally, and most importantly, the methodology permits the study and demonstration of the impact of particular regulations on market development, in particular market breath and depth. This paper does not explore those issues in detail, and focuses instead on presenting the methodology and general uses of the new data; detailed exploration on specific regulations is relegated to further research. The issue of "an appropriate" legal framework, especially in the case of the takeover market, has been poorly studied in the case of emerging markets, yet it is of immediate relevance and practical interest, in particular in Latin America, East and South Asia, and Central Europe.

The literature exploring takeovers issues is extensive, and recent overviews are presented in Burkart and Panunzi (2006), Andrade, Mitchell and Stafford (2001), Bhagat, Shleifer and Vishny (1990), among others. Relevant literature is cited further along in the paper, as specific topics are discussed, e.g. mandatory offers or going private deals.

1. The market for corporate control

Corporate control transactions occur for several reasons. First, in the natural growth cycle of a company, the original entrepreneur may find his brainchild grown beyond the proportions of a small one-owner firm. Due to the need for additional financing, professional management, organizational complexity, costs of running the business, diversification motives, or any other idiosyncratic cause, the main owner may want to sell control of the company. Second, and related, the descendants of the original founder may wish to sever their ties with the family company, because there are succession issues, or the family is distanced from effective company management and does not feel comfortable with the risk exposure without commensurate control, so as to prefer to diversify their financial holdings into investments that would lower their overall risk of value loss. Control may also be sold to a multinational company, which brings in the know-how, marketing, and distribution channels that are inaccessible to a stand- alone firm. In countries with less concentrated ownership, control can be claimed in a hostile Page 3 attempt, by a bidder who believes that company value can be enhanced. Friendly or hostile deals can also be executed for reasons of expected synergies between the acquirer and target.

Control is defined here conventionally as influence over corporate decision-making via a given number of votes in a general assembly2.Control can be embodied in a high level of ownership, veto rights, golden shares, board control, etc. The EU Directive on Takeover Binds, for example, leaves the definition of control to the member states. The most standard legalistic definition, also used for research purposes, is in fact possession or use of over 20% to 50% of the voting rights. This paper uses the specific percentage of votes as legislated in each country to form a variable and explore the effects of this provision on...

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