In the past decades the Brazilian economy has undergone major changes such as macroeconomic stability; achievement of investment grade status for the debt of the government and many individual firms; strong economic growth; and development of pension funds, which became major investors in public company shares. Significant changes were also observed in the stock market. Through the early 2000s, Brazil was seen as having relatively weak corporate governance. Examples of expropriation of minority shareholders by controlling shareholders were common.

In 2000, in response to concern about weak protection for minority shareholders (including extensive use of non-voting shares, few outside directors, and low levels of disclosure), the São Paulo Stock Exchange (BM&FBovespa) created three high-governance markets (Novo Mercado, Level I and Level II). This contributed to a surge in initial public offerings, which had been nearly nonexistent until 2004; a leveling off in the number of listed companies, which had been shrinking; and sharply rising trading volume and liquidity. Most new listings were at one of the premium listing levels; some older companies also migrated their listings to a higher level. In spite of these major changes in the economy and the stock market, little is known about how corporate governance standards have been changing. This article, The Evolution of Corporate Governance in Brazil, aims at filling this gap by providing a picture of the evolution of corporate governance practices in Brazil.

…continue reading: The Evolution of Corporate Governance in Brazil

In a series of articles, Henry Hu and I developed and defined the concept of empty voting. TELUS Corp. has separate classes of voting and nonvoting shares. It proposes to combine them, with a zero premium for voting shares. Mason Capital has taken a (long voting shares, short nonvoting shares) position, is thus long the value of TELUS voting rights, and is campaigning for a share-swap plan which assigns a reasonable value to those rights. TELUS has claimed that Mason is engaging in “empty voting”, and has persuaded a British Columbia court of this (TELUS is incorporated in BC).

I discuss here some aspects of this dispute. For a vote which involves the value of voting rights: (i) Mason has an economic interest in this outcome, and thus is not an empty voter; (ii) many other TELUS shareholders are empty voters, because they have negative or near-zero economic interest in TELUS votes; (iii) TELUS management is conflicted, because they hold mostly nonvoting shares; (iv) voting rights are valuable, and the market premium accorded to TELUS voting shares is a reasonable estimate of their value; in contrast, zero is not a reasonable value; (v) by valuing voting rights at zero, the TELUS board is likely violating its fiduciary duty to treat both share classes fairly; and (vi) if the TELUS voting shareholders reject the zero-premium share-swap, it would likely be a further breach of fiduciary duty for TELUS not to propose a swap on terms which assign a reasonable value to votes.

…continue reading: Equity Decoupling and Empty Voting: The TELUS Zero-Premium Share Swap

In our paper, The Relation between Firm-level Corporate Governance and Market Value: A Study of India, which was recently made publicly available on SSRN, we provide a detailed overview of the practices of publicly traded firms in India, and identify areas where governance practices are relatively strong or weak, relative to developed countries. We also examine whether there is a cross-sectional relationship between measures of governance and measures of firm performance.

We find that most firms meet the board independence rules under Indian law, which require either 50% outside directors or 1/3 outside directors and a separate CEO and board chairman, but 13% (38 firms) do not. The board chairman often represents the controlling business group or other controlling shareholder. Firms are more likely to comply with audit committee requirement, although 1% do not. Related party transactions are common (67% of firms have RPTs representing 1% of more of revenues), but approval requirements for them are often weak. For transactions with a controlling shareholder, only 7% (1%) of firms require approval by non-conflicted directors (minority shareholders). However, 78% of firms nominally require RPTs to be on “arms-length” terms, and 94% disclose them to shareholders. Only about 2/3rds of firms provide annual reports on their websites. For those which do not, there is no good alternate source. Executive compensation is modest by US standards, but CEOs face only a small risk of dismissal. Only about 75% of firms allow voting by mail, even though this has been legally required since 1956. Government enforcement actions against firms are almost nonexistent.

…continue reading: The Relation Between Firm-Level Corporate Governance and Market Value: A Study of India

In our paper How Does Law Affect Finance? An Examination of Equity Tunneling in Bulgaria, which was recently accepted for publication in the Journal of Financial Economics, we provide a simple model which unbundles different forms of “tunneling”, the extraction of firm value by a firm’s controlling shareholders or managers, and derive how each affects firm profitability and valuation. We develop the model partly to extend existing models of tunneling, but primarily to develop predictions which we can test using a natural experiment in Bulgaria, provided by 2002 anti-tunneling reforms.

Bulgaria went through mass privatization in 1998, which was followed by extensive equity tunneling. The 2002 legal changes limit both dilution and freezeouts, and allow us to examine how specific rules can affect specific forms of tunneling, firm valuation, and firm profitability. We model and study empirically two flavors of equity tunneling: dilutive equity offerings (issuance of shares to insiders at below market value); and freezeouts (forced sale of minority shares to the controller for below market value). We find that following the change, minority shareholders participate equally in secondary equity offers, where before they suffered severe dilution; and freezeout offer prices quadruple. At the same time, return on assets declines for high-equity-tunneling-risk firms, suggesting that controlling shareholders partly substitute for reduced equity tunneling by engaging in more cash-flow tunneling. The 2002 legal changes, and controllers’ responses to them, also affect market values. Tobin’s q levels rise sharply for high-equity-tunneling-risk firms relative to low-risk firms, despite the increased cash flow tunneling in high-risk firms. These results are economically large and robust to different ways of estimating tunneling risk, and different valuation measures (price/sales, price/earnings and market/book value of equity).

Our results have implications for asset pricing research in emerging markets. In high tunneling risk markets, investors must estimate not only expected cash flows (as in any market) but also tunneling risk. We find evidence that equity tunneling risk varies widely in cross-section, and that Bulgarian investors consider this risk and update their valuation estimates when legal rules change. Equity tunneling risk, as a factor in explaining equity prices and expected returns, can complement some commonly used factors, such as market risk and momentum, and interact with others, such as firm size and book/market ratio. Size may correlate with tunneling risk (as we confirm below for Bulgaria), and high book/market ratios could reflect high tunneling risk. Investor pricing of equity tunneling risk factors can also help explain home country bias, as local investors may be better equipped to evaluate equity tunneling risk at the firm-level.

The full paper is available for download here.