Editor’s Note: This post is by Lucian Bebchuk of Harvard Law School.
The Review of Financial Studies will publish later this year my paper with Zvika Neeman on “Investor Protection and Interest Group Politics.”
The paper models how lobbying by interest groups affects the level of investor protection. In our model, three groups – insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future – compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors pushing investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, and the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future, we show, reduces but does not eliminate the distortions arising from insiders’ interest in extracting rents from the capital that public firms already possess. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.
Here is a more detailed outline of the article’s analysis, results, and contributions: The paper seeks to contribute to understanding what determines the level of that protection and the reason such protection might fall short of being optimal. Why do countries vary so much in their level of investor protection? Why do levels of investor protection within any given country change over time? When investor protection is too low, is such suboptimality generally due to lack of knowledge on the part of public officials, which should be expected to disappear as they learn more about which governance arrangements are optimal? Or are there some structural political impediments that may enable excessively lax corporate rules to persist even after they are recognized as inefficient? The paper aims to contribute to answering these questions by developing a model of how interest group politics affects the level of investor protection.
To be sure, a country’s level of investor protection may be influenced by long-standing factors such as the country’s legal origin, its culture and ideology, or the religion of its population, all of which lie outside the realm of current interest group politics. But given that countries do change their investor protection arrangements considerably over time, the level of such protection at any given point in time may also result at least partly from recent decisions by pubic officials. The theory of regulatory capture (Stigler (1971) suggests that the regulatory decisions by public officials might be influenced and distorted by the influence activities of rent-seeking interest groups. In the area of finance, Rajan and Zingales (2003, 2004) and Perotti and Volpin (2008) argue that existing firms seeking to deter entry and retain market power lobby for weak investor protection that would make it difficult for potential entrants to raise capital. Our analysis focuses on another conflict among interest groups – the struggle between public firms’ corporate insiders, who seek to extract rent from the capital under their control, and the outside investors who provided them with capital.
We view lobbying on investor protection as important because, in the ordinary course of events, most corporate issues are intensely followed by the interest group with sufficient stake and expertise but are not sufficiently understood and salient to most citizens. When this is the case, politicians can expect their investor protection decisions to have limited direct effects on voting behavior, which implies that these effects do not significantly influence politicians’ investor protection decisions. In contrast, such decisions may be significantly affected by the activities of organized interest groups.
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