How Does Law Affect Finance An Examination of Financial Tunneling in an Emerging Market

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How Does Law Affect Finance? An Examination of
Financial Tunneling in an Emerging Market

• Vladimir Atanasov, College of William and Mary
• Bernard Black, University of Texas at Austin
• Conrad Ciccotello, Georgia State University
• Stanley Gyoshev, Exeter University

Sabancic Conference, Nov. 16, 2007
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Related research areas

• Law and Economic Development
• Law and Finance
• For both, work needed to connect specific laws to
  outcomes
• For identification, need
• important change in law
• firm level data
• Model how change in law affects observables

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Current Law and Finance Research and Our Paper
Finance
Law
Tunneling
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Literature

• Paper is novel.to our knowledge nothing quite
  like this at this point
• maybe why we're on our 4th journal submission ?
• Build on cross-country law and finance studies
  (LLSV etc.)
• country level data
• no legal change
• ? no identification (how does law affect finance?)

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Tunneling

• Tunneling controlling shareholders extract
  value from firms (Johnson et al, 2000)
• What is being tunneled?
• Cash flow tunneling
• Examples, excessive salary, transfer pricing)
• Asset tunneling (stripping)
• Financial (equity) tunneling
• Dilution
• Freezeout

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Bulgaria as Natural Experiment

• Equilibrium Model How Does Financial Tunneling
  Affect Share Prices
• Test the Model with Bulgarian Data
• 2002 legal changes reduce equity dilution and
  freeze-out
• Observe
• Dilution stops
• Freezeouts at premium instead of discount, P/S
  quadruples
• Market value measures (P/E, P/Sales, Tobin's q)
  rise for high risk firms, relative to low-risk
• DiD control group is firms w/o private majority
  owner
• Pre-law propensity to dilute or freezeout

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Underlying Logic of Model

• Changes in law cause minority shareholders to
  update their estimates of financial tunneling
  probability and magnitude
• These estimates affect trading prices.
• Goal illustrate how specific legal rules impact
  specific aspects of tunneling risk and share
  valuation.
• Study value of minority shares agnostic on
  wealth transfer versus value increase

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Model Setup Interaction between Financial
Tunneling and Law

• Three time periods
• t 0, cash flow tunneling
• t 1, dilutive equity issue with prob. pd and
  discount ddilut
• t 2, freezeout with prob. pf and discount
  dfreeze
• Exogenous ownership stakes at t 0
• Total 1 share, a0 by controlling shareholder
• 1 a0 by minority shareholders
• Firm intrinsic value
• Value pre-tunneling Vno-tun
• Value without financial tunneling Vno-fin
• Share price P lt V, due to tunneling risk
• legal change affects dilution, freezeout
• gap between P and V shrinks

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Wealth Impact of Equity Dilution

• Issue parameters
• new shares i
• discount to pre-issue value ddilut
• Minority shareholders purchase k(1 a0)
• Wealth transfer of dilutive offer

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Legal Approaches to Limit Dilution

• Preemptive rights increase k
• Simple participation rights
• Warrants/rights
• Minimum price provisions decrease ddilut
• Market price
• Book value
• Shareholder or director approval
• Offering price decrease ddilut

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Wealth Impact of Freezeout

• Assume freezeout can happen only after dilution
• Freezeout price Pfreeze at discount dfreeze to
  pre-freeze-out market value
• Freeze-out wealth transfer

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Legal Approaches to Limit Freezeout Discount
dfreeze

• Appraisal
• Market Price Rule
• Valuation formulas
• Minority shareholder/director veto

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Payoffs for Minority Investors

• No dilution or freezeout Vno-fin with prob. (1
  pd )
• Dilution but no freezeout 1 ddilut(1
  k)Vno-fin with prob. pd (1 pf )
• Dilution and freezeout 1 ddilut(1 k) (1
  dfreeze) Vno-fin with prob. pd pf
• P sum of these payoffs

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Tunneling and P/E Ratios

• P/E as financial metric that captures investor
  anticipation of financial tunneling
• Assume no-growth Dividend Discount Model
• Discount rate r
• Earnings Dividends
• Cash flow tunneling does not affect P/E
• Affects P and E similarly
• Anticipation of financial tunneling impacts P/E
• Hits P but not E

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Tunneling Probability and Magnitude Numerical
Example

• Company A high pd pf (75)
• Company B low pd pf (25)
• Same expected discounts ddilut dfreeze (60)
• New rules decrease discounts to 0.2
• No change in probabilities
• Change in P/E ratios
• 113 for company A (high tunneling risk)
• 18 for company B (low tunneling risk)

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Applying the Framework to Bulgaria

• 1998 Mass Privatization
• 1999-2001 massive financial tunneling
• Corporate law does not effectively protect
  minority shareholders
• Dilution Simple participation rights, no right
  to transfer
• k 0
• Freeze-out
• Tender offer price 3-month weighted average
  market price
• But, pre-freezeout dilution, market manipulation
• No appraisal rights or minority shareholder veto
• Many firms go dark w/o tender offer effective
  price 0

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Data

• Sample of 822 publicly-traded companies on the
  Bulgarian Stock Exchange (BSE) at year end 1998
• Delisting dates
• Trades and stock prices
• Accounting data
• Ownership and shares outstanding
• Ownership after Mass Privatization auctions
• Year-end ownership for the 1998-2003 period
  (Central Depository)

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2002 Changes in Securities Laws

• Pre-emptive rights
• Capital increase only by issuing publicly-traded
  rights
• Rights in freeze-outs
• Take-out rights if controller accumulates certain
  percentage of shares
• Old weighted-average price rule is replaced by an
  elaborate fair price statute
• Minority shareholder veto
• Enforcement
• new government
• new securities regulator

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Dilution Post-2002

• Regression dilution parameter k 0 ? 1
• Real world first true post-privatization
  offerings
• raise capital, not dilute minority

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Freeze-outs post-2002
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Average P/E 2000-2002 private control vs. other
firms
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Empirical Robustness

• Difference in differences
• firms without private majority controller as
  control group
• Firm fixed effects regressions of P/E, P/S, and
  Tobins Q
• after-minus-before changes for privately control
  firms
• Tunneling propensity results
• Logit estimate pre-law propensity to dilute or
  freezeout based on firms financial ownership
  characteristics
• Firm fixed effects regressions Propensities
  post-law dummy predict after-minus-before changes
  in value ratios

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Propensity results
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All 3 measures, both control groups
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Conclusion

• Micro-level evidence that control of equity
  tunneling is important channel through which law
  affects finance
• Control of equity tunneling Likely necessary
  for emerging market to emerge
• Transferable pre-emptive rights and freeze-out
  protections enforcement by securities regulator
  can have large wealth effects
• Tunneling risk can be an important factor in firm
  valuation opens door to additional asset
  pricing research