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Corporate Governance: Theory & Research (C31CG)

How important is the level of investor protection for


financial market development and development of
real economy?

Madiha Ashraf
Registration number: H00203491
Username: ma24
Lecturer: Dr Faizul Haque
Date: 16th Oct 2014

Table of Contents
1.

Introduction

2.

Investor Expropriation

3.

Laws and Regulations

4.

Effects of Investor Protection

5.

Conclusion

6.

References

Investors face expropriation all over the world; they have fear that they might not get
returns on their investment. Insiders may divert the profits for their private benefits,
invest in risky projects, do transfer pricing, expand the firm beyond necessary and stay on
the job even if they are no more required. Creditors also have fear that company might
not be able to repay them, even they need protection again companys default. Why
investors should get returns is explained by many researchers. Firms are a collection of
investment projects and cash flow it creates are claims by the investors (Modigliani and
Miller 1958). Investors have power to vote and change directors, sue them for
expropriation and even liquidate the firm, this power makes them get cash (Hart 1995). In
this essay I will first discuss the ways of investor protection; I will then move on to
describe how these ways differ among countries and firms. I will end up discussing the
effects of these laws and protection on the valuation of the firms and the growth of
economy.
Nobody is fool here to invest his money unless he is sure of the returns or at least knows
that he has some legal protection. When investors are protected then only they buy
securities. If their protection is weak they would demand higher returns for the risk they
bear; increasing cost of equity and cost of external funds. Lets talk about how investors
are protected. They are protected by the enforcement of regulations and laws. But that
also depends as in some countries courts are not willing to intervene in expropriation
issues, they are corrupt or have political influences. Therefore the effectiveness of
judicial enforcement matters more than what have been described in the books of law.
Firms itself can provide protection by increasing disclosure, appointing independent
boards, monitor shareholders and managers to limit the expropriation of minority
shareholders. These laws vary from country to country thats why every country have
different protection for investors .The legal system of majority of the countries falls
between three of the systems; the English (common law), the French and the German.
(David and Bierley 1985). The common law provides the strongest protection while
French law is the weakest. In common law countries judges can apply fairness opinions
unlike civil law that is only based on statutes. In civil law countries courts do even
intervene in the expropriation transactions and state have greater control to regulate
business activities. Civil law countries turn out to be not much protective of investors.
Therefore in countries with weak protection control is concentrated and pyramidal
structure is also common. In my opinion control in these countries should be spread
among numerous large shareholders; so that together they may exert great pressure to
limit expropriation.
Investor protection encourages the development of financial markets. A lot of research
has been done on this. Stocks are more valuable in countries that are protecting
shareholders; they have high Tobins Q ratio and higher number of listed firms (La Potra
et al 1997). Claessens et al (1999) discusses the effect of greater insider control; using a
sample of East Asian firms he proved that if firms have great insider control on voting
rights their assets have lower valuation. Johnson et al (2000) defined a relation between
investor protection and financial crises. It tells that countries with poor investor

protection treat outsiders well as long as the market is growing because at that time they
need a lot of external financing. This was proved by taking sample of 25 Asian countries
during the crises of 97-98; the result was that the currency depreciated and stock markets
declined. So it can be noted that corporate governance patterns itself affect the value of
the company.
All the evidences prove that the basis of healthy financial markets are laws, regulations
and courts; the extent to which they protect shareholders and creditors. Where the laws
are protective of investors they are willing to finance firms. They are willing to pay more
as they know more profits would come to them as dividends. This increased confidence
of investors result in increased equity demand; increasing the valuation of companies. It
increases the profitability and makes it easier to access capital. More equity purchases
means more capital availability to firms expanding the financial markets. Entrepreneurs
would now have more resources to put them into productive use boosting the real
economy. Not every country have developed stock markets because of the laws there. The
reform can be brought by making civil law countries shift to common law practices. But
this can bring opposition from family dominated firms because it would limit their
expropriation which are in domination since ages. We can conclude that legal rules
governing corporate law have a great impact on stock market development and the
economic growth of the country.

References
Jensen, M., Meckling, W., 1976. Theory of the firm: managerial behavior, agency costs,
and ownership structure. Journal of Financial Economics.
Modigliani, F., Miller, M., 1958. The cost of capital, corporation finance, and the theory
of investment. American Economic Review.
La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny (1999) Investor Protection
and Corporate Governance, Journal of Financial Economics.
Claessens, S., Djankov, S., Lang, L., 2000. The separation of ownership and control in
East Asian corporations. Journal of Financial Economics.
Johnson, S., Boone, P., Breach, A., Friedman, E., 2000a. Corporate governance in the
Asian financial crisis, Journal of Financial Economics.