ABANTE, Vol. 6, Nº 2, pp. 117-147 (octubre 2003) LOOKING BACK AT THE CONTROVERSY: UNEXPECTED WEALTH EFFECTS OF A TRANSITORY CLAUSE* PABLO MORÁN V.** ABSTRACT This paper analyzes the effect of adopting an optional provision contained in a broader regulatory change in Chile (tender offer law or Ley de OPAs). Although the motivation for the Ley de OPAs was to strengthen corporate governance mechanisms in Chile, the availability of this optional provision (transitory article ten) for the controlling shareholders was believed to work the opposite way. In this paper we find no evidence indicating that the decision to adopt this transitory article significantly harmed minority shareholders. Several robustness checks confirm this. However, the evidence indicates that these firms realized on average significantly positive abnormal returns in the weeks that followed the decision. This abnormal return is significant only for firms with less concentrated ownership. We conjecture that this positive reaction is related to the decision to adopt the transitory article. Keywords: Minority shareholders; Ley de OPAs; Artículo décimo transitorio. JEL Classification: G34; G38. RESUMEN Este trabajo analiza el efecto que tuvo la adopción de un artículo que formó parte de un cambio regulatorio en Chile (Ley de OPAs). Aun cuando la motivación de la Ley de OPAs fue el fortalecimiento de los mecanismos de gobierno corporativo en Chile, la disponibilidad de este artículo opcional (Artículo Décimo Transitorio) para los accionistas controladores fue interpretada como un elemento en contra del espíri- tu de la ley. En este trabajo no encontramos evidencia que indique que la decisión de adopción de este artículo transitorio dañó * The author is at the Facultad de Ciencias Empresariales, Universidad de Talca. Most of this paper was written while the author was a graduate student at the John Molson School of Business, Concordia University, Canada. Detailed and insightful comments from Eduardo Walker (editor) and two anonymous referees helped improve substantially this paper. I also thank Sandra Betton, Christine Panasian, and Cristián Troncoso for valuable comments and suggestions on earlier versions of this paper. Remaining errors are, of course, my own. ** Facultad de Ciencias Empresariales, Universidad de Talca, Email: [email protected] 118 ABANTE, VOL. 6, Nº 2 significativamente a los accionistas minoritarios. Varias pruebas de robustez confirman esta conclusión. Sin embargo, la evidencia indica que estas empresas realizaron en promedio retornos anormales positi- vos y significativos en las semanas posteriores a la decisión de adop- ción. Este retorno anormal es significativo solamente para las empre- sas con una menor concentración de la propiedad. Conjeturamos que esta reacción positiva retrasada está relacionada con la decisión de adopción. The potential for private benefits is one of the dimensions that make control valuable. The value of control is usually reflected on the market price differential between shares with equal cash flow rights but different voting power (dual class shares). To some extent, these private benefits of control are also apparent in the significant premiums that bidders are willing to pay in corporate takeovers. Traditionally, the corporate governance lit- erature focused on the agency relation between diffuse shareholders and professional managers. In this situation, the main concern is to generate suitable control and incentive mechanisms that help to align these sharehold- ers’ interests with those of management. Although the literature on corporate governance has made important contributions to our understanding of US corporate finance, it has been recently recognized that other legal environments might generate very different corporate realities. Findings in La Porta et al. (1999) indicate that most firms around the world can be characterized by having a dominant controlling group of shareholders. Shleifer and Vishny (1997) argue that such an ownership structure gives the controlling group the incentive and ability to effectively monitor managers. When this is the case, the most important agency problem is the potential for expropriation by the controlling shareholders. In an attempt to enhance the liquidity of the Chilean capital market, to promote better corporate governance practices, and to facilitate cross-border trade and investment, Chilean authorities have promoted a series of legal reforms during the past few years. The first major regulatory change is known in Chile as Ley de OPAs. The main motivation of this reform was to strengthen the legal framework that protects minority shareholders in Chile.1 Although there was consensus that the Ley de OPAs would improve the Chilean corporate governance mechanisms, a special provision of this 1 For an interesting discussion about the motivation of this law, see Clarke (1999). LOOKING BACK AT THE CONTROVERSY 119 law, known as “transitory article ten”, created a great deal of controversy. Nevertheless, we are not aware of any empirical study documenting the impact of its adoption on Chilean minority interests. The purpose of this paper is precisely to shed some light on this matter. The paper proceeds as follows. The next section reviews the most recent literature that relates corporate governance and legal protection. Section II briefly discusses the characteristics of the Chilean institutional framework that are relevant for the paper’s purposes. Research hypotheses are stated in Section III. Section IV describes our methodology and sample selection criteria. The results of our study are presented in Section V. Section VI discusses some post factum evidence and finally, Section VII summarizes our main findings and conclusions. I. CORPORATE GOVERNANCE AND PRIVATE BENEFITS OF CONTROL The expropriation of creditors and minority shareholders takes place when the controlling group diverts corporate resources for their private benefit. Whenever there is a potential for private benefits for the controlling shareholders, the right to control a corporation becomes valuable. The in- centive for expropriation arises because the controlling group does not bear the full cost of its private consumption. This argument can be considered an extension of Jensen and Meckling’s (1976) about the agency problem between managers and shareholders when ownership is diffuse. There are numerous examples of how controlling shareholders can transfer wealth to themselves. Influence over who is chosen for key positions, such as the CEO or board members, allows the controlling shareholders to pay them- selves excessive compensation, build empires or transfer assets at non- market prices. The sources and consequences of these private benefits of control, and consequently the control premium, have been the subject of extensive re- search in recent years. The Law and Finance literature, surveyed by La Porta et al. (2000b), emphasizes legal protection as a determinant of the potential for expropriation and private benefits available to controlling share- holders. For example, Nenova (2003) studied a sample of 661 dual-class firms from 18 countries and found that investor protection, takeover rules on pricing and mandatory offers, corporate charter provisions, and the extent of law enforcement explain 68 per cent of the systematic variation in the 120 ABANTE, VOL. 6, Nº 2 value of control-block votes. In addition, she showed that the average value of control-block votes is 4.5 per cent of the firm’s market value in common- law countries and 25.4 per cent in French legal origin countries, where investor protection is weaker. For Italy, where legal protection for minorities is poor, Zingales (1994) reports that voting shares trade at a premium of 82 per cent in relation to nonvoting shares. Zingales (1995) argues that if the marginal investor is a small shareholder not directly involved in control, this voting premium can only reflect the expectation that superior voting shares will receive a larger premium in a control contest. He proposes and tests a model in which this premium is a function of the probability that a vote is pivotal in a takeover contest and the magnitude of the private benefits obtainable by the new controlling group. The quality of the legal protection and law enforcement available to the providers of external financing affects the ability of controlling shareholders to expropriate ex post, and thus it also affects the willingness of external financiers to provide funds ex ante. For example, under weak legal protec- tion, minority shareholders will be reluctant to provide financing and, there- fore, growing firms will have more difficulty in raising funds for future investments. Consistent with this view, recent empirical evidence on corpo- rate governance has found important links between a country’s level of legal protection and financial market development (La Porta et al., 1997), market value of firms (La Porta et al., 2002) and dividend policies (La Porta et al., 2000a). In addition, La Porta et al. (1999) find evidence that the degree of legal protection can also explain how cash flows and voting rights are distributed around the world. These findings are consistent with theoretical models proposed by Bebchuk (1999), and Shleifer and Wolfenzon (2002). For example, in Bebchuk’s model the level of private benefits is the main determinant of the founder’s choice between a controlling shareholder structure (CS) and non-controlling shareholder structure (NCS) when the firm goes public.