To Steal or Not to Steal: Firm Attributes, Legal Environment, and Valuation

Data on corporate governance and disclosure practices reveal wide within-country variation that decreases with the strength of investors’ legal protection. A simple model identifies three firm attributes related to that variation: investment opportunities, external financing, and ownership structure. Using firm-level governance and transparency data in 27 countries, we find that all three firm attributes are related to the quality of governance and disclosure practices and that firms with higher governance and transparency rankings are valued higher in stock markets. All relations are stronger in less investor-friendly countries, demonstrating that firms adapt to poor legal environments to establish efficient governance practices. Previous studies show that better legal protection for investors is associated with higher valuation of the stock market (La Porta, et al. (2002)), higher valuation of listed firms relative to their assets or changes in investments (Wurgler (2000)), and larger listed firms in terms of their sales and assets (Kumar, Rajan, and Zingales (1999)). Furthermore, industries and firms in better legal regimes rely more on external financing to fund their growth (La Porta, et al. (1997), DemirgüçKunt and Maksimovic (1998), and Rajan and Zingales (1998)). Although these country-level studies provide valuable insights into the effects of regulatory environment, they leave several important questions unanswered. Do all firms in weak legal regimes suffer from poor corporate governance and do firms in strong legal regimes practice uniformly high-quality governance? Newly released data on 859 firms in 27 countries reveal wide within-country variation in governance and disclosure practices, with the variation increasing as legal environment gets less investor-friendly. These phenomena raise new questions: Does the wider variation in weaker legal regimes simply reflect greater latitudes allowed by lower minimum standards? Or does it reflect firms’ adaptation to poor legal environment, as in Coase (1960), resulting in some firms having higher-quality governance than is required by law? If so, is there a systematic pattern in which firms choose their quality of governance? What are the relevant firm attributes and how are they related to the observed governance practices? Is the quality of governance priced in stock markets, and if so, is it economically significant for corporate decision makers to take notice? To address these issues, we provide a simple model and test its predictions and related conjectures. The model describes how a controlling shareholder may arrive at the optimal level of diversion of corporate resources while facing private costs of diversion that increase with the strength of legal environment. The model predicts that (1) firms with better investment opportunities, higher concentration of ownership, and greater needs for external financing practice better governance; (2) firms that practice better governance are valued higher; and (3) these relations are stronger in weaker legal

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