OUTRIGHT DEFALCATION

In many countries, managers have no qualms about lining their pockets at the expense of the public shareholder. In Russia, for instance, oil companies trade at one-hundredth of what they would trade in the United States.¹⁶ Such an enormous difference cannot be explained simply by differences in market liquidity or risk preferences of participants in the two markets. The only plausible explanation is that the market expects that Russian oil companies will be systematically looted by insiders. This is consistent with repeated accounts of oil being sold by these firms to middlemen controlled by insiders at a below-market price and then resold at market price.¹⁷

Unfortunately, this is not just a Russian phenomenon. Consider the sale of blocks of publicly traded shares large enough to transfer management control to the buying party.¹⁸ The day after the transaction is announced, the market price of the company shares reflects what ordinary shareholders who do not have control over management expect to receive in the long run in dividends and capital appreciation. Any additional amount paid by the acquirers for the controlling block should then reflect some special benefits they expect to receive, which other shareholders will not. In the jargon, these are euphemistically termed “private benefits of control.” They range from the psychic value the acquirer enjoys by being in power to the value they plan to appropriate for themselves at the expense of noncontrolling shareholders through actions like self-dealing (for example, selling oil at rock-bottom prices to a company they wholly own so that they can then resell the oil at market prices and obtain the full profit for themselves). In most developed countries, the estimated value of these private benefits in the period 1990–2000 is small (around 2 percent of their market value), but in a sizable number of countries, it exceeds 25 percent. For example, in Brazil, private benefits may be as large as 65 percent and in the Czech Republic, 58 percent.

The possibility of misappropriation can seriously jeopardize a firm’s ability to obtain finance. In countries where private benefits are larger, equity markets are smaller, fewer companies go public, and ownership tends to be more concentrated.¹⁹ With such concentrated holdings, risk cannot be spread widely, further reducing access.

How can a country escape this underdevelopment trap? One answer is better laws. Private benefits tend to be larger in countries where shareholders have fewer legal protections.²⁰ Of course, it is not just the laws on the books that matter: the quality of legal enforcement matters as well. Even if the courts are fair and efficient, it is costly for individual shareholders to move courts. The possibility of class-action lawsuits and contingency fees can give lawyers the incentive to seek out instances of corporate malfeasance and sue on behalf of shareholders, thus imposing some discipline on managers.

An important role is also played by tax enforcement agencies. The corporate income tax effectively gives the government a large, noncontrolling stake in all companies. Its incentives are perfectly aligned with those of minority shareholders: both want the company to disclose and distribute profits. But the government has a big advantage: it has better enforcement tools and has a large enough stake in each firm to care. For example, the Internal Revenue Service closely scrutinizes the prices at which goods are transferred between related firms to make sure that income is not being transferred to a low-tax entity. Such scrutiny can also help prevent self-dealing, whereby management transfers goods from the public company it runs to a private company it fully owns. The tax authority therefore helps keep management malfeasance in check. The estimated private benefits in a country are indeed lower when it has better tax enforcement.²¹

Of course, corporations themselves have an incentive to put in place strong controls on their management so that their access to finance will improve. A corporation can bind its management with a corporate charter or code of conduct that prohibits share issuances below market price or restricts asset transfers to other firms. Such internally imposed rules go a long way in addressing the undervaluation of Russian companies. The Russian company with the best corporate governance practices (including being cross-listed in the United States) has a ratio of actual market value to potential market value (its value if it were a U.S. company) 450 times higher than one with the worst practices.²²