Do Inefficient Stock Markets Drive Bad Corporate Governance?

By Sergey Chernenko, Fritz Foley, and Robin Greenwood, for Forbes.com, June 2, 2010

Why do minority shareholders continue to hold stock despite the risk of expropriation by controlling shareholders? In this column, Sergey Chernenko, Assistant Professor at the Fisher College of Business at the Ohio State University, Fritz Foley, Associate Professor in the Finance area, Harvard Business School, and Robin Greenwood, Associate Professor at the Harvard Business School, provide two decades of evidence from Japan suggesting that many investors do not foresee these conflicts of interest, even when there is plenty of disclosure. Inefficient stock markets allow majority shareholders–often parent companies–to sell overpriced stock only to buy it back at a later date.

One of the major accomplishments of recent corporate governance research has been to expose the risks confronted by minority shareholders in public companies around the globe. Corporate ownership structures such as pyramids, business groups, and dual class shares leave control in the hands of a limited set of blockholders – exposing minority investors to potential expropriation.

Why, then, do minority shareholders participate in these arrangements? The prevailing academic view since Jensen and Meckling (1976) is that capital markets are efficient in the sense that minority investors foresee the possibility of expropriation by controlling shareholders. As a result, under this view, the share price that minority investors are willing to pay reflects their rational expectations of expropriation and other agency problems. And because outside equity is expensive, controlling shareholders will only raise equity capital from minority investors if there are commensurate benefits, such as attractive growth opportunities that the firm would not be able to finance otherwise.

A new view on why agency problems arise

In recent research (Chernenko et al. 2010), we propose a new and alternative view for the emergence of ownership structures that are prone to severe agency problems. Motivated by the growing literature studying the effects of stock market mispricing on firm behaviour (see for example Stein 1996, Shleifer and Vishny 2003, and Baker 2009), we develop a simple framework for thinking about how stock market mispricing can offset agency costs and induce controlling shareholders to raise outside equity….(continue reading)

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