The Principle of Proportionality: Separating the Impact of Dual Class Shares, Pyramids and Cross-ownership on Firm Value Across Legal Regimes in Western Europe

Bennedsen, Morten; Meisner, Kasper, Nielsen Working Paper The Principle of Proportionality: Separating the Impact of Dual Class Shares, Pyramids and Cross-ownership on Firm Value Across Legal Regimes in Western Europe Working paper, No. 22-2005 Provided in Cooperation with: Department of Economics, Copenhagen Business School (CBS) Suggested Citation: Bennedsen, Morten; Meisner, Kasper, Nielsen (2006) : The Principle of Proportionality: Separating the Impact of Dual Class Shares, Pyramids and Cross-ownership on Firm Value Across Legal Regimes in Western Europe, Working paper, No. 22-2005, Copenhagen Business School (CBS), Department of Economics, Frederiksberg, https://hdl.handle.net/10398/7544 This Version is available at: https://hdl.handle.net/10419/208515 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/ The Principle of Proportionality: Separating the Impact of Dual Class Shares, Pyramids and Cross-ownership on Firm Value Across Legal Regimes in Western Europe∗ Morten Bennedsen†and Kasper Meisner Nielsen‡ August 2005 Abstract: Recent policy initiatives within the harmonization of European company laws have promoted a so-called “principle of proportionality” through proposals that regulate mechanisms opposing a proportional distribution of ownership and control. We scrutinize the foundation for these initiatives by analyzing the use of instruments to separate ownership from control across legal regimes in a sample of over 4,000 publicly traded firms from 14 Western European countries. First, we confirmthenegativeimpacton firm value from disproportional ownership structures previously established in a sample of Asian firms by Claessens et al. (2002). Second, we show that dual class shares have a larger and more significant negative effect on firm value than pyramids and cross holdings. Third, we findthattheimpactof disproportionality and the underlying instruments is inversely related to the level of investor protection. Thus, dual class shares and pyramids substitute legal protection in countries with inadequate investor protection. Fourth, we find no evidence of a significant effect of disproportionality instruments on earnings performance. Finally, we discuss policy implications of these findings in relationship to the process of harmonization of the European capital markets. JEL classifications: G30, G32, G34 and G38 Keywords: Ownership Structure, Dual Class Shares, Pyramids, EU company laws. ∗We would like to thank Ron Anderson, Laurence Booth, Ulrich Hege, Peter H¨ogfeldt, David Reeb, Dogan Tirtiroglu, Daniel Wolfenzon and participants at the ’Conference on Corporate Governance in Closely Held Corporations’, Copenhagen Business School 2005, ’EFMSymposiumonEuropeanCorporateGovernance’, Leeds University Business School 2005, and ’FMA European 2005 Meeting’, Siena for helpful comments and suggestions. We would further like to thank Jonas Herby and Rune Midjord for excellent research assistance. This project has been supported by CEBR (www.cebr.dk) and the Danish Social Science Research Foundation under the project ’GOCOW’. †Corresponding author: Copenhagen Business School and CEBR. Solbjerg Plads 3 C5, 2000 Copenhagen, Denmark. Email: [email protected]. ‡CEBR and CAM, University of Copenhagen. Email: [email protected]. The Principle of Proportionality: Separating the Impact of Dual Class Shares, Pyramids and Cross-ownership on Firm Value Across Legal Regimes in Western Europe August 2005 Abstract: Recent policy initiatives within the harmonization of European company laws have promoted a so-called “principle of proportionality” through proposals that regulate mechanisms opposing a proportional distribution of ownership and control. We scrutinize the foundation for these initiatives by analyzing the use of instruments to separate ownership from control across legal regimes in a sample of over 4,000 publicly traded firms from 14 Western European countries. First, we confirmthenegativeimpacton firm value from disproportional ownership structures previously established in a sample of Asian firms by Claessens et al. (2002). Second, we show that dual class shares have a larger and more significant negative effect on firm value than pyramids and cross holdings. Third, we findthattheimpactof disproportionality and the underlying instruments is inversely related to the level of investor protection. Thus, dual class shares and pyramids substitute legal protection in countries with inadequate investor protection. Fourth, we find no evidence of a significant effect of disproportionality instruments on earnings performance. Finally, we discuss policy implications of these findings in relationship to the process of harmonization of the European capital markets. JEL classifications: G30, G32, G34 and G38 Keywords: Ownership Structure, Dual Class Shares, Pyramids, EU company laws. 2 1 Introduction The European Commission has initiated a number of policy proposals directed at affecting the distribution of ownership and control in European companies.1A common trend in these initiatives is to promote the so-called “principle of proportionality”, which states that it is desirable to have proportional distributions of cash flow and control rights among investors in publicly listed corporations. According to the principle of proportionality it is undesirable to use instruments - such as dual class shares, pyramidal ownership structures, cross ownership, golden shares and voting caps - that create a wedge between the nominal income rights and the voting rights that the ultimate owners of a public corporation possess. In this paper we scrutinize the foundation for this principle in a sample of over 4,000 publicly traded corporations from 14 Western European countries. Ownership concentration provides two effects on the governance of corporations: An incentive effect which makes the monitoring of management more efficient and an entrenchment effect which makes it easier for opportunistic owners to behave in a manner that enriches themselves at the cost of other owners. In general corporations with proportional ownership structures seem to create more value than firms in which ownership of control is more concentrated than ownership of cash flow (Claessens, Djankov, Fan and Lang 2002, Cronqvist and Nilsson 2003). Thus, the present evidence 1The EU Action Plan on ’Modernizing Company Law and Enhancing Corporate Governance in the EU’ from 2003 suggests prohibiting the listing of “abusive” pyramids on the stock exchange and to ”examine the consequences of an approach aiming at achieving a full shareholder democracy (one share - one vote)”. Backed by the recommendations of the Final Report of the High Level Group of Company Law Experts (Winter et al. 2002), the Commission previously proposed the so-called Break-Through rule allowing owners of 75 pct. or more of the cash flow rights in a corporation to exercise control even if they possesslessthan50pct. ofthevotes. Thisproposalwaslaterremovedduetopolitical obstacles. 3 suggests that corporations wishing to maximize firm value should obey the “principle of proportionality”. We confirm the negative impact of disproportional ownership structures on firmvalueinourlargesampleofEuropeanfirms. In addition we take the analysis two important steps forward: The first is to separate the effect of different instruments to create disproportional ownership structures. In particular, it is shown that creating disproportional ownership structures through the use of dual class shares destroys more value than creating disproportional ownership structures through pyramids, which again destroys significantly more value than cross ownership and other instruments. Hence, we show that it is not disproportionality as such that destroys firm value; rather the reduction in value comes from the particular instrument used to create a wedge between ownership and control. The second step is to document that the impact of different instruments depends on the level of legal protection of outside investors. Theoretically, better investor protection provides stronger incentives for managers to work in the interest of the owners, even in the absence of large controlling owners, since the market for corporate control is active and transparent. On the other hand, if investor protection is low, managers may feel little outside pressure and therefore may tend to slack more if they are not monitored closely by large controlling owners. Similarly, the controlling owners’ entrenchment opportunities may also be lower in countries with good investor protection. We interact our measures of disproportional ownership structures with measures of legal investor protection taken from La Porta et.al. (1998). It is shown that the value discount of disproportional ownership generally 4 increases with the level of investor protection and that this effect in particular is very significant for dual class shares and pyramids. For countries with inadequate investor protection, we find no significant impact of these instruments, hence, we provide evidence that disproportional ownership structures and legal investor protection substitute governance mechanisms from the perspective of outside investors. The results of the present paper have important policy implications for the harmonization of EU company laws. Disproportionality decreases firm value and in particular disproportionality created through the use of dual class shares. Thus, on the one hand, this may provide arguments in favor of policy proposals and regulative initiatives that promote the principle of proportionality and make it less attractive to choose dual class shares, pyramids and other instruments. On the other hand, it is also shown that the desirability of such proposals varies significantly across countries and in particular depends on the degree of investor protection on the national level. While limiting the use of dual class shares and pyramids can increase firm value in Northern Europe, this is unlikely to be true for firms in Southern European countries, where these instruments can function as a substitute for investor protection. Our analysis, therefore, supports the view that currently one size does not fit all countries with respect to the harmonization of corporate laws and that high investor protection is a prerequisite for a stringent implementation of the principle of proportionality within the European Union. The paper proceeds as follows: In the next section we present our sample of Western European firms and discuss the data. Section 3 provides a picture of the distribution of ownership and the use of disproportional5 ity instruments in Europe. Section 4 presents the results of our analysis: First, we confirm the negative relationship between disproportional ownership structures and firm value in Western European firms. Second, we disentangle the source of this negative relationship by separating the effects of the instruments that created the disproportionality. Third, we analyze the connection between disproportionality and investor protection and show that the negative impact of disproportional ownership structure is stronger in countries with good investor protection. Fourth, we analyze the impact of disproportionality on earnings performance. Section 5 anlyses the robustness of our results. Finally, section 6 discusses the policy implications of our findings both with respect to creating an internal capital market within the EU and with respect to national codes and principles for good corporate governance. 1.1 Related literature There are a number of studies that have analyzed the impact of disproportional ownership structures on firm value and performance. Claessens et al. (2002) identify empirically the incentive and entrenchment effects of large shareholders. In a sample of 1,301 publicly traded corporations in eight East Asian countries, they show that ownership concentration in itself increases firm value, but that a separation of cash flow and control decreases firm value. They also try to measure the importance of the instruments separating ownership and control rights to shed light on which mechanisms that are driving the results. However, their sample is dominated by pyramidal ownership in Asian business groups and they are therefore not able to disentangle which disproportionality instrument is associated with the valuation discount. Lins (2003) investigates firm performance and managerial owner6 ship in 1000+ corporations in 18 emerging markets and finds that firm value is reduced whenever votes are more concentrated than cash flow. Gompers, Ishii and Metrick (2004) analyze a sample of US firms with dual class shares and show that the relationship of firm value to managerial ownership concentration measured with cash flow is positive and concave, whereas the relationship to voting concentration is negative and convex. Hence, these findings are very similar to the Claessens et al. study of Asian firms. Consistent evidence is provided by Gompers et al. where sales growth, capital expenditures and R&D spending are regressed on managerial ownership. Entrenched managers underinvest, whereas managers with high cash flow rights pursue more aggressive investment strategies. Cronqvist and Nilsson (2003) analyze the impact of controlling minority shareholders on firm value and firm performance in a sample of 309 publicly traded Swedish firms. They show that having controlling minority owners, i.e. a disproportional ownership structure, decreases firm value and performance, an effect that is most significant when these controlling minority shareholders are families. In a sample of 174 Finnish firms Maury and Pajuste (2004) document that firm value decreases if large owners control firms through disproportional ownership structures. These papers all provide evidence that the concentration of ownership and control is associated with both incentive and entrenchment effects. This insight is confirmed currently in a sample of 4,000+ Western European publicly traded firms. Since European capital markets are different from capital markets in emerging countries and in the US (La Porta, Lopez-de-Silanes and Shleifer 1999), the finding that there are incentives and entrenchment effects in a large sample of European firmsisimportantinitself. How7 4Results 4.1 Simple means Before we present the results of our regression analysis, we can illuminate the main contributions of this paper by looking at the simple means of firm value and earnings performance across ownership structures and legal origin. These are presented in Table 4. The first part of the table yields the average and median firm value (Tobin’s Q) and earnings performance (RoA) on the European level for all firms, firms that obey the principle of proportionality, use dual class shares and have a pyramidal ownership structure, respectively. The first observation is that firms with proportional ownership on average have a higher firm value than firms with a disproportional ownership structure. For the whole sample, the mean (median) Tobin’s Q for firms with proportional ownership structure is 1.36 (0.92), which is higher than the mean (median) for firms that have a disproportional ownership structure which yields 1.17 (0.88).11 The second insight from Table 4 is that firms using dual class shares have asignificantly lower firm value than firms with a proportional ownership structure. Firms organized through corporate pyramids have a higher mean firm value than firms with dual class shares, but still have a significantly lower firm value than firms with a proportional ownership structure. The third insight is that the value discount of disproportional ownership structures and instruments to separate ownership from control differs across regions in Europe. Following La Porta et al. (1998) we divide our 11This difference is highly significant, but to save space, significance levels are left out in this subsection, since they will be confirmed in the regression analysis that follows. 14 sample into four regions: the UK & Ireland; the Scandinavian countries (Denmark, Finland, Norway and Sweden); Southern European countries (Belgium, France, Italy, Portugal and Spain), and countries inspired by the German legal system (Germany, Austria and Switzerland). According to La Porta et al. (1998), these four regions represent different legal systems, with outside owners in the UK and Ireland being best protected, followed by outside owners in Scandinavia. Outside owners in Southern Europe are less protected than in Scandinavia but generally slightly better protected than outside owners in countries with a German legal origin. Table 4 yields that the discount on firm value of disproportionality is economically higher in the two Northern European regions than in the two Continental European regions, which is consistent with the hypothesis that the cost of disproportional ownership structures correlates positively with the degree of investor protection. Finally, Table 4 also indicates that there does not seem to be any observable earnings performance differences (measured by return on assets) between firms with proportional ownership structures and firms with disproportional ownership structures in either Northern or Southern Europe. The rest of this section will provide more rigorous evidence in support of these observations. 4.2 The cost of disproportionality We estimate a cross sectional model of the average of the three yearly observations from 1996 to 1998. This is done because Faccio and Lang’s data on the ownership structure in each country are not collected in the same year for all countries. Thus, we assume that the ownership structure is constant 15 for the period 1996 to 1998 and focus on the variation between firms.12 We include country specific’fixed’ effects to control for country specificfirm invariant heterogeneity. This is important if our basic model omits country specific variables, that are correlated with the explanatory variables such as the level of protection of outside investors.13 Table 5 analyzes the relationship between ownership concentration, disproportionality and firm value as measured by Tobin’s Q. In the left side, we focus on the largest owner’s ownership share, whereas in the right side, we use the ownership stakes of the whole group of large owners.14 In this and all other models, we control for size, leverage (debt-to-assets ratio), asset tangibility, sales growth and industry effects. Inthesampleoffirms across Western Europe, there appears to be a negative, but highly insignificant effect of ownership concentration on firm value and firm performance. Hence, on the aggregate level, we cannot conclude any significant linear relationship between firm value and ownership concentration. Claessens et al. find a positive and significant effect of ownership concentration in their sample of Asian firms. Obviously, our result does not exclude that there could be a significant non-linear relationship, as documented by Morck et al. (1988). However, since the literature on these questions is extensive, they will not be further pursued here. In Model 2 of Table 5, a dummy variable is included for whether a given firm has a proportional ownership structure, which is defined as the absence 12For a number of firms we only have one or two yearly observations between 1996 and 1998ofthetangibleassets;thus,forthoseweusetheaverageoftheavailableobservations. We also estimate the cross sectional model based on yearly observations. This has no impact on the results below. 13La Porta et al. (1999) show that the level of investor protection explains country variation in ownership and capital structures. 14We define the group of large owners as the joint ownership of all owners who possess more than 10 percent of the votes. 16 of separating instruments and an equal distribution of cash flow and votes. In both specifications this proportionality dummy is positive and significant at the 5 percent level. Hence, a proportional ownership structure is generally seen to increase firm value in publicly traded Western European firms. The effect is economically large: On average, firms with proportional ownership structures have a 15 pct. higher firm value than firms with disproportional ownership structure. This is consistent with the evidence for Asian firms provided by Claessens et al.,whoshowthatfirm value decreases to the extent that ownership is separated from control. The simple regression model used here has satisfactory explanatory power, with an adjusted R2of around 14 pct. Models 3 and 4 look at the degree of disproportionality. Absolute disproportionality is significant both when we look at the single largest owner and the group of large owners. Again, the marginal effects are large. A 10 pct. increase in the wedge between cash flow and control of the largest owner decreases firm value with 3.2 pct. on average, and 2.0 pct. for a similar increase for the group of largest owners. If we instead use relative disproportionality we notice that the negative impact only is significant in the case where we analyze the group of large owners. Hence, this analysis shows that investors look at whether firms have proportional ownership or not, and in the latter case, at the actual degree of disproportionality. We conclude that our aggregate analysis provide evidence in support of the principle of proportionality since firms with an one-to-one relationship between cash flow and votes indeed seem to have higher valuation relative to firms with disproportional ownership structures. This result raises at least two interesting policy relevant questions: 1) Does it matter how firms create 17 disproportionality and, 2) Are the effects shaped by the legal environment afirm operates in. These questions are addressed next. 4.3 Instrument analysis: Dual class shares, pyramids and cross-ownership. There are many ways a firm can disobey the principle of proportionality: Through the use of dual class shares where the SVSs are possessed by a small group of controlling owners; a chain of corporate ownership (pyramids) concentrating control in the hands of a few ultimate owners; a cross ownership between a pair of corporations; or, voting caps implying that none of the owners can have more than a few percent of the votes. In this section, we analyze how the value discount from disproportional ownership structures depends on which of these instruments is used. There are a number of theoretical contributions that analyze dual class shares. In publicly traded firms with an active market for corporate control, most models have focused on the impact on control fights of having disproportional ownership structures through the use of dual class shares (see Grosmann and Hart 1988, Harris and Raviv 1988, a.o.). In closely held firms, Bennedsen and Wolfenzon (2000) show that having a one-share-onevote rule increases incentives to collaborate with other owners, which may increase firm value. A priori there is no reason to expect that different disproportionality mechanisms work through the same channels. When dual class shares are used, the ultimate owners have a direct contact with a given firm. On the other hand, if chains of corporate ownership are used, the agents representing the ultimate owners may have different constituencies, perhaps reflecting compromises between conflicting interests on a higher level of the pyramid. 18 There are few theoretical studies of pyramidal ownership. The main exception is Almeida and Wolfenzon (2004), who analyze the dual question as to why pyramids arise and what determines the structure of a pyramid. Since pyramids are created to extract private benefits for the group of controlling owners, non-controlling owners should require a discount to invest in such firms. Hence, according to their argument, it would be expected that pyramids have lower firm value than firms with proportional ownership structures. Table 6 provides evidence of the impact of different disproportionality instruments on firm value. Model 5 explains firm value (Tobin’s Q) as a function of the particular instrument used to create disproportionality and our standard control variables. Notice that the impact of the presence of dual class shares on firm value is negative, large and significant at the 1 percent level. The effect is economically large: The firm value of an average European firm with dual class shares is approximately 20 pct. smaller than the average firm with a proportional ownership structure. In Models 6 and 7, we look at the interaction effects of dual class shares and the degree of disproportionality on firm value. Given that firms have dual class shares, the degree of disproportionality has a significant negative impact on firm value when we use the absolute disproportionality measure. However, the negative impact of the interaction of dual class shares and relative disproportionality is insignificant. Thus, we have confirmed that dual class shares, on average, seem to destroy firm value in the European firms in our sample. This is consistent with the argument that dual class shares entrench owners since they possess significant control without internalizing sufficiently cash flow. These results 19 suggest that the capital market reacts negatively to this wedge between ownership and control by discounting the value of the firm. Similar to the value discount of dual class shares, pyramids have a negative and statistically significant effect on firm value in our sample. The estimated coefficients are smaller than those for dual class shares; however, the economic consequences are still large. On average, the firm value of the average European firm with a pyramidal ownership structure is around 8 percent lower than for the average European firm with a proportional ownership structure. The interaction effects between the two measures of disproportionality and pyramidal structure are generally insignificant. Dual class shares and pyramids, thus, seem to have a different impact on firm value. Using an F-test, we strongly reject the null hypothesis that the effect of dual class shares and pyramids are identical. Hence, the two coefficients are both economically and statistically different: Dual class shares have a significantly stronger negative effect on firm value than pyramids. Cross-holdings have a positive effect on firm value, which is significant at the 10 percent level. Even though the impact is much less statistically clear than for the two previous instruments, there are some indications that cross holding, on average, may increase firm value. The interaction effects between cross-holdings and the two measures of disproportionality vary in signs and are highly insignificant. Finally, the impact of other instruments is in most regressions highly insignificant, as are the interaction effects between other instruments and the two disproportionality measures. Notice, however, that firms with cross holdings and other instruments are few in number as documented in Table 3. If we analyze the group of large owners, these results do not change. The 20 economic and statistical impact of dual class shares and pyramids are very similar to the analysis of the single largest owner. Again we reject the null hypothesis that the two instruments have the same impact at the 1 percent level. The effect of cross holdings is still positive and significant at the 10 percent level. Other instruments have an insignificant effect. In summary, this section shows that the type of instrument through which disproportionality is created is indeed important for the effect of disproportionality on firm value. Dual class shares and pyramids have a large negative impact on firm value. In addition, dual class shares have a significantly larger negative effect on firm value than pyramids. This insight delivers important policy implications, which we will return to in the final section below. 4.4 Investor protection and the cost of disproportionality Currently, there are a large number of studies analyzing the impact of investor protection on various topics within corporate finance and firm organization (see survey by La Porta et.al. 2000). In this section, we investigate whether investor protection also plays a role in explaining the impact of disproportionality instruments on firm value. As motivation for this analysis, consider the costs and benefits of dual class shares. The principal benefit is that they reduce the opportunistic behavior of the management in firms with a significant separation of ownership and control. The main cost is the increased opportunities for controlling shareholders to extract rent from non-controlling shareholders. Good investor protection reduces, ceteris paribus, the management’s ability to engage in opportunistic behavior contrary to the interests of the owners, but it also reduces the controlling owners’ ability to extract rent 21 from non-controlling owners.15 However, even in firms where non-controlling shareholders are well protected, there will always be a legal scope for controlling shareholders to expropriate rent for themselves, for instance, through pecuniary and/or non-pecuniary benefits or by influencing business decisions in a way that promotes their own interests. We conclude that since both the costs and benefits of dual class shares are affected by the degree of investor protection, it is not possible to theoretically determine the exact aggregate impact on the value discount of dual class shares. We use the two standard measures of investor protection from La Porta et al. (1998); anti-director and creditor rights. The anti-director rights index summarizes 6 specific decision rights granted to minority shareholders by corporate law, whereas the creditor right index measures the presence of 5 protective rights granted to creditors in case of bankruptcy. The indices increase with the level of legal investor protection and they are positively correlated. In the analysis of ownership structures and firm value, the interaction of anti-director rights with the disproportionality measures is expected a priori to be most important. In Table 7, the two measures of investor protection are interacted with the degree of disproportionality.16 To simplify the presentation of the results we do not report the control variables and industry effect, which are identical to the ones used throughout the analysis. We start by including the interaction of anti-director rights with the proportionality dummy. The interaction effect is positive and highly significant, whereas the proportionality dummy 15This is most evident in transition economies, where insiders’ insufficient ability to commit not to divert outsiders’ investments has been a serious obstacle for increased foreign investment (Shleifer and Vishny 1997). 16Note that our basic regression model includes a fixed country effect and therefore already controls for the direct effect of the level of legal investor protection, since it is constant within each country. 22 becomes negative and marginally insignificant. Thus, the effect of proportional ownership structures increases with the level of investor protection, but is insignificant in countries with low levels of investor protection. A simple F-test of the net effect of a proportional ownership structure reveals that thepositiveeffect kicks in when the anti-director rights score is 3 or higher, whereas the effect is insignificant for scores below 3.17 Similar results are obtained when using the creditor rights index, but Model 2(c) shows that this is mainly due to the positive correlation between anti-director and creditor rights. When both terms are included, only the interaction with the antidirector index is significant. Furthermore, these results are robust towards the measure of disproportionality, since identical results are obtained when investor protection indices are interacted with the absolute degree of disproportionality. The negative effect of disproportional ownership structures increases with the level of investor protection, but the effect is only present for countries with a relatively high level of investor protection. For countries with a high level of investor protection (the UK, Ireland and Scandinavia), thenegativeeffect of disproportional ownership structures are economically important; firms with a disproportional ownership structure and an antidirector rights score of 5 have a 20 percent lower firm value than firms with a proportional ownership structure. Table 8 extends the analysis of the effect of disproportionality into the use of particular instruments.18 We start by including the interaction of the two investor protection indices with the four groups of instruments in Models 5(a) and (b). At the top of Table 8, we notice that the direct effect of 17The F-test of the net effect of proportional ownership structures with an anti-director rights score of 2 yields a F-statistic of 0.61, which is grossly insignificant, whereas the F-value when the score equals 3 is 7.20, which is significant at the 1 percent level. 18Again, control variables are not reported in Table 8. 23 tection of outside investors where agency problems generally are perceived to be smaller. These findings shed new light on some recent policy issues in relationship to the creation of a common internal capital market in the European Union. During the last two decades the European Commission has worked on reforming company laws within the EU. Inspired by the Final Report of the High Level Group of Company Law Experts (Winter et al. 2002), the promotion of the principle of proportionality has been a recurrent theme in this harmonization process. The EU Commission views this process as an essential part of exploiting the benefits of the internal market and as a prerequisite for the integration of European capital markets. The Winter Report suggested the introduction of the much debated Break-Through rule to facilitate takeovers of firms with a disproportional ownership structure.21 The recent EU Action Plan (2003) proposes that within the next four years “abusive” pyramids shall be prohibited from being listed on a stock exchange. Abusive pyramids are defined as holding companies whose sole or main assets are their ownership of shares in another listed company. More generally, there is an increasing focus on shareholder rights and the potential conflicts between controlling and non-controlling groups of owners. We claim that this increased focus on shareholder rights and (some version of) the principle of proportionality are making not only an impact on policy proposals from the European Commissions, but more generally in21The Break-Through rule states that an investor, after acquiring a certain threshold of the cash flow rights to a firm, should be able to break through the firm’s current control structure. The Winter Report suggests that the threshold should be set at 75 percent, so that any owner possessing 75 percent of the total outstanding shares, independently of the presence of dual class shares, should have complete control of the firm. The proposal was included in the initial version of the proposal for a new takeover directive, but was removed in the final version (See European Commission 2002, 2003) 30 fluence the attitude towards corporate governance in many countries both inside and outside the European Union. To back this claim we have collected 53 codes, principles and guidelines on good corporate governance22 and analyzed to what extent they provide discussions and/or recommendations of issues concerning the distribution of cash flow and votes in corporations. Table 12 provides a summary of these findings. A total of 38 codes out of 53 deal with the conflict of interests between controlling shareholders and minority shareholders. Out of these 19 codes directly consider and/or comment on the discrepancy between cash flow rights and voting rights. Eleven codes either recommend that firms follow a one-share-one-vote principle or recommend more generally an alignment between control and ownership. Eight codes explicitly recommend not having dual class shares or comment specifically on the negative effects of having different voting rights attached to shares. Ten codes either emphasize that pyramidal ownership structures shall be disclosed and transparent or directly warn against the use of pyramids. Similarly, 11 codes propose that voting caps either should be disclosed by firms or avoided. Finally, seven codes recommend that shareholder agreements should be disclosed. Many of the codes we have collected are from countries outside Europe; however, the tendency towards more focus on the principle of proportionality and shareholder rights is also clear within the 13 countries from our sample for which a code of conduct was found. Nine of these country codes deal with the potential conflict between controlling and non-controlling owners. 22Our selection procedure is simple: We collected all codes published on the web site of the European Corporate Governance Institute (www.ecgi.org) by January 1, 2005. For each country we picked one code or principle. If a country had more than one code, we selected the most “official” looking code. We excluded Japan and South Africa due to a lack of access and Ireland due to its focus on remuneration only. In addition we included a few codes from international institutions. 31 Six out of these countries comment on the discrepancy between ownership and control. Austria, Denmark and Germany go one step further and recommend an alignment between control and cash flow rights. Germany even recommends not using dual class shares. Spain and Switzerland propose that firms should publish relevant information about pyramidal ownership structures. Voting caps should be avoided according to the German code and declared according to the Danish code. Interestingly, there is almost no discussion of proportionality between ownership and control in the most recent UK code from July 2003. Given that the principle of proportionality plays such a significant role either directly or indirectly both in the process of creating an internal capital market within Europe and in the way that individual European countries think about corporate governance, it is natural to ask whether the results of this paper support these initiatives and recommendations. The answer is mixed: First, it was shown that having a proportional ownership structure increases firm value, but not earnings performance in the total sample, which to some extent supports the principle of proportionality. However, we have found significant regional differences, which are correlated with the level of investor protection. Hence, even though a principle of proportionality can increase firm value in Northern Europe, it is not clear that this proposal would increase firm value in the rest of Europe without additional regulatory initiatives. More generally, our findings support the idea that one size does not fit all countries, i.e. that individual variation in investor protection may be an important factor determining the consequences of implementing a principle of proportionality. 32 Second, our findings indicate that it may be more relevant to focus on the various instruments that create disproportional ownership structures. Even though theoretically it may be hard to understand the difference between dual class shares and pyramids, these two instruments empirically have a different impact on firm valuation. Firms with dual class shares and asufficiently disproportional ownership structure do create less value than other firms. It is worth emphasizing that these firms would have been affected by the now withdrawn EU proposal regarding the introduction of a Break-Through rule. Thus, our analysis provides some support for a BreakThrough rule, but with two caveats: policy makers should understand that a Break-Through rule is likely only to increase firm value (not earnings performance) in general and this effect can only be expected in Northern Europe where investor protection is generally higher. Third, we find a negative effect on firm value from pyramidal structures in Northern Europe; however, the value effects from pyramidal structures are generally smaller than in the case of dual class shares. The EU Action Plan (2003) suggests that in the medium term abusive pyramids should be regulated, but does not suggest specific regulation for dual class shares. Unfortunately, we have no data on holding companies and, therefore, we cannot directly analyze the impact of abusive pyramids relative to other types of disproportional ownership structures. However, the analysis strongly reaffirms the need for more knowledge about the consequences of different kinds of pyramids before such policy initiatives are implemented. Finally, we conclude by repeating the main policy implication of the analysis. Taking the existing variation in the legal protection of outside investors as a given, it is expected that there may be significant regional 33 variation in the economic consequences of implementing a principle of proportionality. A prerequisite for exploiting the full benefit for all regions within the European Union is to have a high level of protection of outside investors. As is currently the case when investor protection varies across regions, there seems to be some truth to the claim that one size does not fit all countries with respect to regulative initiatives aimed at promoting the principle of proportionality. 34 References [1] Almeida, H., and D. 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Simon, (2002), Report of the High Level Group of Company Law Experts on Issues Related to Takeover Bids, Brussels, 2002. [27] Zingales, L. (1994), The Value of the Voting Right: A Study of the Milan Stock Exchange Experience, The Review of Financial Studies,7, 125-48. [28] Zingales, L. (1995), What Determines the Value of Corporate Votes, The Quarterly Journal of Economics, 110, 1047-73. 36 Figure 1, Largest Owner’s Share of Cash Flow and Votes Across Legal Regimes These figures plot the largest owner’s share of cash flow and votes across legal regimes in Europe; the UK & Ireland, Scandinavia (Denmark, Finland, Norway and Sweden), German origin (Austria, Germany and Switzerland) and Southern Europe (Belgium, France, Italy, Portugal and Spain). Above each graph, the total number of firms (N), number of firms with a proportional ownership structure (PP), dual class shares (DCS) and other instruments than dual class shares, i.e. pyramid, cross-holding and other (PCO) are shown. These three different types of firms are marked with a triangle (PP), cross (DCS) and dot (PCO), respectively. All firms with a proportional ownership structure (PP) are located on the Proportionality Line, whereas the lines Trend with PP and Trend without PP show the coefficient on the regression of votes on cash flow with and without firms with a proportional ownership structure (PP), respectively. UK & Ireland 0 0,2 0,4 0,6 0,8 1 0 0,2 0,4 0,6 0,8 1 Share of cash flow S h a r e o f v o t e s Proportionality Line PCO Proportionality DCS Trend without PP Trend with PP N=1742 , PP=959 , DCS=441 , PCO=342 Scandinavia 0 0,2 0,4 0,6 0,8 1 0 0,2 0,4 0,6 0,8 1 Share of cash flow S h a r e o f v o t e s Proportionality Line PCO Proportionality DCS Trend without PP Trend with PP N=736, PP=420, DCS=111, PCO=205 German Origin 0 0,2 0,4 0,6 0,8 1 0 0,2 0,4 0,6 0,8 1 Share of cash flow S h a r e o f v o t e s Proportionality Line PCO Proportionality DCS Trend without PP Trend with PP N=911, PP=486, DCS=226, PCO=199 Southern Europe 0 0,2 0,4 0,6 0,8 1 0 0,2 0,4 0,6 0,8 1 Share of cash flow S h a r e o f v o t e s Proportionality Line PCO Proportionality DCS Trend without PP Trend with PP N=1021, PP=736, DCS=89, PCO=196 Table 1, Explanatory Variables Firm size Measured as log. to sales. Leverage Book-value of debt over book-value of total assets. Asset tangiblity Share of assets that are tangible. Defined as 1 – (intangibles / total assets). Sales growth Growth in sales in the year prior to the observation. Controlling owner’s cash flow stake The share of cash flow held by the controlling owner. We use two definitions of the controlling owner. On the left side of each regression table, the controlling owner is defined as the single largest owner measured by votes, whereas on the right side, the controlling owner is defined as the group of large owners that individually possess at least 10 percent of the votes. Proportionality A dummy taking the value 1 if the controlling owner has an equal share of cash flow and votes, and the firm does not have dual class shares, a pyramidal structure or a cross holding structure. Dual class shares (DCS) A dummy taking the value 1 if the firm has dual class shares. Pyramid (PYR) A dummy taking the value 1 if the firm has a pyramidal ownership structure. Cross holding (CRO) A dummy taking the value 1 if the firm has cross holdings. Other types of disproportionality (OTH) A dummy taking the value 1 if the firm has introduced a disproportional ownership structure through other instruments than dual class shares, pyramid and cross holding. Absolute disproportionality The controlling owner’s share of votes minus cash flow. The left side of the regression tables are based on the largest owner’s holdings, whereas the right side focuses on the group of large owners. Relative disproportionality The controlling owner’s share of votes over cash flow. The left side of the regression tables are based on the largest owner’s holdings, whereas the right side focuses on the group of large owners. Table 2, Summary Statistics, Year = 1997 This table shows the summary statistics on country level for the dependent variables, Tobin’s Q and Return on Assets (RoA), as well as the control variables used throughout the empirical section. Tobin’s Q is defined as market value of equity plus book value of debt divided with book value of assets, whereas RoA is defined as operating profit over book value of assets. Firm size is measured by sales in millions of dollars. Leverage is defined by book value of debt over book value of assets. Asset tangibility is defined as (1 - book value of intangible assets / book value of assets), while sales growth is the growth in sales for the previous year. N reflects the number of observations in the regression models dependent on the endogenous variable, Tobin’s Q and RoA. The degree of investor protection is measured by two variables: Anti Director Rights index (ADR) and Creditor Rights index (CR) from La Porta et al. (1998). ADR is measured on a scale from 0 to 6, where 0 is the lowest degree and 6 is the highest degree, while CR has a minimum of 0 and a maximum of 5. Country Tobins Q RoA Firm size Leverage Asset Tangibility Sales Growth N Investor Protection Mean Median Mean Median Mean Median Mean Median Mean Median Mean Median Tobins Q RoA ADR CR Austria 0.87 0.70 0.07 0.03 671 219 0.26 0.23 0.97 0.99 0.30 0.13 90 89 2 3 Belgium 1.20 0.91 0.08 0.06 1711 245 0.27 0.24 0.95 0.99 0.59 0.14 85 85 0 2 Denmark 1.10 0.83 0.07 0.05 380 77 0.23 0.20 0.98 1.00 0.20 0.16 164 161 2 3 Finland 1.29 0.94 0.09 0.08 861 137 0.29 0.27 0.95 0.98 0.38 0.20 105 103 3 1 France 1.00 0.78 0.04 0.04 2088 214 0.24 0.22 0.91 0.96 0.31 0.13 495 491 3 0 Germany 1.23 0.85 0.04 0.04 2437 235 0.21 0.17 0.96 0.99 0.28 0.10 582 579 1 3 Ireland 1.59 1.11 0.04 0.07 572 176 0.23 0.22 0.95 1.00 0.15 0.15 60 58 4 1 Italy 0.83 0.68 0.04 0.03 2590 442 0.26 0.24 0.96 0.99 0.14 0.12 169 165 1 2 Norway 1.33 1.01 0.07 0.06 536 132 0.32 0.31 0.96 0.99 0.30 0.12 138 137 4 2 Portugal 0.78 0.70 0.04 0.04 579 149 0.25 0.24 0.93 0.99 0.20 0.17 70 67 3 1 Spain 1.08 0.85 0.06 0.05 863 213 0.19 0.16 0.97 0.99 0.51 0.15 146 143 4 2 Sweden 1.80 1.21 0.04 0.07 965 115 0.23 0.21 0.92 0.97 0.54 0.12 200 198 3 2 Switzerland 1.05 0.80 0.06 0.05 1996 281 0.26 0.24 0.97 1.00 0.15 0.09 161 160 2 1 UK 1.47 0.98 0.05 0.06 829 87 0.19 0.16 0.98 1.00 0.20 0.08 1632 1614 5 4 All countries 1.28 0.90 0.05 0.05 1316 143 0.22 0.19 0.96 1.00 0.26 0.11 4096 4050 2.64 1.93 Table 9, The Effect of Disproportional Ownership Structures on Earnings Performance in Western Europe Estimation on Cross Section Data with Fixed Country Effects, Average of the Period 1996-1998 This table reports coefficient estimates from the regression including all 14 Western European countries. The data used are the averages of yearly observations in the period 1996-1998. The explanatory variables are described in Table 1 and summary statistics are provided in Table 2. The left side of the table reports the results when the controlling owner is assumed to be the largest owner measured by votes, whereas the right side assumes that the controlling owner is the group of large owners, which individually holds at least 10 percent of the votes. P-values based on robust standard errors are reported in italics. Dependent Variable Return on Assets Return on Assets Controlling Owners Largest Owner Group of Large Owners Model I Model II Model III Model IV Model I Model II Model III Model IV Firm size 0.012 0.012 0.012 0.012 0.012 0.012 0.012 0.012 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 Leverage -0.054 -0.054 -0.054 -0.054 -0.054 -0.054 -0.054 -0.054 0.008 0.009 0.009 0.008 0.008 0.008 0.008 0.008 Asset tangiblity 0.164 0.164 0.164 0.164 0.165 0.165 0.165 0.165 0.037 0.037 0.038 0.037 0.037 0.037 0.037 0.036 Sales growth 0.003 0.003 0.003 0.003 0.003 0.003 0.003 0.003 0.471 0.465 0.469 0.471 0.471 0.467 0.470 0.471 Controlling owners’ cash flow stake 0.022 0.023 0.022 0.021 0.010 0.010 0.010 0.010 0.010 0.010 0.011 0.011 0.299 0.288 0.304 0.314 Proportionality -0.003 -0.002 0.497 0.711 Absolute disproportionality 0.013 0.006 0.516 0.774 Relative disproportionality -3.91E-05 -6.03E-05 0.441 0.260 Industry effects YES YES YES YES YES YES YES YES Adjusted R-squared 0.037 0.037 0.037 0.037 0.037 0.036 0.036 0.036 N 4050 4050 4050 4050 4050 4050 4050 4050 Table 10, The Effect of Disproportionality Instruments on Earnings Performance in Western Europe Estimation on Cross Section Data with Fixed Country Effects, Average of the Period 1996-1998 This table reports coefficients estimates from the regression including all 14 Western European countries. The data used are the averages of yearly observations in the period 1996-1998. The explanatory variables are described in Table 1 and summary statistics are provided in Table 2. The left side of the table reports the results when the controlling owner is assumed to be the largest owner measured by votes, whereas the right side assumes that the controlling owner is the group of large owners, which individually holds at least 10 percent of the votes. P-values based on robust standard errors are reported in italics. Dependent Variable Return on Assets Return on Assets Controlling Owners Largest Owner Group of Large Owners Model V Model VI Model VII Model V Model VI Model VII Firm size 0.012 0.012 0.012 0.012 0.012 0.012 0.000 0.000 0.000 0.000 0.000 0.000 Leverage -0.053 -0.053 -0.053 -0.053 -0.053 -0.054 0.009 0.010 0.009 0.008 0.008 0.008 Asset tangiblity 0.164 0.164 0.164 0.166 0.165 0.166 0.037 0.037 0.037 0.036 0.037 0.036 Sales growth 0.003 0.003 0.003 0.003 0.003 0.003 0.462 0.468 0.469 0.464 0.468 0.469 Controlling owners’ cash flow stake 0.022 0.022 0.020 0.008 0.010 0.019 0.014 0.010 0.016 0.373 0.314 0.349 Instruments Dual class shares (DCS) -0.006 -0.007 0.216 0.158 Pyramid (PYR) 0.010 0.008 0.030 0.057 Cross holding (CRO) -0.039 -0.042 0.005 0.003 Other types of disproportionality (OTH) -0.013 -0.014 0.169 0.126 Interactions Absolute disproportionality * DCS -0.001 -3.91E-04 0.976 0.986 Absolute disproportionality * PYR 0.035 0.022 0.151 0.366 Absolute disproportionality * CRO -0.272 -0.284 0.000 0.000 Absolute disproportionality * OTH -0.070 -0.073 0.124 0.106 Relative disproportionality * DCS 2.00E-05 5.01E-05 0.868 0.670 Relative disproportionality * PYR -3.94E-05 -7.89E-04 0.742 0.497 Relative disproportionality * CRO -0.004 -0.004 0.001 0.001 Relative disproportionality * OTH -0.002 -0.002 0.487 0.448 Industry effects YES YES YES YES YES YES Adjusted R-squared 0.038 0.037 0.037 0.034 0.036 0.036 N 4050 4050 4050 4050 4050 4050 Table 11, Voting Premiums in Western Europe This table shows the average and median voting premiums from Nenova’s (2003) study of the relative price of superior to limited voting shares. Firms in Austria and Ireland are not included in Nevona’s study and there are no firms with dual class shares in Belgium, Portugal and Spain. N is the number of firms where both share classes are listed on the stock exchange (number of observations in Nevova’s study), whereas Share of All Firms with Dual Class Shares relates this to the total number of firms with dual class shares in our sample. Voting Premium N Share of All Firms with Dual Class Shares Mean Median Denmark 0.0084 0.0029 30 0.462 Finland -0.0503 0.0052 21 0.447 France 0.2805 0.2747 9 0.600 Germany 0.0950 0.0493 65 0.556 Italy 0.2936 0.2993 62 0.838 Norway 0.0583 0.0438 15 1.000 Sweden 0.0104 0.0043 43 0.283 Switzerland 0.0544 0.0147 36 0.404 United Kingdom 0.0957 0.0721 27 0.066 Table 12, Survey of Corporate Governance Codes of Conduct This table surveys codes of conduct, principles and guidelines for good corporate governance around the world. The codes were collected from the European Corporate Governance Institutes website (www.ecgi.org) as of January 1, 2005. We were able to collect codes from 48 countries and 5 international organizations (e.g. OECD). One code or principle was chosen for each country/international organization. In case a country had more than one code, the most recent and most official code was chosen. The countries are divided into three groups: World, European Union and Western Europe, where Western Europe corresponds to the 14 countries included in this paper. The number of available codes was 53, 23 and 13, respectively. The countries included are listed below the table. The codes from international organizations are only included in the ‘World’ category. Recommendations World (N=53) EU (N=23) Western Europe (N=13) N Share N Share N Share The Principle of Proportionality Discussion of conflicts of interest between controlling and minority shareholders 38 0.66 15 0.71 9 0.64 Discussion of the principle of proportionality 19 0.33 11 0.52 6 0.43 Recommends one-share-one-vote or an alignment between ownership and control 11 0.19 5 0.24 3 0.21 Disproportionality Instruments Recommends not using dual class shares or disclosing dual class shares 8 0.14 4 0.19 1 0.07 Recommends not using pyramidal structures or disclosing pyramidal structures 10 0.17 4 0.19 2 0.14 Recommends not using voting caps or disclosing voting caps 11 0.19 6 0.29 3 0.21 Recommends that shareholder agreements should be disclosed 7 0.12 3 0.14 1 0.07 Countries: Australia, Austria, Bangladesh, Belgium, Brazil, Canada, China, Cyprus, Czech Republic, Denmark, Finland, France, Germany, Greece, Hong Kong, Hungary, Iceland, India, Indonesia, Italy, Kenya, Lithuania, Macedonia, Malaysia, Malta, Mexico, New Zealand, Norway, Pakistan, Peru, Poland, Portugal, Romania, Russia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sweden, Switzerland, Thailand, The Netherlands, The Philippines, Turkey, United Kingdom and USA. International organizations: Commonwealth Association for Corporate Governance, European Association of Securities Dealers, International Corporate Governance Network, Latin America Corporate Governance Roundtable and OECD