Controlling family shareholders in developing countries: anchoring relational exchange.

• Author: Gilson, Ronald J.

INTRODUCTION I. THE STRUCTURE Of REPUTATION MARKETS II. CORPORATIONS AS LONG-LIVED REPOSITORIES OF REPUTATION III. THE FAMILY AS A MORE EFFICIENT REPUTATION BEARER IV. WHY MINORITY SHAREHOLDERS? V. THE DYNAMICS OF REPUTATION-BASED EXCHANGE CONCLUSION: HOW IS THE TRANSFORMATION TO RULE OF LAW ENFORCEMENT ACCOMPLISHED? INTRODUCTION

In recent years, corporate governance scholarship has begun to focus on the most common distribution of public corporation ownership: outside of the United States and the United Kingdom, publicly owned corporations often have a controlling shareholder. (1) The presence of a controlling shareholder is especially prevalent in developing countries. In Asia, for example, some two thirds of public corporations have one, most of whom represent family ownership. (2) The law and finance literature, exemplified by a series of articles by Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, Robert Vishny and others, treats the prevalence of controlling shareholders as the result of bad law; more specifically, controlling shareholders are ubiquitous in countries that do not adequately protect minority shareholders from the extraction of private benefits of control by dominant shareholders. (3) The logic is straightforward. Controlling shareholders will not part with control because that will expose them to exploitation by a new controlling shareholder who acquires a controlling position in the market.

The law and finance account of the distribution of ownership, while compelling as far as it goes, is at best partial. I have argued elsewhere that the syllogism is too simple to explain all controlling shareholder systems because we find significant numbers of controlling shareholders in countries with good law. (4) If jurisdictions that adequately protect minority shareholders have a significant number of companies with a controlling shareholder, something other than bad law is at work. And while the link between shareholder protection and distribution of shareholdings remains persuasive with respect to countries with poor shareholder protection--minority shares change hands at a significant discount to controlling shares in such jurisdictions (5)--it still leaves important parts of even this landscape unexplained. It does not, for example, explain why in Asian countries controlling shareholders are likely to be families. And it does not explain, given poor shareholder protection, why we observe minority shareholders at all. Since the law and finance account does not posit the existence of observable limits on how much of a minority shareholder's investment the controlling shareholder can extract, why is not the value of minority shares in such jurisdictions--and, it follows, the number of minority shareholders--zero?

In this Article, I want to continue the effort to complicate the controlling shareholder taxonomy by looking at the impact of bad law in a very different sense than that contemplated by the law and finance literature. In particular, I want to address the effect on the distribution of shareholdings when a jurisdiction provides not only poor minority shareholder protection, but poor commercial law generally. (6) Put differently, the goal is to play out the implications for the distribution of shareholders when the focus is not on conditions in the capital market, where poor shareholder protection has figured so prominently, but on conditions in the product market, where the driving legal influence is the quality of commercial law that supports the corporation's actual business activities. Can bad commercial law help explain shareholder distribution?

In an important sense, the law and finance literature's sharp focus on minority shareholder protection treats the shareholder distribution as independent of what the company actually does. In Miller-Modigliani terms, the distribution of shareholdings is "irrelevant" to the company's actual activities. Just as the division of capital between debt and equity on the fight side of the balance sheet does not, under the irrelevancy propositions, affect the value of real assets on the left side of the balance sheet, (7) the line that separates the two sides of the balance sheet also isolates the distribution of equity among shareholders from the value of the corporation's assets. My hypothesis is that bad commercial law, as opposed to just poor minority shareholder protection as contemplated by the law and finance literature, breaks down the separation between equity distribution and firm value. I posit that the presence of a controlling shareholder, particularly a family controlling shareholder, allows the corporation to better conduct its business, but in a way quite different than the potential for a controlling shareholder to more effectively police the agency conflict between management and shareholders, the productive advantage typically ascribed to a controlling shareholder structure. (8)

Broadening the concept of "bad law" to take into account not only the quality of minority shareholder protection, but also the quality of commercial law more generally, frames the problem. In an environment of bad commercial law, a corporation's basic business depends on its capacity to engage in self-enforcing exchange--that is, commercial transactions where the parties perform their contractual obligations because it is in their self-interest to perform, not because of the threat of legal sanction. With bad commercial law, exchange must be self-enforcing because there are neither authoritative rules nor an effective judicial system to enforce those obligations. (9) Transactions in this circumstance take place in a reputation market, which substitutes for law (or law's shadow) as a means to assure that parties perform their contractual obligations.

Framing the problem as one of commercial contracting in a bad law environment suggests a very different function for shareholder distribution than that contemplated by the law and finance literature. When commerce must take place in a reputation market, in which a corporation's business must be effected through self-enforcing transactions, the distribution of shareholdings, and particularly the presence of family ownership, facilitates the development and maintenance of the reputation necessary for a corporation's commercial success. (10) More speculatively, the role of reputation in the product market may help explain why we observe publicly held minority shares in the capital market even though poor shareholder protection does not impose a formal limit on the amount of private benefits that a controlling shareholder can extract. If bad behavior toward minority shareholders can affect the corporation's reputation in the product market as well as the capital market, then self-imposed limits on controlling shareholders' extraction of private benefits may derive from their concern over success in the product market. Indeed, the corporation may choose to have minority shareholders at all, despite the high price of equity capital in the face of poor minority protection, as a kind of hostage to support its reputation in the product market.

My ambition here is to offer a working hypothesis, an account neither formal in method nor deeply grounded in the history and structure of particular jurisdictions. (11) What happens when we turn the capital market-oriented bad law account of concentrated ownership on its head, and focus instead on how product market-oriented bad law influences the distribution of equity? The value of so minimalist an approach lies in framing the issue clean of the complications inevitably associated with particular jurisdictions, with the hope that if the account proves intriguing, then it will be of assistance in the real task--that of understanding the development of particular national markets and one of the foundations of economic development more generally. Part I sets out the basic problem of commercial exchange in a jurisdiction without effective commercial law. Part II develops how conducting business through a corporation can facilitate reputation formation and maintenance. Part III examines how family ownership can improve a corporation's capacity to act as a reputation bearer in the product market. Part IV then speculates on why a controlling family shareholder might voluntarily limit the amount of private benefit extraction from minority shareholders--not because the treatment of minority shareholders affects the controlled corporation's ability to raise additional equity capital, but because bad behavior will degrade its reputation in the product market. Part V addresses a final speculation about the dynamic character of controlling shareholder systems in developing countries. The role of shareholder distribution described here is one that supports reputation-based product markets. Such markets are limited in scale so that further economic development requires a transition to institutions that support anonymous product markets--a rule-of-law-based commercial system with effective formal enforcement. The transition, however, will be impeded both by the particular characteristics of existing institutions--what Paul Milgrom and John Roberts call "supermodularity" (12)--and by the political influence of those who have large investments that are specific to a reputation-based product market. Part VI concludes by framing the question with which we are left: how does the necessary transition take place in the face of structural and political barriers? (13) More specifically, does the answer relate to the recent historical pattern of economically benevolent dictators observed during the transition period in many countries that have successfully developed?

1. THE STRUCTURE OF REPUTATION MARKETS

   In its most simple form, a self-enforcing commercial arrangement can be based only on the expectation of a long horizon of future transactions. Where two parties expect to...