Going Public without Governance: Managerial Reputation Effects

This paper addresses the agency problem between controlling shareholders and minority shareholders. This problem is common among public firms in many countries where the legal system does not effectively protect minority shareholders against oppression by controlling shareholders. We show that even without any explicit corporate governance mechanisms protecting minority shareholders, controlling shareholders can implicitly commit not to expropriate them. Stock prices of such companies are significantly higher and firms are more likely go public because of this reputation effect. Moreover, insiders divest shares gradually over time, at a rate that is negatively related to the degree of moral hazard. RECENT EMPIRICAL RESEARCH INDICATES THAT in many countries the relevant corporate finance issue is not the traditional agency problem between management and shareholders, but rather the agency problem between the controlling shareholders and the minority shareholders. This problem may arise in some countries for two reasons: ~1! the corporate governance structure of public companies insulates large shareholders—that is, those with a majority of the votes and often with an involvement in the firm’s management—from takeover threats or monitoring;1 and ~2! the legal system does not protect minority shareholders because of either poor laws or poor enforcement of laws.2 Despite the lack of protection for minority shareholders, the average ratio of stock market capitalization held by minorities to gross national product is greater than 40 percent in a sample of 49 countries.3 This raises the question of why people are willing to be minority shareholders when they know * The Wharton School, University of Pennsylvania. Financial support from CAPES, Brazil, is gratefully acknowledged. I wish to thank Andrei Shleifer and Oliver Hart for their many invaluable suggestions and encouragement in pursuing this work. I am also grateful for helpful comments from the editor and two anonymous referees. I also thank Franklin Allen, Drew Fudenberg, Martin Hellwig, Ronen Israel, George Mailath, Eric Maskin, Ernst Maug, Walter Novaes, Tomas Sjostrom, E. Somanathan, Jeremy Stein, and S. Viswanathan. All errors remain my own responsibility. This paper circulated under other titles since its first draft in November 1996. For example, see La Porta, Lopez-de-Silanes, and Shleifer ~1999! for evidence from 27 countries, and Franks and Mayer ~1990, 1994! for evidence in Germany and France. 2 See La Porta et al. ~1998!. See also Pagano and Roell ~1998! for another treatment of the same agency problem considered in this paper. 3 See La Porta et al. ~1997!. THE JOURNAL OF FINANCE • VOL. LV, NO. 2 • APRIL 2000