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The Equal Opportunity Rule and Financial Constraints: is there a
link?
Carlos Acu˜na Silva∗
Abstract
In order to promote financial market development, different governments have introduced The Equal Opportunity Rule (EOR) as a replacement of The Market Rule (MR) to regulate control transactions. However, if firms were free to choose, which ones would voluntary adopt the EOR? By analyzing the Chilean experience, I find that the voluntary adoption of the EOR is positively correlated with financial constraints (small firms tend to adopt the EOR), but it does not alleviate them (the investment-cash flow sensitivity remains unchanged). Overall, these results suggest that the mandatory introduction of the EOR is not an optimal policy.
∗Clapes UC. Email: [email protected]
1. Introduction
Investor protection plays a key role in financial market development (La Porta, L´opez-de-Silanes, Shleifer and Vishny, 1997; Shleifer and Wolfenzon, 2002). Accordingly, many governments have focused on the regulation of control transaction as a mechanism to protect minority shareholders. Usually, this kind of regulation introduces The Equal Opportunity Rule (EOR, also termed Mandatory Bid Rule) as a replacement of The Market Rule (MR). The EOR, which has its origins in UK and now applies in the European Union and in many other countries, implies that the minority shareholders are entitled to participate in transfers of control on the same terms as the controlling shareholder. On the contrary the MR, which is the prevailing rule in the United States, gives freedom on a company’s incumbent controller by enabling sale shares (hence control over the target company) to any acquirer at a price agreed between the two parties. Thus, the transferor of control could retain a control premium, and inefficient transfers can take place (Holderness and Sheehan, 1988). The EOR protects minority shareholders because all shareholders are treated equally, share the control premium and have an exit right in the event of a change of control. By raising the cost of acquisitions, however, the EOR eliminates inefficient control transfers at the cost of preventing a wide range of value- increasing transactions (Bebchuk, 1994). Therefore, if firms were free to choose, which ones would voluntary adopt the EOR? To address this question, this paper focuses on the Chilean Tender Offer Law (also knows as Ley de OPAs), enacted in December 2000. This law introduced the EOR to replace the MR, but firms were given the chance to voluntary adopt the EOR for a three year period (after that period the adoption of the EOR became mandatory), which provides the opportunity to determine which firms prefer to increase minority shareholders protection against expropriation from potential future controlling shareholders, at the cost of increased restrictions on value-increasing transactions. Beside legal norms, the analysis of control transfers should refer to con- centrated/diluted ownership systems (Burkart, Gromb and Panunzi, 2000). In countries characterized by ownership concentration, horizontal agency problems (extraction of resources by the controlling shareholder at the minority share-
trolling shareholder to expropriate minority shareholders is a function of the legal system in which the controlled company is chartered. Consequently the implementation of the MR, accompanied by laws that protect minority share- holders against expropriation from the controlling shareholder (either existing or new ones), may be a better way to foster the development of the capital market. The null effect of the EOR adoption on financial constraints found in this study is consistent with the latter view. Schuster (2013) argues that the MR creates second-best outcomes in some private auctions of control-blocks, by failing to favour the most efficient bidder in taking control. The EOR, in contrast, would lead to the best of the bidders gaining control. However, these arguments do not contradict the above-mentioned approach, in the sense that value-increasing control transfers can take place under the MR if complementary investor protection mechanisms are implemented. This research also relates to the literature that studies firms’ and control transactions characteristics following the enactment of the Chilean Tender Of- fer Law. Morales, Mel´endez and Ram´ırez (2013) find that the introduction of the EOR increased the ownership concentration. Jurfest, Paredes and Riutort (2015) find that control premiums fell significantly after the passing of the Ten- der Offer Law. This work adds to this literature by taking a closer look at the firm’ decision-making process, and by providing evidence of the null effect of the EOR adoption on financial constraints. The rest of the paper is organized as follows. Section 2 presents the theo- retical framework that relates the voluntary adoption of the EOR and financial constraints, thus motivating the hypothesis of this work. Section 3 presents the econometric strategy and data, while Section 4 shows the empirical results. Finally, Section 5 is the conclusion.
2. Hypothesis Development
2.1 Efficiency in Control Sales and Private Benefits of Control Consider a company that has an existing controlling shareholder, which is denoted by C. Let B a potential acquirer of the incumbent controller’s block of shares. The controller’s identity is relevant because it may influence the value of
two parameters, W and P B. Let W > 0 be the net present value of the future dividends of the company. For its part, P B denotes the private benefits of con- trol. In general terms, controllers can obtain private benefits of control through using control to tunnel resources from the firm for their own benefit. Examples of tunneling are transfer pricing favoring the controlling shareholder (sale of outputs to an intermediary controlled by insiders for below-market prices; or purchase of inputs at above-market prices) and loan guarantees using the firm’s assets as collateral (Johnson, La Porta, Lopez-de-Silanes and Shleifer, 2000). Thus, the net present value of the future dividends from the perspective of a minority shareholder -who does not receive any private benefit from control- is equal to W − P B. C and B may differ in either W , P B or both. With regard to W , controllers may differ in their management skills or in their capacity to monitor those in- volved in the management of the company. Likewise, controllers may differ in their capacity to capture private benefits of control. For example, a controller that owns companies that are engaged in business activities which are com- plementary to those of the controlled company has a greater ability to extract value by engaging in self-dealing or the taking of corporate opportunities than a controller that does not own such firms (Bebchuk, 1994). Let WC and P BC denote the values of W and P B, respectively, if the existing controller C retains control. Similarly, WB and P BB denote the values of W and P B, respectively, if B acquires the control. Following Bebchuk (1994), a transfer of control is efficient if and only if WB > WC ⇒ ∆W > 0. In this sense, changes in management and the existence of synergies can increase firm value after the transaction. Conversely, a transfer of control is inefficient if and only if ∆W < 0. 2.2 The Market Rule and The Equal Opportunity Rule There are two legal regimes governing control transactions: the Market Rule (MR) and the Equal Opportunity Rule (EOR). In the first case, the acquirer is under no obligation to extend his offer to minority shareholders, which implies that the company’s incumbent controller may obtain a control premium, and inefficient transfers can take place (Hold- erness and Sheehan, 1988). From the perspective of the acquirer, large private
uses firm size as a proxy for financial constraints. Agency costs generated by asymmetry in the information held by firms and their lenders make the use of collateral inevitable to obtain financing in the credit market. Smaller firms have less assets that could be used as collateral, thus smaller borrowing capacity. Consequently, smaller firms have to rely more on internal funds to finance their investments. Lastly, larger firms have reputations that are more established than those of most smaller companies, which act as a guarantee for outside investors^1. The arguments below suggest that smaller firms are more likely financially constrained. Therefore, to test the empirical prediction the following estimation is made: EORi 2001 = β 0 + β 1 Sizei, 2000 + β 2 Xi, 2000 + εi,t− 1 (1)
where EORit is a dummy variable for whether firm i adopted the EOR in 2001. Sizei, 2000 is the logarithm of total assets in 2000. Based on our previous dis- cussion, β 1 is expected to be negative. Xi, 2000 is a vector of firm characteristics typically associated with financial constraints, such as capital-intensity (prop- erty, plant, and equipment over assets), EBIT over assets, leverage, and Tobin’s Q (the ratio of the sum of total liabilities and market value of equity to book value of total assets) as a proxy for firm valuation^2. 3.1 Data and Descriptive Statistics The sample is composed by almost all non-financial Chilean companies listed on the Santiago Stock Exchange in 2000-2001. The data on financial statements and market variables is obtained from Economatica, a data set that covers publicly-traded companies in Latin America. The data on the EOR adoption is obtained from the Superintendencia de Valores y Seguros (the Chilean stock market). Table 1 presents the descriptive statistics of the EOR adoption and the con- trol variables. The average EOR adoption rate is 66 percent. Figure 1 shows the average EOR adoption rates for percentiles 0-33, 33-66 and 66-100 of size. It can be seen that the adoption of the EOR exhibits a negative correlation (^1) See, for instance, Banerjee and Duflo (2000) for empirical evidence of the positive effects of reputation on firms financing conditions. 2 EBIT over assets and Tobin’s Q are included in the Kaplan and Zingales (1997) index of financial constraints.
with firm size. Figure 2 carries out an analogous exercise, but it focuses on the small firms (33rd percentile and below). The average EOR adoption rate is equal to 90 percent and 85 percent respectively in the first and second groups, while firms in the last group adopted the EOR in only about 55 percent of the cases. When taken together, Figures 1 and 2 suggest that the adoption of the EOR is positively correlated with the level of financial constraints. The follow- ing section evaluates if this hyphotesis can be confirmed.
4. Results
4.1 EOR Adoption and Firm Size Column (1) on Table 2 shows the results obtained by estimating a simplified version of the model described in equation (1), which only considers firm size as an explanatory variable. This exercise serves as a basis of comparison and to confirm or rule out that this variable has an effect on the EOR adoption when other explanatory variables are not considered in the analysis. This specification suggests that a one percent increase in firm size leads to a reduction in the adoption probability by approximately 6 percentage points. Columns (2) to (5) include additional controls. The inclusion of these ad- ditional variables in the specification (corresponding to the Xi, 2000 variables in equation (1)) does not significantly alter the sign, magnitude, or significance of the coefficient associated with firm size. Overall, these results are consistent with the hypothesis that the voluntary adoption of the EOR is positively corre- lated with the level of financial constraints. Furthermore, none of the additional variables is statistically different from zero. In this sense, it is worth pointing out that the coefficient of Tobin’s Q in column (5) is not significant. This finding suggests that the EOR adoption is not correlated with firm valuation. 4.2 Does the adoption of the EOR alleviate firms’ financial con- straints? The previous estimates show that the voluntary adoption of the EOR is pos- itively correlated with the level of financial constraints. Therefore, the purpose of this subsection is to determine whether financial constraints are alleviated by the adoption of the EOR. In particular I test whether, as a result of the EOR adoption, firms are less dependent on internal fund flows to finance their
remaining control variables (gradually moving from column (3) to column (5)). Comparing the results in column (1) with (2) shows that omitting fixed ef- fects biases the effect of cash flows upwards, but the coefficient in column (2) is still significant. According to the regression results in column (2), a one percent increase in cash flows produces a 0.092 percent increase in the firm’s investment. This finding parallels those of Medina and Vald´es (1998) and Gallego and Loayza (2000) for the Chilean economy. The coefficient on the interaction between cash flows and the EOR adoption is negative but not statistically different from zero (column (3)). Once Tobin’s Q is considered, the coefficient associated with the interaction term decreases in magnitude from -0.058 to -0.039, and becomes even more irrelevant in terms of statistical significance (column (4)). The coefficient remains virtually unchanged when the debt to capital ratio is included in the estimation (column (5)). Overall, these results suggest that the adoption of the EOR does not alleviate firms’ financial constraints.
5. Conclusion
In order to encourage growth of financial markets, several governments have introduced the EOR as a replacement of the MR to regulate transfers of con- trol. The EOR increases minority shareholders’ protection against expropri- ation from potential future controlling shareholders, at the cost of increased restrictions on value-increasing transactions. In this paper, I examine the EOR voluntary adoption determinants and look at whether the adoption of the EOR reduces financial constraints. By analyzing the Chilean experience, I find that the voluntary adoption of the EOR is positively correlated with financial con- straints (small firms tend to adopt the EOR), but it does not alleviate them (the investment-cash flow sensitivity remains unchanged). Overall, these find- ings suggest that the mandatory introduction of the EOR is not an optimal policy.
References
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Table 1: Summary Statistics
This table shows descriptive statistics of the variable of interests. The sample is composed by almost all non-financial Chilean companies listed on the Santiago Stock Exchange between 2000 and 2001. The data on financial statements and market variables is obtained from Economatica. The data on the EOR adoption is obtained from the Superintendencia de Valores y Seguros. The dependent variable is a dummy for whether firm i adopted the EOR in 2001. The control variable group include capital-intensity (property, plant, and equipment over assets), EBIT over assets, leverage, and Tobin’s Q (the ratio of the sum of total liabilities and market value of equity to book value of total assets).
Variable Number of Observations Mean Standard Error Dependent Variable EOR Adoption 178 0.66 0.
Control Variables Size 178 17.5 0. Capital Intensity 178 0.47 0. EBIT/Assets 178 0.03 0. Leverage 178 0.4 0. Tobin’s Q 139 1.9 0.
Table 3: Investment-cash flow sensitivity and the EOR adoption
This table shows OLS and panel fixed effect regressions for a sample non- financial of Chilean firms between 1996 and 2004. The dependent variable is the ratio of investment to lagged capital stock ( (^) KIitit− 1 ). Independent variables are
the ratio of cash flow to the lagged capital stock ( (^) KCFit it− 1 ) and the interaction between this variable and a dummy equals to one in the year that firm i adopted the EOR (i.e., the year 2001) and in all subsequent years (EORit); Tobin’s Q (the ratio of the sum of total liabilities and market value of equity to book value of total assets) and the ratio of total debt to the capital stock measured at the beginning of the period ( (^) KDitit− 1 ). Data was obtained from Economatica. Standard errors, in parenthesis, are robust. *p < 0 .1, **p < 0 .05, ***p < 0 .01.
Dependent Variable: (^) KIitit− 1 Variable (1) (2) (3) (4) (5) CFit Kit− 1 0.133^ 0.092^ 0.112^ 0.113^ 0.135* (0.022) (0.042) (0.048) (0.048) (0.054) CFit Kit− 1 x^ EORit^ -0.058^ -0.039^ -0. (0.055) (0.049) (0.054) Tobin’s Q 0.0008*** 0.0008*** (0.0002) (0.0002) Dit Kit− 1 0.027** (0.011)
Firm fixed Effects No Yes Yes Yes Yes Year fixed effects No Yes Yes Yes Yes Observations 809 809 809 809 809
Figure 1: Average EOR Adoption Rate splited by firm size percentiles
The sample is composed by almost all non-financial Chilean companies listed on the Santiago Stock Exchange in 2000-2001. The data on financial statements and market variables is obtained from Economatica. The data on the EOR adoption is obtained from the Superintedencia de Valores y Seguros. Average EOR adoption rate was separated according to percentiles of size, defined as the logarithm of total assets in 2000.
