A growing number of economists believe that a country’s legal environment is a significant factor in financial market growth and development. However, little research has examined exactly how regulations can affect securities markets. Bernard Black, professor of finance at the Kellogg School of Management, and his colleagues provide evidence for one such mechanism, showing that laws that discourage “equity tunneling” can enhance firms’ market value.

Tunneling is the extraction of a firm’s value by the firm’s controlling shareholders or managers. There are three main types: cash-flow tunneling (diversion of ongoing cash flow); asset tunneling (sale of assets by the firm to the controllers at below-market prices, or from the controllers to the firm at above-market prices); and equity tunneling (extraction of value via financial transactions that affect ownership claims rather than the firm’s operations, including share offerings to controllers and freezeouts of minority shareholders, in each case at below-market prices).

Tunneling in Bulgaria
“There was a prominent view after the Soviet Union collapsed that all you needed was to create publicly traded companies and capital markets, to support these public companies, would emerge,” Black says. “The needed laws would emerge later because they would be demanded by the investors. That didn’t happen so smoothly.” He explains that after Bulgarian firms were privatized in 1998, “we got a whole lot of tunneling. Major, often politically connected, investors figured out, ‘I can get control of a public firm relatively cheaply and then dilute or squeeze out the minority shareholders for next to nothing.’”

The enactment of anti-equity-tunneling laws in Bulgaria in 2002 allowed Black and his colleagues, Vladimir Atanasov of the College of William and Mary, Conrad Ciccotello of Georgia State University, and Stanley Gyoshev of Exeter University, to conduct a natural experiment about how regulation can affect equity tunneling—and how equity tunneling in turn affects firm valuation.

Consequences of a New Law
Prior to 2002, Bulgarian firms used equity offerings principally to dilute minority shareholders. When firms issued shares, almost all were purchased by controlling shareholders, often at prices far below market value. The new law provides for tradable preemptive rights: public companies must offer shares to all shareholders proportionally. In other words, if a minority shareholder owns 5 percent of outstanding shares, the firm must offer the shareholder 5 percent of the newly issued equity. A shareholder who does not want to buy additional shares can sell the right to do so to someone else. After the law change, in fact, minority shareholders participated pro rata in share offerings, and offerings were used to raise capital instead of to dilute minority shareholders.

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Similarly, before the 2002 legal changes, freezeout offers were well below market value. Informal freezeouts (“going dark” transactions) were also common; the effective prices for minority shares were close to zero. Between 1999 and 2001, nearly 500 firms (more than half of those listed on the Bulgarian Stock Exchange) either went dark or conducted freezeouts.  The new law required the securities commission to approve the fairness of freezeout prices and banned going dark transactions.  After 2002, freezeouts were at a premium to market prices; previously, they had been at large discounts. 

The bad news, the researchers found, was that insiders with reduced opportunity for equity tunneling engaged in more cash-flow tunneling. After enactment of the legal reforms, return on assets declined for firms at high risk of equity tunneling, relative to lower-risk firms.

The reforms still greatly benefited minority shareholders, however. Share prices rose sharply for firms at high risk of equity tunneling relative to low-risk firms. The increases were concentrated in the quarter when the legal reforms were announced.

“Prices of the firms that were at high risk of tunneling roughly tripled. That’s an astonishing result,” Black says.

The researchers used two methods for estimating tunneling risks. The increases in share price were large using both methods (see Figure 1). There were also large improvements when the researchers used different valuation measures (price/sales, price/earnings, and market/book value of equity).

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Figure 1. Percentage change in firm valuation (measured by Tobin’s q) for firms with high risk of equity tunneling relative to firms with low risk of equity tunneling using two methods of evaluating risk. The solid line shows results using firm financial and ownership characteristics and pre-reform data on equity tunneling events to estimate each firm’s delisting and dilution propensities at year-end 2001, just before the law change. Low-equity-tunneling-risk firms are firms that have below-median propensity for both delisting and dilution. The dashed line shows results using ownership as a direct proxy for equity tunneling risk (a controlling owner has the power and often the incentive to engage in dilution or freezeout). Low-equity-tunneling-risk firms are firms with no majority owner. Measure of firm value is Tobin’s q. The securities law reform became effective in June 2002, but in practice the changes were enforced by the Bulgarian securities agency from the beginning of 2002.


Relevance to U.S. Financial Markets
Black and his colleagues conclude that equity tunneling risk can complement some commonly used factors in explaining equity prices and expected returns, such as market risk and momentum, and interact with others, such as firm size and book/market ratio. He explains that, for example, “Size may correlate with tunneling risk . . . and high book/market ratios could partly reflect high tunneling risk.”

Black says the research is also relevant to investors in the United States. “We don’t have the really gross forms of tunneling that were common in Bulgaria, but excessive compensation to managers and other insiders is a form of tunneling.” He believes better legal controls on insider compensation might benefit U.S. financial markets.

One conclusion from his research, Black says, is that properly regulated securities markets work better than unregulated markets. “Which isn’t to say that we know exactly what the right regulation is, but you can’t just say, ‘The government’s going to mess everything up, so just let the market self-regulate.’ You need regulations in Bulgaria and you need them in the U.S.”


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