Investor Protection and Interest Group Politics

The Review of Financial Studies will publish later this year my paper with Zvika Neeman on “Investor Protection and Interest Group Politics.”

The paper models how lobbying by interest groups affects the level of investor protection. In our model, three groups – insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future – compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors pushing investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, and the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future, we show, reduces but does not eliminate the distortions arising from insiders’ interest in extracting rents from the capital that public firms already possess. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.

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Here is a more detailed outline of the article’s analysis, results, and contributions: The paper seeks to contribute to understanding what determines the level of that protection and the reason such protection might fall short of being optimal. Why do countries vary so much in their level of investor protection? Why do levels of investor protection within any given country change over time? When investor protection is too low, is such suboptimality generally due to lack of knowledge on the part of public officials, which should be expected to disappear as they learn more about which governance arrangements are optimal? Or are there some structural political impediments that may enable excessively lax corporate rules to persist even after they are recognized as inefficient? The paper aims to contribute to answering these questions by developing a model of how interest group politics affects the level of investor protection.

To be sure, a country’s level of investor protection may be influenced by long-standing factors such as the country’s legal origin, its culture and ideology, or the religion of its population, all of which lie outside the realm of current interest group politics. But given that countries do change their investor protection arrangements considerably over time, the level of such protection at any given point in time may also result at least partly from recent decisions by pubic officials. The theory of regulatory capture (Stigler (1971) suggests that the regulatory decisions by public officials might be influenced and distorted by the influence activities of rent-seeking interest groups. In the area of finance, Rajan and Zingales (2003, 2004) and Perotti and Volpin (2008) argue that existing firms seeking to deter entry and retain market power lobby for weak investor protection that would make it difficult for potential entrants to raise capital. Our analysis focuses on another conflict among interest groups – the struggle between public firms’ corporate insiders, who seek to extract rent from the capital under their control, and the outside investors who provided them with capital.

We view lobbying on investor protection as important because, in the ordinary course of events, most corporate issues are intensely followed by the interest group with sufficient stake and expertise but are not sufficiently understood and salient to most citizens. When this is the case, politicians can expect their investor protection decisions to have limited direct effects on voting behavior, which implies that these effects do not significantly influence politicians’ investor protection decisions. In contrast, such decisions may be significantly affected by the activities of organized interest groups.

We model the competition among three organized interest groups for influence over politicians setting the level of investor protection. This investor protection level determines the extent to which “corporate insiders” — managers and controlling shareholders who have some control over corporate decisions — can extract private benefits of control. Beyond a certain point, any further weakening of investor protection is inefficient. Assuming that politicians recognize the efficient level of investor protection, we focus on whether they will generally set investor protection at this efficient level.

One organized interest group in our model consists of the corporate insiders of existing firms. The second group is made up of institutional investors (financial intermediaries) that use funds received from individuals to invest in public companies, and whose interests might overlap with those of “outsider” shareholders in existing companies. The third group consists of owners of private firms (“entrepreneurs”) who plan to take them public. We also allow for the possibility of insiders who plan to raise equity capital for their existing public firms (or for new firms that they will take public) and thus have interests that partly overlap with those of the entrepreneurs. We assume that individual investors, who invest in publicly traded firms either directly or indirectly through institutional investors, are too dispersed to become part of an effective organized interest group focused on investor protection.

We identify and study the equilibrium outcome of the lobbying game between the interest groups and the politician setting the level of investor protection (for simplicity, we assume this choice is made by a single politician). Our analysis identifies factors that might lead to inefficiently low levels of investor protection and excessive private benefits of control. First, corporate insiders may be able to use some of the resources of the publicly traded companies under their control to influence politicians. These insiders have the power to direct their firms’ campaign contributions, to offer positions or business to politicians’ relatives or associates, to use their standing to support issues and causes the politician seeks to advance, and so forth. Because insiders capture the full benefits of any lobbying by their public firms for lower levels of investor protection, while their firms’ (and in turn, other shareholders in their firms) bear some of the costs of such lobbying, insiders have an advantage in the competition for influence over politicians. To win extra private benefits of control, insiders will be willing to spend more corporate resources on lobbying than the value of these extra benefits to them. Essentially, insiders’ lobbying is partly done at the expense of outside shareholders.

Furthermore, institutional investors can be expected to invest less in lobbying against weak investor protection than would be optimal for the class of outsider investors as a whole. While institutional investors must themselves bear the costs of lobbying, they capture only part of the benefits to outside investors resulting from improved investor protection. To begin with, some investors hold shares in companies directly, not through institutional investors. Furthermore, depending on their relationship with their own investors, some institutional investors (for example, mutual fund managers) may capture only a fraction of the increase in the value of portfolios managed by them that better investor protection would produce. As a result, to obtain a given improvement in investor protection, institutional investors will be willing to spend less than the total benefit that such an improvement will produce for outside shareholders.

Another way of seeing the problems we identify is to recognize the existence of an externality. The parties in the lobbying game – corporate insiders, institutional investors, and the politician — are not the only ones affected by weak investor protection. Individuals who invest in existing public firms either directly or indirectly through institutional investors are also adversely affected. These individual outside investors are adversely affected by politicians’ setting low levels of investor protection and by insiders’ using corporate resources to influence politicians. However, because these individuals are not present at the table, as it were, this negative externality is not fully taken into account in the lobbying game, and the resulting level of investor protection is consequently too low.

The problems we identify do not go away when the lobbying game includes entrepreneurs (and existing public firms) that expect weak investor protection to make it more costly for them to raise equity capital in the future. The entrepreneurs prefer an efficient level of investor protection, and their introduction into our model therefore moderates – but, we show, does not eliminate — the bias in favor of excessive private benefits of control. While entrepreneurs do internalize the interests of those public investors who buy IPO shares when they take their firms public, they do not internalize, and neither does anyone else at the lobbying table, the interests of individuals who directly or indirectly hold shares in existing public firms and who are not at the table.

In an economy with existing public firms, choices of investor protection levels affect not only the allocation of cash flows from the capital to be raised from public investors in the future but also the allocation of rents from the capital that public firms already have (Bebchuk and Roe (1999), La Porta et al. (2000), Stulz (2005)). The struggle over these rents, however, need not necessarily lead to an inefficient outcome. Lobbying would produce an efficient outcome if those lobbying on behalf of insiders and outside shareholders were to internalize fully the costs and benefits of investor protection choices. But when such internalization does not fully occur due to one or more of the factors we analyze, the fight over these rents distorts the outcome of the lobbying game and produces suboptimal investor protection levels even in the presence of entrepreneurs lobbying for efficient rules.

We show that the framework we develop permits the incorporation and analysis of many additional factors. In particular, we show how our analysis can be extended and applied to analyze (i) the effects of raising of new capital by existing public firms or by private firms owned by the insiders of such firms, (ii) institutional investors that are themselves a publicly traded company or a conglomerate with publicly traded elements, and (iii) institutional arrangements that make it more difficult to change investor protection levels often.

Our model generates a wide range of testable predictions about the relationship between the levels of investor protection and various factors. One important pattern established by the evidence is the positive correlation between high levels of investor protection and good economic outcomes such as well-developed stock markets and higher levels of economic growth (see, e.g., La Porta et al. 1998, 1999a, 1999b). One possible interpretation of this correlation is that higher levels of investor protection bring about such good economic outcomes. Our results indicate, however, that some of the causality may go in the opposite direction: a high level of investor protection may be, at least partly, the product — rather than the cause — of high economic growth, a developed stock market, or an advanced-stage economy. This effect might be partially responsible for the observed correlation between investor protection and economic and capital markets growth.

In addition, our model provides predictions relating investor protection to the structure of political and legal decision-making, the developmental stage of the economy, the corporate structures dominant in the economy, as well as to scandal waves and stock market crashes. Our results bear on differences in the level of investor protection both over time and around the world. These results can shed some light on patterns identified by a number of existing empirical studies, which we discuss in detail later on, as well as provide a basis for future empirical work.

The paper is available here.