Does Legal Protection of Minority Shareholders Facilitate Stock Market Development?

Abstract

This paper presents a simple model of a firm issuing external equity (going public) in the presence of asymmetric information, and conducts comparative statics analysis of controllers’ private benefits with different levels of minority shareholder protection. The model extends the “crime and punish” framework developed by Becker (1968) and applied by Shleifer and Wolfenzon (2002) to a model of corporate finance, to incorporate the elements of the asymmetric information about “asset in place” in Myers (1984) and Myers and Mugluf (1984). Ceteris paribus, the controller’s share of firm’s asset is a decreasing function of the level of investor protection. And under certain conditions, the improved minority shareholder protection will reduce the private gain of controller to a level failing to compensate the costs of asymmetric information, and hence prevent firm from issuing external equity. Using a newly assembled panel data with shareholder protection index of 25 countries for 11 years, this paper tests the predictions of the model, and find that consistent with the model, better shareholder protection decreases the normalized number of firms listed, yet it still associates with higher market capitalization. (JEL: C23, G34, K22)