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Abstract:
We model and test the mechanisms through which securities law affects tunneling and tunneling affects firm valuation. In 2002, Bulgaria adopted securities law changes which limit two forms of equity tunneling - dilutive equity offerings and freezeouts. We document that following the change, minority shareholders participate equally in secondary equity offers, where before they suffered severe dilution; freezeout offer prices quadruple; and Tobin's q values rise sharply for firms at high risk of tunneling. At the same time, return on assets declines for high-equity-tunneling-risk firms, suggesting that controlling shareholders partly substitute for reduced equity tunneling by engaging in more cash-flow tunneling. We thus present evidence on (i) the importance of legal rules in limiting equity tunneling, (ii) the role of equity tunneling risk as an important factor in determining equity prices; and (iii) substitution by controlling shareholders between different forms of tunneling.

equity tunneling, preemptive rights, dilution, freezeout, corporate governance, securities law, emerging markets

Abstract:
This study examines the emergence of the Bulgarian stock market and the role of controlling blockholders. A new approach using mass privatization auction data measures the premium for control and demonstrates that, in the absence of legal constraints, majority owners extract more than 85% of firm value as private benefits of control. Institutional investors form portfolios of predominantly controlling positions or participate in majority coalitions. Ownership stakes cluster at 51%. After the privatized companies begin trading on the Bulgarian Stock Exchange, majority-owned firms trade at 40-60% discounts. Overall, the results support the Fama and Jensen (1983) view that majority-owned firms cannot persist as publicly traded corporations if the expropriating activities of controlling blockholders are not legally restricted.

private benefits of control, large shareholders, coalition formation

Abstract:
This paper examines the relation between the performance and valuations of publicly-traded subsidiaries in the United States and the ownership stake of their parent companies. Cross-sectional and time-series tests demonstrate that subsidiaries in which the parent owns a substantial minority stake exhibit negative peer-adjusted operating performance and are valued at a 23% median discount relative to peers. In contrast, majority-owned and fully divested subsidiaries show no abnormal performance or valuations. The results of our study indicate that the association between parent ownership and subsidiary performance is nonlinear and that some parents do, in fact, behave opportunistically toward their publicly traded subsidiaries.

ownership structure, expropriation, consolidation, equity carve-out

Abstract:
Managers and controlling shareholders can extract wealth from firms in many different ways. We develop here a framework for analyzing different types of "tunneling" transactions. We divide tunneling into three broad groups: cash flow, asset, and equity tunneling. We model each type of tunneling as decomposable into a probability of tunneling and a magnitude. We present a simple model of how each type of tunneling affects share prices and financial metrics and provide two detailed case studies -- Gazprom in Russia and Coca-Cola in the United States -- to illustrate how these types of tunneling can occur in both emerging and developed markets. Finally, we explore a number of uses of our decomposition approach -- for empirical research into the nature and extent of tunneling; for asset pricing, especially in high-tunneling-risk environments; for legal regulation of tunneling; and for accounting rules.

tunneling, dilution, freezeout, transfer pricing, shareholder protection

Abstract:
We explore the potential for abuse of startup founders and other common stock shareholders by venture capitalists. We first analyze a set of 26 lawsuits involving venture capitalists and entrepreneurs. Our analysis of lawsuits reveals that VC-related litigation is almost always initiated by founders, and most common allegations are dilution and freezeout of founders, followed by expropriation of company assets via related-party transactions. We document that most of the lawsuits that were not promptly settled end up dismissed by judges on procedural grounds, and yet, after winning, the involved VCs have raised significantly less capital than their peers and have syndicated deals with less reputable partners. We next analyze the founder ownership at the going-public stage in a sample of 390 VC-backed IPOs. We find that founders are less likely to be involved in firm governance and have lower ownership in startups backed by less reputable VCs and where VC investment rounds have been insider dominated. The results suggest that the potential for expropriation of equity holders in venture-backed startups has important implications for entrepreneurial activity.

Venture Capital, Tunneling, Dilution, IPOs

Abstract:
This study explores the strategic interaction between large institutional investors and firms that issue put options written on their own stock. The firms experience large positive abnormal annual returns after they sell put options. The vast majority of issued put options expire without being exercised, and the buyers of these options, which are predominantly investment banks, lose money. We propose a model that gives a rationale why an uninformed party, an investment bank will trade in put options with an informed party, the issuing firm, although the expected profits from this trade are negative. The model shows how trading with an informed party can be profitable because the bank can acquire valuable information and afterwards earn abnormal returns on trades in other securities of the same firm. Finally, we outline several predictions from the model, and propose empirical tests to establish our proposition that an investment bank can legally acquire private information and trade profitably on it.

Investment banks, put option, screening model

Abstract:
This paper develops a model that combines features of portfolio theory and corporate governance research. The model analyzes the problem of how large investors form optimal equity portfolios when the return on each investment depends on the size the investment. The optimal solution counterweighs the benefits of higher returns through private benefits of control and monitoring of firm management with the costs of higher transaction prices and bearing diversifiable risk.

The general model predicts that controlling investors will monitor more the firms in which they can appropriate more private benefits of control. Large investors are more likely to buy controlling blocks in smaller firms, firms with higher private benefits of control, and firms where the trading costs of buying large blocks are smaller. A special case is numerically solved using an integer-programming algorithm. The numerical analysis shows that investor utility is strictly increasing in available capital for purchasing controlling blocks. The optimal portfolios of large investors dominate the portfolios of small investors both in terms of expected return and risk. The classical result that the efficient frontier is the same for all investors regardless of their wealth does not hold in the setting of this paper.

Corporate control, large shareholders, portfolio optimization

Abstract:
Using data from the Bulgarian mass privatization auctions, we analyze the bids submitted by institutional investors for shares in newly privatized firms. The results support the hypothesis
that there are private benefits of control that accrue to large blockholders. Institutions with ex ante better ability to monitor and generate higher cash flows for all investors bid less aggressively. Our overall analysis of the determinants of bid prices submitted by institutions shows that, in an economy where small investors have very limited ways to enforce their property rights, institutions primarily take into account the private benefits of control when they evaluate stock holdings.

Abstract:
A large literature examines how contractual terms protect VCs against misbehavior by entrepreneurs. But what constrains misbehavior by VCs? We provide the first systematic analysis of how alleged VC misconduct affects VC reputation using a hand-collected sample of 296 lawsuits involving 221 venture capitalists during the period 1975-2007. We first estimate an empirical model of the propensity of VCs to get involved in litigation. We find that older VCs and VCs with more deal flow and larger funds under management are more likely to litigate; however, the effect is concave. In addition, early-stage VCs and VCs with past litigation history are more likely to participate in litigation. We then analyze the relationship between litigation and VC fundraising, deal flow and network centrality. We find that litigation does not go unnoticed: in subsequent years, VCs involved in litigation as defendants raise significantly less capital than their peers (matched on age, size and performance), invest in fewer and lower quality deals, and syndicate with fewer VC firms. The biggest losers are VCs who participate as defendants in multiple lawsuits.

venture capital, financial contracts, litigation, reputation markets, contract theory

Abstract:
Venture capital contracts give VCs enormous power over entrepreneurs and early equity investors of portfolio companies. A large literature examines how these contractual terms protect VCs against misbehavior by entrepreneurs. But what constrains misbehavior by VCs? We provide the first systematic analysis of legal and non-legal mechanisms that penalize VC misbehavior, even when such misbehavior is formally permitted by contract. We hand-collect a sample of over 177 lawsuits involving venture capitalists. The three most common types of VC-related litigation are: 1) lawsuits filed by entrepreneurs, which most often allege freezeout and transfer of control away from founders; 2) lawsuits filed by early equity investors in startup companies; and 3) lawsuits filed by VCs. Our empirical analysis of the lawsuit data proceeds in two steps. We first estimate an empirical model of the propensity of VCs to get involved in litigation as a function of VC characteristics. We match each venture firm that was involved in litigation to otherwise similar venture firm that was not involved in litigation and find that less reputable VCs are more likely to participate in litigation, as are VCs focusing on early-stage investments, and VCs with larger deal flow. Second, we analyze the relationship between different types of lawsuits and VC fundraising and deal flow. Although plaintiffs lose most VC-related lawsuits, litigation does not go unnoticed: in subsequent years, the involved VCs raise significantly less capital than their peers and invest in fewer deals. The biggest losers are VCs who were defendants in a lawsuit, and especially VCs who were alleged to have expropriated founders.

Abstract:
This Article examines the development of company law in Bulgaria. Like Russia and other Eastern European nations such as Czechoslovakia and Poland, Bulgaria engaged in mass privatization. The Bulgarian Big Bang was in 1998 and over a thousand firms were listed on the Bulgarian Stock Exchange. Similar to several other Eastern European transition economies, the Bulgarian market suffered after its opening from mass expropriation of minority shareholder wealth. Two-thirds of all Bulgarian firms were de-listed within three years (1999-2001) of their first trading on the Bulgarian Stock Exchange. Since 2002, however, the Bulgarian market has made a strong recovery.

The focus of this Article is on changes in two particular areas of the company law - preemptive and appraisal rights, and their linkage to the turnaround in the Bulgarian market. The old (1999) Bulgarian company law did contain both provisions, but despite these legal protections, more than 80% of the de-listed firms went private without any compensation given to their minority shareholders. The remaining firms were de-listed via tender offers for minority stakes, which occurred at about 25% of fair value, on average. Company law changes that became effective in 2002 kept preemptive and appraisal rights in place, but changed their nature as well as the required regulatory approvals.

After company law changes became effective in 2002, the health of the Bulgarian stock market improved dramatically. Tender offers for minority shares decreased in number. Those that did occur began to be at premiums to market value similar to those observed in developed markets. The concentration of ownership in Bulgarian firms began to decrease and liquidity, as measured by the amount of shares traded, began to increase. The valuation of shares also increased markedly.

The changes in company law reflect guidance in the Principles of Company Law for Transition Economies. As the authors of the Principles argued, laws must fit the institutional environment of the transition economy. Those laws directly imported from developed markets may fail in transition markets. Consistent with the Principle V, the changes in the Bulgarian law effective in 2002 placed primary emphasis on the protection of minority shareholders. Changes shifted the reliance away from market prices, judges, and required actions by minority shareholders. They increased reliance on bright line rules, and on the automatic creation of transactional options such as veto power and share purchase.

freeze-out, preemptive rights, appraisal rights, company law

Abstract:
We study the impacts of arbitrage risk and heterogeneity of beliefs on the elasticity of demand for Federal Home Loan Bank System discount notes. A unique dataset allows us to bypass typical endogeneity problems in the estimation of financial asset demand elasticity. We find that demand for FHLB notes is highly, although not perfectly, elastic and has a strong negative relation with proxies for arbitrage risk and heterogeneity of investors beliefs. We also show that demand elasticity drops by more than 50% during the financial crisis originating in August 2007. This drop is explained by contemporaneous increases in arbitrage risk and heterogeneity of beliefs.

debt auctions, demand elasticity, arbitrage risk, Federal Home Loan Bank