Recent research in corporate ownership and control has documented a divergence between the control rights and cash-flow rights of corporate insiders in many publicly-traded firms around the world (e.g., La Porta et al., 1999). Corporate officers and directors often have voting rights substantially in excess of their cash-flow rights, and in many cases, have effective control over all corporate decisions while having claims to less than half of the economic value (Gompers et al., 2009). In such firms, the classic agency conflict between managers and shareholders (Jensen and Meckling, 1976) is exacerbated to a conflict between corporate insiders and outside investors since the corporate insiders have the incentives and ability to divert corporate resources for private benefits at the expense of other investors (Shleifer and Vishny, 1997; Djankov et al., 2008). In line with this view, numerous studies have documented a negative relationship between the control rights-cash-flow rights deviation and corporate valuation in various countries and settings.
While previous studies have tackled the question on whether the divergence between control rights and cash-flow rights (the “control-ownership divergence”) affects corporate values, the specific channels behind this relationship are largely unknown. Intuitively, it seems quite implausible that the large valuation discounts documented in the literature in firms with separation of ownership and control are solely driven by direct expropriation activities. In this paper, we identify an important mechanism through which the insider control-ownership divergence may affect firm values, and show that insider ownership structure has a real impact on corporate financial and investment outcomes. Specifically, using generalized method of moments estimation of an investment Euler equation proposed by Whited and Wu (2006), we examine the impact of the excess control rights of corporate insiders on firms’ external finance constraints. External finance is a particularly important channel to investigate because financial constraints prevent firms from funding all desired investment (Stein, 2003; Billett et al., 2009). As a result, financially constrained firms might be forced to forgo significant investment projects with positive net present values. In fact, Whited and Wu (2006) document that the most financially constrained firms (by quartile) invest 18% less than the least constrained ones.
Corporate finance theories provide a straightforward motivation for the connection between corporate insiders’ control-ownership divergence and firms’ financing constraints. In pursuit of private benefits, corporate insiders and controlling shareholders may seek to expropriate other investors, including minority shareholders and creditors, through various self-dealing activities including outright theft, transfer pricing, investor dilution, executive perquisite, expropriation of corporate opportunities, investment in unprofitable projects for self-interest, asset sales to insiders or affiliated corporations at favorable prices, loan guarantees using the firm’s assets as collateral, and other self-serving financial transactions (Shleifer and Vishny, 1997; La Porta et al., 2000; Johnson, et al., 2000a; Djankov et al., 2008). The “private benefits of control” are reflected by the widely documented premium at which shares with superior voting rights trade (Shleifer and Vishny, 1997). Relevant evidence has been documented not only in developing countries where investor protection might be poor, but also in many developed countries including the U.S.
In extreme cases, as pointed out by Friedman et al. (2003), many bankruptcy cases in both developing and developed countries have been associated with complete looting by corporate insiders and controlling shareholders, leaving the minority shareholders and creditors almost nothing when the firms went bankrupt. Corporate insiders’ incentives to engage in self-dealing activities are especially strong when they have control rights in excess of cash-flow rights, as the excess control rights afford them the ability to do so while bearing a relatively small proportion of the financial consequence (Shleifer and Vishny, 1997, Johnson et al. 2000). Masulis et al. (2009) find evidence that insiders with excess control rights waste corporate resources at the expense of shareholders in the pursuit of private benefits.
Moreover, in effect, the insider control-ownership divergence often creates an extreme example of antitakeover protection (Gompers et al., 2009). The problem of expropriation by insiders is aggravated in such firms without valid takeover threats, as corporate insiders with large control rights get entrenched and managerial discretion cannot be effectively controlled (Jensen, 1993; Shleifer and Vishny, 1997).
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Ownership Structure and Financial Constraints: Evidence from a Structural Estimation
