Power differences and information gaps between a company’s controlling owners and management on one side and other interested parties on the other are a source of agency problems.[1]  Legislation, regulation, and enforcement authorities working at the State level are partly intended to moderate the agency problem in companies and its negative implications on their capital costs.  In addition, companies adopt difference mechanisms and characteristics—such as a high proportion of directors with financial expertise or of independent directors beyond what is required by law—that reflect greater protection of investors in that company (hereinafter: corporate governance).

 

At the beginning of the decade, a number of very significant reforms were approved in Israel in order to strengthen investor protection in public companies.  Among other things, the Economic Division was established in the Tel Aviv District Court, the rules for approving shareholder transactions at the General Meeting of Shareholders were made more rigid, and a law was approved enabling administrative enforcement by the Israel Securities Authority.  A new series of research studies on corporate governance, prepared by Oded Cohen of the Bank of Israel Research Department, examines whether and how the reforms have affected the behavior of controlling owners of public companies in Israel.

 

In the first study[2], an index of the quality of corporate governance was built for companies with a concentrated ownership structure where the controlling owner is the dominant figure who has the ability to use the company’s resources for his personal benefit at the expense of minority shareholders.  The index contains 31 components that examine three dimensions: independence of the Board of Directors, skills of the Board of Directors, and the gap between control and ownership.  The assumption in the study is that a more independent and more highly skilled Board of Directors reflects a higher quality of investor protection.  In contrast, a wide gap between control and ownership reflects a greater incentive to exploit minority shareholders and a lower quality of investor protection.  Based on the index, corporate governance scores were calculated for 120 public companies (excluding financial companies that are subject to special corporate governance regulation, dual-listed companies, and partnerships) traded on the Tel Aviv 100 or the Yeter 50 index in at least one of the years between 2007 and 2014.

 

In the second study[3] the corporate governance quality index was used to examine the effect of the reforms on public companies in Israel.  The research hypothesis holds that insofar as the reforms do have an effect on public companies in Israel, the effect will be more prominent among companies where the shareholders were less protected before the reforms took effect, meaning companies with low corporate governance scores.

 

The findings of the study support this hypothesis, and show that companies with low corporate governances scores before 2011 were traded during that period at lower values than companies with good corporate governance.  From 2011 onward, once the shareholders’ ability to use company resources for their own benefit was restricted, the market value of companies with low-quality corporate governance increased, and the difference between it and the value of companies with good corporate governance disappeared (Figure 1).

 

The study points to the company’s transactions with controlling owners as a potential channel for exploitation of minority shareholders in a company with low-quality corporate governance, the restriction of which following the reforms led to an increase in the market value of these companies.  Accordingly, the study found that prior to the reforms, companies with low-quality corporate governance made more transactions with controlling owners, both in shekel terms and in quantity, than companies with high-quality corporate governance.  Following the reforms, there was a significant decline in the volume of transactions with controlling owners (Figure 2).  The decline was greater among companies with the lowest corporate governance quality prior to the reforms, and is consistent with a greater increase in their market volume following the reforms.

 

Moreover, the third study[4] found that the reduced ability of controlling owners of companies with low-level corporate governance to withdraw resources at the expense of the other shareholders reduced the attractiveness of keeping the company public, and led them to delete the company from trading on the stock market.  Thus, an analysis of a sample of 137 companies that were deleted from trading between 2007 and 2014 (excluding bond companies, financial firms, dual-listed companies, and companies that were forcibly deleted), shows that following 2011, the number of companies deleted from trading on the stock exchange increased (Figure 3).  However, the increase was greater among companies with the lowest corporate governance scores prior to the reforms.  The rate of deleted companies from this group increased by 16 percentage points following the reforms, compared with an increase of just 4 percentage points among companies with high corporate governance scores prior to the reform (Figure 4).  In particular, the rate of deletions among companies where the controlling owners served in senior management positions increased.

 

In summation, the findings of the research project show that the reforms in 2011 led to an improvement in investor protection, due to which controlling owners of public companies with low-quality corporate governance were forced to choose between two options: reducing the use of company resources for their personal benefit at the expense of minority shareholders, thereby leading to an increase in the company’s market value, or being deleted from trading and becoming a private company.

[1] The source of an agency problem in a company has to do with the fact that shareholders from among the public—each of whom hold a small portion of the company’s shares and are therefore entitled to a small portion of the profits the company generates—have no incentive to invest the necessary cost to supervise the management.  The lack of effective supervision may provide an incentive to managers to act in their own benefit at the expense of the company’s other shareholders.

[2] Measuring Corporate Governance Quality in Concentrated-Ownership Firms.

[3] Firm-Level and Country-Level Corporate Governance: Does One Substitute or Complement the Other?

[4] Does Investor Protection Regulation Induce Poorly Governed Firms to go Private?