VoxEU Column Microeconomic regulation

Do inefficient stock markets drive bad governance?

Why do minority shareholders continue to hold stock despite the risk of expropriation by controlling shareholders? This column provides two decades of evidence from Japan suggesting that many investors do not foresee these conflicts of interest, even when there is plenty of disclosure. Inefficient stock markets allow majority shareholders – often parent companies – to sell overpriced stock only to buy it back at a later date.

One of the major accomplishments of recent corporate governance research has been to expose the risks confronted by minority shareholders in public companies around the globe. Corporate ownership structures such as pyramids, business groups, and dual class shares leave control in the hands of a limited set of blockholders – exposing minority investors to potential expropriation.

Why, then, do minority shareholders participate in these arrangements? The prevailing academic view since Jensen and Meckling (1976) is that capital markets are efficient in the sense that minority investors foresee the possibility of expropriation by controlling shareholders. As a result, under this view, the share price that minority investors are willing to pay reflects their rational expectations of expropriation and other agency problems. And because outside equity is expensive, controlling shareholders will only raise equity capital from minority investors if there are commensurate benefits, such as attractive growth opportunities that the firm would not be able to finance otherwise.

A new view on why agency problems arise

In recent research (Chernenko et al. 2010), we propose a new and alternative view for the emergence of ownership structures that are prone to severe agency problems. Motivated by the growing literature studying the effects of stock market mispricing on firm behaviour (see for example Stein 1996, Shleifer and Vishny 2003, and Baker 2009), we develop a simple framework for thinking about how stock market mispricing can offset agency costs and induce controlling shareholders to raise outside equity.

Our argument is as follows. Suppose that during some periods, investors are over-optimistic, failing to see the potential for conflicts of interest between themselves and the controlling owner. Under these conditions, equity is overpriced relative to a valuation which fully accounts for the conflicts of interest between minority and majority investors. Stock market mispricing induces the controlling shareholder to sell overpriced equity, subsequently diverting resources to his benefit. In order to return to the previous ownership structures with the same agency problems, even greater misevaluation is required.

Our basic idea is motivated by the stock market performance of minority investors in publicly held subsidiaries in Japan. It is common practice for large companies in Japan to list their subsidiaries on the stock market, while maintaining a controlling stake thereafter. Although subsidiaries are technically independent companies once they are listed, the potential for the expropriation of minority shareholders is immense. In a case study of NEC Electronics, we document how parent company NEC forced its publicly-listed subsidiary NEC Electronics to bear billions of dollars of wasteful R&D and capital expenditures on behalf of the parent company’s mobile phone line. But minority shareholders in NEC Electronics did not seem to have anticipated this kind of activity, and they earned post-listing returns that were well below those of the aggregate stock market, and well below the returns earned by shareholders of the parent company.

Using a large sample of subsidiaries listed in Japan between 1980 and 2005, we find that the experience of NEC Electronics is not unique. The evidence is consistent with three predictions that follow from our framework.

  • First, the incentive to divert resources is stronger when a controlling shareholder maintains a smaller ownership stake after listing – so these listings require more mispricing. Consistent with this notion, we find that subsidiaries in which the controlling shareholder sells a larger stake at listing generate low post listing returns.
  • Second, we find that subsidiaries that have product market relationships with their parents also generate low post listing returns. The scope for agency problems is high for these kinds of subsidiaries, so more mispricing is required to support them.
  • Third, prices are likely to revert to fundamental value, and when they do, the controlling shareholder often repurchases the subsidiaries to eliminate agency costs. We find that 25% of the subsidiaries in our sample are repurchased before 2007, and that parent shareholders earn positive returns when these repurchases are announced.

The idea that stock mispricing supports the creation of ownership structures prone to agency problems has important implications for corporate governance regulations. Many regulatory proposals are aimed at increased disclosure and transparency. Our research suggests that, by themselves, more disclosure and transparency may not be enough as they will not prevent minority shareholders from overpaying for equity. Experimental evidence suggests that decision makers often ignore conflicts of interest, even when such conflicts are prominently disclosed (Cain et al. 2005). And regulators themselves often express concern that investors will not be able to understand conflicts of interest, even when there is plenty of disclosure.

Consider for example the recent decision of the Securities and Futures Commission of Hong Kong to allow shares of the United Company RUSAL to be listed on the Hong Kong Stock Exchange. The regulators prevented retail investors from participating, despite the risks being disclosed in a thousand-page prospectus.

Our research also contributes to the debate regarding the role of business groups in emerging economies, in particular the extent to which business groups help overcome market inefficiencies or engage in rent seeking behaviour. Without denying their ability to help overcome various market inefficiencies, our research suggests that taking advantage of temporary stock mispricing can contribute to the formation of business groups and other ownership structures prone to agency problems.

Finally, being able to opportunistically raise outside equity when it is overvalued may reduce entrepreneurs’ incentive to lobby for strong corporate governance regulations. This could potentially help explain the persistence of weak protection of minority shareholders in many countries around the world.


Baker, Malcolm (2009), “Capital market-driven corporate finance”, Annual Review of Financial Economics, 1:181-205.
Cain, Daylian M, George Loewenstein, and Don A Moore (2005), “The dirt on coming clean: Perverse effects of disclosing conflicts of interest”, Journal of Legal Studies, 34:1-25.
Chernenko, Sergey, C Fritz Foley, and Robin Greenwood (2010), “Agency costs, mispricing, and ownership structure”, working paper.
Foley, C Fritz, Robin Greenwood and Jim Quinn (2008), “NEC Electronics”, Harvard Business School Case, No. 209001.
Jensen, Michael C, and William Meckling (1976), “Theory of the firm: managerial behaviour, agency costs, and ownership structure”, Journal of Financial Economics, 3:305-360.
Shleifer, Andrei, and Robert W Vishny (2003), “Stock market driven acquisitions”, Journal of Financial Economics, 70:295-311.
Stein, Jeremy C (1996), “Rational capital budgeting in an irrational world”, Journal of Business, 69:429-455.


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