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Investor Rights


The main reason why investors provide external financing to firms is that they receive control rights in exchange. External financing is a contract between the firm as a legal entity and the financiers – investors. This contract gives the investors certain rights vis a vis the assets of the firm and they are called investor rights. In case that the managers of the firm somehow violate the terms of the contract, the investors have the right to appeal to the courts to enforce their rights. Supporters of the theory of optimum shareholder rights reflect the necessity of an optimal amount of rights. This optimum should be formed according to the fact that greater shareholder rights ensure higher value of the firm but on the other hand they create higher company costs. The higher value of the firm caused by enforced shareholder rights can be achieved by greater transparency of governance processes and financial information for investors and acquirers, and protection of minority shareholder rights, may result in less litigation costs. Moreover, greater shareholder-oriented corporate governance may be taken as a positive signal for potential investors and analysts, greater transparency may elevate credit ratings, resulting in a lower cost of debt.

Meanwhile, the costs produced by greater shareholder rights include such factors as disclosure to competitors of strategic and tactical information, slower and less efficient decision-making in a competitive environment, a short-run focus on profitability, resulting in reduced capital investment and research and development expenditures, higher career risk and consequently higher CEO compensation , and higher agency costs for creditors in light of potential for frequent management turnover resulting in lower credit ratings and higher debt costs, and attempts by the CEO to disguise proprietary information to protect competitive position (Chugh and Meador, 2008: 3,4).

External financing is a contract that results in duties and rights. Without any existing system that is guaranteeing these rights no investor could be sure about the loyal observance of his rights by the managers of the company or by other important shareholders. Investor protection seems to be crucial because the expropriation of minority shareholders and creditors by the controlling shareholders is still in many countries extensive. When the investors finance firms, they are facing a risk that the returns on their investments will never materialize because the controlling shareholders or managers expropriate them.


As La Porta, Lopez-de-Silanes, Shleifer and Vishny (1999) suggest “expropriation can take a variety of forms. In some instances, the insiders simply steal the profits. In other instances, the insiders sell the output, the assets, or the additional securities in the firm they control to another firm they own at below market prices. Such transfer pricing, asset stripping, and investor dilution, though often legal, have largely the same effect as theft. In still other instances, expropriation takes the form of diversion of corporate opportunities from the firm, installing possibly unqualified family members in managerial positions, or overpaying executives.” Sometimes it means that the insiders use the profits of the firm to benefit themselves rather than return the money to the outside investors.

Corporate governance is considered as a set of mechanisms through which outside investors protect themselves against expropriation by the insiders. The legal approach to corporate governance holds that the key mechanism is the protection of outside investors through the legal system. “To a large extent, potential shareholders and creditors finance firms because their rights are protected by the law. These outside investors are more vulnerable to expropriation, and more dependent on the law, than either the employees or the suppliers, who remain continually useful to the firm and are thus at a lesser risk of being mistreated.”

Corporate Governance Datasets


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