INTRAGROUP M&A, MINORITY SHAREHOLDERS' PROTECTION, AND LEGAL ORIGIN

INTRAGROUP M&A, MINORITY SHAREHOLDERS’ PROTECTION, AND
LEGAL ORIGIN


Ettore Croci*




This Version: April 2007


Abstract

This paper analyzes how legal-origin families affect minority shareholders’ returns in intragroup
mergers and acquisitions (M&As). I collected data for 1,302 intragroup M&As from 60 countries
to determine (1) whether and where expropriation takes place, and (2) if legal origin explains the
treatment reserved to minority shareholders by the bidder. I find that intragroup acquisitions are
not used to expropriate minority shareholders. This result is common to all of the regions
examined, with the only exceptions being Eastern Europe and legal-origin families. To the
contrary—intragroup M&As actually create value. However, target shareholders do not benefit
from intragroup transactions in the same way. In fact, target shareholders in common law
countries earn returns abnormally higher than those realized by target shareholders in civil law
countries. Thus, while all legal families seem to provide at least a minimum level of investor
protection in case of intragroup M&A, common law gives more power to minority investors when
dealing with controlling shareholders.

JEL classification code: G34.

Keywords: intragroup mergers, intragroup acquisitions, event study, expropriation, legal
origin.





*Università Cattolica del Sacro Cuore, Via Necchi 5, 20121 Milan, Italy, e-mail:
ettore.croci@unicatt.it


Financial support by MIUR - PRIN 2005 (project: L’Action plan UE sulla corporate governance:
un’analisi giuridico-economica delle principali problematiche) is gratefully acknowledged. I
thank Massimo Belcredi, Lorenzo Caprio, Francois Degeorge, and Martin Holmen for their
helpful comments.

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1. Introduction

Recent evidence (La Porta et al. 1999; Claessens et al. 2001; Faccio and Lang 2002) has
shown that that large shareholders and business groups are common, especially outside
the United States. Pyramids are often used to separate ownership from control, increasing
the incentives to control shareholders in order to exploit minority shareholders (Bebchuk,
Krakman, and Triantis 2000). As Faccio and Stolin (2006) argue, groups offer many
possibilities for controlling shareholders to expropriate resources: transfers of assets,
borrowing or lending at non-market rates, and unfair pricing of transactions.
In this paper, I study one of these possibilities: intragroup mergers and
acquisitions—i.e., mergers and acquisitions in which both the acquirer and the target
belong to the same business group.1 Managements and controlling shareholders usually
claim that these transactions are efficient reorganizations of their business groups, but
they can also use intragroup deals to divert assets to their benefit. To some extent, an
intragroup M&A can be viewed as a self-dealing transaction along lines defined by
Djankov et al. (2006). In fact, they define a self-dealing transaction as “a transaction
between two firms controlled by the same person, who can in principle be used to
improperly enrich this person”. Thus, the first goal of the paper is to determine whether
intragroup acquisitions are designed either to take advantage of minority shareholders or
to create value. I examine 1,302 intragroup deals from 60 countries involving publicly
listed target firms during the period 1986–2005. To my knowledge, this is the most
comprehensive database of intragroup transactions available.
Starting with the seminal works of Shleifer and Vishny (1997) and La Porta et al.
(1997, 1998), the impacts of investor protection on corporate governance (La Porta et al.,

1 In the paper, I do not require that the bidder be the parent company.

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2000), corporate valuation (La Porta et al. 2002), cross listing (Reese and Weisbach
2002; Burns et al. 2006), and even earning management (Leuz et al. 2003), have received
considerable attention. La Porta et al. (1997, 1998) document that the legal families from
which modern commercial laws originated (hereinafter called legal origins) play a key
role in determining the degree of investor protection in a given country. The second
objective of this paper is, therefore, to investigate how legal origin affects the treatment
reserved to minority investors in intragroup M&As around the world.
Intragroup mergers can be an ideal venue for exploring investor protection and the
effectiveness of different legal regimes. In fact, since the bidder (or another company in
the same business group) already controls the target firm, there is no change of control at
stake. Bidders acquire shares from minority shareholders, not incumbent controlling
shareholders, and this permits the study of how minority shareholders are treated across
different countries. The fact that the target firms are already part of the business group
also makes intragroup transactions less likely to be driven by managerial empire building
than acquisitions between independent entities.
While I find no evidence that intragroup transactions are designed to expropriate
minority shareholders in target firms (the abnormal return is 11.74% in the event window
[-2, +2]), there is evidence suggesting that these transactions do indeed create value.
Acquirers and parents earn small but positive abnormal returns, and the combined gains
from the deal are, on average, positive. This contrasts with the negative reaction to the
acquisition of public firms usually reported in literature. Legal origin affects minority
investors’ protection in intragroup M&As. In fact, while target share prices increase an
average of 16.68% in countries of English legal origin, target shareholders in French and

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German civil law countries have to settle for a gain of 6.36% and 7.34%, respectively.
Shareholders in countries whose legal system has a Scandinavian origin gain 12.80%
around the time of the acquisition announcement. To put it differently, the highest level
of investor protection guaranteed by the laws, social norms, and traditions of common
law countries gives minority shareholders a stronger bargaining position when dealing
with a controlling shareholder.
Using cross-sectional regression models, I find that legal origin still has a
significant impact on abnormal returns after controlling for factors that have been shown
to affect the market reaction around the acquisition announcement. Target shareholders in
civil law countries realize a lower abnormal return than their counterparts in common law
countries after controlling for firm and deal characteristics and the geographical region.
Conversely, the impact of legal origin on acquirer and parent firms’ returns is negligible.

This paper is part of the growing literature on minority shareholders’
expropriation. While some papers examine dividends (Faccio et al. 2001), debt (Faccio et
al., 2005), tunneling (Johnson et al. 2000; Bertrand et al. 2002), and connected party
transactions (Cheung et al. 2006), there are also a few recent papers that study intragroup
mergers and acquisitions at the single-country level. Bae et al. (2002) study intragroup
mergers in Korea. Bigelli and Mengoli (2004) find evidence suggesting that prices are set
in a way that permits the transfer of wealth toward the parent company in Italian
intragroup deals. Holmen and Knopf (2004) document limited expropriation in Sweden,
and they argue that bad governance is compensated for by legal protection and strong
social norms. Buysschaert, Deloof, and Jegers (2004) document that intragroup equity
sales increase minority shareholders’ wealth in Belgium. Finally, Atanasov et al. (2004)

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examine how a change in the security laws reduced freeze-out bids in Bulgaria. Another
paper related to mine is that of Faccio and Stolin (2006), who examine the effect that an
acquisition made by a European firm belonging to a group has on the company located at
the upper level in the pyramid. They do not find evidence of expropriation.

This paper offers several contributions to the current debate on investor
protection. First of all, it carries out the first worldwide analysis of intragroup M&As.
Second, it rejects the hypothesis that intragroup acquisitions are merely motivated by
expropriation. While this does not mean, of course, that tunneling and minority
expropriation are not a serious issue in many countries, the evidence in this paper
indicates that, at the least, laws and market forces effectively prevent the control of
shareholders so that intragroup acquisitions can be used to steal from minority investors.
On the contrary, the evidence indicates that intragroup M&As create value. Third, the
paper shows that even in transactions where there is no change of control involved,
bidders pay a premium the magnitude of which is economically significant and depends
upon the legal origin. Thus, legal origin sets up conditions under which minority
investors can reap considerable gains even in mop-up transactions.

The remainder of the paper is structured as follows. Section 2 develops the
hypotheses, and Section 3 presents the sample and the data. Section 4 documents
preliminary evidence about the sample firms, and Section 5 presents the event study
analysis. Section 6 reports the results of multivariate regressions. Section 7 discusses
cross-country deals, and robustness checks are presented in Section 8. Section 9 provides
the conclusions.


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2. Hypothesis Development
As mentioned in the introduction, business groups offer many possibilities for controlling
shareholders to expropriate resources. One type of transaction in which the risk of
expropriation is potentially high is the acquisition by the parent company (or another
subsidiary) of a firm belonging to the business group, hereinafter called an intragroup
acquisition (or an intragroup M&A).
In intragroup M&As, the target firm ownership structure is characterized by the
presence of a controlling shareholder. In contrast to the acquisitions usually investigated
in the empirical literature, target minority investors in intragroup M&As do not have to
worry about entrenched managers willing to fight off takeover offers, but they do have to
fear unfairly priced offers made by the controlling shareholder. In fact, controlling
shareholders can potentially use intragroup acquisitions to expropriate resources from
minority investors to their benefit. Figure 1 shows the types of intragroup acquisitions
considered in the paper. The acquisition can be carried out either directly by the parent
company or through a subsidiary.

[Please insert Figure 1 about here]

Minority shareholders rarely have the economic power to block the deal once the
controlling shareholder decides to execute the intragroup acquisition. Even in case of
tender offers, minority shareholders can reject the offer, but then they face a huge risk of
holding illiquid shares in their portfolios if they hold out and the offer succeeds. Roe
(2006) reports that during the decade 1960–1970 insiders set prices in their favor to buy
out public shareholders in going private transactions even in the United States. As

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Enriques (2000) argues, insiders have a de facto power to divert resources to themselves.
The self-dealing potential of intragroup acquisitions leads to the first hypothesis:
Hypothesis 1a: Intragroup M&As are designed to expropriate target firms’ minority
shareholders.
Under this hypothesis, target stock prices should react negatively around the
announcement of an intragroup transaction. Conversely, the bidder’s reaction should be
positive. The prediction for the combined gain is uncertain because the loss to the target
firm’s shareholders can offset the bidder’s gain. As can be easily seen, these predictions
are in sharp contrast to the well-documented empirical evidence for M&As of listed
targets. In fact, in these deals target shareholders usually gain from M&A deals, while
bidders often report negative or negligible abnormal returns (Andrade et al. 2001).
It can also be argued that these transactions are indeed value-increasing
reorganizations of business groups, as controlling shareholders often claim. Moreover, in
some countries minority investors may rely on legal protection and social norms that
make expropriation, if not unfeasible, at least very costly in this kind of transaction.
Holmen and Knopf (2004) find that this is the case for Sweden, but, given the publicity of
these deals, this may be true even in less rich and corruption-free countries. Even in
emerging markets, legal changes to improve investor protection may render expropriation
throughout intragroup acquisitions too costly compared with other expropriation
technologies (Atanasov et al. 2004). In cases of value-increasing reorganizations and at
least minimal investor protection, controlling shareholders may be willing to share part of
the gain with target shareholders. The increase in value can be due to synergies or better
management, but it can also stem from an expropriation-based argument. In fact,

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Almeida and Wolfezon (2006) argue that pyramids have both a payoff and a financing
advantage when the amount of diversion is expected to be high. Thus, getting rid of a
layer in the pyramid may be a way of signaling to the market that diversion is going to be
reduced in the whole business group. These arguments lead to the following hypothesis:
Hypothesis 1b: Intragroup M&As are value-creating transactions, and target firms’
shareholders obtain at least a share of the intragroup M&A’s gains.
This hypothesis predicts that both the market reaction to target firms’ shares and the
combined gain from the transactions are positive.
The second objective of this paper is to determine whether minority shareholders
receive the same treatment across the world. Shleifer and Vishny (1997) define corporate
governance as “the ways in which suppliers of finance to corporations assure themselves
of getting a return on their investment”, but previous literature makes it clear that these
ways differ across countries. The legal approach to corporate governance proposed by La
Porta et al. (1997, 1998) emphasizes the role played by the legal system, both laws and
their enforcement, to protect outside investors (La Porta et al. 2000). In a series of papers,
La Porta et al. show that legal rules protect outside investors differently across the four
legal families: the English, the French, the German, and the Scandinavian. As La Porta et
al. (2000) argue, “differences among legal origins are best described by the proposition
that some countries protect all outside investors better than others”. Their studies
document that common law countries have the strongest protection of outside investors,
while French civil law countries have the weakest.

Although a complete description of legal families goes beyond the goals of this
paper, it is worth noticing that the La Porta et al. (2000) argument does not entirely rely

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on the so-called “judicial” explanation. According to this explanation, common law
protects investors better than civil law because it grants substantial discretion to judges,
who base their decisions on precedents and general principles such as fiduciary duty.
However, as both Beck et al. (2003) and Roe (2006) argue, even in civil law countries
like Germany and France judges sometimes go beyond the mere application of the law.2
Furthermore, as La Porta et al. (2000) argue, there is no guarantee that common law
judges will use their discretion to favor outsiders. They can as well serve political
interests or even help politically connected controlling shareholders.

To complement the judicial view, La Porta et al. (1999b, 2000) argue that legal
traditions differ in the priority they give to individual investors against the state. Beck et
al. (2003) call this difference in priority the “political channel”. While common law has
aimed to protect private property since the beginning, French and German commercial
codes had as their main objective the advancement of the power of the State.3 La Porta et
al. (1999a) find that governments’ intervention in economic activity is higher in civil law
countries, particularly in French ones, than in common law countries.

Since intragroup acquisitions are transactions with a very high self-dealing
potential, the legal origin theory predicts that minority target shareholders will obtain a
higher degree of protection and better (i.e., fairer) treatment in common law countries.4
Hypothesis 2: Target shareholders receive better treatment in intragroup deals in
common law countries.

2 See Lobbe (2004) for a case of expansive lawmaking in Germany related to corporate groups.
3 See Glaeser and Shleifer (2002) for a comparison of the historical evolution of the English and French
legal systems.
4 The legal origin theory does not imply that target firms’ minority shareholders will be expropriated in
these transactions. In fact, the legal origin theory is based on the comparison of different legal families and
thus does not hold that one system is inherently better or worse than another.

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According to this hypothesis, I expect to find the highest abnormal returns for target
shareholders in common law countries. Concerning cross-country acquisitions, I also
expect that acquirers from civil law countries should pay more when they acquire a
subsidiary listed in a common law country than when they acquire a local subsidiary.

Summing up, the paper tests two main hypotheses. First, it tests what drives
intragroup M&As. In fact, intragroup mergers and acquisitions may be caused by the
desire to control shareholders either to divert assets to the detriment of minority
shareholders (Hyp. 1a) or to create value through efficient reorganizations (Hyp. 1b).
Second, the paper investigates how minority shareholders are treated under different legal
systems (Hyp. 2).

3. Sample and Data
The original sample includes 144,047 acquisitions involving public firms reported in
Thomson Financial Securities Data’s Thompson One Banker over the period January
1986 to December 2005. I consider acquisitions whose deal value is at least $1 million
that took place in 60 countries, listed in Table 1, from all over the world.

[Please insert Table 1 about here]


I rely on Thompson One Banker’s ultimate parents to identify potential intragroup
transactions. Thompson One Banker reports the same firm as the ultimate target’s parent
and the ultimate acquirer’s parent in 31,664 deals. I am fully aware that this criterion
does not guarantee the inclusion of all of the intragroup transactions in my sample, but

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