The Dark Side of Shareholder Protection: Cross-country Evidence from Innovation Performance

Abstract: Proponents of minority shareholder protection state that national legal institutions protecting small investors boost stock markets and, in turn, long-term countries’ performance. In this paper, we empirically challenge this argument by focusing, in particular, on country innovation performance, which is central to the long-term development of market economies. We perform three-stage least-square estimation on a sample of 48 countries over 1993-2006 and find that countries with stronger shareholder protection tend to have larger market capitalization but also lower innovation activity. We cope with stock market’s endogeneity and industry heterogeneity, so that this finding is unlikely to be driven by misspecification problems. We interpret our estimation results as follows. It is true that the risk of expropriation at the expenses of individual stockholders can occur as a consequence of block-holder discretion where investor protection is weak. However, small and extensively diversified shareholders are less likely to take interest in long-term corporate results than those who have their wealth disproportionately invested in a given company, and they may use an increased control power to play opportunistic actions against undiversified stockholders, after specific investments are undertaken by the company. Innovation activity, largely based on specific investing, is particularly exposed to such problem, and this turns out to be relevant even at the country-level.