Legal Foundations of Corporate Governance and Market Regulation R. La Porta, F. Lopez-de-Silanes, and A. Shleifer December 2007 LLSV (1997-98) and further Contributions 1) Legal rules of investor protection can be measured and coded across countries using national commercial (primarily corporate and bankruptcy) laws. • Coding showed some countries offer stronger investor protections than others. 2) Legal rules protecting investors vary systematically among legal traditions (LOs): • Laws of common law countries are more protective of outside investors than the laws of civil law, and particularly French civil law countries. • Countries with more protective laws have more developed capital markets 3) Civil law shows a heavier hand of government ownership and regulation • LO predicts government ownership of banks (LLS 2002), burden of entry regulations (DLLS 2002), regulations of labor markets (BLLS 2004), incidence of military conscription (MS 2005a,b), and government media ownership (Djankov et al. 2003c). These indicators are associated with adverse impacts on markets, such as greater corruption, larger unofficial economy, and higher unemployment. • Common law is associated with lower formalism of judicial procedures (DLLS 2003b) and greater judicial independence (LLSP 2004) than civil law. These indicators are associated with better contract enforcement and greater security of property rights. Pervasive influence of LOs and the Legal Origin Theory • Assuming this evidence is correct, it raises an enormous challenge of interpretation: What is the meaning of LO? How can it account for all these correlations? • Following comparative legal scholars, we adopt a broad conception of LO as a style of social control of economic life: • “Civil law is “policy implementing”, common law is “dispute resolving” (Damaska 1986). • French civil law embraces “socially-conditioned private contracting,” in contrast to common law’s support for “unconditioned private contracting” (Pistor 2006). • Zweigert/Kotz characterize legal families not only by the purely judicial institutions (i.e., legal procedures, forms of legal change, patterns of judicial recruitment), but also by the broader attitude, philosophy, or ideology: “The style of a legal system may be marked by an ideology, that is, a religious or political conception of how economic or social life should be organized” (p. 72). • Legal OriginsTheory adopts this broader conception: • Legal families are expressions of fundamental approaches to solving social problems • LOs reflect social attitudes and ideology that lead to large investments not only on legal infrastructure, but also on human capital educating politicians, judges, lawyers, etc.. These investments are not irreversible, but are costly to reverse. • This view explains why when faced with a problem, LOs address them in their own style. Background on Legal Origins McNeill/McNeill (2003) show how information transmission shapes human societies: Information (i.e., technology, language, religion, sports, law and legal systems) is transmitted through trade, conquest, colonization, missionary work, migration, etc.. Some information are transplanted voluntarily, as when people adopt technologies they need difficult to study consequences since it may be endogenous. In other cases, transplantation is involuntary, as in forced religious conversion, conquest, or colonization easier to identify the consequences. Legal origins or traditions present a key example of such often involuntary transmission of different bundles of information across human populations (Watson 1974). Transplantation covers specific laws and codes, individuals with mother-country training and human capital, general approaches/ideologies of the legal system, and elements of the organization of the judiciary. Of course, national laws evolved/adapted to local cultural, religious, and economic conditions, so the legal and regulatory systems of no two countries are identical. But individualization was not complete, so basic transplanted elements have persisted allowing classification into legal families (David/Brierley 1985, Reynolds/Flores 1989) Legal Origins = English = French = German = Scandinavian = Socialist The distribution of Legal Origin Legal Origin, Institutions, and Outcomes Institution Outcomes Time to evict nonpaying te Procedural Formalism Time to collect a bounced Judicial Independence Property rights Corruption Regulation of Entry Unofficial economy Government Ownership of the media Participation Rates Legal Origin Labor Laws Unemployment Conscription Stock market developme Company Law Firm valuation Securities Law Ownership structure Control premium Bankruptcy Law Private credit Government Ownership Interest rate spread of Banks Table I: Financial Institutions and Capital Markets Development (Bar Graph of Negative dummies of Legal Origins in Panel A) (Under construction!!!) Financial Institutions and Capital Markets Development: Size and Breath of Stock Markets Financial Institutions and Capital Markets Development: Private Credit and Interest Rate Spreads Table I: Financial Institutions and Capital Markets Development (Bar Graph of Negative dummies of Legal Origins in Panel A) (Under construction!!!) Government Regulation Corruption and Unofficial Economy Government Regulation and Labor Market Outcomes Table III: Judicial Institutions (Bar Graph of Negative dummies of Legal Origins in Panel A) (Under construction!!!) Judicial Institutions Court Efficiency and Contract Enforcement Summary of the evidence so far • The economic consequences of Legal Origins are pervasive • Compared to the French civil law, common law is associated with: 1) Better investor protection which in turn is associated with improved financial development, better access to finance, and higher ownership dispersion, 2) Lighter government ownership and regulation which are in turn associated with less corruption, better functioning labor markets, and smaller unofficial economies, and 3) Less formalized and more independent judicial systems which are in turn associated with more secure property rights and better contract enforcement. • Most important aspect of the results is how pervasive is the influence of LOs. Why do Legal Origins matter? Why in such a Pervasive way? • In recent years, various scholars, including ourselves, have used the historical narrative to provide a theoretical foundation for the empirical evidence. What are the historical and structural differences among the legal systems that have such pervasive consequences for rules and economic outcomes? How did Common and Civil law diverge? 1) Enlightenment (17th-19th c.): • English Revolution: lawyers and judges on the winning side Judicial independence = Parliament’s desire to create extra check on absolutism. • French Revolution: lawyers and judges were monarchists Napoleonic codes made them automata to will of legislators/executive (LLSV 1999) 2) Middle Ages (12th-13th c.): • England: relatively peaceful & independent knights with a strong king Decentralized dispute resolution w/ knights testimony (juries) was efficient • France: less peaceful, powerful feudal lords, weak king Nobles with power to subvert decentralized justice, so centralized system organized and protected by the sovereign was required (GS 2002) Three Implications of the Historical Analysis for the Economic Consequences of LOs 1. Common law’s built-in Judicial Independence, specially for cases of administrative acts affecting individuals more respectful of private property and contracts (LLPS 2004) 2. Common Law’s emphasis on Judicial Resolution of Private Disputes (vs. legislation) as a solution to social problems greater emphasis on private contracts & orderings, less on government regulation. Its regulation aims to facilitate private contracting rather than to direct particular outcomes. Pistor (2006): French LO embraces socially-conditioned private contracting. Damaska (1986): civil law is “policy-implementing;” common law is “dispute resolving.” 3. Common Law’s Adaptability benefits: Greater respect for jurisprudence as a source of law suggests they will be more adaptable to changing circumstances (Hayek 1960, Levine 2005). Through sequential decisions by appellate courts, it evolves for the better and toward more efficient legal rules (Posner 1973, Rubin 1977, Priest 1977). Legal Origins Theory: Why so much Hysterisis? • How has the influence of LOs persisted over decades or centuries? • What did the British boats bring so different from what the French or the Spaniards brought? • If all transplanted were attitudes toward social control, the effects would not be so persistent. • So, what got transplanted were laws and attitudes that require investments to provide the mechanisms to address social problems in a society. These attitudes have persisted due to the vast investments required in writing laws and educating and training people in them. • The legal system provides a style, and it is that system (as defined by Zweigert/Kotz), with its codes, distinctive institutions, modes of thought and even ideologies, that is very slow to change. It is not irreversible, but it would require large investments to be destroyed. Legal Origins Theory: Why so much Hysterisis? (2) • When private orderings get into a crisis, the civil law approach is to repress it or replace it with state mandates, while the common law is to shore up markets: • Example: Response to the Great Depression and financial crises of the 20th c: Civil law countries: bank nationalization, and suppression of stock markets. US: introduction of securities and banking regulation, and deposit insurance. • Civil law tends to expand government control when a need arises: • Example: Napoleon’s expansion of military conscription, made possible by the existing presence of bureaucracy that could administer the draft (MS 2005b). • State’s presence is less pervasive in common law, so it relies less on administrative solutions, and more on “market-supporting” or “dispute-resolving” ones. • Civil law tends to expand public involvement in new spheres: • Some historians argue that since LOs have differed for centuries, we should observe equal differences in rules and regulations in the 19th c. This is not true: • Public intervention in markets changes over time and responds to social needs or political imperatives, so laws and regulations will change as well, but in ways consistent with national legal traditions: • Labor laws and securities laws are 20th-c. laws responding to social needs. Yet, they took different forms in countries from different legal traditions. The Historical Narratives and the Interpretation of evidence 1) Evidence on judicial independence is a direct confirmation of the historical account: • Common law has less formalized contract enforcement, longer constitutional tenure of Supreme Court judges and greater recognition of case law as a source of law. • These characteristics are predictors of the efficiency of contract enforcement – measured both objectively and subjectively – and of the security of property rights. 2) Evidence on government regulation: consistent with styles for addressing social problems: • Civil law: more likely through government ownership and mandates • Common law: more likely to do so through private contract and litigation. Common law’s regulation supports private contracting vs. dictates outcomes. 3) Evidence on finance is also consistent: • Better shareholder & creditor protection in common law than in French civil law is consistent with the historical narrative of the greater security of private property. • Common law may have advantage in financial markets because they change quickly, i.e., the adaptability of judge-made law, as in Delaware courts (Beck et al, 2003). • The nature of statutory protection of investors in common law countries, as compared to civil law countries, is also broadly consistent with the implications of the historical account. Legal Origin and Culture • Stulz and Williamson (2003) suggest that, in light of the hostility of some of the religious traditions to lending on interest, religion may be a more fundamental determinant of legal rules governing creditor protection than LO. • Licht et al. (2005) present a more sweeping theoretical and empirical case for culture, using broad sociological measures of cultural attitudes. • However, the facts are: • Religion is not as important a determinant of creditor rights as LO (also Djankov et al. 2007). • Most indices of cultural attitudes do not influence creditor rights holding LO constant: • Some evidence that a nation’s masculinity is not conducive to creditor protection, while belief in the independence of children is, • But neither of these makes a big dent in the effect of LO on creditor rights. • We do not propose that culture is unimportant. • But the effects of LOs remain large and significant controlling for culture. Creditor Rights, Culture and Legal Origin: Percentage of Catholic Population Creditor Rights, Culture and Legal Origin: Percentage of People that say Strangers can be Trusted Legal Origins and Politics • Politics presents a broader challenge to the explanatory power of LO: • Hellwig (2000), Rajan and Zingales (2003), Pagano and Volpin (2005, 2006), Perotti and von Thadden (2006), Roe (2006), and Mueller and Philippon (2006). • They mostly deal with Western Europe or the Wealthy West. Political theories: • Sometime in mid 20th c. Continental European countries formed alliances between families that controlled firms and (typically organized) labor. • The alliances were: (1) a response to crises from hyperinflation, depression, or defeat in war; (2) sought to win elections and secure insiders’ economic rents away from the “outsiders,” such as unorganized labor, minority shareholders, corporate challengers, or potential entrants. • When these alliances won elections, they wrote legal rules to benefit themselves: • Families got poor protection of outside shareholders keep control benefits • Labor got social security & worker protection laws keep employment & wages. • Families and labor got the laws protecting them against product market competition. Legal Origins and Politics (2) • Continental Europe vs the US in the 20th c.: • The political story is part of a broader narrative of Continental European history in the 20th c., in which the response to crisis is characterized by the rise of proportional representation (Alesina & Glaeser 2004, Persson & Tabellini 2003), socialist politics (Alesina & Glaeser 2004), and social democracy (Roe 2000). • The US was spared from these events, so it did not get the laws adopted on the Continent. • The legal rules observed in the data, are thus outcomes of this democratic process, and not of “permanent” conditions, such as LOs. • If politics were appropriately controlled for in the regressions, LO would not matter. • Some implications of political theories are plausible and broadly consistent with the evidence: 1. Countries with strong shareholder protections have weak protections of labor and low regulations of entry. 2. We see social democracies in Continental Europe but not in the US. Legal Origins and Politics: An analysis of the Political Theory • What is the evidence when political variables are added to the regressions? • Regressions of legal and institutional rules on 3 variables of the political theories: • Proportional representation = Form of democracy seen as an adaptation to political demands of labor in the early 20thc. Only for democracies! • % years in 1928-95 when chief executive and largest party in legislature were leftist or centrist. • Union density = % total work force affiliated to labor unions in 1997. • Results: • Political variables explain the variation in legal rules only occasionally. • LOs continue to explain the variation even with political variables in, and the difference between common law and French civil law remains highly statistically significant. • Each political variable is surely measured with error, and specifications may not capture the full subtlety of the political theories, but political variables are rarely significant in contrast with LOs. Politics and Legal Origin Legal Origins and Politics: An analysis of the Political Theory (2) • Does the democratic process lead to the observed legal rules? • This is a key implication of all the political models: it predicts that the relationship between LOs and laws should not hold outside democracies. • But under legal theories, LO should predict legal rules in both autocracies and democracies. • Note of caution: • It is NOT our conclusion, nor our belief, that politics do not matter for corporate governance, government regulation, or the structure of the judiciary. • The critics offered a different hypothesis, namely that LO is just a stand-in for politics. • For this hypothesis, there is no support. Table IX: Legal origin in countries with Autocratic governments (5 graphs of the negative dummies of Legal Origins in the various groups of variables) Under Construction !!!! (1) (2) (3) (4) (5) (6) (7) (1) Anti-Self- (2) Disclosure in (3) (4) Debt (5) Govt Ownership (6) (7) Creditor Rights Ln(Steps) Labor laws Anti-Self- Dealing Disclosure in Prospectus Debt Enforcement Ownership GovtBanks Creditor Rights Ln(Steps) Labor laws French Legal Origin Dealing -0.3421a Prospectus -0.3642a -1.1816a Enforcement -14.3174b Banks 0.2822b 0.4438a 0.2040a French Legal Origin -0.3421a [0.0792] -0.3642a [0.0858] -1.1816a [0.2685] -14.3174b [6.6720] 0.2822b [0.1172] 0.4438a [0.0925] 0.2040a [0.0464] German Legal Origin [0.0792] -0.2508 [0.0858] -0.1145c [0.2685] -0.7960b [6.6720] -3.4763 [0.1172] 0.3852b [0.0925] 0.0936 [0.0464] 0.1333b German Legal Origin -0.2508 [0.1487] -0.1145c [0.0639] -0.7960b [0.3729] -3.4763 [7.9660] 0.3852b [0.1514] 0.0936 [0.1618] 0.1333b [0.0559] Ln(GDP per capita) [0.1487] 0.1074b [0.0639] 0.0907b [0.3729] 0.2571b [7.9660] 21.8679a [0.1514] -0.1259c [0.1618] -0.1023b [0.0559] 0.0011 Ln(GDP per capita) 0.1074b [0.0445] 0.0907b [0.0401] 0.2571b [0.0989] 21.8679a [4.3514] -0.1259c [0.0657] -0.1023b [0.0392] 0.0011 [0.0257] Constant [0.0445] -0.2647 [0.0401] -0.0156 [0.0989] 0.3189 [4.3514] -141.9287a [0.0657] 1.2749a [0.0392] 2.8843a [0.0257] 0.3142 Constant -0.2647 [0.3658] -0.0156 [0.3398] 0.3189 [0.8444] -141.9287a [39.5086] 1.2749a [0.4261] 2.8843a [0.3254] 0.3142 [0.2157] Observations [0.3658] 37 [0.3398] 26 [0.8444] 78 [39.5086] 39 [0.4261] 47 [0.3254] 47 [0.2157] 46 Observations R-squared 37 0.36 26 0.46 78 0.22 39 0.51 47 0.18 47 0.32 46 0.28 R-squared 0.36 0.46 0.22 0.51 0.18 0.32 0.28 Table IX: Legal origin in countries with Autocratic governments (5 graphs of the negative dummies of Legal Origins in the various groups of variables) Under Construction !!!! (1) (2) (3) (4) (5) (6) (7) Anti-Self- Disclosure in Debt Govt Ownership Creditor Rights Ln(Steps) Labor laws Dealing Prospectus Enforcement Banks French Legal Origin -0.3421a -0.3642a -1.1816a -14.3174b 0.2822b 0.4438a 0.2040a [0.0792] [0.0858] [0.2685] [6.6720] [0.1172] [0.0925] [0.0464] German Legal Origin -0.2508 -0.1145c -0.7960b -3.4763 0.3852b 0.0936 0.1333b [0.1487] [0.0639] [0.3729] [7.9660] [0.1514] [0.1618] [0.0559] Ln(GDP per capita) 0.1074b 0.0907b 0.2571b 21.8679a -0.1259c -0.1023b 0.0011 [0.0445] [0.0401] [0.0989] [4.3514] [0.0657] [0.0392] [0.0257] Constant -0.2647 -0.0156 0.3189 -141.9287a 1.2749a 2.8843a 0.3142 [0.3658] [0.3398] [0.8444] [39.5086] [0.4261] [0.3254] [0.2157] Observations 37 26 78 39 47 47 46 R-squared 0.36 0.46 0.22 0.51 0.18 0.32 0.28 Legal Origins and Historical Arguments • Suggests the correlation between common law and finance is a 20thc. phenomenon: • If we look at data in the early 20thc the correlation does not exist. Since LOs predate the 20thc, they cannot account for the differences in financial development. • Rajan & Zingales (2003) is the starting critique. Using individual country sources, they show stock market capitalization to GDP as of 1913 for 6 common law and 18 civil law countries (10 French). • Focused on finance But an alternative theory must address all the evidence! • The Historical Argument has two component parts: 1) In 1913, French civil law countries had more developed financial markets than common law countries: • RZ’s 1913 sample: 5 common law countries had average stock market to GDP of 53%, compared to 66% for the 10 French civil law countries. 2) Correlation of common law and financial development emerges over the 20thc, inconsistent with LLSV: • In the “Great Reversal,” the initial (1913) French LO superiority disappears with MarketCap/GDP ratios of 130% and 74% in 1999 for common law and French civil law countries (RZ 2003). Stock market capitalization over GDP (based on Rajan and Zingales, 2003) 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 1913 1923 1933 1943 1953 1963 1973 1983 1993 English Legal Origin French Legal Origin German Legal Origin Scandinavian Legal Origin Legal Origins and Historical Arguments (2) 1) Measurement Problems in Several Countries: • The relevant measure to test LOs’ influence is a country’s capitalization of equities listed on that country’s stock exchange(s) whose shareholders are subject to the country’s legal protection. • RZ undertook to find such numbers, but doing so for early 20thc is difficult because: 1. Many securities trading were bonds rather than stocks, and many were government bonds. 2. Many firms listed were incorporated or had primary listings, in Europe/U.S. So, for a given country, these factors may lead to an overestimate of market value of stocks subject to national shareholder protection laws. For example: A) Cuba: RZ’s most financially developed country in 1913 [MktCap/GDP = 219%]. • The largest company with listed stock was Havana Electric (incorporated in New Jersey) • If one excludes bonds and looks only at stocks, the Cuba ratio falls to 33% and the French civil law average goes from 66% to 47% (i.e., below their common law average). B) Egypt: RZ’s second most financially developed country in 1913 [MktCap/GDP =109%]. • It appears it includes debt (Tignor, 1984). Largest firms incorporated/listed in UK or France. • We estimate a correct observation for Egypt of at most 40% C) Rich countries: • France: RZ estimate 78%, but a recent estimate by Bozio (2002) puts it at 54%. • US: RZ has 39%, but Sylla (2006) proposes the 95% from Goldsmith (1985). Legal Origins and Historical Arguments (3) 2) Compare the two mother countries: England and France. • RZ recognize that England was more financially developed than France in early 20th c. • Standard narratives see Paris as a financial backwater (Kindleberger 1984). • A formal comparison is possible using France, from Bozio (2002), and UK, from Michie (1999), and adjusting to exclude corporate bonds using Goldsmith (1985). 3) Common and civil law countries in 1913 based on Goldsmith (1985): • Consistent with Kindleberger, Britain is ahead of France as far back as the middle of the 19th c., and perhaps even earlier. So, interestingly, is the United States. • Using US 1912 data, Goldsmith has 4 common law and 7 civil law countries. Even with India pulling way down the common law average and no underdeveloped civil law country in 1913’s sample: Common law = 88%; French LO (France & Belgium) = 77%; Overall Civil law = 69%. • Goldsmith’s data has its own problems. But it independently confirms that the relative financial underdevelopment of common law in early 20th c. is a myth. Conclusion: • Contrary to RZ (2003), common law countries appear to be more financially developed than civil law ones at the start of the 20th c, and in particular Britain is ahead of France. • Over the 20th c the differences have widened, which needs to be explained. • The alleged Great Reversal that animated political and historical writings did not really happen. Stock market capitalization over GDP France and Great Britain % 160 140 120 100 80 60 40 20 0 1800 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 France Great Britain Measurement ahead of Policy • This research sheds light on the nature of good reforms, and on the specific policy levers. • Helps understand why so many developing countries end up with inefficiently high levels of regulation, especially in the civil law world. • Even in the developed countries, the levels of regulation of many activities (labor markets and entry) were probably adopted in a less orderly environment, or for reasons of consistency or habit, and as such are excessive for modern markets. • In finance, institutions that replaced markets must now be replaced by those that sustain them. • Developing countries: the mismatch between the institutions and needs is even greater. • The heavy-handed regulatory policy that might work tolerably well in continental Europe translates into over-regulation, corruption, and suppression of entrepreneurship in the developing world. • But, even when the measured rules are not the entire problem, and thoughtless formalistic reforms likely to fail, these rules can provide relevant data and point closer where the problem actually lies. Measurement ahead of Policy (2) • Recent sketchy evidence is broadly consistent with the optimistic view that in some circumstances the laws we measure are the reason for inefficient outcomes: 1) Reductions of entry regulations: • 55 countries lowered administrative costs to start a business in 2005-2006 (DB 2006). • Russia: beneficial effects of firm entry after reforms (Yakovlev/Zhuravskaya 2007) 2) Mixed picture for labor markets: • Labor markets were liberalized in the OECD in the last 15 years, although most reforms pertained to temporary rather than permanent employment (OECD 2006). • No tendency for liberalization in Latin America in the 1990s (Heckman/Pages 2004). 3) Investor protection: • Improvements in shareholder rights in OECD during the 1990s (Pagano/Volpin 2005). • Tendency toward improving shareholder rights in the EU (Enriques/Volpin (2007) Although too little to resolve the problem of related-party transactions. • Emerging markets: some examples of improvement, such as Mexican securities laws (Chong/Lopez-de-Silanes 2008) and bankruptcy reform (Gamboa/Schneider 2007). • Much of the evidence is circumstantial, and confined to the developed world. • But if the world remains peaceful and orderly, the attraction of market-friendly reforms will increase. Conclusions • Since the publication of the two LLSV articles, this research has evolved a great deal: • Nonetheless, the fundamental contribution appears to be standing: • LOs have significant consequences for the institutional framework of the society, and for economic outcomes. • The range of legal, economic, and social spheres where legal origins have consequences has broadened. • Four propositions appear to be correct: 1) Legal rules differ systematically across countries, and these differences can be measured and quantified. 2) Differences in legal rules are significantly accounted for by the differences in LO. 3) Historical divergence in legal traditions (i.e., policy-implementing focus of civil law versus dispute-resolving focus of common law – explains why legal rules differ. 4) The measured differences in legal rules matter for economic and social outcomes. • The outlines of a coherent theory have become clearer but not all the empirical issues have been settled, or that the LO theory will survive further scrutiny.
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