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LAW AND FINANCE Rafael La Porta Harvard University Florencio ...

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LAW AND FINANCERafael La PortaHarvard UniversityFlorencio Lopez-de-Silanes, Harvard UniversityAndrei Shleifer Harvard UniversityRobert W. VishnyUniversity of Chicago2AbstractThis paper examines legal rules covering protection of corporate shareholders andcreditors, the origin of these rules, and the quality of their enforcement in 49 countries. Theresults show that common law countries generally have the strongest, and French civil lawcountries the weakest, legal protections of investors, with German and Scandinavian civil lawcountries located in the middle. We also find that concentration of ownership of shares in thelargest public companies is negatively related to investor protections, consistent with thehypothesis that small, diversified shareholders are unlikely to be important in countries that fail toprotect their rights.31. Overview of the issues.In the traditional finance of Modigliani and Miller (1958), securities are recognized bytheir cash flows. For example, debt has a fixed promised stream of interest payments, whereasequity entitles its owner to receiving dividends. Recent financial research has shown that this isfar from the whole story, and that the defining feature of various securities is the rights that theybring to their owners (Hart 1995). Thus shares typically give their owners the right to vote fordirectors of companies, whereas debt entitles creditors to the power, for example, to repossesscollateral when the company fails to make promised payments. The rights attached to securities become critical when managers of companies act in theirown interest. These rights give investors the power to extract from managers the returns on theirinvestment. Shareholders receive dividends because they can vote out the directors who do notpay them, and creditors are paid because they have the power to repossess collateral. Withoutthese rights, investors would not be able to get paid, and therefore firms would find it harder toraise external finance. But the view that securities are inherently characterized by some intrinsic rights isincomplete as well. It ignores the fact that these rights depend on the legal rules of thejurisdictions where securities are issued. Does being a shareholder in France give an investor thesame privileges as being a shareholder in the United States, India, or Mexico? Would a securedcreditor in Germany fare as well when the borrower defaults as one in Sri Lanka or Italy,assuming that the value of the collateral is the same in all cases? Law and the quality of itsenforcement are potentially important determinants of what rights security holders have and how4well these rights are protected. Since the protection investors receive determines their readinessto finance firms, corporate finance may critically turn on these legal rules and their enforcement. The differences in legal protections of investors might help explain why firms are financedand owned so differently in different countries. Why do Italian companies rarely go public(Pagano, Panetta and Zingales 1998)? Why does Germany have such a small stock market, butalso maintains very large and powerful banks (Edwards and Fischer 1994)? Why is the votingpremium -- the price of shares with high voting rights relative to that of shares with low votingrights -- small in Sweden and the United States, and much larger in Italy and Israel (Levy 1982,Rydquist 1987, Zingales 1994, 1995)? Indeed, why were Russian stocks nearly worthlessimmediately after privatization -- by some estimates one hundred times cheaper than Westernstocks backed by comparable assets -- and why did Russian companies have virtually no access toexternal finance (Boycko, Shleifer and Vishny 1993)? Why is ownership of large American andBritish companies so widely dispersed (Berle and Means 1932)? The content of legal rules indifferent countries may shed light on these corporate governance puzzles. In recent years, economists and legal scholars have begun to examine theoretically thecosts of benefits of alternative legal rules regarding investor rights (e.g., Bebchuk 1995, Gromb1993, Grossman and Hart 1988, Harris and Raviv 1988). The trouble is, there have been nosystematic data available on what the legal rules pertaining to corporate governance are aroundthe world, how well these rules are enforced in different countries, and what effect these ruleshave. There is no systematic knowledge, for example, of whether different countries actually dohave substantially different rules that might explain differences in their financing patterns.Comparative statistical analysis of the legal underpinnings of corporate finance -- and commerce5more generally -- remains unchartered territory.In this paper, we attempt to explore this territory. We examine empirically how lawsprotecting investors differ across 49 countries, how quality of enforcement of these laws varies,and whether these variations matter for corporate ownership patterns around the world. Our starting point is the recognition that laws in different countries are typically notwritten from scratch, but rather transplanted -- voluntarily or otherwise -- from a few legalfamilies or traditions (Watson 1974). In general, commercial laws come from two broadtraditions: common law, which is English in origin, and civil law, which derives from Roman law. Within the civil tradition, there are only three major families that modern commercial lawsoriginate from: French, German, and Scandinavian. The French and the German civil traditions,as well as the common law tradition, have spread around the world through a combination ofconquest, imperialism, outright borrowing, and more subtle imitation. The resulting laws reflectboth the influence of their families and the revisions specific to individual countries. As a result ofthis spread of legal families and the subsequent evolution of the laws, we can compare both theindividual legal rules and whole legal families across a large number of countries. To this end, we have assembled a data set covering legal rules pertaining to the rights ofinvestors, and to the quality of enforcement of these rules, in 49 countries that have publiclytraded companies. For shareholders, some of the rules we examine cover voting powers, ease ofparticipation in corporate voting, and legal protections against expropriation by management. Forcreditors, some of these rules cover the respect for security of the loan, the ability to grab assetsin case of a loan default, and the inability of management to seek protection from creditorsunilaterally. In effect, these rules measure the ease with which investors can exercise their powers6against management. We also consider measures of the quality of enforcement of legal rules indifferent countries and of the quality of their accounting systems. We show that laws vary a lot across countries, in part due to differences in legal origin. Civil laws give investors weaker legal rights than common laws do, independent of the level of percapita income. Common law countries give both shareholders and creditors -- relatively speaking-- the strongest, and French civil law countries the weakest, protection. German civil law andScandinavian countries generally fall between the other two. The quality of law enforcement isthe highest in Scandinavian and German civil law countries, next highest in common lawcountries, and again the lowest in French civil law countries. Having shown that law and its enforcement varies across countries and legal families, weask how the countries with poor laws or their enforcement cope with this problem. Do thesecountries have other, substitute mechanisms of corporate governance? These adaptivemechanisms may be in fact incorporated into the law, or they may lie outside the law. Onepotential adaptation to fewer laws is strong enforcement of laws, but as we pointed out above thisdoes not appear to be the case empirically. Another adaptation, sometimes referred to as "brightline" rules, is to legally introduce mandatory standards of retention and distribution of capital toinvestors, which limit the opportunities for managerial expropriation. We find that only Frenchcivil law countries have mandatory dividends, and German civil law countries are the most likelyto have legal reserve requirements of all the legal families. A further response to the lack of legal protections that we examine is high ownershipconcentration. Some concentration of ownership of a firm's shares is typically efficient to providemanagers with incentives to work, and large investors with incentives to monitor the managers7(Jensen and Meckling 1976, Shleifer and Vishny 1986). However, some dispersion of ownershipis also desirable to diversify risk. As argued by Shleifer and Vishny (1997) and explained furtherin section 6, very high ownership concentration may be a reflection of poor investor protection. We examine ownership concentration in the largest publicly traded companies in our samplecountries, and find a strong negative correlation between concentration of ownership, asmeasured by the combined stake of the three largest shareholders, and the quality of legalprotection of investors. Poor investor protection in French civil law countries is associated withextremely concentrated ownership. The data on ownership concentration thus support the ideathat legal systems matter for corporate governance, and that firms have to adapt to the limitationsof the legal systems that they operate in.The next section of the paper describes the countries and their laws. Sections 3 and 4 thencompare shareholder and creditor rights, respectively, in different countries and different legaltraditions. Section 5 compares the quality of law enforcement and accounting standards indifferent countries and legal traditions. Section 6 focuses on ownership. Section 7 concludes. 2. Countries, Legal Families, and Legal Rules.CountriesMost studies of corporate governance focus on one, or a few, wealthy economies (see,e.g., Rajan and Zingales 1995, Berglof and Perotti 1994, Gorton and Schmidt 1995, Kaplan andMinton 1994). However, corporate governance in all of the three economies that scholarstypically focus on -- the United States, Germany, and Japan -- is quite effective. To understandbetter the role of legal protection of investors, we need to examine a larger sample of countries. 8To this end, we have assembled as comprehensive a sample as possible of countries that havesome non-financial firms traded on their stock exchanges. The sample covers 49 countries fromEurope, North and South America, Africa, Asia, and Australia. There are no socialist or“transition” economies in the sample. A country is selected for inclusion if, based on theWorldScope sample of 15,900 firms from 33 countries and the Moody’s International sample of15,100 non-U.S. firms from 92 countries, that country had at least five domestic non-financialpublicly traded firms with no government ownership in 1993. We restrict attention to countriesthat have publicly traded firms since our primary focus is on protecting investor rights, andwithout public shareholders a discussion of investor rights would be limited. Having at least fivenon-financial private firms is also essential for construction of ownership data.Legal FamiliesComparative legal scholars agree that, even though no two nations’ laws are exactly alike,some national legal systems are sufficiently similar in certain critical respects to permitclassification of national legal systems into major families of law. Although there is no unanimityamong legal scholars on how to define legal families, “among the criteria often used for thispurpose are the following: (1) historical background and development of the legal system, (2)theories and hierarchies of sources of law, (3) the working methodology of jurists within the legalsystems, (4) the characteristics of legal concepts employed by the system, (5) the legal institutionsof the system, and (6) the divisions of law employed within a system” (Glendon et al. 1992, pp. 4-5). Based on this approach, scholars identify two broad legal traditions that pertain to mattersdiscussed in this paper: civil law and common law.1 9The civil, or Romano-Germanic, legal tradition is the oldest, the most influential, and themost widely distributed around the world. It originates in Roman law, uses statutes andcomprehensive codes as a primary means of ordering legal material, and relies heavily on legalscholars to ascertain and formulate its rules (Merryman 1969). Legal scholars typically identifythree currently common families of laws within the civil law tradition: French, German, andScandinavian. The French Commercial Code was written under Napoleon in 1807, and broughtby his armies to Belgium, the Netherlands, part of Poland, Italy, and Western regions of Germany. In the colonial era, France extended her legal influence to the Near East and Northern and Sub-Saharan Africa, Indochina, Oceania, and French Caribbean islands. French legal influence hasbeen significant as well in Luxembourg, Portugal, Spain, some of the Swiss cantons, and Italy(Glendon et al. 1994). When the Spanish and Portuguese empires in Latin America dissolved inthe 19th century, it was mainly the French civil law that the lawmakers of the new nations lookedto for inspiration. Our sample contains 21 countries with laws in the French civil tradition. The German Commercial Code was written in 1897 after Bismarck’s unification ofGermany, and perhaps because it was produced several decades later, was not as widely adoptedas the French Code. It had an important influence on the legal theory and doctrine in Austria,Czechoslovakia, Greece, Hungary, Italy, Switzerland, Yugoslavia, Japan and Korea. Taiwan'slaws came from China, which borrowed heavily from the German Code during its modernization. We have 6 countries from this family in our sample.The Scandinavian family is usually viewed as part of the civil law tradition, although itslaw is less derivative of Roman law than the French and German families (Zweigert and Kotz1987). Although Nordic countries had civil codes as far back as the 18th century, these codes10are not used any more. Most writers describe the Scandinavian laws as similar to each other but“distinct” from others, so we keep the 4 Nordic countries in our sample as a separate family. The common law family includes the law of England and those laws modeled on Englishlaw. The common law is formed by judges who have to resolve specific disputes. Precedentsfrom judicial decisions, as opposed to contributions by scholars, shape common law. Commonlaw has spread to British colonies, including the United States, Canada, Australia, India, and manyother countries. There are 18 common law countries in our sample.To classify countries into legal families, we rely principally on Reynolds and Flores (1989). In most cases, such classification is uncontroversial. In a few cases, while the basic origin of lawsis clear, laws have been amended over time to incorporate influences from other families. Forexample, Ecuador is a French civil law country, which revised its company law in 1977 toincorporate some common law rules; Thailand’s first laws were based on common law, but sincereceived enormous French influence; and Italy is a French civil law country with some Germaninfluence. Most importantly for our study, after World War II, the American occupying army“Americanized” some Japanese laws, particularly in the company law area, although their basicGerman civil law structure remained. In these -- and several other -- cases, we classify a countrybased on the origin of the initial laws it adopted, rather than on the revisions.2 In the UnitedStates, states have their own laws. We generally rely on Delaware law because a significantfraction of large US companies are incorporated in Delaware. In Canada, our data come fromOntario laws, even though Quebec has a French civil law based system. Legal Rules

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