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The Economic Consequences of Legal Origins. Professor Andrei Shleifer Harvard University and NBER Barcelona January, 2007. Modern Theory of Corporate Finance. Earlier research on CG focused on such problems as: Managerial consumption of perquisites (Jensen and Meckling 1976),
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The Economic Consequences of Legal Origins Professor Andrei Shleifer Harvard University and NBER Barcelona January, 2007
Modern Theory of Corporate Finance • Earlier research on CG focused on such problems as: • Managerial consumption of perquisites (Jensen and Meckling 1976), • Managerial effort (Holmstrom 1979), and • Over-investment in pursuit of growth (e.g., Baumol 1959, Jensen 1986). • Last 20 years: Modern theory of corporate finance focuses instead on the ability of corporate insiders to divert corporate wealth to themselves or “private benefits of control” (Grossman and Hart 1988, Hart 1995, Zingales 1994). • Most firms are not “Bearle-and-Means” (1932) corporations: They have owners who control and run them (LLS 1999) • Those in control– controlling shareholders or managers– have the power to divert corporate wealth to themselves through self-dealing in various forms: • Executive perks, excessive compensation, and loans to officers • Transfer pricing and Asset stripping; • Targeted issuance or repurchase of securities; and • Diversion of corporate opportunities.
Modern Theory of Corporate Finance • Empirically, such diversion has been investigated in several contexts: • U.S. savings and loans crisis (Akerlof and Romer 1993), • Asian & Mexican financial crises (La Porta, Lopez-de-Silanes, and Zamarripa 2003, Johnson et al. 2000a), • Legal disputes over tunneling (Johnson et al. 2000b), • CG during transition from socialism (Glaeser et al, 2001) and reform in developing countries (Lopez-de-Silanes 2003). • Estimating private benefits of control from voting premia and the treatment of controlling shareholders in takeovers (Nenova 2003, Dyck and Zingales 2004). • Economists have followed Legal scholars (Clark 1986) pointing to the crucial role of law in the control of investor expropriation: Self dealing limits external finance and leads to financial underdevelopment.
Modern Theory of Corporate Finance • Initial research argues and shows that differences in legal investor protection across countries shape the ability of insiders to expropriate outsiders, and thus determine investor confidence in markets and consequently their development (LLSV 1997, 1998, 2000). • “Law and Finance” made three contributions: • Investor protection explains the development of financial markets. • As a result of colonial transplantation, legal origin is exogenous. Moreover, legal origin is correlated with investor protection. • Legal origin is the explanation of the observed differences in investor protection. • The current debate is about: • The theoretical grounding of the measurement of investor protection, and • Whether LO is at the heart of investor protection. Alternative explanations include culture, the media, and politics.
The Regulation of Self-dealing • Goals: • Develop a measure of investor protection that is both theoretically grounded and describes how societies regulate the self-dealing problem. • Examine whether anti-self-dealing measures are linked to development of financial markets and which regulatory approaches work best. • Identify the determinants of the regulation of self-dealing; Test for alternative theories of what explains investor protection • Shed light on what makes common law different from civil law. • Two impractical approaches to self-dealing: • Laissez faire -- Leave self-dealing unregulated and let courts sort it out. • Prohibit all self-dealing transactions. • Most countries choose to regulate self-dealing through: • Private enforcement mechanisms; and / or • Public enforcement.
Mr. James Mr. James owns 90% of Seller Co. shares Mr. James owns 60% of Buyer Co. shares Seller Co. Buyer Co. Buyer Co. buys equipment from Seller Co. The Proposed Transaction • Simple transaction (purchase of equipment) between two entities (“Buyer” and “Seller”) controlled by the same shareholder (“Mr James”), who is on the board of both firms. • Key Problem: • The proposed transaction may have a business purpose. • For example, purchasing the equipment may lead to expanded sales. • James is on both sides of the transaction and may benefit if Buyer acquires overpriced equipment from Seller.
The Regulation of Self-Dealing • Replicate conditions in an arm’s-length transaction: • Disclosure and approval requirements by law before Buyer acquires Seller’s trucks • Immediate disclosures after the decision to enter the transaction has been made. • Empower shareholders to seek remedy for expropriation through the courts: • Since even a duly approved and disclosed transaction may damage Buyer, litigation may be necessary to obtain restitution. • So, we keep track of how easy it is for shareholders to obtain redress through the courts when the transaction damages Buyer if all disclosure and approval requirements are met. Crucial, since the laws of most countries provide harsh penalties for breaking disclosure and approval requirements. • Factors that affect the odds that the plaintiff prevails in court include liability standards and the right to compel evidence. • Provide fines and criminal sanctions to those who expropriate: • Strength of public enforcement with fines and sanctions applicable to Mr. James and those in charge of approving the transaction.
The Questionnaire & its Process • In cooperation with 9 law firms, we designed an tested a questionnaire covering: • who approves the transaction; • what needs to be disclosed, when and to whom (e.g., Board, Shareholders, etc); • what are the duties of officers, directors, and controlling shareholders; • how the transaction could be rescinded, and by whom; • what causes of action are available to recover damages; • what needs to be proven under each cause of action; • who has standing to sue under each available cause of action; • availability of direct and derivative suits; • access to information and discovery rights; and • fines and criminal sanctions. • We received answers, and back-up laws or precedent, from 102 of the 115 law firms • We read the laws and coded the respondents’ answers. • We conducted follow-up conference calls with the lawyers to seek clarifications • We asked respondents to confirm our coding of the data • We have confirmed our coding for 72 countries (99.3% of market cap in 2003)
Key Clarification: The Scope • We consider garden-variety self-dealing transactions, in which the controllers of companies make choices that may benefit them at the expense of other investors, but follow the law regarding disclosure and approval procedures. All legal approvals and required disclosures were met • We are not dealing with cases of corporate crime such as Enron or Parmalat: To stop such cases, every country uses harsh criminal punishments. • We are interested in a very different situation: • If a controlling shareholder wants to enrich himself but also follow the law, how difficult is it for minority shareholders to thwart the deal before it goes through and to recover damages if it is carried out? • This is one of the key problems of corporations around the world and one of the main objects of corporate governance.
Data • Approval and Ex-Ante Disclosure requirements • Ex-Post Disclosure and Burden of litigation • Public enforcement • Measures of stock market development.
Legal Origins = English = French = German = Scandinavian = Socialist Legal Origin Distribution
Ex-Ante Ex-Post Public Enforcement Regulation and Income Outcomes Results Ex-Ante Control of Self-Dealing
Ex-Post Control of Self-Dealing Ex-AnteEx-Post Public Enforcement Regulation and Income Outcomes Results
Public Enforcement Ex-AnteEx-PostPublic Enforcement Regulation and Income Outcomes Results
Anti-Self-Dealing Index and Block Premium • Figure VI: Partial-regression leverage plot of Block Premium against the index of anti-self-dealing, controlling for Log GDPpc and efficiency of the judiciary..
Anti-Self-Dealing Index and Ln Firms / Pop • Figure VII: Partial-regression leverage plot of Log listed firms per million people against the index of anti-self-dealing, controlling for Log GDPpc and efficiency of the judiciary..
Anti-Self-Dealing Index and IPOs/GDP • Figure VIII: Partial-regression leverage plot of IPOs-to-GDP against anti-self-dealing in regressions controlling for Log GDPpc and efficiency of the judiciary..
Anti-Self-Dealing Index and Ownership Concentration • Figure IX: Partial-regression leverage plot of Ownership Concentration against ex-ante (left) & ex-post (right) anti-self-dealing, controlling for L(GDPpc) & efficiency of the judiciary..
Public Enforcement and Stock Market Capitalization • Figure VIII: Partial-regression leverage plot of stock market capitalization & index of public enforcement, controlling for Log GDPpc and efficiency of the judiciary.
Public Enforcement • Table XI and Figure X show that public enforcement is not associated with more developed stock markets. • Advocates of public enforcement may dismiss our findings by: • Arguing that what deters self-dealing is the probability that criminal sanctions will actually be imposed (rather than their mere existence). • Unfortunately, we lack data on actual enforcement practices to test this. • We have used Bhattacharya and Dakou (2002) but does not work. • Divided Rich versus Poor countries, but does not work. • Conjecture that a proxy for actual enforcement would have a hard time fitting the data since criminal sanctions are simply unavailable in roughly half the sample (32 countries) and this group exhibits enormous variation in the size of stock markets (e.g. Hong Kong vs. New Zealand). • Perhaps a better reason to be cautious about our findings here is that the criminal sanctions most relevant to the development of stock markets may be those applicable under different case facts (e.g., failure to disclose) than ours.
Alternative Theories Politics
Politics and Investor Protection • Investor protection may be determined by politics rather than legal origin [Pagano & Volpin 2005, Perotti & von Thadden 2006, Roe 2000, Rajan & Zingales 2003)]. • Proportional electoral systems are conducive to weaker investor protection than majoritarian systems. • Table XVII Panel A: • Common law countries have sharply higher anti-self-dealing scores. • Proportional representation is associated with lower anti-self-dealing scores. • When both are included, only the latter is statistically significant But multicollinearity makes it difficult (corr -.46). • So, we run univariate regressions for common and civil law countries separately using proportional representation to explain anti-self-dealing regulation (Panel B). • Proportional representation is insignificant in both regressions. • Split into countries above and below the median competitiveness of the legislature (Panel C). If common law is a proxy for electoral rules, it should not predict the development of securities markets in non-democratic countries. Instead, common law is a significant predictor of the anti-self-dealing index in both sub-samples.
Proportional Representation in different Legal Origins • Figure XI: Partial-regression leverage plot of anti-self-dealing index against proportional representation in common law countries (left graph) and civil law ones (right graph) in regressions that control for (log) income per capita and efficiency of the judiciary.
Legal Origin in different Democratic Regimes • Figure XII: Partial-regression leverage plot of anti-self-dealing against legal origin for countries with high (left graph) and low (right graph) competitiveness of the legislature in regressions that control for (log) income per capita and efficiency of the judiciary.
Conclusions • Constructed a new index of shareholder protection for 72 countries (so far). • Addresses specifically the protection of minority shareholders against self-dealing transactions benefiting controlling shareholders. • Better grounded in theory than index of anti-director rights (LLSV 1997, 1998) • Anti-self-dealing index exhibits same properties as both the anti-director rights index, and the indices of shareholder protection through securities laws (LLS 2006). • It is sharply higher in Common law than in French civil law countries. • Statistically significant and economically strong predictor of stock market development across countries. • Results support findings in earlier work, but also show that theoretically-grounded measures of investor protection are closely tied to financial development. • The quality of investor protection is not merely a proxy for non-legal institutions and politics. Law indeed does seem to matter for finance. • Does not mean that non-legal institutions and politics are unimportant • Only that legal rules are not mere proxies for these institutions.
Implications:Progress in the last 10 years 1. Measurement of Investor Protection2. Interpretation of Legal Origin3. Regulatory Strategies and Policy Reform
Implications for the Measurement of Shareholder Protection • 4 measures of shareholder protection with different methodology and different situations • So, what is “the best” measure for researchers to use? • No clear answer measures are highly correlated with each other. • But some differences: • Measures from securities laws: (49 countries) • “Work” best in terms of predicting stock market outcomes • Appropriate for studies of protection of investors buying securities, as opposed to corporate governance per se. • Anti-director rights index: (72 countries) • Advantage of continuity with many previous studies; • Anti-self-dealing index: (72 countries) • Greater conceptual clarity in general, and relevance to the pervasive problem of corporate self-dealing (or tunneling) in particular. crucial • If self-dealing is the central problem of corporate governance in most countries, the law’s effectiveness in regulating this problem is the fundamental element of shareholder protection.
Implications for the Interpretation of Legal Origin • Examination of legal rules gives further insight in pronounced differences in the way Common and Civil law protect investors: • Confirmation of Johnson et al. (2000) conjecture that common law is more suspicious of conflicted transactions, and subjects them to closer scrutiny: Greater disclosure and more arms-length approval. • Central difference between common and civil law: Ex-ante transparency in self-dealing. • Approaches appear to derive from long-standing legal principles which over time are incorporated into the statutes that we actually observe. • Broader vision: • Results are consistent with Djankov et al. (2003) that common law is distinguished from civil law by its encouragement of private solutions to problems of “disorder.” • Statutory law aims to reduce costs of private solutions, not replace w/ public ones. • Mandatory disclosure and arms-length approval are very clear examples of this broader strategy of social control of business associated with common law.
Implications forRegulatory Strategies & Policy Reform • Taken at face value, our work has implications for corporate governance improvement: • The Public sector has a role to play as designer of the rules: • Countries with successful stock markets give shareholders the information they need and the power to act – including both voting and litigation -- on this information. • No evidence that successful countries rely heavily on fines and criminal sanctions (LLS, 2006). • Specific Recommendations for policy reform: • Combine full disclosure of self-dealing transactions with the requirement of approval by disinterested shareholders – inexpensive and straightforward to implement. • Need to set a lower bound, particularly because of concentrated ownership • But, no real reason for it not to work in rich or poor or civil law countries • Combine on-going disclosure of self-dealing transactions with a relatively easy burden of litigation placed on the shareholders, also benefits stock market development – more difficult to implement. Success may depend on general structure and efficiency of legal systems
