Text 36: the law of the market

Imagine that you have a little extra money to invest, and that you are choosing between the shares of two different companies. One is in a country where small shareholders have strong legal protections; the other is in a country where shareholders have no such rights, and where the few that do exist to protect them are only weakly enforced. Which do you invest in? No, this is not a trick question. But economists have had difficulty proving what many investors claim: that countries which treat them poorly have a harder time attracting their money. America and Britain, for example, are hailed as bastions of shareholder capitalism. Yet Germany and Japan, who rely heavily on banks and treat lesser shareholders with disdain, have also thrived. Do shareholders' rights really make a difference to economic performance?

The reason this question is so difficult to answer is because it is hard to say definitively which laws are best for investors. In some cases, laws that make it easier for investors to sell their shares or receive timely information may limit firms' freedom to pursue profitable strategies. Moreover, most big firms are riddled with conflicts of interest among managers, creditors and shareholders. Defining the rights of these groups in a way that maximizes a firm's value is tricky business, and the right solution will be different for different kinds of firms.

For these reasons, many legal experts argue that it is the strength of a country's stock market that determines its company laws, not the other way round. Frank Easterbrook, a prominent American jurist, makes this case in a recent article*. He argues that in countries with deep, liquid capital markets, managers are subject to constant stock market pressures. Where such markets are absent, however, investors must restrain managers in other ways, such as by giving more power to banks and other big institutions. Thus, the laws that determine investors' rights may respond to, rather than determine, the economic environment.

A newly published paper**, however, casts doubt on this theory. The authors take a detailed look at the legal systems of 49 countries, and examine the ways in which those laws affect the size and breadth of capital markets. They classify countries into four different types of legal system, based on the origins of their legal codes, their colonial histories and so forth. First, there are those that rely primarily on English common law, basing legal rules on case precedents and judges' opinions. These countries include Britain and its former colonies, ranging from America and Canada to Australia, Hong Kong and Singapore.

The main alternative to common law is civil law. Based on the classifications of legal scholars, the economists divide civil law countries into three groups. Indonesia, Mexico and Spain, for example, are classified as French civil law countries. Several East Asian nations, including Japan, South Korea and Taiwan, are reckoned to have German-type systems. The Scandinavian countries form a third group unto themselves.

The authors then construct several indices of shareholders' rights, and classify every country according to which protections it has. For example, some countries allow firms to issue non-voting shares to small shareholders, or to dilute their voting power in other ways. Only 11 of the 49 countries give equal voting powers to every share. Even if every share carries equal voting power, it is easier to exercise those rights in some countries than others. In Japan, for example, a shareholder must be present at a company's general meeting to exercise his vote. Since around 80% of Japanese firms hold their meetings during the same week, voting rights are practically worthless. Moreover, it is easier for shareholders to demand a general meeting in some countries than in others. In America, it takes only 1% of shareholders to do so; in Mexico, it takes 33%.

The results of this analysis are stark. First, the economists find, common-law countries are far more protective of shareholders than civil-law countries, those based on the French system are by far the worst. Common-law countries are also more protective of creditors, though the gap over German-law countries is less pronounced, and they do a better job than civil-law countries of enforcing the laws on their books. French-law countries trail the pack on these counts as well. Investors do not take this lying down. In the typical common-law country, the value of the stock market is equal to around 60% of GNP. In civil-law countries, the authors find, markets tend to be far smaller. French-law countries, for example, have an average market capitalization ratio of only 21% of GNP. This pool of willing investors makes a big difference to firms trying to raise cash. As a result, while common-law countries boast 35 listed companies for 1m members of the population, French civil-law countries have only ten. The ability to raise cash is especially important for new companies. For every 1m people, common-law countries average around 2.2 initial public offerings a year. Countries with a French-style legal tradition average less than a tenth that. The message seems clear. Countries with common-law legal system treat investors well, and their companies have an easy time raising capital. Those with French-law systems, by contrast, fail to protect investors, with predictable results.

Of course, many factors other than the legal environment determine the health of a country's financial system. Growth is an obvious one: as a share of output, America's stock market capitalization is actually below the average for common-law countries, many of which are rapidly growing Asian economies. But to those investors, who have been clamoring for legal reforms in many countries, the evidence in favour of their argument is at last beginning to mount.

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* "International Corporate Differences: Markets or Law". Journal of Applied Corporate Finance, Winter 1997.

** "Legal Determinants of External Finance". Journal of Finance, forthcoming.