The Economic Consequences of Legal Origins

Professor Andrei Shleifer

Harvard University and NBER

BarcelonaJanuary, 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:1. Executive perks, excessive compensation, and loans to officers2. Transfer pricing and Asset stripping;3. Targeted issuance or repurchase of securities; and4. 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:1. Investor protection explains the development of financial markets. 2. As a result of colonial transplantation, legal origin is exogenous. Moreover,

legal origin is correlated with investor protection. 3. Legal origin is the explanation of the observed differences in investor

protection.

• The current debate is about:1. The theoretical grounding of the measurement of investor protection, and2. Whether LO is at the heart of investor protection. Alternative explanations

include culture, the media, and politics.

The Regulation of Self-dealing

• Goals:1. Develop a measure of investor protection that is both theoretically grounded

and describes how societies regulate the self-dealing problem. 2. Examine whether anti-self-dealing measures are linked to development of

financial markets and which regulatory approaches work best.3. Identify the determinants of the regulation of self-dealing; Test for

alternative theories of what explains investor protection4. Shed light on what makes common law different from civil law.

• Two impractical approaches to self-dealing:1. Laissez faire -- Leave self-dealing unregulated and let courts sort it out.2. Prohibit all self-dealing transactions.

• Most countries choose to regulate self-dealing through:1. Private enforcement mechanisms; and / or 2. Public enforcement.

Methodology

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 Proposed Transaction

Seller Co.Buyer Co. buys equipment from Seller Co.

Mr. James owns 60% of Buyer Co. shares

Mr. James owns 90% of Seller Co. shares

Mr. James

Buyer Co.

The Regulation of Self-Dealing

1. 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.

2. 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.

3. 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:1. who approves the transaction; 2. what needs to be disclosed, when and to whom (e.g., Board, Shareholders, etc); 3. what are the duties of officers, directors, and controlling shareholders; 4. how the transaction could be rescinded, and by whom; 5. what causes of action are available to recover damages;6. what needs to be proven under each cause of action; 7. who has standing to sue under each available cause of action; 8. availability of direct and derivative suits; 9. access to information and discovery rights; and 10. 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

1. Approval and Ex-Ante Disclosure requirements

2. Ex-Post Disclosure and Burden of litigation

3. Public enforcement

4. Measures of stock market development.

Legal Origin Distribution

Legal Origins = English

= French

= German = Scandinavian = Socialist

Ex-Ante Control of Self-DealingEx-Ante Ex-Post Public Enforcement Regulation and Income Outcomes Results

CountryApproval by disinterested shareholders

Disclosure by Buyer

Disclosure by James

Independent review

Ex-ante disclosure

Ex-ante private control of self-dealing

United Kingdom 1 1.00 1.00 1.00 1.00 1.00United States 0 1.00 1.00 0.00 0.67 0.33Average English origin 0.48 0.62 0.95 0.48 0.68 0.58

France 0 0.00 0.50 0.00 0.17 0.08Spain 0 0.33 1.00 0.00 0.44 0.22Average French origin 0.19 0.30 0.63 0.19 0.37 0.28

Germany 0 0.33 0.50 0.00 0.28 0.14Japan 0 0.33 1.00 0.00 0.44 0.22Average German origin 0.14 0.38 0.43 0.36 0.39 0.27

Sweden 0 1.00 0.00 0.00 0.33 0.17Average Scandinavian 0.00 0.73 0.40 0.20 0.44 0.22

Average Civil Law 0.16 0.37 0.55 0.24 0.38 0.27World Average 0.25 0.44 0.67 0.31 0.47 0.36

Common vs. Civil 2.98 2.28 4.73 2.05 4.23 4.00French vs Common 2.31 2.68 3.74 2.31 4.05 3.42French vs German 0.36 0.62 1.60 1.23 0.20 0.15French vs Scandinavian 1.04 2.36 1.28 0.01 0.59 0.46

Common vs. Civil 0% 3% 0% 4% 0% 0%French vs Common 3% 1% 0% 3% 0% 0%French vs German 72% 54% 12% 22% 84% 88%French vs Scandinavian 30% 2% 21% 95% 56% 65%

T-Stat -- Significance level

T-Stat (numbers in bold are significant at 10%)

Ex-Post Control of Self-DealingEx-Ante Ex-Post Public Enforcement Regulation and Income Outcomes Results

CountryDisclosure in periodic

filings

Standing to sue

RescissionEase of

holding Mr. James liable

Ease of holding approving body

liable

Access to evidence

Ease of proving wrongdoing

Ex-post private control of self-dealing

Anti-self-dealing index

Australia 0.80 1.00 0.33 0.00 0.50 0.75 0.45 0.63 0.76United Kingdom 1.00 1.00 0.50 1.00 0.50 1.00 0.80 0.90 0.95United States 1.00 1.00 1.00 1.00 1.00 0.75 0.95 0.98 0.65Average English origin 0.78 0.90 0.52 0.62 0.74 0.75 0.70 0.74 0.66

France 0.80 1.00 1.00 0.00 0.50 0.25 0.55 0.68 0.38Spain 0.60 1.00 0.00 0.50 0.50 0.25 0.45 0.53 0.37Average French origin 0.42 0.56 0.08 0.30 0.34 0.43 0.34 0.38 0.33

Germany 0.40 1.00 0.00 0.50 0.50 0.25 0.45 0.43 0.28Japan 0.80 1.00 0.00 1.00 1.00 0.75 0.75 0.78 0.50Average German origin 0.56 0.86 0.00 0.39 0.46 0.51 0.44 0.50 0.38

Sweden 0.40 1.00 0.00 0.50 0.50 1.00 0.60 0.50 0.33Average Scandinavian 0.56 0.80 0.00 0.60 0.50 0.80 0.54 0.55 0.39

Average Civil law 0.47 0.67 0.05 0.35 0.39 0.49 0.39 0.43 0.35World average 0.56 0.74 0.19 0.43 0.49 0.56 0.48 0.52 0.44

Common vs Civil 3.89 2.12 6.95 3.02 4.35 4.26 6.40 6.05 6.29French vs Common 4.13 2.80 5.18 3.24 4.26 5.58 6.72 6.26 5.86French vs German 1.37 1.97 1.13 1.06 1.59 1.12 2.09 1.98 0.98French vs Scandinavian 0.89 0.99 0.67 2.30 1.47 4.15 2.77 1.73 0.73

Common vs Civil 0% 4% 0% 0% 0% 0% 0% 0% 0%French vs Common 0% 1% 0% 0% 0% 0% 0% 0% 0%French vs German 18% 6% 27% 30% 12% 27% 4% 5% 33%French vs Scandinavian 38% 33% 51% 3% 15% 0% 1% 9% 47%

T-Stat (numbers in bold are significant at 10%)

T-Stat -- Significance level

Public EnforcementEx-Ante Ex-Post Public Enforcement Regulation and Income Outcomes Results

Applicable fines Prison term Applicable fines Prison term

Australia 1.0 5.0 0.0 0.0 0.5United Kingdom 0.0 0.0 0.0 0.0 0.0United States 0.0 0.0 0.0 0.0 0.0Average English origin 0.43 1.14 0.33 1.43 0.32

France 1.0 5.0 0.0 0.0 0.5Spain 1.0 3.0 1.0 3.0 1.0Average French origin 0.44 2.39 0.34 1.98 0.42

Germany 1.0 5.0 1.0 5.0 1.0Japan 0.0 0.0 0.0 0.0 0.0Average German origin 0.50 3.36 0.36 2.64 0.48

Sweden 1.0 2.0 1.0 2.0 1.0Average Scandinavian origin 0.60 2.40 0.60 0.80 0.55

Average civil law 0.47 2.66 0.37 2.05 0.45World average 0.46 2.22 0.36 1.87 0.41

Common vs Civil 0.32 1.94 0.31 0.81 1.15French vs Common 0.06 1.57 0.08 0.66 0.84French vs German 0.38 0.90 0.09 0.72 0.42French vs Scandinavian 0.66 0.01 1.09 0.95 0.60

Common vs Civil 75% 6% 76% 42% 26%

T-Stat

T-Stat -- Significance Level

Country

Disclosure and approval requirements were metApproving parties Mr. James Public

enforcement index

Results Development of Stock Markets

Economic Effects:Stock Market Cap and Self-Dealing

CountryStock market

capitalization to GDPListed firms per

million populationIPOs to GDP

Block premium

Ownership concentration

Average English origin 85.5 32.6 3.7 4% 44%

Average French origin 42.0 19.6 1.7 16% 55%

Average German origin 48.9 24.2 4.8 15% 34%

Average Scandinavian 90.4 69.4 3.4 2% 37%

Average Civil law 48.6 25.7 2.54 14% 49%World average 59.4 27.7 2.97 11% 47%

Ex-ante anti-self-dealing 32 ppts 1.7 ppts -9 ppts

Ex-post anti- self-dealing 34 ppts 67% 1.8 ppts -10 ppts -9 ppts

Anti-Self Dealing Index 33 ppts 51% 2.0 ppts -10 ppts -9 ppts2 sd = Belgium or Taiwan --> Sing (ex-post)

Table VIII: Economic Impact of Indicators

Table VII: Economic Impact of Indicators

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..

Netherlands

Venezuela

Philippines

Egypt

Mexico

Germany

Brazil

Switzerland

Austria

Norway

SwedenSpain

Turkey

Korea (Rep.)

JapanDenmark

Czech Rep.

France

Argentina

PolandFinland

United States

Portugal

PeruItaly

Taiwan

Chile

Indonesia

ColombiaSouth Africa

Canada

Israel

New Zealand

Thailand

Australia

Hong KongSingapore

MalaysiaUnited Kingdom

-.2

0.2

.4R

esid

ual b

lock p

rem

ium

-.4 -.2 0 .2 .4Residual anti-self-dealing index

coef = -.17912243, (robust) se = .07763217, t = -2.31

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..

Tunisia

Netherlands

Ukraine

Venezuela

Ecuador

Panama

Jordan

Mexico

Uruguay

Egypt

GermanyHungary

PhilippinesSwitzerland

Iceland

Bolivia

GreeceLuxembourg

AustriaBrazil

KenyaCroatia

SwedenNorway

Latvia

Spain

France

Lithuania

El SalvadorDenmarkCzech Rep.

Jamaica

Japan

Argentina

Korea (Rep.)

Slovak Rep.

Turkey

Uganda

Poland

Zimbabwe

Finland

Russia

KazahkstanBelgium

Romania

Italy

Portugal

Sri Lanka

Nigeria

Pakistan

United States

PeruTaiwan

India

Morocco

Chile

Ghana

Colombia

Canada

IndonesiaIreland

Israel

Bulgaria

South AfricaAustralia

China

New Zealand

Hong Kong

Thailand

Singapore

United Kingdom

Malaysia

-4-2

02

4R

esid

ual L

n(f

irm

s-t

o-p

op

ula

tio

n)

-.6 -.4 -.2 0 .2 .4Residual anti-self-dealing index

coef = 1.0847465, (robust) se = .48839839, t = 2.22

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..

NetherlandsJordan

Ecuador

Venezuela

Mexico

Philippines

Germany

Egypt

Switzerland

Uruguay

Greece

Brazil

NorwayAustria

KenyaSweden

Japan

Denmark

Spain

Korea (Rep.)

France

Turkey

Argentina

Zimbabwe

United States

Belgium

Finland

Nigeria

Sri Lanka

Portugal

PakistanIndia

Taiwan

Italy

Peru

Chile

IrelandIndonesia

South Africa

Canada

Colombia

IsraelNew Zealand

Hong Kong

Singapore

Australia

United Kingdom

Thailand

Malaysia

-4-2

02

46

Resid

ual IP

Os-t

o-G

DP

-.6 -.4 -.2 0 .2 .4Residual anti-self-dealing index

coef = 4.1412864, (robust) se = 1.7922779, t = 2.31

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..

NetherlandsPhilippines

Japan

France

Egypt

Ecuador

Korea (Rep.)

GermanyDenmark

Jordan

Switzerland

United States

Austria

Sweden

Greece

Spain

Finland

Venezuela

Uruguay

Nigeria

KenyaBrazil

Sri Lanka

India

TurkeyMexico

Pakistan

PortugalNorway

Belgium

Zimbabwe

Italy

Peru

Argentina

Taiwan

Canada

Chile

Israel

Ireland

Singapore

New Zealand

Hong Kong

Indonesia

South AfricaMalaysia

United KingdomAustralia

Colombia

Thailand

-.4

-.2

0.2

.4

Resid

ual ow

ners

hip

concentr

ation

-.5 0 .5 1Residual ex-ante control of self-dealing

coef = .00438356, (robust) se = .05628251, t = .08

Netherlands

Venezuela

Mexico

Jordan

EcuadorNorway

Uruguay

BrazilGermany

Greece

Argentina

Egypt

Switzerland

Kenya

Philippines

Sweden

Austria

ColombiaSpain

Turkey

Denmark

Zimbabwe

Korea (Rep.)

South Africa

Japan

Belgium

Indonesia

France

Australia

Thailand

Taiwan

Ireland

Finland

Italy

New Zealand

Hong Kong

Chile

Peru

United Kingdom

United States

Portugal

Singapore

Pakistan

Nigeria

Malaysia

Sri Lanka

India

Israel

Canada

-.4

-.2

0.2

.4

Resid

ual ow

ners

hip

concentr

ation

-.4 -.2 0 .2 .4Residual ex-post control of self-dealing

coef = -.18501913, (robust) se = .06574837, t = -2.81

Table XInstrumental Variables Regressions

Stock market capitalization to GDP

Block premium Ln Firms / Pop IPOs / GDPOwnership

concentrationLn GDP/POP 19.6642

a-0.0192 0.6347

a1.0529

a-0.0288

b

[4.3327] [0.0166] [0.0981] [0.2187] [0.0125]

Time to collect on a bounced check -7.0659 0.0449b

0.1738 0.7530 0.0391[6.1241] [0.0226] [0.1455] [0.6423] [0.0274]

Anti-self-dealing index 144.0127a

-0.1340c

1.6940b

6.0566b

-0.1546[47.5366] [0.0720] [0.7966] [2.5357] [0.1067]

Constant -133.3304a

0.1209 -4.6080a

-13.0748a

0.5961a

[49.1809] [0.2638] [1.3773] [4.9534] [0.1840]Observations 72 39 72 49 49R-squared 0.40 0.30 0.46 0.36 0.27

Ln GDP/POP 0.0385b

[0.0154]Time to collect on a bounced check -0.0438

[0.0335]

English legal origin 0.3148a

[0.0500]Constant 0.2514

[0.2445]Observations 72R-squared 0.45Observations 72R-squared 0.43Robust standard error values in brackets

Panel A: Second-stage regression results

Panel B: First-stage regression results for anti-self-dealing index

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.

Netherlands

IcelandIreland

Brazil

Norway

Jamaica

Jordan

Slovak Rep.

Sweden

Finland

Singapore

IndonesiaMorocco

Philippines

UgandaSri Lanka

South Africa

Kenya

Zimbabwe

Turkey

Lithuania

Spain

Czech Rep.KazahkstanItalyHungary

GhanaRussia

Luxembourg

Tunisia

New Zealand

BelgiumRomania

Switzerland

Germany

France

India

Uruguay

TaiwanAustralia

Israel

Canada

Portugal

Chile

Peru

LatviaVenezuelaCroatia

United Kingdom

EgyptArgentinaPoland

China

Colombia

Denmark

UkraineBolivia

Bulgaria

Japan

Korea (Rep.)

Nigeria

Ecuador

Austria

Greece

El SalvadorPanama

Thailand

Malaysia

Mexico

Hong Kong

PakistanUnited States

-100

0100

200

300

Resid

ual S

tock-m

ark

et-

capitalization-t

o-G

DP

-10 0 10 20Residual prison term for Mr. James

coef = 1.2903484, (robust) se = 1.7627707, t = .73

The transaction is not disclosed

Italy

Iceland

Finland

Japan

Ireland

United States

United Kingdom

Taiwan

Hong Kong

NetherlandsArgentina

New Zealand

VenezuelaSlovak Rep.HungaryPanama

Colombia

Jamaica

Lithuania

BulgariaTurkey

Thailand

South Africa

Egypt

Jordan

Sri Lanka

El Salvador

Kazahkstan

PhilippinesChinaIndonesia

KenyaNigeriaGhana

PeruBolivia

Australia

France

Belgium

Greece

Uruguay

MexicoKorea (Rep.)CroatiaBrazil

Zimbabwe

India

Switzerland

Uganda

Denmark

PakistanLuxembourg

Austria

CanadaSweden

Norway

Israel

Germany

PortugalSpain

Singapore

Poland

Czech Rep.

Chile

Latvia

Malaysia

RomaniaEcuadorRussiaMoroccoUkraine

Tunisia-1

00

0100

200

300

Resid

ual S

tock-m

ark

et-

capitalization-t

o-G

DP

-.5 0 .5 1Residual index of public enforcement

coef = -13.808845, (robust) se = 14.548057, t = -.95

All requirements are met

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:

1. 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).

2. 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.

Canada

Zimbabwe

Singapore

Thailand

United Kingdom

Kenya

Malaysia

PakistanUganda

United States

Jamaica

Ghana

New Zealand

Australia

India

Sri Lanka

South Africa

Nigeria

Israel

Ireland

-.4

-.2

0.2

.4

Resid

ual anti-s

elf-d

ealing Index

-1 0 1 2Residual proportional representation

coef = .00284464, se = .0445713, t = .06

Common law countries

Morocco

Egypt

Jordan

Philippines

Chile

Tunisia

France

Korea (Rep.)

Taiwan

Mexico

Japan

El Salvador

Czech Rep.

Greece

SwitzerlandBrazil

Hungary

Germany

Bolivia

Spain

Italy

Iceland

Austria

Finland

Norway

Luxembourg

Venezuela

Denmark

Argentina

Belgium

Indonesia

TurkeyPeru

Uruguay

Ecuador

Netherlands

Poland

PortugalRomania

Colombia

Bulgaria

Sweden

-.4

-.2

0.2

.4

Resid

ual anti-s

elf-d

ealing Index

-2 -1 0 1Residual proportional representation

coef = .00701639, se = .02258909, t = .31

Civil law countries

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.

Norway

Switzerland

Belgium

Denmark

Greece

Czech Rep.

AustriaNetherlands

Korea (Rep.)

IcelandGermany

France

Colombia

BrazilLuxembourg

Sweden

Japan

Portugal

Mexico

Italy

Venezuela

Finland

South Africa

New ZealandUnited Kingdom

India

Australia

Canada

Ireland

Israel

United States

-.4

-.2

0.2

.4R

esid

ual anti-s

elf-d

ealing Index

-.5 0 .5 1Residual legal origin

coef = .41683502, se = .05142007, t = 8.11

High competitiveness of the legislature

Spain

Turkey

Chile

Peru

Uruguay

Argentina

Ecuador

Philippines

Taiwan

Bulgaria

Morocco

Hungary

Indonesia

BoliviaJordanEgypt

Tunisia

El Salvador

Poland

Romania

Ghana

Malaysia

Sri Lanka

Thailand

Zimbabwe

Singapore

Uganda

Jamaica

Pakistan

Kenya

Nigeria

-.4

-.2

0.2

.4.6

Resid

ual anti-s

elf-d

ealing Index

-.4 -.2 0 .2 .4 .6Residual legal origin

coef = .19178978, se = .08203781, t = 2.34

Low competitiveness of the legislature

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:

1. 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.

2. Anti-director rights index: (72 countries) • Advantage of continuity with many previous studies;

3. 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.

Correlations

Ex-a

nte

priv

ate

cont

rol s

elf-d

ealin

g

Ex-p

ost p

rivat

e co

ntro

l sel

f-dea

ling

Jail

Jam

es --

no

disc

losu

re

Publ

ic e

nfor

cem

ent

Anti-

self-

deal

ing

inde

x

Antid

irect

ors

inde

x (re

vise

d)

Disc

losu

re in

pr

ospe

ctus

Pros

pect

us li

abilit

y

Mar

ket

capi

taliz

atio

n to

G

DP

Ex-post private control self-dealing 0.3553

Anti-self-dealing index 0.8777a 0.7597a

Jail James -- no disclosure 0.1093 0.2030 0.1800Public enforcement -0.1591 0.0010 -0.1102 0.0487

Antidirectors index (revised) 0.3607 0.5879a -0.0360 0.0908 0.5522a

Disclosure in prospectus 0.5104b 0.6875a 0.2310 -0.1528 0.6733a 0.5916a

Prospectus liability 0.2213 0.5694a 0.0998 -0.0681 0.4247 0.4469 0.5479a

Market capitalization to GDP 0.2886 0.4554a 0.2393 -0.0099 0.4341b 0.2753 0.4938b 0.4262

Block premium -0.3412 -0.4758 -0.0286 0.2126 -0.4580 -0.2440 -0.5839b -0.4529 -0.4765

Ln(Firms / POP) 0.0671 0.4136b 0.1410 0.1664 0.2587 0.3206 0.4681c 0.4180 0.4940a

IPOs / GDP 0.2861 0.4195 0.2200 0.0344 0.3941 0.2227 0.4368 0.4246 0.6537a

Ln(GDP/POP) -0.0116 0.3284 0.2391 0.1694 0.1602 0.0718 0.1367 0.1700 0.5537a

Implications for the Interpretation of Legal Origin

I. Examination of legal rules gives further insight in pronounced differences in the way Common and Civil law protect investors:

1. 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.

2. Central difference between common and civil law: Ex-ante transparency in self-dealing.

3. Approaches appear to derive from long-standing legal principles which over time are incorporated into the statutes that we actually observe.

II. 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:

1. 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).

2. 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