Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer

Harvard University

Robert W. BishnyUniversity of Chicago

Presentation by Dae-hee Kim

I. Overview of the Issues

Traditional Finance(1958) SECURITIES are recognized by CASH FLOWS

Recent Financial Research (1995) SECURITIES are defined by the RIGHTS they bring to their owners

Co-Authors’ View LAW and the QUALITY of its enforcement are potentially important

determinants of WHAT RIGHTS SECURITY HOLDERS HAVE and how well these rights are PROTECTED

The differences in legal protections of investors in different countries are key to the different ways firms are financed and owned

I. Overview of Study

Empirical Study on 49 Countries how their laws differ how their quality of enforcement varies whether they matter for corporate ownership patterns

Legal Family Tree

II. Countries, Legal Families, and

Legal Rules COUNTRIES Samples: countries with some nonfinancial

firms traded on their stock exchanges49 countries from Europe, North/South America,

Africa, Asia, AustraliaNo socialist or “transition” economiesIncluded if

○ on the basis of both WorldScope and Moody’s International samples,

○ had at least 5 domestic nonfinancial publicly traded firms with no government ownership,

○ in 1993

II. Countries, Legal Families, and Legal Rules

LEGAL FAMILIES

II. Countries, Legal Families, and Legal Rules

LEGAL RULES Co-authors only regard laws pertaining

to investor protection, esp. company and bankruptcy/reorganization laws

Legal relations b/t corp. insiders & corp.

Legal relations b/t corp. & certain outsiders (creditors)

II. Countries, Legal Families, and Legal Rules

LEGAL RULES Co-authors do not discuss

Merger and takeover rules ○ except indirectly by looking at voting mechanisms

Disclosure rules ○ except quality of accounting standards

Regulations imposed by security exchanges○ except exchange-imposed restrictions on the

voting rights for the shares that companies can issues if they are to be traded on the exchange

Banking and financial institution regulations

II. Countries, Legal Families, and Legal Rules

SOME CONCEPTUAL ISSUES? Skeptical that legal rules are binding in most instances, since firms can opt out

! It may be costly for firms to opt out of standard legal rules, since investors might have difficulty accepting nonstandard contracts and judges might fail to understand or enforce them

? Whether more restrictive rules are necessarily more protective of shareholders than the alternative of greater flexibility! Unless enforcement is perfect, simple, restrictive, bright-line rules

which require only a minimal effort from the judicial system to enforce, may be superior

? Even if legal rules matter, these rules could merely be reflecting the differences in some other, exogenous conditions across countries

! Countries typically adopted their legal systems involuntarily. Even when they chose a legal system freely, the critical consideration was language and broad political stance of the law, rather than the treatment of investor protection. Therefore, the legal family can be treated as exogenous to a country’s structure of corporate ownership and finance.

If legal rules, financing and ownership patters are all found to differ substantially across legal families, there is a strong case that legal families, as expressed in the legal rules, actually cause outcomes.

III. Shareholder Rightsto Consider for Investor Protection1. Remedial Rights

One-share-one-vote rule• Better protection when dividend rights are tightly linked to voting rights

2. Antidirector Rights

① Voting by shareholder or authorized representative vs. mail proxy vote directly to firm

② Require shareholders deposit their shares with company or financial intermediary prior to a shareholder meeting, to be kept in custody

③ Allow cumulative voting for directors or have mechanisms of proportional representation on the board, by which minority interests may name a proportional number of directors.

④ Give minority shareholders legal mechanisms against perceived oppression by directors

⑤ Grant preemptive right to buy new issues of stock, which can be waived only by a shareholder vote

⑥ Percentage of share capital needed to call an extraordinary shareholders’ meeting:

Low (Japan 3%) vs. High (Mexico 33%)

3. Right to Mandatory Dividend May be legal substitute for the weakness of other protection of minority shareholders.

III. Shareholder RightsFindings

Common-law countries afford best legal protections to shareholders

French-civil-law countries afford worst legal protections to shareholders

IV. Creditor Rightsto consider for (secured) creditor protection1. Secured creditors can pull collateral from firms being

reorganized without waiting for completion of reorganization

2. Assure secured creditors the right to collateral in reorganization

3. Creditor consent is needed to file for reorganization (as opposed to Chapter 11)

4. Management is replaced by a party appointed by the court or the creditors

5. Remedial creditor rights measure: the existence of a legal reserve requirement which forces firms to maintain a certain level of capital to avoid automatic liquidation

IV. Creditor RightsFindings

Common-law countries offer creditors stronger legal protections against managers

French-civil-law countries offer creditors the weakest protections

On some measures, countries in the German-civil-law family are strongly pro-creditor

Scandinavia, in overall, is a bit lower than that of the German family but higher than that of the French

Evidence indicates that these results are not a consequence of richer countries’ having stronger investor rights; creditors have the weakest protections in these countries

V. EnforcementCriteria (and Findings) for determination of protection

Private credit risk agencies for the use of foreign investors interested in doing business in respective countries

Law enforcement proper: Efficiency of judicial system, Rule of law

Government’s stance toward business: Corruption, Risk of expropriation and Likelihood of contract repudiation by government

Quality of a country’s accounting standards

A strong system of legal enforcement could substitute for weak rules since active and well-functioning courts can step in and rescue investors abused by the management.

V. EnforcementFindings

Level of per capita income may have a more important confounding effect than it did for the laws themselves.

By every single measure, richer countries have higher quality of law enforcement.

Once income is controlled for, French-civil-law countries still score lower on every single measure

VI. Ownership Hypothesis: Companies in countries with poor investor

protection have more concentrated ownership of their shares Large, or even dominant, shareholders who monitor the

managers might need to own more capital, cetris paribus, to exercise their control rights and thus to avoid being expropriated by the managers.

When poorly protected, small investors might be willing to buy corporate shares only at such low prices that make it unattractive for corporations to issue new shares to the public.

* Led by East Asia, where company law has been significantly influenced by US

VII. Conclusion Laws differ markedly around the world

Though in most places they tend to give investors a rather limited bundle of rights

Law enforcement differs a great deal around the world The data support the hypothesis that countries develop

substitute mechanisms for poor investor protection Some are statutory, others regarding ownership concentration Good accounting standards and shareholder protection

measures are associated with lower concentration of ownership

CIVIL LAWS COMMON LAWSFrench German/

Scandinavian

Legal Investor Rights Weaker Stronger

Protection (Shareholders, Creditors)

Weakest In Between Strongest

Quality of Law Enforcement Lowest Highest Next Highest