In recent years, economists have devoted considerable attention to study- ing the economic significance of legal structures, including capital markets.
Most of this research has involved cross-country analyses, comparing different national legal structures with economic outcome variables. We begin by reviewing this existing literature.
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La Porta, et al. Studies
The most significant studies on the economic effect of foundational, cor- porate, and securities law have been conducted by Rafael La Porta and col- leagues at Harvard and elsewhere. The La Porta research has evolved in a manner that greatly informs the understanding of the relationship of law and corporate finance. The group’s studies touch directly on the particular aspects of basic, corporate, and securities law that we address in this book.
A key feature of these studies is their creation of independent variables to measure various types of law. While some of these independent legal vari- ables are rather rudimentary, they represent an important breakthrough for the empirical study of the effects of the law.
In its earliest stage, the La Porta research considered the economic significance of government very generally. In the late 1990s, they focused on legal origins, comparing common law nations with countries who devel- oped under different categories of foundational civil law traditions.2Their study found that nations of the common law tradition offered more legal protections to corporate shareholders and creditors, which in turn meant that those nations had more minority public shareholdings. Around this time, they also found that common law nations were significantly associ- ated with a higher quality of government, as measured by efficiency, rights, and the provision of public goods.3 These studies strongly suggested the practical importance of a nation’s basic foundational law, though their implications were somewhat murky. They left it unclear precisely what fea- tures of the common law yielded economic and government benefits, as compared with the civil law. Nevertheless, it seemed clear that something about legal administration and the courts had a substantial societal effect.
The La Porta group has produced an extensive series of articles about the importance of the law, but the next significant article for our purposes ana- lyzed the effect of corporate law protections on capital markets. In 2000, they explained why legal protections for minority shareholders were criti- cal to corporations’ abilities to obtain external finance.4 Two years later, they conducted an empirical cross-country analysis of the effects of legal shareholder protections.5This study found that companies in nations with greater shareholder protections had higher valuations. While it is difficult to capture the law in variables for quantitative analysis, the authors had developed both binary variables for specific provisions and a continuous summary variable.
The authors moved on to the study of securities laws. In another cross- country analysis, they broke down the components of securities law, coded national protections for these components, and tested them against mea- sures offinancial development.6While public enforcement of the securities
law and other variables appeared to play at best a modest role in financial markets, significant positive results were associated with mandatory dis- closure requirements and with the provision for easier private enforcement of the securities laws. They found that securities law requirements might be more significant for markets than the corporate law protection of investors.
Other Studies
Numerous other authors have studied the effect of various aspects of the law on capital markets, often using La Porta’s measures for the legal vari- ables to be analyzed. This category of studies has burgeoned in the last five years, both as published articles and working papers, and they have enhanced our understanding of the role of the law, primarily through cross- sectional studies of national laws. This section highlights some of these studies.
Researchers at the World Bank have done extensive analyses of capital markets and the effects of legal institutions. Ross Levine, after studying the importance of capital markets to overall economic growth, examined the effect of the law on financial markets and economic growth.7His analysis considered legal variables involving the efficiency of contract enforcement, treatment of creditors and accounting standards, including the data from La Porta, et al. and other sources. Levine found that contract enforcement, legal creditor protections, and financial disclosure all contributed to greater private financial markets.
With his World Bank colleagues, Levine has also sought to measure the relative effects of legal systems, politics, and national endowments (such as geography) for national financial development.8To capture the law, they used the La Porta, et al. standard of national legal origin, as well as their measure for shareholder rights and property rights protection. The authors found that the legal variables dominated the alternative explanations for financial development. In particular, legal origin was the strongest deter- minant, even after controlling for the other possible explanations of financial development, though there was some association for the political and endowment variables. Levine has also traced the chain of connections from original legal origin to greater financial development and economic growth.9Another study found that countries with greater corporate share- holder rights provided higher valuations for banks.10Other research by this group has confirmed this finding. For example, they have found that firms in countries with French legal origin face significantly higher obstacles in accessing external finance than firms in common law countries.11
A separate World Bank study tackled the question from a different angle. This study took a financial organization’s measure of the corporate
governance quality of individual firms in emerging countries and examined the effects of the law.12They found that companies had weaker corporate governance in countries with less shareholder protection and judicial efficiency. They also found that the quality of corporate governance was relatively more financially important in countries with weak legal protec- tions. This finding makes sense, as there would be more variation in gover- nance quality in such nations, and shareholders in these companies do not have the law as a backstop protection and must rely on strong reputational signals.
Omar Azfar and others have promoted a theme they call “market- mobilized capital,” which stresses the importance of free markets but also recognizes the important ways in which government can augment the market. A recent study examined the role of corporate law and creditor protections in augmenting capital markets, using the La Porta, et al. coding for particular provisions of corporate law and scores for creditor protec- tion.13 They found that the creditor and corporate laws had significant effects on national economic growth, operating through the growth of markets for debt and equity, even after controlling for a measure of law enforcement. The effect was a substantial one, even for the United States, in the hundreds of billions of dollars.
Other researchers affiliated with other groups have also pursued this course of study. A study associated with the Italian Centre for Studies in Economics and Finance examined the effect of legal variables, including La Porta, et al.’s origin of legal system and minority shareholder rights, as well as measures of judicial efficiency and rule of law.14In a series of tests of different groups of nations and different measures for financial variables, they found significant positive effects for the generalized legal variables, including legal origin and judicial efficiency but more ambiguous results for the legal protection of minority shareholder rights.
Additional research has shown that developing countries with weaker cor- porate governance protections tend to have thinner equity markets.15 The combination of corporate law and rule of law variables was associated with higher levels of market capitalization.16A number of studies have found that greater protection of minority shareholders tends to produce more public minority shareholding, and this in turn tends to yield more investment and lower cost of capital, with lessened risk.17As expected, they show that such protections assure investors and reduce the private benefits of controlling a corporation (whether for opportunism or mere self-protection). Another clue as to the nature of legal benefits is thefinding that there is much lessfirm- specific information absent shareholder rights, which undermines market efficiency.18A study specific to Poland found that corporate and securities laws enforced by executive regulators have stimulated rapid development of
securities markets.19 Other researchers have specifically examined laws against insider trading and found a positive economic effect, studies which will be examined in greater detail in Chapter 6.
A recent study examined the effect of laws on firms’ cost of capital, as implied in contemporaneous stock price and analyst forecast data, using different valuation models.20After constructing national cost of capital using the La Porta, et al. legal variables for rule of law and securities regu- lation, the authors created a factor analysis measure for the common dimension of some legal variables. They found that both the quality of a country’s basic foundational legal system and the securities laws were asso- ciated with a lower cost of capital, after using control variables for GDP, size of securities markets, and voluntary disclosures.
A separate path of research has examined the foundational law and its eco- nomic effects. A number of studies have been done on national protection of property rights and its economic effects, though most of these studies examine very broad dependent variables such as national economic growth, rather than financial markets. One published study did examine multiple measures of property rights (including survey measures), integrated with financial development, and found that higher protection for property was consistently associated with more efficient allocation of capital.21
The association between legal rules and financial development has gen- erally survived the introduction of new control variables. For example, some authors hypothesized that the differences among nations might truly be a feature of religious culture. They found that religion was indeed a significant determinant of the laws involving creditor rights but that legal origin was more important than religion in explaining laws protecting equity holders.22 The studies have employed a number of alternative control variables, such as ethnolinguistic fractionalization, settler mortal- ity for the legal origin tests, gross domestic product, and other controls.
The cumulation of these studies strongly suggests that law plays a significant role in the growth of external finance. They have found that basic contract laws, creditor protections, corporate laws, and securities laws all contribute to the success of financial markets. Not only are the studies generally consistent, but they have used different dependent variables, different control variables, and to a lesser degree, different sets of nations, which lends greater confidence to their general findings. By its nature, such social scientific research is not totally conclusive, and the studies have some limitations. For example, they tend to be heavily dependent upon the La Porta, et al. coding of the law for independent variables. While there is no particular basis for criticism of the use of this coding, it might be affected by some other unmeasured variable, and further analyses, using different measures, would be beneficial. Moreover, some analyses over time have
found little association between the law and financial measures. These findings, though, could simply reflect a failure to capture quantitatively the true influence of the law, which can be a daunting endeavor.