FINANCE AND ECONOMICS The law of the market Economists have long argued that legal systems have a big impact on in- Sesument Uni now, they have had etough ime proving [IMAGINE at you hae 9 ite era money to invest, and that you are choosingbetween the shares oftwo differ entcompanies.Oneisin country where Rafael La Porta, Florencio Lopex-desi- small shareholders have trong legal pro- lanes and Andrei Shleifer of Harvard tections; the other is in a country where University, and Rober Vishny of the Uni- shareholders have no such rights, and versity of Chicago—take a detailed look: ‘where the few laws that doexistto protect the legal systems of 49 countries, and ex- them areonly weakly enforced, Which do amine the ways in which those laws affect you investin? thesize and breadth of capital markets. No, this is not a trick question. But They classify countries into four dif ‘economists have had difficulty proving ferent types of legal system, based on the ‘what many investors claim: that coun- origins of thei legal codes, their colonial | ties which treat them poorly have a _historiesandsoforth. First there are those | harder time attracting their money. that rely primarily on English common ‘America and Britain, for example, are law, basing legal rules on case precedents hailed as bastions of shareholder capital» ——_ jsm. Yet Germany and Japan, which rely heavily on banks and treat lesser share- holders-with disdain, have also thrived, Do shareholders rights really make a dif- ference to economic performance? ‘The reason this question isso difficult toanswerisbecauseitishard tosay defin- itively which laws are best for investors Jn Some cases laws that make it easier for investors to sell their shares or receive timely information may limit firms free- dom to pursue. profitable. strategies, Moreover, most big firms are riddled with conflicts of interest among manag- and judges opinions. These countries in- ers creditors and shareholders. Defining clude Britain and its former colonies, the rights of these groups in a way that ranging from America and Canada 10 ‘maximises a firm’s value is tricky busi- Australia, Hong Kong and Singapore. ness, and the right solution will bediffer- The main alternative to common law || entfor different kinds of firms. is civil law. Based on the classifications of For these reasons, many legal experts _legalscholas, the economists divide civil- argue that itis the strength ofa country’s law counties into three groups. Indone- |_ stockmarket thatdetermines its company sia, Mexico and Spain, for example, are | laws, not the other way round, Frank classified as French civiblaw countries. Easterbrook, a prominent American ju- Several East Asian nations, including Ja- ristymakesthiscaseinarecentaticletHe pan, South Korea and Taiwan, are reck- argues thatin countries with deep, liquid oned to have German-type systems. The capital markets, managers are subject to Seandinavian countries form a third constant stockmarket pressures. Where group unto themselves. such markets are absent, however, inves- The authors then construct several in- tors _must restrain managers in other dices of shareholders’ rights, and classify ways, such as by giving more power to every country according to which protec- | banks and other big institutions. Thus, tions ithas. For example, some countries the laws that determine investors rights allow firms to issue non-voting shares 0 ‘may respond to, rather than determine, small shareholders, orto dilute their vot ‘theeconomic environment. ing power in other ways. Only 1 ofthe 49, | _Annewly published paper’, however, countries give equal voting powers 0 ev- casts doubt on this theory. The authors eryshare. Even if every share carries equal vot: + “lmemation Cope Difencs Mates or ing power, itis easier to exercise those ‘sea fed Como ant Ws phn some eats than ae 7a oneminans of teal Finance" furl Japan for example,ashareholder mustbe rane chong Dresentatacompany’s general meetingto tee OMI FOC 108 ‘exercise his vote Since around 80% of ap- ‘nese firms hold their meetings during the same week, voting rights are practi- | cally worthless Moreover, it is easier for shareholders to demand a general meet- ing in some countries than in others. In ‘America, it takes only 1% of shareholders todoso; in Mexico, it takes 33% ‘The results of this analysis ae stark First, the economists find, common-law countries are far more protective ofshare- hholders than civiblaw countries. And sec- | ‘ond, among civiblaw countries, those based on the French system are by far the worst. Common-law countries are also ‘more protective of creditors, though the fap over German-law countries is less pronounced, and they do a better job than civiHaw countries of enforcing the lawson their books. French-law countries trail the pack on these counts as well Civil injustice Investors do not ake this ying down n the ypical_commondaw county, the value of the stockmarket is equal 10 round 60% of ne. In eviblaw coun- tres, the authors find, markets end tobe far smaller. Frenchlaw counties, fore ampleyhave an average marketcaptalise tion ratio ofonly a1 of en ee char “This pool of willing investors makes bigaliference tofirms tying raise cash Asa result while common-law countries boast 35 listed companies for im mem bers ofthe population, French eivibiaw countries have only ten. The ability to raise cash isespeciallyimponant for new companies. For every 1m people, com ‘monaw countries average around 22 intial publicoferngs(new company fo- tations) a year. Countries with a French- | | | | | style legal tradition average less than a tenth that. ‘The message seems clear. Countries ‘with common-law legal systems treat in- -vestors well,and their companies havean ‘easy time raising capital. Those with Frenchlaw systems, by contrast, fail 10 protect investors, with predictable result, ‘Ofcourse, many factors other than the legal environment determine the health cof a countrys financial system. Growth is an obvious one: as a share of output, America’s sockmarket capitalisation is actually below the average for common- law countries many of which are rapidly. | growing Asian economies. Butto those in- vestors who have been clamouring for le- fal reforms in many countries, the evi- dence in favour oftheir argument is at Jastbeginning to mount.