Here’s a fascinating abstract from the National Bureau of Economic Research (US) Working Paper.
Investor expropriation¢â¬âalso known as self-dealing or tunneling¢â¬âtakes such forms as excessive executive compensation and perquisites, transfer pricing, insider trading, self-serving transactions, and outright theft. In The Law and Economics of Self-Dealing (NBER Working Paper No. 11883) . . . the focus is on the kinds of cases in which controllers of companies make deals that may benefit them at the expense of other investors, but in which¢â¬âunlike in the Enron and Parmalat scandals¢â¬âthe controllers observe the laws regarding disclosure and approval procedures. One of the primary questions the researchers ask is: if a controlling shareholder wants to enrich himself without breaking the law, how difficult is it for minority shareholders either to thwart the deal or, if it is carried out, to recover damages?
In order to determine which nations best protect minority shareholders from such abuses – and to ascertain how those protections affect a nation’s financial development – the researchers create a hypothetical scenario in which a corporate officer who owns large portions of two companies engages in a self-dealing sales transaction between the firms that benefits the officer via an inflated payment. They presented this scenario to members of Lex Mundi, an association of international law firms that operates in 108 countries. The lawyers were asked to describe the legal barriers in their countries to getting away with such a transaction. Lawyers from 102 countries provided complete answers to the researchers’ questionnaire. The researchers conducted follow-up inquiries, and the sample they used for this paper was based on the responses of 72 lawyers who confirmed the validity of the aggregate data.
The lawyers were asked to describe the minimum legal requirements in force in May 2003 regarding who approves a transaction such as described in the hypothetical scenario; what needs to be disclosed to the board of directors, the stock exchange, and the regulators; the duties of corporate officers, directors, and controlling shareholders; how the transaction’s validity could be challenged; what plaintiffs would need to prove to recover damages; access to information; fines and other penalties, and the like. Based on the data, the authors reached several conclusions. Primary among these is that the index for minority shareholder protection is sharply higher in common law countries, such as the United Kingdom (which ranks fifth on the anti-self-dealing index), than in civil law countries, such as Italy (forty-second on the index). This is consistent with earlier studies that concluded that investor protection is higher in common law countries than in civil law ones.
The researchers also were interested in how the regulation of self-dealing might relate to the development of a nation’s stock market. It was also clear that the index is a statistically significant and economically strong predictor of a variety of measures of stock market development across countries. Foremost among these measures is the ratio of stock market capitalization to GDP. The index results support earlier findings that demonstrated that common law countries have much more valuable stock markets relative to their GDPs than do civil law countries. The results also show that theoretical measures of investor protection are closely linked to financial development.
The researchers could not isolate a single “best” measure of shareholder protection, but concluded that measures of shareholder protection from securities laws appear to work best in terms of predicting stock market outcomes; the data for this, however, was available for only 49 countries. These measures moreover are particularly appropriate for studies of protection of investors buying securities, as opposed to corporate governance per se.
The researchers say that perhaps the most basic conclusion from their data is that laissez-faire – having no public regulation or oversight at all – is certainly not conducive to developing financial markets. Countries with successful stock markets mandate that shareholders receive the information they need and the power to act – including both voting and litigation – on this information.
The empirical results further suggest that an effective strategy of regulating large self-dealing transactions is to combine full disclosure of such transactions with the requirement of approval by disinterested shareholders. Similarly, the results suggest that ongoing disclosure of self-dealing transactions, combined with a relatively easy burden of litigation placed on the aggrieved shareholders, also benefits stock market development.
Finally, the evidence suggests that the government’s power to impose fines and imprisonment for self-dealing transactions that meet disclosure and approval requirements does not benefit stock market development. The authors stress that this is a narrow conclusion, since it does not address the importance of public enforcement in situations where self-dealing transactions are concealed, as in the cases of Enron and Parmalat. To avoid self-dealing, however, it appears best to rely on extensive disclosure, approval by disinterested shareholders and private enforcement.
This is interesting, but I am not sure what, if anyrhing, it says about corporate governance or about the difference between common law and civil law.
We can posit a range of reasons why the difference might occur; the most obvious is that the common law is an english invention and that for a long time london was the centre of world trade, and that even when it lost its position it retained an important place for doing business and for litigation about mercantile issues. This is a position it still has, to some extent. If that is right, then it may be that it is not the form of law that makes the difference, but the substantive content, and the english had more time and more resources to get the content right, and we inherited it.
This process may have received a boost from the american polity, which has always had (but not always observed) a tradition of open discussion, transparency and disclosure.
(The australian experience probably instilled a fear of being dudded in the rest of the common law world, but not more than that.)
I cannot see anything in and of common law itself that would make for better corporate behaviour.
Has anybody paid to read the entire article? does any body know on the ground how much different it is to be involvd in, say, an italian or french company to an australian or american or english one?
You would also need to look at the way the questions were framed to see whether they created an inherent bias in favour of US/UK-style corporate governance solutions and against those employed in European countries. And whether a questionnaire framed and answered in English (as I assume this was) gave English-speaking lawyers an advantage in explaining and justifying the efficacy of their own system by comparison with French, German or Danish lawyers. I can’t claim any particular expertise in corporate governance issues, but in view of Enron, HIH etc etc I’m instinctively suspicious of claims that “common law” solutions to corporate governance are manifestly superior. I seriously doubt that it’s true, although the point Richard Phillips makes may well account for some degree of evolved superiority in British regulatory systems given that country’s long-time position as a key world mercantile and financial centre. If that’s all the study is saying I suggest it’s tritely true, but if they’re claiming that the alleged virtues of the common law have somehow miraculously transferred those advantages to other common law countries as well in the corporate governance area, I’d take a lot of convincing. I’d be looking closely and sceptically at the research methodology. Moreover, AFAIK corporate governance regulation in Australia, UK and the US mostly isn’t an artefact of the common law anyway, it’s a complex top down legislative response to every bit as great an extent as in civil law countries.
In a more general sense, is anyone aware of research from other areas of endeavour showing that the regulatory responses of bureaucrats in common law countries are more effective than those by bureaucrats in civil law jurisdictions? Does the existence of a common law system spawn a distinctively different style of regulation than a civil law system? I simply don’t know, and I might well be completely wrong, but as Richard commented, I can’t on the face of it see any inherent quality of a common law (i.e. predominantly judge-made, precedent-based) system that could be expected to generate superiority of regulatory response. It looks more like jingoism dressed up as social science.
Ken and Richard,
I didn’t read the abstract as necessarily making quite a few of the claims you attribute to it.
1) They do use ‘common law’ to describe certain systems – as is common practice, but that identifies countries of a certain legal tradition. That doesn’t necessarily demonstrate that it’s common law that has done it – the way lawyers in ‘common law’ countries interpret that term (ie judge made law). Certainly a lot of the commercial law and certainly most of the securities law that I’m aware of is statutory rather than judge made and they seem to be focused in securities law.
2) However if the english speaking (and common law) countries have much more highly priced equities markets than the ‘civil law’ countries, then that’s a pretty significant fact in itself and strongly suggests the greater efficiency of those markets – higher equity prices mean lower costs of capital.
3) As I understand it, in some European markets (eg Germany) there are strong cross holdings by banks and so, like Korea there are to some extent ‘families of companies’. It may be that these mechanisms both reduce equity prices (which is likely to depress efficiency by raising the cost of capital) but at the same time mean that ‘self-dealing’ is not directly regulated away (perhaps market structures provide other safeguards).
Hi Nicholas
Your point 3 is exactly the sort of thing I had in mind. It may be that at least some European markets don’t have quite as stringent a code against self-dealing because there are other structural or cultural reasons that make it unnecessary. And it may well be that those reasons also explain their lower priced share markets, as you suggest. But if that’s the case, you’d wonder what useful purpose the research actually serves.
Welcome to economics Ken!
All that mathematical apparatus without much attention to qualitative issues.
But that may not be fair, I’ve not forked out the money to read the paper and the authors probably have some qualitative discussion in there. It’s a question of how penetrating it is and I wouldn’t hold my breath. But I still think the research is very interesting. It turns up some interesting facts and I like its biases – which are that if you want capital markets to work well, investors need good protection from bad behaviour and good information. After that it’s such a big and complex topic that any contribution will be subject to the kinds of concerns you raise.
We may well be able to see a real time experiment in all of this. India is (I over-simplify) a common law country. China is not. Both those babies are just starting to flex their economic muscles, and it may be interesting (to those of us who live another 70 years) to see what happens to their respective stock markets.
Sorry if I suggested that the article was purporting to carry more weight than it did. In part I am a bit used to claims being made about the superiority of the “inquisitorial” civil law criminal jurisdictions, and I was wondering how civil law could make much difference in regulation of equities.
Nicholas is right when he says that, as a matter of form, civil and common law corporations law is similar, because both are, in effect codified, which is not the same in relation to, say, criminal law or contract law.
I still think, without wishing to be jingoist about it, that the idea that there are cultural structures that make for more wealth is interesting. For example, we now have a duty to E Timor, PNG, and perhaps other places to show them how to make a go of it, so they can develop vigorous and self-reliant capitalist economies. what aspects of UK or US or Aus culture should we encourage them to emulate?
BTW, I understand that Louisianna still has, basically, the Code Napoleon. Apart from their superiority in zzydeco music and chilli, do they have a better developed system of securities regulation?
We don’t know about Louisianna’s prowess at securities regulation because securities regulation iin the US is a Federal responsibility. Corporate regulation (broadly the respective duties of insideres to each other within a corporation – management to shareholders for instance – is governed by state law. In that area Delaware has the jump on all the other states hosting around 50 percent of the largest corporations. There’s vigorous competition between states to host corporations, so if there was a particular strength in Louisianna’s Code Napoleon, maybe it would host 50 percent of US corporations instead of Delaware.
Didn’t Rupert Murdoch choose to move Newscorp to Delaware supposedly because he concluded it had extraordinarily lax corporate governance laws that would allow him and other senior executives to get away with self-dealing even more successfully than they had managed in Australia? Or am I thinking of some other Murdoch? I wonder how that squares with the research conclusions about strong corporate governance in common law countries, based on questionnaire responses from the large law firms that make their money out of servicing companies like Newscorp? Might they be gilding the lily just a tad?
It’s a very interesting question Ken on which there’s a lively debate. Certainly plenty of scholars have argued that Delaware just panders to management desires to do down shareholders. The problem with this argument is the econometrics. If that’s the case, then you’d expect share prices to fall on listing in Delaware. Typically they don’t fall and on average they rise a little. If anyone’s interested in the for and against cases, I can send them a neat article on each side of the debate.
Me? Before I read the literature I would have assumed that investors might have to be protected from what it’s possible for corporations to do in Delaware. But I’m thinking now that maybe they can look after themselves. But who knows. The point is that if you have decent securities law, it’s easier to see how the laws of demand and suppy (for funds for corporations) might work in quite a healthy way. If Delaware lets managers self-deal too heavily, invest in the 50% of corporations that are not registered in Delaware.
But I’ve still got an open mind.
Sorry I meant corporate regulation.
NIcholas can you post the for and against arguments on Delaware corporations? or the links? ta.
I still suspect that a lot of this is cultural. It may well be that mogul X or Y incorporates in Delaware, but there is probably a view that you should still buy equities in that company because mogul X is clever and look! he incorporates in Delaware which just shows how clever he is. I remember having a discussion with some relatives in rural qld who are interested and involved share purchasers. They were also great fans of the late Rene Rivkin, and they just viewed each exposure of his shenanigans as proof of his cleverness.
In passing, is the victory of the reds just now proof that virtue is its own reward?