along the dimensions of shareholder protection,creditor protection,and labour regulation-for five countries,over a 35 year period.These are three parent systems,the UK,France and Germany;the world's most developed economy, the US;and its largest democracy,India. Our findings in this paper focus on the patterns of change within and between the indices we have constructed.We do not find that there are significant differences between the way in which legal change,as measured by our indices, occurs in civil and common law jurisdictions.Instead,our results also show that the pattern of change differs depending on the area of law under examination,with creditor rights and labour rights demonstrating much more divergence and heterogeneity than shareholder rights.We interpret this as casting doubt on the plausibility of the mechanisms that have been said to underpin the links posited between legal origins and financial development.The pattern of legal change in civil and common law countries implies that differences in the 'adaptability'of legal systems to changes in the wider economic context are unlikely to be a significant explanatory factor. The rest of this paper is structured as follows.In section 2,we review the law and finance research programme and motivate our current enquiry by identifying gaps in our understanding.Section 3 explains the methodology employed in the construction of our new longitudinal indices of legal institutions.Sections 4,5,and 6 present results relating to the development, respectively,of legal rules protecting shareholders,creditors,and employees. Section 7 synthesises the principal results and concludes. 2.The 'law and finance'research programme and its limitations 2.1 Principal claims Systematic research on the relationship between a country's legal institutions and its corporate governance and financial systems began only in the late 1990s with the pioneering and highly influential work of La Porta,Lopez-de-Silanes, Shleifer and Vishny ('LLSV':see La Porta et al.,1997,1998,1999a,1999b, 2000,2006,2007,2008;Johnson et al.,2000;Djankov et al.,2003,2007,2008; Glaeser and Shleifer,2002,2003;Botero et al.,2004).This literature connects with other recent work on the relationship between financial system and economic development (see Levine,1997;Beck et al.,2003a,2003b;Berkovitz et al.,2003;Pistor et al.,2003,Claessens and Laeven,2003).Moreover,this research has a significant practical importance because the World Bank uses it in order to asses and promote a particular way of legal development (World Bank,various years). 2
2 along the dimensions of shareholder protection, creditor protection, and labour regulation—for five countries, over a 35 year period. These are three ‘parent’ systems, the UK, France and Germany; the world’s most developed economy, the US; and its largest democracy, India.1 Our findings in this paper focus on the patterns of change within and between the indices we have constructed. We do not find that there are significant differences between the way in which legal change, as measured by our indices, occurs in civil and common law jurisdictions. Instead, our results also show that the pattern of change differs depending on the area of law under examination, with creditor rights and labour rights demonstrating much more divergence and heterogeneity than shareholder rights. We interpret this as casting doubt on the plausibility of the mechanisms that have been said to underpin the links posited between legal origins and financial development. The pattern of legal change in civil and common law countries implies that differences in the ‘adaptability’ of legal systems to changes in the wider economic context are unlikely to be a significant explanatory factor. The rest of this paper is structured as follows. In section 2, we review the law and finance research programme and motivate our current enquiry by identifying gaps in our understanding. Section 3 explains the methodology employed in the construction of our new longitudinal indices of legal institutions. Sections 4, 5, and 6 present results relating to the development, respectively, of legal rules protecting shareholders, creditors, and employees. Section 7 synthesises the principal results and concludes. 2. The ‘law and finance’ research programme and its limitations 2.1 Principal claims Systematic research on the relationship between a country’s legal institutions and its corporate governance and financial systems began only in the late 1990s with the pioneering and highly influential work of La Porta, Lopez-de-Silanes, Shleifer and Vishny (‘LLSV’: see La Porta et al., 1997, 1998, 1999a, 1999b, 2000, 2006, 2007, 2008; Johnson et al., 2000; Djankov et al., 2003, 2007, 2008; Glaeser and Shleifer, 2002, 2003; Botero et al., 2004). This literature connects with other recent work on the relationship between financial system and economic development (see Levine, 1997; Beck et al., 2003a, 2003b; Berkovitz et al., 2003; Pistor et al., 2003, Claessens and Laeven, 2003). Moreover, this research has a significant practical importance because the World Bank uses it in order to asses and promote a particular way of legal development (World Bank, various years)
The La Porta et al analysis is based on an empirical and theoretical evaluation of different legal systems,and has been conducted at two discrete levels of generality.The first,and more 'micro',hypothesis,is that the greater the protection afforded to minority shareholders and creditors by a country's legal system,the more external financing firms in that jurisdiction will be able to obtain (the 'quality of law'claim).If good legal institutions can reduce the risk of investor expropriation ex post,then investors will be more willing to advance funds ex ante.The second,and more 'macro',hypothesis,is that the quality of legal institutions varies systematically with the 'origin'of a country's legal system-that is,whether it falls into the Anglo-American common law',or Napoleonic (French-origin),German or Scandinavian 'civil law'systems (the 'legal origins'claim).La Porta et al contend that legal origins thus determine the financing of corporate growth,and through that and other channels,the nature of the financial system and ultimately,perhaps,overall economic growth. A key step in the empirical methodology has been to quantify variations,across countries,in the extent to which certain types of legal rule exist.The resulting indices allow the particular economic correlates of institutional persuasions to be discerned.The cross-sectional regression results accord with the predictions of both the quality of law and the legal origins claims.Specifically,countries using the French civil law system exhibit systematically less protection for minority shareholders,which is in turn correlated with concentrated share ownership;and corporations in common law countries (with stronger shareholder protection)pay out more dividends and have higher share prices than firms in civil law countries. Whilst the intuition underlying the quality of law'claim seems straightforward, it is less obvious why better'quality law should tend to be associated with common law systems.Two mechanisms have been articulated which may underpin the common law's alleged superiority (Beck et al.,2003a,2004;and Levine,2003;Botero et al.,2004).One hypothesis (the 'adaptability'claim) concerns the way in which new rules are produced.Civilian systems are characterised by wide-ranging codification of legal rules,whereas common law systems are distinguished by their reliance on incremental change through the accumulation of judicial precedent.It may be that this ability to shape the law on a case-by-case basis helps to render legal regulation more adaptable to changed circumstances.In contrast,civilian legal systems may suffer from excessive rigidity,as changes may only be made infrequently through legislation.Associated with this is a difference in 'regulatory style':common law systems,it is said,favour market solutions-contract and private 3
3 The La Porta et al analysis is based on an empirical and theoretical evaluation of different legal systems, and has been conducted at two discrete levels of generality. The first, and more ‘micro’, hypothesis, is that the greater the protection afforded to minority shareholders and creditors by a country’s legal system, the more external financing firms in that jurisdiction will be able to obtain (the ‘quality of law’ claim). If good legal institutions can reduce the risk of investor expropriation ex post, then investors will be more willing to advance funds ex ante. The second, and more ‘macro’, hypothesis, is that the quality of legal institutions varies systematically with the ‘origin’ of a country’s legal system—that is, whether it falls into the Anglo-American ‘common law’, or Napoleonic (French-origin), German or Scandinavian ‘civil law’ systems (the ‘legal origins’ claim).2 La Porta et al contend that legal origins thus determine the financing of corporate growth, and through that and other channels, the nature of the financial system and ultimately, perhaps, overall economic growth. A key step in the empirical methodology has been to quantify variations, across countries, in the extent to which certain types of legal rule exist. The resulting indices allow the particular economic correlates of institutional persuasions to be discerned. The cross-sectional regression results accord with the predictions of both the quality of law and the legal origins claims. Specifically, countries using the French civil law system exhibit systematically less protection for minority shareholders, which is in turn correlated with concentrated share ownership; and corporations in common law countries (with stronger shareholder protection) pay out more dividends and have higher share prices than firms in civil law countries. Whilst the intuition underlying the ‘quality of law’ claim seems straightforward, it is less obvious why ‘better’ quality law should tend to be associated with common law systems. Two mechanisms have been articulated which may underpin the common law’s alleged superiority (Beck et al., 2003a, 2004; and Levine, 2003; Botero et al., 2004). One hypothesis (the ‘adaptability’ claim) concerns the way in which new rules are produced. Civilian systems are characterised by wide-ranging codification of legal rules, whereas common law systems are distinguished by their reliance on incremental change through the accumulation of judicial precedent. It may be that this ability to shape the law on a case-by-case basis helps to render legal regulation more adaptable to changed circumstances. In contrast, civilian legal systems may suffer from excessive rigidity, as changes may only be made infrequently through legislation. Associated with this is a difference in ‘regulatory style’: common law systems, it is said, favour market solutions—contract and private
litigation-over 'top down'regulation and enforcement through government agencies in civilian systems. A second hypothesis(the political'claim)focuses on the greater independence accorded to the judiciary under common law than civilian systems.The Napoleonic Code in particular seeks to enshrine constitutionally the primacy of the legislature over other branches of government;the legislature also controls judicial appointments and tenure.In contrast,the judiciary in common law systems typically have greater ability to review the legitimacy of executive acts, and the terms and processes of their appointments give them greater independence.These differences,it is thought,will make common law judges less susceptible to influence by the legislature,and better able to protect individual property rights from rent-seeking activity by the state (Mahoney, 2001;Rajan and Zingales,2003). 2.2 The quality of law'claim and its limitations Indices have been constructed by La Porta et al for a range of different aspects of the law relating to business organisation.In the approximate order in which these were published,they include: G) Shareholder rights (as against company directors-'antidirector rights'-and as against majority shareholders-'minority protection') and creditor rights (LLSV,1997,1998) (ii) Regulations governing firm start-up (Djankov et al,2002) (iii） Contract enforcement (Djankov et al,2003) (iv) Securities regulation (La Porta et al,2006) (V) Labour regulation (Botero et al,2004) (vi)Public creditor protection mechanisms (overlapping with the earlier 'creditor rights')(Djankov et al.,2007). (vii)Self-dealing rules (overlapping with the earlier 'antidirector rights') (Djankov et al,2008). (viii)Bankruptcy procedures (overlapping with the earlier 'creditor rights') (Djankov et al,2007). The methodology has evolved over time,so that a number of limitations in the earlier studies have been ameliorated.However,significant unresolved issues remain. First,for any index to render a meaningful representation of the comparative qualities of underlying legal rules,it is essential that the coding should be accurate and consistent:that is,the numbers used to signify the presence or 4
4 litigation—over ‘top down’ regulation and enforcement through government agencies in civilian systems. A second hypothesis (the ‘political’ claim) focuses on the greater independence accorded to the judiciary under common law than civilian systems. The Napoleonic Code in particular seeks to enshrine constitutionally the primacy of the legislature over other branches of government; the legislature also controls judicial appointments and tenure. In contrast, the judiciary in common law systems typically have greater ability to review the legitimacy of executive acts, and the terms and processes of their appointments give them greater independence. These differences, it is thought, will make common law judges less susceptible to influence by the legislature, and better able to protect individual property rights from rent-seeking activity by the state (Mahoney, 2001; Rajan and Zingales, 2003). 2.2 The ‘quality of law’ claim and its limitations Indices have been constructed by La Porta et al for a range of different aspects of the law relating to business organisation. In the approximate order in which these were published, they include: (i) Shareholder rights (as against company directors—’antidirector rights’—and as against majority shareholders—’minority protection’) and creditor rights (LLSV, 1997, 1998) (ii) Regulations governing firm start-up (Djankov et al, 2002) (iii) Contract enforcement (Djankov et al, 2003) (iv) Securities regulation (La Porta et al, 2006) (v) Labour regulation (Botero et al, 2004) (vi) Public creditor protection mechanisms (overlapping with the earlier ‘creditor rights’) (Djankov et al., 2007). (vii) Self-dealing rules (overlapping with the earlier ‘antidirector rights’) (Djankov et al, 2008). (viii) Bankruptcy procedures (overlapping with the earlier ‘creditor rights’) (Djankov et al, 2007). The methodology has evolved over time, so that a number of limitations in the earlier studies have been ameliorated. However, significant unresolved issues remain. First, for any index to render a meaningful representation of the comparative qualities of underlying legal rules, it is essential that the coding should be accurate and consistent: that is, the numbers used to signify the presence or
absence of particular legal rules,and/or their strength,should be applied in a way that in fact corresponds to the underlying state of the law,and that is consistent across different legal systems.This desideratum would seem to be obvious,but the highly specific and textured nature of legal knowledge is such that it is often difficult for a non-specialist to achieve an accurate characterisation of legal rules.When the coding of LLSV's 'shareholder rights' indices were checked by independent experts,numerous coding errors were revealed (Spamann,2006.2008;Braendle 2006;Cools 2005),to the extent that the principal results are no longer regarded as being entirely robust,even by members of the LLSV research network (Djankov et al,2005). Secondly,the expansive nature of most countries'laws means that selectivity is called for:the factors coded to form the index must act as proxies for the quality of the underlying legal rules.A further potential source of bias concerns the selection of variables to be coded.It is desirable that variables should be selected in accordance with a functional theory about their likely impact on corporate finance practices.However,the more limited the selection,the greater the risk that they will fail to reflect the generality of the underlying legal rules, or that their choice may be subject to a(probably unconscious)home country bias'on the part of the researchers constructing the index,either of which will skew the resulting comparisons.LLSV's 'shareholder rights',creditor rights' and securities law'indices have been criticised on these bases (Berglof and von Thadden,1999;Armour et al,2002;Siems 2005b;Braendle,2006;Cools,2006; Lele and Siems,2007a;Ahlering and Deakin,2007).These problems have been ameliorated in some of the later indices through consideration of a wider range of variables:the Botero et al.(2004)index of labour regulation,for example, consists of 60 variables,and has been shown to produce outcomes which are consistent with indices drawn up using different methodologies,such as large- scale surveys of the opinion of lawyers and industrial relations practitioners (Chor and Freeman,2005). Thirdly,the empirical results supporting the quality of law claim are,by themselves,difficult to interpret.They rely primarily on cross-sectional analyses,using the various legal indices as independent variables regressed onto firm-level data about corporate finance and ownership structures.Whilst these establish correlations consistent with the theoretical predictions,their cross- sectional nature means they are ambiguous as to the direction of causality. Whilst 'good quality'legal rules could enhance investment,it is also plausible that financial structure influences the creation of legal norms. 5
5 absence of particular legal rules, and/or their strength, should be applied in a way that in fact corresponds to the underlying state of the law, and that is consistent across different legal systems. This desideratum would seem to be obvious, but the highly specific and textured nature of legal knowledge is such that it is often difficult for a non-specialist to achieve an accurate characterisation of legal rules. When the coding of LLSV’s ‘shareholder rights’ indices were checked by independent experts, numerous coding errors were revealed (Spamann, 2006. 2008; Braendle 2006; Cools 2005), to the extent that the principal results are no longer regarded as being entirely robust, even by members of the LLSV research network (Djankov et al, 2005). Secondly, the expansive nature of most countries’ laws means that selectivity is called for: the factors coded to form the index must act as proxies for the quality of the underlying legal rules. A further potential source of bias concerns the selection of variables to be coded. It is desirable that variables should be selected in accordance with a functional theory about their likely impact on corporate finance practices. However, the more limited the selection, the greater the risk that they will fail to reflect the generality of the underlying legal rules, or that their choice may be subject to a (probably unconscious) ‘home country bias’ on the part of the researchers constructing the index, either of which will skew the resulting comparisons. LLSV’s ‘shareholder rights’, ‘creditor rights’ and ‘securities law’ indices have been criticised on these bases (Berglof and von Thadden, 1999; Armour et al, 2002; Siems 2005b; Braendle, 2006; Cools, 2006; Lele and Siems, 2007a; Ahlering and Deakin, 2007). These problems have been ameliorated in some of the later indices through consideration of a wider range of variables: the Botero et al. (2004) index of labour regulation, for example, consists of 60 variables, and has been shown to produce outcomes which are consistent with indices drawn up using different methodologies, such as largescale surveys of the opinion of lawyers and industrial relations practitioners (Chor and Freeman, 2005). Thirdly, the empirical results supporting the quality of law claim are, by themselves, difficult to interpret. They rely primarily on cross-sectional analyses, using the various legal indices as independent variables regressed onto firm-level data about corporate finance and ownership structures. Whilst these establish correlations consistent with the theoretical predictions, their crosssectional nature means they are ambiguous as to the direction of causality. Whilst ‘good quality’ legal rules could enhance investment, it is also plausible that financial structure influences the creation of legal norms.3
Reference to legal origin offers a potential resolution to this causal ambiguity The various cross-sectional results based on the LLSV indices show that higher than average quality corporate,securities and labour laws are associated with common law systems;French civilian systems,on the other hand are associated with lower than average quality legal norms(in the sense defined here).As legal origin is,for most countries in the world,exogenous-deriving from whichever of the western powers colonized the country in question-this arguably supports the view that law drives financial development,rather than vice versa (La Porta et al,1997).It is appropriate therefore to consider the 'legal origins'claim in more detail. 2.3 The legal origin'claim and its limitations By 'legal origins',La Porta et al.do not mean the legal rules themselves,but rather the 'infrastructure'of the legal system,'such as the legal codes,legal principles and ideologies,and elements of the organization of the judiciary'(La Porta et al.,2008:288)in a given country.In the latest formulation of their claim,La Porta et al.suggest that legal origins include not just the formal insti- tutions of the legal system but also 'the human capital and beliefs of its partici- pants'(2008:286).They also suggest that legal origin can be broadly con- ceived as 'a style of social control of economic life'(2008:286).This is the context in which they argue for a bifurcation between the common law and civil law systems.Thus the 'civil law is associated with a heavier hand of govern- ment ownership and regulation than common law...[and with]greater corrup- tion,larger unofficial economy,and higher unemployment',while the common law is 'associated with lower formalism of judicial procedures and greater judi- cial independence than civil law',indicators which are 'in turn associated with better contract enforcement and greater security of property rights'(2008:286). Legal origin was initially used as an instrumental variable in order to address the problem of endogeneity,or in other words,the possibility that economic fac- tors were influencing the content of legal rules rather than the other way round (La Porta et al.,1998;Beck et al.,2003a).*In their more recent work,La Porta et al.suggest that legal origin cannot be regarded as a good instrument for the quality of legal rules because it is likely to affect economic outcome variables in a number of different ways.In particular,they suggest that legal origin,unders- tood in the broad sense of 'regulatory style',could be influencing the economy not through the quality of legal rules alone,or even predominantly via this route,but through alternative aspects of the legal infrastructure,such as en- forcement mechanisms (La Porta et al.,2008:299)or prevailing modes of legal interpretation (La Porta et al,2008;300).However,even if legal origin is no longer regarded as a good instrument for verifying the quality of law claim,La 6
6 Reference to legal origin offers a potential resolution to this causal ambiguity. The various cross-sectional results based on the LLSV indices show that higher than average quality corporate, securities and labour laws are associated with common law systems; French civilian systems, on the other hand are associated with lower than average quality legal norms (in the sense defined here). As legal origin is, for most countries in the world, exogenous—deriving from whichever of the western powers colonized the country in question—this arguably supports the view that law drives financial development, rather than vice versa (La Porta et al, 1997). It is appropriate therefore to consider the ‘legal origins’ claim in more detail. 2.3 The ‘legal origin’ claim and its limitations By ‘legal origins’, La Porta et al. do not mean the legal rules themselves, but rather the ‘infrastructure’ of the legal system, ‘such as the legal codes, legal principles and ideologies, and elements of the organization of the judiciary’ (La Porta et al., 2008: 288) in a given country. In the latest formulation of their claim, La Porta et al. suggest that legal origins include not just the formal institutions of the legal system but also ‘the human capital and beliefs of its participants’ (2008: 286). They also suggest that legal origin can be broadly conceived as ‘a style of social control of economic life’ (2008: 286). This is the context in which they argue for a bifurcation between the common law and civil law systems. Thus the ‘civil law is associated with a heavier hand of government ownership and regulation than common law . . . [and with] greater corruption, larger unofficial economy, and higher unemployment’, while the common law is ‘associated with lower formalism of judicial procedures and greater judicial independence than civil law’, indicators which are ‘in turn associated with better contract enforcement and greater security of property rights’ (2008: 286). Legal origin was initially used as an instrumental variable in order to address the problem of endogeneity, or in other words, the possibility that economic factors were influencing the content of legal rules rather than the other way round (La Porta et al., 1998; Beck et al., 2003a).4 In their more recent work, La Porta et al. suggest that legal origin cannot be regarded as a good instrument for the quality of legal rules because it is likely to affect economic outcome variables in a number of different ways. In particular, they suggest that legal origin, understood in the broad sense of ‘regulatory style’, could be influencing the economy not through the quality of legal rules alone, or even predominantly via this route, but through alternative aspects of the legal infrastructure, such as enforcement mechanisms (La Porta et al., 2008: 299) or prevailing modes of legal interpretation (La Porta et al., 2008; 300). However, even if legal origin is no longer regarded as a good instrument for verifying the quality of law claim, La