England, and the United States. The six transplant countries are Spain, Chile and Colombia belonging to French civil law, Japan belonging to the German civil law, and Israel and Malaysia belonging to the common law families We find substantial differences in the capacity of legal systems to innovate along three dimensions, namely, the rate of statutory legal change, the flexibility of corporate law, i.e., enabling vS. mandatory, and the development of new enforcement mechanisms First, our findings suggest that the rate of statutory legal change is substantially higher in origin countries than in transplants. Although common law countries have had a somewhat higher rate of change than civil law countries among the four origin countries, the difference between origins and transplants within each legal family is greater than the differences across legal families. Second, countries with a highly mandatory statutory law exhibit less innovation than countries with a more enabling statutory law. Third, legal institutional innovation, in particular, the creation of new enforcement agents such as regulators, has been higher in countries with a more enabling corporate law than in those with a highly mandatory law Our evidence is drawn from statutory corporate law provisions on issues related to corporate finance. In parallel work, we investigate corporate law more broadly and include the governance structure of the firm as well as the rules governing entry and exist ( Pistor et al., 2002 ). However, it is in corporate finance law where we find both the greatest difference across jurisdictions and the greatest rate of innovation over time In section two. of this paper we explain the meaning of legal innovation and develop a set of propositions to assess the innovative capacity of different legal systems. In 2 Whether the U.S. is a transplant or origin country may be disputed. The U.S. received the common law system by way of transplantation from England. However, since the late 18 century, the legal evolution in 6
6 England, and the United States.2 The six transplant countries are Spain, Chile and Colombia belonging to French civil law, Japan belonging to the German civil law, and Israel and Malaysia belonging to the common law families. We find substantial differences in the capacity of legal systems to innovate along three dimensions, namely, the rate of statutory legal change, the flexibility of corporate law, i.e., enabling vs. mandatory, and the development of new enforcement mechanisms. First, our findings suggest that the rate of statutory legal change is substantially higher in origin countries than in transplants. Although common law countries have had a somewhat higher rate of change than civil law countries among the four origin countries, the difference between origins and transplants within each legal family is greater than the differences across legal families. Second, countries with a highly mandatory statutory law exhibit less innovation than countries with a more enabling statutory law. Third, legal institutional innovation, in particular, the creation of new enforcement agents such as regulators, has been higher in countries with a more enabling corporate law than in those with a highly mandatory law. Our evidence is drawn from statutory corporate law provisions on issues related to corporate finance. In parallel work, we investigate corporate law more broadly and include the governance structure of the firm as well as the rules governing entry and exist (Pistor et al., 2002). However, it is in corporate finance law where we find both the greatest difference across jurisdictions and the greatest rate of innovation over time. In section two. of this paper we explain the meaning of legal innovation and develop a set of propositions to assess the innovative capacity of different legal systems. In 2 Whether the U.S. is a transplant or origin country may be disputed. The U.S. received the common law system by way of transplantation from England. However, since the late 18th century, the legal evolution in
section threewe present the evidence we find in the ten countries included in the analysis Section four concludes 2. Legal Innovation and Propositions Our major proposition is that the capacity of legal systems to innovate is more important than the level of protection a legal system may afford to particular stakeholders at any point in time. Minimum protections may be taken as a first indicator to assess the quality of legal systems. However, such protections may soon be out of date, as changes in the environment or the capacity of economic agents to circumvent established rules and to develop new forms of arbitrage will render previously effective protective mechanisms ineffective. This is true especially in areas such as corporate law and financial market regulation because socioeconomic and technological change is rapid and challenges the legal system persistently. The recent wave of financial accounting frauds in the U.S., a legal system that has been hailed as the most advanced system with regard to financial market regulation, Coffee(2002b)and rock(2002), illustrate that innovative capacity is a continuous challenge Innovative capacity does not specify the type of legal protections different legal systems should adopt or the institutions they should establish. In fact, innovative capacity refers to a given system' s ability to respond to the challenges it faces, which may well differ from those faced by a neighboring system. Therefore, we are not interested in a set of best practice indicators but, in legal change that responds to country or system specific problems. Moreover, we do not limit legal change to changes in the law on the books the U.S. has been sufficiently idiosyncratic( Horwitz, 1977)to justify its classification as an origin country
7 section threewe present the evidence we find in the ten countries included in the analysis. Section four concludes. 2. Legal Innovation and Propositions. Our major proposition is that the capacity of legal systems to innovate is more important than the level of protection a legal system may afford to particular stakeholders at any point in time. Minimum protections may be taken as a first indicator to assess the quality of legal systems. However, such protections may soon be out of date, as changes in the environment or the capacity of economic agents to circumvent established rules and to develop new forms of arbitrage will render previously effective protective mechanisms ineffective. This is true especially in areas such as corporate law and financial market regulation because socioeconomic and technological change is rapid and challenges the legal system persistently. The recent wave of financial accounting frauds in the U.S., a legal system that has been hailed as the most advanced system with regard to financial market regulation, Coffee (2002b) and Rock (2002), illustrate that innovative capacity is a continuous challenge. Innovative capacity does not specify the type of legal protections different legal systems should adopt or the institutions they should establish. In fact, innovative capacity refers to a given system’s ability to respond to the challenges it faces, which may well differ from those faced by a neighboring system. Therefore, we are not interested in a set of best practice indicators but, in legal change that responds to country or system specific problems. Moreover, we do not limit legal change to changes in the law on the books, the U.S. has been sufficiently idiosyncratic (Horwitz, 1977)to justify its classification as an origin country
although data availability implies that this is the least difficult case to establish; rather, we include indicators for the flexibility of corporate law and institutional change Hayek(1973)emphasizes the importance of legal evolution and change and points It that judge made law is evolutionary by nature. Statutory law enacted by legislatures may be swifter at times and may serve to correct judge-made law, but statutory law may also be used to restrict innovation and to infringe on individual liberties Several authors argue that the common law is efficient, because the process of lawmaking by judges on a case by case basis lends itself to efficient rule selection(Priest, 1977 and Rubin, 1977) However, a potential selection bias affects litigation as Bailey and Rubin(1994)argue Finally, a comparative legal analysis emphasizes the differences between code and case law in bringing about legal change(Merryman, 1985, Merryman, 1996 and Zweigert and Kotz, 1998 ). Building on this literature, Beck et al. (2002)use case law, defined as a dummy variable that indicates whether judicial decisions are a source of law, in addition to requirements that statutory law rather than principles of equity are a basis for court ulings as proxies for the adaptability of legal systems. Our approach differs in several respects. The focus of our analysis is on the law governing the corporate enterprise Corporate law has been codified in all major jurisdictions, including the common law families, since the early 19 century. Therefore, we treat statutory law as an important source of information for the innovative capacity of legal systems. In particular, we use the rate of statutory legal change since the first enactment of a formal corporate law as a proxy for legal innovation 8
8 although data availability implies that this is the least difficult case to establish; rather, we include indicators for the flexibility of corporate law and institutional change respectively. Hayek (1973) emphasizes the importance of legal evolution and change and points out that judge made law is evolutionary by nature. Statutory law enacted by legislatures may be swifter at times and may serve to correct judge-made law, but statutory law may also be used to restrict innovation and to infringe on individual liberties. Several authors argue that the common law is efficient, because the process of lawmaking by judges on a case by case basis lends itself to efficient rule selection (Priest, 1977 and Rubin, 1977). However, a potential selection bias affects litigation as Bailey and Rubin (1994) argue. Finally, a comparative legal analysis emphasizes the differences between code and case law in bringing about legal change (Merryman, 1985, Merryman, 1996 and Zweigert and Kötz, 1998). Building on this literature, Beck et al. (2002) use case law, defined as a dummy variable that indicates whether judicial decisions are a source of law, in addition to requirements that statutory law rather than principles of equity are a basis for court rulings as proxies for the adaptability of legal systems. Our approach differs in several respects. The focus of our analysis is on the law governing the corporate enterprise. Corporate law has been codified in all major jurisdictions, including the common law families, since the early 19th century. Therefore, we treat statutory law as an important source of information for the innovative capacity of legal systems. In particular, we use the rate of statutory legal change since the first enactment of a formal corporate law as a proxy for legal innovation
Given the importance of statutory corporate law in all jurisdictions, the simple distinction between case law and statutory law is unlikely to capture major differences across legal families. Therefore, we classify corporate laws on the continuum from mandatory to enabling corporate law following Coffee(1989)and Gordon(1989) Mandatory law means that private agents may not opt out of the allocation of control rights prescribed in the statutory law. By contrast, an enabling law makes most of the statutory provisions optional and allows parties to reallocate control rights. The classification of a corporate law as enabling or mandatory has important implications for the relevance of judge-made law. When law is mandatory, judges may be called upon to enforce these rules but they have comparatively little lawmaking functions because the mandatory nature of the law implies that these functions are reserved for the legislature When law is enabling or optional, judges play an important role in determining the boundaries of the permissible reallocation of control rights and in settling disputes among private actors with different claims to control rights This classification allows us to distinguish between legal systems that belong to the same legal family. In particular, we show that there are important differences within the common law family in the mandatory vs. enabling dimension. The law in Delaware, which is the leading jurisdiction for corporate law within the U.S., represents a highly enabling corporate law. However, England, as well as Malaysia and Israel are located somewhere in the middle of a continuum from mandatory to enabling law. The classification also leads us to reject the proposition by Beck et al. (2002)that Germany falls within the case law category. In many areas of the law e.g., contracts and torts judges in germany carry out important lawmaking functions, but this is not the case for
9 Given the importance of statutory corporate law in all jurisdictions, the simple distinction between case law and statutory law is unlikely to capture major differences across legal families. Therefore, we classify corporate laws on the continuum from mandatory to enabling corporate law following Coffee (1989) and Gordon (1989). Mandatory law means that private agents may not opt out of the allocation of control rights prescribed in the statutory law. By contrast, an enabling law makes most of the statutory provisions optional and allows parties to reallocate control rights. The classification of a corporate law as enabling or mandatory has important implications for the relevance of judge-made law. When law is mandatory, judges may be called upon to enforce these rules but they have comparatively little lawmaking functions because the mandatory nature of the law implies that these functions are reserved for the legislature. When law is enabling or optional, judges play an important role in determining the boundaries of the permissible reallocation of control rights and in settling disputes among private actors with different claims to control rights. This classification allows us to distinguish between legal systems that belong to the same legal family. In particular, we show that there are important differences within the common law family in the mandatory vs. enabling dimension. The law in Delaware, which is the leading jurisdiction for corporate law within the U.S., represents a highly enabling corporate law. However, England, as well as Malaysia and Israel are located somewhere in the middle of a continuum from mandatory to enabling law. The classification also leads us to reject the proposition by Beck et al. (2002) that Germany falls within the case law category. In many areas of the law e.g., contracts and torts, judges in Germany carry out important lawmaking functions, but this is not the case for
the law governing the publicly traded corporation(Aktienrecht). German corporate law is highly mandatory so that case law is virtually absent. Indeed, corporate law textbooks suggest that, because of the scarcity of case law in this area, it is sufficient to read the provisions of the statute(Kubler, 1994) Our third indicator of innovative capacity is legal institutional change. The development of stock markets has been accompanied by the emergence of new lawmaking and law enforcement institutions in the form of regulators, i.e., stock exchanges and state regulators such as the Securities and Exchange Commission(SEC)in the U.s. and the Financial Services Authority(fsa)in the UK (Coffee, 2002a). Recent work attributes the emergence of financial market regulators to the failure of courts to enforce the law effectively enough to deter stock and corporate fraud Glaeser and Shleifer(2003 )argue that this failure in the U. S in the early 20 century is due to the fact that the judiciary was captured by powerful industry groups, which necessitated the creation of a new independent state agent. Pistor and Xu (2003)suggest that, even if courts are impartial, the design of courts as neutral arbiters implies that courts can enforce the law only reactively, i. e, after the victim or a state agent have brought action This limits their capacity to prevent harmful actions from taking place. By contrast, regulators are designed to initiate law enforcement independently, which places them in a better position to prevent harmful actions from occurring. Tentative support for the latter proposition is found in La Porta, Lopez-de-Silanes, and Shleifer(2002), who suggest that According to para. 23 V Aktiengesetz (Law on Joint Stock Companies)all provisions of the law are mandatory, unless explicitly stated otherwise in the law The situation is quite different for closely held corporations( GmbH), for which courts play a very active ole. The reason for the lack of case law governing the Aktiengesellschaft(ag)is widely attributed to the lack of procedural rules that would allow shareholders to take judicial re 10
10 the law governing the publicly traded corporation (Aktienrecht). German corporate law is highly mandatory3 so that case law is virtually absent. Indeed, corporate law textbooks suggest that, because of the scarcity of case law in this area, it is sufficient to read the provisions of the statute (Kübler, 1994).4 Our third indicator of innovative capacity is legal institutional change. The development of stock markets has been accompanied by the emergence of new lawmaking and law enforcement institutions in the form of regulators, i.e., stock exchanges and state regulators such as the Securities and Exchange Commission (SEC) in the U.S. and the Financial Services Authority (FSA) in the UK (Coffee, 2002a). Recent work attributes the emergence of financial market regulators to the failure of courts to enforce the law effectively enough to deter stock and corporate fraud. Glaeser and Shleifer (2003) argue that this failure in the U.S. in the early 20th century is due to the fact that the judiciary was captured by powerful industry groups, which necessitated the creation of a new independent state agent. Pistor and Xu (2003) suggest that, even if courts are impartial, the design of courts as neutral arbiters implies that courts can enforce the law only reactively, i.e., after the victim or a state agent have brought action. This limits their capacity to prevent harmful actions from taking place. By contrast, regulators are designed to initiate law enforcement independently, which places them in a better position to prevent harmful actions from occurring. Tentative support for the latter proposition is found in La Porta, Lopez-de-Silanes, and Shleifer (2002), who suggest that 3 According to para. 23 V Aktiengesetz (Law on Joint Stock Companies) all provisions of the law are mandatory, unless explicitly stated otherwise in the law. 4 The situation is quite different for closely held corporations (GmbH), for which courts play a very active role. The reason for the lack of case law governing the Aktiengesellschaft (AG) is widely attributed to the lack of procedural rules that would allow shareholders to take judicial recourse