sou · GOB311d5 · 2001-01-01 00:00:00 — Equally worrisome is the question of whether these studies capture the true degree of protection enjoyed by investors in different countries. This cannot be understood without being able to specify the nature of the investor and the threat to investor rights. La Porta et al. focus mainly on the protection granted to minority shareholders and creditors against managers and dominant shareholders. But civil law countries may want to protect a different type of investor than minority shareholders or creditors. For example, investing may largely be done through institutions in some civil law countries. 34 See and Zingales (1995). Volym D:80 Supplement 24 also consistent with the finding in La Porta et al. that the three largest owners hold a greater fraction of shares in French civil law countries than in common law countries. These investors may not need the protection afforded minority investors that La Porta et al. There is clearly a problem of causality that cannot be disentangled. If civil law countries do indeed have poor minority investor protection, is it because corporations there do not need to attract such investors since finance is largely intermediated by financial institutions, or is the direction of causality as La Porta et al. suggest; French civil law countries have few minority investors because minority investor protection is so weak. Most importantly, none of the rights investigated by La Porta et al. appears unique to a common law system – the rights are present in at least some of the civil law countries. If there is one thing that the civil- law tradition is good at, it is writing new laws in great detail. Why then do we have this apparent contradiction with civil law countries not introducing seemingly simple, but valuable, statutes that seem to exist in common law countries? Perhaps the failure to introduce laws to protect investors is symptomatic of other, deeper underlying factors. One potential piece of evidence that investor protection may be a symptom and not an underlying cause for financial development is provided by La Porta et al. When their measures of equity market development (such as the number of listed firms per million population) are regressed against the country of origin of the legal system and the index of antidirector rights, the latter is either not significant or marginally statistically significant. When the debt to GNP ratio is similarly regressed, the index of creditor rights has no additional impact once the country of origin of the legal system is accounted for. One possibility is that the aspects of investor protection that are most important for financial development are best proxied for by legal origin. Alternatively, there is something else that is associated with legal origin that leads to financial development but is unrelated to investor protection. We will examine both possibilities in what follows. To summarize, the seminal work by La Porta et al. strongly indicates that countries who have a legal system rooted in English common law tend to have better developed corporate capital markets. controversial is their claim that the reason for this finding is the higher degree of investor protection granted by Common countries, especially because the theoretical link between the two is still missing. Politics, and Financial Development Volym D:81 4.4Common as a Process A third possibility is that Common is more helpful than Civil in making operational legal devices such as ownership, contracts, and corporate structures, and social constructs such as good faith. Therefore, it may not be the specific statutes but the process by which the legal decision is arrived at that puts Common countries at the vanguard of financial innovation and development. The focus of a common law system is on adopting the right process to reach a just solution. The civil law system, instead, expects the judge to apply the law as it is written. These differences would be irrelevant in a world where all future contingencies are anticipated and written in the initial contract or in the law. But contracts are typically incomplete in that they do not specify the rights and duties of all parties in all possible situations that may arise.35 For example, when someone rents a house it is expected that he will subject it to reasonable wear and tear. What is meant by reasonable is usually left unspecified, often because it is too costly to detail the myriad ways in which the house is abused. Instead, the owner and the renter negotiate after the rental period about whether the wear and tear is reasonable, and who will pay for it if not. If they do not agree, a court steps in. Laws themselves are incomplete. While the judge may be equally capable of deciding what is just in a simple rental dispute in both the common law and civil law system, matters can be quite different as the legal form being fought over changes. We will argue that the focus of the common law system on adopting the right process to reach a just solution rather than creating the precise law up front allows it to deal with a far richer set of contingencies than the civil law system. This flexibility of the common law system allows more experimentation. Eventually, the case law stemming from such experimentation affords agents more certainty about the outcomes when a particular contract or form is used, and also results in a richer variety of contractual possibilities and legal forms. By facilitating contractual and legal adaptation, common law enables the production of explicit and richly detailed arm's length contracts. This may partially be a factor why financial markets, entailing arm's length contracts between firms and investors, are more developed in common law countries. We now elaborate on this point. 35 See and (1986). Volym D:82 Supplement 24 4.5Legal Incompleteness – Some examples It may be useful to start with some examples of legal constructs that differ across the two systems and to understand what might drive the difference. We look at two important constructs – the concept of ownership and the notion of the corporation. The legal system is important because it defines the content of the ownership or property right and its limitations. The content refers to the object that is owned, while the limitations are the restrictions imposed on the ability to contract over that particular object. Traditional Roman law defined the ownership of a piece of land as an unlimited right usque ad inferes et usque ad (from the center of the earth to the stars). operationally, the owner has three prerogatives over the property in civil law – the right to usus (use), fructus (enjoy the fruits of), and abusus (sell or destroy). An important difference between civil law and common law, according to legal theorists and , is that civil law does not allow easy fragmentation of these rights, while common law does.36 This means that a variety of ownership structures are possible under common law, which are not under civil law. For example, the concept of trust where the trustee has ownership rights and manages property in the interests of the trust beneficiary is alien to civil law. The trustee under Common has the right to administer and sell the property but does not use it and cannot destroy it. The beneficiary enjoys the fruits of the property, and perhaps the use, but does not have administrative control. Why cannot this structure which involves the fragmentation of ownership not appear easily in civil law countries? The likely reason is that civil law cannot handle easily the myriad contingencies and exceptions that may arise in fragmenting ownership. What if the beneficiary and the trustee dispute a particular action such as the sale of property? Clearly, the resolution under common law would depend on the facts of the case, with the judgment trading off the need to be equitable to the beneficiary without hampering the administrative powers of the trustee. It is far under civil law to determine, a priori, where the balance of ownership rights should lie. Since legislature cannot make the determination, it is easier, though perhaps less efficient, to allow only simpler structures where ownership lies with the beneficiary and the trustee is simply the agent. 36 and , p. Politics, and Financial Development Volym D:83 The ability to demarcate ownership precisely is not just important for relationships between owners and investors, it is also important in the creation and preservation of value. The value of a company is a combination of the value of its assets in place – such as plant and machinery – and the value of its investment opportunities – its plans for future growth. Assets in place are easily identifiable, and are protected by standard property law. By contrast, investment opportunities are to define and, as such, to protect. While it is fairly easy to prohibit an employee or director from competing with the corporation or from using corporate assets for personal use, it is not as easy to prevent her from taking advantage of a business opportunity. Consider for instance the case of Guth vs. Guth, the president of a manufacturer and seller of beverages, bought the formula and trademark of the then bankrupt National on his own personal account. He then built them into valuable properties, in part by having Loft buy lots of Cola. The formula and the trademark did not belong to Loft. But the court ruled that the opportunity to buy and develop them did, and the firm had been unfairly deprived of the opportunity by its President. The court then forced Guth to turn the ownership of to Loft. The rationale behind this decision was that Guth unfairly took advantage of a corporate opportunity that was rightfully the corporation's because it was an activity as to which it [the company] has fundamental knowledge, practical experience and ability to pursue, which is consonant with its reasonable needs and aspirations for expansion (Guth vs. In the , the firm's right to opportunities is not protected by a specific law, but by a doctrine (the corporate opportunity doctrine). The concept is ambiguous. Courts disagree about the proper test for determining whether an opportunity is a corporate opportunity, and case law attempts to define the doctrine more precisely. Nevertheless, the existence of this doctrine in the grants to an outside owner of the firm some control over investment opportunities, and allows her to capture at least some of their value. This makes possible, in the and in other common law countries, the financing of enterprises with valuable future opportunities but assets. The problems encountered in the in elaborating a universally accepted test of what constitutes a corporate opportunity illustrate the horrendous difficulties that would be faced in codifying this concept. Civil law would have to resolve much of the ambiguity up front. But ex ante complete codes are virtually impossible to write since many eventualities are impossible to foresee. Volym D:84 Supplement 24 concepts such as intent and good faith play a part in determining the appropriate outcomes. These concepts are again highly contextual, and are more amenable to being judged ex post, based on fact, rather than ex ante based on theory. Of course, we do not intend to imply that the judge in a civil law system has no discretion, and does not use the facts of the case to arrive at a judgement. All that we imply is the empirical emphasis of the common law system may make it superior in both defining the property that is owned and devising an appropriate sharing of the fruits from, and the control rights over, the property. A country with a civil code has two options in attempting to delineate property rights among different claimants to the firm better. First, it can try to describe rights in a variety of contingencies that can be anticipated, perhaps leading to an inflexible code. This may imply that certain statutes that exist in common law countries – because they can be tempered in operation by the interpretation of the courts – will not exist in civil law countries because they will be overly rigid in operation. Alternatively, civil law can describe some broad-based rights that will suffice for most situations. The judge is then left to interpret in cases that cannot be easily pigeon-holed, with guidance except principles of . In practice, ambiguity will not be resolved over time by the law since precedent does not play an important part in civil law. We have probably overstated the differences between a civil code and a common law system. It is only a matter of time before the most important contingencies associated with a certain contract are observed and appropriate law written. Why cannot civil law replicate what common law does, but with a lag? Instead of the courts making law through cases, the civil code could be modified after a number of judgements reveal the difficulties with the existing law. After all, because the authority to modify the law is centralized in the legislature, a civil law system permits easy modification. Adaptation may not be perfect. If the law is not crafted in the necessary detail to begin with, the courts may not be confronted with the necessary cases that would suggest a change in the law. For instance, if there is no corporate opportunity doctrine to begin with, it is hard for courts to confront the issue and build up experience that would suggest how the law should be rewritten to define more precisely corporate opportunities that are the firms. On the other hand, having a blanket opportunity doctrine without allowing courts to interpret which ones are Politics, and Financial Development Volym D:85 legitimately the firm's may also not result in the necessary experience. Few employees would break away and start their own venture for fear that the product of their effort, if successful, would be deemed to belong to the firm. This could stifle innovation and entry and, equally important, prevent the challenges to the law that lead to its development. In other words, the ability of courts under common law to frame and interpret the law also encourages cases that test and challenge the law and lead to its development. Civil countries could imitate Common countries. However, the wealth of collective experience from case law is hard to codify into precise statutes. It is, in a sense, tacit knowledge that is common knowledge among the participants in the system, but extremely hard to express verbally. Thus while in theory civil law could evolve to capture the richness of the collective experience reflected in common law, in practice adaptation may be delayed and imperfect. Nevertheless, as we will show, complicated legal constructs such as the ability to freely incorporate with limited liability have been quickly adopted in their final form by Civil countries, even though they were perfected after a long period of experimentation in Common countries. Thus it seems implausible that the inability to deal with legal incompleteness is what holds Civil countries back in the long run. Volym D:86 Supplement 24 5The Superiority of Common : A Historical Test La Porta et al. present overwhelmingly evidence that Common countries are more financially developed. Their proposed causal link, however, is fragile. If financial development requires statutes that protect investors and these statutes are not unique to Common , why others countries do not adopt them? Thus, it must be the case that the advantage of Common is not replicable, like the quality of its enforcement process rather than its efficiency. At this point, however, this is only a conjecture, based on the current level of financial development. An independent test of this conjecture can be obtained going back in history. Since the choice of the legal system was done, at the latest, during the 19th century, we could try and look at the major indicators of financial development at the beginning of the 20th century and see whether it is still true that Common countries are more financially developed. Answering this question is complicated by data availability. We have data only on a subset of countries in Table 1, and on only a few measures. To triangulate the true measures, we present data coming from different sources. The first source is Goldsmith (1969), who is the most authoritative source on the history of financial development. He reports some basic statistics for the most developed countries of the time. For comparability, we rearranged them in Table 2. Column I of Table 2a reports per capita () in 1913 and column II the ratio of market values of securities outstanding in 1913 to GNP that year. In the definition of security Goldsmith includes both stocks and bonds, without differentiating between bonds of financial institutions and other bonds. This column, then, should be compared with the sum of columns (II) and (III) in Table 1. The difference in data sources prevents us from drawing any strong conclusion about the difference in levels between 1913 and 1996. Nevertheless, it striking that all the values in 1913 are well above the corresponding 1996 levels. The closest figures are for the (1.5 in 1913 vs. 1.14 in 1996), the most dispersed for (2.5 in 1913 and 0.5 in 1996). Politics, and Financial Development Volym D:87 Financial Development before WWI A: Period 1861-1913 D Asset Banks)/ B: Period 1901-1913 D Asset Banks)/ Source: Goldsmith (1969). We can, however, be more confident about the differences within each period. In 1913 and appear the most developed capital markets, with , , and the close behind. and are a distant last, in part because of their relative economic underdevelopment. Thus, the initial first mover advantage enjoyed by seems to have been eliminated. Although the paucity of observations prevents any statistical testing, there seems to be no connection between type of legal system and level of development. In fact, countries with a similar level of economic development (the first four) have similar levels of financial development. The variability within this group is much less pronounced than in 1996. The real outlier appears to be . In spite of its late industrialization, it has a level of financial development comparable to the first four countries. Unfortunately, for this time period it is difficult to have data on the level of capital formation financed with securities. Since most of the Volym D:88 Supplement 24 securities outstanding in 1913 were probably issued in the period 1861- 1913, Goldsmith approximates the securities issued during the period with the securities outstanding at the end of the period. He then normalizes them by the total GNP produced during the period (column III). Since Gross Capital Formation is roughly of GNP, to make these figures comparable to the one in Table 1 we have to divide them by 0.2 (i.e. to multiply them by 5). After that they should be compared with the last column of Table 1. The 1913 figures appear smaller than the 1996 ones for the and the , but much bigger for and . Since differences in the variable definition can explain more easily an overall difference in the level, not a cross- sectional variation in the difference, this pattern is likely to illustrate a real phenomenon: the importance of securities has grown in some countries, while it has declined in others. Goldsmith tries to refine his estimate of the amount of corporate securities issued by eliminating bonds of mortgage banks, foreign securities, and an estimate of capital gains from the total value of securities outstanding. The adjusted ratio is reported in column IV. The importance of security issues drops substantially for and , which had a large volume of foreign securities issuance (an issue we will discuss momentarily). The country that seems to have financed most with securities is , followed closely by the , with the other developed countries close behind. , , and are, again, far behind. Thus, the adjustment does not substantially modify the conclusions. Column V we reports the ratio of the increase in bank assets to total GNP produced during the period. Excluding , in all the other countries the increase in bank assets accounts for roughly of the GNP, except for the Unites States () and (). Thus, while banks appear very important in , the traditional difference between bank-oriented countries and market-oriented countries does not seem to hold. Following Goldsmith in column VI we sum the adjusted measure of securities issued and the increment in bank assets during the period. This measure is then deflated by the total GNP produced during the period. If the capital to GDP ratio is , the ratio in column IV provides a rough idea of what fraction of investment are financed externally. The difference between Anglo-American economies and the rest of the world, which emerged so clearly in Table I, is not present here. Table 2a does not properly distinguish domestic securities from foreign securities and stocks from bonds. Goldsmith provides this information for a subset of countries and a shorter time period. We report this information in Table 2b. Politics, and Financial Development Volym D:89 Column I does not look substantially different from column II of Table 2a, in spite of the shorter time period and the different sources (these are actual data on securities issued rather than estimates). Column II reports the same ratio, where as numerator we have only dmestic securities. The difference between columns I and II suggests that and were the two main international financial centers, with a distant third. Interestingly, the exhibits almost no foreign issues of securities. In principle, the development of a financial system should be measured by its ability to provide cheap finance to industry, not by the actual amount provided. In fact, the actual amount provided is also a function of the demand of external funds by domestic firms. The fact that and (and to a lesser extent, ) were able to provide more financing than their firms needed is an indication of their advanced level of financial development. Column III reports the ratio of shares issued divided by the total GNP produced during the period. and rely most heavily on equity, followed by the and then . Again there is no evidence that the equity market is more important in Common countries. The difference between columns II and III (reported as column IV) gives us an indication of the importance of the bond market vis-à-vis the stock market. Its importance is highest in () followed by the () and (). Finally, column V reports the ratio of the sum of domestic securities issued plus increase of bank assets to GNP produced during the period. Here the ranking seems to be negatively correlated with the period since the beginning of the industrialization process. The , which started first, finances very of its total production externally – a fact consistent with Gerschenkron (1961). , , , and (at a distance) follow. This result is not necessarily puzzling. The countries that started the industrialization process earlier had more established firms by the beginning of the 20th century, which could finance growth internally. Goldsmiths data are gathered from a variety of sources. To validate his main conclusions we followed two alternative routes. First, the League of Statistical Yearbook has data on equity issues for a small subset of countries starting back in 1913. In Table 3 we report these data deflated by the GDP of that year.37 For ease of comparison we report the same ratio computed in 1996 (data are from the FIBV). 37 Data on GDP are from B.R. , International Historical Statistics, Stockton Press. Volym D:90 Supplement 24 Equity issues over GDP Sources: League of Statistical Yearbook, , International Historical Statistics, and FIBV.