Law and Finance Rafael La Porta; Florencio Lopez-de-Silanes; Andrei Shleifer; Robert W. Vishny The Journal of Political Economy, Volume 106, Issue 6 (Dec., 1998), 1113-1155. Stable URL: http flinksjstor.orgsici?sici=0122-3808'% 281998 12%20 1063 \6%3C 1 L13@3ALAP%3E2.0.CO%SB2-W ‘Your use of the ISTOR archive indicates your acceptance of ISTOR’s Terms and Conditions of Use, available at fp (fw. jstor orglaboutitersihtml. ISTOR's Terms and Conditions of Use provides, in part, that unless You. have obtained prior permission, you ray not download an entire issue of &joumal or multiple copies of aricies, and You may use content in the ISTOR archive only for your personal, non-commercial use. Each copy of any part of a JSTOR twansmission must contain the same copyright notice that appears on the sercen or lnted page of such transmission. ‘The Journal of Folitical Economy is published by The University of Chicago Press. Please contact the publisher for further permissions regaiding the use of this work. Publisher contact information may be obtained at bup:forw jstor org/joummalsuepress html ‘Tae Journal of Political Economy (©1998 The University of Chicago Press ISTOR and the ISTOR logo are trademarks of ISTOR, and are Registered in the US. Patent and Trademase Office. For mote information on ISTOR contact jstor-info@umich edu, ©2003 IsTOR hup:thrwwjstor.orgy Fri Tan 17 08:35:46 2003Law and Finance Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer Harvard Univer Robert W. Vishny University of Chicago “This paper examines legal rules covering protection of corporate sharchalders and ceediors, the ovigin of these rules, andthe qua ity of their enforcement in 49 countries. The rests show that ‘muion la counties yenerally have the strongest, and Fetch chill counties the weakest, legal protections of investors, with Gesman. snd Scandinavian cilia counrles located in the mid dle. We als find that eancentrion af evmership af shares in the largest public companics is negatively related to investor protec tions, consistent with the hypothens that small diveraibedshare- holders are unlikely co be importance in countries chat fail to protect these rights T. Overview of the Issues: In the tradicional finance of Modigliani and Miller (1958), securities are recognized by their eash flows. For example, debt has a fixed promised stream of interest payments, whereas equity entitles its ‘We are grateful to Mark Chen, Steven Friedman, Magdalena Lopez Marton, and Kaga 2huravsiaya for excellent esearch assistance; to Robert Barro, Eric Berslof, Beenaré Black, Berl G. Bylund, Francesco DeNozza, Yoshikata Fuk, Edward Glaeser, 2a Griliches, Oliver Hare, Marcin Hellvig, James Hines, Louis Rapiow, Raghu Rajan, Rolera Romano, Rolf Shog, Fully Wyineersch, Luigi Zingales, and three anonymous celerees for comments; and to the National Science Foundauon for financial support af this research. Documentation af the data on legal rules presented in this paper is atallale fram the authars on request Gouna et at! sce, IS, ro 108368) PIE tee Catcnig Clge Alas ees. e808 /98 ose ONO 20 nang,ag JOURNAL OF POLITICAS. ECONOMY owner to receive dividends. Recent financial research has shown that this is far from the whole story and that the defining feature of vari- ‘ous securities is the rights that they bring to their owners (Hart 1995). Thus shares wypically give their owners the right to vote for directors of companies, whereas debt entitles creditors to the power, for example, to repossess collateral when the company fails co make promised payments, The rigits attached to securities become critical when managers of companies act in their own interest, These rights give investors the power to extract from managers the returns on their investment. Shareholders receive dividends because they can vote out the direc tors who do not pay them, and creditors are paid hecause they have the power to repossess collateral, Without these rights, investors would not be able to get paid, and therefore firms would find it harder (0 raise external finance. But the view that securities are inherently characterized by some intrinsic rights is incomplete as well. It ignores the fact that these tights depend on the legal rules of the jurisdictions in which securi- tics are issued. Does being a shareholder in France give an investor the same privileges as being a shareholder in the United States, In- dia, or Mexico? Would a secured creditor in Germany fare as well when the borrower defaults as one in Sri Lanka or Italy, with the value af the collateral assumed the same in all cases? Law and the quality of its enforcement are potentially important determinants ‘of what rights security holders have and how well these rights are protected. Since the protection investors receive determines their readiness to finance firms, corporate finance may critically urn. on these legal rules and their enforcement. ‘The differences in legal protections of investors might help ex plain why firms are financed and owned so differently in different countries. Why do Italian companies rarely go public (Pagano, Pa neta, and Zingales 1998)? Why does Germany have such a small stock tharket butt also maintain very large and powerful banks (Ed- wards and Fischer 1994)? Why is the voung premium—the price of shares with high voting rights relative to that of shares with low vot ing rights—small in Sweden and the United States, and much larger in Italy and Israel (Levy 1983; Rydquist 1987; Zingales 1994, 1995)? Indeed, why were Russian stocks nearly worthless immediately after privatization—by some estimates 100 times cheaper than Western, stocks backed by comparable assets—and why did Russian compa: nies have virtually no access to external finance (Baycko, Shleifer, and Vishay 1993)? Why is ownership of large American and British companics so widely dispersed (Betle and Means 1932)? The con-LAW AND FINANCE 1115 tent of legal rules in different countries may shed light on these corporate governance puzzles. In recent years, economists and legal scholars have begun to ex- amine theoretically the costs and benefits of alternative legal rules regarding investor rights (¢.g., Grossman and Hart 1988; Harris and Raviv 1988; Gromb 1993; Bebchuk 1994). The trouble is, there have bbeen no systematic data available on what the legal rules pertaining to corporate governance are around the world, how well these rules are enforced in different countries, and what effect these rules have. There is no systematic knowledge, for example, of whether different countries actually do have substandally different rules that might ‘explain differences in their financing patterns. Comparative statist cal analysis of the legal underpinnings of corporate finance—and commerce more generally—remains uncharted territory. In this paper, we attempt to explore this territory. We examine ‘empirically how laws protecting investors differ across 49 countries, how the quality of enforcement of these laws varies, and whether these variations matter for corporate ownership patterns around the world. Our starting point is the recognition that laws in different coun tries are typically not written from scratch, but rather transplanted— voluntarily or otherwise—from 2 few legal families or traditions (Watson 1974). In general, commercial laws come from two broad traditions: common law, which is English in origin, and civil law, which derives from Roman lave. Within the civil tradition, there are only three major families that modern commercial laws originate from: French, German, and Scandinavian, The French and the Get- ‘man civil traditions, as well as the common-law tradition, have spread around the world chrough a combination of conquest, imperialism, ‘outright borrowing, and more subde imication, The resulting laws reflect both the influence of their families and the revisions specific to individual countries. As a result of this spread of legal families and the subsequent evolution of the laws, we can compare both the individual legal rules and whole legal families across a large number ‘of countries, To this end, we have assembled a data set covering legal rules pertaining to the rights of investors, and to the quality of enforce- ment of these rules, in 49 countries that have publicly traded compa- nies. For shareholders, some of the rules we examine cover voting powers, ease of participation in corporate votirig, and legal protec- tions against expropriation by management. For creditars, some of these rules cover the respect for security of the loan, the ability to grab assets in case of a loan default, and the inability of management16 JOURNAL OF POLITICAL ECONOMY to seek protection from creditors unilaterally, In effect, these rules measure the ease with which investors can exercise their powers against management. We also consider measures of the quality of enforcement of legal rules in different countries and of the quality of their accounting systems. We show that laws vary a lot across countries, in part because of differences in legal origin, Civil laws give investors weaker legal rights than common laws do, independent of the level of per capita income. Common-law countries give both sharcholders and cred tors—relatively speaking—the strongest, and French-civillaw coun- tries the weakest, protection. German-civillaw and Scandinavian countries generally fall becween the other evo. The quality of law enforcement is the highest in Scandinavian and German-civiHlaw countries, next highest in common-law countries, and again the low est in French-civiklaw counties, Having shown that law and its enforcement vary across countries, and legal familics, we ask how the countries with poor laws or en- forcement cope with this problem. Do these countries have other, substitute, mechanisms of corporate governance? These adaptive mechanisms may in fact be incorporated into the law, or they may fic outside the law. One potential adaptation (o fewer laws is strong ‘enforcement of laws, but as we pointed out above, this does not ap- pear to be the case empirically. Another adaptation, sometimes re- ferred to as “brightline” rules, is to legally introduce mandatory standards of retention and distribution of capital to investors, which limic che opportunities for managerial expropriation. We find that only French-civil-law countries have mandatory dividends, and German-civillaw countries are the most likely to have legal reserve requirements of all the legal families. A further response to the lack of legal protections that we examine is a high ownership concentration. Some concentration of owner- ship of a firm’s shares is typically efficient to provide managers with incentives to work and large investors with incentives to monitor the managers (Jensen and Meckling 1976; Shleifer and Vishny 1986) However, some dispersion of ownership is also desirable to diversify risk, As argued hy Shleifer and Vishny (1997) and explained further in Section VI, a very high ownership concentration may be a reflec ion of poor investor protection, We examine ownership concentra tion in the largest publicly traded companiesin our sample countries and find a strong negative correlation between concentration of ‘ownership, as measured by the combined stake of the three largest sharcholders, and the quality of legal protection of investors. Poor investor protection in French-iviklaw countries is associated with extremely concentrated ownership. The data on ownership concen-LAW AND FINANCE a7 ‘ration thus support the idea that legal systems matter for corporate governance and that firms have to adapt to the limitations of the legal systems that they operate in. Section IT of the paper describes the countries and their laws Sections II and IV then compare shareholder and creditor rights, respectively, in different countries and different legal traditions. Section V compates the quality of law enforcement and account- ing standards in different countries and legal traditions. Section VI focuses on ownership. Section VIL presents concluding re- marks. IL Countries, Legal Families, and Legal Rules Countries Most studies of corporate governance focus on one or a few wealthy economies (see, eg. Berglof and Perotti 1994; Kaplan and Minton 1994; Rajan and Zingales 1995; Gorton and Schmidt 1996). How- ever, corporate governance in all of the three economies that schol- ars typically focus on—the United States, Germany, and Japan—is quite effective. To understand better the role of legal protection of investors, we need to examine a larger sample of countries. To ¢his end, we have assembled as comprehensive a sainple as possible of countries that have some nonfinancial frmns traded on their stock exchanges, The sample covers 49 countries from Europe, North and South America, Africa, Asia, and Australia. There are no socialist or “transition’” economies in the sample. A country is selected for inclusion if, on the basis of the WorldScope sample of 15,900 firms from 83 countries and che Moody's International sample of 15,100 non-US. firms from 92 countries, chat country had at least five do- mestic nonfinancial publicly traded firms with no government own- ership in 1998, We restrict attention to countries that have publicly traded firms since our primary focus is on protecting investor rights, and without public shareholders a discussion of investor rights ‘would he limited. Having at least five nonfinancial private firms is also essential for construction of ownership data Legal Families ‘Comparative legal scholars agree that, even though no two nations! laws are exactly alike, some national legal systems are sufficiency similar in certain critical respects to permit classification of national legal systems into major families of law. Although there is no una- nimity among legal scholars on how to define legal families,rg JOURNAL OF POLITICAL ECONOMY among the criteria often used for this purpose are the fol- lowing: (1) historical background and development of the legal system, (2) theories and hierarchies of sources of law, (3) the working methodology of jurists within the legal sys tems, (4) the characteristics of legal concepts employed by the system, (5) the legal institutions of the system, and (6) the divisions of law employed within a system. [Glendon, Gordon, and Osakwe 1994, pp. 4-5] ‘On the basis of this approach, scholars identify two broad legal tradi- tions that pertain to matters discussed in this paper: civil law and common lave." The civil, or Romano-Germanic, legal tradition is the oldest, the most influential, and the most widely distributed around the world. Ic originates in Roman law, uses statutes and comprehensive codes a5 a primary means of ordering legal material, and relies heavily on legal scholars to ascertain and formulate its rules (Merryman 1968). Legal scholars typically identify three currently comman families of Jaws within the civi-law cradition: French, German, and Seandina- Vian. The French Commercial Code was written under Napoleon in 1807 and brought by his armies to Belgium, the Netherlands, past of Poland, Italy, and western regions of Germany. In the colonial cra, France extended its legal influence to the Near East and North- em and sub-Saharan Africa, Indochina, Oceania, and French Carih- bean islands, French legal influence as been significant as well in Luxembourg, Portugal, Spain, some of che Swiss cantons, and Italy (Glendon et al, 1994). When the Spanish and Portuguese empires in Latin America dissolved in the nineteenth century, it was mainly the French civil law that the lawmakers of the new nations looked (o for inspiration. Our sample contains 21 countries with laws in the French civil tradition. ‘The German Commercial Code was written in 1897 after Bis marck’s unification of Germany, and perhaps because it was pro- duced several decades later, was not as widely adopted as the French, code. It had an important influence on the legal theory and doctrine Austria, Czechoslovakia, Greece, Hungary, Italy, Switzerland, Yur goslavia, Japan, and Korea. Taiwan's laws came from China, which The celigious cradicions, ch as Jewish low, Canon las, Hinds law, and Muslim lav, appear to be less relevant in steers of investor protection, "Thus the Arabia countries unquestionably belong to Islamic Law 28 Ut a8 family and inher ance ate ‘sconcerned, justas india helongs 0 Hindu law, but economic law of these enantries (including commercial law andthe law of contract and tort) is heaily impressed by the legal thinking of the colonial and mandatory pawere-—the Comtnon Law i {he eate of India, Exench law in the case of mast of the Arah Stated” (Zweigert ane ow 1987, p. 66), We focus an che principal secular legal radidons in Cis study.LAW AND FINANCE rug borrowed heavily from the German code during its modernization. We have six countries from this family in our sample. ‘The Scandinavian family is usually viewed as part of the civiHlaw tradition, although its law is less derivative of Roman law than the French and German families (Zweigert and Kotz 1987}. Although Nordic countries had civil codes as far back as the eighteenth cen- tury, these codes are not used anymore, Most writers describe the Scandinavian laws as similar to each other but “distinct” from oth- ers, so we keep the four Nordic countries in our sample asa separate family The common-law family includes the law of England and those laws modeled on English law. The common law is formed by judges who have to resolve specific disputes. Precedents from judicial deci- sions, as opposed to contributions by scholars, shape common lav, Common law has spread to the British colonies, including che United States, Canada, Australia, India, and many other countries. ‘There are 18 common-law councies in our sample To classify countries into Jegal families, we rely principally on Reynolds and Flores (1989). In most cases, such classification is un- controversial. In a few cases, while the basic origin of laws is clear, laws have been amended over time to incorporate influences from other families. For example, Ecuador, a French-civilaw country, re- vised its company law in 1977 to incorporate some common-law rules; Thailand’s first laws were based on common law but since re- ceived enormous French influence; and Italy is a French-civitlaw country with some German influence. Most important far our study, after World War II, the American occupying army “Americanized” some Japanese laws, particularly in the company law area, although their basic German-civiHaw structure remained, In chese and several other cases, we classify a country on the basis of the origin of the initial laws it adopted rather than on the revisions." In the Uniced States, states have their own laws, We generally rely on Delaware law hecause a significant fraction of large U.S. companies are incorpo- rated in Delaware. In Canada, our data come from Ontario laws, even though Quebec has a system based on French civil law. the European Communicyis currently attempting ca harmonize West European laws, including chose peraining ta corparate governance, by Isuing diecaves (Ane enas and Kenyon sla 1985; Wea 198) Several counaves have charged pars of their laws wo adhere to E.C. direcuves. However, it most instances, che airecaves fre not mandatory, andthe countries are given some lime to change their laws, Moreover, the E.G. directives accommodate a great deal of diversity among coun tries, Asaf 1995-94 —the poine in time for whieh we examine the legal rile of the countries in our sample —E.C. harmanieation haz not generally affected the legal ‘les that we focus on. The ane area in which the FC. impact has heen large, namely Imergers and acquisitions, not an ates that we examine ia dis paper (see below}1120 JOURNAL OF POLITICAL ECONOMY Legal Rules We look only at laws pertaining to investor protection, and speci cally only at company and bankruptey/reorganization laws. Com- ‘pany laws exist in all countries anid are concerned with (1) the legal relations between corporate insiders (members of the corporation, ice,, shareholders and directors) and the corporation itself and (2) the legal relations between the corporation and certain outsiders, particularly creditors. Bankruptcy/ reorganization laws apply more generally than just to companies but deal specifically with proce lures that unfold in the case of failure to pay back debt. All these laws are part of the commercial codes in civillaw countries and exist as separate laws, mainly in the form of acts, in common-law coun- tries, ‘There are several conspicuous omissions from the data set. First, this paper says little about merger and takeover rules, except indi- rectly by looking at voting mechanisms, These rules are spread be- tween company laws, antitrust laws, security laws, stock exchange reg- ulations, and sometimes banking regulations as well, Moreover, these rules have chaniged significandy in Europe as part of EC. legal harmonization. Und recently, takeovers have been an important governance tool in only a few common-law countries, although the situation may change.’ Second, this paper also says little about disclosure rules, which again come from many sources—including company laws, security Jaws, and stock exchange regulations—and are also intended for harmonization across the European Community. We do, however, ook at the quality of accounting standards, which to a large extent is a cansequence of disclosure rules. ‘Third, inthis paper we do not use any information from regula tions imposed by security exchanges. One instance in which this is relevant is exchange-imposed restrictions on the voting rights for the shares that companies can issue if these shares are to be traded con the exchange Finally, a potentially important set of rules that we do not deal with here is banking and financial institution regulations, which might take the form of restricting bank ownership, for example. Much has been made of these regulations in the United States by Roe (1994). “Several readers have pointed ca che US, sate anuisakeover laws as evidence of an anti-minoity sharehalder positon inthe US, leal sytem that our data do not apiure. Bren with all these anticakeover laws, the United States and the United Kingdom sill bave ay Gr the most aegwers of ay couney in the wold, so thee lawsare evidently nat nearly 38 antitakeover as those elsewhereLAW AND FINANCE naa An inspection of company and bankruptcy laws suggests numer- ous potentially measurable differences among countries. Here we focus only an some of the most basic rules that observers of corpo- rate governance around the world (e.g., American Bar Association 1989, 1993; White 1993; Institutional Shareholder Services 1994; In- vestor Responsibility Research Center 1994, 1995; Vishny 1994) be- lieve to be critical to the quality of sharcholder and creditor legal rights. Moreover, we focus on variables that prima facie are interpret- able as either pro-investor or pro-management since this is the di- mension along which we are trying to assess countries and legal famic lies, There are obvious differences in rules between countries, such as, for example, tier structures of boards of directors, that we do not ‘examine because we canmot ascertain which of these rules are more sympathetic to shareholders. Investor rights, as well as the other varie ables we use in this paper, are summarized in table I. We discuss individual variables in more detail in the sections in which they are analyzed and present all che data on individual rights thatwe use in the paper in the relevane tables, Some Conceptual Issues Our goal is to establish whether laws pertaining to investor protec: tion differ across countries and whether these differences have con- sequences for corporate finance. This research design immediately poses some conceptual problems. To begin, some scholars, such as Easterbrook and Fischel (1991), are skeptical that legal rules are binding in most instances, since often firms ean opt out of these rules in their corporate charters, which effectively serve as contracts between entrepreneurs and investors. Indeed, in many countries, firms can opt out of some of the rules we examine, As a practical matter, however, it may be costly for firms to opt out of standard legal rules since investors might have difficulty accepting nonstan- dard contracts and, more important, judges might fail to understand or enforce them, The question of whether legal rules matter is fun- damentally empirical: if opting out were cheap and simple, we would not find that legal rules matter for patterns of corporate ownership and finance. A closely related question is whether more restrictive rules, which reduce the choices available to company founders, are necessarily more protective of sharehoiders than the alternative of greater flex- ibility. 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JOF ay 0 LNOHUC pon se qons ‘uowstsisar sosoduut axepasord uomereioos out jt 20 eR y “srapjorppors Loupe Zuowe spuopusp se ainquispp 01 su sautabaz 9po> [ebsstuoa 10 me Auedaio> ay) fel auoaUt Iau Jo aBewuDoxod 2p eR, Yo) ous2 Woy #2807 >apU aU. 2104 sHPIOHPHEW & 4g Ao payen aq GED req mY anda joys ean ter tenlea aes Jo ao) urspustueyaw soauoutu poruddo a Dip. ur fontiow Jo Gorreuzeard an “Beqisaur siopioqoneys (eiam38 aq oF romontpaue,, s© pojaqe] 2% sy reprorsveys au PneBasBe ope ey a bs rusaed gg 01 funaou_ssopjoyregs LeuIproenx> we s0}[f69 0 -9PIo4 Ter pends a2eg3 yo degsisuuo Jo atleaazad warts yy, “iq {ao pase tddo asa 24 200 Sen, devs ow saop wa uaseueyy sry ssompass po10325, sosse pamaas Wo Seis 20H ON woneztusi091 owt Buio8 soy suonsusoy puspiap Aiorepseyy sits sorenpcry cn spices ue Hissonp se sna sandoo 1123seq Anuaag eu. pin ‘yg Aruna jeuonense, heen, reopen ssou'sng, 2p02 [eR __-uno9 Jaf 12 Jo anes © HY stowwin09 10 wep tavdiGog 0} wel s¥iodso> hq parepunwe Ro} 9) Stax whoa) soBuer pu aL 2p Jo onnjosDr ayy Buspuad darodoue a Jo fej won naan sonar = 4 ac exuedioar pue Sideayeeg "pe ia poutio; a sapu ag, ifn sopae tangy Supeadlle copes try soomnes wandsoeg (pray) CATHY wondanieg, sve $0 30 assis Weeppnt jo Oxsoury aasosax pT ‘ag8tr rouparg Saree 1141126 JOURNAL OF POLITICAL ECONOMY unanticipated way. However, with imperfect enforcement, simple, restrictive, brightline rules, which require only a minimal effort from the judicial system to enforce, may be superior (Hay, Shleifer, and Vishny 1996). Again, the question does not have a lear theoreti- cal answer, and the issue of how legal rules affect corporate finance is ultimately empirical. Even if we were to finel that legal rules matter, it would be possible to argue that these rules endogenously adjust to economnic reality, and hence the differences in rules and outcomes simply reflect the differences in some other, exogenaus, conditions across countries Perhaps some countries chose to have only bank finance of firms for political reasons and then adjusted their laws accordingly to protect. banks and discourage shareholders. Some individual rules are prob- ably endogenous. However, this is where our focus on the legal ori gin becomes crucial, Countries typically adopted their legal systems involuntarily (through conquest or colonization). Even when they chose a legal system freely, as in the case of former Spanish colonies, the crucial consideration was language and the broad political stance of the law rather than the treatment of investor protections. ‘The legal family can therefore be created as exogenous to a country's structure of corporate ownership and finance, If we find chat legal rules differ substantially across legal families and that financing and ‘ownership patterns do as well, we have a strong case chat legal farai- lies, as expressed in the legal rules, actually cause outcomes, II. Shareholder Rights We begin by considering shareholder rights from company laws. The rights measures in this sectian are refined versions of those pre- sented in our working paper (La Porta ec al. 1996). Because shareholders exercise their power by voting for directors, and on major corporate issues, experts focus on voting procedures in evaluating shareholder rights. They include voting rights attached Co shares, rights that support the voting mechanism against interfer- ence by the insiders, and what we call remedial rights. To begin, investors may be better protected when dividend rights are tightly linked to voting rights, that is, when companies in a councry are subject to oneshare-one-vote rules (Grossman and Hart 1988; Har- “We made rwo significant changes: we redefined the cumularve voting variable 1o alo eater the Hight of minority sharcholders for prapartional representation, and we added 2 varlable on preempute rights of minariy shareholders vs buy new SSiuss af stock (See below). In this and the following secuons, all dummies Nave been defined so that | means more protectiveLAW AND FINANCE aay ris and Raviv 1988).’ When votes are tied to dividends, insiders can- not have substantial control of the company withouc having substan- tial ownership of its cash flows, which moderates their taste for {costly} diversion of cash flows relative to payment of dividends. ‘There are many ways out of the one-share-onesvote principle that laws in different countries accommodate, Companies can issue non- voting shares, low- and high-voting shares, founders’ shares with ex- tremely high voting rights, or shares whase votes increase when they are held longer, as in France. Companies can also restrict the total number of votes that any given shareholder can exercise at a share- holders’ meeting, regardless of how many votes he or she conirals. We say that a country has one share-one vote if none of these prac- tices isallowed by law. In our sample, only 1]. countries impose genu- ine oneshare-one-ote rules The next six rights, which we refer to a8 antidirector rights, mea sure how strongly the legal system favors minority shareholders, against managers ar dominant shareholders in the corporate deci sion-making process, including the vating process. First, in some countries, shareholders must show up in person or send an author- ized representative to a shareholders’ meeting to be able to vote. In other countries, in contrast, they can mail their proxy vote directly to the firm, which both enables them to see the relevant proxy infor- mation and makes it easier to cast their votes. In Japan, for example, annual sharcholder meetings are concentrated overwhelmingly on a single day in late June, and voting by mail is not allowed for some sharcholders, which makes it difficult for shareholders to exercise their votes. Second, in some countries, law requires that sharcholders deposit their shares with the company or 2 financial intermediary several days prior 9 a shareholder meeting, The shares are then kept in custody until a few days after the meeting. This practice prevents shareholders from selling their shares for several days around the time of the meeting and keeps from voting shareholders who do not bother to go through this exercise ‘Third, a few countries allow curnulative voting for directors, and a few have mechanisms of proportional representation on the board, by which minority interests may name a proportional number of di- rectors, The effect of either rule, in principle, is to give more power for minority shareholders to put their representatives on boards of directors. * One of the E.G. directives recommends the adoption of oneshare-one-vote rules throughout dhe Commueiry ledoes tot appear cha dis dvecuve is being incorpo rated into national laws too rapidly1128 JOURNAL OF POLITICAL ECONOMY Fourth, some countries give minority shareholders legal mecha. nisms against perceived oppression by directors (in addition to out- right frau, which is illegal everywhere). These mechanisms may in- clude the right fo challenge the directars’ decisions in court (as in the American derivative suit) or the right to force che company to repurchase shares of the minority shareholders who object to certain fundamental decisions of the management or of the assembly of shareholders, such as mergers or asset sales, Fifth, some countries grant shareholders preemptive right to buy new issues of stock, which can be waived only by a shareholder vote. This right is intended to protect shareholders from dilution, whereby shares are issued to favored investors at below-market prices Sixth, we look at the percentage of share capital needed to call an, extraordinary shareholders’ meeting.’ Presumably, the higher this percentage is, che harder it is for minority shareholders to organize a meeting to challenge or oust the management. This percentage varies around the world from 3 percenc in Japan to 83 percent of share capital in Mexico, For each of the first five antidirector rights measures, a country gets a score of 1 if it protects minority shareholders according to this measure and a score of 0 otherwise. We also give each country a L ifthe percentage of share capital needed to call an extraordinary shareholder meeting ist or below che world median of 10 percent. Finally, we add up these six antidirector rights scores inco an aggre- gate score, which ranges from 0 for Belgium to 5 for Ganada and the United States, for example. The last shareholder rights measure, which we treat differently from others, isthe right to a mandatory dividend. In some countries, companies are mandated by law to pay out a certain fraction of theit declared earnings as dividends. Because earnings can be misrepre- sented within the limits allowed by the accounting system, this mea- sure is not as restrictive as it looks. The mandatary dividend right may be a legal substitute for the weakness of other protections of jority shareholders. Table 2 presents the data on shareholder rights. The values of all variables are listed by country, and countries are organized by legal origin. Columns in table 2 correspond to particular legal provisions concerning shareholder rights, and the values in the tables are dum- ‘For the United Sates, our reliance aa Delaware presents a problem since the state eaves up to corporations the percentage of shares needed ta call an extraord= hay shareholder meeting. We use 10 percent for the United States because majority of US. sates (23) use this number,LAW AND FINANGE 112g mies equal to one if the counuy has shareholder protections in that particular area. Table 2 also presents equality of means tests for all the variables by origin. ‘An examination of world means of the variables in table 2 sugyests that relatively few countries have legal rules favoring outside share- holders. Only 22 percent of the countries have one share-one vote, only 27 percent allow cumulative voting or give minorities a right of proportional hoard representation, only 18 percent allow voung by mail, only 53 percent have some appressed minorities mecha- nism, and only 53 percent give minority shareholders a preemptive right to buy new shares. ‘The other clear result in table 2 is that, for many variables, the origin of laws matters. The means of shareholder rights variables are statistically significantly different between legal families. The two variables in which most legal families are similar are one share-one vote, which isan uncommon restriction everywhere (and never hap- pens in Scandinavia, which is therefore different), and cumulative voting /proportional representation, which is also uncorarnon every where (and again never happens in Scandinavia). For the other vari- ables, the differences in shareholder rights beeween legal origins are more substantial. Specifically, two major findings emerge from table 2. First, along a variety of dimensions, common-law countries afford the best legal protections (0 shareholders. They most frequently (39 percent) allow sharcholders to vote by mail, they never block shares for share- holder meetings, they have the highest ($4 percent) incidence of laws protecting oppressed minorities, and they generally require rel- atively litle share capital (9 percent) to call an extraordinary share- holder meeting. The only dimension an which common-law coun- tries are not especially protective is the preemptive right to new share issues (44 percent). Still, the commondaw countries have the highest average antidirector rights scare (4.00) of all legal families. Many of the differences between common-law and civi-law countries, are statistically significant, In short, relative to che rest of the world, common-law countries have 2 package of laws most protective of shareholders ‘Second, along a broad range of dimensions, French-civiHaw ¢oun- ties afford the worst legal protections to sharcholders. Although, they look average on one share-one vote (29 percent} and cumula- tive voting (19 percent) and beter than average on. preemptive rights (62 percent), they have the lowest (G percent) incidence of allowing voting by mail, a low (57 percent, though not as low as German-civil-law countries) incidence of not blocking shares for shareholder meetings, a low (29 percemt, though not as low as Norg seemenartmsrensmaand romeneaines 288S t z 8 3 Es cy (Go 2 of wopDHOKg HOT ones perm silly —_‘Bansory soni nay Guy opmusianday onsopy poroiny _=9a 240 ‘anme5 Aowpasy sovaipiuy 29pkoenys —oLs4iq pasando dieupiocner aanducaig sine oN eS ‘aTHOM, AHL ako ScHLONy IETONEEAVES PeVL agowe wr ast soos oot ‘uve ceueupucrg v wean ae or et cgi ete ‘ase gees sta Moe Se ee eget OT ‘uluo orion yous i wt BE ate woe oe gor oo ws aes wig Sse wot use Tees ask wt E a Bey Moe (eonseg 7) sueope 79 HE a w we w w @ wo we ow sw w ‘ 3 9 ° ° oo i 5 t 5 » $ ° ° a o 3 5 ° 0 rs we oe Co cs wo ¢ t oo 9 ‘0 z o oo 6 oo z 5 o 8 t oo t t t 8 t 0 t 4 o 3 o o» z ° oo ° tw swe % woe w wo t fl ° 1 0 te z t ‘ a 8 t oo 5 6 6 1 8 ° is t t t o 0 5 ‘ € 0 4 t 5 0 a t t t 8 5 i 5 > t t 8 t i 3 5 o oo o oo i 5 5 O38 0 ow t ° 5 1 8 1 ‘i t 6 5 oo 0 or g 0 0 t 8 5 11384132 JOURNAL OF POLITICAL ECONOMY dic countries) incidence of laws protecting oppressed minorities, and the highest (15 percent) percentage of share capital needed to call an. extraordinary shareholders’ meeting. The aggregate antidt- rector rights score is the lowest (2.33) for the French-civiklaw coun- tries, The difference in this score between French civil law and com- mon law is large and statistically significant. I is interesting to note that France itself, except for allowing proxy vating by mail and hav- ing a preemptive right to new share issues, does not have strong legal protections of shareholders, These results suggest that shareholders in the two most widely spread legal regimes—common law and French civil law—operate in very different legal environments ‘The German-civi-law countries are not particularly protective of shareholders either. They have a relatively high frequency of one- share-onevote rules (because of Bast Asia), require few votes to call an extraordinary meeting, and offer preemptive rights in a third of the cases. But they usually block shares before shareholder meetings, never allow voting by mail, and have oppressed minority mecha- nisins in only half of the countries. The average antidirector score for this family is 2.33, exactly the same as that for the French farnily. In Scandinavia, no counury has oppressed minority protections, a onesshare-one-vote restriction, or a cumulative voting/propor- tional representation mechanism, and only Norway allows vating by mail. Ac the same time, no country blocks shares before a share- halder meeting, and three out of fonr give shareholders preemptive rights. The average Scandinavian antidirector rights scare is 3 ‘The ane remedial measure in table 2, namely mandatory divi- dend, shows that mandatory dividends are used only in French-civil- law countries, This result is broadly consistent with the rest of our evidence and suggests that mandatory dividends are indeed a reme- dial legal protection for sharcholders who have relatively few other legal rights ‘The results in panel B of table 2 suggest that che differences in the various measures of shareholder rights between different legal families are often significant and almose always significant when common- and civil-law families are compared. One further question is whether che difference in scores by legal origin just reflects differ- ences in per capita income levels. To address this question, table 3 divides all countries into the bottom 25 percent, middle 50 percent, and top 25 percent by gross national product per capita. The results show, in particular, that antidirector rights scores are independent of per capita income, rejecting the notion that legal rules that are more protective of investors are a reflection of higher per capita In sum, commondaw countries have the relatively strongest, andeax dos > 3505 Ba 8 5 208 Ps ae ore 0 8 Be o% oo soi peg dav 38 cg mo cs 808 2 oe ee ce Bog pets sg wow (Gonawegs) aubayE Fe 0 os ee 0 See so 0 ote we 0 Be iL scene ¥ pupa a1eA 20 ida veda 22d aNO Aowepuyy 0 SSaiissu9 Bd aN fq pniog s9utuEeD ‘SRMORE HOLSAANT AY LAINIOTAAEC, STILnag JOURNAL OF POLITICAL ECONOMY the French-civil-law countries the weakest, protections of sharehold- crs, independent of per capita income, Minority shareholders in Australia can vote hy mail, can trade their shares during a sharchold- ers’ meeting, are protected from certain expropriations by directors, and need 10 organize only 5 percent of the votes to call an extraordi- nary meeting. Minority shareholders in Belgium, in concrast, cannot vote by mail, have their shares blocked during the shareholder meet- ing, are not protected from expropriation by directors, and need 20 percent of share capital to call for an extraordinary meeting. The differences between legal families come out clearly from this analysis, of shareholder rights. IV. Creditor Rights Conceptually, ereditor rights are more complex than shareholder rights, for evo reasons, Fiest, there may be different kinds of credi- tors, with different interests, so protecting rights of some creditors has the effect of reducing the rights of others. For example, in the case of a default, senior secured creditors may have a simple interest in getting possession of collateral no matter what happens to the firm, whereas junior unsecured ereditors may wish to preserve the firm asa going concern so that they can hope to get some of their money back if the firm cums a profit, In assessing credicar rights, wwe take the perspective of senior secured creditors, in part for con- creteness and in part because much of the debt in the world has hat character Second, there are two general creditor strategies of dealing with a defaulting firm: liquidation and reorganization, which require dif ferent rights to be effective. The most basic right of a senior collater alized creditor is the right to repossess—and then liquidate or keep—collaicral when a loan is in default (see Hart 1995). In some countries, law makes it difficult for such creditors to repossess collar eral, in part because such repossession leads to liquidation of firms, which is viewed as socially undesirable. In these countries, creditors ‘may still have powers against borrowers, namely their yates in che decisions for how to reorganize the company, The debate between the wisdom of reorganization and liquidation from che social view- point has been extensive (Aghion, Hart, and Moore 1992; White 1993; Baire 1995) and has raised the question of whether both pro- cedures or just one is needed to protect creditors. Thus a country with a perfect liquidation procedure but totally ineffective reorgani- zation might be extremely protective of creditors simply because re- ‘organization never needs to be used. We score creditor rights inLAW AND FINANCE 1135 both reorganization and liquidation and add up the scores to create a creditor rights index, in part because almost all countries rely to some extent on bath procedures. We use five creditor rights variables in chis analysis. First, in some countries, the reorganization pracedure imposes an automatic stay ‘on the assets, thereby preventing secured creditors from getting pos- session of loan collateral. This rule obviously protects managers and unsecured creditors against secured creditors and prevents auto- matic liquidation. In Greece, for example, secured creditors have the right to foreclose on their property when their claim matures and not when the borrower defaults (Houghton and Atkinson 1993, p. 112). In other countries, in contrast, secured creditors can pull coltateral from firms being reorganized without waiting for comple- ion of reorganization, a right that is obviously of value to them. Second, some countries do not assure the secured creditors the right to collateral in reorganization, In these, admittedly rare, coun- tries, secured creditors ar¢ in line behind the government and work- ets, who have absolute priority over them. In Mexico, for example, various social constituencies need to be repaid before the secured creditors, often leaving the latter with no assets to back up their claims. Third, management in some countries can seck protection from creditors unilaterally by filing for reorganization, without creditor consent, Such protection is called Chapter 11 in the United States and gives managemenc a great deal of power, since at hest creditors can get their money or collateral only with a delay. In other coun- tries, in contrast, creditor consent is needed to file for reorganiza- tion, and hence managers cannot so easily escape creditor demands Finally, in some countries, management stays pending the resolu- tion of the reorganization procedure, whereas in other countries, such as Malaysia, management is replaced by a party appointed by the court ar the creditors. This threat of dismissal may enhance cred itors’ power. As with shareholder rights, we use one remedial creditor rights measure, namely the existence of a legal reserve requirement. This requirement forces firms to maintain a certain level of capital to avoid automatic liquidation, It protects creditors who have few other powers by forcing an automatic liquidation before all the capital is stolen or wasted by the insiders. ‘The results on creditor rights are presented in table 4. In general, the protections of creditor rights analyzed here occur more fre- quently than the protections of shareholder rights. Nearly half of the countries do not have an automatic stay on assets, 81 percentw + ' c 1 c s2uopuy e t 1 a ° 5 39319 a 0 6 a ° 0 Sound oe ¥ 1 C 1 t ity os + t t t t opens & 4 é a ° 0 erquoge. oe 3 ° t r 0 "> o t ° c ° 0 =a or z ° ° t t wna, te C o ° t 0 euuhy w ve w we steer aponpeing w ¥ ' r aan oo t 6 o emg pan a * t U sop pau, or & t a peer, te 5 t t UET OS a 5 L t eugy lees w 5 1 1 siodeBing 9 5 t t went oo 5 t t 2 w 5 t C oeeez SON, oo F 1 t con i 5 t t eu, w F L r Ps i t o ° o pust w 5 t t T ae oo 5 t t c Buoy SoHE ° a 0 peue o 2 a 4 weeny (oe oun st wompaiosg soupes9 = 1) audi 30up95 -Y wd sain penuetiony — voneuwellory preg eny —sssy uo ha aaue9, iewoamy —ONPOR) —uLKeg ION ss0q CRUE BeNOD soy SLOMPAL —SNeCICNNY ON wee pasnboy. RivUsieueyy —SuOWNENRY—pastNS, Seay eT twoy 2842 annoy suing won Pave 1196ai er we 8 ate i a a not site wr Set wate seth C se Tae mse sis ost Mest is95 — * = rs aherue agdees ow % enue adyourueapas ‘0 t 0 apa ° 1 ° ‘ono ° 4 ° rg ° t t ves co cS “s tes oi9g a ° cen 3 : putas 1 5 eaey mao t : Sear é t scsi 5 i ame = » % sess woes 1 * ° ease, ° t a ‘Sun ° ° i eds ° ° ° ised ° 5 ° soured ° 0 ° wal ° t ° yucatan ° ° ° earn w w w wept ° c ° sie 11371138 JOURNAL OF POLITICAL ECONOMY pay secured creditors first, over half restrict the managers’ right to seek protection from creditors unilaterally, and 45 percent remove ‘management in reorganization proceedings. Asin table 2, we see that, for many creditor rights, the legal origin matters. Common-law countries offer creditors stronger legal pratec- tions against managers. They have the highest (72 percent) inc dence of no automatic stay on assets: with two exceptions, they guar antee that secured creditors are paid first (the German-civiblaw and Scandinavian families have no exceptions); they frequently (72 per- cent, behind only Scandinavia) prechide managers from unilaterally seeking court protection from creditors: and they have far and away the highest (78 percent) incidence of removing managers in reorga- nization proceedings. The United States is actually one of the most anticreditor common-law countries: it permits automatic stay on assets, allows unimpeded petition for reorganization, and lets man- agers keep their jobs in reorganization, The average agaregate credi- cor rights score for common-law countries is 3.11—by far the highest among the four families—but this score is only 1 for the United States The French-ivillaw countries offer creditors the weakest protec- dons, Few of them (26 percent, tied with Scandinavia) have no auto- matic stay on assets; relatively few (65 percent} assure that secured creditors are paid first; few (42 percent—still more than German- Tuptcy Reform.” J. Law, Bian, ancl Organization 8 (October 1992): 523- 46. Sa Pora eal. (187) we the oneal La Rots et a (1996) dase Dave reconfirmed thelr results using the refined measures presented in cis paper.LAW AND FINANGE 1153 American Bar Association. Mudtinational Commercial Insstoency. 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