Law and Finance

CONTENT

Abbreviation

1. Introduction

2. Legal and regulatory systems
2.1 Major legal systems in the world
2.2. The legal framework in an economy
2.3 Characterisation of differences in national legal and regulatory systems
2.3.1 Principal Agent Theorem
2.3.2 Shareholders
2.3.2.1 Interdependence between legal systems and shareholder protection
2.3.2.2 Shareholder protection and dividend payoff
2.3.2.3 Influence of investor protection on finance and economy
2.3.3. Corporate Ownership Structure
2.3.3.1 A historical view
2.3.3.2 Triggers for concentration
2.3.3.3 Structure of concentration
2.3.3.4 A critical analysis
2.3.4 Creditor Rights
2.3.5 Soundness of contract enforcement
2.3.6 Level of corporate accounting standards
2.4 Impact of the legal and regulatory environment on Financial Intermediates and on economic growth
2.4.1 Legal and financial framework and firm growth
2.4.2 Financial Intermediaries and Growth

3. Globalization of Law and Finance
3.1 The phenomenon of Convergence
3.1.1 Convergence in financial markets
3.1.2 Convergence of Accounting Practices
3.1.2.1 Institutional Framework
3.1.2.2 Harmonisation Initiatives
3.2 International regulatory cooperation
3.2.1 Regulatory issues and networks
3.2.2 Standard setting instead of strict rules and recent developments in international regulation
3.2.3 Barriers to International Regulatory Cooperation

4. Conclusion

Appendix

Bibliography

Abbreviation

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1. Introduction

The discussion of laws in the financial area and the relationship between law and finance originates back to Ronald Coase (1960).

The Coase Theorem proposes that problems between issuers and investors are resolved through private contracting with the consequence of efficient markets.^[1] The past shows that the Coase Theorem in its purest form, which abandons transaction costs, is not applicable to investor – issuer- relationships, because the existence of transaction costs makes the enforcement of private contracts inefficient. Therefore judicially – enforced and government – enforced laws/ regulations have developed, in order to make contracting and thus the financial market more efficient.

The aim of this paper is to explain to the reader the interdependencies that exist between law and finance by explaining law and finance issues on a theoretical basis and by finally showing the influence of globalization on these law and finance issues.

Important developments are presently happening in the law and finance area of global corporations aiming at a further convergence of both law and finance. Although these developments are to a large extent driven by capital market needs, they will also have consequences for the accounting area in general, regulatory issues and for companies which have not yet decided to turn to the capital markets in order to satisfy their need for capital.

For enabling an in-depth discussion later in this paper we start by differentiating legal systems around the world and introducing the legal framework in an economy. The incorporation and efficiency of the legal framework depends on the legal system.

In a next step differences in legal systems will be characterised and their effects examined.

In order to determine the influence of legal systems on investor rights in great detail, it is necessary to understand the source of conflict, the separation of ownership and control, in companies. This originates in the Principal Agent Theorem.

On the basis of the Principal Agent Theorem, we will then analyse the interdependence between shareholder protection and legal systems. The effectiveness of shareholder protection influences finance and the economy as a whole.

Afterwards will identify the structure of shareholders in companies, because some companies are widely held and others show significant ownership concentration. This difference is once again due to the legal system, the company is operating in. To conclude this part about ownership concentration, the existence of concentration will be critically examined.

Furthermore this paper examines the protection of creditors, i.e. the basic right of a creditor to repossess collateral when a loan is in default, the legal enforcement of contracts by active and well – functioning courts and how accounting standards influence the information asymmetry between investors and issuers.

Afterwards it is investigated whether specific differences in financial systems and legal institutions affect firm growth financed by external funds and how financial intermediaries affect firm growth.

Finally this paper screens the ongoing trend of globalization in law and finance, explaining the convergence in financial markets, the internationalisation of Accounting Practices and the current discussion of International Regulatory Cooperation.

2. Legal and regulatory systems

2.1 Major legal systems in the world

Although each country in the world has its own legal system tied to its political unit, 90% of all the different legal systems originate from two main legal traditions: the civil or common law. The reason for the development of many different legal systems is that the two main legal traditions, either the civil law tradition or the common law tradition, were adapted to the social and cultural context of each country.

The civil law has a major impact on the world, since more than 60% of the world population is influenced by this tradition.^[2] The Latin terminus “ius civile” was first used in the Roman Republic in order to describe actions between citizens.^[3] Over the following decades a law, named civil law, which was highly influenced by the Roman law, developed. The civil law represents a group of laws made by legislative authorities. These laws consist of several detailed codes, which are characterised by a high level of abstraction. The interpretation and application of those laws is left to the judges in the courts.

Within the civil law three different categories/families can be distinguished: French, German and Scandinavian.

In 1807 Napoleon wrote the French commercial code, which spread among a lot of countries around the world. Countries, which applied the French civil law, were for a huge part former colonies of France, for example Argentina, Greece and Venezuela.

In the middle of the fifteenth century, Roman law began to influence Germany. In consequence, Germany developed legislative institutions, which were accepted by the population. In comparison to the French and Scandinavian, Germany included a much more “(…) extensive scientific systematisation of legal thought (…)”.^[4] But a real commercial code was not developed before 1897. Due to this retard, the German commercial code was not as widely adopted as the French Code, but still spread to some countries as for example Austria, Japan, South Korea, Switzerland and Taiwan.^[5]

Finally the Scandinavian family, which includes Nordic countries, makes part of the civil law. For the purpose of this paper this law family is left out, because it did not spread to any other countries than the Nordic countries. Therefore its worldwide influence and importance is very limited.

With a penetration of 30% of the world population, the common law is less spread than the civil law.^[6] The roots of the common law go back until the 12th century. In 1215 King John of England signed the Magna Carta, in which he granted certain rights to the aristocrats and the people. The Magna Carta consists of 61 clauses and was called the “blueprint of English Common law”.^[7] It is important to notice that “no country has clung as firmly as England to its own style of law throughout the centuries or been so free from major convulsions in its legal life”.^[8]

The primary source of law in this legal system is jurisprudence, which means that legal concepts are formed by judges on the basis of cases they solved at the court. Therefore in the common law legal concepts emerge and progress over time.

Common law prevails in the United Kingdom, USA and most Commonwealth countries like for example Australia or Canada.

In the context of corporate governance the importance of differentiating between the civil and common law is due to the fact that legal origins influence the behaviour of financial intermediaries.

2.2. The legal framework in an economy

The application of a legal framework for effective securities regulation is necessary in order to protect investors, to enable fair, efficient markets and to reduce systematic risk.^[9] Systematic risk is the market risk, which investors cannot eliminate through diversification. An efficient and accepted legal framework should be designed by every country, no matter of which origin (court enforced laws (common law) or government enforced regulation (civil law)), but in practice this is not the case. Some countries do not offer sufficient legal investor protection.

The legal framework consists of eight laws:

1.Company Law: Laws concerning company structure, management responsibilities, the issue of securities, information disclosure policies, legal relationships between insiders and outsiders
2.Commercial Law: Contract right (privately negotiated), property and transfer rights of securities
3.Taxation Law: Date, Obligation and Content of Disclosure
4.Bankruptcy and Insolvency Law: Rights of security holders in case of the bankruptcy or insolvency of the company
4.Competition Law: Permissions to intervention in order to enable a fair competition, prevention of unfair entry barriers and abuse of market positions (monopoly)
5.Banking Law: Amount of credits given out to the economy in relation to the equity of a bank
6.Dispute resolution system: Rules in order to enable a fair and efficient judicial system

These laws and the quality of their enforcement are essential elements of corporate governance and finance, but their relevance depends upon the legal system. The following pages will show that differences in investor protection, both shareholder and creditor, are due to legal origins.

2.3 Characterisation of differences in national legal and regulatory systems

2.3.1 Principal Agent Theorem

In earlier centuries companies have been exclusively managed by directors who owned the firm themselves. But over the course of time management had become much more professional, which finally resulted in a separation of ownership and control. The law that included the necessity of identical ownership and control was abandoned for example 1844 in England and 1935 in Delaware.

The Principal Agent Theorem can be described as follows: “Conflicts of interest between corporate insiders, such as managers (…), on the one hand, and outside investors, such as minority shareholders, on the other hand, (…)”.^[10] The separation of ownership and control is the trigger for the conflict. Since managers do not bear the full wealth effect of their decision, there is a danger that they act in their self-interest at the expense of the investors, both shareholders and creditors. Management might abandon maximising shareholder value or expropriate investors.^[11] For example managers could use the funds, provided by investors, to pay excessive salaries or use them for asset sales and transfer pricing.

In consequence outsiders want to protect themselves against expropriation by insiders through a set of mechanism, called Corporate Governance.^[12] Corporate Governance systems vary around the world. The following parts will show that common law countries rely on laws to protect investors, whereas in civil law countries the absence of efficient legal systems leads to another corporate governance system: the concentration of ownership as a substitute for legal protection. The outcomes of theses governance systems will be critically examined and it will be shown which mechanism is more efficient from the viewpoint of attracting external funds.

2.3.2 Shareholders

2.3.2.1 Interdependence between legal systems and shareholder protection

In different legal systems, rules protecting investors originate from different sources of law, for example company or commercial laws.^[13] The more rights the shareholders are granted by law, the better protected they are, because rights give shareholders a certain amount of control. Rights might vary around the world, but to mention some: The right/power to extract information from management about corporate issues and decisions, to vote on corporate issues, to change management, to sue directors, to stop projects which are detrimental to shareholder value and to force dividend payments. In a research, La Porta et al. analysed some of these rights and formed an index out of five rights.^[14] Their research shows that common law countries in general stress shareholder rights in their legal system. For example, the USA and the UK both have an oppressed minorities mechanism in place and shareholders are not required to deposit their shares prior to the General Shareholders’ Meeting.^[15] On the contrary, Germany and France do not have any laws addressing these issues.

La Porta’s research proved that legal investor protection depends on the legal origin of a country, but did not determine the factors, which are responsible for this relationship. In the following we will address this issue further.

In common law, judges solve cases at court and on the basis of these cases legal rules develop. On the contrary, in civil law countries the law consists of several binding legal rules and therefore the freedom of judges in ruling on new cases is limited to the interpretation of the binding legal rules. In case that the management finds a way to expropriate shareholders, justifying this with an acceptable business purpose, the basic jurisdictional rule of “sine poena nulla lege” applies.^[16] Therefore civil law countries either offer protection to a lesser extent than common law countries or no protection at all.

2.3.2.2 Shareholder protection and dividend payoff

Dividends play an important role, because the more dividends managers distribute to shareholders, the fewer funds are left for opportunistic behaviour of the management. The preference of dividends over retained earnings depends on the different taxation rule. Since analysing the tax structure of each country in the world goes beyond the scope of this work, tax effects are ignored and it is assumed that with regard to agency problems, all investors would prefer dividends to retained earnings. Still, the amount of dividends required by investors depends on the future outlook (the growth opportunities) of the company. If growth is expected shareholders will accept lower payoffs and encourage more re-investment.^[17]

The interdependence of investor protection and dividend payoffs was analysed by La Porta et al.^[18] They concluded that common law countries generate higher dividend payoffs, because investors who are better protected, typically have more power to extract dividends. This is called the outcome model and states ”(…) dividends are an outcome of an effective system of legal protection of shareholders”.^[19] Therefore the payment of dividends is not necessarily granted through direct laws, but rather through voting rights, which give shareholders the power to extract dividends. Shareholders can thus vote off the management that pays off low dividends.

Therefore paying off dividends reduces the danger of expropriation, but poorly protected investors don’t have the power to extract dividends and in consequence cannot reduce the danger of expropriation.

2.3.2.3 Influence of investor protection on finance and economy

The following part is going to establish a link between investor protection, which differs according to the prevailing legal systems, and external finance. It will be shown that the less efficient the investor protection is, the smaller the opportunities for external finance and the smaller the capital markets. In order to determine the relationship between legal systems and external finance, it is important to formulate variables describing external finance.^[20] Although there exists a broad range of variables, for the purpose of this analysis we will concentrate on the number of listed domestic companies and the ratio of stock market capitalization to Gross Domestic Product.

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Source: Data from Worldbank, See Appendix

The graph shows that common law countries tend to have a smaller number of the total population per listed domestic company than civil law countries. This means common law countries have more listed domestic companies relative to their population. In average the calculation gives about 73242 people per listed domestic companies in common law and 121080 people per listed domestic companies in civil law countries. Taking very well developed countries, as the UK; USA, France and Germany the population per listed company is lower as the average (UK: 30694, USA: 36806; Germany: 88103 and France: 60847). This is consistent with evidence around the world that well developed countries in general have better access to external finance. But those numbers still show, that common law countries like the UK and the USA have higher relative numbers of listed companies.

The other variable (stock market capitalization per Gross Domestic Product) was widely discussed by a research of La Porta, Lopez-de-Silanes, Shleifer and Vishny.^[21] According to their analysis, common law countries have a by far higher ratio of stock market capitalization to Gross Domestic Product (UK: 100%, USA: 58%) than civil law countries (Germany: 13%, France: 23%).^[22]

The lower number of listed companies in civil law countries is due to the fact that if investor protection is seen as insufficient, companies have problems to raise capital in equity markets, because investors fear expropriation. On the contrary, investors are willing to pay more for financial assets if they are secured against expropriation. The price of securities in the capital market increases. This research is supported by several researches about Initial Public Offerings which show that going public is much more common in common law countries.^[23]

[...]

^[1] See Fees (1997); P.543

^[2] See Unesco (1999); P. 26

^[3] See Clark (1990); P. 65

^[4] Zweigert; Kötz (1998); P. 139

^[5] See La Porta; Lopez-de-Silanes; Shleifer; Vishny (1998); P. 9

^[6] See Unesco (1999); P. 26

^[7] Unesco (1999); P. 26

^[8] Zweigert; Kötz (1998); P. 188

^[9] See International Financial Risk Institute

^[10] La Porta; Lopez-De-Silanes; Shleifer; Vishny (2000a); P. 3

^[11] See Keasey; Thompson; Wright (1997); P. 3

^[12] See La Porta; Lopez-De-Silanes; Shleifer; Vishny (2000b); P. 3

^[13] See Section 2.2

^[14] See La Porta; Lopez-de-Silanes; Shleifer; Vishny; (1998); Table 2

^[15] See La Porta; Lopez-de-Silanes;Shleifer; Vishny (1998); Table 2

^[16] See La Porta; Lopez-de-Shilanes; Shleifer; Vishny (1999); P. 10

^[17] See La Porta; Lopez-de-Silanes; Shleifer; Vishny (2000a); P. 18

^[18] See La Porta; Lopez-de-Silanes; Shleifer; Vishny (2000a); P.1ff

^[19] La Porta; Lopez-de-Silanes; Shleifer; Vishny (2000a); P. 5

^[20] External finance is here limited to equity finance

^[21] See La Porta; Lopez-de-Silanes; Shleifer; Vishny (1997); P. 1134

^[22] See La Porta; Lopez-de-Silanes; Shleifer; Vishny (1997); P. 1134 ff

^[23] See Holmén, Högfeldt 2001