Business History
Vol. 00, No. 0, 2012, 1–19
Does the law and finance hypothesis pass the test of history?
Aldo Musacchioa* and John D. Turnerb
a
Harvard Business School, Boston, USA; bQueen’s University Management School and Queen’s
University Centre for Economic History, Belfast, UK
For the body of work known as the law and finance literature, the development of
financial markets and the concentration of ownership across countries is to a large
extent the consequence of the legal system nations created or inherited decades or
hundreds of years ago. Despite the seemingly historical nature of this explanation, most
of the body of work supporting the law and finance hypothesis has been ahistorical.
This paper summarises the business history literature and provides evidence on investor
protection and financial development over the long run that challenges the main tenets
of the law and finance literature.
Keywords: finance; legal origin; common law; civil law; history
1.
Introduction
In the 1990s, a group of US-based economists published several influential papers
exploring the relationship between law (in the form of investor protection) and financial
development. As financial development could affect law just as easily as law could affect
financial development, these economists searched back in time for a variable that would
allow them to test the direction of causation. The variable they used in their analysis was
legal family or legal origin (i.e. French civil law, German civil law, Scandinavian civil law
and common law). Thus, the law and finance hypothesis was born. This hypothesis can be
summarised as follows. Early in their history, England, France and Germany had
developed different legal styles of controlling business due to their unique histories; these
styles of control were transplanted by these colonial powers and copied by independent
nations rather than starting from scratch, and these styles have proved to be hysteretic as
they determine economic outcomes such as financial development in the present.1 Because
these legal systems were created or adopted before the development of modern financial
markets, the causal story (going from legal origin to financial development) is easy to
defend.
Although many economists and lawyers have challenged the premises and findings of
the law and finance hypothesis, much of the debate, with some notable exceptions
discussed in this paper, has been ahistorical. This is somewhat puzzling given the explicit
historical nature of the legal-origins hypothesis, which argues that history matters.2 It is
*Corresponding author. Email: amusacchio@hbs.edu
ISSN 0007-6791 print/ISSN 1743-7938 online
q 2012 Taylor & Francis
http://dx.doi.org/10.1080/00076791.2012.741976
http://www.tandfonline.com
2
A. Musacchio and J.D. Turner
also puzzling given that history presents the greatest challenge to the law and finance
hypothesis.
The main proponents of the law and finance hypothesis, Rafael La Porta, Florencio
Lopez-de-Silanes, Andrei Shleifer and Robert Vishny, have been so widely cited that
Research Papers in Economics ranks them as the 27th, 19th, 1st and 5th (respectively)
most cited economists in the world as of July 2012. According to Google Scholar, their
seminal 1998 paper on the subject has been cited by 10,891 works as at July 2012.3 As
their work has substantial normative implications, it has had an enormous effect on
securities law and pro-market regulatory reform, particularly through the vehicle of the
World Bank’s Doing Business reports.4 This influence has not always been appreciated,
particularly in France and other French civil law economies.5
As recently suggested by Morck and Yeung, business history, given its methodological
approach and global perspective, can make a valuable contribution to debates about
causation in economics.6 Business historians can look at the broad sweep of history within
different economies and observe and delineate the effect of legal changes and legal origins
on financial development and vice versa. In addition, business history provides a helpful
laboratory where we can look at the development of finance before the era of pervasive
government regulation of financial markets and institutions as well as observing what
happens whenever legal changes are introduced for the first time.
The aim of this paper and this special issue of Business History is to outline the
contributions business history has made and potentially can make to the law and finance
debate. Our main contribution in this paper is to present a range of evidence from business
history which seriously undermines important tenets of the law and finance hypothesis.
This paper is structured as follows. The next section reviews the law and finance
debate as well as discussing some of the weaknesses with the law and finance hypothesis.
The third section of the paper analyses and discusses the contribution business history
can and has made to this debate as well as outlining the contribution of the papers in
this special issue to the debate. The final section summarises the main findings as well as
suggesting further avenues for investigation.
2. An overview of the law and finance debate
Corporate governance is concerned with how suppliers of finance (i.e. shareholders and
creditors) control managers and ensure that they get a return on their investment.
According to Shleifer and Vishny, law and the quality of its enforcement are important
determinants of what rights finance providers have and how well these rights are
protected.7 Consequently, legal protection of suppliers of finance is a major determinant of
the willingness of investors to finance firms.8 Ultimately, the protection of investors is a
major factor in financial development.9
The above hypothesis in and of itself is uncontroversial. However, a group of USbased economists, whom we refer to as the law and finance school, in a series of papers
developed the contentious hypothesis that an economy’s legal origin determines the
strength of its investor protection laws and hence its financial development.10 In addition,
these economists argue that corporate ownership and governance and corporate financial
policy are also determined by a country’s legal origin.11 Legal origin refers to the broad
legal traditions or families that countries adopted as the basis of their commercial laws
either freely or by force. The two broad legal families are common law and civil law.
Common law, which dates from after the Norman invasion of England and is mainly
found in former British colonies, is formed by judges resolving specific disputes, with the
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3
judicial rulings and precedents arising from such cases shaping the common law.12 Civil
law, which has its basis in Roman law and is the most widely distributed legal family,
is created by jurists and legal scholars, and is codified. The most famous examples of civil
codes are the French Commercial Code of 1807 and the German Civil Code of 1897. The
French Code was introduced into several countries in Europe following Napoleon’s
conquests and was imitated by Spain and Portugal, which resulted in the spread of French
civil law to Central and South America. During the colonial era, French civil law was
transplanted into the Near East, Oceania and Africa. The German legal family influenced
some neighbouring European nations as well as Japan, Korea and China. Scandinavia had
its own civil law tradition, but it was not transplanted into other economies.
In the commercial sphere, civil law is viewed as inferior to common law as it is
constructed by legal philosophers rather than emerging from the process of resolving
specific business disputes. This, of course, means that civil law is potentially subject to
greater political interference. In addition, the infrequent revisions of civil law codes means
that they quickly become outdated, whereas the common law is inherently dynamic and
pragmatic in responding to a new business environment and new business practices. For
the law and finance school, ‘common law stands for the strategy of social control that
seeks to support private market outcomes, whereas civil law seeks to replace such
outcomes with state-desired outcomes’.13
According to the law and finance school, legal origins are largely exogenous as they
were transplanted through conquest and colonisation. They therefore use legal origins as a
way to overcome the identification problem associated with testing the hypothesis that
investor protection laws strongly predict corporate ownership and control as well as
financial development. Notably, other studies have shown that legal origin affects more
than finance – e.g. legal origin is found to predict state ownership of banks, labour market
regulation, military conscription, severity of currency and real crises, and government
ownership of media.14
In its empirical work, the law and finance school constructs investor protection indices
which attempt to measure how well an economy’s legal system protects minority
shareholders and creditors from opportunistic directors. The chief leximetrics of the law
and finance school are the anti-director-rights index, anti-self-dealing index and creditor
rights index; the headline finding is that investor protection, as measured by these indexes,
is higher in common law countries.15
A theoretical agency-based model by Shleifer and Wolfenzon implies that investor
protection shapes corporate finance and the empirical evidence of the law and finance school
supports this model.16 Firstly, common law and better investor protection are both
associated with better developed stock markets and financial development.17 Secondly,
common law and better investor protection are closely linked with diffuse ownership,
whereas the civil law is associated with concentrated ownership.18 This relationship may
arise because in an environment where there is poor legal protection of outside shareholders,
concentrated owners may be better able to monitor managers and minority shareholders
would only be willing to purchase shares at a deep discount. Thirdly, common law and better
investor protection are both associated with higher dividend payouts.19 Again, this is
consistent with agency theory as strong investor protection constrains managerial
expropriation and empowers minority shareholders to extract dividends. Fourthly, common
law and better investor protection are both connected to higher valuation of corporate assets,
which is consistent with the idea that law constrains minority shareholder expropriation.20
Fifthly, poor investor protection is negatively correlated with the efficiency of capital
4
A. Musacchio and J.D. Turner
allocation.21 Sixthly, common law and better investor protection are both associated with
better corporate investment returns.22
The law and finance school has generated much criticism from economists and legal
scholars. One of the main criticisms is that the prevalence of statutory law, particularly
in the financial realm, in modern-day common law countries would appear to undermine
the concept and importance of judge-made law.23 However, the law and finance school
responds that statutes reflect jurisprudence and the common law way of doing things and
statutes often require judges to interpret and apply them as well as complex contracts.24
Another major criticism focuses on the coding, classification and empirical strategy of the
law and finance school.25 For example, the coding of many Latin American economies as
French civil law is a gross oversimplification.26 Comparative legal academics question
whether legal origin is exogenous and static.27 Spamann using primary legal sources carefully
recodes the anti-director-rights index of La Porta et al. and finds that none of their key findings
hold using his more accurate index.28 A longitudinal shareholder protection index covering
UK, USA, Germany, France and India for 1970–2005, which has been judiciously coded by
comparative lawyers and economists, does not support the law and finance hypothesis.29
Using the La Porta et al. investor protection data, but making small changes to definitions and
using different statistical techniques, Graff finds that common law is not better than civil.30
Another set of criticisms revolves around the suggestion that the legal origin may be
acting as a proxy for some other variable which has been omitted from the analysis of the law
and finance school. One possibility is that culture is a proxy for legal origins.31 For example,
Stulz and Williamson find that civil law is usually found in societies where the dominant
religion is hierarchical (e.g. Roman Catholicism) and common law is found in societies
which stress individualistic religion (e.g. Protestantism). A further possibility is that legal
origin is a proxy for a society’s historical decision about the role of the state and protecting
property from expropriation by the state.32 In other words, societies which desired limited
government and secure property rights selected a common law legal system. Another
possibility is that legal origin could be a proxy for the way in which law was transplanted and
received in a country.33 An additional possibility is that legal origin could be proxying for
initial colonisation conditions.34 Yet another possibility is that legal origin is a proxy for a
country’s political instability or its electoral system.35
3.
Law, finance and business history
History plays a central role in the legal-origin hypothesis as the hard-wiring of the legal
system in the past determines the present state of investor protection and financial markets.
But why did differences emerge between English common law and French (and to a lesser
extent German) civil law? One explanation focuses on the Glorious Revolution in England
and the French Revolution.36 In the case of the former, lawyers were on the winning side
and, as a result, English law developed judicial independence, respect for private property
and freedom of contract. In the case of the latter, lawyers were on the losing side and, as a
result, there was no judicial independence in French law and the government
administration was expanded to cope with social problems. Another explanation suggests
that the differences did not emerge in the early modern period, but in the medieval era.37
England was relatively peaceful in this era whereas France faced internal and external
threats. Consequently, dispute resolution in England was decentralised to independent
juries, whereas in France, state-employed judges resolved disputes.
However, as freely admitted by the law and finance school, history perhaps provides
the greatest challenge to the legal-origin hypothesis.38 Business history challenges the law
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5
and finance school in at least four ways which we discuss below and which are addressed
in this special issue of Business History.
3.1
Corporate ownership and legal origins
The law and finance school argues that common law results in better legal protection for
minority shareholders, which, in turn, facilitates a separation of ownership from control.
Holderness has recently questioned the contemporary empirical basis for this hypothesis by
providing evidence that ownership concentration in the US is similar to that of many civil
law economies.39 However, business history provides two more substantial problems for the
legal-origin view of ownership: (a) ownership dispersion occurred before the strengthening
of shareholder protections in some countries, and (b) the separation of ownership and
control in corporations was commonplace in some economies in the nineteenth century.40
The law and finance literature, for instance, influenced by the work of Berle and
Means, assumes that ownership separated from control in the United States in the early
part of the twentieth century and they envision it staying like that for decades. Yet Hilt
finds that ownership was separated from control in early nineteenth-century US
corporations despite the fact that corporate law offered few protections to shareholders.41
Furthermore, Lipartito and Morii use ownership data for the largest American corporations
in the 1930s and find less separation between ownership and control, and more ownership
concentration, than Berle and Means found in their 1932 book.42
In other countries, business historians have had similar findings challenging the
historical ‘stability’ or monotonic trends assumed by the law and finance literature. Franks
et al. find that corporate ownership in Japan was dispersed in the first half of the twentieth
century and that the move to concentrated ownership in Japan coincided with a marked
strengthening of investor protection law.43 In the case of Brazil before 1910, Musacchio
finds that ownership concentration was relatively low compared to the modern period,
which implies the modern-day concentration of ownership in Brazil is due more to its
twentieth-century history rather than its civil law legal origin.44
One of the prime counterexamples to the law and finance hypothesis is the case of
Germany prior to 1913. Recent evidence indicates that Germany, despite having a civil
law system, had a very well-developed stock market before 1913 relative to the modern era
and a trend towards diffuse ownership.45
In the case of the UK, Coffee, Cheffins, and Franks et al. argue that the separation of
ownership from control, which by their reckoning occurred sometime between the 1930s and
1970s, preceded the strengthening of investor protection law.46 La Porta et al. have responded
to this criticism by suggesting that new legislation passed at the turn of the twentieth century,
as well as having the best commercial courts in the world, meant that shareholders in the UK
were well protected, with the result that the rise of diffuse ownership in the twentieth century is
unsurprising.47 However, the UK puzzle still persists because recent research has
convincingly argued that diffuse ownership was commonplace by the first decade of the
twentieth century,48 and this separation occurred in a laissez-faire environment with regard to
shareholder protection.49 Firstly, little protection was afforded by legislative law or by the
rules of the organised security markets.50 Secondly, and in complete contradiction to the
above claims of La Porta et al., common law judges in Victorian Britain were averse to
interfering in the internal business affairs of companies in order to protect the interests of
outside shareholders apart from cases of outright fraud.51 If anything, the judiciary was
ideologically hostile towards the concept of protecting outside shareholders, as demonstrated
in the precedent set by Foss v. Harbottle,52 because laissez-faire theory and the practice of
partnerships taught that capitalists could look after themselves.53
6
A. Musacchio and J.D. Turner
In this special issue, Cheffins, Koustas and Chambers contribute further to the debate
regarding corporate ownership in early twentieth-century Britain by examining whether or
not law, in the form of the listing rules of the London Stock Exchange, contributed to the
separation of ownership from control. Consistent with the extant literature, they find that
law does not contribute to the emergence of diffuse ownership.
British companies as well as the wider economy may have seriously underperformed
as a result of this corporate ownership structure, with severe agency problems and
directors expropriating shareholders. However, two papers in this special issue suggest
that this was not the case. First, Braggion and Moore find that despite the profitability of
insider trading and the absence of laws against such practices, insider trading in this era
was very moderate. Second, Foreman-Peck and Hannah find that the separation of
ownership from control in Edwardian Britain did not harm shareholders.
Although the UK evidence does not appear to support the hypothesis that legal origins
do not determine corporate ownership and governance, the UK experience is consistent
with Coffee, who suggests that dispersed ownership arose not because of specific legal
rules per se, but because of the emergence of a decentralised and pluralistic political
regime, which resulted in a private sector relatively free from government interference and
which permitted entrepreneurs to use private contracts to make credible commitments to
small shareholders.54 This is also consistent with Acemoglu and Johnson who argue that
property rights institutions as described by Coffee are more important for economic and
financial development than contracting institutions such as legal protection of investors.55
The question ultimately arises as to how investors protected themselves or how
entrepreneurs made credible commitments to not expropriate minority shareholders in these
laissez-faire regulatory environments where ownership was separated from control. One
possibility is that early corporations constrained the power of insiders vis-à-vis minority
shareholders by using graduated and capped voting scales instead of one-share-one-vote
rules.56 In a sense, these rules had an investor protection rationale. Parglender and Hansmann
in their paper in this special issue argue that this was not the primary rationale for these voting
schemes. They suggest a consumer protection rationale for these rules as most shareholders in
early corporations were also customers, and graduated voting rules prevented corporations
abusing their monopoly power. Hilt takes issue with this view in his paper in this special issue:
his archival evidence of New York corporations in the early nineteenth century supports the
investor protection rather the consumer protection rationale. In the case of the UK in the
Victorian era, recent evidence suggests that graduated voting schemes did not perform an
investor protection role; they appear to have been a hangover from an earlier era.57
Evidence from the Victorian and Edwardian eras suggests that corporate governance
structures which were contained in firm’s founding constitutions provided investors
with protection.58 Dividend policy and capital-market pressure may also have acted as
a substitute for investor protection at this time.59 Trust and proximity of investors to
directors may also have been important in this market.60
3.2
Financial development and law in the long run
If the law and finance hypothesis is correct, common law countries should have been more
financially developed and had higher investor protection in the past than their civil law
counterparts. A further implication of the legal-origin hypothesis is that investor
protection laws and financial development should be correlated over time.
Bordo and Rousseau find a relationship between legal origin and financial development in
the past.61 However, their measure of financial development is the ratio of broad money to
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7
GDP, which is more a measure of banking development rather than financial market
development. Rajan and Zingales, using more appropriate measures of financial market
development, challenge the legal-origin school by highlighting the great reversal puzzle:
financial markets prior to 1913 were more developed in civil law countries than their common
law counterparts, but after 1913, financial markets in civil law countries declined and were
overtaken by common law countries.62 However, the data used by Rajan and Zingales have
been criticised for overestimating stock market capitalisation for several civil law regimes,
whilst underestimating it for some common law countries.63
Musacchio, using new estimates of financial development in 1900 and 1913, finds little
evidence to support the view that there were substantial differences across legal origins at
the turn of the twentieth century.64 According to Table 1, which contains six measures of
financial development for 24 economies in 1913, civil law countries in 1913 may have
been more financially developed than their common law counterparts according to five of
the six financial development metrics we include in this table. In terms of the sixth metric,
stock market capitalisation/GDP, the common law average is a lot higher than the French
civil law average, but below the German civil law average and just above the Scandinavian
civil law average. Overall, the main implication of Table 1 is that the financial systems of
common law countries were not more developed in 1913 than those of civil law countries,
which should not be the case if the law and finance hypothesis holds.
In Table 2, we compare shareholder rights across several economies in c.1910, 1997
and 2005 using the anti-director rights index (ADRI), which measures how well minority
shareholders are protected vis-à-vis directors. Three things are worthy of note. First, there
was not much difference between legal regimes in c.1910, which is contrary to the law and
finance hypothesis. Second, shareholder protection improved in the twentieth century in
all legal regimes. Third, Spamann’s recoding of the anti-director rights index (see above)
means that that the common law no longer provides higher shareholder protection than its
civil law counterparts at the end of the twentieth century.
From Table 3, which compares creditor rights across 13 countries in c.1910 and 1995,
we can see that creditor rights were similar across legal regimes in c.1910. Similarly,
Sgard’s study of bankruptcy law across European economies suggests that all legal
traditions provided strong creditor protection over the period 1808 –1914, but that English
common law provided less protection than its continental counterparts.65 Notably, we also
see from Table 3 that creditor rights have been weakened in these 13 economies during the
twentieth century, particularly in civil law countries.
The fact that there are few differences in shareholder and creditor protection across
legal systems in c.1910 suggests that if legal origin does affect financial development it is
not through the channel of investor protection laws. Furthermore, the changes in investor
protection laws over the twentieth century do not appear to be correlated with legal origin.
Indeed, one of the puzzles for business historians which emerges from the above analysis
is why creditor protection laws appear to have weakened in many countries over the
twentieth century, whereas shareholder protection laws have been strengthened.
There is also an emerging literature which examines the time-series variation of
investor protection laws and financial development. For example, in the case of Brazil, a
civil law country, there is a lot of time variation in creditor rights and corporate bond
market size from the late nineteenth century up to the present day.66 In addition, contrary
to the law and finance hypothesis, there is no evidence to suggest that Brazilian bond
market development is correlated with creditor rights.
In Table 4, we examine the evolution of shareholder and creditor protection laws and
the development of the UK’s stock and bond markets over the course of the twentieth
0.39
0.74
0.02
0.22
0.98
0.95
0.55
0.76
0.44
0.49
1.23
0.73
0.17
0.99
0.20
0.17
0.33
0.44
0.54
0.17
0.56
0.31
0.16
0.37
Australia
Canada
India
South Africa
United Kingdom
United States
Common law average
Austria
Germany
Japan
Switzerland
German civil law
average
Argentina
Belgium
Brazil
Chile
Cuba
Egypt
France
Italy
Netherlands
Spain
Uruguay
French civil law
average
Stock market
capitalisation/GDP
–
0.23
–
–
–
–
0.14
0.07
0.38
0.01
–
0.17
–
0.07
0.08
0.03
0.06
–
–
–
–
0.14
0.04
0.07
Fraction of gross fixed-capital
formation raised via equity
Table 1. Financial development around the world, 1913.
0.01
0.25
0.15
–
–
0.06
0.38
0.05
–
0.31
0.01
0.15
0.20
0.07
0.02
0.18
0.12
0.01
0.10
–
0.04
0.19
0.37
0.14
Stock of corporate
bonds/GDP
0.37
1.00
0.38
–
–
–
1.50
0.48
–
–
0.71
0.74
–
1.66
0.58
0.88
1.04
–
0.42
–
0.40
1.07
0.96
0.71
Private
credit/GDP
15.29
108.70
12.43
20.62
12.69
16.58
13.29
6.32
65.87
–
15.60
28.74
38.72
27.96
7.53
61.53
33.94
61.74
14.65
0.82
–
47.06
4.75
25.80
Listed companies per
million people
0.29
0.68
0.12
0.16
–
–
0.42
0.23
0.22
0.07
–
0.27
1.12
0.53
0.13
0.93
0.68
0.37
0.22
0.04
0.09
0.10
0.33
0.19
Deposits/
GDP
8
A. Musacchio and J.D. Turner
0.86
0.16
0.47
0.51
Stock market
capitalisation/GDP
–
–
0.08
0.08
Fraction of gross fixed-capital
formation raised via equity
0.03
0.06
–
0.06
Stock of corporate
bonds/GDP
2.23
1.12
–
1.67
Private
credit/GDP
38.22
33.51
20.64
30.79
Listed companies per
million people
0.76
0.65
0.69
0.70
Deposits/
GDP
Sources: Stock market capitalisation/GDP, private credit/GDP, and stock of corporate bonds/GDP are from Musacchio, “Law and Finance,” 58. The United Kingdom’s stock of
corporate bonds/GDP is from Coyle and Turner, “Law” and the UK’s stock market capitalisation/GDP for 1913 is based on Musacchio, “Law and Finance” and Coyle and Turner,
“Law.” Proportion of gross fixed-capital formation raised via equity, listed companies per million people, and deposits/GDP are from Rajan and Zingales, “Great Reversals,” 14–17.
The listed companies per million people for Uruguay for 1913 Musacchio, “Law and Finance,” 58.
Denmark
Norway
Sweden
Scandinavian civil
law average
Table 1 – continued
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9
10
A. Musacchio and J.D. Turner
Table 2. Shareholder rights across countries, c.1910, 1997 and 2005.
ADRI, LLSV’s original Spamann’s Corrected
c.1910
ADRI, 1997
ADRI, 1997
Spamann’s Corrected
ADRI, 2005
Common law
United Kingdom
United States
2
3/4
5
5
4
2
5
2
German civil law
Germany
Japan
1
2
1
4
4
5
4
5
French civil law
Italy
France
Brazil
Chile
Egypt
1
2
2
0
2
1
3
3
5
2
2
5
5
5
4
4
5
5
5
4
Scandinavian civil law
Sweden
2
3
4
4
Sources: The ADRI for UK in 1910 is from Cheffins, Corporate Ownership, 36. The ADRI for the US in 1910 is
for the state of Delaware and is from the Cheffins, Banks and Wells paper in this special issue. All the other ADRI
scores for c.1910 are from Musacchio, “Law and Finance,” 68. LLSV original ADRI scores are from La Porta
et al., “Law and Finance,” Table 2. Spamann’s corrected ADRI for 1997 and 2005 are from Spamann,
“Antidirector Rights Index,” Table 1.
Notes: ADRI is the Anti-Director Rights Index, which measures the power of minority shareholder vis-à-vis
directors. It has the following six components: (i) proxy voting by mail allowed; (ii) shares not blocked before
shareholder meetings; (iii) cumulative voting/proportional representation; (iv) provision for minority
shareholders to challenge directors; (v) shareholders have a pre-emptive right to new issues; (vi) capital
required to call an extraordinary general meeting is less than or equal to 10%. If present, each component
contributes a one to the ADRI, which means the maximum ADRI is six. A score of six implies that minority
shareholders are well protected.
century. It is clear that the time-series variation in the size of the UK bond market cannot
be explained by changes in creditor protection scores, which stay constant throughout the
century.67 Similarly, there does not appear to be much correlation between shareholder
protection and the development of the stock market. For example, the anti-director rights
index and the ex post private control of self-dealing index both increased after World War
II, but, as can be seen from Table 4, the ratio of stock market capitalisation to GDP as well
as the fraction of gross fixed-capital formation raised via equity declined.
Building on these previous studies which look at the time-series variation of investor
protection laws and financial development, Cheffins, Bank and Wells in their paper in this
special issue look at the development of investor protection law and the stock market in the
US over the period 1930 – 70. They find that, contrary to what the law and finance
hypothesis would predict, US corporate law did not provide extensive protection to
shareholders in this era. In addition, they highlight that while federal securities law
increased investor protection, this did not result in stock market development.
3.3
Law and finance during industrialisation
If legal origin matters today, it should also have mattered during the first and second eras
of industrialisation. Lamoreaux and Rosenthal suggest that the supposed inflexible civil
law of France offered businesspeople a greater menu of organisational choice during the
late nineteenth and early twentieth centuries than the common law of the US.68 The
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11
Table 3. Creditor rights across countries, c.1910 and 1995.
Creditor rights index, c.1910
Creditor rights index, 1995
Common law
United Kingdom
United States
Canada
Australia
Hong Kong
India
Singapore
Mean of common law
4
2
4
4
2
3
2
3.0
4
1
1
1
4
4
4
2.7
French civil law
France
Belgium
Spain
Argentina
Uruguay
Brazil
Mean of French civil law
3
3
3
3
3
3
3.0
0
2
2
1
2
1
1.3
Sources: Creditor rights for c.1910 are from Musacchio, “Can Civil Law,” 99 and Musacchio, “Law and
Finance,” 67. Creditor rights for 1995 are from La Porta et al., “Law and Finance,” Table 4.
Notes: The four components of the creditor rights index are as follows: (a) no automatic stay on assets; (b) secured
creditors have first priority; (c) creditors approve reorganisation; (d) management does not stay during
reorganisation. Each component scores a one if it is present, with the result that the maximum score for the
creditor rights index is four.
Table 4. The twentieth-century evolution of legal protection and financial development in the
United Kingdom.
Anti-director rights index
Ex post private control of self-dealing
Creditor protection index
Stock market capitalisation/GDP
Stock of traded corporate bonds/GDP
Fraction of gross fixed-capital formation raised
via equity
1900
1913
1938
1950
1970
1999
2.00
0.14
4.00
1.06
0.19
–
2.00
0.14
4.00
0.98
0.19
0.14
2.00
0.14
4.00
1.14
0.12
0.09
3.00
0.14
4.00
0.33
0.061
0.08
3.00
0.64
4.00
0.66
0.032
0.01
5.00
0.64
4.00
1.52
0.01
0.12
Sources: Anti-director rights index and ex post private control of self-dealing index are from Cheffins, Corporate
Ownership, 36–8. Creditor protection index is from Coyle and Turner, “Law.” Stock market capitalisation/GDP
for 1900 and 1913 are based on Musacchio, “Law and Finance” and Coyle and Turner, “Law.” The stock market
capitalisation/GDP figures for 1938, 1950, 1970 and 1999 are from Rajan and Zingales, “Great Reversals,” 15.
Stock of corporate bonds/GDP figures are from Coyle and Turner, “Law.” Proportion of gross fixed-capital
formation raised via equity is from Rajan and Zingales, “Great Reversals,” 16.
Notes: 11946 figure; 21969 figure. Anti-Director Rights Index, which measures the power of minority shareholder
vis –à –vis directors. It has the following six components: (i) proxy voting by mail allowed; (ii) shares not blocked
before shareholder meetings; (iii) cumulative voting/proportional representation; (iv) provision for minority
shareholders to challenge directors; (v) shareholders have a pre-emptive right to new issues; (vi) capital need to
call an extraordinary general meeting is less than or equal to 10%. If present, each component contributes a one to
the index, which means the maximum is six. A score of six implies that minority shareholders are well protected.
The ex post private control of self-dealing averages scores which measure the constraints on a corporate insider
engaging in self-dealing – the maximum score is one (see Djankov et al., “Law and Economics” for the details).
12
A. Musacchio and J.D. Turner
French civil law was also better able to adapt to new business and economic needs than
the common law of the US, and in the US new statutes were required to introduce new
business organisational forms. Similarly, a study of the menu of organisational choices
in Germany, France, the UK and the US reveals that, if anything, the menu of
organisational choices offered to entrepreneurs by the legal systems of the two common
law countries in the nineteenth and twentieth centuries was inferior to that of the two
civil law countries.69 Likewise, in the case of late nineteenth-century Mexico, which had
a civil law regime, it appears that there was also a wider variety of organisational choice
than in common law countries, but this wider menu appears to have had a negligible
effect on capital formation.70 Overall, this evidence questions the supposition made by
the legal-origin school that common law is a lot more flexible and business-friendly than
civil law.
A flaw with much of the law and finance research agenda is that it compares the
political sensitivity of judicial systems because modern legal systems are predominantly
based on statutory law. Therefore, a comparison of the Scottish civil law system with the
English common law system during the first era of industrialisation makes for an
interesting study as it predates the Benthamite-inspired statutory intervention in business
law. Thus, we have a relatively pure contrast of the efficacy of these two legal origins.
Acheson et al. find that the Scottish system gave entrepreneurs wishing to establish
banks a greater organisational flexibility during the Industrial Revolution.71 Unlike their
English counterparts under the common law, Scottish partnership law allowed banks to
separate ownership from control in that only designated officers of the bank, and not every
owner, could enter binding contracts on behalf of the bank. In addition, shares in Scottish
banks were transferable, whereas English partnership law meant dissolution of the bank if
one of the partners wanted to exit. This difference appears to have had real economic
consequences as the Scottish banking system was more stable than England’s during
this era.
Freeman et al. in their contribution to this special issue also compare Scotland with
England. They argue that, in the case of England, statute law had a greater impact than the
common law on the development of corporate governance, whereas in Scotland, judicial
rulings rather than statutes were more important. They also find that law influenced
corporate governance practices less than the law and finance school predicts, with
practices converging after 1825. This, of course, is the opposite of what the legal-origin
school argues.
The legal systems of both England and Scotland appear to have been reluctant to
promote joint-stock enterprises at the expense of the partnership organisational form.72
Indeed, the English common law during the Industrial Revolution was so conservative that
the resulting legal stasis hindered the rise of the joint-stock corporation.73 Ultimately, it
required parliamentary intervention via statutes to facilitate the development of the jointstock corporation in the nineteenth century.74
The role of the legislature in promoting incorporation activity was not unique to
Britain. Hilt’s paper in this special issue stresses that the legislatures in the US engaged in
legal innovation which stimulated the establishment of corporations in order to promote
economic development. Ultimately, according to Sylla and Wright’s contribution to this
special issue, what mattered for the development of US corporations was not legal
tradition, laws or politics, but the development of a superior form of government ushered
in by the Constitution.
Business History
13
3.4 Legal origin, politics and history
A significant challenge to the legal-origin school is that investor protection is endogenous
to the prevailing views of the political majority. One strand of this political-economy view
of financial development essentially argues that a country’s experience of military
invasion, war and occupation during the twentieth century resulted in differences in
politics and political ideologies, which in turn resulted in different policies towards finance
and stock markets.75 Civil law countries experienced greater devastation than common
law countries as a result of the major conflicts of the twentieth century (particularly World
War II), and this difference explains the findings of the legal-origin school. Similarly, Roe
and Roe and Siegel suggest that to understand the disparity in current financial
development, we need to comprehend the effect of the cataclysmic events of the twentieth
century on financial markets.76
Additional support for the political-economy view of financial development comes
from ancient Rome. Ancient Rome is important to the law and finance debate because civil
law has its origins in Roman law, which was documented for posterity by Justinian in the
Corpus Iuris Civilis. Notwithstanding this, Roman law has had considerable influence and
continues to have influence on the development of English common law, which raises
concerns about the sharp dichotomy between civil and common law which is at the heart
of the law and finance hypothesis.77 In addition, Roman law was case law, which made
Roman law highly flexible and enabled it to adapt to the transformation of Rome from a
rural backwater to a sprawling empire.78 A closer look at Roman law and the societas
publicanorum, a form of proto-company in ancient Rome, reveals that this institutional
form flourished in a legally primitive but politically supportive era of the Roman Republic,
but disappeared when Rome became legally sophisticated and when its political support
disappeared.79 This is consistent with the view that law matters little for economic
development and that law merely reflects the interests of the political classes.
4.
Conclusions
Business history suggests that legal origins do not matter – they are not deterministic.
On the other hand, business history suggests that contingent factors such as conflict,
political upheaval, inflation and economic disorder play a larger role in driving financial
development. There is thus a new synthesis emerging when it comes to studying corporate
finance and governance in the past. Laws were important, but legal origins did not
determine significant differences across countries. In fact, differences across countries
were not as cross-cutting as today.
The role of law in the past was simply to uphold and enforce private contracts.
As entrepreneurs, businesspeople and investors were aware of governance problems and
the potential for opportunistic behaviour, they contracted privately to ameliorate these
problems. This implies that rather than waiting for reforms of the whole legal system
of a country or set of countries, business history teaches us that companies need to do
their part.
Following on from this special issue, business history can contribute further to the law
and finance debate in at least four ways. First, we need to know a lot more about the early
development of stock markets and corporate ownership in civil law economies of Europe,
Latin America and Asia. Second, we need case studies on how changes in investor
protection laws occurred across time and space – who championed or lobbied for changes
to investor protection law? Third, we need to know more about how legal families and
laws governing business enterprises were transplanted into colonies and how colonies
14
A. Musacchio and J.D. Turner
received legal families and adapted mother-country commercial laws. Fourth, we need to
know more about doing business in the past and, in particular, how businesspeople across
the globe structured contracts with investors. Consequently, there needs to be much more
archival work looking at company by-laws and constitutions.
Our hope is that the essays included in this special volume will energise the debate
and inspire business historians to work on the history of corporate governance, investor
protections, financial regulation, and financial development.
Acknowledgements
This paper serves as the introduction of the special issue of Business History entitled ‘Law and
Finance: A Business History Perspective’. Thanks to Steve Toms and John Wilson, the journal’s
editors for all their assistance.
Notes
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
La Porta et al., “Economic Consequences,” 306– 7. See Xu, “Role of Law” for a recent survey.
The legal-origin hypothesis is part of a growing literature in economics which stresses the
importance of the effect of historic events on long-term economic development (Engerman and
Sokoloff, “Factor Endowments”; Acemoglu, Johnson and Robinson, “Colonial Origins,”
“Reversal of Fortune”). See Nunn, “Importance” for a recent survey.
La Porta et al., “Law and Finance.”
Michaels, “Comparative Law.”
Fauvarque-Cosson and Kerhuel, “Is Law an Economic Contest?”
Morck and Yeung, “Economics, History, and Causation.”
Shleifer and Vishny, “Survey of Corporate Governance.”
La Porta et al., “Investor Protection and Corporate Valuation.”
La Porta et al., “Legal Determinants,” “Law and Finance,” “Economic Consequences”;
Djankov et al., “Debt Enforcement,” “Law and Economics”; Levine, “Legal Environment,”
“Law”; Levine, Loayza and Beck, “Financial Intermediation.”
La Porta et al., “Legal Determinants,” “Law and Finance.”
La Porta et al., “Investor Protection and Corporate Governance,” “Corporate Ownership,”
“Agency Problems.”
See Dam, “Legal Institutions,” for an overview of the common and civil legal traditions.
La Porta, Lopez-de-Silanes and Shleifer, “Economic Consequences,” 286.
Botero et al., “Regulation of Labor”; Djankov et al., “Who Owns the Media?”; Du,
“Institutional Quality”; Mulligan and Shleifer, “Conscription”; La Porta, Lopez-de-Silanes and
Shleifer, “Government Ownership.”
The details of these leximetrics can be found in La Porta et al., “Law and Finance”; Djankov
et al., “Law and Economics,” “Private Credit.”
Shleifer and Wolfenzon, “Investor Protection.”
La Porta et al., “Legal Determinants.”
La Porta, Lopez-de-Silanes and Shleifer, “Corporate Ownership.”
La Porta et al., “Agency Problems.”
La Porta et al., “Investor Protection and Corporate Valuation.” See also Claessens et al.,
“Disentangling.”
Wurgler, “Financial Markets.”
Gugler, Mueller and Yurtoglu, “Corporate Governance.”
Dam, “Legal Institutions.”
La Porta, Lopez-de-Silanes and Shleifer, “Economic Consequences,” 290– 91.
See Armour et al., “Shareholder Protection,” for a good summary.
Dam, “Legal Institutions.”
Pistor, “Rethinking”; Michaels, “Comparative Law.”
Spamann, “Antidirector Rights Index.”
Armour et al., “Shareholder Protection,” “How Do Legal Rules Evolve?,” “Law and Financial
Development”; Sarkar and Singh, “Law.”
Business History
30.
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
41.
42.
43.
44.
45.
46.
47.
48.
49.
50.
51.
52.
53.
54.
55.
56.
57.
58.
59.
60.
61.
62.
63.
64.
65.
66.
67.
68.
69.
70.
71.
72.
73.
74.
75.
76.
77.
78.
15
Graff, “Law and Finance.”
Licht, Goldschmidt and Schwartz, “Culture”; Stulz and Williamson, “Culture.”
Mahoney, “Common Law”; Klerman and Mahoney, “Legal Origin.”
Berkowitz, Pistor and Richard, “Economic Development.”
Acemoglu and Johnson, “Unbundling Institutions.”
Pagano and Volpin, “Political Economy”; Roe and Siegel, “Political Instability.”
Merryman, Civil Law; Klerman and Mahoney, “Legal Origin.”
Glaesar and Shleifer, “Legal Origins.”
Curran, “Comparative Law,” 863; La Porta, Lopez-de-Silanes and Shleifer, “Economic
Consequences,” 315.
Holderness, “Myth of Diffuse Ownership.”
See Morck and Steier, “Global History,” 38
Hilt, “When Did Ownership.”
Lipartito and Morii, “Rethinking the Separation”; Berle and Means, The Modern Corporation.
Franks, Meyer and Miyajima, “Equity Markets.”
Musacchio, Experiments, 126; Musacchio, “Laws Versus Contracts.”
See Fohlin, “History,” 227; Fohlin, “Does Civil Law,” Finance Capitalism.
Cheffins, “History,” “Does Law Matter?,” Corporate Ownership; Coffee, “Rise of Dispersed
Ownership”; Franks, Mayer and Rossi, “Ownership.”
La Porta, Lopez-de-Silanes and Shleifer, “Economic Consequences,” 319.
Hannah, “Divorce of Ownership”; Foreman-Peck and Hannah, “Extreme Divorce”. Braggion
and Moore, “Dividend Policies,” also find something similar for a small sample of companies
at the turn of the twentieth century.
Campbell and Turner, “Substitutes.”
Ibid., 574 –5.
See Emden, Shareholders’ Legal Guide, 77 – 80.
Foss v. Harbottle (1843) 2 Hare 461 (Chancery Division) Wigram V-C.
Jefferys, Business Organisation, 394.
Coffee, “Rise of Dispersed Ownership.”
Acemoglu and Johnson, “Unbundling Institutions.”
Hilt, “When Did Ownership”; Musacchio, Experiments. See also Dunlavy, “Social Conceptions,”
who argues that voting rights of early corporations reflected social and political conceptions
of democracy.
Campbell and Turner, “Substitutes.”
Ibid. See also the Foreman-Peck and Hannah paper in this special issue.
Campbell and Turner, “Substitutes”; Cheffins, “Dividends.”
See Braggion and Moore in this special issue as well as Chambers and Dimson, “IPO
Underpricing.”
Bordo and Rousseau, “Legal – Political Factors.”
Rajan and Zingales, “Great Reversals.”
La Porta, Lopez-de-Silanes and Shleifer, “Economic Consequences,” 316– 19; Sylla,
“Schumpeter Redux.”
Musacchio, “Law and Finance,” “Can Civil Law.”
Sgard, “Do Legal Origins Matter?”
Musacchio, “Can Civil Law.”
Coyle and Turner, “Law.”
Lamoreaux and Rosenthal, “Legal Regime.”
Guinnane et al., “Putting the Corporation.”
Gómez-Galvarriato and Musacchio, “Organizational Choice.”
Acheson, Hickson and Turner, “Organizational Flexibility.”
Freeman, Pearson and Taylor, “Different.”
Harris, “Industrializing.”
Dicey, Lectures, 245– 6.
Rajan and Zingales, “Great Reversals”; Roe, “Legal Origins”; Perotii and von Thadden,
“Political Economy.”
Roe, “Legal Origins”; Roe and Siegel, “Political Instability.”
See Malmendier, “Roman Law,” “Law and Finance.”
Malmendier, “Roman Law,” 8.
16
79.
A. Musacchio and J.D. Turner
Malmendier, “Law and Finance.”
Notes on contributors
Aldo Musacchio is an associate professor at Harvard Business School and a Faculty Research Fellow
at the NBER. He is the author of Experiments in Financial Democracy: Corporate Governance and
Financial Development in Brazil (CUP, 2009). He has published a number of articles studying the
connection between law and financial development circa 1900.
John D. Turner is a professor of finance and financial history at Queen’s University Belfast and the
director of the Queen’s University Centre for Economic History. He has been a Houblon-Norman
Fellow at the Bank of England as well as the Alfred D. Chander Jr. Visiting Fellow at Harvard
Business School. He has published numerous journal articles on law, finance and history.
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