Explanations for Differences in Levels of Investor Protection

Although, La Porta and colleagues pointed out the importance of legal foundation for investor protection, other theories argue that legal determinants are complex. These theories suggest that the differences in the investor protection level around the world are determined by other variables, particularly important exogenous variables are those related to political economy considerations.

Politics can affect the balance of power between company “insiders” (managers and controlling shareholders) and “outsiders” (non-controlling shareholders). It does so by designing the rules intended to protect minority shareholders, as well as those that influence the contestability of corporate control (Pagano and Volpin, 2001).  Pagano and Volpin (2000) set forth a stylized political-economy model of investor protection. The model suggests that low shareholder protection may result from a political agreement between entrepreneurs (controlling shareholders) and workers aimed at preserving their own rents.  This agreement is reached only in countries where workers do not own shares, or own a small amount of shares where the entrepreneurs believe that low shareholder protection increases their private benefits of control, while high employment protection shelters low productivity workers from the competition of more productive unemployed ones. Therefore, the legal rules can evolve only by exchanging higher investor protection for lower employment protection or vice versa.

This political/financial view emphasizes that those in power influence policies and institutions to their own advantage (North 1990; Olson 1993). Thus, a corporate governance regime can be determined by politicians who have the interests of their voters in mind, these voters may be shareholders or employees of firms. Hence, the evaluation of a regime in a shareholder’s view will be different from that in an employee’s view, and the political decision will depend on the orientation of politicians towards specific voters (Perrotti and Von-Thadden, 2006).

Rajan and Zingales (2003) argue that the development of financial systems and laws does not always evolve consistently over time but rather that cross-country differences in financial development change drastically.  Time-invariant factors, such as legal origin, cannot explain entirely time-variation in relative levels of financial development across countries.  They stress the important role of political forces in shaping policies toward financial markets and intermediaries, and the development of financial systems. In explaining weak legal protection for investors in the civil law countries, they asserted that in those countries, the governance system is more centralised facilitates for the influence of a small group representing private interests, such as large incumbent industrialists and financiers, to implement friendly policies. When these private interests are aligned with national interests, beneficial policies can also be implemented quickly, but when interests are misaligned, matters can become much worse. However, Pistor, et al. (2002; 2003) disagree with Rajan and Zingales (2003) in the area of corporate law, arguing that even acute political changes in England, Germany, and France during the twentieth century did not significantly affect the development of corporate law (Beck and Levine, 2003).

Builidng on La Porta et al.’s (1998) study and findings regarding the relation between shareholder protection and stock market development, Pagano and Volpin (2005) use data for 47 countries for the period between 1993 and 2001, and rely mainly on the Anti-Director Rights Index to present a political economy model featuring three groups of risk-neutral individuals: owner-managers, workers, and rentiers (outside shareholders). The model holds that “regulation is chosen by groups with political power, who shape it in their own interest and defend it against change” (Pagano and Volpin, 2006, p. 317).

While the work of La Porta and colleagues is presented from legal perspective and that of political economy scholars from a political perspective that has produced a great deal of discussions, other factors have also been considered. Stulz and Williamson (2003) argue that culture can affect finance through at least three channels. First, the values that are predominant in a country depend on its culture. For example, charging interest can be a sin in one religion but not in another. Second, culture affects institutions. For instance, the legal system is influenced by cultural values. Third, culture affects how resources are allocated in an economy. Religions that encourage spending on churches or armaments divert resources away from investment in production.

A suitable definition is given by Boyd and Richerson (1985) cited in North (1990, P. 37), who states that culture is a ‘‘transmission from one generation to the next, via teaching and imitation, of knowledge, values, and other factors that influence behaviour.”

The view that culture is an important determinant of economic growth has a long tradition, dating back to at least the work of Weber (1930). In his book, The Protestant ethic and the spirit of capitalism, Weber argued that cultural differences, namely the Calvinist Reformation, played an important role in the development of institutionalised capitalism. Lal (1999, p. 17) argues that “cosmological beliefs—an essential element of ‘culture’—have been crucial in the rise of the West and the subsequent evolution of its political economy”. Religion is a key component of a system of beliefs. Historically, religions have had much to say about the rights of creditors, but less about the rights of shareholders (Stulz and Williamson, 2003)

Nenova (2003) finds that the benefits from control are lower in countries with a Scandinavian civil law tradition than in common law countries. Coffee (2001) argues that the tradition of Scandinavian civil law is similar to other civil law traditions, hence, the lower benefits from control in Scandinavian economies cannot be explained by differences in legal systems.

Licht (2001) used a cross-sectional sample of countries from around the world and drew on two models of cultural dimensions in cross-cultural psychology to analyse the relations between investors’ legal rights—as reflected in the indices of La Porta et al. (1998) – and national cultural profiles (cultural value dimension (CVD).  These dimensions include Harmony, Embeddedness, Hierarchy, Mastery, Affective Autonomy, Intellectual Autonomy, and Egalitarianism. The findings indicate that there is a relation between a country’s shareholder and creditor rights indices and the attitudes of that country towards the examined values.

Stulz and Williamson (2003) used La Porta et al. (1998) data on legal families, shareholder rights, and creditor rights to examine if the differences in culture, proxied by differences in religion and language, could explain differences in investor protection across countries. The results indicated that the relation between culture and investor rights seems especially strong for creditor rights.  Catholic countries systems seem to induce a weaker protection of creditors’ rights and increase the legal formalities to enforce contracts. This may be attributed to the close association between state and church in some Catholic countries, where bureaucracies originated in religious ranks adopted the hierarchical structure of the Catholic Church.

The discussion above clearly indicates that the legal origin argument is controversial. A large literature criticizing LLSV shows the relevance of questioning, among other things, the criteria used for formulating the investor protection measure and hence questioning their results. Such criticisms in turn suggests that the empirical evidence concerning the importance of minority shareholder protection for financial markets performance is far from being irrefutable as well. This thesis takes these criticisms into consideration and contributes new evidence on whether and how legal protection of shareholder matters for financial market development with particular reference made to the MENA region. Accordingly, while the fourth chapter will discuss elaborately the relation between minority shareholder protection and corporate finance, the following section will present the different approaches employed by legal systems to tackle minority shareholders appropriation.


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