The crucial role played by the law in corporate governance and then economic efficiency was understood by early legal scholars (Cheffins, 2001), however, historically, economists have been sceptical of the claim that in general social factors such as law, politics and culture are fundamental to companies and economic growth (Fligstein and Choo, 2005). Some even consider legal rules and regulations to be largely unnecessary and possibly harmful (Stigler, 1964).
In recent decades understanding has developed, largely after the advent of the ‘law and economics theory’ which has brought about the debate on whether legal systems were beneficial for economic growth in general and for corporate governance in particular (Pacces, 2008, p. 218). The legal system can be broadly defined as a system of “inter-related formal institutions gathered around three main functions: (1) setting rules and standards (mainly via laws and regulations) for the operation of the society; (2) law enforcement; and (3) dispute resolution” (Gray, 1991).
Jensen and Meckling (1976) recognized the role of legal systems when they wrote:
The view of the firm points up the important role which the legal system and the law play in social organizations, especially, the organization of economic activity (Pacces, 2008, p. 311).
Corporate governance constitutes an important area where the role of the law has become the subject of intense debate (Cheffins, 2001, p. 2). At the heart of this debate, on law and corporate governance, is the question of whether or not some set of legal rules affects both economic efficiency and market outcomes (Fligstein and Choo, 2005, p. 7).
The pertinence of the law in corporate governance has been argued by legal scholars as insignificant or even trivial (Easterbrook and Fischel 1991; Black, 1990) when compared to the need for competitive capital product and managerial labour markets.
Easterbrook and Fischel (1991) are sceptical that legal rules are binding in most instances, since often firms can opt out of these rules. Coase (1960) holds that the legal system should simply enforce private contracts. As Glaeser et al. (2001, p. 853) when property rights are well defined and “transaction costs” are zero, market participants will organise their transactions in ways that achieve efficient outcomes and when they can do so, it is not necessary for the government to engage in “corrective” actions through taxes, regulations, or even legal rules. The Royal Swedish Academy of Sciences (1991) summarised Coase (1937) first major study “The Nature of the Firm” as follow:
“Alongside production costs, there are costs for preparing, entering into and monitoring the execution of all kinds of contracts, as well as costs for implementing allocative measures within firms in a corresponding way. If these circumstances are taken into account, it may be concluded that a firm originates when allocative measures are carried out at lower total production, contract and administrative costs within the firm than by means of purchases and sales on the market. Similarly, a firm expands to the point where an additional allocative measure costs more internally than it would through a contract on markets.” (Royal Swedish Academy of Sciences, 1991)
The Coase theorem (Coase 1960) explicitly assumes the absence of any transaction costs or other frictions in the bargaining process. The free market guarantees the efficient outcome regardless of who owns what, because there will remain incentives to bargain towards the efficient result until it is achieved (Schlafly, 2007, p. 45). Erudite and experienced financial market participants are permitted by the legal institutions to contrive a mixture of sophisticated and refined private contracts to mitigate complicated agency problems (Coase, 1960; Stigler, 1964; Easterbrook and Fischel, 1991). Nonetheless, for legal systems to have an effect, the courts must enforce these contracts and should be capable to peruse complex contracts and verify technically sophisticated provisions that stimulate particular actions (Glaeser, et al., 2001, p. 854).
These Coasian arguments state that qualified financial system participants should be allowed to develop private contracts, and that the legal system should only enforce these contracts are highly reasonable. However, LLSV (1998) argue that in practical matters it may be costly for firms to opt out of standard legal rules since investors might have difficulty accepting non-standard contracts and, more importantly, judges may fail to understand or enforce them. Moreover, given the difficulty in enforcing complex private contracts, there are potential advantages to developing detailed legal and regulatory frameworks for organising financial transactions and protecting minority shareholders and creditors (Beck and Levine, 2003).
Johnson and Shleifer (2002) state that:
The Coasian idea that private contracts can attain efficient outcomes is powerful and in many instances correct. The right question is how to make it easier for the private sector to write its own efficient contracts. In many cases, this can only be achieved through changing the broader legal rules that underpin capital markets (p. 23).
Given the Coasian dependence on enforcing elaborate private contracts or on a method that augments the support of private contracts with company, bankruptcy, securities laws, etc., it cannot be denied that the position of the legal system is widely recognised.
The idea that laws matter in corporate governance comes from the application of both the agency theory (Pacces, 2008, p. 219) discussed in Chapter 2 and from the institutional theory regulatory perspective (Fiss, 2008, p. 392). Since the introduction of the agency theory in the late 1970s, scholarship on corporate governance has been largely dominated by a legal-economic view of the firm as a nexus of contracts (Jensen and Meckling 1976; Fama and Jensen 1983; Hart, 1995). This approach places a rather narrow conception of corporate governance as primarily concerning the relationship between shareholders and managers (Fiss, 2008: Rubach and Sebora 1998).
Ideally, financiers prefer to sign a complete contract that covers every aspect of how managers run an organisation. However, financiers need the managers to generate returns on their funds and hence take decisions on their behalf. The discussion in Chapter 2 shows that the nexus of contracts covering financiers and managers is so complex that it is not feasible to specify exactly what the manager does in all states of the world, and how profits are allocated (Shleifer and Vishny, 1997, p. 741).
Such contractual incompleteness causes the firm’s behaviour to diverge from the profit-maximizing ideal, as it allows for opportunities for managers to misapply shareholders’ funds and to self-serve. This agency problem and associated cost can be tackled with different non-regulatory mechanisms. The first, as discussed earlier in Sections 2.3 and 2.4 is the incentive contract by which the manager obtains a highly contingent, long-term incentive tied to firm performance thereby aligning their interest with those of owners. The second is the presence of large shareholders with their fiduciary duty to monitor the managers.
However the fact that the agency problem by nature cannot be completely dealt with ex ante via a ‘mechanism design’ contingent on all possible future states means that managers could still behave badly (Zingales, 1998, p. 502; Pacces, 2008, p. 175). In addition, controlling shareholders may avoid their fiduciary responsibility and may also expropriate non-controlling shareholders. This creates the need to solve these conflicts between different parties ex post, when an inefficient misbehaviour, which was not accounted for, materialises) Fama and Jensen 1983; Zingales, 1998(. It is for this reason that external authority matters – it allows incomplete contracts to be adapted to changed circumstances. However, authority has to be established in the first place and proven over time. Given the unavailability of perfectly state-contingent contracts, the fulfilment of the above conditions requires an external set of constraints upon people’s choice of action. These constraints are named institutions (Pacces, 2008, pp. 207-8).
Institutions play this role in at least two different ways. On the one hand, they set the ‘formal rules of the game’, thereby determining the range of feasible choices on how to play it (i.e., constraining authority). On the other hand, they allow ‘the game to be played’ by providing the instruments to implement a particular choice, such as supporting authority (Williamson, 2000, p. 596; Pacces, 2008, p. 208).
The first is an institutional environment shaped by a set of fundamental social norms and legal rules, like a property rights system and electoral rules; the second is an institutional arrangement based on how the entities can cooperate and/or compete as governed by institutional environment, like a firm (Williamson, 1991, p. 287).
These institutional themes evolve itself over many years in the institutional theory. The classical definition of institutions goes back to Hughes (1936), who presented institutions as stable and slowly changing social systems. Institutional theorists (Zucker, 1977, p. 728; Meyer and Rowan, 1977, p. 346) argue that institutions are socially constructed templates for actions, generated and maintained through ongoing interactions.
These institutional perspectives using legal rules and their enforcement fall within the domain of corporate governance, broadly defined by Zingales (1998) as “the complex set of constraints that shape the ex-post bargaining over the quasi-rents generated by the firm”. This is supported by Cioffi’s definition of corporate governance as a “nexus of institutions defined by company law, financial market regulation, and labor law (2000, p. 574).”
Recently, there is a growing body of evidence documenting the quality of institutions that legally protect property rights and show how they contribute to large variations in long-term growth, financial market development, and other important outcomes across countries. The new literature on the importance of law begins with La Porta, Lopez-de-Silanes, Shleifer and Vishny (1996; 1998), who demonstrate that there are systematic differences in the legal rights of investors across countries. The important explanatory factor of these differences is the origin of the legal system. The following section discusses the legal origin argument which paves the way for examining the impact of the degree of shareholder protection on equity market development in a given country.