In the past decade, LLSV spearheaded a rapidly evolving mass of literature emphasising the part played by legal institutions in moulding the national pattern of financial management and economic growth. What the literature argued was a core concept for corporate governance was the protection of investor rights against the expropriation by insiders and legal enforcement of these rights.

The evidence demonstrating the importance of law in finance can be divided into two categories. The first states that the extent of disparities between countries in investor protection laws and its enforcement leads to disparities in financial development. Secondly, the disparities in legal origins account for cross-country differences in investor protection and private property rights protections. Nonetheless there is a large mass of research critical to these evidences.

The critiques can be divided into two categories: first there are studies that interrogate the way in which shareholder protection is measured and attempt to introduce more exact indices (Pistor, 2000; Djankov et al., 2008; Spamann, 2008). Issue number two interrogates the importance of legal origin or history in determining a level of protection, and proposes alternative interpretations for such disparities. These debates, criticisms, and their relevant conclusions are discussed below.

3.3.1 The Relevance of Legal Origin for Levels of Investor Protection:

A series of working papers and studies developed by LLSV documents that the historical origin of a country’s legal system, particularly countries with English common-law origin versus French civil-law origins, is strongly correlated with the privileged level of minority shareholders protection. Countries with stronger legal protections for both shareholder and creditors, such as those with a tradition of English law, appear to have institutions which involve less corrupt governments (LLSV, 1999), more efficient courts and bankruptcy procedures (Djankov et al., 2003), and more informative accounting standards (LLSV, 1998).

The working paper of LLSV (1996), using data from 35 countries, finds that the differences in the nature and effectiveness of financial systems around the world can be attributed, to some extent, to the differences in investor protections against expropriation by insiders, as reflected by the legal rules protecting investors and the quality of their enforcement.

This investor protection was measured by quantifying of legal rules “leximetrics”^[1] in relation to shareholders’ and creditors’ rights. Shareholders’ rights variables coded the legal acts that support the voting rights against interference by the insiders. On the other side, creditor’ rights were measured using five variables concentrating on creditor rights to repossess loan colatterals when a loan is in default and rights in case of reorganisation.

The evidence of LLSV (1996) indicates that legal rules protecting investors and the enforcement of these rules vary clearly among different countries. Countries, with English common-legal origin, provide better protection for investors than the other countries who originate the civil law, especially the French civil law, tradition. The German civil law and Scandinavian countries take an intermediate position in protecting investors. On the other hand, German and Scandinavian civil law have the best quality of law enforcement, while the enforcement in the French civil law is the weakest.

LLSV (1998) “Law and Finance” Paper presents a quantitative shareholders’ rights index called “anti-director rights”. The components of the index are refined versions of those presented in the LLSV (1996). The Index offers six dimensions to assess the degree of protection of minority shareholders against expropriation by insiders by examining voting mechanisms available in company laws, securities laws, stock exchange laws, banking regulations, and accounting standards.

The voting dimensions assess first if the rules permit proxy voting via mail, making it facile for minority shareholders to exercise their right to vote. Secondly, the law requires that shareholder deposit shares with a financial intermediary for a time prior to the general meetings of shareholders, making it more difficult for shareholders to actually vote. In the third instance, the law grants some kind of cumulative voting, making it easier for a group of minority shareholders to appoint at least one director of their choosing.  Fourth, the law subsumes an apparatus giving the minority shareholders, who express a feeling of oppression by the board, the right to sue or to alternatively get relief from the board’s decision. Dimension number five encompasses a law that bequeaths minority shareholders a pre-emptive right to new issues, protecting them from dilution by the dominant shareholders who could alternatively assign new shares for themselves or parties friendly to them. Number six requires the law to be relatively few in shares to call for an extraordinary shareholder meeting, during which the board can presumably be challenged or even replaced, whereas in other cases a large equity stake is needed for that purpose. LLSV (1998) aggregate these six dimensions of shareholder protection into an anti-director rights index by simply adding a ‘1’ when the law is protective along one of the dimensions and a ‘0’ when it is not.

Following the construction of the index, the study empirically examined whether laws protecting investors and its enforcement differed across 49 countries, and whether these variations have consequences for corporate ownership patterns globally. For minor investors, the study analysis suggests that laws differ markedly around the world. In particular, countries with common law origin offer the best legal protection, followed by countries with German and Scandinavian law origin, whilst the countries with French law origin came lower in position. In Table 4, a means for testing different legal origins are classified according to shareholder and creditors rights measures.

More recent research has demonstrated that both legal origin and investor protection are strongly correlated with various aspects of financial development (Demirguc-Kunt and Levine, 2001, Johnson et al., 2000a, Wurgler, 2000, Friedman et al, 2003, and La Porta et al., 2000 and 2002). These studies represent considerable evidence that supports the core claim of the “law and finance” theory.

Since the publication of “Law and Finance” for LLSV in 1998 more than one hundred cross-country quantitative studies have used the anti-director index (Spamman, 2008), not only to examine the association between shareholder protection and corporate finance (Bebchuk and Hamdani, 2009, p. 14) but also for other issues, such as business creation (Hyytinen and Takalo, 2008) and industrial specialization (Ozcan et al., 2003). However, there are many studies that contradict previous results of LLSV (1998) and criticise the essential criteria used for formulating the used anti-director rights as well.

 

Table 4: Findings of LLSV (1998)

Country	Proxy by mail allowed out of 1	Shares not blocked before meeting out of 1	Cumulative voting/ proportional reptn. out of 1	% of share capital to call an ESM out of 1	Preemptive right to new issues out of 1	Oppressed Minority out of 1	Anti-director rights  out of 6
Common law countries (18)	0.39	1.00	0.28	0.09	0.44	0.94	4.00
French origin countries (21)	0.05	0.57	0.29	0.15	0.62	0.29	2.33
German origin countries (6)	0.00	0.17	0.33	0.05	0.33	0.50	2.33
Scandinavian origin countries (4)	0.25	1.00	0.00	0.10	0.75	0.00	3.00

Summarized by the researcher from LLSV (1998)

Pistor (2000) censures a limited amount of used variables to construct the index, arguing that this hardly grants an image indicative of the granted shareholders’ level of legal protection. Consequently, he has expanded the number of variables with the purpose of capturing particular problems for the economies of Eastern Europe.

All aspects of shareholder protection cannot possibly be taken into account. Corporate law in the majority of nations contains hundreds upon hundreds of parts or articles, thus coding all of the details would lead to an unworkable index of many hundred or perhaps even thousands of variables. Therefore, it is imperative to formulate only a very narrow amount of representative variables. Still, the selection of variables has to be comprehensible and ample enough to act as a proxy for the protection of the shareholder in general, which is not the situation with La Porta et al.’s eight variables. They fail to comprehensively capture the most important provisions of the law (Coffee, 2001). For example, Lele and Siems (2007) criticise the variables used by LLSV (1998), whereas the variables for “one share, one vote”, “proxy by mail allowed,” “shares not blocked before the meeting” and “shared capital required to call an extraordinary meeting” deal with divergent facets of shareholders’ voting power, they ignore the more decisive question of the degree of this power, i.e., the concerns over which the shareholders in a general gathering have the capacity to execute any decision-making power. Furthermore, whereas the variable “cumulative voting” may be pertinent to the extent that it seeks to measure the shareholders’ power in the appointment of directors, it ignores more crucial questions such as the dismissal of directors and  other  aspects of a director’s term, e.g., their tenure and compensation.

Armour et al (2009) add that, along with the very limited number of variables, the data is almost entirely based on cross-sectional data. Therefore, they have constructed new shareholder protection indices which take into account a wider range of legal information, wider range of types of legal norms and longitudinal data. Using panel datasets, the findings indicate that countries with common legal origin had stronger shareholder protection over the period 1995-2005, but the study failed to find a link between shareholder protection and stock market development even across countries with common law.

Spamann (2008) offers a fundamental critique of the large number of studies which use the Anti-Director Rights Index data from LLSV (1998). Spamann (2008) questions the accuracy of the index for almost the entire sample and finds that major corrections of the index values are necessary; this was due to what the author describes as several conceptual ambiguities and outright mistakes in coding.

For example, Spamann presents the case of cumulative voting to question whether the mandatory rules or optional rules should be counted. The U.S. Delaware General Corporation Law – the legal statute governing the activities of corporations in the U.S. – does not provide for cumulative voting as mandatory rules. However, LLSV’s (1998) assigns a ‘1’ for U.S. value considering the optional rule sufficient for this variable. Meanwhile, other countries, such as Finland, were assigned a ‘0’ despite considering cumulative voting as an optional rule.

Spamann (2008) findings assert that the Anti-Director Index value from La Porta et al. (1998) has to be corrected for 33 out of 49 countries. The correlation between the accurate values and those from La Porta et al. (1998) is 0.53. These large discrepancies have a number of important consequences: First, unlike the original values from La Porta et al. (1998), accurate Anti-Director Index values are not distributed with significant differences between Common and Civil Law countries. Legal tradition does not predetermine the Anti-Director Index and therefore it should not be treated as exogenous when analysing financial development. Second, the regression results from LLSV (1998) linking the Anti-Director Index to measures of stock market performance cannot be replicated with the more accurate Anti-Director Index values.

Following the criticisms of the Anti-Director Index, Djankov et al (2008) proposed a new modified version. The revised index was for 72 countries based on laws and regulations applicable to publicly traded firms as of May 2003. The new revised index addressed several criticisms relating to the noted conceptual ambiguities and the ad hoc nature of some measures. For example, the new revised index associates shareholder protection with laws that clearly mandate minority shareholders provisions. Accordingly, as discussed earlier in this section, unlike the original Anti-Director Index, a ‘0’ was assigned to the U.S. in the revised index as not having cumulative voting (Djankov et al., 2008, p. 454).

Djankov et al. (2008) also constructed a new index called the “anti-self-dealing index”. The index was based on a hypothetical self-dealing (investor expropriation) transaction between two firms controlled by the same person that can in principle be used to improperly enrich that person. The authors then asked attorneys from Lex Mundi law firms to describe in detail how each country’s legal system regulates this transaction. The study examined two approaches to measure the way in country’s legal system regulated the hypothetical transaction. The first approach sought to measure the regulation of the disclosure and approval for transactions and also the facilitation of private litigation when self-dealing is suspected. This approach was called private enforcement. The second approach (called public enforcement) relied upon public enforcement through sanctions such as fines and prison terms against self-dealing.

After conducting an analysis of the answers of 72 respondents, the study shows that there are clear differences in financial development across legal systems. Comparing with the other legal origins, the common law countries as concluded in their previous studies have more valuable stock markets relative to the GDPs, more listed firms per million people and more IPOs relative to their GDPs. After comparing of the various indexes of shareholders protection, the study also indicate that there is strong correlation between the different measures, but the anti-self-dealing index is preferable to the Anti-Director Rights Index in cross-country empirical work.

This critical review of the literature concerning the measurement of shareholders rights and financial development has shown that earlier studies based upon the work of LLSV (1998) where problematic both conceptually and in the way that various dimensions of protection were measured. The new indices developed and applied by Djankov et al. (2008) address many of these problems. These new measures can be applied to a wider range of national legal systems and allow more rigorous testing of theory and measuring precision. This thesis will build on this foundation to test a new model that incorporates recently developed measures, used by the World Bank as a policy tool for measuring and promoting protection regulations, to conduct a full examination of the relation between minority shareholder protection and equity markets development.

[1] “Leximetrics” is a term used by legal scholars to refer for every quantitative measurement of law (Lele and Siems, 2007).