Shareholders Protection and Stock Market Development

The work of the four financial economists ‘LLSV’ (1997 and 1998) along with subsequent studies (Demirguc-Kunt and Levine, 2001; Johnson et al., 2000a; Wurgler, 2000; and LLSV 1999; 2000 and 2002) demonstrate that better legal ‘investor protection’ is associated with increased breadth and depth of capital markets, a faster pace of new security issues, and a greater reliance on external financing to fund the growth of firms.

In a series of papers, LLSV uses the Anti-Director Index as a quantitative measure for legal shareholder protection to show that a high level of legal shareholder protection and a correspondingly strong enforcement would result in larger stock market capitalisation as a percentage of GDP, high initial public offering and greater numbers of publicly traded companies relative to the population of firms (LLSV, 1997; 1998; 1999).

Demirguc-Kunt and Levine (2001) confirm that strong legal protection of shareholders, low levels of corruption and good accounting regulations are highly correlated with stock market capitalisation. Johnson et al. (2000a) show that the low level of protection of minority shareholder rights played a significant part in the stock market decline during the Asian financial crisis in 1997-98.

In 2006, the LLSV Anti-Director Rights Index was replaced by the authors with quantitative measures of shareholder protection through securities laws and regulations governing security issuance with a focus on mandatory disclosure, liability standards, and public enforcement. The authors then examined a sample of 49 countries and the relationship between their securities laws and a number of indicators of stock market development, including the average ratio of stock market capitalisation held by small shareholders to gross domestic product (GDP), numbers of publicly traded companies relative to population, initial public offering, block premia, access to equity and ownership concentrations. The paper found “little evidence that public enforcement benefits stock markets, but strong evidence that laws mandating disclosure and facilitating private enforcement through liability rules benefit stock markets” (LLSV, 2006, p. 1).

Recently, three of the designers of the Anti-Director Rights Index teamed with a World Bank economist Simeon Djankov[1] (Djankov et al., 2008) and proposed a new modified version of the index. The revised version included 72 countries based on laws and regulations applicable to publicly traded firms, as of May 2003. The new index considers the criticism of the previous index, especially the issue of conceptual ambiguity in the definitions of some of its components and the ad hoc nature of some measures (as discussed in Chapter 3, Section 3.3).

In the same study, the authors also constructed another new index called the “anti-self-dealing index”. This index was built based on hypothetical self-dealing transactions between two firms controlled by the same person that can, in principle, be used to improperly enrich this person. The index includes measures, such as disclosure, public enforcement, approval of self-dealing transactions by disinterested shareholders, shareholders’ legal standing to challenge a self-dealing transaction in court, and the ability to hold controlling shareholders and directors liable for self-dealing transactions.

Using the two indexes, the study reinforced the findings that countries with higher level of shareholders protection have more valuable stock markets relative to the GDPs, with more listed firms per million people and more IPOs relative to their GDPs.

The literature on law and finance is straight-forward: essentially, appropriate minority shareholder protection is a precondition of ownership separation and enables the development of securities markets (Nee and Opper, 2009). Strong legal shareholder protection against insider expropriation reduces asymmetric information problems and the threat of minority shareholder expropriation, thereby encouraging investors to participate in capital markets and they can afford to take minority positions rather than controlling stakes (Boyle and Meade, 2008). The enhanced protection also means that the minority shareholders also demand lower expected rates of return. The consequences of this protection are that firms tend to have dispersed shareholders and capital markets are more liquid and broad. By contrast, where shareholder rights are not well protected, shareholders will compensate for this shortfall by taking controlling positions in a firm and the expected rate of return will be higher (LLSV, 1997, 1998, 2000 and 2002, Demirguc-Kunt and Levine, 2001, and Johnson et al., 2000a). The consequent improvement in the allocation of capital and improved access to external finance for corporations facilitates economic growth (LLSV, 1997).

This logic was approved empirically by LLSV (1997), where they seek to relate the firms’ ability to raise external financing from debt and equity markets in the 49 countries to the legal environment for investment protection. The results indicate that minority shareholder protection, as described by the character of legal rules and the quality of law enforcement, matters for the size and breadth of a country’s capital markets. They note that countries whose financial markets offer firms with better terms of investor protection would have both higher valuations of securities and boarder capital markets in the sense that more firms would access them. Table 7 shows the results of mean values for different legal origins classified according to equity finance variables.

Table 7: Findings of LLSV (1997)

Legal origin Average ratio of

outsider held stock

to GNP (%)

Listed firms per

million people

(on average)

IPO’s per million


(on average)

Common law countries 60 35 2.2
French origin countries 21 10 0.12
German origin countries 46 17 0.2
Scandinavian origin countries 30 27 2.1

Summarized from LLSV (1997)

These statistics show that the counties with common legal origins (characterised with higher level of protection) have a larger number of listed firms and a higher value of IPOs compared with other countries. These results are consistent with another study conducted the following year by Demirgue-Kunt and Maksimovic (1998) who demonstrate that the legal form of investor protection plays a role in understanding the differences in the functioning of the financial markets and the ability of firms to obtain external funds.  Using a sample drawn from 30 developing and developed countries, they show that the proportion of firms that grow at rates exceeding the predicted rate[2] in each country is associated with specific features of a country’s legal and financial systems. Thus, they demonstrate that an active stock market and a well-developed legal system are essential to facilitate firm growth. The same authors, in 2002, examined firms in 40 countries and computed the proportion of firms in each country that rely on external finance and how that proportion differs across different legal systems. They document that the development of a country’s legal system predicts firms’ access to external finance.


Hail and Leuz (2006) used four different statistical models to compute the implied cost of capital from 1992 to 2001 for 35,122 firm-year observations from 40 countries and documented that firms from countries with more extensive disclosure requirements, stronger securities regulations, and stricter enforcement mechanisms – as measured by La Porta (1997, 2006) – tend to exhibit lower country-level cost of capital. Boyle and Meade (2008) summarised the magnitude of shareholder protection indexes effects, based on La Porta et al. (2006) and Hail and Leuz (2006). A summary of these results is given in Table 9 which shows the average change in the stock market development measures as the result of moving from the 10th to the 90th regulatory percentile (approximately the difference between Greece and Canada, as of December 2000).



Table 8: The magnitude of shareholder protection indexes effects as summarised by Boyle and Meade (2008) Measures of financial


Mean effect of increasing regulation index from the 10th to the 90th percentile


  Market capitalisation/GDP 15–39 percentage points
  Firms per capita 28–74%
  Ownership concentration -2 to -13 percentage points


  Turnover/GDP 24–65 percentage points


  Cost of equity  
  All countries -100 to -340 basis points
  Countries with open

capital markets

0 to -100 basis points




Chen et al. (2009) examine the effect of firm-level corporate governance on the cost of equity capital in 559 firm-year observations across 17 emerging markets and estimate the impact of the country-level legal protection of investors. They use several measures of country-level legal protection of investors and extra-legal institutional factors, including mainly the LLSV Anti-Director Index, private enforcement and the public enforcement indices of LLSV (2006) and the anti-self-dealing index from Djankov et al. (2008). The results indicate that firm-level corporate governance and country-level shareholder protection seem to be substitutes for each other in reducing the cost of equity. In countries where the legal system does not impose a high cost on expropriation by corporate insiders, the firm-level corporate governance is more valuable. However, firm-level corporate governance is less valuable in reducing the cost of equity in countries with strong legal protection of investors.

The empirical evidence reported in this literature review indicates that the finance and law theory has some validity in that there are statistical associations between legal systems, minority shareholder protection and the development of capital markets. However, there are several criticisms that can be made of this work which has implications for the research conducted for this thesis.

[1]  Simon Djankov is working currently as Bulgarian deputy Prime Minister and Minister of Finance since July 2009.

[2] The predicted rate is estimated using a financial planning model to obtain the maximum growth rate that each firm in the used countries sample could attain without access to long-term financing.