LLSV and supporting studies represent considerable evidence of a statistical association between measures of stock market development and the degree of protection available to non-controlling shareholders. However, these studies do not remain without criticism. Section (3.3.1) above offered a critique of the LLSV Anti-Director Index which has been used by the studies discussed here.
For example, the same criticisms for the representation of formulated variables used to measure the level of shareholder protection were also used against the current development. However, a particularly important criticism is that that the historical development of national stock markets does not conform well to the claim that increasing shareholder protection drives financial market development. Market capitalization of the US stock market for instance, had already reached 80 per cent of GDP in the late 1920s, when security regulations were almost absent. In spite of a wave of new securities laws and amendments specifying rules on voting rights, proxy contests (Holding Company Act 1935) and insider trading (Section 14 of the 1934 Securities Exchange Act), the market remained within its earlier high of 80 per cent of GDP until the mid-1970s (Nee and Opper, 2009).
Aganin and Volpin (2003) analysed all the companies that traded on the Milan Stock Exchange (MSE) between 1900-2000 to test for a positive correlation between investor protection and stock market development. They conclude that the history of investor protection laws and the development of the Italian stock market throughout the twentieth century is not sufficient to support the law and finance view of the relationship between stock market development and investor protection.
Rajan and Zingales (2003) provide further statistical evidence to contradict the Law and Finance theory showing that data on stock market development in 1913, for 6 common law and 18 civil law countries (10 of them French civil law) indicate that stock markets were, by most measures, more developed in 1913 than in 1980, and that development actually went into reverse between 1930 and 1970—a period characterised by the imposition of stronger and more widespread legal investor protection.
These challenging studies and criticisms indicate that the empirical evidence concerning the importance of minority shareholder protection for financial markets performance is inconclusive. Recently, LLS (2008) provide some counter arguments to the empirical evidence against the law and finance theory. LLS (2008) used the data used by Rajan and Zingales (2003) to highlight that the figures used to measure the country’s stock market capitalisation in the early 20th century did not mirror the real values of MKAP. For example, LLS (2008) show that in 1913, Cuba and Egypt are the most financially developed countries in the Rajan and Zingales (2003) sample. However, they overlooked the fact that although Cuba and Egypt originated from French legal origin, Cuba was a U.S. colony and all the largest companies listed in Egypt were also listed in England and France. Similarly, Rajan and Zingales (2003) did not consider the value of bonds present in the data on stock market capitalisation. Thus, if we were only to remove the bonds, Cuba’s MKAP would drop from 219 per cent down to 33 per cent and Egypt’s would drop from 109 per cent down to 40 per cent, which in turn would significantly reduce the French civil law average. LLS (2008) conclude that common law countries appear to be more financially developed than civil law ones at the start of the twentieth century, and in particular that Britain is ahead of France.
Notwithstanding, LLS (2008) agree that the challenge for the law and finance argument is inherent in explicating the inconsistent parallels – according to law and finance theory- between the growth of the UK stock market and shareholders right improvement amid the twentieth century. The UK may be an exceptional case for evaluating how investor protection affects the development of securities (financial) markets. This is due to the fact that UK capital markets have gone from an absence of investor protection in the first half of the twentieth century to one of most extensive investor protection than anywhere in the world by the end of the century. Franks et al. (2003) note that at the beginning of the century there were active securities markets, firms were able to raise substantial outside equity finance, and there was rapid dispersion of ownership even in the absence of investor protection. The introduction of investor protection in the second half of the century was not associated with greater dispersion of ownership, but rather with more trading in share blocks (Cheffins, 2001, Franks et al., 2003). According to the law and finance view, the UK should have had comparatively inactive equity markets and concentrated ownership in the nineteenth and early twentieth centuries and then had more dispersed ownership and greater equity market activity after 1948 and especially after 1980 and this is clearly not the case.
The studies discussed here have empirically and historically challenged the law and finance theory. They also, from theoretical perspective, question the direction of causality running from minority shareholder legal protection to financial market development (Boyle and Meade, 2008). Under political pressure from shareholders, countries may seek to improve their laws to protect investors as their markets develop (LLS, 2008, p. 298). Consequently, one can contend that the direction of causality between shareholder protection and stock market development can be reversed or that causality might run in both directions.
One study that directly addresses this issue of reverse causality is that of Pagano and Volpin (2005) who build upon La Porta et al.’s (1998) study. Pagano and Volpin present a theoretical 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 in order to examine this relation. In their empirical analysis, the authors use data from 47 countries for the period 1993 to 2001 and rely mainly on the Anti-Director Rights index of shareholder protection constructed by LLSV (1998).
The results indicated that the correlation between shareholder protection and stock market development does not simply reflect causality in one direction from shareholder protection to stock market development, but rather indicates a positive feedback between these two variables. When better investor protection is expected, companies can issue more equity, leading to a broader stock market. In turn, more equity issuance expands the shareholder base and increases the political support for shareholder protection (More details on how we test for causality direction are presented in section 8.4).
There are several other influential papers empirically rejecting the law and finance argument. Pistor et al. (2000) offers a comprehensive analysis of legal change in shareholder and creditor rights protection in transition economies and its impact on the propensity of firms to raise external finance during the period from 1992 through 1998. The authors widen the scope of LLSV’s analysis by extending their body of legal indicators, including indices that capture the strength of the law to handle a broader range of possible conflicts. Their analyses show that effective legal institutions or what they have termed “legality” has overall much higher explanatory power for the level of equity and credit market development than the quality of the law on the books. The development of financial markets cannot be accomplished alone by even radical improvements in the legal framework for the protection of shareholder and creditor rights.
There are, a number of studies that have been conducted as part of a Law, Finance and Development ESRC funded project (mainly carried out by inter-disciplinary scholars from the University of Cambridge, Centre for Business School, CBR, 2007-2009), developed longitudinal measures of cross-national legal variation to assess the relationship between legal and economic variables using time-series and panel-data techniques. Fagernas et al. (2008) analyse a large number of annual legal indicators for 36 years of data starting from 1970 up to 2005 for the four advanced countries: France, Germany, the U.K. and U.S. Fagernas et al. (2008) criticise the dependence of LLSV studies upon cross countries comparisons which treat legal regulations as time-invariant, and use longitudinal data incorporating a 60-variable index to examine the relationship between legal changes related to shareholder protection and stock market development measured by the stock market turnover ratio. They use an Autoregressive Distributive Lag (ARDL) analysis to test for co-integration. The possibility for a beneficial long-term relationship between protective laws for shareholders and the fluctuations of the stock market is rather dubious based on this analysis. Similar results are also reported by Sarkar (2009) using the same legal indicators with an Indian dataset covering 36 years.
In a subsequent paper and using longitudinal data on shareholder protection for the period 1995-2005 and with a sample of twenty countries, Armour et al. (2009) investigate the ‘law and finance’ hypothesis by constructing a new shareholder protection index which takes into account a wider range of legal information and a wider range of types of legal norms. The findings indicate that countries with a common legal origin had stronger shareholder protection over the period 1995-2005. However, considering a possible link between shareholder protection and stock market development, the study failed to find such a relationship even across the common law origin countries which have higher levels of shareholder protection.
Despite these empirical studies contradicting the Law and Finance theory there are numerous other studies supporting the ‘law and finance’ position (Caprio et al., 2007; Brockman and Chung, 2003; Atmaja et al., 2007). These studies illustrate that the rights the legal system provides shareholders, as well as the enforcement of these rights, affects not only the ability of companies to attract external finance and then contribute to financial market development, but that these laws are also associated with a lower concentration of ownership and control (LLSV, 1999), higher valuation (LLSV, 2002), and greater dividend payouts (LLSV. 2000). However, some of these studies have also been challenged by other studies. The following sections will present the main studies that examine the relationship between investor protection and other financial market variables. This will show that even with the presence of numerous studies supporting the ‘law and finance’ position, the empirical evidence as concluded by Black and Khanna (2007) is far from being irrefutable.