International Differences in Investor Protection

"Global financial markets will provide a political and economic impetus for broad improvements in investor protection."

Much evidence links healthy financial markets with the presence of laws, regulations, and courts that protect shareholders and creditors from unscrupulous insiders who otherwise would syphon off profits with impunity. Comprehensive safeguards seem to foster responsible corporate behavior, giving investors the confidence to acquire shares and to extend credit; this in turn increases corporate valuations and provides capital for lucrative expansion opportunities. But there appear to be a number of factors - from resistance to change by special interests to complex divergences in legal practices rooted in centuries-old battles between monarchs and property owners -- that prevent some countries from reaping the fruits of well-managed financial markets.

In Investor Protection: Origins, Consequences, Reform (NBER Working Paper No. 7428), NBER researchers Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny examine why the reach of investor protections varies so much from country to country, despite their clear association with "effective corporate governance." They also consider what can be done to at least lessen, if not close, the gaps. The authors note that "improving such protection is a difficult task," in part because "the nature of investor protection, and of regulation of financial markets more generally, is deeply rooted in the legal structure of each country, and in the origin of its laws."

For example, countries whose legal systems are based on English common law have "the strongest protection of outside investors" while French civil law countries have the weakest. The authors note that the common law system allows judges to apply general principles and legal precedents to alleged investor abuse "even when specific conduct has not been described or prohibited in the statutes." Civil law, by contrast, requires judges to base their rulings on the exact letter of the law. "From this perspective, the vague fiduciary duty principles of the common law are more protective of investors than the bright line rules of the civil law, which can often be circumvented by sufficiently imaginative insiders," they write.

The authors reveal how deeply ingrained these differences are by tracing investor protections back to historical tensions between property owners and monarchs. For example, they point out that strong investor protections found in English common law evolved from a successful move in the 17th century by Parliament to legally protect property owners from the taxing impulses of the crown. Meanwhile, relatively weak safeguards in French civil law, they note, go back to the fact that Napoleon maintained the power over the centralized state, creating a body of law that made it hard for financiers to exercise power over corporations.

Of course, reform is not accomplished by simply advising civil law countries to adopt a common law approach to investor protection. The authors acknowledge that "for most countries, the improvement of investor protection requires radical changes in the legal system," and that invites intense opposition from "families that control large corporations." According to the authors, reforms are seen by these families not only as limiting their ability to take or "expropriate" company assets, but also as making it easier for potential competitors to raise cash and challenge their dominance.

Still, the authors point out that events such as the Great Depression and, more recently, the East Asian financial crisis and Poland's successful transition to a market economy show that opportunities for sweeping reforms "do arise, but under special circumstances" and that they "should not be wasted." Although they caution that there is "no checklist of what needs to be done," the authors do point out that successful regulatory regimes share some common themes, such as "extensive and mandatory disclosure of financial information by the issuers, the accuracy of which is enforced by tightly regulated financial intermediaries."

For countries where change appears to be a long way off, the authors note that companies might "opt into more investor friendly legal regimes" by listing their securities "on an exchange that protects minority shareholders." In addition, companies could be acquired by a foreign firm operating in a country where there are strong investor protections.

Overall, the authors are optimistic that the (currently much criticized) global financial markets will provide a political and economic impetus for broad improvements in investor protection. "The integration of world capital markets makes such reforms more likely today than they have been in decades," they conclude.

-- Matthew Davis

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