Does the Strength of Investor Protection Laws Predict Capital Market Development?
The essay was originally posted on COLUMBIA LAW SCHOOL’S BLOG ON CORPORATIONS AND THE CAPITAL MARKETS.
Which countries provide the strongest investor protection laws? How are such laws related to the level of capital market development and ownership concentration in public companies? In a series of influential works, La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997, 1998, 1999) report that investor protection laws are largely determined by a country’s legal origin, with common law countries generally providing the strongest ones. These scholars also contend that countries with the strongest such laws tend to have the most developed capital markets and the least concentrated ownership of shares in their largest public firms. Further, the scholars advance a causal hypothesis according to which stronger investor protection laws promote market development. On their account, individuals and institutions that diversify their investment portfolios and thus hold only a small fraction of the stocks or bonds issued by a firm (“public investors”), tend to prefer investing in capital markets only where public investors’ rights are well protected.
This series of papers has generated a rich body of literature on the relationship between law and finance. In a recent study, I compare investor protection regimes in the U.S. and Israel to highlight anecdotal evidence that can contribute to the larger debate. While I agree with La Porta et al that investor protection is important for public investors and that effective protection should increase their participation and promote capital market development, the comparison between the U.S. and Israel demonstrates important weaknesses in those scholars’ analysis that have significant policy implications.
For starters, my comparison shows that, unlike in La Porta et al, countries that have a shared legal origin do not necessarily take a similar regulatory approach to protect their public investors. Despite their shared common law background and strong economic and political ties, Israel and the United States take different approaches to investor protection. In fact, their regimes exemplify the contrasting models that currently shape the thinking of policymakers, corporations, investor groups, and academics around the world. One model, exemplified by the U.S., favors lean and enabling corporate and securities codes that leave room for competitive market forces and private ordering to set investor protection arrangements and tailor them to the needs of individual firms. The competing approach, followed by Israel, is premised on the belief that agency costs and market failures preclude effective investor protection by private ordering. According to this view, public investors are best protected by comprehensive, mandatory, and enforceable corporate and securities laws.
Israeli law offers significantly more detailed and comprehensive rules aimed at protecting investors in public companies. For example, a series of Israeli court decisions holds directors and executives in Israeli firms to a higher standard of fiduciary duties than applies to U.S. companies. Also, unlike in America, in Israel mandatory regulation caps the compensation of certain executives and directors in public firms, thereby limiting their ability to spend investors’ money for their own benefit. Mandatory laws in Israel, but not in the U.S., prohibit the separation of voting from cash flow rights in order to reduce the conflict of interest between minority controlling shareholders and public investors. Disgruntled public investors in Israel have greater power to replace disloyal directors between annual meetings.
Yet, contrary to La Porta et al’s hypothesis, and despite the significantly weaker legal protections that the U.S. offers to public investors, its capital markets are dramatically more developed than those in Israel (controlling for size), and the ownership structure of U.S. public firms is far less concentrated. I explain this finding by identifying a major weakness in La Porta et al’s analysis. They only consider investor protection provided by legal rules, but investors can often be protected just as effectively by market forces and market norms. Specifically, I argue that shareholder activism, initiatives by the national stock exchanges, and the securities pricing mechanism often protect U.S. public investors better than the prescriptive and onerous regulations imposed in Israel.
For instance, unlike in Israel, effective public investor campaigns in the U.S. have pushed firms to reduce managerial entrenchment by voluntarily eliminating antitakeover defenses. The national stock exchanges, which are self-regulating private organizations within the constraints of federal requirements and SEC directives, have imposed far more duties on public firms than those imposed by the Israeli stock exchange, most notably requiring listed firms to increase director independence. Furthermore, market forces have moved U.S. firms to elect a significantly higher number of independent directors than required by law, while Israeli public firms merely comply with the lower threshold imposed by local regulation. Also, market forces have pushed U.S. public companies to restrict director over-boarding more effectively than has been achieved by Israeli regulation. In addition to providing stricter protection, U.S. market forces encourage a more nuanced approach to balancing investors’ competing interests than is possible under Israeli law. For example, they push firms to tailor solutions that balance between the pros and cons of term limits for directors and to conduct cost benefit analyses case by case to decide whether to separate the roles of the chairperson and the CEO.
It follows that, contrary to La Porta et al’s analysis, the approach to and strength of investor protection laws is not necessarily associated with a country’s legal origin. In addition, where corporate and securities codes and other regulations have been well calibrated, protection by markets can often be at least as effective as that provided by the law alone. As I further argue in the paper, more legal protection is not better for investors when it imposes unnecessarily high costs on firms and thereby weakens their economic vitality and reduces stock value. Also, these costs may adversely affect the decisions of firms considering whether to become or to remain public corporations, possibly threatening to reduce the number of public corporations and thus the availability of good investment opportunities over the long term. In an attempt to slow the fast decline in the number of public companies in Israel, in 2012 its Securities Authority published rules that aimed to relieve the regulatory burden on smaller and younger firms.
Israel and the U.S. exemplify two countries that have a shared legal origin and strong ties and yet embrace contrasting models of public investor protection. Contrary to La Porta et al’s predictions, the leaner regulatory approach to investor protection in the U.S. is associated with much greater capital market development and significantly less ownership concentration. Evidence of how these countries’ different models function points to the conclusion that securing effective protection for public investors depends not only on the legal protection they provide to their public investors, but also to a significant degree on the synergy between such rules and the country’s market forces, and on the implications of such rules for the economics of public issuers. Policy makers should therefore think long and hard before imposing rules that would chill market forces or excessively burden public firms.
 See Rafael La Porta, Florencio Lopez-de-Silanez, Andrei Shleifer & Robert Vishny, Legal Determinants of External Finance, 52 (3) J. Fin. 1131 (1997); Rafael La Porta, Florencio Lopez-de-Silanez, Andrei Shleifer & Robert Vishny, Law and Finance, 106 (6) J. Pol. Econ. 1113 (1998); Rafael La Porta, Florencio Lopez-de-Silanez, Andrei Shleifer & Robert Vishny, Corporate Ownership Around the World, 54 J. Fin. 471 (1999).