Viewpoint Note No. 109 Which Countries Give Investors the Best Protection? Rafael La Porta, Does the owner of a share of stock in Mexico does Germany have such a small stock mar- Florencio Lopez- have the same rights as a shareholder in Ger- ket, but also maintains very large and power- de-Silanes, many or India? Is a creditor in Italy protected ful banks? Why is the voting premium-the Andrei Shleifer, as well as one in Switzerland? Do laws pro- price of shares with strong voting rights rela- and Robert tecting investors differ among countries in tive to that of shares with limited voting rights- Vishny systematic ways? Are these laws sufficiently small in Sweden and the United States and enforced everywhere? And if there are differ- much larger in Italy and Israel? Indeed, why ences, do they matter for corporate finance? were Russian stocks nearly worthless immedi- This Note reports on an empirical study that ately after privatization-by some estimates one examines these issues by looking at the rules hundred times cheaper than Western stocks governing investor protection and the quality backed by comparable assets-and why do of law enforcement in a sample of countries in Russian companies have virtually no access to Europe. Asia, Africa, and North and South external finance? The content of legal rules in America. different countries may well shed light on these corporate governance puzzles. Investor rights and governance Analytical approach Shares in a company typically give their own- ers the right to vote for its directors, while debt The starting point for the analysis is the recog- gives creditors the power to, for example, re- nition that there are only four broad "families," possess collateral when a company fails to or 'origins," of most laws governing investor make promised payments. Thus, shareholders protection, and commercial laws more gener- receive dividends because they can vote out ally: English, or common, law, French civil law, the directors who do not pay them, and credi- German civil law, and Scandinavian civil law. tors are paid because they have the power to (Most countries adopted their legal system as repossess collateral. Without these rights, in- a result of colonization or conquest by England, vestors would not be able to get paid, and France, or Germany-or Spain, 'which was con- therefore firms would not have the benefit of quered by Napoleon and so adopted its laws raising funds from these investors. from France.) Thus, a study of investor protec- tion in different countries is largely a study of But these rights also depend on the legal rules protection in the four legal families. The focus of the jurisdiction where the securities are is- of the analysis of legal rules is on a fairly nar- sued. And since the protection investors re- row range of differences in two types of laws ceive determines their readiness to finance relating to investor protection: company laws firms, corporate finance may critically turn on and bankruptcy and reorganization laws. these legal rules and their enforcement. Indeed, differences in the legal protection of investors Shareholder rights might help explain why firms are financed and owned so differently in different countries. Why The analysis begins by considering shareholder do Italian companies rarely go public? Why rights under company laws. Because sharehold- LI3u Private Sector Development Department * Finance, Private Sector, and Infrastructure Network Which Countries Give Investors the Best Protection? The survey sample ers exercise their power by voting for direc- * Company law also establishes the percent- Common law tors, evaluations of shareholder rights focus on age of share capital needed to call an ex- tradition voting rights. These include voting rights at- traordinary shareholders meeting-the higher Australia tached to shares, rights that protect the voting the percentage, the harder it is for minority Canada mechanism against interference by insiders, and shareholders to organize a meeting. Hong Kong India remedial rights. Investors may be better pro- Ireland tected when dividend rights are tightly linked Two major facts emerge from the analysis of Israel to voting rights, that is, when companies are shareholder rights in the countries in the Kenya Malaysia subject to one-share-one-vote rules. The idea sample. First, countries with a common law New Zealand is that when. votes are tied to dividends, insid- system afford the best legal protection to share- Nigeria ers cannot appropriate cash flows by maintain- holders. They most frequently allow sharehold- Pakistan Singapore ing voting control despite controlling only a ers to vote by mail, they never block the sale South Africa small proportion of the company's shares. of shares for shareholders meetings, they have Sri Lanka the highest incidence of laws protecting op- Thailand United Kingdom Five other rights essentially describe how easy pressed minorities, and they generally require United States it is for shareholders to exercise their voting a relatively small percentage of shares to call Zimbabwe rights. These rights measure how strongly the an extraordinary shareholders meeting. Second, French civil law legal system favors shareholders relative to countries with French civil law afford the worst tradition managers in the voting process. legal protection to shareholders. They have the Argentina * To vote in shareholders meetings in some lowest incidence of allowing voting by mail, a Breazium countries, shareholders must show up in high incidence of blocking share sales for share- Chile person or send an authorized representative. holders meetings, and a low incidence of laws Colombia In other countries, by contrast, they can vote protecting oppressed minorities, and require Ecuador by mail, which makes it easier for them to the highest percentage of share capital to call France cast their votes. In Japan, for example, about an extraordinary shareholders meeting. Greece 80 percent of companies hold their annual Indonesia meetings the same week, and voting by mail The next step is to ask whether, in a statistical Jordan is not allowed. sense, once all the legal rules are considered Mexico * In some countries, the law requires that share- together, the origin of legal systems matters. Peru holders deposit their shares with the com- The analysis confirms that it does. In Australia Philippines pany or a financial intermediary several days and South Africa, two common law countries, Portugal before a shareholders meeting. This practice a minority shareholder can vote by mail, can Spain Turkey prevents shareholders from selling their trade his shares during a shareholders meet- Uruguay shares for several days around the time of ing, is protected from certain expropriations Venezuela the meeting and keeps shareholders who do by directors, and needs only 5 percent of share German civil law not bother to go through this exercise from capital to call an extraordinary meeting. By con- tradition voting. trast, in Italy and Belgium, whose legal sys- Austria * Some countries allow cumulative voting for tems are based on French civil law, a minority Germnany directors, which in principle gives minority shareholder cannot vote by mail, cannot trade JapanI Republic of Korea shareholders more power to put their repre- his shares during a shareholders meeting, is Switzerland sentatives on boards of directors. not protected from expropriation by directors, Taiwan (China) * In some countries, the law provides minor- and needs 20 percent of share capital to call Scandinavian civil ity shareholders with legal recourse against an extraordinary meeting. law tradition perceived oppression by directors. The mech- Denmark Finland anisms may include the right to sue direc- A final step is to control for income level and Norway tors (as in American derivative suits) or to see whether origin still matters. Again, the re- Sweden force the company to purchase the shares of sults show that it does. Thus, the importance shareholders who object to such fundamen- of legal origin comes out loud and clear from tal changes as mergers or asset sales. this analysis of shareholder rights. Creditor rights pointed by the court or the creditors. This threat of dismissal may enhance creditors' The creditor rights most essential for debt fi- power. nance are those to repossess collateral and to have a say in reorganization. In some coun- The results of the analysis of creditor rights tries, the law makes it difficult for lenders to show a pattern similar to that for shareholder repossess collateral in part because such re- rights. Common law offers the best protection, possession can lead to the liquidation of firms, and French civil law the worst. Thus, it does which is viewed as socially undesirable. In not appear that some legal families protect these countries, lenders may still have some shareholders while others protect creditors- powers against borrowers through their votes though German civil law countries favor se- in decisions on how to reorganize the com- cured creditors. pany and pay off the creditors. The analysis uses four variables for creditor rights. Adaptations * In some countries, the reorganization proce- dure imposes an automatic stay on the debtor How do the countries with poor laws cope with company's assets, preventing secured credi- their consequences? Do firms in these countries tors from getting possession of loan collat- receive no financing? Or is finance made possible eral. This rule obviously protects managers by other, substitute mechanisms of corporate and unsecured creditors against secured governance that have been incorporated into creditors and prevents automatic liquidation. the law or that lie outside the law? One possible In other countries, by contrast, secured credi- adaptation to fewer laws is strong enforcement. tors can pull collateral from firms being Another is to introduce mandatory standards of reorganized without waiting for the reorga- capital retention and capital distribution to in- nization to be completed. vestors; legal scholars sometimes refer to these * Some countries do not ensure secured credi- standards, which limit the opportunities for tors the right to collateral in reorganization. managerial expropriation, as 'bright line" rules. In these admittedly few countries, secured creditors are in line behind the government Yet another adaptation is ownership concentra- and workers, wlho have absolute priority over tion. Some concentration of ownership of a firm's them. In Mexico, for example, various social shares is typically efficient: it provides managers constituencies must be repaid before secured with an incentive to perform, and large inves- creditors, often leaving the creditors with no tors with an incentive to monitor the managers. assets to back their claims. But some dispersion of ownership among small * In some countries, management can seek pro- investors is also desirable to diversify risk. When tection from creditors by unilaterally filing the law protects investors, even small investors for reorganization. without creditor consent. can hope to get something back on their money. Such protection, called Chapter 11 in the When it does not, investors must be large and United States, gives management a great deal powerful to stand up to management and ex- of power against creditors, since creditors can tract payments from it. at best get their money or collateral only af- ter a delay. In other countries, creditors' con- To assess enforcement, the analysis uses five sent is needed to file for reorganization, so measures: efficiency of the judicial system, rule managers cannot so easily escape creditors' of law, corruption, risk of expropriation (out- demands. right confiscation or forced nationalization) by * In some countries, management stays in place the government, and likelihood of contract re- pending the resolution of the reorganization pudiation by the government. In addition to procedure, while in others, such as Malaysia, these rule of law variables, the study uses an management is replaced by an agent ap- estimate of the quality of accounting standards. Which Countries Give Investors the Best Protection? The results show that the quality of enforce- differ markedly around the world, though in ment is highest in Scandinavian and German most places they tend to give investors a rather civil law countries, next highest in the common limited bundle of rights. Countries whose le- law countries, and lowest in French civil law gal systems stem from the common law tradi- countries. And they show that French civil law tion tend to protect investors considerably countries are more likely to have bright line better than do countries whose systems are rules-mandatory dividends and capital reserves. based on civil law, especially French civil law. Countries whose systems are based on Ger- The analysis also shows that the quality of share- man and Scandinavian civil law take an inter- holder protection and the protection of the vot- mediate stance toward investor protection. ing process against manipulation by directors There is no clear evidence that different coun- are significant determinants of ownership con- tries favor different types of investors; the evi- centration. Moreover, between them, these two dence points instead to a stronger stance variables account for the higher concentration favoring all investors in common law countries. of ownership in the French civil law countries. These results support the idea that heavily con- Second. law enforcement too differs a great centrated ownership results from poor protec- deal around the world. German and Scandina- tion of investors-and may in fact substitute for vian civil law countries have the best law en- investor protection. The evidence shows that forcement, although to some extent this reflects Viewvpoint is an opien poor laws do make a difference, and that they their higher average income. Law enforcement forum intended to may have costs. One of the costs of heavily con- is also strong in common law countries, and encourage dissemina- centrated ownership for large firms is that their weakest in the French civil law countries. tion of and debate on core investors are not diversified. The other cost idean, innovations, and frteefrsi ht poal best practices for for these firms is that they probably have diffi- Third, good accounting standards, rule of law, expanding the private culty raising equity finance, since minority share- and shareholder protection have a strong nega- sector. The views holders fear expropriation by managers and tive correlation with the concentration of own- published are those of the authors and slould majority shareholders. Are these results simply ership. This result suggests that inadequate not be attributed to the a consequence of income level? Here again, the protection of investors may be costly. If small World Bank or any of its evidence suggests weaknesses in French civil investors are not protected, companies will be affiliated organizations. Nor do any of the con- law regardless of income level. unable to raise capital from them, and entre- clusions represent preneurs will be unable to diversify their hold- official policy of the Is there a legal trap? ings. High ownership concentration, then, mav World Bank or of its Executive Directors be a symptom of a poorly functioning capital or the countries they Do poor countries offer systematically lower pro- market. represent. tection to investors? The study finds no correla- To order additional tion between income level and shareholder ThisNoteisbasedonalongerpaperbytheaurhlors, Law andFinance" copies please call 202- rights, and, if anything, some creditor rights are (National Bureau of Economic Research Working Paper 5661, Cam- 458-1 111 or contact wxeaker in richer countries. Some countries- bridge, Mass., July 1996). Suzanne Smith, editor, Room G8105, The World such as France and Italy-have managed to get Bank, 1818 H Street, rich despite having few laws protecting inves- Rafael La Porta, Florencio Lopez-de-Silanes NW, Washington, D.C. tors. But richer countries have a higher qualitv (f lopezdesilanesWharvard.edu), and Andrei 20433, or Internet pzednsavr.d) nAde address osmith7@ of law enforcement, and poor countries' failure Shleifer, Harvard UIniversity, and Robert Visbny, worldbank.org. to consistently enforce basic investor protection University of Chicago The series is also may well help keep them poor. available on-line (www.worldbank. org/html/fpd/notes,' Conclusion notelist.htmlt. @Printed on recycled The results of the analysis suggest three broad paper conclusions. First, laws protecting investors