2. Investor protectionWhen investor

2. Investor protection
When investors"nance"rms, they typically obtain certain rights or powers
that are generally protected through the enforcement of regulations and laws.
Some of these rights include disclosure and accounting rules, which provide
investors with the information they need to exercise other rights. Protected
shareholder rights include those to receive dividends on pro-rata terms, to vote
for directors, to participate in shareholders' meetings, to subscribe to new issues
of securities on the same terms as the insiders, to sue directors or the majority for
6 R. La Porta et al./Journal of Financial Economics 58 (2000) 3}27
suspected expropriation, to call extraordinary shareholders' meetings, etc. Laws
protecting creditors largely deal with bankruptcy and reorganization procedures, and include measures that enable creditors to repossess collateral, to
protect their seniority, and to make it harder for"rms to seek court protection in
reorganization.
In di!erent jurisdictions, rules protecting investors come from di!erent sources, including company, security, bankruptcy, takeover, and competition laws,
but also from stock exchange regulations and accounting standards. Enforcement of laws is as crucial as their contents. In most countries, laws and
regulations are enforced in part by market regulators, in part by courts, and in
part by market participants themselves. All outside investors, be they large or
small, shareholders or creditors, need to have their rights protected. Absent
e!ectively enforced rights, the insiders would not have much of a reason to repay
the creditors or to distribute pro"ts to shareholders, and external "nancing
mechanisms would tend to break down.
The emphasis on legal rules and regulations protecting outside investors
stands in sharp contrast to the traditional`law and economicsaperspective on
"nancial contracting. According to that perspective, most regulations of"nancial markets are unnecessary because"nancial contracts take place between
sophisticated issuers and sophisticated investors. On average, investors recognize a risk of expropriation, penalizing"rms that fail to contractually disclose
information about themselves and to contractually bind themselves to treat
investors well. Because entrepreneurs bear these costs when they issue securities,
they have an incentive to bind themselves through contracts with investors to
limit expropriation (Jensen and Meckling, 1976). As long as these contracts are
enforced,"nancial markets do not require regulation (Stigler, 1964; Easterbrook
and Fischel, 1991).
This point of view, originating in the Coase (1961) theorem, crucially relies on
courts enforcing elaborate contracts. In many countries, such enforcement
cannot be taken for granted. Indeed, courts are often unable or unwilling to
invest the resources necessary to ascertain the facts pertaining to complicated
contracts. They are also slow, subject to political pressures, and at times corrupt.
When the enforcement of private contracts through the court system is costly
enough, other forms of protecting property rights, such as judicially-enforced
laws or even government-enforced regulations, may be more e$cient. It may be
better to have contracts restricted by laws and regulations that are enforced
than unrestricted contracts that are not. Whether contracts, court-enforced
legal rules, or government-enforced regulations are the most e$cient form of
protecting"nancial arrangements is largely an empirical question. As the next
section shows, the evidence rejects the hypothesis that private contracting is
su$cient. Even among countries with well functioning judiciaries, those with
laws and regulations more protective of investors have better developed capital
markets.
R. La Porta et al./Journal of Financial Economics 58 (2000) 3}27 7
1Socialist countries had a legal tradition based on Soviet law, but because the laws of these
countries are changing rapidly during the transition out of socialism, La Porta et al. (1998) do not
consider them.
La Porta et al. (1998) discuss a set of key legal rules protecting shareholders
and creditors and document the prevalence of these rules in 49 countries around
the world. They also aggregate these rules into shareholder (antidirector) and
creditor rights indices for each country, and consider several measures of
enforcement quality, such as the e$ciency of the judicial system and a measure
of the quality of accounting standards. La Porta, Lopez-de-Silanes, Shleifer, and
Vishny use these variables as proxies for the stance of the law toward investor
protection to examine the variation of legal rules and enforcement quality across
countries and across legal families.
Legal scholars such as David and Brierley (1985) show that commercial legal
systems of most countries derive from relatively few legal`families,'' including
the English (common law), the French, and the German, the latter two derived
from the Roman Law. In the 19th century, these systems spread throughout the
world through conquest, colonization, and voluntary adoption. England and its
former colonies, including the U.S., Canada, Australia, New Zealand, and many
countries in Africa and South East Asia, have ended up with the common law
system. France and many countries Napoleon conquered are part of the French
civil law tradition. This legal family also extends to the former French, Dutch,
Belgian, and Spanish colonies, including Latin America. Germany, Germanic
countries in Europe, and a number of countries in East Asia are part of the
German civil law tradition. The Scandinavian countries form their own tradition.1
Table 1 presents the percentage of countries in each legal family that give
investors the rights discussed by La Porta, Lopez-de-Silanes, Shleifer, and
Vishny, as well as the mean for that family antidirector and creditor rights
scores. How well legal rules protect outside investors varies systematically
across legal origins. Common law countries have the strongest protection of
outside investors}both shareholders and creditors}whereas French civil law
countries have the weakest protection. German civil law and Scandinavian
countries fall in between, although comparatively speaking they have stronger
protection of creditors, especially secured creditors. In general, di!erences
among legal origins are best described by the proposition that some countries
protect all outside investors better than others, and not by the proposition that
some countries protect shareholders while other countries protect creditors.
Table 1 also points to signi"cant di!erences among countries in the quality of
law enforcement as measured by the e$ciency of the judiciary, (lack of) corruption, and the quality of accounting standards. Unlike legal rules, which do not
appear to depend on the level of economic development, the quality of enforcement is higher in richer countries. In particular, the generally richer Scandina-8 R. La Porta et al./Journal of Financial Economics 58 (2000) 3}27
vian and German legal origin countries receive the best scores on the e$ciency
of the judicial system. The French legal origin countries have the worst quality
of law enforcement of the four legal traditions, even controlling for per capita
income.
Because legal origins are highly correlated with the content of the law, and
because legal families originated before"nancial markets had developed, it is
unlikely that laws were written primarily in response to market pressures.
Rather, the legal families appear to shape the legal rules, which in turn in#uence
"nancial markets. But what is special about legal families? Why, in particular, is
common law more protective of investors than civil law? These questions do not
have accepted answers. However, it may be useful here to distinguish between
two broad kinds of answers: the `judicialaexplanations that account for the
di!erences in the legal philosophies using the organization of the legal system,
and the`politicalaexplanations that account for these di!erences using political
history.
The`judicialaexplanation of why common law protects investors better than
civil law has been most recently articulated by Co!ee (2000) and Johnson et al.
(2000b). Legal rules in the common law system are usually made by judges,
based on precedents and inspired by general principles such as"duciary duty or
fairness. Judges are expected to rule on new situations by applying these general
principles even when speci"c conduct has not yet been described or prohibited
in the statutes. In the area of investor expropriation, also known as self-dealing,
the judges apply what Co!ee calls a`smell test,aand try to sni!out whether
even unprecedented conduct by the insiders is unfair to outside investors. The
expansion of legal precedents to additional violations of"duciary duty, and the
fear of such expansion, limit the expropriation by the insiders in common law
countries. In contrast, laws in civil law systems are made by legislatures, and
judges are not supposed to go beyond the statutes and apply `smell testsaor
fairness opinions. As a consequence, a corporate insider who "nds a way not
explicitly forbidden by the statutes to expropriate outside investors can proceed
without fear of an adverse judicial ruling. Moreover, in civil law countries,
courts do not intervene in self-dealing transactions as long as these have
a plausible business purpose. The vague"duciary 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 su$ciently imaginative insiders.
The judicial perspective on the di!erences is fascinating and possibly correct,
but it is incomplete. It requires a further assumption that the judges have an
inclination to protect the outside investors rather than the insiders