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Abstract:
This paper offers the first comprehensive analysis of legal change in the protection of shareholder and creditor rights in transition economies and its impact on the propensity of firms to raise external finance. Following La Porta et al. (1998), the paper constructs an expanded set of legal indices to capture a range of potential conflicts between different stakeholders of the firm. It supplements the analysis of the law on the books with an analysis of the effectiveness of legal institutions. Our main finding is that the effectiveness of legal institutions has a much stronger impact on external finance than does the law on the books, despite legal change that has substantially improved shareholder and creditor rights. This finding supports the proposition that legal transplants and extensive legal reforms are not sufficient for the evolution of effective legal and market institutions.

shareholder and creditor rights, legal effectiveness, external finance

Abstract:
In Anglo-American law, fiduciary duty is the core legal concept to address conflicts among directors/managers and shareholders. The concept is developed and constantly refined by courts in the process of adjudication. By contrast, most civil law jurisdictions, including many transition economies, either lack the procedural rules that would enable parties to bring such cases to courts, or have not developed a sufficient body of case law to determine the contents and meaning of this concept. This paper asks, whether courts should be allocated the right to define and enforce fiduciary duty principles. Based on our theory of the incompleteness of law, this paper argues that when law is highly incomplete, but the expected harm can be contained and does not cause externalities, allocating lawmaking and law enforcement to courts is optimal. Breaching fiduciary duty is such an area, as harm is typically limited to shareholders of a given company. While courts in transition economies may have difficulties living up to the task of exercising lawmaking rights in this area, we propose that there are few alternatives and that encouraging an active learning process should therefore be encouraged. We investigate emerging case law on the duty of loyalty in Poland and Russia and draw some comparisons to German case law.

incomplete law, transition economies, fiduciary duty, law enforcement

Abstract:
This paper analyses changes in the legal protection of shareholder and creditor rights in 24 transition economies from 1990 to 1998. It documents differences in the initial conditions and a tendency towards convergence of formal legal rules as the result of extensive legal reforms. Convergence seems to be primarily the result of foreign technical assistance programs as well as of harmonisation requirements for countries wishing to join the European Union. The external supply of legal rules not withstanding, the pattern of legal reforms suggests that law reform has been primarily responsive, or lagging, rather than leading economic development. In comparison, the pre-socialist heritage of transition economies has little explanatory power for the observed patterns of legal change. However, countries with German legal heritage seem to favour creditor over shareholder protection and display substantially better creditor protection than other transition economies. The paper discusses the implications of the response pattern of legal change with externally supplied legal solutions for the prospects of effective law enforcement and compliance with the law in transition economies.

Abstract:
This paper analyzes the determinants of effective legal institutions (legality) and their impact on economic development today using data from 49 countries. We show that the way the law was initially transplanted and received is a more important determinant than the supply of law from a particular legal family (i.e. English, French, German, or Scandinavian). Countries that have developed legal orders internally, adapted the transplanted law to local conditions, and/or had a population that was already familiar with basic legal principles of the transplanted law have more effective legality than "transplant effect" countries that received foreign law without any similar pre-dispositions. Controlling for the supply of legal families, we find that legality is roughly one third lower in transplant effect countries. While the transplant effect has no direct impact on economic development, it has a strong indirect effect via its impact on legality. The strong path dependence between economic development, legality and the transplant effect helps explain why legal technical assistance projects that focus primarily on improving the laws on the books frequently have so little impact. Finally, our statistical methodology produces a legality index based on observed legality proxies that almost fully captures their interaction with the way in which the law was transplanted, the supply of particular legal families and economic development.

Abstract:
Corporate law as it exists in any given country today is the result of roughly 200 years of legal change and legal adaptation. Provisions that today are hailed as indicators for good corporate governance did not exist when the first statutory corporate laws were put in place. This simple insight raises the question about the evolution of corporate law. In this paper we analyze ten jurisdictions representing the three major legal families as well as transplant countries and origin countries to explore the patterns of legal change over time. We find origin countries from common law and civil law families have experienced substantial legal change and adaptation over time. By contrast, legal transplants from both legal families have often retained the transplanted law for decades despite substantial economic change. The area of corporate law where we find the most significant change over time are corporate finance provisions. Provisions concerning corporate governance structures and entry and exit rules are also investigated.

Abstract:
This paper studies the design of law-making and law enforcement institutions based on the premise that law is inherently incomplete. Under incomplete law, law enforcement by courts may suffer from deterrence failure, defined as the social-welfare loss that results from the regime's inability to deter harmful actions. As a potential remedy a regulatory regime is introduced. The major functional difference between courts and regulators is that courts enforce law reactively, that is only once others have initiated law enforcement procedures, while regulators enforce law proactively, i.e. on their own initiative. Proactive law enforcement may be superior in preventing harm. However, it incurs high costs and may err in stopping potentially beneficial activities. We study optimal regime selection between a court and a regulatory regime and present evidence from the history of financial market regulation.

Abstract:
This paper studies the design of lawmaking and law enforcement institutions based on the premise that law is inherently incomplete. Under incomplete law, law enforcement by courts may suffer from deterrence failure. As a potential remedy a regulatory regime is introduced. The major functional difference between courts and regulators is that courts enforce law reactively, that is only once others have initiated law enforcement procedures, while regulators enforce law proactively, i.e. on their own initiative. We study optimal regime selection between a court and a regulatory regime and present evidence from the history of financial market regulation.

Abstract:
This paper develops a conceptual framework for the analysis of legal institutions. It argues that law is inherently incomplete and that the incompleteness of law has a profound impact on the design of lawmaking and law enforcement institutions. When law is incomplete, residual lawmaking powers must be allocated; and enforcement agents have to be vested with law enforcement powers. The optimal allocation of lawmaking and law enforcement powers under incomplete law is analyzed with a focus on the legislature, regulators and courts as possible lawmakers, and courts as well as regulators as possible law enforcers. The timing and process of lawmaking and law enforcement differs across these agents. Legislatures are ex ante, courts are ex post lawmakers, regulators have combine ex ante and ex post lawmaking functions. Courts are reactive law enforcers, while regulators are proactive law enforcers in that - unlike courts - they can initiate enforcement procedures. We argue that the optimal allocation of residual lawmaking and law enforcement powers is determined by the degree and nature of incompleteness of law, the ability to standardize actions that may result in harm, and the magnitude of harm and externalities expected from such actions. Under highly incomplete law, regulators are superior to courts when actions can be standardized and, if allowed to proceed, may create substantial externalities. Otherwise courts are optimal holders of lawmaking and law enforcement powers. We apply this analytical framework to the development of financial market regulation in England since the mid 19th century, with comparative reference to developments in the United States and Germany. The comparative evidence suggests that financial market regulators with both residual lawmaking and proactive law enforcement powers emerged in all three jurisdictions in response to ineffective judicial law enforcement of highly incomplete law.

Abstract:
The paper explores how legal change affects lending behavior of banks in twelve transition economies of Central and Eastern Europe. In contrast to previous studies, we use bank level rather than aggregate data, which allows us to control for country level heterogeneity and analyze the effect of legal change on different types of lenders. Using a differences-in-differences methodology to analyze the within country variation of changes in creditor rights protection, we find that the credit supplied by banks increases subsequent to legal change. Further, we show that collateral law matters more for credit market development than bankruptcy law. We also show that entrants respond more strongly to legal change than incumbents. In particular, foreign-owned banks extend their lending volume substantially more than do domestic banks, be they private or state owned. The same holds when we use foreign greenfield banks as proxies for new entrants. These results are robust after controlling for a wide variety of possibilities.

Law, Finance, Bankruptcy, Secured Lending, Banks

Abstract:
This book explores the relationship between legal systems and economic development by examining, through a methodology we call the institutional autopsy, a series of high profile corporate governance crises around the world over the past six years. We begin by exposing hidden assumptions in the prevailing view on the relationship between law and markets, and provide a new analytical framework for understanding this question. Our framework moves away from the canonical distinction between common law and civil law regimes. It emphasizes the constant, iterative, rolling relationship between law and markets, and suggests that how a given country's legal system rolls with economic changes depends significantly on its organization rather than its formal characteristics or legal origin. We find that legal systems around the world differ significantly along two crucial organizational dimensions: their degree of centralization of the lawmaking and enforcement processes, and the primary function law serves in support of market activity, ranging from protective functions to coordinative functions.

We use this analytical framework to understand why countries as diverse as the United States, Germany, Japan, Korea, China, and Russia have all experienced corporate crises in recent years, and to analyze the different institutional responses to these crises. These case studies provide insights into the diversity of legal systems and institutional arrangements that support capitalist activity over time and across a range of societies. They also suggest that systemic legal change is rarely achieved by changes in formal law alone, but is the result of changes in the composition and identity of core constituencies within a given system who use (or avoid) law to advance their position in the market. Among other things, our study suggests the need for new thinking about how and why legal systems change, the limits of convergence even in a world where national laws increasingly look alike, and a new emphasis on the demand for law in the process of legal adaptation and change.

legal systems, economic development, corporate governance

Abstract:
In most countries large business enterprises today are organized as corporations. The corporation with its key attributes of independent personality, limited liability and free tradeability of shares has played a key role in most developed market economies since the 19th century and has made major inroads in emerging markets. We suggest that the resilience of the corporate form is a function of the adaptability of the legal framework to a changing environment. We analyze a country's capacity to innovate using the rate of statutory legal change, the flexibility of corporate law, and institutional change as indicators. Our findings suggest that origin countries are more innovative than transplant countries.

Abstract:
Two parallel literatures have explored differences across legal and economic systems,noting that countries can be loosely grouped into liberal vs. coordinated market economies on the one hand, and common law vs. civil law countries on the other. These two groups largely overlap. Liberal market economies (LMEs) tend to have a common law tradition, while coordinated market economies (CMEs) belong to the civil law family (French or German). This paper argues that this overlap is not coincidental. The link between legal and economic systems are social preferences reffected in basic norms, or ground rules, found in substantive and procedural laws of different countries. These ground rules are more pervasive than their specific incarnation, such as codetermination in Germany, or shareholder primacy in the United States. The paper develops a typology of ground rules, distinguishing between substantive ground rules that allocate decision making rights to either individuals or to the state/collective; and procedural ground rules that determine whether the individual or a collective (or the state) have the primary or exclusive power to seek judicial remedies. The paper uses examples from contract and corporate law to illustrate these ground rules focusing on German law, as an example for the civil law family and a CME, and the US as an example for a common law jurisdiction and LME.

An important implication of this analysis is that each system is highly path dependent and that, therefore, marginal changes of specific incarnations of social preferences are unlikely to fundamentally alter the nature of each system.

economic-legal systems, contract law, corporate law

Abstract:
The global financial crisis that began in 2007 revealed a fundamental weakness in the global financial system: Extensive financial interdependence of financial relations unmatched by a governance regime of similar reach. As multinational banks sought to fortify their capital base in the wake of the unfolding crisis, Sovereign wealth Funds (SWFs) and the banks’ home governments have become mutual stakeholders in some of the largest financial intermediaries with global reach. From the multitude of individual transactions has emerged a network of equity ties that spans the globe. These ties bridge institutional practices and governance regimes that previously operated largely independently of each other. They have the potential of fostering the emergence of a new governance regime for the global financial market place that deviates from earlier prognoses that globalization entails convergence on a single governance model. Instead, the newly created ties that jointly add up to a global financial network enable institutionally and organizationally diverse players to contribute their own perspectives as joint stakeholders in selected financial intermediaries, and indirectly, in the global financial system. This is likely to have important implications for the behavior of these actors in the future and the emergence of new governance solutions for the global market place. The paper discusses two recent cases of collaborative re-capitalization events to illustrate how this regime is evolving in practice.

Global financial crisis, sovereign wealth funds, global finance, global governance

Abstract:
How does the quality of national institutions that enforce the rule of law influence international trade? Anderson and Marcouiller (2001) argue that bad institutions located in the importer's country deter international trade because they enable economic predators to steal and extort rents at the importer's border. We complement this research and show how good institutions located in the exporter's country enhance international trade, in particular, trade in complex products whose characteristics are difficult to fully specify in a contract. We argue that both exporter and importer institutions impact international as well as domestic transaction costs in complex and simple product markets. International transaction costs are a part of the costs of trade. Domestic transaction costs affect complex and simple products differently, thereby changing a country's comparative advantage in producing such goods. We find ample empirical evidence for these predictions: countries that have high quality institutions tend to export more complex products and import more simple products. Furthermore, institutions have a stronger influence on trade via their influence on production costs (comparative advantage) rather than on international transactions costs. International institutions seem to operate as substitutes for domestic institutions, since good domestic institutions are less important for promoting exports in those countries that have signed onto a convention that facilitates the enforcement of foreign and international arbitral awards, namely the New York Convention.

institutions, trade, law, rauch classification, gravity, New York Convention

Abstract:
This paper analyzes the transactions that led to the partial privatization of China’s three largest banks in 2005-06. It suggests that these transactions were structured to allow for inter-organizational learning under conditions of uncertainty. For the involved foreign investors, participation in large financial intermediaries of central importance to the Chinese economy gave them the opportunity to learn about financial governance in China. For the Chinese banks partnering with more than one foreign investor, their participation allowed them to benefit from the input by different players in the global financial market place and to learn from the range of technical and governance expertise offered. This model of bank reform contrasts with the privatization strategies pursued in Latin America and Central and Eastern Europe throughout the 1990s. These different experiences stand for alternative strategies of bank reform - one that relies on top down changes of the rules of the game; another that focuses on inter-organizational learning via observation. It suggests that the latter model may be superior under conditions of uncertainty. The paper discusses the costs and benefits of these alternative models in the context of the global financial crisis.

banking reform, financial crisis, sovereign wealth funds, China, emerging markets

Abstract:
Twenty years after the fall of the iron curtain, which for decades had separated East from West, many countries of Central and Eastern Europe (CEE) are now members of the European Union and some have even adopted the Euro. Their readiness to open their borders to foreign capital and their faith in the viability of market self-governance as well as supra-national governance of finance is both remarkable and almost unprecedented. The eagerness of the countries in CEE to join the West and to become part of a regional and global regime as a way of escaping their closeted socialist past has both benefited and harmed them. There is little doubt that joining the EU and opening to the rest of the world has helped transform these economies at a pace that otherwise would have been unthinkable. Yet, as the global financial crisis reveals, these countries have also remained exceptionally vulnerable to shocks, including those that originate beyond their sphere of influence. This paper looks for explanations in the governance of finance, i.e. the allocation of de jure and de facto responsibilities over financial systems. It argues that as recipient countries of massive capital inflows CEE countries have largely relinquished policy tools to protect their economies and societies against a financial melt down or to respond effectively in a crisis. The policy choices they made – opening their boarders to capital inflows, limiting regulatory oversight by relying on home country regulators of foreign banks, etc. - were aimed at integrating them into the European and the global financial systems. A frequently overlooked side effect of these policies’ cumulative effect has been that they find themselves once more on the periphery - dependent on the goodwill of multilateral organizations over which they have little sway. The paper discusses two strategies to improve the governance of finance in CEE: A European regulator and the assertion of effect-based regulatory jurisdiction over foreign bank activities.

banking regulation, regulatory jurisdiction, global governance

Abstract:
The pattern of legal change in countries that have their legal systems transplanted from abroad differs markedly from countries that develop their own systems, irrespective of the legal family from which their laws come. In transplant countries, law often stagnates for long periods of time; when change takes place, it tends to be radical, if not erratic. External models remain dominant even years after the law was transplanted. Although there is some evidence that transplant countries have engaged in comprehensive legal reforms in response to the pressures of globalization, it is still too early to judge whether these new changes can be taken as a sign that the legal systems in these countries have started a process of endogenous legal evolution.

Abstract:
Transition economies face a fundamental dilemma. They need to develop financial markets, and yet they lack the ingredients it takes to do so. Recipes for legal governance mechanisms that have worked elsewhere, including reactive law enforcement by courts and proactive law enforcement by regulators, may not help in the short to medium term. Using evidence from stock market development in China and Russia, this paper suggests that at least in the short term, administrative governance may be a viable alternative to legal governance in emerging stock markets.

Abstract:
A core part of the transition process in the former socialist countries is the creation of economic institutions that are required for a functioning market economy. The experience of the past years as well as a paradigm shift in the economic literature have brought the role of law in shaping institutions and defining rights and responsibilities of market participants to the forefront of the debate. This chapter contributes to this literature. It cautions against a simple causal relation between the enactment of good law and desired economic outcome variables. The chapter proposes that the efficacy of particular rules depends to a large extent on preexisting conditions. Moreover, different sets of rules interact with each other. In the context of stock market development, the most important sets of legal rules include shareholder property rights and investor protection, as well as stock exchange trading rules. To understand the development of stock markets in transition economies, it is important to analyze the interaction of these different rules within the given constraints of particular countries. The chapter takes the development of the Czech, Polish, and Hungarian stock exchanges as an example. It is suggested that for the development of stock markets in these countries, investor protection rules that differed considerably across countries at the outset of reforms, were more important than shareholder property rights, which were rather similar and weak across the board.

stock markets, transition economies, law on the books, rule of law

Abstract:
Jumpstarting stock markets in transition economies has proved difficult. These countries lack effective legal governance structures and face severe information problems. Yet, not all financial markets failed because of adverse conditions. Using China's initial stock market development as a case study, this paper suggests that administrative governance can substitute for formal legal governance. At the core of this governance structure was the quota system. It created incentives for regional competition and decentralized information collection at the IPO stage. It was also used to punish regions and responsible officials when companies from their regions failed as evidenced in this paper.

Abstract:
We analyze the determinants of effective legal institutions (legality) using data from forty-nine countries. We show that the way the law was initially transplanted and received is a more important determinant than the supply of law from a particular legal family. Countries that have developed legal orders internally, adapted the transplanted law, and/or had a population that was already familiar with basic principles of the transplanted law have more effective legality than countries that received foreign law without any similar pre-dispositions. The transplanting process has a strong indirect effect on economic development via its impact on legality, while the impact of particular legal families is weaker and not robust to alternative legality measures.

Abstract:
This paper is based on a survey of 148 Russian privatization investment funds representing, in terms of size, 69 percent of all investment funds created in connection with the voucher privatization of about 14,000 state enterprises. The investment funds surveyed hold shares in about 5,000 privatized enterprises, thus providing a window into the world of corporate governance of a substantial portion of Russian firms. The paper argues that investment funds, like most other outside investors, have relatively small impact on the governance of Russian firms due to the firms' domination by corporate insiders, particularly management. Given high returns from shareholder activism, the investment funds attempt to influence the firms in their portfolios in a variety of ways (through obtaining board seats and providing them with a range of services), but have extremely poor access to information and are largely unable to prod the firms toward more radical restructuring. In particular, the investment funds are only rarely able to effect managerial changes, although a logistic equation model used shows that firms which do participate in more that one dismissal of top managerial personnel seem to be interested in fundamental restructuring. The paper also describes the main features of the emerging Russian capital market and analyzes the determinants of the trading activity of the investment funds.

Abstract:
The paper analyzes the socio-political roots of co-determination with special emphasis on the factors that led to the adoption of the 1976 Law, and discusses the impact of this law on corporate governance. The paper argues that co-determination was not designed with firm level corporate governance -- that is the control of management by the owners of the company -- in mind. Rather, its purpose was to bridge the gap between capital and labor in society, or to provide social governance over private capital. It is generally held that co-determination has achieved this socio-political goal. However, co-determination also affects firm level governance, or produces governance externalities. This has become increasingly evident in recent years when -- in times of economic difficulties and international competition -- problems in the existing corporate governance structure surfaced. The paper suggests that while co-determination cannot be made responsible for most of the inherent weaknesses in the existing corporate governance system, it has raised the costs of firm level governance and affected the dynamics among the three major parties involved in corporate control, shareholders, employees, and managers. Management is the party that benefits most from this arrangement, because it is in a position to choose its coalition partner from two fractions, who, because of their inherent antagonism as representatives of labor and capital, are less likely to cooperate with each other. This outcome also casts some doubts over the effectiveness of co-determination as social governance over private capital.