The most successful capital markets in the world are those that strike the right balance between trust and regulation, creating the maximum possible freedom for companies while ensuring investors remain adequately protected. Typically, these markets are to be found in countries with common law, which can adapt subtly and rapidly to investor grievances, and with unique trust-building mechanisms built up over centuries of trade
In her recent book, Trust and Honesty: America’s Business Culture at a Crossroads, lawyer Tamar Frankel, a professor at Boston University, points to the decline of ethical standards in US culture and, in particular, in financial markets. She believes this threatens the future performance of the US economy and cites trust as a key component of the operation of financial markets. Those who abuse trust, she argues, diminish markets, economies and societies, as well as themselves.
With corporate scandal and courtroom drama still rocking the US economy, the hunt is on to find the perpetrators of this moral decline. Another prominent US lawyer, Professor John Coffee of Columbia University, has argued persuasively that, until recently, many thought it was the “gatekeepers”, such as auditors, credit rating agencies and investment analysts that acted as the guardians of investor interests. After all, these institutions had such strong reputations at stake (consider Arthur Andersen, the auditors disgraced by the Enron case) that they could not conceivably put themselves at risk by concealing their clients’ wrongdoings or incompetence. Now, he argues, the gatekeepers have become entangled in a web of conflicts that seriously undermine their independence.
Why legal systems are the key determinant of financial performance
So, who are the guardians of financial markets? While lawyers see culture and economic incentives as critical, economists have turned to the law. One influential body of economic literature views the legal system as the main determinant of the performance of financial systems. In the absence of trust or reliable intermediaries, we rely on the law to enforce our rights and contracts.
According to this body of literature, countries can be categorised as belonging to particular “legal families”. These legal families have their origins in common law in some countries and civil law in others. Common law, as practised in the UK and US in particular, and former British colonies in general, has a higher degree of investor protection than the civil law systems of continental European countries and their former colonies.
The relative success of financial markets in the UK and the US can, therefore, be attributed to their systems of investor protection. In particular, law is viewed as the explanation for the most striking difference between Anglo-American capital markets and those in most other countries, namely the much higher level of dispersion of ownership. In a typical large UK or US company, ownership is dispersed among a large number of investors, many of whom are institutional investors such as pension funds and life assurance companies. By contrast, in most other countries, ownership is concentrated in the hands of a small number of shareholders that hold large blocks of shares.
According to the proponents of legal theories of finance, strong legal protection is required to encourage dispersed ownership. In the absence of such protection, smaller investors know that they are exposed to wrongdoing by directors. Their only protection comes from being able to exercise direct control by holding significant blocks of shares.
In this environment, dispersed ownership is inconsistent with weak investor protection. The result is a very different ownership landscape for countries without a common law system: a smaller stock market, less reliance on equity finance, and a capital market that is less responsive to the restructuring needs of industry.
Investor protection in common law countries has also created markets for corporate control, where ownership is transferred to the highest bidder, often in hostile transactions. By contrast, the lack of investor protection in civil law countries, such as Germany and France, allows entrenched management to protect themselves from these markets for corporate control by using pyramids, non-voting shares and poison pills. The result is that the objectives of profitability and shareholder wealth maximisation have been given a low priority.
This view is perhaps best illustrated by a recent comment made to the Financial Times by Ferdinand Piech, chairman of the supervisory board of VW and a member of the family that controls Porsche: “Yes, of course we have heard of shareholder value. But that does not change the fact that we put customers first, then workers, business partners, suppliers and dealers, and then shareholders.” The Piech family controls Porsche through shares comprising 50 per cent of the capital but 100 per cent of the votes.
Supporters of the law and finance thesis provide strong evidence for the view that investor confidence derives primarily from the protection afforded by law and regulation, as well as the quality of its enforcement. They show that differences in the legal protection of investors can indeed explain important cross-country differences in the size of capital markets, and the financial policy of listed companies. They document that common law countries grant better legal protection to investors than countries whose legal systems are rooted in other legal traditions – notably the French, German or Scandinavian systems – and, at the same time, those common law countries tend to have larger stock markets, with greater dispersion of ownership, and a lower cost of capital.
Why common law works better
What are the magical properties of the common law system, according to these authors? And what is lacking in other legal environments, such as the French, Germanic and Scandinavian systems?
Common law allows the courts the discretion, through case law, to develop new devices to protect investors, filling the gap left by a congress or parliament. For example, US and UK courts have struck down many poison pills that were put in place to protect incumbent management from unwelcome or hostile takeovers. The courts have also been instrumental in encouraging disclosure and in adjudicating investor grievances.
By contrast, the civil law systems of France and Germany have relied almost exclusively on statute to protect investors, which has proven slow and cumbersome to respond to change, as well as being plagued by special interest groups and political conflicts. Civil law lacks the flexibility of common law and discourages independence and initiative among the judiciary. Thus, the argument goes, successful capital markets require investor protection and in turn this relies upon a common law system.
The origins of trust in capital markets
Although few would deny the important role of law and investor protection, other theories are emerging to explain the success of particular capital markets. Consistent with the views expressed by Prof Frankel at the beginning of this article, one theory suggests that successful capital markets have developed trust-generating mechanisms such as reputation, cultural affinities and geographic proximity of investors to boards of directors.
To explore the notion that trust is central to the emergence of financial markets, we and several other authors have been analysing the determinants of the evolution of financial markets in different countries over the past 100 years. In simple terms, we have been asking the following question: was investor protection critical to the early development of financial markets?
Our methodology involves a common approach across the different countries. We document the development of corporate laws, securities laws, disclosure rules and so on, and examine the relation of the evolution of these laws to the development of the different countries’ financial systems. We use several indicators of the development of law and of financial markets, including the dispersion of ownership.
Our findings are striking: the most substantial development of financial markets and the greatest dispersion of ownership in general occurred in the absence of strong investor protection. Indeed, in some countries, the most active periods of stock market development and ownership dispersion coincided with the periods of weakest investor protection during the century.
How can this be? In large part, our results are consistent with the significance that Prof Frankel attributes to trust. Financial markets in all the developed economies that we have examined emerged on the basis of informal arrangements rather than formal systems of regulation. In some respects, the question of whether law is a necessary condition is now passé. The much more pertinent issue is: what are the alternative mechanisms?
This is where detailed country analysis is highly informative. We documented quite different methods of upholding trust. In some cases, most notably early German capital markets, Prof Coffee’s gatekeepers, in the form of banks, played a critical role. In others, however, prominent individuals and, in the case of the UK, the proximity of investors to companies appear to have been most critical. For example, in the UK we found that in 1910, in a sample of 26 companies, 56 per cent of shareholders lived within six miles of the board of directors (where the average number of shareholders in each company was 320).
We argue that geographic proximity was an important mechanism for upholding trust between investors and boards of directors. This relationship was reinforced by local stock exchanges, which tended to specialise in the industry that was specific to the locality – for example, Bradford for textiles, Sheffield for steel and Birmingham for rubber. Thus, local stock exchanges, brokers with specialised knowledge and local investors created networks of trust.
We examined a sample of mergers during the same period and found that an equal price rule prevailed in all cases, where the target board recommended the offer to shareholders with the assurance that the board was receiving the same price for their shares as was being offered to outside shareholders. There was no evidence of the two-tier offers that have characterised continental European capital markets, where large shareholders are offered a higher price than smaller shareholders.
In 1920, at a meeting to discuss the merger of two UK steel manufacturers, Alfred Hickman and Stewarts and Lloyds, Mr JG Stewart, the chairman of the latter company, said: “I have been reminded, only a few hours ago, that I might be asked today at this meeting whether the directors have been given any consideration in any shape or form whatever to enable them to see their way to advise this amalgamation.
“I can only say this, gentlemen, that not one farthing, directly or indirectly, has been or will be paid to anybody whatever, either on the staff or on the board of either of these companies, other than one share in Stewarts and Lloyds and 7s 6d in cash per share for whatever shares they hold.”
Why would the target board of directors not negotiate a higher price for their own shares? One explanation is that they wished to maintain their reputation and the trust of other businesspeople.
Beyond the gentleman’s agreement
The critical question is: to what extent can such informal relations be relied on as capital markets expand and economies develop? In one respect, the answer is that they cannot be. The fact that we have seen a steady increase in financial regulation in the UK since the middle of the 20th century is evidence of the failure of less formal relations to survive. And, of course, we cannot expect companies to continue to depend on local stock exchanges as their operations and fund raising activities become global.
Harking back to the days of local markets and trustworthy intermediaries is, to many people, nostalgic irrelevance. In the UK, it is not a coincidence that the equal price rule practised in the first half of the century gave way to a formal requirement of the Takeover Panel, that bidders will not offer differential prices to different shareholders.
Even if it is possible to maintain relations of trust, they come at a price. The principle that “my word is my bond” was commonplace in the City of London until the 1980s. Then the UK underwent an intense period
of financial deregulation, eliminating many cartels, restrictive practices and monopoly abuses, but also many of the close relationships that previously characterised City dealing. Relationships are much easier to uphold among a small group than a large one. Thus, greater competition and lower costs for trading securities have gone hand in hand with a decline in integrity in financial markets.
New systems of financial regulation have sought to fill the gap by sustaining investor confidence while promoting competition and entry into markets. One of the issues that financial regulators periodically have to address is whether their rules are in conflict with competition laws.
Different countries take different approaches to solving this problem. The US has allowed almost unfettered competition combined with the imposition of high retrospective penalties when wrongdoing is uncovered. Other countries such as Germany have restricted entry by requiring financial institutions to hold large amounts of capital. The UK has taken a different course and specifies the basis on which companies should conduct their business.
Striking the right balance between regulation and principles of conduct
The US reliance on the courts has made it highly dependent on detailed rules – misconduct is associated with the violation of specific rules and, as more misconduct is revealed, so more extensive rules are required. Many people feel this vicious circle is epitomised by the Sarbanes-Oxley Act.
Meanwhile, UK authorities are trying to withdraw from detailed rules and instead identify broad principles of conduct. For example, rather than trying to find a precise definition for a conflict of interest, they focus on what might create a conflict and prescribe how to avoid placing an intermediary in a position where a conflict might arise. Such principles are rooted in the “true and fair” view of company accounting.
These differences of approach are just as significant as the fundamental differences between national legal systems described above. Even in countries that are considered to be from the same “legal family”, there will be continual if subtle variations over time. The resulting variety will, of course, be of great value to our understanding of the determinants of successful markets as reliance on local, face-to-face arrangements is replaced by global, internet-based transactions.
Perhaps the best indicator of the future role of trust in financial markets is a non-financial institution: eBay. Those of you who have bought or sold something on eBay will know that buyers and sellers are asked to rate one another on various criteria such as quality of goods, promptness of shipping, promptness of payment and so on. Prospective users of the site, therefore, have a gauge of how trustworthy each buyer and seller is, based on previous transactions.
This is an example of how new technology can calibrate reputation and trust between parties in the absence of legal protection, and in global markets where buyers and sellers never meet. This is a long way from local stock exchanges and local investors but the result may not be very different.
Julian Franks is professor of finance at London Business School, and head of the Centre for Corporate Governance. His research forcuses on regulation, bankruptcy and financial distress, European corporate restructuring and mergers.
Colin Mayer is Peter Moores Professor of Management Studies and Dean-elect at the Said Business School, University of Oxford. His research fouses on corporate finance, corporate governance, financial systems and regulation.
