Corporate governance and investor protection



Corporate governance and investor protection are key drivers of market development. In fact, companies around the world share the same imperatives: the ability to raise new capital, the efficiency of resources allocation, the growth of firm value, and the availability of information to all decision-makers...These imperatives should drive countries and firms in advanced economies to adopt the same and the most efficient corporate rules and structures. But a simple look at corporate ownership structure around the world shows that there are significant differences in corporate governance structures and ownership concentrations. In the United States and in the United Kingdom for instance, publicly traded corporations have diffuse ownership structure, whereas in other advanced economies and especially in Europe, firms continue to have a controlling shareholder.

In fact, recent managerial misbehavior and corporate scandals; e.g. accounting manipulations, self-dealing behavior, excessive sale of stocks by managers just before a decline of share price draw much attention on corporate governance. The Enron scandal and bankruptcy raised serious doubts about the investor protection in US and led to more reform and regulation of the financial market.

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Therefore, on July 30, 2002, the US have adopted the Sarbanes-Oxley act in order to enhance corporate responsibility and financial disclosures and combat corporate and accounting fraud. Various laws and reports around the world came in response to restore confidence and to reinforce investor protection.

Roe (2003) advances the polity to explain the differences in corporate governance around the world. Political institutions, political orientations of governments, coalitions, ideologies and interest groups are the critical variables. Gourevitch (2005) argues that politics shapes corporate governance in creating corporate law. According to Licht (2001), Goldschmidt, and Schwartz (2002-2007), cultural factors seem to have great importance in explaining the differences in corporate governance and ownership patterns. Most countries around the world have changed their rules and inspired from the US reform to better protect their investors.

La Porta, Lopez-de-Silanes, and Shleifer (2008) added new evidence where they showed that the data support more the legal explanation than culture, history, and politics. They also raised the question of investor protection around the world. They argue that rights of investors depend on the legal rules of the jurisdictions where securities are issued. LLSV attribute the differences in legal rules across countries to the differences in their legal origins. They theorize and test empirically their predictions and find that common law countries (US, UK, Canada...) have more protective laws than civil law countries (France, Germany, Italy...). However, the Enron scandal and its bankruptcy raised serious doubts about the investor protection in the US and consequently about the findings of LLSV (1998-2002). Nevertheless, the quick reaction to Enron scandal and the adoption of the Sarbanes-Oxley act of 2002 could be seen as a proof of good protection of US investor. This assertion has to be validated empirically after Enron's scandal in order to enhance La Porta approach and the market auto-regulation by the law (Sarbanes-Oxley act of 2002). Roe (2003) challenges the LLSV theory and advances the polity to explain the differences in corporate governance around the world. Political institutions, political orientations of governments, coalitions, ideologies and interest groups are the critical variables. Gourevitch (2005) argues that politics shapes corporate governance in creating corporate law. According to Licht (2001) and Licht, Goldschmidt, and Schwartz (2002-2007), cultural factors seem to have great importance in explaining the differences in corporate governance and ownership patterns. Most countries around the world have changed their rules and inspired from the US reform to better protect their investors. One question has to be resolved: do these reforms adapt to national culture? Will these reforms be applied or will they be ignored? La Porta, Lopez-de-Silanes, and Shleifer (2008) added new evidence where they showed that the data support more the legal explanation than culture, history, and politics. In this research, we add new evidence on corporate governance patterns by investigating investor protection across countries. We adopt a global approach and do cross-country analysis to explain differences in corporate governance. Specifically, we compare legal, cultural and political explanations of investor protection regulations. In order to do that, we, first, investigate what explain the investor protection regulations around the world. Our attempt is to see if legal rules, culture and politics have a great impact on the actual level of investor protection across countries and determine inevitably the success of the investor protection reforms. It is also interesting to see whether legal systems dominate culture and politics or whether they are complementary. In order to do that, we use a database developed by the World Bank from a survey on 175 countries published in Doing Business 2007. This database can be mobilized for research on corporate governance, since the World Bank has been involved in determining the key characteristics of good laws and made a major contribution by building a valuable index of investor protection. Then, we try to explain the disparity of legal investor protection rules by legal, cultural and political variables. The results show that legal origin remains an important variable in explaining the disparity of legal investor protection rules. However, cultural value dimensions were showed to be an instrument rather than an isolated determinant of investor protection. Politic dimension gives also an additional explicative power to the model when they are added to legal origin and culture. 5

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The remaining of this paper is organized as follow. In section one we will discuss the previous literature concerning the corporate governance, then in section two we will

A survey of previous literature

There are broadly three major issues addressed in the literature to explain the corporate governance patterns: the legal factor of LLSV (1997-2002), the political factor of Roe (2003) and Gourevitch (2003, 2005) and the cultural factor of Licht (2001) and Licht et al. (2002-2007). LLSV (1998) argue that the extent to which a country's laws protect investor rights and the extent to which the laws are enforced are central to understanding the patterns of corporate governance and finance in different countries. Roe (2003) critiques the LLSV theory and states that there are variables other than law and its quality which are important in explaining the differences in ownership structure and corporate governance models around the world. The most critical one of these variables is politics. Laws are made and enforced by political systems. Licht (2001) puts forward a novel theory about the role of culture in the development of corporate governance and financial regulation.

2.1.1. The legal factor

There are hundreds of legal systems in the world. But despite this variety, researchers tried to group them by legal families. The advantage of this classification is that it saves time and energy in description or prediction. The classification depends on the criteria used. In the past, legal systems have often been grouped by geography, race, language, religion or official ideology. Looking at the historical development and substantive features of the legal systems around the world, we can see that many of them fall into one of two families. In the whole of human history only two peoples seem to have founded secular, comprehensive, enduring, and wide spread legal systems: the Romans of the ancient world and the Anglo-Normans of the middle ages. The pedigree of civil law goes back to ancient Rome. The common law world begins in England. The common law system resulted from the victory of private landholders over king and nobility. Laws had been adopted to prevent seizure of land by the sovereign. Common laws were formed by judges who had to resolve specific disputes. After that, common law spread to British colonies including: United States, Canada, Australia, India, and other countries. The civil or Romano Germanic law system is the oldest, the most influential and the most widely distributed around the world. It originates in Roman law, uses statutes and comprehensive codes as a principal means of ordering legal material and relies greatly on legal scholars to formulate its rules. Scholars have identified three civil law traditions: French, German and Scandinavian.

In France, Napoleon created the French civil law system because he did not want judges to have the discretion to restore feudal privileges after the French revolution. The French commercial code was written in 1807 and was brought by army to Belgium, Netherlands, Italy, part of Poland, Saharan Africa, Indochina and French Caribbean islands. France extended her legal 6

influence as well in Luxembourg, Portugal and Spain. It was mainly French civil law that the lawmakers of new nations rely on for inspiration. In Germany, the German civil law system provides for the independence of judges and the protection of individual propriety rights. It consists of a hybrid system that has proved effective in promoting economic growth. One proof of the effectiveness of the German system is that it was borrowed by Japan and Korea which have also experienced economic success. The Scandinavian law system is usually viewed as a part of civil law tradition although its law is less derivative of Roman law than French and German traditions. The legal factor was brought forward by LLSV (1997-2002). They argue that laws and their enforcement are central to understanding the patterns of corporate governance around the world. Legal origin of laws is viewed as the primary factor that affects almost all other variables affecting corporate governance and that exhibits the highest degree of exogeneity. LLSV (1999-2000-2002) have shown that common law and civil law systems have an impact on investor protection, ownership structure and financial markets. Common law countries (US, Canada, New Zealand, Australia...) have the strongest protection of outside investors, both shareholders and creditors, and lead to ownership dispersion and a strong market valuation, whereas French civil law countries (French and Spanish colonies) have the weakest protection leading to ownership concentration. German civil law countries (Germanic countries in Europe and a number of countries in East Asia) and Scandinavian countries are in between and have stronger protection of creditors. LLSV (1998) examine empirically how laws protecting investors differ across 49 countries and how the quality of their enforcement varies. They define an antidirector right index composed of six items (vote by mail, deposit of shares prior to the shareholder meeting, representation of minorities on the board of directors, oppressed minorities mechanisms and minimum percentage of shares that entitles a shareholder to call an extraordinary shareholder meeting). This index ranges from 1 to 6. A country gets the score 1 for each item if it protects minority shareholders and 0 otherwise. The results show that the common law countries have the highest antidirector rights scores (US, Canada, UK, Japan...) and French civil law countries have the lowest antidirector rights scores (France, Germany, Italy...). Furthermore, LLSV control for the GNP per capita and find that antidirector rights scores are independent of the GNP per capita. However, other researchers criticized LLSV investor protection index and developed a new index with contradictory findings. Lele and Siems (2006) built a new shareholder protection index for two kinds of investors: active and passive shareholders. They measure the level of protection of the active shareholder by an aggregation of 32 variables related to shareholder meeting (power of the general shareholder meeting, the involvement of shareholders, voting rules and individual information rights). They measure also the level of protection of passive shareholders by an aggregation of 28 variables covering the aspects of board structure, duration of directors, duties and rights of directors. They coded the development of the law for over three decades 1975-2005 for five countries: Germany, France, UK, US, and India.

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Their main findings are that shareholder protection has been improving during the last three decades, the protection of minority shareholders is significantly stronger in blockholder countries, and that convergence in shareholder protection has taken place since 1993 and increased since 2001. They conclude that the differences among the four developed countries do not confirm the conjecture that there is a distinction between the Anglo-Saxon world and continental Europe.

Djankov, La Porta, Lopez and Shleifer (2008) built a new indicator of investor protection calculated for 72 countries: the anti-self-dealing index against expropriation by insiders. This index focuses on self dealing explicitly while the previous indicators neglected this dimension. The index is established with a formulated questionnaire which treats a hypothetical case study. The anti-self dealing index is calculated by averaging the indices of ex-ante and ex-post private control of self-dealing. Djankov et al (2008) use the anti-self-dealing index to address three objectives. The first is to identify the key factors that determine the structure of self dealing regulations in different countries. They find that legal origin remains an important determinant of investor protection calculated with the new self dealing approach. The second concern is to examine the relationship between the anti-self-dealing measure and the development of the financial market. They find that common law countries have more developed stock markets than civil law countries and particularly French civil law countries4. The results also demonstrate that common law is a good predictor of the anti-self dealing index. Furthermore, neither measure of public enforcement is associated with stock market development. The third objective is to compare the anti-self dealing index with other investor protection measures, namely the anti-director right index. They compare the performance of different measures of investor protection as predictors of financial development. They want to know whether the anti-self dealing index works better than the anti-director right index in explaining financial market development. A comparison between the anti-director right index and the anti-self dealing index indicates that when controlling for the anti-self dealing index, the anti-director index loses significance for stock market capitalization to GDP and ownership concentration. This allows them to conclude that the anti-self dealing index is a more robust predictor of the development of stock markets than the anti-director right index. Lately, La Porta, Lopez-de-Silanes, and Shleifer (2008) challenged the cultural and political perspective and showed that the data support the legal explanation.

4 Specifically, the regulation of self dealing (ex-ante and ex-post private control of self dealing) improves the stock market capitalization to GDP, reduces the private benefit of control, and increases the value of initial public offerings in each country relative to GDP. The ex-post control and the index of self dealing have a positive impact on the number of domestic publicly traded firms. However, only the ex-post private control of self dealing has an effect on ownership concentration (reduces ownership concentration). Anti-self dealing is not associated with ownership concentration.

2.1.2. The political factor

Historical events such as colonization can affect profoundly corporate governance through the transplantation of corporate governance systems and laws. Societies were forced to take the corporate governance system of their conquerors. Berkowitz et al (2003) illustrate that the

legitimacy of a legal system is affected by the condition under which it was transplanted and this legitimacy has an impact on the effectiveness of the legal system. When there is pressure on a population to adopt a legal system, there is low legitimacy and the system will fail to produce an effective rule of law. The transplant of the common law system to the United States, Canada, Australia and the transplant of the French civil law system to Belgium, Netherlands, Italy, part of Poland, Saharan Africa, Indochina, have affected the ownership structures of these countries and the evolution of their financial institutions (Beck, Demirguc-Kunt et Levine 2003). In addition, the civil law or the common law classification is difficult to determine for some countries whose legal systems have been transferred from common law to civil law or from civil law to common law. Such countries have mixed systems influenced by both the civil and the common law systems (South Africa, Zambia, Namibia, Botswana, Sri Lanka, and Israel). Furthermore, some countries have mixed systems that incorporate civil or common law with religious law such as the example of Islamic countries. Another example is India's law which is based both on common law and separate personal law applied to Muslims, Hindus, and Christians. Thus, the classification of countries into common law and civil law systems is beneficial but has some weakness.

This reality provides Roe (2003) and Gourevitch (2003) with the matter to argue that the differences in ownership structure and corporate governance models around the world cannot be explained only by legal origins and quality of laws. Germany and Scandinavia have high quality of laws but do not have dispersed ownership. So something else is at work. This something is politics. Roe (2003) postulates that Germany and Scandinavia have high quality of law but concentrated ownership because they have strong labour and strong social democratic parties. He considers that class struggle (rising from the conflict between managers, owners and workers) is an important determinant of corporate governance. Shareholders, who fear collusion between managers and workers at their expense, try to protect their interests by concentrating their holdings in blocks. Where workers have power in the control of firms and decision making as they do in many of the European social democracies, corporate governance systems tend to favour ownership concentration. Workers are represented on the board of directors and do participate in control of the firm (German codetermination). Where managers and owners have the power and resources to control the firms, corporate governance institutions favour shareholders over stakeholders. Ownership is dispersed, and workers lack formal power on the board of directors (US system of governance). Gourevitch (2003) argues that there are other cleavages. Politics that produce the regulations that shape corporate governance come from coalitions. Country case studies confirm this idea. In Sweden, the social democratic party has dominated the government for most of the past seventy years. Sweden was the model of strong unions and leftist government. In Germany, the Christian democrats have been the key to governments since the Second World War; the same for Italy and other parts of Europe. In the US, populist political movements were the key to creation of unions with lower level of power and in the fragmentation of finance. Farmers, free traders, workers, ethnic groups, investors, all attempted to produce coalitions against the aggregation of economic power. Labour influence on social democracy cannot produce ownership dispersion or governance models, but labour can interact together with other players to produce outcomes. Gourevitch argues that corporate governance literature has neglected to examine the impact of political institutions on shaping outcomes in the way politics deal with regulation on this issue. He argues that political forces (political institutions, political orientations of governments, coalitions, ideologies and interest groups) not only define the laws but also determine how the laws actually operate. Variation in the content of laws and enforcement might be the product of variation in political systems. He notes that where social democracy is strong, strong labour power presses managers to coalesce with them. Owners must consequently seek other means to control managers, and the best alternative is close ownership or ownership concentration. Thus, in social democracies, shareholder rights are weak and shareholder dispersion is low. Gourevitch (2003) extends the channels of political mechanisms that affect corporate governance and ownership to interest group preferences and cross class coalitions between owners, managers and workers on one hand and to political institutions such as electoral law, federalism, legislative-executive relations and party systems on the other hand. The political issue didn't inspire empirical investigation. It can be considered, in our sense, as an elucidation or a complementary argumentation to the legal issue.

2.1.3. Cultural factor

It seems that changing the laws on the books and the act of simply writing investor rights into law is not enough and does not guarantee improvement of corporate governance. Theorists, practitioners and policy makers share the view that cultural factors impact corporate governance and can impede change and legal reforms. Ethnicity, customs, beliefs, shared values and religions appear as primordial factors that affect effective system of corporate governance. For example, the cultural environment in East-central Europe is a potential impediment to change. After the failure of the communist regimes in 1989-1993, a comparative analysis between the Western European countries and the Eastern European countries which had endured communist rule shows that the communist countries are strongly authorized cultural embeddedness and hierarchy. These values are compatible with low perceived legality. Achieving social change through legal reform thus, faces serious obstacles in these countries. Legal factors cannot be effective alone, because other factors such as culture play an important role. Existing cultural values block changes and generate path dependence. Cultural value adaptation and adjustments take place slowly in response to changed life circumstances and favour legal reforms. The question raised in this context is: can we find cultural values compatible with reforms and changes. Licht et al (2005, 252) argue that “the link between societal aversion to litigation and high scores on harmony and uncertainty avoidance implies that in such high scoring countries implementing a new legal regime may require alternative to the courts system”. Thus, in countries where investor protection cannot occur within the court system, active regulation by State is required. They also argue that “cultural emphases on embeddedness and hierarchy prevalent in many developing and transition economies may be conductive to corruption, in parallel to general disregard of the law”. Countries that develop social norms that do not rely on litigation, such as Asian societies, certainly have other mechanisms of governance than the mechanisms known in the West. The cultural factor empirically investigated by Stulz and Williamson (2003) and Licht et al. (2005), shows that cross country differences in corporate governance can be explained by differences between national cultures.

Stulz and Williamson (2003) explore whether differences in culture represented by religion and language, can explain differences in investor protection around the world. They argue that if predominant values in some countries are less supportive of market interactions than in other countries, we would expect a lower degree of investor protection, because the enhancement of investor rights is less valued in these societies, and institutions produced by such cultures regard financial markets as less valuable. They use two proxies for culture: religion as a key component of the system of beliefs and language which is the vehicle to communicate beliefs. Data on legal origin, investor and creditor rights and rule of law are taken from LLSV research. The data on each country's primary religion and primary language is taken from the 2000 CIA World Factbook. The primary religion (Protestant, Catholic, Muslim, and Buddhist) is the religion 10

practiced by the largest percentage of the population of a country. They think that the dominant religion should have the primary influence on that country and that the impact of religion is not proportional as claimed by LLSV. Furthermore, groups of common languages share the same features of organisation and views. Stulz and Williamson identify two main languages in their sample: English and Spanish. The results show that English speaking countries and Protestant countries make it easier for shareholders to vote. They examine the correlation between culture proxies and the enforcement of rights (rule of law, corruption, risk of expropriation, accounting standards). They find that language is irrelevant except for accounting standards. Protestant countries have better enforcement and especially higher standards than Catholic countries. Their results show that the Protestant, Catholic and English speaking countries have higher investor protection than other countries, that Protestant countries have a higher corruption index (less corrupt) than Catholic, Muslim and Buddhist countries, that Protestant and Buddhist countries have a higher repudiation risk, that Protestant and Catholic have a higher expropriation index, that Spanish countries have a lower expropriation index and finally that English speaking countries have a higher accounting index than Spanish countries. Licht et al. (2005) investigate in what way the laws on the books reflect countries' national culture. They use the LLSV dataset to operationalize legal rules, and the cultural value dimensions framework to conceptualise culture. More specifically, they use the culture value dimensions identified in cross-cultural psychology to characterize cultures of different societies and measure culture by Schwartz and Hofstede value dimensions. They demonstrate through a comparative analysis in international that combining classifications based on cultural dimensions and on the legal families can shed some light on the obscure part of the comparative explanation.

1. Two Strategies of Corporate Governance

2.1 Shared Purpose

In their seminal paper, Jensen and Meckling24 show that the separation of ownership and control that is associated with corporate finance produces agency costs. These arise from asymmetric distribution of information between insiders (agents) who act on behalf of outsiders (principals) combined with the fact that results are not perfectly correlated with efforts of the insiders.

Depending on the timing of contracting, action of the agent, and random influences of nature, one distinguishes between moral hazard or hidden action and hidden information, as well as adverse selection. A contractual first best solution cannot be achieved when the agent is risk averse or wealth constrained. In a world of comprehensive contracts, however, a second best result can be achieved by an optimal incentive contract. The design of such contracts is the main concern of a large part of classical contract theory.

Unfortunately, such contracts remain incomplete in the real world. One reason for such incompleteness is the expenses of thinking of every possible future contingency at the time of drafting the contract. Another reason can be unverifiability of some passages before the court due to information asymmetries between the contracting parties and the court.26 Even if principal and agent share the same information about some signals and outcomes resulting from the agent's action, they might not be able to include these in their contract if they are unobservable before the court.

If one party undertakes an irreversible investment after contracting and a necessary bargain over loopholes in the contract occurs afterwards, this party can be exploited by the other party, because sunk costs do not have to be taken into account during the bargain. This creates hold-up costs.27 For example; the price paid by a shareholder to acquire a share at an IPO usually resembles sunk costs because he is commonly not granted a redemption right. The associated financial contract is also very incomplete. Every business decision by management affects the investor's payoff and resembles a situation where such incompleteness is filled in by decision making according to the institutional arrangements of corporate governance.

Parties have to agree on the allocation of residual control rights for all situations that are not specified in the contract. The resulting institutional design constitutes corporate governance.

It assigns control rights for the use of the firm's assets. If control is shared by several individuals

(e.g. several shareholders), decision-making rules are included. The resulting allocation of control rights determines the outcome of decision-making in an unforeseen event. It also determines the mechanisms, by which control can be transferred.

From a normative perspective, as in the classical agency theory, the design of these institutions should be guided by an attempt to minimize hold-up costs. Thus, an optimal institutional arrangement leads to a third best solution, where the sum of the “classical agency costs” and the hold-up costs is minimal. These agency costs are the fundamental component of the costs of capital that are associated with different forms of corporate finance. A third component are additional risk bearing costs that can arise if an investor has to deviate from an optimal investment portfolio in order to mitigate agency costs.

2.2 Differences

In all jurisdictions, the ownership rights of shares consist of two parts. First, an investor has some right to get a share of the generated profits (cash flow right). Second, she can exert some form of control over the assets, usually through exercising voting rights (control rights). The level of concentration of these two rights among shareholders constitutes the distinctive difference between the two financial systems. In countries with an outsider system (OS), dispersed ownership is the predominant ownership structure of most firms. This dispersion refers to both the cash-flow rights and the control rights of ownership.31 “One-share-one-vote” is the predominant rule used in corporate governance devices to distribute control rights among shareholders in OS-countries. In contrast, in economies with an insider system (IS), a more concentrated ownership is common. Not only are cash flow rights more concentrated, but one also finds a departure from one-share-one-vote provisions in the corporate governance arrangements of firms operating under insider systems. Such deviations are not only achieved through the issuing of dual-class shares but also through crossholdings, proxy voting mechanisms, and pyramidal ownership chains. Usually, in contrast to the outsider system, control is exerted by one or a group of controlling shareholders, whose control rights exceed cash flow rights. Thus, the most prominent distinction between outsider systems and insider systems is the different level of control concentration.

In outsider systems, control rights and cash flow rights are usually linked together (one share- one-vote) - resulting in freely tradable dispersed control that lies with numerous outside investors.