Are Shareholder Rights Irrelevant?

The law review article “Antidirector Rights Index” from La Porta et al.’s “Law and Finance” (1998) established an index based upon the presence or absence of six different legal rules to indicate how strongly the rights of shareholders were protected. The index was used to illustrate that stronger legal protections for shareholders were a good thing (citations omitted):

[There were] impressive positive correlations between the ADRI as independent variable and, as dependent variables, the size of equity markets and the dispersion of ownership in listed firms. They also found that the ADRI took significantly higher (i.e., investor-friendly) values in Common Law jurisdictions than in Civil Law jurisdictions, suggesting a causal relationship from law to financial outcomes. Subsequently, various researchers used the ADRI as a measure of legal shareholder protection in almost 100 published cross-country quantitative studies.

The rules measured were:

Preemptive rights to new issues: Equals one when the company law or commercial code grants shareholders the first opportunity to buy new issues of stock, and this right can be waived only by a shareholders’ vote; equals zero otherwise.

Cumulative voting or proportional representation: Equals one if the company law or commercial code allows shareholders to cast all their votes for one candidate standing for election to the board of directors (cumulative voting) or if the company law or commercial code allows a mechanism of proportional representation in the board by which minority interests may name a proportional number of directors to the board, and zero otherwise.

Shares not blocked before meeting: Equals one if the company law or commercial code does not allow firms to require that shareholders deposit their shares prior to a general shareholders meeting, thus preventing them from selling those shares for a number of days, and zero otherwise.

Proxy by mail allowed: Equals one if the company law or commercial code allows shareholders to mail their proxy vote to the firm, and zero otherwise.

Percentage of share capital to call an extraordinary shareholders’ meeting: The minimum percentage of ownership of share capital that entitles a shareholder to call for an extraordinary shareholders’ meeting … [For the ADRI, this component equals one if] the minimum percentage … is less than or equal to 10 percent (the sample median).

Oppressed minorities mechanism: Equals one if the company law or commercial code grants minority shareholders either a judicial venue to challenge the decisions of management or of the assembly or the right to step out of the company by requiring the company to purchase their shares when they object to certain fundamental changes, such as mergers, asset dispositions, and changes in the articles of incorporation. The variable equals zero otherwise. Minority shareholders are defined as those shareholders who own 10% of share capital or less.

The trouble is that when a new study tried to recalculate the index from scratch, the original data proved to be no longer accurate and the correlations between shareholder protections and financial market strength disappeared.

For 33 out of 46 countries, the ADRI value from LLSV (1998) has to be corrected. . . . The correlation between the accurate values and those from LLSV (1998) is only .53.

These large discrepancies have a number of important consequences:

First . . . accurate ADRI values are not distributed with significant differences between Common and Civil Law countries. . . . This challenges any causal interpretation of empirical results derived with the ADRI.

Second . . . the regression results . . . linking the ADRI to measures of stock market size and ownership dispersion cannot be replicated with accurate ADRI values. . . . the collapse of the results that inspired this entire line of research is at least remarkable.

I'm not terribly surprised by this result. Market development is path dependent. Success breeds success, while failure begets failure.

For example, Delaware is the pre-eminent state for the organization of publicly held companies, primarily because is was an attractive jurisdiction for this purpose when a first big wave of publicly held companies emerged, and has not since alienated companies that organized in Delaware. This is true despite the fact that the law of Delaware has been widely adopted elsewhere.

Since La Porta's original article made such a big splash, I suspect that many countries have reacted by adopting reforms. But, equity market size and dispersion of ownership do not change nearly so rapidly as corporate laws can be amended.

Also, La Porta's implication that these laws might cause larger and more dispersed equity markets probably had cause and effect wrong. In two key common law countries with large equity markets and dispersed ownership of stock, at least, i.e. the United States and United Kingdom, industrialization in the 18th-20th centuries was led largely by the private sector. Laws favorable to shareholders, in turn, arose because the growing body of small, but wealthy shareholders demanded them.

In contrast, in most of the rest of the world, industrialization was primarily a product of government owned companies (particularly in France and Italy and much of the Third World), sometimes in combination with insular cartels (for example, in the German, South Korean and Japanese case). In the absence of a large class of private shareholders, there was little pressure to protect shareholder's rights legislatively. In many of this countries, the primary determinant of the size and dispersion of the equity markets is the extent to which anti-trust and privatization programs have been adopted.