Law Matters (A Bit)

• Brian R.Cheffins, Steven A. Bank, & Harwell Wells, Law and History by the Numbers: Use, But with Care, UCLA School of Law, Law-Econ Research Paper 13-21 (2014), available at SSRN.
• Brian R. Cheffins, Steven A. Bank, & Harwell Wells, Questioning "Law and Finance:" US Stock Market Development, 1930-1970, 55 Bus. Hist. 598 (2013), available at SSRN.

The relationship between civil and economic governing institutions and economic development is significant. Law matters to economic development. Acemoglu’s and Robinson’s comprehensive overview in Why Nations Fail: The Origins of Power, Prosperity, and Poverty provides a compelling case for the proposition that extractive institutions, in either sphere of civil life, can significantly retard economic progress and result in poor living conditions for the majority of people in a given society. Largely the province of development economists studying political institutions, the inquiry into the relationship between governance and economics in the corporate sphere was catalyzed by the famous work of Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny (LLSV) in the late 1990s.  The relationship among economic development and the institutions of finance – corporations, markets, and financial institutions – has since progressed from development economics to corporate legal scholarship.

The study of economic development is, necessarily, historical, and is in its nature largely comparative.  A welcome corollary in legal scholarship to the introduction of development economics is a renewed interest in corporate and financial history.  Cheffins, Bank, and Wells (CBW), all excellent contributors to this industry, have performed a notable service with a recent interesting pair of papers.  In Questioning Law and Finance, they turn from the traditional comparative approach of the development literature to examine, longitudinally, what that literature might teach us about economic development in 20th century America as a function of corporate and securities law.  In Law and History by the Numbers, they step back to examine the extent to which empirical research of the type used in the economics literature can shed light on corporate legal analysis.

Financial development in the United States presents, on the surface, something of a paradox.  On the one hand, it has been accepted wisdom that American corporate law (and especially that of Delaware, on which CBW focus), traditionally has been management-friendly and relatively lax with respect to the interests of shareholders.  On the other hand, there is no nation on earth in which equities markets are as broad and deep as in the United States.  One might think that corporate laws that shielded managerial expropriation from shareholders would retard market development.  One would, evidently, be wrong.

CBW examine three proxies for the shareholder-protective nature of Delaware corporate law – LLSV’s anti-director rights index (ADRI), Djankov, La Porta, Lopez-de-Silanes, and Shleifer’s (DLLS) recoding of the ADRI to diminish the positive scoring of enabling statutes, and Spamann’s recoding of the ADRI to account for law in practice.  The refinements from LLSV’s original version to Spamann’s version produce a progressive downgrading of US law.1  In both DLSV’s and Spamann’s versions, US law fares rather poorly when compared with common law regimes, and still poorly, although rather less so, when compared with civil law regimes.  A simplistic reading of these results would imply that the US stock market would be weaker than the average.  But the opposite is true.

The challenge, as CBW see it, is to the “law matters” thesis in the corporate governance segment of the development literature.  If U.S. markets flourished despite poor investor protections, maybe law doesn’t really matter so much at all.  CBW ask whether the work attributed to corporate governance law could, perhaps, be attributed instead to rigorous securities regulation, which began to arise in the United States in the 1930s.  But this won’t do, either, because tracking securities regulation against market development presents another paradox:  The regulated market was desultory during most of the period examined, while the unregulated over-the-counter market flourished.

So the U.S. presents a challenge to the “law matters” thesis, at least with respect to the development of equity markets.  CBW argue that factors other than law, or at least corporate and securities law, are more explanatory than law of this development.  They note a diminution of the collective memory of the 1929 Crash as the market approached revival in the 1950s, the change in trust laws permitting pension funds to invest in equities, and other laws such as the 1954 tax dividend credit provide some of the answers.

CBW are certainly right, that extra-legal factors such as the ones they identify were important drivers in the development of the U.S. equities markets.  The 1950s change in New York trust law was critically important, but also came at time during which the New York Stock Exchange had embarked on an intensive public relations campaign to increase trading volume.  (The NYSE actually commissioned the 1952 Brookings Study to which they refer.)  Significant changes in financial structure also likely mattered, as the Delaware courts in the 1930s (among others) liberalized case law to permit the defeat of preferred stock preferences, thus diminishing the attractiveness of a form of investment quite popular in the first third of the century.  Mid-century also saw the disinvestment of many of the founding families of America’s largest corporations who had, for some time, held controlling interests.  The financial and business landscape was complex.2

CBW’s important work directs us to be careful in the power we attribute to law.  But just as they caution against over-reliance on empiricism, it is also important, as they demonstrate, to be attentive to the normative environment.  Their work ends in the 1970s.  But that decade introduced a series of reforms that have led in the U.S. to the development of a strong ethic of shareholder-centrism that previously was absent from American managerialism.  While not exactly law, this ethic is a natural corollary of changes in the composition of corporate boards (or so I have argued) and, to some extent, changes in corporate law itself.  The development consequences are potentially striking. In their recent paper, The Origins of Stock Market Fluctuations, Daniel Greenwald, Martin Lettau, and Sydney C. Ludvigson, have attributed substantial portions of real stock market wealth since 1980 to shareholder expropriation from workers.3

Putting this trend in light of the governance-development literature tells a frightening story.  One can infer that the institutions of corporate governance that are praised as increasingly democratic are in fact, on a massive scale, an example of precisely the kind of extractive framework that Acemoglu and Robinson argue impoverishes nations.  While the distorting effect the stock market has on wealth distribution was observed as early as the early 1970s, the extraordinary imbalances in wealth distribution that have recently provided political fodder may be attributed to precisely the kinds of factors that interest CBW.  Their contribution is welcome, and one hopes to see it stimulate considerably more attention by corporate legal scholars to questions of law and economic development.

  1. LLSV, DLSV, and Spamann all focus on Delaware law as a proxy for US law as well. []
  2. Lawrence E. Mitchell, Financialism<: A (Very) Brief History, 43 Creighton L. Rev. 323 (2007); Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry (2007). []
  3. Daniel L. Greenwald, Martin Lettau & Sydney C. Ludvigson, The Origins of Stock Market Fluctuations, NBER Working Paper No. 19818 (January 2014). []