Law and Finance

CAMBRIDGE: Only investor rights protected by law bring the power to extract from managers a return on investment. Shareholders receive dividends because they can vote out directors (and indirectly management) who do not pay them; creditors are paid because they have the power to repossess collateral. Without legal rights, investors would not get paid, and firms would lose the power to raise funds. The rights attached to stocks and bonds are what managers give up to get finance.

Countries differ in how they finance and control their companies. Why do Italian companies rarely go public? Why does Germany have a small stock market but very large and powerful banks? Why were Russian stocks nearly worthless immediately after privatization -- by some estimates one hundred times cheaper than Western stocks backed by comparable assets -- and why did Russian companies have virtually no access to external finance? Why is ownership of large American and British companies so widely dispersed? The content of legal rules in different countries sheds light on these questions.

Among the important legal rules that protect investors are shareholder voting rights, and rights that support minority owners against insider manipulation and abuse. Investors may be better protected, for example, when dividend rights are tightly linked to voting rights through the one-share-one-vote principle. Here insiders, who contribute only a fraction of a company’s equity, cannot maintain voting control and appropriate to themselves all the cash flows. But in many countries companies can issue non-voting shares, low and high-voting shares, or shares whose votes increase when they are held longer. Companies in many countries can also restrict the total number of votes that any given shareholder can exercise at a shareholders’ meeting, regardless of how many shares he controls. Remarkably only about 20% of countries around the world have adopted legal rules consistent with the one-share-one-vote principle (although in some countries the principle is strengthened by private stock exchange rules).

Laws may also allow practices that make shareholder rights difficult to exercise, even if they are formally protected. In some countries (20%), shareholders can vote by mail, which makes it easier for them to cast their votes; in others they must show up in person, or send an authorized representative to a shareholders’ meeting. (In Japan, where voting by mail is not allowed, about 80% of companies hold annual meetings in the same week, making it difficult for shareholders to vote.) Or the law may require that shareholders deposit their shares with the company or a financial intermediary several days prior to a shareholder meeting and that owners cannot get them back until a few days after the meeting. Shareholders who do not bother to jump such hurdles are kept from voting.