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Legal Endowments: Rethinking the Importance of Legal History to Corporate Governance [ Volume 1-2011 ]

30 May 2011

1. Introduction

In recent years the economics literature has been alive with discussion on the importance of the historical origins of legal systems to various economics outcomes.[i] Much of this has looked specifically at the relationship between “legal origins” and the ownership structure of corporations in different countries. Relying on the traditional comparative law distinctions between systems, the main writers in the field, La Porta, Lopez-de-Silanes, Shliefer and Vishny (“LLSV”) have put forth the argument that common law systems are more conducive to dispersed shareholdings than civil law systems, where concentrated ownership is the norm.[ii] Differences in the substantive laws relating to investor protection across legal origins are said to explain the difference.

Ownership structures matter to corporate governance, mainly in light of the differing agency problems which different structures present. For corporations with dispersed shareholders, the emphasis is on the relationship between shareholders and management, whereas in those with concentrated shareholdings problems may primarily arise between controlling and minority shareholders. A corollary of the legal origins literature is that legal history matters to corporate governance in part due to its influence on the structure of corporate ownership.

From the point of view of assessing the impact of the historical origins of legal systems on corporate governance, legal scholars such as Milhaupt and Pistor[iii] have criticized this “legal origins literature” for, among other things, viewing national legal systems as a form of “endowment” that evolved in the ancient past and has since remained a largely immutable characteristic of a given country’s economy. Also criticized has been the view that economic changes – such as changes in ownership structure – are largely caused by the nature of the legal system and not the other way around, i.e. that changes in the economy do not cause changes in the legal system.

This paper is concerned with a basic question that animates part of the debate – whether or not the historical origins of a legal system matters to modern day corporate governance. The aim here is not to provide a definitive answer to this question. The much more modest goal is to argue that the main problem with the legal origins literature is not so much the fact that it takes an endowment perspective per se, but that it treats the legal system as a whole as an endowment. This paper asks whether an approach that ignores the formal classification of the historical origins of legal systems and instead focuses on the historical roots of specific, relevant features of a country’s legal system can provide a more useful way of examining the question. In other words it looks at an approach which focuses on the individual “endowments” of a legal system as an alternative to the current one used in the legal origins literature, which treats the legal system itself as a form of endowment.

This paper proceeds as follows. Section one discusses the state of the literature in the field and why an approach which focuses on individual features of a legal system, rather than the system as a whole, as legal endowments may be a useful way of approaching the question. Section two discusses the historical sources of such legal endowments and why the economic literature’s reliance on the traditional comparative law taxonomy is problematic. Section three looks at which types of specific legal endowments have potential implications for corporate governance. Section four looks at the question of how legal endowments might evolve over time.

2. Systemic Legal Endowments

The word “endowment” here is drawn from what Milhaupt and Pistor critically term the “endowment perspective” on the relationship between legal systems and economic development.[iv] The basic idea is that a country’s legal system, with all its specific features, is a type of endowment or inheritance that society has received from its past. As some legal systems are better suited towards promoting certain economic outcomes than others, the argument goes, the type of legal system a country is endowed with will be a determining factor in how countries develop economically.

This perspective traces its roots back to the work of Weber, who argued that the existence of a rational legal system was a necessary precondition to industrialization. In its most recent and prominent guise, however, it has been used by financial economists seeking to demonstrate the importance of legal origin to financial development. The main scholars in the field, LLSV, have argued that the historical origin of a country’s legal system is a determining factor, among other things, in the ownership structure of firms in that country.[v] Companies in countries which received an English legal origin are said to have more dispersed patterns of shareholdings as a result of general effects of the English system’s greater protection of private property rights against state interference. Companies in countries with a French legal origin, on the other hand, usually have more concentrated ownership due to the weaker protections afforded to private property rights by the French legal system.

Though extremely influential, this line of scholarship has been heavily criticized. Spamann, for example, has recently shown that the anti-directors rights index upon which most of these studies is based contains flaws that render many of the claims of the literature – including the claim that the common law provides better shareholder protection than the civil law – unsupportable.[vi] Of more direct interest to the subject of this paper, Milhaupt and Pistor have shown that the notion of legal development upon which the “legal origins” literature is based is problematic. As they note:

“Law is treated as if it were imposed from somewhere outside markets and economic activity – as a precondition to them…. – and then serves as a stable and unchanging foundation for economic life.”[vii]

Looking at a series of recent corporate governance scandals in different countries, they argue that legal systems should not be viewed as an immutable characteristic, but rather as part of a “rolling relationship” in which legal and economic change mutually interact with each other. Demand for legal change among affected constituents combined with the contestability of the law making process will determine whether or not changes in the legal system are possible.

This argument provides a refreshing counterbalance to the predominant view in the legal origins literature, which largely discounts the possibility that legal systems are capable of system-altering change. It does, however, leave open the question of the degree to which the historical origins of a country’s legal system might “matter” in today’s world. While the legal origins theory has rightly been criticized for relying on an overly strong form of path dependence[viii] to explain their theory and for ignoring the possibility of systemic legal change, at the same time few would dispute the fact that at some level, history must matter. The legal origins literature has simply failed to provide an adequate means of assessing how it does so.

The theory does, however, at least provide a useful point of departure from which to discuss the issue, hence this paper’s focus on the concept of “legal endowments”. The regrettably, but necessarily, broad definition of this term is that it is simply an element of a legal system that has been received from an earlier time. This definition leaves much unsaid. When exactly is that “earlier time”? What elements of a legal system are we talking about? How have these been “received”?

The original sin of the legal origins literature from the point of view of assessing the importance of the historical origin of a legal system to present outcomes is that it attempted to answer these questions by taking the traditional comparative law taxonomy of legal systems “off the shelf”. The answer to the first question for most countries was the time at which it received a European legal system. The answer to the second was left in the hands of the comparative law scholars, who divided the world’s legal system using criterion which may not have been entirely relevant to the issues being examined. The answer to the third question was mostly through the process of “transplantation” of legal systems from parents to recipients.

A more full understanding of the issue requires a closer inspection of these and related questions as they relate to specific countries. The working hypothesis here is that some elements of a legal system may usefully be viewed as “endowments” for the purposes of assessing the importance of legal history to contemporary economies. This has to be tempered by the acknowledgment that those endowments are not immutable, but are subject to change – some more so than others. It also must be noted that not all legal endowments “matter” for all purposes. In varying fields different elements of the legal system are going to play greater or lesser roles. Finally, in the temporal realm, it must be noted that not all endowments spring from the same time and place. The reception of a legal system from a European source in the 19th or 20th century may be the source of some such endowments, but it is not obvious that all elements of a legal system would have survived the trip from parent to recipient, nor is it clear that prior or subsequent legal development would be irrelevant.

3. Identifying the Source of a Legal Endowment

A first problem which must be dealt with is identifying the source of an endowment. When and from where do the relevant features of a legal system come into existence? The legal origins literature identifies two possible historical sources for the distinguishing features of the French and English legal systems. The earliest explanation is rooted in the 12th and 13th centuries. At that time, according to this explanation, the French Crown adopted the centralized, inquisitorial system of the Roman Church in order to overcome the weak control of the government over the regions and extend the Crown’s control. At the same time in England, the Magna Carta was enshrining the rights of the nobles to due process against the demands of the Crown, setting the stage for the development of a more decentralized legal system there than would develop in France.[ix]

The second explanation, chronologically speaking, is rooted in the later revolutionary periods in England and France. The English judiciary was on the winning side of the Glorious Revolution in the late 17th century and was thus able to gain a great deal of independence from the Crown. This in turn gave them greater freedom to protect private property rights and freedom of contract. The French judiciary, on the other hand, was on the side of the Ancien Régime during the French Revolution and were thereafter deprived of much of their independence and law-making powers.[x]

It is to be noted that neither of these explanations are geared specifically towards the general question of how the historical origins of a legal system could explain differences in current economic outcomes. Rather, they are geared specifically to the question of why the English legal system is more suited to protecting property and contractual rights than the French system is. This is due to the fact that it was only after the author’s earlier statistical regressions had demonstrated the alleged superiority of the English system to the French that they began to look for a historical explanation for why this was so.

This approach is fraught with problems when applied to a general theory such as the legal origins theory. The first and most obvious is that it only really explains differences in the English and French systems while largely overlooking the historical development of the German and Scandinavian systems which the theory also examines. The second problem is that as some scholars have noted these explanations suggest an extraordinarily strong form of path dependence.[xi] If political events from the 12th to 18th centuries could so affect the suitability of legal systems to protect property rights and freedom of contract, then why would political events in subsequent centuries not have similar influence on the legal system’s development?

A corollary of this is that the identified formative sources of each country’s distinctive legal systems are closely tied to formative political developments in their histories. These occurred largely outside of the legal system itself. In the vast majority of countries in the world today, however, the modern formal legal system was “transplanted” rather than developed over time as in France and England. It does not automatically follow that in transplanting the formalities of a legal system across borders, all of the institutional factors outside of the formal law which may have lent the system to treating private property rights in a certain way would come along. To put the question at its most extreme – do for example the drastically different economic performances of Singapore and Nicaragua trace their origins back to the 12th and 13th century political histories of their respective English and French legal parents? Or are subsequent developments more specific to those countries have greater explanatory value?

When viewed in this context, it becomes much less clear that the notion of “legal origin” as developed by the traditional comparative law scholarship is an appropriate tool by which to examine the issues. The traditional comparative law taxonomies developed by Zweigert and Kötz[xii] use a number of factors – the historical development of the system, the distinctive mode of legal thinking, distinctive legal institutions, sources of law and ideology – in determining how to categorize systems. While some of these factors could be relevant in determining the degree to which a legal system will provide better protection to property and contractual rights, it is not clear that these are the optimal criteria for doing so. Some of them are clearly irrelevant while others which may be relevant are not included.

For these reasons the focus on legal origin as a source of legal endowment seems particularly ill suited in this context for countries which received their legal systems via transplantation. All of the political and institutional developments which influenced the development of the French and English legal systems over the course of several centuries are assumed to have coalesced into the single moment at which those countries received their legal origin from their parent. All prior and subsequent developments specific to that country which may have made their respective judiciaries either more or less capable of protecting private property and contractual rights are excluded from consideration.

To be certain to the extent that one is only interested in learning how the traditional comparative law categorizations are correlated with differences in substantive laws and economic outcomes, the approach taken in the legal origins literature is not necessarily problematic. There is little doubt that the form of law matters and that the traditional distinctions among “legal origins” still have some substantive value and that some legal systems are better suited to certain contexts than others. Equally certain is that in transplant countries the type of system that is transplanted is important and will undoubtedly affect the course of subsequent legal development.

Such an approach will not, however, tell us very much about how the actual historical origin of a country’s legal system might matter today. It will only tell us how one element of that history matters and to this it is only capable of a simple “yes, it does” answer without much further elaboration. For this reason, this paper takes the position that for purposes of assessing the impact of legal history on economic outcomes such as ownership structure, it is necessary to examine the origins of a legal system not at the high level of abstraction that the concept of “legal origin” exhibits, but rather at the level of the individual features of a system which may have an influence. To begin a more thorough inquiry, we must move on to the next logical question, which is to ask what some of those features might be.

4. What Types of Legal Endowments “Matter”?

In this section we briefly consider which types of systemic legal endowments might matter to corporate governance via affects on the ownership structure of firms. The aim here isn’t to provide a comprehensive list of such features, but merely to illustrate the fact that legal scholarship has demonstrated that features beyond those discussed in the legal origins literature matter.

As noted earlier, one of the basic precepts of the legal origins literature is that the ability of a legal system to protect private property rights and freedom of contract are said to influence the types of ownership structure that firms in a given country will have. This hypothesis is by no means universally accepted. Many have argued that factors outside the legal system are responsible for the differences in economic outcomes rather than the legal system itself.[xiii] Others still have found that economic changes such as the move towards dispersed shareholdings have preceded rather than been caused by strengthened legal protections for investors.[xiv]

This paper takes no position on these specific issues, but merely notes that there is nothing in such criticisms that specifically preclude the possibility that certain aspects of a legal system might matter to ownership structure. Many of the arguments put forth on behalf of alternate causal explanations for the data produced by LLSV go mainly to the weight to be put on competing factors. Indeed there is compelling evidence that some such factors may better explain the observed differences, but this does not preclude the possibility and intuitive likelihood that elements of the legal system also matter. Likewise the question of reverse causality (the argument that legal change flows from economic change rather than vice versa) has largely focused on the role of substantive rules created legislatively or by court decisions rather than on general features of the system itself. As Coffee has noted, while the move towards dispersed ownership in the United States generally preceded the enactment of rules protecting shareholder rights, general features of the common law legal system contributed to an overall institutional environment that was conducive to this change.[xv]

For these reasons we may proceed on the premise that general features of a legal system can influence the structure of corporate ownership, with the proviso that the degree to which such features matter may differ widely from country to country and, when weighed against other variables outside the legal system, they may not be the most important. This leads to the question of which such features are worth examining with regard to the issue of ownership structure.

A number of such elements have been put forward. In the legal origins literature, the independence of the judiciary from other organs of state power is seen as an important one.[xvi] A more independent judiciary, the thinking goes, will be more willing and able to protect private property rights against state interference than one in which the judiciary is more subservient to state power. At first glance it is not clear how this factor would relate to corporate ownership structures, as there the main “hurdle” to the rise of dispersed ownership would be concerns related to expropriation by insiders and not the state. It is said, however, that the greater ability of the state to divert resources to favored ends may stunt the development of financial markets and in this way affect ownership structure.

A second element which the legal origins literature looks at is the “adaptability” of the legal system.[xvii] The basic notion here is that differences in sources of law will affect the economic efficiency of different systems which will in turn have implications for the structure of corporate ownership. This relies on Posner’s argument that the common law evolves efficiently as judges are able to respond to changing economic or social conditions on a case by case basis and weed out inefficient rules. Civil law systems will in contrast be less adaptive to changed conditions due to their reliance on statutory amendments as the main source of change to formal legal rules. Critics[xviii] have noted that in reality the differences in law making processes between the Common law and Civil law are exaggerated and that judges in Civil law countries do in effect “make law” while at the same time the ability of Common law judges to do so is not as great as it once was.

It is to be noted, again, that both of these factors are tightly connected to perceived differences between the English and French legal systems. This focus again largely stems from the literature’s conclusion that differences between these two specific legal systems were the most pronounced, a conclusion that was reached before an attempt to develop a theoretical model to explain their findings was made.

Legal scholars have been somewhat less constrained in their analysis and have suggested other features not solely related to the English/ French divide that may be useful. Milhaupt and Pistor have noted that the economics literature has been pre-occupied with the protective role of law in ordering economic affairs.[xix] They argue that an additional distinction needs to be drawn between systems that assign law a protective role in economic affairs and those which assign it a coordinative role. “Coordinative” here refers to the use of law not strictly as a means of protecting substantive rights but as a way of coordinating the activities of market participants towards some economic ends. The same authors also point to the relative centralization of the law making process as a factor.

Legal culture is another type of endowment which the current literature has largely neglected. This concept is capable of at least two meanings, one intrinsic to the legal system and the other extrinsic. The first is the culture and norms of the legal profession itself. How do lawyers, judges and prosecutors view their role in the system and its accepted boundaries? What input does this in turn have on the process of legal change? The second is the views of society as a whole towards the legal system. What do potential users of the system view its role as? What are the incentives and barriers to their using it?

As we are primarily interested here in elements intrinsic to the legal system itself it is the former that is of interest. Kagan has noted that, while it isn’t the main cause, the culture of American lawyers has played a “substantial contributory causal role” in creating the style of adversarial legalism that dominates the US system.[xx] As the ability of the law to affect economic outcomes will in part be a product of the way in which it is used by those who actually run the system, and how they influence the process of legal change, this is a significant factor to consider. Ahlering and Deakin have taken up this theme and noted that the evolution of legal cultures creates “ground rules” which affect the interpretation of laws by those inside the system and that this explains the channel through which legal origin affects the substance of contemporary labor regulations.[xxi]

This is by no means an exhaustive list of potentially significant factors. The purpose here has mainly been to demonstrate that there are a broad range of features of a legal system which may be relevant to economic outcomes. These features will vary from country to country, and are not coterminous with the features that the legal origins theory relies on to explain the facts. In the next section we briefly consider the question of how these features evolve over time.

5. Do Legal Endowments Change Over Time?

Finally we may consider the issue of changes to legal endowments over time. As noted above, one of the major criticisms with the legal origins literature has been a temporal one. The theory that has been developed to explain why legal origins matter is firmly rooted in historical narratives, yet the variables which LLSV tested represented a “snapshot” in time, only reflecting the situation at the time of writing. Rajan and Zingales[xxii] have pointed out that some of the economic outcomes looked at – namely financial market development – have changed significantly over the past century and that in 1913 French systems had better developed financial markets than English ones, the exact opposite of what the legal origins theory states should have been the case.. In the field of substantive law the Cambridge Law, Finance and Development Project[xxiii] has looked at how individual laws develop over time, from 1995 to 2005, and found that many of the differences in shareholder protection laws between civil law and common law systems have been sharply reduced in that time.

In terms of the general features of a legal system itself, there is little doubt that these are capable of change. History is replete with examples of legal systems experiencing such types of change – as indeed the historical examples of the evolution of the English and French systems are evidence. Yet the legal origins literature largely ignores this possibility and any implications to the theory which would flow there from by focusing solely on the notion of a “legal origin” that was received by most countries at some point in the 19th or 20th centuries, since which time it implicitly assumes no systemic changes occurred.

Though not related specifically to the question of how features of legal systems in general change, about a decade ago the corporate governance literature became quite interested in the barriers and incentives to legal and institutional changes affecting corporate governance. Roe and Bebchuck developed a path dependent theory on the development of corporate law rules and ownership structures.[xxiv] Ownership structures at one point in time, according to their theory, will affect subsequent choices both with regard to future ownership structures and to the rules that will be chosen to govern said structures. Efficiency concerns and incumbent interests will influence the subsequent path of development.

Articulating an opposing view of corporate ownership and legal development are Henry Hansmann and Reinier Krakkman, who suggest that systems of corporate governance around the world are converging on the American shareholder-primacy model.[xxv] They argue that factors such as the forces of competition and the rise of shareholder classes are enough to overcome any path dependent barriers to convergence on the American model.

Closely tied to this debate is the question of whether features of the legal system as a whole can also change under the pressure of similar forces. Milhaupt and Pistor[xxvi] note that major crises in corporate governance can foster such change in some circumstances when such crises disturb the make up of constituencies who create demand for legal rules. Aspects of the legal system such as its degree of centralization, its legal culture and so on may affect the degree to which the legal system is capable of changing to accommodate these changing demands. Likewise these demands may create forces which alter these features of the system as a whole.

The basic point here is that the individual endowments of a legal system are capable of change, a fact that has implications for the question of how legal history can affect a country’s system of corporate governance. If a legal system with certain endowments can be said to produce certain economic outcomes as a result, it stands to reason that changes to these endowments may likewise have led to different results.

6. Conclusion

This paper has sought to re-examine the question of how the historical origin of a country’s legal system can affect the structure of corporate ownership. The problems outlined herein with the legal origins literature’s reliance on the traditional comparative law classifications of legal systems prevent the theory from telling us very much about how a country’s legal history can affect economic outcomes, despite that being one of the literature’s main purported aims. This paper suggests that a new approach to this specific question – one that looks not to such classifications but to the historical development of specific, relevant “endowments” of individual country’s legal systems – may provide a clearer picture of how legal development has affected corporate governance over time and today.