While numerous factors play into whether a country has a dynamic financial market, there’s one in particular that stands out. Mauro Guillen, director of The Lauder Institute at Penn and professor of management at Wharton, finds that countries that offer a legal framework to protect minority shareholders tend to have more robust markets because investors are more willing to take risks.
In their paper, “State Capacity, Minority Shareholder Protections, and Stock Market Development,” Guillen and INSEAD professor Laurence Capron evaluated current and historical legislation in more than 70 countries with both established and emerging markets and found that it’s not enough for countries to have legal provisions in place. There also must be a mechanism for enforcement for these provisions to be most effective. While the data is important for policy makers, it also matters to everyday citizens who want to make informed decisions about investing. For that reason, Guillen and Capron have made the data available for a free download.
An edited transcript of the conversation appears below.
What Makes a Robust Market?
We all know that financial markets, and in particular equity markets, don’t develop everywhere in the world to the same extent. We know that the United States and the United Kingdom have very large equity markets, and other countries have much smaller equity markets. My research addresses one of the reasons why we see those differences in the size, vibrancy and dynamism of equity markets, which is the extent to which the interests of minority shareholders are protected. The argument is that when you have strong protections for the interests of minority shareholders, then more people are willing to invest money in the stock market. As a result, what you get is a larger stock market with more turnover and higher capitalization — or more dynamism.
“When you have strong protections for the interests of minority shareholders, then more people are willing to invest money in the stock market. As a result, what you get is a larger stock market with more turnover and higher capitalization — or more dynamism.”
In this research, we coded the legislation existing in more than 70 different countries from 1970 to the present, and we looked for legal provisions that protect the interests of minority shareholders. We found that back in the 1970s, the U.S., the U.K. and other countries with a common-law legal system have very strong protections for minority shareholders. But beginning in the 1990s, and especially over the last 15 years, countries in Eastern Europe, Asia and even some countries in Africa that used to have very weak protections of minority shareholders changed their legislation and introduced quite strong protections, in some cases stronger than those present in the U.S. or the U.K.
In addition to finding that countries that didn’t used to have strong legal protections now have them, we also found that adopting the legal provisions defending the minority shareholders is not enough. You also need to enforce those kinds of regulations. That is a very important finding because it essentially means a lot of countries introduce these reforms only for show, as window dressing. It’s also important to follow up with enforcement, otherwise you don’t get the expected result, which is the growth of stock market capitalization and a more dynamic equity market.
The Curious Case of the Former Soviet Republics
For me, the biggest surprise coming out of this research project was what happened in Eastern Europe and the former Soviet republics, including Russia. Most of these countries became independent in the 1990s, so they didn’t have their own separate corporate legislation. They were very aggressive in terms of introducing advanced laws that protected minority shareholders. My assumption going in was that in these countries, the effects wouldn’t be that great in terms of stock market development because I thought they were just adopting these things to tell the International Monetary Fund that, yes, they were introducing reforms. They were adding all of these legal provisions just because they felt that it was the right thing to do. I was surprised to see that even within that set of 20 to 35 countries, the implementation of these laws has resulted in the growth of the stock market, which is something that I don’t think most people would have expected, and I certainly was not expecting.
How Individual Investors Benefit
I think my research has implications for practitioners — especially investors — and for policy makers. For investors, we all know that the world has become one big marketplace, and capital is chasing the best returns. But, obviously, you need to take into consideration the legal framework. It’s not the same to invest in the U.S. equity market as it is to invest in, say, the Nigerian equity market or in the Chinese equity market for a variety of reasons. My research calls attention to the importance of legal institutions, because at the end of the day portfolio investors want to be protected. They want to be able to sue. They want to be able to have legal mechanisms at their disposal if they believe that they’ve been taken for a ride. That’s the implication for investors. I offer them a map.
“At the end of the day, portfolio investors want to be protected…. They want to be able to have legal mechanisms at their disposal if they believe that they’ve been taken for a ride.”
For policy makers, I think the lesson is also clear that it does pay to introduce market-oriented reforms in the form of legal institutions that support economic exchange and investment. Governments around the world are competing against each another to attract investment, so it is very important for governments to realize that they need to have the right legal framework in place because the development of their equity markets ultimately depends on the extent to which protections for minority investors are in place and actually enforced.
I think the conventional wisdom is that there are safe markets in the world in which it is OK to invest and you’re likely not to lose your money unless the market goes south. That means it’s very difficult for either the government or other interests to expropriate investors, which happens in many parts of the world. I think that conventional wisdom is largely true — that is to say, you can classify countries according to how easy it is for you to protect your rights as a minority investor. I think my research addresses this myth that whatever the situation was back 30 years ago continues to be the same today. That is to say, we observe that laws and regulations concerning minority shareholders change all the time. Countries that used to have very low protections today actually have very strong protections in place. It’s very important for investors, and for the general public, to understand those legal frameworks because otherwise you could be making big mistakes as to exactly how you allocate your investments. Let’s not forget that most of us have a pension fund, and we can make choices about how we allocate the money that we have in it between U.S. equities and foreign equities. I think it’s really important for us as citizens who have pension funds to understand these dynamics and how legal institutions can affect the returns to our investments.
What I think is unique about our research is how comprehensive the data are. We have hired more than 50 legal experts from different countries who read the relevant legislation and coded all of these different legal provisions. It is the detail that we have in our data, the fact that we’ve covered more than 70 countries over 45 years, that I think is unique about our research.
“For policy makers, I think the lesson is also clear that it does pay to introduce market-oriented reforms in the form of legal institutions that support economic exchange and investment.”
A Step Further: How Financial Crises Are Resolved
Now that we have this data on minority shareholder protections around the world, we are planning to examine what happens after a major financial crisis such as the one that took place in 2008. As we know, there’s a lot of restructuring. We want to understand whether the way in which crises are resolved and assets are restructured is different depending on the strength of different stakeholders in the firm. And one very important stakeholder, of course, is minority shareholders. We are expecting that the ways in which crises unfold and ultimately are resolved is different depending on whether the country has very strong protection of minority shareholders versus another in which those protections are very weak.