Does Enforcement Intensity Explain Financial Development?

Classes may have ended here at Harvard, but the Law and Economics Seminar closed the Spring on a high note with a fascinating presentation by John Coffee of his new paper Law and the Market: The Impact of Enforcement.  The central thesis of the paper is that the intensity with which securities laws are enforced, rather than legal origin, explains differences in financial development across countries.

Professor Coffee’s paper contributes to a scholarly debate, now nearly a decade old, as to whether legal origin adequately explains differences in development.  The seminal paper on this subject concluded that common-law nations experienced faster growth than their civil-law counterparts, but the legal origins analysis has recently come under methodological and substantive criticism.  This paper argues that enforcement of securities law, rather than the source of the substantive law on the books, explains differences in financial development across countries.  Professor Coffee offers very persuasive evidence for that claim, although I’m less convinced that the evidence supports the policy implications offered in the piece.

The paper compares both enforcement inputs–that is, the amount of money spent on enforcement efforts–and enforcement outputs–the penalties levied against financial-market wrongdoers–across countries.  The inputs analysis confirms Howell Jackson‘s and Mark Roe‘s conclusion in a recent paper that the “amount of public resources devoted to financial regulation appears to be systematically higher in countries from common law origins as compared to countries with civil law origins.”  The “outputs” analysis, which relies on another recent paper written by Professor Jackson, shows that common-law countries, and particularly the United States, impose far greater financial penalties on securities-law violators.

The differences in enforcement outputs in the United States, even adjusted for GDP, are striking.  The Securities and Exchange Commission brings more than 5,000 enforcement actions each year, nearly twice the adjusted figure in the United Kingdom and five times the number of cases brought in Germany.  Annually U.S. issuers pay public sanctions of more than $1.8 billion.  But it’s private enforcement of securities laws that really distinguishes the U.S.: each year class actions and arbitral awards result in more than $2 billion in fines paid by issuers of U.S. securities.  (In 2005 that figure rose to $3.5 billion–excluding the $6.2 billion paid by WorldCom that year.)

Professor Coffee argues that more aggressive enforcement of securities laws in the United States explains why the cost of equity capital here is comparatively low, and why foreign issuers receive a valuation premium for listing on American exchanges.  But, as his paper acknowledges, stringent enforcement may also explain why some foreign issuers are fleeing from U.S. capital markets.

I have no difficulty agreeing with the claim that differences in enforcement intensity play some role in explaining these dynamics.  What is less clear, though, is what, if anything, we should do about it.  Professor Coffee suggests that although substantially more intense public enforcement in the United States is desirable, we may wish to curb private enforcement such as securities litigation, because the specter of a huge securities judgment may be driving foreign issuers out of American capital markets.  (In particular, Professor Coffee refers to the Royal Ahold class action, which resulted in a $1.1 billion judgment paid by a foreign issuer to mostly American investors.)

It seems to me that public and private enforcement are equivalents for purposes of deterrence: whether the judgment is paid to the Treasury or to shareholders (and their lawyers), the judgment deters executives from violating securities laws.  If we curb private enforcement of securities laws here, we’ll either need correspondingly to increase public enforcement, notwithstanding an already-taxed SEC Enforcement Division, or else deter fewer prospective violators of our laws.  And, as Professor Coffee explains, deterrence by way of enforcement intensity has yielded substantial benefits in American securities markets, including a lower cost of equity capital.

Law and the Market: The Impact of Enforcement generated a lively debate among students and faculty, due in no small part to Professor Coffee’s engaging and highly persuasive presentation.  The paper is a must-read for those with an interest in the continuing scholarly debate over the causes for differences in financial development.