Questioning ‘Law and Finance’: US Stock Market Development, 1930-70

Brian Cheffins is a Professor of Corporate Law at the University of Cambridge.

Since the late 1990s, a “law and finance” literature emphasizing quantitative comparative research on the relationship between national legal institutions on the one hand and corporate governance and financial systems on the other has achieved academic prominence. An important tenet of the law and finance literature is that corporate law “matters” in the sense it does much to explain how durable and robust equities markets develop. While “law and finance” has an important forward-looking normative message, namely that countries must enact suitable laws to reach their full economic potential, the thesis that corporate law influences stock market development seems to be well-suited to offer insights into if, when and how a country develops a corporate economy widely held companies dominate. Law and finance thinking implies that this should not occur in the absence of corporate law providing significant stockholder protection. In Questioning “Law and Finance”: U.S. Stock Market Development, 1930-70, recently published on SSRN, we draw upon events occurring in the United States to cast doubt on this logic.

At first glance, arrangements in the U.S. fit well with law and finance thinking, since the U.S. has both well developed equity markets by global standards and a legal regime that reputedly provides substantial protection for investors. In fact, matters are from straightforward. Probably most puzzling is the interrelationship between the law and finance logic and the conventional wisdom concerning the evolution of U.S. corporate law since the late 19th century. It is generally accepted that state corporate laws which were strict in the 19th century became more permissive and offered less protection to shareholders after New Jersey began in the late 1880s a “race”, subsequently won by Delaware, to make available legislation that would be attractive to corporate management. If “quality” corporate law is a pre-condition for strong equities markets and if state competition was progressively eroding shareholder rights throughout the 20th century, how did the stock market oriented corporate economy for which the U.S. is renowned develop?

We set the stage for our analysis by using various statistical measures to show that stock market development was stultified in the U.S. for at least a quarter-century following the 1929 Wall Street crash. We then draw upon the law and finance literature methodology to ascertain the extent to which corporate law in fact provided protection to shareholders as the 20th century progressed. An innovative and controversial feature of the law and finance research program is an emphasis on quantification, with law being reduced to numerical values to facilitate statistical analysis of its impact. With respect to corporate law, the most popular such measure is a six point anti-director rights index (ADRI) economists Rafael La Porta, Florencio López-de-Silanes, Andrei Shleifer and Robert Vishny (LLSV) developed in the late 1990s. Correspondingly, in order to ascertain the contribution corporate law made to stock market development in the U.S. we determine what ADRI score out of six points U.S. corporate law would have merited going back through time.

U.S. corporate law is largely a matter for the states and, being cognizant of Delaware’s success, we use its law as our proxy for a “national” ADRI score. The manner in which corporate law has been scored by reference to the ADRI has evolved and been refined over time. Correspondingly, to score Delaware law we focus primarily on the ADRI methodology used by Djankov La Porta, López-de-Silanes and Shleifer (DLLS) for a 2008 article and by Spamann in a 2009 article.

According to both DLLS and Spamann, the ADRI scores of the U.S. (i.e. Delaware) corporate law are below average by global standards. Given the current low ADRI score and given the general consensus that the competition among states for incorporation business occurring in the 20th century served to erode shareholder rights while enhancing managerial flexibility, the most obvious direction for U.S. (Delaware) corporate law to have gone throughout the 20th century would have been from a high score downwards. A trend of this sort might well help to explain from a law and finance perspective why the U.S. currently combines “weak” corporate law with a stock market-oriented corporate economy. Arguably what would have been happening is that “strong” corporate law would have provided the legal foundation for the stock market to achieve prominence, thus creating a path dependence that meant publicly traded companies could continue to flourish even as shareholder protection diminished.

While it might be expected that Delaware’s ADRI score would have dropped steadily as the 20th century progressed, we show this did not occur. Instead, Delaware’s score only changed once, in 1967, falling one point out of six, thus moving the U.S. from average or slightly below average by current global standards to well below average. Our analysis correspondingly suggests that the notion of a Delaware-led “race” should not be taken for granted and indicates that at no point during the 20th century was the quality of U.S. corporate law as high as would be anticipated if “good” corporate law provided a legal springboard for the development of U.S. equities markets.

The ADRI focuses exclusively on corporate law, which means that in the U.S. context it misses a crucial element of investor protection, namely federal securities law. While a widely held view is that corporate law protected investors less rigorously as the 20th century progressed, a federal counter-trend emerged with the enactment of the Securities Act of 1933 and the Securities and Exchange Act of 1934. Arguably, as law and finance thinking would predict, these reforms provided a secure regulatory foundation for the development of equities markets in a way that corporate law did not. However, as our data on stock market development between 1930 and 1970 shows, stock markets in the U.S. were in the doldrums for at least two decades following federal intervention in the field of securities regulation. Moreover, over the same time period the lightly regulated “over the counter” (OTC) market flourished relative to national stock exchanges subject to the full range of federal securities laws. The upshot is that while the law and finance literature indicates that the quality of corporate law does much to explain the configuration of equities markets across countries, our paper suggests that in the case of the United States the story has been rather different.

The full paper is available for download here.

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