Over the past two decades, a series of influential papers in economics and finance have found institutions to be powerful predictors of economic and financial development that exert persistent effects over time. One of the most prominent examples of these persistence studies is the law and finance hypothesis, which argues that a country’s legal origin is a powerful predictor of its present investor protection laws and its financial development (La Porta et al, 1998). But because few studies have explored whether correlations between institutions and economic and financial outcomes hold in the past, we cannot be certain the alleged persistence of the effects of legal origins passes the test of history (Morck and Yeung, 2011; Musacchio and Turner, 2013). If these relations were not significant in the past, the correlations observed today might instead be the product of events that have not been considered and incorporated into the statistical work of these institutional studies.
In a recent paper, we examine law and finance in Britain c.1900, which has been a major fly in the ointment of the law and finance hypothesis (La Porta et al, 2008). Why is this the case? First, it appears that ownership had separated from control before or around 1900, which is contrary to the predictions of law and finance theory because this should not have happened before shareholder protection law was strengthened (Foreman-Peck and Hannah, 2012; Acheson et al, 2015). Second, according to Rajan and Zingales (2003), the UK had the most developed stock market in the world in 1913, which is contrary to the law and finance hypothesis given the weak state of UK shareholder protection law. However, the accuracy of Rajan and Zingales’s figures has been questioned because they conflated bonds and stocks for the UK. In addition to this issue, La Porta et al (2008) highlight that companies in many countries cross-listed on the London stock market, for example, and, because what matters is the legal regime of the country in which a company is listed, companies cross-listed in London were perhaps borrowing Britain’s legal system and, hence, not subject to the legal tradition of their home country. This possibly could result in an overestimate of the size of the domestic British capital market.
The first contribution of our paper is that we provide a new estimate of the market value of the British share and corporate bond markets, which does not conflate bonds and shares and which differentiates between the market value of domestic and colonial and foreign securities. In order to measure the market capitalization of the domestic UK share and bond markets c.1900, we code by hand all the securities listed in the Stock Exchange Official Intelligence and Investor’s Monthly Manual to generate new point estimates for 1895, 1900, 1913 and 1929. We collect data on the legislation under which companies were incorporated to help us differentiate between companies incorporated in the UK, and hence subject to UK law, and those incorporated in foreign countries. Because most companies in the UK incorporated under two different routes—a high-shareholder-protection route and a low-shareholder-protection route—we also differentiate between companies based on the legislation they were incorporated under. Our results imply that there is no correlation between investor protection laws in the UK and the size of its domestic capital market, which casts some doubt upon the law and finance hypothesis.
However, was the UK a unique case in this era with its weak shareholder protection law and highly developed capital markets? To address this question, we collect and examine fragmentary evidence on creditor and shareholder rights across countries at the turn of the twentieth century. This evidence reveals that, across common law and civil law countries, creditor rights included in bankruptcy laws were quite similar and that the protection of shareholders did not rely strongly on government or court enforcement of shareholder rights (ie there was convergence on weak shareholder rights). The implications of this finding are threefold. First, Britain was not unique in having weak shareholder protection and developed capital markets c.1900. Second, there was a divergence of investor protection laws during the twentieth century. Third, the similarity of investor protection in the past across legal origins suggests that legal origin does not appear to explain the differences in investor protection which are manifest today.
In the paper, we also examine potential substitutes for statutory legal protection, which may resolve the puzzle of the coexistence of a thriving stock market and weak shareholder protection. The possibility which may have the most merit is that firms used their contractual freedom to provide protection to shareholders via their articles of association. Recent work by Acheson et al (2019) examines articles of association of c.500 UK companies between 1862 and 1899 and finds that companies included relatively high levels of shareholder protection in their articles. Furthermore, Acheson et al (2019) find that changes to UK investor protection law and stock exchange regulations simply reflected the practice of companies as revealed in their articles of association.
Christopher Coyle is a Lecturer in Finance at Queen’s Management School, Queen’s University Belfast.
Aldo Musacchio is a Professor of International Business at Brandeis International Business School.
John D. Turner is a Professor of Finance and Financial History at Queen’s Management School, Queen’s University Belfast.