Do norms matter? A cross-country evaluation.

• Jurisdiction: United States
• Date: 01 June 2001
• Author: Coffee, John C., Jr.

INTRODUCTION

That corporate behavior may be more shaped and determined by social norms than by legal rules seems to be an idea whose time has come.(1) Respected academics have placed the relative efficacy of social norms as compared with legal rules at the center of the debate over the judicial role in corporate law, and some have suggested that there are areas of internal corporate behavior and decisionmaking that courts should monitor less rigorously because social norms adequately govern behavior.(2)

Although the relevance of norms cannot be denied, the problem with this debate is that it has an ineffable and subjective character. Of course, individuals internalize norms, seek to maximize their reputational capital, and function in teams that operate based on informal systems of consensus and cooperation. They do so within both corporations and all other forms of social organization. But once this is said, can any testable propositions be framed? In particular, can a corporation's perceived compliance with norms that are not legally enforced be shown to affect the market value of its securities?

This brief Article will answer both that compliance with nonlegally enforceable social norms can significantly affect market value and that innovative legal engineering designed to develop credible signals of such compliance may be one of the most important services that corporate attorneys can perform for their clients. In particular, existing research has shown that (1) it is feasible to measure the private benefits of control that those holding voting control over the corporation are likely to extract from minority shareholders, and (2) a credible signal that a controlling shareholder will cease or reduce the expropriation of such private benefits appears to produce a significant increase in the corporation's stock price. The unresolved question is what constitutes a credible signal.

This Article starts with the recognition that the average private benefits of control vary significantly across countries. But why? The simplest explanation ascribes this variation to differences in law between jurisdictions: for example, the law of jurisdiction X could privilege controlling shareholders by allowing them to extract benefits from their corporation in the form of above-market salaries or non-pro-rata payments in connection with self-dealing transactions. But, this explanation cannot fit all cases. To illustrate, if the substantive law is essentially similar between two jurisdictions while the private benefits of control appear to be significantly different, then some other explanation must be found. One possible alternative explanation could involve differences in enforcement mechanisms: one jurisdiction might have established powerful and well-incentivized mechanisms of private enforcement, while another jurisdiction having the same substantive law did not. Or, one jurisdiction might invest more heavily than the other in public enforcement. Still, if these explanations also fail (or, at least, seem implausible), then the next most logical explanation involves social norms. That is, if two jurisdictions having similar legal rules and enforcement systems appear to permit controlling shareholders to extract on average very different levels of private benefits, then we may be witnessing a difference in prevailing norms. This Article will argue that this pattern is not only possible, but pervasive.

Part I of this Article will offer evidence that suggests that the social norms regarding the behavior of controlling shareholders do differ--and differ significantly--across jurisdictions. Even within jurisdictions having relatively similar legal rules, the level of compliance with these norms appears, on average, to differ materially. Although some of this variation no doubt can be explained in terms of differences in enforcement risks, it will be argued that the magnitude of these differences cannot be explained plausibly on any such deterrence-related basis.

Part II will turn to possible explanations for the magnitude of these differences in the private benefits of control across jurisdictions. It will take the uncharacteristic step (for a corporate law article) of seeking to relate these differences to other social characteristics that distinguish the jurisdictions being compared--in particular, to the levels of law compliance and crime within the jurisdiction. Although no satisfactory metric exists for measuring law compliance across jurisdictions, some reasonable proxies do suggest a rough correspondence: namely, societies with high crime and/or low social cohesion are also characterized by high private benefits of control.

Part III will then turn to the potential for value creation through credible signaling that a corporation will comply with social norms that are not legally enforced. On the one hand, this Article will suggest that there are incentives for a race to the top: that is, corporations that do bond themselves to protect the interests of minority shareholders beyond the level that is mandated legally or is enforced in their home jurisdiction, and that credibly signal this intent, can enhance significantly their share prices. Such creative legal engineering can more than pay for itself because some evidence already suggests that corporations in countries with weak legal systems can more than double their stock price through such self-help measures.(3)

On the other hand, there is also a reverse side to this coin: if controlling shareholders in "amoral" jurisdictions that are characterized by high private benefits of control were to acquire control of corporations incorporated in "moral" jurisdictions characterized by low private benefits of control (but in which the expropriation of private benefits was not legally constrained), a movement in the reverse direction toward greater inefficiency could begin. If controlling shareholders in "amoral" jurisdictions are not deterred by internalized norms or by the threat of reputational loss then they would have every logical incentive to acquire control in order to extract greater private benefits than had the preceding controlling shareholder in the "moral" jurisdiction. Once, such perversely motivated takeovers would have been infeasible because of the high national barriers to transnational takeovers. Today, however, in capital markets that are increasingly globalized and in which corporate control is increasingly contestable, movements in both directions seem both possible and plausible.

1. SOCIAL NORMS AND THE PRIVATE BENEFITS OF CONTROL: A CROSS-COUNTRY COMPARISON

   An important new body of research has argued that legal rules protecting the rights of investors--and minority shareholders in particular--are essential to the development of deep and liquid securities markets.(4) In a provocative series of articles, Professors Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny (hereinafter "LLS&V") have documented the existence of significant differences among countries in terms of the breadth and liquidity of their capital markets, the ownership concentration of publicly traded firms, the dividend policies of firms, and the access of firms in these markets to external capital--differences that correlate closely with the nature of each country's legal system. More to the point, they have found that common law countries seem to outperform civil law countries by a significant margin in terms of both the depth and liquidity of their capital markets and the degree of dispersion in share ownership. Why? LLS&V conclude that the superior quality of the legal protections afforded minority shareholders in common law jurisdictions principally explains these differences.(5)

   Yet, although LLS&V have unquestionably shown a statistically significant correlation between strong capital markets and certain specific legal protections that tend to characterize common law legal systems, correlation does not prove causation. The confounding problem of multicollinearity thus makes its customary appearance here, as it often does when attempts are made to determine the true independent variable that influences the dependent variable.(6) Of the various nagging doubts surrounding their research, perhaps the most perplexing is the possibility that the specific legal protections identified by LLS&V are really proxies for some deeper, but hidden, characteristic of common law legal systems.

   The point here is not to reject their "law matters" thesis, which would be highly plausible even in the absence of strong statistical correlations between minority legal protections and ownership dispersion. Rather, it is to suggest that the line between law and norms may be harder to define than this body of research has yet recognized. Specifically, investors may invest in public corporations in common law legal regimes (and may not invest in similar corporations in civil law legal regimes) less because they believe they have enforceable legal rights that adequately constrain managers and controlling shareholders than because they believe managers and controlling shareholders in these common law legal regimes will abide by a series of legally nonenforceable norms. These norms (and the related corporate governance practices that implement them) may as a practical matter restrict unfair self-dealing and otherwise limit the potential for expropriation of the minority shareholder's investment. In short, investors invest because they expect to be treated "fairly" in a common law legal system (and have been treated so in the past), and they refrain from making similar investments in a civil law regime (or they make them only at severely discounted prices) because they have the opposite expectations (and possibly the opposite experience in the past).

   Although the specific norms and governance practices that facilitate investment could have a close association with statutory...