Strong Financial Laws Without Strong Enforcement: Is Good Law Always Better than No Law?

• DOI: http://doi.org/10.1111/jels.12011
• Published date: 01 June 2013
• Author: Mark Humphery‐Jenner
• Date: 01 June 2013

Strong Financial Laws Without Strong

Enforcement: Is Good Law Always Better

than No Law?

Mark Humphery-Jenner*

This article examines whether strong laws are effective when regulatory institutions are weak.

This has become especially relevant due to criticisms of financial market regulation in the

United States. I test the impact of imposing strong laws on a weak regulatory environment

by using China’s principled reforms to market manipulation law as a natural experiment.

The results from difference-in-difference tests suggest that China’s principled law reforms

did not improve the market’s information environment, as proxied by the level of informed

trade and information asymmetry. This implies that principled law reform is ineffective if the

regulatory environment is weak.

I. Introduction

This article analyzes whether strong law is effective in the presence of weak regulatory

institutions. This is a live issue for policysetters as they attempt to reform the financial

system to prevent future market misconduct. This has become particularly relevant as the

European Union has attempted to reform securities laws under the Markets in Financial

Instruments Directive (MiFID) (see Cumming et al. 2011), and the regulation of financial

markets in the United States has sustained recent criticism (Coffee & Sale 2009; Fisch 2009;

Karmel 2009; Baker 2010). I use a difference-in-difference methodology to disentangle the

effects of the design of new laws from their actual implementation and I find that strong law

in the presence of weak regulations might actually worsen market conditions. This provides

additional empirical support for the prediction in Bhattacharya and Daouk (2009) that “no

law” can sometimes be better than “good law.” This also suggests that empirical law and

finance work should carefully distinguish between the mere presence of laws and their

enforcement.

Market manipulation is a key problem in China’s securities markets. One key type of

market manipulation is manipulation by issuing “false statements” that inflate (or deflate)

*Assistant Professor at the Australian School of Business, University of New South Wales, Sydney NSW 2052; email:

M.HumpheryJenner@unsw.edu.au.

This article is based on a chapter of my Ph.D. thesis at Leiden University. This article benefited from comments

from Koen Caminada, Douglas Cumming, Ted Eisenberg, Ronan Powell, Jo-Ann Suchard, Wim Voermans, and three

anonymous reviewers.

bs_bs_banner

Journal of Empirical Legal Studies

Volume 10, Issue 2, 288–324, June 2013

288

stock prices. A key remedy for such false statements is a shareholder class action.1In 2001,

their prevalence, and subsequent consumption of court time, induced China’s Supreme

People’s Court (SPC) to refuse to hear market manipulation cases. Subsequently, on

January 9, 2003, China’s Supreme People’s Court promulgated a guideline judgment that

made principled legal reforms to compensation for market manipulation. The judgment

has equivalent status to legislation. There were no reforms to the regulatory institutions.

This problem was amplified because regulatory approval was still necessary in order for

shareholders to pursue a class action. Thus, while the law became stronger, it was still

difficult for shareholders or regulators to enforce it. The prevalence of market manipula-

tion coupled with the presence of strong law and weak regulation provides a natural

experiment in which to test the impact of good law in the absence of good regulation. This

enables me to disentangle the effects of regulatory strength and legal strength.2

Strong laws can create value. La Porta et al. (1997, 1998) and Spamann (2010) show

that rules that protect shareholder rights encourage economic development. Cumming

et al. (2011) show that strong stock exchange rules (cf. legal rules) increase market liquid-

ity. Bruno and Claessens (2010) indicate that stringent investor protection can increase

corporate value (depending on the quality of the firm’s own internal corporate govern-

ance). Becher and Frye (2011) find that (in the United States) strong regulation can

complement strong corporate governance. The desire for strong legal rules was one moti-

vation for the European Unions’s implementation of MiFID and the Takeover Directive

(Committee of Wise Men 2001; Prodi 2002; Clarke 2009; McCahery & Vermeulen, 2010).

Strong laws are likely to be ineffective, and might be detrimental, if there is weak

regulation. In the context of false disclosures, for example, if there is no law but there is

wrongful conduct (i.e., issuing a false statement), then there will be a general state of

noncompliance and a general distrust of corporate announcements. In this case, a corpo-

ration does not have an especial incentive to release falsely positive statements because it is

unlikely that shareholders will place much credibility in them, thereby reducing the advan-

tage gained by trading on private information (because everyone needs to become privately

informed). By contrast, if there is a strong law that is not enforced, then some companies will

comply with the law, but the noncompliers will deviate even more on the assumption that the

compliers raise the general level of credibility of corporate announcements, thereby creat-

ing an incentive to issue falsely positive statements. The presence of compliers and (poten-

tially serious) noncompliers raises the incentives for a trader to gather private information.

This would increase the presence of informed trade and potentially reduce market quality.

China has strong laws on market manipulation by false statements. The SPC

issued a guideline-type judgment on January 9, 2003 vis-à-vis private remedies for market

manipulation by false statements. Humphery-Jenner (2011) argues that China’s rules on

1The impact, and undesirability, of such conduct has received significant attention in the United States (Cox et al.

2005, 2006, 2008; Fox 2005, 2006; Peng & Röell 2008; Bai et al. 2011; Humphery-Jenner 2011, 2012).

2This contrasts with some prior studies that examine the impact of the “first enforcement” of insider trading laws. The

issue with examining the first enforcement date is that if regulators are strong, they might deter misconduct and thus

a strong law in a strong regulatory environment might actually appear to be underenforced.

Is Good Law Always Better than No Law? 289

false statements are legally justified, containing principled rules on causation, remoteness,

and mitigation. China has a poor reputation for securities law enforcement (Chen et al.

2005; Pistor & Xu 2005). China’s regulatory regime did not change following the legal

change.

This article uses the promulgation of strong false statement regulations on January 9,

2003 as a natural experiment with which to answer the question: Is good law sufficient to

improve market behavior in the absence of good regulation?

I examine whether the law reform improved the financial environment by reducing

the presence of informed trade, as proxied by the probability of informed trade (PIN), the

adverse selection component of the bid-ask spread, the absolute order imbalance, and (in

Appendix A) the daily bid-ask spread.3This is based on two streams of literature. First, the

legal environment can influence market microstructure and trading behavior (Macey &

O’Hara 1997; Ciccotello & Hatheway 2000; Mahoney 2003; Daouk et al. 2006). Second,

improved disclosure can influence the firm’s information environment, as proxied by

microstructure measures of information asymmetry and informed trade (following Brown

& Hillegeist 2007; Chung et al. 2010), and by the firm’s cost of capital (Bhattacharya et al.

2003; Daouk et al. 2006). This implies that a way to test the efficacy of law reform is to test

whether it improved the firm’s information environment, as proxied by intraday measures

of informed trade and information asymmetry.

I test the impact of the SPC’s January 9 interpretation by using a difference-in-

difference approach. The treatment sample is the set of firms that listed on the Shanghai

Stock Exchange or the Shenzhen Stock Exchange. The control sample comprises firms

listed on the Hong Kong Stock Exchange, the Taiwan Stock Exchange, or the Korean Stock

Exchange (KOSDAQ). I ensure robustness to violations of the parallel trend assumption by

using a propensity score radius-matching-type approach and by examining various control

sample compositions.

The results show that the SPC’s interpretation did not reduce informed trade.

Instead, the results suggest that informed trade, as proxied by PIN and the absolute order

imbalance, increased following the SPC’s interpretation. This implies that absent a strong

regulatory framework, good law is not sufficient to improve the economic environment.

These results support prior modeling by clearly disentangling enforcement and law

by using a natural experiment. Cumming and Johan (2008) argue in favor of enhanced

global market surveillance. Bhattacharya and Daouk (2002) find that the corporate cost of

equity does not change after the introduction of insider trading laws, but does decrease

after the first prosecution. Chen and Hao (2011) similarly find that enforcement of insider

trading laws lowers underwriter gross spreads. Daske et al. (2008) find that legal quality

influences the impact of adopting mandatory international financial reporting standards

(IFRS), although they examine a sample of relatively developed countries. Bhattacharya

and Daouk (2009) predict that if there is no law, then everyone is in a “bad equilibrium.”

However, if there is good law that is not enforced, then (1) some people will comply and (2)

3These are established measures of informed trade. An increase in the level of informed trade to uninformed trade

suggests a less transparent and “fair” market environment (following Aktas et al. 2007).

290 Humphery-Jenner