Although, La Porta and colleagues pointed out the importance of legal foundation for investor protection, other theories argue that legal determinants are complex. These theories suggest that the differences in the investor protection level around the world are determined by other variables, particularly important exogenous variables are those related to political economy considerations

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Explanations for Di erences in Levels
of Investor Protection
Ramy Abdu Follow
Jul 8, 2019 · 5 min read
Although, La Porta and colleagues pointed out the importance of legal
foundation for investor protection, other theories argue that legal
determinants are complex. These theories suggest that the differences in
the investor protection level around the world are determined by other
variables, particularly important exogenous variables are those related to
political economy considerations.
Politics can affect the balance of power between company “insiders”
(managers and controlling shareholders) and “outsiders” (non-controlling
shareholders). It does so by designing the rules intended to protect minority
shareholders, as well as those that influence the contestability of corporate
control (Pagano and Volpin, 2001). Pagano and Volpin (2000) set forth a
stylized political-economy model of investor protection. The model suggests
that low shareholder protection may result from a political agreement

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between entrepreneurs (controlling shareholders) and workers aimed at
preserving their own rents. This agreement is reached only in countries
where workers do not own shares, or own a small amount of shares where
the entrepreneurs believe that low shareholder protection increases their
private benefits of control, while high employment protection shelters low
productivity workers from the competition of more productive unemployed
ones. Therefore, the legal rules can evolve only by exchanging higher
investor protection for lower employment protection or vice versa.
This political/financial view emphasizes that those in power influence
policies and institutions to their own advantage (North 1990; Olson 1993).
Thus, a corporate governance regime can be determined by politicians who
have the interests of their voters in mind, these voters may be shareholders
or employees of firms. Hence, the evaluation of a regime in a shareholder’s
view will be different from that in an employee’s view, and the political
decision will depend on the orientation of politicians towards specific voters
(Perrotti and Von-Thadden, 2006).
Rajan and Zingales (2003) argue that the development of financial systems
and laws does not always evolve consistently over time but rather that cross-
country differences in financial development change drastically. Time-
invariant factors, such as legal origin, cannot explain entirely time-variation
in relative levels of financial development across countries. They stress the
important role of political forces in shaping policies toward financial
markets and intermediaries, and the development of financial systems. In
explaining weak legal protection for investors in the civil law countries, they
asserted that in those countries, the governance system is more centralised
facilitates for the influence of a small group representing private interests,
such as large incumbent industrialists and financiers, to implement friendly
policies. When these private interests are aligned with national interests,
beneficial policies can also be implemented quickly, but when interests are
misaligned, matters can become much worse. However, Pistor, et al. (2002;
2003) disagree with Rajan and Zingales (2003) in the area of corporate law,
arguing that even acute political changes in England, Germany, and France
during the twentieth century did not significantly affect the development of
corporate law (Beck and Levine, 2003).
Builidng on La Porta et al.’s (1998) study and findings regarding the
relation between shareholder protection and stock market development,

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Pagano and Volpin (2005) use data for 47 countries for the period between
1993 and 2001, and rely mainly on the Anti-Director Rights Index to
present a political economy model featuring three groups of risk-neutral
individuals: owner-managers, workers, and rentiers (outside shareholders).
The model holds that “regulation is chosen by groups with political power,
who shape it in their own interest and defend it against change” (Pagano
and Volpin, 2006, p. 317).
While the work of La Porta and colleagues is presented from legal
perspective and that of political economy scholars from a political
perspective that has produced a great deal of discussions, other factors have
also been considered. Stulz and Williamson (2003) argue that culture can
affect finance through at least three channels. First, the values that are
predominant in a country depend on its culture. For example, charging
interest can be a sin in one religion but not in another. Second, culture
affects institutions. For instance, the legal system is influenced by cultural
values. Third, culture affects how resources are allocated in an economy.
Religions that encourage spending on churches or armaments divert
resources away from investment in production.
A suitable definition is given by Boyd and Richerson (1985) cited in North
(1990, P. 37), who states that culture is a ‘‘transmission from one
generation to the next, via teaching and imitation, of knowledge, values,
and other factors that influence behaviour.”
The view that culture is an important determinant of economic growth has
a long tradition, dating back to at least the work of Weber (1930). In his
book, The Protestant ethic and the spirit of capitalism, Weber argued that
cultural differences, namely the Calvinist Reformation, played an important
role in the development of institutionalised capitalism. Lal (1999, p. 17)
argues that “cosmological beliefs — an essential element of ‘culture’ — have
been crucial in the rise of the West and the subsequent evolution of its
political economy”. Religion is a key component of a system of beliefs.
Historically, religions have had much to say about the rights of creditors,
but less about the rights of shareholders (Stulz and Williamson, 2003)
Nenova (2003) finds that the benefits from control are lower in countries
with a Scandinavian civil law tradition than in common law countries.
Coffee (2001) argues that the tradition of Scandinavian civil law is similar

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to other civil law traditions, hence, the lower benefits from control in
Scandinavian economies cannot be explained by differences in legal
systems.
Licht (2001) used a cross-sectional sample of countries from around the
world and drew on two models of cultural dimensions in cross-cultural
psychology to analyse the relations between investors’ legal rights — as
reflected in the indices of La Porta et al. (1998) — and national cultural
profiles (cultural value dimension (CVD). These dimensions include
Harmony, Embeddedness, Hierarchy, Mastery, Affective Autonomy,
Intellectual Autonomy, and Egalitarianism. The findings indicate that there
is a relation between a country’s shareholder and creditor rights indices and
the attitudes of that country towards the examined values.
Stulz and Williamson (2003) used La Porta et al. (1998) data on legal
families, shareholder rights, and creditor rights to examine if the
differences in culture, proxied by differences in religion and language,
could explain differences in investor protection across countries. The results
indicated that the relation between culture and investor rights seems
especially strong for creditor rights. Catholic countries systems seem to
induce a weaker protection of creditors’ rights and increase the legal
formalities to enforce contracts. This may be attributed to the close
association between state and church in some Catholic countries, where
bureaucracies originated in religious ranks adopted the hierarchical
structure of the Catholic Church.
The discussion above clearly indicates that the legal origin argument is
controversial. A large literature criticizing LLSV shows the relevance of
questioning, among other things, the criteria used for formulating the
investor protection measure and hence questioning their results. Such
criticisms in turn suggests that the empirical evidence concerning the
importance of minority shareholder protection for financial markets
performance is far from being irrefutable as well. This thesis takes these
criticisms into consideration and contributes new evidence on whether and
how legal protection of shareholder matters for financial market
development with particular reference made to the MENA region.
Accordingly, while the fourth chapter will discuss elaborately the relation
between minority shareholder protection and corporate finance, the

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following section will present the different approaches employed by legal
systems to tackle minority shareholders appropriation.
Politics Investment Economics Economy Finance
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