Two Decades of Law & Finance: What Concept of Law (if any)?

In 2017, the so-called Law and Finance School (‘LFS’) will celebrate its 20^th anniversary. Starting with Rafael La Porta, Florencio Lopez-de-Silanes, Andrey Shleifer, and Robert Vishny’s two seminal articles from 1997 and 1998 respectively (La Porta et al 1997, 1998), a plethora of papers have since presented a sheer endless number of variations on the initial argument that ‘law matters’ for corporate governance, financial development, and ultimately economic growth (more precisely: the legal level of minority shareholder protection determines companies’ ownership structures, and thus the size of stock markets).

The LFS has also given rise to a large critical literature, which challenges several of the LFS’ key aspects, including the way in which law is measured (Spamann 2010; Armour et al 2009); the claim that systematic differences in legal institutions across countries stem from their ‘legal origins’ (Siems 2007; Aguilera & Williams 2009); and the claims about substantive differences in company law causing differences in corporate governance outcomes, defying, thus, the ‘law matters’ thesis altogether (Cheffins 2000; Coffee 2000). In reaction to some of these criticisms, the LFS has increasingly moved away from making specific claims about the role of substantive differences in national company laws, towards broader claims about differences in countries’ ‘regulatory style’, in the relationship between the judiciary and the government, and even in ‘philosophies of government’.

This paper proceeds on the assumption that dodging criticisms about the ‘law matters’ thesis by defining ‘law’ increasingly broadly and vaguely is the wrong answer. Rather, what the LFS needs is a better theoretical grounding that allows researchers to specify not just that law matters, but also how and why we would expect it to matter. In other words, we disagree with critics who argue that the LFS takes law too seriously; rather, it does not take it seriously enough. The review of forty-six LFS papers published between 1997 and 2015 reveals that there simply is no coherent concept of law underlying this stream of law and economics.

Different studies have criticised aspects of the LFS’s concept of law, such as its narrow focus on law’s protective function (Milhaupt & Pistor 2008) and its neglect of law’s inherently dual nature as an instrument of private and public ordering (Deakin et al. 2015). This paper builds on these criticisms, but provides a more comprehensive attempt to systematically map the concept of law that can be found in the LFS. It focuses on three dimensions of a concept of law: law’s nature and role in the economy, its relationship with morals and other extra-legal standards, and its role in creating ‘reasons for action’. The paper shows that the LFS’s concept of law is internally incoherent and is inconsistently applied. Thus, while some LFS studies explicitly draw on the Hayekian concept of law as a functional-evolutionary system, they depart from the Hayekian theory in their strong teleological focus on legal reforms. Similarly, the LFS strongly focuses on law’s coercive function via the threat of punishment and enforcement in courts of laws. This suggests proximity with a classical Austinian legal positivist view, which the LFS rejects explicitly and resolutely in other passages, notably regarding the positivists’ purely formal-procedural definition of law. Finally, we observe a recent ‘legal realist turn’ in the LFS that seems to results from the application of the ‘homo oeconomicus’ model of man not just to managers and shareholders – as in classical agency theory –, but also to judges. Contrary to earlier LFS studies (that stipulated that common law systems gave judges much leeway to protect shareholder interests), judges too are now considered to pursue their own interests rather than those of shareholders. This focus on what judges make of the law suggests proximity with legal realism, but contrasts with distinctly non-realist elements in the LFS, most important of which is the largely substantive definition of ‘good law’. All these disparate elements of legal theory in the LFS studies clearly do not add up to a coherent concept of law.

This is an astonishing finding given the centrality of law as main explanatory factor of various outcomes in the LFS. It may also go some way in explaining why the empirical findings from LFS-inspired studies are often weak or not robust (see Schiehll & Martins 2016).

The paper concludes by arguing that we need to take legal theory and philosophy seriously in order to develop more robust empirically testable propositions and research designs to investigate not just whether but also how law matters. This is a daunting endeavour, which requires interdisciplinary expertise. Based on the present paper, we now collaborate with Ruth Aguilera (Northeastern University), Simon Deakin (University of Cambridge), Katharina Pistor (Columbia University), and Mathias Siems (Durham University) to further explore ways in which to achieve this goal.

References:

Aguilera, R. and Williams, C. (2009). “’Law and Finance’: Inaccurate, Incomplete, and Important,” Brigham Young University Law Review 2009(6): 1413-1434

Armour, J., Deakin S., Sarkar P., Siems M., and Singh A. (2009). "How do legal rules evolve? Evidence from a cross-country comparison of shareholder, creditor and worker protection." CBR Working Paper 382.

Cheffins, B. R. (2001). "Does Law Matter? The Separation of Ownership and Control in the United Kingdom." Journal of Legal Studies 30.

Coffee, J. C. (2000). "The Rise of Dispersed Ownership: The Role of Law in the Separation of Ownership and Control." Columbia Law and Economics Working Paper 182: 1-95.

Deakin, S., Gindis, D., Hodgson, G., Huang, K. & Pistor, K. (2015). Legal Institutionalism: Capitalism and the Constitutive Role of Law. CBR Working Paper, 1-40.

La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny. (1997). "Legal Determinants of External Finance." the Journal of Finance 52(3): 1131-1150.

____ (1998). "Law and Finance." Journal of Political Economy 106(6): 1113-1155.

Milhaupt, C. J. and K. Pistor (2008). Law & Capitalism: What Corporate Crises Reveal about Legal Systems and Economic Development around the World. Chicago, Chicago University Press.

Schiehll, E. & H. Martins. (2016). “Cross-National Governance Research: A Systematic Review and Assessment,” Corporate Governance: An International Review, 24(3): 181-199.

Siems, M. (2007). Reconciling Law & Finance and Comparative Law. McGill Law Journal, 52, 55-81.

Spamann, H. (2010). "The “Anti-Directors Rights Index” Revisited,” Review of Financial Studies 23(2): 467-486.

Gerhard Schnyder is a Reader in Comparative Management at King’s College London.