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The Concept of Law in ‘Law and Finance’: Towards a Comprehensive Framework

Gerhard Schnyder

[email protected]

Paper to be presented at the

28th Annual SASE Meeting University of California, Berkeley

June 24-‐26, 2016

Very first draft – work in progress

ABSTRACT

Since its inception in the late 1990s, the Law and Finance School (LFS) has become a very influential line of research in the area of corporate governance. La Porta and co-‐authors have published a series of papers that argued for the crucial importance of law in determining countries’ corporate governance systems. As the name of the school suggests, law is considered a key variable in explaining both corporate governance outcomes and overall economic performance. This paper reviews the LFS literature and shows that in spite of the centrality of law, it is based on a surprisingly ‘thin’ theory of law and does not have much to say about how law is conceptually expected to impact firm-‐level practices. In other words, while a lot of effort has gone into empirically showing that law matters for corporate finance and governance outcomes, much less effort has been spent on the question how we would expect law to matter. The paper shows that this is a major neglect that not only limits the theoretical contribution of the LFS, but also undermines empirical strategies used to test the link between law and economic outcomes. The present paper aims to fill this gap by developing a more comprehensive and theoretically grounded framework that explains not just whether, but how law can be expected to impact economic outcomes via corporate practices. The paper discusses implications for empirical research by developing empirically testable propositions regarding the link between law and finance.

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1. Introduction

Scholars have argued for some time that certain wide-‐spread theories in management scholarship, such as agency theory, adopt a ‘thin view of institutional environment[s]’ (Aguilera & Jackson 2003: 449). This tendency can even be observed in fields of studies that attribute much importance to the explanatory power of institutional factors such as law. Indeed, this paper shows that the Law and Finance School (hereinafter LFS) has astonishingly little to say about law considering that law figures so prominently as its key explanatory variable.1 The paper argues that this is a serious neglect, which not only limits the conceptual and theoretical contribution of the LFS, but also undermines empirical studies that attempt to test hypotheses derived from the LFS. More precisely, the LFS is crucially based on the notion that ‘law matters’ for economic outcomes (Coffee 2000, Armour et al. 2009a). Yet, the extant literature remains surprisingly silent about the conceptualisation of how exactly ‘law matters’, i.e. how law affects firm-‐ and macro-‐level economic outcomes.

The LFS has come under a great deal of criticisms on various grounds. For one their measure of the quality of company law have been in terms of the consistency of coding (Spamann 2006, Braendle 2005) and the choice of variables to be included (Armour et al. 2009a). Moreover, various aspects of the historical analysis as well as the characterisation of common-‐ versus civil law that the LFS provides have been criticised and rejected (e.g. Dam 2006; Siems 2007, 2005). The proponents of the LFS have reacted, on the one hand, by developing new empirical measures (Djankov et al. 2008) and, on the other, by retreating somewhat from the originally strong claims about the causal importance of substantive legal rules in explaining corporate governance outcomes. Indeed, the Anti-‐Director Rights Index (ADRI) used six items as substantive criteria to proxy for the level of legal minority shareholder protection (MSP). Increasingly, however the focus shifted towards more basic differences in the functioning of legal systems in different countries. Glaeser & Shleifer (2002), for instance, see the main difference between English common law and French civil law in the degree of centralisation of the legal system and the level of control of the ‘sovereign’ over judges: “the difference [between common and civil law] can be plausibly trace to the fundamental choice of state-‐controlled versus independent justice” (p.1196). Many other studies in the area reveal an even broader understanding of the differences, whereby the different types of legal systems are mainly a proxy for different degrees of state intervention in the economy or for different ‘regulatory styles’ (La Porta, Lopez-‐de-‐Silanes, Shleifer (LLS) 2008). This has also raised questions whether it is indeed law that matters for economic outcomes, or whether other, unmeasured factors – such as historical contingency and politics – may have more explanatory power (Coffee 2000, Cheffins

1 For a similar point about ‘property rights’ in economics more broadly see Deakin et al. 2015; Lueck & Miceli 2007.

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2001, Roe & Siegel 2009). These are well-‐known criticisms and replies, which have been extensively discussed in the literature (see for instance Deakin et al. 2011; Armour et al. 2009a).

The present paper starts from there, arguing not so much that the LFS overplays its hand when stating that ‘law matters’, but that it does not provide the theoretical tool to understand why and how we would expect it to matter. In other words, the LFS’s problem is not that it takes law too seriously, but that it does not take it seriously enough. The solution to the criticisms of the LFS should not be to abandon the investigation of how substantive differences in laws affect differences in corporate governance outcomes, but to develop and then test a more solid theoretically-‐based framework of how we would expect law to matter.

An extensive review of the articles that can be considered the core of the LFS to date, confirms previous scholarship’s observation that the LFS narrowly focuses on the ‘protective function of law’ (Milhaupt & Pistor 2008), but it also reveals that it is based – often implicitly – on a narrow conception of how law impacts (economic) actors. This view comes closest to what is known in legal theory as ‘the coercive view of law’ where the main mechanism of how law matters is through threat of punishment. The literature review also shows that the LFS draws on various strands of legal scholarship, but that the ‘concept of law’ that is emerging is not coherent and indeed may be contradictory across different studies. This paper argues that this is a non-‐negligible omission, which may be part of the explanation why it has been proven surprisingly difficult to clearly establish a link between legal MSP and economic outcomes (see Coffee 2001, Cuomo et al. 2012). If we are interested in testing the question ‘does law matter?’ it would seem important to first ask the question ‘how do we expect law to matter?’ The latter question hinges, in turn, on a clear conceptualisation of the link between laws and firm-‐level practices. Legal theory has been used to great effect to advance management theories, where such theories are oftentimes needed, but rarely explicitly marshalled (see Oosterhout et al. 2006 for the use of Fuller’s (1964) concept of internal morality to advance business ethics, Lan & Heracleous 2010 for the use of legal theory to advance agency theory). In a similar vein, this paper attempts to remedy the considerable shortcoming in the LFS by explicitly developing empirically testable hypotheses based on legal theory.

The paper proceeds as follows: Part two reviews what the LFS literature has to say about how law impacts firm-‐level outcomes. Part three presents current debates about the coercive view of law and presents an alternative conceptualisation of the link between law and firm-‐level outcomes, based on legal theory. Part four develops testable propositions based on the preceding discussion. A last part concludes.

2. Literature Review: The ‘Thin’ Concept of Law in Law & Finance

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The Law and Finance School is a term that has come to be used to designate an approach related to a series of influential papers co-‐authored by La Porta, Lopez-‐de-‐Silanes, Shleifer and Vishny (often shortened to LLSV) and various co-‐authors starting in 1997.2 It is broadly speaking cognate to New Institutional Economics (NIE) and the Law and Economics (L&E) school with both of which it has affinities, but also certain differences. The LFS started of by focussing on investigating in comparative fashion the impact of legal factors on different characteristics of firm-‐level corporate finance and corporate governance. As this section will show, over the years, however, it has increasingly broadened its scope, going beyond company law – and indeed law per se – as key independent variable, investigating instead broad institutional-‐regulatory factors’ impact on various economic and societal outcomes. Thus, authors associated with the LFS have investigated as independent variables employment protection, bankruptcy law, creditor protection, and broader factors such as constitutional provisions. The dependent variables were initially ownership structures (dispersion or concentration) and market capitalisation, but then came to include a variety of outcomes including firm-‐level growth and military conscription (see for a summary of the first ten years of the research La Porta et al. 2008).

This section provides a systematic review of the work that can be considered the core of the LFS. To this effect, a list of all articles published by the original authors LLSV since 1997 was compiled based on their personal web pages and online Curricula Vitae. Articles that did not focus on legal or institutional factors as key explanatory or dependent variables, but only included them as controls and articles that did not refer to the LFS main claims at all were excluded (e.g. Chong et al. 2014). Similarly, papers that did have legal factors as their key variables, but focused on an area other than corporate governance and finance were excluded (Djankov et al. 2010 on disclosure regulations for politicians). To these papers, a handful of articles authored not by the original group (LLSV), but by later co-‐authors and articles in the LFS tradition often cited by LLSV were added. Overall, this left us with 42 articles published between 1997 and 2015, which can be considered to constitute the core of the LFS.

This section attemtps to distill from this wealth of publications the concept of law that underlies the LFS. The question the paper tries to answer is: what are the theortical assumptions regarding the impact of law on economic outcomes that inform the LFS research programme? The section proceeds by first explaining the two core claims of the LFS, which are the ‘quality of law claim’ (QLC) and the ‘legal origins thesis’ or theory (LOT). The initial ambition of the LFS was to explain cross-‐

2 Initially, this approach designated itself as the ‘legal approach to corporate governance’ (e.g. LLSV 2000: 4), but it soon branched out to investigate phenomena that go well beyond corporate governance and finance, which makes the term LFS more appropriate.

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country differences in ownership structures and the availability of external finance (LLSV 1997, 1998, 1999a). The key argument and main novelty of LLSV’s work was to argue that it was a country’s laws that determined different corporate governance structures across countries (size of stock markets, type of corporate finance, ownership structure). More precisely, the LFS focused on certain substantive characteristics of a country’s company law, which taken together, provided a measure of its ‘quality’, where quality meant high levels of minority shareholder protection (LLSV 1997, see Armour et al. 2009a). However, the LFS quickly evolved from explaining economic outcomes based on the QLC, to a more fundamental argument that has been termed the Legal Origin Thesis (LOT) (see Armour et al. 2009a). The LOT links the characteristics of law to more fundamental features of a country’s legal system and distinguishes in particular common law from civil law countries.

This section discusses both these central claims in turn. It then turns to analysing what concept of law the LFS is based on by asking three questions in order of increasing specificity: Firstly, and very broadly, what postulates does the LFS make about the importance of law in the economy? Secondly, how does the LFS define ‘good’ law? Thirdly, what does the LFS have to say about the way in which law impacts economic actors?

2.1 The Quality of Law Claim: Property Rights and the Protective Function of Law

The quality of law claim hints already at an important element of the LFS’s conception of law, i.e. the importance attributed to the protective function of law. Scholars have criticised the LFS for narrowly focussing on just one function of law, namely the protective function (Milhaupt & Pistor 2008). Indeed, the quality of law is largely defined as the extent to which company law protects investors’ rights and in particular their property rights. In their seminal article ‘Law & Finance’ from 1998, LLSV state that

“Law and the quality of its enforcement are potentially important determinants of what rights security holders have and how well these rights are protected. Since the protection investors receive determines their readiness to finance firms, corporate finance may critically turn on these legal rules and their enforcement” (p.1114)

Similarly, LLSV (2000:4) state that:

“The legal approach to corporate governance holds that the key mechanism is the protection of outside investors (whether shareholders or creditors) through the legal system, meaning both laws and their enforcement. […] To a large extent, potential shareholders and creditors finance firms because their rights are protected by the law. These outside investors are more vulnerable to expropriation, and more dependent on

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the law, than either the employees or the suppliers, who remain continually useful to the firm and are thus at a lesser risk of being mistreated.”

Two points are important here: firstly, it is indeed the function of protecting property rights which is at the heart of the LFS from the beginnin; Secondly, the first quote hints at the fact that shareholder rights are not just protected by law, but may actually be created by law in the first place (« what rights security holders have »). This hints at the constitutive function of law (Deakin et al. 2015) whereby law does not just protect certain pre-‐existing or objective rights or states of fact, but it actually is the reason why these rights exist in the first place. This quote from 1998 is, however, one of the rare places in the LFS where the constitutive function is acknowledge and it is not done explicitly. Most of the LFS literature seems rather to suggest that shareholder rights pre-‐exist the law and are or are not protected by a given country’s legal rules. This latter view may derive from the “contractual view of the firm” (Jensen & Meckling 1976, Grossman&Hart 1988, Hart 1995) which LLSV cite as the basis for the LFS. Thus, the contractual view “[…] sees the protection of the property rights of the financiers as essential to assure the flow of capital to firms” (La Porta et al. 2008: Footnote 1). However, it also explains why shareholder rights may be conceived as pre-‐legal in nature: they may be contractual rights that simply are protected under general contract or tort law. To be sure, the LFS distinguishes itself from other streams in the NIE tradition and from L&E precisely by going beyond the purely contractualist view (e.g. Stigler 1964; Easterbrook & Fischel 1991; cf. Glaeser & Shleifer 2002: 1223). This departure from the Coasian approach, however, is mainly explained by a stronger focus on problems with judicial enforcement of complex contracts, which may make (public) legal rules more efficient than purely private contracting (Glaeser et al. 2001). The contractual view still remains, however, the basis for the LFS (see LLS 2008), which may explain why it tends to neglect the constitutive function of law regarding shareholder rights.

Consequently, the protective function of law is at the centre of the quality of law claim. The law’s role is to protect economic actors’ – here minority shareholders’ – property-‐ and other rights (similarly LLSV 1997: 1149; Mahoney 2001: 523). Various LFS studies refer to the long pedigree of this idea, citing Smith (1776) and Montesquieu (1748) – and at times Locke 1690 – as the main sources for the insight that ‘good economic institutions must secure property rights’ (Djankov et al. 2003: 596 [new comparative economics]; also Djankov et al. 2003[courts]: 453; Glaeser et al. 2003: 200; 2004: 272; La Porta et al. 2004).

The protection of property rights explains then the link with financial development. If institutions – which are equated here with law (see discussion below) – enable “people to keep the returns on their investment, make contracts, and resolve disputes” (Djankov et al. 2003: 596), then a sentiment of security will lead people to invest their capital, rather than burying it in their garden, promoting thus the development

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of financial markets (ibid. citing Smith 1776). In modern terms, if laws guarantee property rights and hence return on investments, the incentive structure will be such that sources for external finance are readily available to companies, allowing firms to grow faster (Levine 1999).

Legal scholars have criticised this narrow conception of law. Milhaupt and Pistor (2008: 17) write: ‘According to the prevailing view, law fosters economic activity (exclusively) by protecting property rights.’ And to continue: ‘This view amounts to ‘a formalistic and deterministic view of the relation between law and markets’ (Milhaupt & Pistor 2008: 7-‐8; also Armour et al. 2009a).

To be fair, though, some of the LFS articles do contain a somewhat more variegated view of the functions of law than the usual narrow focus on the protection of property rights. Thus, Djankov et al. (2003: 596) state that:

“Since the days of the Enlightenment, economists have agreed that good economic institutions must secure property rights, enabling people to keep the returns on their investment, make contracts, and resolve disputes.”

Here, two additional functions of law are mentioned: Enabling people to make contracts hints at the enabling-‐ or coordinative function of law rather than its protective one. Indeed, the type of enabling legal rules defining the criteria that a valid contract has to fulfil are a fundamentally different type of legal rules compared to rules that constrain actors by proscribing or prescribing certain behaviours (cf. Hart 1961 discussed below). Solving disputes is the third function that Djankov et al. (2003) refer to. This is a function of law that mainly relates to the laws enforcement through litigation or other dispute settlement procedures. Yet, if some papers suggest a broader conceptualisation of why law is expected to matter, Milhaupt and PIstor (2008) are right in saying that this is done only in passing and there is no discussion of the theoretical or empirical implications of this multi-‐functionality of law on the causal link between law and economic outcomes.

The literature distinguishes different very broad functions of law. Very broadly speaking, the Thomist view holds that the primary function of law is to guide conduct, which is also the view Fuller (1969) adopts. Others include doing justice (Moore 1992) and licensing coercion (Dworkin 1988). In addition, Finnis (1980) sees law’s main purpose to be to coordinate activity. This coordinative function of law is important but very largely neglected in the LFS literature (MIlhaupt & Pistor 2008). This function does not consist in law primarily determining and protecting actors’ rights, but provides them with instruments that help them coordinate their economic activities with other actors while negotiating the precise allocation of property rights within the boundaries of the law (Milhaupt & Pistor 2008: 7). Legal instruments such as contracts come closer to the second function than to the protective function.

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In the earlier papers of the LFS’s formalism was expressed in the definition of the quality of company law via a simple indicator capturing the extent of shareholder protection. This Anti-‐Director Rights Index (ADRI) was simply the sum of six dummy variables, which measured different shareholder rights that were – according to LLSV’s assessment – crucial for shareholders’ to make sure they get ‘their money back’ (cf. Shleifer & Vishny 1997). Here, the LFS uses a substantive definition of the quality of law directly associated with six specific rights. However, it very soon changed somewhat in focus. Rather than measuring the ‘quality of law’ per se, the focus shifted to a more fundamental – and in some respects contradictory claim – namely that different legal origins of countries’ company laws was the underlying factor explaining the differences in the nature of law and hence in economic outcomes. The next section turns to this second key claim.

2.2 The Legal Origin Theory: A Broad Conception of Law…or Something Else?

The legal origin theory (LOT) associates economic outcomes not so much with the substantive content of laws, but with the more fundamental nature of the ‘regulatory style’ in a given country (La Porta et al. 2008). In this respect it stands in contradiction with the QLC. The latter suggests that countries can choose their laws in an instrumental fashion to achieve certain desired outcomes. Indeed, the need for (radical) legal reform is one of the key themes of the LFS and is explicitly advocated in various papers (see in particular Hay & Shleifer 1998, LLSV 1999a: 512; 2000; Johnson et al. 2000; LLSV 2006) and has indeed been applied in the investor protection section of the World Bank’s ‘Doing Business’ programme (Ohnesorge 2009). The LOT, on the other hand, suggests very strong path dependence at work, which makes it highly unlikely that a country can move away from its original legal system whose fundamental characteristics may have been established as far back as the 12th century (Glaeser & Shleifer 2002; cf. Armour et al. 2009a).3

Initially, the LOT was born out of a methodological concern: Since there is a difficult question about the endogeneity of law and the economic context (see Glaeser et al. 2004), LLSV used ‘legal origin’ as an instrument variable to control for this endogeneity (LLSV 1999a: 505). Legal origin was first simply defined as the historical origin of a country’s legal system in one of four ‘mother systems’: Common Law, French-‐, German-‐, and Scandinavian Civil Law (LLSV 1998: 1126). Despite its methodological beginnings, legal origin soon acquired a life of its own and became the key explanatory variables in the LFS framework. Subsequently, various economic and societal outcomes were explained referring to legal origins rather than substantive features of company law as the main explanatory variable.

3 The main mechanism via which this path dependency can be overcome however, is through ‘legal transplants’, i.e. the import of legal rules from other countries either voluntarily, through conquest or colonialisation (e.g. Djankov et al. 2003). The concept of transplants and problematic ‘transplant effects’ (Berkowitz et al. 2003) associated with it raise a whole host of new questions (see for a discussion Larsson-‐Olaisson 2014).

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Thus, LLS, in a review article of their own research, list among the outcome variables that can be explained by legal origins: government ownership of banks, the burden of entry regulations, regulation of labour markets, incidence of military conscription, and government ownership of the media (La Porta et al. 2008: 286).

However, the idea of legal origins and the use of the concept in empirical research has been extensively criticised. Siems (2007) has shown that it is far from obvious how to classify different countries into one of the four ‘mother systems’. Also, critiques have observed that the LFS is not clear on the precise mechanism that explains why legal origins should matter, or in other words why common law should be expected to be superior to civil law in terms of economic outcomes (see Armour et al. 2009a). The question arises whether legal origin develops its effect indeed through the quality of company law to cause the observed outcomes, or whether legal origin is a proxy for something else, e.g. culture (Armour et al. 2009b; see Mahoney 2001 for an acknowledgement of this point).

The most explicit acknowledgement perhaps that LOT is about something quite different than law is a paper by Mahoney (2001). The author uses Hayek to argue that it is not the substantive nature of laws in common law countries that explains their superior economic outcomes, but the different philosophies of government and the resulting differences in the structure of the state. In a nutshell, common law countries tend to define liberty based on the Humian-‐Lockian tradition as individual liberty, while civil law countries follow a Hobbesian-‐Rousseauist tradition of seeking to achieve liberty through collective goals pursued by the state (Mahoney 2001: 511). This philosophical difference leads according to Mahoney (2001) to a difference in the structure of government: common law countries tend to adopt institutions that fragment the power of government, by creating various independent authorities (e.g. the courts), while civil law countries tend to concentrate governmental power more, which also implies that institutions such as courts are less independent from the executive branch of government. More importantly for the purpose of this paper, however, Mahoney’s (2001) analysis moves away from the LFS focus on the role of law in the economy.

Other LFS papers, however, do attempt to specify more precise mechanisms that link legal origins to outcomes. The most explicit discussion identifies two channels: firstly, the ‘adaptability channel’ and secondly the ‘political channel’ (Beck et al. 2003).

The adaptability channel claims that common law systems allow judges more discretion in interpreting legal rules on a case-‐by-‐case basis than civil law systems. This leads to efficient evolution of the law through litigation and elimination of inefficient rules by courts (Beck et al. 2003 citing Posner 1973). The litigation-‐based system of common law also implies that judges have a great deal of discretion, which they can use to apply broad principles such as ‘fairness’, ‘fiduciary duty’, ‘duty

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of loyalty’, and ‘duty of care’ to cases that are not explicitly covered in any statutory law (Johnson et al. 2000). Consequently, common law judges can react to new kinds of wrongdoings by insiders and protect investors efficiently (LLSV 2000). Civil law, on the other hand, is seen as rigid, formalistic, and based on the principle that anything that is not explicitly forbidden is allowed (LLSV 2000: 9). As a result, insiders will be able to invent new ways of expropriating shareholders without the judges having any means to stop them from doing so, unless the law changes. Broad common law principles may hence be a better way of protecting investors than the written ‘bright-‐line rules’ typical of civil law statutes.

Various authors have criticised the LFS for this – in their view – too strong contrast between the two generic legal systems, which is according to them greatly exaggerated and out-‐dated, underestimating the adaptability of the civil law system (see Armour et al. 2009b, Dam 2006, Siems 2007, Roe & Siegel 2009). Siems (2007) showed that civil law systems use ‘framework laws’, which provide quite a substantial amount of flexibility for judges to adapt bright-‐line rules to changing circumstances. Dam (2006) argued forcefully that in today’s world, the idea that common law countries relied less on statutes and regulations and more on principles such as ‘fiduciary duty’ was plain wrong, as codification has increased dramatically even in common law countries. As for the efficiency of litigation, Posner himself – who had introduced the thesis of efficiency of common law (Posner 1973) – together with authors from the LFS have found contrary evidence to the notion that common law converges to efficiency thanks to ‘adversarial adjudication’ through private litigation. Based on a case study of the so-‐called Economic Loss Rule (ELR), Niblett et al. (2010) found no convergence to efficiency over a 30-‐year period of litigation.

The second, ‘political’ channel by which legal origin affects the quality of law refers to two fundamentally different goals of law in the two systems: common law, so the argument runs, was mainly created to protect private property rights against the power of the English monarchy, while civil law emerged to strengthen the grip of the French king over powerful local interests (Glaeser & Shleifer 2002) and was further developed after the French revolution to “solidify state power”, to limit the leeway of judges (Beck et al. 2003: 654), and to implement state policy (LLS 2008: 286; also Mahoney 2001; Djankov et al. 2003). While earlier LFS studies suggested that legal origins diverged after the French revolution, Glaeser and Shleifer (2002) argue that these differences can be traced back to the 12th century when France and England made fundamental choices about the centralisation or decentralisation of state control over the judiciary. While the English crown in the 12th century enjoyed a relatively peaceful phase and enjoyed strong control over local lords, France was in a state of contestation of the King’s power by local lords, which implied that there was a threat to law enforces at the local level (Glaeser & Shleifer 2002). As a result, the French crown moved to a centralised system based on state-‐employed judges in order to protect law enforces from strong local pressures, while the English

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monarchy had the luxury of relying on a decentralised judiciary system thanks to the relative weakness of local lords (Glaeser & Shleifer 2002). Fundamentally, then, the difference between civil law and common law is one of state control versus independent judiciary (Glaeser & Shleifer 2002: 1196).

On this account, a key difference between different legal origins is indeed ‘judicial independence’. La Porta et al. (2004) investigate the role of constitutional rules of judicial independence, as an important check in a political system. They find indeed that judicial independence leads to greater economic freedom and conclude that it might be the ‘micro-‐foundation’ of the positive impact of English legal origin on economic outcomes (La Porta et al. 2004: 449). This analysis, based on constitutionally guaranteed checks-‐and-‐balances enshrined in the political system, however, seems already far removed from the substantive claims made about the quality of law in the earlier work.

This shift away from a narrow – but seemingly clear – definition of legal origins as a country’s legal system being ‘rooted in one of the four mother systems’ and being associated with substantive legal features, is quite explicit in the LFS literature. More recent LFS studies explicitly define legal origin as “a style of social control of economic life (and maybe of other aspects of life as well)” (LLS 2008: 286), where “English Legal Origin is a broad indicator of a market-‐supporting regulatory stance” (Gennaioli et al. 2014: 290). Mahoney (2001: 523) explicitly rejects the substantive link and argues that legal origins reflect different ‘philosophies of government’.

The more recent definitions of legal origin, then, are not so much about specific, substantive characteristics of common law versus civil law, but rather about the different purposes and structures of the legal and indeed political systems in these two broad families. The purpose of common law is, according to this interpretation, one of dispute resolution, while civil law is considered to have as its main purpose to implement state-‐made policies (LLSV 2008: 285, citing Damaska 1986; Glaeser & Shleifer 2002). Common law is hence considered less politicised, leading to smaller and more fragmented governments, and focused on supporting private market outcomes, while civil law seeks to achieve ‘state-‐desired allocations’ through centralised policy implementation (LLS 2008).

This does raise the question why we should use legal origin to capture such broad characteristics of the polity (e.g. judicial review and independence) rather than using measures of the centralisation of policy-‐making, the number of formal veto points in policy-‐making, or similar measure of the (de-‐)centralisation of a polity common in political science. More importantly, however, this shift towards increasingly broad definition of legal origins leads the LFS, however, to the verge of rather culturalist arguments about the superiority of certain civilisations over others. LLSV (2004: 445) most explicitly make this point stating that there are “significant benefits of the Anglo-‐American system of government for freedom.”

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Already LLSV (1997b:333) employed similarly culturalist arguments essentially arguing that Catholicism (and Islam) are inferior to Protestantism in terms of economic outcomes, because they prevent the emergence of ‘horizontal trust’ among people.

In short then, the LFS – also pressured by critiques of the initial claims – has moved into a increasingly broad – but also vague – theory that ultimately does not say much more than that market-‐based, non-‐interventionist system of the Anglo-‐Saxon countries is superior to others in terms of economic development and freedom.

In this sense, the very designation of this stream of research as ‘Law & Finance’ becomes a misnomer, because the causal arguments made are very marginally about law and are much more about broad characteristics of the role of the state and of markets in different countries. Civil law features such as more government ownership, more regulation, and closer ties between the government and the judiciary are expected to lead to more corruption, rent-‐seeking, a larger informal economy, and higher levels of unemployment. Common law is associate with legal independence, contract enforcement, and hence protection of property rights, which is associated with better economic outcomes (LLSV 2008: 286).

This is an unfortunate development, because it moves the attention of the theory away from explaining not just that law matters, but also how it matters. Indeed, a central thesis of the present paper is that the shift from quality of law to legal origins, however defined, has considerably weakened the analytical power of the LFS approach and has undermined the initial attempts to contribute to our understanding of the impact of institutional factors on economic outcomes. The more recent LFS studies could quite conceivably renounce any reference to the law. The goal of the present paper, however, is to investigate and refine our understanding of why we would expect law to play an important role in the economy. Therefore, moving away from questions substantive law to broader historical, cultural, and political factors does not seem to be the right strategy. Instead, we ask a series of questions regarding the concept of law in the LFS, which will allow us to further clarify – rather than avoid – the question of how law matters.

2.3. What is the role of law in the economy?

As noted above, it is certainly a key contribution of the LFS to have brought ‘law’ into the debate on what determines differences in national corporate governance systems. In this respect, LFS can broadly be categorised as a New Institutional Economics (NIE) approach (LLSV 1999b). Ronald Coase, Harold Demsetz and Douglas North’s work – all of which are usually associated with the NIE approach – are often cited in the LFS literature. In this respect, LFS may also be considered close to the Law and Economics school, which is often associated with the rise of NIE. However, LLSV are clear on distinguishing their approach – which they call ‘legal approach to corporate governance’ in some of their papers (LLSV 2000) –

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from the L&E school. Thus, LLSV (2000: 7) state that “The emphasis on legal rules and regulations protecting outside investors stands in sharp contrast to the traditional `law and economics’ perspective on financial contracting.” Indeed, they reject the more libertarian ideas in the field, which consider – based on the Coase theorem (Coase 1960) – that rational actors will find optimal solutions to allocation problems via private contracts, as long as the contracts are enforced (Stigler 1964; Easterbrook&Fischel 1991). In such situations no regulations of markets is required. The LFS rejects this view and emphasises the importance of laws and even government regulation in certain – limited – circumstances when enforcement of contracts cannot be taken for granted (LLSV 2000: 7). Indeed, much of the LFS literature is about finding out under what circumstances certain institutional choices are optimal. Most explicitly, Glaeser and Shleifer (2003: 403) argue that depending on the general level of ‘law and order’ in a country, a system based on pure private litigation in public courts may not be optimal.4 Rather, if law and order is only moderate in a country, some state regulation may be more efficient. Law and regulation play hence have a more important – and potentially more benign – role than in the traditional L&E literature. To be sure, the LFS is eager to stress that state intervention is always second best to private, decentralised, market-‐based solutions. Thus, Glaeser and Shleifer (2003) consider that private litigation is indeed the best solutions in very advanced countries with high levels of law and order. LLSV (2000: 22) state that government regulation should be used only if contracts are not enforceable. These cases, however, are very rare. Shleifer (2005: 440) approvingly cites the Chicago School’s view that “the domain of market failure or socially harmful conduct that is not automatically controlled by impersonal forces of competition is extremely limited.” Nevertheless, there are cases in which state regulation may be warranted and achieve optimal outcomes. These cases include situations where economic and political inequality is high, which favours the subversion of courts by powerful litigants, leading to a situation where the “strong” not the “just’ win court cases (Glaeser & Shleifer 2002; Glaeser et al. 2003). Depending on the “enforcement environment” – i.e. the cost of enforcement –, different types of legal systems may hence be optimal, including in some cases public regulation (Djankov et al. 2003: 605; Glaeser & Shleifer 2002). Therefore, LFS treats the choice of the optimal legal regime as an empirical question, which leaves room even for state intervention and regulation; although, the authors seem to 4 It should be noted that there is possibly some circularity in the argument here: ‘law and order’ is not defined at the outset of the paper, but p.423 refers to Coase 1960 and equates ‘securing property rights’ with ‘establishing law and order’. This would imply that the above argument essentially states that the protection of property rights via courts or regulation depends on the level of the (de facto?) protection of property rights. From the remainder of the paper, however, it would rather seem that ‘law and order’ is considered to be a more general tendency among a country’s population to respect the law or follow rules. This could possibly be interpreted as a Weberian understanding of legitimacy, i.e. that, in general, laws are accepted to be binding (cf. Green 2013: 489). Either way, the argument does border on tautology here in the sense that they investigate what institutional choices are optimal to secure property rights depending on different levels of ‘law and order’, which in turn is defined as the extent to which property rights are de facto secure.

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consider state intervention second best and only required in situations where the overall institutional or socio-‐economic environment (law and order, inequality) is sub-‐optimal. Thus, on the finding that French-‐civil law countries often have credit registration agencies that do seem to work well, they consider this to be a “rare example of an apparently successful state intervention” (Djankov et al. 2007: 301).

In short then, the LFS distinguishes itself from other branches of NIE in that it is more open to the efficiency of various governance mechanisms and attributes law a larger role in the economy than other approaches. Indeed, while many scholars writing in the L&E tradition consider the role of legal rules to be secondary compared to private contracts (Easterbrook & Fischel 1991) or market forces (Fama 1980), LLSV consider law to matter in important ways for the nature and development of financial markets. This view is based on what LLS (2008: FN1) consider to be the ‘standard proposition’ in corporate law, i.e. that legal protection of outside investors limits expropriation by insiders and promotes financial development.

The originality of the initial LFS studies was also to go beyond this broad statement that ‘law matters’ and empirically determine which aspects of law matter. This question will be investigated in the next sub-‐section.

2.4 What is good law?

The ‘quality of law’ claim is crucial to the early LFS studies. Quality of company law refers to the level of protection from expropriation by insiders that law affords minority shareholders: higher levels of MSP are equated with ‘better quality’ (LLSV 1997, 1998, 1999a, 2000). The choice of the term ‘quality’ is telling here, because it refers to an explicit normative judgement, which is also reflected in the use of terms like ‘improve’, ‘better’, etc. to characterise legal changes (e.g. LLSV 1999a: 505; 2000: 6, 20; Glaeser et al. 2003: 272), and of the terms ‘good law’, ‘good governance’, ‘good government’ (e.g. LLSV 1997a: 1194), which are pervasive in the LFS literature. LLSV (1999b: 223) explicitly state their normative stance writing that they narrowly define ‘good’ as what is “good-‐for-‐economic-‐development”. Good law is hence defined as law that leads to good (or efficient) economic outcomes. This is broadly in line with the economic analysis of law tradition (Posner 1973) and NIE, which is very much concerned with outcomes and the efficiency of law on which the LFS clearly draws. In this context, the early studies present the Anti-‐Director Rights Index (ADRI) as one empirically tested proxy of substantive standards for good company law. These substantive standards, however, are not to be seen as purely the result of positive law. Rather they are standards that ought to apply in any country. Consider the following passage in Johnson et al. (2000: 3), defining “tunnelling” transactions: “[A] controlling shareholder can simply transfer resources from the firm for his own benefit through self-‐dealing transactions. Such transactions [of ‘tunnelling’] include outright theft or fraud, which are illegal

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everywhere though often go undetected or unpunished, but also asset sales, contracts such as transfer pricing advantageous to the controlling shareholder, excessive executive compensation, loan guarantees, expropriation of corporate opportunities, and so on.” This passage shows that transactions are categorised as tunnelling – and hence considered to be ‘bad’ – even when they are not prohibited by the laws of the country in question. Further, the passage even implies that ‘theft’ and ‘fraud’ have an objective existence independent from the positive law in a given country, although they happen to be made illegal in virtually all legal systems. This clearly hints at the existence of external standards to judge the quality of law and reveals the underlying concept of law in LFS.

Similarly, Djankov et al. (2008) investigate the extent to which minority shareholders can oppose self-‐dealing transactions by controlling shareholders. The focus is explicitly on transactions where ‘a controlling shareholder wants to enrich himself while following the law’ (Djankov et al. 2008: 432). Again, if the controlling shareholder follows the law, i.e. the transaction is not illegal per se, the question arises on what normative basis the assessment is made that minority shareholders should be able to prevent the transaction or to sue for damages if it does go through. The implicit answer is that ‘self-‐dealing’ is considered ‘bad’ per se possibly – but not explicitly – based on general principles such as ‘fairness’, ‘fiduciary duty’, or the respect of property rights. But this is precisely the point, if we assess the ‘quality’ of a country’s laws against some external standard, which is not explicitly part of the positive law in question, we are already making assumptions about the concept of law that is being applied. The LFS acts on the assumption that laws have to live-‐up to certain criteria to be considered ‘good’ or even valid.

This view is quite incompatible with both a legal positivist view of the law and with the constitutive function of law. Positivists like John Austin (1832) posited two fundamental principles: Firstly, laws are orders issued by a supreme, legally unlimited sovereign and backed by the threat of punishment. Secondly, such orders do not need to conform with any substantive moral standards or social norms in order to be considered valid law. The fact that it emanates from a sovereign is sufficient. This view is most strongly opposed by natural law theories that consider valid law only law that is in accordance with certain substantive principles. In other words, morally ‘bad law’ is not considered law at all. Strong legal positivism, as defended by Austin and Kelsen (1967), on the other hand posits a strict separation of law and morality and social custom. Therefore, for a legal positivist, the acts that are outlawed as ‘theft’ and ‘fraud’ only become ‘theft’ and ‘fraud’ once the law defines them as such. There may be social norms that consider ‘theft’ and ‘fraud’ to be morally condemnable, but as long as the law does not agree with these social norms, there is no reason to assess the quality of the law against external moral standards about what is right or wrong. Positive law, from this perspective, does not have to follow social morality.

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From the constitutive point of view, ‘theft’ and ‘fraud’ are creations of the law in the first place (see Deakin et al. 2015; Sarat & Kearns 1993). That is to say, if the law does not define them as such, they do not have an object existence outside the law. The constitutive role of the law is neglected by the LFS.

On the other hand, however, certain LFS studies refer to another criterion for ‘good’ law, which is not substantive but what one could call a legitimacy criteria, i.e. the extent to which a given law is enforceable in a given context, because it is acceptable to its population. Thus, LLSV (2000:22) state:

“[G]ood legal rules are the ones that a country can enforce. The strategy for reform is not to create an ideal set of rules and then see how well they can be enforced, but rather to enact the rules that can be enforced within the existing structure.”

The quality of law is hence also related to the question of enforcement. Enforcement is indeed a major concern of the LFS. Different factors affecting the ‘enforcement environment’ are analysed: The competence and incentives of judges (Glaeser et al. 2001; Glaeser & Shleifer 2002;), the degree of subversion of courts by particular interests (Glaeser et al. 2003; Glaeser & Shleifer 2003), the quality of government (LLSV 1999b), as well as characteristics of jurisprudence in common law countries such as the role of precedents (Gennaioli and Shleifer 2007a, 2007b, 2008, Niblett et al. 2010). Here, however, we find an additional element, i.e. that enforcement will also depend on the degree to which laws reflect the ‘communities standards’. Glaeser and Shleifer (2002: 1202) even suggest that a decentralised judiciary implies that ‘community standards of justice’ are more closely reflected in the legal system, which may be one of the reasons for English common law’s superiority.

More fundamentally, the question of proximity with community standards reveals a further departure from legal positivism. Associating the ‘quality’ of law with the degree to which it reflects ‘community standards’ hints at a distinctly non-‐positivist conception of law in the LFS. There are various elements in the LFS literature that confirm this view of a non-‐positivist concept of law. Thus, in a rare explicit reference to legal theory, LLS (2008: footnote 2) associate legal positivism, which they summarise as conceiving of law as the ‘expression of the will of the legislator as supreme interpreter of justice’ with the socialist legal tradition, which they clearly reject (LLS 2008: FN2).

More generally, the above-‐mentioned broad definitions of legal origins also make the boundary between law and other, non-‐legal social norms of conduct more permeable, hinting at a non-‐positivist conception of law. Thus, already LLSV (1997a) hint at the possibility that what drives the association between the legal system and economic outcomes may be societal factors that filter into the legal system. LLSV (1997a: 1150) acknowledge that ‘[l]t is possible that some broad underlying factor, related to trust, influences the development of all institutions in a

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country, including laws and capital markets.’ One such factor, which has been explored in the LFS, is ideology. Thus, Zweigert and Kotz (1998:72) state that "the style of a legal system may be marked by an ideology, that is, a religious or political conception of how economic or social life should be organized". This line of thought is also explored in LLSV (1997b) where the level of trust in a society is related to the prevailing religion in a country. Indirectly, the LFS postulates hence a connection between the law and rules stemming from non-‐legal sources such as ideologies, religions, and – presumably – other moral norms more generally.

Therefore, we can conclude that the LFS rejects legal positivism whose main tenant – at least in its exclusive or hard form – is the notion of a strict separation of law and morals. The LFS’s acknowledgement of ideological, religious, and ‘community standards’ as a fundament for legal rules as well as the assessment of law against external criteria both suggest that laws are conceived of as having to fulfil certain substantive criteria. LFS clearly does not seem to adhere to a positivist conception of law, what alternative concepts of law does it adhere to instead? Here, a discussion of the LFS’s customary conception of legal rules may provide some insights.

Probably the most explicit statement of the view that legal rules necessarily need to be grounded in a society’s practices can be found in Hay and Shleifer (1998: 402): ‘Whenever possible, laws must agree with prevailing practice or custom.’ The reason for this necessary correspondence between law and social practice is not a pragmatic concern with the effectiveness of laws: ‘If public laws violate the practice, then private parties may refuse to enforce them either on their own or with ultimate reference to courts. The coordination benefit of public laws would then be lost’ (ibid. 1998: 402). A gap between social custom or practice and law will hence lead to a reduced efficiency of the legal system. This view is in line with old institutional scholarship and in particular Commons’s (1924) understanding according to which to be enforceable, laws must be perceived as reasonable, appropriate, and fair (see Deakin et al. 2015: 3). This may be interpreted as a concern with a fundamental willingness of a society to follow the law in general. Indeed, the above-‐mentioned concern in Glaeser and Shleifer (2003: 403) that a certain level of ‘law and order’ needs to be present in order for a court-‐based system to be effective. This idea, which we may seem tautological at first glance, becomes understandable if we interpret precisely as implying a certain willingness of the population to accept the law as legitimate. Here this Weberian legitimacy may be the result of the closeness of legal rules to the social morality of the society in question.

Therefore, like LLSV (2000, cf. supra), Hay and Shleifer (1998) define ‘good rules’ in a first instance via their acceptability: ‘good legal rules are those likely to be adopted by private parties for both structuring and enforcing their transactions, as well as used by courts’ (Hay&Shleifer 1998: 401). The definition of ‘good law’ is here a purely pragmatic and practical one, which does not presuppose any specific

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substantive content of legal rules to be considered ‘good’, but simply that they are accepted.

This focus on acceptability recalls what has come to be known as Hart’s (1961) ‘practice theory of rules’ (Hart 2012[1961]: 254-‐5). On this ‘soft’ legal positivist account, legal systems are necessarily based on ‘social rules’, which – however – are not defined in a substantive or normative way, but rather are defined as social practices that are generally used and accepted as guides for action (Hart 2012[1961]: 89). More precisely:

“Social Rules of a group [are defined] as constituted by a form of social practice comprising both patterns of conduct regularly followed by most members of the group and a distinctive normative attitude to such patterns of conduct which I have called ‘acceptance’” (Hart 2012[1961]: 255)

Here, the key characteristic of a valid rule is a widespread expression of endorsement, but not a cognitive belief in the legitimacy of the rule on normative grounds (Perry 2006). This pragmatic and non-‐cognitivist view of rules seems in line with the concept of law that the LFS adopts, albeit implicitly.

However, this view, while acknowledging a fundamental role for norms, downplays the extent of the normative nature of law (Perry 2006). Hart (2012[1961]: 256) himself, in the post-‐script to the second edition of ‘The Concept of Law’ (TCL) – published posthumously in 1994 –,acknowledges that Dworkin is correct in pointing out that the ‘practice theory’ only applies to conventional rules. Conventional rules are defined as rules that are based on a consensus of convention, whereby the reason for people for acceptance of the practice is because most other people follow the rule as well. Such rules are different from the situation where a social practice is followed not by convention within a group, but by its individual members’ independent conviction. Conversely, Hart accepts that his practice theory is not a sound explanation of individual or social morality or enacted – as opposed to customary – legal rules, which do not require specific acceptance as long as they were enacted in accordance with the rules for adopting enacted rules that the rule of recognition establishes (ibid.). The above-‐mentioned view in some LFS studies that legal rules should be customary rules whose main characterised is (or ought to be) their acceptance in a society appears to be subject to the same shortcoming as Hart’s conception of rules as social practice. Indeed, it is at best a partial description of what law is.

The customary nature of legal rules is not the only criterion for their ‘goodness’ however. As mentioned above, in some places, the LFS does make explicit statements about the content of legal rules that substantively defines ‘good law’. Hay and Shleifer (1998: 401) explicitly add to the criterion of the acceptance of rules that ‘some rules facilitate trade better than others.’ The facilitation of trade –

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and economic activity more generally presumably – constitutes hence a substantive criterion for good law. Here we can observe some affinity of the LFS’s concept of law with another important strand of customary-‐conventional theory of law, which is the evolutionary-‐functionalist theory of F. A. Hayek (1960; 1983). Hayek’s (2011[1960]: 115-‐6) idea of law as a spontaneous order that crystallises as a result of a process of ‘adaptive evolution’ through survival of the fittest rules has indeed influenced some authors in the LFS tradition. Besides explicitly Hayekian papers (Mahoney 2001, see supra), different LFS publications refer to Hayekian concepts. La Porta and Shleifer (2009) and Djankov et al. (2003a) for instance base their conceptualisation of legal procedure and its impact on the economy on an explicitly Hayekian analysis (also LLSV 1999b, Glaeser & Shleifer 2002). Thus, Djankov et al. (2003a: 600) cite Hayek’s evolutionary view as one among others that may explain how efficient laws emerge.

It is hence worth looking at Hayek’s evolutionary theory of law in some more detail. Hayek’s theory of law has some affinities with Hart’s concept of law. Thus, in Law, Legislation & Liberty (2013[1982]: p.125 and FN19), Hayek points to the importance of the distinction between ‘rules of just conduct’ and ‘rules of organisation of government’. He cites Hart (1961), suggesting that this distinction is indeed equivalent to Hart’s distinction between ‘primary rules’ that are addressed to ‘law takers’ and ‘secondary rules’, which are the rules establishing how valid law needs to be adapted and changed. Primary rules are, in Hayek’s view, the original type of laws, which guarantee a society’s liberty. They are substantively defined as negative ‘rules of just conduct’ protecting individuals’ private sphere from interference by the state and others. They constitute together the system that he calls nomocracy, which allows him to distinguish rules of just conduct (nomos) from ‘other commands called law‘ (Hayek 2013[1982]: 200). Secondary rules, on the other hand, are useful and acceptable as long as they simply aim at enforcing the rules of just conduct. Indeed, enforcing the latter is the only justification for the use of coercion, which is determined by secondary rules (Hayek 2013[1982]: 130). This is where Hayek departs from Hart. Hayek’s concept of law is based on a substantive definition of what valid law is. Therefore, he rejects Hart’s claim that the acceptance by a society’s officials of a ‘Rule of Recognition’ (RoR) constitutes a sufficient basis of validity for any positive law. Rather, Hayek – while acknowledging the existence of a RoR – considers that the RoR alone would not confer on the pre-‐existing law its validity (Hayek 2013[1982]: 130). In order for law to be valid, it will also need to conform with substantive criteria, the most fundamental of which are that law is limited to defining in negative fashion what conducts the subjects of the law have to refrain from in order not to infringe on others’ private sphere and that these rules be universal. Universality is in turn defined as a negative test which assesses whether rules are ‘end-‐independent’, i.e. they do not attempt to achieve a specific outcome, and that they only refer to facts which can be known or readily ascertained by all rule-‐takers (Hayek 2013[1982]: 205). This departure from Hart is

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not surprising given Hayek’s aversion for legal positivism. While Hayek calls Hart the most effective critique of older forms of legal positivism, the fact remains that Hart’s theory is still a positivist one, which essentially provides a purely formal definition of valid law.

Hayek’s concept of law is at the same time broader and narrower than Hart’s and other positivists’. Narrower in the sense that law is only what conforms to certain substantive criteria of legal rules, but at the same time broader in that the sources of law are more varied, because law is not exclusively defined as the commands that emanate from a sovereign. Indeed, Hayek (2012[1982]: 69) famously held that ‘law is older than legislation’. This also relates to the question of enforcement: While he holds that unenforced rules cannot be considered law (a contrario Deakin et al. 2015), he also considers – with Hart – that the existence of a centrally organised system of sanctions is not a necessary condition for the existence of a legal system (Hayek 2013[1982]: 200). Thus, rules that are enforced by social pressure or ostracism can be considered law too, as long as the rules conform to the criteria of valid law (negativity, generality, and universality). This is where the departure from Hart emerges the most clearly: In Hart’s (1961) view, the existence of a system of secondary rules is the defining element distinguishing a system of law from more archaic, pre-‐modern types of customary and tribal systems of social rules. Law is indeed defined as the union of primary and secondary rules. Hayek (2013[1982]: 314-‐5) rejects this view, stating that a legal system does not necessarily require secondary rules. This difference with Hart becomes understandable when we consider that Hayek essentially equates the secondary rules with ‘public law’, which in turn is – according to him – what legal positivists such as Kelsen focus on. He considers that only a very narrow range of secondary rules are permissible (those aiming at enforcing primary rules), while most secondary rules constitute a ‘corruption’ of the legal system, which aim at imposing state policies or the interests of certain interest groups on the population. Hayek (2013[1982]: 211) associates the latter project with socialism and considers that “all the leading modern legal positivists have been public lawyers and in addition usually socialists.” As mentioned above, the LFS seems to follow Hayek in his rejection of legal positivism as essentially a socialist theory.

Hayek also partly follows Dworkin in that he agrees with the latter that legal systems are more than a ‘system of rules’ in that it also contains less explicit elements that Dworkin (1977) calls ‘principles’ and Hayek himself calls ‘unarticulated’ or implicit rules (Hayek 2013[1982]: 315). But again, Hayek’s concept of law is narrower than Dworkin’s in the sense that ultimately it boils down to the protection of individual rights through the enforcement of negative rules of just conduct. Hayek thus explicitly abolishes the distinction between duty-‐imposing rules and power-‐conferring rules: ‘All the rules which state the conditions under which property can be acquired and transferred, valid contracts or wills made, or other ‘rights’ or ‘powers’ acquired and lost, serve merely to define the conditions on

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which the law will grant the protection of enforceable rules of just conduct’ (Hayek 2013[1982]: 201). This view in turn derives from Hayek’s narrow conception of justice as merely being the absence of injustice (cf. Gamble 2013) and it explains why the protective function of law becomes the main function of law. Rules of just conduct are negative in that they do not normally impose positive duties on people, but negative duties to abstain from certain conducts (Hayek 2013[1982]: 202). Indeed, while Hayek’s account of liberty relies – contrary to more libertarian accounts – very strongly on law, the purpose of law is narrowly defined as ‘merely [serving] to prevent conflict and to facilitate co-‐operation by eliminating some sources of uncertainty’ (Hayek 2013[1982]: 204).

Clearly, the LFS largely accepts Hayek’s account notably in terms of the protective function of law, its limited scope, and extent. However, on some points Hayek’s theory of law may not be a good basis for some of the LFS claims. Most importantly, Hayek’s notion of nomocracy is based on a resolute rejection of goal-‐orientated systems (teleocracy). Any system that aims at achieving certain collective goals is, in Hayek’s view, subject to the erroneous naivety of ‘constructivism’ and ‘pragmatism’. He criticises legal positivism as part of a pragmatist philosophy, explicitly referring to pragmatist philosophers, but also marginalist economists: "legal positivism, like the other forms of constructivist pragmatism of a William James or John Dewey or Vilfredo Pareto, is therefore profoundly antiliberal in the original meaning of the word, though their views have become the foundations of that pseudo-‐liberalism which in the course of the last generation has arrogated the name” (Hayek 2011[1982]: 209). Hayek’s theory rejects hence both legal positivism – whom he reproaches its absence of substantive definition of law – but also the teleological-‐utilitarian paradigm according to which law can be used to achieve certain collective goals. The LFS, on the other hand, does contain quite clear utilitarian, instrumentalist, and ultimately teleological claims, notably regarding the feasibility and desirability of legal reform (see supra).

Hayek only considers law to be real law that is historically grown and emerged from a process of evolutionary progress towards efficient rules not in the sense of their outcome, but in the sense of creating a Great Society where individuals’ liberties are optimally protected from interference by others and by the state. The LFS notion of efficiency or optimality of a regulatory regime is a different one. For instance, Glaeser & Shleifer 2002[regulatory state] and Djankov et al. (2003) consider the rise of the statute-‐based regulatory state in the US during the progressive era and the relative decline of a purely court-‐based private litigation system of the earlier period, as an efficient choice to adapt the system to a new, more complex economic and social environment. This can be seen as broadly in line with certain functionalist-‐evolutionary theories that interpret the crisis of legal formalism as a result of the increasing complexity of society (see Teubner 1981). Hayek (1960) on the other hand saw this evolution not as an efficient choice, but rather part of the

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regrettable ‘decline of the rule of law’, due to the rise of ‘social constructivism’ and socialism.

In short, there are several elements in Hayek’s account that resonate with what we have seen so far as central elements of the LFS approach to law: firstly, the claim that there should be proximity of law and spontaneously grown systems of norms of a society; secondly, the substantive definition of ‘good’ or ‘valid’ law in terms of the extent to which it is conducive to economic activity and market exchanges. Thirdly, the relative narrow definition of legal rules as protections of individual rights from both other individuals and the state (cf. Djankov et al. 2003). Fourthly, the implication of Hayek’s theory of law is that decentralised political systems will produce better outcomes than centralised systems, because they draw more on local knowledge and limit state interference (cf. especially Glaeser & Shleifer 2002 [LO] and Mahoney 2001). However, there are also aspects regarding which the LFS seems to depart from Hayek, notably regarding the instrumental use of law to achieve specific goals. This latter point is also related to the question the paper turns to now, i.e. how exactly does law change economic actors’ behaviour?

2.5 How does law impact on economic actors’ behaviours?

So far we have discussed the broad issues of the general role of law in the economy and the question of the quality of law. However, if we define law as a mechanism of social control that works by influencing actors’ behaviours, it would seem crucial to look at the ways in which law achieves changes in actors’ behaviours. This section analysis the LFS literature regarding this aspect.

The main observation based on the LFS literature is that it has not much to say at all about this point. Indeed, while there are some broad references to the incentives that law creates for different actors, which influences their behaviour (cf. LLSV 1997, 1998), there is no explicit discussion of how exactly law impacts economic actors. One important point to note, however, is the very strong focus of much of the LFS on the enforcement of law. Indeed, Milhaupt & Pistor (2008: 5) summarises – certainly in a somewhat caricatural way – the LFS as being summarised in the simple equation “good law + good enforcement = good economic outcomes“. The idea that law is only law if it is properly enforce was present in the LFS studies from the beginning. Yet, the question of enforcement has progressively taken on a more important place. Shleifer (2005: 442) even calls his approach to regulation an “enforcement theory of regulation” in the sense that it is the problem of enforcement that determines the choice of the optimal system of social control of the economy (a litigation-‐based court system or public regulation). The focus on enforcement hints at an important underlying assumption, i.e. that law is mainly being followed by actors, because thy fear the consequences of non-‐compliance. This is the realist and strong positivist view of law, that is sometimes called the command-‐ or coercive theory of law.

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The LFS has indeed increasingly shifted from studying the content and nature of legal rules ‘on the books’ towards asking questions about the application of these rules by judges; including their decisional biases (notably Niblett et al. 2010). This ‘legal realist turn’ of the LFS can be traced back at least to 2007 and in particular to the joint work of Andrei Shleifer with Nicola Gennaoile (Gennaioli & Shleifer 2007a, 2007b, but also Balas et al. 2009, Niblett et al. 2010, Gennaioli et al. 2014). These papers explicitly adopt a legal realist view, which argues that law is what the judge says it is. This realist stance and the focus on law enforcement reveals an underlying concept of law which realism shares with strong positivism, that the only reason actors follow legal rules, is because legal rules are commands backed up with threats of punishment. If the punishment were not credible, we would not expect laws to matter for economic actors. Enforcement through courts and punishment thus becomes a crucial element of laws. Shleifer & Wolfenzon (2002), for instance, explicitly refer to Becker’s (1968) model of ‘Crime and Punishment’ as basis for their economic model. They define the quality of investor protection not through a list of legal shareholder rights, but as “likelihood that the entrepreneur is caught and fined for expropriating from shareholders:” (Shleifer & Wolfenzon 2002: 4). This statement is remarkably close to Oliver Wendell Holmes’s “prediction theory of law” according to which law should be defined simply as the prediction of how courts will decide and what the likelihood of punishment will be. This, was, according to Holmes (1897) the point of view that the ‘bad man’ would take towards the law, i.e. all the ‘bad man’ cares about when making decisions is the likelihood of being caught when infringing the law. This is Holmes’s legal realist stance, but it also comforms with Austin’s positivist idea that the threat of punishment is a defining characteristic of law. Defining law in this way implies hence basing it on a pessimistic anthropology where actors do not follow the law for the sake of following it, but to avoid punishment. It is in this respect that Holmes’s view seems compatible with the LFS’s focus on the fear of punishment. Indeed, the underlying conception of actors as a homo oeconomicus whose pursuit of maximal utility is not responsive to norms and duties, but only by cost-‐benefit calculations and incentives, may explain why the LFS is quite naturally drawn to a realist view of law. To some extent, however, this contradicts the previously established proximity of the LFS with Hayek’s concept of law, who was – as mentioned above – very critical of the pragmatist philosophy to which O. W. Holmes was close.

It is precisely this pessimistic view of human beings that have led the LFS scholars to increasingly focus on the role of judges. Indeed, contrary to Coasians such as Stigler (1964) or Easterbrook and Fischel (1991) who were optimistic about the sufficiency of private contracts and their enforcement in courts of law for efficient outcomes, the LFS applies the homo oeconomicus model to judges as well and asks ‘why should we expect judges to invest the necessary effort in order to understand complex contracts?’ (see Glaeser et al. 2001, Glaeser & Shleifer 2002, Shleifer 2005). It is the application of the homo oeconomicus concept to not just litigants, but judges,

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that leads the LFS to consider the role of judges to be crucial and that make them less optimistic about courts and the optimality of a litigation-‐based systems than other L&E scholars associated with the Chicago School of Economics (Shleifer 2005; Djankov et al. 2003b).

In this respect, the realist approach adopted in recent years by the LFS certainly makes a contribution to the literature to the extent that it challenges more optimistic economic accounts of the role of courts and judge-‐made law, which may overestimate the efficiency of such systems. However, this has also had the effect of diverting attention from the fact that law does not impact actors only when it is being enforced in a court of law. Indeed, that was Hart’s (1961) famous objection to Holmes’ bad man argument: ‘Why’ – he asked – ‘should not law be equally if not more concerned with the ‘puzzled man’ or ‘ignorant man’ who is willing to do what is required, if only he can be told what it is?’ (Hart 2012[1961]: 40) Indeed, Hart observed that the majority of people do not get in conflict with the law and may hold the view that it is their duty to obey the law for the sake of obeying the law, rather than as the result of a conscious calculation of costs and benefits associated with the likelihood of punishment. On this account, it is by no means obvious that the threat of punishment and the likelihood of enforcement are the only or even the main mechanism through which law deploys its effect on the economy. We will come back to this criticism of the command theory of law in section 3.

In sum then, while the LFS diverges from other branches of neo-‐institutionalist economics in the importance it ascribes to laws and regulations, very few papers in the LFS tradition explicitly state what concept of law the studies are based on. Nevertheless, a few regularities emerge from the above review of the core contributions to this literature. Firstly, the LFS rejects legal positivism in terms of the validity of laws as emanating purely from the will of a sovereign. Instead, the LFS adheres to the view that laws need to fulfil certain substantive criteria for it to be qualified as a ‘good’ or ‘quality’ law. Conversely, not everything that is enshrined in the law can be considered as proper legal rules. This hints at a non-‐positivist view of law, which can most closely be associated with a Hayekian evolutionary-‐, rather than a natural law view.5 ‘Good law’ lives up to the criteria of protecting individual (property) rights, favouring trade, but also is close to a community’s own standards.

At the same, time in terms of the way in which law affects economic actors, the LFS does adopt a view that seems close to Austinian positivism, or Holmseian realism, that defines laws as orders backed up by the threat of punishment or as probability of punishment. Indeed, fear for punishment and the incentives thus created seem to be the only reason why actors in the LFS conception would obey the law. This makes the LFS conception of law compatible with modern economic theories about rationality and motivation, in particular with Becker’s (1968) work. 5 Hayek saw indeed his spontaneous evolution theory of law as a third way of explaining law beyond positivism and natural law doctrines (Hayek 2013[1982]: 223).

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Secondly, despite these quite clear positions on positivism and realism, the LFS is much less clear on the precise way in which law deploys its impact on economic outcomes. In the earlier LFS studies, this question is largely treated implicitly and reduced to questions of incentives created by effective protection of property rights or the absence thereof. Well-‐protected property rights create positive incentives to invest, lack of protection creates negative incentives to abstain from investing. Very little is said about how law affects the main target of legal rules however – Holmes’s proverbial ‘bad man’, or the ‘insiders’ who are the ones doing the expropriating in the LFS framework. Here the LFS has strongly focused on the question of effectiveness of law enforcement and the incentives this creates for potential wrongdoers in terms of fear for punishment.

Judicial decision-‐making is indeed a focal point of analysis and the application by judges of broad legal principles, as opposed to ‘bright-‐line legal rules’, is considered a key advantage of common law systems over civil law ones. Increasingly, however, the LFS has moved to a more pessimistic, explicitly legal realist, understanding of the role of courts that analysis judicial decisions in similar terms as any other opportunistic, selfish actor using the tools of modern economic theories of rational behaviours. This has led the LFS to challenge more optimistic accounts of courts. It has also led the LFS to adopt an adversarial view of law, where it is assumed to deploy its effect main in cases where it is enacted through lawsuits. Various legal scholars, however, have pointed out that law suits and punishment are law’s plan B (Greene 2012, 2015), while plan A is to rely on people following the low for reasons other than (the threat of) punishment. Such less dramatic functions of law, however, are largely neglected by the LFS.

Finally, it should be noted that in a parallel development of the LFS, there has been a considerable shift away from the focus on law as key explanatory variable. This change can be illustrated in the various conceptions of institutions that can be found in the LFS literature. Early work often referred to North (1981, 1991) definition of institutions as humanly designed constraints and ‘rules of the game’. In these early studies, laws were essentially equated with institutions. Over time, however, and to an important part driven by the increasing importance of the ‘legal origin’ variable, the LFST started to use the term institution in quite a different way. For one, certain studies turned to use the term ‘regulation’ instead of laws, which may imply that the type of ‘rules’ under examination has broadened from legislature-‐ and judge-‐made law to include administrative acts made by ‘governments’ and regulatory agencies. This may also explain why the object of investigation has increasingly become broader moving from company law narrowly defined, to ‘regulation’ and then policies and the characteristics of the polity. This change has, in turn, led to quite strong qualification of the initial claims about the importance of institutional factors in determining economic outcomes. Thus, Glaeser et al. (2004) argue that policies of investment in human capital are a more important driver of economic development than institutions. Indeed ‘good’ policies are often adapted by dictatorial regimes,

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and ‘good institutions’ follow afterwards (Glaeser et al. 2004: 271). More generally, the focus on and redefinition of ‘legal origin’ has led to a shift away from the substantive nature of the legal rules under investigation towards more fundamental features of different countries’ legal and political systems. Legal origin was first simply meant to mean the ‘historical grounding’ of a legal system in one of four mother systems. But it then became a proxy for a ‘regulatory style’ and a style of social control over economic life and other areas. At one stage, this was simply equated with the extent of state intervention in different countries, and the argument soon became that Anglo-‐Saxon countries are inherently superior to others. But more recent studies attempted to elucidate the source of this superiority more concretely by investigating constitutional features of different countries, most notably judicial independence and constitutional review (La Porta et al. 2004). Here, then, the focus has shifted quite radically from the content of the laws protecting rights in the 1990s to features of the political system, as defined by a country’s constitution. One could argue, therefore, that more recent scholarship in the LFS tradition has very little to do with law indeed.

This latter development is regrettable, because it attempts to avoid difficult questions raised by the initially confident statement “law matters!” not by attempting to answer the question “how does law matter?”, but by avoiding the debate altogether, shifting the focus onto more fundamental features of different countries. This paper attempts to show it is worthwhile to persist in investigating whether/how law matters. The next section develops a framework that can enrich the LFS concept of law in order to make the theory both analytically and empirically stronger.

3. What Links Law to Practices? A Comprehensive Framework for the Analysis of Law and the Economy

The extensive literature review revealed that the LFS follows legal positivism and realism regarding the key question of how law deploys its impact on economic activity. While the question is not often explicitly addressed in the LFS literature, it seems clear that the focus is on the creation of negative incentives for wrongdoers via the threat of punishment. This view comes close to the ‘coercive view’ of law and also explains the LFS’s strong focus on judge-‐made law and the role of courts.

This section turns to discussing the coercive view of law in more detail in order to present various objections and to further develop the conceptual link between law and economic activity/behaviours based on alternative views.

3.1. Threat, Coercion, and Punishment: Law’s “plan A” or “plan B”?

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The command-‐, imperative-‐ or coercive theory of law is primarily associated with John Austin, Hans Kelsen, and other so-‐called ‘strong legal positivists’, but it is also close to some realist accounts. The focus is on the coercive effect of law, as a command issued by a sovereign and enforced through (the threat of) punishment (see Green 2012, Schauer 2014). Similarly, the legal realist Oliver W. Holmes famously used the notion of the ‘bad man’, as the addressee of laws and considered that his incentives to avoid ‘doing bad’ derived from fear of costs associated with doing so (Green 2012: xxxi). Holmes (1897: 459) wrote:

‘If you want to know the law and nothing else, you must look at it as a bad man, who cares only for the material consequences which such knowledge enables him to predict.’

The coercive view of law has been subject to a great deal of criticism over the years. Already Hart (1961) argued that the fear of punishment was not the reason why the average citizen obeys the law. Indeed, officials and law-‐abiding citizens do so out of a moral conviction that laws ought to be obeyed more than for fear of negative consequences. The debate has not abated until today. In a recent book-‐length defence of the coercive view, Schauer (2014) accuses authors such as Hart (1961) and Green (2012) to marginalise the inherently coercive nature of law. Very schematically, Schauer (2014) argues that the use or threat of coercion or force – the two terms are used interchangeably – is what makes law achieve its primary purpose, which is to guide action by making us do things that we would not otherwise do. Green (2015) rejects this view arguing that ‘the force of law’ is certainly to an important extent grounded in the use of coercion, but also – if not more – in the imposition of duties and the exercise of power. While coercion and power need to be distinguished from each other, they are also different from duties, which are not based on the use or threat of physical force or on influence through power, but on the creation of normative expectations to which subjects are expected to conform (Green 2015: 3). Green (2015) considers indeed that the creation of normative duties – not coercion or power – is the primary way in which law guides subjects’ actions, or – in Green’s (2015:7) words – it is law’s ‘Plan A’. Hart, too believed that ‘[t]he principal functions of the law as a means of social control are not to be seen in private litigation or prosecutions, which represent vital but still ancillary provisions for the failures of the system. It is to be seen in the diverse ways in which the law is used to control, to guide, and to plan life out of court’ (Hart [1961]2012: 40; emphasis added). On this view, then, the normative aspect of law (imposing a duty and motivating actors to follow a norm) is more important than its coercive function (threatening actors with the use of sanctions, including physical force). Green's (2015) concept of law like Hart’s (1961) implies that law is 'coercive if necessary, but not necessarily coercive'.

The notion of moral duties imposed by legal rules raises another important issue, i.e. the one of what rules a legal system is made up of. Green (2015: 6) acknowledges

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that law is not composed on duty-‐imposing rules alone, but ‘will also have other sorts of rules, including rules that confer rights, grant permissions, create powers and so forth’. Yet, according to Green (2015) they do constitute the fundamental unit of a legal system, because all legal rules can ultimately be expressed in terms of duties. Thus, permissions are rules about the cancellation of a duty; powers are rules about the capacity to create, waive, or modify duties.

Green’s focus on duties is broadly in line with legal positivism whose view that legal rules are ‘commands’ can be seen as compatible with the duty-‐imposing legal rules. The contrast is starker here with Hayek’s assertion that ‘real law’ is defined by negative norms of proper conduct. Indeed, Hayek (1982) stressed the unity of true legal rules, as being merely negative in nature, i.e. they protect individuals’ rights by prohibiting others from infringing on them. As such, they do not impose any particular duty beyond abstaining from certain actions.

Yet, Green’s duty-‐imposing conception of legal rules does contrast with legal positivism not because of the notion of duty as such, but in terms of the motivation for subjects to follow rules. The command theory views duties as orders either to judges about the conditional use of coercion (‘punish if a person does/does not do X’) (as per Kelsen), or to subjects directly (as per Holmes or Austin). In either case, the ultimate motivation has to do with the fear of sanction, while Green’s conception – following Hart – focuses on moral behaviours of the addressees of law. Indeed, Kelsen even famously declared that enabling or power-‐conferring rules are only fragments of rules, and that properly understood, duty-‐imposing rules too rely on the threat of force (Green 2015: 9).

But even this view of law being composed of both negative rules as well as moral duty-‐imposing rules may be too narrow. Indeed, Hart (1961) himself criticised Austin for only considering the duty-‐imposing aspect of law, which may be an accurate description of criminal law, but not necessarily other types of law. According to Hart (1961), Austin forgets the power-‐conferring aspects of law, whose primary effect on actors is not to impose restrictions to their behaviour under the threat of sanctions, but to enable actors to do certain things they would not be able to do without the law. These include for instance, entering a contract, establishing a company, issuing certain types of securities etc. Therefore, rather than a purely constraining force, law also has enabling and coordinating effects on economic actors by providing not so much prohibitions but guidelines as to how certain activities should be undertaken (Milhaupt & Pistor 2008). In this sense, law has a constitutive effect: Like the rules of football do not just regulate the corner kick, but actually create it in the first place, so law does not just regulate the economic ‘game’, but in actual fact fundamentally shapes the economy through the rules and institutions that it puts at actors’ disposal (Deakin et al. 2015, Schauer 2009).6

6 The neglect of law’s enabling effect, has a direct correspondence in institutional scholarship more broadly: Jackson and Deeg (2008) observe that much of institutional scholarship in the management

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Nevertheless, advocates of the coercive view argue that even enabling rules have a coercive impact on the subjects of law in the sense that they create a legal institution that subjects are now expected to use instead of non-‐legal alternatives. The non-‐legal alternatives are thus crowded out in coercive fashion by the law in question (Schauer 2014; a contrario Green 2015).

Schauer’s (2014) criticism of Hart and Green is essentially a pragmatist one, which crucially hinges on the notion that the conceptual statement that law may indeed – theoretically – be able to function without the use of coercion, human nature is such that in practice no legal system in the world can dispense of the coercive side of law. Green (2015) convincingly shows that neither himself nor Hart would contest that claim, but contrary to Schauer, they consider that the conceptual analysis of law’s nature is important. Schauer (2014) on the other hand considers in a true pragmatist’s fashion that all that matters is what law is like in reality, not what it is like in theory. In Green’s (2015: 24) summary of Schauer’s position ‘Conceptual truths about law, if there are any, matter less than contingent, empirical truths about the law we have.' Again, Schauer’s conception is very close to Holmes’s and other legal realists’ view. What matters to the pragmatist is what the judges do, which implies that law becomes merely a prediction of the use of coercion by the judge and a corresponding evaluation by the subject – the bad man – of the material consequences of infractions.

The proximity of the realist and ultimately pragmatic conception of law with modern day economics, both regarding its underlying anthropology (compare ‘bad man’ and homo oeconomicus) and the focus on empirical prediction as main criterion for validity (cf. Schnyder 2012CGI) is striking. The coercive view reduces obedience essentially to an economic matter. Green (2015: 7) states that ‘sanctions are subject to the ordinary economy of threats, costs against benefits’ and lack therefore the ‘binding, categorical force’ that duties claim to have. As a result, coercive sanctions cannot explain the normative character of law. Conversely, the purely economic nature of ‘motivation by threat’ may explain the focus on coercion and on the protective function that the LFS provides: given that homo sapiens is defined as a homo oeconomicus, any impact of law that relies on an appeal to actors’ moral, emotional, or social sense does not make sense in this framework. Modern economic theory in the wake of the rise of the Chicago School and the homo oeconomicus model of human behaviour, turned the behaviour of Holmes’s ‘bad man’ – a concept that also presupposed the existence of the ‘good man’ – from the exception into the norm of human behaviour. Deception, cheating, lying become the natural behaviours not behaviours associated with ‘bad people’ who should be the law’s main concern (see Williamson 1985). This one-‐dimensional anthropology, focused on the deceitful nature of human beings, may be the main explanation for the narrow focus of LFS on the fear of punishment and the complete absence of discussion of other functions of law. Indeed, as Coffee (2001: 2165) puts it: “In a world in which all actors are assumed to be amoral and to be deterred only by the prospect of sanctions, this [i.e. the focus on positive law and its enforcement] might exhaust the possible explanations [of human behaviour]”.

tradition sees institutions purely as a constraints on economic actors, neglecting, thus, the enabling effect some institutions can have on actors.

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Legal theorists who do not buy into the model of homo oeconomicus, however suggest that the ‘coercive function’ of law with its focus on constraints and sanctions may be too limitative to explain the effect that law has on economic activity. How then would we expect law to matter for economic activity? Two answers to this question can be found in the literature: firstly, incentives and secondly the expressive function of law. Indeed, Green (2012: xxxii) states that ‘[c]oercion is the hard edge of the law’s power; the incentivizing and expressive character of legal norms belongs to its soft edge.’

Regarding the first one of these two additional mechanisms – incentives – the LFS conceptualisation of law does acknowledge their importance, although they are only considered in relation with the threat of coercion. Thus, as mentioned in section 2, the link between legal shareholder protection and ownership concentration is explicitly conceptualised based on incentives: Increasing protection of property rights means that investors do not have to fear expropriation by insiders, which incentivises shareholders to abandon large controlling stakes in favour of more diversified portfolios with minority positions in many firms. Also, the more recent LFS studies – in particular those in the legal realist paradigm – closely look at the incentives that judges have to either favour shareholders or their own career interests (Glaeser et al. 2001). Incentives do come in as a behavioural mechanism, based on the economic analysis of human behaviour. But the LFS does not consider incentives as a direct means for law to influence behaviours. Indeed, law can actively create incentives – other than threat of punishment –, e.g. by increasing the costs of certain types of behaviours through legal rules (e.g. smoking) (cf. Green 2012). LFS neglects this aspect of law. Here, however, I will focus on another omission, which is the ‘expressive character of legal norms’.

3.2 The expressive and normative view of law

Law’s effect on actors may to an important degree stem from the fact that it signals to the addressees of law what appropriate behaviour is. This hints at the crucial question of the moral aspects of legal rules and the link between law and morality. The relationship between law and morality has been central to many debates in legal theory. A key issue that has opposed legal positivists to other legal theories is whether laws do or should reflect certain moral norms to be considered valid. Lon Fuller (1964) famously argued against Hart’s positivism, that law needed to follow certain – procedural – principles of ‘internal morality’ in order to be considered valid law. Hart (1961), on the other hand, saw law and morals as rather distinct, although his positivism does allow for moral norms to be built in the legal system, as the fundament of the so called Rule of Recognition upon which a legal system’s validity is based. By and large though, law and morals are not necessarily equal and legality can – according to Hart – indeed be used for immoral purposes (Green 2008). The debate about the separation of law and morals has also a more practical side, which was mentioned above: i.e. to what extent law should correspond with a

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society’s moral rules in order to facilitate rule-‐following and enforcement. The LFS seems to favour a close correspondence between the two. This corresponds with certain theories in legal scholarship, which considers that the ‘moral credibility’ of law is enhanced when it closely corresponds with a society’s moral standards. This in turn is important for law to acquire what Green (2013) calls a ‘Weberian legitimicay’ of being accepted as binding. However, there is an additional dimension to the question of law and morality, which becomes relevant here, as it specifies an additional channel through which law influences economic activity. This additional channel is precisely the expressive function of law and relates to the question whether law can (and should) shape social morality. Some legal theorists have indeed asked the opposite question to the one ‘to what extent should law reflect a society’s morality?’ namely ‘to what extent can and should law shape the morality of a society.’ Green (2013) argues that law impacts not just people’s incentives, but also how they perceive and normatively evaluate different behaviours. At first glance, this contradicts more classical definitions of morality, such as the one of H. L. A. Hart (1961), which explicitly distinguishes morality from law by the fact that it is ‘immune’, to deliberate changed (cf. Green 2013: 477). However, while Green (2013) accepts the view that there are in the domain of morality no rules for changing the rules – Hart’s ‘secondary rules’ the existence of which define a legal system –, he considers that intentional actions – such as legislation – can gradually shift norms or ‘help create new meanings of certain acts’ (p.483). The prime example Green provides is the criminalisation of certain acts. In his own terms:

"The creation of crimes normally aims to make people accept, or to take more seriously than they already do, the idea that the relevant delict is not merely prohibited or officially disapproved, but wrong. (Green 2013: 483).

Conversely, decriminalisation of certain acts – e.g. homosexual relationships – is likely to lead to changes in a society’s attitudes towards such acts: "It is widely conceded that criminalization can stigmatize an activity; why doubt that decriminalization can do the opposite?" (Green 2013: 486). Similarly, Robinson and Darley (2007: 28) argue based on empirical research that “[c]riminal law is perhaps unique in its ability to inform, shape, and reinforce social and moral norms on a society-‐wide level." On this account then, law may be able to influence the way people behave not just through the threats it makes or through the incentives it creates, but also through the moral norms of appropriatness of certain acts that it signals. To be sure, this may be a position that is difficult to accept for scholars who ground their understanding of human behaviour in a purely rationalistic model of man. Indeed, Green (2013: 481) states that '[t]he idea that law might change the hearts and minds of its subjects, and not merely incentivize their conduct, is sometimes met with derision’7 (2013: 481). And it would seem that the LFS is sufficiently

7 He adds, ‘[o]r at any rate it is when people have in mind changes for the better; is seems easier for them to believe that law can change attitudes for the worse.)' (2013: 481).

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strongly grounded in the homo oeconomicus model of human nature to explain why no mechanisms beyond punishment and incentives are considered to explain law’s impact on economic actors. Yet, as Coffee (2001: 2165) stated “But an alternative set of explanations [to explaining differences in actors’ behaviour through differences in legal incentives and enforcement] emerges if we postulate that the principal actors in corporate governance may internalize norms and act in accordance with them.” One such alternative explanation is precisely that law may signal what appropriate behaviour is and that actors should conform with it. This is what Sunstein (1996) called the expressive function of law. Milhaupt & Pistor (2008: 34) contend that “[o]ften, the signals sent by law may be more potent or novel than the legal provisions themselves”. An important implication of this view is that the law may deploy its effect quite independently of the question whether the law is actually enforced or not (Deakin et al. 2015). This effect may explain, for instance, why certain types of international law are adopted although it is well known from the beginning that enforcement will depend on states being willing to forgo some of their sovereignty. In spite of the limited means of enforcement, international law may still develop an effect merely by signalling to actors what sorts of behaviours are acceptable. The addressees of international law may adapt their behaviours not for fear of punishment – as per the command theory of law – but out of a sense of moral obligation or a concern with legitimacy. This perspective can be called the ‘normative-‐‘, ‘expressive-‐‘, or ‘signalling function of law’. It is increasingly well supported by empirical evidence notably from experimental research. 4. Empirical Implications: Investigating law and economic outcomes

The preceding discussion shows that the link between law and economic outcomes may be far more complex than the LFS suggests. Law can perform various functions and hence be associated with various different ways of how it affects firm-‐level practices and through them overall economic outcomes. Moreover, the different purposes and functions of law are not mutually exclusive, but the same law can have several or all of these effects at the same time (Green 2012, Milhaupt & Pistor 2008).

What does appear clearly, however, is that the different functions of law and channels through which they affect firm behaviours have far-‐reaching implications for empirical research in this area. If the expected mechanism that links law to firm-‐level outcomes is fear for punishment, we would have different hypotheses of how companies react to a new law than if the main mechanism were the normative signals emanating from the law. This section briefly sketches out some of the implications of the discussion and develops several propositions to refine the investigating into the link between law and corporate governance in empirical research.

There may be fundamentally new ways of investigating the link between company law and corporate governance outcomes in order to test for some of the complexities of the complexities of the theoretical relationships between the two.

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For instance, the discussion of the normative view and the link between legal change and changes in moral norms may best be investigated based on individual-‐level surveys of normative attitudes towards certain practices or similar methods. Here, we limit the discussion to the most widely used kind of data in this field, i.e. country-‐level measures of the legal environment (such as LLSV’s ADRI) and country-‐ or firm-‐level measures of corporate governance outcomes and practices. This allows us to derive concrete testable hypotheses for empirical research.

The first concept of law discussed above was the command theory, which expects companies to react to legal change for fear of judicial repercussions, i.e. lawsuits and fines. This view would postulate a relative limited impact of law on corporate practices, i.e. only when a specific practice is directly targeted by the legal change would we expect a company to react. Consequently, if this were the only, or even the main effect of legal rules on corporate practices, empirical studies should focus on investigating the direct correspondence between legal variables and firm-‐level variables, e.g. the prohibition of dual class shares in the law and their existence at firm level. A longitudinal study could then investigate whether a given corporate practice changed before or after the relevant legal rule changed, which would allow it to draw conclusions regarding the impact of law on corporate governance practices. Surprisingly, however, very few studies adopt this empirical strategy corresponding to their implicit conceptualisation of legal rules, as coercive and authoritative orders. LLSV’s (e.g. 1997) studies use the legal measure as a broader proxy for the legal environment and are interested in broader outcome variables (ownership structures) rather than corresponding mechanisms at the firm-‐level. Other studies who investigate the role of law in corporate governance too use LLSV’s measure without investigating the corresponding corporate governance practices at the firm level, but unrelated features of a company’s corporate governance system.

As an example, Cuomo et al. (2012) in a study investigating explicitly the impact of legal change on corporate change in Italy use the Anti-‐Director Rights Index (ADRI) developed by La Porta et al. (1997, 1998), a revised version of the ADRI that corrects certain coding errors (Djankov et al. 2008) and a new Anti-‐Self-‐dealing index (ASDI) also developed by Djankov et al. (2008). They also use for certain analyses the CBR Shareholder Protection Index (SPI) (Siems et al. 2009). These are aggregate measures of legal MSP at the country level, which were developed in comparative studies and do not necessarily capture all aspects of the Draghi law and other legal reforms that have taken place in Italy.8 More importantly, these measures do not necessarily focus on the same aspects of corporate governance that Cuomo et al. (2012) use as dependent firm-‐level variables. The ADRI for instance

8 However, arguably Mario Draghi – the main sponsor of the Draghi law – was himself strongly influenced by the ADRI. One could hence expect that the changes brought about by that law is actually captured very well by this index. Or rather conversely: the law reflects the ADRI.

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does not contain any measures for ownership structures, the existence of pyramid structures or syndicate agreements among shareholders, which are the control-‐enhancing mechanisms (CEM) investigated by Cuomo et al. (2012). An increase in the ADRI does hence not directly affect any of the firm-‐level practices investigated by Cuomo et al. (2012).9 To be sure, this is not necessarily an absurd way of proceeding. However, it reveals an inconsistency between the implicit assumptions about how law is expected to matter (the coercive view) and the empirical procedure used to test whether law matters.

If we do take the coercive view of law seriously, we would have to test the following proposition:

P1: Controlling for other factors, an increase in legal shareholder protection will only lead to an increase in the degree of shareholder-‐orientation in those practices that are directly targeted by the reform.

From the normative perspective, on the other hand, we would expect that legal reform may impact corporate governance practices at the firm level even if a given practice is not explicitly targeted by the legal reform. The legal change may signal in broad terms that the norm of ‘shareholder value’ is considered appropriate, or it may be perceived as signalling that the state or judges will not tolerate practices that are detrimental to shareholders. In this case,

P2: An increase in legal shareholder protection is associated with an increase in shareholder-‐orientated practices, regardless of the correspondence of legal provisions with corporate practices.

A third possibility is that law matters not so much through its coercive force, nor through the normative signals it sends, but rather through broader incentives that it creates for companies. Again, the empirical study by Cuomo et al. (2012) constitutes a good example that refers to such an incentive mechanism: the authors argue that the reason why we would expect higher levels of minority shareholder protection in the law to affect control enhancing mechanisms, is that better laws reduce the amount of private benefits of control that insiders can extract from the firm. This reduces the incentives to stick with such corporate governance mechanisms. In order to distinguish this incentive perspective from the signalling or normative perspective we can formulate the following proposition referring to the level of PBCs:

P3: Legal change that is not directly target at a given corporate practice will have a stronger impact on corporate change in countries where PBCs are higher than in others.

9 The six variables included in the ADRI are ‘Proxy by mail allowed’, ‘Shares not blocked before AGM’, ‘Cumulative voting / Proportional representation’, ‘Oppressed minority rights’, ‘Pre-‐emptive rights to new issues’, ‘percentage of shareholders needed to call extraordinary AGM’ (La Porta et al. 1997).

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The operationalisation of these propositions into testable hypothesis is certainly not easy. Indeed, the granularity of data needed in order to investigate the quite subtle differences among the mechanisms that these propositions postulate may be a practical challenge. Nevertheless, they do constitute a guideline for researchers in designing more rigorous tests of the impact of law on corporate governance outcomes than is often the case currently.

5. Conclusion

This paper revisited the Law and Finance School literature in order to determine what concept of law can be explicitly and implicitly found in the core studies in this field. The surprising conclusion of the literature review was that LFS actually has very little to say about how exactly law is expected to matter for economic outcomes. Indeed, the LFS seems mainly to be an attempt to apply economic theory and econometric methods to legal phenomena rather than the other way round. The legal theory underlying LFS is tentative, underdeveloped, and at times contradictory. The field has increasingly moved away from the key claim that it is indeed law that matters. Rather, broad cultural and political factors have become more important than actual substantive legal features in explaining corporate governance outcomes. This paper has argued that taking legal theory seriously is an important step if we want to take the content that ‘law matters’ seriously.

Implicitly and – more rarely– explicitly, the LFS literature suggests that law mainly matters through its function of protecting property rights as well as creating incentives and that it deploys its effect on economic actors through the threats of punishment that stem from the enforcement of law. Indeed, the importance associated to enforcement issues in the LFS literature hints at the underlying command theory of law: the main reason why firms would follow laws is the fear of punishment.

The paper then discussed alternative theories and attempted to go beyond the basic functions of property rights protection and incentive creation. It argued that the moral or normative role of law has been neglected in the LFS literature. If, as legal scholarship suggests, laws impact behaviours not only through threats and incentives, but also through normative signals, existing tests of the law matters hypothesis may be flawed, as they do not capture all the potential impacts law has on corporate practices. Indeed, the neglect of certain functions and impacts of law on economic outcomes may affect the accuracy and validity of empirical findings from studies in this area. In other words, in order to answer accurately the question ‘does law matter?’ this paper suggests that we first need to tackle the question ‘how do we expect law to matter?’ It is hoped that the paper provides a useful first step in guiding empirical research into these questions into new, more promising directions.

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