The Role of Law in Stock Market Development

14 April 2005

Discussion OverviewDiscussion Overview

• General Principles of Corporate Law

• Regulation of the Market

• A Brief History of Stock Markets

• Models of Securities Regulation

• More Questions

Theory of Law and Stock Market Development

• “The Law Matters Theory”– Minority Rights

– Disclosure Rules

– Common Law vs. Civil Law Systems

• “The Law Doesn’t Matter (or Hurts) Theory” – The Market produces necessary information.

– Unnecessary regulation eliminates beneficial risk sharing and taking

• Market Failure and Transaction Cost Economics– Well designed law can reduce transaction costs.

– How do you design good legal rules?

Characteristics of Publicly Traded Companies

 • Separate Legal Personality: Company is a separate legal entity distinct from

its management and shareholders. 

• Limited Liability: The liability of company shareholders for debts and injuries can not exceed their investment.

 

• Separation of Ownership from Control: The shareholders are dispersed, and specialised management makes daily decisions.

 

• Share Liquidity and Transfer: Shareholder can transfer an interest in the

company to another legal person with relative ease.

Characteristics of Market Regulation

• Investor Protection– Mandatory Disclosure Rules

– Prohibitions Against Insider Trading

– Minority Shareholder Rights

• Competitive Markets– Antitrust / Competition Law and Policy

• Reduction of Systematic Risk– Broker Registration

– Prudential “Capital” Requirements for Intermediaries

Rise of Amsterdam’s Stock Market (1595-1602)Rise of Amsterdam’s Stock Market (1595-1602)

• Amsterdam becomes an International City– Independence from Spain (the fall of Antwerp 1585)– Pluralism. Between 1606-1620, 73% of all men and women who had issued notice

of an intended marriage had been born outside Amsterdam.

• International Trade creates new Capital Requirements– Before 1500, two month trade voyages to France, Portugal and Spain were

financed by sole proprietorships and partnerships one ship at a time.

– By 1565, risky and capital intensive twelve month trade voyages to South America, West Africa and Caribbean require larger partnerships lasting more than one voyage. Permanent companies formed with shares.

– In 1595 Voyages to Asia begin.• 4x Cost of African and Caribbean Voyages• Round Trips 24 Months, some ten to fifteen years to wind up • Between 1595-1601 20% of Ships Lost at Sea

Rise of Amsterdam’s Stock Market (1595-1602)Rise of Amsterdam’s Stock Market (1595-1602)Solutions to Capital ConstraintsSolutions to Capital Constraints

• Mechanics of Amsterdam Stock Market – Semi-Permanent Investments (10 Year Commitment)– First Limited Liability Company in the World– Transferability (No printed shares only ledger) (Liquidity) (Strangers)– No participation in Management

• Results– 1,100 of 50,000 Amsterdam Adults owned shares (small investors)– Share Prices 15% above Par Value in 1602– By 1607 approximately 33% of Stock Transferred– Shares as Collateral for Loans (no registration)– Interest Rate Decline from 8% to 5.5%

• Market Evolution– Extend Investment Commitment to Twenty Years . . . Indefinitely

Shareholders & Trades on Amsterdam Stock Exchange (1603-1612)Source: Oscar Gelderblom, “Completing the Financial Revolution: The Finance of the Dutch East India Trade and the Rise of the Amsterdam Capital Market” (2003)

Investment and Returns from Amsterdam Stock Ex. (1595-1608)Source: Oscar Gelderblom, “Completing the Financial Revolution: The Finance of the Dutch East India Trade and the Rise of the Amsterdam Capital Market” (2003)

Average Interest Paid on Amsterdam Money Market (1596-1620)Source: Oscar Gelderblom, “Completing the Financial Revolution: The Finance of the Dutch East India Trade and the Rise of the Amsterdam Capital Market” (2003)

Amsterdam’s Tulip Mania Bubble (1637): Regulation Begins

• The Tulip Craze– 1593 Tulips Imported

– Tulip Mosaic “Flames of Color”

– 2000% increase in Month

– For example (One Tulip traded for four tons of wheat, eight tons of rye, one bed, four oxen, eight pigs, 12 sheep, one suit of clothes, two casks of wine, four tons of beer, two tons of butter, 1,000 pounds of cheese, one silver drinking cup.).

• Tulip Crash– From $76,000 to $1 in 6 weeks.

• Regulation– Futures and Option contracts unenforceable

– Dutch Economy crippled for decades.

England’s South Sea Bubble (1720): Regulation Begins

• The Agreement– Finance British War Debt

– 6% & South American Trade Monopoly

– Issues Stocks

• Fraud – Newspapers bribed (Spanish Ports)

– Lavish Corporate Offices

– IPOs everywhere

• The Reaction– Stock Gains 1000% in Months.

– No Profits, Issue more Stock

– Management sells – stock crashes

• Regulation– South Sea Bubble Act and No Shares

Development of Stock Markets in the United States

• Two Problems– Crisis of Confidence

– Family Ownership

• Crisis of Broker and Consumer Confidence in Markets– New York Courts refused to enforce Futures & Option Contracts after 1792

– Decentralized Market for Sellers and Buyers

• Voluntary Membership Associations (NYSE 1792-1858) – 24 Brokers and Merchant Members (Transferable by Sale)

– Decreased transaction costs of identifying buyers and sellers

– Assurance of trading partner’s credit worthiness (qualifications “black book”)

– Implicit reputation for trustworthiness

– Better access to Price information (exit restrictions)

– Quality of Securities (Trading Lists)

– Dispute Resolution (1792 statute – unintended consequence, Corrupt Courts)

New York Stock Exchange (1820-1840)Source: Stuart Banner, “The Origin of The New York Stock Exchange, 1791-1860 “27 J. Legal Stud. 113 (1998).

Year Stocks Listed Average Daily Trading Volume (in Shares)

1820 28 156

1825 69 1,108

1830 58 456

1835 80 8,475

1840 112 4,266

Separation of Ownership from Control

• From 19th Century Family Owners to Berle/Means “Arms-Length” Business– 1900-1930 people owning stock increased from 500,000 to 10,000,000– 1900-1930 daily share volume increased from 1,000,000 to 10,000,000

• The Merger Wave and Holding Companies– Sherman Antitrust Act– Between 1897-1903, over 1800 large industrial companies disappeared – 50% of consolidations create holding companies with 40% market share (US Steel).– Regional owners given Preferred Stock– 80% of these holding companies listed on NYSE.

• Investors– After South Sea, Tulips & other crashes investors very reluctant to invest in industry.– Weak Disclosure Laws and Limited Minority Rights, No Centralized Regulation– Monopoly Profits, Investment Banks, Interest Rates, and Ownership (Signaling)

– 1920’s further dispersal of ownership. Irrational Exuberance.

• The 1929 Crash: Between 1929-1932 stocks decline 90%

The Models and Emerging Alternatives • U.S. Model: See Slides 2 & 3

• German Model (3rd Largest Economy)

– Insider/Control Model with highly concentrated ownership– 1897-1903 “The Land of Cartels”– Capital Gains Tax & Government Intervention (Railroads)– Japan and Much of Asia follows this Model

• Chinese Model (7th Largest Economy)

– An Odd Combination• Highly concentrated ownership (60% Government)• Neither Private nor Public Enforcement of Investor Rights• Many IPOs and Best Transition Stock Market

– Administrative System with Strong Incentives• Provincial Quota System

Concluding QuestionsConcluding Questions

• In the absence of law what mechanism do people use to organize their individual and commercial activities?

• In the presence of law, how do people organize their commercial activities?

• What are some possible strategies for the development of Vietnam’s Stock Exchange?

• Questions