How To Quantify Legal Rules Speaker: Prof. Gerner-Beuerle Date: 17 June 2024 The law in "Law and Finance" (and more generally in empirical legal studies) - Two main methodological designs: • 1. A policy change affects only a subset of a population: differences-indifferences • 2. Exploiting existing legal differences across jurisdictions or firms: economic outcomes as a function of legal variable(s) (and some controls) Differences-In-Differences - Example from recent literature: staggered adoption of universal demand laws in US states - Causal inferences possible if the parallel trends assumption is satisfied - Generally easy to code since change is conceptualized in a binary manner Legal Rules As Explanatory Variables In OLS etc. - Often of the form: • economic outcomeit = at + bt+Lawit + CtControlsit + eit - Lawit is a vector of legal variables representing individual legal rules or a legal index - Famous indices: • "Anti-Director Rights index" ("ADR index"), La Porta et al. • "Anti-self-dealing index", Djankov et al. • "Governance index" ("G-index"), Gompers, Ishii, and Metrick "Entrenchment index" ("E-index"), Bebchuk, Cohen, and Ferrell • "Management Insulation index" ("MI-index"), Ferreira et al. Methodological Problems - Legal origins / legal families as a meaningful differentiator? - Relevance of legal variables - Consistency of coding - Endogeneity and reverse causality - Index construction: • Weighting of index components • Functional substitutability • Complementarity • Contingency Weighting - G-Index: Gompers et al., Corporate Governance and Equity Prices, The Quarterly Journal of Economics, 2003, 118(1): 107 - The index construction is straightforward: for every firm we add one point for every provision that restricts shareholder rights (increases managerial power). This power distinction is straight- forward in most cases, as is discussed below. While this simple index does not accurately reflect the relative impacts of different provisions, it has the advantage of being transparent and easily reproducible. - - Delay • Blank check • Classified board • Special meeting • Written consent Protection • Compensation plans • Contracts • Golden parachutes • Indemnification • Liability • Severance - - - Voting • Bylaws • Charter • Cumulative voting • Secret ballot • Supermajority • Unequal voting Other • Anti greenmail • Directors' duties • Fair price • Pension parachutes • Poison pill • Silver parachutes State • Anti greenmail law • Business combination law • Cash-out law • Directors' duties law • Fair price law • Control share acquisition law Functional Substitutability - Legal mechanism 1 present in jurisdiction A but not in B, functionally equivalent mechanism 2 present in jurisdiction B but not in A - Example • Derivative action and Company Directors' Disqualification Act in the UK • Ineffectiveness of the derivative action until 2006 (Foss v Harbottle: minority shareholders lawsuit only if the act complained of "amounts to ... a fraud on the minority and the wrongdoers are themselves in control of the company") partly compensated by disqualification proceedings - Results in omitted variable bias if not accounted for; causal inferences not justified Complementarity - One legal rule does not operate effectively without a second rule - Example: substantive and procedural rules, e.g., behavioral standard + enforcement - Results in measurement error without interacting the variables: a stringent behavioural standard does not matter if it cannot be enforced Contingency - The effect of one rule is contingent on prior decisions or circumstances, which are, in turn, constrained or enabled by other legal rules - Example: regulation of self-dealing - Results again in measurement error Self-Dealing Index (Djankov et al.) - Ease of holding an interested director liable: equals 0 when the interested director is either not liable or liable only in cases of bad faith, intent, or gross negligence. Equals 1/2 when the interested director is liable if he either influenced the approval or was negligent. Equals 1 if the interested director is liable if the transaction is unfair, oppressive, or prejudicial. - Approval by disinterested shareholders: equals 1 if the transaction must be approved by disinterested shareholders, and zero otherwise Conceptualizing Interdependence - Three analytical steps: • 1. Identification of relevant legal mechanisms • 2. Grouping into building blocks comprising rules that are complementary or contingent on another rule, but not on rules belonging to other building blocks • 3. Mapping of interdependencies within building blocks Example: Directors' Duties - Starting point: risk of monetary liability sets incentives and thus influences the behavior of directors - Risk of monetary liability is a function of: • The range of conduct amounting to a breach of duty • Conduct excluded ex ante from the set of behavior potentially amounting to a breach of duty • Right of directors to be indemnified by the company or coverage of D&O insurance • Conduct that can be excluded ex post from the set of behavior that potentially amounts to a breach of duty • Ease with which potential breaches of duties can be enforced