The effect of formation rules on the functioning of capital markets: lessons from history

Carsten Gerner-Beuerle (LSE) on link between formation rules and the development of capital markets

An earlier post  (in Dutch) discussed the risk of moral hazard when limited liability allows company owners to take excessive risks without needing to fear personal losses. This goes to the expense of company creditors. Minimum capital requirements were suggested as a remedy since this raises the stakes for company owners and thus discourages excessive behavior.

A recent analysis of corporate and financial regulation in Britain and Germany in the 19th century argues, however, that stringent formation rules, such as minimum capital requirements, could possibly hamper the development of financial markets (see: C. Gerner-Beuerle, ‘Law and Finance in Emerging Economies: Germany and Britain 1800-1900, The Modern Law Review, Vol. 80 Iss. 2, March 2017, 263-298).

In contrast to a widely-held belief in the literature, the author argues that the relative development of Britain’s financial market in the 19th century cannot be explained by its advanced rules on financial disclosure alone. According to the author, the success of the financial markets of both countries differed due to diverging legal regimes governing the formation of corporations.

In Britain, it was fairly easy to form a company with limited liability. A corporation was considered a bundle of contracts and thus, following the freedom of contract principle, it was almost completely up to the parties to give shape to the corporation. In Germany, on the other hand, legal reforms made the formation of a corporation much costlier. Legislation prescribed a minimum par value of shares, subscription of all shares was mandatory and at least one fourth of the nominal value needed to be fully paid up.

One of the purposes of these reforms was to exclude small investors from the market for capital since the German legislator was convinced big investors were more capable of making good investment decisions. In addition, it was expected that since larger sums were invested, investors would be more concerned with the way the company was managed. This would lead to better governance and a more stable and solid capital market, the German legislator believed. This resonates with the argument for minimum capital requirements as explained above.

In hindsight, however, the British laissez-faire approach delivered better results. The stringent formation requirements in Germany led to a relatively low number of corporations with high amounts of legal capital. Due to a high minimum par value of shares, the trading volumes of stock remained low which eventually affected the liquidity of the capital market.

The author points out that future research needs to assess whether these findings can be generalized. This means I should be careful with making too strong a conclusion. What seems clear, however, is that measures imposing stringent requirements on the formation of corporations can possibly negatively affect the well-functioning of capital markets.

Ensuring sufficient creditor protection is important and minimum capital requirements definitely contribute to this end. We better not forget, however, that such measures never exist in isolation. Research like this reminds us of other interests, such as a healthy market for capital, which should always be part of the delicate balancing act legal reform inevitably is.

Wouter-Jan Leys 

Author: Wouter-Jan Leys

Research Master in Law student at KU Leuven and Tilburg University

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