Why Investor Trust (and Not the Law) Matters: Japanese Lifetime Employment's Role as a Non-Legal Mechanism for Credible Investor Trust

Abstract

Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Schleifer, and Robert Vishny (the “Gang of Four”) have captivated comparative corporate law scholars with their empirical research which claims to prove that ‘law’ is the key to economic development. A foundational principle in their theory is that legal protections for investors are necessary for larger financial markets and economic growth. The Gang of Four reason that rational investors will not trust corporate management and in turn, will not invest without strong legal protections. Post-war Japan is one of the wealthiest countries in the world. For over half a century it has built and maintained one of the world’s most successful financial markets. Even after the bubble burst, empirical studies that measure the size, liquidity, depth and efficiency of Japan’s financial market consistently rank it among the ‘elites’ of the world. Based on the Gang of Four’s theory, post-war Japan must have provided vigorous legal protections for investors. In fact, the opposite is true. A hallmark of post-war Japanese corporate governance is its extremely weak investor protection. Shareholder rights have been scarcely exercised and Japan’s largest creditors often voluntarily subrogate their limited creditor rights. The obvious question that arises is: why have investors so wholeheartedly trusted management in post-war Japan? Lifetime employment provides the answer. Japan’s post-war lifetime employment system inextricably ties the financial and social future of corporate management to the success of the company. This ensures investors that management is credibly constrained from self-enrichment and motivated to maximize performance. With such an assurance, it makes rational sense for investors to invest. Importantly, law plays merely a complementary role in lifetime employment. This demonstrates that the Gang of Four’s theory — that ‘law’ is critical in the development of successful financial markets — is incorrect.