Weak Legal Institutions Research Articles

A Comparative Study of Antecedents to Contracting Practice in Buyer-Seller Relationships in Egypt and China

The purpose of this study is to analyze the influences of transaction factors on inter-firms relationships in different businesses. The study focuses on the comparison between the Chinese and Egyptian business with regarding to buyer and seller relationships in textile industry in order to find out the differences in buyer-seller relationships between Egypt and China and how the cultural factors influence the contracting practice between these two countries. Therefore, transaction cost analysis (TCA), relational contracting theory (RCT) and resource dependence theory (RDT) would act as the important tools to find out how the business relationship works in different culture background. Combining the three theories, we can conclude the general view about the transaction mechanism in the two countries. Chinese market situation, weak legal system and informal institutions combining with the “guanxi” embedded business environment make the Chinese small firms rely on the relational contracting more than formal contracting. Meanwhile, the high value for law makes Egyptians prefer to formal contracting. The findings highlight the fact that the level of contracting mechanism was found to be more positive in Egypt than in China and was statistically significant. In other words, the Egyptians tend to use the formal transactional mechanisms which emphasize legal conditions and incentive systems, whereas the Chinese prefer the relational mechanisms that govern exchanges through moral control and trust in the relationships between the buyers and suppliers. A hierarchical multiple regression approach employing the OLS regression model was carried out and the findings show that almost 30% of contracting mechanisms can be explained by the model, while the remaining percentage (70%) can be explained by other factors not included in the research model. In addition, the findings revealed that the association between supplier specific investments and contracting becomes significantly more enforced in Egypt than in China when the size of the buying firm increases. Furthermore, contracts have a control effect on buyer-supplier relationships in case of unanticipated eventualities.

The origin of the country-of-origin image: the role of law

Purpose Country of origin has profound effects on consumer behavior; yet few studies have examined an antecedent of these effects: why some countries enjoy a positive image while others suffer a negative one. Developing an institutional theory of country image, the authors argue that weak legal institutions at the country level increase firm opportunistic behavior that expropriates consumers and decrease the product quality of local brands, thus decreasing the country’s image regarding its products and brands. Design/methodology/approach This study measures country image for products and brands using the number of valuable brands (i.e. brands included in the top 500 brands from 2008 to 2016) in a particular home country. Data concerning the rule of law in each country come from the World Bank, and data on the efficiency of countries’ judicial systems comes from Djankov et al. (2007). We also collect patent data from the US Patent and Trade Office, national culture from Hofstede Insights and GDP and GDP per capita from the World Bank as control variables. Panel Poisson regression, Tobit regression and truncated regression are used in the analyses. Findings Supporting the institutional theory of country image, both the rule of law and efficiency of the judicial systems show positive and significant effects on country image, even when economy size (GDP), degree of economic development (GDP per capita), level of technology and skill (patents) and culture are controlled. Practical implications To improve their country’s image and the brand value of local firms, policymakers should strive to strengthen legal institutions aimed at punishing firm opportunistic behavior in their countries. Originality/value Previous research on the country-of-origin effect has not yet appreciated the role of legal institutions in developing the construct of country image.

China’s rule of law in New Era: the rise of regulation and formalism

ABSTRACTChina’s financial development and economic growth is achieved under weak legal institutions. The literature attributes this counterexample of law–finance–growth nexus to (a) alternative mechanisms in China such as incentives, reputation and relationships and (b) a well-functioning xinfang system with common law features. In recent years, China has made increasing efforts to strengthen its rule of law. The Communist Party of China (CPC) has taken the lead by launching a far-reaching campaign against corruption, establishing a system of inspection tours, and promulgating a large number of regulations. We argue that using regulations to complement laws is effective: CPC has enough bureaucratic prowess to crack down on corruption whereas the courts are subject to subversion by powerful interests. We also discuss the drawbacks of this approach: regulations aiming at ex ante control of corruption substantially increase procedural formalism and limit the discretion of local governments and state-owned enterprises.

Does religion matter to informal finance? Evidence from trade credit in China

ABSTRACTInformal finance plays an important role in transitional economies with weak legal institutions, such as China. As a major informal finance instrument, trade credit relies on informal institutions and enforcement. The paper argues that religion enhances the ethical climate in which firms do business, and it predicts that religiosity increases trade credit, in that religion enhances enforcement by increasing non-pecuniary cost and reducing risk-taking. The results based on Chinese non-state listed firms between 2003 and 2013 confirm the prediction that firms located in high-religiosity regions are associated with more trade credit, especially in regions where formal institutions are weak or formal financing channels are limited. Furthermore, the paper shows that religiosity reduces overdue trade credit. Finally, the results are driven by Buddhism, Taoism and Christianity, but not Islam.

Corruption and Doing Business in Emerging Markets

Corruption is a serious international problem with many damaging effects particularly in emerging market countries. We investigated to what degree overregulation and inadequate legal institutions contributed to corruption of small and medium-sized enterprises (SME) in emerging markets. Unlike other studies, we used data from the World Bank?s Doing Business annual series which provides indicators of the regulatory and legal environments facing SME. We had three major research questions. (1) Which government obstacles to conducting business in the form of overregulation and inadequate legal institutions contribute most to corruption? (2) Which are more closely linked to corruption, excessive regulations or weak legal institutions? (3) Which of the components, from which the World Bank?s indicators are derived, have the largest impact on corruption? We regressed Transparency International?s Corruption Perception Index on the nine World Bank indicators and five control variables for 51 emerging market countries from 2007 to 2015. This study concludes that all five regulation indicators, but only one of four legal indicators, contributed to corruption. While past studies have linked regulation and corruption, our contribution was identifying specifically which of the World Bank?s measures of the regulatory and legal environment cause corruption. In addition, our results also corroborate those of previous studies regarding our five control variables. Policy wise the World Bank has long advocated reducing regulations to improve SME operating efficiency. Our results further support such a policy because of its important additional benefit of reducing corruption and its many toxic effects.

Returnee CEOs Under Weak Institutions: Blessing or Curse?

This paper studies CEOs with overseas experience, known as returnee CEOs. We show that Chinese returnee CEOs are associated with inferior performance, lower market reactions to appointment announcements and an adverse regulatory environment. We argue that CEOs’ international expertise is acquired at the opportunity cost of local social capital, such as political and business ties, which is more critical than expertise in transition economies with weak legal institutions. The negative effect disappears when social capital is acquired, regional legal institutions are strong or returnees’ international expertise is in demand. Exploiting an exogenous increase in the supply of returnee talent as a result of new provincial policies, we find the results consistent.

Country-level institutions, firm value, and the role of corporate social responsibility initiatives

Drawing on transaction cost theories and the resource-based view of a firm, we posit that the value of corporate social responsibility (CSR) initiatives is greater in countries where an absence of market-supporting institutions increases transaction costs and limits access to resources. Using a large sample of 11,672 firm-year observations representing 2445 unique firms from 53 countries during 2003–2010 and controlling for firm-level unobservable heterogeneity, we find supportive evidence that CSR is more positively related to firm value in countries with weaker market institutions. We also provide evidence on the channels through which CSR initiatives reduce transaction costs. We find that CSR is associated with improved access to financing in countries with weaker equity and credit markets, greater investment and lower default risk in countries with more limited business freedom, and longer trade credit period and higher future sales growth in countries with weaker legal institutions. Our findings provide new insights on non-market mechanisms such as CSR through which firms can compensate for institutional voids.

State Ownership and Corporate Governance in China: An Executive Career Approach

China’s state-owned enterprises (SOEs) now comprise over sixty percent of the largest 500 companies in China and more than ten percent of Fortune Global 500 companies in the world. Despite their importance to China’s domestic economy and foreign investment strategy, many governance characteristics of the SOEs remain a black box, including the SOEs’ executive composition and recruitment development. This Article shifts away from the typical focus on how corporations function (i.e., corporate structure) to an examination of the people in charge. Such an approach is important for understanding corporate governance and economic development in countries with weak legal institutions. Using this approach, this Article investigates the legal guidelines for SOE executive recruitment and the evolution of the educational, political, and career attributes of the CEOs of China’s large SOEs over the past decade. Furthermore, this Article utilizes legal, historical, sociological, and comparative methods to explain the change and stability of executive composition in China’s large SOEs. In sum, SOE executive recruitment shows an orientation toward politically-bounded and firm-specific professionalism, as well as some faint potential for bottom-up and competition-driven marketization. SOE recruitment guidelines and the empirical findings in this Article raise questions about the adequacy and capacity of existing international laws and enforcement mechanisms to cope with the rise of Chinese SOEs, the challenges to improving Chinese corporate governance, and the underlying forces that form apparent similarities in elite composition across countries.

Returnee CEOs Under Weak Institutions: Blessing or Curse?

This paper studies CEOs with overseas experience, known as returnee CEOs. We show that Chinese returnee CEOs are associated with inferior performance, lower market reactions to appointment announcements and an adverse regulatory environment. We argue that CEOs’ international expertise is acquired at the opportunity cost of local social capital, such as political and business ties, which is more critical than expertise in transition economies with weak legal institutions. The negative effect disappears when social capital is acquired, regional legal institutions are strong or returnees’ international expertise is in demand. Exploiting an exogenous increase in the supply of returnee talent as a result of new provincial policies, we find the results consistent.

Relationship‐specific Investments and Intellectual Property Rights Enforcement with Heterogeneous Suppliers

AbstractThis paper examines the impact of intellectual property rights (IPR) enforcement on multinationals' choice of input suppliers and industry profits in a host economy. The framework consists of suppliers with heterogeneous capabilities who must engage in a relation‐specific investment to customize intermediate inputs upon a transfer payment by final producers. An outsourcing contract with better technologically endowed suppliers requires a lower transfer and generates a higher surplus. Stronger IPR enforcement leads firms to self‐select into better quality suppliers on average by reducing their outside option. Weak legal institutions instead make it possible for a larger range of suppliers, including the less capable ones, to form partnerships by granting them a larger outside option. A better IPR environment is more likely to harm lagging countries where the technology distribution is characterized by less capable suppliers.

Unequal inequalities: Do progressive taxes reduce income inequality?

This paper analyzes the effect of changes in the structural progressivity of national income tax systems on observed and actual income inequality. Using several unique measures of progressivity over the 1981–2005 period for a large panel of countries, we find that progressivity reduces inequality in observed income, but has a significantly smaller impact on actual inequality, approximated by consumption-based Ginis. An empirical comparative analysis shows that the differential effect on observed versus actual inequality is much larger in countries with weaker legal institutions. We also find that structural progressivity has a greater equalizing effect in environments that support pro-poor redistribution. Substantial differences in inequality response to changes in top versus bottom rates are also uncovered.

A research note: Are auditors unable to detect classification shifting or merely not willing to report it? Evidence from India

Research indicates that auditors fail to curb classification shifting in countries with relatively weaker legal institutions. However, it is not known whether auditors are unable to detect misclassifications or if they are merely not motivated to report them. We conduct two experiments to examine this issue. Our results indicate that auditors are sensitive to classification shifting while assessing fraud risk and audit effort. However, their willingness to report such misclassifications is affected by the overall legal liability regime of the region in which their clients operate. More specifically, our results indicate that the presence of weaker legal regimes reduce the litigation risk faced by auditors which make them less likely to report misclassifications. On the other hand, auditors are significantly more likely to report misclassifications by qualifying their audit report if a company is cross-listed in a country with strong institutional controls and legal regime.

Institutional Voids or Entry Barriers? Business Groups, Innovation and Market Development in Emerging Economies.

The paper presents an empirical analysis of the innovative activities of business groups. It compares the innovativeness of group-affiliated firms (GAFs) and standalone firms (SAFs), and it investigates how country-specific institutional factors – financial, legal, and labor market institutions – affect the group-innovation relationship. The paper outlines two competing views, the institutional voids and the entry barriers theses, and analyses their contrasting predictions on the role of institutional and market development. The empirical analysis is based on the most recent wave of the World Bank Enterprise Survey (period 2010-2011), and it focuses on a sample of 6500 manufacturing firms across 20 Latin American countries. The econometric results point out that GAFs are on average more innovative than SAFs. Across countries, the superior innovation performance of GAFs is stronger for national economies with weaker legal institutions (as predicted by the institutional voids thesis), and for countries with more efficient labor market regulations (as postulated by the entry barriers thesis).

Product Market Competition, Legal Institutions, and Accounting Conservatism

ABSTRACT In this study, we examine product market competition's role in shaping accounting conservatism in an international setting. Using a large dataset from 38 countries, we find evidence that product market competition is positively associated with accounting conservatism in countries with strong legal institutions, but not in countries with weak legal institutions. Moreover, the positive association is significantly more pronounced in countries with high-quality financial reporting environments comprising a higher earnings quality, more frequent and greater disclosure practices, and the more stringent enforcement of insider trading regulations. Our empirical findings suggest that product market competition and strong legal institutions jointly drive accounting conservatism.

Do audit committees reduce the agency costs of ownership structure?

We investigate the agency costs of corporate ownership structure and the role of audit committees in mitigating their effect. Using China as a laboratory, where audit committees are voluntary, we study the demand for and value relevance of audit committees conditional on the various agency costs of corporate ownership. Audit committees complement existing internal governance systems by reducing the agency conflicts embedded in ownership structure. They are always value relevant, the magnitude of which depends upon the level and complexity of the ownership lattice. Audit committees substitute for inefficient external regulatory environments, particularly where weak legal institutions predominate. Our results are robust to firm size, investment level and financial leverage.

Relationship-Specifiic Investments and Intellectual Property Rights Enforcement with Heterogeneous Suppliers

This paper examines the impact of intellectual property rights (IPR) enforcement on multinationals' choice of input suppliers and industry profits in a host economy. The framework consists of suppliers with heterogeneous capabilities who must engage in a relation-specific investment to customize intermediate inputs upon a transfer payment by final producers. An outsourcing contract with better technologically-endowed suppliers requires a lower transfer and generates a higher surplus. Stronger IPR enforcement leads firms to self-select into better quality suppliers on average by reducing their outside option. Weak legal institutions instead make it possible for a larger range of suppliers, including the less capable ones, to form partnerships by granting them a larger outside option. A better IPR environment is more likely to harm lagging countries where the technology distribution is characterized by less capable suppliers.

Relationship-Specific Investments and Intellectual Property Rights Enforcement with Heterogeneous Suppliers

This paper examines the impact of intellectual property rights (IPR) enforcement on multinationals' choice of input suppliers and industry profits in a host economy. The framework consists of suppli-ers with heterogeneous capabilities who must engage in a relation-specific investment to customize intermediate inputs upon a transfer payment by final producers. An outsourcing contract with better technologically-endowed suppliers requires a lower transfer and generates a higher surplus. Stronger IPR enforcement leads firms to self-select into better quality suppliers on average by reducing their outside option. Weak legal institutions instead make it possible for a larger range of suppliers, including the less capable ones, to form partnerships by granting them a larger outside option. A better IPR environment is more likely to harm lagging countries where the technology distribution is characterized by less capable suppliers.

Country-Level Institutions, Firm Value, and the Role of Corporate Social Responsibility Initiatives

Drawing on transaction cost theories and the resource-based view of a firm, we posit that the value of corporate social responsibility (CSR) initiatives is greater in countries where an absence of market-supporting institutions increases transaction costs and limits access to resources. Using a large sample of 11,672 firm-year observations representing 2,445 unique firms from 53 countries during 2003-2010 and controlling for firm-level unobservable heterogeneity, we find supportive evidence that CSR is more positively related to firm value in countries with weaker market institutions. We also provide evidence on the channels through which CSR initiatives reduce transaction costs. We find that CSR is associated with improved access to financing in countries with weaker equity and credit markets, greater investment and lower default risk in countries with more limited business freedom, and longer trade credit period and higher future sales growth in countries with weaker legal institutions. Our findings provide new insights on non-market mechanisms such as CSR through which firms can compensate for institutional voids.

The Effect of Shareholder Litigation Risk on the Information Environment: The Case of Cross-Listed Firms

I examine the effects of shareholder litigation risk on cross-listed firms’ information environment, as captured by information asymmetry. In order to disentangle the effects of shareholder litigation risk from those of confounding factors, I exploit a quasi-natural experiment in the form of a reduction in shareholder litigation risk resulting from the 2010 Supreme Court ruling in Morrison v. National Australia Bank. After the ruling, I document higher information asymmetry for cross-listed firms, especially for the firms with low US share activity. I also find higher information asymmetry in bad news firm-quarters and for firms from countries with weak legal institutions. I interpret my findings as evidence that shareholder litigation risk is an important factor in shaping the information environment. By implication, these findings suggest that improvements in foreign firms’ information environment upon listing in the US, as documented in prior literature, stem in part from the greater litigation risk associated with the US listing.

Political rights and equity pricing

We examine the influence of political rights on the implied cost of equity capital using a sample of firms from 44 countries. We find that firms' equity financing costs are lower when political rights are stronger. We further find that political institutions' direct impact on the cost of equity capital is incremental to that of legal institutions. Economically, our results imply that a one standard deviation increase in political rights is associated with a 38 basis point decrease in corporate cost of equity capital. In additional analyses, we find that the effect of political rights on equity pricing is more pronounced in countries with weak legal institutions.