Brazilian President Dilma Rousseff’s visit to Washington early this month offers an occasion to consider how some once-poor countries have broken out of poverty, as Brazil has. Development institutions like the World Bank have advocated improving business law as an important way to do so. Are they right?
Such thinking goes back at least as far as Max Weber’s argument that an effective business environment requires a legal structure as predictable as a clock. Investors, it is thought, need clear rules and effective courts. Security of contract and strong mechanisms that protect investors are, in this view, foundational for financing economic growth. If a potential financier is unsure of being repaid, he or she will not invest, firms will not grow and economic development will stall. Rules and institutions come first; real economic development follows.
However, compelling as this logic seems, Brazil’s rise does not confirm it: Financial and economic growth was not preceded by — or even accompanied by — fundamental improvements in courts and contracts.
Growth is unmistakable: Brazil’s financial markets have expanded robustly, with stock-market capitalization rising from 35 percent of GDP in 2000 to 74 percent in 2010. In the eight years prior to 2004, only six companies went public; in the eight years since, 137 have. Last year, Brazil overtook the UK — often held up as an exemplar of contractual security — as the world’s sixth-largest economy.
And yet legal change was not central in Brazil’s success. Brazilian courts were reputed in 2000 to handle investors’ lawsuits slowly and poorly, and they are reputed to handle them slowly and poorly today. Even basic features of business organization — like limiting shareholders’ obligation for corporate debts — are said by Brazilian legal experts, such as Bruno Salama, to remain an open question, with shareholders potentially exposed to unlimited liability, especially in labor and tax lawsuits.
If courts are not protecting investors, is something else doing the job? One major change was new stock-exchange rules, which, fitfully, have strengthened outside investors’ confidence, though only for new companies. For legal academics, most prominently Columbia University’s John Coffee, stock exchanges have historically been the first step toward protecting investors. That view is supported by research conducted by Ronald Gilson, Henry Hansmann and Mariana Pargendler, who have analyzed how Brazil’s Novo Mercado — the stock exchange’s new segment for initial public offerings — has protected investors in newly listed companies.
However, stock exchanges have limits, particularly in Brazil. In the absence of reliable and efficient courts, they cannot sue to enforce their rules. Their only recourse is to push recalcitrant firms off the exchange.
The Novo Mercado dealt with this problem by subjecting disputes involving its newly listed companies to arbitration, far from the courts. Commercial arbitration — and courts’ obligations to enforce the arbitrators’ decisions — can assure investors, even if the courts generally do not.
However, arbitration — which has yet to be deeply tested for resolving disputes on the Novo Mercado — does not seem to be the linchpin of Brazil’s recent success, which followed a century of erratic financial development. After all, the institutional innovations apply only to new companies that volunteer to list their shares on the Novo Mercado, and thus do not cover the overwhelming majority of existing firms in the Brazilian economy, which were previously listed on the main stock exchange and are stuck with the old rules, old institutions and an ineffective court system.