Volume II Issue 2(4) Winter 2011

91

Biannually Volume II

Issue 2(4)

Winter 2011

ISSN 2068-696X

J

AS

ER

S

ournal of Advanced Research in Law and Economics

Volume II Issue 2(4) Winter 2011

92

Contents:

Journal of

Advanced Research in Law and Economics is designed to provide an outlet for theoretical and empirical research on the interface between economics and law. The Journal explores

1

Why do French Civil – Law Countries have Higher Levels of Financial Efficiency? Simplice A. Asongu University of Liège, HEC–Management School, Belgium … 94

5

Churches and Private Educational Institutions as Facilitator of Money Laundering: the case of Nigeria Kato Gogo Kingston School of Law, University of East London, United Kingdom … 136

2

„Economic Constitution‟ in Practice: the Enforcement of Competition Law in Albania Petrina Broka University of Tirana, Faculty of Law, Department of Civil Law, Albania, Ermal Nazifi Albanian University/Albanian Competition Authority Albania … 109

6

Common Law vs. Civil Law: Which System Provides more Protection to Shareholders and Promotes Financial Development Prabirjit Sarkar Jadavpur University, Kolkata, India … 143

3

A Semantic Interpretation of the Values of Shall in Economics English as Target Language Roxana Goga–Vigaru Spiru Haret University, Faculty of Law and Public Administration, Craiova, Romania … 120

7

Prohibition of Parallel Imports as a Hard Core Restriction of Article 4 of Block Exception Regulation for Vertical Agreements: European Law and Economics Nikolaos E. Zevgolis Athens University of Economics and Business, Athens, Greece, Panagiotis N. Fotis University of Central Greece, Athens, Greece … 163

4

On the Deterrent Effect of Individual Versus Collective Liability in Criminal Organizations Laetitia Hauret CEPS/INSTEAD, Differdange Eric Langlais EconomiX and CEREFIGE, Nancy University Carine Sonntag ICN Business School, Nancy … 125

Winter 2011 Volume II, Issue 2(4)

Editor in Chief Madalina Constantinescu Spiru Haret University, Romania

Co-Editors

Russell Pittman International Technical Assistance Economic Analysis Group Antitrust Division, USA

Eric Langlais EconomiX CNRS and Université Paris Ouest-Nanterre, France

Editorial Advisory Board

Huseyin Arasli Eastern Mediterranean University, North Cyprus

Jean-Paul Gaertner Ecole de Management de Strasbourg, France

Shankar Gargh Editor in Chief of Advanced in Management, India

Arvi Kuura Pärnu College, University of Tartu, Estonia

Piotr Misztal Technical University of Radom, Economic Department, Poland

Peter Sturm Université de Grenoble 1 Joseph Fourier, France

Rajesh K. Pillania Management Developement Institute, India

Rachel Price-Kreitz Ecole de Management de Strasbourg, France

Andy Stefanescu University of Craiova, Romania

Laura Ungureanu Spiru Haret University, Romania

Hans-Jürgen Weißbach, University of Applied Sciences - Frankfurt am Main, Germany

ASERS Publishing http://www.asers.eu/asers-publishing ISSN 2068-696X

Journal of Advanced Research in Law and Economics

93

Journal of Advanced Research in Law and Economics is designed to provide an outlet for theoretical and

empirical research on the interface between economics and law. The Journal explores the various understandings that economic approaches shed on legal institutions.

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WHY DO FRENCH CIVIL–LAW COUNTRIES HAVE HIGHER LEVELS OF FINANCIAL EFFICIENCY?

Simplice A. ASONGU

University of Liège, HEC–Management School, Belgium [email protected]

Abstract

The dominance of English common–law countries in prospects for financial development in the legal–origins debate has been debunked by recent findings. Using exchange rate regimes and economic/monetary integration oriented hypotheses, this paper proposes an ‘inflation uncertainty theory’ in providing theoretical justification and empirical validity as to why French civil–law countries have higher levels of financial allocation efficiency. Inflation uncertainty, typical of floating exchange rate regimes accounts for the allocation inefficiency of financial intermediary institutions in English common–law countries. As a policy implication, results support the benefits of fixed exchange rate regimes in financial intermediary allocation efficiency. Keywords: banking, allocation efficiency, exchange rate, inflation, economic integration. JEL Classification: D61, G20, K00, P50, R10.

1. Introduction Contrary to mainstream literature (Mundell 1972; La Porta et al. 1998; Beck et al. 2003), recent findings

have partially rejected the dominance of English common–law countries in prospects for financial development (Asongu 2011). The overwhelming edge of French civillaw countries in financial intermediary allocation efficiency has reignited the legal–origins debate in the law–finance nexus. This paper cuts adrift the mainstream cross–country legal–origins approach and uses regional–legal origins to provide theoretical justification and empirical validity as to ‘why’ French civil–law countries exhibit higher levels of financial allocation efficiency. It is worth noting that recent findings have stopped at ‘if’ French legal systems provide for conditions that enhance financial intermediary allocation efficiency. The issue of ‘why’ has remained elusive hitherto, which is the concern this work seeks to address. For the purpose of clarity and logical presentation of the paper, literature on the law–finance nexus could be clubbed into the following strands.

The first strand entails a growing body of work which suggests that cross–country differences in legal–origin explain cross–country differences in financial development. La Porta et al. (1998): hence LLSV (1998) pioneered this strand and ever since many authors have taken to them in the assertion that English common–law countries provide for a legal atmosphere that fosters conditions for financial development than their French civil–law counterparts. They postulate that countries with common–law traditions (French civil–law legacies) express the strongest (weakest) legal protection to shareholders and creditors (LLSV 1998, 2000). The margin English legal origin countries exert over countries with French civil–law origin has been generalized and extended to many other aspects of management and government: more informative accounting standards (LLSV1998), better institutions with less corrupt governments (LLSV 1999) and more efficient courts (Djankov et al. 2003). While this strand has been focused on elucidating ‘if’ legal origin matters in financial development, the issue of ‘why’ legal origin matters remained unaccounted for until Beck et al. (2003) assessed some theories to address it.

In the second strand, Beck et al. (2003) account for ‘why’ legal origin matters in finance by empirically assessing two channel–based theories. The political channel underlines the importance of priorities legal traditions attribute to the rights of individual investors vis–à–vis the state. It follows that championing of investors rights should induce favorable conditions for financial development. The adaptability channel postulates that legal traditions differ in their capacity to adapt to changing and evolving business circumstances. This implies countries in which legal systems provide for adjustments in relation to changing and evolving circumstances should have a higher propensity to financial development. Thus, this strand solves the ‘why’ puzzle in asserting that legal origin matters in financial growth because traditionally, legal origins differ in their ability to adapt and adjust to changing and evolving economic conditions.

In the third strand we find literature boosting the nexus that financial development significantly contributes to a country’s overall economic growth (McKinnon 1973). This optimism is shared and broadened empirically at



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the country level (King, and Levine 1993; Levine, and Zervos 1998; Allen et al. 2005), as well as at industry and firm levels (Jayaratne, and Strahan 1996; Rajan, and Zingales 1998).

The fourth strand addresses the law–finance–growth relationship. It theoretically and empirically provides evidence of the link among law, finance and economic growth at firm, industry and country levels (Demirguc–Kunt, and Maksimovic 1998; Beck, and Levine 2002).

The fifth strand which is for the most part dedicated to sub–Saharan African countries was pioneered by the Mundell (1972) conjecture, which emphasized that Anglophone countries shaped by British activism and openness(to experiment) would naturally experience higher levels of financial development that their Francophone neighbours (powered by French reliance on monetary stability and automaticity)1. Recent literature on the African continent has either wholly (Agbor 2011) or partially (Asongu 2011) confirmed the edge of English common–law countries in growth and finance prospects respectively2. Historically it should be noted that the partition of sub–Saharan Africa into French and British spheres in the 19th century resulted in the implementation of two distinct colonial policies3.

The unique contribution of this paper to the literature is to explain ‘why’ French civil law countries experience higher levels of financial intermediary allocation efficiency than English common–law countries. The rest of the paper is organized in the following manner. Section 2 discusses the links among financial efficiency, inflation and the law–finance theory, and presents resulting testable hypotheses. Data sources and methodology are discussed and outlined in Section 3 respectively. Empirical analyses and discussion of results are reported in Section 4, followed by a conclusion in Section 5.

2. Financial efficiency, inflation and law–finance –theory 2.1 Inflation and regional–legal origin

We postulate that inflation is inherently associated with common–law countries than civil–law countries. This is because countries with English legal tradition are inherently opened (to capital and trade) and competitive. Trade (exchange rate) reflects inflation especially in floating exchange rate regimes. It follows that inflation should be higher in floating (English common–law) rate regimes than in fixed (French civil–law) exchange rate regimes (Mundell 1972)4.

2.2 Inflation, uncertainty and financial allocation efficiency 2.2.1 Inflation, noise and uncertainty

Quite often, inflation introduces noise into the price system and this noise leads to decisions that, ex–post are mistakes that would not have occurred in the absence of inflationary noise. The famous ‘island’ model of Lucas (1972) elucidates this hypothesis. A condition for inflation to introduce noise into the system is that inflation must carry with it some uncertainty about static and/or intertemporal relative prices. Evidence that inflation and uncertainty travel together has been provided by many authors (Okun 1971; Logue, and Willet 1976; Foster 1978; Engle 1983; Evans, and Wachtel 1993). However these studies may disagree in some details, there does appear to be a consensus that inflation and inflation uncertainty move hand in glove.

1 ‘The French and English traditions in monetary theory and history have been different… The French tradition has

stressed the passive nature of monetary policy and the importance of exchange stability with convertibility; stability has been achieved at the expense of institutional development and monetary experience. The British countries by opting for monetary independence have sacrificed stability, but gained monetary experience and better developed monetary institutions.’ (Mundell 1972, pp. 42 – 43).

2 While Agbor (2011) assesses how legal-origin affects economic performance, Asongu (2011) proposes four theories in assessing why legal-origin matters in growth and welfare. Both studies are focused on the sub-Saharan part of the African continent.

3 The British and French implemented two distinct colonial policies. While the French imposed a highly centralized bureaucratic system that clearly underlined empire-building, the British on their part administered pragmatic decentralized and flexible policies. Economic and business ambitions dominated British colonial activities who sought to transform their colonies into commercially viable trading countries through the indirect-rule: producing raw material and consuming British manufactures. The French on their part championed imperial ambitions through the policy of assimilation.

4 ‘The French and English traditions in monetary theory and history have been different… The French tradition has stressed the passive nature of monetary policy and the importance of exchange stability with convertibility; stability has been achieved at the expense of institutional development and monetary experience. The British countries by opting for monetary independence have sacrificed stability, but gained monetary experience and better developed monetary institutions.’ (Mundell 1972, pp.42-43).


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2.2.2 Why inflation matters in financial allocation efficiency? As we must have earlier observed, inflation injects noise into the smooth functioning of the price system

and thus influence’s decisions of banks and other financial institutions. This added noise comes with mistakes in decision making that would not have been made without inflation–induced uncertainty. Banks end up holding too much of mobilized funds. Inflation therefore leads to a different pattern (ratio) of bank deposits on bank credit (allocation efficiency). In substance, inflation is like a distortionary tax that causes a reduction in the bank’s allocation efficiency. Thus the allocative cost caused by inflationary noise quantitatively affects the ability of a bank to lend mobilized funds because the lending price depends on perceptions of tomorrow’s value of money. Since inflation adds noise to the lending price system and therefore affects perceptions of the time value of money, the argument for misallocation of mobilized funds holds grounds as bank resources maybe shifted to inefficient ends. As point out by Summers (1991) inflation and its accompanying uncertainty leads to resources being devoted to ‘dealing with’ inflation rather than the fundamental issues the banks ‘really care about’(allocation of credit to economic agents). To put this in perspective, with inflation and corresponding uncertainty financial institutions tend to employ more inflation forecasters and indexation specialists which diverts some proportion of mobilized funds. Indeed financial institutions in economies associated with high levels of inflation and uncertainty tend to see more recipients of cheques lobbying for faster cheque–clearing services. This constraint requires banks to retain a higher proportion of deposits (in a bid to meet–up with the uncertainty in demand for liquidity) and this affects their allocation efficiency (bank credit on bank deposits).

More so bankers( aware inflation will erode the time value of money) are slow to lend–out mobilized funds because of uncertainty in the increase of interest rate to compensate(associate) for(to) the inflationary noise It follows that inflation affects financial allocation efficiency through misallocation of resources: on the one hand more mobilized funds (deposits) are used to fight inflation and on the other hand a greater chunk of mobilized funds is retained by banks to assuage the uncertainty of bank–run.

2.3 Testing the „inflation uncertainty theory‟ In order to assess the ‘inflation uncertainty theory’ we shall examining two testable hypotheses. H1: Inflation is higher in common–law countries due to floating exchange rate regimes, in comparison to

French civil–law countries with fixed exchange rate regimes. First and foremost, we shall have to cut adrift the legal origins debate that is based on colonial legacy at

cross–country levels. A more convenient approach is the adoption of economic/monetary regional–legal origins. Should we limit our empirical framework to crosscountry level analysis, the basis for exchange rate regimes (on which the concept of inflation is founded; Section 2.1) will not be accounted for. Most French civil–law countries are associated with monetary regions in which financial discipline and inflation are dictated and controlled respectively by regional central banks.

Hypothesis 1 will be further elucidated by means of comparative statistics to be outlined in Section 3.1.5. H2: Inflation reduces financial intermediary allocation efficiency. Testing this hypothesis we entail four steps: Firstly, we confirm that inflation is detrimental to banking system allocation efficiency (and robustly

financial system allocation efficiency), conditional on other exogenous determinants of financial intermediary allocation efficiency;

Secondly, we assess if regional–legal origins explain regulation quality and the rule of law (which are used as our endogenous explaining control variables at the second–stage of the TSLS approach);

Thirdly, we show that regional–legal origins (monetary/economic or both) which determine exchange rate regimes are exogenous to inflation and financial intermediary efficiency, (conditional on other potential determinants of inflation and financial efficiency);

Lastly, we examine if regional–legal origins explain banking system efficiency (and robustly financial system efficiency) beyond their ability to explain cross–country (cross–regional) variations in inflation; conditional on other potential exogenous determinants of financial intermediary efficiency (rule of law and regulation quality)5.

5 As we have pointed-out in the second-step, other potential determinants of financial efficiency must have

theoretical basis and empirical validity. Thus, the instruments (regional legal-origin) must explain the rule of law and regulation quality before they can be integrated at the second-stage of the TSLS approach as endogenous explaining variables of control. This is the purpose of the second-step.


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2.4 The concept of financial intermediary efficiency Here we neither refer to the profitability–oriented concept of financial efficiency nor to the production

efficiency of decision making units in the financial sector (through Data Envelopment Analysis: DEA). What we seek to address is the ability of banks to effectively meet their fundamental role of transforming mobilized deposits into credit for economic operators.

3. Data and Methodology 3.1 Data

Our data is obtained from African Development Indicators (ADI) of the Work Bank (WB) and the Financial Development and Structure Database (FDSD). Due to limitations in time series properties of law and regional indicators6, we are obliged to restrict our data span (madeup of 34 countries) from 1996 to 2008 (see Appendix 3). As we must have earlier emphasized we cut adrift the legal origins debate of cross–country levels and focus on cross–regional levels7.

Inflation data based on Consumer Price Index is obtained from ADI of the WB.

3.1.1 Financial intermediary efficiency Borrowing from Asongu (2011) countries with French civil–law legacy will turn to experience higher levels

of financial intermediary allocation efficiency both at bank (banking system efficiency) and economic (financial system efficiency) levels. In accordance with the Financial Development and Structure Database (FDSD) we measure banking system efficiency and financial system efficiency with ‘bank credit on bank deposits: Bcbd’ and ‘financial system credit on financial system deposits: Fcfd’ respectively. Bcbd can robustly be checked by Fcfd as it accounts for over 87% of its variations (see Appendix 4).

3.1.2 Instrumental variables After scrutinizing all economic/monetary regions in Africa (Appendix 1), we narrow down member states

of regions with respect to constraints of data availability (Appendix 2) before selecting regions based on testable hypotheses, legal origins and correlation analysis (Appendix 3). We choose two economic/monetary regions dominated by French legal traditions (CEMAC and UEMOA) which constitute the CFA zone. We also select two economic regions dominated by English common–law origin (SADC and COMESA). Beside the motivation of testable hypotheses, the choice of these regions is also based on correlation analysis to avoid problems related to overparametizing and multicolinearity (Appendix 4).

3.1.3 Control variables In accordance with the literature (Levine, and King 1993; Hassan et al. 2011; Asongu 2011) we shall

control for trade, population growth, GDP per capita growth and government expenditure in the finance regressions. The control variables are obtained from ADI of the WB.

3.1.4 Choice of endogenous explaining variables for control at the second–stage of the TSLS a. Regulatory Quality According to the World Bank the quality of regulation measures perceptions on the ability of the

government to formulate and implement sound policies and regulations that enable and foster private sector development. The concept is appreciated by both representative and non–representative sources. The indicator is measured in percentile rank from 0 to 100.

b. Rule of Law This indicator captures perceptions on the extent to which agents abide by and have confidence in the

rules of society, particularly the quality of property rights, contract enforcement, the courts, the police, as well as

6 For regional data, most economic regions in Africa were created in the 1990’s in the heat of structural adjustment

policies imposed by the International Monetary Fund. For law data, the World Bank began collecting indicators on the quality of law in Africa only after the pioneering work of LLSV (1998) was first published as working paper at the National Bureau of Economic Research (NBER) in 1996.

7 A more convenient approach is the adoption of economic/monetary regional-legal origin. Should we limit our empirical framework to country-level analysis, the basis of exchange rate regimes (on which the concept of inflation is founded; Section 2.1) will not be accounted for. Most French civil-law countries are associated with monetary regions in which financial discipline and inflation are dictated and controlled respectively by regional central banks.


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the likelihood of crime and violence. It is appreciated in percentile rank from 0 to 100 from a plethora of criteria with representative and non–representative sources.

What is worth noting is that, these two measures incorporate the four indicators considered by Beck et al. (2003) in theorizing the political and adaptability channels of law.

These endogenous explaining variables of control must be empirically verified at the second–step of the validation of hypothesis 2 before they can be used at the fourth–step (second–stage regressions in the Two–Stage Least Squares method).

3.1.5 Brief comparative analyses from Table 1 The last column of Table 1 depicts that relative to French–civil law regions, common–law regions have on

average higher levels of inflation. This mean is 2.811% for the Franc zone and 52.188 %( 11.869%) for the SADC (COMESA) region. The corresponding high uncertainty associated with inflation is measured by the standard deviation. While on average the Franc Zone has an inflation–uncertainty of 10.474% those of SADC and COMESA are 367.38% and 13.647% respectively. Thus this is confirmation of Hypothesis 18.

As expected, regulatory quality, trade and GDP per capita growth are higher in English common–law regions than in French civil–law regions. This is consistent with the law–finance literature (LLSV 1998; Beck et al. 2003; Agbor 2011). Also the presence of higher levels of allocation efficiency in French civil–law regions confirm recent findings (Asongu 2011) on which the object of our work is based.

3.2 Methodology In accordance with the law–finance literature (Beck et al. 2003; Agbor 2011) we use the Two–Stage–

Least–Squares (TSLS) with dummies of regional origins as instrumental variables. Beside the many advantages of using TSLS, the object of our paper (which is to assess if regional origins

affect financial efficiency through inflation) requires an Instrumental Variable (hence IV) estimation technique. This IV approach will entail the following steps:

justify the object of a TSLS over an Ordinary Least Squares (OLS) estimation method through the

Hausman test for endogeneity; show that the instruments (regional origins) explain the endogenous components of the explaining

variable (inflation), conditional on other covariates (control variables); assess the validity of the instruments through an Over–Identifying Restriction (OIR) test. Above steps entail the following models:

First stage regression:

Inflation it = (British) it (French) it Xit (1)

Second stage regression:

Financialefficiency (Inflation) it iXit (2)

In the two equations, X is the set of exogenous variables that are included in some of the second–stage

regressions. For the first and second–stage equations, v and u, respectively denote the error terms. Instrumental variables are the five regional origin dummies.

8 H1: Inflation is higher in common-law countries

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Table 1. Comparative Summary Statistics

Stats Legalorigin Regional origin

Efficiency Law Control Variables Instruments(Regions)

Inflation Bank Finance Reg. Quality

Rule of Trade

GDPpcg

Pop. Growth

Gov. Exp.

French Civil Law Regions Common–law

Bcbd Fcfd Law CEMAC UEMOA CFA.ZONE SADC COMESA

Mean

French CEMAC 0.847 0.827 0.217 0.150 78.018 1.105 2.387 10.526 ––– ––– ––– ––– ––– 1.182

Civil UEMOA 0.831 0.832 0.323 0.283 60.377 0.889 2.906 12.676 ––– ––– ––– ––– ––– 3.957

Law CFA.ZONE 0.837 0.830 0.282 0.232 68.073 0.972 2.706 11.810 ––– ––– ––– ––– ––– 2.811

Common SADC 0.611 0.737 0.420 0.430 97.682 3.235 1.914 16.546 ––– ––– ––– ––– ––– 52.188

Law COMESA 0.645 0.681 0.326 0.352 80.773 2.112 2.289 14.443 ––– ––– ––– ––– ––– 11.869

Data 0.708 0.750 0.332 0.330 77.646 2.202 2.336 14.147 0.131 0.210 0.342 0.263 0.289 18.844

S.D

French CEMAC 0.316 0.297 0.124 0.122 39.014 5.202 0.614 3.860 ––– ––– ––– ––– ––– 13.456

Civil UEMOA 0.228 0.224 0.125 0.155 19.620 4.422 0.442 4.441 ––– ––– ––– ––– ––– 7.600

Law CFA.ZONE 0.265 0.252 0.135 0.157 30.841 4.723 0.572 4.335 ––– ––– ––– ––– ––– 10.474

Common SADC 0.289 0.607 0.194 0.205 45.132 3.436 0.767 6.086 ––– ––– ––– ––– ––– 367.38

Law COMESA 0.242 0.278 0.169 0.222 52.630 3.516 1.432 5.476 ––– ––– ––– ––– ––– 13.647

Data 0.301 0.409 0.171 0.211 39.886 4.246 1.023 5.418 0.338 0.408 0.474 0.440 0.453 193.57

Min

French CEMAC 0.188 0.178 0.078 0.019 25.710 –11.137 1.555 2.650 ––– ––– ––– ––– ––– –100.00

Civil UEMOA 0.207 0.243 0.083 0.014 29.993 –29.63 2.092 6.484 ––– ––– ––– ––– ––– –3.502

Law CFA.ZONE 0.188 0.178 0.078 0.014 25.710 –29.630 1.555 2.650 ––– ––– ––– ––– ––– –100.00

Common SADC 0.133 0.137 0.044 0.024 33.491 –7.797 0.548 6.331 ––– ––– ––– ––– ––– –100.00

Law COMESA 0.177 0.253 0.044 0.029 17.859 –15.156 –1.075 4.588 ––– ––– ––– ––– ––– –2.405

Data 0.133 0.137 0.044 0.014 17.859 –29.630 –1.075 2.650 0.000 0.000 0.000 0.000 0.000 –100.00

Max

French CEMAC 1.718 1.646 0.580 0.457 156.86 29.062 3.826 24.196 ––– ––– ––– ––– ––– 12.431

Civil UEMOA 1.244 1.189 0.698 0.519 104.39 10.483 3.699 25.162 ––– ––– ––– ––– ––– 50.734

Law CFA.ZONE 1.718 1.646 0.698 0.519 156.86 29.062 3.826 25.162 ––– ––– ––– ––– ––– 50.734

Common SADC 1.400 2.606 0.792 0.810 209.41 17.114 3.165 35.138 ––– ––– ––– ––– ––– 4145.1

Law COMESA 1.413 1.615 0.792 0.810 255.01 10.655 10.564 31.237 ––– ––– ––– ––– ––– 132.82

Data 1.718 2.606 0.792 0.810 255.01 29.062 10.564 35.138 1.000 1.000 1.000 1.000 1.000 4145.1

Obs.

French CEMAC 65 60 50 50 65 65 65 65 ––– ––– ––– ––– ––– 64

Civil UEMOA 104 104 80 80 84 104 104 95 ––– ––– ––– ––– ––– 91

Law CFA.ZONE 169 164 130 130 149 169 169 159 ––– ––– ––– ––– ––– 155

Common SADC 130 126 100 100 130 130 117 115 ––– ––– ––– ––– ––– 128

Law COMESA 140 137 110 109 141 143 143 141 ––– ––– ––– ––– ––– 143

Data 489 477 380 379 472 494 481 454 494 494 494 494 494 465

S.D: Standard Deviation. Min: Minimum. Max: Maximum. Obs: Observations. Bcbd: Bank credit on Bank deposits. Fcfd: Financial system credit on Financial system deposits. Reg: Regulation. Popg: Population growth. Gov.Exp: Government Expenditure. GDPpcg: GDP per capita growth. CEMAC: Economic and Monetary Community of Central African States. UEMOA: Economic and Monetary Community of West African States. CFA ZONE: FRANC ZONE. SADC: Southern African Development Community. COMESA: Common Market for Eastern and Southern Africa.

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4. Cross–region regressions Section 3.1.5 has partially settled the first hypothesis of whether common–law countries exhibit higher

levels of inflation and inflation uncertainty. In this section we shall empirically confirm Hypothesis 1 and address the second hypothesis.

4.1 Inflation, efficiency, law and regional origin This section presents results for steps 1 and 2 of Hypothesis 2. We assess the importance of inflation in

explaining financial intermediary efficiency (Panel A of Table 2 for step 1 of Hypothesis 2). We unconditionally regress banking system efficiency on inflation (Model 1) and test for the significance of inflation as a detriment to banking efficiency. Next we control for other potential determinants of banking efficiency (Model 2) before robustly validating our results with financial system efficiency regressions of the same order (Model 1* and Model 2*).

All results are significant both at coefficient (significance of t–statistics for the inflation variable) and overall model (significance of Fisher statistics) levels. The negative sign of the significant inflation estimate point to the detrimental effect inflation and corresponding inflation uncertainty xert on financial intermediary efficiency.

Panel B of Table 2 addresses the second–step of Hypothesis 2. This step is essential for our choice of endogenous explaining control variables at the second–stage of the TSLS estimation method. In practice and fact, control variables must a priori be endogenous to (explainable by) instruments both from theoretical and empirical perspectives. Literature has already addressed the theoretical foundation (LLSV 1998; Beck et al. 2003) where much emphasis is laid on the edge common–law countries have on the quality of regulation and rule of law over French civil–law countries. The comparative summary statistics depicted in Table 1 justify this assertion. But we cannot limit ourselves at those because our objective is not to prove the edge one legal system has over the other. Our law variables are essentially control variables and therefore only their endogenous quality with respect to regional–legal origins is of interest to us. In other words, we are interested in pointing–out that the endogenous components of the rule of law and quality of regulation can be explained by the instruments.

Table 2. Regressions for First and Second steps of Hypothesis 2

Panel A :First–Step of Hypothesis 2

Banking System Efficiency Financial System Efficiency

Model 1 Model 2 Model 1* Model 2*

Bcbd Bcbd Fcfd Fcfd

Constant 0.722*** 1.070*** 0.768*** 1.165***

(51.50) (15.41) (39.35) (11.49)

Control Variables

Inflation –0.0001** –0.005*** –0.0001* –0.007***

(–2.448) (–4.962) (–1.820) (–3.668)

Trade ––– –0.002*** ––– –0.003***

(–5.154) (–6.027)

GDPpcg ––– –0.007* ––– –0.010*

(–1.965) (–1.860)

Pop. Growth ––– –0.032** ––– –0.056***

(–2.185) (–2.684)

Gov. Exp. ––– –0.003 ––– 0.006

(–1.404) (1.481)

Fisher test 5.993** 11.321*** 3.313* 10.579***

Adjusted R² 0.010 0.112 0.005 0.107


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Observations 460 409 450 399

Panel B: Second–Step of Hypothesis 2

French Civil–law regions (Instruments)

Regulatory Quality Rule of Law

Model 3 Model 4 Model 3* Model 4*

UEMOA 0.323*** ––– 0.283*** –––

(12.29) (9.364)

CEMAC 0.217*** ––– 0.150*** –––

(6.527) (3.927)

CFA.ZONE ––– 0.282*** ––– 0.232***

(13.59) (9.698)

English Common–law regions (Instruments)

SADC 0.339*** 0.339*** 0.339*** 0.339***

(13.34) (13.24) (11.58) (11.48)

COMESA 0.203*** 0.203*** 0.227*** 0.227***

(8.375) (8.318) (8.114) (8.045)

Fisher test 145.87*** 189.76*** 105.43*** 135.77***

Adjusted R² 0.605 0.599 0.525 0.517

Observations 380 380 379 379

*, **, ***: significance levels of 10%, 5% and 1% respectively. Student t–statistics are presented in brackets. F–test: Fisher–test. Bcbd: Bank credit on Bank deposits. Fcfd: Financial system credit on Financial system deposits. Pop: Population. Gov.Exp: Government Expenditure. GDPpcg: GDP per capita growth. CEMAC: Economic and Monetary Community of Central African States. UEMOA: Economic and Monetary Community of West African States. CFA ZONE: FRANC ZONE. SADC: Southern African Development Community. COMESA: Common Market for Eastern and Southern Africa.

Panel B of Table 2 therefore assesses the importance of regional–legal origin in explaining cross–regional variances in the rule of law and regulation quality. We regress our law indicators on the UEMOA, CEMAC, CFA–ZONE, SADC and COMESA regional origin dummy variables and also test for their joint significance (Fisher test). Results show that distinguishing regions by legal origin helps explain cross–regional differences in the rule of law and quality of regulation. These findings are in accordance with the literature as pointed–out above. Therefore in this second–step of Hypothesis 2, we have empirically justified the law variables we shall use as endogenous explaining variables of control at the second–stage of the TSLS methodology.

4.2 Regional origin, inflation and financial allocation efficiency In this section, results in Table 3 present cross–region regressions to assess the importance of regional–

legal origin in explaining cross–regional differences in financial system efficiency on the one hand and inflation on the other hand. Thus the third–step of Hypothesis 2 is looked at. Results for model 7(7*) confirm Hypothesis 1 in asserting that common–law regions exhibit higher levels of inflation than French civil–law regions. It is also worth notice that these results confirm the first condition for the TSLS methodology where–by, the instruments (regions) must explain the endogenous explaining variable (inflation) conditional on other potential determinants of inflation (control variables). Results for UEMOA and CEMAC are robust to that of the CFA–ZONE.

Models 5(5*) and 6(6*) assess the importance of legal origin in explaining cross–region variances in financial efficiency. Banking system efficiency results are robust to those of financial system efficiency both in terms of estimated coefficients and joint significance of regional instruments (Fisher statistics).


102

Table 3. Allocation efficiency, inflation and regional origin regressions

Third–Step of Hypothesis 2

Efficiency and Inflation(First–Stage regressions)

Banking Syst. Efficiency Financial SystEfficiency Inflation

French Civil–law regions (Instruments)

Model 5 Model 6 Model 5* Model 6* Model 7 Model 7*

Bcbd Bcbd Fcfd Fcfd Inflation Inflation

UEMOA 0.661*** ––– 0.669*** ––– –1.433 –––

(14.10) (10.74) (–0.787)

CEMAC 0.556*** ––– 0.550*** ––– –3.468* –––

(10.13) (7.321) (–1.862)

CFA.ZONE ––– 0.545*** ––– 0.549*** ––– –5.449***

(13.65) (10.49) (–3.912)

English Commonlaw regions (Instruments)

SADC 0.105** 0.119*** 0.260*** 0.274*** 4.433*** 4.501***

(2.332) (2.513) (4.304) (4.408) (3.015) (3.002)

COMESA 0.286*** ––– 0.284*** ––– 6.260*** –––

(7.169) (5.312) (4.392)

Trade 0.003*** 0.004*** 0.003*** 0.004*** ––– –––

Control Variables

(9.928) (13.62) (7.069) (10.07)

GDPpcg 0.014*** 0.014*** 0.012** 0.011* ––– –––

(3.311) (3.001) (2.094) (1.902)

Pop.growth ––– ––– ––– ––– 2.252*** 3.124***

(4.598) (6.820)

Gov. Exp ––– ––– ––– ––– –0.084 –0.013

(–1.141) (–0.181)

F–test(for Instruments) 234.67*** 303.37*** 139.60*** 189.63*** 30.77*** 39.53***

Adjusted R² 0.750 0.722 0.647 0.624 0.296 0.266

Observations 467 467 455 455 428 428

Bcbd: Bank credit on Bank deposits. Fcfd: Financial system credit on Financial system deposits. Pop: Population. Gov.Exp: Government Expenditure. GDPpcg: GDP per capita growth.*, **, ***: significance levels of 10%, 5% and 1% respectively. Student t–statistics are presented in brackets. F–test: Fisher–test. Syst: System. CEMAC: Economic and Monetary Community of Central African States. UEMOA: Economic and Monetary Community of West African States. CFA ZONE: FRANC ZONE. SADC: Southern African Development Community. COMESA: Common Market for Eastern and Southern Africa.

4. 2 Second–stage inflation and financial efficiency regressions This section presents results on the fourth–step of Hypothesis 2. Table 4 addresses two main issues: (1)

the concern of whether the exogenous components of the inflation indicator explain financial intermediary efficiency; (2) the issue of if regional–legal origin explains financial intermediary efficiency through some other mechanisms beside the inflation channel.

To make this assessment we use the TSLS regressions. The significance of the estimated coefficient of inflation in Model 8(8*) addresses the first issue. The second issue is addressed by the test for the overidentifying restrictions (OIR). The null hypothesis of the OIR–test is that regional–legal origin dummies (instruments) are not correlated with the error term in the equation of interest (equation 2). Thus the rejection of null hypothesis of the OIR–test is the rejection of the view that regional–legal origin explains financial intermediary efficiency only through the inflation channel. Thus when other potential exogenous determinants of financial efficiency are controlled for, the OIR–test becomes a general specification test for the validity of instruments (regional–legal origin).


103

Although the first issue is addressed in Model 8, rejection of the null hypothesis of the OIR test shows that regional–legal origin explains banking system efficiency through some other mechanisms than the inflation channel. Models 9(9*) and 10(10*) address the second issue with regard to regulation quality and the rule of law respectively. Model 9 on banking system efficiency (that is robust to Model 9* on financial system efficiency) attest to the fact that regional–legal origin does not explain cross–country differences in financial intermediary efficiency beyond the inflation channel when the law channel of regulation–quality is controlled for. Evidence of this is provided by the result of the OIR–test which fails the reject the null hypothesis. On the other hand, when the rule of law channel is controlled for, as expressed in Model 10(10*) for banking system efficiency (financial system efficiency), there is failure to reject the null hypothesis (rejection of the null hypothesis) of the OIR–test. What do these results tell us; they point to the fact that regional–legal origin does not explain banking system efficiency through some other mechanisms other than the inflation channel when the rule of law channel is controlled for (Model 10). However, from a financial system perspective, even when the rule of law channel is controlled for, regional–legal origin still explains financial system efficiency through some other mechanisms than the inflation channel (Model 10*). This could be explained by the complexity of the financial system in developing countries which entails much more implicit variables of law (in micro financial institutions and local co–operatives) than in the formal banking sector (banking system) regulated by the governments and central banks.

Another crucial aspect worth noting is the sign of the estimated coefficients. In the absence of other potential determinants of financial efficiency (absence of endogenous variables of control) the inflation coefficients reflect a wrong positive sign (Models 8 and 8*). However, when law is controlled for, the inflation coefficients have the right negative signs (Models 9(9*) and 10(10*)). The validity our TSLS estimation method is justified by the rejection of the null hypothesis of the Hausman test in all 6 regressions. This rejection suggests estimates by OLS are not consistent due to endogeneity.

Table 4. Allocation efficiency and inflation channel regressions

Fourth–Step of Hypothesis 2

Financial Allocation Efficiency(Second–Stage regressions)

Banking System Efficiency Financial System Efficiency

Model 8 Model 9 Model 10 Model 8* Model 9* Model 10*

Bcbd Bcbd Bcbd Fcfd Fcfd Fcfd

Inflation Channel

Inflation 0.013*** –0.007* –0.007* 0.015*** –0.005* –0.005

(3.180) (–1.835) (–1.745) (3.227) (–1.749) (–1.627)

Control Variables

Reg. Quality ––– 2.581*** ––– ––– 2.554*** –––

(6.183) (8.274)

Rule of Law ––– ––– 2.515*** ––– ––– 2.494***

(5.811) (7.624)

Hausman test 172.674*** 302.729*** 359.423*** 200.7*** 116.208*** 197.262***

OIR(Sargan) test 9.299* 1.587 4.236 6.729 2.225 6.427**

P–values [0.054] [0.662] [0.120] [0.150] [0.526] [0.040]

Adjusted R² 0.012 0.019 0.005 0.007 0.026 0.008

Observations 460 353 352 450 345 344

Instruments (Economic/ Monetary Regions)

French Civil– Law

UEMOA UEMOA CFA UEMOA UEMOA CFA

CEMAC CEMAC ZONE CEMAC CEMAC ZONE

English Common–Law

SADC SADC SADC SADC SADC SADC

COMESA COMESA COMESA COMESA COMESA COMESA

*, **, ***: significance levels of 10%, 5% and 1% respectively. Bcbd: Bank credit on Bank deposits. Fcfd: Financial system credit on Financial system deposits. Reg: Regulation. . (): z–statistics. Chi–square statistics for Hausman test. LM statistics for Sargan test. [ ]: p–values. OIR: Overidentifying restriction test. CEMAC: Economic and Monetary Community of Central African States. UEMOA: Economic and Monetary Community of West African States. CFA ZONE: FRANC ZONE. SADC: Southern African Development Community. COMESA: Common Market for Eastern and Southern Africa.


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5. Conclusion While recent literature (Asongu 2011) has debunked the dominance of English common–law countries in

prospects for financial development, it has failed to establish empirically why French civil–law countries exert such overwhelming dominance in financial intermediary efficiency over their counterparts with common–law origin. In this paper, we have presented an ‘inflation uncertainty theory’ in providing theoretical validity and empirical justification as to why countries with French legal origin have an edge in financial allocation efficiency. In cementing the Asongu (2011) hypothesis we have cut adrift the legal origins debate at cross–country level by using exchange rate regimes and economic/monetary integration oriented hypotheses. This shift in approach is premised on the fact that the concept of inflation expressed by exchange rate regimes cannot be accounted for at country–level because most French civil–law countries are associated with monetary regions in which financial discipline and inflationary targets are dictated and controlled respectively by the regional central banks.

Our results show that inflation uncertainty that is typical of floating exchange rate regimes accounts for the allocation inefficiency of financial intermediary institutions in English common–law countries when other potential determinants of financial allocation efficiency are controlled for. As a policy implication, results support the benefits of fixed exchange rate regimes in financial intermediary allocation efficiency.

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APPENDICES

Appendix 1. Presentation of Economic and Monetary Regions

Regions Definition Member states Num.

ECOWAS (CDEAO)

Economic Community of West African States

Benin, Burkina Faso, Cape Verde(1976), Côte d’Ivoire, Gambia, Ghana, Guinea, Guinea–Bissau, Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, Togo, Mauritania (2000). (5/1975)

15

UEMOA

West African Economic and Monetary Union

Benin, Burkina Faso, Côte d’Ivoire, Guinea–Bissau (5/1997) °, Mali, Niger, Senegal, and Togo. (1/1994)

8

ECCAS (UDEAC)*

Economic Community of Central African States

Angola(1999)°, Burundi, Cameroon, Central African Republic, Chad, D.R.Congo, Equatorial Guinea, Gabon, Congo, Rwanda, Sao Tomé and Principe.(1985)

11

CEMAC

Economic and Monetary Authority of Central Africa

Cameroon, Central African Republic, Chad, Congo, Equatorial Guinea, and Gabon. (1999)

6

CFA ZONE

CEMAC plus UEMOA

Cameroon, Central African Republic, Chad, Congo, Equatorial Guinea, Gabon, Benin, Burkina Faso, Côte d’Ivoire, Guinea–Bissau, Mali, Niger, Senegal, and Togo (9/1939)

14

SADC

South African Development Community

Angola, Botswana, D.R Congo(1997)°, Lesotho,Malawi, Mauritius(1995)°, Mozambique, Namibia (1990)°, Swaziland, Tanzania, Zambia, Zimbabwe, South Africa(1990)°, Seychelles(2004–2007°) and Madagascar(2005)° (1980)

15

SACU South Africa Customs Union South Africa, Botswana, Lesotho and Swaziland. (1970) 4

EAC East African Community Burundi (2007), Kenya, Rwanda (2007), Tanzania and Uganda. (2001) 5

COMESA

Common Market for Eastern and Southern Africa

Burundi, Comoros, D.R Congo, Djibouti, Egypt(1999)°, Eritrea, Ethiopia, Kenya, Libya(2006)°, Madagascar, Malawi, Mauritius, Rwanda, Seychelles(2001)°, Sudan, Swaziland, Uganda, Zambia, Zimbabwe.(1994)

19

IGAD

Intergovernmental Authority on Development

Djibouti, Ethiopia, Eritrea (1993)°, Kenya, Somalia, Sudan, Uganda. (1986)

7

UMA Arab Maghreb Union Algeria, Morocco, Tunisia, Libya, Mauritania (1989) 5

Countries with dates in brackets are non–founding members. ° Date of entry into regional community. Bold dates in brackets represent creation dates. Countries in Italics have withdrawn their membership. * Founded in 1985 but became effective only by 1999. Num: Number.

Appendix 2. Selected regions and countries(based on data availability)

Regions Member states Number

ECOWAS (CDEAO)

Benin, Burkina Faso, Cape Verde(1976)°, Côte d’Ivoire, Gambia, Ghana, Guinea, Guinea–Bissau, Mali, Niger, Nigeria, Senegal, Sierra Leone and Togo.(5/1975)

13

UEMOA Benin, Burkina Faso, Côte d’Ivoire, Guinea–Bissau (5/1997) °, Mali, Niger, Senegal, and Togo. (1/1994) 8


107

ECCAS (UDEAC)*

Angola(1999)°, Burundi, Cameroon, Central African Republic, Chad, Gabon, Congo and Rwanda.( 1985)

8

CEMAC Cameroon, Central African Republic, Chad, Congo and Gabon. (1999) 5

CFA ZONE

Cameroon, Central African Republic, Chad, Congo, Gabon, Benin, Burkina Faso, Côte d’Ivoire, Guinea–Bissau, Mali, Niger, Senegal, and Togo.(9/1939)

13

SADC

Angola, Botswana, Lesotho, Malawi, Mauritius (1995)°, Mozambique, Swaziland, Tanzania, Zambia and South Africa(1990)°. (1980)

10

SACU South Africa, Botswana, Lesotho and Swaziland. (1970) 4

EAC Kenya and Tanzania. (2001) 2

COMESA Burundi, Egypt(1999)°,Kenya, Madagascar, Malawi, Mauritius, Rwanda, Seychelles(2001)°, Sudan, Swaziland and Zambia.(1994)

11

IGAD Kenya and Sudan. (1986) 2

UMA Algeria, Morocco and Tunisia. (1989) 3

Countries with dates in brackets are non–founding members. ° Date of entry into regional community. Bold dates in brackets represent creation dates.

Appendix 3. Selected regions based on testable hypotheses and correlation analysis

Legal–Origin Regional Origin Type of Integration Number

French Civil–Law Regions

CEMAC UEMOA CFA ZONE

Monetary and Economic Monetary and Economic Monetary

5 8 13

English Common–Law Regions

SADC COMESA

Economic Economic

10 11

108

Appendix 4. Correlation Analysis

Financial Intermediary Development Law Control Variables Instrumental Variables

Depth Efficiency Activity Size Reg. Qua

Rule of

Law

Infl.

Tra de

Popg

Gov. Exp.

GDPg

GDP pcg

ECO WAS

UE MOA

EC CAS

CE MAC

CFA Zone

SA DC

SA CU

E A C

CO ME SA

IGAD

UMA M 2

Fd gdp

Bc bd

Fcfd Pcrb Pcrb

of Dba cba

1.00 0.97 –0.07 –0.00 0.74 0.59 0.39 0.40 0.63 –0.06 0.30 –0.46 0.33 –0.05 0.05 –0.14 –0.20 –0.34 –0.28 –0.37 –0.03 –0.00 –0.02 0.21 –0.07 0.35 M2

1.00 –0.04 0.06 0.80 0.68 0.46 0.48 0.68 –0.05 0.32 –0.49 0.37 –0.01 0.10 –0.21 –0.27 –0.34 –0.29 –0.44 0.07 0.10 –0.01 0.25 –0.05 0.31 Fdgdp

1.00 0.87 0.40 0.42 0.25 0.19 –0.00 –0.11 –0.23 0.01 –0.07 –0.09 –0.08 0.08 0.21 0.15 0.18 0.31 –0.19 0.07 –0.09 –0.13 –0.03 0.03 Bcbd

1.00 0,53 0.67 0.28 0.30 0.10 –0.08 –0.23 –0.04 0.04 –0.09 –0.07 –0.00 0.10 0.08 0.07 0.14 –0.01 0.27 –0.09 –0.13 –0.05 0.02 Fcfd

1.00 0.93 0.51 0.61 0.62 –0.06 0.10 –0.41 0.24 –0.02 0.07 –0.16 –0.16 –0.27 –0.24 –0.31 0.10 0.20 –0.03 0.10 –0.04 0.34 Pcrb

1.00 0.45 0.57 0.53 –0.05 0.05 –0.35 0.26 –0.03 0.05 –0.18 –0.16 –0.23 –0.21 –0.29 0.18 0.34 –0.03 0.04 –0.04 0.25 Pcrbof

1.00 0.48 0.45 –0.09 0.21 –0.29 0.27 0.06 0.13 –0.14 –0.01 –0.25 –0.23 –0.18 0.23 0.32 0.11 –0.04 –0.06 0.29 Dbacba

1.00 0.79 –0.09 0.04 –0.27 0.19 0.02 0.08 –0.05 –0.02 –0.43 –0.26 –0.20 0.30 0.32 0.09 –0.02 –0.10 0.16 Reg.Qua

1.00 –0.09 0.23 –0.34 0.34 0.00 0.08 –0.05 –0.11 –0.47 –0.33 –0.33 0.28 0.30 –0.03 0.06 –0.24 0.16 Rule of L

1.00 0.10 0.03 –0.14 0.07 0.07 –0.04 –0.03 0.10 –0.03 –0.05 0.10 –0.02 –0.01 –0.02 –0.00 –0.02 Inflation

1.00 –0.40 0.37 –0.01 0.08 –0.16 –0.20 –0.43 –0.26 –0.20 0.31 0.35 –0.15 0.05 –0.19 –0.02 Trade

1.00 –0.33 0.22 –0.01 0.30 0.29 0.15 0.01 0.26 –0.23 –0.29 0.08 –0.02 0.03 –0.30 Popg

1.00 –0.02 0.06 –0.11 –0.13 –0.19 –0.27 –0.31 0.25 0.50 0.00 0.03 –0.03 0.08 Gov. Exp.

1.00 0.97 –0.03 –0.09 0.02 –0.09 –0.14 0.10 –0.04 0.00 –0.01 0.03 –0.00 GDPg

1.00 –0.09 –0.15 –0.01 –0.10 –0.20 0.14 0.02 –0.01 –0.01 0.02 0.06 GDPpcg

1.00 0.71 –0.37 –0.28 0.41 –0.43 –0.24 –0.17 –0.46 –0.17 –0.21 ECOWAS

1.00 –0.26 –0.20 0.71 –0.30 –0.17 –0.12 –0.32 –0.12 –0.15 UEMOA

1.00 0.75 0.30 –0.16 –0.17 –0.12 –0.04 –0.12 –0.15 ECCAS

1.00 0.53 –0.23 –0.13 –0.09 –0.24 –0.09 –0.11 CEMAC

1.00 –0.43 –0.24 –0.17 –0.46 –0.17 –0.21 Fr. ZONE

1.00 0.57 0.12 0.14 –0.14 –0.17 SADC

1.00 –0.08 –0.02 –0.08 –0.10 SACU

1.00 0.10 0.47 –0.06 EAC

1.00 0.36 –0.18 COMESA

1.00 –0.06 IGAD

1.00 UMA

M2: Monetary Base. Fdgdp: Financial system deposits. Bcbd: Bank credit on Bank deposits. Fcfd: Financial system credit on Financial system deposits. Pcrb: Private domestic credit by deposit banks. Pcrbof: Private domestic credit by financial institutions. Dbacba: Deposit bank assets on central bank assets plus deposit bank assets. Reg.Qua: Regulation Quality. Infl: Inflation. Popg: Population growth. Gov.Exp: Government Expenditure. GDPpcg: GDP per capita growth. CEMAC: Economic and Monetary Community of Central African States. UEMOA: Economic and Monetary Community of West African States. CFA ZONE: FRANC ZONE. SADC: Southern African Development Community. COMESA: Common Market for Eastern and Southern Africa. ECOWAS: Economic Community of West African States. ECCAS: Economic Community of Central African States. SACU: Southern African customs Union. EAC: East African Community. IGAD: Intergovernmental Authority on Development. UMA: Arab Maghreb Union.

109

‘ECONOMIC CONSTITUTION’ IN PRACTICE: THE ENFORCEMENT OF COMPETITION LAW IN ALBANIA

Petrina BROKA

University of Tirana, Faculty of Law, Department of Civil Law, Albania [email protected]

Ermal NAZIFI Albanian University/Albanian Competition Authority Albania1

[email protected] Abstract:

Proper enforcement of competition rules is one of the pillars of the free market economy of Albania. It is also a very important factor for the integration of Albania in the EU. Therefore these rules have been considered as an economic constitution. The effective enforcement of competition rules can be done by public institutions via administrative procedures (public enforcement) or directly by the parties affected from breaches of competition law by actions in courts (private enforcement). In the case of Albania, public enforcement has been in a process of continuous evolution. On the other hand there have been no cases of private enforcement so far despite the potential of such cases especially in actions for damages following on the decisions of the Albanian Competition Law. However more effort is needed in such areas as the collection of fines, acceptance of recommendations from the part of the government, etc. For a fully effective implementation of competition rules all institutional stakeholders, the courts and businesses should be engaged in order to contribute positively for the development of the Albanian economy.

Keywords: Albanian Competition Authority, competition law and policy, private enforcement, public enforcement, advocacy.

JEL Classification: K21, L40.

1. Introduction Competition rules have been considered as one of the most important aspects of the economic

constitutional law in the EU2. Indeed they have been considered as an economic constitution3. The Albanian lawmakers seem to agree with this idea, since in the preamble of the law ‘On protection on competition’ they refer specifically to Article 11 of the Constitution4. This article establishes that the Albanian economy is based on a market economy and on freedom of economic activity. Therefore effective enforcement of competition law is to be considered as a crucial element for the development of Albania as a new market economy. Enforcing institutions of competition rules are like the referee in a football match to make sure that the players stick to the (competition) rules of the ‘game’. In the competition law the aim of the ‘game’, is the establishment of a free and efficient market. In the case of Albania ‘the rules of the game’ are prescribed in the law ‘On protection of competition’ 5 and the ‘referee’ is the Albanian Competition Authority (ACA) as well as the court in the private enforcement cases.

Another strong motivation for implementing competition law in Albania is the European integration process which is based in Stabilization and Association Agreement (SAA)6. This agreement, aims to support

1 Disclaimer: The views, opinions, positions or strategies expressed by the authors in this paper, are theirs alone,

and do not necessarily reflect the views, opinions, positions or strategies of Albanian Competition Authority. 2 For a detailed analysis of Competition law as economic constitution law See (Cruz 2002) 3 (Këllezi 2004) page 3. 4 (Qendra e Publikimeve Zyrtare 2009) 5 The law no. 9121, dated on 07.28.2003 ‘On competition protection’, Fletorja Zyrtare No. 71, (2003), pages 3189-

3211. 6 Albania has signed the SAA, in June 2006. On 1 April 2009, the SAA has entered into force after the ratification of

this agreement, from the Albanian Parliament, European Parliament and the Parliaments of all member states of the European Union.




110

Albania’s economic transition, and integration into the EU’s single market. A very important part of the SAA is the implementation of a competition law and policy based on EU standards7.

2. The competition rules Competition in Albania is regulated by the law no. 9121, dated 28.07.2003 ‘On Protection of Competition’

(LPC). It is enforceable on all sectors of the economy and for all undertakings, private and public, that exercise their activity in the territory of the Republic of Albania. This law is applicable as well, for enterprises that exercise their activity outside the territory of Albania but their activity affects the Albanian market.8

An effective enforcement of competition rules can be achieved mainly in two ways. One way is through the enforcement of competition rules from a public body. In the case of Albania, this is done from the Albanian Competition Authority. It is an independent body composed of two organs – the Competition Commission – the decision making body and the Secretariat – the executing and investigative body. The Authority can be considered successful on its enforcement activities. It has conducted many investigations and fined different companies for breaches of competition law in considerable amounts. It has also conducted sectorial inquiries9 and reviewed from the competition law point of view many laws in the light of its competition advocacy duties10.

The second possibility is the private enforcement of competition law from the courts. The law ‘On protection of competition’ has established the right of individuals and companies to file a suit if they can be or have been harmed from anticompetitive behavior of other players in the market. This can be done independently from the public enforcement procedures started from the Albanian Competition Authority.11 Unfortunately to the best knowledge of the authors12 there has not been any case of private litigation in Albania despite the potential for such cases following on the decisions for breach of competition rules stipulated from the Albanian Competition Authority.

In this article we will focus on the analysis of both aspects of competition law enforcement and analyze some of the key cases on competition law from the Albanian Authority and the Courts.

2.1. A short history of competition rules in Albania During the communist regime (1944 – 1900), Albania has witnessed one of the most controlled and

planned economies in Europe. According to Amik Kasoruho13, a famous Albanian writer and translator:

‘the key methods of this novelty [communism], that it was using to impose itself were not inferior to medieval methods, such as; disappearance of the freedom of speech and thought, elimination of any movement outside the framework of the communist party, nationalization and prohibition of private property, prohibition of any economic activity outside the frame of state production, canalization of societal production on the benefit of the state….’.

It is needless to say that during these years there was no room for free and effective competition and therefore there was no need on protecting it. After the 1990’s Albania started its transition phase to a fully functional market economy. In the end of 1995 the first law on competition was approved from the Albanian Parliament14. This is the first, most significant step forward in the field of competition law in Albania. This law established the first competition protection institutions that were the Directorate of Economic Competition and the Competition Commission. These two institutions were not independent bodies. The Directorate15 was part of the

7 See (Broka, and Laçi, The evolution of Albanian Competition Law and Policy and its implementation, as a

challenge for the EU integration 2010) for a detailed analysis of the importance of competition rules for the EU integration of Albania.

8 LPC, Article 2. 9 Based on Article 41 of the LPC the ACA, can start a general investigation procedure. 10 See (Autoriteti i Konkurrencës 2006) pp. 33-40 as well as (Autoriteti i Konkurrencës 2011), pp. 26-31, for the 2010

advocacy activities. 11 LPC, Article 65(2). 12 No information neither on the site of the Albanian Competition Authority www.caa.gov.al nor in the site of the

Tirana District Court http://www.gjykatatirana.gov.al . 13 (Kasaruho n.d.) 14The law no. 8044, dated on 07.28.2003 ‘On competition’, Fletorja Zyrtare No. 27, (1995), page 1153. 15 Albanian Council of Ministers, Decision No. 248, date on June 14, 1997, ‘For the functioning and organization of

the Directorate on Economic Competition’.

http://www.caa.gov.al/

http://www.gjykatatirana.gov.al/


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Ministry of Trade and Economy structure while the members of the Commission were appointed from the minister in charge for trade. The law included provisions on both antitrust issues and unfair competition.

This law was in force for almost 8 years but its implementation in practice was not considered enough to fulfill the European standards in the field of competition law and the law was not properly enforced in practice16. The bodies that were in charge of implementing it were considered weak in order to implement the duties that came from the stabilization and association process17.

In a report of the European Commission18 it was stated that:

‘The development of competition policy in Albania remains at its initial stage, despite the existence of basic legislation since 1995. Implementation is extremely weak, due in particular to the clearly insufficient resources devoted to this area. … A serious effort will be necessary in this field if Albania is to be able to take on and implement obligations under an SAA. The ‘de facto’ situation in Albania, where the grey economy remains very important, does not allow fair competition between companies belonging to the formal and the ‘informal’ economy. This has a serious detrimental effect on companies willing to invest and legally operate in Albanian. Albania will need to make considerable efforts in this area in order to be able to properly implement the provisions of a future SAA.’.

It was clear that was a pressing need for a deep reform on competition law in Albania, this not only in order to cope with the obligations deriving from the relations with the European Union but, most importantly, to improve the situation of business entities willing to ‘play by the rules’. This reform needed to reflect the acquis communautaire, and create an independent body in charge for the implementation of the law. The new law ‘On protection of competition’, was approved from the Albanian Parliament in 2003. As mentioned before, it created an independent authority in charge of the implementation of the law19. It was focused only on prohibited agreements, abuse of dominance and merger control. It does not contain provisions on unfair competition20 and state aid21.

The LPC was amended in 201022, in order to improve its application and to bring it more in line with the EU’s acquis. Different amendments were done in the field of agreements and exemptions, abuse of Dominance, merger control, fines, procedures, etc23. A major novelty was the introduction of liberalization clauses similar with article 106 of the Treaty on the Functioning of the European Union. In this way the LPC is applicable in cases of public undertakings, as well as undertakings that have exclusive or special rights.

2.2 The Albanian Competition Authority The Authority is structured in two parts: the executive and investigative part which is the Secretariat of the Authority, the decision–making body which is the Competition Commission.

16 See Weishaar, and Milaj 2007, p. 19 and (Këllezi, Albania: Introducing competition law 2009) 17 See (Nair 2006) p. 31 18 See (Commision of the European Communities 2001) p. 24-25. 19 The details of the stipulations of the law in the fields of prohibited agreements, abuse of dominance, merger

control etc fall outside the scope of this article. For more information please refer for example to (Dajkovic 2004), (Lekaj, and Skendaj 2009), etc.

20 Unfair competition is regulated by Article 638 of the Albanian Civil Code. The law no. 8044 ‘On competition’ (now abolished and replaced by the LPC) also contained provisions on unfair competition.

21The law no. 9374, dated on 21.04.2005 and approved on 21.04.2005 ‘On State Aid’, Fletorja Zyrtare No. 36, (2005), page 1311.

22The law no. 10317 dated on 16.09.2010 ‘On some amendments in the law no. 9121, dated on 28. 07. 200 3 ‘On Competition Protection’.

23 For a brief review in English of the amendments See (Gruda, Melani, and Bushati, Application of Competititon Policy and Law in Small and Transition economies- Albanian Case 2011), for a detailed analysis in Albanian, See (Broka, and Nazifi, Risitë në të drejteën shqiptare të konkurrencës 2011)


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The structure of the Secretariat is approved by the Parliament of Albania24. All members of the secretariat are civil servants and their status is regulated by the law on civil servants25. This assures a greater level of stability and independence of the staff.

On the other hand the independence of the commission is a question of an utmost importance. The law states, that the members of the commission should be elected from the Parliament by a simple majority. The parliament will consider two candidates for each position of the commission and chose one of them. In order to have a politically balanced Commission one member is nominated from the president of Albania, two members are nominated from the Council of Ministers and two members are nominated directly from the Parliament. In the practice of the Parliament, the two nominations have been proposals from the opposition party. In order to be a member of the Commission, a minimum of 15 years of experience is needed. The law also requests that the candidate should be a lecturer at university or hold an academic degree in the fields of law or economics26. Actually the members of the commission are three economists and one lawyer. One of the positions is still vacant.

The actual formula has been criticized because of the possibility of control over the majority the parliament by the government. In (Project against corruption in Albania (PACA) 2010)27 is stated that:

‘Given the appointment process for the CC [Competition Commission], in the Albanian context the effective control of the Parliament by the Government raises some doubts over the Commission’s real independence. In theory at least, the ability of the government majority to determine four of five CC members may create potential for decisions that favor– business interests close to those that control the government, or conversely damage business interests close to opposition forces.’

In order to ensure a better independence of ACA, it is proposed that other institutions should be included

in the process of the proposing of the members of the Commission. Also more lawyers should be included in the Commission.

‘To ensure the operational independence of ACA, it may be wise to consider an appointment process that is broader in the sense of the institutions proposing members (for example including the Constitutional Court or other institutions of key importance), and in which the required education and professional experience of the CC members is made more stringent. The expert believes specifically that the law should alter professional requirements of members to try and ensure a higher representation of lawyers in the Commission, and to require an educational background on European competition law. This would enhance the ACA’s ability to defend its decisions (if necessary in court and against enterprises enjoying the services of the best lawyers), as well as assisting communication with other regulatory bodies, as well as with other the countries counterparts institutions’28.

3. The activity of ACA: achievements and challenges We have seen that the most important ‘player’ in the field of competition law is the Albanian Competition

Authority. Its activity is very important for the whole functioning of the competition protection system. Since the establishment of the ACA, the Albanian Competition Commission has taken a total of 21029 decisions and it has

24 In the law it was foreSeen that the structure of the authority, is approved by the commission. But this provision

was amended by the law No. 9584 dated 17. 07. 2006 ‘On salaries, reward and structures of Constitutional independent institutions and other independent institutions established by law’.

25 The law No.8549, dated on 11.11.1999 ‘Statusi i nëpunësit civil’, Fletore zyrtare No.36, page 1381. 26 This was a new criteria’s were introduced with the law no.9499, dated 03.04. 2006, ‘on Some amendments in the

law 9121, date 28.7.2003 ‘on the protection of competition’, Fletore Zyrtare Nr.37, page: 1160. 27 (Project against corruption in Albania (PACA) 2010). 28 Ib id. 29 According to the website of the Albanian Competition Authority the latest decision is decision no. 210, Dated

21.12. 2011.


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fined 30 undertakings and one individual with a total level of fines of 1.093.263.130 lek (approximately 7.5 million Euros)30.

Table 1. Number of decisions of ACA

Year

Tot

al N

o. o

f

deci

sion

s

Con

cent

ratio

ns

Abu

se o

f

dom

inan

ce

Pro

hibi

ted

agre

emen

t (ca

rtel

s)

Exe

mpt

ion

of

agre

emen

ts

By

Law

s

Rec

omm

enda

tions

Fin

es d

ecis

ions

Oth

er

2004 13 2 – – – 6 1 – 4

2005 17 – – – – 2 3 1 11

2006 14 4 – – – – 1 1 8

2007 25 9 1 3 – 4 2 5 2

2008 29 11 1 – 1 4 5 – –

2009 36 8 1 2 1 2 10 2 10

2010 34 6 3 2 – 7 5 2 9

2011 42 10 – 1 – 6 5 1 20

Total 210 50 6 8 2 31 31 12 71

Source: (Autoriteti i Konkurrencës 2011) up to the year 2010.The analysis of decisions during the year 2011 was

done from the authors)

The public enforcement of competition law has been evaluated very positively from the European Union, in the progress reports of recent years. The EU has declared that Albania has done ‘some progress’31, ‘progress’32 or ‘good progress’33, scoring high compared to other institutions. In the Transitions Report 201134, it is stated that the implementation of competition law has been strengthened. Also locally the Albanian Consumers Protection Office (ZMQ), a consumers association has awarded twice the Albanian Competition as best public institution in consumer protection.

However despite this success in the public enforcement of competition law, there are different problems that need to be addressed. The main problem remains the (non) collection of fines imposed from the Albanian Competition Authority35. These fines are to be collected from the Bailiffs office.

As mentioned below one of the duties of the ACA is the so called competition advocacy36. The Albanian Competition Authority has reviewed different legal acts in order to exam their effect on the competition in the market. After reviewing these acts, ACA issues a decision on recommendations that is directed to different institutions such as the government, the Parliament, regulatory bodies, etc. These recommendations are not obligatory. Unfortunately these institutions can simply ignore those recommendations.

According to the PACA assessment37:

30 See (Autoriteti i Konkurrencës 2011) p.52. ACA can put fines to a level of up to 10% of the previous year annual

turnover of the companies. 31 See (European Commision 2007)p. 29, and (European Commision 2011), p 35. 32 See (European Commission 2005), p. 42, (European Commision 2006) p. 27, and (European Commison 2008) p.

30, 33 See (European Commision 2009) p. 29. 34 See (European Bank For Reconstruction and Development 2011), p. 111. 35 See (Autoriteti i Konkurrencës 2011), page 52. According to ACA officials declarations during personal interviews

the situation hasn’t changed in 2011. 36 See footnote no. 9 of this article. 37 (Project against corruption in Albania (PACA) 2010), p.18.


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‘The ability of the Government to ignore Commission recommendations entirely in such cases appears to imply wide space for corruption in the form of collusion of persons that control the government with business interests to ensure unfair favorable market conditions for the latter. The weakness of the Commission in this respect appears to have led to its resignation from attempts to assert itself, most recently relating to the recent Government decision to issue only one 3G mobile license…’

Another major issue is the length of judicial review proceedings. Although ACA has issued some important decisions against major companies, they are still being reviewed from the courts of different levels. In one case although the decision has been taken from the court, the text of the decision and the arguments are not yet available after more than a year. This situation can be improved by the reform on the administrative system of justice in Albania which will establish a specialized Administrative Court system and new, faster procedures for judicial review38. Unfortunately, it is still a draft and due to political conflicts, its voting has been blocked because it is required that it has to be approved by a qualified majority of 3/5 of the Albanian Parliament Members39.

Despite the fact that anyone, even anonymous complainants, can address the Competition Authority, still there is a lack of complaints from individuals or companies, on matters of competition law and many important investigations start ex officio. This shows that there is a little awareness on the importance of the issues that can be tackled through the competition law and the instruments of the ACA can use for an effective enforcement of the law. Therefore further steps are to be taken in order to improve the competition culture in Albania. Another important aspect of the work of the ACA should be the promotion of the leniency program40. Despite the success that these programs have in other jurisdictions, in Albania there is not yet any application for leniency. This must be connected to the general economic climate in Albania and the fear of retaliation from competitors and business partners alike.

Representatives of ACA have always declared that the main objective of their work is not to protect the competitors but competition and therefore in order to limit the harm of companies and consumers they are interested to see more cases of commitment decisions. One of these cases is the T–Bills market case41 when Raiffeissen Bank (RZB) offered commitments after the allegations for a possible exploitative abuse case in the commissions for the purchase of T–bills through this bank. This was a ‘win–win’ decision since the Authority could not prove these allegations and accepted the commitments offered from RZB, to cap the commission and to promote the investment on t–bills alongside the investment on deposits.

The Albanian lawmakers should consider the introduction of more sanctions of personal nature such as director’s disqualification or even criminal sanctions42. And the ACA should consider using more often the individual sanctions based on article 78 of the LPC.

Of course these measures should be accompanied with further practical and theoretical training and motivation for the staff of ACA as well as an increase of the staff.43 More financial resources from donors as well as from the government should be used to promote scholarly studies of competition law in Albania. In EU countries and US, the gap between the practical application of competition law and scholarly research is not problematic since both practitioners and academics publish widely on competition law and economic issues. In many occasions they switch from one position to the other and in this way they can better contribute to this discourse from both sides. But in the case of Albania there are few academics that have as a main research area competition law or competition policy44.

38 See (Ministria e Drejtësisë 2010) 39 Article 81 of the Albanian Constitution. See (Qendra e Publikimeve Zyrtare 2009), p. 19 40 The word ‘leniency program’ is used to describe all programs that offer either full immunity from sanctions incurred

for the involvement in a cartel or a significant reduction of their scope or level in exchange for a freely volunteered disclosure of information on the cartel. See inter alia (Autoriteti i Konkurrencës 2006) p. 56.

41See decision of ACA no.142, dated on 15.03.2010. 42 For more discussion on this topic See (Broka, and Nazifi, Are criminal punishment necessary for proper

enforcement of comnpetition law in Albania? 2010). 43 See (European Commision 2011), p. 35. 44 According to (Colino 2011): ‘The gap between the academic study of competition law and the practical application of the law is a narrow one, and many practitioners contribute regularly to the literature of the subject’, p.

18. On the other hand, there is still no proper book on competition law or in industrial economics in Albanian language. It is studied in ‘bits and pieces’ in Microeconomics books, EU Law and Business Law books. There are also few articles


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4. Private enforcement of competition rules Another major problem of the public enforcement of competition law is that the ACA cannot offer any

compensation to competitors or the consumers from damages suffered as a consequence of a breach of competition law. But as mentioned before, the law, in principle, establishes a system of private enforcement of competition law, in parallel with the public system of competition law enforcement. Based on the Article 65 of the LPC, a person impeded in its activity, by a prohibited agreement as referred in Article 4 of this law, or by an abusive practice as referred in article 9 of this law, may take an action in court and request:

a. removal or prevention of the practices restricting competition which risks to be carried out or are carried out in contradiction of these articles;

b. reparation or compensation from damages caused by these practices, in accordance with relevant provisions of the Civil Code of the Republic of Albania.

The case can start even if a public enforcement procedure is ongoing (the ACA is investigating in the same case). The parties have two options: In the first place they can wait for the ending of the investigation of the authority and then proceed with the private action in the court (follow on actions). Secondly, they can go directly to court and submit their evidence on breaches of competition law that have affected them or their business (stand – alone action). Usually, it will be easier to bring a case following on a decision of the Authority which can be obliged by the court to disclose all information that they have on the case even if it constitutes commercial or trade secret45. But on the other hand it might take different months even years before a final decision of the competition authority. This aspect should be taken in account when considering which strategy to follow (stand alone vs. follow up suits).

In order to ensure removal or prevention of the obstacle to competition, the District Court of Tirana may rule, at the petitioner's request, in particular, that:

a. contracts are null in whole or in part, with a retroactive effect; b. the undertaking at the origin of the obstacle must conclude contracts on market terms with the

undertaking impeded under the conditions usually pertaining to the business concerned. The successful party may recover attorney fees and other expenses made for the trial. This might be an

incentive to start private actions. However this might turn to a negative aspect if the respondent has ‘deep pockets’, and can hire best law firms and consultancies and threat the plaintiff that it will suffer a lot of damages from the recovery of the attorney fees.

To date, there is no information available on any action brought forward based on the Article 65 of the LPC (no information from ACA as well as the Tirana District Court). This comes from several reasons especially the lack of awareness of the legal community as well as lack of awareness from the public about this tool. Other factors are length of proceedings, lack of credibility of the judiciary46, etc.

Even some judges do not have enough knowledge about this topic.47 Specific training on competition law should be provided for judges in order to improve the situation.

On the other hand also the civil procedures do not facilitate this process. For example there are no clear provisions for class or representative actions48.

5. Case study: The investigation in the wheat flour market After major public concern the Albanian Competition Authority Started an ex officio investigation in the

Wheat flour production and grain import destined for the production of bread.

published in international journals. See for example (Dajkovic 2004), (Këllezi, Albania: Introducing competition law 2009) (Gruda, and Milo, SMEs development and competition policy in Albania 2010), etc.

45 See article 224 of the Albanian Civil procedure Code. 46 According to Business anti corruption portal: ‘ Corruption in the Albanian judicial system is widespread, as

assessed by several sources’ See, http://www.business-anti-corruption.com/ar/country-profiles/europe-central-asia/albania-version-3/corruption-levels/judicial-system/

47 For more See Decision of the Hight Court No.337, dated on 29.07.2010. http://www.gjykataelarte.gov.al/. In this case Gjirokastra District Court and the Supreme Court of Albania apparently have no knowledge of the fact that unfair competition is out of the scope of the LPC which deals only with prohibited agreements, abuse of dominance, merger control and liberalization. See also footnote 19 of this article.

48 Currently this issue is under discussion in EU level. It is expected that the Commission will adopt a communication in regard of collective redress in EU, after the public consultation held in 2011. For more information on the initiatives of DG Competition in the field of actions for damages check http://ec.europa.eu/competition/antitrust/actionsdamages/index.html

http://www.gjykataelarte.gov.al/


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During the years 2005–2006, the wheat market sale has been very concentrated. From the analysis of market shares results that for the years 2005–2006, the five main competitors, altogether own almost 100% of the market.

The HHI index in the year 2005 was 2,765, following a decrease in the year 2006 and again falling to 2,036 during the year 2007. The level of concentration has decreased from year to year by achieving a proportional share during the first eight months of the year 2008 between two enterprises. However, the level of market concentration at 1,842 in that year is still high.

From the analysis of wheat flour sales market for bread production resulted that this market presents the character of an oligopolistic market with three enterprises with consolidated market shares during the years 2005–2008.

From the down raids, performed by the Secretariat of the Competition Authority on date 22.01.2009 at the premises of one of the enterprises (Alpha Company49) it resulted that in the computers of the finance department, various files containing info about transactions running between Alpha Company and another company (Beta Company). These companies were the largest players in the market. They contained data on joint imports during the year 2008, such as: quantities, prices, costs, custom taxes, VAT, custom clearance payments.

The main findings of the investigation were: These two enterprises that have a significant economic strength in the market of flour production and

sale for bread production, exchange information on the offer, therefore are knowledgeable on each–other’s offering strength,

These enterprises maintain accurate data on each–others, quantities, prices, costs, custom taxes, VAT, custom payments, custom clearance payments, etc.,

Share customs expenses, spedition expenses and other expenses, Maintain accurate data on each–others obligations (cash–ins and debit situations), data on amount of

wheat purchased and customs expenses, Jointly own a very high percentage of the wheat import and sales as well as wheat production market,

own high technology and processing capacities, thus becoming a powerful factor in limiting free and effective market competition,

These enterprises have sufficient market power to cause restrictions of competition, because the degree of concentration, stemming from the considerable market shares. The countervailing power of all the other competitors is smaller than that of Alpha and Beta. The countervailing power of the client (small mills and bread producers) is very small. The enterprises have created stability over the years regarding the market share and represent two of three main competitors (CR3) in all the markets concerned.

What is more important, during the period of the agreement, the enterprises Atlas Sh.a and Bloja Sh.a, have not demonstrated a competitive behavior in the flour production and sales market, because:

Referring to the tax bills of flour sales of the companies during one month, results that both companies have applied the same price of the sale of flour,

These two companies follow the same trend of the sales price of flour for the period March to August 2008. On February 25 and 27 of 2008, these companies have increased the sales price of the flour with the same index of 1.2613,

The written records of the estimates derived from tax authorities, turned out that these two enterprises often applied the same sale price for the flour product during February 2008.

49 The two companies will be called Alpha and Beta


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Figure 1. Level of prices of wheat flour during 2008

Source: Albanian Competition Authority.

The communication between the competitors followed by coordinated pricing strategies was considered a prohibited agreement from the Albanian Commission. The Competition Commission concluded that the enterprises did not compete in the relevant market, as the evidence and the analysis of relevant markets shows, these enterprises coordinate market behavior terms of determining the sales price of the relevant products, and by sharing the sources of supply (wheat imports).

Obviously both companies appealed this decision in Tirana District Court. In the case of one company, he court decided on April 2010 to accept the action and the revocation the Decision of the Commission of Competition Authority by a two to one majority. Up to now, this decision has not been yet finalized from the judge although the dissenting opinion has been prepared.

In the case of the other company, Tirana District Court decided to accept the action and the revocation of the Decision of the Commission of Competition Authority. The argument of the court was that there was no forbidden agreement between the parties, the electronic evidence did not constituted an agreement and data was kept for accounting purposes. The decision did not give detailed argumentation on these issues and it did not say anything about the identical prices and the identical increase of the price index.

This case is important because of two main reasons. Firstly it showed that the court is facing a lot of difficulties in analyzing competition cases because of the lack of skills or will to argument their decisions thoroughly. Secondly, this case had enormous potential for private actions for damages suffered from clients and competitors. But of course as mentioned before their countervailing power is low and they still have to cope with the power of these two big players in the market.

6. Conclusions Albania has entered in the free market system after suffering from one of the most planned and closed

economies in Europe for almost 50 years and a long transition period afterwards. One of the pillars of the economy is a market characterized from free and effective competition. Albania has put in place a system of competition protection combining public enforcement and private enforcement of competition law. The legal framework is based in EU competition rules.

However in order to have a really free and effective competition much more efforts are needed. In the first place all fines imposed from the ACA, should be collected. This would be a great tool for the advocacy of competition. This will increase also the number of leniency applications. However it is important to issue commitment decisions whenever it is possible. The penalties imposed should be more personal. They should not only be directed to the company but to the individuals behind breaches of competition law. The introduction of director’s disqualification as well as criminals sanctions should be explored.

But it is very important for the work of the competition Authority to focus on Advocacy issues. The government and other public institutions are not obliged to follow the recommendations of the ACA. But anyway they should do their best in order to respect these recommendations. Commitment decisions should be used whenever it is possible instead of only penalties decisions. This is very important in order to create a positive image for the ACA. In this way, competition advocacy targeted to the public and the businesses would be easier.

Judicial review of competition decisions is a very important part of the ‘puzzle’. Judges need to be trained in order to issue more argumented decisions that will help building on the jurisprudence of competition law in

30 , 0 35 , 0 40 , 0 45 , 0 50 , 0 55 , 0 60 , 0

Jan - 08 Shk - 08 Mar - 08 Pri - 08 Maj - 08 Qer - 08 Kor - 08 Gsh - 08

Level of prices of the sale of wheat flour 2008

ALPHA BETA


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Albania. The new administrative justice system that is expected to be established in Albania will help for a faster and more effective judicial review.

An important factor is the encouragement of private litigation in Albania. This requires a full study of the legislative and policy issues in order to determine the necessary steps to be taken and the role of public institutions in order to enhance this process.

Finally it is very important that research and study of competition law and competition policy in Albania is encouraged. It will help to narrow the gap between theory and practice and it will involve all actors form public and private sector, academia and judiciary. Only by joint efforts of all actors Albania will have a fully free and effective competition and a developed economy where better products with cheaper prices can be delivered to all consumers.

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[22] Ministria e Drejtësisë. ‘Relacion mbi projekt–ligjin për gjykimin e konflikteve administrative dhe organizimin e drejtësisë administrative.’ Report on Draft law, 2010.

[23] Nair, A. 2006. Albania. In Competition Regimes in the World: A Civil Society Report, edited by Pradeep S. Mehta. Jaipur: Consumer Unity & Trust Society.

[24] Project against corruption in Albania (PACA). ‘Preliminary assessment of the Albanian competition authority for the purpose of anti–corruption risk assessment.’ Technical Paper, Department of Information Society and Action Against Crime, Council of Europe, 2010.

[25] Qendra e Publikimeve Zyrtare. Kushtetuta e Republikës së Shqipërisë. Tirana: Qendra e publikimeve zyrtare, 2009.

[26] Weishaar, S.E., and Milaj, J. 2007. Ligji për konkurrencën në Shqipëri dhe koherenca e tij me acquis communautaire: zbatimi i përbashkët i neneve 3(g), 10(2), 81 dhe 82 të Traktatit të Komunitetit Europian. E drejta parlamentare dhe ligjore (Qendra e studimeve parlamentare), no. XL (2007): 4–28.

***

[27] Politika Kombëtare e Konkurrencës. Tirana: Aferdita, 2006.

[28] Raporti Vjetor 2010 dhe Synimet Kryesore të Punës Për Vitin 2011. Tirana, 2011.


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A SEMANTIC INTERPRETATION OF THE VALUES OF SHALL IN ECONOMICS ENGLISH AS TARGET LANGUAGE

Roxana GOGA–VIGARU

Spiru Haret University, Faculty of Law and Public Administration – Craiova, Romania [email protected]

Abstract:

The aim of this paper is to quantify and analyse the meanings of ‘shall’ in point of deontic and epistemic values in a corpus of economics texts made up of financial issues of the Sectorial Operational Programme Human Resources Development 2007–2013–October 2007: Strategy, Financial Plan, Implementation, and Partnership. Since modal verbs express the speaker’s attitude towards the utterance, it is very interesting to investigate the occurrences of ‘shall’ and analyse its values in the above mentioned corpus.

Keywords: deontic, epistemic, modal verbs, meaning, functional interpretation. JEL Classification: G28, G00,

1. Introduction Modals are a feature of English that makes it possible for speakers and writers to fit their statements to

the style required by particular settings. Words, sentences and phrases acquire content when we utter them on particular occasions and what that content is may differ from one context to the next one, so it is the task of semantics to describe all those features of the meaning of a linguistic expression that stay invariable in whatever context the expression may be used. This category of verbs needs to be studied and understood by non–native speakers, as their use could be very problematic because they vary in form and type and they are among the most challenging concepts.

Modals are very important because they involve communication about advice, about obligation or permission and also about our interpretation of events, our judgments about what we think happened or is happening, and modals also help us to express our decisions about what we think, about what we know and how strongly we believe that our knowledge is correct.

The present study focuses on the uses of the modal verb shall in English as target language in point of deontic and epistemic meanings. The corpus consists of economics texts made up of financial issues of the Sectoral Operational Programme Human Resources Development 2007–2013–October 2007: Strategy, Financial Plan, Implementation, Partnership. Shall appears in our Economics corpus 63 times out of which 40 of its occurrences with epistemic meaning and 23 with deontic meaning, although, according to Stefanescu ‘it is generally assumed that shall does not occur with epistemic meaning’. In some of its appearances, depending on the context and on the reader’s perspective upon the text, it may appear that instead of epistemic meaning, shall is used deontically. Although traditional grammarians specify that shall is used to express simple futurity or unstressed intention in the first person, and in the second and third person to express command, obligation, promise we have come across a few examples that show exactly the opposite. In our corpus, the most frequent construction containing shall is that in which the modal is followed by a bare infinitive (60.31% of all the cases where shall appears), followed by the construction ‘shall + passive infinitive’ (39.69%).

The fundamental problem of shall is that it can take on a number of meanings and in our case shall is mostly used with three meanings: to describe present action, to impose obligation and to describe future actions, where it may be replaced by will.

Used with third person subjects, shall suggests the speaker’s volition to give an order and it is stronger than must ‘as it does not only express an obligation, but also a guarantee that the action will occur’ (Maurizio Gotti 2003:275). However, this use is considered archaic and ‘authoritarian’ by Quirk and Palmer (Quirk et al. 1985:230; Palmer 1990:74).

In this matter we may consider the examples:

‘The Competition Council, acting as the Contact Point as regards State 1 aid, between the European Commission on one side and Romanian authorities, State aid’s grantors and beneficiaries on the other side, shall ensure the strict observance of the notification requirements.’



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‘In addition, any information required by the Commission and by the World Trade Organization regarding state aid schemes, individual state aids or ‘de minimis aid’ shall be provided according to the applicable rules.’ ‘The procurement of all contracts financed through the Structural and Cohesion Funds and corresponding national co–financing shall be done in compliance with EU legislation and primary and secondary national legislation implementing the EU provisions on public procurement.’

In the above examples, shall is used deontically and it implies obligation, necessity and a certain constraint. Unlike the cases where shall appears in the first person and where the source of constraint is very often the speaker himself and the obligation seems to be undertaken by the subject himself , with ‘third person subjects, shall represents the speaker as determined to bring something about or prevent it’ (Stefanescu 1988: 189). In the first example it is a necessity for the Competition Council to ensure the strict observance of the notification requirements as it is the Contact Point between the European Commission and Romanian authorities and State aid’s grantors and beneficiaries and given the fact that this may be one of its duties, the meaning of shall is very close to that of must.

As for the other two examples, the value of shall is still deontic, its purpose being that of imposing an obligation. Firstly, some information regarding state aid schemes and individual state aids is needed and it must be provided according to some rules which are applied. We may notice that the obligation is not imposed on the subject of the sentence so it is not clear who owes the obligation. Still, in the same paragraph of our corpus additional information is provided and by reading thoroughly the text we may find out that the subject of obligation is represented by the SOP HRD Annual Implementation Reports.

It happends the same with the other example if we consider and interpret it as it appears in our corpus. The meaning of shall is also close to that of must, that is imposing an obligation according to the EU legislation and the example may appear in the form that is presented here:

‘The procurement of all contracts financed through the Structural and Cohesion Funds and corresponding national co–financing must be done in compliance with EU legislation and primary and secondary national legislation implementing the EU provisions on public procurement.’

The subject of the obligation is also unknown, so, like in the previous example, we do not know who owes

the obligation. Yet, the sentence may be re–interpreted as: ‘The procurement of all contracts financed through the Structural and Cohesion Funds and corresponding national co–financing shall comply with EU legislation…’

In this case, the obligation is imposed to the subject of the sentence, so we do not need to find in the text who owes the obligation.

Sometimes it is difficult to decide whether shall expresses futurity or it is used with deontic meaning and even the context may lead to various interpretations as it may not be sufficiently clear. Let us consider the following examples:

‘Attracting and retaining more people in employment, reducing unemployment and inactivity, by increasing the demand and supply of labour, are key objectives of Romania’s HRD Strategy. The activities envisaged to be funded by the ESF shall aim at improving the attractiveness of jobs and the quality of labour productivity, preventing exclusion from the labour market, reducing regional disparities in terms of employment, unemployment and labour productivity, especially in regions lagging behind.’ ‘Since youths’ and older workers’ unemployment rates are higher than for other groups, this key area of intervention shall aim at facilitating progress in employment, whether it is first time entry, a move back to employment after a break or the wish to prolong the active life.’

Our first interpretation of the use of shall in these two examples is that it expresses epistemic meaning, giving the possibility of replacing it with will and describing, in the first example, that the activities envisaged to be funded by the ESF will aim at improving the attractiveness of jobs, considering all these the purpose of the


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activities, and in the second example, the key area of intervention will aim at facilitating progress in employment, this action being considered as a consequence of the fact that youths’ and older workers’ unemployment rates are higher than for other groups.

The other interpretation of these two examples is marked by the deontic meaning of shall in both of them, as it may be replaced by must denoting obligation:

‘The activities envisaged to be funded by the ESF must aim at improving the attractiveness of jobs and the quality of labour productivity, preventing exclusion from the labour market, reducing regional disparities in terms of employment, unemployment and labour productivity, especially in regions lagging behind.’ ‘Since youths’ and older workers’ unemployment rates are higher than for other groups, this key area of intervention must aim at facilitating progress in employment, whether it is first time entry, a move back to employment after a break or the wish to prolong the active life.’

In the first example, the value of shall may be interpreted as being deontic by taking into account the context with particular reference to the sentence before, so in order to attract and retain more people in employment, the activities must aim at improving the attractiveness of jobs and the quality of labour productivity. The same happens with deontic shall in the second example where the fact that this key area of intervention must aim at facilitating progress represents a consequence of the fact that youths’ and older workers’ unemployment rates are higher than for other groups, the value of shall expressing a certain constraint upon the subject of the sentence.

‘The view of WILL and SHALL as markers of the future tense stated that SHALL is the form that occurs with the first–person subjects ‘I’ and ‘we’ while ‘will’ occurs with second– and third–person subjects; similar statements were made for ‘should’ and ‘would’. Evidence that this was simply not true of conversational English was convincingly supplied in the 1920s by Fries (1925, 1927) and it is now generally accepted that ‘will’ and ‘would’ regularly occur after ‘I’ and ‘we’, even when used in a ‘pure’ future sense. This does not, however, exclude the use of ‘shall’ with first person subjects in a futurity sense (although with other persons it is always deontic)’ (Palmer 1995, 137).

The results of our analysis contradict Palmer’s theory about the use of shall with second and third person subjects only with deontic meaning. Our corpus analysis shows that we have 34 appearances of shall expressing futurity and 6 occurrences where it may be replaced with a present tense verb describing a present action or a status. In our corpus, shall is mostly used in its epistemic meaning to express prediction or futurity which mark the probability or predictability of a future state of affairs and it is necessary to highlight the fact that the type of inference expressed indicates a high degree or probability close to certainty. The example from our corpus show that, with this value, shall is most likely to be a stylistic device expressing the same basic meaning as that of will (Ehrman 1966, 56). Let us take a look at the example below:

‘The active employment measures shall also include training programmes in the field of entrepreneurship for the youth and long term unemployed and the inactive people, including the rural area and subsistence agriculture, enabling them to become active on the labour market, to get the basic knowledge on how to elaborate a business plan, the applicable legislation they have to comply with, marketing issues, clinet–orientated strategies.’

In this appearance shall is used epistemically expressing futurity, its value being synonymous with that of will. We may be sure of the value of shall used here given the fact that, earlier in the text, it is specified that these types of measures were addressed in the Employment Act, which was enforced in 2002 and the specific objectives, which include these active employment measures, will contribute to the achievement of the overall objective of Priority Axis 5.

In the following example, shall is used with the same value:

‘The strengthening of the NGOs sector shall have positive effects on the delivery of social services to family members who otherwise would not have had the possibility to enter the labour market.’

The fact that shall in the above example indicates a high degree of probability is strengthened by the information offered by the context. We may find out, earlier in the corpus, that the strengthening of the NGOs sector is included in the Key Area of Intervention 3 ‘Development of partnerships and encouraging initiatives for


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social partners and civil society’, whose objectives are to support and strengthen the civil society’s representative’s capacity to elaborate and implement project and to provide quality services.

In the example:

‘This key area of intervention is complementary to Priority Axis 1 which addresses the general education system and where also schools for children with special education needs shall benefit from the modernization process.’

the epistemic value of ‘shall + infinitive’ covers more or less the same semantic range as ‘will + infinitive’. Since under this Priority Axis the targets are all those marginal groups who need special attention in a particular way and that cannot be included in the main policies it is a clear fact that schools for children with special education needs are included in these groups and, thus, will benefit from the modernization process.

In the following example, shall is used as a more formal variant of will in order to express futurity, so its meaning is also epistemic:

‘The operation funded under this key area of intervention shall aim at eliminating discrimination and discriminatory practices on multiple grounds including ethnic origin, disability or age.’

Earlier in the context it is stated that promoting equal opportunities on the labour market represents an objective as the reality shows that there are cases of women’s discrimination on the labour market and that women returning to work after a break often experience direct discrimination and prejudice. So, in order to avoid the reluctance of employers to invest in their training and career planning the operations’ purpose is to eliminate ‘discrimination and discriminating practices on multiple grounds including ethnic origin, disability or age’.

Further on, we take a look at the following example where shall appear five times:

‘SOP HRD shall promote educational offers in schools as well as school programmes on entrepreneurship, with a view to instil in students the entrepreneurial spirit, skills and abilities (PA1, KA1). At the same time, SOP HRD shall support the individuals by ensuring the necessary training in the field of entrepreneurship for the people willing to start a business (PA3, KA1). Under this area of intervention, SOP HRD shall also ensure the training of management levels and executive staff with a view to improve companies’ management and their efficient action on the market. All of these will complement the operations proposed under SOP IEC PA1 ‘An innovative productive and eco–efficient system’, KAI3 ‘Promoting entrepreneurial culture’ which shall support the entrepreneurs to develop business incubators, shall provide consulting support, as well as support for enterprises’ integration in supplier chains and clusters.’

Taking into account the context in which shall appears we may interpret it as an epistemic modal with a value similar to that of will expressing futurity very close to certainty. All the actions of SOP HRD are part of the entrepreneurship development and, thus, may be considered as future plans and purposes of this programme. However, outside the context and without knowing that the actions represent a planned programme of development, we may interpret shall as being deontic by imposing an obligation to SOP HRD in order to achieve the entrepreneurship development, its actions being a condition for achieving that goal. Thus, the sentences may become:

‘SOP HRD must promote educational offers in schools as well as school programmes on entrepreneurship…’ ‘At the same time, SOP HRD must support the individuals by ensuring the necessary training in the field of entrepreneurship for the people willing to start a business’ ‘Under this area of intervention, SOP HRD must also ensure the training of management levels and executive staff…’ ‘All of these will complement the operations proposed under SOP IEC PA1 ‘An innovative productive and eco–efficient system’, KAI3 ‘Promoting entrepreneurial culture’ which must support the entrepreneurs to develop business incubators, must provide consulting support, as well as support for enterprises’ integration in supplier chains and clusters.’


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We encounter the same situation in the following example:

‘Also, within the PA2 ‘Linking life long learning with labour market’, KAI ‘Access and participation in CVT’, SOP HRD shall support cross–sector activities in the field of environmental training.’

Here we may consider shall as being epistemic because it expresses a future action denoting possibility very close to certainty, as Priority Axis 2 has already been established and it contains certain fixed purposes which are very likely to happen.

As a conclusion, it is essential to mention that the results that arise from the corpus are not entirely representative for the economics register where English is considered target language, being translated from Romanian and should not serve as a basis for drawing general conclusions as the volume of the corpus is small and it does not include all kinds of economics translated documents.

References [1] Ehrman, M.E. 1966.The meanings of the modals in present–day American English. Mouton and Co.

Publishers.

[2] Gotti, M. 2003.’Shall’ and ‘will’ in contemporary English: A comparison with past uses.

[3] Palmer, F.R. 1990. Modality and the English Modals. Longman Linguistic Library. London: Longman.

[4] Palmer, F.R. 1995. Mood and Modality. Cambridge: Cambridge University Press.

[5] Quirk, R., Greenbaum, S., Leech, G., Swartvik, J.A. 1980. Grammar of Contemporary English, Longman.

[6] Ștefănescu, I. 1988. English Morphology–The nominal and verbal categories, Facultatea de Filologie, Bucuresti.

[7] Thompson, P. 2000. Academic writers putting modal verbs to work. Paper delivered at the ESSE–5 Conference, Helsinki.


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ON THE DETERRENT EFFECT OF INDIVIDUAL VERSUS COLLECTIVE LIABILITY IN CRIMINAL ORGANIZATIONS

Laetitia HAURET

Centre d’Etudes de Populations, de Pauvreté et de Politiques Socio–Economiques/International Network for Studies in Technology, Environment, Alternatives, Development,

Differdange, Luxembourg [email protected]

Eric LANGLAIS Nancy University, EconomiX and CEREFIGE, France

Eric.Langlais@u–paris10.fr. Carine SONNTAG

ICN Business School, Nancy, France carine.sonntag@icn–groupe.fr.

Abstract:

Our paper addresses the question of the deterrent effect of a monetary sanction associated to a collective rather than an individual liability, when crimes are realized within a hierarchical gang (defined as a criminal organization where the leader is a sleeping partner and several agents are active partners in the illegal or criminal activity). We develop a model where the active gang members face contradictory incentives to commit a crime. On the one hand, public authorities try to deter each gang member by imposing sanctions; on the second, the leader of the gang try to keep his members enough active in the gang by threatening them of private sanctions. We show that sanctions based on individual liability are inefficient to deter gang’s members since the leader overreacts on the public sanctions. In contrast, we show that a regime of collective liability, allowing the judge to sanction the sleeping partner even if he hasn’t realized any crime himself, can reach enough deterrence of the members of the gang.

Keywords: Gangs deterrence, individual and collective liability, optimal law enforcement. JEL Classification: K0, K42.

1. Introduction There is a broad consensus in Law & Economics literature, since Becker’s seminal work (1968), on the

relevance to apply severe penal sanction on isolated criminal. However, the optimal enforcement of law in the context of criminal organization is still an open question. In fact, when applied to criminal organizations, the analysis of the optimal design of law enforcement is fuzzed by the welfare implications of the structure of the illegal market. Illegal activities develop on vertically integrated markets where a dominant firm aims at extracting a surplus from smaller business firms (Konrad, and Skaperdas 1997, 1998, Poret 2002, Mansour et al. 2006). Alternatively, the criminal organization emerges as a vertically structure, such as a Mafia or a gang, having the power to regulate the entry in the criminal activity of individuals who has to pay a license to engage in illegal business (Garoupa 2000). The criminal organization may then induce fewer offenses either due to the vertical integration or to a cooperative or collusive behaviour of criminals (Reinganum 1993). Consequently, it has been argued that mechanisms of internal control in criminal organization appear as close substitutes to public punishment, and finally allows the public enforcer to undertake tougher law enforcement policies. Moreover, Mansour and al. show that deterrence policy can have a pernicious effect on criminality. In fact, deterrence policy can produce the split of criminal organization and therefore the increase of criminal output and the reduction of criminal price (Buchanan 1973). However, Garoupa (2000) emphasizes that when the Mafia exerts costly extortions on its members, it is not necessarily correct that tougher policies should be chosen by the public enforcer and/or that the existence of a criminal organization results in a higher social welfare.

The economic literature on law enforcement generally holds that the issue of the allocation of sanctions within a gang is irrelevant, given the vertical structure and/or institutional features of the market for crimes. It is generally recognized that the criminal organization has the main characteristics of an agency relationship, where the Principal (the leader or the Mafia) has to discipline the Agents (the dominated firms or the affiliated members) and considers an incentive constraint when proposing some contractual arrangements. Thus, the conclusion





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suggested by Shavell (1997) in his analysis of corporate liability also holds: the specific allocation of public sanctions is irrelevant since they can always be redistributed between the leader and the Agents through the contractual arrangement. Nevertheless, the allocation of sanctions matters as soon as one of the parties is financially constrained (having a limited wealth) or the Principal has limited liability in controlling his affiliated members. Differences in risk perception between the gang leader and the active members (Privileggi et al. 2001) may be another reason explaining why the allocation of sanctions is not indifferent.

Here, we argue that the allocation of sanctions is not neutral in hierarchical criminal organizations. The endogenous formation of gang has been investigated in the literature, focusing on the existence of social interactions within gangs. Sah (1991), Glaeser et al. (1996), Patacchini, and Zenou (2005) develop an analysis of the formation of criminal groups where individuals are influenced by their peers when deciding to commit offenses. Criminologists (Baatin–Pearson et al. 1998, Thornberry et al. 1993) also show that the criminal activity is more intensive in gangs than isolated. Gangs enroll agents that have a naturally greater propensity to commit crimes, explaining that more crimes occur. In addition, the organizational context of the gang facilitates the fulfillment of crimes, which increases the incentives of gang members to act illegally. Two mechanisms explain this pure effect of the gang on crime intensity. Firstly, the cost–benefit ratio of crime is decreased within a gang (economies of scale, sharing of illegal human capital, division of labour). Secondly, interactions within a gang create incentives to commit crimes. Gang members are in competition to obtain a leadership power, that generally imply to commit more crimes (Herbert et al. 1997). Moreover, peers can reward or sanction the members of the gang when these last ones deviate from a behaviour norm. If the objective of the gang is the maximization of its reputation through a norm of realization of a given level of crime, members who would have committed a level of crime below the norm may be sanctioned by the gang. As a result, more crime is committed within the gang. As mentioned by Herbert et al. (1997, p. 56), a gang member is « aggressor, because he commits violent acts on his name or on the behalf of the group, and the victim, because if he doesn’t act violently, the gang which gives him the statute he needs the more, encounters the danger to lose his own statute and its identity »50.

Our paper is not explicit with the issue of gang formation, and instead, we suppose that the existing hierarchy among the members is exogenously given. In a typical way, this corresponds for example to new forms of international criminal organizations with a leader operating outside of the territory where the crimes will be committed, but entering with local active criminals in a temporary association. In this setting, the paper addresses more specifically the central question of the deterrent effect of a monetary sanction based either on the individual liability or collective liability, when crimes are realized within a hierarchical gang, within which the leader is a passive actor and command several active partners. Our framework extends the usual approach of law enforcement to criminal teams when the leader of a gang has the opportunity to inflict a sanction to the gang members when they refuse to realise a crime for the gang. In this context, the choice of the member of the gang to commit a crime is twice influenced. On the one hand, the more the crime’s benefit and the private sanction’s risk, the more he commits crime. On the other hand, the more the public sanction, the less he commits crime. We show that sanctions based on individual liability, even if increased according to the principle of the ‘circonstance aggravante’, are inefficient to deter gang’s members, when the leader threatens them of a private sanction51. Sanctioning the leader in addition to the sanction of members can lead to optimal deterrence of the members of the gang. Our model is then an illustration of a case when sanctions based on collective liability are more deterrent than sanctions based on individual liability. The paper is organised as follows. Section 2 presents the model and the main assumptions. Section 3 shows the conditions of inefficiency of individual sanctions when the leader of a gang can impose private sanctions to its members. Section 4 reveals the fundamental role of the sanction of the leader in addition to the one of gang members to achieve a deterrent effect of public policies. Section 5 discusses the various results and concludes.

50 Translation from the authors. 51 Realizing a crime within a group is considered as a ‘circonstance aggravante’ in the French criminal code, witch

results in an increase of the individual sanction ladder compared to the one that punishes the same individual act committed alone. For instance, « theft is punished with 3 years of imprisonment and a fine of 45 000 euros » when realized by an individual criminal (Art. 311-3 CPN), it is « punished with 5 years of imprisonment and a fine of 75 000 euros, when committed by several persons acting as authors or accomplice, without constituting an organized gang » (Art 311-4 CPN) and finally, « theft in organized gang is punished with 15 years of imprisonment and a fine of 150 000 euros » (Art. 311-9 CPN) [Translation from the French criminal code (CPN)].


127

2. Model and main assumptions Assume the existence of a hierarchical gang monopolizing the market for crimes, with a leader who does

not realize any crime and several members who are the active criminals. We consider a case where the gang members and the leader act cooperatively, in the sense that they share the illegal benefit and comply with the rules of the gang. The leader receives a part (1 β) of the illegal benefit captured by a member of the gang (b),

with β the part of the benefit kept by the gang member (β]0,1[)52. The authorities and the gang leader do not observe (neither ex ante nor ex post) the type of individual criminals, and just know that this type has a uniform distribution function defined on [0,1].

Public authorities enforce an expected sanction (pf) to deter individual gang members to commit the crime : p is the probability of apprehension and conviction that each member faces when committing a crime and f is a monetary sanction imposed by public authorities in case of conviction; we will assume that f ≤ F, where F represents the maximum possible sanction of the member of the gang (for example the own criminal wealth, which is a basic assumption in the literature). On the other hand, the leader could be punished with a monetary sanction s≤S where S is the maximum possible sanction for the leader.

Two polar cases will be investigated in the paper: on the one hand, the situation corresponding to a limit case where S = 0; on the other hand, a case where the public authority can enforce a S > 0.

To begin with and as a matter of comparison, let us recall what are the basic predictions of a canonical

framework à la Becker (i.e. setting β=1 and =0; see Becker (1968), and Garoupa 2000, 2001): in a competitive criminal market, maximal fines are always optimal, and the equilibrium values for the probability of sanction, the

level of deterrence and the expected sanction are given by

F

ch

F

Bp

1and

F

ch F

Bp

Bb ,

implying as is well–known that some level of under–deterrence is optimal: hB

b . Obviously, some restrictions

such as 1,0

F

ch and F >1 give sufficient conditions in order that the equilibrium value for bB and thus

for pB are set in 1,0 . These conditions will be supposed to hold throughout the paper.

3. The failure of law enforcement with hierarchical gangs: an example First, let us consider the case for an international criminal organization, for which the leader is neither a

native nor a resident of the country where the crime is committed, while the active members are (obviously) residents. Thus, it is natural in such a case to set S=0, since when there exists no international mechanism of law enforcement, or in absence of a high level of cooperation between national enforcers allowing at least bilateral agreements concerning the extradition of criminals, then national enforcers have by no means the opportunity to punish the leader (neither to seize his personal wealth, not to use prison sentences) 53.

In the following paragraphs, we study the characteristics of a monopolized market for crime with a hierarchical organization of the gang.

3.1 The members of the gang Each risk neutral gang member decides to commit a crime or not depending on the monetary gain he gets

(b) and on incentives he receives from the authorities on one side and from the leader on the other side. On the contrary, when the criminal refuses to commit a crime, the member suffers a private sanction imposed by the leader δ. The cost of the private sanction for the criminal is the monetary equivalent of psychological or physical hurts imposed by the leader of the gang to his deviant members, ie those who do not commit crime. Given contrary incentives from public authorities and the leader of the gang, each member will commit a crime if:

f) b( p b )1( p (1)

52 We assume that β is exogenously set. An endogenous determination of β during a bargaining stage between the

leader and the other gang members would not affect the main conclusions of the paper, but instead would introduce secondary difficulties due to a lengthy analytical resolution of the model. Given our assumption that the leader does not observe the criminals’ types (b), β is understood as corresponding to their mean type E(b), w.l.o.g.

53 On the other hand, for national criminal organizations for which both the leader and the active criminals operate in the country where the crime is committed, it is relevant to assume that S > 0. This last case will be investigated in the next section.


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Equivalently, these exists a threshold benefit

pf

b

~ such that if the criminal is of type b

~b , he

commits the crime; otherwise he is honest and suffers the private sanction. Thus, everything being equal, the existence of a gang modifies the deterrent equilibrium threshold by two

different channels as compared to a competitive one (as compared to the threshold labelled FB

pB

b ).

Firstly, the marginal criminal in a gang may be of a greater type than the marginal criminal without a hierarchical gang, as a result of the sharing of the illegal benefits between the active members and the leader (given that β < 1). Secondly, the marginal criminal in a gang may be of a smaller type than the marginal criminal without a hierarchical gang, since paper studies which of the first or of the second effect dominates at equilibrium.

3.2 The leader of the gang

Assume that α[0,1] is the implementation cost of a level δ of private sanction54 to each member who decides not to commit a crime, implying that the total cost faced by the leader increases with the number of deviant members at a constant rate (αδ). Considering that S=0, the leader chooses the level of private sanction imposed to deviant members that maximises his expected benefit:

b db 1 EB1

b

~

~

b (2)

meaning that the leader’s net benefit, depending on the number of members deciding to commit a crime, equals the sum of benefits taken from the criminals (1st term) minus the cost he faces to punish deviant members (2nd term). The necessary and sufficient conditions for an interior solution to the leader’s maximisation problem are:

02

pfpf

pf (3)

021

(4)

Since 0 , the Second Order Condition (4) requires to hold that : 0 2 - - 1 . From (3), the

reaction function of the leader is reduced to:

pf (5)

with

2 1

1> 1 as a result of the SOC once again. This means that the best response of

the leader to the increase in sanctions by the enforcer, is also to increase (more than proportionally) his own private sanction. More precisely, we obtain the following result:

Proposition 1. Whatever the level of public sanctions to punish the criminal members of a gang, its leader imposes a greater private sanction to inactive members (δ > pf).

As a result, remark that soon as the public enforcer chooses a p > 0, the associated level of deterrence

satisfies : 0b~

given that according to (4) we obtain δ > pf. Thus, everything else held equal, the threat that

the authorities impose through the possible use of an individual sanction on gang members is inefficient, since none will be deterred to commit the crime; hence:

Corollary 1. If S = 0, it is socially worth that public authorities do not monitor criminal activities (p=0 is efficient).

54 Throughout of the paper we focus only on the situations where the non negativity constraint ≥ 0 holds.


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The situation considered here is one where public authorities are deterred from investing in crimes control. When imposing individual sanctions to criminals affiliated to a gang, the public authorities fail to deter these members to commit crimes since at any level of (public) expected sanction, the leader of the gang in fact over reacts by imposing a private sanction greater than the public expected sanction ( pf ).

Thus, the main consequence is obvious: Corollary 2. When sanctioning the leader is not feasible (S = 0), the monopolized criminal market yields a

larger (in fact, the maximal) number of crimes committed as compared to the competitive one ( 0~b < bB).

4. Recovering the effectiveness of public enforcement on criminal gangs Suppose now that the leader can be sanctioned by authorities when gang members commit a crime (S >

0). Remark that this does not change the general definition of the threshold

pfb~

. However, we will show

that this leads to alternative equilibria on the monopolized market which have sharp differences as compared both to the previous case and to the competitive market.

4.1 The leader of the gang The net benefit function of the leader can now be written:

b db p s b βEBb

~1

1

~ (6)

where s represents the sanction imposed by the authorities to the leader in case of conviction. The reaction function of the leader is now55 :

sfp (7)

where according to the SOC

21 > 0. The choice of the level of the private sanction depends

on two effects: the level of expected sanction imposed to the members and the level of expected sanction imposed to the leader of the gang. The first one tends to increase the answer of the leader (over reaction) whereas the second tends to reduce the level of private sanction (δ) imposed56.

4.2 The public authorities The objective of public authorities is to maximise the social welfare by adjusting their policy through the

amount of monetary sanctions imposed to criminals, denoted as f, and to the leader, denoted as s, on the one hand, and the expenditures in monitoring and sanctioning, p, on the other hand. We assume that the monitoring and sanctioning cost is represented by a constant marginal cost c > 0. The choice of the optimal policy for (p, f, s) is obtained through the maximisation of the social welfare function:

cp b α δdb hb W b

~

1)(1

~ (8)

under two constraints: f ≤ F and s ≤ S. The social welfare is the sum of benefits less harms from the crime (1st term) reduced on one side by the cost of the private sanction (2nd term) and on the other side by the cost of law enforcement (3rd term). Following Becker (1968) it is easy to see that the constraints on fines will bind, i.e. the public authority will choose to impose the maximum monetary sanctions. The reason is that f and s

55 Using the FOC, and given that the same SOC still holds : 0 2 1

.

56 However, it is obvious that when the enforcer monitors illegal activities, a necessary condition for leader to use his

own threat of sanction (δ > 0) is 0 sf - otherwise, it is not effective. This point will be more detailed when we will

study the equilibria.


130

are costless in this model – the social welfare is independent of s. Thus, if f < F, it is possible to reduce the cost of enforcement and to increase the amount of the sanction, by maintaining the expected sanction. Knowing that in any equilibrium we must have f* = F, s* = S, we can now focus on the FOC for the enforcer which writes as57:

F

cb h

)1(

~

(9)

This implies the following result: Proposition 2. In any interior equilibrium where it is socially efficient that the public enforcer chooses to

control the illegal activity (i.e. p > 0), there exists some level of under–deterrence (i.e. hb ~

).

The proof is straightforward. Let us write (9) as : F

cb h

)1(

~. Given that the RHS of this

new equality is positive, it is obvious that the LHS is also positive and thus that in equilibrium: bh~

.

Finally, denoting F

c h

β β 1

1> 1 and solving (9) for the reaction function of the public

authorities leads to:

h h βδ

pF

(10)

where 0 hh (given that F

ch according to the competitive equilibrium). This implies that as the

leader increases the level of his private sanction, the public authorities react also by increasing the probability of control of the gang members.

4.3 The equilibria

Several alternative equilibria may occur for a monopolized market for crime. To see this, first remark that since we must have f* = F and s* = S in any equilibrium, the system (7)–(10) now writes equivalently as:

SFp : Reaction Function of the gang leader

h h pF : Reaction Function of the enforcer

Thus two kinds of equilibrium may exist depending on the sign of SF , which is the slope of the

leader’s reaction function. Let us assume first that the leader’s reaction function is negatively sloped, i.e.

F

SSF 0 . It is straightforward to see that in such a case, it is individually efficient for

the gang leader to never punish the inactive criminals: ; in contrast, it is efficient for the public

enforcer to choose a positive level of monitoring p*= h h F

> 0, in order to enforce a level of

deterrence h h b *~

. This kind of equilibrium has the following properties:

Proposition 3. Assume that

F

S. Then, the NE of the monopolized criminal market (*=0,p*) yields

a higher level of deterrence (thus, a smaller number of crimes) than the competitive one. Moreover, if the

maximum fine on active criminals is large enough, i.e. )1( h

cF , then both the expected sanction and the

57 Once again, the SOC holds: 0 2

2F

2

2

p

W


131

cost of monitoring for the enforcer are smaller than in a competitive market. However, as )1( h

cF , then

both the expected sanction and the cost of monitoring for the enforcer are larger than in a competitive market. The proof is straightforward, since simple calculations show that:

1*~signBbbsign

h

F

csignFBpFpsignBppsign )1(**

As a result, Bbb *~

is always true, but we obtain both that Bpp * and FpFp B* soon as

hF

c )1( whereas Bpp * and FpFp B* hold soon as h

F

c )1( .

Remark that when 0 , the equilibrium is still different from the competitive one à la Becker.

Let us assume now that the condition 0 SFF

S

holds; then any equilibrium of the

> 0. Now, private sanctions and public monitoring are strategically complement decision variables (both reaction functions are positively sloped): the best response for any of the two parties to an increase in the level of the control of his opponent, is to also increase his own control. Explicitly solving the system (7)–(10) gives us58 the couple (p**, δ**) such that:

hh

SFp

** ,

hhSF

SF

**

which leads to an associated level of deterrence equal to:

hhSF

SFb

)1(**

~.

This equilibrium has some remarkable properties as compared both to the case of a competitive market for crimes, and to the previous case of the monopolized one:

Proposition 4. Assume that

F

S. Then, the NE equilibrium of the monopolized criminal market

(**,p**) may correspond to a smaller level of deterrence (thus, a larger number of crimes), a higher expected sanction and a larger cost of monitoring for the enforcer than in a competitive market. But the opposite results may also hold.

The result is straightforward: on the one hand, it is obvious that b** may be larger than

F

ch F

Bp

Bb , since > 1 and

F

ch hh ; but on the other hand, it may be smaller as well

since

1)1(

SF

SF

. The same line of reasoning applies to the comparison of

F

ch

F

Bp

1and

p**. Hence the net effect both on the level of deterrence and on the cost of public monitoring at equilibrium will depend on the specific value of the technological and behavioral parameters of the model (which is of secondary interest for our purpose).

5. Discussion and conclusion The specific organisational context of the gang, apprehended here through the threat of private sanction

in case of deviation from the gang objective, shows how individual public sanctions may become inefficient. The possibility for the leader to threaten the gang members reduces to null the deterrent effect of the public policy so

58 Moreover, it can be verified that this equilibrium is asymptotically stable (See Funderberg, and Tirole 1991). On

the other hand, in the appendix we give some conditions required in order that 1,0**~

b and 1,0** p .


132

that no member is deterred to commit a crime in the gang. As a consequence, one may consider the possibility that the organizational context of the gang increases the number of criminals.

The conclusions in proposition 1 and corollaries 1, 2 differ from the one in Garoupa (2000) who shows that the number of criminals when gangs exist is the same than when it doesn’t. These different results are based on two elements. On one hand, in Garoupa (2000) the agents have to pay a rent to the principal to enter on the illegal market, corresponding to a fixed price independent from the illegal benefit of the crime. In our model, principal and agents act in cooperation because each one of them receives a part of the benefit from the crime and because agents bear the private sanction of the principal only if they deviate from the norm. On the other hand, in Garoupa (2000), the principal invests ex ante in an enforcement mecanism to be sure that the agents pay the rent. The private enforcement cost in the gang is independent of the number of inactive criminals on the illegal market. On the contrary, in our model, the private enforcement cost in the gang is a function of the number of deviant criminals.

As a consequence, public individual sanctions may fail to reach a deterrent effect in a monopolized market for crime where criminals operate in a hierarchical gang. Specifically, soon as the gang leader has the opportunity to escape from public punishment but may inflict to the active members a private sanction which inflates the public sanction once they are caught, the threat of punishment by the legal enforcer ceases to maintain an effective deterrence.

Proposition 3 exhibits a situation which is the dual of the one of corollary 1, in the sense that the leader is now deterred from exerting the threat of sanction on the members of the gang. As a result, it appears that the

monopolized market leads to a smaller number of crimes than the competitive one soon as the ratio F

Sis large

enough, i.e.

F

S . Another consequence is that, generally speaking, it is not necessary for public authorities

that the sanction imposed to the leader be larger than the sanction inflicted to a gang member (S > F) to reach a positive level of deterrence: in a sense, this depends on the sharing rule of the criminal benefits. To see this, remark that σ < µ is obtained soon as β > ½. Thus, when gang members retain a large proportion of their illegal benefits (β > ½), it is sufficient (although not necessary) that S > F for public authorities to reach an efficient control of criminal activities; but public authorities also fulfil this objective even when S < F. In contrast, when gang members retain a small proportion of their illegal gains (β < ½), public authorities cannot deter criminals when S < F, and S > F is not sufficient to yield enough deterrence.

At the same time, proposition 3 shows that despite a smaller number of crimes (a smaller probability of crime) the expected sanction and the cost of public monitoring are not necessarily smaller in a monopolized market than in a competitive one. This depends on the size of the maximal fine which is applied to the members of the gang (all else held equal, and specifically, given the size of h the external cost of the illegal act), and the monopolized market allows a smaller monitoring cost of the illegal activities for public authorities only when the maximal fine on active members is large enough. Otherwise, the larger level of deterrence obtained in the monopolized market requires a higher enforcement cost.

The main consequence of proposition 4 is that the common view according to which the concentration of the criminal market improve the social welfare, since it enhance the efficiency and effectiveness of public control regarding illegal activities (allowing a smaller number of crime realizations and saving on the cost of public

monitoring) cannot be generally sustained. Specifically, soon as the ratio F

Sbecomes small enough, then the

monopolized market may lead to a smaller level of deterrence. Remark that the ambiguity which appears in proposition 4 cannot be easily ruled out in contrast to proposition 3.

Empirical studies have shown that, everything being equal, criminals affiliated to gangs are more involved in criminal activities than those who are not (Thornberry et al. 1993, Battin–Pearson et al. 1998). This difference of behaviour may be explained by the fact that criminal organisations create incentives to commit crime. Then, members of gangs fearing to be victims of private sanction are more likely to commit crime when affiliated to criminal organizations. These incentives from the gang must be taken into account by the public authorities to efficiently deter gang members from crime. We show that an individual expected sanction may lead to a null deterrence when criminals are affiliated to gang, although the same expected sanction is efficient for isolated criminals. In fact, the leader of the gang over reacts on the public policy by imposing a level of private sanction greater than the public expected sanction. Punishing the members of the gang and their leader may create efficient deterrence.


133

The French criminal law proposes two answers to deal with crimes committed in groups. Firstly, each criminal is convicted on the basis of the acts he realized himself, even if the criminal action was a collective one. Nevertheless, realizing a crime within a group is considered as a ‘circonstance aggravante’ witch results in an increase of the individual sanction ladder compared to the one that punishes the same individual act committed alone. Secondly, following the actual tendency to prosecute for a collective liability all members of a group, the liability for the criminal act is extended to the person who ‘intentionally, helping or assisting, makes easier the preparation or consumption of the criminal act [or] by promise, threat, order, authority abuse or power brings about the criminal act or gives instructions to commit it’ (Art 121–7 CPN)59. As a consequence, the gang’s leader can be convicted as author of the crime at the same level of sanction as the members of a gang even if he hasn’t committed the crime himself (Art 121–6 CPN). This second solution challenges the principle of individualisation of the sanction, which states that each person is responsible for his own actions, and its legitimacy has been hotly discussed since the XVIIth century on the basis that, in the context of crimes in groups, it reduces the liability (Fauconnet 1920, p. 330).

The argument in proposition 1 and corollaries 1 and 2 implies that the French law based on the ‘circonstance aggravante’ may be inefficient in creating any deterrence when the leader of a gang, or its peers, have the possibility to impose private sanctions that thwart the incentives created by the public ones. The public authorities should then apply the second type of law relative to crimes in gang: convicting the leader of the gang for complicity even if he hasn’t committed any crime. It might be possible to influence the incentives inside the gang and create, by the way, an efficient deterrence for the members of the gang.

On the other hand, the adoption in France of the ‘loi Perben II’ (March, 9th, 2004) which was presented as the adaptation of the French criminal code to the modern forms of criminality has raised many criticisms. Contradictors insisted that it promotes a sharp reduction of privacy rights which would by no way be compensated by the uncertain gains of effectiveness in the control and deterrence of criminal activities. A close controversy emerged in United Kingdom in 1998, at the time where the European Convention of Human Rights has been incorporated into the English & Welsh criminal law. Opponents to the reform argued that it would lead to a weakness in the penal code effectiveness, while promoters such as advocates of human rights rejected on principle any arguments based on efficiency analysis. But as the arguments pro collective liability is imprecise, it opens a window for law and economics to justify the use of collective responsibility. Our paper takes an agnostic view on such an issue, and tries to assess the circumstances under which such a repressive law fulfils its objective. In some sense, the two French laws of ‘circonstance aggravante’ and leader liability for acts realised under his influence cannot be imposed separately when the leader (or the peers) have means to incite members to crimes. Although our model cannot pretend to full generalisation, it illustrates the legitimacy of collective sanctions from a deterrent point of view.

Acknowledgements We thank Nuno Garoupa, Cécile Bourreau–Dubois, Roberto Galbiati, Dominique Demougin and Martina

Samyer for helpful comments and discussions. In addition, we benefited from comments by participants at the European Association of Law and Economics Conference in Madrid (2006), the SIDE Meeting in Rome (2006), the French–German Talks in Kassel (2006), the AES Meeting in Nancy (2006), and at the internal seminar of BETA in Nancy (may 2007).

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[2] Becker, G. 1968. Crime and Punishment: an economic approach. Journal of Political Economy, n°2, volume 76, pp. 169–217.

[3] Buchanan, J.M. 1973. A defense of organized crime, in S. Rottenberg Ed., The economics of crime and punishment, Washington: American Enterprise Institute, pp. 119–132.

[4] Case, A., and Katz, L. 1991. The Company You Keep: The Effects of Family and Neighborhood on Disadvantaged Youths. NBER Working Paper, n°3705.

59 Translation of the French criminal code from the authors : La personne qui « sciemment, par aide ou assistance,

en a facilité la préparation ou la consommation [ou] qui par don, promesse, menace, ordre, abus d'autorité ou de pouvoir aura provoqué à une infraction ou donné des instructions pour la commettre » (Art 121-7 CPN).


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[5] Fudenberg, D., and Tirole, J. 1991. Game Theory, The MIT Press.

[6] Fauconnet, P. 1920. La Responsabilité. Etude de Sociologie. Edition Alcan, Paris.

[7] Garoupa, N. 2000. The economics of organized crime and optimal law enforcement. Economic Inquiry, n°2, Vol. 38: 278–288.

[8] Garoupa, N. 2001. Optimal probability and magnitude of fines. European Economic Review, Vol. 45:1765–1771.

[9] Garoupa, N. 2007. Optimal law enforcement and criminal organization. Journal of Economic Behavior and Organization, Vol. 63: 461–474.

[10] Glaeser, E., Sacerdote, B., and Scheinkman, J. 1996. Crime and Social Interactions. Quarterly Journal of Economics, n°2, Vol. 111: 507–548.

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[13] Huff, R. 1998. Comparing the criminal behavior of youth gangs and at–risk youths. Research in Brief National Institute of Justice, US Department of Justice.

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[17] Patacchini, E. and Zénou, Y. 2005. Crime and conformism. CEPR discussion paper n°5331.

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[19] Poret, S. 2002. La structure verticale d'un réseau de distribution de drogues illicites et politique répressive optimale. Document de travail du CREST n° 2002–07.

[20] Privileggi, F., Marchese, C., and Cassone, A. 2001. Agent's liability versus Principal liability when attitudes toward risk differ. International Review of Law and Economics, Vol. 21: 181–195.

[21] Reinganum, J. 1993. The law enforcement process and criminal choice. International review of Law and economics, Vol. 13: 115–134.

[22] Shavell, S. 1997. The optimal level of corporate liability given the limited ability of corporations to penalize their employees. International Review of Law and Economics, Vol. 17: 203–213.

[23] Sah, R. 1991. Social Osmosis and Patterns of Crime. Journal of Political Economy, n°6, Vol. 99: 1272–1295.

[24] Thornberry, T., Krohn, M., Lizotte, A., and Chard–Wierschem, D. 1993. The role of juvenile gangs in facilitating delinquent behaviour. Journal of Research in Crime and Delinquency, n°1, Vol. 30: 55–87.

http://www.centrejeunessedemontreal.qc.ca/irds/pdf/rapp_f.pdf

http://www.crest.fr/pageperso/poret/papier3.pdf

http://www.crest.fr/pageperso/poret/papier3.pdf


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APPENDIX

Let us have a look at the conditions required in order that 1,0**~

b and 1,0** p in proposition

4.

It is easy to see that p** > 0 requires that

F

Swith a trivial case 0

F

S obtained when σ < λ.

On the other hand, b** > 0 needs that

1

F

S.

But, we also have p** < 1 when )( hhFF

S

and b** < 1 soon as

)(1

1))(1(

hhhh

F

S

, assuming that the conditions required to have Ω >

0 are met. To summarize, the solution in proposition 4 is supported by a set of conditions which can be

expressed (for example) as both an upper and a lower values for the ratioF

S: we must have

,,

1max

F

S.


136

CHURCHES AND PRIVATE EDUCATIONAL INSTITUTIONS AS FACILITATOR OF MONEY LAUNDERING: THE CASE OF NIGERIA

Kato Gogo KINGSTON

University of East London, School of Law, England

Abstract

There is worldwide concern over the ways in which criminally acquired assets are being concealed, transferred and preserved. Many countries including Nigeria have enacted laws against money laundering; drugs trafficking; and, corruption. The study investigates the association of money laundering through the private schools and churches; and, four independent variables namely: Laws and Regulations, enforcement efficiency, banking compliance and corruption. The multiple regression models of Aldrich (2005), and Fisher (1922) are employed to investigate the association of the variables. The study hypothesize that money laundering in Nigeria is enhanced by the proliferation of churches and private educational institutions by which finances are largely unchecked by the authorities to such degree that defective banking regulations; lack of government control of the funds of private schools and faith groups; inadequate enforceability of anti–money laundering laws; and, corruption are the propelling factors. The study suggests that private schools and churches in Nigeria are facilitating money laundering, corruption and organised crimes. It finds that there are serious loopholes in Nigeria’s money laundering laws which enable criminal assets to be preserved and protected under the auspices of schools and church assets. The study concludes that there is urgent need for the overhaul of the national criminal laws and the regulation of the assets of private schools and churches in such ways that can deprive the criminal concealment of illegally acquired assets.

Keywords: assets, crime, money laundering, Nigeria, churches, fraud techniques. JEL Clasiffication: K14, K40, E40.

1. Introduction Money laundering, terrorism and drugs trafficking are among the most prevalent global criminal activities.

Money Laundering refers to the process and act of concealing illegally acquired assets through legally constituted institutions such as banks. Simply put, it is the act of hiding stolen and corruptly acquired assets from the preying eyes of the regulatory authorities. Masciandaro (2000) defined money laundering as ‘an autonomous criminal economic activity whose essential economic function lies in the transformation of liquidity of illicit origin, or potential purchasing power, into actual purchasing power usable for consumption, saving, investment or reinvestment’. In essence, ‘money laundering is a process in which assets obtained or generated by criminal activity are moved or concealed to obscure their link with the crime’ (IMF 2005). Amedeo et al. (2008) observes that money laundering is ‘a multiplier of criminal financial activities’ and a major process that strengthens ‘the ties between the real and the financial side of criminal economy’.

Money laundering is necessitated by the desperate need to: (1) hide the source and proprietary ownership of the assets; (2) retain control of the assets; and, (3) disguise and neutralise suspicion.

The perpetrators of money laundering routinely use three methods in their illicit transactions namely: Assignment; Shielding; and Mixing. Assignment involves the placement of the illicit assets into legitimate financial and social institutions in order to be able to convert the assets into smaller units for easier mode of transfer. Shielding is the disguising process which involves various attempts to erase the trail of the assets from the source of origin. The shielding process requires the transfer of assets through foreign banks; electronic transfer of company shares; and, stocks dealing. Mixing strategy of money laundering is complex and sophisticated ways by which launderers are able to convincingly integrate the proceeds of crime into ‘legitimate’ economy. The process involves the establishment of companies in different countries; the entering of joint venture with legitimate foreign investors; the use of legitimate firms to export and transfer funds abroad; the use of private institutions and non–profit organisations (including churches) to safeguard and maintain banking transactions etc.

As far back as the 1930s, money laundering has been regarded as crime by the United States government. It is very difficult to accurately estimate the value of money laundering due to the covert nature of the criminal activity. In 2000, it was estimated that approximately 3.9% of the global gross domestic product


137

(GDP) originated from criminally acquired assets and the world’s money laundering is more than US$2.5 trillion yearly (see IMF 2002; Agarwal, and Agarwal 2004).

The European Union Council on the ‘prevention of the use of the financial system for the purpose of money laundering’ Directive 91/308/EEC of 1991 provides extensive list of acts which constitute money laundering as follows:

‘(1) the conversion or transfer of property, knowing that such property is derived from criminal activity or from an act of participation in such activity, for the purpose of concealing or disguising the illicit origin of the property or of assisting any person who is involved in the commission of such activity to evade the legal consequences of his action; (2) the concealment or disguise of the true nature, source, location, disposition, movement, rights with respect to, or ownership of property, knowing that such property is derived from criminal activity or from an act of participation in such activity; (3) the acquisition, possession or use of property, knowing, at the time of receipt, that such property was derived from criminal activity or from an act of participation in such activity; (4) participation in, association to commit, attempts to commit and aiding, abetting, facilitating and counselling the commission of any of the actions mentioned in the foregoing paragraphs. Knowledge, intent or purpose required as an element of the abovementioned activities may be inferred from objective factual circumstances...’

Walker (1994, and 2007) suggests that corruptly acquired assets account for the highest volume of money laundering and closely followed by assets acquired through narcotic drugs trafficking. Money laundering cannot succeed without the existence of enabling environment of crime and corruption. Edgardo, and van Dijk (2003) argue that ‘organized crime and corruption are shaped by the lack of strength of the control mechanisms of the State and civil society’.

Schneider (2008) explains that it is extremely difficult to effectively device adequate measures for the control of international and domestic money laundering because money laundering is ‘defined almost differently in every country, the measures taken against it are different and vary from country to country’; and, there is lack of an approved international organisation responsible for the enforcement of uniform control of money laundering across national boundaries.

Guiora, and Field (2007) suggest that one of the problems confronting the enforcement of money laundering is the sophistication of ‘Informal Value Transfer Systems’ also known as ‘underground banking’ which does not necessarily comply with the customary banking procedures. Between 1999 and 2009, underground banking practices have led to the liquidation of several banks in Nigeria.

Edgardo (2008) investigated the legal and economic factors determining the success and failure of the fight against organized crimes using data from 107 countries which are known to be highly corrupt and lacking good governance. Edgardo suggests that national level official data produced and published by the law enforcement agencies are inadequate and cannot be relied upon because of the politics involved in crime prevention in different countries thus the information on the extent of organized crime activity in a country had to be developed from other sources to obtain primary data. In consideration of the data collection challenges, Edgardo (2008) adapted the data of the World Economic Forum’s survey which provided information on the extent of victimization of businesses by organized crimes across the globe and finds that the most valuable and reliable strategy that is likely to curb organized crimes are connected to those that give adequate attention to ‘high level public sector corruption’ and for the measures to be successful, four requirements must be met as follows:

1. The introduction of impartial justice system allowing for adequate use of discretion by the courts without interference by the State and the powerful few in the society,

2. Protection of evidence, and swift ‘convictions based on evidentiary material provided by financial intelligence systems aimed at the systematic confiscation of assets in the hands of criminal groups and under the control of illegal businesses linked to organized crimes’,

3. Intensive and consistent investigation of allegation of ‘high level public sector corruption’, and 4. The introduction of awareness policies to encourage ‘the operational presence of government and/or

non–governmental preventive programmes’. Edgardo’s study offers significant insight into the understanding of organised crimes; however, the

findings are too vague and cannot be realistically applicable to all countries.


138

The data used and the model of analysis are likely to produce fluke outcome. The study also failed to recognise the extent of some governments’ participation in organised criminal activities. Where corruption is entrenched in the body politics of a country, it is practically impossible for the government to effectively enforce anti–corruption laws making it impossible for organised crimes of huge final values to be controlled.

Although the present study focuses on private educational institutions, churches and money laundering; previous studies on the effect of religion on crime have produced mixed results. Stack, and Kposowak (2006), and Pettersson (1991) argue that the most efficient method of analysing the effects of religion on crime is the use of quantitative model. They went further to identify ‘the barriers of crime, as tax fraud acceptability, and religiosity, braking down the levels of religious adherence’; in essence, social cohesion and mitigating circumstances influence the rate of criminality. This finding is affirmed by Lee (2006). On the other hand, Cook, and Powell (2003) suggest that the social persuasion and influence that occurs within religion does not affect the rates of criminality.

Nevertheless, financial crimes are among the world’s fastest growing illicit activities. It fosters other vices including narcotic trade, terrorism, homicide and people trafficking.

These have led countries to enact stringent laws to deal with the problems. For instance, in the United Kingdom, the Money Laundering Regulations 2007; the Financial Services and Markets Act of 2000; and, the Proceeds of Crime Act 2002 stipulate the ways of dealing with suspicious as well as criminal assets. In the European Union, the European Union Directive 2005/60/EC prohibit the ‘use of the financial system for the purpose of money laundering and terrorist’. In the United States, the Patriot Act of 2001 and the Bank Secrecy Act of 1970 (as amended by Anti–Money Laundering Acts) regulates the financial institutions and persons with regards to money laundering and criminal assets.

In Nigeria, there are laws directed toward the prevention of money laundering and other economic crimes. The laws are: The Money Laundering Act 1995; The Money Laundering (Prohibition) Act 2004; the Failed Banks (Recovery of Debts) and Financial Malpractices in Banks Act 1994; the Banks and other Financial Institutions Act 1991; and, the Advance Fee Fraud and Other Fraud Related Offences Act 1995 (formerly, Decree 419).

The Economic and Financial Crimes Commission established in 2004 is responsible for the overall enforcement of the anti–money laundering and all economic crimes legislation in Nigeria.

Despite the prevailing laws and regulations, money laundering and other organized crimes continue to prevail and develop in Nigeria. It is important to mention that all the prevailing laws on money laundering and criminal concealment of illicit assets in Nigeria are principally directed towards corporate entities and individuals thus, have one central defect; they fail to widen the scope of coverage of the regulated entities to include non–profit organisations, associations, private educational establishments and faith groups such as Mosques and churches. It is this loophole that is being exploited by criminals.

According to official sources in Nigeria including the central bank and the Economic and Financial Crimes Commission, Nigeria’s money laundering activities in 2009 and 2010 is estimated at US$1.250 billion. In 2010, Economic and Financial Crimes Commission in Nigeria affirmed that files containing evidence of money laundering of the sum of US$35 million involving a church was missing from the custody of the law enforcement agency leading to the termination of legal actions against the church.

2. Methods and materials Fundraising is a major source by which churches sustain their existence and schools fees and other

charges are the official known sources of private schools’ fund. In some countries, the bank accounts of religious and charitable organisations are seen as ‘sacred’ and unquestionable. There is continuous proliferation of private educational institutions and churches in Nigeria; almost every street in the Southern part of the country is host to at least one church. Each church including all its branches posses at least one bank account. There is no legislation for the monitoring and supervision of the sources of church funds; there is no regulation as to the maximum amount of money that churches and the private educational institutions can hold in their bank accounts and, there is no peg on the maximum number of bank accounts each church can operate. This provides huge money laundering opportunities for corrupt politicians and organised criminals to be able to conceal criminally acquired assets.

The data used were collected from 16 States in Southern Nigeria namely: Lagos, Ondo, Ogun, Ekiti, Oyo, Rivers, Cross River, Akwa Ibom, Edo, Delta, Bayelsa, Imo, Abia, Anambra, Ebonyi, and Enugu. The data consist of the current and savings account of 5 large and 5 medium size churches; 16 private secondary schools (one from each State) and 10 private universities. The large churches refer to those with minimum total estimated members of 5,000 and the medium size churches are those with an estimated total of 3,000 members.


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The churches chosen for this analysis are those that have a minimum of five branches across different cities and the private secondary schools chosen are those that have existed for at least five years. The data include: the number of bank accounts held by each church branch and each school; the volume of monies in the bank; the frequency of bank deposits and transfers; and, the number of private properties acquired in the name each of the educational institution and each branch of churches.

Data analysis was conducted using multiple regression statistical technique of Aldrich (2005) and Fisher (1922. The Multiple Regression statistical model involves the prediction of the action of one variable also known as the dependent variable on the basis of their score values weighed against many other variables known as independent variables. In this paper, money laundering through Nigerian private educational institutions and churches are single parameter representing the dependent variable and the independent variables measured are: Laws and Regulations (LR), Enforcement efficiency (EE), Banking compliance with national regulations (BC) and corruption (CR).

Table 1 presents the results of the multiple regressions. The R–square is 0.6615 adjusted for sample bias resulting in R= 0.6181 meaning that 61% of the change in the dependent variable (Money laundering through private educational institutions and churches) can be explained by change in the independent variables LR, EE, BC and CR. The F–statistic is 0.1587 and statistically significant on the Durbin–Watson level of confidence of 5%. The regression parameters show that changes in the independent variables would result to the change in the dependent variable. The illustrate that the laxity in the four independent variables in Nigeria contribute significantly toward the prevalence of money laundering and other organised financial crimes. However, it is difficult to ascertain the measurability of money laundering because it is not directly observable (Amedeo et al. 2008).

Table 1. Summary of Results of Multiple Regression

Equation Parameters

R Square Adjusted R square Standard Error F – Statistic

0.6615 0.6181 137.7381 0.1587

Multiple Regression Equation

Independent Analysis

Coefficients Standard Error

R Squared

Gradient

Intercept

Intercept LR BC EE CR

119.476 33.467 4.086 21.178 49.45

134.566 32.267 2.017 14.017 23.703

0.627 0.751 0.659 0.609

1.59 3.91 29.59 33.63

482.4 412.66 336.84 425.07

Note: Durbin–Watson Statistic is 2.89787; Critical D–W Values: Lower (Dl) = 0.69; Upper (Du) = 1.97; Critical F–

Statistic at 95% Confidence is 3.25917; there is positive Auto–correlation at 5% confidence

3. Discussion The multiple regression results show positive association of the dependent variable with all four

independent variables. This suggests that money laundering through the private educational institutions and churches is intertwined with corruption, ineffective enforcement of laws, weakness of the laws, and lack of adequate compliance by the financial institutions.

It also suggests that the fiscal structure of Nigeria is affecting the country’s risk rating. This is consistent with Edgardo, and van Dijk (2003) which states that:

‘A country’s financial and liquidity risk ratings are all positively related to the organized crime index ... higher country risk ratings are associated with higher levels of organized crime’.

Corruption is endemic in Nigeria, perpetrators range from top level government officials to business men and firms. Between 2000 and 2010 not less than 15 former State governors, 5 bank executives, and 4 firms have been charged with corruption and money laundering related offences involving an estimated US$270 billion. The bulk of the stolen assets have been traced to foreign bank accounts. The process and strategies adopted by the


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Nigerian government to deal with money laundering suspects lack transparency; there is selective enforcement of anti–corruption laws in that some suspects cannot be indicted and are simply untouchable due to the extensive network and powers of the persons and firms benefiting from financial crimes in the country.

The judiciary in Nigeria is not independent enough to be able to handle cases of money laundering against certain persons and certain firms. In Attorney General of Rivers State v. the Economic and Financial Crimes Commission & 3 Others suit No. FHC/PHC/CSI78/2007, the plaintiff (Justice Mary Odili) was the wife of former Rivers State governor and acting in her capacity as the State Attorney General; sought perpetual injunction to restrain the defendant (authorised anti–fraud and anti–corruption agency of the federal government) from investigating and indicting former Governor Peter Odili (her husband) on the grounds that the defendant’s activities were unlawful interference with the internal affairs of the government of Rivers State. The injunction was granted by the court on the grounds that the defendant’s investigation of the former governor was ‘invalid, unlawful, unconstitutional, null and void’. The injunction further forbids the defendant from publishing the report of the criminal investigations to which Peter Odili was personally mentioned and, also forbids the defendant from taking further actions concerning the former governor regarding alleged corruption, looting of State treasury and money laundering.

In Federal Republic of Nigeria v. Ibori & others FHC/ASB/IC/09, the defendants were acquitted by Nigerian court of 170–count of corruption and money laundering however, one of the defendants was later convicted on the same charges in a separate suit filed in the United Kingdom court.

The study finds that corrupt government officials and politicians in Nigeria that are actively involved in harvesting the proceeds of crime are very conscious of the possibility of being arrested and charged in Europe and the United States therefore, have devised various methods of concealment including, conversion of all stolen monies into foreign currencies and storing such monies in large concrete underground bunkers usually in their secret country–side homes; purchasing of multiple houses using the names of friends and churches; giving the assets to churches on secret trust agreements whilst proclaiming such assets to be anonymous donations and gifts to the churches, establishing private educational institutions in the name of unsuspected business persons or entering into anonymous joint–ventures with others to establish same; and, using the names of friends to buy large quantity of securities and shares in blue chip firms. These criminal ways of concealment are energised by the prevalence of corruption in the country. According to the United Nations Convention against Corruption:

‘Corruption is a complex social, political and economic phenomenon that affects all countries. Corruption undermines democratic institutions, slows economic development and contributes to governmental instability. Corruption attacks the foundation of democratic institutions by distorting electoral processes, perverting the rule of law and creating bureaucratic quagmires whose only reason for existing is the soliciting of bribes. Economic development is stunted because foreign direct investment is discouraged and small businesses within the country often find it impossible to overcome the ‘start–up costs’ required because of corruption.’

The above statement of the UN Convention against corruption seems to have summed up the negative effects of corruption however, the UN has not been able to device the mechanism by which the problem of corruption could be eradicated rather, it delegate the duties of corruption control to individual national governments. It is foreseeable that corrupt national governments cannot eradicate corruption.

The study suggest that churches in Nigeria are autonomous private governments immune from national legal control mechanism in that the churches and charitable organisations control proprietary rights including huge volume of liquid assets without the need for accountability to the national government. It also suggests that government does not control and monitor the finances of private educational institutions. This void in the national control of churches is the prime reason for the prevalence of money laundering within the church private government; this is consistent with Hills (2001).

The churches and private educational institutions in Nigeria are conveniently conducting money laundering business in the face of the apparent weak corporate governance, low ethical standards, and lack of banking transparency in the country. This is consistent with Ogunleye (2001) which suggest that the banks cannot be free of criminality due to ‘uncontrollable or external factors that influence bank performance’. The present study further finds that the weakness of banking regulation is correlated to money laundering activities, in conformity with Ogunleye (1999, and 2001) which suggests that fraud and inadequate risk management in the banking sector caused the liquidation of 36 banks in Nigeria.


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The study finds that the establishment of multiple branches of same church enabling each branch to operate separate bank account in various banks facilitates the splitting of huge criminal assets into small units for easier concealment by the churches and private educational institutions. The study also finds that the churches appoint several individuals as pastors and encourage them to break away to establish new independent churches to facilitate the splitting of large size illicit assets to smaller units for the concealment in banks and other financial institutions. The church officials including pastors are also actively engaging in several criminal activities including rape, deception, extortion, false miracles/healings, adultery, incest, sodomy, organised armed robbery, drugs trafficking and large scale fraud.

4. Conclusion In terms of policy implication, in the light of the findings of this study, there is urgent need to legislate to

control the activities of all association of persons including faith groups and there is urgent need for governments around the world to actively scrutinise the assets of private enterprises; this may be very challenging however, there could be mechanism in place for monitoring the rate of fund transfers by firms, private educational institutions and churches. The starting point could be in the form of compulsory requirement for registration of all associations including religious groups and allied units and routine declaration of assets whilst the sources of the assets should be transparent.

The registration process should include the declaration of compliance with national money laundering laws and the regular declaration of assets including the sources of the assets. There should be maximum value of assets which each branch of a church is allowed to hold. However, it may be difficult to enforce the laws in the light of the growing sophistication used by money launderers who are actively using the private educational institutions, churches and other covert mode of operations.

References [1] Agarwal, J.D., and Agarwal, A. 2004. Globalization and international capital flows. Finance India, Vol. 19/1:

65–99.

[2] Aldrich, J. 2005. Fisher and Regression. Statistical Science 20 (4): 401–417.

[3] Argentiero, A., Bagella, M., and Busato, F. 2008.Money Laundering in a Two Sector Model: Using Theory for Measurement. CEIS Tor Vergata Research Papers Series, Vol. 6, Issue 8, No. 128.

[4] Cook, K.J., and Powell, C. 2003.Christianity and punitive mentalities: A qualitative Study.Crime, Law & Social Change 39: 69–89

[5] Durbin, J., and Watson, G.S. 1951. Testing for Serial Correlation in Least Squares Regression, II. Biometrika 38: 159–179

[6] Buscaglia, E., and van Dijk, J. 2003. Controlling Organized Crime and Corruption in the Public Sector. Forum on Crime and Society, Vol. 3, Nos. 1 and 2, December.

[7] Buscaglia, E. 2008. The Paradox of Expected Punishment: Legal and Economic Factors Determining Success and Failure in the Fight against Organized Crime. Review of Law & Economics Vol. 4 Issue 1

[8] Fisher, R.A. 1922.The goodness of fit of regression formulae, and the distribution of regression coefficient. J. Royal Statist, Soc. (Blackwell Publishing) 85 (4): 597–612.

[9] Guiora, A.N., and Field, B.J. 2007. Using and Abusing the Financial Markets: Money Laundering as the Achilles’ Hell of Terrorism, U. Pa. Journal of International Law, Vol. 29:1

[10] Hills, R.M. 2001.The Constitutional Rights of Private Government.University of Michigan Law, Public Law Research Paper No. 003. Michigan Law and Economics Research Paper No. 01–002

[11] IMF. 2002. Caribbean Offshore Financial Centres: Past, Present, and Possibilities for the Future. prepared by Suss, Esther C./Williams, Oral H./ Mendis, Chandima, IWF Working Paper, Washington D.C. May 2002.

[12] IMF. 2005. The IMF and the Fight against Money Laundering and the Financing of Terrorism, online at: http://www.imf.org/external/np/exr/facts/aml.htm

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[14] Masciandaro, D. 2000. The Illegal Sector, Money Laundering and Legal Economy: A Macroeconomic Analysis. Journal of Financial Crime, November (2): 103–112.

[15] Ogunleye, R.W. 2001. Sensitivity of Bank Stock Returns to Market and Interest Rate Risks: An Empirical Investigation. NDIC Quarterly, Vol. 11 (1 / 2): 57–77.

[16] Ogunleye, G.A. 1999. AA Review of Banking Activities and its Regulatory Framework inNigeria: The Past, Present and Future. NDIC Quarterly, Vol. 9 No. 4.

[17] Pettersson, T. 1991. Religion and Criminality: Structural Relationships between Church Involvement and Crime Rates in Contemporary Sweden. Journal for the Scientific Study of Religion pp. 279–91.

[18] Schneider, F. 2008. Money Laundering and Financial Means of organized Crime: Some Preliminary Empirical Findings, Unversita Commerciale, Luigi Bocconi, Paolo Baffi Centre on Central Banking and Financial Regulation, Centre Research Paper Series No. 2008–16.

[19] Stack, S., and Kposowak, A. 2006. The Effect of Religiosity on Tax Fraud Acceptability: A Cross–National Analysis. Journal for the Scientific Study of Religion 45(3):325–51.

[20] UNODC Action against Corruption and Economic Crime, United Nations Convention against Corruption online at: http://www.unodc.org/unodc/en/corruption/index.html

[21] Walker, J. 2007. Measuring Global Money Laundering. Paper presented at the conference ‘Tackling Money Laundering’, University of Utrecht, Utrecht, Netherlands, November.

[22] Walker, J. 1994. Estimates of the extent of money laundering in and through Australia, Paper prepared for the Australian Transaction Reports and Analysts Center, September 1994.


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COMMON LAW VS. CIVIL LAW: WHICH SYSTEM PROVIDES MORE PROTECTION TO

SHAREHOLDERS AND PROMOTES FINANCIAL DEVELOPMENT

Prabirjit SARKAR Jadavpur University, Kolkata, India

[email protected]

Abstract This study re–examines the theory of legal–origin on the basis of a new longitudinal dataset for four

OECD countries (UK, USA, France and Germany) over a long time span 1970–2005. It observes that the civil law countries (France and Germany) provided better minority shareholder protection. Through dynamic panel data modelling our study shows that minority shareholder protection has a long–term favourable effect only on stock market listing of firms. Thus, our study questions the proposition that common–law countries provide more protection to their shareholders; it also casts doubt on the related proposition that shareholder protection promotes stock market development.

Keywords: shareholder protection, investor protection, Corporate Governance, Law and Finance.

JEL Clasiffication: G30, G38, K22, K40.

1. Introduction The idea that law matters for a proper capitalist development can be traced back to the writings of famous

German social scientist, Max Weber. Comparing the experience of industrialising countries of Western Europe with other countries Weber concluded that a rational legal system is a precondition for the emergence of capitalism. Some legal scholars call it ‘endowment perspective’ because it treats legal system as an endowment (created by fixed investment) which determines the path of development ‘without itself being subject to change’ (for details see Milhaupt, and Pistor 2008:18–22).

North (1990) had a similar viewpoint. He argued that rich nations have managed to form proper institutions that protect property rights and enforcement contracts while poor countries lack these institutions and so fail to develop.

The works of La Porta, Lopez–de–Silanes, Shleifer and Vishny (henceforth, ‘LLSV’, 1997, 1998) and the subsequent works by them and their followers (see La Porta et al. 1999, 2000; 2006, 2008; Djankov et al. 2003; Glaeser, and Shleifer, 2002, 2003; Beck et al. 2003a, 2003b; Botero et al. 2004) infused a strong ‘leximetric’ flavour to this ‘endowment perspective’ of law. La Porta and his collaborators and followers used (by and large) binary variables (0, 1) to quantify the quality of various types of law existing in a large number of countries protecting the interests of the their shareholders, creditors and labourers (these are what we call ‘leximetric’ data). The countries were classified according to their ‘legal origin’: English common law and civil law are two broad categories. The civil law systems were further sub–divided into those of French, German and Scandinavian origin. Through various cross–section regression studies of these ‘leximetric’ data, it was argued that English common law systems are more market–friendly; they provide higher level of shareholder and creditor protection to promote financial development and create more employment opportunities by providing less protection of their labour.

This literature connects with other contemporary works which show financial development promotes economic growth (see King, and Levine 1993; Levine 1997, 2001, 2003; Levine, and Zervos 1998; Levine et al. 2000; Beck et al. 2000b; Claessens, and Laeven 2003). Hence, the conclusion that follows from this whole gamut of literature is that legal origin matters for economic development. Some works even find that the common law countries grew faster than the civil–law countries (Mahoney 2001).

There are two inter–linked postulates that can be found in this literature: ‘Quality of Law’ or ‘law matters’ and ‘Legal Origin’ (see also our earlier paper, Armour et al. 2009a):

1. ‘Quality of Law’: Legal rules shape economic outcomes according to how far they support market–based economic activity as suggested in new institutional economics (North 1990). It is argued that legal protection of the interests of the shareholders and creditors will increase the flow of investments and enhance



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the availability of external finance to firms (La Porta et al. 1998, 2008; Djankov et al. 2003; Claessens, and Laeven 2003).

2. ‘Legal Origin’: The quality of legal institutions varies systematically with the ‘origin’ of a country’s legal system—that is, whether it falls into the Anglo–American ‘common law’, or French, German or Scandinavian ‘civil law’ systems.

LLSV and others asserted the superiority of common law because of ‘adaptability’ and ‘political’ factors (Beck et al. 2003a, and Botero et al. 2004):

The ‘adaptability’ argument can be traced back to Hayek (1960). It is related to the process of framing new rules. Judges interpret the law in common law countries; this ability to shape the law on a case–by–case basis helps to make legal regulation more adaptable to changing circumstances. In civil law countries judges are bound by long explicit laws and codes leaving them with little discretion so that civil law systems may suffer from excessive rigidity, as changes may only be made by fits and starts through legislation.

The ‘political’ factor focuses on the greater independence provided to the judiciary under common law system. Therefore, the common law judges are less susceptible to influence by the legislature, and are better able to protect individual property rights from encroachment by the state. In contrast, in a civil law system, the legislature has greater control over legal institutions, including judicial appointment, selection and tenure. Hence, the judiciary is less able to protect individual property rights from the clutches of the state. In the words of Mahoney (2001, 505):

‘There are structural differences between common and civil law, most notably the greater degree of judicial independence in the former and the lower level of scrutiny of executive action in the latter, that provide governments with more scope for alteration of property and contract rights in civil law countries’.

The works of LLSV and their followers, which support ‘the endowment perspective of law’, have created a furore in the academic world. At the same time, their works have driven the legal reform policies of the World Bank and other institutional organisations towards Anglo–Saxon legal system (thereby adding another dimension to globalisation, which can be called ‘globalisation of law’). The World Bank has funded much of the subsequent works of LLSV and created a database that assigns score to each country for their legal institutions to protect the interests of shareholders, creditors, employers (vis–à–vis employees) and other stakeholders.

In this perspective, we shall re–examine the LLSV theory on the basis of a new dataset available from the source of Centre for Business Research, CBR (University of Cambridge, UK) for four OECD countries (UK, USA, France and Germany) over a long time span 1970–2005.60 In the LLSV theory of legal origin, the three countries, England, France and Germany, may be termed as ‘mother countries’. These are essentially countries where different legal systems originated, and subsequently spread to developing countries often through colonisation and conquest. In the US, not a mother country, the Anglo–Saxon system reached a high level of development and the model was exported to other countries.

The rest of the paper is organised as follows. The next section provides a critique of the LLSV theory. Sections 3 and 4 outline the results of our empirical analysis and Section 5 concludes.

2. Legal Origin Theory: A Critique The legal origin postulate suffers from serious conceptual problems. Scholars of comparative law argue

that the classification of countries by reference to legal origins is not always clear and point out that in reality most legal systems are hybrids. For instance, South African law derives from both civil law and common law traditions; Japanese company law used to be based on the German model but, since the 1950s, has been heavily influenced by the US law; Swiss company law is influenced by the UK legal system and, due to the influence of the EU, UK law itself has become more ‘continental’ (Siems 2007). The mechanisms by which legal origins exert their influence—through the ‘political’ and ‘adaptability’ channels are strongly questioned by the modern scholars of corporate law. For example, under current French practice judges interpret the law whereas English judges on the other hand have less scope than before in view of the detailed descriptions contained in modern English law, such as the company law (Deakin, and Singh 2008). The French judges are also able to have discretions by appealing to the Roman law concept of ‘good faith’.

Furthermore, the empirical base of the LLSV theory can be questioned and a number of strong critical points can be raised (see also, Armour et al. 2009a):

60 CBR data over a long time span, 1970-2005 are available for five countries: four OECD countries covered in this

paper and India. Indian data on shareholder protection were examined in a separate paper (Sarkar 2009).


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1. LLSV data lack transparency. For any index to be a meaningful representation of the effects of legal rules across different jurisdictions, it must contain coding which corresponds to the state of the law in the different countries under review. It should take into account relevant cross–national differences in the operation of legal rules. There is always room for differences of view in the way that legal rules are interpreted. When the coding of LLSV’s ‘shareholder rights’ indices was checked by independent experts, numerous coding errors were revealed, casting serious doubts on the main findings of LLSV (Spamann 2006, 2008).

2. A second problem relates to the selection of variables. A functional theory of how legal rules work in relation to economic variables is needed to guide the selection process. In the absence of such theory, there lies a danger of ‘home country bias’ on the part of the researchers constructing the index. LLSV’s legal indices have been criticized on these bases (Ahlering, and Deakin 2007).

3. A third problem concerns the aggregation of the variables coded. The indices are constructed from the unweighted sums of the various measures. It is not clear how significant each variable is in its contribution to the overall business environment. The scores given to particular variables or groups of variables should be weighted on a country by country basis to reflect the comparative law principle of functional equivalents: the same variable may play a completely different functional role in different countries, or different variables may play the same role, with their relative importance varying from one context to another (see Ahlering, and Deakin 2007). For example, regulatory takeover codes are generally thought to play a major role in underpinning minority shareholder rights and encouraging the dispersion of ownership in some common law systems, such as the UK and Australia, but this type of regulation is absent in the United States. In the latter country certain specific rules of securities law, the law of fiduciary duties and a more permissive approach to shareholder–led litigation play a similar role (Armour, and Skeel 2007).

4. Fourthly, the legal indices in large part rely only on formal legal rules—that is, the ‘law on the books’, as opposed to the ‘law in action’. Differences in judicial quality, legal procedure, social norms, and a host of other factors may make the operation of legal rules in practice very different from their formal characterization. The gap between formal law and law in practice does not affect all countries equally; this poses a problem for the indexing methodology. Moreover, the form taken by a particular law may reflect the practical impact of that rule on parties subject to it. That may depend on factors outside the scope of the legal indices, including social and cultural norms beyond the law. The social or economic effect of a given legal rule can only be understood by seeing law as part of a system of interlinked norms, some of which are extra–legal in nature (Zweigert, and Kötz 1998).

5. The majority of the LLSV indices provide a cross–sectional view of the law. Most of them describe the law as it stood in the second half of the 1990s. It does not provide any idea regarding the direction of causality. While a proper legal framework could promote financial development and economic growth, it is also plausible that financial development influences the creation of appropriate legal environment. A number of case studies of the evolution of company law at the national level suggest that for both USA and UK financial market developments preceded legal change (Cheffins 2001; Coffee 2001).

With the above points in mind, CBR (Centre for Business Research, University of Cambridge, UK) scholars have constructed new indices on shareholder protection. The CBR approach differs from that of LLSV in a number of respects (see Armour et al. 2009a):

Firstly, CBR indices take into account a wider range of legal and regulatory information, which are functional equivalent of ‘hard’ laws whereas LLSV focused mainly on ‘positive’ legal rules. All primary legal sources are set out in the documents constituting the CBR datasets, a practice not followed by LLSV.61

A second difference is that a wider range of values is used in CBR data to consider the effects of a given rule. On the contrary, many of the LLSV codings use binary variables (0, 1): for the existence a given rule the code is 1 otherwise it is 0. This procedure does not take into account the possibility of ambiguity or uncertainty in the interpretation of a legal provision. In the CBR data intermediate values between 0 and 1 are arrived at based on interpretative judgments by legal experts.

Thirdly, the CBR data cover a wider range of legal norm than LLSV. In practice, many rules of company law and securities law are ‘default rules’ which may apply or not depending on how the parties to particular transactions choose to deal with them. The norms of corporate governance codes, which follow the ‘comply or explain’ approach, offer an illustration of this: companies have a choice of either conforming to the relevant norm,

61 These are available online, on the website of the Centre for Business Research (CBR) at the University of

Cambridge. See ⟨http://www.cbr.cam.ac.uk/research/programme2/ project2-20.htm⟩.


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or disclosing their reasons for not complying with it. However, this is also a feature of many statutory rules of core company law. Each of these types was included within the CBR coding.

Fourthly, and most fundamentally, CBR indices are all longitudinal. Legal rules were coded as they have evolved over time. These data allow us to track legal changes over time and to analyze their relationship to economic development. In the next two sections, we shall re–examine the LLSV legal origin hypothesis on the basis of these CBR data for four OECD countries (UK, USA, France and Germany) over a long time span 1970–2005.

3. Legal Protection of Shareholders: Common Law vs. Civil Law In the CBR data on shareholder protection there are 60 legal variables for each country; each variable

has 36 annual observations over the period 1970–2005(for the exhaustive list of variables considered see the original data source mentioned in footnote 2). Every variable takes a value between zero (the lowest level of protection) and one (the highest level of protection); many take intermediate values. Thus, if a country were to have the maximum level of protection, the indicators would sum up to 60 assuming uniform weight for all the variables (we shall use unweighted average so that the minimum value of the index is zero and the maximum value is one). In order to make comparative statements about legal protection for shareholders in different countries it would be useful to aggregate the variables. In line with much of the literature, we use the un–weighted sum of all variables as an aggregated index of shareholder protection. This procedure thus assumes that all variables are equally important which is of course unlikely to be true but assigning unequal weights risks the exercise becoming too arbitrary. A simple un–weighted average of all 60 variables (hereafter ALLSP) gives an aggregate picture of shareholder protection. Corporate law is often designed to protect the dispersed shareholders from mangers and board and also to protect minority shareholders from the majority (see Coffee 2002; Kraakman et al. 2004). Therefore, we shall use two broad sub–categories of ALLSP: shareholder protection against board and management (hereafter SPBRD) – the unweighted average of 42 variables and shareholder protection against other shareholders (minority shareholder protection – often called investor protection, hereafter SPMIN) – the unweighted average of the remaining 18 variables.

The two sub–categories are described below: a. Protection against board and management (SPBRD): It covers all the rules and regulations that protect

the shareholders against the activities of board and management. These rules deal with the powers of the general meeting of the shareholders (regarding the amendments of the articles of association, mergers and divisions, sale of substantial assets of the company, dividend distributions, election of the board of directors, directors’ appointment, remunerations and dismissal, directors’ self–dealing of substantial transactions etc.), the agenda setting power of the shareholders in the general meeting, the power of the shareholders to call for an extra–ordinary shareholder meeting, the shareholders’ right to demand information and to get access to the register of shareholders and beneficial owners etc.

b. Protection of minority shareholders against the majority shareholders (SPMIN): It covers the issue of quorum in the extra–ordinary shareholder meeting, supermajority requirements (e.g., 2/3 or 3/4) for amendments of the articles of association, mergers, and voluntary liquidations, provision of protection of out–voted minority shareholders, prohibition of voting by interested shareholders, disclosure of major share ownership, provision of mandatory bid and public offer for acquisition etc.

In Table 1 we have presented the quinquennial average shareholder protection indices (three series, ALLSP, SPBRD and SPMIN) for the four countries under study. Through simple averaging, we have also calculated the quinquennial average shareholder protection of common law group (UK and USA) and the civil law group (France and Germany). All these are plotted in a number of diagrams.

Figure 1 shows that in the first quinquennium (1970–74), UK had the lowest level of aggregate shareholder protection (ALLSP) while Germany had the highest level of aggregate shareholder protection followed by USA and France. In the subsequent quinquennia, all the four countries made a number of changes in their law to provide more and more shareholder protection. Changes were more pronounced in UK and France; while Germany tried to catch up in the 1990s, the US law lagged behind. Hence, in the first 6 years of the current millennium for which we have the relevant CBR data there is not much difference in the state of legal protection of shareholders in the three countries. Our aggregation at the level of legal origin (see also our earlier study, Sarkar, and Singh, 2010) shows that in each quinquennium shareholder protection is more in the civil law countries than that in the common law countries (Figure 2).


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Table 1. Shareholder Protection in Four OECD Countries, 1970–2005 (Period Averages)

Period & Series

France Germany UK USA Common Civil

Board & Management (SPBRD)

1970–74 0.46 0.47 0.46 0.46 0.46 0.47

1975–79 0.46 0.47 0.47 0.47 0.47 0.47

1980–84 0.47 0.50 0.50 0.48 0.49 0.48

1985–89 0.55 0.51 0.54 0.49 0.52 0.53

1990–94 0.57 0.51 0.57 0.51 0.54 0.54

1995–99 0.58 0.52 0.64 0.52 0.58 0.55

2000–05 0.65 0.60 0.68 0.59 0.63 0.63

Minority (SPMIN)

1970–74 0.50 0.53 0.42 0.50 0.46 0.52

1975–79 0.50 0.54 0.43 0.54 0.49 0.52

1980–84 0.50 0.56 0.46 0.55 0.50 0.53

1985–89 0.54 0.56 0.46 0.48 0.47 0.55

1990–94 0.60 0.56 0.47 0.46 0.47 0.58

1995–99 0.54 0.58 0.47 0.42 0.45 0.56

2000–05 0.56 0.64 0.47 0.45 0.46 0.60

Aggregate (ALLSP)

1970–74 0.47 0.49 0.45 0.48 0.46 0.48

1975–79 0.47 0.49 0.46 0.49 0.47 0.48

1980–84 0.48 0.52 0.49 0.50 0.49 0.50

1985–89 0.54 0.52 0.51 0.49 0.50 0.53

1990–94 0.58 0.52 0.54 0.50 0.52 0.55

1995–99 0.57 0.54 0.59 0.49 0.54 0.56

2000–05 0.63 0.61 0.62 0.54 0.58 0.62

Source: Calculated from CBR (University of Cambridge) data available in

http://www.cbr.cam.ac.uk/research/programme2/project2–20.htm.

http://www.cbr.cam.ac.uk/research/programme2/project2-20.htm


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Figure 1. Aggregate Shareholder Protection in Four OECD Countries, 1970–2005

Figure 2. Common Law vs. Civil Law: Aggregate Shareholder Protection, 1970–2005

At the disaggregative level, it appears that in the field of shareholder protection relating to board and management (SPBRD) there is not much gap between UK and France and between Germany and USA (Figure 3). We find not much difference between common law and civil law (Figure 4). That means the distinction between the two groups arises in the field of minority shareholder protection (SPMIN). Both Germany and France provided more and more minority shareholder protection in contrast to its steady decline in the USA and stagnation in the UK (Figures 5 and 6).

Figure 3. Shareholder Protection Relating to Board and Management in Four OECD Countries, 1970–2005

0.40

0.45

0.50

0.55

0.60

0.65

1970-74 1975-79 1980-84 1985-89 1990-94 1995-99 2000-05

France Germany UK USA

0.40

0.45

0.50

0.55

0.60

0.65

1970-74 1975-79 1980-84 1985-89 1990-94 1995-99 2000-05Common Law Civil Law

0.40

0.45

0.50

0.55

0.60

0.65

0.70

1970-74 1975-79 1980-84 1985-89 1990-94 1995-99 2000-05France Germany UK USA


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Figure 4. Common Law vs. Civil Law:Shareholder Protection Relating to Board and Management, 1970–2005

Figure 5. Minority Shareholder Protection in Four OECD Countries, 1970–2005

Figure 6. Common Law vs. Civil Law: Minority Shareholder Protection, 1970–2005

To examine the same question at a more rigorous level, consider all the 36 years (1970–2005) of

observations for each country to get a panel dataset of 144 observations. We use the dummy variable for common law origin countries (COM) and fit the following regression with a time–trend:

0.40

0.45

0.50

0.55

0.60

0.65

1970-74 1975-79 1980-84 1985-89 1990-94 1995-99 2000-05

Common Law Civil Law

0.40

0.45

0.50

0.55

0.60

0.65

1970-74 1975-79 1980-84 1985-89 1990-94 1995-99 2000-05


0.40

0.45

0.50

0.55

0.60

0.65

1970-74 1975-79 1980-84 1985-89 1990-94 1995-99 2000-05

Common Law Civil Law


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Y = a + b.COM + c.t (1)

where Y = the shareholder protection index (ALLSP or SPBRD or SPMIN), COM is the dummy variable = 1 for common law countries (UK, USA) and zero for other countries (France and Germany) and t is the time–trend. This regression procedure shows that common law countries and civil law countries do not differ in shareholder protection relating to board (SPBRD) – the dummy (COM) is not statistically significant. Contrary to the LLSV legal origin hypothesis, the minority shareholder protection and so the aggregate shareholder protection is lower in the common law countries – the dummy is negative and highly significant for the dependent variables, SPMIN and ALLSP (Table 2). Our result holds irrespective of whether we add time–trend in the regression equation (1).

Table 2. Shareholder Protection in Common Law vis–à–vis Civil Law Countries, 1970–2005: Dummy Variable Analysis1

Series Intercept(a) Dummy for Common Law Countries (COM)

Time Trend (t)

R–Square

1.Aggregate Shareholder Protection (ALLSP)

0.458* –0.022* 0.004* 0.706

2. Shareholder Protection Concerning Board and Management (SPBRD)

0.425* 0.004x 0.005* 0.732

3. Minority Shareholder Protection (SPMIN)

0.534* –0.083* 0.001* 0.539

* Significant at 1 per cent level (based on robust standard errors). x Not significant even at 10 per cent level (based on robust standard errors). 1 The following regression equation has been fitted through OLS:

Y = a + b.COM +c.t

where Y is shareholder protection index (ALLSP or SPBRD or SPMIN), t is the time trend and COM is the dummy variable = 1 for common law countries (UK, USA) and zero for other countries (France and Germany). To sum up, our study of the leximetric data of four major countries (from the perspective of legal origin) over a long span of time (1970–2005) does not support the LLSV proposition that the common law is superior to civil law in protecting the interests of shareholders. Rather we find that overall civil law is superior to common law because of better minority shareholder protection in the civil law countries. There is also a tendency towards divergence because of declining minority shareholder protection in the USA coupled with its sluggish improvement in the UK.

4. Does Law Matter? In this section, we shall examine ‘whether law matters’: whether a country with higher shareholder

protection experiences greater development of its stock markets. To examine this proposition we shall consider the following indicators of stock market development (used one at a time) along with shareholder protection indices (taken one at a time) discussed in the earlier section (SPBRD, SPMIN, and ALLSP):

1. Market capitalisation or the value of the shares of listed firms to GDP, MKAPY. 2. Value of total shares traded on the stock exchange to GDP, VTRDY. 3. Turnover ratio, which is the ratio of the value of total shares traded to average real market

capitalization, TURN. 4. Number of domestically incorporated companies listed in the country’s stock exchange per million of

population, LISTPOPM. The data source of the three series, MKAPY, VTRDY and TURN is the Financial Structure Dataset of

World Bank (see Beck et al. 2000a). The data on legal protection of shareholders are from online CBR (Cambridge, UK) source (as already mentioned). All other data are from the World Development Indicators of World Bank.

The periodic (mostly quinquennial) averages of the indicators of stock market and development are plotted in Figures 7 to 10. These show that for all the indicators of stock market development (excepting


151

turnover ratio), the common law countries (UK and USA) are better placed. They had higher market capitalisation and value of trading (both relative to GDP) throughout the period 1976–2005 for which we have data. This is also true for stock market listing (per million of population) over the period 1980–2005.

We have also replicated the dummy variable analysis of annual data conducted in the earlier section to supplement our graphical analysis of quinquennial average data. We have considered additional dummies (intercept and slope dummies) for the period, 2001–2005 in order to take into account the impact of dotcom bubble bursting and subsequent recovery. This procedure supports our graphical observation: the common–law group has statistically significant higher market capitalisation, higher value of stock trading (both relative to GDP) and higher number of listed firms (per million of population); only for turnover ratio the difference is not statistically significant (Table 3). Now the crucial question is how far this higher stock market development in the common–law group is due to its shareholder protection. We shall seek an answer to these questions through dynamic panel data modelling (discussed below). To control for the level of economic activity of a country we shall consider real GDP in purchasing power parity constant dollars, deflated by population (PPPCY) available from World Bank source (World Development Indicators).

Figure 7. Stock Market Capitalisation (relative to GDP) in Four OECD Countries, 1976–2005

Figure 8. Value of Stock Trading (relative to GDP) in Four OECD Countries, 1976–2005

0

0.5

1

1.5

2

1976-80 1981-85 1986-90 1991-95 1996-2000 2001-2005


0

0.5

1

1.5

2

2.5

1976-80 1981-85 1986-90 1991-95 1996-2000 2001-2005



152

Figure 9. Stock Market Turnover Ratio in Four OECD Countries, 1976–2005

Figure 10. Stock Market Listing of Firms per Million of Population in Four OECD Countries, 1980–2005

Table 3. Stock Market Development in the Common Law vis–à–vis the Civil Law Countries since the 1970s: Dummy Variable Analysis1

Series & Period of Analysis Intercept (a)

Dummy for Common Law Countries (COM)

Time Trend (t)

dummy for 2001– 2005 (d2001)

t.dummy for 2001– 2005 (sd2001)

R– Square

Market Capitalisation–GDP ratio (in natural log), LMKAPY, 1976–2005

–3.121** 1.212** 0.078** 3.993* –0.125* 0.91

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

1976-80 1981-85 1986-90 1991-95 1996-2000 2001-2005


0

5

10

15

20

25

30

35

40

45

50



153

Series & Period of Analysis Intercept (a)

Dummy for Common Law Countries (COM)

Time Trend (t)

dummy for 2001– 2005 (d2001)

t.dummy for 2001– 2005 (sd2001)

R– Square

Value of Stock Trading–GDP ratio (in natural log), LVTRDY, 1976–2005

–5.234** 1.237** 0.146** 6.012** –0.186** 0.894

Stock Market Turnover Ratio (in natural log), LTURN, 1976–2005

–2.112** 0.025 0.068** 2.303 –0.069 0.656

Number of Firms Listed in the Stock Market per million of population (in natural log), LLISTPOPM, 1980–2005

2.058** 1.256** 0.006 0.951 –0.03 0.854

* Significant at 5 per cent level (based on robust standard errors). ** Significant at 1 per cent level (based on robust standard errors). 1 The following regression equation has been fitted through OLS:

Y = a + b.COM +d.t +e.d2001 +f.sd2001

where Y is the alternative stock market development indicators (alternatively LMKAPY, LVTRDY, LTURN, LLISTPOPM), COM is the dummy variable = 1 for common law countries (UK, USA) and zero for other countries (France and Germany), t is the time trend, d2001 is dummy for dotcom bubble that assumes the value zero for 1970–2000 and =1 for 2001–2005 and sd2001=d2001*t varies accordingly.

Dynamic Panel Data Analysis: Estimates of Short run and Long–run Relationships For a large time dimension of panel data (as we have here), Pesaran, and Smith (1995) showed that the

traditional procedures for estimation of pooled models, such as the fixed effects, instrumental variables, and generalized method of moments (GMM) ‘can produce inconsistent, and potentially very misleading estimates of the average values of the parameters in dynamic panel data models unless the slope coefficients are in fact identical (Pesaran, and Shin 1999, p.622). Therefore, to ascertain the nature of the relationships between financial development and shareholder/creditor protection we shall use the Pesaran–Shin dynamic panel data analysis. We start with a postulate of long–run relationship involving X (four stock market development indicators such as MKAPY, VTRDY, TURN and LISTPOPM), Y (per capita GDP, PPPCY in natural log) and Z (various shareholder protection indexes taken one at a time):

Xit = i Yit + i Zit + it (2)

where i (=1,2,3,4) represents countries, t (=1,2,… T) represents periods (years), i i are the long–run parameters and it is the error term.

We are interested to know whether there exist long–term and short–term effects of Z (shareholder protection) along with Y (per capita GDP measuring economic activities) on X (stock market development indicators respectively) and whether there exists a stable adjustment path from the short–term relationship (if any) to the long–run relationship. Following Pesaran, and Shin (1999), our panel data analysis is based on the following error correction representation:

p–1 q–1 r–1

ΔXit = i it–1) + ij ΔXi, t–j + ik ΔY i, t–k + il ΔZi, t–l + + it (4)

=1 k = 0 l = 0


154

where Δ is the difference operator, i is the country–specific error–correcting speed of adjustment term, ij,ik

and ij are the coefficients of the lagged variables, is the country fixed effect and it is the disturbances

term. The existence of a meaningful long–run relationship with a stable adjustment dynamics requires i < 0. Under this general structure, we can have three alternative models. On one extreme, we can have

dynamic fixed effect estimators (DFE) where intercepts are allowed to vary across the countries and all other parameters and error variances are constrained to be the same. At the other extreme, one can estimate separate equations for each country and calculate the mean of the estimates to get a glimpse of the over–all picture. This is called mean group estimator (MG). Pesaran, and Smith (1995) showed that MG gives consistent estimates of the averages of parameters. The intermediate alternative is pooled mean group (PMG) estimator, suggested by Pesaran, and Shin (1999). It allows intercepts, short–run coefficients and error variances to differ

freely across the countries but the long run coefficients are constrained to be the same; that means, i =

and i or all i while i may differ from group to group.

Using the STATA ado developed by Blackburne, and Frank (2007) we have estimated all the three alternative models, MG, PMG and DFE. Based on Lag Exclusion Wald Test for each variable separately we have determined the lag structure (p, q, r).62 Our findings are presented below:

1. In none of the three models, we find short–term or long–term effect (favourable or unfavourable) of aggregate shareholder protection, ALLSP on the four stock market development indicators. This is also true for the shareholder protection relating to Board, SPBRD (Table 4, Parts A and B). In our earlier study (Sarkar, and Singh 2010) we arrived at the similar conclusion on the basis of a time–series analysis of the individual country cases.

2. As regards the impact of minority shareholder protection on stock market development indicators, the same conclusion cannot be drawn because of one remarkable exception. This is the case of stock market listing in the DFE model: the effect of minority shareholder protection on stock market listing is negative in the short–run but positive in the long–run and there exists a stable adjustment path from the short–run relationship to the long–run relationship. A series of Hausman tests support the DFE model and so it can be concluded that minority shareholder protection matters for stock market listing.63 There is another minor exception: a negative short–term effect on turnover ratio was observed in the DFE model but no significant long–term effect (Table 4, Parts C–(iii) and (iv)).

Table 4. Short–run and Long–run Relationships between Legal Index and Stock Market Variables 1976/80–2005:

Dynamic Panel Models

Period of Analysis/Models1 PMG MG DFE

A. Impact of Aggregate Shareholder Protection Index, ALLSP (Z) on

(i) Stock Market Capitalization , LMKAPY (X)

Long–term Relationship

Y (LPPPCY) 5.415*** –1.432 2.531***

Z (ALLSP) 2.651 16.076 3.331

Short–term Relationship

–0.158 –0.297*** –0.164***

ΔXt–1 0.373*** 0.421*** 0.454***

ΔYt 1.114 1.058 0.374

ΔYt–1 0.221 0.756 –0.639

62 We have considered a uniform lag-structure for all the countries, as the STATA ado used here does not have this

option. It is theoretically possible to consider different lag structures for different countries on the basis of some information criteria.

63 Our individual country case studies.(reported in Sarkar, and Singh, 2010) could not find this result that supports the ‘law matters’ proposition of the legal origin theory.


155


ΔZt –1.453 –1.094 –0.678

–8.997 –11.156 –4.456**

Chosen Model2 DFE

(ii) Value of Stock Trading, LVTRDY (X)


Y (LPPPCY) 6.614*** 6.722*** 6.224***

Z (ALLSP) –2.949 –1.744 2.658


–0.279*** –0.382*** –0.221***

ΔYt 3.606 4.164 2.999

ΔYt–1 –2.551 –1.475** –1.039

ΔZt –0.068 –0.212 –1.917

–18.433 –28.029** –14.408***

Chosen Model2 PMG

(iii) Turnover Ratio, LTURN (X)


Y (LPPPCY) 3.628*** 3.185*** 3.5***

Z (ALLSP) –1.282 –1.672 –0.798


–0.499*** –0.508*** –0.388***

ΔYt 1.611 1.731 1.529

ΔYt–1 –1.886 –2.187 –0.389

ΔZt 0.913 1.753 –0.579

–18.168 –19.049*** –13.699***

Chosen Model2 PMG

(iv) Stock Market Listing, LLISTPOPM (X)


Y (LPPPCY) 1.444*** 0.099 –0.116

Z (ALLSP) –1.549 0.097 1.108


–0.361** –0.511 –0.287***

ΔYt 1.989** 1.923** 1.78

ΔYt–1 –0.103 0.625 0.319

ΔZt 0.234 –0.029 –0.544

–4.078 –1.141 0.932

Chosen Model2 MG

B. Impact of Shareholder Protection relating to Board, SPBRD (Z) on



Y (LPPPCY) 2.887*** –0.017 2.269**


156


Z (SPBRD) 0.335 8.758 3.039


–0.167*** 0.283*** –0.15***

ΔXt–1 0.465*** 0.44*** 0.469***

ΔYt 0.412 0.735 0.189

ΔYt–1 –0.026 0.427 –0.427

ΔYt–2 –1.324 0.205 –0.703

ΔZt –0.146 –1.046 –0.977

–4.998*** –10.505 –3.749*

Chosen Model2 PMG



Y (LPPPCY) 7.221*** 7.042*** 5.456***

Z (SPBRD) –3.965 0.616 4.496


–0.273*** –0.382*** –0.224***

ΔYt 2.806 3.793 3.092

ΔYt–1 –2.044* –1.259 –1.282

ΔZt 0.448 0.597 –1.439

ΔZt–1 1.642 0.899 –1.049

–19.458*** –31.655*** –13.064**

Chosen Model2 PMG



Y (LPPPCY) 3.583*** 3.294** 3.031***

Z (SPBRD) –0.878 0.249 0.919


–0.479*** –0.502*** –0.38***

ΔYt 1.244 1.511 1.683


157


ΔYt–1 –1.168 –1.337 –0.313

ΔZt 1.204 1.911 0.072

ΔZt–1 0.792 1.175 –0.628

–0.17345*** –20.463 –11.988***

Chosen Model2 DFE

(iv) Stock Market Listing, LLISTPOPM (X)


Y (LPPPCY) 1.607*** 0.218 0.254

Z (SPBRD) –1.782 –0.404 –0.304


–0.368**

–0.455*** –0.279***

ΔYt 1.879** 1.866** 1.723

ΔYt–1 0.678 1.076 0.059

ΔZt 0.035 –0.06 –0.939

ΔZt–1 1.101 0.934 0.424

–4.727* –2.756 0.087

Chosen Model2 DFE

C. Impact of Minority Shareholder Protection, SPMIN (Z) on



Y (LPPPCY) 3.178*** 3.002** 3.207***

Z (SPMIN) 0.987 10.377 1.623


–0.198** –0.352*** –0.159***

ΔXt–1 0.462*** 0.411*** 0.471

ΔYt 1.123* 1.363* 0.585

ΔYt–1 –0.905*** 0.895 –0.888

ΔZt 1.316 –0.608 0.397

ΔZt–1 0.998 0.519 –0.065

–6.636** –14.877** –5.365**

Chosen Model2 PMG



Y (LPPPCY) 5.954*** 5.633*** 6.746***

Z (SPMIN) –0.057 4.759 1.68


158



–0.269*** –0.379*** –0.226***

ΔYt 2.806 4.159 2.74

ΔZt 0.331 0.414 –1.792

–16.432*** –26.177** –15.789***

Chosen Model2 PMG



Y (LPPPCY) 3.436*** 2.604*** 3.326***

Z (SPMIN) 0.082 4.307 0.172


–0.529*** –0.519*** –0.41***

ΔYt 1.904 1.801 1.293

ΔZt 0.677 0.386 –2.189

ΔZt–1 –2.969 –3.272 –4.219***

–18.632*** –17.162*** –13.966***

Chosen Model2 PMG

(iv) Stock Market Listing, LLISTPOPM (X) 3


Y (LPPPCY) 1.025*** 0.007 0.114

Z (SPMIN) –1.084 –10.23 2.545*


–0.428* –0.613*** –0.322***

ΔYt 1.625 1.631 2.149**

ΔYt–1 –0.659 –0.174 0.05

ΔZt 3.082 4.898** 0.321

ΔZt–1 1.625 1.863 –0.175

ΔZt–2 0.901 1.138 –1.479*

–3.169* 1.832 0.071

Chosen Model2 DFE

* Significant at 10 per cent level. ** Significant at 5 per cent level. *** Significant at 1 per cent level.

1. The regressors are estimated from the following long–term relationship and its error correction form. Long–run Relationship:

Xit = i Yit + i Zit + it

Error Correction Form:

p–1 q–1 r–1

ΔXit = i it–1) + ij ΔXi, t–j + ik ΔY i, t–k + ij ΔZi, t–l + i + it j =1 k = 0 l=0

where Δ is the difference operator, i is the group–specific error–correcting speed of adjustment term,

ij,ik and ij are the coefficients of the lagged variables, i is the country–specific effect and it is the


159

disturbances term. The existence of a meaningful long–run relationship with a stable adjustment dynamics

requires i < 0. 2. An appropriate model is chosen on the basis of a series of Hausman tests. 3. Due to non–availability of data, the period of analysis is 1980–2005.

5. Summary and Conclusion Analysing the available data of the legal origin ‘mother’ countries over a long time span, 1970–2005, our

study finds that the civil law countries (France and Germany) provide more minority shareholder protection. Furthermore, our study questions the related proposition that ‘law matters’; it finds no clear evidence in favour of a favourable effect of shareholder protection on stock market development. Using dynamic panel data models it concludes that only one aspect of shareholder protection matters for stock market development; it is minority shareholder protection which is observed to have a long–term favourable effect on only one indicator of stock market development, namely the number of firms listed in the stock market relative to total population. Perhaps the minority shareholder protection discourages firms to list their shares in the short–run (we got short–term negative relationship) but in the long–run it popularizes the stock market giving an incentive for firms to rely more on stock market. To sum up, our study based on longitudinal data for four OECD countries does not support the proposition that common–law countries provide more protection to their shareholders which in turn promote their stock market developments.

Acknowledgements I am grateful to L'Institut d'Études Avancées (IEA), Paris for funding this study and equally thankful to

Professors Ajit Singh and Simon Deakin for encouraging me to further my research by involving me in the project, ‘Law, Finance and Development’ by means of several visiting fellowships at the Centre for Business Research at the University of Cambridge, UK) between 2007–2010.

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PROHIBITION OF PARALLEL IMPORTS AS A HARD CORE RESTRICTION OF ARTICLE 4 OF BLOCK EXCEPTION

REGULATION FOR VERTICAL AGREEMENTS: EUROPEAN LAW

AND ECONOMICS

Nikolaos E. ZEVGOLIS Athens University of Economics and Business, Athens, Greece

[email protected]

Panagiotis N. FOTIS University of Central Greece, Athens, Greece

[email protected] Abstract

This paper attempts to highlight the main principles of Competition Law (regulatory and case law framework) covering the prohibition of parallel imports and to reveal the main effects of it on the competitive structure of the market. Especially, the regulatory framework relates Block Exception Regulation 330/2010 with Block Exception Regulation 461/2010 in order to determine whether prohibition of parallel imports constitutes a hardcore restriction or not, while the economic analysis evaluates it in a vertical market with few suppliers & buyers which sell goods to the final (domestic) consumers. The results indicate that the prohibition of parallel imports by upstream sellers cause vertical restraints to the domestic customers of the buyers. In any case, this paper focusing mainly on consumer welfare, does not necessarily link parallel imports with the notion of parallel trade and/or parallel exports as well as it does not provide the pros and cons of parallel trade. Keywords: Antitrust Law, vertical restraints, block exception regulation, market imperfection, consumer

nondurables, repeated games of Oligopoly Theory.

JEL Classifications: D43, K21, L13, L43, L67.

1. Introductory remarks Block Exception Regulation (BER) 330/201064 (ex BER 2790/9965) states that article 101(1) of the Treaty

shall not apply to vertical agreements, whereas such agreements contain vertical restraints (ar.2) and the market share held by the supplier does not exceed 30 % of the relevant market on which it sells the contract goods or services and the market share held by the buyer does not exceed 30 % of the relevant market on which it purchases the contract goods or services (ar. 3).

Also, BER 461/201066 (ex BER1400/200267) declares that article 101(1) of the Treaty shall not apply to vertical agreements relating to the conditions under which the parties may purchase, sell or resell spare parts for motor vehicles or provide repair and maintenance services for motor vehicles, which fulfil the requirements for an exemption under Regulation (EU) No 330/2010 and do not contain any of the hardcore clauses listed in Article 5 of this Regulation, (see below) whereas such agreements contain vertical restraints (article 4).

However, both BERs contain hardcore restrictions that remove the benefit of the block exemption. Especially, article 4 of BER 330/2010 (see below) outlines the basic categories of hardcore restrictions, for which the exception provided for in the abovementioned article 2 of BER shall not apply to vertical agreements.

The main question which this paper tries to answer is whether prohibition of parallel imports constitutes a hardcore restriction of BER for vertical agreements, that is a per se approach. For this purpose, we analyse the existing regulatory framework in combination with case law in a real economic environment so as to determine if

The views expressed herein are purely those of the authors and do not necessarily reflect the Hellenic Competition

Commission. Warm thanks are expressed to Mrs Danielle Apostolatos. Usual disclaimer applies.

64 O.J. L102/1, 23.4.2010. 65 O.J. L336/21, 29.12.1999. 66 O.J. L 129/52, 28.05.2010. 67 O.J. L 203/30, 1.8.2002.




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the prohibition of parallel imports by upstream suppliers may cause vertical restraints in the downstream market and especially the customers of the buyers68.

The remainder of the paper is organized as follows: Sections 2 and 3 provide as well as evaluate the main principles of BER 330/2010 & BER 461/2010 respectively. Section 4 combines both BERs, while section 5 highlights some administrative anticompetitive measures. Section 6 imports the theoretical argument into real economic environment. Lastly, section 7 provides some conclusions.

2. The content of the General Block Exemption Regulation (BER 330/2010) 2.1 Hardcore restrictions

Logically, it would be expected that the prohibition of parallel imports would be explicitly referred as a hardcore restriction in the content of article 4 of BER 330/10 (‘Restrictions that remove the benefit of the block exemption — hardcore restrictions’). According to this, ‘The exemption provided for in Article 2 shall not apply to vertical agreements which, directly or indirectly, in isolation or in combination with other factors under the control of the parties, have as their object:

(a) the restriction of the buyer's ability to determine its sale price, without prejudice to the possibility of the supplier to impose a maximum sale price or recommend a sale price, provided that they do not amount to a fixed or minimum sale price as a result of pressure from, or incentives offered by, any of the parties;

(b) the restriction of the territory into which, or of the customers to whom, a buyer party to the agreement, without prejudice to a restriction on its place of establishment, may sell the contract goods or services69,

(c) the restriction of active or passive sales to end users by members of a selective distribution system operating at the retail level of trade, without prejudice to the possibility of prohibiting a member of the system from operating out of an unauthorised place of establishment;

(d) the restriction of cross–supplies between distributors within a selective distribution system, including between distributors operating at different level of trade;

(e) the restriction, agreed between a supplier of components and a buyer who incorporates those components, of the supplier’s ability to sell the components as spare parts to end–users or to repairers or other service providers not entrusted by the buyer with the repair or servicing of its goods’70.

It is obvious that there are no specific provisions for the prohibition of parallel imports as a hardcore restriction. Consequently, according to the basic principle governing BER 330/2010 (as well as the former BER 2790/99), which provides that whatever is not prohibited by article 4 is permitted71, it would be expected that the prohibition of parallel imports is not a hardcore restriction.

However, the significance of parallel trade protection is mentioned in the new Guidelines about vertical restraints72, mainly in paragraph 25, where it is referred as an instance that ‘if after a supplier's announcement of a unilateral reduction of supplies in order to prevent parallel trade, distributors reduce immediately their orders and stop engaging in parallel trade, then those distributors tacitly acquiesce to the supplier's unilateral policy. This can however not be concluded if the distributors continue to engage in parallel trade or try to find new ways to engage in parallel trade’73.

In any case, in our view, before someone can come to a conclusion whether the prohibition of parallel trade constitutes a hardcore restriction or not, it would be wise to examine the following issues: Firstly, the necessity of focusing on the interpretation of article’s 4 content of the Block Exemption 330/2010 and the consideration of the guidelines about vertical restraints in combination with the content of Regulation 461/2010 and its relevant guidelines, secondly, the possibility that such a point of view would come in contradiction with

68 According to BER 330/2010, 1(i), ‘customer of the buyer’ means an undertaking not party to the agreement which

purchases the contract goods or services from a buyer which is party to the agreement.’ 69 Except from (i) the restriction of active sales into the exclusive territory or to an exclusive customer group reserved

to the supplier or allocated by the supplier to another buyer, where such a restriction does not limit sales by the customers of the buyer, (ii) the restriction of sales to end users by a buyer operating at the wholesale level of trade, (iii) the restriction of sales by the members of a selective distribution system to unauthorised distributors within the territory reserved by the supplier to operate that system, and (iv) the restriction of the buyer's ability to sell components, supplied for the purposes of incorporation, to customers who would use them to manufacture the same type of goods as those produced by the supplier’.

70 See O.J. L102/1, 23.4.2010, p. 5. 71 See Dethmers F. & Posthuma de Boer P. (2009) p. 425. 72 O.J. C130/01, 19.05.2010. 73 See para. 25 (a).


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the settled case law about parallel imports and thirdly, the characteristics of the markets in which parallel trade prohibition is imposed.

2.2 Prohibition of parallel imports as an effective measure for RPM The hardcore restriction set out in article 4(a) of the BER 330/2010 focuses on Resale Price Maintenance

(RPM), that is, agreements or concerted practices having as their direct or indirect object the establishment of a fixed or minimum resale price or a fixed or minimum price level to be observed by the buyer. In the case of contractual provisions or concerted practices that directly establish the resale price, the restriction is clear cut.

However, RPM can also be achieved through indirect means. Examples of this include: an agreement fixing the distribution margin, fixing the maximum level of discount the distributor can grant from a prescribed price level, making the grant of rebates or reimbursement of promotional costs by the supplier subject to the observance of a given price level, linking the prescribed resale price to the resale prices of competitors, threats, intimidation, warnings, penalties, delay or suspension of deliveries or contract terminations in relation to observance of a given price level. Direct or indirect means of achieving price fixing can be made more effective when combined with measures to identify price–cutting distributors, such as the implementation of a price monitoring system, or the obligation of retailers to report other members of the distribution network that deviate from the standard price level.

Similarly, direct or indirect price fixing can be made more effective when combined with measures which may reduce the buyer's incentive to lower the resale price, such as the supplier printing a recommended resale price on the product or the supplier obliging the buyer to apply a most–favoured–customer clause. The same indirect means and the same ‘supportive’ measures can be used to make maximum or recommended prices work as RPM.

However, the use of a particular supportive measure or the provision of a list of recommended prices or maximum prices by the supplier to the buyer is not considered in itself as RPM74. Nevertheless, it should also be assessed that in few cases75, maximum and recommended prices will work as a focal point for the resellers and might be followed by most or all of them; in such cases the possible competition risk is that maximum or recommended prices may soften competition or even facilitate collusion between suppliers.

The strategy of parallel imports’ prohibition may be seen as a measure which reduces the buyer’s incentive to reduce resale price by diminishing the sources of supply. Such a strategy may dangerously raise the level of selling prices of the products in question, since the elimination of sources of supply restricts the ability of the buyer to distribute the product in a profitable way. As a consequence of this, the consumer welfare is negatively influenced.

Consumer welfare may also be negatively influenced in cases where the abovementioned strategy takes place in markets where the buyers resell the products in question to domestic customers of the buyers. In our view, such a product market example may have more severe anticompetitive effects since the buyers of the downstream market are not export oriented firms.

Lastly, by imposing a price floor, an upstream firm increases the non–cooperative profits of downstream firms and makes collusion relatively less profitable. As a result, collusion may be destabilized and the price floor enables a manufacturer to prevent collusive behavior among downstream firms (Overvest B 2010).

2.3 The argument of exclusive supply Hypothetically speaking, if someone is in favour of the opinion that the prohibition of parallel imports is not

a hardcore restriction, he or she could argue that, since the prohibition of parallel imports seem to have the same results with an exclusive supply agreement, therefore de facto constitutes an exclusive supply.

Nevertheless, at this point an absolutely necessary distinction ought to be made: the exclusive supply of specific products of a trademark is not the same with the exclusive supply of a specific trademark by itself; in the first case, the exclusive supply of specific products of a specific trademark is legal, since it does not prohibit the parallel imports of these products of the same trademark; If a retailer can find the same products of the same trademark by a cheaper source of supply (for instance, a wholesaler or an authorized dealer in an other member state), he can buy them in order to resell them without breaking the exclusive supply agreement.

74 See O.J. L102/1, 19.05.2010, para. 48. 75 See O.J. L102/1, 19.05.2010, para 227.


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On the contrary, the exclusive supply of a specific trademark by itself, which actually constitutes exclusive source of supply76 and not exclusive supply, should be treated in a completely different way, because it de facto constitutes an indirect (but effective) prohibition of parallel imports; in this case, the real purpose of the exclusive supply agreement concerning not specific products but a trademark as a whole is not a non compete obligation77, but to prevent the retailer from finding products of the same trademark in lower prices by other sources. So, the point of view that prohibition of parallel imports constitutes an exclusive supply agreement and therefore ought to be allowed as a practice is postponed; an exclusive supply agreement which indirectly prevent parallel imports is always (inherently) illegal.

3. The content of the Motor Vehicles Block Exemption Regulation (BER 461/2010) 3.1 The content of supplementary guidelines

The necessity for protection of parallel trade in the motor vehicles sector is formulated absolutely clearly in the Commission notice — Supplementary guidelines78 on vertical restraints in agreements for the sale and repair of motor vehicles and for the distribution of spare parts for motor vehicles79,80. The Commission considers the protection of parallel trade in the motor vehicles sector as an important competition objective, since the internal market has enabled consumers to purchase motor vehicles in other Member States and take advantage of price differentials between them81.

The main concept of the internal market is the consumer's ability to buy goods in other Member States. This ability is especially important as far as motor vehicles are concerned, given the high value of the goods and the direct benefits in the form of lower prices accruing to consumers buying motor vehicles elsewhere in the Union. It cannot be ignored that the specific nature82 of the motor vehicle ought to be taken into account, since it is one of the most complex products83. The Commission is therefore concerned that distribution agreements, generally but also specifically in this particular sector, should not restrict parallel trade, since this cannot be expected to satisfy the conditions laid down in Article 101(3) of the Treaty84. It is remarkable that the European Court of Justice (ECJ) in its C–338/00P (Volkswagen/Commission) decision clearly ruled that ‘[…] a measure which is liable to partition the market between Member States cannot come under those provisions of Regulation No 123/85 that deal with the obligations which a distributor may lawfully assume under a dealership contract. The Court of First Instance properly held in paragraph 49 of the judgment under appeal that, although that regulation provided manufacturers with substantial means by which to protect their distribution systems, it did not authorise them to adopt measures which contributed to a partitioning of the market (Bayerische Motorenwerke,

76 Exclusive sourcing is something different, since in this case the existence of exclusive distributors is demanded;

according to para 162 of the Guidelines on vertical restraints [O.J. C130/01, 19.05.2010], ‘[e]xclusive sourcing, requiring the exclusive distributors to buy their supplies for the particular brand directly from the manufacturer, eliminates in addition possible arbitrage by the exclusive distributors, which are prevented from buying from other distributors in the system’.

77 See D.G. Goyder (2004), p. 187. See also para 129 of the Guidelines on vertical agreements [O.J. C130/01, 19.05.2010] referring that: ‘Under the heading of ‘single branding’ fall those agreements which have as their main element the fact that the buyer is obliged or induced to concentrate its orders for a particular type of product with one supplier. That component can be found amongst others in non- compete and quantity-forcing on the buyer. A non- compete arrangement is based on an obligation or incentive scheme which makes the buyer purchase more than 80% of its requirements on a particular market from only one supplier. It does not mean that the buyer can only buy directly from the supplier, but that the buyer will not buy and resell or incorporate competing goods or services’ [emphasis added].

78 O.J. C138/16, 28.05.2010. 79 See Clark, J., and Simon, S. (2010), pp. 1-13 and Simon, S. (2010), pp. 83-91. 80 The new guidelines about the motor vehicle sector are called ‘supplementary’, since they should be read

combined with the guidelines on vertical agreements. According to Clark, J., and Simon, S. (2010), p. 3, ‘[t]he guidelines carry the word supplementary in their title to signal that they have to be read in conjunction with the General Vertical Guidelines’.

81See the Commission notice — Supplementary guidelines on vertical restraints in agreements for the sale and repair of motor vehicles and for the distribution of spare parts for motor vehicles [O.J. C138/16, 28.05.2010], para 48.

82 See Karydis, G., and Zevgolis, N. (2009), p.95. 83 As Goyder, D.G. (2004), p.203 has mentioned: ‘The motor car is probably the most complex consumer product of

all, as well as being the most expensive purchase that many consumers ever make’. See also Vezzoso, S. (2004), p.190-191 who wrote: ‘The whole concept was centred on the belief that the car was not an ordinary good’.

84 The notion that cross-border trade restrictions may harm consumers has been confirmed by the Court in Case C-551/03 P, para 67 and 68; Case C-338/00 P, para 44 and 49 and Case T-450/05, para 46-49.


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cited above, paragraph 37)’85. That said, the application of a BER 461/2010 should never be used as an excuse for the partitioning of the market. Besides, compartmentalisation of the market is not included (and cannot be included) in the purposes of a Block Exemption Regulation.

3.2 Case law in motor vehicle sector The relevant case law can safely be considered as settled, since the Commission has brought several

cases against motor vehicle manufacturers for impeding parallel trade, and its decisions have been largely confirmed by the European Courts86. This experience shows that restrictions on parallel trade may take a number of forms (direct or indirect)87,88.A supplier may put pressure on distributors, threaten them with contract termination, fail to pay bonuses, refuse to honour warranties on motor vehicles imported by a consumer or cross–supplied between distributors established in different Member States, or make a distributor wait significantly longer for delivery of an identical motor vehicle when the consumer in question is resident in another Member State. The relative remarks of Advocate General Antonio Tizzano in the General Motors case (C–551/03P) are very characteristic. According to his view, ‘ […] such an objective [compartmentalisation of the single market89] can be achieved not only by direct restrictions on exports but also through indirect measures aimed at deterring a dealer from making foreign sales, particularly by influencing the economic and financial conditions of such operations. The Court of Justice has thus regarded as inherently restrictive of competition measures which, like the measure at issue here, ‘make parallel imports more difficult’90 by subjecting them to treatment less favourable than that reserved for official imports or ‘restricting the buyer’s freedom to use the goods supplied in accordance with his own economic interests’ 91,92‘. The Advocate General’s point of view had been accepted by the ECJ93.

The case where a distributor is unable to obtain new motor vehicles with the appropriate specifications needed for cross–border sales constitutes a particular example of indirect restrictions on parallel trade94. In those specific circumstances, the benefit of the block exemption may depend on whether a supplier provides its distributors with motor vehicles with specifications identical to those sold in other Member States for sale to consumers from those countries (the so–called ‘availability clause’)95.

4. Distribution of new motor vehicles as a point of combination of the two Block Exemption Regulations

It could be said that the two Block Exemptions, ie 330/2010 and 461/2010, are actually combined. According to recital 10 of the preamble of the BER 461/2010, with regard to distribution of new motor vehicles96, there are not any more significant competition shortcomings which would distinguish this sector from other economic sectors (such as vertical relations) ‘and which could require the application of rules different from and stricter than those set out in Regulation (EU) No 330/2010’.

The market–share threshold, the non–exemption of certain vertical agreements and the other conditions laid down in Regulation 330/2010 normally ensure that vertical agreements for the distribution of new motor vehicles comply with the requirements of Article 101(3) of the Treaty. Therefore, vertical agreements for the distribution of new motor vehicles ought to benefit from the exemption granted by Regulation (EU) No 330/2010, subject to all the conditions laid down therein.

85 O.J. C138/16, 28.05.2010, para 49. 86 See Case IV/35.733 — VW, Case COMP/36.653 — Opel, Case COMP/36.264, Cases F-2/36.623/36.820/37.275. 87 O.J. C138/16, 28.05.2010, para 49. 88 See indicatively Bellamy, C., and Child, G. (2001), para. 7-053. See also Korah V. & O’Sullivan D., (2002), p. 58. 89 Addition made by the authors. 90 Judgment in Cases 96-102, 104, 105, 108 and 110/82, para 6. 91 Judgment in Case 319/82, para 6. 92 Such principles are also to be found in the Community rules governing the application of Article 81 EC to

distribution agreements [already Article 101 of the Treaty]. 93 See Court’s decision, para. 68. 94 O.J. C138/16, 28.05.2010, para. 50. 95 Joined Cases 25 and 26/84. 96 See the Commission Evaluation Report on the Operation of Regulation (EC) No 1400/2002 concerning motor

vehicle distribution and servicing (28 May 2008), p. 14 and the Commission Communication on The Future Competition Law Framework applicable to the Motor Vehicle sector of 22 July 2009 [COM(2009) 388].


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Furthermore, since the settled case law about the protection of parallel trade concerns basically the distribution of new motor vehicles, it is obvious that the protection of parallel imports or exports –either concerning vertical agreements in the new motor vehicles sector or vertical agreements in an other sector – is (and should be) the same: it is about a hardcore restriction, consequently per se approach.

5. Administrative anticompetitive measures – measures of having equivalent effect Nevertheless, in some cases it is a member state (and not the manufacturer of a motor vehicle or a

producer generally) which creates an indirect restriction on parallel trade or negatively influences parallel trade by specific administrative means; it is about the case of measures having equivalent effect. For instance, concerning the sector of motor vehicles, the ECJ in its recent decision C–170/0797 (Commission of the European Communities v Republic of Poland) declared that, by subjecting imported second–hand vehicles registered in other Member States to a roadworthiness test prior to their registration in Poland, whereas domestic vehicles with the same characteristics are not subject to such a requirement, the Republic of Poland had failed to fulfil its obligations under Article 28 EC (already Article 34).

It is estimated that the ratio of the above mentioned decision of the ECJ adds up to its decision C–154/85 (Commission of the European Communities v Italian Republic)98. In this case the ECJ ruled that article 30 (then 28 and already 34) of the Treaty, prohibiting measures having equivalent effect to a quantitative restriction, is infringed by an increase by a member state (Italy) in the number of administrative requirements involving the production of documents necessary for parallel imports of vehicles, whether new or already registered, from other member states.

Those requirements, which make registration of the vehicles more complicated, longer and most costly, cannot be justified on grounds of public policy connected with the detection or prevention of dealing in stolen vehicles99, since they cannot be regarded as necessary for that purpose (principle of proportionality). That is, a case where the information required duplicates that supplied by the authorities of the exporting member state and less restrictive measures would be sufficient to achieve the desired objective. In reality, it was about an unacceptable distinction between domestic and imported goods (motor vehicles).

6. The sector of detergents for domestic use in Greece 6.1 National Law

According to the national regulatory framework which rules the sector of detergents for domestic use in Greece, a Greek wholesaler who intends to make parallel imports concerning detergents is obliged to follow very strict rules. More specifically, firstly, the free circulation of detergents for domestic use is based on European legislation (ie mainly on Regulation 648/2004100 and Regulation 907/2006101 with the Directives 67/548/EEC102 and 1999/45/EC103, as they have been amended). In Greece the application of the abovementioned legislation is controlled and applied by the State’s General Chemical Laboratory and the Supreme Chemical Council.

These two public organisations adopt unjustifiably (in our view)104 the stricter interpretation of the provisions in the abovementioned legislation, and the result is that the Greek regulatory framework is formed in a completely different way in comparison with the framework applied to the rest of the European Union. The marking (do you mean marketing?) of detergents for domestic use that can be circulated legally in Greece is significantly stricter in Greece than in other member states (even more in comparison with the corresponding products circulated in third countries). In practice, the potential importer of detergents for domestic use has to deposit all the necessary documents105 – between them, the specific content of each detergent in centigrams – to the abovementioned public organisations, in order to be licensed for the imported detergents. Actually, the

97 The case concerns second hand vehicles. 98 [1987] ECR 2717. 99 See para. 14 of the Court’s decision. 100 OJ L104/01, 08.04.2004. 101 OJ L168/05, 21.06.2006. 102 OJ 196/1, 16.08.1967. 103 OJ L 200/1, 30.07.1999. 104 In our view, in issues of consumer protection the Greek authorities can not presented as more ‘sensitive’ then the

German or the French authorities, for example. 105 The authors cannot refer in this paper in full detail all the necessary preconditions demanded for ‘ legal’ parallel

imports of detergents for domestic use in Greece. However, if necessary, they can provide with further details-information about these preconditions.


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Greek regulatory framework regarding the sector of detergents for domestic use constitutes a kind of measure having equivalent effect106. It is obvious that under these strict circumstances the ‘legal’ parallel imports of detergents for domestic use in Greece are practically almost impossible. The national legal framework for parallel imports in the specific sector is extremely strict, perhaps the most rigorous in the E.U.107.

Due to the above measure having equivalent effect and the concentrations that have taken place, the sector of detergents for domestic use in Greece constitutes an oligopolistic market where only a small number of firms are active.

Therefore, the sector of detergents for domestic use in Greece constitutes an oligopolistic market where only a small number of firms are active, because of the existence of measures having equivalent effect and the concentrations that have taken place108. These activated firms have the possibility to raise their profit margin in upper levels, due to the absence of competition in the specific market109.

6.2 Competitive restraints The Greek example of parallel import prohibition concerns vertical restrictions imposed in distribution

agreements. There is an upstream and a downstream market in which firms in both markets (sellers110 in upstream market and buyers111 in downstream market) behave in an oligopolistic way. In the upstream market there are few but large producers/sellers of final goods whereas in the downstream market there are firms/buyers that sell the upstream firms’ products to the final consumers (domestic costumers of the buyers).

The upstream market especially involves the production and distribution of daily consumer goods to retailers112, such as detergents for domestic use. Upstream producers may also export the products in different geographical downstream product markets. Each producer specialises in individual products or product groups, such as fresh products, or dry food or non–food products (i.e. detergents). The latter are grouped into small segments each of which constitutes an individual product market, both from the demand and the supply side. In each product market a producer113 may hold a dominant position of economic strength or it is assumed to be the leader of the market114 (see Figure 1).

In the downstream market the firms are not export oriented. That is, they distribute the products to domestic final consumers. Therefore, the clause of prohibition of parallel imports includes both imports (directly) and exports (indirectly). The downstream firms provide a basket of foodstuffs and non–food household consumables sold in a supermarket environment115.

106 See Dassonville case [8/74, ECR 1974, 837] and Cassis de Dijon case [120/78, ECR. 1979, 649]. 107 Probably, this is the reason why the Greek market mainly in the sector of detergents for domestic use is one of

the most expensive (or maybe the most expensive) in the E.U. 108 See Fotis, P., Polemis, M., Zevgolis, N. (2011), p. 76-77 for a review of major concentrations that have been

cleared by Hellenic Competition Commission during the period from 1995 to 2010. Also, See Fotis, P., Polemis, M., Zevgolis, N. (2009), p. 219-222 and Fotis P., Polemis M. (2011) for a financial and statistical analysis of concentrations in Greece respectively during the same period. In Fotis P., Polemis M. (2011) there is a review of the use in economic tools in merger analysis.

109 See Zevgolis, N., and Fotis, P. (2009), p. 1184-1190. According to the paper, the clause of prohibition of parallel imports constitutes a hardcore restriction of competition, since, ceteris paribus, it consists of a barrier to entry for potential competitors. By prohibiting the supply of products of a significant brand name by cheaper sources of supply, the clause has as its indirect (if not direct) object the maintenance of a minimum level of supply prices and resale prices of the specific products. As far as it concerns the Greek geographical market, the clause of prohibition of parallel imports aggravates the already restrictive national regulatory framework which rules the sector of detergents for domestic use, having as its result the restriction –if not the disappearance- of parallel imports of the specific products.

110 Sellers, wholesalers and producers are used interchangeably. 111 Supermarkets and buyers are used interchangeably. 112 A small fraction of the upstream sales are sold to downstream wholesalers. Since that fraction of upstream sales

consists of less than 10% of the total sales in the downstream market, in the remainder of the paper will assume that retailers are the only buyers of the upstream sales.

113 The same producer or different producers in each product market. 114 Stackelberg product market whereas the other firms of the product market are assumed to be the followers. 115 See for example, inter alia, cases No IV/M.1612 (Wal-Mart/ASDA), No. IV/M. 784-Kesko/Tuko; No. IV/M. 1221-

Rewe/Meinl or No. IV/M.1541-Kingfisher/ASDA.


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Figure 1. The Upstream & Downstream markets of daily consumer goods

The clause of parallel imports prohibition creates barriers to entry for potential competitors in the

upstream market. The latter leads, ceteris paribus, to a restriction of competition in this market. Potential competitors with easy and effective entry in the upstream market may possibly prevent an already active firm in the upstream market from increasing the selling price of the final product to the supermarkets116.

Also, the decrease (diminution) of competition intention by the mean of such a clause enforces the already powerful existence of upstream firms (sellers) with strong trademarks, driving a segmentation of the specific market in comparison with the rest of the national markets in the E.U. The prohibition of parallel imports creates almost automatically more available space for the already existing firms in the upstream market, active in the specific market, to raise or at least stabilize their market share and consequently to enforce their market power in the national market.

6.3 An example 6.3.1 Competition in the upstream & downstream markets

In the downstream market a supermarket (costumer of buyers) may prefer to import the final good from different European geographic markets and takes advantage of price differentials between them117. The scope of this strategy is to increase the supermarket’s market share via a decreased selling price of the final good118.

However, if all the supermarkets exercise the same strategy, the effect on each supermarket’s market share and consequently on its profits, depends on the juncture where the strategy takes place. Generally speaking, whether each supermarket cannot foresee competitor’s counteraction, it is possible to overestimate the potential gaining from the abovementioned strategy.

Additionally, the pursuit of the same strategy for a long period of time by all supermarkets, may lead in a ‘war of attrition’. This refers to a situation where the object of firms in a product market is to induce the competitors to give up and, consequently, to suffer economic losses in the short – run until their rivals exit the market. In such an environment, firms try to abstain closing plants and giving up market share as they would increase their costs119. This situation in game theory is referred to as a ‘prisoner’s dilemma’120.

116 Motta, M., (2009), p. 104. 117 For an example See para. 48 of the Commission notice — Supplementary guidelines on vertical restraints in

agreements for the sale and repair of motor vehicles and for the distribution of spare parts for motor vehicles [O.J. C138/16, 28.05.2010].

118 The supermarket will not increase the price of the final good in the future since that will give the opportunity to the other supermarkets to enjoy increased profits.

119 Sectors characterized by increasing returns to scale and/or large costs of exit in case of high fixed or sunk costs are among the fundamental examples in which a ‘war of attrition’ may take place.

120 See Tirole, J. (1998), p. 425-426.

Upstream Producers of daily consumer goods (Detergents)

Few Oligopolists Sellers

Downstream Supermarkets

Few Oligopolists Buyers

Domestic Final Consumers “Customers of the Buyers”

Exports

Foreign Geographic Markets


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In the upstream market, producers of the final good get the point that downstream firms would not preferred to engage in a ‘price war’ since that may ultimately eliminate their profits. At the same time, they realize that potential explicit or tacit collusive behavior from the supermarkets may cut down their profits, especially in the case where the upstream market ‘behaves’ competitively.

Therefore, upstream firms will try to eliminate the possibility of the aforementioned behavior by imposing vertical restrictions in distribution agreements. Such a policy smuggles away the risk of anticompetitive practices by the downstream firms and ensures the upstream firm’s profits in upper normal levels. The final goal of strategic interaction between upstream & downstream firms is to enhance the ‘producer welfare’ without considering the probable reduction of ‘consumer welfare’ via high prices of final goods.

Downstream firms recognize the increased strategic power of upstream firms with respect to their ability to bargain better terms in distribution agreements. They also realize that eventually, cooperation with sellers will reach a settlement which increases their profits.

6.3.2 A repeated game among upstream suppliers and costumer of buyers of detergents for domestic use

Both producers and supermarkets prefer to cooperate rather than to engage in a «war of attrition». Also, both of them are patient, that is, they prefer to get the profits which accrue from the long – run time span, rather than to get the short – run returns and they communicate in frequently temporal periods. Therefore, if supermarkets choose not to cooperate with upstream producers, the short – run payoff is less than the long – run profits (see Table 1).

Table 1. One – Shoot game upstream suppliers and costumer of buyers (supermarkets) of detergents for domestic use

Buyer (supermarket)

Seller (producer)

Strategies CHEAT NO CHEAT

NO COOPERATION 25, 25 50, 0

COOPERATION 0, 50 40, 40

Payoffs in mil. euro Cheat/No Cheat: imports/no imports of final good from different geographical areas Cooperation/No cooperation: distribution agreement/no distribution agreement which prohibits imports of final good from a different geographical areas

Additionally, an upstream seller will eventually realize whether a supermarket strives to cheat by choosing not to cooperate while, the profits from cheating are less than the cost of cheating.

The payoffs of buyer and seller are their profits121. Consumer welfare increases as soon as all the other supermarkets in the downstream market do not follow the same strategy. The Nash equilibrium of the static game reveals that the selling price of the final good remains low since each player simultaneously maximizes its profit by choosing the dominated Nash equilibrium.

The dominated strategy for supermarkets is cheat and the equivalent dominated strategy for producers is no cooperation (25>1 & 50>40)122. The static game results in a dominated Nash – equilibrium even though both players may increase their profits by ‘communicating’ between each other (the payoffs for both players are 40). However, if all the supermarkets follow to cheat, that will trigger a war price among each other which eventually results in profit losses. Although this is the best scenario for the consumers, firms in both levels of the vertical chain realize that the best for them is not to independently choose their strategies.

Suppose now that upstream and downstream firms communicate in frequently temporal periods. That is, the game is repeated in the near future. We assume that the static game of complete information is repeated infinitely, with the results of all previous periods observed before the current period begins. For each t period the

results for each 1t preceding periods of the game are observed before the tht period begins. In our example

the periods cover different distribution agreements among producers and supermarkets. The results of the distribution agreements are known to both them before the new period begins.

121 The lower the selling price of the final good, the higher the market penetration and hence the profits of an

individual supermarket. 122 The first column presents the producer’s payoff and the second column presents the supermarkets’ payoff.


171

We denote r

p

1

1 the discount factor123 of producers and supermarkets where is the probability

that the game will end immediately after a period and is the probability that the game continues at least one more period. The payoffs for each chosen set of strategy by upstream and downstream firms are given by the 2X2 game matrix in Table 1.

The present value of the infinite sequence of payoffs nt ,......,3,2,1 is given by

t

i

t payoffpayoffpayoffpayoff

1

1

3

2

21 ......... (1)

Equation (1) reflects both the time value of money & the probability the game will end. Equation (1)

reflects both the time value of money & the probability the game will end. For example, at 1t , the payoff

worths

r

payoffp

1

1, while in 2t it worths

r

payoffp

1

12

.

Following payoffs in Table 1 we argue that cooperation among producers and supermarkets may occur in every period of distribution agreements (or, cooperation may occur in every period of a subgame perfect outcome of the infinitely repeated game) if both sides from the vertical chain commit from the outset that they choose the high payoff equilibrium (cooperation). Otherwise, they will choose the low payoff equilibrium (cheat) in the subsequent periods124.

Upstream firms will cooperate with downstream firms if the latter do not import the final good from different European geographical areas. Downstream firms prefer not to import the final good since the profits from cooperation are higher than the profits from cheating.

A supermarket cooperates if 125. According to figure 2, the straight distance AB depicts a lump sum payoff of a supermarket after cheating and the distance ΒΓ shows the reduction of supermarket’s payoff if

an upstream producer decides to follow the trigger strategy. A supermarket cheats whether BAB and

cooperates if the distance AΓ is higher than the distance ΒΓ (that is, AB ). Figure 2 depicts the payoffs of the infinitely repeated game among producers and supermarkets according to the aforementioned trigger strategy. 50 Payoffs 40

25

Figure 2. Payoffs of the infinitely repeated game among producers (sellers) and supermarkets (buyers)

123 The value today of a euro to be received one period later, where is the interest rate per period. 124 This strategy is called trigger strategy.

125 The infinite payoff when a supermarket cheats or cooperates is

or

correspondingly. A

supermarket cooperates if

or

Periods of distribution agreements

A

B

Γ


172

Following cooperation, the price of final goods remains in upper normal levels. Supermarkets do not cheat (import the final good) and therefore the consumer welfare decreases.

7. Concluding remarks The main question which this paper tries to answer is whether prohibition of parallel imports constitutes a

hardcore restriction of Block Exception Regulation for vertical agreements, that is, a per se approach. In our view, the answer is yes. The prohibition of parallel imports is a measure which reduces the buyer’s

incentive to decline resale price by diminishing the sources of supply, and consequently raising dangerously the selling prices and reducing the consumer welfare. An exclusive supply of a specific trademark by itself (exclusive source of supply), constitutes the same, since it prevents the retailer/buyer from finding products of the same trademark in lower prices by other sources. Above all, it constitutes an important anti–competitive objective for the internal market since it prevents consumers from purchasing products being imported from other Member States and taking advantage of price differentials between them.

The abovementioned conclusions are further enhanced, at least in some cases, by the structure of the market and the national law of the member state (measures of having equivalent effect constitute an indicative example) where the prohibition of parallel imports takes place.

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