Quality of the legal system and financial contracting

Does the legal system really matters for economic outcomes? In a recent TILEC discussion paper, Marco da Rin (TILEC) and co-authors Laura Bottazzi (Bologna) and Thomas Hellmann (British Columbia) focus on the venture capital market and develop a theory and empirical test of the ways the legal system affects the relationship between venture capitalists and entrepreneurs. When some actions on both sides are not fully contractible, in a legal system where investors are generally more protected the optimal contract calls for them to give more informal support to entrepreneurs and to receive more downside protection (instruments such as debt or preferred equity). Those predictions are tested on a hand-collected sample of capital venture deals in 17 European countries and clearly supported. The results hold for legal origin, using the common interpretation that the Anglo-Saxon common law system is better for investors than systems based on civil law. They also hold for two widely used index measures of the quality of the legal system: the rule of law and the degree of procedural complexity. The paper is forthcoming in the Journal of Financial Intermediation.