LEGAL PROTECTIONS FOR INVESTORS: A PRIORITY FOR THE
HEMISPHERE
Allan Roth *
Introduction
In connection with the goal to “promote further legal convergence in the area of
inter-American business transactions” (SLA/OAS-CIDA Project Background Paper), this
paper addresses the needs in the area of investor rights. For reasons stated in the body of the
paper, the focus is on the capital market and the protection of investors in shares.
The modern corporation depends on a healthy capital market in order to meet the
competitive needs of a global society, and investors in the capital market depend on adequate
legal protections in order to participate in the capital market. Investor protections may take
many forms, and it is important to assure that the forms adopted are effective and are
perceived as effective by the investors themselves. What should be the goals of the OAS
member states in strengthening those protections throughout the hemisphere?
Laws Protecting Investors are Important for Economic Development and Growth
It is well established that a country’s financial system plays a key role in its
economic growth and stability. It is also acknowledged that the capital market is a key part
of any financial system.1 Scholars generally agree that the size and breadth of the capital
market affects economic development and growth.2 As noted in a recent scholarly paper:3
* * * In countries with strong shareholder protection, investors can afford
to take minority positions rather than controlling stakes. As a result, firms
tend to have dispersed shareholders as owners, and capital markets are
rather liquid. By contrast, where shareholder rights are not well protected,
*
Mr. Allan Roth is Professor emeritus at Rutgers University and possesses extensive experience in
providing consulting services on legal and financial reforms around the world.
1
Thorsten Beck and Ross Levine, “Stock Markets, Banks, and Growth: Correlation or Causality,”
World Bank Working Paper #2670 (July 2001); Thorsten Beck, Aslý Demirgüç-Kunt, Ross Levine
and Vojislav Maksimovic, “Financial Structure and Economic Development: Firm, Industry, and
Country Evidence,” World Bank Working Paper #2423 (June 2000) [http://econ.worldbank.org].
2
Thorsten Beck and Ross Levine, “Stock Markets, Banks, and Growth: Correlation or Causality,”
World Bank Working Paper #2670 (July 2001) [http://econ.worldbank.org].
3
Katharina Pistor, “Patterns of legal change: shareholder and creditor rights in transition
economies,” European Bank for Reconstruction and Development Working paper #49 (2000), citing
A. Shleifer and R.W. Vishny, "A Survey of Corporate Governance", 52 Journal of Finance 737-783
(1997).
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investors will compensate this deficiency by taking controlling stakes. This
leads to high levels of ownership concentration.
In addition to studies from a macroeconomic vantage, research shows that financial
market development is especially important for small firms and for the formation of new
enterprises. Inadequately developed financial systems also hinder large firms by limiting the
availability of long-term capital.4 Well functioning financial markets facilitate access to
external funds for firms with good investment opportunities. The resulting improved
efficiency in the capital allocation process enhances economic growth.5
Extensive research by economists and lawyers confirms the significant impact that
law and legal institutions have on the financial system’s development and growth. The
Nobel laureate Douglass C. North,6 highlighting the important relationship between a
country’s legal institutions and its economic development, emphasized that secure property
rights are critical for capital markets to develop and flourish. In turn, secure property rights
“require political and judicial organizations that effectively and impartially enforce contracts
across space and time.”7 In the words of one scholarly study:8
* * * [T]he legal rights of outside investors and the efficiency of the legal
system in enforcing those legal rights is strongly and positively linked with
GDP growth, industrial performance, new firm formation, and firm
growth. The legal system importantly influences financial sector
development and this in turn influences firm performance, the formation of
new firms, and national growth rates.
They conclude that “policy makers should . . . focus on strengthening the rights of
outside investors and enhancing the efficiency of contract enforcement.”9
Of particular interest is a series of studies conducted by Professors Rafael La Porta,
Florencio Lopez-de-Silanes, Andrei Schleifer and Robert Vishny that highlight the
importance of legal protections for investors.10 A 1996 study concluded that the
Inessa Love, “Financial Development and Financial Constraints: International Evidence from the
Structural Investment Model,” World Bank Working Paper #2694 at 24, Sept.200.
http://econ.worldbank.org
5
Id. at 3.
6
Douglass C. North, Institutions, Institutional Changes And Economic Performance (Cambridge
University Press: 1990).
7
Id. At 121.
8
Thorsten Beck, Aslý Demirgüç-Kunt, Ross Levine and Vojislav Maksimovic, “Financial
Structure and Economic Development: Firm, Industry, and Country Evidence,” World Bank Working
Paper #2423 at 6(June 2000).
9
Id. at 6-7. See also, Beck, Demirgus-Kunt and Levine, “Law, Politics and Finance,” World Bank
Working Paper #2585 (Feb. 2001).
10
Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Schleifer and Robert Vishny, “Legal
Determinants of External Finance, 52 Journal of Finance 1131 (1997); Shleifer and Vishny, “A
Survey of Corporate Governance,” 52 Journal of Finance 52 (1997); La Porta, Lopez-de-Silanes and
Schleifer, “Corporate Ownership Around the World,” 54 Journal of Finance 471 (1999); La Porta,
Lopez-de-Silanes, Schleifer and Vishny, “Investor Protection: Origins, Consequences, Reform,”
National Bureau of Economic Research Working Paper #7428 (1999) [http://www.nber.org/papers].
4
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effectiveness of a financial system is correlated to the legal rules protecting investors and the
quality of the enforcement of those rules.11 In the words of the authors [emphasis in the
original]:
The rights attached to securities become tremendously important once it is
recognized that managers of companies act in their own interest.
Investors’ rights give them the power to extract from these managers the
returns on their investment. Thus shareholders receive dividends because
they can vote out the directors who do not pay them, and creditors are paid
because they have the power to repossess collateral. Without these rights,
investors would not be able to get paid, and therefore firms would not have
the benefit of raising funds from these investors. The rights attached to
securities are what managers and entrepreneurs give up to get finance.
But the view that securities are inherently characterized by some intrinsic rights is
incomplete as well. It ignores the obvious point that these rights depend on the legal rules of
the jurisdictions where these securities are issued. Does being a shareholder in France give
an investor the same privileges as being a shareholder in the United States, India, or Mexico?
Would a secured creditor in Germany fare as well when the borrower defaults as one in
Taiwan or Italy, assuming that the value of the collateral is the same in all cases? Law and
the quality of its enforcement are potentially important determinants of what rights security
holders have and how well these rights are protected. Since the protection investors receive
determines their readiness to finance firms, corporate finance may critically turn on these
legal rules and their enforcement.
In a succeeding study,12 the same scholars compared a sample of 49 countries
according to a measure of the quality of legal protections for investors and of law
enforcement in those countries. They concluded that the “legal environment has large
effects on the size and breadth of capital markets across countries.”13 In the absence of
effective legal protections, the capital market does not attract small, diversified investors.
Summarizing the various reported research, a recent World Bank working paper
concluded14:
Professors La Porta, Lopez-de-Silenes and Schleifer are at Harvard, Professor Vishny is at the
University of Chicago.
11
La Porta, Lopez-de-Silanes, Shleifer and Vishny, “Law and Finance,” National Bureau of
Economic Research Working Paper #5661 at pp. 2-3(1996).
12
La Porta, Lopez-de-Silanes, Shleifer and Vishny, “Legal Determinants of Growth,” 52 Journal of
Finance 1131 (1997).
13
Id. at 1132; see also, Katharina Pistor, “Patterns of legal change: shareholder and creditor rights
in transition economies,” European Bank for Reconstruction and Development Working paper no. 49
(May 2000); La Porta, Lopez-de-Silanes, Shleifer and Vishny, “Investor Protection: Origins,
Consequences, Reform,” National Bureau of Economic Research Working Paper #7428 (1999)
(published as “Investor Protection and Corporate Governance,” 58 Journal of Financial Economics 3
(Oct. 2000).
14
Thorsten Beck, Aslý Demirgüç-Kunt, Ross Levine and Vojislav Maksimovic, “Financial
Structure and Economic Development: Firm, Industry, and Country Evidence,” World Bank Working
Paper #2423 at p. 40 (June 2000).
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* * * Economies grow faster, industries depending heavily on external
finance expand at higher rates, new firms are created more easily, firms’
access to external financing is higher, and firms grow more rapidly in
economies with a higher levels [sic] of overall financial sector
development and in countries with legal systems that more effectively
protect the rights of outside investors.
The Modern Corporation is Dependent on a Developed Capital Market
The limited liability enterprise, or “corporation”, is designed to facilitate raising
capital from outside investors. The attribute of limited liability for the investors is designed
to encourage strangers to the enterprise to contribute capital. The governance structure of
the corporation is designed to allow a separation of management and ownership and for the
professionalization of management.
The modern corporation requires outside capital to achieve optimum levels of
efficiency and to meet the needs of global competition. The absence of effective financial
markets creates distortions in the economy that reduce competitiveness. For example, in one
country in which the author served as a technical advisor, businesses—especially small- and
medium-sized businesses-lacked sources of long-term capital. Some of the resulting
distortions were noted by the author as follows:
Business firms--both large and small--tend to rely heavily on internal
financing. Managers of several firms with whom we spoke were proud of
the low external debt carried by their firms. This means that capital
expansion is either to be financed by retained earnings, rolled-over bank
overdrafts or some combination of the two. This can be expected to inhibit
managements from expanding the scale of their operations, with the result
that firms may not achieve optimum scales of operations to maximize
efficiencies. Alternatively, the need to generate investment capital from
earnings impels managers to set high profit margins--which seems a
common practice--with the result that prices are high. When coupled with
the pressure on management to pay a large percentage of earnings as
dividends, this pressure to generate high levels of profits to provide
working capital and expansion capital is accentuated.
Investors are more inclined to provide the needed capital where they are afforded
adequate legal protections. La Porta et al find that that “the [legal] protection investors
receive determines their readiness to finance firms,” and they show that the legal
environment significantly affects the size and breadth of capital markets across countries. 15
By diminishing financing constraints, effective legal protection allows for more efficient
capital allocation.
La Porta, Lopez-de-Silanes, Shleifer and Vishny, “Investor Protection: Origins, Consequences,
Reform,” National Bureau of Economic Research Working Paper #7428 (1999) (published as
“Investor Protection and Corporate Governance,” 58 JOURNAL OF FINANCIAL ECONOMICS 3
(Oct. 2000).
15
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Civil and Common Law Distinctions
The research of Professors La Porta, Lopez-de-Silanes, Shleifer and Vishny
indicates that investor protections are stronger and more effective in common law countries
than in the civil law countries. 16 They also examined the quality of the enforcement of the
laws to protect investor in various countries, considering the quality of enforcement in terms
of the efficiency of the judiciary and the quality of accounting standards. From this
examination, they concluded that while enforcement generally is more effective in affluent
countries than in economically less developed countries, countries following the French civil
law tradition have the “worst quality of law enforcement” among the groups of legal systems
studied.17 In short, the type of legal system appears more important to the effectiveness of
legal protections for investors than the level of economic development.
The reason for the disparity between common law and civil law countries in the
quality and effectiveness of investor protections is speculative. These scholars suggest two
lines of analysis: Judicial and political.18
The judicial explanation is that judge-made law is inherent in common law systems,
and judges are at liberty to evolve new standards of conduct in the face of new types of
behavior by corporate managers and other insiders. Civil law judges are more constrained in
evolving new standards since they are dependent upon the legislature to initiate the
formulation of rules and standards. The common law judges, then, are more pro-active on
behalf of investor protections than their civil law counterparts.
The political explanation focuses on the differences in the historical development of
the countries that originated the common and civil law traditions. In England, where the
Crown gradually lost power over the courts to Parliament and the landed interests, the judges
perceived their role to be the protectors of private rights against interference by the Crown.
In France and Germany, it is argued, the kings were never dominated by the legislature, and
the state interest continued to dominate the courts. Civil law courts, therefore, were less
likely than common law courts to side with investors over the state or the commercial
interests aligned with the state.19
The conclusion of this research is that “the nature of investor protection, and of
regulation of financial markets more generally, is deeply rooted in the legal structure of each
country, and in the origin of its laws. Reform on the margin may not successfully achieve
the reformer’s goals.”20
Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishny, “Legal
Determinants of External Finance,” 52 JOURNAL OF FINANCE 1131, 1149 (1997); La Porta,
Lopez-de-Silanes, Shleifer and Vishny, “Investor Protection: Origins, Consequences, Reform,”
National Bureau of Economic Research Working Paper #7428 at 8 (1999) (published as “Investor
Protection and Corporate Governance,” 58 JOURNAL OF FINANCIAL ECONOMICS 3 (Oct.
2000).
17
La Porta et al, NBER Working Paper #7428 supra n. 16 at 9.
18
Id. at 9, 10-13.
19
Id. at 11.
20
Id. at 32.
16
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Those who would reform the laws providing investor protection must be mindful of
these factors. Not only must the text of the law be changed, but the attitudes of lawyers and
judges must be influenced to embrace the changes and the underlying reasons for them.
What should be the Goals of the OAS Member States in Strengthening Investor
Protections throughout the Hemisphere?
As national borders become less relevant to financial markets and investment, the
laws and practices by which those markets are structured are becoming more integrated.
One need point only to the European Union's harmonization of securities laws, the growing
influence of the International Organization of Securities Commissions, the United
States-Canadian Multijurisdictional Disclosure System and the WTO Understanding on
Trade in Financial Services to highlight the transnationality of financial markets and
institutions. Indeed, one commentator has suggested that domestic laws regarding securities
disclosure should be replaced “with unified disclosure standards to be used by domestic and
foreign issuers in all developed markets.”21
At one time, it was feared that freely allowing borders to be crossed would result in
a “race to the bottom” by regulators;22 business would flock to the jurisdiction that had the
least regulation. That view has given way to the opposite expectation; experience has not
borne out the prediction of a race to the bottom. Because effective regulation produces more
efficient markets, competitive forces make the more regulated jurisdictions more attractive,
not less. Professor Coffee, for example, suggests that foreign companies eagerly submit to
the world’s most rigorous securities laws to gain the economic advantages of the U.S.
market.23
It is thus in the interests of the OAS member states to strengthen their respective
laws providing protections for investors. Indeed, over the past three decades, vigorous
efforts at strengthening these laws have been made in a number of member countries. It is
now time to coordinate this effort on a multinational basis to facilitate cross-border
investment and enhance economic growth domestically and regionally. The OAS could
provide the impetus for this effort.
If there is to be some effort to integrate or coordinate the investor protective laws in
the OAS member states, there are choices to be made. Since investor protections have been
demonstrated to be so critical to economic development, it would follow that the countries
with the most effective investor protective laws would have a competitive advantage. Other
countries would want to improve their legal protections for investors to equalize their
Uri Geiger, “Harmonization Of Securities Disclosure Rules In The Global Market—A Proposal,”
66 FORDHAM L. REV. 1785, 1786-87 (1998).
22
William Cary, “Federalism and Corporate Law: Reflections Upon Delaware,” 83 YALE L.J. 663,
666 (1974). Cf. Ralph Winter, Jr., “State Law, Shareholder Protection And The Theory of The Firm,”
6 J. LEGAL STUD. 251,, 254-262 (1977).
23
John C. Coffee, Jr., “The Future As History: The Prospects for Global Convergence in Corporate
governance And Its Implications,” 93 NW. L.REV. 641 (1999).
21
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competitive positions. This is the reasoning of those who urge “convergence” of law.24
Convergence has been described as a “dynamic of institutional change” whereby
“competition between systems and institutions will over time self-select the most effective
institutions, and different systems will converge on these.”25 A counter view is that
“institutions develop along path dependent trajectories. Institutional change is incremental
and shaped by pre-existing conditions. Thus, systems will continue to diverge rather than
converge.”26 Both are essentially reactive strategies - how will institutions develop if left on
their own.
A more pro-active approach could be through “harmonization” of laws.
Harmonization may be through reciprocity or commonality (uniformity). Using disclosure
requirements to illustrate the point, with reciprocity, if the disclosure satisfies the
requirements of the home country, it will be acceptable in the host country. With
commonality, all countries strive to achieve agreed upon standards and procedures for
disclosure.
The European Union has used both.27 Through a series of directives for member
countries to adopt basic provisions in their laws, the EU has set minimum standards for the
entire common market.28 Each member is free to adopt more extensive or stringent
requirements, but the minimum standards assure a level of investor protection that is
acceptable to all members. This is the commonality element.
Under the EU directives, compliance with the requirements of any member state
must be accepted by any other member state. For example, if a prospectus meets the
requirements of the German law and has been approved by the appropriate German
authority, it must be accepted as valid in France. This is the reciprocity element.
The EU could have set minimum standards without requiring compliance in one
country to be acceptable as compliance in every other country. Reciprocity does encourage
“arbitrage”, if not a race to the bottom. Why bother to comply with the more stringent
requirements when complying with the least stringent requirements, through reciprocity,
allows full access to the market where the requirements are most stringent?
Accordingly, when reciprocity is dependent upon adherence to harmonized
minimum standards that meet the test of world-wide best practices, it need not produce
regulatory arbitrage. For example, the OAS member states might agree upon fairly rigorous
common requirements for a prospectus and then agree that any prospectus meeting the
minimum requirements and accepted in any other member state would qualify as meeting the
24
Ibid.
Katharina Pistor, “Patterns of legal change: shareholder and creditor rights in transition
economies,” EBRD Working paper #49 (May 2000) at p. 3.
26
Ibid.
27
See generally, Uri Geiger, “Harmonization Of Securities Disclosure Rules In The Global
Market—A Proposal,” 66 FORDHAM L. REV. 1785 (1998).
28
Council Directive 93/22 1993 O.J. (L. 141) 27; Council Directive 89/298, 1989 O.J. (L. 124) 8;
Council Directive No. 87/345, 1987 O.J. (L 185) 81; Council Directive No. 82/121, 1982 O.J. (L 48)
26; Council Directive 80/390, 1980 O.J. (L.100) 1.
25
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requirements in every other state.
A similar approach may be applied with respect to standards for the competence and
financial accountability of capital market professionals. A broker qualified in one member
state by reason of passing required examinations and meeting minimum capital requirements
that conform to harmonized common standards could be permitted to transact in another
member state-either directly or through a domestically qualified broker.
On the other hand, harmonization in the form of uniformity, rather than
commonality, might be better in connection with accounting standards. Variations in
accounting standards and practice by country are impediments to cross-border transactions.
Where countries have significant policy differences with respect to financial reporting, these
differences ought to be susceptible to accommodation within a common set of accounting
standards and practices.
If the OAS member states are to be pro-active in the area of laws providing investor
protection, what is the nature of the protection to be provided?
Types of Legal Protections for Investors
It becomes the task of the legal system to devise appropriate forms of protection for
investors and to assure the protections provided are effective. It may be useful to distinguish
between protections related to the investment process and protections as shareholders-usually small, minority holders-in connection with the management of their investment in
the company.
In the first instance, equity investors are savers willing to enroll those savings in the
capital markets by buying shares. Accordingly, one set of protections is related to the
investment process itself. These are issues of securities regulation under the laws of most
countries, and for instance include disclosure requirements, availability of dependable
professionals, a liquid trading market and effective enforcement mechanisms.
In the second instance, once the saver has purchased securities and has become a
shareholder in a company, protections are needed as a minority shareholder. These are the
issues related to corporate governance, such as voting rights, governing board structures, exit
mechanisms and the adequacy of investor remedies, and are dealt with in company/corporate
law or commercial law.
In the literature of corporate governance, investor protections are sometimes
distinguished as “voice” or “exit” strategies.29 By exit strategy is meant protecting the
shareholder’s right to sell out of the investment if he/she is dissatisfied. “Voice” strategies
focus on protecting the shareholders’ capacity to hold company management to account
through shareholders’ statutory rights.
Katharina Pistor, “Patterns of legal change: shareholder and creditor rights in transition
economies,” European Bank for Reconstruction and Development Working paper No. 49 p.10 (May
2000).
29
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1.
Protections related to the investment process (securities regulation)
The protections needed to attract average citizens to participate in the capital
markets are often provided in separate, securities laws. The laws governing the formation
and operation of companies typically also include provisions designed to protect the public
in the investment process. Among the latter are provisions against watered stock, assuring
full funding of founder shares, etc.
Any system of investor protections needs both to provide adequate protection in fact
and to enable small investors to feel protected. At the same time, it is important to set
realistic levels of public expectation; care must be taken not to promise more than can be
delivered, or the two objectives come into conflict. In the light of this, against what risks
can, and should, average investors be protected?
Disclosure as investor protection
In some jurisdictions, investor protection is in the form of a government agency's
"merit review" of a proposed offering of securities to the investing public. For example, at
one time, some laws required that, before a public offering of securities could be made, an
administrator had to find the proposed offering to be “fair, just and equitable” to prospective
investors. Under this standard, the administrator had wide latitude to evaluate the merits of
the offering.
To the extent that merit review laws are sought to be applied to protect investors
against the risk of investment loss, they are unrealistic and unworkable: An investor in a
business is inherently at risk as to how well the business will prosper; this aspect of
investment needs to be understood by every investor at the outset. If an attempt were made
to shield investors from being invited to invest in businesses that are too risky, the question
invariably arises as to what degree of risk is excessive--and who is to decide? Some
investors are willing and able to assume high levels of risk in the hope of high levels of
rewards. Some businesses are very risky, yet, from risky new ventures often come new
technologies and new products. To deny these high-risk businesses the opportunity to
compete for capital could choke off experimentation and development of innovative
products and services.
Laws can, however, help to assure that investors have adequate information
presented in accurate form so that they, the investors, can make an intelligent assessment of
the risks involved and can decide which risks they are willing to take. Laws also can assure
that remedies are available to investors in the event of fraud or unfair dealings. For these
reasons, under the laws in the majority of the world's market economies, the basis for
providing protections for investors and promoting market efficiency is full and fair
disclosure of critical information about the companies that issue the securities traded and
transparency in the market itself.
Since information is of the essence of the market mechanism, relying upon
disclosure as the mainstay of the regulatory system harmonizes with the objectives of
regulation and minimizes the interference with market forces. It is axiomatic that a "perfect
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market entails perfect information". The investor is offered the protection of adequate and
accurate information, but the investment decision and the investment risks are his/hers.
For a disclosure system to work, the form and content of disclosure must be
standardized and the making of appropriate disclosure must be supervised and monitored by
a public agency. Securities laws achieve these objectives by establishing prospectus
requirements, accounting standards and requirements for periodic reports.
The company managers charged with the responsibility to make disclosure perforce
must develop adequate information systems to generate the information and data to be
reported. A useful by-product, therefore, is the development of more sophisticated
management information systems that serve as a vital management tool as much as a means
of complying with disclosure requirements.
Laws governing the capital market are also concerned with assuring the competence
and reliability of the professionals who serve public investors. Moreover, since investors
would not readily be persuaded to buy shares if they did not believe they could sell them if
necessary, or if they wanted to take a profit or reduce a loss, the viability of the markets in
which securities are traded also is an important aspect of investor protection. Finally, it is
one thing to pronounce standards and requirements and another to make sure that they are
followed. Accordingly, the means available for enforcement of the requirements and
standards set is a vital aspect of investor protections in the capital markets.
Dependable professionals
Whatever information is required to be disclosed must be analyzed and interpreted.
In the first instance, this can be expected to be done by professionals in the financial
institutions, but the advantages of increased information and of the skill effectively to use it
for analysis and decision-making can be expected to be availed by others in time. Individual
investors can educate themselves to utilize the available information; professional advisers
can come into service to counsel investors.
A broad-based capital market depends on reliable and knowledgeable professional
intermediaries to serve both the demand and supply sides of the market. Even sophisticated
members of the public may require help from professional analysts and advisers when it
comes to matters related to investment in shares. Shares are complicated property interests.
To evaluate complex financial information, even in the most expansive formats, requires
special understanding and skill. Accordingly, it is critically important to the development of
a broad-based capital market that investors have resort to professionals who have the
capacity and skill to understand share investment, to evaluate company performance, to
analyze financial data and to interpret all of this for public investors.
In addition, investments in shares need to be marketed as a concept and as specific
opportunities. A Wall Street adage is that "shares are sold, not bought", which means that
investors must be persuaded to undertake share investments. Enterprising brokers are
inevitably a mainstay of any promotional effort. Of course enterprising zeal must be
accompanied with accountability to prevent abusive practices.
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Laws are required to establish professional standards and qualifications and to
provide mechanisms for holding professionals accountable for failure to meet the standards
set.
Liquid trading markets
Whereas the financial benefits of holding a bond or debenture are finite and fixed by
the instrument (the holder of the paper waits the term of the loan to receive the return of
principal and the interest rent charged), the purchaser of a share of stock depends on a liquid
trading market for important aspects of his investment return. A share investor may seek
investment rewards in the form of distributions of earnings to the owners (dividends) or by
selling his shares at a price significantly higher than he paid for them because the value of
the business has increased dramatically. If the market accurately reflects the value of an
investment in a company because the participants in the market are fully aware of
developments regarding the company, then the investor's expectations can be satisfied. The
market must also, however, be sufficiently active with buyers and sellers so that when
someone wants to buy, there is another person willing to sell, and vice versa. The market's
capacity for allowing sellers to sell when they want and buyers to buy when they want is
referred to as the market's "liquidity". Liquid securities trading markets are critically
important elements of the capital market.
In most countries, some form of government authorization is required to organize
and operate a stock exchange. Countries differ, however, in their attitude regarding the
relative roles of the stock exchange and the government as regulators of the trading markets.
In some countries, a government agency exercises direct regulatory power over the trading
market. In others, the stock exchange acts as the primary regulator.
Stock exchanges traditionally have served a regulatory function with respect to their
members and the trading practices on the exchange. The self-interest of the brokers requires
that each broker should comply with the rules and be financially accountable for trades. The
reputation of all brokers on the exchange would be injured if the credibility and reliability of
any broker is called into question. Investor confidence in the reliability and fairness of the
marketplace is crucial to all participants. Accordingly, the stock exchange inevitably
becomes an organization that oversees its members' conduct and the trading activities on its
market.
Some commentators argue that the stock exchange is a better regulator of the trading
markets than is the government. First, stock exchanges "have strong incentives to adopt rules
that benefit investors in order to attract transactions to the exchange and thereby maximize
profits to exchange members." 30 Second, stock exchanges are competitive organizations,
and the competitive pressures on them, it is argued, are likely to produce a superior set of
rules for the purposes for which they are intended to those that would be imposed by
governments, where such competitive pressures are absent. Finally, the stock exchanges are
closer to the situation to be regulated and therefore are better informed than the government
can be. Their regulations will be more appropriate to the conditions as a result.
Paul G. Mahoney, “The Exchange As Regulator,” Symposium: The Allocation of Government
Authority, 83 VA. L. REV. 1453 (1997). See also, Marcel Kahan, “Some Problems With Stock
Exchange-Based Securities Regulation,” 83 VA. L. REV. 1509, 1510, 1516-18 (1997).
30
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The stock exchange’s power usually derives from a combination of contract and
statute. Members (i.e., the brokers) agree to be bound by the stock exchange constitution
and rules, and they thereby accept the authority of the exchange to impose disciplinary
sanctions. One need only peruse the list of disciplinary proceedings taken by the New York
Stock Exchange and the fines imposed to appreciate how effective stock exchange
enforcement actions can be.31 The companies whose shares are traded enter into listing
agreements, and these agreements commonly impose obligations on the companies designed
to protect investor interests.
On the other side, it is argued that the stock exchange’s primary loyalty is to its
members to promote the trading market business for their interests. Stock exchange staff
are, indirectly, employees of the members and lack the independence to act contrary to
member interests, even if the public interest so requires. Some of the arguments are
summarized in the following quotation from Professor Kahan of New York University:32
Even to the extent that an exchange has the power to adopt regulations, it
is limited in its ability to sanction violations of its regulations. In
particular, an exchange would lack the right to impose criminal sanctions
for violations of its rules, and it might even be limited in its power to
impose fines. Thus, at least where criminal sanctions are part of the
optimal sanction scheme, governments play an important role in defining
and enforcing securities regulations. * * *
A final problem with delegating regulatory powers to exchanges is that exchanges
have imperfect incentives to police violations of their rules. In areas where violations
otherwise often remain undiscovered . . . policing has two effects: It increases the likelihood
of detecting violations, and it increases the likelihood of finding and punishing the violator.
The first effect, however, is one that an exchange may prefer to do without. From the
perspective of an exchange, the optimal image to convey to the public is that no violations of
its rules occur, an image that is blunted by the discovery of violations, even if the violator is
found and punished. Thus, to the extent that an exchange believes that, absent policing,
certain violations are likely to remain undiscovered, its incentives to engage in such policing
are substantially reduced. Outside enforcers such as the federal government have no
equivalent stake in maintaining a public image that no violations occur. Thus, outside
enforcers may be superior to stock exchanges in policing violations of securities regulations.
With a strong government regulatory agency overseeing the stock exchange in the
exchange’s fulfillment its responsibilities as a self-regulator of its members and its markets,
the stock exchange can be an effective force for investor protection. Through listing
requirements for independent directors and for other safeguards of good corporate
governance, the stock exchange can be a protagonist of investor interests. To assure that it
plays these roles effectively, however, the stock exchange must be accountable to the
regulatory agency and to challenges by investors in the courts.
31
The discliplinary proceedings are listed at: http://www.nyse.com/regulation/regulation.html
Marcel Kahan, “Some Problems With Stock Exchange-Based Securities Regulation,” 83 VA. L.
REV. 1509, 1510, 1516-18 (1997).
32
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Clearing and settlement
The clearing and settlement process is an intricate part of the trading system, and its
efficacy is also significant in connection with the protection of investors. Market efficiency
implies that funds flow on the basis of informed evaluations of risk and potential return.
Transaction costs are a function of market efficiency. If the processing of transactions (i.e.,
trades in the marketplace) is inefficient, corrupt or imposes risks on the other party to the
transaction that the transaction will not be fulfilled, then clearing and settlement "costs"
become a major element of transaction costs. Antiquated requirements for verifications and
paper processing cause delay and uncertainty. In many trading markets, a nettlesome issue
is how to deal with the risk that a broker might default and not have the financial capacity to
meet obligations assumed in the marketplace. As one commentator summarized:33
Clearance and settlement logistics presents [sic] one of the most important,
albeit excruciatingly boring, areas that regulation must address to ensure
an efficient stock market. Clearance and settlement refers to the process of
confirming and paying stock transactions.
The process involves
determining what the counterparts owe, what they are due to receive, and
on what date they will receive it. Absent an efficient clearing and
settlement system, parties to a stock transaction incur the risk of either not
receiving payment or not receiving the stock purchased. These risks
increase as the volume of trade grows. * * *
The role of law is to facilitate the clearing and settlement process. Often, the
commercial laws need to be modified to take account of contemporary electronic
technologies for record keeping and communication. It would seem critical to smooth crossborder transactions that national systems for clearing and settlement are coordinated, indeed,
highly uniform. Harmonization of the laws and processes related to clearing and settlement
should have a high priority.
Enforcement mechanisms
Of significant concern for any body of laws designed to protect public investors is
how the requirements and standards that are established are to be enforced. If disclosures
are not made, or are made improperly, what punishment will be imposed on the violator or
what remedies will investors have?
To enforce the laws enacted for the protection of investors, many countries have
created specialized agencies. These agencies are responsible for administering the laws
governing disclosure related to securities transactions, the professional intermediaries in the
capital market, the trading markets for securities and other laws intended to provide
protections for public investors in securities. They make rules and regulations, determine the
qualifications required to serve as a capital market professional intermediary, conduct
investigations and initiate actions to punish violations of law or of its rules.
33
William C. Philbrick, "The Paving of Wall Street in Eastern Europe: Establishing The Legal
Infrastructure for Stock Markets in The Formerly Centrally Planned Economies," 25 LAW & POL'Y
INT'L BUS. 565, 599-601 (1994).
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If the principal enforcement of the laws protecting investors is by the regulatory
agency, the emphasis is on punishment. The implication is that the individual violator will
be discouraged from acting the same way again and others will be discouraged from
committing violations in the first place. The injured investor, however, does not personally
benefit from punishment to violators - other than to derive some degree of personal
satisfaction from knowing that justice has been done.
More to the point is providing rectification to the injured investor. The remedies can
include those that the investor pursues on his/her own initiative and behalf. Or a government
agency, professional association or class of investors may be empowered to seek remedies
that flow to the injured investor. Establishing remedies for injured investors accomplishes
two purposes. First, the investor is compensated for the loss he/she incurs as a result of the
wrong done. Second, by making the wrongdoer pay for the damage he/she does, the
consequences for violating the law are more significant, and we discourage others from
acting as the wrongdoer did. Third, the violator is twice sanctioned—once by the
government action (whether a civil injunction or a criminal penalty) and again by the private
civil remedial action.
In either case, the protections afforded to investors are made meaningful, and
investors gain confidence from knowing this. For the capital market to achieve and sustain
the broad base of participation needed, this investor confidence is vital.
2.
Corporate governance protections
“Exit” and “Voice” protections
“Exit” protections relate essentially to the liquidity and fairness of the securities
trading markets. Company/corporate laws that restrict shareholders from disposing of their
shares without company/corporate approval or that impose extensive bureaucratic processes
on share sales are clearly an impediment to the effectiveness of the capital market.
Similarly, trading markets that do not have effective and efficient systems for clearing and
settling transactions impede transfers, impose risks and increase transaction costs.
Exit protections are most important if the focus is on affording dissatisfied investors
with the opportunity to divest their holdings. By the time the investor learns of the
company’s problems, however, the value of his/her investment may have been lost. In the
recent U.S. case involving the Enron Corporation, for example, by the time investors learned
of the company’s problems, the market for the shares had declined precipitously—it was too
late. Frequently this is the case: the barn door is closed after the horses have exited the barn.
“Voice” protections involve critical issues of corporate governance. They relate to
the Law’s effectiveness in dealing with the fact that, at times, there may be divergence
between the interests of shareholders and managers. On the one hand, managers should have
some accountability to the company’s owners—even if they are minority shareholders. On
the other hand, professional managers should be free to exercise their professional judgment
without having pesky shareholders looking over their shoulders.
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Another issue of “voice” concerns the responsibilities of major blockholders to
minority shareholders. Blockholders are in a position to influence managers to make
decisions that benefit the blockholders’s interests even if those decisions prejudice the
interests of minority shareholders.
Tools of voice protection
The tools available to address these “voice” issues include-—












the imposition of meaningful and enforceable duties on company managers;
the imposition of meaningful and enforceable limitations on blockholders’s
exercise of their voting power and influence;
the structure of the board and the voting system used to elect directors;
the power to discharge officers and directors, with or without reason;
quorum requirements for shareholder meetings;
audit committees that report to the shareholders;
supermajority requirements for key decisions;
the right of minority shareholders to require the convening of a shareholder
meeting;
price, and perhaps fairness, protection in takeover bids;
the absence of provisions for stakeholder representation on the governing board
so that shareholder interests are not diluted;
shareholder class actions against managers or blockholders; and
effective prohibitions on self-dealing and unfair “related party transactions” by
managers and blockholders.
Board structure
For obvious reasons, stress has been placed on structuring the board in a way that
assures it will be independent of operating management and will be an effective watchdog of
the corporate interest. (Embraced within the “corporate interest” are the appropriately
balanced interests of the shareholders, the public and other stakeholders.) Some mix of
disinterested, truly independent directors is deemed a sine qua non of an effective board.
The question is how to achieve this mix.
In some countries, the responsibility for defining the board structure is assumed by
the stock exchange in its listing requirements. A number of stock exchanges require that the
boards of listed companies include a specified percentage of independent directors, and
“independence” for this purpose is defined by the exchange listing requirements.34 The
author is not familiar with statutory attempts to address the issue.
In India, there has been discussion of requiring companies to have an independent
audit of their corporate governance comparable to their financial audit. Standards would be
set for governance audits, and the outside auditor’s report would be included in the annual
report along with the financial statements.
34
A summary of these may be found in Weil, Gotshal and Manges, op. cit. n.34 supra.
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A rich literature of corporate governance has evolved in the past decade examining
these and other mechanisms.35 At times, it is made to appear that the formulation of an ideal
system of corporate governance is merely a matter of correctly selecting the appropriate mix
of these tools. Whether there can be an ideal legal paradigm for investor protection
generally or for corporate governance in particular is questionable.36 It is submitted,
however, that experience suggests that the particular choice of tools may be less important
than the will to render effective those that are chosen.
Rendering Investor Protections Effective
Whatever may be the mix of specific investor-protective measures set forth in the
statutory text, the value of those protections depends on how they are rendered effective.
Statutory requirements for adequate and accurate disclosure, for example, must be backed up
with strong penalties for failure to comply. Unless enforcement is strong and vigorous, the
laws do not have an impact on shaping conduct and achieving the desired results.
As one respected commentator has observed, the participants in the corporation
function “in the shadow of the law, knowing that courts . . . will to some uncertain extent
serve as an arbiter to determine how the powers granted to management by the corporate
charter may be exercised under unforeseen circumstances.”37 Litigation is at the heart of any
enforcement of investor protection laws; hence, a country’s Judiciary and Bar are critical to
the effectiveness of whatever protections the law provides.
Corporate and securities laws are complex and the business transactions at issue
often are complicated and unusual. Judges need to be well trained in corporate and
securities laws; they must understand sophisticated business practices. Judges also must be
able to manage complex litigation so that their courtroom does not become mired by any
particular case. Lawyers must be trained to understand the complexities of corporate and
securities laws so that they can effectively advise clients and fulfill their responsibilities as
officers of the court. Judges must be sufficiently respected and self-confident to be able to
control the conduct of the lawyers and litigants before them so that the court room does not
become a venue for harassment and gamesmanship.
Enforcement requires a mix of government and private civil remedies. Where a
societal interest is at issue, government is an appropriate enforcer of the law. The investment
process transpires in a public marketplace, and there is a societal interest in the integrity and
reliability of that marketplace. Fraud and deception are anti-social behaviors and justify
public concern. Violations of the conditions of licensing by capital market professionals are
also matters of public concern and appropriate areas for government to be the initiator of
litigation against the offenders.
35
See for example, the World Bank website on corporate governance and the literature cataloged
thereon: http://www.worldbank.org/html/fpd/private sector/cg/codes.htm.
36
Amanda Perry, “An Ideal Legal System for Attracting Foreign Direct Investment? Some Theory
And Reality,” 15 AM. U. INT’L L.REV. 1627 (2000).
37
John C. Coffee, Jr., “The Mandatory/Enabling Balance In Corporate Law: An Essay On The
Judicial Role,” 89 COLUM. L. REV. 1618, 1621-22 (1989).
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Where the issue is financial loss to private parties in private transactions, however,
the government’s role seems more attenuated. To what extent, for example, is the disregard
of a statutory duty or of minority shareholder interests by the management of a private
business firm a matter of societal interest? Moreover, government cannot possibly meet the
responsibility of being the litigator to remedy all claims of this sort. No government can
meet the costs and satisfy the staffing needs of such a responsibility.
Often the enforcement burden falls, in the first instance, on the government
regulatory agency not because of societal interest or efficient use of government resources
but because of an absence of an adequate court system and a lack of tradition of private suits
to enforce civil remedies. As a result, investor protections are not adequate and capital
market development is thwarted.
Recognizing this, in the U.S. and England, for example, strong measures have been
taken to promote enforcement through private actions to secure remedies for fraud and
violations of disclosure requirements. The statutes include provisions for civil liabilities that
are enforceable by individual investors rather than by the government regulatory agency.
For example, § 11 of the U.S. Securities Act of 1933 imposes an absolute liability on persons
who sign a registration statement that includes contains a false or misleading statement of a
material fact. Liability is to any purchaser of the shares covered by the registration
statement. The signer has the burden to prove that he/she exercised due diligence. In
addition, some of the general antifraud sections of the securities laws often afford a basis for
private civil liability suits by injured investors.
In England, the Financial Services Act38, §200, provides that a person commits an
offense if:
(a) for the purposes of or in connection with any application under this
Act; or
(b) in purported compliance with any requirement imposed on him by or
under this Act, he furnishes information which he knows to be false or
misleading in a material particular or recklessly furnishes information
which is false or misleading in a material particular.
Section 62 of that Act creates a private right of action for damages on the part of
injured investors. Under that section, a contravention of the rules or regulations made in
connection with the provisions related to Conduct of Investment Business and other
specified standards "shall be actionable at the suit of a person who suffers loss as a result of
the contravention subject to the defenses and other incidents applying in actions for breach
of a statutory duty."
Similarly, Article 156 of the Mexican law governing commercial companies 39
provides that:
38
References are to the Financial Services Act of 1986, as reprinted in Ernest & Young, Companies
Act Handbook (4th ed. Compiled by Richard Jenkins, 1995).
39
English translation of Mexican General Law Of Commercial Companies, as published in
Westlaw, 1997 WL 686794 (West)
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The director who has a conflict of interest with the company in any
transaction must disclose it to the other directors and abstain from any
discussion or decision with respect thereto. The director who violates this
provision shall be liable for any loss or damage incurred by the company.
In order to enforce this provision by instituting an action in the courts to hold the
wayward director liable, Article 163 of the Mexican law requires that the suing shareholders
own at least 33% of the company’s stock.
The shareholders who represent at least thirty-three percent of the
capital stock may directly institute proceedings for civil damages
against the directors, as long as the following requirements are
satisfied:
I.
Such claims include all damages in favor of the company and
not only those relating to the personal interest of such shareholders;
II.
That such shareholders did not concur in the decision taken by
the general assembly of shareholders not to take action against the
defendant directors, if such was the case.
Any recovery which is obtained as a result of such claims shall be
received by the company.
This restriction seriously limits the effectiveness of the remedial provision.
Brazil’s company law is much more protective of minority shareholders. That law
provides for civil liability actions against officers “for losses caused to company property.”40
The action must be authorized by a shareholders’ meeting, but if the shareholders’ meeting
fails to authorize a suit, holders of 5% of the shares may file the action. If the shareholders’
meeting authorizes the suit but it is not brought, any shareholder may institute the action.
Under Article 117 of the Brazilian companies law, a minority shareholder may hold a
controlling shareholder,41 (as defined in the statute) “liable for damages caused by acts
performed which abuse his power”. The acts that constitute an “abuse of power” are defined
in the statute.
40
Article 159, English translation of Law No. 6404 of December 15, 1976, as amended to
December 26, 1995.
41
Article 116, id., defines controlling shareholder as follows:
A controlling shareholder is an individual or a legal entity, or a group of individual or legal entities
joined by a voting agreement or under common control, who:-(a) possesses rights which permanently assure him the majority of votes in resolutions in general
shareholders' meetings and the power to elect a majority of company officers; and
(b) in fact uses his authority to conduct corporate activities and to guide the operations of departments
of the company.
Sole Paragraph. A controlling shareholder shall use his powers to make the company accomplish its
purpose and perform its corporate activities. He shall have duties and responsibilities towards all other
shareholders, those who work for the company and the community in which it operates, the rights and
interests of which he must loyally respect and heed.
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Notwithstanding these exemplary statutory provisions offering protections for
minority shareholders, several experienced attorneys concluded in a recent law review article
that “minority shareholders [in Latin American corporations] are in a weak position”.42 The
dramatic failure of Enron Corp in the United States that dominated the news in early 2002
illustrates the fragility of the position of minority shareholders even in a country that prides
itself on its attention to investor protections.
Conclusion
It has been demonstrated that healthy capital markets require laws that effectively
protect investor interests. The architecture of these laws may vary in detail according to
national choice, but there are many elements that are generally accepted: (1) Adequate and
accurate disclosure of material facts concerning the company on a timely basis. (2) A
corporate governance system that is fair to the minority shareholders and provides effective
oversight of managers. (3) Liquid and fair trading markets. (4) Responsible and
accountable professionals to service investor needs.
With respect to these generally accepted elements, harmonization of laws among the
member states should be sought. The mode and extent of harmonization may, and perhaps
should, differ from subject area to subject area. By making a start, however, investor
protection will be strengthened throughout the region. When world-wide best practices are
adopted as the harmonized standard, problems of regulatory arbitrage associated with
reciprocity are minimized. For example, the OAS member states might agree on fairly
rigorous common requirements for a prospectus and then agree that any prospectus meeting
the minimum requirements and accepted in any other member state would qualify as meeting
the requirements in every other state. A similar approach might be applied to standards for
the competence and financial accountability of capital market professionals. On the other
hand, a single, agreed set of accounting standards and practices conforming to the highest
international standards should be the goal, rather than have each member state adopt its own.
In this way, international acceptance of financial statements prepared in all OAS member
states would be encouraged, and the entire region would benefit.
Underpinning all of this must be meaningful stringent enforcement of the laws
providing these protections. Enforcement entails not only action by regulatory agencies of
the state but ready remedies for investors to obtain compensation for losses wrongly
incurred. Without a strong, knowledgeable judiciary and legal profession, investor
protections provided in the written laws are illusory.
Jose W. Fernandez, Antonio Delpino, Jose Lau Dan and Rafael Diaz-Granados, “Corporate
Caveat Emptor: Minority Shareholder Rights In Mexico, Chile, Brazil, Venezuela And Argentina,” 32
U. MIAMI INTER-AM. L. REV. 157 (2001).
42
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